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Financial Management 9th Edition C Correia Digital
Instant Download
Author(s): C Correia
ISBN(s): 9781485129578, 1485129575
Edition: 9th
File Details: PDF, 23.03 MB
Year: 2019
Language: english
 52mm

Financial Management Ninth

Edition
N i n t h E d i t i o n
Now in its 9th edition, Financial Management is the leading text on the theory and application of corporate finance in southern
Africa. Set against the backdrop of recent developments in financial markets, instruments and financial theory, the text refers to
real-world applications and financial decisions by South African companies.

The book includes chapters on:  the time value of money  risk and return  portfolio management  financial statement
analysis  bond and equity valuations  the cost of capital  capital budgeting  working capital management  sources of
finance  capital structure  leasing  dividends and share buybacks  mergers, acquisitions and corporate restructuring 
risk management and derivatives  international finance  business planning and financial modelling  corporate strategy and
business models.

New features
• behavioural finance and how biases can impact on corporate financial decision making
• sections on market efficiency, market anomalies, ETFs and investor behaviour
• meets the requirements of Version 10 of SAICA’s Competency Framework, effective from January 2019, in respect to
financial management, financial risk management and corporate strategy
• incorporates the latest developments that affect corporate finance: King IV; tax legislation; the Companies Act; rules of
the JSE and capital markets; International Financial Reporting Standards (IFRS); official guidelines on corporate valuations
and integrated reporting, business rescue, rules on mergers and acquisitions and competition law
• expanded sections on the use and drawbacks of IRR and Excel® functions such as XNPV and XIRR
• sections on Value at Risk (VaR), Monte Carlo simulation in Excel® and expanded chapter on derivatives
• expanded sections on forecasting and the market and income approaches to valuation
• new section on retirement planning, living annuities and pensions

Financial
• sections on smart contracts, distributed ledger systems (blockchain) and business disruption
• expanded sections on CAPM and multi-factor models
• new sections on leases and the impact of IFRS16 (effective from 2019) on equity valuations, the cost of capital,
financial ratios and capital structure
• new section on the resource-based view of the firm and how this aligns with integrated reporting
• expanded guidance sections at the end of key chapters to assist readers to better understand and integrate key areas
in finance
• inclusion of recent ITC questions and solutions.

Management
Other features
• professional ethics and codes of conduct updated in terms of revisions by SAICA and CFA
• use of Excel® models to provide detailed explanations of each topic in finance

Carlos Correia
• extensive number of questions provided per chapter
• relevant examples used to demonstrate application of finance theory
• reference to insights and views of Warren Buffett on finance theory.

Support material
Support material is made available to all prescribing institutions. It includes:  answers to all chapter questions  PowerPoint®
slides  multiple choice question tests and solutions  selected readings  videos and Excel® models.

This book is recommended for  undergraduate and postgraduate commerce or business students  ITC and APC candidates
N i n t h E d i t i o n
 practising accountants  internal and independent auditors  business managers, corporate finance practitioners, strategists
and analysts.

Carlos Correia
www.juta.co.za
 9TH EDITION

financial
management

Financial_BOOK_2018_new.indb 1 2018/12/07 12:48

Financial_BOOK_2018_new.indb 2 2018/12/07 12:48
 9TH EDITION

financial
management
Carlos Correia

Founding authors:
Carlos Correia, David Flynn, Enrico Uliana,
Michael Wormald

Main contributor:
Johnathan Dillon

Contributors:
Obeid Mahomed Zwelakhe Mnguni
Darron West Greg Beech
Ameer Amod Gary Swartz
Gizelle Willows Kwasi Okyere-Boakye
Joel Stern Etienne Swanepoel
Glen Holman

Financial_BOOK_2018_new.indb 3 2018/12/07 12:48

 Financial Management

First published in 1987

Second edition 1988
Third edition 1993
Fourth edition 2000
Reprinted 2001, 2002
Fifth edition 2003
Reprinted 2003 (twice), 2005
Sixth edition 2007
Reprinted 2007, 2008, 2010 (twice)
Seventh edition 2011
Reprint 2012
Eighth edition 2015
Reprinted 2015, 2016, 2017, 2018
Ninth edition 2019
Juta and Company (Pty) Ltd
First floor, Sunclare building, 21 Dreyer street, Claremont 7708
PO Box 14373, Lansdowne 7779, Cape Town, South Africa
www.juta.co.za
© 2019 Juta and Company (Pty) Ltd
ISBN 978 1 48512 957 8 (Print)

ISBN 978 1 48512 958 5 (WebPDF)

All rights reserved. No part of this publication may be reproduced or transmitted in any
form or by any means, electronic or mechanical, including photocopying, recording, or
any information storage or retrieval system, without prior permission in writing from
the publisher. Subject to any applicable licensing terms and conditions in the case of
electronically supplied publications, a person may engage in fair dealing with a copy of this
publication for his or her personal or private use, or his or her research or private study.
See section 12(1)(a) of the Copyright Act 98 of 1978.

Project manager: Carlyn Bartlett-Cronje

Proofreaders: Helen Correia, Edith Viljoen, Tarryn Witten and Ross Compton
Cover designer: Jacques Nel
Typesetter: Wouter Reinders
Indexer: Clifford Perusset
Typeset in 10 pt on 12 pt Dutch BT

The author and the publisher believe on the strength of due diligence exercised that
this work does not contain any material that is the subject of copyright held by another
person. In the alternative, they believe that any protected pre-existing material that
may be comprised in it has been used with appropriate authority or has been used in
circumstances that make such use permissible under the law.

Financial_BOOK_2018_new.indb 4 2018/12/07 12:48

 Contents – a concise overview

Chapter 1 Overview of financial management . . . . . . . . . . . . . . . . . . . . . . . . . . . 1-1

Chapter 2 The time value of money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2-1

Chapter 3 Risk and return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-1

Chapter 4 Portfolio management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4-1

Chapter 5 Financial statement analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5-1

Chapter 6 Valuations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6-1

Chapter 7 The cost of capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7-1

Chapter 8 Capital budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8-1

Chapter 9 Further issues in capital budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . 9-1

Chapter 10 Capital budgeting: Risk analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10-1

Chapter 11 Working capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11-1

Chapter 12 Current asset management and short-term financing . . . . . . . . . . . 12-1

Chapter 13 Sources of finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13-1

Chapter 14 Capital structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14-1

Chapter 15 Leasing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15-1

Chapter 16 Dividends and share buy-backs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16-1

Chapter 17 Mergers, acquisitions and corporate restructuring . . . . . . . . . . . . . 17-1

Chapter 18 Risk management and derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . 18-1

Chapter 19 International financial management . . . . . . . . . . . . . . . . . . . . . . . . . 19-1

Chapter 20 Business planning and financial modelling . . . . . . . . . . . . . . . . . . . 20-1

Chapter 21 Corporate strategy and business models . . . . . . . . . . . . . . . . . . . . . 21-1

Tables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . T-2

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . I-1

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Financial_BOOK_2018_new.indb 6 2018/12/07 12:48
 Contents

Preface...........................................................................................................................................xxv
What does the book offer?.........................................................................................................xxvi
What resources does the book offer to the instructor?............................................................xxix
How does the book fit in with SAICA’s Competency Framework for Financial
Management?..............................................................................................................................xxxi

Chapter 1 Overview of financial management...........................................................................1-1

Learning objectives.......................................................................................................................1-1
Introduction..................................................................................................................................1-1
1 The context of financial management...................................................................................1-2
Development of financial management................................................................................1-2
Links with economics..............................................................................................................1-2
Links with accounting.............................................................................................................1-2
2 The environment of financial management..........................................................................1-3
Forms of business organisations............................................................................................1-6
Taxation....................................................................................................................................1-8
Taxation of company profits...................................................................................................1-9
Capital gains tax......................................................................................................................1-9
Dividend withholding tax.......................................................................................................1-9
3 What is the fundamental objective of financial management?.........................................1-10
Why is profit maximisation not the right objective for corporate finance?.....................1-10
Manipulation of accounting profits.....................................................................................1-10
Accounting profits and the cost of capital..........................................................................1-11
Risk........................................................................................................................................1-11
Shareholders want management to maximise value...........................................................1-11
Focus of financial management on decision-making.........................................................1-11
Economic Value Added (EVA)............................................................................................1-12
What about the ethics of maximising value?......................................................................1-13
4 The role of the financial manager.......................................................................................1-14
Opportunities to create wealth............................................................................................1-14
Investment in operating assets.............................................................................................1-14
Investment in financial assets...............................................................................................1-15
Selecting the optimal finance mix........................................................................................1-15
Finance from capital markets..............................................................................................1-16
The interaction of investment and financing decisions......................................................1-17
From the real world: BHP, Shoprite, Truworths,Vodacom and Pioneer Foods...............1-20
5 Fundamental concepts of corporate finance......................................................................1-21
Present Value.........................................................................................................................1-21
Time value of money............................................................................................................1-21
Risk and return.....................................................................................................................1-21
No Arbitrage Principle.........................................................................................................1-21
Efficient markets...................................................................................................................1-22
Portfolio theory.....................................................................................................................1-23
Capital asset pricing model..................................................................................................1-23
Financial analysis..................................................................................................................1-23
6 Do managers act in the interest of shareholders?.............................................................1-23
Management incentives, share options and the financial crisis.........................................1-25
Another agency problem: shareholders and bondholders.................................................1-26
7 Doing the right thing: ethics in business and King IV......................................................1-27
8 Corporate Governance and King IV....................................................................................1-27
The King IV Code................................................................................................................1-28
What is the board’s primary governance role and responsibilities?.................................1-29

vii

Financial_BOOK_2018_new.indb 7 2018/12/07 12:48

 King IV Principles.................................................................................................................1-30
The audit committee.............................................................................................................1-32
Directors and the separation of the CEO and the chairperson functions........................1-32
Sustainability and integrated reporting...............................................................................1-32
Risk management..................................................................................................................1-32
Information Technology (IT) and its role in corporate finance........................................1-33
Solvency and liquidity tests..................................................................................................1-33
Business rescue......................................................................................................................1-33
Does corporate governance pay?.........................................................................................1-33
Auditors.................................................................................................................................1-34
From the real world … application of King IV by Netcare...............................................1-35
What does Charlie Munger think about corporate governance?......................................1-35
Case study: Tiger Brands and society..................................................................................1-36
9 Corporate Strategy...............................................................................................................1-37
Porter’s Five Forces Model..................................................................................................1-37
Rivalry among existing firms................................................................................................1-37
Threat of substitute products...............................................................................................1-38
Threat of new entrants and barriers to entry......................................................................1-39
Bargaining power of buyers..................................................................................................1-40
Bargaining power of suppliers.............................................................................................1-40
Competitive strategies: cost leadership and differentiation..............................................1-41
SWOT analysis......................................................................................................................1-41
PESTEL analysis...................................................................................................................1-43
Sustainability related issues..................................................................................................1-44
10 Behavioural Finance.............................................................................................................1-45
11 Structure of the text..............................................................................................................1-45
Summary................................................................................................................................1-45
Appendix 1.1 An introduction to behavioural finance.......................................................1-46
Appendix 1.2 Professional ethics and codes of conduct....................................................1-52
Appendix 1.3 Stakeholder considerations and good corporate citizenship......................1-55
Questions...............................................................................................................................1-59

Chapter 2 The time value of money............................................................................................2-1

Is compound interest ‘the most powerful force in the universe’?.............................................2-1
Learning objectives.......................................................................................................................2-1
Introduction..................................................................................................................................2-1
1 Future value............................................................................................................................2-2
Single amount, single period..................................................................................................2-2
Single amount, multiple periods, annual interest compounded..........................................2-2
Single amount, multiple periods, non-annual compounding...............................................2-7
Annual effective rate..............................................................................................................2-8
Continuous compounding......................................................................................................2-9
Interpolation............................................................................................................................2-9
Series of investments, ordinary annuity (FVA) – multiple investments and multiple
periods...................................................................................................................................2-10
Series of investments, annuity due......................................................................................2-12
Future values when the timing of the cash flows and the compounding periods differ.....2-13
2 Present values.......................................................................................................................2-13
Single amount, single period, annual discounting..............................................................2-14
Single amount, multiple periods, annual discounting........................................................2-14
Stream of cash flows, ordinary annuity (PVA)...................................................................2-15
Stream of cash flows, annuity due.......................................................................................2-16
Stream of cash flows, deferred annuity...............................................................................2-18
Uneven stream of cash flows................................................................................................2-19
Perpetuities............................................................................................................................2-20
Growing perpetuities............................................................................................................2-20

viii

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 Growing annuity....................................................................................................................2-21
Inflation and real returns.....................................................................................................2-21
3 Some real-world applications..............................................................................................2-22
Retirement planning.............................................................................................................2-22
Loan amortisation schedules................................................................................................2-23
Mortgage loan.......................................................................................................................2-24
4 Financial calculators and spreadsheets..............................................................................2-25
Using financial calculators...................................................................................................2-25
Using Excel spreadsheets.....................................................................................................2-27
5 The role of interest rates......................................................................................................2-30
The expectations theory.......................................................................................................2-32
The liquidity preference theory...........................................................................................2-32
The market segmentation theory.........................................................................................2-33
6 Applying the time value of money principles to bonds......................................................2-33
Perpetuals and 100-year bonds............................................................................................2-36
Summary................................................................................................................................2-38
Self-study problems...............................................................................................................2-39
Solutions to self-study problems..........................................................................................2-40
Appendix 2.1: Retirement planning: living annuities, the 4% rule and the looming
pension crisis.........................................................................................................................2-43
Questions...............................................................................................................................2-54

Chapter 3 Risk and return..........................................................................................................3-1

The 21st Century: a time of financial crisis and recovery for equities.....................................3-1
Learning objectives.......................................................................................................................3-1
Introduction..................................................................................................................................3-2
1 The concept of risk.................................................................................................................3-3
Business risk............................................................................................................................3-3
Financial risk...........................................................................................................................3-7
Total company risk..................................................................................................................3-8
2 Measuring expected return and risk.....................................................................................3-9
Measuring the expected return on a single share.................................................................3-9
Measuring risk for a single share.........................................................................................3-10
The mean–variance rule.......................................................................................................3-11
3 Interpreting the summary statistics....................................................................................3-12
Properties of a normal distribution.....................................................................................3-12
Comparison of single shares................................................................................................3-14
Co-efficient of variation.......................................................................................................3-15
The z score.............................................................................................................................3-16
Co-variance and correlation.................................................................................................3-18
Value at Risk (VaR)..............................................................................................................3-19
Expected Shortfall.................................................................................................................3-20
Historical returns..................................................................................................................3-21
4 Risk and return in financial markets.................................................................................3-23
Emerging markets.................................................................................................................3-30
Volatility and time periods: the Rip van Winkle solution to risk......................................3-31
What does Warren Buffett think?........................................................................................3-31
Risk-adjusted measures of performance.............................................................................3-32
From the real world: Unit trust funds.................................................................................3-33
What returns did Warren Buffett achieve with Berkshire Hathaway?.............................3-34
Summary................................................................................................................................3-35
Appendix 3.1 A behavioural finance perspective on risk and return................................3-36
Appendix 3.2 Compound annual returns, arithmetic averages and total shareholder
returns....................................................................................................................................3-39
Self-study problems...............................................................................................................3-42
Suggested solutions...............................................................................................................3-43

ix

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 Questions...............................................................................................................................3-44

Chapter 4 Portfolio management................................................................................................4-1

Diversify to reduce risk................................................................................................................4-1
Learning objectives.......................................................................................................................4-1
Introduction..................................................................................................................................4-2
1 Two-asset portfolio risk and return......................................................................................4-2
Measuring two-asset portfolio returns..................................................................................4-2
The principles of portfolio risk..............................................................................................4-3
Measuring two-asset portfolio risk........................................................................................4-7
Positioning an investor on the efficient frontier.................................................................4-12
2 Multiple-share portfolio risk and return............................................................................4-13
The benefits of diversification.............................................................................................4-15
Introducing a risk-free asset.................................................................................................4-16
3 Beta analysis.........................................................................................................................4-18
Beta as a measure of portfolio risk......................................................................................4-19
Beta and the capital asset pricing model (CAPM).............................................................4-21
4 The efficient markets hypothesis.........................................................................................4-24
The weak form......................................................................................................................4-24
The semi-strong form...........................................................................................................4-25
The strong form....................................................................................................................4-25
Market efficiency: the evidence...........................................................................................4-25
Evidence of the efficiency of the JSE..................................................................................4-26
Is the CAPM used in practice?............................................................................................4-27
5 Exchange traded funds (ETFs) and unit trusts.................................................................4-28
From the real world..............................................................................................................4-30
Summary................................................................................................................................4-30
Guidance to portfolio management: the risk and return concepts linking Chapters 3
and 4.......................................................................................................................................4-31
Self-study problem................................................................................................................4-33
Suggested solution................................................................................................................4-34
Appendix 4.1 Calculating the beta co-efficient..................................................................4-35
Appendix 4.2 Perspectives: Estimating the beta co-efficient.............................................4-39
Appendix 4.3 Perspectives: Behavioural finance................................................................4-44
Appendix 4.4 Investment decision-making under conditions of uncertainty...................4-46
Appendix 4.5 Prospect theory..............................................................................................4-48
Questions...............................................................................................................................4-49

Chapter 5 Financial statement analysis.....................................................................................5-1

Companies and investors employ financial ratios to evaluate performance............................5-1
Learning objectives.......................................................................................................................5-1
Introduction..................................................................................................................................5-2
1 Annual financial statements and the Integrated Report.....................................................5-2
Integrated Report...................................................................................................................5-2
From the real world: Truworths’ Integrated Report............................................................5-5
Annual Financial Statements.................................................................................................5-5
Statement of Comprehensive Income (Statement of Profit or Loss and
Other Comprehensive Income).............................................................................................5-7
Statement of Financial Position.............................................................................................5-8
Statement of Cash Flows........................................................................................................5-8
2 Objectives of financial analysis and stakeholders...............................................................5-9
Shareholders............................................................................................................................5-9
Credit grantors........................................................................................................................5-9
Management..........................................................................................................................5-10
Employees..............................................................................................................................5-10
Customers..............................................................................................................................5-10

Financial_BOOK_2018_new.indb 10 2018/12/07 12:48

 Suppliers................................................................................................................................5-11
Acquisition and merger analysts..........................................................................................5-11
Auditors.................................................................................................................................5-11
Government...........................................................................................................................5-11
3 Limitations of accounting data............................................................................................5-11
Monetary expression.............................................................................................................5-11
Simplification and summarisation.......................................................................................5-12
Flexible accounting policies.................................................................................................5-12
Inflation.................................................................................................................................5-12
4 Approaches to financial statement analysis.......................................................................5-12
Comparative financial statements........................................................................................5-12
Index analysis........................................................................................................................5-13
Common size analysis...........................................................................................................5-14
Ratio analysis.........................................................................................................................5-15
5 Application of ratio analysis................................................................................................5-15
Liquidity ratios......................................................................................................................5-15
Asset management ratios.....................................................................................................5-16
Debt management ratios......................................................................................................5-19
Profitability ratios.................................................................................................................5-21
Cash flow ratios.....................................................................................................................5-24
Market value ratios...............................................................................................................5-25
6 Structured ratio analysis......................................................................................................5-26
Du Pont analysis....................................................................................................................5-26
7 Failure prediction.................................................................................................................5-28
Financial distress models......................................................................................................5-28
8 Limitations of ratio analysis................................................................................................5-29
9 Economic Value Added (EVA™)..........................................................................................5-30
The use of EVA to measure performance..........................................................................5-32
Perspectives on EVA™ by Joel Stern..................................................................................5-33
10 What’s behind the numbers?...............................................................................................5-34
Understand the business and the industry sector...............................................................5-34
Understand management’s motives for selecting accounting policies..............................5-34
Understand the key drivers of value....................................................................................5-35
Understand which accounting policies are flexible............................................................5-35
Accounting for leases............................................................................................................5-35
Understand the warning signs..............................................................................................5-36
Understand the business and financial risks facing the company.....................................5-38
Sensitivity analysis.................................................................................................................5-38
Further factors to consider when analysing a company.....................................................5-38
From the real world..............................................................................................................5-41
Summary................................................................................................................................5-42
Guidance on Financial Analysis..........................................................................................5-43
Self-study problems...............................................................................................................5-45
Solutions to self-study problems..........................................................................................5-47
Appendix 5.1 Sustainable growth........................................................................................5-48
Appendix 5.2 The three most crucial ratios in equity analysis..........................................5-51
Appendix 5.3 Truworths and the outcomes of the six capitals..........................................5-55
Questions...............................................................................................................................5-56

Chapter 6 Valuations...................................................................................................................6-1
Pricing on the JSE and value: Why Edcon used valuation principles to go private................6-1
Learning objectives.......................................................................................................................6-1
Introduction..................................................................................................................................6-1
1 Valuation – an overview.........................................................................................................6-2
What are the fundamental building blocks of a valuation?.................................................6-2
2 The effect of risk and return on valuations..........................................................................6-3

xi

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 3 Required rate of return..........................................................................................................6-3
4 Valuation of debentures and bonds.......................................................................................6-4
Debentures and bonds in perpetuity.....................................................................................6-4
Redeemable debentures and bonds.......................................................................................6-5
From the real world … Valuation of Eskom bonds..............................................................6-7
5 Valuation of preference shares..............................................................................................6-8
Cumulative non-redeemable preference shares...................................................................6-9
Non-cumulative preference shares......................................................................................6-10
Redeemable preference shares............................................................................................6-10
6 Valuation of ordinary equity................................................................................................6-10
Dividend discount model......................................................................................................6-11
Constant growth in dividends...............................................................................................6-11
Limitations.............................................................................................................................6-14
Zero growth in dividends.....................................................................................................6-14
Valuing shares with a non-constant growth rate.................................................................6-15
Valuing shares which do not pay dividends for many years...............................................6-17
From the real world: Woolworths........................................................................................6-17
Price multiples (relative valuation).....................................................................................6-18
The price-earnings (P/E) ratio.............................................................................................6-18
Using EBITDA or EBIT multiples to determine enterprise value...................................6-21
Market to book ratio............................................................................................................6-22
Price to sales ratio.................................................................................................................6-23
Free cash flow model (discounted cash flow model).........................................................6-23
Terminal values......................................................................................................................6-24
The Economic Value Added (EVATM) approach................................................................6-26
Valuation of rights.................................................................................................................6-28
The impact of share options on equity valuations..............................................................6-28
Leases and valuations...........................................................................................................6-29
7 Valuations and the financial manager................................................................................6-30
Pitfalls....................................................................................................................................6-30
Challenges.............................................................................................................................6-31
Perspectives: Valuations in the real world..........................................................................6-31
Summary................................................................................................................................6-33
Self-study problems...............................................................................................................6-33
Solutions to self-study problems..........................................................................................6-34
Appendix 6.1 Lack of marketability discount and other adjustments..............................6-37
Appendix 6.2 Exploring selected issues in valuations........................................................6-39
Appendix 6.3 Perspectives: The subjective nature of valuations.......................................6-42
Questions...............................................................................................................................6-43

Chapter 7 The cost of capital......................................................................................................7-1

The weighted-average cost of capital of Sasol...........................................................................7-1
Learning objectives.......................................................................................................................7-1
Introduction..................................................................................................................................7-1
1 The weighted-average cost of capital....................................................................................7-2
2 The weighted-average cost of capital – principles and formula.........................................7-3
3 The pooling of funds approach..............................................................................................7-4
4 Component costs of capital....................................................................................................7-6
Cost of new debt (Kd).............................................................................................................7-8
The cost of debt and Section 24J of the Income Tax Act....................................................7-9
Cost of preference shares (Kp).............................................................................................7-11
Cost of shareholders’ equity.................................................................................................7-12
Dividend yield and growth method.....................................................................................7-13
Capital asset pricing model (CAPM)..................................................................................7-14
Bond yield plus a risk premium method.............................................................................7-14
5 Weighting components of capital structure........................................................................7-15

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 6 Calculating the WACC.........................................................................................................7-17
7 Breaks in the WACC.............................................................................................................7-18
8 Funds from the non-cash flow items...................................................................................7-19
9 Estimating the cost of capital of divisions..........................................................................7-19
10 Operating leases, capital structure and the weighted-average cost of capital................7-21
11 The weighted-average cost of capital – some practical issues..........................................7-22
The risk-free rate..................................................................................................................7-22
The market (equity) risk premium......................................................................................7-23
Surveys...................................................................................................................................7-24
Using the dividend growth model to determine the market risk premium......................7-24
Other indicators of the market risk premium.....................................................................7-25
Warren Buffett’s view...........................................................................................................7-25
Betas.......................................................................................................................................7-25
Adjustments to the cost of equity and WACC....................................................................7-26
The financial crisis, emerging markets and the cost of capital..........................................7-26
Taxation..................................................................................................................................7-28
The role of hurdle rates........................................................................................................7-28
From the real world: The cost of capital of South African firms......................................7-28
Summary................................................................................................................................7-31
Guidance on cost of capital..................................................................................................7-31
Appendix 7.1 CAPM and the Fama-French Three-Factor Model....................................7-33
Does CAPM work?...............................................................................................................7-33
Fama-French Three-Factor Model......................................................................................7-34
Other factor models..............................................................................................................7-35
Appendix 7.2 The Downside CAPM: A robust alternate to the CAPM?........................7-36
Self-study problems...............................................................................................................7-38
Solutions to self-study problems..........................................................................................7-40
Questions...............................................................................................................................7-43

Chapter 8 Capital budgeting.......................................................................................................8-1

Expanding horizons: Kumba scales up production to meet demand for iron ore...................8-1
Learning objectives.......................................................................................................................8-1
Introduction..................................................................................................................................8-1
1 Types of investment projects..................................................................................................8-2
Replacement or expansion.....................................................................................................8-2
Independent and mutually exclusive projects.......................................................................8-3
Divisible and indivisible projects...........................................................................................8-3
2 Capital budgeting techniques................................................................................................8-3
Net present value (NPV)........................................................................................................8-4
The internal rate of return (IRR).........................................................................................8-5
Payback method......................................................................................................................8-8
Accounting rate of return.......................................................................................................8-9
Discounted payback..............................................................................................................8-11
The profitability index..........................................................................................................8-11
Modified internal rate of return..........................................................................................8-12
Economic Value Added (EVA™) or economic profit........................................................8-12
3 Cash flow determination......................................................................................................8-14
Beginning-of-project cash flows...........................................................................................8-15
Annual operating cash flows................................................................................................8-15
Cash flow determination – some rules................................................................................8-16
Taxation..................................................................................................................................8-19
Depreciation allowances.......................................................................................................8-19
Recoupments and scrapping allowances.............................................................................8-21
Taxation effects of replacement decisions...........................................................................8-23
Capital Gains Tax..................................................................................................................8-23
End-of-project cash flows.....................................................................................................8-24

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 Application............................................................................................................................8-25
4 Post-audits.............................................................................................................................8-27
Summary................................................................................................................................8-28
Self-study problems...............................................................................................................8-29
Solutions to self-study problems..........................................................................................8-30
Guidance on capital budgeting............................................................................................8-32
Appendix 8.1 NPV/IRR: Conflict in rankings....................................................................8-34
Questions...............................................................................................................................8-36

Chapter 9 Further issues in capital budgeting..........................................................................9-1

It is Ayoba time! Connecting Africa and the Middle East........................................................9-1
Learning objectives.......................................................................................................................9-1
Introduction..................................................................................................................................9-1
1 Comparing projects with unequal lives................................................................................9-2
Unequal lives and project evaluation....................................................................................9-2
Replacement chains................................................................................................................9-4
Equivalent annual annuities...................................................................................................9-4
Equivalent annual costs..........................................................................................................9-5
2 Capital budgeting under inflation.........................................................................................9-5
Inflation and the discount rate..............................................................................................9-6
Investment bias.......................................................................................................................9-6
Discounting cash flows at the real rate of return.................................................................9-7
Depreciation deductions........................................................................................................9-7
Adjusted real approach..........................................................................................................9-9
3 Capital rationing.....................................................................................................................9-9
Capital constraints and project rankings.............................................................................9-10
Profitability index..................................................................................................................9-10
The ranking of indivisible projects......................................................................................9-11
Multi-period capital rationing..............................................................................................9-11
Further perspectives on capital rationing...........................................................................9-13
4 Assessed tax losses................................................................................................................9-14
The utilisation of assessed losses.........................................................................................9-14
New ventures and ring-fencing provisions..........................................................................9-15
Synopsis..................................................................................................................................9-16
5 Abandonment value and optimal economic lives...............................................................9-16
Continuing evaluation..........................................................................................................9-16
Optimal economic life..........................................................................................................9-17
Replacement timing..............................................................................................................9-18
6 Real (strategic) options........................................................................................................9-20
Examples of real (strategic) options....................................................................................9-21
7 Capital budgeting: a behavioural finance perspective.......................................................9-22
Self-study problems...............................................................................................................9-26
Solutions to self-study problems..........................................................................................9-27
Summary................................................................................................................................9-29
Appendix 9.1 The timing of cash flows, XNPV and XIRR...............................................9-30
Appendix 9.2 Capital budgeting in the real world.............................................................9-32
Appendix 9.3 Multiple internal rates of return..................................................................9-35
Questions...............................................................................................................................9-37

Chapter 10 Capital budgeting: Risk analysis..........................................................................10-1

A golden sunset..........................................................................................................................10-1
Learning objectives.....................................................................................................................10-1
Introduction................................................................................................................................10-2
1 Traditional measures of risk...............................................................................................10-2
Expected value and probability distributions......................................................................10-3
The Hillier model for multiple periods...............................................................................10-5

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 A note on expected values, probabilities and firm size......................................................10-7
2 Decision trees........................................................................................................................10-8
3 Certainty equivalents..........................................................................................................10-11
4 Sensitivity analysis.............................................................................................................10-12
5 Break-even analysis............................................................................................................10-14
Zero net present value........................................................................................................10-14
Accounting break-even analysis.........................................................................................10-15
6 Scenario analysis................................................................................................................10-16
7 Abandonment and expansion.............................................................................................10-16
8 Monte Carlo simulation.....................................................................................................10-18
9 The capital asset pricing model.........................................................................................10-19
Project beta of an all-equity firm.......................................................................................10-20
Financial leverage and project betas.................................................................................10-21
More on market risk...........................................................................................................10-22
10 Risk-adjusted discount rates versus certainty equivalents.............................................10-23
11 Risk-adjusted discount rates versus the weighted-average cost of capital....................10-23
12 Further thoughts on risk analysis in capital budgeting..................................................10-24
Future uncertain cash outflows..........................................................................................10-24
Volatility and risk – a case study........................................................................................10-24
Corporate strategy and project risk...................................................................................10-26
Project management, project failure and other factors...................................................10-29
Self-study problems.............................................................................................................10-31
Solutions to self-study problems........................................................................................10-33
Summary..............................................................................................................................10-38
Appendix 10.1 Capital budgeting – risk analysis with Excel®........................................10-39
Scenario Manager...............................................................................................................10-39
Tornado graphs in Excel.....................................................................................................10-40
Data tables...........................................................................................................................10-41
Goal Seek............................................................................................................................10-41
Form controls......................................................................................................................10-42
Probability distributions.....................................................................................................10-42
Monte Carlo simulation with Excel...................................................................................10-43
Questions.............................................................................................................................10-49

Chapter 11 Working capital......................................................................................................11-1

Every cloud has a silver lining...................................................................................................11-1
Learning objectives.....................................................................................................................11-1
Introduction................................................................................................................................11-1
1 What is working capital?......................................................................................................11-2
2 The objective of working capital policy...............................................................................11-3
The working capital cycle.....................................................................................................11-3
The impact of inflation on working capital policy..............................................................11-5
The impact of changes in sales on working capital policy.................................................11-5
3 Working capital policies.......................................................................................................11-5
4 Working capital financing policies......................................................................................11-7
Working capital management by small business............................................................... 11.10
From the real world............................................................................................................11-10
Working capital management around the world..............................................................11-12
5 Working capital strategies and cash flows.......................................................................11-13
6 Forecasting working capital requirements.......................................................................11-15
7 Forecasting sales.................................................................................................................11-17
Factors to be considered.....................................................................................................11-17
Subjective forecasting.........................................................................................................11-18
Objective forecasting..........................................................................................................11-18
Summary..............................................................................................................................11-19
Appendix 11.1 Cash flows, working capital and indirect taxation (VAT).......................11-20
Self-study problem..............................................................................................................11-22

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 Solution to self-study problem...........................................................................................11-23
Questions.............................................................................................................................11-23

Chapter 12 Current asset management and short-term financing........................................12-1

Cash is king.................................................................................................................................12-1
Learning objectives.....................................................................................................................12-1
Introduction................................................................................................................................12-1
1 Credit policy..........................................................................................................................12-1
Creditworthiness...................................................................................................................12-2
Setting the collection policy.................................................................................................12-3
Setting settlement discount policy.......................................................................................12-3
Analysing the impact of a change in credit policy on profitability....................................12-3
Analysing the impact of a change in credit policy: net present value analysis.................12-7
2 Accounts receivable management........................................................................................12-8
Making money out of offering credit to customers............................................................12-9
From the real world: Truworths and Mr Price....................................................................12-9
3 Inventory management.........................................................................................................12-9
Inventory models.................................................................................................................12-10
Inventory control systems...................................................................................................12-14
Just-in-time (JIT) inventory management........................................................................12-14
Supply chain management (SCM).....................................................................................12-15
Inventory management and logistics: the case for distribution centres and cross-
docking.................................................................................................................................12-16
From the real world: Shoprite............................................................................................12-17
Advantages of distribution centres....................................................................................12-17
Cross-docking......................................................................................................................12-19
4 Cash management...............................................................................................................12-21
Reasons for holding cash....................................................................................................12-21
The management of float, cash concentration and electronic funds transfer................12-21
Cash budgets.......................................................................................................................12-22
5 Financing current assets....................................................................................................12-25
Accruals...............................................................................................................................12-25
Trade credit..........................................................................................................................12-25
Factoring and invoice discounting.....................................................................................12-26
From the real world: Pick n Pay and invoice financing....................................................12-29
Bank overdrafts...................................................................................................................12-29
Bankers’ acceptances (bank bills)......................................................................................12-29
Revolving credit facility......................................................................................................12-30
Repurchase agreements (Repo market)...........................................................................12-31
Short-term financing: advantages and disadvantages......................................................12-32
Summary..............................................................................................................................12-33
Guidance on working capital.............................................................................................12-33
Self-study problems.............................................................................................................12-34
Solutions to self-study problems........................................................................................12-35
Questions.............................................................................................................................12-39

Chapter 13 Sources of finance..................................................................................................13-1

A lion retreats.............................................................................................................................13-1
Learning objectives.....................................................................................................................13-1
Introduction................................................................................................................................13-1
1 Financial markets.................................................................................................................13-2
Money and capital markets..................................................................................................13-2
Primary and secondary markets...........................................................................................13-2
Formal and over-the-counter (OTC) markets....................................................................13-2
Spot and derivative markets.................................................................................................13-2
The Johannesburg Stock Exchange.....................................................................................13-3

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 Alternative Exchange – AltX...............................................................................................13-6
A2X Markets.........................................................................................................................13-7
Alternative methods of obtaining a listing..........................................................................13-8
Raising capital by listed companies.....................................................................................13-8
Setting an issue price............................................................................................................13-8
Rights issue............................................................................................................................13-9
Some facts about market liquidity.....................................................................................13-10
The JSE Derivatives Market..............................................................................................13-11
The JSE Debt Market.........................................................................................................13-11
2 Financial institutions.........................................................................................................13-13
Banks....................................................................................................................................13-13
Investment institutions.......................................................................................................13-14
Private equity and venture capital.....................................................................................13-14
Special institutions..............................................................................................................13-17
3 Equity-related instruments................................................................................................13-19
Ordinary shares...................................................................................................................13-19
Retained earnings...............................................................................................................13-20
Preference shares................................................................................................................13-20
4 Debt instruments................................................................................................................13-22
Corporate bonds, notes and debentures...........................................................................13-22
Long-term loans..................................................................................................................13-24
Bank loans...........................................................................................................................13-24
Fixed interest rate loans.....................................................................................................13-25
Variable interest rate loans................................................................................................13-26
Unsecured notes..................................................................................................................13-27
Foreign loan or bond financing..........................................................................................13-27
Credit ratings.......................................................................................................................13-27
Short-term debt...................................................................................................................13-29
5 Hybrid instruments............................................................................................................13-29
6 Comparison of debt and equity.........................................................................................13-30
Return..................................................................................................................................13-30
Risk......................................................................................................................................13-30
Control.................................................................................................................................13-31
From the real world – corporate bonds and borrowings.................................................13-32
7 Inflation-linked bonds........................................................................................................13-33
8 Alternative sources of finance............................................................................................13-34
Peer-to-peer lending...........................................................................................................13-35
Crowdfunding......................................................................................................................13-36
Online invoice trading platforms.......................................................................................13-36
Supply chain finance...........................................................................................................13-36
9 Financing for black economic empowerment (BEE) entities..........................................13-37
From the real world: Sasol and Absa BEE transactions.................................................13-41
10 Islamic Finance...................................................................................................................13-43
From the real world … Islamic Finance and the JSE......................................................13-43
Guidance when presented with problems relating to sources of finance.......................13-44
Summary..............................................................................................................................13-47
Self-study problems.............................................................................................................13-47
Solutions to self-study problems........................................................................................13-48
Questions.............................................................................................................................13-49

Chapter 14 Capital structure....................................................................................................14-1

Learning objectives.....................................................................................................................14-1
Introduction................................................................................................................................14-2
1 Risk profile............................................................................................................................14-2
Business risk..........................................................................................................................14-2
Financial risk.........................................................................................................................14-3

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 2 Leverage (gearing)................................................................................................................14-3
Impact on earnings...............................................................................................................14-4
Impact on risk........................................................................................................................14-4
3 Optimal capital structure....................................................................................................14-8
The Modigliani-Miller approach.........................................................................................14-8
Trade-off theory..................................................................................................................14-11
Pecking order and signalling theories................................................................................14-13
Debt financing, free cash flow and conflicts between management and shareholders....14-13
4 Agency costs and inverted incentives: conflicts between shareholders
and bondholders.................................................................................................................14-14
Investing in high-risk projects............................................................................................14-14
Running off with the money...............................................................................................14-15
No further investment by shareholders.............................................................................14-15
Playing for time...................................................................................................................14-15
Changing the capital structure of the firm........................................................................14-16
The use of loan covenants to manage shareholder and bondholder conflicts...............14-16
From the real world: Loan covenants at Aspen and Gold Fields...................................14-17
5 The impact of inflation.......................................................................................................14-17
6 The need for flexibility.......................................................................................................14-18
Target capital structure.......................................................................................................14-18
Short-term deviation from target.......................................................................................14-18
Financial flexibility..............................................................................................................14-19
Market timing theory..........................................................................................................14-19
7 Debt and tax shields...........................................................................................................14-20
8 Financial leverage and a firm’s weighted-average cost of capital..................................14-23
9 Personal taxes.....................................................................................................................14-24
10 Capital structures in South Africa and around the world..............................................14-25
From the real world............................................................................................................14-27
11 Edcon: Capital structure and valuation of tax shields....................................................14-29
12 Capital structure decisions - a behavioural finance perspective....................................14-31
Summary..............................................................................................................................14-32
Guidance on capital structure............................................................................................14-32
Appendix 14.1 Global debt and debt-equity ratios..........................................................14-35
Self-study problem..............................................................................................................14-37
Solution to self-study problem...........................................................................................14-37
Questions.............................................................................................................................14-38

Chapter 15 Leasing....................................................................................................................15-1
Leasing in the airline sector is no laughing matter..................................................................15-1
Learning objectives.....................................................................................................................15-1
Introduction................................................................................................................................15-2
1 Types of leases.......................................................................................................................15-2
Direct lease............................................................................................................................15-2
Sale and lease-back...............................................................................................................15-2
Leveraged lease.....................................................................................................................15-3
2 Off-balance sheet financing and leasing.............................................................................15-3
3 The accounting for leases in terms of IFRS 16..................................................................15-4
The effect of IFRS 16 on financial statements, ratios and processes..............................15-5
Is a contract a lease or does the contract contain a lease?................................................15-6
Non-lease components.........................................................................................................15-7
Lease term, lease payments and the discount rate.............................................................15-8
Structuring considerations....................................................................................................15-8
Application of IFRS 16: an example...................................................................................15-9
4 Advantages of leasing.........................................................................................................15-10
Changing technology...........................................................................................................15-10
Tax advantages.....................................................................................................................15-11

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 Obtaining 100% debt financing.........................................................................................15-11
Operating flexibility............................................................................................................15-11
Reduction in operating leverage........................................................................................15-11
Coping with uncertain demand..........................................................................................15-11
Specialisation effects on maintenance, residual values and purchase costs...................15-12
Standardisation of contracts...............................................................................................15-12
Fewer restrictions................................................................................................................15-12
Off-balance sheet financing................................................................................................15-12
Avoidance of capital expenditure controls and budgetary constraints...........................15-12
5 Evaluating the leasing decision.........................................................................................15-12
Selecting an appropriate discount rate..............................................................................15-13
Calculating the net present cost.........................................................................................15-14
The present cost of leasing.................................................................................................15-14
The present cost of borrowing and buying........................................................................15-14
The net advantage of leasing and NPV.............................................................................15-16
From the real world............................................................................................................15-18
6 The adjusted present value approach...............................................................................15-20
Summary..............................................................................................................................15-22
Self-study problems.............................................................................................................15-22
Solutions to self-study problems........................................................................................15-23
Appendix 15.1 Operating lease capitalisation and other pertinent leasing issues.........15-27
Questions.............................................................................................................................15-30

Chapter 16 Dividends and share buy-backs............................................................................16-1

The dividend cut that made headlines around the world........................................................16-1
Learning objectives.....................................................................................................................16-2
Introduction................................................................................................................................16-2
1 Dividend relevance – active variable or passive residual?................................................16-2
The residual approach to dividends....................................................................................16-3
2 Factors affecting the dividend decision..............................................................................16-7
The legal requirements of the Companies Act 71 of 2008: solvency and liquidity tests....16-7
Contractual obligations........................................................................................................16-8
Information content of dividends........................................................................................16-8
Taxation................................................................................................................................16-10
The nature of shareholders................................................................................................16-12
3 Dividend payment policies.................................................................................................16-12
Stable dividend amount......................................................................................................16-12
Stable payout ratio..............................................................................................................16-13
Special dividends.................................................................................................................16-14
Stable dividend plus special dividend................................................................................16-15
4 The payment of dividends..................................................................................................16-16
What happens to the share price when a share goes ex-dividend?.................................16-17
Share splits and capitalisation issues.................................................................................16-18
From the real world: Sub-division of the ordinary share capital of Assore...................16-19
Dividend reinvestment plans (DRIPs) and scrip dividends.............................................16-20
5 Share buy-backs..................................................................................................................16-21
What is the effect of a share buy-back on the Statement of Financial
Position of a company?.......................................................................................................16-22
Why should companies repurchase their own shares?.....................................................16-22
Requirements and consequences of engaging in a share buy-back.................................16-23
From the real world............................................................................................................16-25
Dividends in specie..............................................................................................................16-26
Dividend yields....................................................................................................................16-27
How important are dividends to investor returns............................................................ 16.29
Dividend policy and share repurchases: what is the evidence in South Africa..............16-30
From the real world … AB InBev cuts dividend..............................................................16-31

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