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A dividend is a payment made out of the firm’s earnings to its owners, in the
form of either cash or shares (stock).
The policy decision required applies to ordinary shares, as these are the ones
whose dividends are not defined and are determined by management.
Preference shares carry a fixed rate of dividend that has to be paid whenever
a dividend would have been declared.
Forms of dividend
There are primarily three forms of dividend, cash dividend, stock dividend and
dividend in kind.
Cash dividend This is the most common form of dividend. The declared
dividend is paid out as cash for example $30,00 per share for each share that
is outstanding.
30 May 2004
The following time line can be used to illustrate the sequence of specific dates
that are of interest when looking at dividends. It is important to note the
activities that take place at each respective date and how they are related to
those that follow and precede each specified activity.
1
Share trades cum – div that is Share trades ex – div that is
cumulative of dividend excluding dividend
Declaration date This is the date on which the board of directors passes a
resolution to pay a dividend.
Ex – dividend date It is the date before the date of record, establishing those
individuals entitled to a dividend. In Zimbabwe the period is four business
days and in the United States two business days.
Record date This is the date at which a holder must be on record in order to
be designated to receive a dividend.
Payment date It is the date when the dividend cheques are posted or in
cases where funds are transferred electronically, it is the date when the
electronic funds transfer is effected.
DIVIDEND POLICIES
Dividend policy refers to a firm’s plan of action to be followed whenever a
decision concerning dividends must be made. The policy should be
formulated with the following two objectives in mind:
1. Maximisation of shareholder wealth and
2. Provision of sufficient financing.
There are generally three broad dividend policies that could be pursued by
firms.
Time (Years)
2
POLICY II – CONSTANT DIVIDEND PER SHARE
A firm pursuing this policy pays a certain fixed amount per share as dividend
for example $25,00. This amount is paid out year after year regardless of the
level of earnings. This might even mean the payment of a dividend even when
the company has incurred a loss. This policy does not mean that the amount
of dividend is fixed for all times to come. As earnings grow the dividend is
increased and once increased it is maintained at the new level. While
earnings may fluctuate yearly, the dividend per share remains constant.
EPS
($)
DPS
&
EPS DPS
Time (Years)
DIVIDEND THEORIES
Management has to decide whether dividends are an active variable or a
passive residual. This in turn depends on whether management believes that
dividends have any effect on the value of the firm.
If a firm can earn a higher return than its cost of capital it will retain the
earnings to finance investment projects. If retained earnings fall short of the
funds required it will raise external funds, both equity and debt to make up the
shortfall. If retained earnings exceed the requirements of funds to finance
3
acceptable investment opportunities the excess earnings would be distributed
as dividends.
The general theory of the irrelevance argument assumes that investors are
indifferent between dividend and capital gains. If the firm can earn more than
the equity capitalization rate (ke) investors would be content with the firm
retaining earnings. If the return were less than the ke, investors would prefer
to receive the earnings (dividends).
They argue that given a firm’s investment decision, a firm has two options – to
retain its earnings to finance the attractive investments or to distribute the
earnings as dividends and raise an equal amount through the sale of new
shares to finance its investment programme. When dividends are paid out the
market price of the shares will increase. However, the additional shares
issued will decrease the terminal value of the shares. What the investors
would have gained will be neutralized completely by a reduction in the
terminal value of the shares. This situation creates indifference between
dividend and retention of earnings MM argue.
4
Taxes The MM argument that rates of tax levied as capital gains tax and on
dividend income are the same is not always true. Dividend withholding tax is
levied at a higher rate than capital gains tax (for shares that are quoted on the
stock exchange). This arrangement may create a situation where those in a
high-income bracket (those receiving taxable dividends) may prefer retention
of earnings to postpone tax and pay it as capital gains tax on disposal of
shares.
5
Investors being rational want to avoid risk (the possibility of not getting a
return on investment). Payment of a current dividend removes any chance of
risk. If a firm retains its earnings in order to pay a future dividend this
introduces uncertainty as to the amount of the dividend and its timing.
Rational investors penalize future dividends because of uncertainty, as they
prefer near dividends, which are certain.
Dividend Payout ratio If a firm has a long established dividend payout ratio;
it becomes bound by the ratio, as shareholders would be expecting that ratio
to be paid out.
Desire for current income Investors such as retired persons and widows
regard dividends as a source of funds to meet their current expenses. If
dividends were to be reduced they sell their shares. They dig deep into their
principal to sustain themselves. It would be preferable if they were to dig deep
into their pockets rather than principal.
6
II. A defined amount of profits to be paid as dividends may be
stipulated for example $40 million.
III. Insisting upon a defined minimum amount of earnings having to
be retained.
OR
DPS = Net profit after interest and preference dividend paid to ordinary shareholders
Number of ordinary shares outstanding
7
OR
OR
Stock splits and dividends have the same impact on the corporation and the
shareholders:
1. They increase the number of shares outstanding and
2. They reduce the value per share.
STOCK SPLIT
This is the subdivision of a firm’s stock that leads to an increase a firm’s
outstanding shares without any change in owner’s equity. A stock split is
expressed as a ratio instead of a percentage for example a three for one
stock split. This would mean a share is split into three new shares.
The stock is currently trading for $5,00. Assume a 10 percent stock dividend.
8
Present the shareholders equity after the stock dividend.
Solution
A 10 percent stock dividend brings in 1 000 additional ordinary shares at
$5,00.
$
Common stock ($1,00 par 11 000 outstanding shares) 11 000,00
Share premium [20 000 + (1 000 * $4,00)] 24 000,00
Retained earnings ($70 000 - $5 000) 65 000,00
100 000,00
9
If the firm’s dividend policy was based on a constant payout ratio of 40
percent for all years with positive earnings and a zero payout otherwise,
determine the annual dividend for each year.
If the firm had a dividend payout of $1,00 per share, increasing by $0,10 per
share whenever the dividend payout fell below 50 percent for two consecutive
years, what annual dividend did the firm pay each year?
If the firm’s policy was to pay $0.50 per share each period except when
earnings per share exceeds $3,00, when an extra dividend equal to 80
percent of earnings beyond $3,00 would be paid, what annual dividend did the
firm pay each year?
Discuss the pros and cons of each dividend policy described in a through c.
PROBLEM 2
A firm has the following information at the end of two financial periods:
2003 2004
$ $
EBIT 70 000 100 000
Taxation for the year 10 000 30 000
Interest 10 000 10 000
Dividend paid 30 000 40 000
Number of ordinary shares 100 000 110 000
Current market price of a share $5 $6
At the end of the trading period 2002 the firm’s share price was $5,50.
Calculate for the two years the following:
PROBLEM 3
X and Y are two fast growing companies in the engineering industry. They are
close competitors and their asset composition, capital structures, and
profitability records have been very similar for several years. The primary
difference between the companies from a financial management perspective
is their dividend policy. Company X tries to maintain a non – decreasing
dividend per share, while company Y maintains a constant dividend payout
ratio. Their recent earnings per share (EPS), dividend per share (DPS), and
share price (P) history are as follows:
10
Company X ($) Company Y ($)
Year EPS DPS P (range) EPS DPS P (range)
1 9.30 2.00 75 – 90 9.50 1.90 60 – 80
2 7.40 2.00 55 – 80 7.00 1.40 25 – 65
3 10.50 2.00 70 – 110 10.50 2.10 35 – 80
4 12.75 2.25 85 – 135 12.25 2.45 80 – 120
5 20.00 2.50 135 – 200 20.25 4.05 110 – 225
6 16.00 2.50 150 – 190 17.00 3.40 140 - 180
7 19.00 2.50 155 - 210 20.00 4.00 130 - 190
Determine the dividend payment ratio (D/P) and price to earnings ratio (P/E)
for both companies for all the years.
Determine the average D/P and P/E for both the companies over the period 1
through 7.
Management of company Y is puzzled as to why their share prices are lower
than those of company X, in spite of the fact that profitability record of
company Y is slightly better (particularly for the past three years). As a
financial consultant, how would you explain the situation?
PROBLEM 4
The following is the earnings per share (EPS) record for ABC Ltd over the
past 10 years:
Required:
Determine the annual dividend paid each year in the following cases:
If the firm’s dividend policy is based on a constant dividend payout ratio of
50% for all years.
Pay a dividend of $8.00 per share increasing to $10.00 per share when
earnings exceed $14.00 per share for two consecutive years.
Pay a dividend of $7.00 per share each year except when EPS exceeds
$14.00 per share, when an extra dividend equal to 80% of earnings beyond
$14.00 would be paid.
Which type of dividend policy will you recommend to the company and
Why?
PROBLEM 5
What is a dividend?
What is a stable dividend? Why should a firm follow such a policy?
The abbreviated income statement of MTB Limited for 2004 is as follows:
Turnover $28 772 000
Profit before Taxation $ 3 299 000
Profit after Taxation $ 1 737 000
11
Number of shares 14 131 124
Price per share $ 0,47
PROBLEM 6
(a) Muzanzi Ltd’s expected net income for next year is $1 million. The
company’s target and current capital structure is 40% debt and 60% common
equity. The optimal capital budget for next year is $1.2 million. If Muzanzi Ltd.
uses the residual theory of dividends to determine next year’s dividend pay
out, what is the expected payout ratio?
(b) Shingai Ltd. has a current and target capital structure of 30% debt and
70% equity. This past year the company, which uses a residual dividend
theory, had a dividend payout ratio of 47.5% and net income of $800 000.
What was the company’s capital budget?
(c) Kuvharwa Ltd’s optimal capital structure calls for 40% debt and 60%
equity. The interest rate on debt is a constant 12%; its cost of equity from
retained earnings is 16%; its cost of equity from new stock is 18%; and its
marginal tax rate is 40%. The company had the following investment
opportunities:
12
CHAPTER 2
Firms should operate with some net working capital. The amount of net
working capital required differs from firm to firm. Net working capital provides
a margin of safety where cash inflows and outflows do not coincide. If there is
little or no working capital, there is a higher risk of technical insolvency.
Permanent working
Capital
Time in months
13
DECISIONS TO BE MADE CONCERNING WORKING CAPITAL
The management of working capital requires management to make two very
important decisions.
DECISION I
TRADE – OFF BETWEEN PROFITABILITY AND RISK (INVESTMENT
DECISION)
When evaluating a firm’s net working capital attention must be paid to the
trade – off between profitability and risk. The level of a firm’s net working
capital has a bearing on its profitability as well as risk. Profitability will be
measured by profit after expenses while risk would be the probability that the
firm would become technically insolvent and fail to meet its obligations when
they become due for payment.
EXAMPLE
MUNHUMUTAPA INVESTMENTS LTD.
14
BALANCE SHEET AT 30 DECEMBER 2004
ASSETS $
Non – current assets 860 000
Property, plant and equipment 860 000
Assume that the company earns approximately 4 percent on its current assets
and 10 percent on non – current assets.
1. Compute the current profitability, net working capital and current
assets/total assets ratio.
2. Assume an additional investment of $60 000,00 in current assets other
things being equal. Calculate profitability, net working capital and
current/assets ratio.
3. Now assume an increase in the level of investment in fixed assets of
$60 000,00, other things being equal. Re – calculate profitability, net
working capital and ratio of current assets/total assets.
Solution
Current position
Profitability: Current assets = 4/100 * $540 000 = $21 600
Non – current assets = 10/100 * $860 000 = $86 000
$107 600
15
$104 000
DECISION 2
DETERMINING THE FINANCING MIX (FINANCING DECISION)
Other than the profitability – risk trade – off, another important consideration is
determining the appropriate mode of financing the current assets. There are
two sources of finance:
Short – term sources (current liabilities)
Long – term sources (share capital and long – term borrowings)
16
The question to be answered is how much finance should be short – term and
how much should be long – term? The answer to this question depends on
which approach to financing current assets is adopted.
Time in months
17
Diagrammatical illustration of the approach
Time in months
EXAMPLE
The projected total funds requirements for Gobvu Investments for the year
2005 are given as follows:
Assuming that short – term finance cost 3 percent and long – term finance 8
percent:
1. Compute the cost of financing associated with the hedging approach.
2. Compute the cost of financing associated with the conservative
approach.
3. Indicate the risk considerations associated with the two approaches of
financing.
4. Compute the cost of financing associated with the middle of the road
approach.
18
Cost considerations
The cost of a financing plan has a bearing on the profitability of a concern.
Cost of short – term funds = average annual short – term loan * interest rate
Where average annual short – term loan = total monthly seasonal requirements
Number of months
Cost of long – term funds = average annual long – term funds requirements * interest
rate
Total cost of financing = Cost of short – term finance + cost of long – term finance
Risk considerations
The hedging approach is more risky when compared to the conservative
approach because of the following reasons:
1. The hedging approach has no net working capital since current assets
just equal current liabilities. There is therefore no margin of safety.
Again no long – term finances are used to finance seasonal working
capital requirements.
2. The hedging approach involves an almost full utilization of the capacity
to use short – term funds and in emergency situations it may be difficult
to satisfy the short – term needs of the organisation. The conservative
approach conserves an organisation`s short – term borrowing capacity
for unexpected needs to avoid technical insolvency. It however
exhausts an organisation`s capacity to utilize long – term finance.
19
TRADE – OFF BETWEEN THE HEDGING AND CONSERVATIVE
APPROACHES/MIDDLE OF THE ROAD/COMPROMISE APPROACH
This financing approach strikes a balance between the two extreme methods
of financing current assets that is the hedging approach and the conservative
approach. The exact trade – off between risk and profitability will differ from
case to case depending on the risk preference of the decision – maker. One
possibility is to take the average of the maximum and minimum monthly
working capital requirements of the concern. This may then be financed
through long – term sources of finance with short – term sources for additional
fund requirement.
In the above example the revised amount to be financed through long – term
financing can be re – computed as follows:
This would be the amount of funds the firm would use each month in the form
of long – term funds. Additional funds, if needed, should be from short – term
sources of finance.
The previous example can be re – visited and the total funds requirement
broken down into revised permanent and variable working capital
requirements.
Estimated total funds requirement: Compromise approach
Total funds Long – term Short – term
Requirement Funds Funds
Month ($) ($) ($)
January 85 000 79 500 5 500
February 80 000 79 500 500
March 75 000 79 500 0
April 70 000 79 500 0
May 69 000 79 500 0
June 71 500 79 500 0
July 80 000 79 500 500
August 83 500 79 500 4 000
September 85 000 79 500 5 500
October 90 000 79 500 10 500
November 80 000 79 500 500
December 75 000 79 500 0
27 000
No short – term sources of funds are required in March, April, May June and
December as long – term sources available exceed total requirements of
funds. For the other months short – term sources of finance should be
arranged.
20
Cost of financing under the compromise approach
Summary
Maximum
Net working Degree of Total cost Level of
Capital Risk Of financing Profitability
Financing plan ($) ($)
Hedging 0.00 Highest 5 810,00 Highest
Compromise 10 500,00 Intermediate 6 427,50 Intermediate
Conservative 21 000,00 Lowest 7 200,00 Lowest
Concluding generalisation
The lower the net working capital, the higher the risk for technical insolvency
and the higher the expected profits.
Policy changes
Some firms relate their current assets volume (current assets policy). A policy
change affects the level of working capital. A change from a conservative
policy (high level of current assets to sales) to an aggressive policy will have
an impact on the level of working capital.
Technology changes
Technological developments can shorten the operating cycle. This reduces
the need for working capital and vice versa.
21
The objective of working capital management is to have neither too much nor
too little working capital. The following factors determine the amount of
working capital required by a business.
Production cycle
The larger the production cycle, the larger will be the funds tied up and the
larger the working capital needed and vice versa. A good example will be
distilleries. Organisations having shorter production cycles for example
bakeries do not need a huge investment in working capital.
Business cycle
Business fluctuations lead to cyclical changes and shifts in working capital
especially seasonal working capital. During a boom, there is greater need for
additional working capital to meet increased demand. A decline in business
activity is followed by a decrease in demand and a fall in inventories and book
debts.
Production Policy
A steady production policy independent of shifts in demand leads to an
accumulation of inventories during the off – season. This has to be supported
by an additional investment in working capital, which remains tied up in
inventories. Production matched to demand policy reduces the time working
capital is tied up in inventories hence a reduction in investment in working
capital.
Credit policy
The credit given by a firm to its debtors affects working capital. A liberal credit
policy increases book debts and increases the need for additional working
capital. This need is, however, reduced if the firm in turn is given liberal terms
by its suppliers.
22
Inflation
Inflation necessitates the use of additional funds for maintaining even the
existing level of activity. For the same level of working capital, higher cash
outlays will be required. Thus inflation will create the need for a change in
working capital.
Operational efficiency
Changes in operational efficiency also affect working capital. An improvement
in operational efficiency produces more for a given level of inputs.
Requirements for working capital will therefore be reduced and vice versa.
PRACTICE PROBLEMS
PROBLEM 1
Santo Gas has forecast its total funds requirements for the coming year as
follows:
Month Amount
January $7 400 000
February 5 500 000
March 5 000 000
April 5 300 000
May 6 200 000
June 6 000 000
July 5 800 000
August 5 400 000
September 5 000 000
October 5 300 000
November 6 000 000
December 6 800 000
PROBLEM 2
What is working capital management?
What is the objective of working capital management?
23
P Ltd has investigated the profitability of its assets and the cost of its funds.
The results indicate:
Current assets earn 1%
Non – current assets earn 13%
Current liabilities cost 3%
Average cost of long – term funds 10%
PROBLEM 3
How are net working capital, liquidity, technical insolvency, and risk related?
Why is an increase in a firm’s ratio of current to total assets expected to
decrease both profits and risk as measured by net working capital
Halgera Investment Limited has forecast its total fund requirements for the
coming year as follows:
The firm’s cost of short term and long – term financing is expected to be 4%
and 10% respectively.
What is the basic premise of the hedging approach for meeting a firm’s funds
requirements? What are the effects of this approach on the firm’s profitability
and risk?
24
Calculate the cost of financing using the hedging approach
What is the conservative approach to financing a firm’s funds requirements?
Calculate the cost of financing using the hedging approach
Indicate the basic profitability – risk trade – off associated with each of the
these plans
Calculate the cost of financing using the compromise approach
Indicate any two factors that explain variations to the amount of working
capital of an enterprise
List any four determinants of a company’s working capital requirements
PROBLEM 4
Jena limited forecast its seasonal financing needs for the next year as given
below. Assuming that the firm’s permanent funds requirement is $4 million,
calculate the total annual financial costs using the aggressive strategy and
conservative strategy, respectively. Recommend one of the strategies under
each of the following conditions:
CHAPTER 3
25
Basic objective
The basic objective of cash management is to keep the investment in cash as
low as possible while keeping the firm operating efficiently and effectively.
Speculative motive
This is the need for the organization to hold cash to take advantage of
additional investment opportunities such as bargain purchases.
Precautionary motive
This is the need to hold cash as a safety margin. The cash balances held will
act as a financial reserve.
Transaction motive
This is the need to hold cash to satisfy normal disbursement and collection
activities associated with the firm’s ongoing operations.
LIQUIDITY MANAGEMENT
Liquidity management is concerned with the establishment of optimal quantity
of liquid assets a firm should have on hand. It is one particular aspect of
current asset management.
CASH MANAGEMENT
Cash management is concerned with optimising mechanisms for collecting
and disbursing cash.
FLOAT
Float is the difference between book cash (ledger balance) and bank cash
(available or collected balance). The difference represents the net effect of
cheques in the process of clearing. There is a disbursement float and a
collection float.
Disbursement float
This float emanates from cheques written by the firm. The cheques written
decrease the firm’s book balance but with no immediate change to its
available balance.
Collection float
Collection float emanates from cheques deposited by the firm. It increases the
firm’s book balance but with no immediate change to its available balance.
Float management
This involves controlling the collection and disbursement of cash. When
collecting cash, the objective is to speed up collection and reduce the lag
between the time customers pay their bills and the time it becomes available.
26
The objective of cash disbursement is to control payments and minimize the
firm’s costs associated with making payment.
Availability delay This is the time required to clear a cheque through the
banking system.
Time
Collection time
27
Post office post office
Box 1 box 2
CASH CONCENTRATION
This is another technique that can be adopted to speed up collections. Cash
concentrations are procedures for moving cash from multiple banks into the
firm’s main accounts. A concentration bank pools the funds obtained from
local banks contained within some geographic area.
Customer customer
Payments payments
28
Firm sales
Office
Customer
Payments
Customer
Payments
Concentration
Bank
Firm Cash
Manager
29
practically possible. In pursuing this objective the firm should not compromise
its relationship with the suppliers as these may withdraw trade credit.
Writing out cheques on a geographically distant bank.
Mailing checks from remote post offices.
CONTROLLING DISBURSEMENTS
The general idea of disbursement management is to have no more than the
minimum amount necessary to pay bills held in the company’s disbursement
accounts. The following two approaches can be adopted to achieve this
objective.
cash cash
transfer transfer
safety balances
payroll supplier
account account
30
cash operating cycle is to reduce the cash operating cycle as much as is
possible without adversely affecting the operations of the firm.
Raw materials conversion time (RMCT) This is the average time from
purchase of raw materials to when they actually enter the production process.
Creditors conversion time (CCT) This is the period from purchase of raw
materials on credit to when the firm actually makes cash payment for the raw
materials.
Finished goods conversion time (FGCT) It is the average time taken to sell
goods that have come out of the production line.
Debtors conversion time (DCT) This is the period from when goods are sold
to when the firm receives payment from debtors. It is also known as the
average credit period taken by debtors.
CCT is deducted because during that period the firm would not have been
paid cash for raw materials.
EXAMPLE
31
The following information has been collected for the purpose of calculating the
cash operating cycle.
31 December
2000 2001
$ $
Credit sales 3 240 000 3 600 000
Purchases of raw materials 1 125 000 1 687 500
Raw materials consumed 1 080 000 1 440 000
Cost of goods manufactured 2 160 000 2 880 000
Cost of goods sold 1 800 000 2 700 000
Debtors 540 000 800 000
Creditors 156 250 375 000
Stocks: Raw materials 90 000 60 000
Work in progress 60 000 120 000
Finished goods 25 000 75 000
Assuming a 360 day year calculate the cash operating cycle for both years.
Comment on the change that you arrive at.
Solution
2000 2001
RMCT = $90 000/($1 080 000/360) = $60 000/($1 440 000/360)
= $90 000/3 000 = $60 000/4 000
= 30 days = 15 days
COC2000 = 30 – 50 + 10 + 5 + 60 COC2001 = 15 – 80 + 15 + 10 + 80
= 55 days = 40 days
32
BAUMOL – ALLAIS – TOBIN (BAT) MODEL
The aim of this model is to calculate the optimal amount of marketable
securities to be liquidated whenever the concern requires cash. The
calculated level of marketable securities will maximise interest received on
marketable securities while minimising the cost of selling marketable
securities.
Assumptions
The BAT model is based on the following two assumptions:
a) Cash is instantaneously replenished.
b) There is a gradual use of cash.
Cash ($)
C/2
(average cash)
Time
Fig. The Baumol – Allais – Tobin model
As can be seen from the above diagram, the BAT model is based on the
inventory management’s economic order quantity (EOQ)
EXAMPLE
A company has an average cash disbursement of $1 200 000,00 per year.
The company holds its monetary resources as cash or marketable securities.
The marketable securities carry an interest rate of 20 percent and it costs the
company $15,00 to convert any amount of marketable securities into cash.
Solution
Marketable securities to be liquidated = 2 * $1 200 000,00 * $15,00
0.20
= $13 416,41
33
Problems with the BAT model
The model has two main problems emanating from the underlying
assumptions of the model.
Cash is not always instantaneously replenished.
Cash is also not gradually used. Cash movements are generally
random.
The model indicates that the firm sells marketable securities when a lower
limit of cash is reached. Marketable securities are purchased when the upper
limit of cash is reached as it becomes necessary to reduce cash.
Cash ($)
Maximum cash
Return point
Spread
Minimum cash
Time
Fig. The Miller – Orr model
34
Calculate the maximum cash (upper cash limit). To obtain the
maximum cash use the following approach:
Calculate the return point. The return point is the point to which the
cash balance should return when marketable securities are purchased
or sold.
EXAMPLE
A company has a minimum balance of $15 000,00 and a standard deviation of
daily cash flows of $5 000,00. An annual interest rate of 9 percent can be
obtained on marketable securities. Transaction costs for sale or purchase of
securities is $15,00.
Solution
Variance = Standard Deviation2
= $5 000,002
= $25 000 000,00
= $31 201,26
35
= $25 400,42
BANKING POLICY
Organisations that make regular bank deposits should come up with a
banking policy. The objective of coming up with such a policy is to establish
an optimal banking frequency. Greater banking frequency brings in more
interest but it results in higher banking costs such as transportation, labour,
security and stationery.
EXAMPLE
Gore Ltd has annual cash receipts of $50 000 000,00 that are spread evenly
over the 50, 5 day working weeks in a year. Within each week, receipts on
Monday, Thursday and Friday are twice as much as those on Tuesday and
Wednesday. At present all monies are banked on Friday. A daily banking
proposal has been made. The firm estimates that the total cost of each
banking is $600,00. The firm always maintains a credit balance that is
presently receiving interest at 36 percent per annum.
Requirement
Using simple daily interest and weekly analysis, should the new proposal be
adopted?
Solution
Weekly cash receipts = $50 000 000,00/50
= $1 000 000,00
Daily rate of interest = 36/360/100
= 0.00100
Breaking down the weekly sales into daily sales
Day Factor Receipts
Monday 2 2/8 * ($1 000 000,00) = $250 000,00
Tuesday 1 1/8 * ($1 000 000,00) = $125 000,00
Wednesday 1 1/8 * ($1 000 000,00) = $125 000,00
Thursday 2 2/8 * ($1 000 000,00) = $250 000,00
Friday 2 2/8 * ($1 000 000,00) = $250 000,00
8
36
Monday 250 000,00 4 0.00100 * $250 000,00 * 4 =$1 000
Tuesday 125 000,00 3 0.00100 * $125 000,00 * 3 = $ 375
Wednesday 125 000,00 2 0.00100 * $125 000,00 * 2 = $ 250
Thursday 250 000,00 1 0.00100 * $250 000,00 * 1 = $ 250
Friday 250 000,00 0 0.00100 * $250 000,00 * 0 = $ 0
$1 875
The new proposal (daily banking) should be rejected as it has higher costs.
PROBLEM 1
The managing director of your company has seen a statement in the financial
press which suggests that at all times, but particularly when liquidity is a
problem, management should pay particular attention to the cash operating
cycle.
Year 1 Year 2
Stock – Raw materials 20 000 27 000
8. Work in progress 14 000 18 000
9. Finished goods 16 000 24 000
Purchases 96 000 130 000
Cost of goods sold 140 000 180 000
Sales 160 000 200 000
Debtors 32 000 48 000
Creditors 16 000 19 500
PROBLEM 2
Gamwa Ltd is a company that operates a retail outlet, oil processing and
bakery at Nyaningwe Growth point. The growth point is 60 kilometers away
37
from Masvingo, which is the nearest place, where banking facilities can be
obtained.
The current practice is to bank the receipts for the previous day on a daily
basis, i.e. 6 times a week. The company would like to review the situation
given the costs that are involved in daily banking.
It ahs been established that the company spends $100,00 on fuel and pays a
security guard $200,00 for each banking. In addition, it is estimated that the
company incurs $300,00 in lost profit because the truck is being used for
banking duties instead of other deliveries.
The proposal under review is that the company banks only on Tuesday and
Friday. On these days the company has a larger truck, which goes to
Masvingo to collect goods, therefore there would be no additional costs to the
firm in terms of furl and lost profit. The company is currently not utilizing this
truck to carry cash. If the two day banking is adopted the company would still
be required to pay the guard $200,00 for the 6 days because of a contract that
the company has with the security firm although he will be idle.
The company makes daily cash receipts of $160 000,00, 7 days a week and
any money banked is used to reduce an overdraft facility which carries an
interest rate of 36%
Requirement
10. Should the company change its banking policy?
11. What other factors would you have to take into account before making
a final decision on whether or not to change the banking policy?
PROBLEM 3
The cash balances of Northlea Investments Ltd have declined significantly
over the last 12 months. The following financial information is provided:
Year to December
2002 2003
$ $
Sales 573 000 643 000
Purchases of raw materials 215 000 264 000
Raw materials consumed 210 000 256 400
Cost of goods manufactured 435 000 515 000
Cost of goods sold 420 000 460 000
Debtors 97 100 121 500
Creditors 23 900 32 500
Stocks:
12. Raw materials 22 400 30 000
13. Work in progress 29 000 34 300
- Finished goods 70 000 125 000
38
Calculate the cash operating cycle for 2002 and 2003.
State the strategies that Northlea Investments Ltd can use to reduce the cash
operating cycle.
Is having knowledge on the cash operating cycle likely to be of value to an
organization? Briefly explain.
CHAPTER 4
MANAGEMENT OF DEBTORS
39
There are two important issues to look at when one looks at the management
of debtors from a financial management point of view. The first issue deals
with what the organisation looks at before granting credit to prospective
clients. The other deals with the nature of evaluation to be undertaken before
the organization can change its credit policy.
Character
The organisation conducts an analysis to determine if the prospective
customer will try to honour an obligation. The organization looks at the
applicant’s payment record with other entities to get an indication of the
applicant’s character.
Capacity
Capacity is the ability of an applicant to pay the obligation. To get an
indication of the applicant’s capacity the organization looks at the income
generating capacity of the applicant.
Capital
Capital in this context will be the net worth and financial position of the
applicant. Ratio analysis will be used by the organization when evaluating the
applicant.
Collateral
Collateral refers to the assets pledged by the applicants as security for the
credit facility. The organisation looks at the value and liquidity of the assets
pledged by the applicant.
Conditions
These are general macroeconomic conditions prevailing. These affect the
applicant’s ability to honour an obligation.
Credit terms
Credit terms reflect the business conditions that the organisation will have
agreed with its customers.
This statement means that a debtor obtains 2 percent discount on the invoice
price if they pay within 10 days otherwise the full invoice price is due within 30
days.
Effective discount
40
Firms should set cash discounts carefully. If the cash discount is high, less
cash is received from a given sale. To establish if the discount is acceptable,
the firm has to compute the effective discount rate.
A firm should not give discounts whose effective rate is higher than the return
on invested funds.
EXAMPLE
A firm considers a return on investment of 35 percent as adequate. Given this
required rate of return, are the following credit terms: 2.10 net 30 acceptable?
Solution
Compute the effective discount rate and compare it with the required rate of
return.
These credit terms are unacceptable as the effective discount rate is higher
than the required rate of return on investment.
The following circumstances may trigger the need for change of policy:
1) Customer complains.
2) Changes in environment and competition.
3) Observation from the credit control department.
EXAMPLE
Management of Jive Investments Ltd is considering changing the credit policy
to attract customers who have moved to competitors with more favourable
terms. The firm, which sells all goods on credit, presently sells 135 000 units
at a price of $20,00 per unit. The change in credit policy would result in an
increase in the number of units sold to 160 000 but the price will remain the
same.
The present terms offered by the firm are 1/10 net 20. The suggested credit
terms are 3/15 net 45. At present 25 percent of the customers take advantage
of the 1 percent discount. With the new policy it is expected that 30 percent of
the customers will take advantage of the new discount.
41
The average collection period is expected to increase from the current 18
days to 45 days. The variable cost ratio is 80 percent and is expected to
remain unchanged. The bad debt loses are expected to change from 5
percent to 1.5 percent of sales for which cash discounts are not taken. The
opportunity cost associated with an investment in working capital is 30
percent per annum.
Required
Evaluate the proposal and indicate to management if the new policy should be
implemented.
Solution
A change in policy affects sales, debtors, bad debts and cash discounts.
Sales
The organisation should be interested in a change in contribution.
Computation of contribution per unit:
Unit selling price $20,00
Unit variable cost (80% * $20,00) 16,00
Contribution per unit 4,00
Bad debts
Bad debts = Credit sales for which discount is not taken * bad debt percentage (%)
= Sales * (1 - % of customers taking discount) * Bad debt percentage
Cash discounts
42
Cash discount = Sales * Percentage of customers taking discount * discount
percentage.
Carrying cost of old sales = (Change in ACP/365) * old sales * opportunity cost
Summary
$
Change in contribution 100 000,00
Change in debtor carrying costs (74 712,33)
Change in bad debts 67 650,00
Change in cash discounts 22 050,00
70 887,67
43
PRACTICE PROBLEMS ON MANAGEMENT OF DEBTORS
PROBLEM 1
The directors of Tawedzerwa Ltd are considering changing their credit policy
to attract customers who have moved to their competitors with favourable
credit terms.
The current policy calls for 3/15 net 30. Of the current $2,6 million sales, $2,4
million are on credit and 70 per cent of the customers take advantage of the 3
per cent discount. The new credit policy would call for 5/10 net 60 and only 60
per cent of the customers are expected to take advantage of the cash
discount. The average collection period is expected to increase from the
current 20 days to 30 days. Sales are expected to increase to $2,9 million if
the new credit terms are used, with cash sales remaining constant. The gross
profit margin of 20 per cent is expected to remain unchanged, as well as the
bad debt losses which amount to 2 per cent of sales for which cash discounts
are not taken.
Requirement
Make calculations to show the effect of these changes, and to advise the
directors whether they would be financially justified to change the policy, and
State what factors should the directors consider before changing the credit
policy.
PROBLEM 2
A firm is trying to decide whether to change its credit policy in order to meet
increased foreign competition. The present credit terms of the firm are 2/5 net
30. The firm makes sales of $2 400 000 annually, the average collection
period is 36 days and 20% of customers take the discount. The bad debts are
1.5% of sales for which a discount is not taken.
The alternative that is being considered by the firm is to change the credit
terms to 3/15 net 45. This is expected to increase sales to $3 000 000
annually, increase the average collection period to 48 days, decrease bad
debts by 0.5% and increase customers taking discount to 40%.
If the cost of the short term financing is 30% and the firm’s variable cost ratio
is 75% determine whether the firm should adopt the new policy.
CHAPTER 5
44
INVENTORY MANAGEMENT
Inventories are idle goods in storage waiting to be used. They include raw
materials, work in progress and finished goods.
Importance of inventories
1. Inventories act as a buffer to decouple or uncouple the various
activities of the firm so that all do not have to be pursued at exactly the
same rate. These activities are purchasing, production and selling.
2. Inventories smooth out time gap between supply and demand.
3. Holding inventories may contribute to lower production costs. This is as
a result of bulk purchases.
4. Inventories provide a way of “storing” labour (make more now, free up
labour later).
5. Inventories can provide quick customer service (convenience).
ABC Classification
Storeroom inventory is classified into categories called ABC.
“A” These are items of the highest priority. They are outstandingly important
and require the tightest controls. They require close follow up and accurate
records. 10 percent of the category A items volume accounts for 70 percent of
the total inventory value.
“B’’ These are items of average importance. The items are the priority when
low or out of stock. Normal controls are used and good records should be
maintained for these items. ‘’B’’ items account for 20 percent of the total
inventory value and 20 percent of the inventory volume.
“C” These are relatively unimportant items. They are items of lowest priority.
They require the simplest methods of control. Minimum/Maximum controls
can be used for ordering these items. The items are usually expensed, as
there are no records for them. These items represent 10 percent of the total
value and 70 percent of the volume.
45
Economic Order Quantity (EOQ)/Re- order Quantity
The economic order quantity is the amount of orders that minimizes total
variable costs required to order and hold inventory. This decision requires a
trade off illustrated below:
Trade offs
Ordering more frequently Vs. Ordering less frequently
Carrying costs
They are storage costs like depreciation, warehouse insurance, insurance of
inventory against fire and theft, clerical and accounting costs and opportunity
cost of funds.
EOQ Model
For every two items held in inventory, two questions have to be asked.
a) When should a replenishment order be placed?
b) How much should be ordered?
EOQ Assumptions
There are three main assumptions associated with the EOQ model:
There is a single product with a constant and known demand rate.
Goods arrive at the same day they are ordered.
No shortages are allowed. The organisation re – orders inventory when
the inventory reaches zero (0).
Q* = 2C0D
CH
EXAMPLE
46
A firm’s inventory planning period is one year. Its inventory requirement for
this period is 1 600 units. Assume that its acquisition costs are $50,00 per
order. The carrying costs are expected to be $1,00 per unit per year for an
item.
Method 1
The economic order quantity is 400 units as this is the one that minimizes
total costs.
Method 2
47
for each operation, MRP determines a scheduling for the operations and raw
material purchases.
MRP is a system that dissects products into materials and parts necessary for
purchasing, inventorying, and priority planning purposes. By using a computer
a manager can analyse product design specifications to pinpoint all the
materials and parts necessary to produce the finished product. Merging this
information with computer inventory records assists management to know the
quantities of each part in inventory and when each is likely to be used. MRP
ensures that the right materials are available when needed.
48
PROBLEM 1
Manikai Ltd has just been awarded a five year contract with its only customer
to buy up to 20 000 tonnes of the customer’s black peppercorn each year.
The contract allows Manikai Ltd to take delivery of any multiple of 1000
tonnes it likes at any time during the year. The supply contract stipulates,
however, that the peppercorn cannot be resold but must be used in the
company’s production of peppers. This process is carried out continuously
throughout the year.
The company estimates that ordering and receiving costs per batch of
peppercorns will amount to $500 per batch irrespective of the batch size. In
addition to the above, before the peppercorns are stored they must be
sprayed with a preserving chemical at a cost of $20 per tonne.
Requirement
14. Calculate the economic order quantity, ignoring the silo costs and state
the number of orders that will be placed each year.
15. Calculate the total costs of stock holding and stock ordering per
annum.
16. Calculate how many silos should be built if it is the company’s
objective to minimize overall costs. You may assume that all cash flows
except the costs of constructing the silos occur at the end of the
relevant years. Ignore inflation and taxation.
17. Discuss the disadvantages of using the simple economic order quantity
formula.
CHAPTER 6
49
SOURCES OF FINANCE
This section looks at medium to long – term sources of finance available to
organizations.
EQUITY
Advantages of equity
Maturity
Perpetual equity has no maturity dates. The company need not save money
for redemption of equity.
Restrictive covenants
Debt agreements place restrictions on the company’s operations. Equity has
no such restrictions.
Disadvantages of equity
Diversity of shareholders
Each new issue brings additional owners. This increases the diversity of
interests that the company has to accommodate.
Income dilution
50
Existing shareholders share the income with new shareholders. This dilutes
earnings of present shareholders if the additional funds are not used to
generate additional income.
Cost
A new share issue is usually more expensive than debt. This is because with
each new issue, floatation costs, underwriting and legal fees are incurred.
PREFERENCE SHARES
Preference shares are generally used because of their flexibility. Preference
dividends can be passed unlike interest on debt. In addition, issuing
preference shares does not dilute ownership.
Passing dividends
Preference dividends can be passed without penalty unlike debt.
Ownership dilution
Unlike equity, preference shares do not dilute ownership.
Indenture terms
Unlike debentures, preference shares do not carry strict restrictions. This
gives flexibility to the organization, as there will not be too many restrictive
covenants.
Maturity
For perpetual preference shares there is no need to set aside funds for
redemption.
Cost
Preference shares have a higher yield than debentures because they are
more risky than debentures.
Taxation
Dividends are not tax deductible. Interest on debt is tax deductible.
Accumulation
Passed dividends are usually cumulative.
DEBT FINANCING
51
Features
1. It carries a fixed rate of interest.
2. Interest on debt has to be paid whether profits are earned or not.
3. Debt has a preferential claim to assets in the event of liquidation.
Lower yield
Yield on debentures is usually lower than that on preference shares because
of lower risk. This means that the use of debentures lowers the firm’s
weighted average cost of capital.
Control
The use of debt instead of instead of ordinary shares does not dilute control.
This is because debenture holders are lenders and are not involved in the
management of the organization unless the organisation is not up to date
obligation payments.
Taxation
Cost of debt is lowered because interest on debt is a tax – deductible
expense. This leads to tax savings by the company.
Fixed maturity
Debt financing is usually of fixed maturity and the principal has to be repaid.
This can create serious cash flow problems for the organisation when the debt
matures unless the organisation would have created a sinking fund
investment arrangement.
Restrictive covenants
Debenture agreements can stifle the company’s operations. The provisions on
dividends and further borrowing could run contrary to corporate policy.
LEASE FINANCING
A lease is a contractual arrangement under which the owner of an asset (the
lessor) agrees to allow the use of his assets by another party (the lessee) in
exchange for periodic payments (lease – rents) for a specified period of time.
Types of leases
52
Operating lease
This is an arrangement in which the lessee acquires the use of an asset on a
period – to - period basis. The period is relatively short for example 6 months
to 1 year. The lease can be cancelled at the option of the lessee. The
operating lease is generally more expensive than a financial lease.
Financial lease
A financial lease is an arrangement that involves a relatively longer – term
commitment on the part of the lessee. The lease cannot be cancelled. The
lessee is responsible for maintenance so this arrangement is less expensive
from the lessor`s point of view.
Direct lease
The lessee identifies the asset they would want to use and arranges for a
leasing contract with the manufacturer. The manufacturer will be the lessor
with this type of lease.
Evaluation procedure
(a) Determine the after tax cash outflows for each year under the lease
alternative. This will be arrived at by multiplying the lease payment with
the tax adjustment.
(b) Determine the after tax cash outflows for each year under the buying
alternative based on borrowing. The amount = Loan instalment (Gross
cash outflow) less tax advantage of interest (I * t) less tax shield due to
depreciation allowance.
(c) Compare the present value of the cash outflows associated with
leasing and buying alternative by employing after tax cost of debt as
the discount rate for the purpose.
53
(d) Select the alternative with a lower present value of cash outflow.
EXAMPLE
Hot Spot Ltd wishes to access a machine for 5 years. Financial institutions are
prepared to arrange a lease or lent the required amount at 14 percent to
acquire the machine.
If leasing is chosen the organization will pay annual end of year lease rentals
of $120 000,00 for 5 years. All maintenance, insurance and other costs are to
be borne by the lessee.
If the machine is bought, at a cost of $343 300,00, the firm would have a 14
percent five year loan to be paid in five equal annual instalments, each
instalment becoming due at the end of each year. The machine would be
depreciated on a straight – line basis with no salvage value.
Required
Advise the company which option to choose assuming lease rentals are paid:
a. At the end of the year
b. In advance.
Solution
a. After tax lease payment = $120 000,00 * (1 – 0,50)
= $120 000,00 (0.50)
= $60 000,00
Borrowing alternative
Computation of loan instalment
= $100 000,00
54
Loan at the Payment outstanding at
Year Loan beginning of the Interest Principal the end of the
end instalment year on loan repayment year
1 2 3 4 (3 * 14%) 5[(20 – (4)] 6[(3) – (5)]
1 100 000,00 343 300,00 48 062 51 938 291 362
2 100 000,00 291 362,00 40 791 59 209 232 153
3 100 000,00 232 153,00 32 501 67 499 164 654
4 100 000,00 164 654,00 23 052 76 948 87 706
5 100 000,00 87 706,00 12 294* 87 706 -
*Balancing item
Depreciation = $343 300
5
= $68 660
Recommendation
The organization should buy the asset outright because the present value of
buying is less than the present value of leasing.
b) Present value of cash outflows when cash lease payments are made in
advance.
If this is the arrangement, the first lease payment will be made at time zero
(now) but the tax benefit will only be enjoyed the following year.
Recommendation
It is still cheaper to borrow the funds and buy the asset outright when lease
rentals are made in advance.
55
PRACTICE PROBLEMS ON SOURCES OF FINANCE
PROBLEM 1
Water Glass enterprises (Pvt) Ltd is considering installing a computer. It is to
decide whether the computer is to be purchased outright (through 14%
borrowings) or to be acquired on lease rent basis.
The firm is in the 50% tax bracket. The other data available are:
Purchase of Computer:
Leasing of Computer:
Lease charges $450 000
(To be paid in advance)
Maintenance expenses To be borne by lessor
Requirement
Advise the company as to whether it should purchase the computer or acquire
it on lease.
PROBLEM 2
Mupunga Ltd is an industrial concern that desires to acquire a diesel
generating unit costing $2 000 000 which has an economic life of ten years at
the end of which the asset is not expected to have any residual value. The
concern is considering the alternative choices of:
Lease payments are to be made in advance and the lessor requires the asset
to be completely amortised over its useful period and the asset will yield a
return of 10%.
The cost of debt is worked at 16% per annum. The lender requires the loan to
be repaid in 10 equal annual installments, each installment becoming due at
the beginning of the year. An Average rate of tax of 50% is to be assumed. It
is expected that operating costs would remain the same under either method.
The firm follows straight-line method of depreciation.
Requirement
As a financial consultant, indicate what your advice will be.
56
PROBLEM 3
Murambatsvina Investments is expanding its facilities. In the coming year, the
company will either purchase or lease equipment, which it plans to use for 4
years and then, replace with new equipment. Its current tax bracket is 50%.
The other data are as follows:
Purchase
The purchase price of the equipment is $4 000 000
The expected salvage value after 4 years is $1 000 000
The equipment is subject to straight line method of depreciation
Funds to finance the equipment can be obtained at 16%
The loan is to be repaid in 4 equal annual installments due at the end of each
year
The equipment will increase annual revenues by $3 000 000 and increase
annual non-depreciation operating costs by $2 000 000.
Leasing
The annual lease rent is $1 000 000
The lease rent is payable at the end of each year for 4 years
The equipment will increase annual revenues by $3 000 000 and increase
annual non-depreciation operating costs by $1 900 000 as the lessor will pay
$100 000 for the maintenance costs associated with the equipment.
Requirement
Determine whether the company should purchase or lease the equipment.
CHAPTER 7
57
A MERGER
A merger is the joining together of two previously separate corporations. A
true merger in the legal sense occurs when both businesses dissolve and fold
their assets and liabilities into a newly created third entity. This entails the
creation of a new entity.
A TAKEOVER
A takeover is the acquiring of control of a corporation, called a target, by stock
purchase or exchange, either hostile or friendly. A friendly takeover is a
takeover, which supports the wishes of the target company’s management
and board of directors. A hostile takeover is a takeover, which goes against
the wishes of the company’s management and board of directors.
AN ACQUISITION
An acquisition is the taking possession of another business. It is the same
thing as a takeover or buyout.
A STRATEGIC ALLIANCE
A strategic alliance is a partnership with another business in which the parties
combine efforts in a business effort involving anything from getting a better
price for goods by buying in bulk together to seeking business together with
each of the parties providing part of the product. The basic idea behind
alliances is to minimize risk while maximizing leverage.
PARTNERSHIP
This is a business in which two or more individuals carry on a continuing
business for profit as co – owners. Legally, a partnership is regarded as a
group of individuals rather than as a single entity, although each of the parties
files their share of profits on their individual tax returns.
A C
58
Economic
Activity E F
B D
Business cycles
Time
A lot of mergers take place at points ABCD. In other words there is a high
incidence of merger activity at points ABCD. At points E and F there is
relatively less merger activity.
Points A and C
Once the business cycle comes up, general demand increases, increasing
business confidence. The increase in general demand creates large reserves
of capital for discretionary spending. These discretionary resources are often
used to finance expansion. At these points mergers are conducted with
aggressive intent.
Points B and D
During a recession general demand decreases. This reduces the level of
business confidence. The decline general demand reduces profit levels.
Organisations become unsure of what the future holds: hence they grow in
size for security. They want to safeguard themselves from being taken over by
other entities. At these points mergers are conducted with defensive intent.
Types/Categories of mergers
HORIZONTAL MERGER
A horizontal merger occurs when two firms in the same industry and in the
same line of business combine to form one large company essentially doing
the same business as before. Thus mergers take place between firms that are
actual or potential competitors occupying similar positions in the chain of
production.
VERTICAL MERGER
This occurs when two firms in related industries combine. The firms could be
at different levels of production or at different levels of the distribution channel.
Vertical mergers therefore take place between firms at different levels in the
chain of production for example a manufacturer and a retailer. Vertical
mergers can be defined as being either forward or backwards.
Backward integration/merger
This is a merger that is motivated by the desire to secure a source of raw
materials.
Forward integration/merger
59
This is a merger that is motivated by the desire to control a distribution
system.
A reverse takeover occurs when a company buys out a larger company. This
is what often happens when a private company takes over a publicly listed
company. Typically, a public company that is taken over by the private
company will remain listed, and the private company will use the acquisition
as a means of gaining a listing. Reverse takeovers are usually very rare
events.
Improving efficiency
For most firms improving operations for example financial management could
increase earnings. Firms like these become targets for acquisition by other
firms with better management. If a firm is not doing well this will be reflected in
a lower share price that could encourage a takeover bid.
Inefficiencies can be ironed out by other methods that are not easy for
example sackings. These are easier after a restructuring because managers
do not generally demote or sack themselves.
Tax relief
A company may be unable to claim tax relief through not generating profits. It
may therefore wish to combine with another firm or firms, which are
generating taxable profits.
60
A firm may be generating a substantial amount of cash but having a few
profitable investment opportunities (investments which yield more than the
opportunity cost of capital). This firm could therefore use the surplus cash to
acquire another company. This is because if the company does not make an
acquisition, someone else may acquire the company instead, because of its
lucrative cash resources, and re - deploy the organisation`s cash resources
for them.
Diversification
Mergers can result in risk reduction because when diversifying firms combine
with those having returns that are negatively collated to their revenue
streams.
But others argue that this is spurious (dubious and not genuine) as the major
objective should be wealth maximization and not risk reduction. Remember
risk reduction leads to reduced profits. In any case critics argue that
shareholders themselves could do that diversification.
Undervalued securities
One reason also given to justify a merger is that the securities of the acquiree
are “undervalued”. The proposition is however dangerous. If management
believes that they can identify such companies, which are undervalued, they
should buy such shares in a wide variety of such companies. It is not
necessary to have to acquire and manage other companies merely to take
advantage of any under valuation.
61
(a) To increase market power
(b) To build an empire
(c) To expand production without price reduction
(d) To acquire capacity at reduced prices (acquisition of undervalued
shares)
(e) Quicker entry into new market
(f) To acquire key personnel on sites
Value of target firm = Current price per share * number of outstanding shares
EXAMPLE
The following information is given:
Current market value of share $37,00
Number of shares in issue 12 000 000
What is the value of the firm?
Solution
Value per share = Total Assets (at revised book values) – total liabilities assumed
Number of shares in issue
EXAMPLE
62
C Ltd. is considering acquiring D Ltd. The owners of D Ltd. Have supplied C
Ltd. with the following balance sheet data to help in the valuation process.
D Ltd.
1.The land and buildings can be rented at a current rental of $1.6million per
annum in perpetuity. The required rate of return on such property is 20%.
2.The plant and machinery can only be liquidated at a price of $10million but
have a replacement value of $20million.
3.The debentures are irredeemable, have a par value of $100.00 and their
current required rate of return is 20%
4.Preference shares are trading at 75 cents and have a par value of $1.00.
5.The firm’s investments are for speculative purposes and have a current
market value of $1.35million.
6. $500 000.00 worth of debts are thought to be irrecoverable.
7.A stock check revealed that the stock is actually worth $2 2500 000.00.
8.The bank could still advance the overdraft in case of a take over.
Requirement
How much should C Ltd. Offer as a minimum price for each ordinary share in
D Ltd?
Solution
63
$
ASSETS
Land and buildings $1 600 000/0.20 8 000 000
Plant and machinery 10 000 000
Investment 1 350 000
Cash 60 000
Debtors $5 000 000 - $500 000 4 500 000
Stock 2 250 000
26 160 000
LIABILITIES (10 407 500)
Creditors 3 600 000
Bank overdraft 1 250 000
Preference shares 2 210 000 * $0.75 1 657 500
Debentures [12/100 * $6 500 000]/(0.20) 3 900 000
15 752 500
Ordinary shares outstanding 8 000 000
Value per share $1,97
METHOD OF PAYMENT
Payment for a merger can be by cash, ordinary shares, debentures and
preference shares.
Cash offers
Cash is paid to shareholders of the target firm.
64
b) If a cash purchase is considered when liquidity is poor, the company
may have to sell more assets in order to realize the needed funds.
EXAMPLE
The summarized Balance Sheet of Target Ltd as at 31 December 2003 is
given below.
Negotiations for the take over of Target Ltd result in its acquisition by A Ltd.
The purchase consideration consists of:
(a) $330 000 13% Debentures of A Ltd for redeeming the 12% Debentures
of Target Ltd.
(b) $100 000 12% Convertible preference shares in A Ltd for the payment
of the preference share capital of Target Ltd.
(c) 150 000 equity shares in Target Ltd to be issued at its current market
value of $15,00.
(d) A Ltd would meet dissolution expenses estimated to cost $30 000.
65
The break – up figures of eventual disposition by Target Ltd of its unrequired
assets and liabilities are:
(iii) Investments $125 000
(iv) Debtors $350 000
(v) Inventories $425 000
(vi) Payment of current liabilities $190 000.
The project is expected to generate operating cash flow after tax of $700 000
for 6 years. It is estimated that fixed assets of Targets Ltd would fetch $300
000 at the end of year 6.
Requirement
As a financial consultant, comment on the financial prudence of the merger
decision by A Ltd.
Solution
Computation of the cost of acquisition
$
13% Debentures 330 000
12 % Convertible preference shares 100 000
Equity share capital (150 000 * $15,00) 2 250 000
Dissolution expenses 30 000
Payment of current liabilities 190 000
(2 900 000)
Proceeds from sale of assets 1 000 000
Investments 125 000
Debtors 350 000
Inventories 425 000
Bank balance 100 000
($1 900 000)
Benefits of acquisition
Cash flow after tax (1 – 5) $ 700 000
Cash flow after tax (6) ($700 000 + $300 000) $1 000 000
R Ltd is expected to benefit from the merger of Target Ltd, as the NPV is
positive.
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SHARE SWAP
Where the mode of payment is a share swap, a suitable exchange ratio is
needed. The market price per share (if available) or the earnings per share
may be used to establish the exchange ratio.
Requirement
- What is the exchange ratio of market prices?
- What is the pre- merger EPS and the P/E ratio for each company?
- What was the P/E ratio used in acquiring ABC Ltd?
- What is the EPS of XYZ Company after the acquisition?
- What is the expected market price per share of the merged
company?
Solution
(a) Exchange ratio = Market price of Acquirer
Market price of acquiree
= [1.6 * $35]
1 * $40
= 1.40
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= $1 500 000 + $450 000
300 000 + 120 000 (1,6 * 75 000)
= $1 950 000
420 000
= $4,64
= $4,64 * 7 times
= $32,48
Use of proxies
The acquiring firm asks individual shareholders to sign over their proxies. The
proxies are then used at a shareholders meeting discussing the proposed
take – over. The directors of the acquiree on the other hand would seek
proxies to fight the take over. This results in a proxy war.
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Finding external help (White knight)
The target firm may look for a white knight. This is a company, which the
company approaches with the aim of being taken over.
Changing articles
A change from a simple majority to a super majority may be effected to the
articles to make it difficult to get the support to sanction the transaction.
Poison pills
A poison pill is a suicidal move that makes the firm unattractive to purchase.
The following are examples of the poison pills.
i. Borrowing at terms that require immediate payment of debt if the firm is
involved in a merger.
ii. Selling of some of the company’s most prized assets (crown jewels)
making the firm unattractive without the assets.
iii. Granting golden parachutes to its executives in case of a take over. A
golden parachute is a large cash drain on the firm if it is involved in an
acquisition.
Poor marketing
Successful businesses are those that understand and meet their customer’s
requirements. Detailed market research is essential for new and expanding
businesses. Details relating to potential size of the market, extent of
competition, customer preferences and tastes are important. Lack of market
research when entering new markets results in poor sales and return on
investment.
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A business plan should cover aspects such as marketing, finance, sales and
promotional plans as well as detailed breakdowns of costings and profit
predictions. Failing to plan is planning to fail.
Lack of finance
Insufficient finance means that the business will be unable to take
opportunities that are available to them.
Poor management
Weak and inexperienced management is one of the major causes of business
failure. Managers need to understand their customers, make correct financing
decisions and understand the business that they are in if they are to be
successful.
Overspending
Spending too much on frivolous luxuries instead of products or services that
improve the bottom line can lead to business failure.
Lack of innovation
Some businesses never change; they lose their market share when a new
company comes along with a new way of doing things.
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PREDICTION OF BUSINESS FAILURE
When financial ratios are used correctly they can act as very powerful
indicators in the interpretation of financial statements. In the analysis of
corporate stability and the detection of potential corporate failure ratios can
also be used as Z- scores.
The Z- score for any given company can be compared with the threshold
value above which the company can be classified as safe but below which it
should be considered as candidate for failure. This threshold is applicable to
companies in many different industries.
THL LTD: Profit and loss account for the year ended 31 December 1997
19x7 19x6
$000 $000
Turnover 15 955 17 160
Cost and expenses (15 093) (15 458)
Depreciation (429) (483)
Profit on sale of Investments 85 -
Interest receivable 545 520
Government grants 41 83
Profit before taxation 1 104 1 822
Taxation (416) (542)
Profit on ordinary activities after tax 688 1 280
Dividends (552) (535)
Retained Profit 136 745
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Balance sheet as at 31 December 1997
19x7 19x6
$000 $000
Fixed assets:
Tangible fixed assets 3 249 2 722
Current assets:
Stocks 2 624 2 255
Debtors 2 878 3 678
Investments - 406
Cash at Bank and in Hand 7 072 6 726
Total current assets 12 574 13 065
Current liabilities:
Creditors 4 116 3 890
Net current assets 8 458 9 175
Net capital employed 11 707 11 897
1. ALTMAN’S Z – SCORE
X1 = Working capital
Total Assets
X2 = Retained earnings
Total Assets
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X3 = Profit before Interest and Tax
Total Assets
X4 = Market Capitalisation
Book value of Debts
X5 = Sales
Total Assets
Companies scoring above this score are considered safe whilst companies
scoring below 1.8 should be considered potential failures. Altman believes
that the Z score equation can distinguish between ‘safe’ and ‘potential failures’
up to 2 to 3 years before the actual event.
19x6 19x7
X1 = Working Capital = 9 175 8 458
Total assets 2 722+ 13 065 3 249 + 12 574
= 0.581 = 0.535
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= 0.6972 + 0.7014 + 0.2706 + 1.3908 + 1.087
= 4.147
According to the Altman’s pass mark, both the scores imply that THL Private
limited company is safe.
2. ROBERTSON’S Z – SCORE
This score concentrate on the rate of change in the score from one year to
another. To interpret the results of the Z – Score technique Robertson found
that if the score falls by 40% or more in any year, then any changes have
occurred in the financial health of the company. Consequently the company
should carry out immediate investigations to identify the cause of the deadline
and hopefully stop it.
If the score falls by 40% or more for a second successive year, the company
is likely to face liquidation unless major changes are carried out.
19x6 19x7
X1 = (Sales – Total assets) = (17 160 – 15 787) (15 955- 15 823)
Sales 17 160 15 955
= 0.080 = 0.008
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Current liabilities 3 890 4116
= 2.139 = 1.908
The change in the Z Score from 19x6 to 19x7 is a fall of 18.3% (3.062 –
2.502) / 3.062 x 100%. Even though it is a drop in value there is no real cause
for concern as the threshold value is a fall of 40%.
Changing leadership
Old leadership will be associated with failure and new leadership will be
required. In any event old leaders may be unwilling to implement turnaround
strategies.
Asset sales and closures A failing business can divest as many unwanted
assets as possible. Unwanted but profitable assets may bring in the much-
needed cash, which is then invested in improving the remaining lines of
operation.
Improving profitability
Failing businesses can also try to improve their profitability. Profitability of the
operations that remain may be improved by:
1. Laying off white and blue collar employees
2. Investing in labour saving equipment
3. Tightening financial controls
4. Cutting back on marginal products
5. Reengineering business process to cut costs and boost productivity
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6. Introduction of total quality management processes.
Acquisitions
This may be a surprising strategy but it is a common turnaround strategy.
It involves making acquisitions primarily to strengthen the competitive
position of a company’s remaining core operations.
PROBLEM 1
You have been provided the following financial statements of two companies:
Anger Ltd is the acquiring company, and exchanging its shares on a one-for-
one basis for Trust Ltd’s shares. The exchange ratio is based on the market
prices of the shares of the two companies.
PROBLEM 2
A Ltd decided to take over the business of T Ltd as at 31 December (current
year); the summarized balance sheet of T Ltd as at that date was as follows:
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Assets $
Land and buildings 300 000
Plant and machinery 580 000
Inventories 70 000
Debtors 35 000
Bank 15 000
1 000 000
Liabilities
Equity share capital 500 000
(50 000 shares of $10,00 each)
General reserve 250 000
Profit and loss 120 000
13% Debentures 100 000
Current liabilities 30 000
1 000 000
Additional information
A Ltd agreed to take over all the current assets at their book values but the
fixed assets were to be revalued as under for the purpose:
* Land and buildings, $500 000
* Plant and Machinery, $500 000
* These sums apart, A Ltd is required to pay $50 000 for goodwill
and also to bear dissolution expenses of $10 000 (to be paid
directly by A Ltd).
The expected realization from current assets (other than bank balance) is $90
000.
Purchase consideration was as $130 000 in cash to pay 13% debentures and
other liabilities and the balance is to be paid in equity shares of A Ltd.
Expected benefits (CFAT) accruing to A Ltd are as follows:
Year CFAT
1 $200 000
2 $300 000
3 $260 000
4 $200 000
5 $100 000
Further it is estimated that the market value of T Ltd’s fixed assets would be
$600 000 (Land and buildings) and $40 000 (Plant and machinery) at the end
of 5th year.
Requirement
Do you think A Ltd is likely to be benefited by taking over T Ltd?
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PROBLEM 3
The following is the balance sheet of XYZ Co. Ltd as at 31 December (current
year) as follows:
Assets $
Plant and machinery 250 000
Furniture and fittings 5 000
Inventories 90 000
Debtors 25 000
Bank balance 10 000
380 000
Equity and liabilities
Equity share capital 200 000
(10 000 shares of $20,00 each)
13% Debentures 100 000
Retained earnings 50 000
Creditors 30 000
380 000
The company is absorbed by ABC Co. Ltd at the above date. The
consideration for the absorption is the discharge of debentures at a premium
of 10%, taking over the liability in respect of sundry creditors and a payment
of $14,00 in cash and one share of $10,00 in ABC Ltd at the market value of
$16,00 per share in exchange for one share in XYZ Co. Ltd. The cost of
dissolution of $10 000 is to be met by purchasing company.
Inventories are expected to realize $100 000 and expected collection from
debtors are $20 000.
Expected yearly benefits/CFAT from the business of XYZ Ltd are $150 000 for
five years; Assuming zero salvage value of fixed assets and firm’s cost of
capital of 14%, comment on the financial soundness of the ABC’s
management decision regarding the merger.
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PRACTICE PROBLEMS ON BUSINESS FAILURE
PROBLEM 1
Mouth Ltd is contemplating taking over Teeth Ltd. The following balance
sheet, income statement and notes have been made available:
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Balance Sheet
Assets $
Land and buildings 12 600 000
Plant and equipment 6 400 000
Investments 3 200 000
Total 22 200 000
Current assets
Cash 100 000
Debtors 1 400 000
Stock 800 000
Total 2 300 000
Current liabilities
Creditors 1 600 000
Short term borrowing 900 000
Total 2 500 000
Income Statement
$
Turnover 20 000 000
Operating income 3 800 000
Interest 2 500 000
Net income 300 000
Notes:
Land and buildings have a current market value of $15 million.
Equipment has a current value of $2 million but would require $11 million to
replace.
3 Investments are 1 million shares that have just paid an annual dividend of
20 cents per share. The dividend is expected to have a constant growth of
12% for the foreseeable future and the required rate of return on this
investment is 20%.
Long-term borrowing is through $100 par, 20% coupon debentures that have
a current yield of 24%. The debentures have 20 years to maturity.
Preference stock is privately placed and there is $200 000 in accumulated
dividends.
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Calculate the debt to equity ratio (D/E), current ratio (CR), times interest
earned (TIE), and net profit margin (NPM) and comment on the financial
viability of the company given industry average ratios of:
Debt to equity 40%
Current Ratio 2.05
Times Interest Earned 6x
Net Profit Margin 8%
You have determined that the following equation is able to differentiate those
companies that are likely to go bankrupt and those that will not go bankrupt.
Using the net asset value approach determine the price per share that the
company should be prepared to pay the other company.
CHAPTER 9
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and foreign exchange management is implemented. The foreign exchange
market spans the globe.
Provision of credit
The movement of goods between countries takes time so a means must be
devised to finance inventory in transit. The exporter may provide the finance
or the importer may meet the finance requirements for inventory in transit. The
foreign exchange market provides a third source of credit through specialized
instruments such as banker’s acceptances (A draft accepted by a bank – an
unconditional promise of that bank to honour or make payment on the draft
when it matures) or letters of credit (An instrument issued by a bank at the
request of an importer, in which the bank promises to pay a beneficiary upon
presentation of documents specified in the letter of credit).
MARKET PARTICIPANTS
The foreign exchange market consists of two tiers (layers placed one on top
of the other).
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Five broad categories of participants operate within these two tiers
Dealers use brokers because they want to remain anonymous. The identity of
the participants may influence short – term quotes (of foreign exchange) for
example large companies may pay heavily because of their ability to pay.
Spot transactions
A spot transaction requires an almost immediate delivery of foreign exchange.
In the interbank market it is the purchase of foreign exchange with delivery
and payment between banks to be completed normally on the second
business day.
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A spot transaction between a bank and its commercial client does not
necessarily involve waiting for two days for settlement.
Forward transactions
A forward transaction requires delivery of foreign exchange at some future
date. It requires delivery at a future value date of a specified amount of one
currency for a specified amount of another currency. The exchange rate is
established at the time the contract is agreed upon but payment and delivery
are not required until maturity. Forward exchange rates are normally quoted
for value dates of one, two, three, six and twelve months.
Swap transactions
A swap transaction is the simultaneous purchase and sale of a given amount
of foreign exchange for two different value dates. The following are types of
swap transactions.
(i) “Spot against forward” swap – The dealer buys a currency in the
spot market and simultaneously sells the same amount back to the
same bank in the forward market. As this is executed as a single
transaction with the same bank, the dealer incurs no unexpected
foreign exchange risk. The difference between the spot and forward
rates is known and fixed.
Direct quotes
This is a home currency price of one unit of foreign currency for example
Zim$18 000/UK Pound.
Indirect quotes
This is the price of foreign currency to one unit of home currency.
Foreign exchange selling rate quotations are reported daily in the financial
section of most major newspapers.
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and offer (sell) at a slightly higher price, making their profit from the spread
between the buying and selling prices.
Cross rates
Many currency pairs are not actively traded so their exchange rate is
determined through their relationship to a widely traded third currency. For
example an Australian tourist wants to purchase Danish currency to pay for a
visit to Copenhagen. The Australian dollar (A$) is not actively traded with the
Danish Krone (DKr). Both currencies are actively traded with the US dollar.
Assume the following quotes:
The Australian tourist can exchange 1.3806 A$ for 1US$ and buy 6.4680 DKr.
The cross rate is calculated as follows:
= A$0.2135/DKr
The theory is only applicable to securities with maturities of one year or less
since forward contracts are not routinely available for periods longer than one
year.
START END
$1 000 000 Times 1.02 $1 020 000
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Times
S = 150Yen/$ 90 days F90 = Yen =148. 5294/$
Divided by
Yen 150 000 000 Times 1.01 Yen 151 500 000
If the investor chooses to invest in the dollar money market he will earn an
interest of $20 000 at the end of 90 days. The investor may choose to invest
in a non-dollar money market instrument of identical risk and maturity for the
same period. If he chooses this option he converts the US dollars into Yen at
the spot rate of exchange (S Yen 150/$), invest the money in the Yen money
market and at the end of the period convert the resulting proceeds back to
dollars. The investor evaluates the returns from the dollar money market and
the Yen money market.
Ignoring transaction costs, if the returns in dollars are equal between the two
alternative money market investments this is interest rate party (IRP). The
transaction is “covered” because there is a guaranteed exchange rate back to
dollars at the end of 90 days.
For the two alternatives to be equal any differences in interest rates must be
exactly offset by the difference between the spot and forward exchange rates.
Illustration of CIA
A Hong Kong Investor has 135 000 000 Yen. The spot rate is, S Yen
135.00/$. The 180 day forward rate F180 = Yen 134.50/$. Interest in the Euro
dollar market is 8% per annum. Interest in the EuroYen market is 5% per
annum.
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$1 000 000 Times 1.04 $1 040 000
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Purchasing Power Parity
Fisher effect
International Fisher effect
Interest rate Parity
Forward rate as unbiased predictor of future spot rate.
Under a freely floating exchange rate system, future spot exchange rates are
theoretically determined by the interplay of differing national rates of:
Inflation
Interest rates
Fisher effect
This is a theory that states that nominal interest rates in each country are
equal to the required real rate of return to the investor plus compensation for
the expected amount of inflation.
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Caused by a change in exchange unexpected change in exchange
Rates. Rates.
Transaction exposure
Impact of settling outstanding obligations
entered into before change in exchange rates but
to be settled after change in exchange rates
Time
TRANSACTION EXPOSURE
This is the potential for a change in the value of outstanding financial
obligations entered into prior to a change in exchange rates but not due to be
settled until after the exchange rates change. It deals with changes in cash
flows that result from existing contractual obligations.
OPERATING EXPOSURE
Operating exposure is more important for the long – run health of the
business than changes caused by transactions and translation exposure. But
operating exposure is subjective because it depends on estimates of future
cash flow changes over an arbitrary time horizon.
An expected change in foreign exchange rates is not included in the definition
of operating exposure because both management and investors should factor
this information into their evaluation of expected operating results.
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(among foreign exchange rates, national inflation rates and national interest
rates and product markets) when it occurs but must already have prepared
the firm to react in the most appropriate way. This can be best accomplished if
a firm diversifies internationally both its operations and its financing base.
Diversifying operations
If a firm’s operations are diversified internationally, management is pre –
positioned both to recognize disequilibrium. A disequilibrium occurs when the
purchasing power parity is in temporary disequilibrium. The Purchasing Power
Parity holds that if the spot exchange rate between two countries starts in
equilibrium any change in the differential rate of inflation between them tends
to be offset over the long run by an equal but opposite change in the spot
exchange rate. Management might notice a change in comparative costs in
the firm’s own plants located in different countries. It might also observe
changed profit margins or sales volume in one area compared to another
depending on price and income elasticities of demand and competitor’s
reactions.
A purely domestic firm does not have the option to react to an international
disequilibrium condition in the same manner as a multinational firm. This is
because it lacks the comparative data from its own internal sources. By the
time external data are available from published sources, it is often too late to
react. Even if the domestic firm recognizes the disequilibrium condition it
cannot quickly shift production and sales into foreign markets in which it has
had no previous presence.
Diversifying financing
If a firm diversifies its financing sources, it will be pre – positioned to take
advantage of temporary deviations from the international Fisher effect.
International fisher effect holds that the spot exchange rate should change in
an equal but opposite direction to the difference in interest rates between two
countries. If interest rate differentials do not equal expected changes in
exchange rates, opportunities to lower a firm’s cost of capital will exist. But to
be able to switch financing sources, a firm must already be well known in
international investment community, with banking contacts firmly established.
This position is not available to a domestic firm that is limited to sourcing
finance from the domestic market.
Multinationals can also reduce default risk by matching the mix of currencies
they borrow to the mix of currencies they expect to receive from operations.
This strategy can be used to neutralize transaction and translation exposure
in addition to operating exposure. This strategy is however difficult to
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implement in practice because firms cannot predict either the magnitude or
currency of denomination of cash flows very far into the future. Unexpected
changes in exchange rates may alter the very flows management will be
trying to predict thus changing the currency mix to be matched.
CONTRACTUAL TECHNIQUES
Contractual techniques use hedges as well as swap agreements. A hedge is
a contract or arrangement that provides defense against the risk of loss from
a change in foreign exchange rates.
(1) Forward market hedge This involves a forward contract and a source of
funds to fulfill a contract. The forward contract is entered into at the time the
transaction exposure is created. If funds to fulfill the forward contract are on
hand or are due because of a business operation the hedge is considered
“covered”, “perfect”, or “square” because no residual foreign exchange risk
exists. Funds on hand or to be received are matched by funds to be paid.
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Swap agreements A foreign exchange swap is an agreement between two
parties to exchange a given amount of one currency for another and after a
period of time to give back the original amounts swapped.
Currency swap This resembles a back – to back loan except that it does not
appear on a firm’s balance sheet. Two firms agree to exchange an equivalent
amount of two different currencies for a specified period of time. Currency
swaps can be negotiated for a wide range of maturities up to at least ten
years. If funds are more expensive in one country than another a fee may be
required to compensate for the interest differential.
OPERATING STRATEGIES
Transaction exposure can be partially managed by adopting strategies that
have the effect of offsetting existing foreign exchange exposure. Two
operating strategies particularly useful in managing transaction exposure are
the use of leads and lags and of re-invoicing centers.
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always results in changing the cash and payables position of one firm, with
the reverse effect on the other firm.
Re-invoicing centers
Re-invoicing centre
Singapore
Accounting exposure is the potential for a gain or loss in the parent’s net
worth and reported net income that arises because of exchange rates change.
Basic conventions for translation
The current rate method All assets and liabilities are translated at the
current rate of exchange; the rate of exchange in effect on the balance sheet
date. Income statement items are translated at either the actual exchange
rate on the dates the various revenues, expenses, gains and losses are
incurred or at a weighted average exchange rate for the period.
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Monetary/Non monetary method Monetary assets (cash, marketable
securities, Debtors and long term receivables) and monetary liabilities (current
liabilities and long term debt) are translated at current exchange rates, while
all other assets and liabilities are translated at historical rates.
Income statement items are translated at the average exchange rate for the
period, except for depreciation and cost of sales that are directly associated
with non monetary assets or liabilities. These items are translated at their
historical rate.
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