Contents – a concise overview - University of Cape Town Financial statement analysis 5-1 ... ..David Jones ... Series of investments, ordinary annuity (FVA) – Multiple investments

Contents – a concise overview

Chapter Chapter Description Page

Ch1 Overview of financial management 1-3

Ch2 The time value of money 2-3

Ch3 Risk and return 3-1

Ch4 Portfolio management 4-1

Ch5 Financial statement analysis 5-1

Ch6 Valuations 6-1

Ch7 The cost of capital 7-1

Ch8 Capital budgeting 8-3

Ch9 Further issues in capital budgeting 9-1

Ch10 Capital budgeting: risk analysis 10-1

Ch11 Working capital 11-1

Ch12 Current asset management and short-term financing 12-1

Ch13 Sources of finance 13-3

Ch14 Capital structure 14-1

Ch15 Leasing 15-1

Ch16 Dividends and share buy-backs 16-3

Ch17 Mergers and acquisitions 17-1

Ch18 Futures 18-1

Ch19 Options 19-1

Tables

Index

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SECTION A: INTRODUCTION

1. OVERVIEW OF FINANCIAL MANAGEMENTLearning objectives..........................................................................................................1-3

Introduction .....................................................................................................................1-3

1. The context of financial management ....................................................................1-3Development of financial management .....................................................................1-4Links with economics ...............................................................................................1-4Links with accounting...............................................................................................1-4

2. The environment of financial management ...........................................................1-5What are the major forces currently shaping the Australian economy? .....................1-5What are the forms of business organization? ...........................................................1-7The sole proprietorship.............................................................................................1-7The partnership ........................................................................................................1-8The company ............................................................................................................1-8The taxation system ..................................................................................................1-9

3. What is the fundamental objective of financial management? ...........................1-11Why is profit maximization not the right objective for corporate finance?..............1-11The objective of business operations.......................................................................1-12Focus of financial management on decision making ...............................................1-13Economic Value Added (EVA).................................................................................1-14What about the ethics of maximising value? ...........................................................1-15

4. The role of the financial manager ........................................................................1-15Opportunities to create wealth................................................................................1-15Investment in operating assets ................................................................................1-16Investment in financial assets..................................................................................1-16Selecting the optimal finance mix ...........................................................................1-17The interaction of investment and financing decisions............................................1-19From the real world….Wesfarmers .........................................................................1-20

5. Fundamental concepts in corporate finance........................................................1-21Present value...........................................................................................................1-21Time value of money ..............................................................................................1-21Risk and return .......................................................................................................1-21Financial analysis ....................................................................................................1-21From the real world…..David Jones........................................................................1-23Efficient markets .....................................................................................................1-24Portfolio theory.......................................................................................................1-25Capital asset pricing model .....................................................................................1-25Do managers act in the best interests of shareholders?............................................1-25Another agency problem: shareholders and bondholders........................................1-27

6. Structure of the text..............................................................................................1-27

Summary ........................................................................................................................1-28

Questions .......................................................................................................................1-28

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SECTION B: FOUNDATIONS FOR DECISION MAKING

2. THE TIME VALUE OF MONEY Learning objectives..........................................................................................................2-3Introduction .....................................................................................................................2-31. Future values ...........................................................................................................2-4

Single sum, single period ..........................................................................................2-4Single sum, multiple periods, annual interest compounded......................................2-4Single sum, multiple periods, non-annual compounding..........................................2-8 Annual effective rate .................................................................................................2-9Continuous Compounding .....................................................................................2-10Interpolation ...........................................................................................................2-11Series of investments, ordinary annuity (FVA) – Multiple investmentsand multiple periods...............................................................................................2-12 Series of investments, annuity due..........................................................................2-13Future values when the timing of the cash flows and the compoundingperiods differ...........................................................................................................2-14

2. Present values........................................................................................................2-15Single sum, single period, annual discounting ........................................................2-16Single sum, multiple periods, annual discounting...................................................2-16Stream of cash flows, ordinary annuity (PVA) .........................................................2-17Stream of cash flows, annuity due...........................................................................2-19Stream of cash flows, deferred annuity....................................................................2-21Uneven stream of cash flows...................................................................................2-23Perpetuities .............................................................................................................2-23Growing perpetuities...............................................................................................2-24Growing annuity .....................................................................................................2-25Inflation and real returns ........................................................................................2-25

3. Some real world applications ...............................................................................2-26Retirement planning................................................................................................2-26Loan amortisation schedules ...................................................................................2-28Mortgage loan .........................................................................................................2-28Using financial calculators ......................................................................................2-29What to watch out for when using a financial calculator ........................................2-30Using Excel spreadsheets ........................................................................................2-32

4. The role of interest rates ......................................................................................2-34The expectations theory ..........................................................................................2-36The liquidity preference theory...............................................................................2-36The market segmentation theory.............................................................................2-38

5. Applying the time value of money principles to bonds......................................2-38Summary ........................................................................................................................2-41Self-study problems .......................................................................................................2-42Questions .......................................................................................................................2-46

3. RISK AND RETURN Learning objectives..........................................................................................................3-1Introduction .....................................................................................................................3-11. The concept of risk .................................................................................................3-2

Business risk .............................................................................................................3-3Financial risk ............................................................................................................3-6Total company risk....................................................................................................3-7

2. Measuring expected return and risk ......................................................................3-8Measuring the expected return on a single share ......................................................3-9Measuring risk for a single share.............................................................................3-10 The mean–variance rule ..........................................................................................3-11

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3. Interpreting the summary statistics.....................................................................3-12Properties of a normal distribution .........................................................................3-12 Comparison of single shares ...................................................................................3-13Coefficient of variation............................................................................................3-15The z score..............................................................................................................3-16Covariance and correlation .....................................................................................3-17

4. Risk and return in financial markets ...................................................................3-19

Summary ........................................................................................................................3-21

Self-study problem.........................................................................................................3-22

Questions .......................................................................................................................3-23

4. PORTFOLIO MANAGEMENTLearning objectives..........................................................................................................4-1

Introduction .....................................................................................................................4-1

1. Two-asset portfolio risk and return .......................................................................4-2Measuring two-asset portfolio returns .......................................................................4-2The principles of portfolio risk .................................................................................4-3Measuring two-asset portfolio risk ............................................................................4-7Positioning an investor on the efficient frontier.......................................................4-13

2. Multiple-share portfolio risk and return .............................................................4-15The benefits of diversification .................................................................................4-16Introducing a risk-free asset ....................................................................................4-18

3. Beta analysis..........................................................................................................4-20Beta as a measure of portfolio risk ..........................................................................4-21Beta and the capital asset pricing model (CAPM)....................................................4-23

4. The efficient markets hypothesis .........................................................................4-28The weak form........................................................................................................4-28The semi-strong form..............................................................................................4-29 The strong form ......................................................................................................4-29Testing for market efficiency ...................................................................................4-29Evidence of the efficiency of the ASX......................................................................4-30

Summary ........................................................................................................................4-31

Appendix 4.1: Calculating the beta coefficient............................................................4-31

Self-study problem.........................................................................................................4-34

Questions .......................................................................................................................4-37

5. FINANCIAL STATEMENT ANALYSIS Learning objectives..........................................................................................................5-1

Introduction .....................................................................................................................5-1

1. Annual reports ........................................................................................................5-1Statement of Financial Performance (Income statement)...........................................5-4Statement of Financial Position (Balance sheet).........................................................5-4Statement of Cash flows............................................................................................5-4

2. Objectives of financial statement analysis.............................................................5-5Equity investors ........................................................................................................5-5Credit grantors..........................................................................................................5-6Management .............................................................................................................5-6Employees.................................................................................................................5-7Acquisition and merger analysts................................................................................5-7 Auditors ....................................................................................................................5-7Other interested parties.............................................................................................5-7

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3. Limitations of accounting data ...............................................................................5-7Monetary expression .................................................................................................5-8Simplification and summarization.............................................................................5-8Flexible accounting policies ......................................................................................5-8Inflation ....................................................................................................................5-8

4. Approaches to financial statement analysis...........................................................5-9Comparative financial statements..............................................................................5-9Index analysis ...........................................................................................................5-9Common size analysis.............................................................................................5-10Ratio analysis ..........................................................................................................5-11

5. Application of ratio analysis ................................................................................5-12Liquidity ratios........................................................................................................5-13Asset management ratios.........................................................................................5-13 Debt management ratios .........................................................................................5-15 Profitability ratios....................................................................................................5-17Cash flow ratios ......................................................................................................5-19Market value ratios .................................................................................................5-19

6. Structured ratio analysis.......................................................................................5-20Du Pont analysis .....................................................................................................5-20

7. Failure prediction .................................................................................................5-23Financial distress models ........................................................................................5-23

8. Limitations of ratio analysis.................................................................................5-24

9. Economic Value Added .........................................................................................5-25

10. What’s behind the numbers? ................................................................................5-27Understand the business and the industry sector....................................................5-27Understand management’s motives for selecting accounting policies ......................5-27Understand the key drivers of value........................................................................5-28Understand which accounting policies are flexible..................................................5-28Understand the warning signs and red flags ...........................................................5-28Understand the business and financial risks facing the company............................5-30From the real world… Standard & Poor’s, ATO, AustralianBureau of Statistics, ANZ

Summary ........................................................................................................................5-32

Self-study problems .......................................................................................................5-33

Appendix 5.1: Sustainable growth ...............................................................................5-37

Questions .......................................................................................................................5-41

6. VALUATIONSLearning objectives..........................................................................................................6-1

Introduction .....................................................................................................................6-1

1. Valuation – an overview..........................................................................................6-2What are the fundamental building blocks of a valuation?........................................6-3

2. The effect of risk and return on valuations ...........................................................6-3

3. Required rate of return ...........................................................................................6-4

4. Valuation of debentures and bonds........................................................................6-4Debentures and bonds in perpetuity .........................................................................6-5Redeemable debentures and bonds ...........................................................................6-5From the real world…Repco notes ........................................................................6-7

5. Valuation of preference shares ...............................................................................6-7Cumulative non-redeemable preference shares .........................................................6-8Non-cumulative preference shares ............................................................................6-9Redeemable preference shares...................................................................................6-9

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6. Valuation of ordinary equity ..................................................................................6-9Dividend discount model........................................................................................6-10

Constant growth in dividends ......................................................................................6-10Role of future earnings ................................................................................................6-13Limitations ..................................................................................................................6-14Zero growth in dividends .............................................................................................6-14Valuing shares with a non-constant growth rate ..........................................................6-15Two stage valuation.....................................................................................................6-15From the real world…Woolworths ....................................................................6-17

Price multiples (relative valuation)..........................................................................6-18The price-earnings (P/E) ratio.....................................................................................6-18Market to book ratio ...................................................................................................6-20Price to sales ...............................................................................................................6-21

Free cash flow model ..............................................................................................6-17The Economic Value Added (EVA) approach ..........................................................6-25

7. Valuations and the financial manager ..................................................................6-26Pitfalls .....................................................................................................................6-27Challenges ..............................................................................................................6-28

Summary ........................................................................................................................6-28


Questions .......................................................................................................................6-33

7. THE COST OF CAPITALLearning objectives..........................................................................................................7-1

Introduction .....................................................................................................................7-1

1. The weighted average cost of capital (WACC)......................................................7-2

2. The weighted average cost of capital – principles and formula ...........................7-3

3. The pooling-of-funds approach ..............................................................................7-4

4. Component costs of capital ....................................................................................7-6Cost of new debt (Kd) ..............................................................................................7-8Cost of preference shares (Kp) ..................................................................................7-9Cost of shareholders’ equity ....................................................................................7-11Dividend yield and growth method ........................................................................7-11Capital asset pricing model method ........................................................................7-12

5. Weighting components of capital structure.........................................................7-13

6. Calculating the WACC .........................................................................................7-14

7. Breaks in the WACC .............................................................................................7-15

8. Funds from non-cash flow items..........................................................................7-17

9. Marginal projects ..................................................................................................7-17

10. The weighted average cost of capital – some practical issues............................7-18The risk-free rate.....................................................................................................7-18The market (equity) risk premium..........................................................................7-19

Historical premiums ....................................................................................................7-19Surveys .......................................................................................................................7-20Using the dividend growth model to determine the market risk premium ....................7-20Warren Buffet’s view....................................................................................................7-21

Betas .......................................................................................................................7-21Dividend imputation...............................................................................................7-21

Summary ........................................................................................................................7-22


Questions .......................................................................................................................7-28

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SECTION C: INVESTMENT DECISIONS

8. CAPITAL BUDGETINGLearning objectives..........................................................................................................8-3

Introduction .....................................................................................................................8-3

1. Types of investment projects..................................................................................8-4Replacement or expansion ........................................................................................8-4Independent and mutually exclusive projects ...........................................................8-5Divisible and indivisible projects...............................................................................8-5

2. Capital budgeting techniques.................................................................................8-5Net present value (NPV) ...........................................................................................8-6The internal rate of return (IRR) ...............................................................................8-7Payback method......................................................................................................8-10Accounting rate of return........................................................................................8-11Other methods........................................................................................................8-13Economic Value Added (EVA) or economic profit...................................................8-14

3. Cash flow determination ......................................................................................8-16Beginning-of-project cash flows ..............................................................................8-17Annual operating cash flows ...................................................................................8-18Cash flow determination – some rules ....................................................................8-18Taxation ..................................................................................................................8-22End-of-project cash flows........................................................................................8-25Application .............................................................................................................8-25

4. Post-audits .............................................................................................................8-27


Summary ........................................................................................................................8-32

Appendix 8.1 NPV/IRR: conflict in rankings ...............................................................8-32Different levels of investment ..................................................................................8-32Timings of cash flows differ ....................................................................................8-33

Appendix 8.2 More on taxation and capital budgeting 8-35Effective life ............................................................................................................8-36Adjustable value......................................................................................................8-37Capital Gains Tax....................................................................................................8-37

Questions .......................................................................................................................8-39

9. FURTHER ISSUES IN CAPITAL BUDGETINGLearning objectives..........................................................................................................9-1

Introduction .....................................................................................................................9-1

1. Comparing projects with unequal lives .................................................................9-1Unequal lives and project evaluation ........................................................................9-2Replacement chains...................................................................................................9-4Equivalent annual annuities ......................................................................................9-4Equivalent annual costs ............................................................................................9-5

2. Capital budgeting under inflation..........................................................................9-6Inflation and the discount rate ..................................................................................9-6Investment bias .........................................................................................................9-6Discounting cash flows at the real rate of return .......................................................9-7Depreciation deductions ...........................................................................................9-8Adjusted real approach ...........................................................................................9-10

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3. Capital rationing ...................................................................................................9-11Capital constraints and project rankings .................................................................9-12Profitability index....................................................................................................9-12The ranking of indivisible projects..........................................................................9-13Multi-period capital rationing .................................................................................9-13

4. Assessed tax losses ...............................................................................................9-15The utilization of assessed losses.............................................................................9-15New ventures and ring-fencing provisions ..............................................................9-16Synopsis..................................................................................................................9-16

5. Abandonment value and optimal economic lives................................................9-17Continuing evaluation.............................................................................................9-17Optimal economic life.............................................................................................9-18Replacement timing ................................................................................................9-20

6. Strategic options ...................................................................................................9-22Examples of strategic options..................................................................................9-23


Summary ........................................................................................................................9-28

Appendix 9.1 Capital budgeting practices in Australia, the UK,South Africa and USA ...................................................................................................9-28

Capital budgeting techniques in use .......................................................................9-28Risk assessment and use of quantitative methods ...................................................9-30Firm size .................................................................................................................9-31Cost of capital .........................................................................................................9-32Specific issues .........................................................................................................9-33

Appendix 9.2 Multiple internal rates of return ...........................................................9-34Projects with no internal rate of return ...................................................................9-36Conclusion..............................................................................................................9-37

Questions .......................................................................................................................9-38

10. CAPITAL BUDGETING: RISK ANALYSISLearning objectives........................................................................................................10-1

Introduction ...................................................................................................................10-1

1. Traditional measures of risk.................................................................................10-2Expected value and probability distributions ..........................................................10-3The Hillier model for multiple periods ...................................................................10-4A note on expected values, probabilities, and firm size...........................................10-7

2. Decision trees ........................................................................................................10-9

3. Certainty-equivalents..........................................................................................10-11

4. Sensitivity analysis .............................................................................................10-12

5. Break-even analysis.............................................................................................10-15Zero net present value...........................................................................................10-15Accounting break-even analysis ............................................................................10-16

6. Scenario analysis.................................................................................................10-17

7. Abandonment and expansion.............................................................................10-17

8. Computer simulation..........................................................................................10-19

9. The capital asset pricing model .........................................................................10-21Project beta of an all-equity firm...........................................................................10-21Financial leverage and project betas......................................................................10-22More on market risk .............................................................................................10-23

10. Risk-adjusted discount rates versus certainty equivalents ...............................10-24

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11. Risk-adjusted discount rates versus the weighted average cost of capital ......10-25

12. Further thoughts on risk analysis in capital budgeting....................................10-26Future uncertain cash outflows.............................................................................10-26Volatility and risk – a case study of BHP Billiton...................................................10-26

13. Project risk: strategic perspectives ....................................................................10-28Industry profitability .............................................................................................10-28Rivalry among existing firms.................................................................................10-29Threat of substitute products ................................................................................10-29Threat of new entrants and barriers to entry.........................................................10-30 Bargaining power of buyers...................................................................................10-31Bargaining power of suppliers...............................................................................10-31Competitive strategies: cost leadership and differentiation ....................................10-31Conclusion............................................................................................................10-33

Self-study problems.....................................................................................................10-33

Summary ......................................................................................................................10-42

Appendix 10.1 Capital budgeting – risk analysis with Excel ...................................10-42NPV profile ...........................................................................................................10-43Scenario analysis ...................................................................................................10-43Probability distributions........................................................................................10-44Computer (Monte Carlo) simulation with Excel ...................................................10-45

Questions .....................................................................................................................10-49

11. WORKING CAPITALLearning objectives........................................................................................................11-1

Introduction ...................................................................................................................11-1

1. The objective of working capital policy...............................................................11-2The working capital cycle .......................................................................................11-2 The impact of inflation on working capital policy...................................................11-3The impact of changes in sales on working capital policy .......................................11.4

2. Working capital policies .......................................................................................11-5

3. Working capital financing policies.......................................................................11-6

4. Forecasting working capital requirements ..........................................................11-9

5. Forecasting sales .................................................................................................11-10Factors to be considered .......................................................................................11-10Subjective forecasting............................................................................................11-11Objective forecasting.............................................................................................11-12

Summary ......................................................................................................................11-13

Self-study problem ......................................................................................................11-14

Questions .....................................................................................................................11-15

12. CURRENT ASSET MANAGEMENT AND SHORT-TERM FINANCINGLearning objectives........................................................................................................12-1

Introduction ...................................................................................................................12-1

1. Credit policy..........................................................................................................12-1Creditworthiness.....................................................................................................12-2Setting the collection policy ....................................................................................12-2Setting settlement cash discount policy...................................................................12-3Analysing the impact of a change in credit policy ...................................................12-3Analysing the impact of a change in credit policy – net present value analysis .......12-5

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2. Accounts receivable management ........................................................................12-7

3. Inventory management .........................................................................................12-8Inventory models ....................................................................................................12-9Inventory control systems .....................................................................................12-13Just-in-time (JIT) inventory management..............................................................12-14

4. Cash management ...............................................................................................12-15Reasons for holding cash.......................................................................................12-15Cash budgets ........................................................................................................12-16

5. Financing current assets.....................................................................................12-19Accruals ................................................................................................................12-19Trade credit...........................................................................................................12-19Factoring and invoice discounting ........................................................................12-21Bank overdrafts .....................................................................................................12-23Bankers’ acceptances (bank bills) ..........................................................................12-24Short-term financing: advantages and disadvantages.............................................12-25

Summary ......................................................................................................................12-26


Appendix 12.1: The derivation of the economic order quantity (EOQ) model.......12-32

Questions .....................................................................................................................12-33

SECTION D: FINANCING DECISIONS

13. SOURCES OF FINANCELearning objectives........................................................................................................13-3

Introduction ...................................................................................................................13-3

1. Financial markets..................................................................................................13-3Classification of financial markets ...........................................................................13-3 The Australian Stock Exchange (ASX).....................................................................13-5

Instruments traded on the ASX ...................................................................................13-5ASX listing requirements .............................................................................................13-8

Rights issues............................................................................................................13-8Placement of shares...............................................................................................13-10Some facts about equity raisings in Australia ........................................................13-11Private equity and venture capital financing..........................................................13-13Some facts about market liquidity.........................................................................13-13

2. Financial institutions ..........................................................................................13-14Banks ....................................................................................................................13-14Investment institutions..........................................................................................13-15 Venture capital and private equity.........................................................................13-15

3. Equity-related instruments .................................................................................13-15Ordinary shares.....................................................................................................13-16Retained earnings..................................................................................................13-16Preference shares...................................................................................................13-16From the real world… Alinta................................................................................13-17

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4. Debt-related instruments....................................................................................13-18Debentures and corporate bonds ..........................................................................13-19Some facts on corporate bond issues in Australia..................................................13-20Mortgage loans......................................................................................................13-21Long-term Loans...................................................................................................13-21

Fixed interest rate loans............................................................................................13-22Variable interest rate loans........................................................................................13-24Unsecured loans subject to a negative pledge.............................................................13-24

Unsecured notes ...................................................................................................13-25Foreign loan or bond financing.............................................................................13-25Credit ratings ........................................................................................................13-25Leases ...................................................................................................................13-26Short-term debt ....................................................................................................13-26

5. Hybrid instruments.............................................................................................13-28

6. Comparison of debt and equity .........................................................................13-28Return...................................................................................................................13-28Risk.......................................................................................................................13-29Control .................................................................................................................13-30

Summary ......................................................................................................................13-31


Questions .....................................................................................................................13-33

14. CAPITAL STRUCTURELearning objectives........................................................................................................14-1

Introduction ...................................................................................................................14-1

1. Risk profile ............................................................................................................14-2Business risk ...........................................................................................................14-2Financial risk ..........................................................................................................14-2From the real world… Wesfarmers and Orica.........................................................14-3

2. Leverage (gearing).................................................................................................14-4Impact on earnings .................................................................................................14-4Impact on risk ........................................................................................................14-5

3. Optimal capital structure......................................................................................14-8The Modigliani–Miller approach .............................................................................14-8Relaxing the assumptions......................................................................................14-10A practical approach .............................................................................................14-11

4. Pecking order theory ..........................................................................................14-12Internally generated funds ....................................................................................14-12Debt......................................................................................................................14-13Convertible debt ...................................................................................................14-13Equity ...................................................................................................................14-13

5. The impact of inflation .......................................................................................14-13

6. The need for flexibility .......................................................................................14-15Target capital structure..........................................................................................14-15Short-term deviation from target...........................................................................14-15 Qantas – a case of capital management .................................................................14-16Quintrex ...............................................................................................................14-16

Summary ......................................................................................................................14-17

Self-study problem ......................................................................................................14-17

Questions .....................................................................................................................14-18

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15. LEASINGLearning objectives........................................................................................................15-1

Introduction ...................................................................................................................15-1

1. Types of leases ......................................................................................................15-2Operating leases......................................................................................................15-2Financial leases .......................................................................................................15-3Structuring of leases................................................................................................15-3

Direct lease .................................................................................................................15-4Sale and leaseback ......................................................................................................15-4Leveraged lease ...........................................................................................................15-4

2. What are the effects of leases on the financial statements? ...............................15-5What are the requirements of the Accounting Standard (IAS 17)? ..........................15-6

3. Advantages of leasing ...........................................................................................15-7Changing technology ..............................................................................................15-8Tax advantages ........................................................................................................15-8Obtaining 100% debt financing ..............................................................................15-8Operating flexibility ................................................................................................15-8Reduction in operating leverage ..............................................................................15-9Coping with uncertain demand ..............................................................................15-9Specialisation effects on maintenance, residual values and purchase costs ..............15-9Standardisation of contracts ....................................................................................15-9Fewer restrictions....................................................................................................15-9Off-balance sheet financing.....................................................................................15-9Avoidance of capital expenditure controls and budgetary constraints .....................15-9

4. Evaluating the leasing decision ..........................................................................15-10Selecting an appropriate discount rate ..................................................................15-10The present cost of leasing....................................................................................15-11Calculating the net present cost ............................................................................15-11The present cost of borrowing and buying............................................................15-12The net advantage of leasing and NPV..................................................................15-14

5. From the Real World ......................................................................................…15-15Qantas ..................................................................................................................15-15BHP Billiton ..........................................................................................................15-16Alinta Gas .............................................................................................................15-16What is wrong with the analysis and accounting for leases? .................................15-16What is wrong with leasing in the public sector? ..................................................15-17

6. The adjusted present value approach ................................................................15-17

Summary ......................................................................................................................15-19


Questions .....................................................................................................................15-25

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SECTION E: INTEGRATED DECISIONS

16. DIVIDENDS AND SHARE BUY-BACKSLearning objectives........................................................................................................16-3

Introduction ...................................................................................................................16-3

1. Dividend relevance – active variable or passive residual?..................................16-3The residual approach to dividends ........................................................................16-5

2. Factors affecting the dividend decision ...............................................................16-8Legal and contractual requirements ........................................................................16-8Information content of dividends............................................................................16-8Dividend imputation and taxation ..........................................................................16-9The nature of the shareholders..............................................................................16-13

3. Dividend payment policies .................................................................................16-14Stable dividend amount ........................................................................................16-14Stable payout ratio ................................................................................................16-14Stable dividend plus bonus...................................................................................16-14

4. The payment of dividends ..................................................................................16-15What happens to the share price when a share goes ex-dividend? ........................16-16Bonus issues and share splits ................................................................................16-17Dividend reinvestment plans (DRPS) ....................................................................16-18

5. Share buy-backs ..................................................................................................16-20Equal access buy-backs.........................................................................................16-21Selective buy-back ................................................................................................16-21On-market buy-back.............................................................................................16-21Other buy-backs ...................................................................................................16-21Why should companies repurchase their own shares? ..........................................16-22Dividends in specie...............................................................................................16-23

6. Dividend Yields ...................................................................................................16-24

Summary ......................................................................................................................16-25


Appendix 16.1: An analysis of a share buy-back offer – Foster’s Group .................16-30

Questions .....................................................................................................................16-33

17. MERGERS AND ACQUISITIONSLearning objectives........................................................................................................17-1

Introduction ...................................................................................................................17-1

1. Types of mergers ...................................................................................................17-2

2. Reasons for mergers..............................................................................................17-2Operating economies ..............................................................................................17-3Managerial skills .....................................................................................................17-3Tax considerations – assessed losses........................................................................17-4Use for excess liquidity ...........................................................................................17-4Diversification.........................................................................................................17-4Lower financing costs .............................................................................................17-4 Replacement costs...................................................................................................17-5Technology..............................................................................................................17-5Uncertainty and change ..........................................................................................17-5

3. The structuring of takeover offers and taxation .................................................17-5Financing ................................................................................................................17-6Capital Gains Tax (CGT).........................................................................................17-6

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4. Are mergers successful?........................................................................................17-7

5. Terms of mergers ..................................................................................................17-8Dividend discount model........................................................................................17-9Free cash flow (discounted cash flow) analysis .....................................................17-10

6. Methods for valuing take-overs ..........................................................................17-10Give vs. Get ..........................................................................................................17-10Synergies...............................................................................................................17-11Premium ...............................................................................................................17-11Cash vs shares.......................................................................................................17-12Cash......................................................................................................................17-12Shares ...................................................................................................................17-12Gain ......................................................................................................................17-14Share offer.............................................................................................................17-14A combined cash and share offer ..........................................................................17-15Alternative method ...............................................................................................17-17Value adding principle ..........................................................................................17-17

7. Reverse takeovers................................................................................................17-20

8. Defensive tactics .................................................................................................17-21Proactive measures................................................................................................17-21Reactive measures .................................................................................................17-22

9. Regulation of takeovers ......................................................................................17-23

10. Legal procedures .................................................................................................17-23Formal takeover offer............................................................................................17-24Tender offer or on-market offer.............................................................................17-25Creeping takeover .................................................................................................17-25Trade Practices Act................................................................................................17-26Foreign Takeovers Act...........................................................................................17-26

11. Divestitures .........................................................................................................17-26Spin-offs and demergers........................................................................................17-27Split-ups ...............................................................................................................17-28Equity carve-outs ..................................................................................................17-28Split-offs ...............................................................................................................17-28

12. Management buy-outs.........................................................................................17-29

Summary ......................................................................................................................17-33


Appendix 17.1 Exchange ratios ..................................................................................17-36

Questions .....................................................................................................................17-42

18. FUTURESLearning objectives........................................................................................................18-1

Introduction ...................................................................................................................18-1

1. Rationale for financial risk management .............................................................18-1Reducing corporate taxes paid ................................................................................18-2Decreasing transaction costs....................................................................................18-3Avoiding investment decision errors .......................................................................18-3

2. Fundamental derivative instruments ...................................................................18-3Forward and futures contracts ................................................................................18-3Margin requirements...............................................................................................18-4Marking to market ..................................................................................................18-5Reading newspaper quotes......................................................................................18-6

3. Pricing of futures and forward contracts.............................................................18-8Theoretical futures price based on arbitrage arguments ..........................................18-8

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4. Convergence of futures price to spot price at expiry .......................................18-10

5. Basis.....................................................................................................................18-10

6. Major types of futures traders............................................................................18-11Arbitrageurs ..........................................................................................................18-11Hedgers.................................................................................................................18-11

7. Managing commodity exposure .........................................................................18-12

8. Managing short-term interest rate exposure(using 90-day BABS futures contracts) ..............................................................18-13

9. Managing equity portfolio exposure ..................................................................18-15

Summary ......................................................................................................................18-17

Questions .....................................................................................................................18-17

19. OPTIONSLearning objectives........................................................................................................19-1

Introduction ...................................................................................................................19-1

1. Options ..................................................................................................................19-1

2. Components of option pricing .............................................................................19-2

3. Principles of option pricing..................................................................................19-4

4. Black-Scholes option pricing model.....................................................................19-7Valuation of a call-option ........................................................................................19-8

5. Binomial option pricing model ............................................................................19-9One-period binomial option pricing model ............................................................19-9Multi-period binomial option pricing model.........................................................19-11

6. Put-call parity ......................................................................................................19-11

7. Option pay-offs ...................................................................................................19-13Pay-off for the writer of a naked call .....................................................................19-15

8. Options use and synthetic positions..................................................................19-16

9. Option strategies.................................................................................................19-17Bullish-call spread.................................................................................................19-18Bearish-call spread ................................................................................................19-19Long (bottom) straddle .........................................................................................19-19Long strangle ........................................................................................................19-20Strap .....................................................................................................................19-21Short (top) straddle...............................................................................................19-22Strip......................................................................................................................19-23

Summary ......................................................................................................................19-23

Questions .....................................................................................................................19-24

SECTION F: TABLES

A. Future value of $1 ...............................................................................................Tables-2

B. Future value of an annuity of $1 per period......................................................Tables-4

C. Pesent value of $1 ...............................................................................................Tables-6

D. Present value of an annuity of $1 per period ....................................................Tables-8

E. The standard normal distribution ....................................................................Tables-10

INDEX................................................................................................................................Index-1

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Documents

Contents – a concise overview - University of Cape Town Financial statement analysis 5-1 ... ..David Jones ... Series of investments, ordinary annuity (FVA) – Multiple investments