Bba2 FM2 2023 SG

BACHELOR OF
BUSINESS
ADMINISTRATION
Financial Management II
Contact details:
Regenesys Business School
Tel: +27 (11) 669-5000
Fax: +27 (11) 669-5001
E-mail: [email protected]
www.regenesys.co.za
This study guide highlights key focus areas for you as a student. Because the field of study in question is so
vast, it is critical that you consult additional literature.
Copyright © Regenesys, 2023
All rights reserved. No part of this publication may be reproduced, stored in, or introduced into a retrieval
system, or transmitted, in any form, or by any means (electronic, mechanical, photocopying, recording, or
otherwise) without written permission of the publisher. Any person who does any unauthorised act in relation
to this publication may be liable for criminal prosecution and civil claims for damages.
CONTENTS
1. RECOMMENDED RESOURCES ........................................................................................................... 1
1.1 BOOKS .............................................................................................................................................. 1
1.2 ARTICLES.......................................................................................................................................... 1
1.3 MULTIMEDIA ..................................................................................................................................... 2
2. INTRODUCTION TO THIS COURSE ..................................................................................................... 3
2.1 LEARNING OUTCOMES ................................................................................................................... 3
2.2 PERSONAL FINANCE AND INVESTMENTS.................................................................................... 4
2.2.1 KEY CONCEPTS RELATED TO FINANCIAL MANAGEMENT............................................... 4
2.2.2 AN INTRODUCTION TO ASSET MANAGEMENT .................................................................. 8
2.2.3 ASSET CLASSES AND RISK.................................................................................................. 8
2.2.4 ASSET CLASSES – GUIDELINES FOR BUILDING THE RIGHT INVESTMENT................. 17
2.2.5 SOCIALLY RESPONSIBLE INVESTING............................................................................... 22
2.2.6 PERSONAL FINANCE AND INVESTMENT PITFALLS ........................................................ 23
2.2.7 PROTECTING YOUR ASSETS ............................................................................................. 23
2.2.8 KEY POINTS ......................................................................................................................... 24
2.3 VALUATION OF INVESTMENTS .................................................................................................... 25
2.3.1 DEFINING VALUE ................................................................................................................. 25
2.3.2 TYPES OF SECURITIES (INVESTMENTS).......................................................................... 28
2.3.3 KEY INPUTS TO VALUATION .............................................................................................. 29
2.3.4 THE BASIC VALUATION MODEL ......................................................................................... 30
2.3.5 VALUATION OF DEBENTURES (OR BONDS) .................................................................... 33
2.3.6 VALUATION OF PREFERENCE SHARES ........................................................................... 36
2.3.7 VALUATION OF ORDINARY SHARES ................................................................................. 37
2.3.8 KEY POINTS ......................................................................................................................... 40
2.4 THE COST OF CAPITAL ................................................................................................................. 41
2.4.1 FRAMEWORK FOR COST OF CAPITAL.............................................................................. 41
2.4.2 DEBT (BORROWED MONEY) .............................................................................................. 42
2.4.3 EQUITY (SHAREHOLDERS’ MONEY) ................................................................................. 45
2.4.4 WEIGHTED AVERAGE COST OF CAPITAL (WACC) .......................................................... 49
2.4.5 ECONOMIC FACTORS TO CONSIDER ............................................................................... 50
2.4.6 USING THE WACC FOR INVESTMENT DECISIONS .......................................................... 51
2.4.7 KEY POINTS ......................................................................................................................... 51
2.5 PROJECT APPRAISAL ................................................................................................................... 53
2.5.1 CAPITAL RATIONING ........................................................................................................... 53
2.5.2 COMPETING PROJECTS ..................................................................................................... 58
2.5.3 KEY POINTS ......................................................................................................................... 62
2.6 DIVIDEND POLICY .......................................................................................................................... 63
2.6.1 DIVIDEND TAX ...................................................................................................................... 63
2.6.2 TYPES OF DIVIDENDS......................................................................................................... 64
2.6.3 DIVIDEND POLICY................................................................................................................ 69
2.6.4 AN ALTERNATIVE TO DIVIDENDS - BUYBACKS ............................................................... 72
2.6.5 KEY POINTS ......................................................................................................................... 74
2.7 ETHICS AS A SUCCESS AND FAILURE FACTOR RELATED TO FINANCIAL MANAGEMENT.. 75
2.7.1 OVERVIEW OF CORPORATE GOVERNANCE ................................................................... 75
2.7.2 BRIBERY AND CORRUPTION IN BUSINESS...................................................................... 76
2.7.3 THE KING REPORT IV: A SOUTH AFRICAN PERSPECTIVE............................................. 78
2.7.4 KEY POINTS ......................................................................................................................... 79
3. REFERENCES ...................................................................................................................................... 80
4. APPENDIX ............................................................................................................................................ 85
5. GLOSSARY OF TERMS ....................................................................................................................... 93
6. VERSION CONTROL ........................................................................................................................... 94
List of Tables
TABLE 1: COMPARING A MONEY MARKET FUND AND A MONEY MARKET ACCOUNT .......................... 9
TABLE 2: EQUITY VERSUS DEBT SECURITIES.......................................................................................... 28
TABLE 3: VALUATION PROCESS ................................................................................................................. 30
TABLE 4: CONCEPTS ASSOCIATED WITH DEBENTURES (OR BONDS) ................................................. 33
TABLE 5: BEST PRACTICES FOR PREVENTING AND DETECTING CORRUPTION ................................ 77
List of Figures
FIGURE 1: ASSET CLASS RANKING ............................................................................................................ 14
FIGURE 2: RISK PROFILE CHART ................................................................................................................ 15
FIGURE 3: PERCENTAGE OF TIME MONEY IS LOST DURING VARIOUS HOLDING PERIODS ............. 18
FIGURE 4: SOUTH AFRICAN STOCK MARKET (FTSE/JSE) ....................................................................... 19
FIGURE 5: ASSET CLASS RETURN OVERVIEW: REAL RETURNS ........................................................... 21
FIGURE 6: ASSET CLASS RETURN OVERVIEW: NOMINAL RETURNS .................................................... 22
FIGURE 7: KEY INPUTS TO VALUATION ..................................................................................................... 29
FIGURE 8: OVERVIEW OF THE COST OF CAPITAL ................................................................................... 42
FIGURE 9: DIVIDEND PAYOUT CHRONOLOGY .......................................................................................... 69
1. RECOMMENDED RESOURCES
Various resources are recommended to help you complete this course.
1.1 BOOKS
These books are recommended for this course:
• Marx, J., de Swardt, C., Beaumont Smith, M., & Erasmus, P. (2017). Financial Management in Southern Africa
(5th ed.). Pearson Education South Africa.
• Stoltz, A., Viljoen, M., Gool, S., Meyer, C., & Cronje, R. (2007). Financial Management: Fresh Perspectives (1st
ed.). Pearson Education South Africa.
• Titman, S., Keown, A.J., & Martin, J. D. (2020). Financial management: Principles and applications, 14th global
edition. Pearson International.
Please ensure that you order or download your textbooks before you start the course.
1.2 ARTICLES
● Fernando, J. (2022). Working capital. https://www.investopedia.com/terms/w/workingcapital.asp (accessed 8

August 2023).
● South African Revenue Service. (2021). Comprehensive Guide to Dividends Tax (Issue 4).
https://www.sars.gov.za/wp-content/uploads/Ops/Guides/LAPD-IT-G19-Comprehensive-Guide-to-Dividends-
Tax.pdf (accessed 8 August 2023).
● The Institute of Directors in South Africa (IoDSA). (2016). The King Report IV. https://www.adams.africa/wp-
content/uploads/2016/11/King-IV-Report.pdf (accessed 8 August 2023).
© Regenesys Business School 1

1.3 MULTIMEDIA
● Eller College. (2010, September 15). Aaron Beam on ethics in corporate finance [Video]. YouTube.
http://www.youtube.com/watch?v=8mkXSLN8UXs (accessed 8 August 2023).
● Franklin Templeton Academy. (2015, December 3). Understanding asset classes, [Video] YouTube.
https://www.youtube.com/watch?v=8g8gPAqFxmM (accessed 8 August 2023).
● MoneyWorks4meVideos. (2013, November 8). Understanding Risk and Return tradeoff, [Video]. YouTube.
https://www.youtube.com/watch?v=y6-qLdNoYI0 (accessed 8 August 2023).
● Theexpgroup. (2012, October 5). Profitability Index, capital rationing and risk [Video]. YouTube.
http://www.youtube.com/watch?v=ebKpNniMSOE (accessed 8 August 2023).
● Vivien. (2012, July 23). The causes and effects of the 2008 financial crisis, [Video]. YouTube.
https://www.youtube.com/watch?v=N9YLta5Tr2A (accessed 8 August 2023).

2. INTRODUCTION TO THIS COURSE
Welcome to the course on Financial Management and Valuation! This comprehensive program is
designed to equip you with the essential knowledge and skills needed to navigate the complex world
of finance, investments, and valuation in the realm of business administration. Throughout this
course, you will gain a deep understanding of various financial concepts and learn how to make
informed decisions that can significantly impact a company's financial health and success.
2.1 LEARNING OUTCOMES
On completing this course, you should be able to:
• Explain valuation terminology, concepts, and inputs;

• Determine the worth of investments (debentures, preference shares, and ordinary shares)
using valuation models;
• Calculate the cost of debt financing (term loans and bonds);
• Calculate the cost of equity financing (common shares, preference shares, and retained
earnings);
• Determine the weighted average cost of capital for a company;
• Apply project appraisal techniques (capital rationing and “make or buy” approach);
• Explain dividend terminology and policy decisions;
• Understand ethical issues facing financial managers;
• Understand various personal finance and investment concepts;
• Relevance of Financial Management in Business Administration.
The number of notional learning hours set out in the table under each section heading provides
guidance on how long to spend studying each section of this course. Set yourself a schedule to
ensure that you spend a suitable period of time on each section, covering the required sections
relevant to each assignment, and giving yourself enough time to prepare for the examination.

2.2 PERSONAL FINANCE AND INVESTMENTS
Timeframe Minimum of 20 hours
• Understand various personal finance and investment concepts; and

Learning outcomes
• Relevance of Financial Management in Business Administration.
• Marx, J., de Swardt, C., Beaumont Smith, M., & Erasmus, P. (2017). Financial Management
in Southern Africa (5th ed.). Pearson Education South Africa.
Recommended • Stoltz, A., Viljoen, M., Gool, S., Meyer, C., & Cronje, R. (2007). Financial Management: Fresh
reading Perspectives (1st ed.). Pearson Education South Africa.
• Titman, S., Keown, A.J., & Martin, J. D. (2020). Financial management: Principles and
applications, 14th global edition. Pearson International.
Recommended • Fernando, J. (2022). Working capital.

articles https://www.investopedia.com/terms/w/workingcapital.asp (accessed 8 August 2023).
• Franklin Templeton Academy. (2015, December 3). Understanding asset classes, [Video].
YouTube. https://www.youtube.com/watch?v=8g8gPAqFxmM (accessed 8 August 2023).
• MoneyWorks4meVideos. (2013, November 8). Understanding Risk and Return tradeoff,
Recommended
[Video]. YouTube. https://www.youtube.com/watch?v=y6-qLdNoYI0 (accessed 8 August
multimedia
2023).
• Vivien. (2012, July 23). The causes and effects of the 2008 financial crisis, [Video].
YouTube. https://www.youtube.com/watch?v=N9YLta5Tr2A (accessed 8 August 2023).
Personal finance and investments play a crucial role in an individual's financial well-being and
Section overview long-term security. Taking control of one's finances and making informed investment decisions
can lead to a more stable and prosperous financial future.
2.2.1 Key concepts related to Financial Management
Financial management plays a vital role in business management, ensuring the effective allocation
of resources, managing risks, making capital structure decisions, planning and forecasting, and
evaluating performance. By implementing sound financial management practices, businesses can
enhance their financial health, make informed decisions, and maximise shareholder value. Key
reasons why financial management is relevant are as follows:
Read more about the role of financial management in the following recommended text:

Budgeting and Planning
Effective financial management allows organisations to create realistic budgets and financial plans.
It involves forecasting sales, determining expenses, and setting financial targets. By developing
comprehensive budgets, management can allocate resources efficiently, plan for growth, and
monitor financial performance against the set goals.
Budgeting and planning are crucial components of effective financial management for businesses.
They provide a roadmap for achieving financial goals, managing resources efficiently, and making
informed decisions.
Here are some real-world examples of how budgeting and planning have been essential in financial
management for businesses:
A budget is a forecast of revenue and expenses over a specified period and is an integral part of
running a business efficiently. There are a number of different types of budgets, such as:
• A static budget is a budget with numbers based on planned outputs and inputs for each
of the firm's divisions.
• A cash-flow budget helps managers determine the amount of cash being generated by
a company during a period.
• Flexible budgets contain the actual results and are compared to the company's static
budget to identify any variances.
(Elmarraji, 2021)
Cash Flow Management
Maintaining a healthy cash flow is vital for any business. Financial management helps businesses
to monitor and control cash inflows and outflows, ensuring that there is sufficient liquidity to cover
operational expenses, inventory purchases, and other financial obligations. By managing cash flow
effectively, management can avoid cash shortages, minimise borrowing costs, and make timely
payments to suppliers.
A business must carefully plan and budget its cash flow to ensure it has sufficient funds to cover
expenses, invest in growth opportunities, and meet financial obligations. By forecasting cash
inflows and outflows, a business can identify potential cash shortfalls or surpluses in advance. This
allows the company to take proactive measures like securing additional financing or optimising its
working capital to maintain healthy cash flow.
A business might forecast increased cash outflows during the holiday season and plan
accordingly by adjusting inventory levels, staffing, and marketing expenses.

Inventory Management
Businesses typically invest a significant portion of their capital in inventory. Effective financial
management helps optimise inventory levels by determining the appropriate amount of stock to
maintain.
By monitoring inventory turnover, analysing sales patterns, and managing supplier relationships,
organisations can strike a balance between having enough inventory to meet customer demand
and minimising holding costs.
Budgeting and planning help businesses mitigate financial risks by providing a structured approach
to identifying and addressing potential challenges. By conducting scenario analysis and contingency
planning, companies can assess the impact of different risk factors on their financial performance
and develop appropriate strategies to manage them.
A manufacturing company might create a budget that accounts for potential supply chain
disruptions, currency exchange rate fluctuations, or changes in raw material prices. This allows the
company to develop risk mitigation strategies such as diversifying suppliers, hedging currency
exposure, or renegotiating contracts.
Cost Control
Financial management assists businesses in identifying and controlling costs. By conducting regular
cost analyses, businesses can assess their spending patterns, identify areas of inefficiency, and
implement cost-saving measures. This could involve negotiating better supplier contracts, improving
operational processes, or eliminating unnecessary expenses. Effective cost control helps
organisations to maintain profitability and competitive pricing.
Read more here on the important role of cost control and working with capital efficiently:
• Fernando, J. (2022). Working capital.

https://www.investopedia.com/terms/w/workingcapital.asp (accessed 8 August 2023).
Budgeting enables businesses to monitor and control expenses effectively. By setting clear spending
limits and regularly comparing actual costs against the budgeted amounts, businesses can identify
areas of overspending and take corrective actions.
A software development company might set a budget for marketing expenses and track the actual
spending on various promotional activities. If the actual costs exceed the budget, the company can
evaluate the effectiveness of different marketing channels and optimise its spending to achieve
better cost efficiency.

Determining Pricing Strategies
Financial management plays a crucial role in determining pricing strategies for products. It involves
considering various factors such as production costs, market demand, competitor pricing, and profit
margins. By analysing pricing data and conducting financial modeling, management can set optimal
prices that balance profitability and customer value.
A business must carefully plan and budget its cash flow to ensure it has sufficient funds to cover
expenses, invest in growth opportunities, and meet financial obligations. By forecasting cash inflows
and outflows, a business can identify potential cash shortfalls or surpluses in advance. This allows
the company to take proactive measures like securing additional financing or optimising its working
capital to maintain healthy cash flow.
Budgeting and planning allow businesses to measure and evaluate their financial performance. By
comparing actual results against budgeted figures, companies can identify variances and analyse
the reasons behind them. This analysis helps in identifying areas of improvement, potential cost
savings, and revenue-enhancing opportunities. For instance, a hospitality chain may compare the
actual revenue and expenses of its individual hotels against the budgeted targets. This allows the
company to assess the performance of each location, identify underperforming properties, and take
corrective actions.
Financial Decision-Making
Financial management provides the necessary information and tools to support informed decision-
making in their businesses. Whether it is evaluating investment opportunities, assessing expansion
plans, or considering financing options, financial management helps management to analyse the
potential risks and rewards of different choices. It enables business owners and managers to make
sound financial decisions that align with the company's objectives.
By developing financial projections and conducting feasibility studies, businesses can assess the
financial viability of potential ventures. This process involves estimating costs, expected revenues,
and projected returns on investment.
A manufacturing company planning to open a new production facility would develop a detailed
budget to cover construction costs, equipment purchases, hiring, and operational expenses. This
helps in determining the financial feasibility and anticipated returns of the expansion.
Overall, financial management is essential for maintaining financial stability, optimising resources,
making informed decisions, and ensuring long-term success in a highly competitive industry.

2.2.2 An introduction to Asset Management
Before we introduce the asset classes, it is important that you understand what asset management
means from a personal financial perspective. Asset management refers to the management of
customers’ investments by investment professionals. These financial intermediaries invest on behalf
of their customers giving them access to a wide range of traditional and alternative products.
For example, to facilitate asset management, a bank can offer asset management accounts.
An asset management account is an account at a bank (or other financial institution) that “allows the
account holder to place money for both banking and investment services. When money is placed into
the account, it is automatically placed into a money market account, which carries a higher interest
rate than normal cheque or savings accounts. The account holder can then direct money to various
banking and investment services.”
(Financial Dictionary, 2015)
Asset classes are formed by groups of securities that:
• Have similar financial characteristics;

• Behave similarly in the marketplace; and
• Are subject to the same laws and regulations.
The four main asset classes are:
• Cash and cash equivalents (money market instruments);

• Fixed income (bonds);
• Property; and
• Equities (stocks or shares).
It is important to note that stock might also refer to inventory and therefore the goods kept on the
premises of a business or warehouse that are available for sale. In the case above, however, stock
refers to a type of security that signifies ownership in an organisation.
2.2.3 Asset Classes and Risk
Let us look at the risk attached to these four asset classes.
Cash and cash equivalents
Cash and cash equivalents are the safest asset class, but provide the lowest return. They include
on-call deposits in banks and other short-term interest-bearing investments. This asset class can
provide temporary shelter during periods of market volatility.

People approaching retirement might choose this asset class over a riskier class such as equities,
since retirees are likely to be more risk averse, and preserving capital is more important to them than
growing capital.
Both money market funds and money market accounts fall into the cash asset class. Table 1
provides a useful comparison (Discovery Invest, 2015).
TABLE 1: COMPARING A MONEY MARKET FUND AND A MONEY MARKET ACCOUNT
MONEY
MONEY MARKET
Attributes MARKET
FUND
ACCOUNT
Both usually invest in short-term, fixed-income investments such as US
treasuries. By definition, short-term, fixed-income investments are those ✔ ✔
with maturities of less than one year.
Both money market funds and money market accounts usually offer
higher interest rates than savings accounts (the short-term investment ✔ ✔
instruments used have the potential for higher returns).
Both types of investment offer flexibility and liquidity, typically allowing
investors to draw their cash from an ATM.
✔ ✔
The one key difference is that a money market fund is a collective
investment scheme (unit trust fund) and not a bank account.
✔
Like other types of unit trust funds (and like equity and bond funds),
money market funds incur expenses that are passed on to the fund’s ✔
investors.
Unlike unit trust funds that are invested in equities that fluctuate in value, money market funds (which
are also unit trust funds) aim to have a constant net asset value (NAV) of R1. The aim is never to
lose money – investors will always get their original invested capital back (Discovery Invest, 2015).
Fixed income (bonds)
Fixed-income investments such as bonds are also interest-bearing, but have a longer period of
maturity (usually 12 months and longer). Governments, government institutions, municipalities, and
companies borrow money from investors by issuing them debt instruments called bonds. These
bonds provide a fixed income – the bondholder is entitled to an annual cash interest payment that is
fixed at the time of purchase.
This asset class is relatively safe (ie offers a locked-in interest rate) but the investor is still exposed
to some risk. If inflation or short-term interest rates rise during the period to maturity, the investor
loses out (remember there is an inverse relationship between bond yields and bond prices). For
instance, assume that a person buys a bond with a 10% annual coupon and a par value of R1000.
The yield on this bond equals its par value divided by the interest amount of R100 (10% of R1000).

The yield of this bond is thus R100/R1000 = 10%. Should the bond price increase to R1100, the
yield would become R100/R1100 = 9.09%.
This example illustrates the inverse relationship between bond yields and bond prices. Although
the interest amount is still the same, as it is calculated from the par value, the yield is lower because
the bond price has increased.
A bond fund is a collective investment scheme that invests in bonds and debt instruments – often
referred to as fixed-income funds. Bond funds typically pay periodic dividends that “include interest
payments on the fund’s underlying bond holdings plus periodic realised capital appreciation”
(Discovery Invest, 2015). Individuals approaching retirement choose bond funds as part of their
portfolio of investments.
Property
Property (real estate) includes a wide spectrum of investments from housing (residential) to office
blocks (commercial) and warehouses (industrial). Property as an investment is purchased and then
leased out to create income. Although property should offer a steady income (after expenses) and
the investor should benefit from capital growth, it is considered to be a high-risk asset class with
returns proportionate to this risk.
The property market is typically adversely affected by a rise in interest rates and therefore it tends
to have a low correlation with interest-bearing investments (especially cash) (Savings Institute,
2015). In addition, the growth rate of the economy, purchase price, and location of the property are
key factors influencing potential returns.
There is a range of property investment options, including (Discovery Invest, 2015):
• Direct investment (purchase of physical property) – investors must be certain about the
earning potential of the property (in an over-speculated property market, there may be many
properties without tenants);
• Listed property shares (we mention this here although these are similar to equities; when
choosing to invest in listed property shares, investors should be aware they will be exposed
to the property market, which fluctuates with interest rates and the economy);
• Property unit trust funds (a common method of accessing property investments; unit trust
funds are exposed to a range of high-quality properties; these funds are scrutinised for value
by fund managers who are skilled at making informed decisions); and
• Property syndicates (have attracted much bad publicity with properties being overvalued
and in some cases, outright fraud, which has left many investors ruined financially).

Property Versus Shares
Considering the information below, would you prefer a buy-to-let property or an equity investment? Why?
Property vs shares
Answer: This is a difficult question to answer because it requires a crystal ball to know how each will perform! One
should rather make a decision based on what these different asset classes provide.
Residential property
• You can build up a good retirement fund using residential property

• By the time you retire, your mortgages would be paid off or close to paid off and you would have a steady
income
• The downside is:
o You have to manage tenants
o You also cannot liquidate (sell) your investment quickly
o You also need to make sure you keep money aside in case interest rates go up, increasing your
mortgage repayments. You also need money for maintenance and repairs
• Since 1966, average annual house price growth after inflation has been 0.9%
• Real estate has had an average return of 8.6%
Shares
• Over the long term, equities are the best-performing asset class
• Adjusting the annual average returns of the JSE All Share Index (Alsi) for inflation, the Alsi has provided
investors with a real (after-inflation) return of about:
o 15% per annum over the past 10 years
o 9% over the past 20 years and
o 11% for the past 30 years
• It is also the most volatile in that share prices can fall significantly in the short term
• This should be considered only for a long-term investment of at least five years, but preferably 10 years
• Many people build up a portfolio of high-quality shares, which then provide a tax-free income in retirement
through the payment of dividends
• The price at which you buy shares plays an important role in your total return
• Fund managers believe that the market is fairly valued at the moment, which means it is neither expensive
nor cheap
• Fund managers are expecting returns of about 10% to 12% per year from the share market over the next
five years
Probably the best strategy is to have a well-diversified portfolio with exposure to shares and listed property both
locally and offshore.

Listed property
• Listed property is a portfolio of commercial properties such as shopping centres, warehouses, and offices
that are owned by a management company that is listed on the stock exchange
• Listed property is very attractive to someone who is looking for income from their investments as it pays
rental income
• The yield (the income as a percentage of the share price) on listed property is about 8% currently, before tax
• The share price of the listed property can fluctuate
• However, if you are only worried about the income, you can ignore the short-term price movements
• Be aware that the income is taxable
• Listed property has outperformed the equity market over the last 10 years; however, that has been during a
period of falling interest rates
• If we saw an increase in inflation and interest rates, that would have a negative effect on the price of listed
property shares
Against this background, the following table presents some advantages and disadvantages of property and equities.
INVESTING IN PROPERTY VERSUS INVESTING IN EQUITIES

Property Equities
Pros Physically touch and feel Pros Diversified risk
Tangible investment Liquidity
Stability Potential for higher returns
Flexibility
Exposure to different markets
Cons Illiquid Cons More volatile
High closing costs Short-term depreciation of share prices
Rates and taxes Economic downturn
Maintenance
Manage tenants
Interest rate risk
Equities
Equities are the best-performing asset class over the long term but are the most volatile in the short
term, so carry the highest risk (Discovery Invest, 2015). When purchasing shares, investors are
taking a direct share in the profits (or losses) of companies. Companies are subject to many
competing forces, and the state of the economy.
There are different types of shares, which are broadly categorised as follows:
• Large-capitalisation stocks (referred to as large-cap stocks) – large and established

companies (fall within the top 40 largest companies by market capitalisation on the FTSE/JSE
All Share Index);

• Middle-capitalisation stocks (referred to as mid-cap stocks) – medium-sized companies
that fall just behind the large cap stocks in market capitalisation (on the FTSE/JSE All Share
Index); and
• Small-capitalisation stocks (referred to as small-cap stocks) – small companies with a
market capitalisation of less than R5-billion (on the FTSE/JSE All Share Index). These stocks
are not traded as frequently as mid and large cap stocks and so investor information is more
limited. The small caps can be a source of high growth and high returns in an investment
portfolio (Discovery Invest, 2015).
An equity fund is a collective investment scheme that invests primarily in stocks. A growth fund is
one that includes stocks of high growth companies (or those whose earnings are expected to rise).
Value funds are in search of value companies whose expected earning potential is higher than their
current stock valuation. Investment banks offer a range of funds (eg general funds, mining and
resources funds, financial, and industrial funds).
Now that you understand the main asset classes and the risk involved in each, watch the following
video clip and identify any other asset classes that could satisfy your personal finance and
investment needs.
• Franklin Templeton Academy. (2015, December 3). Understanding asset classes, [Video].
YouTube. https://www.youtube.com/watch?v=8g8gPAqFxmM (accessed 8 August 2023).
Asset Classes
1. Explain which asset class would be your preferred choice, and why.
2. Why have property syndicates attracted so much bad publicity?
Against this background, it is useful to note that many investments (such as pension funds) are made
up of a number of asset classes, eg a mix of:
• Defensive assets, ie primarily income-producing assets such as cash and fixed-income

securities; and
• Growth assets, ie those that offer the potential for capital growth as well as income (they
tend to produce higher returns than defensive assets in the longer term but have greater
volatility, eg equity).
This mix of assets is tailored to a type of investor risk profile. Many assessments can be used to
assess an investor’s risk profile. Follow the link below and complete the online Investor Personality
Test. This test reports on, among other things, your risk-taking biases, and offers suggestions for
improving what might be problematic tendencies regarding your investing decisions.

Identify Your Risk Profile
Visit the following website and complete the investor personality test:
http://tests.marketpsych.com/test_question.php?id=8
1. Are you a risk-averse investor?

2. Identify some of your problematic tendencies with respect to your investing decisions.
3. How can you mitigate these tendencies?
Let us look at the relationship between asset type and return: cash and cash equivalents rank the
lowest in terms of risk and return, with equities ranking the highest.
FIGURE 1: ASSET CLASS RANKING
Compare this with your risk profile. Can you see where you might be more comfortable investing?

FIGURE 2: RISK PROFILE CHART
Aggressive Versus Conservative Investor
1. In light of the previous two figures, which asset class would an aggressive investor prefer?
2. Which asset class would a conservative investor prefer?
The following short video clip provides a simple but important understanding of the risk and return
trade-off.
• MoneyWorks4meVideos. (2013, November 8). Understanding Risk and Return tradeoff,

[Video]. YouTube. https://www.youtube.com/watch?v=y6-qLdNoYI0 (accessed 8 August
2023).
Consider the outcomes of a potential investment below and select the one that you feel you would
be most comfortable with:
You invest R100 000 for 10 years. Given the best- and worst-case scenarios below, which
investment option would you choose? (NB: the best- and worst-case scenarios are equally probable.)
A. Best case outcome: R500 000 – worst case outcome: R50 000
B. Best case outcome: R850 000 – worst case outcome: zero
C. Best case outcome: R300 000 – worst case outcome: R65 000
D. Best case outcome: R150 000 – worst case outcome: R100 000

Now that you have insight into the relationship between risk and return in the various asset classes,
let us briefly look at the different types of risks that you should be aware of from a personal finance
and investment perspective.
Types of investment risks
Here are some of the types of risks that can influence investments:
Business risk
Also called unsystematic risk, this refers to the risk associated with a particular company, such as
liquidation. Diversification will reduce this risk in a portfolio.
Interest rate risk
Interest rate risk refers to the possibility that a fixed-rate debt instrument might decrease in value
due to an interest rate increase.
Inflationary risk
Also known as purchasing power risk and refers to the risk that future inflation will cause the
purchasing power of cash flow relating to an investment to decrease.
Liquidity risk
Liquidity risk relates to the possibility that an investor might not be able to sell (or buy) as and when
desired.
Market risk
Also called systematic risk, this risk affects all companies in the same manner, for example, a natural
disaster.
Social, political, or legislative risk
Risk associated with government policy or unfavourable government action, such as nationalisation.
Currency risk
The risk of a change in prices of one currency against another – for example, the devaluation of the
naira in Nigeria for MTN.

Reinvestment risk
In a time of falling interest rates, bondholders who have bonds coming due face the difficulty of
investing the proceeds in bond issues that will render them equal or greater interest rates than the
redeemed bonds.
(Investopedia, 2015a)
There are ways for investors to manage risk, as discussed in the following section.
Risk management
Risk in trading and investing can be quantified and managed using stop losses. These are pre-
determined levels up to which you are willing to tolerate risk. Losses beyond the stop loss level will
not be tolerated, and the position will be closed. Stop losses can be executed manually, or
programmed automatically on some trading platforms.
Types of stop losses
• Normal stop;
• Closing stop; and
• Trailing stop.
Considering our discussion of the various asset classes and their degree of risk, we now turn to the
performance of the main asset classes in South Africa.
2.2.4 Asset Classes – Guidelines for Building the Right Investment
Equities for the long term
Considering the past 90 years, South African equities have comfortably been the best-performing
asset class. A similar trend can be observed in the rest of the world. It is important to have growth
assets in your investment mix to deliver higher real returns, especially in a world where people are
living longer (Old Mutual Investment Group, 2015).
Cash
Cash is the worst-performing asset class, and although there are times when cash is the best-
performing asset, it is usually only when markets crash. Over the past 90 years, cash has provided
a real return of less than 1%. This figure is even worse for the rest of the world, where real returns
have averaged -0.3% (Old Mutual Investment Group, 2015).

Time
Fear is one of the main reasons investors prefer cash to shares. Equities can be scary if one
considers the 2008 crash (see the video clip below). However, time can be used to manage risk. For
example, on average, a day trader loses money 45% of the time, but holding equities for a year
reduces the loss rate to 21%. Once you extend your holding period for more than three years, you
are less likely to lose money (Old Mutual Investment Group, 2015). Also, the longer your investment
time horizon, the more risk you can afford to take.
Learn more about the causes and effects of the 2008 financial crisis
• Vivien. (2012, July 23). The causes and effects of the 2008 financial crisis, [Video]. YouTube.
FIGURE 3: PERCENTAGE OF TIME MONEY IS LOST DURING VARIOUS HOLDING PERIODS
(Old Mutual Investment Group, 2015)
The 2008 stock market crash is a good example of how losses can be reduced or recovered over
the long term. Consider Figure 4 in this regard, and note the upward trend over time (2008-2014).

FIGURE 4: SOUTH AFRICAN STOCK MARKET (FTSE/JSE)
(Tradingeconomics.com)
Inflation is the enemy
It is important to consider real returns (returns after adjusting for inflation). For instance,
Zimbabweans were very pleased to receive interest rates of 60% on their money, but with inflation
at 90%, they were actually going backwards (Old Mutual Investment Group, 2015). Investments must
be structured to track or beat inflation. If your capital does not grow at the same rate as inflation,
maintaining your lifestyle becomes difficult, and your whole life can eventually change for the worse.
Investing in inflation-beating assets carries some market risk, but that should not be a reason to
invest only in cash. Investing all or most of your money in cash guarantees that your capital will not
beat inflation. In fact, this might even be a greater risk than market volatility (Ingram, 2013).
An important concept linked to inflation is purchasing power. With all else equal, inflation decreases
the number of goods and services that you can buy. A simple way to explain purchasing power is to
imagine if you earned the same salary as your grandfather. Obviously, you could survive on much
less a few generations ago, but due to inflation, you now need a greater salary just to maintain the
same quality of living (Investopedia, 2015c).
The following illustration is a simple example of the negative effect of inflation on purchasing power.

(Kruger, 2010)
Consider the effect of inflation on purchasing power. If you earned the same salary that a person earned
in 1972, could you buy a Wimpy burger today?
You now need a greater salary to maintain the same quality of living. Compare the prices on the menu to
current prices and you will realise just how much of an enemy inflation can be.

Compounding is a powerful wealth generator
The key lesson here is to start saving as soon as possible, leave your money for as long as you can
and let compounding do the work for you. Without reinvesting your income, returns are lower and it
is therefore important to tick the dividend reinvest box on your investment application form (Old
Mutual Investment Group, 2015).
There are various tools to calculate the future value of your savings.
Visit the MyWealth Investments website at http://www.mywealthinvestments.co.za/ and

experiment with the following calculators:
• Savings-interest calculator
• Retirement-savings calculator
These calculators enable you to view the powerful effect of compounding and therefore the
importance of reinvesting your income or interest earned.
Don’t put all your eggs in one basket
Diversification, and therefore blending different asset classes, can be useful to manage risk. Figure
5 shows how a balanced fund performed against various other asset classes.
FIGURE 5: ASSET CLASS RETURN OVERVIEW: REAL RETURNS

FIGURE 6: ASSET CLASS RETURN OVERVIEW: NOMINAL RETURNS
Although blending different asset classes can be useful to manage risk, getting the right balance of
assets is not easy. In the next section, we address this problem and discuss asset allocation.
2.2.5 Socially Responsible Investing
Some people invest for more than just a financial return, aiming also to make a positive contribution
in a country and globally (Chamberlain, 2013). For example, you might not want to invest in
companies that pollute the environment or that produce addictive substances such as alcohol or
tobacco.
In South Africa, the Johannesburg Stock Exchange (JSE) introduced the Socially Responsible
Investment (SRI) index in May 2004. A key objective of the SRI index is to recognise the companies
that deliver on the triple bottom line (economic, social and governance reporting). In addition, the
index aims to provide a benchmark for comparing socially responsible and non-socially responsible
companies. The SRI index can be regarded as a reliable corporate social responsibility signal for
investors longing to invest in a responsible manner given that firms are required to meet specific
criteria to participate on the SRI index (Gladysek and Chipeta, 2012).
Social Responsible Investing
1. Would you consider an SRI strategy? Why, or why not?

2. List some of the criteria that companies must meet to qualify for inclusion on the JSE SRI Index.
3. The above-mentioned criteria, if met, show that companies have integrated triple-bottom-line practices. The
indicators are in three broad categories. Explain these broad themes.
4. What are the key objectives of the JSE SRI Index in South Africa?

2.2.6 Personal Finance and Investment Pitfalls
Swart (2007:104) notes that many people fall into one or more of the following investment pitfalls:
• They do not consider their investment goal (reason for investment), and instead compare the
return on different investments;
• They do not understand the importance of a life policy for their financial future;
• They underestimate the negative influence of inflation with respect to their investments and
retirement income;
• They lack the knowledge of investment criteria to compare and choose investments;
• They do not know their own financial situation;
• Wrong brokers are chosen;
• They invest in a product because other people do;
• They invest because they are greedy;
• They change their investments all the time based on what they hear from friends or what they
have read in the newspaper; and
• They use recent experience as a reference for what will happen in the future, and
consequently base their investment decisions on recent events (recency bias).
(Adapted from Swart, 2007:104)
Pitfalls
Research and answer the following questions:
1. Why is it important to have a life policy for your financial future?

2. How would you choose the right broker for financial advice?
3. Why is it not a good idea to invest all your money in a single asset class?
Now that you have more insight into various aspects of asset classes, let us look at how you can
protect your assets.
2.2.7 Protecting Your Assets
It is always possible that you lose income and assets because of one or more of the following events:
• Theft;
• Fire;
• Illness;

• Disability;
• Death;
• Retrenchment;
• Divorce;
• Lawsuits;
• Accidents;
• Signing surety for somebody else’s debt; and
• Retirement.
These are to mention but a few. It is important to protect yourself in all areas against different risks.
It is important to make a will directing what should happen to your assets after your death in order
to avoid it from going to the wrong people. After your death, the executor (attorney, financial adviser
or bank) will assign your assets to the right people. In addition, the executor ensures that all your
debts are paid after your death. In this regard, it is sensible to have an appropriate insurance policy
(eg life policy). Keep a copy of your will in a safe place and give a copy to your bank, attorney, or
financial adviser. The administration of your estate (handing over your assets to other people) is
costly and you should plan accordingly (Swart, 2007:115-119).
It is important to plan how to protect our health over the long term, as health is probably our greatest
asset. Healthcare planning is costly and has to be included in a household budget. Health care
planning may be one of the most critical areas in personal financial planning. Important factors to
consider concerning health care include medical costs, private vs public hospitals, and medical aid
schemes (Swart, 2007:115-119).
2.2.8 Key Points
• Cash, as an asset class, has the lowest risk of losing capital but the highest risk of losing
purchasing power due to inflation;
• Bonds (bonds and bond funds) are typically suited to investors looking for a relatively low-
risk investment that provides a monthly income;
• Property, as an asset class, offers diversification and different performance characteristics;
• A share of stock is the smallest unit of ownership in a company – when owning shares one
is effectively a part owner of the company and thus dependent on the company’s
performance (this can be diversified through owning a portfolio of shares or participating in
equity funds);
• Pension funds provide a mix of asset classes and typically vary from country to country;
• A stop-loss order is a valuable method to manage risk on investments or trades;
• Asset allocation is a technique that intends to balance risk and create diversification by
dividing assets among the main asset classes such as cash, bonds, real estate, etc;
• A key objective of the SRI Index is to recognise the companies that deliver on the triple
bottom line (economic, social, and governance reporting);
• It is important to protect your assets against various events such as theft, fire, death, etc; and
• There are numerous investment pitfalls, not least of which is underestimating the negative
influence of inflation.

2.3 VALUATION OF INVESTMENTS
• Explain valuation terminology, concepts, and inputs; and

Learning outcomes
• Determine the worth of investments (debentures, preference shares, and ordinary shares)
using valuation models.
Recommended • Stoltz, A., Viljoen, M., Gool, S., Meyer, C., & Cronje, R. (2007). Financial Management:
reading Fresh Perspectives (1st ed.). Pearson Education South Africa.
In this section we look at valuation – the process that links risk and returns to help us determine
the worth, or value, of investments. In finance, the price is what an investor pays for his or her
investment (eg shares), whereas the cost is what the company has to pay the investor for the use
Section overview
of his or her money. Here we consider the valuation of investments from the investor’s
perspective, whereas the section that follows focuses on the cost of capital from the company’s
perspective.
2.3.1 Defining Value
Before we consider the different types of securities, let us review your understanding of four
important terms:
• Par value (or face value);

• Market value;
• Book value; and
• Economic value.
Par value (face value)
Par value is the nominal value at which the asset is issued in the primary market. The par value is
important for accounting purposes since the shareholders’ interests in the company appear in the
balance sheet at par value. Today, most stocks (shares) are issued with either a very low par value
(such as one cent per share) or no-par value at all.
“Corporations issue shares with no par value because it helps them avoid a liability to
stockholders should the stock price take a turn for the worse. For example, if a stock was trading
at $5 per share and the par value of the stock was $10, theoretically the company would have a
$5 per share liability.”
(Investopedia, 2013e)

Par value has no relation to the market value of a stock. A no-par-value stock can still trade for a
significant amount. It all depends on what the market feels the company is worth.
The common stock, par value of Facebook shares is $0.000006 per share. However, the stock is
trading in the market at approximately $88 per share (as at 26 June 2015).
It is also useful to note the following in the use of the terms “shares” and “stocks”:
“Generally, the terms ‘shares’ and ‘stocks’ are used interchangeably – it has more to do with
syntax than financial or legal accuracy. However, ‘stock’ is typically used to describe the
ownership of certificates of any company and in general ‘shares’ refers to the ownership of
certificates of a particular company. So, if you say you own stocks, you are generally referring to
your overall ownership in one or more companies. Technically, then if you say you own shares,
the question then becomes, shares in what company?”
(Investopedia, 2013a)
Market value
Market value is the value at which the shares trade in the marketplace (eg on a securities exchange
such as the New York Stock Exchange, Johannesburg Stock Exchange, or over-the-counter
securities market such as the National Association of Securities Dealers Automated Quotations
System – Nasdaq). The shift in the market value is attributed to investor expectations – if investors
expect a firm to generate a higher income in the future they will be prepared to pay more for the
firm’s shares (ie they will expect to receive higher dividends or returns on their investment).
Market value added is the amount by which the firm’s ordinary shares increase in market value over
a certain period (Marx et al, 2017, p.166).
The primary market is the market for new issues. When the firm is issuing, for example, shares
for the first time it is called initial public offering (IPO). After the initial sale, the securities trading will
be conducted on the secondary market.
On a secondary market, investors buy securities from other investors instead of the issuer
(previously issued securities are resold).
(Van Wyk, Botha, and Goodspeed, 2012, pp.202 & 366)
Market capitalisation
Market capitalisation is the number of shares that have been issued by the business multiplied by
the market price per share. That is, it is the total market value of the business.

For example, if a company has 1.5 million shares outstanding at a share price of $25, its market
capitalisation is $37.5 million (1.5 million × $25). Companies can be categorised based upon the
size of the market capitalisation (mega-cap market cap over $200 billion; large-cap $10 billion-
$200 billion; mid-cap $2 billion-$10 billion; small-cap $300 million to $2 billion; and micro-cap $50
million-$300 million) (Shafae, 2006).
Apple Inc has a market capitalisation of $906.01 billion (as at 12 August 2019) (a mega-cap).
Book value
We use the term “book value” for both fixed assets and ordinary shares.
“The book value of fixed assets is the value of the assets such as land, buildings, and plant and
equipment indicated in the Statement of Financial Position (formerly the Balance Sheet). The
book value of fixed assets is the cost of buying and installing these assets minus accumulated
depreciation.
“The book value of ordinary shares is the amount per share to be received if all assets are sold
(liquidated) for the book value and if the proceeds remaining after paying all liabilities (including
preference shares) are divided among the ordinary shareholders.”
(Marx et al, 2017, p.166)
A relatively high book value per share in relation to stock price often occurs when a stock is
undervalued (and vice versa).
Apple Inc.’s book value as at 29 June 2019 was $21.29 per share. The share is trading (as at 12
August 2010) at $200.48 per share. This suggests that the share may be overvalued in relation to
its assets.
Economic value (intrinsic value)
Economic value is based on the investor’s required rate of return, which depends on the cash flows
the investment is likely to provide and its level of risk (Stoltz et al, 2007, pp.155-156). This is the
primary focus of this section of the study guide.
Intrinsic value: “Underlying value of a firm separate from its market value or share price and
based on both quantitative factors (capital, earnings, revenue) and qualitative factors
(management quality, intellectual capital, past record). The intrinsic value of a firm may be higher
or lower than its stock market value, indicating that the firm is overvalued or undervalued.”
(Business Dictionary, 2013a)

As we can see with the Apple Inc example above, the intrinsic value may be higher than the book
value due to future expected earnings potential.
If the securities market is working efficiently, the market value and the intrinsic value of a security
will be equal.
For a market to be efficient all information must be available – all investors work with the same
complete information. Consider that if the markets are truly efficient it is extremely difficult for an
investor to make extra profits.
2.3.2 Types of Securities (Investments)
Companies raise finance through equity and or debt. Therefore, investors have two different options
– to be shareholders or to be lenders. Table 2 distinguishes between these forms of financing, known
as equity or debt securities.
TABLE 2: EQUITY VERSUS DEBT SECURITIES
Equity Ordinary • Shareholders expect to be suitably rewarded for risk when investing in
(shareholders) shares shares;
• If the company’s board of directors declare a dividend, every ordinary
shareholder has the right to receive dividends;
• Shareholders expect dividends and an increase in the share price (capital
gain);
• These shares have a stated “par value”, but this is more of a technicality –
the true value of an ordinary share is based on the price obtained through
market forces, the value of the underlying business, and investor sentiment
toward the company; and
• To maximise wealth, shareholders buy undervalued shares (ie economic
value is greater than the market price), and sell them once they become
overvalued (ie market price is greater than the economic value).
Preference • Preference shareholders typically earn a fixed dividend;
shares • Preference dividends are paid before ordinary dividends; and
• There are various types of preference shares (ie cumulative and non-
cumulative, participating preferred, and convertible).
Debt Bonds • The investor loans money to an entity (corporate or government) for a
securities defined period of time (maturity date) at a fixed interest rate (coupon);
(lenders) • Categories of bonds include corporate bonds and municipal bonds;
• The company is legally obliged to pay the interest and repay the principal as
agreed;

• Two important features include credit quality and duration, which together
determine the bond’s interest rate;
• Bond maturities range from 90 days to 30 years; and
• The cash flows from debt securities are more certain than the cash flows
from either preference or ordinary shares (debt securities carry a lower risk
than shares).
Debentures • A type of debt instrument that is not secured by physical assets or collateral
– backed only by the general creditworthiness and reputation of the issuer;
• Interest-bearing securities;
• Include government-issued treasury bonds (T-bond) or treasury bills (T-bill);
• Typically considered to be risk-free because government, at worst, can print
more money or raise taxes to pay these types of debts; and
• Can take the form of convertible debentures although in this case the interest
may be lower.
(Stoltz et al, 2007, pp.153-155; Investopedia, 2013a-d)
2.3.3 Key Inputs to Valuation
The key inputs to the valuation process are shown in Figure 7.
FIGURE 7: KEY INPUTS TO VALUATION
Cash
flows
Timing
Discount rate
(Stoltz et al, 2007)

The value of any asset depends on cash flow (returns), which may be regular, intermittent, or only
a single cash flow during ownership. Because of the time value of money (as we saw in course
one), we prefer to receive cash flows earlier rather than later. And, as you know (also from course
one), the required rate of return of an asset tells us about the relationship between risk and return.
When the risk is high, an investor will require a high rate of return (and vice versa). The required rate
of return is determined by the discount rate (to find the present value of the expected future cash
flows).
If the risk is high, your required rate of return will be high. This means your discount rate will be
high which will lower the value (and vice versa).
(Stoltz et al, 2007, p.158)
2.3.4 The Basic Valuation Model
Valuation is a process of estimating the intrinsic value of an asset. Broadly, this process follows three
steps and uses a variety of concepts and models. You will notice that some of the concepts, tools,
and models were covered in course one (eg opportunity cost and CAPM).
TABLE 3: VALUATION PROCESS
Action Concepts, tools and models

Step 1 Estimate cash flow stream for each period (month, quarter, year). • Data
• Spreadsheet
Step 2 Determine the required rate of return for each cash flow based on • Opportunity cost
how risky that cash flow is and bearing in mind what returns you could • Required rate of return
get on other investments (the opportunity cost). Consider too, that you (CAPM)
may need to use constant rates over time, or you may need to use
different rates for each cash flow.
Step 3 Discount each cash flow by its required rate of return to find its • Valuation model
present value. Then, add the present values to find the intrinsic value
of the asset.
(Adapted from Stoltz et al, 2007, pp.158-159)
The present value of a number of future cash flows is the sum of all their individual present values
as shown in the formula below (Marx et al, 2017, p.167).

𝐶𝐹! 𝐶𝐹" 𝐶𝐹#
𝑉= + + ⋯ +
(1 + 𝑘 )! (1 + 𝑘 )" ( 1 + 𝑘 )#
Where:
𝑉 = the (present) value of the asset

𝐶𝐹! = the cash flow expected at the end of year t (or period t)
𝑘 = the required return (the discount rate)
𝑛 = the number of periods for which we invest the asset
Different letters may be used in formulae, for example, you may see either a “k” or an “r” in the
equation. These letters represent the “required rate of return” or “cost of capital”.
Using the present value interest factor notion (PVIFk,n) means you can rewrite the basic valuation
model as follows (Marx et al, 2017, p.167):
𝑉 = $𝐶𝐹! × 𝑃𝑉𝐼𝐹",! * + $𝐶𝐹$ × 𝑃𝑉𝐼𝐹",$ * + ⋯ + $𝐶𝐹% × 𝑃𝑉𝐼𝐹",% *
Where:
𝑉 = the (present) value of the asset

𝐶𝐹! = the cash flow expected at the end of year t (or period t)
𝑘 = the required return (the discount rate)
𝑛 = the number of periods for which we invest the asset
Note: The 𝑃𝑉𝐼𝐹$,# can be obtained from the financial tables and is calculated as the present value
of R1. Namely:
1
𝑃𝑉𝐼𝐹$,# =
( 1 + 𝑘 )#
By substituting the expected cash flows (CFt) over the relevant period (n) and the appropriate
discount rate (k) into the basic valuation model, one is able to determine the value of any asset
(Marx et al, 2017, p.167).
V in the above equations is the same as PV (present value) from your first course. We use
different symbols here because you will be looking at different values, for example Vd for the
value of a debenture.

Consider the following example.
You are considering investing in an asset that will provide you with the following cash flows:
• Year 1: R0
• Year 2: R4,000
• Year 3: R12,000
• Year 4: R25,000
• Year 5: R32,000
An alternative investment could have earned you 12% and there is a risk premium of 2% (total of
14%). Determine the value of the asset over the next five years. Note, for column C refer to the
tables on page 94 of your prescribed textbook (Stoltz, 2007). Column D is equal to column B × C.
t CFt 𝟏 PVt = CFt × PVIF14%,t

PVIF14%,t =
(𝟏.𝟏𝟒)𝒕
A B C D
1 R0 0.877 R0.00
2 R4,000 0.769 R3,076
3 R12,000 0.675 R8,100
4 R25,000 0.592 R14,800
5 R32,000 0.519 R16,608
PV = R42,584
This means the value of the asset over the next five years is R42,584.
The same valuation model can be applied to the valuation of:
• Debentures (or bonds); and

• Ordinary and preference shares.

2.3.5 Valuation of Debentures (or Bonds)
Before we value debentures (or bonds), it is useful to understand associated concepts. These are
defined in the Table 4.
TABLE 4: CONCEPTS ASSOCIATED WITH DEBENTURES (OR BONDS)
Par value This is the amount the issuing enterprise will pay the creditor on the maturity date, which is
stated on the debenture. The amount on an issued debenture is fixed, however, the trading
price of the debenture will fluctuate in response to changing economic and market
conditions.
Maturity date Every debenture has a maturity date (expiry date) – the date on which the principal amount
(the par value) must be repaid by the issuing enterprise.
Coupon interest rate The interest promised on the debenture is also fixed (stated as a percentage, it is the
coupon interest rate or contractual interest rate).
(Adapted from Stoltz et al, 2007, p.162)
Let us start by considering a simple bond that matures in four years, has a coupon rate of 10% and
a maturity value of R100. For simplicity, let us assume the bond pays interest annually and a discount
rate of 8% should be used to calculate the present value. The cash flow for this bond will be:
• Year 1 = R10
• Year 2 = R10
• Year 3 = R10
• Year 4 = R110 (principal plus coupon)
The present value of each cash flow is:
• Year 1 = R10/1.08 = R9.2593

• Year 2 = R10/1.082 = R8.5734
• Year 3 = R10/1.083 = R7.9383
• Year 4 = R110/1.084 = R80.8533
The value of this security is then the sum of the present values of the four cash flows. That is, the
present value is R106.62 (R9.2593 + R8.5734 + R7.9383 + R80.8533).
Alternatively, the value of the bond (DB) is equal to the present value of the stream of coupons to be
received during the life of the bond and the par value to be received on maturity. That is:
𝐶' 𝐶( (𝐶) + 𝑀)
𝐷𝐵 = + +
(1 + 𝑘 )' (1 + 𝑘 ) ( ( 1 + 𝑘 ))

Where:
C = is the coupon amount (coupon rate × par value)

k = is the discount rate
M = is the par value
Therefore, the value of the bond can be calculated by using the annuity approach since the coupon
on the bond is an annuity. In that case, the value of the bond is equal to:
𝐷𝐵 = $𝐶 × 𝑃𝑉𝐼𝐹𝐴",% * + (𝑀 × 𝑃𝑉𝐼𝐹",% )
Note: 𝑃𝑉𝐼𝐹𝐴",% is obtained in the present value of an annuity table while 𝑃𝑉𝐼𝐹",% is from the present
value of a single amount table.
𝐷𝐵 = (10 × 3.312) + (𝑅100 × 0.735) = 𝑅33.12 + 𝑅73.50 = 𝑅106.62
Present Value
1. What is the present value of a five-year security with a coupon rate of 7% paid annually, assuming a discount
rate of 5% and a par value of R100? Follow the steps given above.
In practice, the market value of the bond will fluctuate depending on the discount rate (or expected
return of the investor), trading at par, a premium or at a discount. Work through the example provided
in your textbook pages162-164, example 7.2 (Stoltz et al, 2007), which provides you with a formula
to simplify the calculation for the valuation of a debenture (or bond).
Valuation of a Debenture
1. When the required return is greater than the coupon rate of a debenture, the value of the debenture will be less
than its par value (the debenture will sell at a discount). True or false?
2. Calculate the value of the debenture given below (interest is paid annually).
Debenture Par value Coupon rate Years to maturity Required return

A R200 8% 12 12%
Once you have tried the above calculation on your own, work through the solution provided in the Appendix to check
your calculations.

Whenever the required return of a debenture differs from its coupon rate, the value of the
debenture will differ from its par value (an increase in interest rates and or the riskiness of the
enterprise will raise the required rate of return) (Stoltz et al, 2007:164).
Yield to maturity (or redemption yield)
“If you buy debt today and keep it until it matures, the rate of return you receive from now until the
maturity date is called the yield to maturity (YTM).”
Therefore, if you “buy the debenture at par value and keep it for the full period, the YTM consists
entirely of an interest yield. But if the purchase price of the debenture is different from its par
value, the YTM consists of the interest yield plus a positive or negative capital gains yield (the
difference between the purchase price and the current value).”
We can say that the YTM is the internal rate of return (IRR) – the sum of all future cash flows from
the bond (coupons and principal) is equal to the price of the bond. Note the following:
• If a debenture’s coupon rate is less than its YTM, then the debenture is selling at a discount;
• If a debenture’s coupon rate is more than its YTM, then the debenture is selling at a premium;
and
• If a debenture’s coupon rate is equal to its YTM, the the debenture is selling at par.
The formula for the approximate yield to maturity is shown as follows (Marx et al, 2017, p.170):
𝑴,𝑫𝑩𝟎
𝒊+H 𝒏
I
𝑨𝒑𝒑𝒓𝒐𝒙𝒊𝒎𝒂𝒕𝒆 𝒚𝒊𝒆𝒍𝒅 = 𝑴0𝑫𝑩𝟎
H 𝟐
I
Where:
𝑖 = the annual interest (as an amount)

M = the par value
DB0 = the current value of the debenture
𝑛 = the years to maturity
Work through the following example.
Assume SA Breweries Ltd issued debentures at R1,000 each with an annual coupon rate of 15%.
Further, assume the debenture is currently trading at R840 with 10 years to maturity. Calculate
the YTM. The approximate YTM will be:

!222,342
150 + H !2
I
𝐴𝑝𝑝𝑟𝑜𝑥𝑖𝑚𝑎𝑡𝑒 𝑦𝑖𝑒𝑙𝑑 = !2220342
= 18.04%
H $
I
This means that the debenture is trading at a discount (ie the debenture’s coupon rate is less
than its YTM).
(Marx et al, 2017, p.170)
2.3.6 Valuation of Preference Shares
Preference shareholders receive a fixed income during the investment period. The difference
between preference shares and debentures is that the return from preference shares comes in the
form of dividends. And, while debentures have a maturity date, most preference shares are
perpetuities (no fixed maturity date). The formula for the valuation of preference shares is (Stoltz et
al, 2007, pp.167-168):
𝐷
𝑉& =
𝑘&
Where:
𝑉* = value of a preference share at time zero
𝐷 = annual dividend
𝑘* = required rate of return on preference share
Consider the following examples.
1. ABC issued 12% preference shares with a par value of R60. If the cost of preference shares
is 14%, what is the current value of the preference shares?
Answer:
Dividend = 0.12 × R60 = R7.20

Value of preference shares = D/kp
= R7.20/0.14
= R51.43

Share Questions
1. XYZ Ltd issued 7.5% preference shares with a par value of R10. If the cost of preference shares is 6%, what
is the value of the preference shares?
2. ABC Ltd pays a preference dividend of R5 per share. If the required rate of return of 17%, how much should
you pay for the shares?
Once you have tried the above calculations on your own, work through the solutions provided in the Appendix to check
your calculations.
2.3.7 Valuation of Ordinary Shares
As with the valuation of debentures, the value of ordinary shares should be the present value of all
future returns. Note Marx et al’s (2017, p.171) statement:
“Some argue that selling the share at a price above that originally paid can earn a capital gain in
addition to dividends, but what is really being sold is the right to all future dividends. The
conclusion to such an argument is that only dividends are relevant.”
(Marx et al, 2017, p.171)
As a consequence of this, we consider three models that help us to find the present value of future
dividends:
• Zero growth (as with preference shares);

• Constant growth; and
• Variable growth.
Zero growth
This approach assumes a constant dividend stream (the same equation as the valuation model for
preference shares).
𝐷!
𝑃5 =
𝑘6
Where:
𝑃+ = value of an ordinary share at time zero

𝐷' = the dividend per share expected at the end of year 1
𝑘, = the required rate of return on ordinary shares

An investor expects Company X to pay an annual dividend of R2 per share and the required rate of
return is 12%. We can calculate the value of this ordinary share as follows:
𝑅2
𝑃5 = = 𝑅16.70
0.12
Constant growth (also known as the Gordon growth model)
This approach assumes that dividends will grow at a constant rate, ie “g”. If “g” is constant, then the
formula will be:
𝐷!
𝑃5 =
𝑘6 − 𝑔
Where:

𝑔 = constant dividend growth rate
Note: D1 = D0 (1 + g). Where you are given the current dividend, or the dividend that has already
been paid, you will need to calculate D1 for yourself.
Assume Company X is expected to pay a dividend of R2 per share next year, and the company’s
dividend growth rate is 8% and the required rate of return is 12%. We can calculate the value of
this ordinary share as follows:
𝑅2
𝑃5 = = 𝑅50
0.12 − 0.08

Growth Question
Assume you are analysing a share that pays $0.50 in dividends per quarter (or $2 per year). Your research shows
that the dividend has increased by an average of 8% per year over several decades but the growth is slowing down.
You estimate that the dividend will continue to grow by an average of 5% per year going forward. Using the Gordon
growth model, calculate a fair price for the stock given that you want an 11% return on your investment.
When you have completed the calculation refer to the Appendix for the worked solution.
Variable growth
This approach allows for changes in the dividend growth rate (not catered for in the above two
approaches). The model assumes that the level of dividend growth depends on the stage of the
lifecycle the company is in. For example, high-growth companies might be able to pay higher
dividends as their income grows rapidly, whereas mature companies might be able to sustain only
modest and constant growth in dividends.
The steps are (Stoltz et al, 2007, p.171):
1. Calculate cash dividends at the end of each year during the initial growth period.
2. Calculate the present values of the cash dividends in step 1 and then add the present values
for the initial growth phase.
3. Find the value of the share at the end of the initial growth phase by applying the constant
growth model to the next phase.
4. Add the values from steps 2 and 3 to get the value of the share.
Management reflections:
The value of any asset today depends on its future cash flows, eg:
• Preference shares (level and ongoing stream);

• Ordinary shares (typically a growing stream of cash flows); and
• Debenture (limited series of even cash flows).
No matter what the pattern of cash flows, the basic valuation of these flows is the same: discount
each future cash flow to the present at the rate that reflects both the time value of money and the
uncertainty of the flow. The higher the discount rate, the lower today’s value will be and vice versa.
When management’s decisions or actions cause investors to expect higher dividends, the value of
the enterprise increases. If management can increase the levels of expected returns without
changing the risk such actions will increase the wealth of the owners.

When risk increases, the investors’ required return would also increase. An increase in the
required return will lead to a decrease in the value of the shares. So, when management makes
decisions that increase the risk, the share value will tend to decrease.
(Adapted from Stoltz et al, 2007, pp.176 & 178)
Apply Your Knowledge
Whirlpool Executives is considering a cash purchase of Ballyhoo shares. During the year just completed, Ballyhoo
earned R4.25 per share and paid cash dividends of R2.55 per share. Ballyhoo’s earnings and dividends are expected
to grow at 25% per year for the next three years, after which they are expected to grow at 10% per year to infinity.
Determine the maximum price per share that Whirlpool should pay for Ballyhoo if the investor has a required return of
15% on investments with risk characteristics similar to those of Ballyhoo (Stoltz et al, 2007, p.179).
2.3.8 Key Points
• The par value is important for accounting purposes since the shareholders’ interests in the
company appear in the balance sheet at par value.
• The shift in the market value is attributed to investor expectations – if investors expect a firm
to generate a higher income in the future, they will be prepared to pay more for the firm’s
shares.
• The primary market is the market for new issues. When the firm is issuing shares for the first
time, that event is called an initial public offering (IPO).
• In a secondary market, investors buy securities from other investors, not from the issuer
(previously issued securities are resold).
• If the securities market is working efficiently, the market value and the intrinsic value of a
security are equal.
• If you buy debt today and keep it until it matures, the rate of return you receive from now until
the maturity date is called the yield to maturity.
• It is important to understand the valuation of:
o Bonds and debentures;
o Preference shares; and
o Ordinary shares.

2.4 THE COST OF CAPITAL

• Calculate the cost of debt financing (term loans and bonds);
Learning • Calculate the cost of equity financing (common shares, preference shares and retained
outcomes earnings); and
• Determine the weighted average cost of capital for a company.
• Marx, J., de Swardt, C., Beaumont Smith, M., & Erasmus, P. (2017). Financial Management in
Southern Africa (5th ed.). Pearson Education South Africa.
Recommended • Stoltz, A., Viljoen, M., Gool, S., Meyer, C., & Cronje, R. (2007). Financial Management: Fresh
reading Perspectives (1st ed.). Pearson Education South Africa.
Unless you know the cost of your capital, you will not know the total cost of your products. This
Section section looks at the different types of capital (debt and equity) and a technique – the weighted
overview average cost of capital – to calculate the expected return on investment (the expected average future
cost of total weighted funds).
2.4.1 Framework for Cost of Capital
In this section we look at each of the components in Figure 8 (cost of capital), which together make
up the weighted average cost of capital (WACC). We start by looking at the two arms independently:
• Debt (borrowed money); and

• Equity (shareholders’ money).
After examining these separately, we will combine them to determine the weighted average cost of
capital (WACC) of all the different types of capital the company uses. We do this using a five-step
process that takes into consideration the market value of the firm, after-tax costs of each component
of the funding, and the capital structure.
“Weighted average cost of capital reflects the expected average future cost of funds over the
long run; found by weighting the cost of each specific type of capital by its proportion in the firm’s
capital structure.”
(Gitman, 2010)
Remember that companies discount cash flows at WACC to determine the net present value (NPV)
of a project with similar risks (refer to your course one for our discussions on NPV).

When the company fails to achieve the WACC (required rate of return) it will lose value,
reputation will be impaired, and the company will find it more and more difficult to attract public
money.
FIGURE 8: OVERVIEW OF THE COST OF CAPITAL
Cost of Capital
Debt%(borrowed%money)% Equity%(shareholders'%money)%
Corporate(loans( Term(loans( Common( Retained( Preferred(shares(

(Bonds/debentures)( shares( earnings(
Coupon(rate( Interest( Cost(similar(to( Interest(

Dividends(
that(of(common(
shares(
Weighted%average%cost%of%capital%
2.4.2 Debt (Borrowed Money)
The cost of a term loan
The South African Revenue Service (SARS) regards interest as a tax-deductible cost in the
statement of comprehensive income (ie interest is added in as an expense before tax is calculated).
This has the effect of reducing the cost of debt. Consider the following example:

Company ABC is in the 28% tax bracket. On applying for a R100,000 loan the bank quoted an
interest rate of 15%. What is the company’s after-tax cost of debt 𝑘' ?
We use the formula (where T is the tax rate): 𝑘- = 𝑘. (1 − 𝑇)
After tax cost of debt 𝑘. is 0.15 × (1 – 0.28), which is 0.11 or 11%.
This means that instead of paying 15% on R100,000 (R15,000), Company ABC pays 11% on
R100,000 (R11,000). Remember interest on a loan is a tax-deductible expense that reduces the
cost of debt.
Therefore, we can say that the cost of a term loan must take into consideration the after-tax cost of
the debt (Stoltz et al, 2007, p.186).
The cost of bonds
Large companies use bonds when they need long-term credit. To find the cost of a bond, several
costs must be considered, ie flotation and discount costs.
A flotation cost is an expense involved in selling a new security issue. This expense includes
items such as underwriting fees, registration of the issue, and legal fees (paid to the issuing
company). Flotation costs depend on the size and riskiness of an issue as well as on the type of
security to be sold.
(Financial Dictionary, 2013)
Stoltz et al (2007, p.187) recommend three steps to calculating the cost of a bond for a company:
• First deduct the expenses from the bond price (ie flotation costs and, if applicable, a discount
to make the offer more appealing to investors);
• Then calculate the before-tax cost of the bond (ie either by calculating the yield to maturity
(YTM) or by calculating the internal rate of return (IRR) which we covered in course one);
and
• Finally adjust for tax as we did for the term loan above (ie 𝑘- = 𝑘. (1 − 𝑇)).
Assume the following for XYZ Company raising long-term credit through bonds:
1. Bond unit of R1,000

2. Discount rate of 2.5% (R25)
3. Flotation cost of 2% (R20)
4. Coupon rate of 8% (R80)
Therefore, total amount per unit available = R1,000 – R25 – R20 = R955

On issue, XYZ Company gains only R955 and thereafter it has to pay R80 annually until maturity
date, at which point it must repay the investor the principal amount of R1,000.
We can find the before-tax cost of the bond by using our YTM formula:
/012!
𝑖+ K L
)
𝐴𝑝𝑝𝑟𝑜𝑥𝑖𝑚𝑎𝑡𝑒 𝑦𝑖𝑒𝑙𝑑 = /312!
K (
L
Where:
M = the par value
DB0 = the price of the bond (adjusted for expenses)
',4440 677
80 + K L
(4
𝐴𝑝𝑝𝑟𝑜𝑥𝑖𝑚𝑎𝑡𝑒 𝑦𝑖𝑒𝑙𝑑 = ',4443 677
K (
L
82.25
= = 8.41%
977.50
Finally, we adjust for tax using our formula: 𝑘- = 𝑘. (1 − 𝑇)
If the company is in the 28% tax bracket, then:
𝑘- = 8.41(1 − 0.28)
= 6.06%
This means the after-tax cost of the bond is 6.06% (ie R60.60 on every R1,000 unit).
(Adapted from Stoltz et al, 2007, pp.186-189)
Note that in both of the above cases, we get the after-tax cost of the debt.

Debt Questions
1. Management is considering raising long-term credit through a bond issue. Explain the factors that must be
considered and the steps to follow to calculate the cost of the bond (state the equations required for the
calculation).
2. An investment consortium issues a 15-year bond to finance a safety structure to protect Chapman’s Peak Drive
from rockfalls. It offers a coupon rate of 8% (units of R1,000) and a discount of 2% to attract overseas investors.
Calculate the before-tax cost of debt and the after-tax cost of debt, assuming their tax rate is 28% and flotation
costs are 1.5%.
2.4.3 Equity (Shareholders’ Money)
We now look at the other arm of our diagram – the equity side. This includes the costs of:
• Common shares;
• Retained earnings; and
• Preference shares.
Cost of common (ordinary) shares
As we have seen, shareholders receive dividends. The company pays these from the earnings it has
generated through making profitable investments with shareholders’ money. The company does not
pay out all its profits in dividends – it retains a portion of these, which it reinvests in the company (to
grow the company). The portion that it pays as dividends is the dividend pay-out ratio.
𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 (𝐸𝑃𝑆)
We can say that the dividends that the company pays out are its cost of common shares. We use
two models to find the cost of newly issued shares (Stoltz et al, 2007, p.191):
• The constant-growth valuation model (the Gordon growth model); and

• The capital asset pricing model (CAPM).

Gordon growth Model
We have already encountered constant-growth in the previous section (7.1) – but from the investor’s
perspective. Remember, the Gordon growth model says that the present value of a company’s future
dividends determines the value of a share (𝑃( ) and that it can be calculated as follows:
𝑫𝟏
𝑷𝒐 =
𝒌𝒔 − 𝒈
Where:

𝑔 = constant dividend growth rate
Reworking the above formula, the required rate of return (or cost of ordinary shares) can be
expressed as:
𝑫𝟏
𝒌𝒔 = o p + 𝒈
𝑷𝒐
Consider the following example:
Assume the present market value of XYZ Company ordinary shares is R32, the expected
dividend is R2.50 (D1) and the expected growth rate in dividends is 11% per annum. Further,
assume the flotation costs of the new shares is R2 per share, therefore the net proceed per share
is R30 (32 - 2). We can use the Gordon growth model to estimate the cost of the company’s
ordinary shares.
2.50
𝑘6 = o p + 0.11
30
= 0.0833 + 0.11
= 0.1933 𝑜𝑟 19.33%
(Marx et al, 2017, p.338)

Be careful to recognise the difference between current (D0) and expected dividend (D1). If you
have the current dividend then the formula will read as follows:
𝑫𝟎 (𝟏 + 𝒈)
𝒌𝒔 = s u+𝒈
𝑷𝟎
Capital asset pricing model (CAPM)
The CAPM is an alternative method, which takes the risk-return requirements of the company directly
into account by means of the beta coefficient (we covered the beta coefficient and CAPM in course
one). Remember, the formula states:
𝒌𝒔 = 𝑹𝒇 + 𝜷9𝒌𝒎 − 𝑹𝒇 ;
Where:
𝑘, = the cost of ordinary shares

𝑅- = the risk-free rate of return
𝛽 = the beta coefficient
𝑘. = the market rate of return on all assets
Note: You need to solve the brackets first 9𝑘. − 𝑅- ; then multiply the answer by 𝛽 and then
finally add 𝑅- .
Your company’s financial managers have the following information: the risk-free rate is currently
12%, your company’s beta coefficient is 0.9 and the return on the JSE’s overall index is currently
18.6%. Calculate the cost of your company’s ordinary shares.
𝑘, = [12 + 0.9(18.6 − 12)]%
= 17.94%
(Marx et al, 2017, p.341)

Cost of retained earnings
When earnings (profits) are held back, equity increases. We can say that these retained earnings
belong to the shareholders, but shareholders have not received them yet. Essentially, the
shareholders will expect the same return on the retained earnings, so we can say that the cost of
retained earnings is the same as the cost of common (ordinary) shares. However, keep in mind there
are no flotation costs on retained earnings, which makes them cheaper.
Cost of preference shares
The cost of preference shares is calculated using the following formula:
𝑫𝒑
𝒌𝒑 =
𝑵𝒑
Where:
𝑘* = the cost of the preference shares

𝐷* = the cash dividend per preference share
𝑁* = the net proceeds on the sale of the preference shares
(Marx et al, 2017, p.336)
XYZ Company intends to raise additional financing by issuing 12% preference shares with a par
value of R50 and a dividend of R6 per share per year. If the company expects to realise R48 per
share, what is the cost of the preference share financing?
6
𝑘: =
48
= 0.125 𝑜𝑟 12.5%
Cost of Shares
You are given the following information: rate of return on RSA150 stock is 6% and the market rate of return is 10%.
Using the CAPM model, calculate the cost of ordinary shares in ABC, a local manufacturer with a beta coefficient of
1.75.

2.4.4 Weighted Average Cost of Capital (WACC)
Once you have calculated the costs of specific sources of financing (debt and equity) and you know
the firm’s capital structure (ie proportion of debt-to-equity financing), you can determine the overall
weighted average cost of capital.
The weighted average cost of capital (WACC) reflects the expected average future cost of
funds over the long run. It is found by weighting the cost of each specific type of capital by its
proportion in the firm’s capital structure (Gitman, 2010).
XYZ Company has 30% debt, 10% preference share, and 60% ordinary share financing. Using
these component costs, we can calculate the WACC.
Source of Pre-tax After-tax Weight Weighted cost

financing cost cost
Debt 18.00% 10.80% 0.30 3.24%

Preference 12.50% 12.50% 0.10 1.25%
shares
Ordinary shares 19.33% 19.33% 0.60 11.60%
WACC 100 16.09%
(Marx et al, 2017, p.343)
Note that only the debt portion is affected by tax. Preference and ordinary dividends are paid
after paying tax and as such do not have a tax benefit. Therefore, the cost of the preference and
ordinary shares is already in after-tax terms.
Why WACC is so important:
“WACC is one of the most important figures in assessing a company’s financial health, both for
internal use (in capital budgeting) and external use (valuing companies on investment markets). It
gives companies an insight into the cost of their financing, can be used as a hurdle rate for
investment decisions, and acts as a measure to be minimised to find the best possible capital
structure for the company.
“WACC is a rough guide to the rate of interest per monetary unit of capital. As such, it can be used
to provide a discount rate for cash flows with similar risk to that of the overall business.”
(QFinance, 2013)

Cost of Capital
Coffee Worldwide has the following capital structure:
• Common share capital: R300,000

• 7% preference shares: R100,000
• Long-term loan: R200,000
The cost of equity is 3% and Coffee Worldwide pays 12% on the bank loan. It pays 35% income tax. Determine its
weighted average cost of capital (WACC).
2.4.5 Economic Factors to Consider
By changing the capital structure, a company can raise or lower its WACC. Using the example given
above, increasing the debt portion (after-tax cost of 10.80% versus 12.50% and 19.33%) would lower
the WACC. However, this would increase the company’s financial risk exposure with regard to the
fixed interest commitments (remember the interest on debt must be paid, whereas dividends are
desirable but not compulsory).
“In establishing a target capital structure, management must be guided by the degree of risk
relating to the industry in which the business is operating and by the availability and cost of
long-term funds. If there is a high degree of operating risk, the business may have difficulty in
raising long-term loans and might have to rely on more costly share capital funding” (Marx et
al, 2017, p.343).
Capital Questions
1. What are we referring to when we talk about the cost of capital?

2. How does a firm’s tax rate affect its cost of capital?
3. Why is the cost of retained earnings the same as existing common shares?
4. Does a flotation cost affect the cost of a firm’s capital? Explain.
5. What does the firm’s weighted average cost of capital tell us?

2.4.6 Using the WACC for Investment Decisions
A company should make only those investments for which the expected return is greater than the
WACC (investing in a project that does not produce a return greater than the cost of the debt would
not make economic sense). For example, if the internal rate of return (IRR) of a project is greater
than the company’s WACC, the company should undertake the project. Refer to course one for IRR
methodology.
“The acceptance of projects, starting with those that have the greatest positive difference between
the IRR and the WACC, down to the point at which the IRR just equals the WACC, should result in
the maximum total NPV, and therefore the optimisation of the business’ value for shareholders.”
(Marx et al, 2017, p.344)
1. One of your project managers approaches you with the following question: “Why don’t we simply use the interest
rate that we can earn on an investment to determine whether my project is worthwhile?” What response would
you give him or her?
2. Would a company in a country with a relatively high tax rate for companies tend to use mainly equity finance or
mainly debt finance? Explain.
2.4.7 Key Points
• The South African Revenue Service (SARS) regards interest as a tax-deductible cost.
• The cost of a term loan must take into consideration the after-tax cost of the debt.
• Large companies use bonds when they need long-term credit.
• The cost of a bond is calculated as follows:
o First deduct the expenses from the bond price (ie flotation costs and if applicable a
discount to make the offer more appealing to investors);
o Then calculate the before-tax cost of the bond, ie either by calculating the yield to
maturity (YTM) or by calculating the internal rate of return (IRR); and
o Finally adjust for tax (ie 𝑘- = 𝑘. (1 − 𝑇)).
• We use two models to find the cost of newly issued shares:
o The constant-growth valuation model (the Gordon growth model); and
o The capital asset pricing model (CAPM).
• The cost of retained earnings is the same as the cost of common (ordinary) shares.
• Cost of preference share is the ratio of the dividend per preference share to the net proceed
on the sale of preference shares.

• By changing the capital structure, a company can raise or lower its WACC.
• A company should only make investments for which the expected return is greater than the
WACC.

2.5 PROJECT APPRAISAL
Learning outcome • Apply project appraisal techniques (capital rationing and “make or buy” approach).
Recommended • Theexpgroup. (2013). Profitability Index, capital rationing and risk [Video]. YouTube.
multimedia http://www.youtube.com/watch?v=ebKpNniMSOE (accessed 10 August 2023).
While financial managers would like to pursue all projects with a positive net present value, not all
investment projects may be possible (eg due to a shortage of investment funding or a limitation on
other resources). Financial managers may also be faced with other decisions that force them to
Section overview
make choices (eg between competing projects). In this section, we examine how organisations
appraise their projects when there are limited resources and we consider a project appraisal
approach for “make or buy” decisions where choices have to be made.
2.5.1 Capital Rationing
Consider a slowdown in the economy, high interest rates and already high debt levels in your
company. Management may find it difficult to raise all the fresh equity capital it needs from the
market, or debt capital in the form of loans, under these conditions. Consider too, that there may be
nonfinancial reasons that prevent your company from undertaking all potentially profitable new
investment projects, eg the inability to manage all the projects simultaneously. The list of nonfinancial
factors is extensive but the following provides some indication of possible nonfinancial factors:
• Complying with legal or regulatory requirements (health and safety in particular);

• Conforming to industry standards;
• Staff morale;
• Impact on reputation;
• Impact on relationships with other stakeholders (suppliers, customers, local community);
• Human resource limitations;
• Protecting intellectual property; and
• Possible environmental issues.
When management cannot carry out all potentially profitable projects due to financial constraints,
(those with positive NPVs or IRRs greater than WACC) they use a technique called capital rationing
to determine which projects should take precedence.

Capital rationing: Management’s approach to allocating available funds among competing
investment proposals: only the proposals that maximised the total net present value (NPV) of the
investment are selected.
(Business Dictionary, 2013b)
For capital rationing, management uses the profitability index (PI) (or cost-benefit index) method
to decide which projects can be undertaken when there is a shortage of investment capital. We will
use an example to explain this approach.
Below, this example sets out three possible projects each with a positive net present value (NPV),
using a weighted average cost of capital (WACC) of 10% as the discount rate. All three projects are
attractive. But assume that your company has a limit on its capital expenditure of R20-million, so it
can invest either in project A (R20-million), or in projects B (R10-million) and C (R10-million), but not
in all three.
Capital rationing using NPV – projects A, B and C
Project Investment Cash flow Present Cash flow Present Total

(Rm) (Rm) Value (Rm) value NPV
Year 0 Year 1 Year 2
A -20 +60 54.55 +10 8.26 +43
B -10 +10 9.09 +40 33.06 +32
C -10 +10 9.09 +30 24.79 +24
Notice that when the NPVs of project B and C are added together (R56m) they have a combined
higher NPV than project A (R43m). Therefore, from the data given above, projects B and C should
be selected. Now let us consider the Profitability Index (PI), which is expressed as:
𝑁𝑃𝑉 (𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠)
𝑃𝐼 = 1 +
𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 (𝑐𝑜𝑠𝑡𝑠)
or
𝑡𝑜𝑡𝑎𝑙 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠

𝑃𝐼 =
𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑜𝑠𝑡𝑠
For the three possible projects, the PIs are shown in the example below.

Using PI to determine the magnitude of profitability
Project Initial investment PV (cash flows or Profitability

(costs) benefits) index
(Rm) Year 0 (Rm) (PI)
A -20 +62.81 3.14
B -10 +42.15 4.22
C -10 +33.88 3.39
If we rank the projects, project B has the highest PI, followed by project C and lastly project A, which
has the lowest PI. Therefore, if your company’s capital expenditure budget is R20-million, then it
should undertake project B, followed by project C.
The PI approach, while simple, helps to rank projects by the magnitude of their profitability.
The company’s intention is to get the largest benefit for the available funds. That is, those
projects should be selected that give the highest ratio of present value to initial outlay. This ratio
is the profitability index. Top-ranked projects should be undertaken until funds are exhausted.
(Professional Management Education, 2010a)
The two formulas, NPV and PI, are often confused because they are both used for a similar purpose.
However, while the profitability index indicates the relative value of an investment (benefits to costs),
the net present value indicator measures the absolute value of an investment.
However, what happens if the highest ranked projects, according to the PI index, do not exhaust all
the available funds and the next best project is indivisible (can only be completed in its entirety)?
Failure of the PI rule due to indivisibility
Suppose that your company has a budget ceiling of $1m. Following the ranking by PI, the firm
would choose A and C from the table given below. These projects cost $850,000 of the total
budget and have a total NPV of $180,000.
The next best project is E, which needs an investment of $200,000, while your company only has
$150,000 left out of its budget to spend (the $150,000 left unspent will be a waste of capital
resources).

Project Outlay ($) NPV ($) PI Rank
A 500,000 110,000 1.22 1
B 150,000 (75,000) 0.50 6
C 350,000 70,000 1.20 2
D 450,000 81,000 1.18 4
E 200,000 38,000 1.19 3
F 400,000 20,000 1.05 5
If we examine the various combinations of projects satisfying the budget limit, we find the
package of C, E and D to be the best. They exhaust the entire budget and have a total NPV of
$189,000. Thus, your company can choose two lower ranked, small projects – E and D – in place
of the higher ranked, large project A.
(Professional Management Education, 2010b)
Keep in mind that the PI approach provides a basis from which to work. However, it is less effective
when projects are indivisible and when there is a risk of unused budgets.
Also keep in mind that the PI approach does not tell us anything about other resource constraints
(eg human resource constraints), when two proposed projects are mutually exclusive, or when one
project is dependent on another.
Keep in mind too that some projects are inherently riskier, and therefore a hurdle rate may have to
be applied over and above the weighted average cost of capital.
For example, in the first example, a WACC of 10% was used across all three projects (A, B and C).
What if one of the projects, say B, was much riskier? The financial manager may decide to impose
a further 2% hurdle rate on the current 10% discount rate to take account of the increased level of
risk. Depending on the comparisons being made, this could change the project appraisal decision
significantly.
This video summarises our discussions on the profitability index approach:

• Theexpgroup. (2013). Profitability Index, capital rationing and risk [Video]. YouTube.

Profitability and Other Questions
Watch the above video. This video provides a practical example of concepts from course 1 and in this section thus far.
Discuss project appraisal in your company using key terms from our discussions and the video:
1. The application of NPV and PI;

2. Capital rationing with divisible projects and indivisible projects;
3. “Soft rationing” (internal forces) and “hard rationing” (external forces);
4. Nonfinancial factors for consideration in investment appraisal;
5. Risk and uncertainty;
6. Sensitivity analysis;
7. Scenario analysis;
8. Simulations; and
9. Expected value.
Now work through the following task:
Investment Questions
Study the table below and then answer the questions that follow.
Project Year 0 Year 1 Year 2 Year 3 Year 4 NPV when

($m) ($m) ($m) ($m) ($m) discounted at 10%
A -100 +20 +40 +60 +80 +50.96
B -150 -50 +100 +100 +140 +57.94
C -60 +20 +40 +40 - +21.29
D -100 +60 +60 +100 - +79.26
E -50 +20 +40 +60 +40 +73.64
F -100 +30 +30 +30 +30 -4.91
1. In a nonrationing situation, what is the total capital outlay required in Year 0 for all projects with positive NPVs?
2. By how much would projects A to E raise shareholders’ wealth?
3. Assume that the company is limited to $300 million in investment capital in Year 0. Which projects can be selected
given this constraint (assume all projects are divisible)?
4. With limited investment capital of $300 million in Year 0, by how much will shareholders’ wealth increase?
(Adapted from Lumby and Jones, 2003, pp.152 & 153)

2.5.2 Competing projects
By competing projects, we mean mutually exclusive projects. For example, either project A or B must
be selected. The classical example of this is the make or buy problem. In addition to this problem,
we also consider choices between projects with unequal life spans.
The make or buy problem
With the phenomenal surge in global outsourcing over the past decade, the make-or-buy decision is
one that managers have to grapple with frequently.
In the example below, the company must decide between manufacturing a component in-house or
outsourcing the component. For simplicity, tax has been excluded from the calculations. However,
keep in mind that a cost-saving project typically has tax implications in the same way that a revenue-
generating project would have tax implications.
In the in-house option, manufacturing costs and the opportunity cost of assembly line floor costs are
included. In both instances, a weighted average cost of capital (discount rate) of 12% has been used.
Make-or-buy decision
Cost of making the component in-house (R’000)
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Plant and -1,200 0 0 0 0 +200
equipment
Manufacturing -300 -324 -350 -378
costs
Opportunity cost -200 -200 -300 -300
(assembly line)
Total in-house -1,200 -500 -524 -650 -678 +200
costs
Discount factor 1.0 0.893 0.797 0.712 0.636 0.567
for WACC of
12%*
Discounted cash -1,200 -447 -418 -463 -431 +113
flow
NPV -2,846
*Refer to the tables on page 94 of your textbook (Stoltz, 2007).

Cost of buying the component (outsourcing) (R’000)
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Purchase 0 -900 -1,000 -1,200 -1,350 0
costs
Discount 1.0 0.893 0.797 0.712 0.636 0.567
factor for
WACC of
12%
Discounted 0 804 797 854 859 0
cash flow
NPV -3,314
In the above example, the cost of producing the component in-house is less (R2 846 000 versus
R3,314,000) and therefore the component should be manufactured in-house. While the financial
factors clearly indicate that in-house is more cost effective, other nonquantifiable factors must still
be considered when determining make-or-buy decisions. For example, in the outsourcing option, the
reliability and quality of supply must be determined – what is the probability that components will be
ready on time, at the required quality? An advantage of outsourcing is flexibility in the face of rapid
changes in the market (in-house investment costs are avoided).
As with our discussions on capital rationing, a hurdle rate in addition to the WACC rate may be
required to allow for the additional risks associated with each option.
Comparing assets with unequal life spans
Consider the situation where a company needs to determine how long to keep an asset before
replacing it. An example of this type of decision is the replacement of vehicles. The following example
demonstrates how the annualised equivalent method applies in such cases (CIMA, 2012):
Just in Time Every Time (JITET) is a large organisation that specialises in delivering goods from
retailers to consumers. The company, which has more than 100 vans, is considering whether it
should replace these vehicles after three, four, or five years. The tables below contain the
investment appraisal for each option based on a weighted average cost of capital of 10%.
However, the NPVs calculated for each option cannot be compared because each covers a
different period.
Replace the vans after three years

Year Investment (£) Running costs (£) Residual value (£) Net cash flow
(£)
0 -15 000 -15,000
1 -9,900 -9,900
2 -10,000 -10,000
3 -10,100 6,000 -4,100
4 0
5 0

Cost of capital 10% NPV -35,345
Replace the vans after four years

Year Investment Running costs (£) Residual value (£) Net cash flow
(£) (£)
0 -15,000 -15,000
1 -9,900 -9,900
2 -10,000 -10,000
3 -10,100 -10,100
4 -10,400 4,000 -6,400
5 0
Replace the vans after five years

Year Investment (£) Running costs (£) Residual value (£) Net cash flow (£)
0 -15,000 -15,000
1 -9,900 -9,900
2 -10,000 -10,000
3 -10,100 -10,100
4 -10,400 -10,400
5 -11,200 1,000 -10,200
While we could calculate an average for each option as follows, this would not provide a valid
comparison:
• Three years: £35,345 / 3 = £11,782

• Four years: £44,224 / 4 = £11,056
• Five years: £53,289 / 5 = £10,658
These calculations indicate that JITET should use a five-year replacement cycle because this
produces the lowest annual cost (not a valid comparison). Calculating an annualised equivalent
cost for each option is the only way to compare the three options.
To do this, a cumulative discount factor or annuity factor must be obtained for three, four, and five
years. Turn to page 98 of your textbook (Stoltz, 2007) and read the discount factors under 10%
for periods 3, 4, and 5:
• 2.487
• 3.170
• 3.791
So, the annualised equivalent costs of each option are as follows:

• Three years: £35,345 / 2.487 = £14,212
• Four years: £44,224 / 3.170 = £13,951
• Five years: £53,289 / 3.791 = £14,057

From these calculations, JITET should use a four-year replacement policy, since this entails the
lowest annual cost.
(CIMA, 2012)
As we have seen, most investment appraisal projects have qualitative factors (nonfinancial factors)
associated with them. In this case, JITET might be concerned that using older vehicles could tarnish
the company’s image. It is not easy to make the perfect decision but calculating annualised
equivalent costs for these types of decisions will help companies to compare apples with pears.
Other concepts to consider:
• NPV considers the time value of money, which means that a unit of currency received in
the future is worth less than the same unit of currency received today due to factors like
inflation and the potential to earn a return on investment (Fernando, 2023). In the context
of a project, NPV calculates the difference between the present value of expected cash
inflows (revenues) and the present value of expected cash outflows (costs). If the NPV is
positive, it indicates that the project is expected to generate more value than it costs and is
thus considered a good investment (Fernando, 2023).
Perpetuity refers to a series of cash flows that continue indefinitely. An example of a

perpetuity might be a bond that pays a fixed amount of interest every year forever.
Calculating the NPV of a perpetuity involves discounting these infinite cash flows back to
their present value (Fernando, 2023). In certain scenarios, the NPV to perpetuity is used to
simplify the valuation of projects or investments that have a long-lasting impact, where it is
assumed that cash flows continue indefinitely.
• The profitability index (PI), also known as the benefit-cost ratio, is a financial metric used to
assess the attractiveness of an investment or project. It is calculated by dividing the present
value of expected future cash inflows by the present value of expected future cash outflows
(CFI, 2023). This index helps decision-makers compare different projects with varying cash
flow patterns and initial investment amounts. A PI greater than 1 indicates that the project
is expected to generate more value than it costs, and the higher the PI, the more attractive
the investment (CFI, 2023).
In business and investment scenarios, different projects might require varying levels of
initial investment. When comparing projects using traditional financial metrics like NPV or
IRR (Internal Rate of Return), it might be challenging to directly compare projects with
unequal initial investments (CFI, 2023). This is because these metrics focus on absolute
values, which can lead to incorrect conclusions when comparing projects of different sizes
but this is considered using the profitability index methodology comes to the rescue in this
situation.
By considering the ratio of the present value of cash inflows to the present value of cash
outflows, the profitability index normalises the comparison across projects of different sizes.
This allows decision-makers to better assess which project provides the highest return
relative to its cost, even when initial investments vary (CFI, 2023).

1. Explain why management should use the profitability index (PI) method to determine which projects can be
undertaken when there is a shortage of investment capital.
2. Discuss the limitations of the PI method.
3. Identify examples of competing projects (eg mutually exclusive projects) in your workplace. Outline the factors that
should be considered when quantifying the costs of each. Discuss the nonquantifiable risks and how you would
account for these.
2.5.3 Key Points
• When management cannot carry out all potentially profitable projects due to financial
constraints, they use a technique called capital rationing to determine which projects should
take precedence.
• For capital rationing, management uses the profitability index (PI) (or cost-benefit index)
method to decide which projects can be undertaken when there is a shortage of investment
capital.
• With mutually exclusive projects only one project can be chosen, for example, either project
A or project B must be selected.
• With the phenomenal surge in global outsourcing over the past decade, the make-or-buy
decision is one that managers have to grapple with frequently.

2.6 DIVIDEND POLICY
Learning outcome • Explain dividend terminology and policy decisions.
• South African Revenue Service. (2021). Comprehensive Guide to Dividends Tax (Issue 4).
Recommended
https://www.sars.gov.za/wp-content/uploads/Ops/Guides/LAPD-IT-G19-Comprehensive-
article
Guide-to-Dividends-Tax.pdf (accessed 10 August 2023).
Since dividends amount to large cash outlays and signal different things to their shareholders, this
entire section is devoted to dividend policy and associated topics. As you will see from the
Section overview
discussions, at the heart of all dividend policies lies the question: “Should the firm pay out money
to its shareholders, or should the firm keep that money and invest it for its shareholders?”
2.6.1 Dividend Tax
Depending on the country in which your company operates, different tax laws pertaining to dividends
apply. The following excerpt applies to South Africa (currently aligning with international norms):
“In 2007 the minister of finance announced that secondary tax on companies (STC) would be
replaced by dividends tax. On 20 December 2011 dividends tax legislation was finalised and the
first phase of dividends tax was implemented on 1 April 2012. The main objectives of the change
are to align South Africa with international norms where the recipient of the dividend, not the
company paying it, is liable for the tax relating to the dividend; and to make South Africa a more
attractive international investment destination by eliminating the perception of a higher corporate
tax rate coupled with lower accounting profits.
“In simple terms, dividends tax is a tax imposed on shareholders at a rate of 15% on receipt of
dividends, whereas STC is a tax imposed on companies (at a rate of 10%) on the declaration of
dividends. Dividends tax is categorised as a withholding tax, as the tax is withheld and paid to
SARS by the company paying the dividend or by a regulated intermediary (ie a withholding agent
interposed between the company paying the dividend and the beneficial owner), and not the
person liable for the tax, ie the beneficial owner of the dividend.”
(SARS, 2013)
The starting point for your studies must be an investigation into the tax implications for dividends,
both from the company and the shareholder’s perspectives as they apply to the country in which the

company operates. While some countries are aligning to international best practice, others may still
apply different principles.
Dividend withholding tax (DWT) is a tax on dividends received by a shareholder and is called a
withholding tax because the entity paying the dividend must subtract the tax from the dividend and
withhold the tax before paying the net dividend to the shareholder. In South Africa, DWT replaced
secondary tax on companies (STC), which bring South Africa in line with the tax regimes of other
countries that apply DWT. This is primarily in order to encourage investment into the country
(GrayIssue, 2013; SARS, 2013).
Non-resident investors may be eligible for relief from double tax on their dividends in terms of the
double taxation agreement if the dividend is also subject to tax in the foreign country.
Read more on SARS and SA Tax here:
• South African Revenue Service. (2021). Comprehensive Guide to Dividends Tax (Issue 4).
https://www.sars.gov.za/wp-content/uploads/Ops/Guides/LAPD-IT-G19-Comprehensive-
Guide-to-Dividends-Tax.pdf (accessed 10 August 2023).
2.6.2 Types of Dividends
In this section we consider:
• Cash dividends;
• Scrip dividend (or bonus dividend);
• Share split (stock split); and
• Consolidations.
Terminology differs from country to country, for example in the United Kingdom a stock split is
referred to as a “scrip issue”, “bonus issue”, “capitalisation issue”, or “free issue”, (Investopedia,
2013g). However, in general the following terms apply:
Cash dividend
This is the most common type of dividend. Many (but not all) listed companies pay regular cash
dividends. For example, in the United States this may be every quarter whereas in South Africa this
might occur only annually.
Occasionally a company might pay an extra dividend, which may or may not be repeated in the
future. When a dividend is referred to as a special dividend, this indicates that it is a once-off payment
that will not be repeated in the future (Firer et al, 2008, p.544).

Scrip dividend
A scrip dividend is a dividend payment made in the form of additional shares, rather than cash (no
cash flow implications for the company). This occurs when the company’s liquid cash is in short
supply.
Scrip dividends are generally in the form of fractions paid per existing share (eg a company issues
a stock dividend of 0.05 shares for each single share held) (Investopedia, 2013f), or as part of a
scrip dividend programme as shown in the example below (Royal Dutch Shell plc).
“ When a firm issues scrip dividends, it increases the number of shares in issue, and each
shareholder’s shares increase in proportion to the shares they already hold. But since there are
more shares in issue, each share is worth less.
Scrip dividend programmes may, however, offer some tax advantages and dealing costs as shown
in the example below:
Royal Dutch Shell plc scrip dividend programme
Royal Dutch Shell (RDS) provides shareholders with a choice to receive dividends in cash or in
shares via a scrip dividend programme. Under the programme shareholders can increase their
shareholding in RDS by choosing to receive new shares instead of cash dividends if declared by
RDS.
Joining the programme may offer a tax advantage in some countries compared with receiving
cash dividends. In particular, dividends paid out as shares will not be subject to Dutch dividend
withholding tax (currently 15 per cent) and will not generally be taxed on receipt by a UK
shareholder or a Dutch corporate shareholder.
Shareholders who elect to join the programme will increase the number of shares held in RDS
without having to buy existing shares in the market, thereby avoiding associated dealing costs.
(Shell, 2012)
Share split (or stock split)
A share split occurs when a company divides existing shares in issue into two or more new shares.
Note that although the number of shares outstanding increases by a particular multiple, the total
money value of the shares remains the same as before the split (no value has been added by the
split) (Investopedia, 2013g). For example, in a two-for-one split, each share is worth half as much
after the split as it was before.

Eleventh Split in Stock’s 92-Year History
Atlanta, April 25, 2012 – The board of directors of Coca-Cola Company today voted to
recommend a two-for-one stock split to shareowners. The split would be the 11th in the stock’s
92-year history and the first in 16 years. “Our recommended two-for-one stock split reflects the
board of directors’ continued confidence in the long-term growth and financial performance of our
Company,” said Muhtar Kent, chairman and CEO of the Coca-Cola Company.
The shareowners of the Coca-Cola Company approved the two-for-one stock split on 10 July
2012 taking the number of shares in issue from 5.6-billion to 11.2-billion.
(Coca-Cola Company, 2012)
Reasons for scrip dividends and share splits
As we can see from the Shell example, there are potential tax and transaction cost benefits for
shareholders and cash-flow benefits for companies when scrip dividends are paid.
A share split may be a signal that a company expects to achieve high growth in the future, as we
saw in the Coca-Cola example. Another reason for a share split is to improve the liquidity of a share
if the share price is considered too high (too high a share price may discourage trading).

Task – Mini Case Study
Read the following case study and answer the questions that follow:
Google splits its stock
Stock splits and stock dividends are empty gestures from an intrinsic value standpoint because they change none of
the fundamentals of a company. The value of a business rests on its capacity to generate high returns (and cash
flows) from existing investments, its potential for value creating growth and the risk in its operations. Splitting your
stock (or its milder version, stock dividends) change the number of units in the company without affecting value.
Thus, in a two for one stock split, you, as a stockholder, will end up with twice the number of shares, each trading at
half the intrinsic value per share that they used to.
Google started with an impressive earnings report (earnings growth of 60% and revenue growth of 24%) and ended
with an announcement that they would be splitting their stock, with a twist.
There are two areas where stock splits or dividends can affect prices, either positively or negatively. (A) By altering
the price level, a stock split can affect trading dynamics and costs, and alter your stockholder composition. The “splits
are good” argument goes as follows: when a stock trades at a high price (say $800/share), small investors cannot
trade the stock easily and your investor base becomes increasingly institutional. By splitting the stock (say ten for
one), you reduce the price per share to $80/share and allow more individuals to buy the stock, thus expanding your
stockholder base and perhaps increasing trading volume and liquidity. The “splits are bad” argument is based upon
transactions costs, with the bid-ask spread incorporated in these costs. At lower stock price levels, the total
transactions costs may increase as a percent of the price. The effect has been examined extensively and there is
some evidence, albeit contested, that the net effect of splits on liquidity is small but positive.
The Google split: since the split is a two for one split at a $650 stock price, there is not much ammunition for either
side of the price level argument. At $325/share, Google will remain too expensive for some retail investors and the
transactions costs and trading volume are unlikely to change much. As one of the largest market cap companies in
the market, I don't think liquidity is the biggest problem facing Google stockholders.
(B) Perceptions: A stock split may change investor perceptions about future growth potential in both good and bad
ways. The “splits are good” school argues that only companies that feel confident about future earnings growth will
split their shares, and that stock splits are therefore good news. The “splits are bad” school counters that splits are
empty gestures (and costless to imitate) and that companies resort to these distractions only because they have run
out of tangible ways of showing growth or value added.
The Google split: I would find it odd that a company that just reported good growth in earnings and dividends would
use a stock split as a signal. In fact, I am looking forward to seeing the full filing. Perhaps there is bad news hidden
behind the healthy growth that Google does not want me to pay attention to. Or Google is looking down the road at
the oncoming competition (from Facebook and its social media allies) and does not see good things happening. Or
maybe a split is sometimes just a split (with no information about the future)...

The twist in this stock split, ie that the shares that will be created in the split will have no voting rights, is the more
intriguing part of the story. In talking about the rationale for the split, here is what Larry Page said: “We have
protected Google from outside pressures and the temptation to sacrifice future opportunities to meet short-term
demands”. Talk about chutzpah! What outside pressure? And to do what? And what temptation is Page alluding to?
Brin and Page think that you (as stockholders) are too immature to know what’s good for you in the long term, and
they want to make these decisions for you. I think it is absurd to make the argument that Google would somehow
have been stymied in its long-term decision-making, if it did not have the shareholder structure that it has now.
I will wager that there is not a single decision that Google has made over the last decade that they would not have
been able to make with a more democratic share voting structure (one share, one vote). The difference is that they
would have had to explain these decisions more fully, which is a healthy thing for any management in a publicly
traded company to do. In fact, what the stock split signals (to me) is that Google is planning more controversial (and
debatable) big decisions in the future and they do not want to either explain these decisions or put them up for a fair
vote.
Here is my response to the Googlers – price it in. The logical response to the loss of control is to price it in, effectively
discounting the price you pay for low-vote or no-vote shares, relative to full-vote shares. Conceptually, it is not difficult
to do. You have to build in the expectation and likelihood that managers will misbehave in the future, and that you will
not be able to stop them. In practice, though, investors often value low-vote shares based upon recent management
performance/behaviour, paying too high a price when managers are behaving and performing well and pushing down
the price too low, after managers disappoint them.”
(Adapted from Damodaran, 2012)
Questions:
1. What have you learnt from the case study?

2. In your opinion, is there merit in dividend policy? Does dividend policy matter?
3. Do you agree with the author’s response – “price it in”? Why, or why not?
Consolidations
Share consolidations are used to make shares and dividends more attractive to institutional investors
that may consider penny shares too volatile. For example, a company with 25 pence shares may
implement a one-for-four consolidation – the par value will rise to 100 pence per share. This would
have the effect of reducing shares in issue to one quarter of the previous level. The share price,
earnings per share and dividends per share would rise by a factor of four, but the price-earnings
ratio and yield would remain unchanged (Timetotrade, 2013).
Declaration of dividends
The board of directors make the decision to pay a dividend. Once the dividend has been declared it
becomes a debt of the firm and cannot easily be rescinded. The declaration is stated in a number of
ways (Firer, Ross, Westerfield and Jordan, 2008, p.545), for example:
• In monetary terms (eg in cents per share);

• As a percentage of the market price (the dividend yield); and
• As a percentage of net profits or earnings per share (the dividend payout).

The timing of dividend payments affects the share price. Consider the chronological process outlined
in Figure 9:
FIGURE 9: DIVIDEND PAYOUT CHRONOLOGY
Declaration date: Directors pass a resolution to pay a

dividend to all registered shareholders.
Ex-dividend date: To make sure that dividend payments go

to the right people an ex-dividend date is established. This
date is the last date to register, ie if you buy the share before
this date then you are entitled to the dividend ("with dividend"
or "cum dividend"); if you buy the share after this date then
the previous owner will get the dividend.
Record date or date of payment: The dividend cheques are

mailed or deposited electronically on the date of payment to
shareholders listed in the company share register at the close
of business on the record date.
(Adapted from Firer et al, 2008, p.545)
In general, we expect that the price of a share will go down by about the dividend amount when
the share goes ex-dividend.
2.6.3 Dividend Policy
There are many factors that affect dividend policy from both the company’s and shareholders’
perspectives, notwithstanding that companies operate in different industries, which require different
strategies. The mini case study below (focusing on the technology sector) highlights some of these
considerations:
Google CFO Pichette Says, ‘We Need Cash for Acquisitions’
Shareholders in Apple, Google and Microsoft are putting pressure on the technology giants to
pay dividends. But piling up cash is considered necessary to remain flexible. If the opportunity for
an acquisition arises, each of the big players wants to be ready to take it. Otherwise, they risk
falling behind. Cash is king – which is why large US technology firms are currently doing
everything in their power to defend their king against the invaders that are their shareholders.

American technology giants are currently facing heavy opposition from their shareholders. The
most prominent case has been that of Apple, which has amassed $143-billion in cash reserves.
Apple’s rivals have the same policy: Microsoft currently holds $68-billion in cash, to which it adds
approximately $2-billion each year. Google has piled up $48-billion in cash and does not intend to
pay any dividends in the foreseeable future.
Google has the luxury of not receiving as much pressure from its shareholders as Apple, partly
because its stock has delivered a good return for long-term investors (the share currently trades
at $800 – more than nine times the price in 2004 of $85).
Google purchased Motorola Mobility in May 2012 for cash ($12.5-billion). The primary goal of the
acquisition was to gain control of Motorola’s 17,000 patents (they were needed to protect the
Android ecosystem which rival Apple has challenged in an open patent war).
This shows how crucial cash is in the highly competitive mobile and online market. Given that all
the major players hoard cash, those who don’t risk falling behind – at least this is what Pichette
wants to make his shareholders believe.
(Backhaus, 2013)
Dividend Questions
1. David Einstein, a fund manager, brought Apple to court in New York demanding a dividend of 4%. In the end he
was able to get a temporary restraining order against the dividend decision taken during the shareholders’
meeting in early March 2013. Argue for and against David Einstein’s actions – from the perspective of the
shareholder and the company.
2. Given our discussions thus far, reflect on the following question: “Should the firm pay out money to its shareholders,
or should the firm keep that money and invest it for its shareholders?
Companies can do four things with their cash:
• Save it (cash and equivalents, pay down debt);

• Spend it (acquisitions);
• Reinvest it (new projects, expansion projects); and
• Distribute it (dividends and buybacks).
With a finite amount of cash flow each year, companies must decide on how much cash must be
apportioned to the above. Firstly, consider that decision-makers must consider the company’s stage
in the growth cycle (from new to mature), and then its financial health (see example below), the tax
environment, and what shareholders want.

Company XYZ, generating high returns on equity (eg 20%-plus), reinvests all its cash in projects
that continue to produce returns well above the cost of equity.
Investors want this too (in lieu of a dividend) since it maximises shareholder value.
There are cases, however, and more often than not with companies in the mature stage, that do not
have enough value-enhancing projects for all of the cash they generate. The board must consider
alternative uses for the extra cash flow.
If the board expects the extra cash flow to be a one-time event, they may declare a special one-time
dividend or buyback shares. On the other hand, if they expect there will be extra cash flow year after
year, they may establish a regular dividend programme where a portion of the company’s cash flow
is returned to shareholders periodically throughout the year (The Analyst, 2012).
While this appears relatively straightforward, as we have seen with Google and Apple, peer
behaviour and shareholder preference can complicate the process. The three main theories on
dividends help us to understand why shareholders have varying interests in dividends (The Analyst,
2012):
• Dividend irrelevance;
• Tax aversion; and
• Bird-in-hand.
Dividend irrelevance
This theory (based on research by Miller and Modigliani) says that in a world of no taxes, no
investment costs, rational investor behaviour, and infinitely divisible shares, dividends should be
irrelevant to shareholders. If an investor wants cash, the theory maintains that the investor can simply
sell a portion of shares and create their own dividend.
While the theory includes many assumptions, many large investors still subscribe to it. However, for
the smaller investor, trading costs make this a less attractive theory.
Assuming that the investor wants to keep trading costs below 1% and that he or she pays £10
commissions, he or she would need to sell at least £1,000 worth of his or her position each time
to create his or her own dividend and keep costs in check.
Tax aversion
As with trading costs, taxes reduce the realised return (depending on the tax regimes that apply).
Therefore, investors with high tax rates will prefer to own shares that pay lower dividends or none at
all.

Bird-in-hand
This theory (developed by Gordon and Lintner) like the proverb “a bird in the hand is worth two in
the bush”, suggests that investors should prefer to have cash in hand today rather than uncertain
capital gains in the future. These investors place a higher value on dividends than on future capital
appreciation.
From the above, we can see that shareholders view dividend policy differently. Further, a company’s
dividend policy provides insights into its relationship with shareholders, and conversely,
shareholders use signals from corporate dividend policy to determine corporate strategy.
Refer to your recommended textbook (Stoltz et al, 2007, p.247) and consider additional theories
about how shareholders want the firm to handle dividends.
2.6.4 An Alternative to Dividends - Buybacks
A share repurchase by the company is beneficial to the shareholder because it causes earnings
per share to increase. This is because the share repurchase reduces the number of shares in
issue, but has no effect on total earnings, and therefore earnings per share increase.
When a company has spare cash that it cannot invest in new value-creating projects, it can
repurchase its own shares, thus making an investment in its future returns (the benefits from the
repurchase will exceed the returns it would have earned on the spare cash) (Firer et al, 2008,
p.561 & 562).
If a company’s stock is suffering from low financial ratios, buying back stock can give some
of the ratios a temporary boost. Key ratios such as the earnings per share (EPS) and price:
earnings ratio (P: E) look better because they are based on the number of outstanding
shares.
Another reason companies buy back stock is to cover large employee stock option programmes.
A further reason to buy back shares is to protect the company from unfriendly takeovers by other
companies (by gathering outstanding shares off the open market the company makes it more
difficult for a raider to take control).

Task – Mini Case Study
Read the following mini case study and then answer the question that follows.
Are buybacks really a bargain?
On the 20th of August 2008, ICT resourcing group Paracon Holdings announced the repurchase of 36.3-million of its
shares from black economic empowerment (BEE) shareholder WDB Investment Holdings. WDB had originally
purchased 99-million Paracon shares in 2003 at 48 cents, a 25.1% stake in the firm. Paracon repurchased the 36.3-
million shares at R1.35 per share for a total of R49-million, which WDB could then use to settle its R49-million debt
with the Industrial Development Corporation. WDB would then own the remaining 60-million shares unencumbered
and could receive Paracon’s dividends, which previously would have gone to service the debt.
For Paragon the transaction made sense on a number of fronts. Firstly, Paracon would acquire the shares at a
discount to their market value, making it a positive NPV transaction. Secondly, it enabled WDB to settle its debt
without having to sell its shares on the open market, which would have diluted Paragon’s BEE shareholding. By
buying back the shares and cancelling them, Paragon reduced the total number of shares in issue, lessening the
reduction in its BEE shareholding. Thirdly, Paracon saw the repurchase as an effective use of its existing cash
resources.
In addition to simply returning cash to shareholders, companies also typically say they do so because they believe
their share is undervalued. Yet new research shows that companies often use creative financial reporting to push
earnings downward before buybacks, making the share seem undervalued and causing its price to bounce higher
after the buyback. That pleases investors, who then amplify the effect by pushing the price even higher.
“Managers who are acting opportunistically can use their reporting discretion to reduce the repurchase price by
temporarily deflating earnings,” argue Guojin Gong, Henock Louis and Amy Sun at Penn State University’s Smeal
College of Business. Observing data from 1,720 companies, the authors say companies can easily create an
apparent slump by speeding up or slowing down expense recognition, changing inventory accounting, or revising
estimates of bad debt – all classic methods of making the numbers look worse, without actually breaking accounting
rules. The penalty for being caught deliberately managing earnings in advance of a buyback could be severe. With
the backdating scandals that popped up regularly in the early 2000s, executives would no doubt be wary of deflating
earnings just to get a boost from a buyback. Still, that’s what Louis believes some are doing. “I don’t think what
they’re doing is illegal,” he says. “But it’s misleading their investors.”
Question:
Do you agree that corporate managers would manipulate their share’s value prior to a buyback, or do you believe that
corporations are more likely to initiate a buyback to enhance shareholder value?
(Gitman, 2010)

Work through the following questions:
The Stanger Steel Company has earnings available for ordinary shareholders of R2-million and has 500,000 issued
ordinary shares at R60 per share.
The firm is currently contemplating the payment of R2 per share in cash dividends.
1. Calculate the firm’s current earnings per share (EPS).

2. Calculate the firm’s current price: earnings (P: E) ratio.
3. If the firm can repurchase the shares at R62 per share, how many shares can be purchased in lieu of making the
proposed cash dividend payment?
4. How much will the earnings per share be after the proposed repurchase?
5. If the share sells at the old P: E ratio, what will the market price be after the repurchase?
6. Compare and contrast the earnings per share before and after the proposed repurchase.
7. Compare and contrast the shareholders’ position under the dividend and repurchase alternatives.
(Gitman, 2010)
2.6.5 Key Points
• Depending on the country in which your company operates, different tax laws pertaining to
dividends apply.
• Various types of dividends exist, and for the purpose of this course, the following types are
important:
o Cash dividend;
o Scrip dividend (or bonus dividend);
o Share split (stock split); and
o Consolidations.
• The board of directors make the decision to pay a dividend, and once the dividend has been
declared, it becomes a debt of the firm and cannot easily be rescinded.
• Companies operate in different industries, which require different dividend policy strategies.
• There are many theories on dividends to help us understand why shareholders have varying
interests in dividends.

2.7 ETHICS AS A SUCCESS AND FAILURE FACTOR RELATED TO
FINANCIAL MANAGEMENT
Learning outcome ● Understand ethical issues facing financial managers.
● Marx, J., de Swardt, C., Beaumont Smith, M., & Erasmus, P. (2017). Financial
Management in Southern Africa (5th ed.). Pearson Education South Africa.
Recommended ● Stoltz, A., Viljoen, M., Gool, S., Meyer, C., & Cronje, R. (2007). Financial Management:
readings Fresh Perspectives (1st ed.). Pearson Education South Africa.
● Titman, S., Keown, A.J., & Martin, J. D. (2020). Financial management: Principles and
● Eller College. (2010). Aaron Beam on ethics in corporate finance [Video]. YouTube.
Recommended
multimedia ● The Institute of Directors in South Africa (IoDSA). (2016). The King Report IV.
https://www.adams.africa/wp-content/uploads/2016/11/King-IV-Report.pdf (accessed 10
August 2023).
Financial managers act as agents for the company and its shareholders. They must prepare
reports, oversee accounting functions, plan for and monitor investments, oversee cash
management functions, be involved with banks and other financial institutions, etc, and hence
Section overview are required to uphold the highest ethical standards. Financial managers must be alert to the
myriad of unethical practices and should strive for unimpeachable integrity. For this reason,
your studies would be incomplete without a section dedicated to the ethical considerations
financial managers must make.
2.7.1 Overview of Corporate Governance
Corporate governance is the system that directs and controls companies. It is made up of both
regulatory and market mechanisms, for example:
• The Sarbanes-Oxley Act of 2002 (US, 2002) – an attempt to legislate several of the principles
contained in the following two documents:
o The Cadbury Report (UK, 1992); and
o Principles of Corporate Governance (OECD, 1998 and 2004).
• The Bribery Act and the Companies Act in the United Kingdom;
• The Foreign Corrupt Practices Act (FCPA) in the United States; and
• The King IV Report on Corporate Governance in South Africa.
Laws are enforceable. However, compliance with principles and codes found in different countries
and issued by stock exchanges, corporations, institutional investors or associations of directors and

managers with the support of governments and international organisations, are not mandated by law
(although codes linked to stock-exchange listing requirements may have a coercive effect) (OECD,
2015).
Task – Research
1. Using the internet, find out about the corporate governance regulatory mechanisms in the country (or countries)
in which you work. Use a mind map (or table format) to capture key elements.
2. Access two stock exchanges and search their websites using “corporate governance” as the search criterion. Note
the key points, for example, the Johannesburg Stock Exchange must apply rigour in implementing governance
procedures to maintain the unquestionable separation of its regulatory role and its role as a listed entity.
2.7.2 Bribery and Corruption in Business
Bribery (as defined by the Bribery Act, UK) is described as offering an advantage (financial or non-
financial) intending to persuade or reward another person to perform their duties improperly. The
Organisation for Economic Co-operation and Development (OECD) has a working group on bribery.
Since its inception in 1999, many individuals and entities have been sanctioned in criminal
proceedings for bribery. Further, the working group conducts rigorous country evaluations, from
which recommendations for effectively investigating and prosecuting bribery flow (OECD, 2011).
The importance of fighting bribery and corruption has been recognised as a top global priority by the
leaders of the Group of 20 (G20) states. The success of the working group reveals that inclusive and
effective global governance is possible:
1. Bribery distorts markets, raises the cost of doing business, and is non-competitive.
2. In 2007 South Africa became the 37th country worldwide (and the first African nation) to sign
the OECD Anti-bribery Convention, which seeks to combat the use of bribery in international
business transactions.
(Gitman, 2010)
The Bribery Act (UK) is considered the gold standard for prosecuting corruption.
“The Bribery Act (UK) criminalises the making of all bribes, worldwide, no matter how small. More
importantly, even if a company has a policy of allowing ‘facilitation payments’ (see definitions
below) the courts may not view its policies as constituting ‘adequate procedures’ under Section 6
of the Companies Act in the UK. This would be the case even if it was a US-based entity trading
in the UK and therefore thought itself able to make facilitation payments with impunity” (Lawler,
2013).

“Failure of a commercial organisation to take necessary steps to prevent bribery committed on its
behalf is also now criminal. Penalties are severe, including up to 10 years of imprisonment, fines
of unlimited amount, the potential for property confiscation and disqualification of directors of
involved organizations. Unlike the FCPA, the UK law does not allow ‘facilitation payments’ made
in connection with routine official actions” (Verschoor, 2011.)
Facilitation payments, which differ from country to country, are defined as:
“Payments that are typically demanded by low-level and low-income officials in exchange for
providing services to which one is legally entitled without such payments.”
(Business Anti-Corruption Portal, 2013)
“A form of bribery to expedite or facilitate the performance by a public official of a routine

government action.”
(Business Anti-Corruption Portal, 2013)
A distinction is generally made between facilitation payments and outright bribery and corruption. In
some countries it may be considered normal to provide small unofficial payments under certain
circumstances, although this practice is illegal in most countries. Six principles from the Bribery Act
(UK) provide a useful framework (shown in Table 5) to prevent and detect corruption.
TABLE 5: BEST PRACTICES FOR PREVENTING AND DETECTING CORRUPTION
Proportionate Procedures should be proportionate to the bribery risks the company faces and to the nature,
procedures scale, and complexity of the commercial organisation’s activities (locally and internationally).
These should be clear, practical, accessible, and effectively implemented and enforced.
Top-level Senior management should foster a culture in which bribery is never acceptable. Achievement of
commitment objectives should never be expected to allow corrupt behaviour.
Risk Make periodic informed and documented assessments of the potential internal and external risks
assessment of bribery. The risk-management approach should be tailor-made to the organisation’s needs.
Due diligence Mitigate identified bribery risks by exercising due diligence (reasonable steps taken by a person in
order to satisfy a legal requirement). Operations in sensitive areas require greater vigilance.
Communication Ensure, through internal and external communications, that your organisation’s bribery prevention
(including policies and procedures are embedded and understood throughout the organisation. Employees
training) at all levels should regularly assert their anti-bribery compliance.
Monitoring and Monitor and review bribery prevention practices and make improvements where necessary.
review Maintenance of anti-bribery actions will help mitigate the risk of “failure to prevent bribery”
provisions.
(Verschoor, 2011)

Watch this interview with fraudster Aaron Beam, founding chief financial officer of Health
South:
• Eller College. (2010). Aaron Beam on ethics in corporate finance [Video]. YouTube.
1. Reflect on the case of Aaron Beam [link to video clip given above]. What is the potential for a similar type of fraud
in your organisation (or one with which you are familiar)?
2. Identify the regulatory and market mechanisms that direct and control bribery and corruption as they relate to
financial management in your organisation.
3. Refer to the glossary of terms at the end of this study guide. Based on the regulatory and market mechanisms
applicable to your organisation, and the defined terms, assess the potential risks to your organisation relating to
bribery and corruption.
4. Using the six-step frameworks given above, outline recommendations to manage bribery and corruption better in
your organisation.
2.7.3 The King Report IV: A South African Perspective
The King Report IV was released in November 2016 replacing the previous report (King III)(IoDSA,
2016). This report outlines principles and recommended practices that organisations can adopt to
enhance their governance, ethical conduct, sustainability, and accountability (IoDSA, 2016). It places
emphasis on transparency, stakeholder engagement, integrated thinking and the responsible use of
business and environmental resources(IoDSA, 2016).
Key aspects of King IV include:
• Ethics and Corporate Citizenship

• Stakeholder Engagement
• Integrated Reporting
• Risk Management and Sustainability
• Leadership and Corporate Culture
• Remuneration and Accountability
• Information and Technology Governance

• Internal Audit and Assurance
(IoDSA, 2016).
For more information access a copy of the King Report IV here:

• The Institute of Directors in South Africa (IoDSA). (2016). The King Report IV.
https://www.adams.africa/wp-content/uploads/2016/11/King-IV-Report.pdf (accessed 10
August 2023).
2.7.4 Key Points
• Corporate governance is the system that directs and controls companies towards
accountability and transparency.
• The importance of fighting bribery and corruption has been recognised as a top global
priority by the G20 leaders.
• The Bribery Act (UK) is considered the gold standard for prosecuting corruption.
• The King IV report represents a significant milestone in the advancement of corporate
governance in South Africa.

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4. APPENDIX
Section 2.3
Question: Calculate the value of the debenture given below (interest is paid annually).
Debenture Par value Coupon rate Years to maturity Required return
A R200 8% 12 12%
Solution:
Using the formula: 𝑉0 = (𝐼 × 𝑃𝑉𝐼𝐹𝐴$,# ) + (𝑀 × 𝑃𝑉𝐼𝐹$,# )
A: Vd = (R200 × 0.08 x 6.1944) + (R200 × 0.2567)

= R99.11 + R51.34
= R150.45
Remember: PVIFA (present value interest rate factor for one rand annuity discounted at i percent
for n periods) table is on page 98 of your textbook; and PVIF (present value interest rate factors for
one rand compounded at i percent for n periods) table is on page 94 of your textbook.
So if the investor feels that 12% is an appropriate required return (considering the risk level) he or
she would be prepared to pay R150.45 for this debenture and keep it until maturity. He or she will
receive the desired return of 12% at R150.45, even though the coupon rate is 8%.
Question: XYZ Ltd issued 7.5% preference shares with a par value of R10. If the cost of
preference shares is 6%, what is the value of the preference shares?
Solution: Dividend = 0.075 × R10 = R0.75

Value of preference shares = D/kp
= R0.75/0.06
= R12.50
Question: ABC Ltd pays a preference dividend of R5 per share. If the required rate of return of
17%, how much should you pay for the shares?
Solution: Value of preference shares = D/kp

= R5.00/0.17
= R29.41

Question: Assume you are analysing a share that pays $0.50 in dividends per quarter (or $2 per
year). Your research shows that the dividend has increased by an average of 8% per year over
several decades, but the growth is slowing down. You estimate that the dividend will continue to
grow by an average of 5% per year going forward. Using the Gordon growth model, calculate a fair
price for the stock, given that you want an 11% return on your investment.
Solution: The formula shows that it would be fair to trade $35 in present value for the sum value of
all future dividends.
𝐷!
𝑃5 =
𝑘6 − 𝑔
2.10
= = $35
0.11 − 0.05
Question: Whirlpool Executives is considering a cash purchase of Ballyhoo shares. During the year
just completed, Ballyhoo earned R4.25 per share and paid cash dividends of R2.55 per share.
Ballyhoo’s earnings and dividends are expected to grow at 25% per year for the next three years,
after which they are expected to grow at 10% per year to infinity.
Determine the maximum price per share that Whirlpool should pay for Ballyhoo if the investor has a
required return of 15% on investments with risk characteristics similar to those of Ballyhoo.
Solution: The calculations are as follows:
Do = 2.55 (given)
D1 = D0 × 1.25 = 3.19 PV (D1) = D1 / (1 + ks) = R2.77 (ks = 0.15)

D2 = D1 × 1.25 = 3.98 PV (D2) = D2 / (1 + ks)2 = R3.01
D3 = D2 × 1.25 = 4.98 PV (D3) = D3 / (1 + ks)3 = R3.27
D4 = D3 × 1.10 = 5.48
P3 = D4 / (ks – g) = R5.48 / (0.15-0.10) = R5.48 / 0.05 = R109.60
PV of shares at end of Year 3 = P3 × (PVIF15%,3) [or P3 / (1 + ks)3]

= R109.60 × 0.6575
= R72.06
Value of the share = PV (D1) + PV (D2) + PV (D3) + PV (P3)

= R2.77 + R3.01 + R3.27 + R72.06
= R81.11
Note: the factor 0.6575 (0.658) can be read from the tables on page 94 of your textbook (Stoltz et
al, 2007).

Question: An investment consortium issues a 15-year bond to finance a safety structure to protect
Chapman’s Peak Drive from rockfalls. It offers a coupon rate of 8% (units of R1,000) and a discount
of 2% to attract overseas investors. Calculate the before-tax cost of debt and the after-tax cost of
debt assuming their tax rate is 28% and flotation costs are 1.5%.
Solution: Based on the information given:
1. Bond unit of R1,000

2. Duration of 15 years
3. Discount rate of 2% (R20)
4. Flotation cost of 1.5% (R15)
5. Coupon rate of 8% (R80)
6. Tax rate of 28%
Therefore, total amount per unit available = R1,000 – R20 – R15 = R965.
On issue, the company only gains R965 and thereafter it has to pay R80 annually until maturity date
(after 15 years) at which point it must repay the investor the principal amount of R1,000. We can find
the before-tax cost of the bond by using our YTM formula:
12 45<
𝑖+f #
g
𝐴𝑝𝑝𝑟𝑜𝑥𝑖𝑚𝑎𝑡𝑒 𝑦𝑖𝑒𝑙𝑑 = 16 45<
f g
"
Where:
M = the par value
DB0 = the price of the bond (adjusted for expenses)
! 7772 89:
80 + f g
!:
𝐴𝑝𝑝𝑟𝑜𝑥𝑖𝑚𝑎𝑡𝑒 𝑦𝑖𝑒𝑙𝑑 = ! 7776 89:
f g
"
81.75
= = 8.38%
982.50
Therefore 8.38% is the pre-tax cost
Adjustment for tax: 𝑘' = 𝑘 0 (1 − 𝑇 )
𝑘' = 8.38(1 − 0.28)
= 6.03%
Therefore 6.03% is the after-tax cost.
Question: You are given the following information: rate of return on RSA150 stock is 6%; and the
market rate of return is 10%. Using the CAPM model calculate the cost of ordinary shares in ABC,
a local manufacturer with a beta coefficient of 1.75.
Solution:
𝑘6 = 𝑅; + 𝛽$𝑘< − 𝑅; *
𝑘6 = 0.06 + 1.75(0.10 − 0.06)
= 0.13 𝑜𝑟 13%
Question: Coffee Worldwide has the following capital structure:
• Common share capital: R300,000

• 7% preference shares: R100,000
• Long-term loan: R200,000
The cost of equity is 3% and Coffee Worldwide pays 12% on the bank loan. It pays 35% income tax.
Determine its weighted average cost of capital (WACC).
Solution:
Type of capital Amount Weighting Weighted cost WACC
Equity R300,000 50% 0.5 × 0.03 0.015
Preference shares
R100,000 16.7% 0.167 × 0.07 0.012
Long-term debt R200,000 33.3% 0.333 × 0.12 × (1 – 0.35) 0.026
Total capital R600,000 100% WACC 0.053
(Remember to include tax factor in long-term debt)
Therefore the WACC is 5.3%.
Question: One of your project managers approaches you with the following question: “Why don’t
we simply use the interest rate that we can earn on an investment to determine if my project is
worthwhile?” What response would you give him or her?
Guided response: Firstly, using borrowed money and paying interest enables the business to
reduce its tax liability. Therefore, the business will use the after-tax cost of debt financing which will
be less. Secondly, if the business is not financed by debt alone you have to take the equity financing
into account and the opportunity cost associated with it.
Question: Would a company in a country with a relatively high tax rate for companies mainly use
equity finance or mainly use debt finance? Explain.
Guided response: The higher the tax rate, the more advantageous it is to use more debt finance
than equity finance. This may be ascribed to the fact that interest may be deducted from earnings
before tax (hence it is a means of tax planning). The same cannot be done with dividends on shares.
Dividends do not enjoy the same advantage as interest from a tax point of view, although current tax
laws should always be checked for latest changes.

Section 2.5
Question: Study the table below and then answer the questions that follow.
Project Year 0 Year 1 Year 2 Year 3 Year 4 NPV when discounted at

($m) ($m) ($m) ($m) ($m) 10% ($m)
A -100 +20 +40 +60 +80 +50.96
B -150 -50 +100 +100 +140 +57.94
C -60 +20 +40 +40 - +21.29
D -100 +60 +60 +100 - +79.26
E -50 +20 +40 +60 +40 +73.64
Total 460 +283.09
F -100 +30 +30 +30 +30 -4.91
1. In a nonrationing situation, what is the total capital outlay required in Year 0 for all projects
with positive NPVs?
2. By how much would projects A to E raise shareholders’ wealth?
3. Assume that the company is limited to $300m in investment capital in Year 0. Which projects
can be selected given this constraint (assume all projects are divisible)?
4. With a limited investment capital of $300m in Year 0, by how much will shareholders’ wealth
increase?
Solution:
1. In a nonrationing situation, all the projects in the table above would be accepted, except for
project F, which has a negative NPV (-$4.91m). In order to undertake all projects with positive
NPVs the company would require a total of $460m in Year 0.
2. Projects A to E will raise shareholders’ wealth by $283.09m.
3. As shown below accept projects E, D, A, and one-third of B if constrained by investment
capital of $300m.
Project 𝑵𝑷𝑽 = Benefit-cost

𝟏+
𝒀𝒆𝒂𝒓 𝟎 𝑶𝒖𝒕𝒍𝒂𝒚 PI Ratio Ranking
A 1 + (50.96 / 100) = +1.51 3
B 1 + (57.94 / 150) = +1.39 4
C 1 + (21.29 / 60) = +1.35 5
D 1 + (79.26 / 100) = +1.79 2
E 1 + (73.64 / 50) = +2.47 1
F 1 + (-4.91 / 100) = -0.95 6
𝑃𝑉 𝑜𝑓 𝐹𝑢𝑡𝑢𝑟𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤𝑠 𝑁𝑃𝑉

𝑃𝐼 = 𝑜𝑟 1+
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 I𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Project Outlay ranking NPV ($m) Year 0 ($m)
E 1 73.64 50
D 2 79.26 100
A 3 50.96 100
B 4 19.31 (⅓ of 57.94) 50 (⅓ of 150)
Totals 223.17 300
4. With a limited investment capital of $300m in Year 0 shareholders’ wealth will increase by
$223.17
Total NPV = $73.64 + $79.26 + $50.96 + ⅓ ($57.94) = $223.17

Section 2.6
Questions: The Stanger Steel Company has earnings available for ordinary shareholders of R2m
and has 500,000 issued ordinary shares at R60 per share.
The firm is currently contemplating the payment of R2 per share in cash dividends.
1. Calculate the firm’s current earnings per share (EPS).

2. Calculate the firm’s current price/earnings (P/E) ratio.
3. If the firm can repurchase the shares at R62 per share, how many shares can be purchased
in lieu of making the proposed cash dividend payment?
4. How much will the EPS be after the proposed repurchase?
5. If the share sells at the old P/E ratio what will the market price be after the repurchase?
6. Compare and contrast the earnings per share before and after the proposed repurchase.
7. Compare and contrast the shareholders’ position under the dividend and repurchase
alternatives.
Solutions:
1. Earnings per share (EPS):
𝑅2,000,000 (𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒)

𝐸𝑃𝑆 = = 𝑅4 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
500,000 (𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒)
2. Price/earnings (P/E) ratio:
𝑅60 (𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒)

𝑃/𝐸 = = 15
𝑅4 (𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒)
3. Proposed dividends = 500,000 shares × R2 per share = R1,000,000
𝑅1,000,000
𝑆ℎ𝑎𝑟𝑒𝑠 𝑐𝑎𝑛 𝑏𝑒 𝑟𝑒𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑑 = = 16 129 𝑠ℎ𝑎𝑟𝑒𝑠
𝑅62
4. After the proposed repurchase:
Shares outstanding = 500,000 – 16,129 = 483,871
2,000,000
𝐸𝑃𝑆 = = 𝑅4.13 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
483,871

5. Market price = R4.13 per share × 15 = R61.95 per share.
6. The earnings per share (EPS) are higher after the repurchase because there are fewer
shares outstanding (483,871 shares versus 500,000 shares) to divide up the firm’s R2m of
available earnings.
7. In both cases, the shareholders would receive R2 per share – a R2 cash dividend in the
dividend case or an approximately R2 increase in the share price (R60 per share to R61.95
per share) in the repurchase case (note the difference of R0.05 per share difference is due
to rounding).
(Gitman, 2010:783)

5. GLOSSARY OF TERMS
Term Explanation
Abuse of functions Abuse of functions refers to a public employee or public office holder who is doing something
which is illegal or something that the official has no legal authority to do, in order to obtain
personal economic benefit or cause illegal damage to others. One sort of abuse of office is
the misuse of information. That is, if an official, in reliance on information that she or he has
acquired by virtue of her or his office, speculates on the basis of this information or acquires
a pecuniary interest in any property, transaction, or company which might be affected by
such action or information or helps another to do any of these actions.
Bribery To offer, promise or give any undue pecuniary or other advantage, whether directly or
through intermediaries, to a foreign public official, for that official or for a third party, in order
that the official act or refrain from acting in relation to the performance of official duties, in
order to obtain or retain business or other improper advantage.
Collusion Collusion is an agreement, usually secretive, which occurs between two or more persons to
limit open competition by deceiving, misleading, or defrauding others of their legal rights, or
to obtain an objective forbidden by law typically by defrauding or gaining an unfair
advantage. It can involve an agreement among companies to divide the market, set prices,
or limit production. It can involve wage fixing, kickbacks, or misrepresenting the
independence of the relationship between the colluding parties.
Embezzlement Embezzlement is the fraudulent appropriation of money or property by a person entrusted to
safeguard the assets in another's interests. A person entrusted with private or public
resources can commit embezzlement.
Extortion Extortion is the unlawful use of one's position or office to obtain money through coercion or
threats. One example would be when customs officials request undue “customs duties” from
importers as a condition to clear their goods.
Fraud Fraud is a criminal offence in most jurisdictions. It involves the use of deception, trickery and
breach of confidence to gain some unfair or dishonest advantage.
Gifts Gifts and hospitality may be corrupt, may be used to facilitate corruption, or may give the
appearance of corruption. Gifts may include cash or assets given as presents, and political or
charitable donations. Hospitality may include meals, hotels, flights, entertainment or sporting
events. Many companies cover the use of gifts in their codes of conduct.

6. VERSION CONTROL
Date of Publication: March, 2021

Publisher: Regenesys Management
Place of Publication: Sandton
Document Change History
Date Version Initials Description of Change

01 August 2023 1 KA SG revised, formatted according to RBS conventions and a new
assignment written for 2023.
08 August 2023 2 KA 2 requests made by BZ accounted for.
10 August 2023 2 ZKM Edited

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BACHELOR OF

Copyright © Regenesys, 2023

Various resources are recommended to help you complete this course.

These books are recommended for this course:

● Fernando, J. (2022). Working capital. https://www.investopedia.com/terms/w/workingcapital.asp (accessed 8

© Regenesys Business School 1

© Regenesys Business School 2

2.1 LEARNING OUTCOMES

On completing this course, you should be able to:

• Explain valuation terminology, concepts, and inputs;

© Regenesys Business School 3

Timeframe Minimum of 20 hours

• Understand various personal finance and investment concepts; and

Recommended • Fernando, J. (2022). Working capital.

2.2.1 Key concepts related to Financial Management

© Regenesys Business School 4

Cash Flow Management

© Regenesys Business School 5

• Fernando, J. (2022). Working capital.

© Regenesys Business School 6

© Regenesys Business School 7

Asset classes are formed by groups of securities that:

• Have similar financial characteristics;

The four main asset classes are:

• Cash and cash equivalents (money market instruments);

2.2.3 Asset Classes and Risk

Let us look at the risk attached to these four asset classes.

Cash and cash equivalents

© Regenesys Business School 8

TABLE 1: COMPARING A MONEY MARKET FUND AND A MONEY MARKET ACCOUNT

Fixed income (bonds)

© Regenesys Business School 9

There is a range of property investment options, including (Discovery Invest, 2015):

© Regenesys Business School 10

• You can build up a good retirement fund using residential property

© Regenesys Business School 11

INVESTING IN PROPERTY VERSUS INVESTING IN EQUITIES

• Large-capitalisation stocks (referred to as large-cap stocks) – large and established

© Regenesys Business School 12

• Defensive assets, ie primarily income-producing assets such as cash and fixed-income

© Regenesys Business School 13

1. Are you a risk-averse investor?

FIGURE 1: ASSET CLASS RANKING

© Regenesys Business School 14

Aggressive Versus Conservative Investor

• MoneyWorks4meVideos. (2013, November 8). Understanding Risk and Return tradeoff,

© Regenesys Business School 15

Types of investment risks

Interest rate risk

Social, political, or legislative risk

© Regenesys Business School 16

Types of stop losses

2.2.4 Asset Classes – Guidelines for Building the Right Investment

Equities for the long term

© Regenesys Business School 17

FIGURE 3: PERCENTAGE OF TIME MONEY IS LOST DURING VARIOUS HOLDING PERIODS

(Old Mutual Investment Group, 2015)

© Regenesys Business School 18

Inflation is the enemy