Kudakwashe-Fin Man B

CHAPTER 1

DIVIDEND POLICY DECISION

A dividend is a payment made out of the firm’s earnings to its owners, in the form of either cash or shares (stock).

The policy decision required applies to ordinary shares, as these are the ones whose dividends are not defined and are determined by management. Preference shares carry a fixed rate of dividend that has to be paid whenever a dividend would have been declared.

Forms of dividendThere are primarily three forms of dividend, cash dividend, stock dividend and dividend in kind.

Cash dividend This is the most common form of dividend. The declared dividend is paid out as cash for example $30,00 per share for each share that is outstanding.

Stock dividend (Scrip) It is a dividend in the form of stock (shares). It is usually the preferred option if an organisation is experiencing liquidity problems.

Dividend in kind This is the use of a company’s products as dividend. This type of dividend is not common in Zimbabwe. A wine producing concern for example, may distribute wine as dividend to its shareholders.

Dividend payment proceduresThe board of directors makes a dividend declaration. Once declared dividends become a debt to the firm, which cannot be easily rescinded. The following example illustrates the procedures to be followed from when dividends are declared until they are finally paid.

EXAMPLE The directors of A Ltd have proposed a final dividend number 65 of $40,00 per share to be paid to shareholders registered in the company’s books on 8 July 2004. Dividend payment will be made on or about 15 July 2004. The company’s register will be closed between 4 July and 8 July 2004.

By order of the company

30 May 2004

The following time line can be used to illustrate the sequence of specific dates that are of interest when looking at dividends. It is important to note the activities that take place at each respective date and how they are related to those that follow and precede each specified activity.

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Share trades cum – div that is Share trades ex – div that is cumulative of dividend excluding dividend 30 May 2004 4 July 2004 8 July 2004 15 July 2004 Declaration date Ex – dividend date Record date Payment date

Declaration date This is the date on which the board of directors passes a resolution to pay a dividend.

Ex – dividend date It is the date before the date of record, establishing those individuals entitled to a dividend. In Zimbabwe the period is four business days and in the United States two business days.

Record date This is the date at which a holder must be on record in order to be designated to receive a dividend.

Payment date It is the date when the dividend cheques are posted or in cases where funds are transferred electronically, it is the date when the electronic funds transfer is effected.

DIVIDEND POLICIESDividend policy refers to a firm’s plan of action to be followed whenever a decision concerning dividends must be made. The policy should be formulated with the following two objectives in mind:

1. Maximisation of shareholder wealth and2. Provision of sufficient financing.

There are generally three broad dividend policies that could be pursued by firms.

POLICY I – CONSTANT/TARGET PAYOUT RATIOA firm pursuing this policy pays out a constant percentage of net earnings as dividend to shareholders. With such a policy dividend payments fluctuate proportionately with earnings. The dividends become volatile in keeping with fluctuations in earnings.

($) DPS & EPS EPS DPS

Time (Years)

Fig. Dividend payment under a constant/target payout ratio

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POLICY II – CONSTANT DIVIDEND PER SHAREA firm pursuing this policy pays a certain fixed amount per share as dividend for example $25,00. This amount is paid out year after year regardless of the level of earnings. This might even mean the payment of a dividend even when the company has incurred a loss. This policy does not mean that the amount of dividend is fixed for all times to come. As earnings grow the dividend is increased and once increased it is maintained at the new level. While earnings may fluctuate yearly, the dividend per share remains constant.

EPS

($) DPS & EPS DPS

Time (Years)

Fig. Dividend payment under a constant dividend per share

POLICY III – LOW REGULAR DIVIDEND PER SHARE PLUS EXTRA DIVIDENDA firm pays out a low and sustainable dividend to shareholders every year. During years of marked prosperity the firm pays an extra dividend over and above the regular dividend.

DIVIDEND THEORIESManagement has to decide whether dividends are an active variable or a passive residual. This in turn depends on whether management believes that dividends have any effect on the value of the firm.

There are conflicting opinions regarding the impact of dividends on the valuation of the firm.

The irrelevance of dividends (general theory)The argument in support of the general theory on irrelevance is that the dividend policy of the firm is part of its financing. As part of the financing decision of the firm, the dividend policy of the firm is a residual decision and dividends are a passive residual.

When a firm has sufficient investment opportunities it will retain earnings to finance the investments. If acceptable investments were inadequate, earnings would be distributed to shareholders.

If a firm can earn a higher return than its cost of capital it will retain the earnings to finance investment projects. If retained earnings fall short of the funds required it will raise external funds, both equity and debt to make up the shortfall. If retained earnings exceed the requirements of funds to finance

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acceptable investment opportunities the excess earnings would be distributed as dividends.

The amount of dividend will fluctuate year – by – year depending on available acceptable investment opportunities. The dividend payout ratio can be zero or 100%.

The general theory of the irrelevance argument assumes that investors are indifferent between dividend and capital gains. If the firm can earn more than the equity capitalization rate (ke) investors would be content with the firm retaining earnings. If the return were less than the ke, investors would prefer to receive the earnings (dividends).

The irrelevance of dividends: MM hypothesisFranco Modigliani and Morton Miller give a comprehensive argument in support of the irrelevance of dividends.

They argue that given a firm’s investment decision, a firm has two options – to retain its earnings to finance the attractive investments or to distribute the earnings as dividends and raise an equal amount through the sale of new shares to finance its investment programme. When dividends are paid out the market price of the shares will increase. However, the additional shares issued will decrease the terminal value of the shares. What the investors would have gained will be neutralized completely by a reduction in the terminal value of the shares. This situation creates indifference between dividend and retention of earnings MM argue.

In other words their argument is that investors are indifferent between dividend and retention of earnings. This they argue is because of the balancing nature of internal financing (retained earnings) and external financing (dividend payment).

The argument presented by MM is based on the following assumptions:1. Perfect capital markets. This is a market that is characterised by the

following: Rational investors Free information available to all Zero transaction costs Infinitely divisible securities Zero floatation costs No large enough investor to influence security market prices

2. No taxes. Alternatively they assume that there is no difference in tax rates applicable to capital gains and dividends.

3. A given investment policy not subject to change.4. Perfect certainty as future investments and profits of the firm.

A critique of the MM hypothesisThe MM proposition is based on unrealistic assumptions. The proposition can therefore be viewed as untenable because of the following arguments.

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Taxes The MM argument that rates of tax levied as capital gains tax and on dividend income are the same is not always true. Dividend withholding tax is levied at a higher rate than capital gains tax (for shares that are quoted on the stock exchange). This arrangement may create a situation where those in a high-income bracket (those receiving taxable dividends) may prefer retention of earnings to postpone tax and pay it as capital gains tax on disposal of shares.

Floatation costs The presence of floatation costs (underwriting commissions, brokerage and other expenses) affects the balancing nature of internal financing (retention of earnings) and external financing (dividend of payment). The two methods of financing are not perfect substitutes because of floatation costs. The costs reduce the net proceeds from the sale of new shares leaving them less than the face value of shares issued. To be able to make use of external funds, equivalent to the dividend payment, the firm would have to sell shares for an amount in excess of the retained earnings. External financing through the issue of shares will be more costly than financing via retained earnings.

Transaction costs It is also unrealistic to assume that if the shareholder desires current income when they sell part of their shareholding they incur no transaction costs. To get current income equivalent to the dividend if paid, the investor would have to sell securities in excess of the income that he will receive (to cater for transaction costs).

Uncertainty Uncertainty makes the dividend decision relevant. MM argue that shareholders are indifferent between a dividend now (a near dividend) and retention of earnings to be received in future in the form of an increase in share price (a distant or future dividend). Myron Gordon and John Lintner argue that because of uncertainty investors are not indifferent, they prefer near dividends. The amount to be paid in future cannot be forecast with precision.

Informational content of dividends/Financial signaling Payment of a dividend contains vital information to investors. This information is usually related to profitability or vice versa. If a firm used to pay a stable dividend and suddenly increases its dividend payout this signifies improved future profitability. The dividend policy is likely to change the market price of the shares.

Relevance of dividends: The Gordon model The Gordon model considers the dividend decision to relevant. It considers the dividend decision to be an active variable in determining the value of the firm.

The Gordon argument is based on the following assumptions:1. Investors are risk – averse and2. Investors put a premium on returns that are certain and

discount/penalize returns that are not certain.

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Investors being rational want to avoid risk (the possibility of not getting a return on investment). Payment of a current dividend removes any chance of risk. If a firm retains its earnings in order to pay a future dividend this introduces uncertainty as to the amount of the dividend and its timing. Rational investors penalize future dividends because of uncertainty, as they prefer near dividends, which are certain.

Determinants of Dividend PolicyThe dividend policy of a concern is a function of a number of factors.

Dividend Payout ratio If a firm has a long established dividend payout ratio; it becomes bound by the ratio, as shareholders would be expecting that ratio to be paid out.

Stability of dividends Investors prefer stable dividend in as much as they prefer a stable dividend payout ratio.

Desire for current income Investors such as retired persons and widows regard dividends as a source of funds to meet their current expenses. If dividends were to be reduced they sell their shares. They dig deep into their principal to sustain themselves. It would be preferable if they were to dig deep into their pockets rather than principal.

Informational contents/Financial signaling Investors use dividends and changes in dividends as a source of information about the firm’s profitability. They know that the firm will only change dividends if management foresees a permanent earnings change.

Requirements of institutional investors Institutional investors are only required to invest in companies that have a record of continuous and stable dividend. Because of the large size of funds they have available for investment their demand for shares will have an enhancing – effect on its price thereby increasing shareholders wealth.

Legal requirements Legal requirements specify the conditions under which dividends must not be paid.

a) Cash dividends cannot be paid out of paid up capital as this amounts to a reduction of capital (capital impairment rule).

b) Legislation restricts the dividend to be paid to be paid out of the firm’s current profits plus past accumulated retained earnings.

c) If a firm is technically or legally insolvent it cannot legally pay cash dividends.

Contractual requirements These are important when a company accepts external loans, preference share capital or lease contracts as part of its financing. The restrictions can limit the payment of cash dividends. The restrictions can take any of the following forms:

I. Prohibition of payment of dividend in excess of a defined percentage for example 30 per cent of distributable profits.

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II. A defined amount of profits to be paid as dividends may be stipulated for example $40 million.

III. Insisting upon a defined minimum amount of earnings having to be retained.

Growth prospects This refers to the investment opportunities available to the concern. For a growing concern, the availability of external funds and its associated cost have a significant bearing on the firm’s dividend policy.

Financial requirements A firm’s financial requirements are directly related to its investment needs. Dividend policy should be formulated on the basis of foreseeable investment needs. Abundant investment opportunities will normally lead to a low payout ratio and vice versa.

Liquidity (Availability of funds) Liquidity as used in this context refers to the availability of funds. Dividend policy should be developed after considering the firm’s ability to raise funds and the promptness with which that financing can be obtained.

Stability of earnings Generally the more stable the income stream of a concern, the higher the dividend payout ratio and vice versa. Growing firms with stable earnings can raise debt funds at a relatively lower cost because of a smaller total risk (business and financial).

Control considerations Management may employ dividend policy as an effective instrument to maintain its position and control. Management may opt for a low dividend payout and high retention ratio to finance investment (to avoid debt finance with covenants or equity capital which may dilute control).

Access to capital markets If a firm has easy access to capital markets (because of size or financial strength), it may follow a liberal dividend policy. If a firm has limited access to capital markets, it is likely to adopt a low dividend payout ratio since the firm relies heavily on retained earnings as a source of financing investment opportunities.

USEFUL RATIOS AND FORMULAEThe following ratios and formulae are useful when one is looking at dividends and dividend policy.

Dividend payout = Total dividend to ordinary shareholders (cash dividends) Total net earnings belonging to equity holders

If the payout is needed as a percentage, the above formula is multiplied by 100

OR

Dividend payout = Dividend per ordinary share (DPS) Earnings per share (EPS)

DPS = Net profit after interest and preference dividend paid to ordinary shareholders Number of ordinary shares outstanding

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OR

DPS = Total ordinary cash dividend paid Number of ordinary shares in issue

Dividend cover = Earnings available to ordinary shareholders Ordinary dividend

OR

Dividend cover = EPS (Earnings per shares) DPS (Dividend per share)

Dividend Yield = Dividend per share * 100 Market price per share

Earnings Yield = Earnings per share * 100 Market price per shares

Yield is expressed as a percentage

Price Earnings ratio = Market price per share Earnings per share

BONUS SHARES (STOCK DIVIDENDS) AND STOCK (SHARE) SPLITSSTOCK DIVIDEND A stock dividend is a payment made by the firm to its owners in the form of stock, diluting the value of each share outstanding. The stock issued is issued on a pro rata basis. The stock issue is expressed as a percentage for example 20 percent. This would mean one (1) additional share would be issued for every five (5) existing shares.

Stock splits and dividends have the same impact on the corporation and the shareholders:

1. They increase the number of shares outstanding and2. They reduce the value per share.

STOCK SPLITThis is the subdivision of a firm’s stock that leads to an increase a firm’s outstanding shares without any change in owner’s equity. A stock split is expressed as a ratio instead of a percentage for example a three for one stock split. This would mean a share is split into three new shares.

EXAMPLE (STOCK DIVIDEND)The following information is given:

Common stock ($1,00 par 10 000 outstanding shares)Share premiumRetained earnings

$10 000,0020 000,0070 000,00100 000,00

The stock is currently trading for $5,00. Assume a 10 percent stock dividend.

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Present the shareholders equity after the stock dividend.

SolutionA 10 percent stock dividend brings in 1 000 additional ordinary shares at $5,00.

Common stock ($1,00 par 11 000 outstanding shares)Share premium [20 000 + (1 000 * $4,00)]Retained earnings ($70 000 - $5 000)

$11 000,0024 000,0065 000,00

100 000,00

EXAMPLE (STOCK SPLIT)Referring to the above example and assume a two – for – one stock split.

Show the owner’s equity after the stock split.Solution

Common stock ($0.50 par 20 000 shares outstanding)Share premiumRetained earnings

$10 000,0020 000,0070 000,00

100 000,00

Rationale for a stock split1. Stock splits bring the market price of shares within a more popular

range as a result of a larger number of shares outstanding.2. The larger number of outstanding shares will also promote more active

trading in the share due to availability of floating stock.

Rationale for a bonus offer1. A bonus offer leads to conservation of corporate cash.2. Bonus/split announcements improve the prospects of raising additional

funds especially through the issue of convertible debentures.

PRACTICE PROBLEMS ON DIVIDENDSPROBLEM 1A firm has had the earnings per share over the past 10 years shown in the following table.

Year Earnings per share1988198719861985198419831982198119801979

$4.00 3.80 3.20 2.80 3.20 2.40 1.20 1.80 -0.50 0.25

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If the firm’s dividend policy was based on a constant payout ratio of 40 percent for all years with positive earnings and a zero payout otherwise, determine the annual dividend for each year.

If the firm had a dividend payout of $1,00 per share, increasing by $0,10 per share whenever the dividend payout fell below 50 percent for two consecutive years, what annual dividend did the firm pay each year?If the firm’s policy was to pay $0.50 per share each period except when earnings per share exceeds $3,00, when an extra dividend equal to 80 percent of earnings beyond $3,00 would be paid, what annual dividend did the firm pay each year?

Discuss the pros and cons of each dividend policy described in a through c.

PROBLEM 2A firm has the following information at the end of two financial periods:

2003$

2004$

EBITTaxation for the yearInterestDividend paidNumber of ordinary shares Current market price of a share

70 00010 00010 00030 000

100 000$5

100 00030 00010 00040 000

110 000$6

At the end of the trading period 2002 the firm’s share price was $5,50.Calculate for the two years the following:

Earnings per share (2 marks)Price Earnings ratio (2 marks)Earnings yield (2 marks)Dividend per share (2 marks)Dividend yield (2 marks)Dividend cover (2 marks)Interest cover (2 marks)Holding period returns (6 marks)

PROBLEM 3X and Y are two fast growing companies in the engineering industry. They are close competitors and their asset composition, capital structures, and profitability records have been very similar for several years. The primary difference between the companies from a financial management perspective is their dividend policy. Company X tries to maintain a non – decreasing dividend per share, while company Y maintains a constant dividend payout ratio. Their recent earnings per share (EPS), dividend per share (DPS), and share price (P) history are as follows:

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Company X ($) Company Y ($)Year EPS DPS P (range) EPS DPS P (range)

1 9.30 2.00 75 – 90 9.50 1.90 60 – 802 7.40 2.00 55 – 80 7.00 1.40 25 – 653 10.50 2.00 70 – 110 10.50 2.10 35 – 804 12.75 2.25 85 – 135 12.25 2.45 80 – 1205 20.00 2.50 135 – 200 20.25 4.05 110 – 2256 16.00 2.50 150 – 190 17.00 3.40 140 - 1807 19.00 2.50 155 - 210 20.00 4.00 130 - 190

Determine the dividend payment ratio (D/P) and price to earnings ratio (P/E) for both companies for all the years.Determine the average D/P and P/E for both the companies over the period 1 through 7.Management of company Y is puzzled as to why their share prices are lower than those of company X, in spite of the fact that profitability record of company Y is slightly better (particularly for the past three years). As a financial consultant, how would you explain the situation?

PROBLEM 4The following is the earnings per share (EPS) record for ABC Ltd over the past 10 years:

Year EPS ($) Year EPS ($)109876

20.0019.0016.0015.0016.00

54321

12.006.009.00

-2.001.00

Required:Determine the annual dividend paid each year in the following cases:If the firm’s dividend policy is based on a constant dividend payout ratio of 50% for all years.Pay a dividend of $8.00 per share increasing to $10.00 per share when earnings exceed $14.00 per share for two consecutive years.Pay a dividend of $7.00 per share each year except when EPS exceeds $14.00 per share, when an extra dividend equal to 80% of earnings beyond $14.00 would be paid.Which type of dividend policy will you recommend to the company and

Why?

PROBLEM 5

What is a dividend? What is a stable dividend? Why should a firm follow such a policy? The abbreviated income statement of MTB Limited for 2004 is as follows:

Turnover $28 772 000Profit before Taxation $ 3 299 000Profit after Taxation $ 1 737 000

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Number of shares 14 131 124Price per share $ 0,47

If the company is planning to purchase new equipment worth $5 million and the firm wants 25% of the cost to be financed by current income, what will be the dividend cover? If the company has a policy of paying 50 percent of its net income as dividend:What will the dividend per share of the company be? If the firm still has to finance the equipment purchase in (i) what is the amount of external financing that it will have to seek? If the company always pays a dividend of 1 cent per share plus a bonus and the bonus is any earnings per share over 10 cents, what is the total dividend that will be paid by the firm What is a bonus stock dividend? What would be the rationale for such a dividend? In relation to dividend payment procedures, explain the following:Declaration date Ex – dividend date Record date Payment date

PROBLEM 6(a) Muzanzi Ltd’s expected net income for next year is $1 million. The company’s target and current capital structure is 40% debt and 60% common equity. The optimal capital budget for next year is $1.2 million. If Muzanzi Ltd. uses the residual theory of dividends to determine next year’s dividend pay out, what is the expected payout ratio?(b) Shingai Ltd. has a current and target capital structure of 30% debt and 70% equity. This past year the company, which uses a residual dividend theory, had a dividend payout ratio of 47.5% and net income of $800 000. What was the company’s capital budget?

(c) Kuvharwa Ltd’s optimal capital structure calls for 40% debt and 60% equity. The interest rate on debt is a constant 12%; its cost of equity from retained earnings is 16%; its cost of equity from new stock is 18%; and its marginal tax rate is 40%. The company had the following investment opportunities:

Project A: Cost = $5 million: IRR = 22%Project B: Cost = $5 million: IRR = 14%Project C: Cost = $5 million: IRR = 11%

Kuvharwa Ltd expects to have a net income of $7 million. If the company bases its dividends on the residual policy, what will its payout ratio be?

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CHAPTER 2

WORKING CAPITAL MANAGEMENT

Working capital can be looked at from a gross or net perspective. Gross working capital is the total of an organisation’s current assets. Net working capital can have two meanings:

1. Net working capital can be looked at as the difference between current assets and current liabilities.

2. Net working capital can also be looked at as that portion of a firm’s current assets financed by long – term funds

Objective of working capital management The goal of working capital management is to manage a firm’s current assets and current liabilities so as to maintain a satisfactory level of working capital. This level of working capital will ensure sufficient liquidity in the operation of the business as measured by the current ratio, acid – test ratio and net working capital.

Firms should operate with some net working capital. The amount of net working capital required differs from firm to firm. Net working capital provides a margin of safety where cash inflows and outflows do not coincide. If there is little or no working capital, there is a higher risk of technical insolvency.

PERMANET/FIXED WORKING CAPITALFirms require some defined minimum amount of working capital to keep their operations running. This minimum level of working capital that is necessary on a continuous basis is the permanent or fixed working capital.

TEMPORARY/FLUCTUATING/SEASONAL/ VARIABLE WORKING CAPITALIn addition to the minimum working capital required on an ongoing basis, firms also require additional working capital during certain periods like the festive season. This additional working capital that is needed to meet fluctuations in demand as result of seasonal changes is the variable working capital.

Amount of Temporary workingWorking capital ($) capital

Permanent working Capital

Time in months

Fig. Components of working capital

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DECISIONS TO BE MADE CONCERNING WORKING CAPITALThe management of working capital requires management to make two very important decisions.

DECISION ITRADE – OFF BETWEEN PROFITABILITY AND RISK (INVESTMENT DECISION)When evaluating a firm’s net working capital attention must be paid to the trade – off between profitability and risk. The level of a firm’s net working capital has a bearing on its profitability as well as risk. Profitability will be measured by profit after expenses while risk would be the probability that the firm would become technically insolvent and fail to meet its obligations when they become due for payment.

Evaluation of the trade – off To make an evaluation of the trade – off that exists between profitability and risk, the following assumptions will be made:

1. The firm being evaluated is a manufacturing concern. A manufacturing concern is chosen here because of the amount of working capital investment carried by such firms.

2. Current assets are less profitable than fixed assets.3. Short – term funds are less expensive than long – term funds.

The evaluation can be illustrated by computing the ratio of current assets to total assets. Some firms maintain a ratio of current assets to total assets. The ratio indicates the percentage of total assets represented by current assets. A change in the ratio will reflect a change in the amount of current assets.

EXAMPLEMUNHUMUTAPA INVESTMENTS LTD.

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BALANCE SHEET AT 30 DECEMBER 2004ASSETSNon – current assetsProperty, plant and equipment

Current assetsCurrent assets

TOTAL ASSETS

EQUITY AND LIABILITIESCapital and reservesCapitalNon – current liabilitiesLong – term debt

Current liabilitiesCurrent liabilities

TOTAL EQUITY AND LIABILITIES

$860 000860 000

540 000540 000

1 400 000

600 000600 000480 000480 000

320 000320 000

1 400 000

Assume that the company earns approximately 4 percent on its current assets and 10 percent on non – current assets.

1. Compute the current profitability, net working capital and current assets/total assets ratio.

2. Assume an additional investment of $60 000,00 in current assets other things being equal. Calculate profitability, net working capital and current/assets ratio.

3. Now assume an increase in the level of investment in fixed assets of $60 000,00, other things being equal. Re – calculate profitability, net working capital and ratio of current assets/total assets.

SolutionCurrent positionProfitability: Current assets = 4/100 * $540 000 = $21 600 Non – current assets = 10/100 * $860 000 = $86 000 $107 600

Net working capital = $540 000 - $320 000 = $220 000

Current assets/total assets ratio = $540 000/$1 400 000 = 0.39

An increase in the ratio of current assets to total assetsAn additional investment of $60 000,00 in current assets other things being equal reduces non – current assets by the same amount.

Profitability: Current assets = 4/100 * $600 000 = $24 000 Non – current assets = 10/100 * $800 000 = $80 000

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$104 000



An increase in the ratio of current assets to total assets decreases profitability because current assets are assumed to be less profitable than non – current assets. The increase in the ratio also decreases the risk of technical insolvency because an increase in current assets, assuming no change in current liabilities will increase net working capital.

A decrease in the ratio of current assets to total assetsAn increase in the level of investment in non – current assets (a decrease in the ratio of current assets to total assets) of $60 000,00, other things being equal, reduces current assets by the same amount.

Profitability: Current assets = 4/100 * $480 000 = $19 200 Non – current assets = 10/100 * $920 000 = $92 000 $111 200



A reduction in the ratio of current assets to total assets increases profitability and risk. Profitability increases because non – current assets (more profitable than current assets) increase. Risk increases because a decrease in current assets (with current liabilities remaining constant) reduces net working and hence increases risk.

Effects of changes in current assets of Munhumutapa LtdInitialValue

($)

Value afterIncrease(+) ($)

Value afterDecrease

(-) ($)Ratio of current assets to total assetsProfit on total assetsNet working capital

0.39107 600220 000

0.43104 000280 000

0.34111 200160 000

DECISION 2DETERMINING THE FINANCING MIX (FINANCING DECISION)Other than the profitability – risk trade – off, another important consideration is determining the appropriate mode of financing the current assets. There are two sources of finance:

Short – term sources (current liabilities) Long – term sources (share capital and long – term borrowings)

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The question to be answered is how much finance should be short – term and how much should be long – term? The answer to this question depends on which approach to financing current assets is adopted.

THE HEDGING APPROACH/MATCHING APPROACH/AGGRESSIVE APPROACHThe hedging approach suggests that long – term funds should be used to finance permanent working capital requirements while short – term sources of finance should be used to finance temporary or seasonal working capital requirements. When this approach to financing current assets is adopted, short – term financing requirements (current assets) will just be equal to the short –term financing available (current liabilities). This effectively means that there will be no working capital, which is a very risky arrangement.

Diagrammatical illustration of the hedging approach

Total working capital requirements

Required Total funds requirementFunds Short – term funds ($)

Seasonal working capital Requirement

Long – term finance Permanent working capital requirement

Time in months

THE CONSERVATIVE APPROACHThis method of financing suggests that the estimated financial requirement (projected funds requirement) should be made from long – term sources of funds. Short – term sources are used for emergency situations only or when there is an unexpected outflow of funds.

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Diagrammatical illustration of the approach

Total working capital requirement Total funds requirementFundsRequired($)

Seasonal working capital requirement

Long – term finance Permanent working capital requirement

Time in months

EXAMPLEThe projected total funds requirements for Gobvu Investments for the year 2005 are given as follows:

Month

Total fundsRequired

($)

PermanentRequirements

($)

SeasonalRequirements

($)JanuaryFebruaryMarchAprilMayJuneJulyAugustSeptemberOctoberNovemberDecember

85 00080 00075 00070 00069 00071 50080 00083 50085 00090 00080 00075 000

69 00069 00069 00069 00069 00069 00069 00069 00069 00069 00069 00069 000

16 00011 000 6 000 1 000 0 2 50011 00014 50016 00021 00011 000 6 000

116 000

Assuming that short – term finance cost 3 percent and long – term finance 8 percent:

1. Compute the cost of financing associated with the hedging approach.2. Compute the cost of financing associated with the conservative

approach.3. Indicate the risk considerations associated with the two approaches of

financing.4. Compute the cost of financing associated with the middle of the road

approach.

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Cost considerationsThe cost of a financing plan has a bearing on the profitability of a concern.

Cost of short – term funds = average annual short – term loan * interest rate

Where average annual short – term loan = total monthly seasonal requirements Number of months

Cost of long – term funds = average annual long – term funds requirements * interest rate

Cost of short – term funds = ($116 000/12) * 3/100 = $9 666,66667 * 3/100 = $290,00

Cost of long – term funds = [$69 000 * 12] * 8/100 12 = $69 000 * 8/100 = $5 520,00

Total cost of financing = Cost of short – term finance + cost of long – term finance

Cost of financing for the Hedging approach = $290,00 + $5 520,00 = $5 810,00

Cost of financing (Conservative) approach = Highest projected funds requirements * interest rate

Cost of financing: Conservative approach = $90 000,00 * 8/100 = $7 200,00

Risk considerationsThe hedging approach is more risky when compared to the conservative approach because of the following reasons:

1. The hedging approach has no net working capital since current assets just equal current liabilities. There is therefore no margin of safety. Again no long – term finances are used to finance seasonal working capital requirements.

2. The hedging approach involves an almost full utilization of the capacity to use short – term funds and in emergency situations it may be difficult to satisfy the short – term needs of the organisation. The conservative approach conserves an organisation`s short – term borrowing capacity for unexpected needs to avoid technical insolvency. It however exhausts an organisation`s capacity to utilize long – term finance.

The hedging approach can therefore be argued to be a high profit (because of low cost) – high risk (because there is no working capital) approach to financing current assets while the conservative approach can be argued to be a low profit (because of high cost) – low risk (because of high working capital) approach to financing current assets.

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TRADE – OFF BETWEEN THE HEDGING AND CONSERVATIVE APPROACHES/MIDDLE OF THE ROAD/COMPROMISE APPROACHThis financing approach strikes a balance between the two extreme methods of financing current assets that is the hedging approach and the conservative approach. The exact trade – off between risk and profitability will differ from case to case depending on the risk preference of the decision – maker. One possibility is to take the average of the maximum and minimum monthly working capital requirements of the concern. This may then be financed through long – term sources of finance with short – term sources for additional fund requirement.

In the above example the revised amount to be financed through long – term financing can be re – computed as follows:

Permanent working capital = $90 000 + $69 000 2 = $79 500,00

This would be the amount of funds the firm would use each month in the form of long – term funds. Additional funds, if needed, should be from short – term sources of finance.

The previous example can be re – visited and the total funds requirement broken down into revised permanent and variable working capital requirements.Estimated total funds requirement: Compromise approach

Month

Total fundsRequirement

($)

Long – termFunds

($)

Short – termFunds

($)JanuaryFebruaryMarchAprilMayJuneJulyAugustSeptemberOctoberNovemberDecember

85 00080 00075 00070 00069 00071 50080 00083 50085 00090 00080 00075 000

79 50079 50079 50079 50079 50079 50079 50079 50079 50079 50079 50079 500

5 500500

0000

5004 0005 500

10 500500

027 000

No short – term sources of funds are required in March, April, May June and December as long – term sources available exceed total requirements of funds. For the other months short – term sources of finance should be arranged.

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Cost of financing under the compromise approach

Cost of short – term funds = [$27 000,00/12] * 3/100 = $2 250,00 * 3/100 = $67,50

Cost of long – term funds = [$79 500,00 * 12] * 8/100 12 = $79 500,00 * 8/100 = $6 360,00

Total cost of financing = $67,00 + $6 360,00 = $6 427,50

Summary

Financing plan

MaximumNet working

Capital($)

Degree ofRisk

Total costOf financing

($)

Level ofProfitability

HedgingCompromiseConservative

0.0010 500,0021 000,00

HighestIntermediateLowest

5 810,006 427,507 200,00

HighestIntermediateLowest

Concluding generalisationThe lower the net working capital, the higher the risk for technical insolvency and the higher the expected profits.

FACTORS BRINGING ABOUT CHANGES IN WORKING CAPITALA number of factors can explain the variations that take place to the amount of working capital that the entity experiences.

Changes in sales and operating expensesHigher levels of cash, inventories and debtors to support the increase in sales accompany an increase in sales volume. A decline in sales has the opposite effect. An increase in operating expenses must also be supported by a larger amount of working capital and vice versa.

Policy changesSome firms relate their current assets volume (current assets policy). A policy change affects the level of working capital. A change from a conservative policy (high level of current assets to sales) to an aggressive policy will have an impact on the level of working capital.

Technology changesTechnological developments can shorten the operating cycle. This reduces the need for working capital and vice versa.

DETERMINANTS OF WORKING CAPITAL

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The objective of working capital management is to have neither too much nor too little working capital. The following factors determine the amount of working capital required by a business.

General nature of businessBusinesses conducting their operations on a cash basis and service concerns, do not need to maintain large inventories as is required by businesses conducting their operations on credit. Manufacturing concerns require huge amounts of working capital.

Production cycleThe larger the production cycle, the larger will be the funds tied up and the larger the working capital needed and vice versa. A good example will be distilleries. Organisations having shorter production cycles for example bakeries do not need a huge investment in working capital.

Business cycleBusiness fluctuations lead to cyclical changes and shifts in working capital especially seasonal working capital. During a boom, there is greater need for additional working capital to meet increased demand. A decline in business activity is followed by a decrease in demand and a fall in inventories and book debts.

Production PolicyA steady production policy independent of shifts in demand leads to an accumulation of inventories during the off – season. This has to be supported by an additional investment in working capital, which remains tied up in inventories. Production matched to demand policy reduces the time working capital is tied up in inventories hence a reduction in investment in working capital.

Credit policyThe credit given by a firm to its debtors affects working capital. A liberal credit policy increases book debts and increases the need for additional working capital. This need is, however, reduced if the firm in turn is given liberal terms by its suppliers.

Growth and expansionOther things being equal, firms in growth industries require more working capital than static firms.

Vagaries in the availability of raw materialsThe availability of core raw materials on a continuous basis without interruption affects the requirement for working capital. If the raw material is not readily available, it may be necessary to build up inventories. This creates a need for additional working capital and vice versa.

22

InflationInflation necessitates the use of additional funds for maintaining even the existing level of activity. For the same level of working capital, higher cash outlays will be required. Thus inflation will create the need for a change in working capital.

Operational efficiencyChanges in operational efficiency also affect working capital. An improvement in operational efficiency produces more for a given level of inputs. Requirements for working capital will therefore be reduced and vice versa.

PRACTICE PROBLEMS

PROBLEM 1Santo Gas has forecast its total funds requirements for the coming year as follows:

Month AmountJanuaryFebruaryMarchAprilMayJuneJulyAugustSeptemberOctoberNovemberDecember

$7 400 000 5 500 000 5 000 000 5 300 000 6 200 000 6 000 000 5 800 000 5 400 000 5 000 000 5 300 000 6 000 000 6 800 000

3. Divide the firm’s monthly funds requirement into a permanent and a seasonal component and find the monthly average for each of these components.

4. Describe the amount of long-term and short-term financing used to meet the total funds requirement under (1) an aggressive strategy and (2) a conservative strategy.

5. Assuming short-term funds cost 10 percent annually and long-term funds cost 16 percent annually, use the averages found in a to calculate the total cost of each of the strategies described in b.

Discuss the profitability-risk trade-offs associated with the aggressive strategy and the conservative strategy.

PROBLEM 2What is working capital management? What is the objective of working capital management?

23

P Ltd has investigated the profitability of its assets and the cost of its funds. The results indicate:Current assets earn 1%Non – current assets earn 13%Current liabilities cost 3%Average cost of long – term funds 10%

The current balance sheet is as follows:

ASSETSNon – current assetsCurrent assets

LIABILITIESNon – current liabilitiesCurrent liabilities

$

30 00010 00040 000

35 000 5 00040 000

What is the net profitability? The company is contemplating lowering its net working capital to $3 500 by (i) either shifting $1 500 of current assets into non – current assets, or (ii) shifting $1 500 of its Non – current liabilities into current liabilities. Work out the profitability for each of these alternatives Which alternative do you prefer? Why? (d) Can both these alternatives be implemented simultaneously? How would it affect the net profitability?

PROBLEM 3

How are net working capital, liquidity, technical insolvency, and risk related? Why is an increase in a firm’s ratio of current to total assets expected to decrease both profits and risk as measured by net working capital Halgera Investment Limited has forecast its total fund requirements for the coming year as follows: Month Amount ($) Month Amount ($)JanuaryFebruaryMarchAprilMayJune

30 00030 00040 00060 000

100 000150 000

JulyAugustSeptemberOctoberNovemberDecember

200 000180 000110 00070 00040 00020 000

The firm’s cost of short term and long – term financing is expected to be 4% and 10% respectively.What is the basic premise of the hedging approach for meeting a firm’s funds requirements? What are the effects of this approach on the firm’s profitability and risk?

24

Calculate the cost of financing using the hedging approach What is the conservative approach to financing a firm’s funds requirements? Calculate the cost of financing using the hedging approach Indicate the basic profitability – risk trade – off associated with each of the these plans Calculate the cost of financing using the compromise approach Indicate any two factors that explain variations to the amount of working capital of an enterprise List any four determinants of a company’s working capital requirements

PROBLEM 4Jena limited forecast its seasonal financing needs for the next year as given below. Assuming that the firm’s permanent funds requirement is $4 million, calculate the total annual financial costs using the aggressive strategy and conservative strategy, respectively. Recommend one of the strategies under each of the following conditions:

Short-term funds cost 9% annually, and long-term funds cost 15 percent annually.Short-term funds cost 10% annually, and long-term funds cost 13 per cent annually.Both short term and long term funds cost 11 % annually

Month Seasonal requirements

JanuaryFebruaryMarchAprilMayJuneJulyAugustSeptemberOctoberNovemberDecember

$0

300 000 500 000 900 0001 200 0001 000 000 700 000 400 000 0 200 000 700 000 300 000

CHAPTER 3

CASH AND LIQUIDITY MANAGEMENT

25

Basic objectiveThe basic objective of cash management is to keep the investment in cash as low as possible while keeping the firm operating efficiently and effectively.

Motives for holding cashThere are three main motives for holding cash.

Speculative motiveThis is the need for the organization to hold cash to take advantage of additional investment opportunities such as bargain purchases.

Precautionary motiveThis is the need to hold cash as a safety margin. The cash balances held will act as a financial reserve.

Transaction motiveThis is the need to hold cash to satisfy normal disbursement and collection activities associated with the firm’s ongoing operations.

LIQUIDITY MANAGEMENTLiquidity management is concerned with the establishment of optimal quantity of liquid assets a firm should have on hand. It is one particular aspect of current asset management.

CASH MANAGEMENTCash management is concerned with optimising mechanisms for collecting and disbursing cash.

No discussion on cash management can be meaningful without highlighting the concept of float and how it is managed.

FLOATFloat is the difference between book cash (ledger balance) and bank cash (available or collected balance). The difference represents the net effect of cheques in the process of clearing. There is a disbursement float and a collection float.

Disbursement floatThis float emanates from cheques written by the firm. The cheques written decrease the firm’s book balance but with no immediate change to its available balance.

Collection floatCollection float emanates from cheques deposited by the firm. It increases the firm’s book balance but with no immediate change to its available balance.Float managementThis involves controlling the collection and disbursement of cash. When collecting cash, the objective is to speed up collection and reduce the lag between the time customers pay their bills and the time it becomes available.

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The objective of cash disbursement is to control payments and minimize the firm’s costs associated with making payment.

The disbursement float has three parts:Mailing time This is the time when cheques are trapped in the postal system.

Processing delay It is the time it takes the receiver of a cheque to process the payment (issuing a receipt) and depositing it in a bank for collection.

Availability delay This is the time required to clear a cheque through the banking system.

Systematic over drafting/cheque kitingThis refers to the use of funds that are not yet available. (Issue of cheques against uncollected cash). It is illegal.

COLLECTION AND CONCENTRATIONEarlier own it was indicated that the objective of cash collection is to speed up collections and reduce the lag between the time customers pay their bills and the time cash becomes available. To understand the techniques involved, it is preferable to highlight how cash is collected first and then illustrate how the collection itself can be speeded up.

Cash collection process

Customer Company Company Cash makes receives deposits becomes payment payment payment available

Time

Mailing processing availability Time delay delay

Collection time

LOCK BOX COLLECTION SYSTEMEmploying the lock box collection system can speed up cash collections. The system requires the setting up of special post office boxes to intercept payments for accounts receivable. A local bank maintains a lock box. The bank collects cheques several times a day and deposits them directly to the company’s account.

Customer customer customer customer Payments payments payments payments

27

Post office post office Box 1 box 2

Local bank collects funds from Post office boxes

Envelopes opened, deposit slip Prepared

Details deposit of cheques Receivables into bank account Sent to firm

Firm processes bank cheque clearing Receivables system

Fig. Overview of the lock box processing

Advantages of the lock box arrangement The lock box system reduces mailing time as cheques are received at

a nearby post office instead of head office. Processing time is also reduced.

CASH CONCENTRATIONThis is another technique that can be adopted to speed up collections. Cash concentrations are procedures for moving cash from multiple banks into the firm’s main accounts. A concentration bank pools the funds obtained from local banks contained within some geographic area.

Customer customer Payments payments

28

Firm sales Office

Customer Payments

Local bank Post Office Deposits lock box receipts

Customer Payments

Concentration Bank

Firm Cash Manager

Maintenance Disbursements Short term Maintenance Of cash reserve activities investments compensating Of cash balances at Creditor bank

Fig. Lock boxes and concentration banks in cash management system

Advantages of cash concentration1. Cash collections end up in many different banks and bank accounts.

By routinely pooling its cash the firm simplifies its cash management by reducing the number of accounts to be tracked.

2. By having a large pool of funds available, the firm can negotiate better rates on short – term investments.

Increasing disbursement floatThe following techniques can be used to increase the disbursement float. It should be borne in mind that one of the objectives of disbursement management is to delay making a payment as long as is legally and

29

practically possible. In pursuing this objective the firm should not compromise its relationship with the suppliers as these may withdraw trade credit.

Writing out cheques on a geographically distant bank. Mailing checks from remote post offices.

These two techniques are an example of what is sometimes referred to as “playing the float game”

CONTROLLING DISBURSEMENTSThe general idea of disbursement management is to have no more than the minimum amount necessary to pay bills held in the company’s disbursement accounts. The following two approaches can be adopted to achieve this objective.

Zero – balance accountsThis sis a disbursement account in which the firm maintains a zero balance, transferring funds in from a master account only as needed to cover cheques to be presented for payment. This way a safety balance is only maintained in the master account. The arrangement frees up cash to be used elsewhere.

No zero – balance accounts Two zero – balance accounts

Payroll Supplier Master account Account Account Safety balance ******** ******* *****************

cash cash transfer transfer

safety balances payroll supplier account account

Fig. Zero – balance accounts

Controlled disbursements accountsThese are accounts to which the firm transfers an amount that is sufficient to cover demands for payment. Amounts to be paid that day are known in advance and the bank notifies the firm to effect the necessary funds transfer.

CASH OPERATING CYCLEA cash operating cycle can be defined as the period from payment for raw materials to receipt of money from debtors. The period represents the time that the firm’s cash is tied up in its operations. The basic strategy behind the

30

cash operating cycle is to reduce the cash operating cycle as much as is possible without adversely affecting the operations of the firm.

Computation of the cash operating cycleA cash operating cycle is made up of conversion periods. The starting point would be to calculate the various conversion periods and finally calculate the cash operating cycle.

The conversion periods are calculated as follows:

Raw materials conversion time (RMCT) This is the average time from purchase of raw materials to when they actually enter the production process.

RMCT = Value of raw materials in stock Raw materials consumed per day

Creditors conversion time (CCT) This is the period from purchase of raw materials on credit to when the firm actually makes cash payment for the raw materials.

CCT = Value of creditors Purchases of raw materials per day

Work – in –progress conversion time (WIPCT) It is the average time taken to convert raw materials into a finished product. It is also known as the average production period.

WIPCT = Value of work – in – progress Cost of goods manufactured per day

Finished goods conversion time (FGCT) It is the average time taken to sell goods that have come out of the production line.

FGCT = Value of finished goods Cost of goods sold per day

Debtors conversion time (DCT) This is the period from when goods are sold to when the firm receives payment from debtors. It is also known as the average credit period taken by debtors.

DCT = Value of debtors Value of sales per day

COC = RMCT – CCT + WIPCT + FGCT + DCT

CCT is deducted because during that period the firm would not have been paid cash for raw materials.

EXAMPLE

31

The following information has been collected for the purpose of calculating the cash operating cycle.

31 December 2000 2001 $ $

Credit salesPurchases of raw materialsRaw materials consumedCost of goods manufacturedCost of goods soldDebtorsCreditorsStocks: Raw materials Work in progress Finished goods

3 240 000 1 125 0001 080 0002 160 0001 800 000

540 000156 250

90 00060 00025 000

3 600 0001 687 5001 440 0002 880 0002 700 000

800 000375 000

60 000120 000

75 000

Assuming a 360 day year calculate the cash operating cycle for both years. Comment on the change that you arrive at.

Solution2000

RMCT = $90 000/($1 080 000/360) = $90 000/3 000 = 30 days

CCT = $156 250/($1 125 000/360) = $156 250/3 125 = 50 days

WIPCT = $60 000/($2 160 000/360) = $60 000/6 000 = 10 days

FGCT = $25 000/($1 800 000/360) = $25 000/5 000 = 5 days

DCT = $540 000/($3 240 000/360) = $540 000/9 000 = 60 days

COC2000 = 30 – 50 + 10 + 5 + 60 = 55 days

2001= $60 000/($1 440 000/360)= $60 000/4 000= 15 days

= $375 000/($1 687 000/360)= $375 000/$4 687,50= 80 days

=$120 000/($2 880 000/360)= $120 000/8 000= 15 days

= $75 000/($2 700 000/360)= $75 000/7 500= 10 days

= $800 000/($3 600 000/360)= $800 000/10 000= 80 days

COC2001 = 15 – 80 + 15 + 10 + 80 = 40 days

CASH MANAGEMENT MODELSThere are two main cash management models, the Baumol – Allais – Tobin (BAT) model and the Miller – Orr model.

32

BAUMOL – ALLAIS – TOBIN (BAT) MODELThe aim of this model is to calculate the optimal amount of marketable securities to be liquidated whenever the concern requires cash. The calculated level of marketable securities will maximise interest received on marketable securities while minimising the cost of selling marketable securities.AssumptionsThe BAT model is based on the following two assumptions:

a) Cash is instantaneously replenished.b) There is a gradual use of cash.

Cash ($)

C/2 (average cash)

TimeFig. The Baumol – Allais – Tobin model

As can be seen from the above diagram, the BAT model is based on the inventory management’s economic order quantity (EOQ)

Optimal replenishment for the firm

= 2 * annual cash disbursement * cost of sale of securities Interest rate

EXAMPLEA company has an average cash disbursement of $1 200 000,00 per year. The company holds its monetary resources as cash or marketable securities. The marketable securities carry an interest rate of 20 percent and it costs the company $15,00 to convert any amount of marketable securities into cash.

Compute the optimal amount of marketable securities to be converted into cash whenever securities are sold.

SolutionMarketable securities to be liquidated = 2 * $1 200 000,00 * $15,00 0.20

= $13 416,41

Marketable securities worth $13 416,41 should be sold at each liquidation.

33

Problems with the BAT modelThe model has two main problems emanating from the underlying assumptions of the model.

Cash is not always instantaneously replenished. Cash is also not gradually used. Cash movements are generally

random.

MILLER – ORR MODELThe Miller – Orr model is a stochastic model that aims at determining the amount of marketable securities to be sold or purchased whenever there is need for such transactions. A stochastic model is a model based on real life assumptions.

The model indicates that the firm sells marketable securities when a lower limit of cash is reached. Marketable securities are purchased when the upper limit of cash is reached as it becomes necessary to reduce cash.

Cash ($)

Purchase marketable securities

Maximum cash

Return point

Spread

Minimum cash Sell marketable securities

TimeFig. The Miller – Orr model

Begin by determining the lower limit of cash. This is the preferred minimum cash balance and it could be the cash that may be required for precautionary purposes for example.

Calculate the spread. The spread is the difference between the upper limit and lower limit of cash. It is obtained by using the following formula:

Spread = 3 * 3 ¾ * Transaction costs * daily variance of cash flows Daily interest rate

34

Calculate the maximum cash (upper cash limit). To obtain the maximum cash use the following approach:

Maximum cash = Minimum cash + Spread

Calculate the return point. The return point is the point to which the cash balance should return when marketable securities are purchased or sold.

Return point = Lower Limit + [Spread/3]

When these values are known, the amount of marketable securities to be bought or sold can now be established.

Cash replenishment (Value of marketable securities to be sold) = Return Point – Lower Limit.

Cash reduction (Value of marketable securities to be bought) = Upper Limit – Return Point.

EXAMPLEA company has a minimum balance of $15 000,00 and a standard deviation of daily cash flows of $5 000,00. An annual interest rate of 9 percent can be obtained on marketable securities. Transaction costs for sale or purchase of securities is $15,00.

Assuming a 360-day year what amount of marketable securities should the firm sell or buy whenever such transactions are required?

SolutionVariance = Standard Deviation2

= $5 000,002

= $25 000 000,00

Daily interest rate = 0.09/360 = 0.00025

Spread = 3 3 ¾ * $15,00 * $25 000 000,00 0.00025

= $31 201,26

Upper limit = $15 000,00 + $31 201,26 = $46 201,26

Return point = [$15 000,00 + ($31 201,26/3)] = [$15 000,00 + $10 400,42]

35

= $25 400,42

Marketable securities to be purchased = $46 201,26 - $25 400,42 = $20 800,84

Marketable securities to be sold = $25 400,42 - $15 000,00 = $10 400,42

Problem with the miller – Orr modelThe problem with the Miller – Orr model lies in the determination of the firm’s daily cash flow variance.

BANKING POLICYOrganisations that make regular bank deposits should come up with a banking policy. The objective of coming up with such a policy is to establish an optimal banking frequency. Greater banking frequency brings in more interest but it results in higher banking costs such as transportation, labour, security and stationery.

EXAMPLEGore Ltd has annual cash receipts of $50 000 000,00 that are spread evenly over the 50, 5 day working weeks in a year. Within each week, receipts on Monday, Thursday and Friday are twice as much as those on Tuesday and Wednesday. At present all monies are banked on Friday. A daily banking proposal has been made. The firm estimates that the total cost of each banking is $600,00. The firm always maintains a credit balance that is presently receiving interest at 36 percent per annum.

RequirementUsing simple daily interest and weekly analysis, should the new proposal be adopted?SolutionWeekly cash receipts = $50 000 000,00/50 = $1 000 000,00Daily rate of interest = 36/360/100 = 0.00100Breaking down the weekly sales into daily salesDay Factor ReceiptsMondayTuesdayWednesdayThursdayFriday

211228

2/8 * ($1 000 000,00) = $250 000,001/8 * ($1 000 000,00) = $125 000,001/8 * ($1 000 000,00) = $125 000,002/8 * ($1 000 000,00) = $250 000,002/8 * ($1 000 000,00) = $250 000,00

Computation of interest lostLost interest: Friday banking (current policy)

Day Receipts ($)Idle

Days Lost interest

36

MondayTuesdayWednesdayThursdayFriday

250 000,00125 000,00125 000,00250 000,00250 000,00

43210

0.00100 * $250 000,00 * 4 =$1 0000.00100 * $125 000,00 * 3 = $ 3750.00100 * $125 000,00 * 2 = $ 2500.00100 * $250 000,00 * 1 = $ 2500.00100 * $250 000,00 * 0 = $ 0 $1 875

Total cost = Banking cost + Lost interest

Total cost (current policy – Friday banking)Banking cost = $600,00 * 1 = $600,00Lost interest = $1 875Total cost associated with current policy = $600,00 + $1 875,00 = $2 475,00

Total cost – Proposed policy (Daily banking)Banking cost = $600,00 * 5 + $3 000,00Lost interest = NIL (as all proceeds will be banked daily)Total cost = $3 000,00 + $0 = $3 000,00

The new proposal (daily banking) should be rejected as it has higher costs.

PRACTICE PROBLEMS ON CASH AND LIQUIDITY MANAGEMENT

PROBLEM 1The managing director of your company has seen a statement in the financial press which suggests that at all times, but particularly when liquidity is a problem, management should pay particular attention to the cash operating cycle.

6. What is a cash operating cycle?7. From the information given below, prepare a memorandum for the managing director, commenting on the cash operating cycle and suggesting how it might be improved.

Year 1 Year 2Stock – Raw materials8. Work in progress9. Finished goodsPurchasesCost of goods soldSalesDebtorsCreditors

20 00014 00016 00096 000

140 000160 000

32 00016 000

27 00018 00024 000

130 000180 000200 000

48 00019 500

PROBLEM 2Gamwa Ltd is a company that operates a retail outlet, oil processing and bakery at Nyaningwe Growth point. The growth point is 60 kilometers away

37

from Masvingo, which is the nearest place, where banking facilities can be obtained.

The current practice is to bank the receipts for the previous day on a daily basis, i.e. 6 times a week. The company would like to review the situation given the costs that are involved in daily banking.

It ahs been established that the company spends $100,00 on fuel and pays a security guard $200,00 for each banking. In addition, it is estimated that the company incurs $300,00 in lost profit because the truck is being used for banking duties instead of other deliveries.

The proposal under review is that the company banks only on Tuesday and Friday. On these days the company has a larger truck, which goes to Masvingo to collect goods, therefore there would be no additional costs to the firm in terms of furl and lost profit. The company is currently not utilizing this truck to carry cash. If the two day banking is adopted the company would still be required to pay the guard $200,00 for the 6 days because of a contract that the company has with the security firm although he will be idle.

The company makes daily cash receipts of $160 000,00, 7 days a week and any money banked is used to reduce an overdraft facility which carries an interest rate of 36%

Requirement10.Should the company change its banking policy?11.What other factors would you have to take into account before making a final decision on whether or not to change the banking policy?

PROBLEM 3The cash balances of Northlea Investments Ltd have declined significantly over the last 12 months. The following financial information is provided:

Year to December

SalesPurchases of raw materialsRaw materials consumedCost of goods manufacturedCost of goods soldDebtorsCreditorsStocks:12.Raw materials13.Work in progress - Finished goods

2002$

573 000215 000210 000435 000420 00097 10023 900

22 40029 00070 000

2003 $

643 000264 000256 400515 000460 000121 50032 500

30 00034 300

125 000

All purchases and sales are made on credit.

38

Calculate the cash operating cycle for 2002 and 2003.State the strategies that Northlea Investments Ltd can use to reduce the cash operating cycle.Is having knowledge on the cash operating cycle likely to be of value to an organization? Briefly explain.

CHAPTER 4

MANAGEMENT OF DEBTORS

39

There are two important issues to look at when one looks at the management of debtors from a financial management point of view. The first issue deals with what the organisation looks at before granting credit to prospective clients. The other deals with the nature of evaluation to be undertaken before the organization can change its credit policy.

Credit granting decisionsBefore the organization can grant credit to an applicant, it has to consider five (5) “Cs”.

Character The organisation conducts an analysis to determine if the prospective customer will try to honour an obligation. The organization looks at the applicant’s payment record with other entities to get an indication of the applicant’s character.

CapacityCapacity is the ability of an applicant to pay the obligation. To get an indication of the applicant’s capacity the organization looks at the income generating capacity of the applicant.

CapitalCapital in this context will be the net worth and financial position of the applicant. Ratio analysis will be used by the organization when evaluating the applicant.

CollateralCollateral refers to the assets pledged by the applicants as security for the credit facility. The organisation looks at the value and liquidity of the assets pledged by the applicant.

ConditionsThese are general macroeconomic conditions prevailing. These affect the applicant’s ability to honour an obligation.

Credit termsCredit terms reflect the business conditions that the organisation will have agreed with its customers.

Consider the following: 2/10 net 30

This statement means that a debtor obtains 2 percent discount on the invoice price if they pay within 10 days otherwise the full invoice price is due within 30 days.

Effective discount

40

Firms should set cash discounts carefully. If the cash discount is high, less cash is received from a given sale. To establish if the discount is acceptable, the firm has to compute the effective discount rate.

The effective discount is computed as follows;

Effective discount = Discount percentage * 365 (100 – discount percentage) (Credit period – discount period)

A firm should not give discounts whose effective rate is higher than the return on invested funds.

EXAMPLEA firm considers a return on investment of 35 percent as adequate. Given this required rate of return, are the following credit terms: 2.10 net 30 acceptable?

SolutionCompute the effective discount rate and compare it with the required rate of return.

Effective rate = 2/[100 – 2] * 365/[30 – 10] = 2/98 * 365/20 = 0.0204 * 18.25 = 37.24%

These credit terms are unacceptable as the effective discount rate is higher than the required rate of return on investment.

CHANGING CREDIT TERMSCredit terms in operation at one time may not always remain ideal terms for all times to come. Because of changing circumstances, it may become necessary to evaluate the need to change credit terms.

The following circumstances may trigger the need for change of policy:1) Customer complains.2) Changes in environment and competition.3) Observation from the credit control department.

EXAMPLEManagement of Jive Investments Ltd is considering changing the credit policy to attract customers who have moved to competitors with more favourable terms. The firm, which sells all goods on credit, presently sells 135 000 units at a price of $20,00 per unit. The change in credit policy would result in an increase in the number of units sold to 160 000 but the price will remain the same.

The present terms offered by the firm are 1/10 net 20. The suggested credit terms are 3/15 net 45. At present 25 percent of the customers take advantage of the 1 percent discount. With the new policy it is expected that 30 percent of the customers will take advantage of the new discount.

41

The average collection period is expected to increase from the current 18 days to 45 days. The variable cost ratio is 80 percent and is expected to remain unchanged. The bad debt loses are expected to change from 5 percent to 1.5 percent of sales for which cash discounts are not taken. The opportunity cost associated with an investment in working capital is 30 percent per annum.

RequiredEvaluate the proposal and indicate to management if the new policy should be implemented.

SolutionA change in policy affects sales, debtors, bad debts and cash discounts.

SalesThe organisation should be interested in a change in contribution.Computation of contribution per unit:Unit selling price $20,00Unit variable cost (80% * $20,00) 16,00Contribution per unit 4,00

Change in contribution = Change in units * contribution per unit = 25 000 * $4,00 = $100 000,00

Bad debtsBad debts = Credit sales for which discount is not taken * bad debt percentage (%) = Sales * (1 - % of customers taking discount) * Bad debt percentage

Bad debts before changeCredit sales = 135 000 * $20,00 = $2 700 000,00

Bad debts = $2 700 000,00 * (1 – 0,25) * 5/100 = $2 700 000,00 * (0.75) * (0.05) = $101 250,00

Bad debts after changeCredit sales = 160 000 * $20,00 = $3 200 000,00

Bad debts = $3 200 000,00 * (1 – 0.30) * 1.5/100 = $3 200 000,00 * (0.70) * (0.015) = $33 600,00

Decrease in the level of bad debts = $101 250,00 - $33 600,00 = $67 650,00 Cash discounts

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Cash discount = Sales * Percentage of customers taking discount * discount percentage.

Discounts before change = $2 700 000,00 * 25/100 * 0.01 = $6 750,00

Discounts after change = $3 200 000,00 * 30/100 * 0.03 = $28 800,00

Change in discount = $6 750,00 - $28 800,00 = ($22 080,00)

Carrying cost of debtorsThe carrying cost of debtors is computed in two parts: the carrying cost of incremental sales and the carrying cost of old sales.

Carrying cost of incremental salesCarrying cost of incremental sales = (New ACP/365) * cost of incremental sales * opportunity cost of funds.

Cost of sales = Change in sales * variable cost ratio = $500 000,00 * 0.80 = $400 000,00

Carrying cost of incremental sales = 45/365 * 4400 000,00 * 0.30 = ($14 794,52)

Carrying cost of old sales = (Change in ACP/365) * old sales * opportunity cost

Carrying cost of old sales = (45 – 18)/365 * $2 700 000,00 * 0.30 = 27/365 * $2 700 000,00 * 0.30 = ($59 917,81)

Change in debtor carrying cost = ($14 794,52) + ($59 917,81) = ($74 712,33)

Summary

Change in contributionChange in debtor carrying costsChange in bad debtsChange in cash discounts

$100 000,00(74 712,33)67 650,0022 050,0070 887,67

The policy should be implemented.

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PRACTICE PROBLEMS ON MANAGEMENT OF DEBTORS

PROBLEM 1The directors of Tawedzerwa Ltd are considering changing their credit policy to attract customers who have moved to their competitors with favourable credit terms.

The current policy calls for 3/15 net 30. Of the current $2,6 million sales, $2,4 million are on credit and 70 per cent of the customers take advantage of the 3 per cent discount. The new credit policy would call for 5/10 net 60 and only 60 per cent of the customers are expected to take advantage of the cash discount. The average collection period is expected to increase from the current 20 days to 30 days. Sales are expected to increase to $2,9 million if the new credit terms are used, with cash sales remaining constant. The gross profit margin of 20 per cent is expected to remain unchanged, as well as the bad debt losses which amount to 2 per cent of sales for which cash discounts are not taken.

The opportunity cost associated with an investment in working capital is 20 per cent per annum.

RequirementMake calculations to show the effect of these changes, and to advise the directors whether they would be financially justified to change the policy, andState what factors should the directors consider before changing the credit policy.

PROBLEM 2A firm is trying to decide whether to change its credit policy in order to meet increased foreign competition. The present credit terms of the firm are 2/5 net 30. The firm makes sales of $2 400 000 annually, the average collection period is 36 days and 20% of customers take the discount. The bad debts are 1.5% of sales for which a discount is not taken.

The alternative that is being considered by the firm is to change the credit terms to 3/15 net 45. This is expected to increase sales to $3 000 000 annually, increase the average collection period to 48 days, decrease bad debts by 0.5% and increase customers taking discount to 40%.

In addition it is expected that because of the increased sales the amount of cash held by the firm will increase by $50 000 and the amount of inventories by $100 000.

If the cost of the short term financing is 30% and the firm’s variable cost ratio is 75% determine whether the firm should adopt the new policy.

CHAPTER 5

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INVENTORY MANAGEMENTInventories are idle goods in storage waiting to be used. They include raw materials, work in progress and finished goods.

Importance of inventories1. Inventories act as a buffer to decouple or uncouple the various

activities of the firm so that all do not have to be pursued at exactly the same rate. These activities are purchasing, production and selling.

2. Inventories smooth out time gap between supply and demand.3. Holding inventories may contribute to lower production costs. This is as

a result of bulk purchases.4. Inventories provide a way of “storing” labour (make more now, free up

labour later).5. Inventories can provide quick customer service (convenience).

Objective of inventory managementThe basic objective of inventory management is to establish optimal levels of investment in inventories.

Inventory management techniques/models

ABC ClassificationStoreroom inventory is classified into categories called ABC.

“A” These are items of the highest priority. They are outstandingly important and require the tightest controls. They require close follow up and accurate records. 10 percent of the category A items volume accounts for 70 percent of the total inventory value.

“B’’ These are items of average importance. The items are the priority when low or out of stock. Normal controls are used and good records should be maintained for these items. ‘’B’’ items account for 20 percent of the total inventory value and 20 percent of the inventory volume.

“C” These are relatively unimportant items. They are items of lowest priority. They require the simplest methods of control. Minimum/Maximum controls can be used for ordering these items. The items are usually expensed, as there are no records for them. These items represent 10 percent of the total value and 70 percent of the volume.

Managing inventories by ABCABC analysis is the method of classifying items involved in a decision situation on basis of their relative importance. Its classification may be on the basis of monetary value, availability of resources, and variations in lead – time or part criticality to running of a facility. Management needs to look at a descending dollar and volume chart in order to make decisions on ABC analysis.

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Economic Order Quantity (EOQ)/Re- order QuantityThe economic order quantity is the amount of orders that minimizes total variable costs required to order and hold inventory. This decision requires a trade off illustrated below:

Trade offsOrdering more frequently

Higher ordering costsSmaller average inventoryLower inventory holding costs

Vs. Ordering less frequently

Lower ordering costsLarger average inventoryHigher inventory holding costs

Costs of holding inventory

Ordering costs/acquisition/set – up costsThese are costs involved in preparing a purchase order or requisition form and receiving, inspecting and recording of goods received to ensure both quantity and quality.

Carrying costsThey are storage costs like depreciation, warehouse insurance, insurance of inventory against fire and theft, clerical and accounting costs and opportunity cost of funds.

EOQ ModelFor every two items held in inventory, two questions have to be asked.

a) When should a replenishment order be placed?b) How much should be ordered?

The EOQ model answers these questions.

EOQ AssumptionsThere are three main assumptions associated with the EOQ model:

There is a single product with a constant and known demand rate. Goods arrive at the same day they are ordered. No shortages are allowed. The organisation re – orders inventory when

the inventory reaches zero (0).

Q* = 2C0D CH

Where C0 = ordering cost (fixed cost to place an order). D = annual demand in units. CH = holding cost per item per unit of time (e.g. per year). Q* = optimal quantity to be ordered (EOQ).

EXAMPLE

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A firm’s inventory planning period is one year. Its inventory requirement for this period is 1 600 units. Assume that its acquisition costs are $50,00 per order. The carrying costs are expected to be $1,00 per unit per year for an item.

The firm can produce inventories in various lots as follows:1. 1 600 units2. 800 units3. 400 units4. 200 units5. 100 units.

Which of these order quantities is the EOQ?

Method 1

Number of orders = Total inventory requirement Order size

Average inventory = Order size 2

Inventory cost for different order quantities12345678

Size of order (units)Number of ordersCost per orderTotal ordering cost (2 * 3)Carrying cost per unitAverage inventory (units)Total carrying cost (5 * 6)Total cost (4 + 7)

1 6001

$50,00450,00

41,00800

$800,00$850,00

8002

$50,00$100,00

$1,00400

4400,00$500,00

4004

$50,00$200,00

$1,00200

$200,00$400,00

2008

$50,00$400,00

$1,00100

$100,00$500,00

10016

$50,00$800,00

$1,0050

$50,00$850,00

The economic order quantity is 400 units as this is the one that minimizes total costs.

Method 2

Short – cut approach (Mathematical approach) EOQ = 2 * 1 600 * $50,00 1 = 400 units

MATERIAL REQUIREMENT PLANNING (MRP)This is a scheduling procedure for production processes that have several levels of production. Given information describing the production requirements of the several finished goods of the system, the structure of the production system, the current inventories for each operation and the lot sizing procedure

47

for each operation, MRP determines a scheduling for the operations and raw material purchases.

MRP is a system that dissects products into materials and parts necessary for purchasing, inventorying, and priority planning purposes. By using a computer a manager can analyse product design specifications to pinpoint all the materials and parts necessary to produce the finished product. Merging this information with computer inventory records assists management to know the quantities of each part in inventory and when each is likely to be used. MRP ensures that the right materials are available when needed.

MANUFACTURING RESOURCE PLANNING (MRP II)MRP II is a well – defined formal system used in manufacturing. It is a philosophy, which brings together all parts of the organisation using tools to plan activities rather than reacting to circumstances.

MRP II is an established technique for making materials and other production resources available in harmony with the organization`s production plan. It is a system that ensures that inventory is balanced in demand. The MRP II routine draws information from many other areas of the organization`s system, to make suggestions about purchase and works orders that need to be placed, and others that should be cancelled or re – scheduled. The system can run as often as the organization wishes, and is frequently run as a daily routine.

The information provided by MRP II helps to strengthen the team – working between production and purchasing. Panic buying and overstocking can become a thing of the past leading to predictable prices and smoother production. MRP II calculates requirements for goods, sub – assemblies and raw materials and links back to the purchase order schedule.

MRP II can lead to improved inventory management and a cut in overall programme costs.

JUST IN TIME (JIT)/ LEAN MANUFACTURINGJust in time is a manufacturing philosophy, which leads to the production of the necessary units in necessary quantities at the necessary time with the required quality. It is an approach to achieving excellence in the reduction of or total elimination of waste. Waste here refers to non – value added activities. The waste takes the following forms: overproduction, unneeded inventory, defective products, transport and waiting time.

JIT manufacturing can be referred to as a system of enforced problem solving. It is referred to as such since managers have the choice between putting a huge effort in finding and solving causes of production problems, or they can live with an intolerable level of interruptions in production. This is a situation where one has to put huge efforts (money and personnel) and is highly undesirable and is therefore an enforced system.

PRACTICE PROBLEMS ON INVENTORY MANAGEMENT

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PROBLEM 1Manikai Ltd has just been awarded a five year contract with its only customer to buy up to 20 000 tonnes of the customer’s black peppercorn each year. The contract allows Manikai Ltd to take delivery of any multiple of 1000 tonnes it likes at any time during the year. The supply contract stipulates, however, that the peppercorn cannot be resold but must be used in the company’s production of peppers. This process is carried out continuously throughout the year.

The company estimates that ordering and receiving costs per batch of peppercorns will amount to $500 per batch irrespective of the batch size. In addition to the above, before the peppercorns are stored they must be sprayed with a preserving chemical at a cost of $20 per tonne.

The peppercorns will be stored in special silos with a capacity of 1 100 tonnes. Each silo will cost $9 500 and incurs maintenance costs of $100 per annum. The silos will have a life of five years. Other stock holding costs will amount to $5 per tonne per annum.

The company’s cost of capital is 10%

Requirement14.Calculate the economic order quantity, ignoring the silo costs and state the number of orders that will be placed each year.15.Calculate the total costs of stock holding and stock ordering per annum.16. Calculate how many silos should be built if it is the company’s objective to minimize overall costs. You may assume that all cash flows except the costs of constructing the silos occur at the end of the relevant years. Ignore inflation and taxation.17.Discuss the disadvantages of using the simple economic order quantity formula.

CHAPTER 6

SOURCES OF FINANCE

49

This section looks at medium to long – term sources of finance available to organizations.

EQUITY

Fundamental rights and privileges of equity holdersLimited liability Shareholders cannot lose more than they have

invested in organization.Transfer rights Shareholders may give away or sell shares to

anyone they chose.Dividends Shareholders share the profits of the company if

dividends are declared. There is no guarantee of dividend.

Pre - emptive Shareholders have the right to subscribe proportionately to any new share issue.

Voting Shareholders have the right to vote at annual general meetings.

Residual claims to assets

On cessation, shareholders have the right to corporate assets after claims and other security holders` claims are satisfied.

The advantages and disadvantages of the sources of finance will now be discussed. The advantages and disadvantages will be looked at from the perspective of the company since it is the company that will be in need of financing.

Advantages of equity

Fixed contractual paymentWith equity there is no fixed contractual payment. Dividend payment is not a right to shareholders. This gives flexibility to the company in using corporate funds.

MaturityPerpetual equity has no maturity dates. The company need not save money for redemption of equity.

Restrictive covenantsDebt agreements place restrictions on the company’s operations. Equity has no such restrictions.

Disadvantages of equity

Diversity of shareholdersEach new issue brings additional owners. This increases the diversity of interests that the company has to accommodate.

Income dilution

50

Existing shareholders share the income with new shareholders. This dilutes earnings of present shareholders if the additional funds are not used to generate additional income.

Non – tax deductibility of dividendsUnlike interest on debt, dividends are not tax deductible. Other things being equal equity therefore becomes more expensive compared to debt.

Cost A new share issue is usually more expensive than debt. This is because with each new issue, floatation costs, underwriting and legal fees are incurred.

PREFERENCE SHARESPreference shares are generally used because of their flexibility. Preference dividends can be passed unlike interest on debt. In addition, issuing preference shares does not dilute ownership.

Advantages of preference share capital

Passing dividendsPreference dividends can be passed without penalty unlike debt.

Ownership dilutionUnlike equity, preference shares do not dilute ownership.

Indenture termsUnlike debentures, preference shares do not carry strict restrictions. This gives flexibility to the organization, as there will not be too many restrictive covenants.

MaturityFor perpetual preference shares there is no need to set aside funds for redemption.

Disadvantages of preference share capital

CostPreference shares have a higher yield than debentures because they are more risky than debentures.

TaxationDividends are not tax deductible. Interest on debt is tax deductible.

AccumulationPassed dividends are usually cumulative.

DEBT FINANCING

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Features1. It carries a fixed rate of interest.2. Interest on debt has to be paid whether profits are earned or not.3. Debt has a preferential claim to assets in the event of liquidation.

Advantages of debt financingFixed costInterest on debt is fixed. Being fixed, debenture holders do not participate in any residual income.

Lower yieldYield on debentures is usually lower than that on preference shares because of lower risk. This means that the use of debentures lowers the firm’s weighted average cost of capital.

ControlThe use of debt instead of instead of ordinary shares does not dilute control. This is because debenture holders are lenders and are not involved in the management of the organization unless the organisation is not up to date obligation payments.

TaxationCost of debt is lowered because interest on debt is a tax – deductible expense. This leads to tax savings by the company.

Disadvantages of debt financingContractual obligationA contractual obligation (interest payment) is entered into and this results in financial risk. There is no flexibility in terms of interest payments. Non – payment of interest can lead to bankruptcy.

Fixed maturityDebt financing is usually of fixed maturity and the principal has to be repaid. This can create serious cash flow problems for the organisation when the debt matures unless the organisation would have created a sinking fund investment arrangement.

Restrictive covenantsDebenture agreements can stifle the company’s operations. The provisions on dividends and further borrowing could run contrary to corporate policy.

LEASE FINANCINGA lease is a contractual arrangement under which the owner of an asset (the lessor) agrees to allow the use of his assets by another party (the lessee) in exchange for periodic payments (lease – rents) for a specified period of time.

Types of leases

52

Operating leaseThis is an arrangement in which the lessee acquires the use of an asset on a period – to - period basis. The period is relatively short for example 6 months to 1 year. The lease can be cancelled at the option of the lessee. The operating lease is generally more expensive than a financial lease.Financial leaseA financial lease is an arrangement that involves a relatively longer – term commitment on the part of the lessee. The lease cannot be cancelled. The lessee is responsible for maintenance so this arrangement is less expensive from the lessor`s point of view.

Sale and lease backThe firm sells an asset it already owns to another party and leases (hires) it back from the buyer. It is an option preferred by firms facing liquidity problems. This is the option that was taken by OK with their first street building.

Direct leaseThe lessee identifies the asset they would want to use and arranges for a leasing contract with the manufacturer. The manufacturer will be the lessor with this type of lease.

Leveraged lease (Third party lease)The lessor borrows funds from the lender, who will normally be a financial institution. The funds are needed to fund acquisition of the asset. The lessor then services the debt using the lease payments charged to the lessee.

Leasing as a financing decisionLessee’s point of viewThe evaluation of leasing as a source of finance decision will be looked at from the point of view of the lessee since it is the lessee who would be in need for finance.

Evaluation procedure(a) Determine the after tax cash outflows for each year under the lease

alternative. This will be arrived at by multiplying the lease payment with the tax adjustment.

After tax lease rental = L (1 – t)

(b) Determine the after tax cash outflows for each year under the buying alternative based on borrowing. The amount = Loan instalment (Gross cash outflow) less tax advantage of interest (I * t) less tax shield due to depreciation allowance.

(c) Compare the present value of the cash outflows associated with leasing and buying alternative by employing after tax cost of debt as the discount rate for the purpose.

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(d) Select the alternative with a lower present value of cash outflow.

EXAMPLEHot Spot Ltd wishes to access a machine for 5 years. Financial institutions are prepared to arrange a lease or lent the required amount at 14 percent to acquire the machine.

The firm’s tax rate is 50 percent.

If leasing is chosen the organization will pay annual end of year lease rentals of $120 000,00 for 5 years. All maintenance, insurance and other costs are to be borne by the lessee.

If the machine is bought, at a cost of $343 300,00, the firm would have a 14 percent five year loan to be paid in five equal annual instalments, each instalment becoming due at the end of each year. The machine would be depreciated on a straight – line basis with no salvage value.

RequiredAdvise the company which option to choose assuming lease rentals are paid:

a. At the end of the yearb. In advance.

Solutiona. After tax lease payment = $120 000,00 * (1 – 0,50) = $120 000,00 (0.50) = $60 000,00

b. After tax cost of debt (ki) = kd (1 – t) = 14%(0.50) = 7%

a) Year end paymentsPresent value of cash outflows (leasing alternative)

Year - endAfter – tax lease payment Discount factor @7% Present value

1 - 5 $60 000,00 4.100 $246 000,00

Borrowing alternativeComputation of loan instalment

Loan instalment = Amount of loan PVIFA 5 years @ 14%

= $343 300,00 3.433

= $100 000,00

Determination of the interest and principal components of the loan instalmentPrincipal

54

Year end

Loan instalment

Loan at the beginning of the year

PaymentInterest on loan

Principal repayment

outstanding at the end of the year

1 2 3 4 (3 * 14%) 5[(20 – (4)] 6[(3) – (5)]

12345

100 000,00100 000,00100 000,00100 000,00100 000,00

343 300,00291 362,00232 153,00164 654,00

87 706,00

48 06240 79132 50123 05212 294*

51 93859 20967 49976 94887 706

291 362232 153164 654

87 706-

*Balancing itemDepreciation = $343 300 5 = $68 660

Tax shield on depreciation = $68 600 (0.50) = $34 330

Present value of cash outflows (Borrowing option)

Year - end

Loan instalment

Tax advantage on interest payment

Tax adjustment on depreciation

Net cash outflow

Discount factor @7%

Present value

12345

100 000100 000100 000100 000100 000

24 03120 39516 25011 526 6 147

34 33034 33034 33034 33034 330

41 63945 27549 42054 14459 523

0.9350.8730.8160.7630.713

38 91639 54340 34241 30642 440

202 547

RecommendationThe organization should buy the asset outright because the present value of buying is less than the present value of leasing.

b) Present value of cash outflows when cash lease payments are made in advance. If this is the arrangement, the first lease payment will be made at time zero (now) but the tax benefit will only be enjoyed the following year.

Year Lease payment Tax shieldCash flows after taxes

Discount factor

Present value ($)

01 – 4

5

120 000120 000

-

-60 00060 000

120 00060 000

(60 000)

1.0003.38720.7130

120 000203 232(42 780)280 452

RecommendationIt is still cheaper to borrow the funds and buy the asset outright when lease rentals are made in advance.

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PRACTICE PROBLEMS ON SOURCES OF FINANCEPROBLEM 1Water Glass enterprises (Pvt) Ltd is considering installing a computer. It is to decide whether the computer is to be purchased outright (through 14% borrowings) or to be acquired on lease rent basis.

The firm is in the 50% tax bracket. The other data available are:

Purchase of Computer:

Purchase price Annual maintenance (to be paid in advance) Expected economic useful life Depreciation Salvage value

Leasing of Computer: Lease charges (To be paid in advance) Maintenance expenses

Payment of loan:

$2 000 000$50 000 per year

6 yearsStraight-line method$200 000

$450 000

To be borne by lessor

6 year- end equal installments of $514 271

RequirementAdvise the company as to whether it should purchase the computer or acquire it on lease.

PROBLEM 2Mupunga Ltd is an industrial concern that desires to acquire a diesel generating unit costing $2 000 000 which has an economic life of ten years at the end of which the asset is not expected to have any residual value. The concern is considering the alternative choices of:

taking the machinery on lease, orpurchasing the asset outright by raising a loan.

Lease payments are to be made in advance and the lessor requires the asset to be completely amortised over its useful period and the asset will yield a return of 10%.

The cost of debt is worked at 16% per annum. The lender requires the loan to be repaid in 10 equal annual installments, each installment becoming due at the beginning of the year. An Average rate of tax of 50% is to be assumed. It is expected that operating costs would remain the same under either method. The firm follows straight-line method of depreciation.

RequirementAs a financial consultant, indicate what your advice will be.

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PROBLEM 3Murambatsvina Investments is expanding its facilities. In the coming year, the company will either purchase or lease equipment, which it plans to use for 4 years and then, replace with new equipment. Its current tax bracket is 50%. The other data are as follows:

PurchaseThe purchase price of the equipment is $4 000 000The expected salvage value after 4 years is $1 000 000The equipment is subject to straight line method of depreciationFunds to finance the equipment can be obtained at 16%The loan is to be repaid in 4 equal annual installments due at the end of each yearThe equipment will increase annual revenues by $3 000 000 and increase annual non-depreciation operating costs by $2 000 000.

LeasingThe annual lease rent is $1 000 000The lease rent is payable at the end of each year for 4 yearsThe equipment will increase annual revenues by $3 000 000 and increase annual non-depreciation operating costs by $1 900 000 as the lessor will pay $100 000 for the maintenance costs associated with the equipment.

RequirementDetermine whether the company should purchase or lease the equipment.

CHAPTER 7

MERGERS AND ACQUISITIONS

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A MERGERA merger is the joining together of two previously separate corporations. A true merger in the legal sense occurs when both businesses dissolve and fold their assets and liabilities into a newly created third entity. This entails the creation of a new entity.

A TAKEOVERA takeover is the acquiring of control of a corporation, called a target, by stock purchase or exchange, either hostile or friendly. A friendly takeover is a takeover, which supports the wishes of the target company’s management and board of directors. A hostile takeover is a takeover, which goes against the wishes of the company’s management and board of directors.

AN ACQUISITIONAn acquisition is the taking possession of another business. It is the same thing as a takeover or buyout.

RELATED TERMS – DEFINITIONSA JOINT VENTUREA joint venture occurs when two or more businesses join together under a contractual agreement to conduct a specific business enterprise with both parties sharing profits and losses. The venture will be for one specific project only, rather than a continuing business relationship as in a strategic alliance.

A STRATEGIC ALLIANCEA strategic alliance is a partnership with another business in which the parties combine efforts in a business effort involving anything from getting a better price for goods by buying in bulk together to seeking business together with each of the parties providing part of the product. The basic idea behind alliances is to minimize risk while maximizing leverage.

PARTNERSHIPThis is a business in which two or more individuals carry on a continuing business for profit as co – owners. Legally, a partnership is regarded as a group of individuals rather than as a single entity, although each of the parties files their share of profits on their individual tax returns.

Climate for merger activityThere are certain conditions when mergers flourish. Propensity to merge increases when industrial activity/economic activity is either high or low.

A C

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Economic Activity E F

B D

Business cycles

Time

A lot of mergers take place at points ABCD. In other words there is a high incidence of merger activity at points ABCD. At points E and F there is relatively less merger activity.

Points A and COnce the business cycle comes up, general demand increases, increasing business confidence. The increase in general demand creates large reserves of capital for discretionary spending. These discretionary resources are often used to finance expansion. At these points mergers are conducted with aggressive intent.

Points B and DDuring a recession general demand decreases. This reduces the level of business confidence. The decline general demand reduces profit levels. Organisations become unsure of what the future holds: hence they grow in size for security. They want to safeguard themselves from being taken over by other entities. At these points mergers are conducted with defensive intent.

Types/Categories of mergersHORIZONTAL MERGERA horizontal merger occurs when two firms in the same industry and in the same line of business combine to form one large company essentially doing the same business as before. Thus mergers take place between firms that are actual or potential competitors occupying similar positions in the chain of production.

VERTICAL MERGERThis occurs when two firms in related industries combine. The firms could be at different levels of production or at different levels of the distribution channel. Vertical mergers therefore take place between firms at different levels in the chain of production for example a manufacturer and a retailer. Vertical mergers can be defined as being either forward or backwards.

Backward integration/mergerThis is a merger that is motivated by the desire to secure a source of raw materials.

Forward integration/merger

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This is a merger that is motivated by the desire to control a distribution system.

CONGROMERATE MERGER This is a result of a combination of firms in unrelated businesses.

REVERSE TAKE OVER (RTO)Two definitions can be provided for what a reverse takeover is.

A reverse takeover occurs when a company buys out a larger company. This is what often happens when a private company takes over a publicly listed company. Typically, a public company that is taken over by the private company will remain listed, and the private company will use the acquisition as a means of gaining a listing. Reverse takeovers are usually very rare events.

Alternatively a reverse takeover could be viewed as one way for a company to become publicly traded, by acquiring a public company and then installing its own management team and renaming the acquired company. A reverse takeover is also known as a reverse acquisition.

Motives for expansionEconomies of scaleEconomies of scale are all about spreading fixed cost. Mergers can bring about economies of scale. Economies of scale can be found in all the three types of merger. Savings will come from sharing central units such as management and accounting services.

Merging is not always the best way of achieving economies of scale – It is easier to buy another entity than to integrate it with existing operations afterwards. (Century disposed Orion Insurance)

Improving efficiencyFor most firms improving operations for example financial management could increase earnings. Firms like these become targets for acquisition by other firms with better management. If a firm is not doing well this will be reflected in a lower share price that could encourage a takeover bid.

Inefficiencies can be ironed out by other methods that are not easy for example sackings. These are easier after a restructuring because managers do not generally demote or sack themselves.

Tax reliefA company may be unable to claim tax relief through not generating profits. It may therefore wish to combine with another firm or firms, which are generating taxable profits.

Profitable investment opportunities

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A firm may be generating a substantial amount of cash but having a few profitable investment opportunities (investments which yield more than the opportunity cost of capital). This firm could therefore use the surplus cash to acquire another company. This is because if the company does not make an acquisition, someone else may acquire the company instead, because of its lucrative cash resources, and re - deploy the organisation`s cash resources for them.

Using complementary resourcesMany small firms may have a unique product but lack the engineering and sales organizations necessary to produce and market it on a large scale. Such firms may merge with a larger company. Both companies benefit. The small firm has an instant engineering and marketing department and the larger company obtains the revenue and benefits, which the unique product can bring.

DiversificationMergers can result in risk reduction because when diversifying firms combine with those having returns that are negatively collated to their revenue streams.

But others argue that this is spurious (dubious and not genuine) as the major objective should be wealth maximization and not risk reduction. Remember risk reduction leads to reduced profits. In any case critics argue that shareholders themselves could do that diversification.

Lower cost of financeBy pooling their sources of funds, one or more companies may reduce their costs. The cost of raising a new issue of equity or debt can be high. A small company may have profitable investment opportunities, which it cannot support due to inability to gain access to the capital markets. In such cases a merger may be an attractive proposition.

Unused debt capacityIt is also suggested that a firm becomes vulnerable to a takeover if it does not make full use of its borrowing capacity. This is because of considerable advantages to borrowing through the tax deductibility of interest. The tax deductibility of interest increases the value of the firm.

Undervalued securitiesOne reason also given to justify a merger is that the securities of the acquiree are “undervalued”. The proposition is however dangerous. If management believes that they can identify such companies, which are undervalued, they should buy such shares in a wide variety of such companies. It is not necessary to have to acquire and manage other companies merely to take advantage of any under valuation.

Other reasons for expansion

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(a) To increase market power(b) To build an empire(c) To expand production without price reduction(d) To acquire capacity at reduced prices (acquisition of undervalued

shares)(e) Quicker entry into new market(f) To acquire key personnel on sites

VALUATION OF THE TARGET FIRMThe valuation of the target firm is needed because it provides the basis for negotiating the price to be paid at acquisition. There are two approaches that could be used to value a target firm.

Use of market valuesFor a quoted company the current market values can be used. When this approach is adopted, the value of the firm will be obtained as follows:

Value of target firm = Current price per share * number of outstanding shares

EXAMPLEThe following information is given:Current market value of share $37,00Number of shares in issue 12 000 000What is the value of the firm?

Solution

Value of the firm = $37,00 * 12 000 000 = $444 000 000

The Net Asset value methodThe value for each share for purposes of negotiation will be arrived at as follows:

Value per share = Total Assets (at revised book values) – total liabilities assumed Number of shares in issue

EXAMPLE

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C Ltd. is considering acquiring D Ltd. The owners of D Ltd. Have supplied C Ltd. with the following balance sheet data to help in the valuation process.D Ltd.

Balance Sheet as at 31 December 2003Assets: Land and buildings 5 000 000

Plant and machinery 12 000 000Investments 2 000 000Goodwill 500 000

19 500 000

Current assets: Cash 60 000Debtors 5 000 000Stock 2 500 000

7 560 000Current liabilities: Creditors (3 600 000)

Bank overdraft (1 250 000)Net current assets 2 710 000

22 210 000

Financed by: Ordinary shares of $0.50 each 4 000 000Reserves 9 500 00015% Preference shares 2 210 00012% Debentures 6 500 000

22 210 000

1.The land and buildings can be rented at a current rental of $1.6million per annum in perpetuity. The required rate of return on such property is 20%.2.The plant and machinery can only be liquidated at a price of $10million but have a replacement value of $20million.3.The debentures are irredeemable, have a par value of $100.00 and their current required rate of return is 20%4.Preference shares are trading at 75 cents and have a par value of $1.00.5.The firm’s investments are for speculative purposes and have a current market value of $1.35million.6. $500 000.00 worth of debts are thought to be irrecoverable.7.A stock check revealed that the stock is actually worth $2 2500 000.00.8.The bank could still advance the overdraft in case of a take over.

RequirementHow much should C Ltd. Offer as a minimum price for each ordinary share in D Ltd?

Solution

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ASSETSLand and buildingsPlant and machineryInvestmentCashDebtorsStock

LIABILITIESCreditorsBank overdraftPreference sharesDebentures

Ordinary shares outstandingValue per share

$1 600 000/0.20

$5 000 000 - $500 000

2 210 000 * $0.75[12/100 * $6 500 000]/(0.20)

$

8 000 00010 000 000

1 350 00060 000

4 500 0002 250 000

26 160 000(10 407 500)

3 600 0001 250 0001 657 5003 900 00015 752 500

8 000 000$1,97

METHOD OF PAYMENTPayment for a merger can be by cash, ordinary shares, debentures and preference shares.

Cash offersCash is paid to shareholders of the target firm.

Advantages to the shareholders of the target firm(a) The price they will receive is obvious. In a share offer the movement in

share price will affect their wealth.(b) Use of cash gives shareholders the freedom to invest in any alternative

investment without incurring transaction costs of selling shares.

Disadvantages to the shareholders receiving the cashi. They immediately become liable to any capital gains tax that

may have arisen. This is not the case if they receive shares in exchange.

ii. They may well receive less in a cash offer from a share issue. Empirical evidence suggests this. This is the case if the value of the share increases after the takeover.

Advantages to the purchasing company1. It often represents the only quick, reasonable approach to use when

resistance is expected.2. It normally increases its own earnings per share.3. It causes less dilution of ownership.

Disadvantages for the purchasing companya) Its liquidity is reduced. Sometimes a company’s liquidity position may

be low and during times of a financial squeeze, there may be no credit available.

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b) If a cash purchase is considered when liquidity is poor, the company may have to sell more assets in order to realize the needed funds.

MERGER AS A CAPITAL BUDGETING DECISIONA merger decision is a capital budgeting decision. Being a capital budgeting decision appropriate capital budgeting evaluation techniques have to be used to evaluate a potential take over. This section will highlight how the net present value technique can be used to make such an evaluation.

EXAMPLEThe summarized Balance Sheet of Target Ltd as at 31 December 2003 is given below.

BALANCE SHEET AT 31 DECEMBER 2003

ASSETSNon – current assetsProperty, plant and equipmentInvestments

Current assetsInventoriesDebtorsBank

TOTAL ASSETS

EQUITY AND LIABILITIESCapital and reserves200 000Ordinary shares of $10,00 eachRetained earnings13% Preference shares

Non – current liabilities12% DebenturesCurrent liabilitiesCurrent liabilities

TOTAL EQUITY AND LIABILITIES

$

2 000 0001 900 000100 000

1 000 000500 000400 000100 000

3 000 000

2 500 0002 000 000400 000100 000300 000300 000

200 000200 000

3 000 000

Negotiations for the take over of Target Ltd result in its acquisition by A Ltd. The purchase consideration consists of:

(a) $330 000 13% Debentures of A Ltd for redeeming the 12% Debentures of Target Ltd.

(b) $100 000 12% Convertible preference shares in A Ltd for the payment of the preference share capital of Target Ltd.

(c) 150 000 equity shares in Target Ltd to be issued at its current market value of $15,00.

(d) A Ltd would meet dissolution expenses estimated to cost $30 000.

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The break – up figures of eventual disposition by Target Ltd of its unrequired assets and liabilities are:

(iii) Investments $125 000(iv) Debtors $350 000(v) Inventories $425 000(vi) Payment of current liabilities $190 000.

The project is expected to generate operating cash flow after tax of $700 000 for 6 years. It is estimated that fixed assets of Targets Ltd would fetch $300 000 at the end of year 6.

The firm’s cost of capital is 15%.

RequirementAs a financial consultant, comment on the financial prudence of the merger decision by A Ltd.

SolutionComputation of the cost of acquisition

13% Debentures12 % Convertible preference sharesEquity share capital (150 000 * $15,00)Dissolution expensesPayment of current liabilities

Proceeds from sale of assetsInvestmentsDebtorsInventoriesBank balance

$330 000100 000

2 250 00030 000

190 000(2 900 000)

1 000 000125 000350 000425 000100 000

($1 900 000)

Benefits of acquisitionCash flow after tax (1 – 5) $ 700 000Cash flow after tax (6) ($700 000 + $300 000) $1 000 000

Present value computation

Year Cash flow ($)Discount factor

@15%Present

Value ($)0

1 – 56

(1 900 000) 700 0001 000 000

1.00003.35220.4323

(1 900 000)2 346 540 432 300 878 840

R Ltd is expected to benefit from the merger of Target Ltd, as the NPV is positive.

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SHARE SWAPWhere the mode of payment is a share swap, a suitable exchange ratio is needed. The market price per share (if available) or the earnings per share may be used to establish the exchange ratio.

EARNINGS PER SHAREXYZ Company wants to acquire ABC Ltd by exchanging its 1.6 shares for every share of ABC Ltd. XYZ anticipates to maintain the existing price earnings ratio subsequent to the merger also. The relevant financial data are furnished below:

XYZ Company ABC LtdEarnings after taxes (EAT)Number of equity shares outstanding (N)Market price per share (MPS)

$1 500 000300 000

$35,00

$450 00075 000$40,00

Requirement - What is the exchange ratio of market prices?- What is the pre- merger EPS and the P/E ratio for each company?- What was the P/E ratio used in acquiring ABC Ltd?- What is the EPS of XYZ Company after the acquisition?- What is the expected market price per share of the merged

company?Solution

(a) Exchange ratio = Market price of Acquirer Market price of acquiree = [1.6 * $35] 1 * $40 = 1.40

(b) EPS and P/E ratio XYZ Company ABC Ltd

(a) EAT(b) N(c) EPS (a)/(b)(d) P/E ratio (MPS/EPS)

$1 500 000300 000

$5,007 times

450 00075 000

$6,006,67 times

(c) Implied P/E ratio in acquisition of ABC Ltd.

= Market price offered to acquiree Current EPS of Acquiree

= $56,00 (1,6 * $35,00) 6 = 9,33 times

(d) EPS of XYZ Company after merger

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= $1 500 000 + $450 000 300 000 + 120 000 (1,6 * 75 000)

= $1 950 000 420 000

= $4,64

(e) Expected market price after merger

= $4,64 * 7 times

= $32,48

FIGHTING OFF A HOSTILE OFFERA hostile offer is an unwelcome offer. The following techniques can be used to fight a hostile offer.

Use of proxiesThe acquiring firm asks individual shareholders to sign over their proxies. The proxies are then used at a shareholders meeting discussing the proposed take – over. The directors of the acquiree on the other hand would seek proxies to fight the take over. This results in a proxy war.

Direct discouragement of shareholdersShareholders of the target firm are discouraged from accepting the offer. Media space or individual letters are written to shareholders discouraging them from accepting the take over.

Increasing dividend paid by the firmThe directors of the target firm can increase dividends to entice shareholders from parting with their investment (shares).

Disclosure of more informationThe directors of the target firm can disclose information like revised profit forecast having higher profitability levels or assets may be revalued upwards.

Issuing bonus sharesThe directors of the target firm can also issue bonus shares. This increases the number of shares shareholders from the target firm would be having. This may compel them to think twice before deciding to support a potential take – over.

Initiating a share splitSometimes the directors can also initiate a stock split. This increases the number of shares in circulation making it difficult fir the acquirer to gain control.

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Finding external help (White knight)The target firm may look for a white knight. This is a company, which the company approaches with the aim of being taken over.

Raising legal issuesIf the intended merger creates a monopoly, the target firm may raise regulatory issues and use these to fight off the intended acquisition.

Issuing more sharesThe greater the number of shares, the more difficult it is to gain control of the company.

Changing articlesA change from a simple majority to a super majority may be effected to the articles to make it difficult to get the support to sanction the transaction.

Poison pillsA poison pill is a suicidal move that makes the firm unattractive to purchase. The following are examples of the poison pills.

i. Borrowing at terms that require immediate payment of debt if the firm is involved in a merger.

ii. Selling of some of the company’s most prized assets (crown jewels) making the firm unattractive without the assets.

iii. Granting golden parachutes to its executives in case of a take over. A golden parachute is a large cash drain on the firm if it is involved in an acquisition.

REASONS FOR BUSINESS FAILUREIn general terms a failing business is one which is failing to meet its financial obligations. Businesses fail because of a number of reasons.

Poor marketingSuccessful businesses are those that understand and meet their customer’s requirements. Detailed market research is essential for new and expanding businesses. Details relating to potential size of the market, extent of competition, customer preferences and tastes are important. Lack of market research when entering new markets results in poor sales and return on investment.

Cash flow problemsMany businesses struggle because of poor cash flow management. It is not enough to have a good idea and a good product without the necessary short-term finances. Many businesses try to grow too quickly and end up borrowing too much money externally resulting in crippling interest payments and repayment charges.

Poor business planning

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A business plan should cover aspects such as marketing, finance, sales and promotional plans as well as detailed breakdowns of costings and profit predictions. Failing to plan is planning to fail.Lack of financeInsufficient finance means that the business will be unable to take opportunities that are available to them.

Failure to embrace new technologies and new developmentsIn a fast changing world businesses that succeed are the ones that make best use of advanced modern technologies in an appropriate way. If a business operates with outdated technologies and methods frequently it finds itself at a cost disadvantage hence it cannot compete with its more dynamic rivals.

Poor managementWeak and inexperienced management is one of the major causes of business failure. Managers need to understand their customers, make correct financing decisions and understand the business that they are in if they are to be successful.

Poor human resource relationsPoor human resource relations can be a cause for failure. Successful businesses motivate their employees to work hard to help the business to succeed.

Lack of clear objectivesSuccessful businesses have clearly focused and communicated objectives that enable everyone in the organization to pull in the same direction.

Failure to pay taxes

OverspendingSpending too much on frivolous luxuries instead of products or services that improve the bottom line can lead to business failure.

Lack of innovationSome businesses never change; they lose their market share when a new company comes along with a new way of doing things.

Growing too quickly or too slowlyGrowing too quickly leads to overtrading (getting too much stock). Growing too slowly leads to under trading (too little stock).

Signs of business failureThe following are signs of business failure:Diminishing bank balancesHiding or ignoring problemsProduct failure or service qualityLack of specialist staff - Poor or lack of communication with banks

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PREDICTION OF BUSINESS FAILURE

When financial ratios are used correctly they can act as very powerful indicators in the interpretation of financial statements. In the analysis of corporate stability and the detection of potential corporate failure ratios can also be used as Z- scores.

Z- Scores A Z – score equation consists of a number of ratios, which are weighted according to their perceived usefulness and then added together. When the equation is applied to a company’s financial statements it will result in a single value, which is the Z – score.

The Z- score for any given company can be compared with the threshold value above which the company can be classified as safe but below which it should be considered as candidate for failure. This threshold is applicable to companies in many different industries.

It is generally accepted that Z-score do exhibit some predictive power of corporate failure. There are a number of equations in existence:

(a) Altman’s Z – score(b) Robertson’s Z - score

THL LTD: Profit and loss account for the year ended 31 December 1997

19x7 19x6 $000 $000Turnover 15 955 17 160 Cost and expenses (15 093) (15 458)Depreciation (429) (483)Profit on sale of Investments 85 -Interest receivable 545 520 Government grants 41 83 Profit before taxation 1 104 1 822Taxation (416) (542)Profit on ordinary activities after tax 688 1 280Dividends (552) (535)Retained Profit 136 745

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Balance sheet as at 31 December 1997

19x7 19x6 $000 $000Fixed assets:Tangible fixed assets 3 249 2 722

Current assets:Stocks 2 624 2 255Debtors 2 878 3 678Investments - 406Cash at Bank and in Hand 7 072 6 726Total current assets 12 574 13 065

Current liabilities:Creditors 4 116 3 890Net current assets 8 458 9 175Net capital employed 11 707 11 897

Capital and Reserves:Called up share capital 1 424 1 424Share premium account 15 15Revaluation Reserve 1 249 1 258Other Reserves 333 334Profit and loss account 7 965 7 908Shareholders’ funds 10 986 10 939Provision for liabilities and charges Deferred taxations 630 830Deferred incomeGovernment grants 91 128Net Capital employed 11 707 11 897

1. ALTMAN’S Z – SCORE

Professor Altman devised the original Z – Score equation in 1968:

Z = 1.2x1 + 1.4x2 + 3.33+ 0.6x4 + 1.0x5

Where Altman selected ratios are:

X1 = Working capital Total Assets

X2 = Retained earnings Total Assets

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X3 = Profit before Interest and Tax Total Assets

X4 = Market Capitalisation Book value of Debts

X5 = SalesTotal Assets

Definitions used in the ratios are as follows:

Working capital = Current assets less current liabilities.Total Assets = Fixed assets + Investments + Current Assets.Retained earnings = Accumulated reserves.Market capitalization = Number of shares x share price (or book value of equity, reserves and preference if not quoted).Book value of debt = All debt – short –and long term.

The pass mark for Altman’s Z is stated as 3.0.

Companies scoring above this score are considered safe whilst companies scoring below 1.8 should be considered potential failures. Altman believes that the Z score equation can distinguish between ‘safe’ and ‘potential failures’ up to 2 to 3 years before the actual event.

Example of Z score: THL Private Limited Company

19x6 19x7X1 = Working Capital = 9 175 8 458

Total assets 2 722+ 13 065 3 249 + 12 574 = 0.581 = 0.535

X2 = Retained earnings = 7 908 7 965 Total assets 15 787 15 823 = 0.501 = 0.503

X3 = PBI and Tax = 1 822- 520 1 104 - 545 Total assets 15 787 15 823 = 0.082 = 0.035

X4 = Market Capitalisation = 10 939 10 986 Book value of debt 3 890 + 830 4 116+ 630

= 2.318 = 2.315

X5 = Sales = 17 160 15 955 Total assets 15 787 15 823 = 1.087 = 1.008

Z – Score (19x6) = 1.2 (0.581) + 1.4 (0.50)+ 3.3(0.082)+ 6(2.318) + 1.0(1.087)

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= 0.6972 + 0.7014 + 0.2706 + 1.3908 + 1.087 = 4.147

Z – Score (19x7) = 1.2(0.535)+1.4(0.503)=3.3(0.035)+0.6(2.315)+1.0(1.008) = 0.642 + 0.7042 + 0.1155 + 1.389 + 1.008 = 3.859

According to the Altman’s pass mark, both the scores imply that THL Private limited company is safe.

2. ROBERTSON’S Z – SCORE

This score concentrate on the rate of change in the score from one year to another. To interpret the results of the Z – Score technique Robertson found that if the score falls by 40% or more in any year, then any changes have occurred in the financial health of the company. Consequently the company should carry out immediate investigations to identify the cause of the deadline and hopefully stop it.

If the score falls by 40% or more for a second successive year, the company is likely to face liquidation unless major changes are carried out.

Z = 3.0x1 + 3.0x2 + 0.6x3 + 0.3x4 + 0.3x5

Where X1 = (sales – Total assets) Sales

X2 = Profit before tax Total assets

X3 = (Current assets – Total Debt) Current liabilities

X4 = (Equity – Total Borrowings) Total Debt

X5 = (Liquid assets – Bank Overdraft) Creditors

19x6 19x7 X1 = (Sales – Total assets) = (17 160 – 15 787) (15 955- 15 823) Sales 17 160 15 955 = 0.080 = 0.008

X2 = Profit before tax = 1 822 1.104 Total assets 15 787 15 823 = 0.115 = 0.070

X3 = (Current Assets –Total Debt)=(13 065 – 4 746) (12 574-4 720)

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Current liabilities 3 890 4116 = 2.139 = 1.908

X4 = Equity – Total Borrowings = (10 939 – 4 746) (10 986 – 4 720) Total Debts 4 746 4720 = 1.305 = 1.328

X5 = Liquid assets – Bank O/D = (3 678 + 6 726) (2 878 + 7 072) Creditors 3 890 4116 = 2.675 = 2.417

Z–Score (19x6) = 3.0 (0.080)+3.0(0.115)+0.6 (2.139) + 0.3(1.305)+0.3(2.675) = 3.062

Z-Score (19x7)= 3.0(0.008)+ 3.0(0.070)+ 0.6(2.139)+ 0.3(1.305)+0.3(2.675) = 2.502

The change in the Z Score from 19x6 to 19x7 is a fall of 18.3% (3.062 – 2.502) / 3.062 x 100%. Even though it is a drop in value there is no real cause for concern as the threshold value is a fall of 40%.

REORGANIZATION PLANS FOR FAILING BUSINESSESThere are a number of reorganization plans or turnaround strategies that can be adopted to revive failing businesses.

Changing leadershipOld leadership will be associated with failure and new leadership will be required. In any event old leaders may be unwilling to implement turnaround strategies.

Redefining strategic focusSometimes a reevaluation of a company’s business level strategy may be undertaken. A failed cost leader may reorient toward a more focused or differentiated strategy. For a diversified organization redefined strategic focus means identifying businesses with best long-term profit and growth prospects and concentrating in these.

Asset sales and closures A failing business can divest as many unwanted assets as possible. Unwanted but profitable assets may bring in the much-needed cash, which is then invested in improving the remaining lines of operation.

Improving profitabilityFailing businesses can also try to improve their profitability. Profitability of the operations that remain may be improved by:

1. Laying off white and blue collar employees2. Investing in labour saving equipment3. Tightening financial controls4. Cutting back on marginal products5. Reengineering business process to cut costs and boost productivity

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6. Introduction of total quality management processes.

AcquisitionsThis may be a surprising strategy but it is a common turnaround strategy. It involves making acquisitions primarily to strengthen the competitive position of a company’s remaining core operations.

PRACTICE PROBLEMS ON MERGERS AND TAKE OVERS

PROBLEM 1You have been provided the following financial statements of two companies:

Trust Ltd Anger LtdEarnings after taxesEquity shares outstandingEarnings per sharesPrice-earnings ratioMarket price per share

$700 000$200 000

$3,5010 times$35,00

$1 000 000$400 000

$2,5014 times$35,00

Anger Ltd is the acquiring company, and exchanging its shares on a one-for- one basis for Trust Ltd’s shares. The exchange ratio is based on the market prices of the shares of the two companies.

18.What will EPS be subsequent to the merger?19.What will be the change in EPS for the shareholders of Trust Ltd and Anger Ltd?20.Determine the market value of post-merged firm.21.Ascertain the gain accruing to shareholders of both the firms.

PROBLEM 2A Ltd decided to take over the business of T Ltd as at 31 December (current year); the summarized balance sheet of T Ltd as at that date was as follows:

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AssetsLand and buildingsPlant and machineryInventoriesDebtorsBank

LiabilitiesEquity share capital(50 000 shares of $10,00 each)General reserveProfit and loss 13% DebenturesCurrent liabilities

$300 000580 000 70 000 35 000 15 000

1 000 000

500 000

250 000120 000100 000 30 000

1 000 000

Additional informationA Ltd agreed to take over all the current assets at their book values but the fixed assets were to be revalued as under for the purpose:

* Land and buildings, $500 000* Plant and Machinery, $500 000* These sums apart, A Ltd is required to pay $50 000 for goodwill and also to bear dissolution expenses of $10 000 (to be paid directly by A Ltd).

The expected realization from current assets (other than bank balance) is $90 000.Purchase consideration was as $130 000 in cash to pay 13% debentures and other liabilities and the balance is to be paid in equity shares of A Ltd.Expected benefits (CFAT) accruing to A Ltd are as follows:

Year CFAT12345

$200 000$300 000$260 000$200 000$100 000

Further it is estimated that the market value of T Ltd’s fixed assets would be $600 000 (Land and buildings) and $40 000 (Plant and machinery) at the end of 5th year.

The cost of capital of T Ltd is 25%.

RequirementDo you think A Ltd is likely to be benefited by taking over T Ltd?

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PROBLEM 3The following is the balance sheet of XYZ Co. Ltd as at 31 December (current year) as follows:

AssetsPlant and machineryFurniture and fittingsInventoriesDebtorsBank balance

Equity and liabilitiesEquity share capital (10 000 shares of $20,00 each)13% DebenturesRetained earningsCreditors

$250 000 5 000 90 000 25 000 10 000380 000

200 000

100 000 50 000 30 000380 000

The company is absorbed by ABC Co. Ltd at the above date. The consideration for the absorption is the discharge of debentures at a premium of 10%, taking over the liability in respect of sundry creditors and a payment of $14,00 in cash and one share of $10,00 in ABC Ltd at the market value of $16,00 per share in exchange for one share in XYZ Co. Ltd. The cost of dissolution of $10 000 is to be met by purchasing company.

Inventories are expected to realize $100 000 and expected collection from debtors are $20 000.

Expected yearly benefits/CFAT from the business of XYZ Ltd are $150 000 for five years; Assuming zero salvage value of fixed assets and firm’s cost of capital of 14%, comment on the financial soundness of the ABC’s management decision regarding the merger.

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PRACTICE PROBLEMS ON BUSINESS FAILUREPROBLEM 1Mouth Ltd is contemplating taking over Teeth Ltd. The following balance sheet, income statement and notes have been made available:

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Balance SheetAssetsLand and buildingsPlant and equipmentInvestmentsTotalCurrent assetsCashDebtorsStockTotal

Total assets

Liabilities and Owners Equity

Current liabilitiesCreditorsShort term borrowingTotal

Long term borrowingPreference stock (22% cumulative)

Ordinary shares (50 cents)ReservesTotal Equity

Total Liabilities and Owners Equity

$12 600 000

6 400 0003 200 000

22 200 000

100 0001 400 000

800 0002 300 000

24 500 000

1 600 000900 000

2 500 000

8 000 0004 000 000

1 500 0008 500 000

10 000 000

24 500 000

Income Statement

TurnoverOperating incomeInterestNet income

$20 000 000

3 800 0002 500 000

300 000

Notes:Land and buildings have a current market value of $15 million.Equipment has a current value of $2 million but would require $11 million to replace.3 Investments are 1 million shares that have just paid an annual dividend of 20 cents per share. The dividend is expected to have a constant growth of 12% for the foreseeable future and the required rate of return on this investment is 20%.Long-term borrowing is through $100 par, 20% coupon debentures that have a current yield of 24%. The debentures have 20 years to maturity.Preference stock is privately placed and there is $200 000 in accumulated dividends.

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Calculate the debt to equity ratio (D/E), current ratio (CR), times interest earned (TIE), and net profit margin (NPM) and comment on the financial viability of the company given industry average ratios of:

Debt to equity 40%Current Ratio 2.05Times Interest Earned 6xNet Profit Margin 8%

You have determined that the following equation is able to differentiate those companies that are likely to go bankrupt and those that will not go bankrupt.

Z = -0.01098D/E + 1.25CR + 0.1234TIE + 0.0275NPM

And that a company with a score of less than 2.0 is likely to go bankrupt.

Determine whether the above company is likely to go bankrupt.

Using the net asset value approach determine the price per share that the company should be prepared to pay the other company.

CHAPTER 9

INTRODUCTION TO INTERNATIONAL FINANCIAL MANAGEMENT

THE FOREIGN EXCHANGE MARKETThe foreign exchange market provides the physical and institutional environment in which foreign exchange is traded, exchange rates determined

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and foreign exchange management is implemented. The foreign exchange market spans the globe.

FUNCTIONS OF THE FOREIGN EXCHANGE MARKETThe foreign exchange market is the mechanism by which one may transfer purchasing power between countries, obtain or provide credit for international trade transactions, and minimize exposure to the risks of exchange rate changes.

Transfer of purchasing powerTransfer of purchasing power is necessary because International trade and capital transactions normally involve parties living in countries with different national currencies. Each party would usually want to hold its national currency so one or more of the parties must transfer purchasing power to or from its own national currency. The foreign exchange market provides the mechanism for carrying out these purchasing power transfers.

Provision of creditThe movement of goods between countries takes time so a means must be devised to finance inventory in transit. The exporter may provide the finance or the importer may meet the finance requirements for inventory in transit. The foreign exchange market provides a third source of credit through specialized instruments such as banker’s acceptances (A draft accepted by a bank – an unconditional promise of that bank to honour or make payment on the draft when it matures) or letters of credit (An instrument issued by a bank at the request of an importer, in which the bank promises to pay a beneficiary upon presentation of documents specified in the letter of credit).

Minimizing foreign exchange riskNeither the importer nor the exporter may wish to carry the risk of exchange rate fluctuations. Each party may prefer to earn a normal business profit on the international transaction rather than risk an unexpected change in anticipated profit should exchange rates suddenly change. The foreign exchange market provides “hedging” facilities for transferring the foreign exchange risk to someone else.

MARKET PARTICIPANTSThe foreign exchange market consists of two tiers (layers placed one on top of the other).

The interbank or wholesale marketThis is a market for large sums of foreign exchange usually multiples of millions of U.S dollars or other currencies.

Client of retail marketThis is a market for specific amounts of foreign currency sometimes down to the last cent.

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Five broad categories of participants operate within these two tiers

Banks and nonblank foreign exchange dealers (traders)Banks and a few nonblank foreign exchange dealers operate in both the interbank and client markets. They profit from buying foreign exchange at a “bid” price and reselling it at a slightly higher “offer” (ask) price. Competition among dealers keeps the spread between bid and offer thin contributing to the efficiency of the foreign exchange market.

Individuals and firms conducting commercial and investment transactionsIndividuals and firms make use of the foreign exchange market to facilitate execution of commercial or investment transactions. This group consists of importers and exporters, international portfolio investors, multinational firms and tourists.

Speculators and ArbitragersSpeculators and arbitragers profit from trading within the market itself. Their motive differs from that of dealers in that speculators and arbitragers operate only in their own interest without a need or obligation to serve clients or to ensure a continuous market. Dealers seek profit from the spread between bid and offer and only incidentally seek to profit from a change in general price levels (exchange rate). Arbitragers seek to profit from simultaneous price differences in different markets.

A large proportion of speculation and arbitrage is conducted by traders in the foreign exchange departments of banks on behalf of the bank. Banks act both as exchange dealers and as speculators and arbitragers but they seldom admit to speculating – They talk of “taking an aggressive position”.

Foreign exchange brokers (buyers and sellers of foreign exchange for others)Foreign exchange brokers are matchmakers who facilitate trading between dealers without themselves becoming principals in the transaction. They charge a small commission for their service. They maintain instant access to hundreds of dealers worldwide via open telephone lines.

Dealers use brokers because they want to remain anonymous. The identity of the participants may influence short – term quotes (of foreign exchange) for example large companies may pay heavily because of their ability to pay.

TYPES OF FOREIGN EXCHANGE TRANSACTIONSTransactions in the foreign exchange market are executed on a “spot”, “forward” or “swap” basis.

Spot transactionsA spot transaction requires an almost immediate delivery of foreign exchange. In the interbank market it is the purchase of foreign exchange with delivery and payment between banks to be completed normally on the second business day.

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A spot transaction between a bank and its commercial client does not necessarily involve waiting for two days for settlement.

Forward transactionsA forward transaction requires delivery of foreign exchange at some future date. It requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency. The exchange rate is established at the time the contract is agreed upon but payment and delivery are not required until maturity. Forward exchange rates are normally quoted for value dates of one, two, three, six and twelve months.

Swap transactionsA swap transaction is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. The following are types of swap transactions.

(i) “Spot against forward” swap – The dealer buys a currency in the spot market and simultaneously sells the same amount back to the same bank in the forward market. As this is executed as a single transaction with the same bank, the dealer incurs no unexpected foreign exchange risk. The difference between the spot and forward rates is known and fixed.

(ii) “Forward – forward” swap – This is a more sophisticated swap. The dealer sells a currency forward for delivery at a given value date for example two months and simultaneously purchases back the currency forward for delivery at a given value date for example three months.

FOREIGN EXCHANGE RATES AND QUOTATIONSA foreign exchange rate is the price of one currency expressed in terms of another currency. A foreign exchange quotation or quote is a statement of willingness to buy or sell at an announced price.

Direct quotesThis is a home currency price of one unit of foreign currency for example Zim$18 000/UK Pound.

Indirect quotesThis is the price of foreign currency to one unit of home currency.

Foreign exchange selling rate quotations are reported daily in the financial section of most major newspapers.

Bid and offer quotationsInterbank quotations are expressed as bid and offer (ask). A bid is the rate at which a dealer is willing to buy another currency and an offer is the rate at which a dealer is willing to sell that currency. Dealers bid (buy) at one price

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and offer (sell) at a slightly higher price, making their profit from the spread between the buying and selling prices.

Cross ratesMany currency pairs are not actively traded so their exchange rate is determined through their relationship to a widely traded third currency. For example an Australian tourist wants to purchase Danish currency to pay for a visit to Copenhagen. The Australian dollar (A$) is not actively traded with the Danish Krone (DKr). Both currencies are actively traded with the US dollar. Assume the following quotes:

Australian dollar A$1.3806/US$Danish Krone DKr6.4680/US$

The Australian tourist can exchange 1.3806 A$ for 1US$ and buy 6.4680 DKr. The cross rate is calculated as follows:

Australian dollars/US dollar = A$1.3806/US$Danish Krone/US dollar DKr6.4680/US$

= A$0.2135/DKr

INTEREST RATE PARITY (IRP)The theory of interest rate parity (IRP) provides the linkage between the foreign exchange markets and the international money markets. The theory states: “The difference in the national interest rates of securities of similar risk and maturity should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency, except for transaction costs”.

The theory is only applicable to securities with maturities of one year or less since forward contracts are not routinely available for periods longer than one year.

Illustration of Interest Rate Parity (IRP)Assume the following:A US investor has US$1 000 000 which he wishes to invest. The US dollar money market offers an interest rate of 8% per annum. The Yen money market offers an interest of 4% per annum. The spot exchange rate is 150Yen/$ and the forward 90 day rate is 148.5294 Yen/$. If the investor chooses to invest in the Yen money market the following will take place:

START END$1 000 000 Times 1.02 $1 020 000

Dollar money market

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TimesS = 150Yen/$ 90 days F90 = Yen =148. 5294/$ Divided by

Yen money market

Yen 150 000 000 Times 1.01 Yen 151 500 000

If the investor chooses to invest in the dollar money market he will earn an interest of $20 000 at the end of 90 days. The investor may choose to invest in a non-dollar money market instrument of identical risk and maturity for the same period. If he chooses this option he converts the US dollars into Yen at the spot rate of exchange (S Yen 150/$), invest the money in the Yen money market and at the end of the period convert the resulting proceeds back to dollars. The investor evaluates the returns from the dollar money market and the Yen money market.

Ignoring transaction costs, if the returns in dollars are equal between the two alternative money market investments this is interest rate party (IRP). The transaction is “covered” because there is a guaranteed exchange rate back to dollars at the end of 90 days.

For the two alternatives to be equal any differences in interest rates must be exactly offset by the difference between the spot and forward exchange rates.

COVERED INTEREST ARBITRAGE (CIA)The spot and forward exchange markets are not constantly in a state of equilibrium described by the interest rate parity. When the market is not in equilibrium, the potential for “risk less” or arbitrage profit exists. The arbitrager who recognizes such an imbalance will move to take advantage of the disequilibrium by investing in whichever currency offers a higher return on a covered basis. This is called covered interest arbitrage (CIA).

Illustration of CIAA Hong Kong Investor has 135 000 000 Yen. The spot rate is, S Yen 135.00/$. The 180 day forward rate F180 = Yen 134.50/$. Interest in the Euro dollar market is 8% per annum. Interest in the EuroYen market is 5% per annum.

Euro dollar rate = 8.00% per annum

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$1 000 000 Times 1.04 $1 040 000

Dollar money market

S = Yen 135.00/$ 180 Days TimesDivided by F180 =Yen134.50/$

Yen money market

Yen 139 880 000Yen135 000 000 Times 1.025 Yen 138 375 000

START Euro yen rate = 5.00% per annum END

The CIA stepsStep 1. Convert 135 000 000 Yen at the spot rate of Yen135.00/$ to obtain US$1 000 000.Step 2. Invest the US$1 000 000 in a Euro dollar account for six months earning 8% per annum (4% for six months).Step 3.Simultaneously sell the proceeds US$1 000 000 forward for Yen at the six month forward rate of 134.50 Yen/$. This “locks in” gross Yen revenues of 139 880 000 Yen.Step 4.Calculate the cost (opportunity cost) of funds used at the Euro yen rate of 5.00% per annum or 2.50% for six months, with principal and interest then totaling 138 375 000 Yen. The profit on covered interest arbitrage is 139 880 000 Yen (proceeds) – 138 375 000 Yen (cost) = 1 505 000 Yen.

Covered Interest Arbitrage is a process whereby an investor earns a risk free profit by (1) borrowing funds in one currency (2) exchanging those funds in the spot market for a foreign currency (3) investing the foreign currency at interest rates in a foreign country (4) selling forward at the time of original investment, the investment proceeds to be received at maturity, (5) using the proceeds of the forward sale to repay the original loan and (6) having a remaining profit balance.

FORCES BEHIND EXCHANGE RATE MOVEMENTSThe present international monetary system is characterized by a mix of freely floating, managed floating and fixed exchange rates therefore no single general theory is available to forecast exchange rates under all conditions. There are however certain basic economic relationships, called parity conditions, which help explain exchange rate movements. These are:

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Purchasing Power ParityFisher effectInternational Fisher effectInterest rate ParityForward rate as unbiased predictor of future spot rate.

Under a freely floating exchange rate system, future spot exchange rates are theoretically determined by the interplay of differing national rates of:InflationInterest rates

Purchasing Power ParityThis is a theory that states that the price of internationally traded commodities should be the same in every country, and hence the exchange rate between the two currencies should be the ratio of prices in the two countries.

Fisher effectThis is a theory that states that nominal interest rates in each country are equal to the required real rate of return to the investor plus compensation for the expected amount of inflation.

International Fisher EffectThe theory states that the spot exchange rate should change by an amount equal to the difference in interest rates between two countries.

Interest rate parityThe theory states that the difference in national interest rates for securities of similar risk and maturity should be equal to but opposite in sign to the forward exchange rate discount or premium for the foreign currency.

Forward rate as an unbiased predictor This is a theory by some forecasters that for major freely floating currencies, foreign exchange markets are efficient and forward exchange rates are unbiased predictors of future spot exchange rates.

TYPES OF FOREIGN EXCHANGE EXPOSURE

There are three types of exposure, operating exposure, accounting exposure and transaction exposure.

Conceptual comparison of differences between operating, transaction and accounting foreign exchange exposure

Movement in time whenExchange rate changes

Accounting exposure Operating exposureAccounting – based changes in Change in expected cash flowsConsolidated financial statements arising because of an

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Caused by a change in exchange unexpected change in exchangeRates. Rates.

Transaction exposure

Impact of settling outstanding obligationsentered into before change in exchange rates but

to be settled after change in exchange rates

Time

OPERATING EXPOSURE/ECONOMIC EXPOSUREThis is the potential for a change in expected cash flows, and therefore value of a foreign-based affiliate as a result of an unexpected change in exchange rates. Operating exposure therefore measures the change in the present value of the firm that results from changes in future operating cash flows caused by an unexpected change in exchange rates.

ACCOUNTING EXPOSURE/TRANSLATION EXPOSUREThis is the potential for an accounting derived change in owner’s equity resulting from exchange rate changes and the need to restate financial statements of foreign affiliates in a single currency of the parent corporation.

It measures potential accounting - derived changes in owner’s equity that result from the need to “translate” foreign currency statements of affiliates into a single reporting currency in order to prepare world wide consolidated financial statements.

TRANSACTION EXPOSUREThis is the potential for a change in the value of outstanding financial obligations entered into prior to a change in exchange rates but not due to be settled until after the exchange rates change. It deals with changes in cash flows that result from existing contractual obligations.

OPERATING EXPOSUREOperating exposure is more important for the long – run health of the business than changes caused by transactions and translation exposure. But operating exposure is subjective because it depends on estimates of future cash flow changes over an arbitrary time horizon.An expected change in foreign exchange rates is not included in the definition of operating exposure because both management and investors should factor this information into their evaluation of expected operating results.

MANAGING OPERATING EXPOSUREThe objective of operating exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firm’s future cash flows rather than merely hoping for the best. To meet this objective management must not only recognize a disequilibrium condition

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(among foreign exchange rates, national inflation rates and national interest rates and product markets) when it occurs but must already have prepared the firm to react in the most appropriate way. This can be best accomplished if a firm diversifies internationally both its operations and its financing base.

Diversifying operationsIf a firm’s operations are diversified internationally, management is pre – positioned both to recognize disequilibrium. A disequilibrium occurs when the purchasing power parity is in temporary disequilibrium. The Purchasing Power Parity holds that if the spot exchange rate between two countries starts in equilibrium any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot exchange rate. Management might notice a change in comparative costs in the firm’s own plants located in different countries. It might also observe changed profit margins or sales volume in one area compared to another depending on price and income elasticities of demand and competitor’s reactions.

Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies. Management might make marginal shifts in sourcing raw materials, components or finished products. If spare capacity exists production runs can be lengthened in one country and reduced in another. The marketing effort can be strengthened in export markets where the firm’s products have become more price competitive because of the disequilibrium position.

A purely domestic firm does not have the option to react to an international disequilibrium condition in the same manner as a multinational firm. This is because it lacks the comparative data from its own internal sources. By the time external data are available from published sources, it is often too late to react. Even if the domestic firm recognizes the disequilibrium condition it cannot quickly shift production and sales into foreign markets in which it has had no previous presence.

Diversifying financingIf a firm diversifies its financing sources, it will be pre – positioned to take advantage of temporary deviations from the international Fisher effect. International fisher effect holds that the spot exchange rate should change in an equal but opposite direction to the difference in interest rates between two countries. If interest rate differentials do not equal expected changes in exchange rates, opportunities to lower a firm’s cost of capital will exist. But to be able to switch financing sources, a firm must already be well known in international investment community, with banking contacts firmly established. This position is not available to a domestic firm that is limited to sourcing finance from the domestic market.

Multinationals can also reduce default risk by matching the mix of currencies they borrow to the mix of currencies they expect to receive from operations. This strategy can be used to neutralize transaction and translation exposure in addition to operating exposure. This strategy is however difficult to

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implement in practice because firms cannot predict either the magnitude or currency of denomination of cash flows very far into the future. Unexpected changes in exchange rates may alter the very flows management will be trying to predict thus changing the currency mix to be matched.

MANAGING TRANSACTION EXPOSURETransaction exposure measures gains or losses that arise from the settlement of financial obligations whose terms are stated in a foreign currency. Transaction exposure arises from:Purchasing or selling on credit goods or services whose prices are stated in foreign currencies.Borrowing or lending funds when repayment is to be made in a foreign currency.Being a party to an unperformed foreign exchange forward contract.Acquiring assets or incurring liabilities denominated in foreign currencies.

Transaction exposure can be managed by contractual techniques and by adopting certain operating strategies.

CONTRACTUAL TECHNIQUESContractual techniques use hedges as well as swap agreements. A hedge is a contract or arrangement that provides defense against the risk of loss from a change in foreign exchange rates.

(1) Forward market hedge This involves a forward contract and a source of funds to fulfill a contract. The forward contract is entered into at the time the transaction exposure is created. If funds to fulfill the forward contract are on hand or are due because of a business operation the hedge is considered “covered”, “perfect”, or “square” because no residual foreign exchange risk exists. Funds on hand or to be received are matched by funds to be paid.

In some situations funds to fulfill the forward exchange contract arenot already available or due later but must be purchased in the spotmarket at some future date. This hedge is “open” or “uncovered”. Itinvolves considerable risk because the hedger must take a chance onpurchasing foreign exchange at an uncertain future spot rate in orderto fulfill a forward contract. Purchasing of such funds at a later date isreferred to as “covering”.(2) Money market hedge This also involves a contract and a source of funds to fulfill that contract. In this instance the contract is a loan agreement. The firm seeking the money market hedge borrows in one currency and exchanges the proceeds for another currency. Funds to fulfill the contract – that is to repay the loan – may be generated from business operations (in which case the money market hedge is “covered”). Alternatively funds to repay the loan may be purchased in the foreign exchange spot market when the loan matures. In this instance the money market hedge is “uncovered” or “open”.

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Swap agreements A foreign exchange swap is an agreement between two parties to exchange a given amount of one currency for another and after a period of time to give back the original amounts swapped.

Back – to – back or Parallel loans This involves two business firms in separate countries arranging to borrow each other’s currency for a specified period of time. At an agreed terminal date they return the borrowed currencies. The operation is conducted outside the foreign exchange market although spot quotations may be used as the reference point for determining the amount of funds to be swapped. Such a swap creates a covered hedge against exchange loss, since each company in its own books borrows the same currency it repay

Currency swap This resembles a back – to back loan except that it does not appear on a firm’s balance sheet. Two firms agree to exchange an equivalent amount of two different currencies for a specified period of time. Currency swaps can be negotiated for a wide range of maturities up to at least ten years. If funds are more expensive in one country than another a fee may be required to compensate for the interest differential.

Credit swap This is an exchange of currencies between a business firm and a bank (often the central bank) of a foreign country, which is to be reversed at some future date. A credit swap protects only the principal amount involved. It does not protect earnings on that principal that might be remitted to the parent as a return on the parent investment.

OPERATING STRATEGIESTransaction exposure can be partially managed by adopting strategies that have the effect of offsetting existing foreign exchange exposure. Two operating strategies particularly useful in managing transaction exposure are the use of leads and lags and of re-invoicing centers.

Leads and lags Firms can reduce transaction exposure by accelerating or decelerating the timing of payments that must be made or received in foreign currencies. To lead is to pay early. A firm holding a soft currency and having debts denominated in a hard currency will lead by using that soft currency to pay the foreign currency debts as soon as possible, before the soft currency drops in value. The lag is to pay late. The firm holding a hard currency and having debts denominated in a soft currency will lag by paying those debts late, hoping that less of the hard currency will be needed. If possible, firms will also lead and lag their collection of receivables, collecting soft currency receivables early and collecting hard foreign currency receivables later.

Leading and lagging may be done between affiliates or with independent firms. Assuming that payments will be made eventually, leading or lagging

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always results in changing the cash and payables position of one firm, with the reverse effect on the other firm.

Re-invoicing centers

This is a separate corporate subsidiary that manages in on location all transaction exposure from intracompany trade. Manufacturing affiliates sell goods to distribution affiliates of the same firm only by selling to a re-invoicing center, which in turn resells to the distribution affiliate. Title passes to the re-invoicing center, but the physical movement of goods is direct from manufacturing plant to distribution affiliate. Thus the re-invoicing center handles paperwork but has no inventory.

Re-invoicing centre structure

Korean manufacturing Physical Goods Japanese Affiliate Sales affiliate Invoice in Invoice in Won Yen

Re-invoicing centre Singapore

The Korean manufacturing unit of a multinational firm invoices the firms reinvoicing centre in Singapore in Korean won. The reinvoicing centre in turn invoices the firms’ Japanese sales affiliate in yen. Thus all operating units deal only in their own currency and all transaction exposure lies with the reinvoicing centre.

MANAGING ACCOUNTING/TRANSLATION EXPOSURETranslation exposure results because foreign currency denominated financial statements of foreign affiliates must be restated into the parent companys’ reporting currency so the parent company can prepare consolidated financial statements.

Accounting exposure is the potential for a gain or loss in the parent’s net worth and reported net income that arises because of exchange rates change.Basic conventions for translationThe current rate method All assets and liabilities are translated at the current rate of exchange; the rate of exchange in effect on the balance sheet date. Income statement items are translated at either the actual exchange rate on the dates the various revenues, expenses, gains and losses are incurred or at a weighted average exchange rate for the period.

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Monetary/Non monetary method Monetary assets (cash, marketable securities, Debtors and long term receivables) and monetary liabilities (current liabilities and long term debt) are translated at current exchange rates, while all other assets and liabilities are translated at historical rates.

Income statement items are translated at the average exchange rate for the period, except for depreciation and cost of sales that are directly associated with non monetary assets or liabilities. These items are translated at their historical rate.

3.Current/Non current method All current assets and current liabilities of foreign affiliates are translated into home currency at the current exchange rate, while non current assets and non current liabilities are translated at historical rates.

Temporal Method This is a variation of the monetary/non monetary method. If the foreign affiliate keeps all of its accounts on a historical cost basis, the temporal method is in fact identical to the monetary/non monetary method. If the foreign affiliate restates any unexpected assets (eg. Inventory) to market value, the temporal method provides for their translation at the current exchange rate.

Managing translation exposure The main technique to manage accounting exposure is called a balance sheet hedge.

Balance Sheet Hedge This requires an equal amount of exposed foreign currency assets and liabilities on a firm’s consolidated balance sheet. If this can be achieved for each foreign currency, net accounting exposure will be zero. A change in exchange rates will change the value of exposed assets in an equal but opposite direction to a change in the value of exposed liabilities. If a firm translates by the monetary/non monetary method, a zero net exposed position is called monetary balance.

- End of module -

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Kudakwashe-Fin Man B

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