Mancosa MBA financial management summary and revision, Study Guides, Projects, Research of Financial Management

Download Mancosa MBA financial management summary and revision and more Study Guides, Projects, Research Financial Management in PDF only on Docsity! ne MANCOSA HOHORIS UNITED UNIVERSITIES MBA FINANCIAL MANAGEMENT LECTURE NOTES JANUARY 2019 P. OSEI-SEKYERE TABLE OF CONTENTS CHAPTER 1: INTRODUCTION TO FINANCIAL MANAGEMENT. . . . . . . . . . . . . . . . . . . 1 CHAPTER 2: RISK AND RETURN. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 6 CHAPTER 3: LONG-TERM FINANCING. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 7 CHAPTER 4: COST OF CAPITAL. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 2 CHAPTER 5: FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY. . . . . . . . CHAPTER 6: FOREIGN EXCHANGE AND INTERNATIONAL CAPITAL BUDGETING. . CHAPTER 7: MERGERS AND ACQUISITIONS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . CASE STUDIES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . BIBLIOGRAPHY. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . [i] CHAPTER ONE INTRO TO FINANCIAL MANAGEMENT 1.1. INTRODUCTION The Financial Management Module is tailored to provide students with the analytic and theoretical tools required to master practical issues in finance, with applications to financial management in business firms, financial institutions, government, and not-for-profit entities. While some attention will be given to the descriptive, institutional, and historical aspects of the field, primary emphasis is placed on the analytical foundations of the discipline, emphasizing theory and methods of analysis and making extensive use of relevant techniques of economic analysis, mathematics, and statistics to enhance decision-making. The key focus of the module is Corporate Finance, the objective of which is the study of the major decision-making areas of managerial finance and some selected topics in financial theory. The course reviews the theory and empirical evidence related to the investment and financing policies of the firm and attempts to develop decision-making ability in these areas. [1] 1.2. DEFINITION Finance is generally defined as the art and science of managing money. According to Skae et al. (2014: 1), financial management as a discipline seeks to optimise the financial resources of, and returns to, an entity. This is generally accomplished by optimising two primary activities, namely: (1) financing activities, by deciding which sources of funding (debt or equity?) should be used by the entity and what the optimal proportion is for the various sources used, and (2) investing activities, by deciding which investments should be undertaken within the limitations of available funds and the identified feasible (can it be done?) and viable (does it derive positive return?) investment projects. If both financing and investing activities are optimised, the value of the entity will increase, and hence shareholders’ wealth is optimised over the long-term, which is the important outcome of financial management. Value is also created by the entity in a variety of ways for stakeholders other than the shareholders. It is therefore also important to understand the needs, interests and expectations of stakeholders in relation to the entity, as well as how value for each stakeholder group is derived and measured (Skae et al., 2014: 2). [2] 1.3. FINANCIAL MANAGEMENT AND FINANCIAL MANAGERS Financial Managers actively manage the financial affairs of a business, making decisions in the best interests of the firm’s shareholders (Agency problem: dispersion of ownership confers control to management). Thus, from a shareholder’s point of view, he/she must be concerned with 3 basic types of DECISIONS: 1. Capital Budgeting (forms part of investing activities): The process of IDENTIFYING, EVALUATING and SELECTING a firm’s Long-term investments is called Capital Budgeting. The role of the financial manager includes: - Identifying investment opportunities for the firm; - Evaluating the size, timing and risk of future cash flows is the essence of capital budgeting; and - Choosing the methodology to be used to evaluate the investments in order to make the best financial decisions. 2. Capital Structure of the firm (forms part of the financing activities): This refers to the specific MIXTURE of long-term debt and equity the firm uses to finance its operations. What mixture of equity and debt is the best for the firm? The mixture chosen will affect both the RISK and VALUE of the firm (Cost of Capital). How should long-term financing be OBTAINED and MANAGED? (i.e., what are the least expensive sources of funds for the firm? Note: the expenses associated with raising long-term financing can be considerable!). Thus, a [3] A sole proprietorship is a business owned by one person who operates it for his /her own benefit. The typical sole proprietorship is a small business, e.g., a plumber. The sole proprietor has unlimited liability; his or her total wealth can be taken to satisfy claims (liabilities) against the company. 1.4.2. PARTNERSHIP A partnership consists of 2 or more owners not exceeding 20 in number, conducting business together for profit. They are usually larger than sole proprietorships. Finance, insurance and real estate firms are the common types of partnership. Most partnerships are established by a written contract. They have unlimited liability, and each partner is legally liable for all the debts of the partnership. Partners are taxed in their personal capacities. 1.4.3. COMPANIES A company can be designated as a public company (in which case its name ends with the word LIMITED, abbreviated as Ltd), or as a private company (its name ends with the words proprietary Limited, abbreviated as (Pty) Ltd). A private company is any company that is not state-owned and is prohibited from offering its shares to the general public. A private company is taxed at a flat rate on its taxable income. Information in a private company is only available to shareholders. A public company, on the other hand, may raise capital from the public at large. [6] The relative ease of transferring ownership, unlimited life of the business entity and limited liability (debts) are the main reasons why this form of ownership is preferred when it comes to raising cash. For example, a company can increase its equity position by selling new shares to attract new investors. In South Africa, a company can either be a for-profit company or non-for-profit company (Companies Act 71 of 2008). Often called a “legal entity,” a company has the powers of an individual (legal personality) in so far as it can sue and be sued, be a party to a contract, and acquire property in its own name. A company is incorporated by lodging its Memorandum of Incorporation (MOI) and various supporting documents to the Companies and Intellectual Property Commission (CIPC). The MOI is defined as a document that sets out the rights, duties and responsibilities of shareholders, directors and others within a company. A company may trade only when the Commissioner has issued it with a certificate to commence business. SIMILARITIES & DIFFERENCES BETWEEN PRIVATE & PUBLIC COMPANIES Private company Public company Separate legal entity from owners Separate legal entity from owners Perpetual succession is allowed Perpetual succession is allowed Most private companies are not required to have an auditor Is obligated to have an auditor and an audit committee. A social and ethics committee is also required. Need no appoint a company secretary Must appoint a company secretary [7] Shares cannot be listed on a stock exchange Shares and debentures can be listed on a stock exchange Transferability of shares is restricted. E.g. existing shareholders must have the first right of refusal, if any shareholder wants to sell his/her shares. Shares are freely transferable. A Close Corporation (CC) is a simple, inexpensive form of ownership, existing as a separate entity from its owners (members). Under the Act (Companies Act-2008), A private company is designed to take the place of a close corporation as no new CC’s may be allowed to be registered. However, existing CC’s may continue to operate until they are deregistered or converted into a private company. 1.5. FINANCIAL MANAGEMENT GOALS The owners of a company are distinct from its managers. Agency problem: dispersion of ownership confers control to management. Actions of the financial manager should be in accordance with meeting the objectives of the firm’s owners; its shareholders. Thus, from a shareholders point of view, the financial manager must prioritise 3 basic questions: Goal 1: Profit Maximization Most financial managers believe that maximising profit is the firm’s objective. To do this, the financial manager must take certain actions that are expected to make a major contribution to [8] and bonds, Examples of intermediaries include insurance brokers, banks and real estate agents. 1.6.2. Financial Markets A financial market is a marketplace for the creation and exchange of financial assets, where buyers and sellers participate in the trade of assets such as equities, bonds, currencies and derivatives. If you buy or sell financial assets, you will participate in financial markets in some way or the other. The interplay between the firm and financial markets is a key part of the financial cash cycle of the firm. Securities refers to the various types of equity and debt that may be issued by the firm. Financial markets brings buyers and sellers together where debts and equity securities are bought and sold. Examples of the global stock exchanges include the New York Stock Exchange (NYSE), London Stock Exchange (LSE). [11] The South African Financial Markets include the Johannesburg Stock Exchange (JSE), Bond Exchange of South Africa (BESA), South African Futures Exchange (SAFEX), Yield X (for interest rate and currency instruments), and ALTX. ALTX is an alternative public equity exchange for small and medium-sized listings in South Africa operated in parallel with and wholly owned by the JSE Securities Exchange. Today THE JSE offers five financial markets namely, Equities and Bonds as well as Financial, Commodity and Interest Rate Derivatives. [12] NYSE NASDAQ - US JA PA N E X. G ROUP EURONEXT LS E G ROUP HONG K ONG E X. SHANGHAI S E TM X (T ORONTO) SHENZHEN S E DEUTSCHE B ORSE SIX SW IS S S E BOM BAY S E NSE IN DIA AUST RALIA S E S. K OREAN S E NASDAQ - OM X (N ORDIC S E) BM E S PA NIS H S E BM &F B OVESPA JS E TA IW AN S E SIN GAPORE S E 0 5 10 15 20 25 TOP GLOBAL EXCHANGES (2014) NAME OF EXCHANGE U S$ T R IL LI O N The market value of an exchange is computed as: market capitalisations of alllisted firms (¿) TotalMarket Value=∑ ¿ Where Market capitalisationof a firm=Number of shares×Share price [13] An investor can choose to purchase directly any one of a number of different securities. Alternatively, an investor can invest in some sort of a mutual fund, which bundles a set of direct investments and then sells shares in the portfolio of financial instruments it holds. Direct investment can be classified by the time horizon of the investment: Investment in debt that have a life of less than one year are usually called money market instruments (Treasury Bills, Bankers’ Acceptance, FRAs). Investments with maturities of more than one year are generally called capital market instruments (debts and equity).  Money markets is where short-term debt securities (money market instruments such as marketable securities, bankers’ acceptances and treasury bills, FRAs) are traded. Individuals, [16] businesses, governments, and financial institutions have temporary idle funds that they wish to put to some interest- bearing use. Transactions usually do not last more than 12 months.  Capital markets are markets for the raising and trading of securities of a long-term nature. Company shares are traded on stock exchanges (JSE); company and government bonds, bonds of parastatal (SOEs) are traded on the interest rate division of the JSE.  Derivative markets are markets for trading of instruments which are structured on underlying assets such as stocks and bonds. The structure of the course envisioned here is depicted in Figure 1, which shows the common core of Managerial Finance. The flow of finance to and from the firm as illustrated below informs the study and practice of managerial finance: Figure 1: The flow of finance 1.7. THE FLOW OF FINANCE [17] The cash flow between a firm and financial markets as illustrated above, entails 5 stages: Stage 1: The raising of capital (finance) Stage 2: The investment of the capital raised in operating assets (i.e. assets used in the operations of the firm). Stage 3: Using the assets to produce or provide goods and or services for sale to customers Stage 4: Controlling the day-to-day operating costs to ensure that an operating profit is realised. Stage 5: The distribution of the profit from the operations: - Provision for payment of interest on loan to providers of the loan capital financing; - Provision for company tax due on the profit realized; - Rewarding the shareholders (the providers of share capital financing), through a return of some of the profit attributable to them; - Refinancing the firm using retained earnings. At each stage, managers must make the best decisions. At stage 1, the decision is a choice between different types of capital must be assessed, usually referred to as the gearing decision. [18] The Risk/Return Trade-off diagram From the perspective of Financial Management, risk may be categorized into 4 main forms: Business risk, operating risk, financial risk and total risk. 2.2. TYPES OF RISK 3.2.1. Business Risk Business risk means the possibility of experiencing a financial loss in business. Business risk arises from the nature of the environment in which a specific or individual company operates. Business risk is influenced by the general economic conditions (inflation, labour unrest etc.) to which the firm is exposed and the type of industry in which a company is involved. Business risk emanates from fluctuations in profit before interest and taxes and arise largely through changes in demand and variability of costs and price (operational challenges). [21] Getting to grips with the total risks faced by the firm is a key part of financial management Business risk can be analysed by Environmental factors: PESTEL ANALYSIS; SWOT 3.2.2. Operating Risk Operating risk arises from the nature of the operating activities of the firm. The type of industry often determines the general cost structure of a firm (proportions of fixed and variable costs, capital or labour-intensive production processes) and/or the pattern of sales revenue. Mainly the proportion of a firm’s fixed costs to its total production cost. Cost-Volume-Profit Analysis can be used to assess the operating risk. A Critical Stage in the flow of Finance entails controlling the operating costs. This is necessary in order to provide an operating profit for subsequent distribution 3.2.3. Financial Risk Financial risk arises from the extent to which a firm relies on debt to finance its operations (i.e. risk arising from financial leverage). When a firm borrows, it is liable for the repayment of the debt and this includes interest payments on that debt. Whilst operating risk refers to the proportions of the firm’s fixed total production costs, financial risk is essentially illustrated by the proportion of debt capital to the total capital of the firm. Interest payments can be thought of as the firm’s fixed [22] cost of finance. Financial risk is totally driven by management decisions. Thus, financial risk is entirely under the control of the firm’s management. 3.2.4. Total Risk The Total risk of a company is the combination of the business, operating and financial risks. The financial risk is the only risk variable totally subjected to managerial control. Controlling the degree of total risk is an important managerial function. Practical experience shows that companies with a high degree of business and operating risks usually have a low degree of financial risk, while companies with a low degree of business and operating risk have more scope for using debt capital (higher financial risk). An important consideration when understanding risk profiles of firms is to compare firms within the same industry. This provides useful insights into changes in the composition of risks over time. Comparison with other firms allows the assessment of both the risk inherent in an industry and the risk specific to each firm. Analysing changes in risk components and total risk over time illustrates the firm’s performance and gives an indication of changes in the cost and financial structures that occur within a company. TOTAL RISK = BUSINESS↑ + OPERATING↑ + FINANCIAL↓ [23] includes the judicious use of OPTIONS, SWAPS, INSURANCE CONTRACTS, and INVESTMENT PORTFOLIO DESIGN etc. The relationship between risk and return called the security market line, or SML. The SML is based on the β coefficient, one of the centre-pieces of modern finance. Risk and Return of a Single Asset The two key determinant of security prices are expected risk and expected return. The return on an asset or investment for a given period, τ , is the annual income received plus any change in market price (usually expressed as a per cent of the opening market price). Symbolically, the one-period actual (expected) return, R: R= Dτ+(Pτ−Pτ−1) Pτ−1 Where, Dτ=annualincome∨cashdividend at the end of the period , τ Pτ=security priceat tie period , τ (closing∨ending security price) Pτ−1=security price at tie period , τ−1(opening security price) Risk Management Risk: The variability of the actual return from the expected returns associated with a given asset/investment is defined as risk. The greater the variability (volatility), the riskier the security [26] is said to be. The greater the certainty of the return (e.g. T-bills), the less the volatility and, therefore, the less the risk. Risk (volatility) of asset returns is measured using standard deviation (or variance) of returns using the historical data of the asset’s returns. ∑ of squared deviations Historical Variance , Sx 2 =¿ themean ¿ (Number of observations−1) = ∑ (x− x́ ) 2 n−1 Standard Deviation , Sx=square root of the variance=√∑ (x− x́ ) 2 n−1 Volatility is a measure of the jumpiness of the time series (price, rate or yield) of data we have. There are two very different notions of volatility:  Implied volatility: the volatility which can be backed out of an appropriate pricing formula. It is a function of the term τ = T-t and the strike price X.  Realised or historical volatility: This is backward-looking volatility. It is a measure of the ‘jumpiness’ revealed by historical data. Implied volatility includes market sentiment and nervousness, not to mention fees, so it is usually higher than historical volatility. [27] EXAMPLE: We use historical data to calculate the historical average of the annual returns. Year Actual Return, R Deviation from the Mean, (R−Ŕ) Squared Deviation 1 0.15 0.15 – 0.105 = 0.045 0.002025 2 0.09 0.09 – 0.105 = -0.015 0.000225 3 0.06 0.06 – 0.105 = -0.045 0.002025 4 0.12 0.12 – 0.105 = 0.015 0.000225 Totals 0.42 0.004500 Average Return, Ŕ 0.42 4 =0.105 Variance: σ x 2 = ∑ (R−R̄ ) 2 n−1 = 0 . 0045 4−1 =0 . 0015 [28] Coefficient of variation ,CV= Standarddeviation Mean = σ Ŕ As a matter of fact the CV is a much superior metric when comparing asset risks since it considers the relative size (expected value) of the assets. EXAMPLE: A company is trying to choose between two investment proposals A and B. project A has a standard deviation of R6 500 while project B has a standard deviation of R7 2000. The firm’s financial manager wishes to know which investment to choose, given each of the following combinations of the expected values. (a) Project A and project B both have expected net present value of R15 000. (b) Project A has expected net present value of R18 000 and project B has expected net present value of R22 000. SOLUTION: (a) Project A and project B both have expected net present value of R15 000. The manager should choose project A because the expected NPV of both projects is the same while the standard deviation, and therefore the volatility or risk, is smaller for project A compared to B. [31] (b) Project A has expected net present value of R18 000 and project B has expected net present value of R22 000. To determine the relative acceptability of the two projects as given in case (b), we have to compute and compare the coefficients of variations for the projects. Coefficient of Variation(CV )= Standard deviation(SD ) Mean ( x́) Project A : CV A= SD A x́ A x100= R6500 R18000 x100=36.11% Project B : CV B= SDB x́B x 100= R7200 22000 x100=32.73 % Since CV B<CV A , Project B has a lower volatility or risk compared to Project A, therefore, the acceptability of Project B is greater than that of Project A. 2.4. ANNOUNCEMENTS AND SURPRISES The return achieved on any share traded in a financial market is composed of two parts. Expected or normal return from a share/investment is the first part of the return that shareholders in the market predict or expect. The second part of the return on the share is the uncertain or risky part (Firer, Ross, Westerfield, Jordan, 2012:404). [32] The following list comprises of examples of unexpected information:  news from a company’s research and development programme  release of gross domestic product (GDP) government figures  actual sales figures exceeding projected/budgeted figures  a surprise announcement of a drop in interest rates. For an in-depth discussion on this topic refer to Firer-pp 404-406 and www.moneyweb.co.za We can now summarise return as: Actual Total Return=Expected return (E (R ))+Unexpected Return(U ) Actual Return=E (R )+Systematic portion+Non−systematic portion Actual Return=E (R )+Market risk (m)+ε Actual Return=E (R )+m+ε Where m=market risk∨systematic portionof the surprise ε=unsystematic portion 2.5. RISK IN A PORTFOLIO OF INVESTMENTS A portfolio is an investment that involves a combination of two or more securities (assets). A large number of portfolios can be [33] - Also known as non-diversifiable risk or market risk - Includes such things as changes in GDP, inflation, interest rates, etc. Unsystematic Risk are risk factors that affect a limited number of assets - Also known as unique risk and asset-specific risk - Includes such things as labour strikes, part shortages, etc. - For an example if the workers of a small firm announce a strike it is unlikely to disrupt the entire SA economy but it is likely to affect the primary competitors of the company. Portfolio diversification is the investment in several different asset classes or sectors. Standard Deviation as a Measure of Risk [36] In statistics and probability theory, standard deviation (represented by the symbol sigma, σ) shows how much variation or "dispersion" from the average (mean, or expected value) exists. A low standard deviation indicates that the data points tend to be very close to the average or expected return (i.e., lower variability), revealing a lower expectation of risk. A high standard deviation indicates that the data points are spread out over a large range of values and inherently carries more risk. The standard deviation of returns is used to measure of total portfolio risk. The diagram depicts the behaviour of the total portfolio risk (y axis) as more securities are added (x axis). With the addition of securities, the total portfolio risk declines, as a result of the effects of diversification, and tends to approach a lower limit. Research has shown that, on average, most of the risk-reduction benefits of diversification can be gained by forming portfolios containing 15 to 20 randomly selected securities. For well diversified portfolios, unsystematic risk is very small. The total risk for a diversified portfolio is essentially equivalent to the systematic risk. The total risk of a security can be viewed as consisting of two parts: Total security risk = Non-diversifiable risk + Diversifiable risk The expected return and risk premium on an asset depends only on that asset’s SYSTEMATIC RISK!! The β [37] coefficient is a measure of how much systematic risk a particular asset has relative to an average asset. Systematic Risk: The overall risk that affects a large number of securities and cannot be diversified away. They are market-wide effects, and thus, they are sometimes called market risk, or undiversifiable risk. Affects almost all assets in the economy. Unaffected by naïve diversification. To a diversified investor, only systematic risk matters. May be reduced by an investment strategy based on multiple markets. The reward for bearing risk depends only on the systematic risk of the investment. Non- Systematic Risk: Asset-specific or unique risk. They affect a single risk or a small group of assets. They can be reduced through diversification. A portfolio of 15 – 20 asset is sufficiently diversified to eliminate most non-systematic risks. Highly diversified portfolios tend to have almost no unsystematic risk. There is no reward for bearing non-systematic risk (i.e. the market does not reward risks that are borne needlessly. 2.5.1 Allowing for Systematic risk A discussion of systematic risk needs to begin with grasping the concept of the efficient frontier. What are the attributes of [38] The points marked on the efficient frontier correspond to the positions of three different investors, each of whom prefers the level of return and risk associated with the chosen point to any other on the frontier. Each investor has a series of indifference curves, and will choose to be situated on the highest indifference curve that is tangential to the best available investment opportunities. The average investor is risk averse, and so will only support more risky undertakings if the reward for doing so is at a suitably high level, hence the slope of these indifference curves. The most advantageous result an investor can obtain would therefore be where one of his/her indifference curves is tangential to the efficient frontier, for at that point all specific risk would have been removed, and no greater utility could be derived from moving to any other position.  An investor choosing position A does not wish to be exposed to too much risk, and is therefore satisfied with a limited expected return.  An investor choosing position B is willing to take on more risk, for an additional return.  An investor choosing position C is less risk averse still, but must be compensated by a higher return than investor B. No investor would wish to remain in a position to the right, or below, the efficient frontier as in that case specific risk would still [41] exist. No opportunities currently exist to the left, or above, the frontier. Note: the efficient frontier is a curve, because the extra return for accepting extra risk is not constant – eventually no additional return will be on offer, no matter what the risk, so the curve flattens. 2.5.2 Using CAPM to measure Systematic Risk The Capital Asset Pricing Model (CAPM) allows investors to determine the required rate of return on a share, based on the risk associated with that share. The CAPM is a model for pricing an individual security or portfolio. For individual securities, we make use of the security market line (SML) and its relation to expected return and systematic risk (beta) to show how the market must price individual securities in relation to their security risk class. The expected return on a risky investment depends on three things: 1. Rf = rate of return on risk-free investments 2. β = beta coefficient, systematic (market) risk of equity 3. Rm−R f = market risk premium For a given level of systemic risk, the CAPM determines the expected rate of return for any investment relative to its beta value. It is the benchmark formula for estimating the expected return on a security, portfolio, or project, by investors, or management, who desire to [42] eliminate unsystematic risk through efficient diversification. It assesses the required return for a given level of non-diversifiable, systematic (market) risk. As a consequence, they can tailor their portfolio of investments to suit their individual risk-return (utility) profiles. The beta ( β ) measures the volatility of the returns of the share relative to the overall market, which has a beta of one (1). A company with a beta greater than one is more volatile (risky) than the average, while a beta of lower than 1 indicates less volatility. Hence the greater the risk, the greater the return. β= ΔR s ΔRm = R s2−R s1 Rm2−Rm1 Therefore is company X had a β of 1.2 and company Y had a β 0.8, X is considered to carry more risk than the market and Y would carry less risk. CAPM is defined as follows: Re=R f+β (Rm−R f ) Where, Re = the return expected from the share Rf = the risk free state of return (=0) Rm = the return expected from the market as a whole β = the beta (relative volatility) of the share; measure of sensitivity The beta of a company requires statistical calculation of the covariance of the share relative to that of the market as a whole. [43] As Figure 2.6 illustrates, the expected risk-return of Rm from a balanced market portfolio (M) will correspond to a beta ( β=1 ), since the portfolio cannot be more or less risky than the market as a whole. The expected return on a risk-free investment ( Rf ) obviously has a beta β=0. Portfolio A (or anywhere on the Rf−M ) represents a lending portfolio with a mixture of risky and risk-free securities. Portfolio B represents a borrowing portfolio, because beyond M, additional securities are purchased by borrowing at the risk-free rate of interest. You should note that, while high betas correspond to high- expected returns, this does not necessarily mean that these returns will be achieved. 2.7.1 CAPM and Investment Projects We can now apply what we have learned about CAPM, betas and shares to the cost of capital used to appraise investment projects. [46] Figure 2.6.THE SECURITY MARKET LINE It would seem sensible to include in this cost of capital an allowance for systematic risk, if the beta of the shares of our company enables us to calculate the return required for investing in our risky shares. However, we should note that the value of the beta, and therefore Re, is based on existing perceived systematic risk. If we change the nature of our business or the way it is financed we are also changing systematic risk, and thus beta. So, when we need to appraise a project, which does not fit in our usual type of business, we could use, instead of the beta already given for our company’s activities, the beta relating to companies already dealing in projects of the type we are now considering. For example, if a furniture manufacturer were contemplating a project in gardening, the average beta for gardening firms could be used to estimate a cost of capital (the required return) rather than the beta of the furniture manufacturer at this date. If the project has a positive NPV when discounted at the cost of capital so calculated, then it would be acceptable, and its systematic risk would have been allowed for. Does CAPM Work? There are a number of assumptions behind the derivation of CAPM, some of which we shall be referring to again when looking at a firm’s gearing and its dividend policy. The problem areas are:  Taxes are ignored  Charges for dealing in securities are ignored [47]  All investors and lenders can borrow as much as they like at the risk-free rate  All investors have the same perceptions with regard to risk and return of each security/project. As these assumptions are not true in real life, some managers may well decide that CAPM is flawed and thus not worth using. Many researchers have carried out tests to see how well CAPM can explain and predict event. For example, by calculating betas for securities based on monthly returns (dividends and capital gains) for those securities compared to those for the market portfolio, it is possible to assess whether CAPM adequately explains the returns for the securities for the period in question. Most tests until relatively recently obtained results which supported CAPM. However, more recent research has suggested that, while there is a correlation between expected returns and beta, other factors such as the size of the company are also important. There are also difficulties in measuring the expected market return (over what period? Which starting point should we take?) and deciding what can be taken as a risk-free asset to identify the risk-free rate. (Note: CAPM is derived post-tax – it is important to ensure that Rf as well as Rm is a post-tax figure.) While there are undoubtedly imperfections in CAPM’s assumptions (more complicated models have been derived to try to [48] 1.1. What are the betas of the two stock? (4) Let AS denote “aggressive stock” and DS “defensive stock”. The betas of the 2 stocks are: β AS= 32%−2% 20%−5% = 30% 15% =2.0 βDS= 14 %−3.5% 20%−5% = 10.5% 15 % =0.7 1.2. What is the expected rate of return on each stock if the market return is equally likely to be 5% of 20%? (4) E (RAS )=∑ j=1 2 p j R j=0.5×32%+0.5×2%=17 % E (RDS )=∑ j=1 2 p jR j=0.5×14%+0.5×3.5%=8.75 % 1.11. Assuming that the T-Bill rate is 8% and the market return is equally likely to be 5% or 20%, draw the security market line (SML) for this economy. (5) E (RM )=∑ j=1 2 p jR j=0.5×20%+0.5×5%=12.5 % [51] 1.12. Plot the two securities on the SML graph. What are the alphas of each? (5) Based on the CAPM, the expected rate of return of the stocks are: E (RAS )=R f+β AS (Rm−R f )=8 %+2.0 (12.5 %−8 %)=17.00 % E (RDS )=R f+βDS (Rm−Rf )=8 %+0.7 (12.5 %−8 % )=11.15 % [52] Alpha ,αs=Actual Return−Expected Returnbased onCAPM For the aggressive stock, AS α AS=17%−17%=0 % Thus, the aggressive stock AS is alpha neutral. For the defensive stock, DS: αDS=8.75 %−11.15%=−2.4 % Thus, the defensive stock DS is alpha negative. 1.13. What hurdle rate should be used by the management of the aggressive firm for a project with the risk characteristics of the defensive firm's stock? (2) The project has the same risk characteristics as the defensive stock, thus its beta is the same as the defensive stock’s beta, β project=βDS=0.7 . Thus, the hurdle rate is 11.15%, the fair rate of return on the defensive stock. 2.9. Modern Portfolio Theory According to Jacquier (2013: 23), Modern Portfolio Theory (MPT) refers to the design of optimal portfolios and its implication for asset pricing. Starting with Markowitz's (1952) seminal mean- [53] μП=E (RП )=∑ i=1 N w iRi And the standard deviation of the return, the risk or volatility, is σ П=√∑i=1 N w i 2σ i 2 +∑ i=1 N ∑ j=1 ; j ≠ i N wiw jσ iσ j ρij Where ρij is the correlation coefficient between the returns on assets i and j . Alternatively, the expression can be written as: σ П=√∑i=1 N ∑ j=1 N wiw jρij σ i σ П Where ρij=1 for i= j According to MPT, all rational investors should hold portfolios that are not on the efficient frontier and that there exists a particular weighting of assets allocation ,wi ¿ , along the efficient frontier for which the portfolio has the greatest expected return for a given level of risk. This benchmark portfolio (market portfolio) is a tangency portfolio which lies at the point where a straight line drawn from the risk-free rate is tangential to the efficient frontier. According to Baker and Filbeck (2013: 1), portfolio diversification works best when financial markets are operating normally; during periods of turmoil, correlation is a standardized measure of co- movement between returns of two securities or market. Again according to MPT, all rational investors should hold their risky assets in the same proportions as their weights in the [56] market portfolio. According to modern portfolio theory, investors who do not follow a portfolio perspective, which entails regular evaluation of individual assets and investments according to their contribution to the risk and return of the portfolio, bear risk that is not rewarded with greater expected return (Baker and Filbeck 2013:1). Different types of assets sometimes change in value in opposite directions. For example, the movement of prices on the stock market often differ from that of prices in the bond market; thus, an investor could form a portfolio using both of these types of assets to generate lower overall risk than either individually. Diversification can lower risk even if assets' returns are positively correlated. Important Points: - The risk-return characteristics of the portfolio are improved as the number of assets in the investment opportunity sets increases. - The composition of the minimum variance portfolio for any level of expected return depends on the expected return of the assets, their variance and correlations, and the number of assets in a portfolio. PORTFOLIO MANAGEMENT An Investment Portfolio is made up of at least two assets. [57]  The expected rate of return on a portfolio is the weighted average of the expected rates of return on the assets that make up the portfolio. For an n-asset portfolio, let the weight of asset j be denoted by w j , and the expected return by E (R j ) , then the expected return of the portfolio can be defined by the equation. R w j E(¿¿ j) E (RP )=∑ j=1 n ¿  The total risk of a portfolio made up of two assets, A and B is defined by the equation2: σ P 2 =wA 2 σ A 2 +wB 2 σ B 2 +2wA wB (σ 12) ¿ (w Aσ A ) 2 + (wBσB ) 2 +2wAwB( ρABσ Aσ B) Where, σ12=covariance betweenthereturns of assets A∧B ρ12=coefficient of correlationbetween the returnsof assets A∧B Portfolio risk is less than the sum of the risks of the individual assets that make up the portfolio. This is the benefit of diversification. Note that −1≤ ρ12≤1. 2 This idea was first developed by Harry Markowitz, in the seminal work, ‘Portfolio Selection’, Journal of Finance, 7 (March 1952), pp. 77-91. This work laid the foundation for the development of the Capital Asset Pricing Model (CAPM). [58] PortfolioVaraince= 1 N average variance+(1− 1 N )average covariance As N→∞ , portfolio varaince→average covariance . In general as N ↑, portfolio variance steadily approaches average covariance. This is essentially the limit – the level of systemic risk – below which portfolio risk cannot be reduced through naïve diversification. For a 3-asset portfolio: The return can be computed as: E (RP )=∑ j=A C w j E (R j )=w A E (RA )+wBE (RB )+wC E (RC ) The standard deviation (volatility) can be computed as: σ P=√w A 2 σ A 2 +wB 2 σB 2 +wC 2 σC 2 +2w AwBσ Aσ B ρAB+2wA wC σ Aσ C ρAC+2wBwC σ BσC ρBC Effect of Different Weights on Correlation  When correlation equal +1, the risk-return combinations that results from altering the weights lie along a straight line between the 2 assets risk-return profiles.  As correlation falls, the curvature of this line increases.  When correlation equal -1, the curve is represented by two straight line that meet at the vertical axis (zero-risk portfolio) with some combination. [61] Deriving the Efficient Frontier  The minimum variance frontier reduces the investment opportunity set to a curve that contains only those portfolios that entail the lowest level of risk for each level of expected return.  The global minimum variance frontier is the portfolio of risky assets that entails the lowest level of risk among all portfolios on the minimum variance frontier.  Investors aim to maximize return for every level of risk. Therefore, all portfolios above and to the right of the global minimum variance portfolio dominate those that lie below and to the right of the global minimum variance portfolio.  The section of the minimum variance frontier that lies above and to the right of the global minimum variance portfolio is referred to as the Markowitz efficient frontier. EXAMPLE An institutional investor is considering three mutual funds. The first is a T-bill money market fund that yields a sure rate of 6%, the second is a US-based long-term corporate bond fund and the third is a JSE-listed stock fund. The probability distributions of risky funds (the last two funds) are displayed in Table 1.1 below: [62] Table 1.1 Expected return Standard deviation Stock fund 17% 35% Bond fund 9% 27% Based on the estimates of the quantitative analysts of your investment firm, the correlation between Stock fund and Bond fund returns is 0.09. Using an investment proportions for the stock fund of 0 to 100% in 5%, tabulate and draw the investment opportunity set of the two risky funds. SOLUTION Stock fund 17% 35% ρSB=0.09 Bond fund 9% 27% Portfolio Weights Standard deviation Retur n Stock fund Bond fund 1 0% 100.00 % 27.00% 9.00% 2 5.0% 95.0% 25.87% 9.40% 3 10.0% 90.0% 24.86% 9.80% 4 15.0% 85.0% 24.00% 10.20 [63] σ ¿ σ ¿ 2(¿2¿¿2−ρ12σ 1σ 2) ¿ 2w1(¿1¿¿2+σ 2 2 −2ρ12 σ1σ2)=¿ ¿ ¿ Thus, making w1 the subject, we have: w1 ¿ = σ2 2 −ρ12σ1σ2 σ1 2 +σ2 2 −2ρ12 σ1σ1 and w2 ¿ =1−w1 ¿ Where, w1 ¿ =optimalweight of asset 1 w2 ¿ =optimalweight of asset 2 σ1 2 =varianceof asset 1 σ2 2 =varianceof asset 2 ρ12σ 1σ 2=covarianceof returns of the2assets ρ12=coefficient of correlationbetweenthe returnsof the 2assets Plugging in the values: w1 ¿ = σ2 2 −ρ12σ1σ2 σ1 2 +σ2 2 −2ρ12 σ1σ1 w1 ¿ = (27 % ) 2 −0.09(35 %)(27 %) (35%) 2 +(27 %) 2 −2 x0.09(35 % )(27%) =0.36098 ∴w2 ¿ =1−w1 ¿ =1−0.36098=0.63902 Therefore, [66] Minimum Variance Portfolio Return, R E(¿¿ p) ¿ R E(¿¿ p)=w1 ¿ R1+w2 ¿ R2=0.36098 x17%+0.63902 x9%=11.89% ¿ The standard deviation of portfolio returns ( σ2 ) σ P 2 =(wA σ A ) 2 +(wBσ B ) 2 +2 ρABwA wB (σ Aσ B ) σ P 2 =(0.36098 x 35%) 2 +(0.63902 x27% ) 2 +2x 0.09x 0.36098 x0.63902 x27%x35% σ P=√(0.36098 x35% ) 2 +(0.63902x 27% ) 2 +2 x 0.09x 0.36098x 0.63902x 27%x35% σ P=√159.62553649+297.6846425316+43.5972800844=√500.9074591=22.28 % The red dotted arrows reflect the expected return and standard deviation of the returns of the minimum variance portfolio. Deriving the Market Portfolio: Mathematically, the market portfolio is the point of intersection of the security market line and the efficient frontier. Let ( σM ; E (RM ) ) represent the coordinate of a benchmark portfolio such that: E (Ri )−R f= E (RM )−R f σM σ i For a 2-asset portfolio: 1−w (¿¿A)E (RB ) E (RP )=wA E (RA )+wBE (RB )=w AE (R A )+¿ σ P=√w A 2 σ A 2 +wB 2 σB 2 +2wAwBσ A σB ρAB [67] 1−w w A 2 σ A 2 +(1−wA) 2σB 2 +2w A(¿¿ A)σ A σB ρAB ¿√¿ Thus, for a 2-asset portfolio, the exact values of the parameters of the optimal portfolio can be computed analytically via the proportion of the optimal risky portfolio invested in asset 1: w1 opt = [E (R1)−Rf ]σ2 2 −[E (R2 )−R f ] ρ12σ 1σ 2 [E (R1 )−R f ]σ 2 2 +[E (R2 )−R f ]σ1 2 −[E (R1 )−R f+E (R2 )−Rf ]ρ12 σ1σ2 This is the portfolio with maximum Sharpe ratio; Sharpe ratio constitutes the best-known measure of performance. It is used to rank mutually exclusive investments. Brandt (2009) discusses these intertemporal dynamic strategies. Instability of the Minimum-Efficient Frontier Small changes in the risk-return characteristics of individual assets can cause relatively large changes in the minimum variance frontier. The instability can arise from: - The inputs used in mean-variance optimization, which are subject to random variation. - The distribution of asset returns, which is not constant over time. The problem with an unstable minimum-variance frontier is that it becomes misleading and loses its usefulness. Further, the optimization may result in unreasonably large short positions and frequent portfolio rebalancing, which is costly. EXAMPLE [68] 3.1. INTRODUCTION All companies require capital or funding either to start the business or for expansion. A company could either borrow the money (debt financing), sell off shares (equity financing) or engage in a combination of the two. In this chapter we briefly examine some of the ways in which a firm raises capital, an insight into venture capital for start-ups is discussed and finally a decision to either lease or buy an asset is evaluated. 3.2. EQUITY FINANCING - ORDINARY SHARES Equity is the capital provided to a firm by its owners, and its most important characteristic is the ownership claim it represents. Equity is often defined as the residual value of the company i.e. [71] the difference between the value of a firm’s total assets and total liabilities. In the process of ordinary business, shareholders have a claim on the residual earnings of a firm, after all expenses, including interest, have been paid. Shareholders may receive these residual earnings in the form of dividends, but a firm is not obliged to automatically pay dividends. An equity shareholder makes a return through only ways, the first is through receiving dividends and the second is capital appreciation of their shares. Equity holders, being the owners of the company, have the right to control the firm and do so through voting for and choosing directors/managers who run the company on their behalf. In addition, shareholders have the right to vote on major decisions affecting the firm, such as merger and take-over offers, or the sale of subsidiaries. 3.3. EQUITY FINANCING 3.3.1. Preference Shares In addition to ordinary shares, companies may also issue preference shares, which have some of the characteristic of ordinary equity and some of the characteristics of debt. Preference shares typically have stated fixed dividend and can be redeemable, therefore resembling debt as far as the firm has a [72] fixed commitment and the original capital can be repaid. Alternatively, preference shares may be participating, which means that preference shareholders are entitled to a share of the residual earnings of a firm. Some preference shares may have a convertibility provision, which allows them to be converted into ordinary shares under certain circumstances. For tax purposes, preference shares are treated, as equity and preference dividends are not tax-deductible. Distinguish between:  A participating preference share and a convertible preference share. According to Ross et al. (2012: 217), preference shares are a class of equity securities usually bearing a fixed rate of dividend. They have preference over ordinary shares in the payment of dividends and in the distribution of company assets in the event of liquidation. From a legal and tax point of view, preference shares are a form of equity securities; however, the preference shareholders usually have no voting privileges unless the payment of preference dividends is in arrears. According to Bodie, Kane and Marcus (2013: 39), preference shares have features of both equity and debt. Firstly, like a debt security, it promises to pay to its holder a fixed stream of income each year; in this sense, it resembles an infinite-maturity or perpetuity bond. Secondly, like a bond, it does not give the holder voting power to influence the management of the firm. [73] In a rights issue, the company sets out to raise additional funds from its existing shareholders. A rights issue provides existing shareholders the opportunity to purchase additional shares. These shares are normally offered at a price lower than the current share price quoted, otherwise shareholders will not be prepared to buy, since they could have purchased more shares at the existing price anyway. The company cannot offer an unlimited supply at this lower price; otherwise the market price would fall to this value. Accordingly, the offer they make to the existing shareholders is limited. For example, they may offer one new share for every four held. Assuming this rights issue is taken up by the existing shareholders, the market price of the shares will readjust to a value above that of the rights issue but below the original market price. All things being equal, the new value of the shareholders’ investment should equal the original value plus the money paid for the shares in the rights issue. If a shareholder ignores the rights issue, the number of shares held will have remained the same but the value of each will have dropped. So ignoring the rights issue is not a recommended course of action. Let us look at an example, a company’s shares are trading at 500c each, and the directors announce a 1 for 4 rights issue at 400c. After the issue, the company’s shares can be expected to fall to [76] (4 ×500 c+1×400 c ) 5 =480 c This means that the right to buy 1 new share at 400c is worth 480c – 400c i.e. 80c. This will determine the value of the rights in the market place. The company will sell any rights not taken up, and compensate the shareholders accordingly. 3.3.4. Retained Earnings The equity capital used by a firm effectively comes from two sources: funds directly raised by the firm through the sale of newly issued shares, and funds retained from the cash flows generated during the course of business. The latter is commonly known as retained income (earnings), and represents the accumulated funds that the company chooses not to distribute to shareholders in the form of dividends. Retained earnings has an impact on the growth rate of a business, the more funds a business chooses to retain the quicker their growth rate. 3.3.5. Dividend and Dividend Policy A dividend refers to a cash payout from profits of a company. Dividend policies differ from company to company and often take into account the needs of the shareholders. The controversial question of how dividend policy affects a company’s value has varied opinions. Some believe that an increase in dividend payout reduces the value of the company, whilst others believe that it actually increases the company value. [77] The Miller and Modigliani theory states that the dividend decision in a perfect capital market (no taxes, transaction costs etc.) is irrelevant, as investors are indifferent to returns in the form of dividends (Skae & Vigario, 2015: 427). It would appear that financial managers favour a fair level of dividends payment policy, with a long-term payout rate, dividends are increased slowly, in order to avoid wild fluctuations as sudden shifts in dividend policy will directly affect the share price. The dividend policy in a perfect world has no effect on market value. However, in reality, where dividends and capital gains are taxed, investors would require a higher returns to compensate for their tax disadvantage. It is therefore impossible to provide a formula that can be used to establish the correct dividend payout ratio for any given situation. Financial advisors/managers have to exercise their judgements and at the same time consider the following factors:  The tax position of shareholders  The clientele effect  The tax position of the firm  The cash position of the firm and debt repayment schedule  The rate of growth and profit level  The stability of earnings  The maintenance of a target dividend policy. [78] 3.4.DEBT FINANCING The ultimate goal of long term financing is to acquire capital at the lowest possible cost. Debt is generally referred to as the capital that a firm borrows for a limited period of time. The most important characteristic of debt is that it does not constitute an ownership claim on a firm. A debt obligation is a contractual agreement, which usually states the amount borrowed, the interest payable and the dates at which interest payments and capital repayments are due. An important feature of debt financing is that interest payments are tax-deductible i.e. the firm’s tax liability is calculated only after interest payments have been deducted from the firm’s earnings. In the case of insolvency, claims of debts in general, including bonds, are honoured before those of both common stock and preferred stock. However, different types of debt may also have a hierarchy among themselves as to the order of their claim on assets. If interest on debts (bonds etc.) is not paid, the bond trustees can classify the firm as insolvent and force it into bankruptcy. A BOND is a type of debt or long-term promissory note, issued by the borrower, promising to pay its holder a predetermined and fixed amount of interest per year and on maturity the face value of the note. There are a number of types: DEBENTURES; [81] SUBORDINATED DEBENTURES; MORTGAGE BONDS; EUROBONDS (issued in country different from the one in whose currency the bond is denominated); ZERO & VERY LOW COUPON BONDS (e.g. selling a $1000 bond at a discount for $350) and JUNK BONDS (high risk bonds with ratings of BB or below). 3.4.1. Debentures A debenture is a document issued by a company containing an acknowledgement of debt. It need not give, although it usually does, a charge on the assets of the company. Usually a debenture is a bond provided in exchange for money lent to the company. Debentures can be offered to the public only if the application form is accompanied by a prospectus. The company agrees to repay the principal to the lender by some future date, as well as a fixed coupon or interest payment for a specific period. These periods can be semi-annually or annually. A debenture holder is considered a senior creditor of the company and the interest has to be paid to debenture holders before a dividend is paid to any class of shareholder. The Companies Acts define “debenture” as including debenture stock and bonds, it is quite common for the expressions “debenture” and “bond” to be used interchangeably. Company debentures can also be referred to as “loan share”. Secured or unsecured debentures: - Debentures and debenture shares can be secured or unsecured. It is usual, [82] however, to use the expression “debenture” when referring to the more secure form of issue, and “loan share” for less secure issues. As a form of hierarchy, some debentures are given subordinated standing in case of insolvency. The claim of the subordinated debentures are honoured only after the claims of, first, secured debt and unsubordinated debentures have been satisfied. For any unsecured long-term bonds, the earning ability of the issuing firm is paramount to the bondholder. Viewed as more risky than secured bonds, investors demand a higher yield than secured bonds provides. To the issuing firm, the major advantage of debentures is that no property has to be secured by them. This allows the firm to issue debt and still preserve some future borrowing power. 3.4.2. Convertibles A convertible is a loan which may be converted into ordinary shares in the company under specific conditions. One advantage, which is often quoted for convertible debt, is that it is cheaper than ordinary debt finance since the conversion option allows the security to be issued with a lower coupon rate than would otherwise be the case. Convertibles are seen as a way of issuing deferred equity. This may be particularly advantageous if existing shareholders want to minimise any loss of control since the number of shares issued via a convertible will be smaller than if straight equity were issued. [83] (1) The design of these securities (Why do bonds have embedded options? (E.g. Convertible Bonds, Callable & Putable bonds) What is the role of preferred stock? Etc.); (2) The issuing process for these securities (What do investment banks do? Is the underwriting process important for the cost of capital?); (3) The pricing of these securities (How are credit risk in bonds and loans priced?) The securities covered include corporate and junk bonds, bank loans, common and preferred equity, commercial paper, securitization, as well as some recent innovations. Other topics include the role of embedded options in corporate bonds; the role of bank and loan covenants; the function of bond rating agencies; exchange offers; prepackaged bankruptcies; bankruptcy Chapter 11; workouts; debtor-in-possession financing; and pricing credit risk. The course is designed to be complementary to Advanced Corporate Finance and Fixed Income Securities CURRENT YIELD = ANNUAL INTEREST PAYMENT/ MARKET PRICE OF BOND • Convertibles/Warrants • Loans: - • Bank overdrafts: - technically an overdraft is regarded as a temporary finance to cover short-term cash deficits. Drawing cash against an established line of credit. [86] 3.6.LEASES Lease agreements are a common source of finance for the funding of moveable assets. Under the terms of a lease agreement, the lessee has use of the asset for the duration of its useful life, whilst the lessor still retains control/ownership of the asset in exchange for an agreed lease payment. It must be stated clearly here that leases are financing decisions, not capital budgeting decisions. Leases: It is a contractual agreement for use of an asset in return for a series of payments; it is an alternative to buying the asset. Lessor is the legal asset owner who gives the lessee the permission to use the asset (usually finance houses often subsidiary of banks); Lessee is the one paying the lessor for the right to use the asset. International Accounting Standards (IAS 17) classifies leases as finance leases or operating leases. Finance/Capital: - A longer-term lease, which is generally non- cancellable. Lessee has the option to acquire ownership of the asset. Lessee assumes virtually all of the benefits and risks of ownership of the leased asset. Lease term is at least 75% of economic life of asset. Ownership of asset of is transferred to lessee. Finance leases are leases that have substantially all the risks and rewards incidental to ownership transferred to the [87] Lessee (User)Lessor (owner) lessee, whether or not the title is eventually transferred. The lessor is only a financier and usually not interested in the assets. All other leases are classified as operating leases (Firer et al., 2012:776). Assets could be aircrafts, ships, buildings, heavy machinery etc. According to Marshall, McManus and Viele (2016:196): “A capital lease (or financing lease) results in the lessee (renter) assuming virtually all the benefits and risks of ownership of the leased asset. For example, the lessee of a car from a dealership may sign a noncancelable lease agreement with a term of five year requiring monthly payments sufficient to cover the cost of the car, plus interest and administrative costs. A lease is a capital lease if it has any of the following characteristics:  It transfers ownership of the asset to the lessee  It permits the lessee to purchase the asset for a nominal sum (a bargain purchase price) at the end of the lease term.  The lease term is at least 75% of the economic life of the asset.  The present value of the lease payments is at least 90% of the fair value of the asset.” The economic impact of a capital lease in not really different from buying the asset outright and signing a NOTE PAYABLE that will be paid off, with interest, over the life of the asset. - Sale and leaseback: - Firm sells a non-current assets it has already bought. [88]  Leasing may require fewer restrictive covenants than secured borrowing  Leasing may encumber fewer assets than secured borrowing.  According to Skae et al. (2014:267), “even though leasing is generally more expensive than outright purchase (if assets are kept for most of their expected life), leasing is often preferred because it helps to mitigate risk. Merits and Demerits to the Lessee and to the Lessor! EFFECTS OF VOLATILITY ON INVESTMENTS Financial volatility can add to the drag on returns by making both households and companies more risk averse. If consumers are unsettled by wild markets, and particularly their implications for the stability and predictability of investments as well as the availability of financing, they could decide to spend less; and companies could scale back their investment outlays. This would weaken markets further, threatening a cocktail of adverse spillover and spillbacks. The damage from increased financial volatility can force firms to deleverage, which can spill over in a meaningful sense onto real economic activity. A recent example of “Lease or Buy decision” occurred at SAA. The board headed by Ms. Dudu Myeni, wanted a completed capital [91] lease approach vis-à-vis the National treasury that recommended a lease option. You know the story. Another example related to Former commissioner of Police, Mr. Bheki Cwele, who was fired because he signed a costly lease agreement with a company when it was less expensive to buy. You need to know this stuff. IAS Changes regarding Asset management: in terms of International Accounting Standards for property, Plant and Equipment (PPE), IAS 16, the initial recording of an asset in the Asset Register will be done @ COST. This is the case for purchases made after 1 APRIL 2004. Before then assets were recorded at FAIR VALUE. FINANCIAL EVALUATION OF LEASING The process of financial appraisal in a lease transaction generally involves 3 steps: i. Appraisal of client, in terms of financial strength and credit worthiness ii. Evaluation of the security/collateral security offered and, iii. Financial evaluation of the proposal. The most critical part of the leasing transaction, both to the lessor and lessee, is the financial evaluation of the proposal. The objective is to identify the cheaper source of finance to a lessee and better investment alternative to the lessor. [92] EXAMPLE 1: Messi Tiles are a global company with their head office in Midrand, Johannesburg, South Africa. Due to increase in sales both locally and abroad and the weak rand (South African currency), the company wishes to acquire their own manufacturing plant. The plant may be purchased outright or leased. The Purchase Option 1. The plant will be purchased directly from Itala Tiles in Italy at a cost of 150 000 Euros. 2. The annual service costs will amount to R8 000 per annum for the first 2 years and R10 000 for the remaining 3 years. [93] Operating Lease Capital/finance Lease Using Loan Purchase Cash payment @ year 0