Finman 244

Chapter 1

Introduction:

• All businesses are guided by corporate financial principles

• Financial function: Flow of capital to and from businesses

• Decisions to be made:

• Financing decisions

• Investment decisions

• Relationship between acquisition and application of capital

Defining financial management:

• Process of creating value in organisation

• Planning, organising, directing and controlling financial activities

• Value created = increase in the wealth of the shareholders

• Financial management ≠ Accounting

• Accounting: a historical perspective (report)

• Financial managers: Focus on value creation. Use information from accountants to

make decisions

Lt assets

ST assets (inventory, cash …

day to day activities)
Capital budgeting:

→ Compare the cost of the asset with the initial investment with the inflow of that asset over time

→ Present value of future> initial investment= positive = invest

• Only invest in value-adding non-current assets

• Determine cash flows

▪ Size – how much initial investment is required (cash outflow) and how
much income will be received (cash inflows)

▪ Timing – when and for how long income will be received

▪ Risk – the likelihood of receiving the income= invest in a project and then
consumers don’t like the product

• Positive vs negative NPVs

Capital structure:

→The combination of debt and equity that a company uses to fund the firm

Three options available:

▪ Borrow long-term funds (debt) – risk increase

▪ Use savings of the company (retained earnings)

▪ Issue more shares (equity) – ownership implications

• Debt is the cheapest

Working capital management:

→Working capital =
• How will you approach the day-to-day financial management? current assets and
▪ Will you sell new product for cash, credit or both? current liabilities

▪ Who will receive credit and who will not? →Inventory

management (buying
▪ How many days until debtors must pay?
raw material,
▪ Will you pay expenses in cash or on credit? transporting etc.…) is NB
• All these decisions are important to ensure: depending on the nature
of the business
▪ Firms function efficiently

▪ sufficient resources to remain profitable and liquid.

The goals of financial management:

→Profit maximisation

▪ Increase revenue and decrease operating and other expenses

▪ Main flaws:

1. Manipulated through malpractice

2. Ignores the issues of timing and risk

→Maximising the rate of return

▪ Ratio of net profit after tax to total assets

▪ Same risks associated with profit maximisation (still uses accounting values)

→Maximising shareholders’ wealth

▪ Shareholder’s wealth influenced by number of shares and current share price

▪ Only engage in activities that will positively influence the current share price

▪ Forward looking goal

▪ Profit and rate of return maximization = short-term goals

▪ Share price maximization: Short-term and long-term goal

• Links to environmental, social and corporate governance (ESG) aspects

→Stakeholder considerations

Stakeholders:

• People involved in the business and/or on whom the business has an impact

• Shareholders
• Employees
• Suppliers
• Customers
 • Why is it important to also consider the interests of other stakeholders of a company and
not just shareholders' interests?
→Boycott= revenue will decrease= people will think twice about working for company =
company struggles to get best talent
Suppliers won’t supply on credit

→Fined= the company can get fined for unethical practices= less dividend for
stakeholders

Corporate forms of business:

• Sole proprietorship

• Partnership

• Companies

▪ Non-profit companies

▪ For-profit companies

• Close corporations

SELF STUDY: Section 1.5

Agency problem:

• The shareholders (principals) appoint managers (agents) to look after their interests

• Agency relationship: The relationship between the principal and the agent

• Agency problem: When the agent does not make decisions in the best interest of the
principal.

▪ Managers make decisions for the protection of their own best interest instead of
focusing on what is best for the shareholders.

Agency costs:

Agency cost: Any costs that arise due to the agent (managers) not taking decisions to maximize the
wealth of the shareholders (principals)
→Managerial compensation plans:

▪ Performance linked to share price and often includes share options

▪ Performance assessed by profitability measures, incentives include cash bonuses

• Idea: we can control the agent if we make the shareholders (we give them shares) = they
will think twice as to engaging in a project with less value (more value would mean they
benefit as well) = Agency costs can be controlled if managers have financial motivation

Financial markets and institutions:

Financial markets: Brings together the suppliers and seekers of funds.

• Money market:

▪ short-term securities (marketable securities).

▪ no physical location; and

▪ maturity of one year or less

• Capital market:

▪ long-term securities (shares and bond exchanges).

▪ maturity of more than one year

JSE provides primary and secondary market

Ethics and ESG considerations:

• Ethics” refers to the character and guiding beliefs of a person, group or institution

• Ethical decisions refer to decisions based on what is good, right, just and fair when
interacting with others= do no harm

• Morality refers to the customs that are defined by society at a specific point in time

Unethical behaviour:
Ethics = individual
• Creative accounting, discrimination, price fixing
Morality= society
• King IV Report offers corporate governance
guidelines on how to go about creating an ethical
culture in a business
 Chapter 2

Introduction

• External capital providers often struggle to find relevant financial information

• Companies provide annual financial reports

• Includes financial statements:

Be comfortable with
▪ Statement of financial position
compiling statements
▪ Statement of profit or loss / comprehensive income

▪ Statement of cash flows

Objective of financial reporting:

• Listed firms prepare financial reports according to International Financial Reporting

Standards (IFRS) - type and nature of the information

• 3 main aspects:

• Directed towards potential external-capital providers

• Information about economic resources, claims on these resources and changes in

resources and claims

• Other useful information (non-financial related aspects)

Users of financial reporting:

• Primary users: existing and potential equity investors, lenders and other creditors (debt
providers); customers; employees; state

Stakeholders:

• Shareholders more people are looking into the

financials and asking what the
• Management
implications for myself, and others are
• Providers of debt capital

• Government

• Others (customers, employees, competitors)

Information provided by financial reporting:

• Information about a company’s economic resources (assets) and claims on these resources
(equity and liabilities)

• Three main aspects:

➢ Provide summary of financial position

➢ Financial performance
➢ Change in financial position
Qualitative characteristics of useful financial information:

➢ Relevant and faithfully represented

➢ Verifiable
➢ Timely = this year that recaps on the preceding 12 moths
➢ Understandable = what does the information tell you
➢ Comparable = woollies vs checkers e.g., return on assets
➢ Accurate and objective

The standardization of financial statements:

• Financial statements need to be comparable

➢ Statements may not be comparable as a result of different accounting standards or

reporting dates (SA: IFRS)
➢ Solution
➢ Standardise published financial statements
▪ Sustainable value creation

▪ International Integrated Reporting Council (IIRC)

➢ Six types of capital

Statement of financial position:

Summary of a firm’s financial position at a specific time (usually end of reporting period)
Non-current assets

• Property, plant and equipment @ cost price

➢ Physical assets e.g., property, equipment, vehicles, buildings

➢ Shown at original cost price

➢ Weakness of SFP: if assets are in use for long, the cost price no longer reflects the
replacement (current) value of the asset

➢ Solution: revaluation reserve (reserve relates to the equity side)

Accumulated depreciation

➢ Provided for in SPL, accumulated in SFP= depreciation for this year goes to SPL

➢ Indication of the total depreciation provided for PPE = all depreciation for lifetime n SFP

PPE at carrying value = ALWAYS USE @CV

➢ PPE @ carrying value = PPE @ cost price – accumulated depreciation

➢ Supposed you bought an asset for R100 000 with a useful lifetime of 8 years. What is the
carrying value of the asset today (end of year 3) if straight-line depreciation is applied?

➢ Cost price = R100 000

➢ Accumulated depreciation for 3 years = (100 000/8) * 3 Either % or over a

= 37 500 (at the end of year 3) number of years

➢ Carrying value = 100 000 – 37500

= 62 500

Assets under construction

• Asset not yet completed

• Shown separately from PPE
• No depreciation provided

Intangible assets (identifiable vs non-identifiable)

 ➢ Identifiable (e.g., computer software) = can provide amortisation over
lifetime of asset= similar to depreciation = on a year-by-year basis show in
the SPL

➢ Non-identifiable (e.g., goodwill) = cannot provide annual amortisation.

Annual impairment test – difference written off in statement of profit or
loss. impairment= difference between goodwill

Goodwill:

Company acquires another at a price higher than the fair

value of assets obtained through the transaction.

Valuation is challenging

• Financial assets (reported at fair value)

➢ Investment in securities Take the % of the final
o Less than 20% amount and put it in the
o Also, long-term fixed deposits SPL
➢ Investment in associate
o Owns 20% - 50% of shares in another company

➢ Long-term loans granted = you will get investment income

➢ Post-retirement benefit assets= assets available to cover claims by retired

employees that are part of the entity defined benefit plan = not something you need
to calculate

➢ Deferred tax assets

• Difference in accounting (depreciation) and tax treatment (wear-and-tear)

Deferred tax example – Page 45

• Delivery vehicle bought for R150 000

• Expected lifetime of 2 years, straight line depreciation
• SARS wear-and-tear allowance over 3 years
• Wear-and-tear: 150 000 / 3 = 50 000 per year
• Depreciation: 150 000 / 2 = 75 000 per year
Our depreciation was
higher than what
SARS expected =
differed tax Asset

Current Assets
Total equity

• Breakdown of different forms of equity capital to finance company’s assets

• Includes all capital provided by different shareholders

• Important to distinguish between contributions of different types of shareholders

 Retained earnings=
difference goes to SPL

Dividends of
preference and
ordinary goes to SPL

Liabilities

Non-current liabilities

• Post-retirement obligations

➢ Healthcare and pension benefits that needs to be supplied to employees once they
retire
• Deferred tax liabilities
➢ Similar to deferred tax assets
➢ Occurs when taxable income is larger than accounting income (what we have vs what
SARS has)
You can have differed tax and liability because you have different assets

Current liabilities

➢ Short-term financial liabilities = bank overdraft or short-term loan for a year

➢ Tax payable to SARS = don’t need to compile the cashflow statement = will give it to you
➢ Other current liabilities

▪ Liabilities in disposal groups, short-term provisions, short-term deferred income

Statement of profit or loss (statement of comprehensive income)

• Summary of financial performance for a financial year matching income and expenses

•
• Revenue (sales or turnover)

➢ Income received for the sale of products or services

Cost of sales

➢ All costs directly incurred to generate revenue

➢ Cost of raw materials, purchase of inventory, transport cost
Gross profit

➢ Generated by sales activities

➢ Gross profit = Revenue – cost of sales

Other operating income

➢ Generated as part of operating activity

Operating expenses
➢ Expenses incurred to support primary activities
➢ E.g., depreciation, amortisation, operating lease charges

Operating profit
➢ Profit resulting from primary activities of business

Investment income
➢ Dividends and interest received

Finance costs
➢ Interest paid on debt financing= all NCL and CL that are interest bearing
Income tax expense

➢ Company tax payable to SARS (calculated on profit before tax)

➢ See tax rate provided per question

Non-controlling interest

➢ Portion of profit that belongs to minority shareholders

Preference shares dividends

➢ Dividends paid to preference shareholders
➢ Preference above ordinary shareholders

Attributable earnings

➢ Pay dividends vs retain earnings

Ordinary share dividends

➢ Total amount paid to ordinary shareholders in the form of dividends

➢ Amount received per share (cents) x number of ordinary shares

Transfer to general reserve

Retained earnings

➢ Portion of the profits that are not paid out as dividends, but reinvested
➢ Transferred to reserves (distributable) of business
➢ Can be used to finance business’s activities

How will they ask

questions?
→ give me a shuffled list
and then I calculate e.g.,
NCA or any SPL or SFP item
→ be able to work up and
down in SPL & get values
from ratios
 Chapter 3

Why do we do ratio analysis?

• Provide more information in format that is comparable over time and between companies
and/or industries

• Ratios are more understandable than the financial figures in financial statements

• Meaningful relationships between items from the financial statements are investigated

Requirements for financial ratios

• Primary objective =Simplify the evaluation of the financial performance and position

• Requirements:

1. Meaningful =Logical comparison between items from financial statements = relationship between
investigated variables needs to be logical (look at 2 items from the statement that have a
relationship)

2. Relevant = True indication of financial performance= only include relevant amounts

3. Comparable
• Across industries and over time
• Ratio calculated in a consistent manner

Norms of comparison

Ratios should not be interpreted in isolation

Conventions
• Norms developed over time (e.g., Current ratio 2:1)
• May differ between firms/industries

Comparison over time = look at 5 years’ worth of current ratios to determine the liquidity

Comparison between similar companies

• Determine the competitive position of the company relative to its competitors

244 calculates ratios differently to 214

Profitability ratios
• Evaluates efficiency of a company utilising its capital to generate turnover/revenue

• Possible to calculate the profitability of different capital items = assets/ equity etc…

• The higher the return on a capital item, the more efficiently it has been used

Small investment in assets and it generates a large income = company is highly profitable = assets
used efficiently = i.e., HIGHER RATIO= MORE EFFICIENT

Return on assets (%)

• Measures how efficiently total assets are utilised to generate turnover

▪ Compares profit after tax with total assets

Profit after tax
ROA = Average total assets x 100

How can we improve ROA = Improve profit after tax or reduce average total assets or
combination of the two → business must be careful not to decr total assets to a level that
isn’t sustainable?

• Higher ROA = using assets more efficiently

• Careful not to reduce assets too much – negative effect on activities in the future

• ROA steadily declines for 5 years

• Profit margin stayed more or less the same, but investment in assets increased.

What might it imply?

- investment in assets is not being used efficiently to generate more profit because even
though the business has invested more in assets- they are still making more or less the
same profits with the increased amount of assets being employed

Return on equity (%)

• Indicates return generated on total equity

• Total equity includes ordinary shareholders’ equity, preference share capital and minority /
non-controlling interest
Profit after tax
ROE= x 100
Average equity
• The higher the ratio the better for equity providers/investors = business is more efficient in
utilizing equity to generate income

• incr in equity over time but profit remains the same= equity is not being employed
efficiently to generate more profit

• Compare to other firms in the same industry

 Return on shareholders’ equity (%)

• Shareholder’s equity includes ordinary shareholders’ equity and preference share

capital
Profit after tax -non-controlling interest
ROSE= x 100
Average shareholders' equity
Note that non-controlling interest is withdrawn from profit after tax, as we now only
consider a part of equity (namely average shareholders’ equity)

Return on ordinary shareholders’ equity (%)

• Ordinary shareholders’ equity includes ordinary share capital and reserves

Profit after tax -non-controlling interest -preference dividends
ROSHE= Average ordinary shareholders' equity
x 100

Profit margins
• Indication of the percentage of turnover that reflects as profit after deductions are made

• Profit margins could influence profitability ratios

Higher profit margins should increase profitability levels

Gross profit margin (%)

• Portion of revenue that is realised as gross profit after cost of sales has been subtracted
Gross profit
GP = x 100
Turnover

Please note: Turnover and revenue are synonyms

• Higher = better

• GP>industry = could hold a competitive advantage in that sector = e.g., better quality,
perception, branding or product costs

• GP could decrease should competition increase=

e.g., you a first mover in a n industry and you able to sell a product that nobody
else sells→ this means you can have high margins cause of no competition

then competitors enter the market offering a similar product→ this will drive your
gross profit margin downwards because you will now need to compete within the
industry
Mark-up

NB to distinguish between mark-up % and gross profit %

Gross profit
Mark-up = x 100
Cost of sales

Note that gross profit margin is determined as a % of revenue while mark-up is

determined as a % of cost of sales

Operating profit margin (%)

• Portion of revenue that is realised as operating profit after operating expenses have been
subtracted
Operating profit
OP = Revenue
x 100

• Increasing OP margin = positive sign

• Investors should be looking for strong, consistent OP margins

OP decr – result of incr in operating expenses

Earnings before interest and tax margin (%)

• Profit made by a company’s operating and investment activities excluding finance cost
Operating profit + Investment income
EBIT = Revenue
x 100

OR
Probit before tax + Finance cost
EBIT = Revenue
x 100

Net profit margin (%)

• Portion of turnover available after tax is paid

• Important to the equity providers

▪ Indication of portion of the turnover that belongs to non-controlling interest

holders, which can be paid out as ordinary or preference dividends or can be
reinvested as part of the company’s reserves
Profit after tax
NP = Revenue
x 100
Turnover ratios
• Indicates speed with which an investment in assets is converted into turnover

▪ Higher → utilized more times per year → turnover → higher total profit

Factors influencing turnover ratios:

• Type of products
• Nature of industry Always given in times

Higher= better

Total asset turnover ratio (times)

• Indicates efficiency with which total assets are utilised to generate turnover
Turnover
TA = Average total assets

Higher TA value = more times in a year the investment in total assets is being converted into
turnover = efficiently utilizing assets to generate a revenue

If a company improves the TA ratio while maintaining the same profit margins, its return on
assets should increase

Property, plant and equipment turnover ratio (times)

• Evaluates the utilisation of a company’s investment in PPE

Turnover
PPE turnover = Average PPE @ carrying value

Carrying Value = Cost price – Accumulated depreciation

Current asset turnover ratio (times)

• Number of times per year that the investment in the current assets is converted into
turnover
Turnover
CA turnover = Average current assets

Trade receivables turnover ratio (times)

• Number of times per year that investment in trade receivables is converted into turnover
Turnover
Trade receivables turnover =
Average trade receivables

A decrease = TR are being used less efficiently, which could also lead
to a decrease in the CA turnover ratio.
Inventory turnover ratio (times)

• Cost of sales is determined by the amount of inventory that is sold

Cost of sales
Inventory turnover =
Average inventory

• High = less resources are tied up in inventory = a sign that the firm’s inventory is too lean =
unable to keep up with the high demand

• Very industry specific (e.g., flower shop vs jewellery store) = flower shop inventory will be
turnover much more time than a jewelry stores inventory

How could efficiency be improved?

decr in inventory or incr in cost of goods sold = improved ratio and improved inventory efficiency

Trade payables turnover ratio (times)

• Evaluates efficiency with which company utilises trade payables to finance its purchases
Purchases
Trade payables turnover = Purchases = (Closing balance of inventory + COS) – Opening
Average trade payables balance of inventory

• Interpret answer: 6 times= the firm has paid of the credit extended to the 6 times during the
period or once every 61 days = increases as more purchases are made or as more accounts
payable decr

TP ratio > industry = paying off creditors more quickly than other competitors in the industry
Liquidity ratios
Liquidity refers to ability to honour short-term obligations
• Adequate liquidity: sufficient current assets to cover current liabilities
• If liquidity is consistently at insufficient levels = solvency problems could occur

Current ratio

Compares all current assets and current liabilities

• Conventional norm of comparison 2:1 = R2 of CA for every R1 of CL
• Value less than one: less than R1 of current assets to cover R1 of current liabilities – this
could indicate insufficient liquidity

Current assets
Current ratio = Current liabilities

• NB: keep in mind the nature and type of business = ratio too high = firm carrying too much
inventory, but this all depends on the nature and type of business

Quick (acid-test) ratio

Norm = 1:1 = R1 CA for R1 CL

• Not all current assets are included (remove “less liquid” CA)

➢ Takes time to sell inventory

➢ Prepayments cannot be reclaimed

Value of quick ratio more conservative estimate of current assets available to cover current
liabilities
Cash + short-term investments + trade receivables
Quick ratio = Current liabilities

OR Too low = firm too heavily

dependent on inventory
Current assets - inventory - prepayments
Quick ratio = Current liabilities

Cash ratio

• Focus is solely placed on cash and cash equivalents available

▪ Cash ratio indicates if sufficient cash is available to cover current liabilities

Cash
Cash ratio = Current liabilities

• Most conservative liquidity ratio

• Cash and marketable securities = most liquid

 Turnover times
• Also provide an indication of the liquidity of a firm

• Turnover times of current assets provide indication of time (days) it takes to convert
investment into turnover

• More efficient management of working capital components could result in improved

liquidity

• 360 days Longer turnover times: weaker liquidity

Trade receivables turnover time (days)

• Average time it takes to convert investment in TR into turnover = how long the credit
customers take to pay their accounts
Average trade receivables
Trade receivables turnover time = x 360
Turnover

Increase in the value of ratio over time could be:

• A sign of decreased liquidity = TR taking longer to pay back the debt
• An indication that credit terms are too lenient = allowing too many days for TR to be
repaid back

Inventory turnover time (days)

• Average time it takes to convert inventory into turnover = how long the item has been in the
business before it is sold
Average inventory
Inventory turnover time = x 360 Decr = positive effect on inventory
Cost of sales

• Increase in inventory turnover time = negative

effect on liquidity= longer it takes for you to sell inventory → the slower the income is
received form the investment in inventory

• Danger of long turnover time period = inventory become obsolete, at risk of damage or
unusable

Trade payables turnover time (days)

• Average payment period of trade payables

▪ Prefer longer or shorter period?

Average trade payables
Trade payables turnover time = x 360
Purchases
 • Trade payables turnover time decreases trade payables are repaid earlier = negative effect
on liquidity

Longer the time it takes to pay TP→ the better for the business and the better for liquidity

Cash conversion cycle

• Indication of the time it takes from when cash is spent on purchase of inventory until it is
received back again from creditor customers

CCC = Trade receivables turnover time + Inventory turnover time – Trade payables turnover time

▪ Inverse relationship between CCC and profitability; could improve profitability by

reducing CCC= incr in CC = decr in profitability → Improve profitability by reducing
CCC

Solvency ratios
• Company’s ability to cover its obligations when it closes down its operating activities

• Comparison between total assets and total debt capital

▪ Assets > Liabilities = solvency is sufficient

▪ If this is not the case: long-term survival of the company may be at risk

Debt to assets ratio

• Provides an indication of the portion of the total capital requirement that is financed by
means of debt capital
Total debt The higher the value of this ratio, the weaker the solvency
Debt: assets ratio = Total assets
position
Interpret answer= 0.35 = 35% of businesses assets are financed by debt = 65% assets is covered by
equity capital

Debt to equity ratio

• Compares amount of debt capital with equity capital

Total debt
Debt: equity ratio = Total equity Higher = weaker the solvency= more debt is being
employed than equity within the business

• DE = 1 = the firm uses the same amount of debt capital and equity capital = creditors have
claim to all assets in the case of liquidation= leaving nothing for shareholders

Financial leverage ratio

 • Average amount of total assets is compared with the average equity capital included in the
company’s capital structure
Average total assets Higher= weaker solvency = incr reflects
Financial leverage ratio = Average total equity
an incr in the use of debt capital

Coverage ratios
- ability to meet obligations Given in times
- not able to meet obligations = solvency

- ratio’s focus on an obligation that the company is legally bound to consider and then compare it to
its revenues of the obligation

Finance cost coverage (times)

• Finance cost payable on debt capital = legally enforceable obligation

➢ If finance cost is not paid debt capital providers can take legal action to collect it
➢ FCC ratio indicates if sufficient profits are available to pay finance cost

Higher = more likely the firm will meet

EBIT
Finance cost coverage = the debt repayment obligations and
Finance cost
the firm is generating strong profits
compared to their obligations

Fixed payments coverage ratio (times)

• Fixed payments: obligations that company always needs to honour

• Usually consist of finance cost and lease payments

Profit before tax + finance costs + lease payments

Higher = better for business= more than
FP coverage = Finance costs + lease payments sufficient profit to cover these fixed
payments

• Less than 1: insufficient profits to make these fixe payments → use reserves from previous
years in the form of retained earnings or they would need to source additional capital, but
this will come at an additional cost

Preference dividend coverage ratio (times)

• Indicates if sufficient profits are available to pay preference dividends

▪ Preference dividends can only be paid after provision has been made for all other
obligations
 Profit after tax - non-controlling interest
Preference dividend coverage = Preference dividends

Higher= sufficient profit available to pay obligation

Investment ratios
• Of importance to existing and potential shareholders

➢ potential benefits
➢ if the investment in the shares of the company is expected to increase or decrease in
value over time

Earnings per share (EPS) ratio

• Indication of the attributable earnings that was earned per ordinary share during the year
(cents)
Always in cents
Profit after tax -Non-controlling interest -Preference dividends
EPS = Average number of ordinary shares issued Higher = better = consider the trends over
time and compare companies in the same
industry
Attributable earnings
EPS = Average number of ordinary shares issued
Ratio largely dependent on #shares in issue

- bigger firm = more shareholders= profits

Manipulated: divided amongst more

- buy-back = improve the EPS ratio without improving the earnings potential in the business =
business isn’t actually generating increasing profits over time

Dividends per share ratio

• Indicates the amount that investors receive per share in the form of ordinary dividends
(cents)

▪ Only a portion of the EPS is declared as an ordinary dividend

▪ Portion not paid out reinvested as retained earnings

Ordinary share dividend
DPS = Average number of ordinary shares

Price earnings ratio

• Indication of how many Rands investors is prepared to pay for each R1 EPS that is earned

▪ If P:E ratio is greater than one, it is usually an indication that investors expect
company to continue to grow in future
Indication of the market’s perception of risk and
future growth and earnings of the business

Ratio >1 = investors expect the company to

continue to grow in the future
 Price per share
P:E ratio = Earnings per share

Dividend pay-out ratio

• Represents portion of attributable earnings that is paid to investors

• Remaining portion is reinvested as part of retained earnings

Dividend playout ratio =

Ordinary dividends declared 0.4→ 40% of every R1 attributable earnings is
Attributable earnings
being paid out to shareholders = 60%
reinvested back into the business in the form of
retained earnings

• Low dividend payout ratio = more reinvestment which could lead to value creation

Ordinary dividend coverage ratio

• Ordinary shareholders have last claim on profits

Attributable earnings
Ordinary dividend coverage = Ordinary dividends declared

• Focus is placed on attributable earnings

➢ Dividends usually only declared if sufficient profits are available

➢ If ODC < 1, reserves from previous years used or additional debt capital obtained (comes
with additional finance costs)

Market-to-book-value ratio

• Compares market capitalisation of shares with book value of shareholders’ equity

Market capitalisation of ordinary shares
Market-to-book value =
Book value of ordinary shares

• Market capitalisation = MP per share x number of ordinary shares

• Indication of the price investors are willing to pay in relation to the book value

Financial gearing
• Effect that the use of debt capital has on ROSE

➢ Efficient use of debt capital =Incr return for shareholders

➢ Inefficient use of debt capital = negative effect on return of shareholders’ equity

• Two important factors to consider when evaluating financial gearing:

 ➢ ROA
➢ Cost associated with debt capital (RD)

• If company is able to generate ROA in excess of RD:

➢ Return on capital will be higher than its cost.

➢ Surplus profit will be transferred to shareholders increasing ROSE
➢ Company experiences positive financial gearing

Return on asset> cost of debt debt=

1000* 15%= 150 positive financial gearing = increased
use of debts capital results in a higher
900*10% = 90 return on shareholders’ equity which
60/100 (ordinary is the 60% we see in company A
shares) = 60%

Financial gearing summary

ROA = return on assets
Positive:
Break down of the return ratios RD= cost of debt
ROA>RD and ROSE>ROA
- more debtUnderstand
beneficial to ROSE
what affect changes in the components of the ratios haveROSE
in the overall on
effect of the
= Return
company = identify why a specific return ratio, changed over a specific period
shareholders’ equity
Negative
ROA<RD and ROSE<ROA
- earning less on debt than what it’s costing them to have that debt = not advantageous to increase the amount of debt
capital in their capital structure → negative affect on shareholders’ equity

No financial gearing
ROA=RD and ROSE=ROA
- return on assets is the same as what it is costing you to finance that asset
ROA * leverage = ROE

Net profit margin * total asset turnover = ROA

Any changes in tax burden, interest burden and EBIT margin will impact net profit margin= impact
ROA = impact ROE

Chapter 4

Introduction

❑ Companies need debt and equity capital to grow and prosper. Investors evaluate companies
using financial, ethical and ESG criteria (environmental social and governance)

❑ Consequences of weak ESG management? = not looking at the grey areas

❑ Volkswagen emission scandal: massive outcry of discontent by slighted customers and

shareholders on social media.

❑ The consequences of the emissions scandal will be felt for years to come.

❑ Other examples: Facebook = didn’t protect their user’s info, Boeing

❑ Local companies are also increasingly in the spotlight for dubious activities.

❑ E.g., Steinhoff and Tiger Brands

❑ Companies that wish to avoid negative publicity and adverse price movements should heed
calls by investors to improve ESG risk management.

A company should not separate financial performance and ethical considerations = this
is the new status quo

Companies report in an integrated manner= speaks about financial performance and

ESG and links all of that to different types of Capital

Avoid negative publicity which causes negative share price movement = Take ESG into
account

& If there is a negative situation then be open and honest about the situation
Responsible investing (RI)
 ❑ Definition: The integration of ESG considerations into investment analyses and ownership
practices. (In addition to considering financial performance) = a responsible investor would
like to see what the esg aspects and the financial considerations → If I compare a couple of
companies in my sector, which company will I choose

Investment analysis= looking at share price movement & incorporating esg

Ownership practice= align the investment decisions with the esg aspects and the financial
performance aspects

❑ E: What is the company doing to reduce the adverse impact of climate change, reduce
waste, reduce water consumption, minimise pollution, use clean technologies, alternative
energy sources and green buildings (amongst others) = what is the specific company doing
to decrease its negative environmental footprint.

❑ S: What is the company doing to promote broad-based black economic empowerment (B-
BBEE), uphold human rights, develop employees, improve health and safety, reduce
HIV/AIDS, create new jobs- does that go back to the local community= humans working in
the company

❑ G: What is the company doing to ensure director independence = promote race, gender, age
and experience diversity at board level, remunerate executives fairly (what is a fair
remuneration package compared to broader packages), ensure accurate reporting (amongst
others) = corporate governance – top leadership structure (board of directors (made up of
executive leaders) & what they are doing)

❑ Example: Consumer goods and consumer services companies

❑ Positive (excels in a specific esg aspect) and Negative aspects? = be transparent in

both & how they deal with negative and if this improved over time (was there a
turnaround)

E management

Company that catches fish= do they source the fish in a sustainable manner (breed plant?); do they
have initiatives to take plastic from the ocean (clean up the ocean)

Take into account= some companies just by the nature of the company will have a more negative
environmental footprint = the idea is that we acknowledge the environmental footprint and deal
with it in an environmentally good way = improve

- efficient energy= water

- pollution

S:

- develop skills

- help the public

G:

- diversity in senior levels

International Organization for Standardization PRI guidelines

(ISO) 1 400

S management

Employees, customers and suppliers

-Fish company has a number of employees going on boats = how do they provide safety for these
employees

-do they provide equal opportunities for these employees in terms of different races, gender etc.
- if something happened on the boat- how do they treat that incident = health and safety

- also applies to customers and products = is the product safe to consumers that steers entirely away
from child labour = health and safety

❑ Consider occupational fatalities and safety incidents.

❑ B-BBEE = working conditions

❑ Invest in employee skills development = uplift employees and enhance their skills

❑ Corporate social investment spends = school clothing or soccer equipment to children

G management

Statement from a
company’s report

Laying out the

classification of
members & age and
gender diversity
- top decision-making structure = board of directors = executive managers=is a specific percentage of
executives on the board classified as independent = do we give them fair pay= look at the
relationship between the top management and the shareholders (how do you value them) =
business ethics

- we need a diverse spectrum of individuals that can bring open mindedness to the company

- board makes decisions that have a substantial implication on E & S

❑ Complete the sentence. In the South African context, most responsible investors focus on
the ________ component of ESG risk management.

A. Corporate governance

Responsible investing strategies

We have regional investors and institutional investors

1. Negative or exclusionary screening

• Avoiding or excluding investments in ‘undesirable’ countries, industries and companies=

investors have criteria-and based on that criterion, we will include or exclude a company
based on our portfolio

- what we deem as undesirable will differ between individuals based on your personal
circumstances
e.g., negative screen companies that is
involved in deforestation = you will have
• Investor rationale? peace of mind that when you invest your
hard-earned money then you not
➢ Peace of mind.
participating in negative environmental
➢ Invest in line with moral or religious convictions. actions

➢ “Do no harm”.

• Very subjective: who exactly should be excluded= not clear-cut criteria

• Returns are on par with unscreened portfolios= you won’t be negatively impacted by
excluding companies→ but if you don’t bring the negative aspect to a company’s attention
then you will not engage in changing the status quo of that company → you will limit your
diversification possibilities

• Most negative screens in SA are based on Shari’ah law. (Religious motives)

 Recognise that they have a good
attempt to ESG

- this can be very personal in terms

of how an investor applies a specific
screen

- positive screening can relate to

companies that have a negative
impact but are actively trying to
combat this negative impact
(deforestation but then plant new
2. Norms-based or positive screening
trees somewhere else)
• Providing capital at lower cost to good corporate citizens.

➢ Companies that try to limit their impact on the environment, uplift communities,
develop employees, treat customers fairly, etc.

➢ Criteria often based on the United Nations Global Compact (UNGC) Principles and
the OECD Guidelines for Multinational Corporations and International Treaties.

• One of the first local RI funds (Community Growth Equity Fund) used norms-based screens.

The 10 UNGC principles

➢ Reduce exposure to ESG-related fines, litigation and negative publicity.

➢ Earn returns that are on par with conventional (unscreened) portfolios. = can have a
sound continuous in terms of Esg that you value → less negative publicity or esg
fines → share price and profits go down→ negatively impacted in terms of the value
of your investment in that company

➢ Clean conscience.

3. Best-in-class screening

❑ Combination of negative and positive screens.

 ❑ Invest in the best and avoid the rest= do screening avoid companies you don’t want to invest
in → have a look in the companies that meet certain positive screening criteria and then
based on that short list you can create a diversification portfolio

❑ Rationale similar to norms-based screening.

❑ Create more efficient portfolios from a diversification point of view.

❑ Top performing companies are often included in RI indices= this is easier for you as an
investor because you know that companies in this index have already been screened (you
don’t have to do the work yourself)

For test:
4. Impact investing - know calc, interpretation, theoretical
❑ Investing with the aim of: discussion and theory

➢ generating social and environmental impact alongside financial returns. (

-environmental focus- invest in a windfarm and make an impact in the E aspect of

esg

- social focus- invest in uplifting the local community and focus on the S

➢ Investing in wind farms, micro-finance institutions and social

infrastructure such as roads and water and electricity networks.

❑ Some disadvantages.

- long term investment (takes time to really gain returns from ESG perspective= buy the
shares and keep them for years).

-challenging to measure E and S “returns” = you don’t see it reflected that easily= get
researchers in to really evaluate the impact of the investment on the community

5. Shareholder activism

❑ Shareholders exercising their voting rights and engaging management to change corporate
policies and practices.

❑ Strategies:

➢ Exit (divestment) = some things you don’t agree with

• Sell some or all the shares owned in a company.

• Problem= if you exist and you a small investor then the management won’t
even realise that there is a problem = limited impact especially if you are a
retail investor

➢ Voice (private)

• Write confidential letters and/or emails to the board about info you
dissatisfied with
 • Negotiate with management/board behind closed doors= for large investors

e.g., executive renumeration = increasingly shareholders in SA are becoming

dissatisfied with seemingly exorbitant executive remuneration packages →
institutional investors increase the engagements with top leaders (the
board) before they vote at the annual meeting → they would like to indicate
that they are unsatisfied with either the size or the compilation of the
executive renumeration packages

➢ Voice (public)

• File a shareholder resolution= item to be filed that will be voted on at the

AGM → any shareholder can go to the AGM & ask a question

• Oppose a management resolution by voting against it= e.g., vote against the
executive renumeration package

• Stimulate public debate on an issue of concern by talking to the press and/or

discussing the matter at conferences= e.g., raise the issue on social media.

• Initiate legal proceedings to enforce shareholder rights

Shareholder activism in SA

• The choice of mechanism is influenced by the business culture in a country.

o Most activism in SA takes place behind closed doors to maintain investor-investee

relationships= mostly institutional investors = entail that other investor (minority
investors – retail- might not be aware of these negotiations at all)

- they prefer closed doors because you don’t want to name and shame
investors in public

o Private and public activism is on the rise in SA= a short summary of engagement

• Very few shareholders speak up in public, Mr Theo Botha being the exception.

o He mainly engages on governance issues, particularly executive remuneration.

o The ‘Botha sting’ hurts. = if he criticizes the company in public = the share prices will
be negatively impacted= not naming and shaming but just getting your voice heard

Summary: Shareholder activism

• Characteristics of companies that are likely to be targeted.

o Large, those with poor financial performance and weak corporate governance.
• Activists globally and in SA are successful in improving environmental and social practices,
replacing underperforming executives and reducing seemingly excessive executive
remuneration. → There is a good track record of those that actively oppose companies on
ESG concerns and bring these aspects under companies return
• Role of institutional investors = most of the shareholder activists that have a success record
in SA are institutional investors, but a growing number of retail (individual investor) are
following Bothas method of voicing their opinion

-SA focus on impact investing

- asking questions at agm = public voice mechanism & legal proceedings to get the info

-in test= be able to identify the approach (exit or voice public/private)

Important role players in the RI industry
❑ Regulators

❑ Industry associations

➢ E.g., Institute of Directors in South Africa (IoDSA), Principles for Responsible

Investment (PRI) and Association for Savings and Investment South Africa (ASISA)

The PRI principles

❑ Most large asset owners, asset managers and services providers in SA are signatories to
these six principles:

➢ Incorporate ESG issues into investment analysis and decision-making processes.

➢ Be active owners and incorporate ESG issues into ownership policies and practices.

➢ Seek appropriate disclosure on ESG issues by the investee companies= you need to
make informed decisions from given information

➢ Promote the acceptance and implementation of the principles within the

investment industry

➢ Work together to enhance effectiveness in implementing the principles= get more

investors to actively invest in a responsible manner

➢ Report on activities and progress towards implementing the principles.

Important role players in the RI industry

❑ ASISA was instrumental in changing pension fund legislation in SA in 2011 (Regulation 28).

➢ Pension funds are required to develop an investment policy statement describing

the fund’s approach to trustee education, B-BBEE and ESG.

➢ Fewer restrictions on making alternative investments (including impact

investments).

❑ ASISA introduces CRISA (Code for Responsible Investing in South Africa) in 2011

➢ Offers guidance to investors pertaining to the application of the King III guidelines
and the PRI initiatives

➢ Not legislation

➢ Regulation 28 and CRISA are currently being revised

Important role players in the RI industry

❑ Investors and other stakeholders need material ESG information to make informed
decisions= you can score each aspect to discover the extent of the information
 ❑ GIIN and SAIIN (the global and Southern African impact investing networks).

❑ ESG data providers (such as MSCI; Bloomberg)

❑ Index providers (such as FTSE; Dow Jones; MSCI).

❑ Consultants (ISS Proxy Voting Services; Glass Lewis; Proxy View; Mercer; GraySwan
Investments) = advise pension funds on how you should vote on a certain resolution

❑ Academics and researchers= students working on projects

Integrated reporting
❑ Holistic and integrated representation of a company’s performance in terms of both its
finance and sustainability.

➢ International drivers: GRI and IIRC.

➢ Local drivers: King reports and IRC South Africa.

❑ Based on two fundamental and interconnected concepts: capital and value creation=

❑ Capital no longer on refers exclusively to debt and equity provided by shareholders,

bondholders and bankers

❑ some critique is the primary audience is investors= focus is to a large extent shareholder
As part of esg discussion- you can talk about the different capital

Exercise

Suppose a local technology company called IT Galore Ltd. plans to introduce a new patented
product. The forecasted revenue for the following year is based on the assumption that the rollout
will be successfully completed by 30 October this year. The new product should be installed by
trained technicians. The company is, however, currently experiencing a shortage of these
individuals.

❑ Recall that integrated reporting is based on two fundamental concepts, namely capital and
value creation.

❑ Identify two types of capital that are the most applicable to IT Galore’s current situation.

Test yourself
 ❑ Complete the sentence. The Association for Savings and Investments SA launched the
_____________ to provide guidance to institutional investors on complying with the
amended pension fund legislation.

A. CRISA

Investors who avoid investing in companies due to concerns about forced labour do so on
__________ grounds.

A. social

Research shows that companies with more diverse boards of directors (in terms of age, gender and
race) are ________ desirable for responsible investors than companies with less diverse
directorates.

A. more

An investor who uses a best-in-class screening strategy can invest in a “dirty industry” (such as oil
and gas) but will only select the best performing company in this industry based on ESG
considerations.

B. True = screening isn’t excluding all companies for the positive side= you pick those eho
manage the negative environmental footprint

Concluding remarks

❑ Responsible investors have increased in number, prominence and impact.

❑ Companies that fail to improve their ESG risk management policies, practices and reporting
are likely to face increased investor scrutiny and public criticism.

❑ The impact of lapses on the company’s reputation and share price could be quite severe.

❑ Managers need to be proactive in dealing with shareholder activists’ requests; clear

communication is key.

❑ All shareholders (irrespective of size) have a responsibility to hold directors and managers
accountable!
 Chapter 8

Introduction

• Where do governments obtain money from?

➢ By charging tax

➢ By issuing bonds = it is a form of debt capital= people giving them money

Where do companies obtain money?

➢ By issuing shares (equity)

➢ By issuing bonds (debt capital)

➢ Other forms of debt capital

A bond/debenture is a promise to pay a certain amount on a specific date and to pay interest on a
regular basis to the bondholder ( it is a type of loan, an IOU)

• Companies mainly use the capital obtained in this manner for expansions

• Municipalities use it for infrastructure development (e.g., 2010 FIFA World cup)

What is a bond?

Form of debt financing used by governments or corporate sector to finance expansion.

• The public buys the bond from the borrower (issuer) and becomes the bondholder (lender)

• The issuer is obliged to pay interest (coupons) to the lender at fixed intervals

• At the end of the life of the bond (maturity), the bond issuer has to repay the principal
amount (nominal amount/face value)

Bond has an issue price

You purchase the bond at the market price

Characteristics of bonds
Relationship between issue and market price depends on the
coupons Fixed amount that will be repaid to you at the
end of the lifetime of the bond
Periodic payment on the bond= fixed
How many times in the year will you
pay the coupon?
Over how many periods will you do the bond
calculation (2 coupons a year for 5 years =
10coupon periods)

Market interest rate = fluctuate

Yield-to-maturity (YTM) rate

• Also represents the bondholders’ opportunity cost: what he/she could have earned if
he/she did not buy the bond

– The market interest rate is usually used as a proxy

• Chapter 11: Cost of capital

• WACC = ke Ve + kp Vp + kd (1−T) Vd

Prime lending rate in South Africa

Bond values and interest rates

coupon rate is solid line

because it doesn’t change; YTM can change over time

A= if we invested in the market, we would have received more than the coupons we could earn on
the bond → to compensate an investor to actually still be interested in a bond → sell bond at a
discount

B= we earn more from this coupon which means it sells at a premium= we pay a higher price
because we would earn a higher coupon on the bond

C= bond will sell at its nominal value

South African context

• Bonds are traded through the JSE

• Timeline example: R100 000 bond, sold at the nominal value with a 5% coupon rate and 10
years to maturity.
 • Sold at nominal value = current price is also 100 000 (at the end of the lifetime the company
will give me the 100 000 back)

Market interest rate= coupon rate=5%= its selling at its nominal value

At year 10- the 100 will also be

paid

Bond valuation

• Calculating the value of a bond = 5 variables

• With any 4 variables, the 5th can be calculated

Orang c = clear memory = do things before every calc

PMT= coupon per period= if it is R100 coupon paid twice a year = the PMT is
R50
• The present
I/YR= don’tvalue
put inofdecimal=
a bond isjust
made upwhole
keep of 2 types of cash
number e.g.,flows:
8

N=➢ The constant

in periods= coupon
10-year periodpayments over thetwice
and get coupons lifetime of theN bond
a year= = 20 (annuity)

PV=➢willThe nominal
have valuesign
a negative (a once-off
(outflow)payment on the maturity date)
• NB: Both types of cash flows are discounted to calculate the present value of the bond

Calculate the present value

Suppose you want to invest in a bond with a nominal value of R1 000 (FV). The bond pays 4.5%
annual coupons (1000*0.045) & orange PMT 1 = to show its one per year. The current YTM is 5%
(annually compounded). The maturity of the bond is 10 years. Determine the present value of the
bond.
NB how often are coupons paid?

• E.g., annual, semi-annual, quarterly etc.

• How many coupon payments are made per year?

• And for the entire time to maturity period?

• NB impact on the following inputs: Time to maturity (N), coupon payment (PMT) and YTM
(I/YR)

• E.g., R1 000 bond, 10% coupon (payment every six months),10 years maturity and 8% YTM

• Coupon every six months = (R1 000 x 10%)/2 = 50

• Time to maturity = 10 x 2 = 20

• Interest rate: 2 options (only use of the two options) = yield to maturity

• Either divide the interest rate (YTM) by two OR insert the interest rate (YTM) as
provided and insert 2 P/YR= Put at 8 and then orange pmt 2 = do it this way cause
easier

If you use the 2nd option, NB to reset P/YR to 1 afterwards for future calculations
Calculator functions:

Calculate the present value

10% * 10 000= 1000 PMT; PV must be -

1ornage pmt = cause once in a year

Because coupon rate is a %

of the FV

Bond example

Suppose the City of Cape Town issues bonds for infrastructure development. The municipality issues
500 000 R1 million bonds with a 10-year maturity. The coupon rate is 12% and coupons are paid
semi-annually.

• Calculate the semi-annual coupon per bond.

(1 000 000 x 0.12)/2 = R60 000=PMT

Semi-annual coupon payments

South African bonds are mostly semi-annual in nature

• Semi-annual = two coupon payments per year (every 6 months)

• Take the following into account:

 ▪ The maturity time doubles (maturity x 2)

▪ The coupon payment has to be halved (coupon is paid every 6 months)

▪ The yield-to-maturity has to be halved (YTM ÷ 2) OR P/YR 2 on the HP calculator

and insert the YTM as provided

Calculate the yield-to-maturity

Lloyd just bought semi-annual bonds with a nominal value of R1 000 each that matures in 13 years.
The coupon rate is 7%. He bought the bonds at 103% of the nominal value. Calculate the YTM.

NB to clear memory of calculator before starting the question!

N = 13 x 2 = 26 = you wanting to get it into periods

PMT = (1 000 x 7%)/2 = 35

FV = 1 000

PV = 1 000 x 103% = - 1 030 (Use +- function on HP calculator) = show as outflow

2 orange pmt

Answer= I/yr= 6.65

Example: Determine the PV of a bond

Ladybird Ltd. sells bonds with a nominal value of R1 000 each that pay annual coupons at a rate of
12%. The time to maturity is 7 years. The YTM is 13%. What will you now pay (present value) for a
Ladybird bond?

N=7

PMT = (1 000 x 0.12) =120

I/YR = 13 & 1 orange pmt

FV = 1 000

PV = - 955.77 (trading at a discount= market value lower than fV= could have earner more on the
market)

coupon payments.

Adjustments for semi-annual coupons:

• The maturity date (N) must double

• The coupon amount (PMT) must half

• Input YTM as I/YR and the times per period as P/YR OR half YTM (P/YR should then
by default be 1)
 • Ladybird Ltd.’s bonds with a nominal value of R1 000 have semi-annual coupon payments at
a rate of 12% over a period of 7 years. The YTM is 13%. Determine the present value a
Ladybird bond.

2 orange PMT

Calculate the yield-to-maturity

1000*0.08=80

80/2=40 PMT

1000*1.02=1020

Types of bonds

Government bonds

• Treasury bill: Maturity less than 1 year

• Treasury notes: Maturity between 1 and 10 years

• Treasury bonds: Maturity longer than 10 years

• Safest investment; substantial risk in developing countries

Municipal bonds

• Issue bonds to help finance capital expenditure on infrastructure (e.g., Gautrain)

• Advantage: interest received is tax-exempt

Corporate bonds

• Higher yields – higher risk

• Short-term, intermediate and long-term

• Companies are classified according to:

• Specific industry

• Credit rating (high vs low)

 • Growth in the number of firms issuing green bonds

Convertible bonds

• Gives the owner the right to convert the nominal amount of the bond to ordinary
shares of issuing company at a fixed ratio (conversion ratio)

• Conversion price: Specified when issued

Junk bonds

• High-yield bonds= high risk high return

• Highly risky and speculative companies= possible gains but high risk

• Higher yields compensate for default risk

Zero-coupon bonds

• No coupon payments, just the nominal value gets repaid

• Offered at a considerable discount to par.

• Why= market value is less than future value= considerable discount

• Example: Electronix Ltd. is selling 10-year zero coupon bonds with a nominal value of R1 000
at a YTM of 7%. What is the value per bond if you should buy it now?

Extendable and retractable bonds

Time to maturity longer or shorter = in this case time to maturity isn’t fixed

• Lower coupon rate

• More than one maturity date

• Extendable: extend initial maturity to a later date

➢ Take advantage of potentially falling interest rate (if interest rate decreases,
bond price increases)

• Retractable: shorten initial maturity

➢ Potential increases in interest rate: Bond price decreases

Foreign-currency bonds

• Issued in a currency other than the currency of the issuer’s country

USA issue a bond in another country then the name of the band would be yankee
(only when USA in other country)

• Examples:

➢ USA = Yankee bonds

➢ Japanese Yen bonds = Samurai bonds

➢ British Pound bonds = Bulldog bonds

➢ New Zealand dollar bonds = Kiwi bonds

Bond values and interest rates

Inflation-linked bonds

• Adjust nominal value with the change in inflation (measured by CPI (consumer price
index)), coupon is therefore also adjusted

• Released in 2000 in South Africa= RSA retail bonds

 • Change in inflation measured by the Consumer Price Index (CPI)

Class exercise

Xian decides to invest in a semi-annual R1 000 bond that pays a coupon rate of 12%. The bond
matures in 10 years. She now pays R980 for the bond.

a) Determine the YTM.

NB! Pmt/2; 2 orange pmt; 20 N … insert the rest = 12.35

b) Is the bond selling at a discount or premium? Motivate your answer.

12.35>12= discount

PV<FV = discount

c) What would the YTM be if she would pay R1 090 for the bond instead of R980?

Re-enter the PV; then press I/YR= 10.52

Bond markets

• Most bond markets are OTC markets (over the counter)

• OTC = not a physical trading location

• Collection of dealers around the world who buy and sell bonds (via electronic networks)

• Bond markets = financial markets

Bond ratings

• Rated according to the creditworthiness of the issuing entity= links to risk and return

• Higher default= higher risk= higher return to expect

• Independent agencies; consider likelihood of default

• World’s leading rating agencies (approximately 90-95% of world market share):

Don’t need to know off by heart but will need to be able to
• Moody’s
interpret
• Standard & Poor’s (S&P)
Expected to apply= investor risk averse or risk loving which
• Fitch will determine which bond to take

• Coupons are dependent on the rating

• Higher rating = less likely that the issuer will default on payments

• The lower the risk, the lower the return A rating less risky
than riskier as
• Ratings can change as the situation in a company or country changes you go down
• SA current S&P rating: BB- with a stable outlook
Implications of junk status

• According to the rating agencies, the chance that the government will default is high

• As such, there is more risk for investors who buy these bonds = higher rate of return

• This means that the government must pay more interest

• People are willing to speculate in a junk bond = possible for quick return= risky

Credit ratings: Class question Closer to retirement=

risk averse= don’t want
to lose your well-earned
income
Risks for bondholders

• Inflation can decrease the purchasing power of future coupons and the nominal value

• Interest rates may decrease

• The issuer can go bankrupt

• It could be difficult to sell the bond

The higher the risk, the higher the rate of return investors expect

What determines bond returns?

-possible return investor would be interested in

• Inflation premium: The nominal interest rate is dependent on the expected inflation rate
and the real interest rate; if the real interest rate and/or inflation rate increase, the
coupon rate would increase and vice versa= high inflation= the inflation premium will
have an impact on if they should buy the bond

• Interest-rate premium: How high is the risk that the interest rate will change?

➢ The longer the time to maturity = greater risk= greater fluctuations in the market
interest rate

• Credit-risk premium: How high is the risk of defaulting on coupon payments?

➢ Bond ratings indicate if the risk for default is high

➢ High risk= lower bond rating (B or C)

• Liquidity premium: How difficult is it to sell the bond?

- short term ability to cover short term debt with ST asset

- how easy or difficult is it to sell the bond = depends on what type of bond you have

Class exercise

You want to invest in a R1 000 bond that is currently selling for

R1 100(bond is selling at a premium because you can get more for the bond) The bond matures in 4
years and makes annual coupon payments. The yield-to-maturity (YTM) is 12%.

1.1 Do you expect the coupon rate to be higher or lower than the YTM? Motivate your answer.
Premium cause PV>FV which means coupon rate is higher

1.2 Determine the annual coupon rate.

Pmt=152.92 …. 152.92/1000= 15.29

1.3 What would the quarterly coupon payment be if the bond has quarterly instead of annual
coupon payments?

37.96 (change N=16; 4 orange PMT)

The influence of interest and inflation rates

• Interest rate isn’t adjusted for inflation

• Inflation: the sustained increase in the general price level (decreasing purchasing power of a
currency)

• Nominal interest rate: Not adjusted for inflation (inflation still included)

• Real interest rate: Adjusted for inflation

• The Fisher effects Suppose the nominal interest rate is 12% and the inflation rate is
4%. Calculate the real interest rate.
• 1 + n = (1 + r) x (1 + i) OR
1 + n = (1 + r) x (1 + i)
• r + 1 = [(1 + n) / (1 + i)] (1 + 0.12) = (1 + r) x (1 + 0.04)
n = nominal interest rate 1.12/1.04=1.0769
r = real interest rate 1 + r = 1.0769
i = inflation r = 7.69%

Class exercise: Interest rate change

Bond A is a 5% coupon bond and Bond B is an 8% coupon bond. Both bonds have a nominal value of
R1 000, annually pay coupons and maturity of 12 years. The current market interest rate is 9%.

If the interest rate drops by 3% after one year, determine the percentage price change for both
bonds.

Bond A
N = 12; PMT = 50; FV =1 000; I/YR = 9%
Calculate PV = R713.57
If the interest rate drops after one year:
N = 11; PMT = 50; FV = 1 000; I/YR = 6%
Calculate PV = R921.13
% Change: [(921.13 - 713.57)/ 713.57] x 100 = 29.09%

One year later= N=11

Drop by 3%= 9-3=6%

To get change: after-before/before ….

This is why you need both PV values

Price change of 24.70 %

Class exercise
Ann decides to invest in a semi-annual R1 000 bond that pays a coupon rate of 12%. The bond
matures in ten years. Suppose she pays R960 for the bond today.
Determine the yield-to-maturity (YTM).
Determine the YTM be if she paid R1 200 for the bond instead of R960.

Determine the yield-to-maturity (YTM). Determine the YTM be if she paid R1 200 for the bond
N = 10 x 2 = 20 instead of R960.
PMT = (12% x 1 000)/2 = 60
make pv= -1200
FV = 1 000
PV = -960 I/YR= 8.93
P/YR = 2
YTM = 12.72% (show rate per annum)

Suppose you own 25 convertible bonds issued by Water Scarce Ltd. at R1 000 each. All your
bonds will be converted into ordinary shares at a conversion price of R50 per share on 30
October. Determine the conversion ratio and the total number of ordinary shares that you will
receive.

Conversion ratio: R1 000/50 = 20

Total number of ordinary shares: 20 x 25 = 500

not all bonds will be converted into ordinary shares (will be specified when you buy the bond)

20 x25x80% = if they only convert 80%

Suppose City of Cape Town decides to issue inflation-linked bonds. They intend to use the capital to
fund new water-related projects. Their time-to-maturity and nominal value are the same than that
of a company called Blue Drop. This company’s bonds are not inflation-linked. Explain how the
inflation-linked bonds of the City of Cape Town differ from Blue Drop’s bonds.

The nominal value of the inflation-linked bonds increases in line with inflation (as measured by the
Consumer Price Index).

As the nominal value rises, the coupons also increase.

 Chapter 9

Introduction

• Shares: A subdivision making up a portion of the company’s capital

• Shares represent investors’ ownership in a company

• Voting power = shareholders can use their voting power to vote for and against resolutions
within your company= can make responsible decisions

• “Acceptable return”? = differs from investor to investor in terms of what you perceive as an
acceptable financial and Esg return

Development of stock exchanges globally

• First ‘stock exchange’ in Europe was established in the 12th century

– French King ‘Phillip the Fair’

• LSE opened in 1773

• JSE established in 1887, one year after gold was found on the Witwatersrand

• 1996: Moved from an open outcry trading system to centralised, automated trading system

• JSE acquired the South African Futures Exchange (2001), and the Bond Exchange of South
Africa (2009) is a wholly owned subsidiary of the JSE

Ordinary and preference shares

Ordinary shares

• Dividends not guaranteed

• Right to vote at annual general meetings (AGMs)

• Pre-emptive right to purchase additional shares = right to obtain free shares (bonus)

B-class ordinary shares (second class of ordinary shares)

• Fewer or no voting rights

• Lower repayment priority in the event of a bankruptcy

• Dividends can be high

• Best suited for investors seeking long-term investments and those willing to
accept higher risk to achieve higher return
Preference shares

• Typically, no voting rights at AGMs

• Preferential treatment w.r.t. the distribution of profits and assets in the case of
liquidation

• Fixed annual dividend rate= bought share for R1 and dividend% is 10% = you would
receive R1

5 types of preference shares

Cumulative

• Dividends that have not been paid in a particular period will accumulate over time

• Shareholder remains entitled to these dividends

• If something happened in a company and the preference share could not be paid
then that shares dividend can accumulate and the next year they will be entitled to
that year and the previous year

Non-cumulative

• Do not entitle shareholders to missed dividends

• Not entitles to give the missed dividend

Participating

• Allows higher dividend if company performs better than expected

• Dividends have a lower limit but no upper limit

• Dividend at 10c per preference share= if company outperforms then they can get
more dividend = have a lower limit so you receive at least 10c but can increase

Convertible

• Allows shares to be converted into a predetermined amount of ordinary shares

Redeemable

• Shares can be called back by issuing company at stated maturity date

Share value

Market value

• Current price of a share

• E.g., consult Sharedata or Sharenet websites

• Determined by the forces of demand and supply in the secondary market= market
value either up or down
You bought a share in the company at the
• Market capitalisation: issue price= compare that with the market
value to determine if the investment
increased or decreased

Market value fluctuates and is irrational

considerations come into place
 = Market price per share x number of issued ordinary shares

Book value (BV)

• Market value ≠ book value

• Book value = Total assets – all liabilities – preference share

capital – intangible assets
Ordinary shareholders' equity
BV per share = Number of issued ordinary shares

• Market value > book value = value created

Intrinsic value:

• Used by prospective investors when evaluating investment opportunities

• Intrinsic value > market value = share is undervalued: buy= paying less than what
you valued it= the share is less in the market

• Intrinsic value < market value = share is overvalued: do not buy (sell if you own it)=
you paying more in the market than what you deem the share is worth

Ideally you would like to pay less for the share than what you value it at for your intrinsic value

• Dividend discount model

- zero dividend growth = growth
-constant dividend growth = dividend incr every year
-variable dividend growth = growth fluctuates every year

• Free cash flow model

• Relative valuation techniques

1. Dividend discount model

Used to determine the PV of future dividends (intrinsic value of a share)

Where:

D1 D2 Dn
Pˆ0 = + ++
(1 + ke ) (1 + ke )
1 2
(1 + ke )n

P̂0 = intrinsic value of a share (today)

D1 = the expected dividend paid at the end of period 1

D2 = the expected dividend paid at the end of period 2

Dn = the expected dividend paid at the end of period n

ke = rate of return required by ordinary shareholders (discount rate) = take future dividend and
work that ack to the value today
 P̂0 depends on expected future dividends as well as the required rate of return (ke)

ke incorporates investors’ views on the riskiness of a company

Dividend policy and ‘pattern’ of future dividend payments, depends on various factors, including:

Macro-level: Political, legal, economic, social and technological factors

Market factors: Consumers, suppliers and competitors

Micro-level: Company-specific factors such as brand loyalty and operational efficiency

1.1 Zero dividend growth

• Typically, applicable to preference shares = the company fixes the dividend percentage on
the issue price = no growth in the dividend

• Growth rate (g) = 0 ∴ 𝐷1 = 𝐷2 = 𝐷3 = … = 𝐷∞

̂0 = 𝐷
𝑃 𝑘 𝑝

– kp = required rate of return of preference shareholders/cost of preference share

capital= companies percepective is a cost; shareholder – return

– Present value of a perpetuity

Zero dividend growth example

Seagull Ltd. has issued preference shares that pay an annual dividend of R7 per share (fixed dividend
amount). Shareholders require a return of 11% on their investment. Calculate the intrinsic value per
preference share.
D
P̂ 0 =
𝑘𝑝

7
= 0.11

= R63.64

You want to invest in 5% preference shares issued by the Football Ltd. at R100 per share (dividend is
5% of 100). The shares are currently selling at R120 per share (market price per share). Determine
your expected rate of return.

a) 4.17%

b) 5.00%

c) 10.00%
d) 24.00%

1.2 Constant dividend growth

• Also known as Gordon model

• Some companies opt to increase dividends at a constant annual rate over the long-term

– Sends a signal to the market that the entity is financially sound

• Constant growth rate (g), forever

D0= last paid dividend

1.2 Constant dividend growth

Ke-g in decimal format

RECAP Ke is a cost from the company
perspective

Intrinsic value of a share today (𝑃̂0 ) depends on:

• The dividend to be paid in the next period, namely 𝐷1

 • divided by the difference between the required rate of return by ordinary shareholders and
the constant dividend growth rate.
𝐷 (1+𝑔)
𝑃̂0 = 𝑘0 − 𝑔
𝑒

• NB assumption: g < ke

Constant dividend growth example

Fibre Technologies Ltd. has just paid an ordinary share dividend of R1.20 and dividends are expected
to grow at a constant growth rate of 8% indefinitely. Investors require a rate of return of 14%.
Determine the intrinsic value per ordinary share.
𝐷 (1+𝑔)
𝑃̂0 = 𝑘0 −𝑔 D0= 1.2; g=0.08; ke=0.14
𝑒

= R21.6 intrinsic value

What is D1= 1.20*0.08= 0.096+1.2=1.296=1.30 (2dp)

Pay more on the market compared to the intrinsic value= not sensible
decision
Constant dividend growth class question

Determine the intrinsic value per ordinary share for Fibre Technologies two years from now.

• Where the Gordon model is applicable, we can rearrange the formula to calculate expected
rate of return

You as an investor can interpret the

market price relative to the intrinsic
value (p0 vs P (>)0

You can also interpret the required

rate of return with the expected rate
of return (ke vs k (>) e

Constant dividend growth example

Investors are interested in purchasing ordinary shares in Squid Ltd. The market price is R80 per share
(P0) and the last dividend that was paid by the company was R2 per share (D1). Dividends are
expected to grow at a constant rate of 5% per (g) year forever. What is the return that investors
expect to earn should they invest in these shares? (k (>) e)
 𝐷1
𝑘̂𝑒 = 𝑃0
+𝑔

2(1.05)
If you require 8% return on investment,
= 80
+ 0.05 should you invest in this company’s
ordinary shares?
= 0.07625 x 100
No = the expected rate of return is less
= 7.63%
than the return we require

1.2 Constant dividend growth

Applicable decision rules:

• If expected return > required return

• Intrinsic value > market value

∴ the share is undervalued = buy (invest)

• If expected return < required return

• intrinsic value < market value

∴ the share is overvalued = do not buy (sell if you own it)

1.3 Variable dividend growth

• Dividend growth change over time

• E.g., start-up companies; successful new product launch

• Market entrants: ↑ competition = ↓ profit margins

• High growth and constant growth rates

5 steps to determine share value:

1. Calculate the dividends during the high-growth period(s).

2. Calculate the PV of the high-growth dividends.

3. Determine the value of all the constant dividends that will occur after the high-
growth period.

4. Determine the PV of the constant dividends after the high-growth period.

5. Find the sum of all the PVs (steps 2 + 4).

Variable dividend growth example = not gordem cause Gordon is constant forever

BlueFin Ltd. has just paid a dividend of R5 per ordinary share. Dividends are expected to grow at 30%
p.a. for the next three years due to the successful launch of a new product. Thereafter, dividend
growth will decrease to 10% p.a., indefinitely. If investors require a 20% rate of return, determine
the intrinsic value per ordinary share.

• Determine the applicable variables:

➢ Current dividend (D0) = R5

➢ High-growth rate (g1) = 30% for three years

➢ Constant growth rate (g2) = 10% per year forever thereafter

➢ Required rate of return (ke) = 20%

Step 1: Calculate the dividends during the high-growth period

Year 1: D1 = D0(1 + g1) = 5 × (1 + 0.30) = 6.50

Year 2: D2 = D1(1 + g1) = 6.50 × (1 + 0.30) = 8.45

Year 3: D3 = D2(1 + g1) = 8.45 × (1 + 0.30) = 10.99

→ grow at 30% for three years; use rounded answer; every dividend is an answer on its own

Step 2: Calculate the PV of high-growth dividends→ discount it back

FV = 6.50; N = 1; I/YR = 20%; compute PV = 5.42

FV = 8.45; N = 2; I/YR = 20%; compute PV = 5.87

FV = 10.99; N = 3; I/YR = 20%; compute PV= 6.36

Total PV of high-growth dividends: 17.65

Step 3: Determine the value of all the constant dividends that will occur after the high-growth period

• In this example, the high-growth period ends after three years, and the constant
̂3 :
growth starts in year 4. Therefore, we need to find 𝑃

D (1 + g 2 ) 10.99(1.1) Can’t take PV of dividend 3 and grow to

Pˆ3 = 3 = = 120.89
(ke − g 2 ) (0.2 − 0.1) dividend 4

Must take the actual value (10.99)

Step 4: Determine the PV of the constant dividends after the high-growth period

Determine the PV of the amount that you calculated in step 3 P3 is associated with D4
FV = 120.89; N = 3; I/YR= 20%; PV = R69.96 You are discounting back 3 years to get the
PV
Step 5: Get the sum of all the PVs (i.e., those calculated in steps 2 and 4)

17.65 + 69.96 = R87.61 Would investors be interested in purchasing BlueFin shares

if the market price is R89 per ordinary share?

No, you won’t pay more in terms of what you would get in
terms of the estimated intrinsic value

2. Free cash-flow valuation model

Free Cashflow valuation model

• Can be used in cases where the company does not pay dividends

• This is a second type of operation you can do

• Free cash flow: Cash flow that is available to all investors after provision has been made for
investments in assets

*Ordinary shareholders, preference shareholders and debt holders

Value of equity = value of non-operating assets + value of operations – value of non-equity claims

Value of non-operating assets

• Assets that are not used in day-to-day operations of the business (not considered part of a
company’s core operations)

• Examples:

– Listed and unlisted investments

– Selected PPE (e.g., unused equipment) = market value estimates

– Long-term loan granted= doesn’t contribute to your prime revenue

•
Value of operations Depreciation= you wrote
FCF = Operating income this off over time but not
- tax on operating income item so add back
+ depreciation and amortisation
- NB! Do everything in this
- capital expenditures
- change in working capital order

Two components:

1. Forecast the company’s FCFs over the forecast horizon

2. Value of continuing operations after the forecast horizon (terminal value)

• terminal value

• Only valid if a business is expected to operate in perpetuity and if its economic life is not
limited by a finite resource = expect the growth indefinitively

Projected capital and working capital

aren’t part of SPL

To get operating profit: we take depr

out because it’s an expense
 Here we work with operating
profit, so we add the depr=
you are adding a non-cash
item back

Sign is important

Put the FV as is (forget about the bracket)

Get calc and then put bracket around if FV

was neg

The working back period to get

to the PV is the same as the
number of years if the
forecasting horizon
Step 5: Determine the sum of the PVs (See steps 2 and 4)

Value of operations Total answer of value of operations but we

=3 581 294 + 107 584 132 still need to take into account the value of
equity
= R111 165 426

LT liabilities at the market value

Value of non-equity claims

• Long-term loan: R10 million

• Market value of bonds:

N = 10

I/YR = 5

PMT = 8 (100 x 8%)

FV = 100

PV = 123.17

123.17 X 10 000 = R1 231 700

• Provision for pollution-related fine = R15 million

Total value of non-equity claims = R26 231 700= 15 000 000 + 1 231 700 + 10 000

Value of Marlin’s equity:

 Value of non-operating assets R17 900 000

+ Value of operations R111 165 426

- Value of non-equity claims (R26 231 700)

=
R102 833 726

Advantages:

• Quantifies the implicit assumptions and projections of buyers and sellers

• Less susceptible to overvaluing a company during market bubbles and periods of

high earnings

Disadvantages:

• Very sensitive to assumptions, results can be highly volatile

• Not always possible to project FCFs accurately over long periods of time

Price-earnings (P/E) ratio

• Reflects how much investors are willing to pay per Rand of reported earnings

• Companies with strong growth prospects = high P/E ratio

• Riskier firms = lower P/E ratios

Market price per share
• P/E ratio = Earnings per share

Attributable earnings
• EPS =
Average number of issued ordinary shares
Market efficiency

• Theoretically, in an efficient market =Share prices are in equilibrium:

➢ Market values = intrinsic values= in practice, this hardly happens

➢ expected rates of return = required rates of return

• No gains can be made by investors who engage in fundamental and/or technical

analysis

• Share prices react quickly to new information

➢ Good news = higher price

 ➢ Negative news = lower price

➢ en

Chapter 10 = behavioural finance

Introduction

❑ As indicated in Chapter 9, a stock market (like the JSE) is said to be efficient if, at any given
time, a share’s price:

➢ fully reflects all available information about the company in question.

- there are 3 forms of market efficiency:

 1. weak form = share price reflects all historic information about a
company such as share price movements, dividend payments,
trading volumes= info available to all investors on websites such as
share data = price reflects historic

2. Semi-strong form efficiency implies that prices reflect public

information=This information is available to all investors and
includes information contained in a company’s most recent
integrated report, on their website and in SENS announcements.
SENS = Stock Exchange News Service

3. Strong form efficiency implies that prices reflect private or inside

information =This information is only available to insiders and
includes details of an upcoming merger or special dividend that
have not yet been announced (only insiders have access to this
information); significant legal disputes, share repurchase plans,
stock splits, changes in dividends, public or private sales of
additional securities and defaults).

➢ rapidly adjusts to new information; and

- According to the efficient market hypothesis (EMH), share prices react within
minutes to new information.

Information is regarded as ‘new’ if it relates to something that the market did not
know before and if the information could affect the company’s value.

➢ If the news exceeds the market’s expectation, it is considered good news.

Given increased demand for the share, the price will increase. (Market
participants evaluate the news relative to their expectations)

➢ If an announcement falls short of the market’s expectation, it is considered

bad news. The share price typically falls in such a case.

➢ If an announcement is in line with the market’s expectation, the share price

generally does not react.
❑ The share price of Aquarius Platinum Ltd. soared to an eight-month high on 6 October
2015 as investors applauded the cash offer made by Sibanye Gold Ltd. for the target’s
entire issued share capital. At 9.57am, Aquarius shares were up 43.54% to R2.42, valuing
the company at about R2.6bn.

❑ The EMH states that security prices cannot be predicted. Prices are said to follow a
random walk (change in an unpredictable pattern- ST changes).

➢ is in equilibrium.

→ a share’s price is in equilibrium if its expected return equals its required

(CAPM) return and if its intrinsic value equals its market value.
→ In an efficient market, active investors cannot outperform passive investors.
 → Active investors create their own portfolios based on selected trading rules
and/or investment criteria.

→ A Shari’ah compliant fund is an example of an actively managed fund

→ Passive investors invest in tradable market indices (called tracker funds)

which mirror a particular stock market.
→ Although markets are efficient most of the time, some anomalies have been
observed= active investors outperforming passive investors= behavioral
finance explains these anomalies
→ One of the basic premises of behavioral finance is that investors do not
always act rationally. (No logic or reason= solve problems & draw
conclusions)

Irrational behaviour

❑ An irrational decision disregards logic and reason. It could be made due to emotional
distress (panic) or cognitive deficiency (think with heart and not with head)

❑ A great deal of academic research has been undertaken to determine why people exhibit
irrational behaviour, none more so than in the fields of economics and finance.

❑ In contrast to traditional financial theories, which suggest how investors and financial
managers should make decisions, behavioural finance theories describe how they actually
make these decisions. = often irrational and influenced by emotions

Overview of what will be covered in the chapter:

❑ Herding= Irrational behaviour can occur when investors and financial managers blindly
follow others when making decisions

❑ Errors can creep in when they engage in mental accounting (treating money differently
based on its source and/or purpose).

❑ Sub-optimal decisions can occur when investors and financial managers use heuristics when
making decisions.

❑ Affect and familiarity

❑ Irrational behaviour can occur when investors and financial managers exhibit certain biases.

❑ Anchoring, conservatism, status quo and confirmation

❑ Costly mistakes can be made when investors and financial managers exhibit overconfidence,
illusions of control and excessive optimism.

❑ Irrational behaviour can occur when investors and financial managers make decisions to
avoid regret.

❑ Prospect theory

Herding

❑ Following others (the herd / the crowd) blindly when making decisions.
 ❑ Herding is also called the bandwagon effect= doing as everyone is doing

❑ Real life example: the mindless following of fashion trends whether or not they are
flattering and/or practical

❑ Why?

❑ People tend to mirror the decisions of those around them= want to belong to a
community= pressure to conform

❑ People validate their decisions by claiming that it cannot be wrong if everybody else
is making the same decision.

❑ Investment example: Investing in or divesting from certain companies, industries or

countries based on what others are doing without doing fundamental or technical
analysis= buy and sell because everyone else is doing it.

❑ Is the herd always, right?

❑ No! ‘Chasing the market’ could lead to the formation and bursting of investment
bubbles.

❑ One of the first recorded investment bubbles occurred in the Netherlands in the 17th
century. At the height of ‘tulip mania’ (February 1637) some tulip bulbs sold for
more than 10 times the annual income of a skilled craftsman (as high as $35 000).
When the bubble burst, prices plunged to around $1 each.

❑ Several other bubbles and crashes followed, e.g., real estate in Japan in 1990 and
the US in 2007, IT stocks in 1987, [Link] companies in 2000 and the 2008 sub-
prime crisis.

Contempt: A bull market typically starts when a

market is at a low and investors scorn stocks.

Doubt and suspicion: They try to decide whether

what they have left should be invested in a safe
haven such as a money market fund. They have
burnt their fingers with stocks and vow never to
invest again.

Caution: The market then gradually starts

showing signs of recovery. Most investors remain
cautious, but prudent investors are already
drooling at the possibility of profit.

Confidence: As stock prices rise, investors’

Greed and conviction: Investors’ enthusiasm is followed by greed, which feeling of mistrust changes to confidence and
is often accompanied by numerous IPOs on the stock market. ultimately to enthusiasm. Most investors start
buying their stocks at this stage.
Indifference: Investors look beyond unsustainably high price-earnings
ratios. Enthusiasm: During this stage, prudent investors
are already starting to take profits and get out of
Dismissal: As the market declines, investors show a lack of interest that the stock market, because they realise that the
quickly turns to dismissal. bull market is coming to an end.
Denial: Then they reach the denial stage where they regularly affirm
their belief that the market definitely cannot fall any further.

Fear and panic: Concern starts to take a hold and fear, panic and despair
soon follow.
 ❑ Refer to the investor psychology cycle on the previous slides. When is herding the most
likely to occur?

➢ During periods of crisis (when people experience fear and panic) and during strong
bull markets (share price keeps on rising = when enthusiasm and greed cloud
investors’ judgement).

Mental accounting

❑ Creating separate mental accounts for different elements of one’s budget or investment
portfolio and treating these accounts differently.

❑ Example: some people have separate mental accounts for credit and cash purchases. As
they treat these accounts differently, they tend to pay more for the same item when buying
on credit rather than paying in cash. irrational=All spending reduces one’s bank account=
shouldn’t create these separate mental accounts

Imagine that you are retired and use two sources to fund your monthly expenses: a pension (65%)
and dividends from Company A in which you own shares (35%). As a result of new investment
opportunities, Company A’s managers have decided to omit the next quarter’s dividend. You now
have a choice. You can either reduce your consumption by 35% over the next 3 months, or you can
sell some of your shares and spend the proceeds on consumption. What would you do?

❑ Research shows that 90% of people presented with these two options cut their
consumption by 35%. Why?

➢ Most people have separate mental accounts for “income” and “capital”.

• The “income” account typically contains their salary, dividends (from

shares), coupons (from bonds), rental income and interest (from money
market instruments).

• The “capital” account contains the actual shares, bonds, rental property and
money market instruments.

➢ People tend to use the following rules: “consume-from-income” and “don’t-dip-

into-capital”. = don’t sell shares to use for monthly expenses

➢ Linkages: Anchoring; Regret avoidance

Heuristics (mental shortcuts)

❑ A heuristic is a rule of thumb, an educated guess, an intuitive judgement or common sense.

❑ Heuristics are typically used when an individual is faced with a complex problem or has
incomplete information= rely on your gut feeling
 ❑ “While heuristics can speed up our problem and decision-making processes, they can
introduce errors. Just because something has worked in the past does not mean that it will
work again. Relying on an existing heuristic can also make it difficult to see alternative
solutions or come up with new ideas.”

❑ Conventional theories suggest that investors and financial managers should use
sophisticated valuation techniques (such as the DDM introduced in Chapter 9) to determine
the intrinsic value of a share= most financial managers prefer to use simplistic valuation
measures such as Price/Earnings, Price/Sales and the Price/Earnings to Growth (PEG) ratio.
Why? -These ratios are easy to use, make intuitive sense and only involve a few variables

Affect heuristic

❑ Being unduly influenced by emotions, intuition and ‘gut feeling’ when making decisions.

➢ Emotions (such as fear and greed) are strong feelings shaped by

one’s circumstances, experience, mood or relationships with others.

➢ This heuristic is similar to being in love (thinking with your heart, not
your head) = disregard logic and reason

❑ Research shows that investors who have positive feelings towards a company often see it as
having low risk and high reward (have a bad experience= negative feelings toward the
company = perceived high risk and low reward).

❑ Green investors have been shown to exhibit this bias.

❑ Cause? Humans are inherently emotional beings.

❑ Is one’s ‘gut feel’ always, right?

❑ No! Failure to do careful analyses could result in sub-optimal decisions.

❑ This heuristic is amplified under time pressure.

❑ Linkage: Confirmation bias; Regret avoidance

Affect heuristic - for reflection

❑ Would you exclude companies from your portfolio that pollute the environment?

❑ What about companies that have a significant impact on the natural environment, but that
are taking pro-active steps to reduce their eco-footprint?

❑ What about those companies that use child labour?

Familiarity heuristic

❑ Favouring that which is familiar, e.g.

➢ using the same hairdresser, doctor, pharmacist and mechanic year in and year out.

➢ investing in “household names”; believing that these investments offer lower risk
and higher expected returns than unfamiliar companies.
 ➢ Financial managers using the same supplier’s year in and year out= not because of
better services or prices- because they familiar

❑ Cause? People are creatures of habit; often scared of the unknown; “better the devil you
know than the one you don’t know”.

❑ It might also be difficult to access information on unfamiliar companies (be it small or

foreign companies).

❑ This heuristic explains why German investors prefer to invest in German companies and why
South African investors prefer to invest in JSE-listed companies. What are the consequences
of this so-called “home bias”?

➢ Limited diversification = more securities,

lower the portfolio risk= best portfolio is
one that is spread out among different
countries

❑ Linkages: Anchoring (sticking to what you know or

have experience with); Affect heuristic (in the case
of patriotic investors)

Biases

❑ A bias is a predisposition or inclination towards error. Biases are based on unconscious

mental activities inherent in every human which produce “predictable deviations from
reality”.

Anchoring bias

❑ Forming an estimate relative to some or other reference point (anchor). The

reference point is often the first piece of information received, but could also be
past experiences, purchase prices or analysts’ recommendations.

➢ The easiest way to sell a R10 000 watch is to show the customer a R30 000
watch first…

➢ Marketers, real estate agents and secondhand car dealers often use this
bias to their advantage= show more expensive first, then everything else
“becomes” cheaper

❑ Research shows that people generally overlook new information and under-estimate
unknown values (especially if little or no information is available).

❑ Assume that you inherited R1 million and invested the entire amount in one JSE-listed
company on 1 January 2020 at a price of R200 per share. You paid a transaction fee of 1.5%.

➢ Due to the COVID-19 pandemic, the share price dropped to R140 by 1 May 2020.
Would you have sold your shares then or would you have held onto them?

➢ Assume that you held on. On 1 July 2020 the share price dropped further to R80.
Would you have sold your shares then or would you have held onto them?

➢ Assume that you held on. Today’s price is R200. Will you sell your shares now or will
you still hold onto them?
 ❑ Most investors will sell their shares when the price reaches the original purchase price
(R200) as this is their reference point.

➢ This is stupid as they don’t break-even when considering transaction and

opportunity costs.

Anchoring has the same impact on experts and non-experts alike.

❑ Linkages: Conservatism bias; Status quo bias; Regret avoidance

Conservatism bias

❑ conservative person is generally one who is cautious and slow to make changes in his/her
life.

❑ In behavioural bias this bias refers to investors who are too slow in updating their beliefs in
response to new information (as defined earlier). As such they buy/sell too late. This bias
leads to momentum in security prices.

❑ A security is said to have momentum if a large decrease (increase) in its price is

followed by additional losses (gains) i.e., the price trend continues in the same
direction.

❑ An example of momentum is illustrated on the next slide.

❑ Many investors immediately sold their BP shares after the Deepwater

Horizon disaster anticipating huge fines and the re-allocation of large sums
of money to clean up the environment.

❑ Some, however, only sold their shares in the weeks that followed.

❑ Why would investors refrain from selling all their shares when bad news becomes public (as
was the case for BP)?

❑ They consider themselves to be long-term investors and don’t want to reduce

portfolio diversification.

❑ Causes? People are afraid of change; they are stubborn; they don’t want to admit defeat.

❑ This bias also explains why some managers keep on investing in unprofitable projects.

❑ Linkages: Affect heuristic; Anchoring; Status quo bias

Status quo bias

❑ Investors and financial managers perceive changes from the status quo (the current
situation) as a loss.

❑ As such they prefer to do nothing when presented with new information.

❑ Danger: By failing to explore new alternatives, investors and financial managers could suffer
substantial opportunity costs.
 ➢ The cost of an alternative that must be forgone to pursue a certain action; the
benefits one could have received by taking an alternative action.

❑ Linkages: Anchoring; Conservatism bias

Confirmation bias

❑ Searching for or interpreting information that confirms existing beliefs, ignoring contrary
views. (I’m always right)

❑ This bias is stronger for emotionally charged issues and for deeply entrenched beliefs.

❑ It results in investments being made despite advice or research suggesting that it is not a
good idea to do so.

❑ Linkages: Herding; Overconfidence; Excessive optimism

Overconfidence

❑ Over-estimating one’s abilities and actual performance relative to others and expressing
unjustified certainty in the accuracy of one’s beliefs and forecasts.

❑ There is no shortage of examples of overconfident investors and managers who got

themselves into trouble with the law.

❑ Nick Leeson’s unauthorized investments in index futures contracts bankrupted his

employer, Barings Bank, in 1995. Leeson incurred a $1.3 billion loss that destroyed the
centuries-old financial institution. Barings Bank was the British government’s bank for many
years. Leeson tried to run from the police, but eventually spent 6.5 years in prison.

❑ Causes? Overconfidence typically occurs when individuals have a strong internal locus of
control (feeling of that they the master of their own destiny) and a high level of self-esteem.
It could also be explained by a desire to attain a higher social standing (respect, prominence
and influence in the eyes of others).

- men on average are more confident investors but women are better investors based on
risk adjustment= overconfident investors trade more= more transaction fees which reduce
their performance

- the Beckmann and Menkhoff study say that women are more risk aversive but the
discrempensy between confidence between the genders is so small

- nelson studies say almost no difference between risk aversion in genders

❑ Overconfident investors tend to take unwarranted risks, trade excessively, hold risky
positions in smaller and newer companies and focus on too few industries.

❑ This behavioural pitfall could also explain why some financial managers:

❑ overpay for target companies in mergers and acquisitions.

 ❑ frequently engage in share repurchases (they believe that their company is
undervalued and that by repurchasing shares, the share price will rise).

❑ consider debt to be less risky than equity. As such they use more debt than rational
managers.

❑ under-estimate the true cost of debt. This error causes them to use the wrong
WACC when evaluating the capital projects.

Illusions of control

❑ Over-estimating one’s ability to control future events.

❑ People tend to under-estimate risk when they feel they are in control and over-estimate risk
when they do not feel in control of a situation.

❑ Investors and financial managers who do in-depth analyses before investing sometimes
believe that their hard work and insight give them control over the future of the
investments they own.

❑ This bias explains failed attempts to time the market, excessive trading and inadequate
portfolio diversification.

❑ Linkages: Confirmation bias; Overconfidence; Excessive optimism

If you want real control, drop the illusion of control. Let life live you. It does anyway.
Byron Katie

In 1996, Kodak was the 4th most valuable brand in the USA. Digital cameras, however, became
more affordable resulting in lower roll film sales in 2001. Management (erroneously) attributed
this trend to the 9/11 attacks. While other companies were investing in new technologies,
Kodak thought that consumers would not be interested in digital photography and would
continue to prefer roll film cameras. In 2005, dwindling sales of roll films forced Kodak to start
producing digital cameras. By then, the iPhone was introduced, and people started using their
smartphones to take pictures. Kodak tried to produce other products, but without much
success. They filed for bankruptcy protection in 2012 and emerged from it in 2013 and has since
started producing smart phones.

Excessive optimism

❑ Over-estimating the frequency of favourable events/outcomes and under-estimating the

frequency of unfavourable events/outcomes such as losing

❑ Empirical evidence shows that people are only correct about 80% of the time when we were
“99% sure”.

❑ Excessive optimism = Investing in “hot stocks” (share prices increase rapidly over a short
space of time), often without doing proper research. Contributes to the creation of
investment bubbles (and inevitable disappointment).

❑ Causes? Similar to overconfidence.

❑ Linkages: Confirmation bias; Overconfidence; Illusions of control; Herding

 ❑ When is a “hot stock” too hot?

❑ Research suggests that a Price/Earnings ratio in excess of 25 should be viewed with

caution (see next slide).

❑ In March 2000, just before the [Link] bubble burst, the Price/Earnings ratio for the
NASDAQ was 175…= on average, investors were willing to pay S175 for S1 of earning
= ridiculous

❑ Why are ABInBev and Heineken’s P/E ratios so high at present?

Regret avoidance

❑ Traditional theories state that utility (satisfaction with an investment) is an upward sloping
curve= So: the more wealth you accumulate, the happier you are…
 ❑ The conventional utility function fails to show that people dislike losing money more
than they like winning it= regret is a very powerful emotion (regret is more powerful
than the joy experienced when you gave certain gains)

❑ Prospect theory thus proposes that utility should be determined by comparing gains and
losses relative to a certain starting point.

❑ This utility function is concave for gains, but convex for losses; the slope for gains is flatter
than the slope for losses.

❑ Happiness increases at a decreasing rate when winning; a doubling of wealth

does not lead to a doubling of utility.

❑ Unhappiness increases at an increasing rate when losing.

Happiness resides not in possessions, happiness dwells in the soul. By desiring little, a poor man
makes himself rich. Democritus, philosopher (circa 460BC to 370BC)

❑ Most people want to avoid the unpleasant feeling of regret when losing money (or anything
else for that matter).

❑ Studies show that the experience of regret with a particular type of investment reduces the
tendency to make a similar investment in future.

Avoiding behavioural pitfalls

❑ Educate yourself be aware of heuristics and biases.

❑ Understand the influence of these pitfalls on decision-making and how they are
interrelated.

❑ Do in-depth analyses before investing.

❑ Seek contrary viewpoints.

 ❑ Take time. Step back to evaluate your decisions in a neutral light.

Keep records of your decisions / motives

Summary and conclusions

❑ Although most stock markets are efficient most of the time, some share price movements
cannot be explained by traditional financial theories.

❑ Behavioural finance addresses some of the shortcomings of traditional financial theories by

recognising that investors and financial managers sometimes behave irrationally.

❑ Behavioural finance also acknowledges that emotions might influence decisions.

❑ After the 2008 global financial crisis the acclaimed finance professor Robert Merton
remarked: “The amount of risk we take personally or collectively is not a physical given
constant. We chose it. Behavioural finance offers a means to choose wisely, as it affects
both individual decision making and market efficiency. Ignore behavioural risk at your own
peril.”

❑ The turmoil on financial markets as a result of the COVID-19 pandemic bears further
testimony of how irrational investors can be.

❑ As a future participant in financial markets, you need to be aware of behavioural pitfalls and
should take pro-active steps to avoid them.

See lecture 3 week 7 for the questions to these answers:

1. private= info does not know cause announcement hasn’t been made

2. public= announcement has been made

3.
4. b= some of the shareholders will sell their shares which influences the companies share price

5. B= give you an idea of how the overall market it is progressing

6. Yes= larger companies merging with the smaller competitors

7. heart= you would something along the lines of you saving someone’s life

Head= argue that there is no substitute for blood; it is safe and easy

- use a combination of head and heart

8. affect= rely on your gut feeling, rely on my emotion

- positive emotion is one of the reasons for me to increase my shareholdings

9. south African investor= go with what is familiar= ShopRite

10. D= company is investing into themselves

Affect= I know my company is doing well so invest in that= emotions

Familiarity= my own company

anchoring bias= you know what is happening in your own company

11. D= one of your oldest clients – always been good clients- just going through a difficult patch- not
updating your belief that they have been slow to pay cause you’ve known them for a while
12. The manager won’t invest into the cheaper alternative thereby reducing profitability. He will
most likely also use more debt than a rational manager = go with the expense machine without
looking at the cheaper alternative; use more debt to finance the decision

13. c= any information that comes in that is different to what it is, is seen as a loss

14.D= they all linked to each other

15. B= don’t want to dip into your capital account

16.

17.

18.
19.

20.
 Chapter 11

Introduction

Cost of capital: cost to an entity for raising capital

• Cost = price paid to gain access to finance (%)

➢ Interest= LT loan, mortgage, debentures

➢ Dividends= share investments

• Capital = in order to do business- finances are required

➢ Debt instruments =bonds, debentures, loans, overdrafts

➢ Equity instruments=ordinary shares, preference shares

Pooling of funds

• Various sources of finance are pooled or grouped together= various sources of finance are
grouped together to fund a particular capital project

• Entities aim to establish a long-term optimal capital structure

➢ Target capital structure = e.g. 50% debt; 50% equity = so when financing new
projects- they use 50% debt and 50% equity

• Investments are financed out of this pool of funds at the weighted average cost of capital
(WACC)

Cost of capital

• “Cut-off rate” between worthwhile and less worthwhile investments

- any projects bellow your WACC= don’t invest into

• WACC is the preferred cost, rather than the cost of each individual source

• Weighted average cost of ALL capital raised (debt and equity)

• 3 components: NB!

1) Cost of ordinary shareholders’ equity (ke)

2) Cost of preference shareholders’ equity (kp)

3) Cost of debt (kd)

Types of equity financing

1) Ordinary shares

➢ Shareholders = owners

➢ Capital gain and dividends

➢ Trades on JSE: Primary( listed for the very first time) and secondary market(shares
being resold)

2)Preference shares

➢ Fixed dividend rate

➢ Different types of preference shares (chapter 9)

• Reserves and retained earnings

➢ Opportunity cost

3) Long-term:
WACC only looks at non-current
➢ Debentures
liabilities
➢ Mortgage

➢ Long-term loans

• Short-term (less than 1 year - IGNORE):

➢ Short term loan

➢ Overdraft

➢ Creditors

➢ Tax payable

➢ Dividends payable

Overview:
1) Cost of ordinary shareholders’ equity (ke)
• Fairly challenging to calculate as the cost must include the risk undertaken by the
shareholders.

• Also known as cost of ordinary shares or cost of equity.

• Required rate of return of ordinary shareholders = cost of equity= how much they expect to
earn if they invest into your business

• Can be calculated in one of two ways:

1. Dividends

➢ If company pays dividends

➢ Dividend discount model (Chapter 9)

➢ Constant dividend growth model: Gordon model (Chapter 9)

2. Capital Asset Pricing Model (CAPM)

➢ Takes risk into consideration= captures that risk that ordinary shareholders
take when they invest into the business

Cost of ordinary shareholders’ equity (ke)

METHOD 1: DIVIDEND DISCOUNT MODEL

• Size, frequency and stability of dividends depends on a firm’s dividend policy

• Market price of a share: assumed to be present value of future dividends where a constant
annual dividend is paid in perpetuity

• Dividend discount model formula (Chapter 9):

Where:

Ke = cost of ordinary shares

D0 = current dividend

P0 = ex-dividend market price of ordinary shares

G = expected constant annual growth rate in dividend

Cost of ordinary shareholders’ equity (ke)

Example 11.1

Growth Ltd’s ordinary shares are currently trading at R4 per share. A dividend of 30 cents per share
has just been paid and the directors estimate that dividends will increase by 10% per year in
perpetuity. Calculate the cost of ordinary shares.

NB! Don’t adjust the shareprice for the dividend cause they tell you the
dividend has already been paid

Question 3 – page 373

DEF Ltd has ordinary shares in issue that are currently trading at R30 per share. The next dividend is
expected to be R2 per share. If DEF Ltd adopts a dividend growth rate of 5%, which is expected to
remain constant indefinitely, calculate the cost equity.

• Estimating the expected growth rate (g) in dividends is often the most challenging aspect of
the model.

• use historical dividend information = assuming the historical average annual growth rate will
continue in perpetuity= calculate the growth rate

2016-2017= 1 yr; 2017-

2018= 2yr; 2018=2019= 3yr

I/YR 14.447%
METHOD 2: CAPITAL ASSET PRICING MODEL (CAPM)

• Takes risk into consideration

• CAPM formula (Chapter 10)

Where:

ke = cost of ordinary shares

rf = risk-free rate of return (government security)

ß = beta coefficient of the share/entity

rm = return on the market portfolio

(eg. FTSE/JSE All Share Index)

rm – rf = market risk premium

• Risk-free rate (rf) – return on risk free securities: government bonds

• Return on the market portfolio (rm) – return that is expected on a portfolio of securities that
are generally invested in equities.

• Market risk premium (rm – rf) – return in excess of government bonds

Beta coefficient – measure of the market risk (i.e. volatility)

Example 11.3

Capital Ltd has a beta of 1.3. The expected return on the market portfolio is 15% and the current
risk-free rate is 8%. Calculate the cost of ordinary shareholders’ equity

=17.1%

Market risk premium =15-8=7%

Question 2 – Page 373

ABC Limited has a beta of 1,2. The rate of return on risk-free assets is currently 9% and the market
risk premium is 7%. Calculate the cost of ordinary shares for ABC Ltd.

9+7= 16 !!

Question 18 – page 372

• Eighteen Ltd has a beta of 0.8 and a cost of equity of 14%. If the return on the market
portfolio is 15%, calculate the risk-free rate of return.

= looking for the risk free rate= solve for x

CALCULATING BETA

• Beta coefficient: measure of volatility

 • Beta = Change in share price of an entity

• Change in the index

• Beta of market index = 1= beta of more than one means that the share price is more
volatile or more risky than the market; beta of less than one means that the companies
returns are less risky than the market; if it has a beta of 1 means it moves inline with the
market

Example 11.4

Assume Beta Ltd. is one of the JSE Top 40 entities listed on the JSE. The share price of the company
has decreased by 18% over the past 12 months. The JSE/FTSE Top 40 index has decreased by 15% in
the past 12 months. Calculate the beta of the company.
Returns are more
• Beta = Change in share price of an entity risky than the
market
• Change in the index

Cost of preference shareholders’ equity (kp)

• Preference dividends are not deductible for tax purposes

• Calculation depends on whether preferences shares are redeemable or not

➢ Non-redeemable – use perpetuity principles

➢ Redeemable – use annuity principles

• NON-REDEEMABLE PREFERENCE SHARES

• The cost of non-redeemable preference shares can be calculated as follows:

NB! Preference shareholders receive a

fixed dividend
• Where:
 • NON-REDEEMABLE PREFERENCE SHARES

• Example 11.5

• Non-redeemable Ltd. has 9% non-redeemable preference shares in issue. The preference

shares pay an annual dividend of 9 cents and are currently trading at R1.08. Calculate the
cost of the preference shares. (NB! UNIT OF MEASUREMENT= keep it the same)

Question 4 – page 375

GHI Ltd has 11% (referring to the dividend that is paid out ) R2 non-redeemable preference shares in
issue. If the preference shares are currently trading at R1,80, calculate the cost of the preference
shares.

REDEEMABLE PREFERENCE SHARES

The cost of redeemable preference shares can be calculated using annuity principles.

PV = the current market price of the preference shares

FV = the value of the preference shares at redemption adjusted for any discount or premium on
redemption

n = the number of periods until the preference shares are redeemed

PMT = the fixed gross (before tax) dividend paid on issue value of the preference shares

i= the cost of preference shares to be calculated

REDEEMABLE PREFERENCE SHARES

Example 11. 6

Redeemable Ltd. has 9% redeemable preference shares in issue. The preference shares pay an
annual dividend of 9 cents and are currently trading at R1.08. The preference are redeemable at par
in 5 years’ time. Calculate the cost of the preference shares.

PV = current market value of the share = -1.08

FV = nominal value = 1 ( assume 1 if not given a value)

n = number of periods until preference share is redeemed = 5

PMT = fixed dividend = 1 x 9% = 0.09

i = cost of preference share =7.05%

3) Cost of equity
Tax effect:
 ➢ Ordinary and preference share dividends are paid from profit after tax

➢ ke and kp are thus after tax costs of capital

Cost of debt (kd):

- Ordinary and preference shares are calculated form after tax profits

Debt is before tax= adjust for tax

• Interest rate that an entity must pay on any new debt issued

• Can be obtained by observing the current interest rates in the market= cost of debt depends
on what is happening in the market

• Principles of bond valuation – Chapter 8

• Difference between cost of preference shares and cost of debt

➢ interest on debt is tax-deductible

• Debt capital

➢ Redeemable (annuity)

REDEEMABLE DEBT CAPITAL

• Cost of redeemable debt can be calculated using annuity principles

• PV = the current market price of the debt

• FV = the value of the debt at redemption, adjusted for any discount or premium on
redemption

• n = the number of periods until the debt is redeemed

• PMT = the fixed net interest paid on the nominal value of the debt

• i = the cost of debt to be calculated

Interest is tax deductible – Calculate cost of debt after tax

➢ Calculate rd before-tax / OR / use given market interest rate

➢ Adjust interest rate for tax (multiply by 1-T)

 PMT calculated
from R100=
nominal value

Debentures is bonds issued by corporates

I/YR= 11.54

Weighted average cost of capital (WACC)

Overall return that an entity must generate on existing assets to maintain value of ordinary shares,
preference shares and debt.

Cost of each source of finance weighted by the proportion of finance used.

WACC determined because each cost of capital component has different cost.

Different costs due to different levels of risk

costdebt(1- tax) < [Link] < costordinary shares

• Debt cheapest source of finance

o lowest cost of capital
o tax deductible
• Preference shares second cheapest
o rank ahead of ordinary shares on liquidation
• Ordinary shares most expensive
o ultimate owners of company and bear most risk=compensated for taking on this risk
is aa higher rate of return
Use market values of long-term sources of capital

➢ Use book values if market values are not available

3 steps to calculate WACC :

Step 1:

Calculate the after-tax cost of each source of finance= cost for ord, pref and debt

Step 2:

Determine the weight of each component – should lie between 0-100- total to 100% (debt 30; pref
50; ord 20)

Step 3:

Determine the contribution of each component and then add each contribution together to obtain
the WACC (step 1 x step2)

Lowest; debt
Highest= ord shares

Weighting= percentage contribution per

Example
components = must always total 100
Suppose ordinary shares are currently trading at R50 and there are 3 million shares in issue. The firm
has R25 million preference shares and R75 million debt. The tax rate is 40%.

The following costs of capital sources are provided to you:

(Step 1)

kd = 10% (before tax), ke = 14%, kp = 9%

You are expected to calculate the firm’s WACC.

Step 2: Determine the weight of each component

Ve =50 x 3 million shares= R150 million

Vp =25 million

Vd = 75 million

Total value =250 milion

we = 150/250= 0.6

wp = 25/250=0.1

wd = 75/250=0.3

Step 3: Contribution of each component added together

Weke + Wpkp + Wd kd (1 − t)
=11.1

Question 15 – page 374

Suppose that Fifteen Ltd’s cost of ordinary shares is 15%, the cost of preference shares is 12% and
the before-tax cost of debt is 9%. If the target capital structure is 50% ordinary shares, 20%
preference shares and 30% debt, and the tax rate is 28%, what is Fifteen Ltd’s WACC?

=11.84% (should be falling between your lowest

and highest cost)
Question 6 – page 375

MNO Ltd has a cost of ordinary shares of 18% and a before-tax cost of debt of 8%. If the target debt-
to-equity ratio is 0,50 and the current tax rate is 28%, calculate WACC.

=11.88

• WACC assumes when entity raises finances it is added to a pool of funds = risk profile of the
additional finance that the business takes on is said to be the same as the target capital
structure that they already have in place

• WACC can be used as discount rate when calculating NPV for new investments= when we
are appraising investments using the NPV method and we discounting our cashflows; we can
discount it as the WACC of capital in order to determine if it is worth investing into an
investment opportunity= only invest in projects that yield a positive NPV

• WACC assumes capital structure of company is constant – to ensure capital structure is

constant, use target capital structure= any additional financing is in this proportion

• New investments do not have a significantly different risk profile to entity’s existing
investments

• All cash flows are constant perpetuities

• Only invest in a project if the expected rate of return > WACC = if you calc a WACCC of 10%;
business invests in a project that is expected to yield 8%= can’t invest into a project that is
expected to yield 8 cause it is costing more to invest than the return

• IRR > WACC

Why? = interpret

• Use the WACC as discount rate to calculate the NPV of a project or investment

• Reasons for using WACC when appraising investments:

➢ New capital investments must be financed by new sources of finance or retained

earnings, and WACC includes the cost of these new sources of finance

➢ WACC reflects a firm’s LT capital structure and cost of capital

Marginal cost of capital

• WACC assumption: Capital structure stays constant (in line with target capital structure)=
whichever new investment the business will make will be in line with their optimal capital
structure

• Company considers large investment project that will affect the capital structure
considerably = assumptions of WACC not possible
This is why we need to consider the marginal cost of capital:

• Marginal cost of capital: additional cost over and above what it is already costing the
business to get to that next rand of capital that they require in order to make this large
capital investment

➢ At the current rate in the market to acquire equity or debt

• In practice: Actual capital structure fluctuates around the target capital but stays within the
same ratios to one another in terms of debt to equity

Gearing

The more debt capital = the more

geared= higher the financial leverage
of the business

Why use debt?

- cheapest form of financing= interest

payments are debt deductible

- there is a threshold of where debt is

too much (neg financial leverage)

Utilizing debt in your capital structure could have a

positive effect on returns
Optimal capital structure
• Leads to lowest possible WACC

• Leads to highest share price

➢ Maximizing shareholder wealth

• Two theories:

➢ Trade-off theory

➢ Pecking order theory

1) TRADE OFF THEORY

• Compare costs and benefits of debt finance

➢ Tax benefit vs risk of bankruptcy

➢ Value of firm that utilises debt can increase to a specific level, but beyond that level
the disadvantages of bankruptcy costs exceed the tax benefits.

➢ Value of company is at its highest when WACC is at its lowest.

• Positive relationship between financial leverage and profitability.

• Optimal (target) capital structure: Combination of long-term sources of finance that leads
to the lowest WACC.
As we move to the right=
the firm is more geared=
using more debt

Where wacc is the least=

optimal capital structure

Beyond this point= cost

of debt and cost of equity
increases considerably
which then increases
your wacc = more debt=
higher cost of debt but
also because the risk of
bankruptcy becomes
higher, ordinary
shareholders now require
a higher rate of return so
cost of equity also goes
up
2) PECKING ORDER THEORY

• Asymmetric information: Managers are more informed than investors regarding promising
opportunities in the company

• Financing hierarchy:
 1st = Internal funds=retained earnings or reserves

2nd = debt= lowest cost of financing

3rd = new Equity = = ordinary shares and preference shares

• Negative relationship between financial leverage and profitability= the more leverage the
lower profitability

• No optimal capital structure = source financing according to the finace hirachy rather

Excersize:

Additional info:

Ordinary shares:

The company has a beta of 1.5. The required rate of return on the market portfolio is 12%. The
applicable risk-free rate is 8%. The shares currently trade at R12 per share.

Non-redeemable preference shares:

The preference shares are currently trading at a premium of R2 per share. The company pays a
constant dividend of R0.50 per share.

Debentures:

The company issued debentures with a coupon rate of 6% compounded semi-annually and a
nominal value of R1 000. The time to maturity is 30 years. The debentures currently sell at their
nominal value.

Suppose the applicable company tax rate is 28%.

1. The cost of non-redeemable preference shares. =0.5/(3+2)= 10%

[Link] cost of debentures as used for the WACC calculation. (after tax cost) =

3. The cost of ordinary shares.

Rule:

B of market is 1= share has a

value of more than 1=
return is more risky than
market

= 14% higher risk

4. Adco Ltd.’s weighted average cost of capital (WACC).

12000000/20000000= 60%

Weight* cost then sum it

together = 11.55= WACC

5. Calculate Adco’s WACC using the formula

6. Suppose Adco is looking to invest in a project with an expected rate of return of 13%, should the
firm go ahead with the investment? Motivate your answer.

3YES= what I can earn is more than what its costing me to invest ( WACC<IRR)

Exercise 2:

1. Cost of ordinary shares:

2. Cost of non-redeemable preference shares:

3. Cost of redeemable debentures: after tax =6.5(1-0.28)= 4.68%

4. Galore Ltd.’s weighted average cost of capital (WACC).

5. Calculate Galore’s WACC using the formula.

Costs from Q1-3

62.5*26= 16.25

6. Suppose Galore is looking to invest in a project with an expected rate of return of 15%, should the
firm go ahead with the investment? Motivate your answer.
Notes:

i. There are 305 000 ordinary shares in issue. The current market price is R6 per share.

ii. The current market value of preference shares is R152 500. There are 10 200 preference
shares outstanding.

iii. The current market value of Tapioka’s debentures is R1 067 500. The cost associated with
debentures is 12% (compounded annually).
Exclude this cause you only
iv. The bank overdraft bears interest at a rate of 20% per annum. including LT

1. Cost of ordinary shares:

Issue value per preference

2. Cost of preference shares: share *17% to get to the
dividend

3. Cost of debentures: 12(1-0.3)= 8.4%

4. Weights per capital component:

6. Calculate Tapioka’s WACC using the formula. 7. Suppose Tapioka is looking to invest in a
project with an expected rate of return of
22%, should the firm go ahead with the
investment? Motivate your answer.

YES IRR>WACC
 Chapter 10= risk and return

Introduction

• Chapter 9 – Required return

• Any capital project that adds value

➢ MUST yield a return in excess of its required rate of return

• Investors demand higher required rates of return from riskier projects

• Evaluate the return and risk characteristics of single (individual) securities

• Portfolios

Assessing the return and risk characteristics of a single security

• Return and risk characteristics of financial assets can be assessed from two perspectives:

➢ Ex post (using historic data)

➢ Ex ante (using expected future data)

1) Single Security : Historic Data (ex post)

 NB! Always put in %
Always write down formula and all
calcs; They give method marks

Adding all the returns over the periods together & dividing by 5

- Should be in Rands

This is an advantage
2) Evaluating expected returns(ex ante)

• Making estimates about future returns involves uncertainty= The longer the period= the
more uncertain those estimates become

• Probability theory

• A probability refers to the chance or odds that a future event will occur

Probabilities always have to add up to 100%.

Example 10.3

Assume that you are interested in buying ordinary shares in Vegan Ltd.

Using your insight of the local economy and demand for beer, you attach the following probabilities
to five possible states of the economy.

You also determine a likely rate of return of the Vegan Ltd. shares for each of the economic states.

Sum of the probability * anticipated rate

= 5%= if you invest , you will expect on average a 5%

return over the next year

Risk
Returns and risk must be evaluated.

RISK

➢ Possibility that actual returns differ from expected returns

➢ Volatility of investment returns

➢ Risk = dispersion of returns from the average= the further away the actual return is from the
expected return, the higher the risk

➢ Extent to which actual/expected returns differ from the average return= you want it to be
as close as possible to each other

➢ Statistical measures

- 𝜎 2 – variance= allows you to calc sd

- 𝜎 – standard deviation= calc risk

 ➢ Variance = measures how far each data item (return) is from the mean
(average)

➢ Standard deviation =

Evaluating historic risk

Historic risk can be calculated by means of the variance (2) and standard deviation

2 =
1
n −1
( 2
) ( 2
)
r1 − r + r2 − r +  + rn − r ( )
2

 = 2
The greater the standard deviation:

➢ the more actual returns tend to differ from the average expected return

➢ the more spread out the actual returns tend to be

➢ the more risk there is when investing in a particular security.

We want small sd !!

Evaluating expected risk

We want to find the expected variance and that would mean we need to take the sum of the
probability * the difference (anticipate-expected)

Expected risk can also be calculated by means of the variance (2) and the standard
deviation, but now probabilities are incorporated.

n
 =  Pri  ( ri − rˆ)2
2

i =1

expected r= 5%
Interpretation?

• If you invest in the ordinary shares of Vegan Ltd., you can expect to earn an average return
of 5%.

• ASSUMING RETURNS ARE NORMALLY DISTRIBUTED.

• There is at least a two-thirds chance that the actual return will fall within one standard
deviation from the expected average return.

Sd means that the returns will fall within 1 sd

• Thus there is a two-thirds likelihood that the actual return will fall within the range of

➢ 14.49%(5% + 9.49%) and -4.49%(5% - 9.49%)

This gives you 68% range

68% of all the actual returns should fall within

1 sd of the mean; that whole 2/3 is a range of
+- 1 sd from mean

95% should fall within 2sd of the mean

99.7% of all returns should fall withing 3 sd

from the mean
3 Scenarios

1. 2 Investments; same r; different σ = choose one with smaller σ= if you getting the same
return; you would rather have lower risk

2. 2 Investments; same σ; different r =choose one with higher r=rather higher return for the
same amount of risk you take

3. 2 Investments; one has higher r; other has lower σ = Use Coefficient of variation (CV) = shows risk
per unit of return

Coefficient of variation:

The CV standardises the risk and return characteristics of securities


CV =
rˆ
CV for Vegan Ltd.
Example 10.4 = 9,49 ÷ 5 = 1,9

Interpretation:
For every 1% return that Vegan Ltd. offers, investors can
expect returns to vary by 1,9%

Interpretation:
For every 1% return that Vegetarian Ltd. offers, investors
can expect returns to vary by 1,27%
Risk averse investor chooses the lowest
Select Vegetarian Ltd. as it has a lower CV and hence lower risk-per-unit of return

Assessing expected portfolio returns

Investors interested in future returns – ex ante

Expected return of a portfolio:

n
rˆp =  wi  rˆi
i =1
Assessing expected portfolio returns

Weight?

Where: Each security forms part of the portfolio

E.g. You own shares worth a R1 000 in Company A and shares worth R2 000 in Company B (total
portfolio is R3000)

➢ Weight security A = 1 000 / 3 000 = 0.33

➢ Weight security B = 2 000 / 3 000 = 0.67

Example 10.5

You would like to invest in a portfolio consisting of two shares, A and B. You will invest R100 000 and
R300 000 in the two shares respectively. Based on your economic forecasts, the average expected
returns of the two shares are 10% and 25%. What is the return that you expect to earn on this
portfolio?

NB! Which one is fraction and whole

numbers

Always show answer as %

Assessing expected portfolio risk

Given that the returns of securities in a portfolio tend to move together, we can measure the
extent to which the returns of the securities in the portfolio move together by using:

CovrA ,rB =  Pri  (rA,i − rˆA )(rB ,i − rˆB )

n

i =1
➢ the covariance

A positive covariance implies that securities’ returns move in same direction over time – a negative
covariance implies opposite directions= security A return increase means security B return also
increases cause there is a positive covariance

CovrA ,rB
=
 A B
➢ correlation coefficient (also called rho)

Interpretation of the correlation coefficient Correlation coefficient can only vary

between a +1 and a -1
If  = −1, If  = +1, The closer to the +-1= the stronger
If  = 0,
security returns security returns
security returns the relationship between the returns
are perfectly are perfectly
are not of the shares
negatively positively
correlated at all
correlated correlated
Perfect negative correlation= a incr; B
decr
-1 0 +1
Perfectly positive correlated= if A
returns incr then B returns also incr
If  < 0, security If  > 0, security
returns move in the returns move in the
opposite directions same direction

Perfect negative correlation: ρ= -1

Why do we want to calculate 𝜌 ?

• Returns of securities operating in same industry often exhibit positive correlation

➢ Good when industry is up – bad when industry is down

• Diversification = effective when combining securities with negative correlation (don’t want
positive because both could end up doing poorly)

➢ E.g. Furniture retailer & Debt collection company economy grow, interest rate low=
buy more furniture; buy more on credit cause interest rates are low; debt collection
company won’t be doing as well because economy isn’t struggling (visa-versa)

• Reality – difficult to find companies that are negatively correlated with rest of market

• Strive to include securities with lowest positive correlation(closer to 0 not necessarily

negative; least amount of positive correlated)

Example 10.6

Risk= sd= variance

Portfolio risk: A closer look

• Investors want highest return for lowest risk

• By combining securities that are negatively correlated, the risk of a portfolio can be
substantially lowered = incr & decr

Can risk ever be completely eliminated? No!

• Total portfolio risk consists of two elements

➢ Diversifiable (company-specific) risk

➢ Non-diversifiable (market) risk

Diversifiable (company-specific) risk

➢ Risk that is unique to one or a few companies .

➢ Examples: strikes, shortages of raw materials, pollution, failed marketing campaigns,

lawsuits, fraud, etc.= industry specific

➢ Can be diversified away in a large portfolio.

➢ Also called non-systematic risk.

Non-diversifiable (market) risk

➢ Risk that affects large numbers of companies in a market= almost every company
will be affected

➢ Examples: unexpected global market events (such as 9/11), and unexpected changes
in economic conditions (such as interest-rate hikes and oil-price surprises)= big
global events

➢ Cannot be eliminated irrespective of the size of the portfolio .

➢ Also called systematic risk.

Orange line= inherent risk of

Total portfolio risk = diversifiable risk + non-diversifiable risk the portfolio

Adding more securities into

portfolio= total risk which is
both market and entity
specific risk= will decrease
but only till a specific point
(market risk can never be
diversified away)

= investors should only be

concerned with market risk,
they can add other securities
into their portfolio to
diversify other risks & you
can measure a portfolios
exposure to market risk by
calculating the beta
Calculate your portfolio’s expected rate of return.

4. Calculate the expected standard deviation of your portfolio.

𝜎 2 = 𝑤𝑆2 𝜎𝑆2 + 𝑤𝐵2 𝜎𝐵2 + 2𝑤𝑠 𝑤𝐵 𝐶𝑜𝑣𝑆,𝐵

(0.6)2nd (16.43)2nd + (0.4)2nd (25.3)2nd +2(0.6)(0.4)(405)= 393.99
2nd= squared

22+-19.85= 2.15 & 41.85= high variance= high risk portfolio = you want the sd to be as close as
possible because that implies bigger chance that actual is in line with expected

Beta coefficient

• As company-specific risk can be diversified away, investors are only rewarded for bearing
market risk.

• A security’s exposure to market risk can be measured by calculating its beta coefficient ()

➢ It indicates the degree to which its returns tend to move with the overall market
(FTSE/JSE All Share Index)
 Covri ,rM
i =
 M2
= beta coefficient of security i

= covariance of the returns of security i and the overall market

= variance of the returns of all securities contained in the market portfolio

n
 p =  wi   i
i =1
Formula to calculate beta coefficient of a portfolio: weight * beta= then add all
together

INTERPRETATION:

•  = 1: the security’s returns move in sync with those of the market; it has the same
risk as the average share= return will increase by 10%

•  > 1: the security’s returns are more volatile than those of the average share; it has
more market risk= e.g B=2; return increase by 20%

•  < 1: the security’s returns are less volatile than those of the average share; it has
less market risk= e.g. b= 0.5= return increase with 5 %

•  < 0: the security’s returns move in the opposite direction as compared to the rest
of the market= B=-1, return decrease by -10%

• JSE All-Share Index (ALSI) usually representative of market portfolio

Example 10.7

n
 p =  wi   i
i =1
Additional example

Example: 3 shares in portfolio

20000/5000=0.25=weighting

Portfolio risk is lower than average portfolio (market portfolio)= less risky= B is less than 1

The capital asset pricing model (CAPM) and the security market line (SML)

Investors should base their investment decisions on the following rules:

➢ If expected return > required return, buy the share as it is undervalued

➢ If expected return < required return, do not buy the share as it is overvalued

CAPM and SML

The required rate of return on an investment can be calculated by using the SML from the CAPM :

r = rf +  i (rM − rf ) Rf= will always have a B of 0

Rf is min required rate of investor

Where:
Rm= B=1
r= required rate of return
Anything above the line= acceptable for an
rf=risk-free return on a government security investor ; bellow line = rejected
Bi=beta coefficient of the ith security Start with a B od 0 = risk free=rate of return
rm= return of the overall market portfolio is minimum required rate of return

B of 1= required rate of return= market rate

of return

Anything higher than market return (b>1) =

required rate of return is higher than
market
 B is higher than market B =
required rate of return is higher
than the market rate of return

Expected return is 17%

17%> 15.6%= in the green area=

acceptable area= invest in the
security because it is under
valued; expected rate of return>
required rate of return

If expected is on the SML= it is

neither under or overvalued; it is
perfectly valuated
Example 10.8
Expected is above the sml = acceptable area= buy the shares
Multi-factor asset pricing models
The Capital Asset pricing Model has been criticized because it only takes into account the
market risk

Arbitrage pricing theory

➢ A share’s required rate of return should be evaluated in terms of its sensitivity to a

range of macroeconomic factors= you should take inflation, tax rate changes ,
dividend yields into account= not only market risk

Multi-factor models= value of the company

➢ Three-factor model (market risk, size, value factors)

➢ Five-factor model (market risk, size, value, operating profit, investment factors)=
extended the 3 factors model

Additional exercise A

1. Calculate the average expected rate of return for WoolMart.

2. Calculate the average expected rate of return for the market.

3. Expected standard deviation for Woolmart.

4. Expected standard deviation for Market

5. Calculate the covariance between the return rates of the company (Woolmart) and the market.

6. Calculate the correlation coefficient between the return rates of the company and the market.

Answers:

1. first calc anticipated rate of return and then use the usual formula
2.

3. first need to calculate the variance

Interpret: expect that the actual returns of the share

has a 68% chance that it will fall within 1 standard
deviation of the expected return = deduct 6.96 from
the 8.3 and add it to the 8.3= range of 1.34
4.

5.
+ = move in the same direction

6.

Interpret: strong positive correlation between the

security and market

Additional exercise B

[Link] ALFA’s historical one year holding period return rate for 2018.

[Link] BETA’s historic risk.

3. Calculate the expected rate of return of the portfolion

Answer:

1.

2.
3.

Chapter 13 = Distribution policy

RECAP

❑ What are the main decisions that financial managers typically make (Chapter 1)?

➢ Which long-term assets should be bought?

• Capital budgeting → which machinery you require for your business; do you
need to invest in a plant = LT asset needed to make the product you require
to sell

➢ How should these long-term assets be financed?

• Capital structure→ borrow; raise capital by issuing share or combination of

both

➢ How should day-to-day operations be managed?

• Working capital management → stock level; how much cash you need in
your bank; sell on credit?; daily opporations; working capital management

❑ Another important decision deals with the allocation of attributable earnings

If a company has positive attributable earnings=they have a choice to:

• retain those earnings (reinvest it into the business)

➢ Replace= machinery needs replacement or refurbishment
➢ Expansion= growth project= you need a positive NPV; look to acquire a new company
(merges and acquisitions)
➢ Repay debt= you highky leveraged and need to repay some debt to manage your cash
flows
• distribute it to their shareholders
➢ cash/Share dividends
➢ share repurchase= buyback= you target specific shareholders and offer them a better
price( you incentivise them to sell them that you can buy back their shares)→ leads to
the number of shares in the market decreasing = your investment will have a larger
stake in the company because there are less shares in the available market

The choice between these options can have major consequences for the company; by distributing
the earnings you make most shareholders happy by getting cashflow but the company itself has
access to less cash so when opportunities come around; the company can’t invest in them or they
will have to raise the money externally by borrowing which will increase the debt costs = balancing
act= most companies do a little but of both

Introduction
❑ A company’s distribution policy describes:

➢ The format of distributions e.g. cash dividends vs share repurchases vs share

dividends.

➢ The size of distributions= how much company is distributing to shareholders

• Dividend per share (DPS = Ordinary dividends / # of ordinary shares);

Dividend payout ratio (DPR% = DPS/EPS)
 • Total Rand value of share repurchases

➢ The frequency of distributions.

• Dividends are often paid twice a year (interim and final)- interim dividend is
usually a little smaller than final divided ( just an indication of what is to
come) – some companies often pay quarterly dividends

• Share repurchases may occur once every few years or never

➢ The stability of distributions over time= some shareholders really invest in share for
the cash dividend they want to receive= want to invest in a company that receives a
specific level f dividends frequently

❑ Stock splits and consolidations are also discussed in this chapter.

❑ In theory, attributable earnings should be invested in projects that will increase P 0 in future,
thereby resulting in capital gains for shareholders.

❑ In practice, this does not always happen…

❑ The decision between retaining and distributing earnings is a complex balancing act. The
well-known American economist Fischer Black even called it a puzzle.1

❑ Consequences of distributing too little: some shareholders may be unhappy. If they sell their
shares, the share price will  and the cost of equity (ke) will .

❑ 1. Black, F. 1976. The Dividend Puzzle. The Journal of Portfolio Management, 2(2):5-8.

❑ Consequences of distributing too much: the company might have to raise costly external
capital if an opportunity presents itself and they don’t have sufficient R/E. Flotation costs
will  ke.
 ❑ Recall that the intrinsic value of a company (expressed on a per share basis) can be
determined by:

where:

❑ From a mathematical point of view, P0 should increase if:

➢ The expected dividend (D1) 

➢ The dividend growth rate (g) 

➢ The required rate of return (r) 

Information content / Signaling theory

❑ Shareholders do not always react positively to news of a cash dividend or share repurchase.
Recall that they compare new information to their expectations before reacting (buying or
selling shares). Keep in mind that the interim dividend is usually smaller than the final
dividend.

❑ According to this theory, an  in DPS generally conveys a message that the company is
performing well. It also signals that managers have confidence in the future performance of
the company and hence the company’s ability to continue paying a dividend in future.

❑ A  in DPS generally creates the perception that the company is not performing well.

Clientele effect

❑ The clientele effect suggests that shareholders can be categorised according to their income
needs and that they react differently to distribution decisions.

❑ Some clientele prefer companies that pay a regular cash dividend.

❑ Others prefer companies that rather retain their earnings.

❑ NB: this clientele group assumes that retained earnings will be invested in projects that will
contribute to the company’s profitability and share price appreciation (growth) in future.

Test yourself :

Assume that you are a pensioner. Which of the following companies should rather not be include in
your portfolio?

- Tesla= no dividends; risky shares= doesn’t appeal to retirees

-Distell= no dividend but this is because of expansion and is assumed that will resume

- Tabaco= got a yield and pay out ratio= appealing to pensioner

Dividend irrelevance
❑ Modigliani and Miller (M&M) were the first scholars to investigate whether shareholders
are interested in a company’s distribution decision= does it really have an impact on the
share priace of the company

❑ M&M argued that shareholders don’t care about a company’s dividend policy. Stated
differently: dividends are irrelevant.

➢ NB: In the 1960s, share repurchases rarely occurred, hence the focus on dividends.

❑ M&M said shareholders can create their own dividends if a company fails to pay a cash
dividend in a particular year; they could do so by selling some or all of their shares.

- home made dividend= sell shares when they get more dividend than expected then they
reinvest that into shares ( not practical cause often shareholders doesn’t like to sell shares)

❑ NB assumption: these “homemade dividends” are only possible in efficient markets and in
markets where there are no taxes or transaction costs= major flaw in their theory

❑ Assumptions markets are efficient (Page 426). These include:

➢ Personal taxes or corporate income taxes do not exist

➢ No flotation or transaction costs= not true cause if you decide to distribute

dividends, you may not have cash in your company = raise additional equity or debt
if you need to invest= floatation cost/ cost to borrow capital

➢ Dividend policy has no impact on capital budgeting

➢ Information readily available

➢ Leverage no impact on cost of capital

Assumptions not true

Example:

Keep it Ltd. and Distribute it Ltd. are the same size, operate in the same industry and have the same
investment opportunities. Both companies have total assets of R1 million and generated R300 000 in
net cash flow during 2019. The companies generated a return of 10% and investors require a return
of 10%. Both companies invested R300 000 in positive NPV projects in 2020 and each company has
250 000 shares outstanding. The current share price is therefore R4.00 per share (1 million / 250 000
shares).
 Old textbook but not expected to
do it in exam

Keep it= only pay capital gains tax once they sell their share ; distribute= pay dividend taxes;
floatation costs for issuing the shares (they worse off than the guys that didn’t pay dividend)

❑ Are M&M’s assumptions realistic? No! = you have to take the real world cost and taxes into
account; the fact that market isn’t efficient

❑ Do shareholders like selling shares if they need cash?

➢ No! = most shareholders would not want to sell a share to get cash, they would
rather keep the asset to appreciate and only sell it once they feel the asset has
grown as much as it could

➢ Recall from behavioural finance that most people have separate mental accounts
for “income” and “capital”.

• The “income” account contains their salary, dividends, rental income,

coupons and other forms of interest.

• The “capital” account contains the actual shares, bonds, rental property and
money market instruments.

➢ People tend to use the following rules: “consume-from-income” and “don’t-dip-

into-capital”.1

Sun international didn’t pay

dividend but used that money
to repay debt
[Link] to the clientele theory, Sun International’s distribution policy will most likely appeal to:
young people who have just started careers= clientele theory= investors are not the same, they have
their own needs and preferences; some investors invest for capital growth or other investors depend
on their cashflow from the dividend= retired people usually prefer a company that pays a steady
stable consistent dividend

3. True or false: Investors generally react negatively when a company fails to pay a dividend.= YES=
its all about the expectation of a shareholder= if a company used to pay a dividends & then change
it= share price will decline

RECAP

Dividend relevance
❑ In contrast to M&M, five theories have emerged to show that dividends are relevant (Pages
426-427). These include:

➢ Bird-in-the-hand explanation

➢ Information content / signaling explanation

➢ Tax preference explanation

➢ Agency explanation

➢ Catering explanation

1) Dividend relevance: bird-in-the-hand explanation

Based off an old proverb: a bird in the hand is better than two birds in the bush= what you already
own is a certainty where as there is only an expectation or hope of getting something more in the
future

❑ If a dividend is declared, the shareholder will almost certainly receive the cash payment=
provides certainty and he knows what to expect

❑ This is not necessarily the case with capital gains (investors can only hope that the retained
earnings that were re-invested actually translate into share price appreciation in future).

❑ This theory is also based on the notion of time value of money.

❑ A dividend received today can be invested to earn a return.

❑ Waiting for a capital gain involves an opportunity costs= might have to forgo certain
opportunities that are available today if you are waiting for the capital gain that may never
actually happen

❑ Inflation also plays a role= what you buy with your money today may be different to what
you buy with your money in 5 years time

❑ According to this theory, shareholders prefer companies:

 - that pay dividends to those that don’t.

- with higher DPRs than those with lower DPRs.

2) Dividend relevance: information content / signaling explanation

Information content is all about the information that is conveyed to the market if a dividend is
announced → dividend can be seen as a signal about managements views about the future
prospects and performance of the company→ divided declared= positive signal as the management
is confident that the company can sustain the dividend & will probably pay a dividend in future if
they have a distribution policy

❑ Recall that a dividend can be interpreted as a signal about management’s views about the
future prospects and performance of the company.

❑ Which behavioural biases could influence the signal that management wants to send with
its distributions?
All 3 may result in management
- Overconfidence (DPS could be too high) declaring dividends per share that
is too high for the actual earnings
- Illusions of control (DPS could be too high)= in control of the future growth of the
in the company
company

- Excessive optimism (DPS could be too high)= might declare a dividend that is actually
too high in comparison what should be declared in the company & they may be
better off if they retained some of that money to invest in other future projects

3) Dividend relevance: tax preference explanation

Dividend is relevant in SA due to the fact that both dividend & capital gains are taxed in SA

❑ Dividend tax rate in SA for individuals1 = 20%

❑ Capital gains tax (CGT) rate in SA for individuals2 = 18%→ calculated by taking the inclusion
rate of 40% for individuals and multiplying that by their marginal tax rate ( currently the
maximum tax rate for individuals is 45%) = 40*45= 18% maximum capital gains tax = can be
lower because some individuals may not be paying at 45%

❑ According to this theory, individuals subject to taxation in SA prefer companies that retain
earnings to those that pay dividends as the tax rate on dividends (20%) is higher than the tax
rate on capital gains (18%).

❑ Can also delay CGT

4) Dividend relevance: agency explanation

❑ Recall that managers are agents who should always act in the best interests of shareholders

❑ Unfortunately, they don’t always do this

❑ If excess cash is distributed to shareholders, managers’ ability to consume perquisites, build

empires and engage in M&As to enhance their personal income and prestige will be limited.

❑ Some scholars believe that dividends may serve as a mechanism to hold managers
accountable for their actions, especially in countries with poor investor protection.
 ❑ According to this theory, shareholders in countries where investors’ rights are often
disregarded prefer companies:

❑ that pay dividends to those that don’t.

❑ with higher DPRs than those with lower DPRs= if a company has a distribution policy
to declare high dividend or distribute all profits= when management require capital
to invest into profitable projects= they will have to optain the finace for this
externally( raise capital by issuing shares or borrow money= they will be subject to
more scrutiny & monitoring in accordance to what is required to raise that capital)
e.g. if there is a high dividend payout ratio, management will be under increased
scrutiny

❑ To what extent are investors’ rights protected in SA?

- Legislation = protection of consumers

- The King reports on corporate governance = Framework for JSE listed companies
that they have to comply with

- Shareholder activism = shareholders have the right to voice their dissatisfaction

5) Dividend relevance: catering explanation

❑ In line with the clientele effect, this theory states that companies adjust their distribution
policies to meet different shareholders’ needs for current income= shareholders are never
the same = only applicable to large shareholders as sometimes a large shareholder will take
up the majority of the shareholding of the company = those shareholders will be in contact
with the board & will make it know if they prefer being paid a dividend or not → In these
instances where you’ve got one or two large shareholders & just a few smaller shareholders
= distribution policy may be adjusted to meet those large shareholders needs

❑ In SA, shareholders who favour dividends can invest in unit trusts which are especially
created for this purpose, such as the Marriot Dividend Growth Fund.1

What do you notice about the nature of the companies in which this unit trust invests?
 Most of the companies are older companies that have
been established for years, reasonably mature →
these type of unit trusts will look at the history of
dividend payments = see if the payments are stable
and consistent; try and invest in those types of
company where they know there is a consistent
dividend payment and high dividend yield

The format of distributions

Cash dividends, share dividends or a share repurchase ( buy back shares from existing shareholders)

Trend has been steadily increasing= interesting because an opposite trend has
been observed globally ( share repurchases has increased & have been
substituting dividend for share repurchase because its just a slow uptake since
repurchase was only allowed in 1999)

Dividend tax only introduced in SA in 2012= at that point many companies

actually decided to increase their dividend pay out ratio to compensate
shareholders for the loss that they would have experienced. Increase dividend
per share in order to guarantee that the net dividend that shareholders receive
after paying tax would be reasonably the same compared to their expectation

2015 Dividend tax increased= same trend as companies may again increase the
dividend pay out

❑ Share repurchases
 ➢ Scholars argue that companies are increasingly substituting cash dividends with
share repurchases.

➢ This is not entirely true in the SA context.1

❑ By buying back shares, management signals that:

➢ there is no better investment than the company itself.

➢ they are confident about future performance.

➢ the share is undervalued (i.e. that its market value < intrinsic value)= positive signal
to the market = buying the share at a premium= willing to pay more to buy back the
share compared to the current market

Some other reasons for share buy backs :

o the company may want to have a different capital structure ( e.g. more debt than
equity/ make use of the benefits of being able to deduct interest / equity heavy
o used for making sure hostile takeovers don’t take place

Not all shareholders are keen on share repurchases= the tax for repurchases and dividend is
different so might be in a better position with a share repurchase but NB! The number of shares in
the market will decrease with share repurchase = the earnings oer share of a company will increase (
it is divided by less) = this will look good & management will often receive bonuses because the
company is “ performing well” but this is an artificial increase because no actual value was added to
the company

Different dividend models

❑ The residual distribution level (Page 434)

➢ Dividend policy of residual amounts

➢ Dividends are only paid once all financially feasible investment opportunities
(projects) have been financed.

❑ Fixed dividend cover

➢ Aim of this model: if the company is doing well (high EPS), shareholders share in the
good fortune (i.e. they receive a high DPS)

➢ If the company is doing poorly= don’t want to declare a dividend because the
company is actually not performing

➢ Want the shareholder to share in the good and bad years

➢ The company thus pays a fixed % of earnings= fixed dividend cover model=
dividends in line with the earnings of the company (doing well= good dividends;
doing poorly= will decrease)

❑ Constant growth
 ➢ Aim of this model: keep dividends stable and provide shareholders with a constant
income

➢ The company thus pays a fixed DPS; this DPS is maintained until the level of earnings
rises to such an extent that a higher DPS can be sustained.

➢ In some cases the company maintains a constant growth rate to keep up with
inflation.

➢ Identify this model if there is a fixed DPS that is being paid or when the dividend
increases at a constant percentage each year

❑ Q7 Page 445: Leftover Ltd. follows the residual distribution model to determine its dividend
payments. After completing its capital budgeting process, it was determined that one of the
following three capital investments may be required during the next financial year: a capital
investment of R2m, R4m or R6m. The company’s ATTRIBUTABLE EARNINGS are expected to
be R3m. Under the company’s target capital structure, 30% of the total capital should be
financed by means of debt capital. Calculate the amounts of dividends or new ordinary
shares that will be required under each of the three scenarios.

❑ Scenario 1:

➢ Capital required: R2m

➢ Equity requirement: 70% of R2m = R1.4m

➢ Attributable earnings= R3m> Equity requirement = enough profit to pay for this
project

➢ Residual= 3-1.4= R1.6m cash dividend

❑ Scenario 2:

➢ Capital required: R4m

➢ Equity requirement: 70% of R4m = R2.8m

➢ Attributable earnings= R3m> Equity requirement

➢ Residual= R200 000 cash dividend = if they retain 2.8m of the profit then there is
R200 000 cash left to be distributed as dividend

❑ Scenario 3:

➢ Capital required: R6m

➢ Equity requirement: 70% of R6m = R4.2m

➢ Attr. earn = R3m < Equity requirement = problem= there is nothing left to declare a
dividend ; we need to raise that equity in the market somewhere= so the difference
between the 4.2 M that we need to invest into the project and the 3M is actually
new equity that we have to raise

➢ INSIFFICIENT attributable earnings = no dividend = issue ordinary shares to raise the

money for 1.2m
Test yourself

1. The choice between cash dividends and share repurchases refers to which element of a
company’s distribution policy?

A. Format of the distribution

2. The ______________ theory explains why shareholders like dividends based on the notion that
cash received today is better than the promise of future capital gains?

A. bird-in-the-hand

True or false?

3. A dividend cut always sends a negative signal to the market about a company’s financial
prospects- False= it does sometimes send a negative signal but not always= you have different
shareholders with different preferences & some would prefer this situation

4. Shareholders in South Africa prefer dividends to capital gains as the tax rate on dividends is
currently higher than the tax rate on capital gains- False= second part(current tax rate> cap gain=
20%>18%) is true but you will pay less tax if you don’t get a dividend & rather hold the share for a
longer period to get capital growth or appreciation & then pay capital gains tax whenever you sell it

5. Excess cash should not “lie around” for managers (agents) to use for their personal benefit. It
should rather be paid out to shareholders- True= agency theory= if they pay out the dividends then
they need to raise the cash somewhere else if they want to invest in projects= they will be subject to
much more scrutiny whereas if they got hold of the cash themselves, they can do with it whatever
they want

6. Companies adjust their dividend policies to cater for the needs of their largest shareholders- True
e

7. Which dividend model does company A follow? Company B? Div cover= EPS/DPS

Company A=2 for every year = fixed div

model

Company B= 1.7; 2.5; 3.0 = Constant

growth= fixed div per share; if DPS
increased ever year with the same
amount (60, 65,70) then it would also
Different dividend models be Constant growth
❑ Fixed dividend cover

➢ Aim of this model: if the company is doing well (high EPS), shareholders share in the
good fortune (i.e. they receive a high DPS) and vice versa.

➢ The company thus pays a fixed % of earnings.

➢ Constant growth

➢ Aim of this model: keep dividends stable and provide shareholders with a constant
income.
 ➢ The company thus pays a fixed DPS; this DPS is maintained until the level of earnings
rises to such an extent that a higher DPS can be sustained.

➢ In some cases the company maintains a constant growth rate to keep up with
inflation.

Dividend payment process

❑ Declaration date:

➢ Date on which the dividend is declared by board of directors.

➢ Once a dividend is declared, it is owed by the company to the shareholders= it is a

liability to them on their statement of financial position = legally obliged to make
that payment

➢ Date of declaration when the company is liable to pay this dividend to the
shareholders

❑ Last date to trade cum-dividend:

➢ Shareholders on this date qualify for the dividend payment. If shares are sold after
this date, they still receive dividends.

❑ Ex-dividend date:

➢ Date after a person buys the specific share is not entitled to a dividend.

➢ Usually share price increases after the signal that dividend has been declared=
usually appositive sign depending on if it is the expected dividend= usually the share
price incr a little bit & then stays stable & then at the ex dividend it will fall again=
share is worth less because when you buy the share- you get it without the dividend

❑ Last day to register/record date:

➢ Date is set on which all shareholders that should receive a dividend have to be
registered.

➢ So that the company paying the dividend has a list of all shareholders that they need
to legally pay dividend to

❑ Date of payment:

➢ When the share register is finalized and all the shareholders that are to receive
dividends are registered, payments are made.

❑ See Figures 13.5 & 13.6 (Page 437-438) for an illustration of this process.
Share dividends
Assume that a company wants to reward shareholders, but they do not have sufficient cash to pay a
cash dividend= share amount will increase but its not a cash amount

➢ In such a case, they can issue share dividends

➢ Existing shareholders receive shares rather than cash.

➢ Share of the company increase in the market but your total % in that company
remains the same= your ratio is the same

❑ Share dividends are also called bonus shares or a capitalization issue.

➢ See Q8 Page 446

➢ Advantages of bonus shares

→ Shareholders avoid paying dividend tax.

→ They will only pay capital gains tax once they sell their shares for profit in
future.

Example: Share dividends

Shop-with-us Ltd. declared a 15% capitalistation issue. The company has 1 million issued ordinary
shares to the value of R5m. You own 150 000 shares in the company. How many shares will you own
after the capitalisation issue?

= 150 000*1.15= 172500 shares

How many issued shares will the company have after the capitalisation issue?

= 1 000 000*1.15= 1150 000 share

Stock splits
❑ Managers engage in stock splits when shares are deemed to be overvalued, i.e. too
expensive to buy the share

❑ For instance, a 2-1 share split:

➢ An existing shareholder will have double the number of shares he/she had before.

➢ The share price will halve (bring it in line with competitors and creating a higher
demand).

➢ Number↑ Price ↓

➢ Happens when you want to bring it in line with your competitors= create a higher
demand= more tradeable because you decreased the price of the share
Consolidations
❑ Also known as reverse stock splits.

❑ Occurs when shares are undervalued or if the company wants to increase the share price to
avoid being delisted.

❑ For instance, a 2-1 reverse share split:

➢ An existing shareholder will have halve the number of shares he/she had before.

➢ The share price will double (increasing the share price to a more “respectable”
level).

❑ You want to increase the share price to a more respectable level

NB! With stock splits & consolidations the share capital does not change= the number of shares
will change but the value won’t change

Stock split and consolidation (Q3 Pg 444)

Amachange Ltd’s current shareholder equity is as follows:

➢ Preference shares = R400 000

➢ Ordinary share capital (500 000 shares) = R1 000 000

➢ Reserves = R200 000

➢ Retained earnings = R800 000

➢ Shareholders’ equity = R2 400 000 (sum of above)

a) Calculate the ordinary share capital if the company declares a 3 for 1 stock split.

b) Ignore a). Indicate the ordinary share capital if the company declares a 2 for 5 consolidation
of shares.

Stock split and consolidation (Q3 Pg 444)

Quick answers :IT DOES NOT CHANGE

Proof:

a) Calculate the ordinary share capital if the company declares a 3 for 1 stock split.

Current ordinary share capital = R1m

Current no of shares in issue = 500 000

Current book value per share = 1m/500 000 = R2 per share

New no of shares (500 000 x 3) = 1500000

New book value per share = 2/3 =0.666667

New ordinary share capital =1500000*0.666667= R1m= remains the same

Proof:

b) Indicate the ordinary share capital if the company declares a 2 for 5 consolidation of shares.

Current ordinary share capital = R1m

Current no of shares in issue = 500 000

Current book value per share = 1m/500 000 = R2 per share

New no of shares = 500 000*(2/5)= 200 000

New book value per share = 2*(2/5) = R5

New ordinary share capital = 200 000 * 5= R1m

Additional exercise W12L1

1.1Compute and interpret the ordinary dividend cover if the dividend is paid.

Ordinary dividend cover (Page 90)

= Attributable earnings/ ordinary dividend

=(profit after tax-Pref div) / Ord div

= 140 000-20 000/ 0.6*150 000

120000/90000=1.33 times

Interpretation: FruitEx’s attributable earnings is 1.33 times larger than their ordinary dividend

1.2

Assume that the company’s ordinary dividend cover was 2.5 times in the previous financial year.
Comment on the trend of this ratio.

- The ordinary dividend cover decreased from 2.5 times to 1.33 times. This shows that there are less
attributable earnings available to pay the ordinary dividend than before

1.3Calculate the ordinary share capital should management rather buy back shares.
 With share buybacks the
ordinary share capital does not
remain the same = it will
Size of buyback? decrease with the amount of the
Similar to size of dividend(60c * 150 000) =R90 000 share buy back

1.4

Are shares always repurchased at the current market price? Motivate your answer.

2. Identify the correct answer combination.

i) A company’s DPS will fluctuate if they follow a fixed dividend cover policy.

ii) A company following a residual dividend model does not send a consistent signal to shareholders
about the company’s performance.

iii) The catering theory is closely aligned to the clientele effect.

iv) The intrinsic value of a company’s ordinary shares will decrease if the dividend growth rate
increases.

❑ Statements (i), (ii) and (iii)

3. MK Ltd. follows a residual dividend model. The company’s attributable earnings is R10 million.
Under the company’s target capital structure, 40% of the total assets should be financed with debt.
The company’s weighted average cost of capital (WACC) is 12%. The following independent
investment opportunities are available:

• Project A: Investment of R12 million; offers an expected rate of return of 15%.

• Project B: Investment of R6 million; offers an expected rate of return of 10%.

Calculate the total value of dividends OR new ordinary shares that will be required based on the
company’s capital budget.

❑ Independent means all acceptable projects qualify for funding. This is not the case with
Mutually exclusive projects.

= Only project a is acceptable as its expected rate of return (15%)> WACC (12%)

Capital required: 12m

Equity requirement: 60% of R12m= R7.2m

Attributable earnings= R10m> Equity requirement = should be some cash available to distribute as
dividend

Residual= 10m-7.2m= R2.8m cash dividend

4. Refer to Question 3. MK’s decision to follow a residual dividend model primarily relates to which
of the following elements of the distribution policy?

(i) The format of distributions.

(ii) The size of distributions.

(iii) The stability of distributions.

A. Statement (ii)

Additional exercise W12L2

1.1 Calculate the value of dividends that could be paid out or new ordinary share capital required to
finance the investments.

Which projects are acceptable?

- All 3 projects are acceptable as the ROI’s> WACC (15%)

- Capital requirement= 3+2+4= R9m

-Equity requirement= 60% x 9= R5.4m

The value of dividends that could be paid out or new ordinary share capital required to finance the
investments.
1.2 Calculate the DPS that will be paid out if only project C is accepted? Total cap = 10 000 000

R4 000 000 = debt= 40%

Equity= 60%

Additional exercise

2. The following information for CARS-FOR-YOU is provided: If 70% reinvested= 30% div can be
declared

2.1. Calculate the dividend per share if 70% of the attributable earnings are reinvested in the
company.
2.2Assume management decides to distribute a share dividend rather than a cash dividend. A 1-for-5
capitalisation issue will take place at the current market price of R5 per ordinary share. Calculate the
value of ordinary shares after the capitalisation issue took place.

2.2.2 Calculate the value of distributable reserves after the capitalisation issue took place

Company will finances shares from a distributable reserve- usually retained earnings = retained
earnings decr = share capital incr= R4m-R1m= R3m

2.3. Calculate the EPS after the capitalisation issue.

2.4 Assume that a subdivision of shares takes place in the ratio 4-for-2 ordinary shares instead of the
bonus share issue. Calculate the ordinary share capital in the statement of financial position after
the subdivision occurred.
2.5 Calculate the EPS after the stock split has taken place.

3. According to the agency theory, dividends are relevant because:

A. dividends can be used to hold managers accountable for their actions.

4. Research shows that shareholders often view capital gains and dividends as two separate aspects.
They perceive dividends as a more permanent form of income which can be consumed without
significantly impacting the investor’s total wealth. Explain why this kind of reasoning is irrational.

-both contribute to total wealth. Why make a distinction?

-Mental Accounting: Segregation decisions: creating separate “mental accounts” for different
elements of one’s budget or investment portfolio (based on the source and or purpose of the
money); treating these accounts differently

Conclusions
❑ A company has several options when deciding what to do with its attributable earnings
(Figure 13.1).

❑ M&M argued that a company’s dividend policy is irrelevant. This model, however, does not
hold in reality.

❑ Various theories have emerged to show that dividends are relevant: bird-in-the-hand;
information content / signaling, tax preference, agency and catering (which relates to the
clientele effect).
❑ A company has several options when deciding what to do with its attributable earnings
(Figure 13.1).

❑ M&M argued that a company’s dividend policy is irrelevant. This model, however, does not
hold in reality.

❑ Various theories have emerged to show that dividends are relevant: bird-in-the-hand;
information content / signaling, tax preference, agency and catering (which relates to the
clientele effect).

❑ The distribution decision has a profound impact on the other fin man decisions and a
company’s attractiveness as a potential investment.

❑ Stock splits and consolidations are methods to either  or  the number of issued shares
by splitting or consolidating the current shares. Both have an influence on the firm’s share
price.