CASH ANALYSIS AND MANAGEMENTCash is the life blood of every business because without it, a business would not runCash gi...
These items are captured by the cash flow statement accordinglyA cash flow layout is identified as follows:             ...
IAS 7STANDARD LAYOUT OF THE CASH FLOW STATEMENT     Net cash flow from operating activities                 ▼             ...
NET CASH FLOW FROM OPRATING             ACTIVITIES DIRECT METHODCash from sales*                            xxxxLess Cash...
INDIRECT METHOD-NOTE ONEOperating profit                            xxxxADD: Depreciation                            xxxAD...
=NET cash flow from operating activities  XXXXNOTE TWO OF CASH FLOWUsually changes in cash- BANK balance and  ODMAY TAKE...
Cashflow statement when used with other  corporate reports will help bankers and other  users of F/I assess: Coy’s abili...
The reasons for differences between profits and cashflows arising from normal operating activityThe value of a business ...
SOURCES Of CASHINTERNAL SOURCES Business operations-basically NOTE 1 Reducing investment in business assets- reduce  st...
Economic factors etcTHE SOURCES INCLUDELoans- short-term, medium-term, long-termShares –various typesDebentures- basic...
IAS 7-CAH FLOW STATEMENTThe objective of IAS 7 is to require the presentation of information about the historical changes...
RELEVANT CASH FLOWS operating activities are the main revenue-producing  activities of the enterprise that are not invest...
Financing- these include:SHARES NAMELY Going public- advantagesOwners can diversify-growthIncreases liquidityFacilita...
 Going public-disadvantagesCost of reportingDisclosuresSelf-dealings-???Inactive market/low price- fight for a market...
Medium-termLong-term NOTEThe way these are arranged is important.Managers dont want to finance for example  long-term...
Long-term loans are preferredUNBALANCED FINANCIAL DEVELOPMENTSIts top management’s job to maintain an appropriate balanc...
And, within the first category an acceptable  relationship must exist between: Share capital and Loan capitalIt should...
These issues require proper planning- as management often fail to achieve a balanced financial structure either because i...
OVER-TRADINGThis is a situation which will occur when the volume of business activity is excessive in relation to the fin...
 The company would therefore find it difficult to pay wages  due to employees, debts due to suppliers, tax payable to  th...
OVER-CAPILIZATIONOccurs when management is unable to make full  use of the capital available.In this case, it may be pru...
CASH OPERATING CYCLEDefined as the gap that exists between the time it takes for payments for goods or raw materials rece...
WORKING CAPITAL to be financedCALCULATION Calculate the time which the product spends in  each stage of its progression ...
Raw materials- held in stock and then transferred to productionWork in progress- actual processing of raw materialsFini...
Creditors- these finance the production and selling cycle from the time raw materials/goods are received into stock until...
Liquidity (quick) ratio = current assets-inven                        Current LiabilitiesPurpose is to examine solvency....
EXAMPLE OF COMPUTATION Raw material stock= raw materials stocks                       raw materials consumed+production p...
Good to take an example at this stage on COC                     SAN LIO                    28
WORKING CAPITAL MANAGEMENTNeed to observe the relationship between the  cash operating cycle and working capital by  look...
WORKING CAPITAL MANAGEMENTDefined as the excess of current assets over current liabilitiesShed more light on the short-t...
This is certainly unique to every industry e.g. a retailer who sells goods for cash may operate with a much lower ratio t...
It should be noted the recommended Working Capital ratio is 2:1.The working capital ratio = Current assets              ...
EFFICIENCY RATIOSTHE INVENTORY CONVERSION PERIOD= Inventory * 365 (IN DAYS   Sales Tells us how long it takes to convert...
CREDIT POLICY Credit period- what is the length of time buyers are  given to pay for their purchases? Discounts given- u...
PAYABLE S DEFERRAL PERIOD= Payables*365 ( IN DAYS)  PurchasesOR= Payables *365  Cost of goods sold This basically the av...
TAXATION EFFECTSIAS 12 particularly deals with the management of  income taxDEFINES THE FOLLOWING Temporary difference:...
 Deductible temporary difference: A temporary  difference that will result in amounts that are tax  deductible in the fut...
 Current tax assets and liabilities should be  measured at the amount expected to be paid to  (recovered from) taxation a...
VALUE ADDED TAXTax charged at every stage ‘VALUE’ is added to a productOrganizations subjected to VAT receive cash net o...
VAT transactions should be carefully analyzed for  cash budget purposesEXAMPLEMaarifa Limited had a credit balance payabl...
1. Prepare the company’s VAT account for the   first three months of 2010, showing the   balance due at 31 March 20102. Pr...
VALUE ADDED TAX ACCOUNTJan 2010 -VAT paid 16,000 Jan 1 2010 B/F 16000VAT on purchases * 37,500 VAT Sales *      55,500Marc...
CASH ACCOUNTDR Sales cash Ksh 425,500CR Purchases cash Ksh 287,500TRADING ACCOUNTDR Purchases (net of VAT)= Ksh 250,000CR ...
This may mean that VAT is actually paid out to the government before the cash is received from customersOn the other han...
PROJECTS WITH UNEQUAL LIVES when choosing between mutually exclusive projects,   we must first determine if they can be r...
 Lets call these projects A and B as follows PROJECT A is a SIX year period projectCASH FLOWS ARE AS FOLLOWS:YR0        ...
PROJECT B is a THREE year projectCASH FLOWS ARE AS FOLLOWSYR0                   KSH-20,000YR1                   KSH 7,000...
NPV PROJECTS A AND BYR           CF                DF        PVYR0        KSH -40,000        1        -40,000YR1        KS...
BYR          CF                DF         PV(KSH)YR0       KSH-20,000         1          -20,000YR1        KSH 7,000      ...
BUTAlthough the analysis suggests that Project A should be selected, this analysis is incomplete, and the decision to cho...
THE COMMON LIFE APPROACHTherefore, to make a proper comparison of Projects A and B, we could apply the replacement chain ...
For Project B, however, we must add in a second  project to extend the overall life of the combined  projects to six year...
NPV OF B ON COMMON LIFEYR0       KSH-20,000        1       -20,000YR1        KSH 7,000        0.8929     6,250.30YR2      ...
EXPANSION AND STRATEGIC OPTIONS Strategic management is the formal and structured  process by which an organization estab...
 Kenichi Ohmae (1983) defined strategy as the way in which  a corporation endeavours to differentiate itself positively  ...
CAPITAL STRUCTURE OF A FIRMDefined as the proportionate re-alignment of a companys different funding sources, including d...
NOTE: Balance sheet shows assets and how they are financed- IAS 1 guides on full disclosureLong-term sources of finance ...
This so in order that we can achieve the ideal WORKING CAPITAL RATIO of 2:1 i.e. half the value of current assets should ...
The optimum structure depends on such factors as the nature of the trade undertaken, the likely stability of profits (pro...
The initial investment increased by the amounts of profits earned and retained in the business and is reduced by lossesP...
Credit purchases of additional stock needed to expand a successful coy and credit sales also affect the balance between c...
Flows of resources take place with trading, and these have an impact on the enterpriseThe impact may be beneficial or de...
PRACTICAL ASPECTSThe value of a firm is the present value of its  expected future cash flows (FCFs) discounted at  its We...
The implication of this is that the only way any  DECESION can change a firm’s value is by  affecting its: Free cash flo...
Debt increases the cost of stock rs- this is because the fixed claim of debt-holders makes the residual claim of stockhol...
 The risk of bankruptcy increases the cost of debt rd-  this is because with higher bankruptcy risk, debt-  holders will ...
 Bankruptcy threat also negatively affects the  productivity of workers and managers and this  again reduces NOPAT and FC...
 When business is performing well, managers may  waste cash flow on unnecessary expenditures e.g.  expensive cars. This i...
BUSINESS AND FINACIAL RISK Business risk is the risk a firm’s common shareholders  would encounter if the firm had no deb...
ROIC= NOPAT = EBIT(1-T)           Capital          Capital= Net Income to common stockholders + After tax interest payment...
 Business risk depends on the following factors: Demand variability- the more stable the demand is, the  lower the firm’...
 Ability to develop new products in a cost effective  and timely fashion- the faster the possibilities to  develop new pr...
The extent to which costs are fixed- the harder it is for the firm to vary its costs (they are fixed) the higher the busi...
FINANCIAL RISKThis is the additional risk that the common stockholders have to content with because of a decision to FINA...
CALLED SO because the debt-holders who receive a fixed interest payments BEAR NONE of the business riskIn CONCLUSION- fi...
It is important to appreciate how a trade-off between the two should be managed since they affect the VALUE of the firm. ...
OPERATING LEVERAGEThis term is used in business to mean-that- other things constant, a relatively small change in sales r...
 Operating leverage aspect can be use well illustrated by  break-even analysisREVENUE                            +VE EBIT...
High operating leverage     Low operatingleverage                    SAN LIO                   79
MODIGLIANI AND MILLER-NO TAXES Assumptions of the theory of these two gentlemen There are no brokerage costs There are ...
The argument of this theory is that if all these  assumptions hold: then a firm’s VALUE is not  affected by its CAPITAL S...
Thus if MM CAPITAL STRUCTURE THEORY assumptions are correct- then it would not matter how a firm finances its operations ...
MM THE EFFECT OF CORPORATE TAXES This followed a relaxation of the assumption-no taxes  and means corporations will facto...
THUSMM tax shield formulaVL= VU + PV OF TAX SHIELDAccording to MM, the PV of the tax shield =  Corporation tax T*the amo...
MILLER: CORPORATE & PERSONAL               TAXESThis theory of Miller, without Modigliani, brings   in the aspects of per...
He argued that due to these tax implications: Investors are willing to accept comparatively low  BEFORE tax returns on s...
The deductibility of interest on the other hand  favors the use of debt financingAccording to Miller, the net impact of ...
WHERETc= Corporate Tax rateTs= personal tax on income from stocksTd= tax rate on income from debt accordinglyNOTEMille...
However, experts still believe that there is a   tax advantage to debtEXAMPLEIf we assume a Tc 40%, Td=30% and Ts=12%Then...
THE TRADE-OFF THEORYMM theory assumes no bankruptcy costsThe truth is that bankruptcy can be quite costly because this e...
When there is huge debt in the capital structure bankruptcy gets more complicated- particularly if debt is utilised to pu...
Thus according to this theory,VL= VU + Value of any side effects which include:The tax shiedThe expected costs due to ...
THE SIGNALING THEORY MM assumed symmetric information i.e. investors  have the same information about a firm’s prospects ...
 Thus debt offering is taken as a positive SIGNAL On the other hand- a firm with negative  prospects would go for stock/...
A firm with better prospects would not sell shares- because it wants to avoid EPS dilution- hence it will go for debt fin...
Since issuing stock sends the wrong signals, and thereby depressing the stock price even when the company’s prospects are...
ASYMMETRIC SITUATIONThis drives an entity to raise capital in a PECKING ORDER thus:Raise capital internally by reinvesti...
SUMMARYEstimating the optimal capital structure of a firm  should involve the following STEPS namely: Estimate the inter...
GENERALLY-FIRMS CONSIDER: Sales stability- stable sales will allow for taking more  debt Asset structure- assets that ar...
 Taxes- the higher the firm’s taxes, the greater the  advantage for debt finance Control- debt may be a better option wh...
The firm’s internal conditions- a firm with better future prospects would rather go for debt finance until the higher exp...
Upcoming SlideShare
Loading in …5
×

Cash analysis & management

473 views
314 views

Published on

Published in: Economy & Finance
0 Comments
0 Likes
Statistics
Notes
  • Be the first to comment

  • Be the first to like this

No Downloads
Views
Total views
473
On SlideShare
0
From Embeds
0
Number of Embeds
2
Actions
Shares
0
Downloads
9
Comments
0
Likes
0
Embeds 0
No embeds

No notes for slide

Cash analysis & management

  1. 1. CASH ANALYSIS AND MANAGEMENTCash is the life blood of every business because without it, a business would not runCash gives more liquidity than securities- thus the reason business people dont take all their cash and invest it in interest-bearing securitiesThus determining how much cash has been generated in every bottom line year in criticalIs should be noted that there are transaction items that hit the balance sheet which dont hit the P &L and vice versa SAN LIO 1
  2. 2. These items are captured by the cash flow statement accordinglyA cash flow layout is identified as follows: SAN LIO 2
  3. 3. IAS 7STANDARD LAYOUT OF THE CASH FLOW STATEMENT Net cash flow from operating activities ▼ PLUS OR MINUS Investing Activities ▼ Financing ▼ EQUALSINCREASE OR DECREASE IN CASH OVER THE PERIOD SAN LIO 3
  4. 4. NET CASH FLOW FROM OPRATING ACTIVITIES DIRECT METHODCash from sales* xxxxLess Cash paid for purchases * (xxxx)Less cash paid for admin expenses (xxx)Less cash paid for distribution expenses (xxx)LESS TAXATION (xxx)Net cash flow from operating activities xxxx*CASH FROM SALES= Sales +opening debtors –closing debtors*CASH PURCHASES= Purchases+ open creditors- closing creditors SAN LIO 4
  5. 5. INDIRECT METHOD-NOTE ONEOperating profit xxxxADD: Depreciation xxxADD: loss on sale of fixed assets xxxLESS: Profit on sale of fixed assets (xxx)INCREASES IN STOCKS (XXX)DECREASE IN STOCKS XXXINCREASE IN DEBTORS (XXX)DECREASE IN DEBTORS XXXINCREASE IN CREDITORS XXXDECREASE IN CREDITORS (XXX)LESS TAXATION (XXX) SAN LIO 5
  6. 6. =NET cash flow from operating activities XXXXNOTE TWO OF CASH FLOWUsually changes in cash- BANK balance and ODMAY TAKE AN ILLUSTRATION SAN LIO 6
  7. 7. Cashflow statement when used with other corporate reports will help bankers and other users of F/I assess: Coy’s ability to generate future net cashflow Whether a coy is able to meet its financial obligations e.g. payment of dividends, interest etc The effect on the coy’s financial position of investments undertaken during the accounting period SAN LIO 7
  8. 8. The reasons for differences between profits and cashflows arising from normal operating activityThe value of a business since the statement provides a useful information for business valuation models based on estimates of likely future cashflows SAN LIO 8
  9. 9. SOURCES Of CASHINTERNAL SOURCES Business operations-basically NOTE 1 Reducing investment in business assets- reduce stocks for example Retained earnings Loans from directorsEXTERNAL SOURCES- DEPENDS ON The nature of the business The size of the business Directors involved SAN LIO 9
  10. 10. Economic factors etcTHE SOURCES INCLUDELoans- short-term, medium-term, long-termShares –various typesDebentures- basically loan agreementGovernment- grantsBondsFriends and family members SAN LIO 10
  11. 11. IAS 7-CAH FLOW STATEMENTThe objective of IAS 7 is to require the presentation of information about the historical changes in cash and cash equivalents of an enterprise by means of a statement of cash flows, which classifies cash flows during the period according to operating, investing, and financing activities SAN LIO 11
  12. 12. RELEVANT CASH FLOWS operating activities are the main revenue-producing activities of the enterprise that are not investing or financing activities, so operating cash flows include cash received from customers and cash paid to suppliers and employees –WILL SEE MORE IN WC management investing activities are the acquisition and disposal of long-term assets and other investments that are not considered to be cash equivalents Management of liquid resources- short-term investments –usually within a year –e.g. stocks assets SAN LIO 12
  13. 13. Financing- these include:SHARES NAMELY Going public- advantagesOwners can diversify-growthIncreases liquidityFacilitates raising new corporate cashEstablishes a value for the firmSets up merger negotiationsIncreases potential markets SAN LIO 13
  14. 14.  Going public-disadvantagesCost of reportingDisclosuresSelf-dealings-???Inactive market/low price- fight for a market shareControl- voting rightsLOANS AND DEBENTURES These are interest bearing funds and could beShort-term SAN LIO 14
  15. 15. Medium-termLong-term NOTEThe way these are arranged is important.Managers dont want to finance for example long-term investments with short-term loans. This is a recipe for corporate failureIn fact it is important to WATCH for any short- term loans . Can the firm pay these as they fall due in the short-term SAN LIO 15
  16. 16. Long-term loans are preferredUNBALANCED FINANCIAL DEVELOPMENTSIts top management’s job to maintain an appropriate balance between:Long-termMedium-termShort-term finance SAN LIO 16
  17. 17. And, within the first category an acceptable relationship must exist between: Share capital and Loan capitalIt should be noted that once expansion occurs, additional long-term finance is needed to cover the cost of fixed assets and working capital requirements; while a reduction in the scale of a company’s operations may permit the repayment of certain sources of finance SAN LIO 17
  18. 18. These issues require proper planning- as management often fail to achieve a balanced financial structure either because it does not plan, ahead or because unexpected events occur.There are two main aspects of unbalanced financial development namely:Over-tradingOver-capitalization SAN LIO 18
  19. 19. OVER-TRADINGThis is a situation which will occur when the volume of business activity is excessive in relation to the finance provided by the shareholdersA situation like this will lead to the company to start going for external finance in the form of loan capital, bank overdrafts, and trade creditIn essence management has attempted to undertake too much too quickly meaning the company is left with insufficient resources to meet its currently maturing liabilities SAN LIO 19
  20. 20.  The company would therefore find it difficult to pay wages due to employees, debts due to suppliers, tax payable to the government, etc The signs of over-trading should be looked for in the balance sheet and they include: A decline in the ratios of debtors /creditors and current assets/current liabilities A low figure of working capital A high ratio of fixed assets to working capital A severe shortage of cash Bankers are particularly interested in this scenario (over- trading) because it is common cause of business failure SAN LIO 20
  21. 21. OVER-CAPILIZATIONOccurs when management is unable to make full use of the capital available.In this case, it may be prudent for management to return capital to the members either by purchasing or redeeming some of its shares or by canceling shares not unrepresented by assets.SOLUTIONS?Return part of the capital by: Purchasing shares/redemption of shares Repayment of loan capital SAN LIO 21
  22. 22. CASH OPERATING CYCLEDefined as the gap that exists between the time it takes for payments for goods or raw materials received into stock AND the collection cash from customers following their saleDuring this period, the goods acquired together with the value added in the case of manufacturers must be financed by the coyNOTE the shorter the length of time between the initial outlay and the ultimate collection of cash the smaller is the value of W/C SAN LIO 22
  23. 23. WORKING CAPITAL to be financedCALCULATION Calculate the time which the product spends in each stage of its progression from acquisition to sale and actual cash receipt LESS the period of credit received from suppliersElements in the calculation include: Stocks-held for a time then used or sold. These would include: SAN LIO 23
  24. 24. Raw materials- held in stock and then transferred to productionWork in progress- actual processing of raw materialsFinished goods-transferred from factory to ware houseDebtors – the average age of debts should be found from the values of debtors and sales SAN LIO 24
  25. 25. Creditors- these finance the production and selling cycle from the time raw materials/goods are received into stock until they are paid for. The period is found from the values of creditors and purchasesLiquidity check may be used alongside W/C management SAN LIO 25
  26. 26. Liquidity (quick) ratio = current assets-inven Current LiabilitiesPurpose is to examine solvency. Concentrates attention more directly on a coy’s prospect of paying its debts as they fall due by excluding current assets which will not be converted into cash within the next couple of months.Called the acid test of solvency SAN LIO 26
  27. 27. EXAMPLE OF COMPUTATION Raw material stock= raw materials stocks raw materials consumed+production period= Work in progres COG manufactured+finished goods stocks= finished goods COG Sold+credit to customers = debtors SalesLESS Credit from suppliers=Creditors Purchases of raw=CASH OPERATING CYCLE IN DAYS SAN LIO 27
  28. 28. Good to take an example at this stage on COC SAN LIO 28
  29. 29. WORKING CAPITAL MANAGEMENTNeed to observe the relationship between the cash operating cycle and working capital by looking at our example and identifying whether or not WORKING CAPITAL HAS INCREASEDThis done by analysing movement in: Stocks Debtors CreditorsFor the two years 2009 and 2008 SAN LIO 29
  30. 30. WORKING CAPITAL MANAGEMENTDefined as the excess of current assets over current liabilitiesShed more light on the short-term solvency of the coy i.e. its ability to pay debts as they fall dueThe gist of the matter is to determine the rate at which current assets are converted into cash and how quickly current liabilities are paid SAN LIO 30
  31. 31. This is certainly unique to every industry e.g. a retailer who sells goods for cash may operate with a much lower ratio than a manufacturer who sells goods on credit. This is because for the manufacturer, goods sold are ‘tied up’ as debts before cash becomes available.On the same vain, the period for which stocks are held varies from industry to industry e.g. a small metal manufacturer may convert raw materials into finished goods much faster than a construction company SAN LIO 31
  32. 32. It should be noted the recommended Working Capital ratio is 2:1.The working capital ratio = Current assets Current LiabilitiesAnd the result is given as a ratioThe above arguments guide on what should be an acceptable ratio (and not just a conclusion of an ideal 2:1)Again this is closely linked to the cash operating cycle SAN LIO 32
  33. 33. EFFICIENCY RATIOSTHE INVENTORY CONVERSION PERIOD= Inventory * 365 (IN DAYS Sales Tells us how long it takes to convert raw materials raw materials into finished goodsRECEIVABLE COLLECTION PERIOD= Receivables *365 (In days) Sales Tells us how long it takes to convert receivables after a sale into Cash. SAN LIO 33
  34. 34. CREDIT POLICY Credit period- what is the length of time buyers are given to pay for their purchases? Discounts given- usually given for early settlement of accounts. If payment not done within the discount period, then FULL amounts are paid Credit standards- means the required financial strength of acceptable credit customers. Lower credit standards boost sales BUT also increase the possibility of bad debts Collection policy- usually gauged by its efficiency in- terms of collecting slow-paying accounts SAN LIO 34
  35. 35. PAYABLE S DEFERRAL PERIOD= Payables*365 ( IN DAYS) PurchasesOR= Payables *365 Cost of goods sold This basically the average length of time between the purchase of materials and labor and subsequent cash payment for these SAN LIO 35
  36. 36. TAXATION EFFECTSIAS 12 particularly deals with the management of income taxDEFINES THE FOLLOWING Temporary difference: A difference between the carrying amount of an asset or liability and its tax base. Taxable temporary difference: A temporary difference that will result in taxable amounts in the future when the carrying amount of the asset is recovered or the liability is settled SAN LIO 36
  37. 37.  Deductible temporary difference: A temporary difference that will result in amounts that are tax deductible in the future when the carrying amount of the asset is recovered or the liability is settled CURRENT TAX-Current tax for the current and prior periods should be recognised as a liability to the extent that it has not yet been settled, and as an asset to the extent that the amounts already paid exceed the amount due. SAN LIO 37
  38. 38.  Current tax assets and liabilities should be measured at the amount expected to be paid to (recovered from) taxation authorities, using the rates/laws that have been enacted or substantively enacted by the balance sheet dateTREATMENT/EFFECT Accrued items go the balance sheet CASH ITEMS go to the CASH FLOW statement CASH ITEMS are itemized in Cash budget/cash forecast SAN LIO 38
  39. 39. VALUE ADDED TAXTax charged at every stage ‘VALUE’ is added to a productOrganizations subjected to VAT receive cash net of VAT deductions and therefore this effect must be taken into accountThere is a further cash effect when the VAT collected called the output tax less any tax paid on purchases (input VAT) is chargedIf the input tax exceeds the output tax, reimbursement of the difference is made to the company SAN LIO 39
  40. 40. VAT transactions should be carefully analyzed for cash budget purposesEXAMPLEMaarifa Limited had a credit balance payable in January 2010 on its VAT account of KSH 16,000 on December 2009. During the first three months of 2010 the organization made cash purchases net of VAT of KSH 250,000 and cash sales including VAT of KSH 425,500. Assume rate of VAT of 15%REQUIRED SAN LIO 40
  41. 41. 1. Prepare the company’s VAT account for the first three months of 2010, showing the balance due at 31 March 20102. Prepare a schedule showing the appropriate numbers relating to purchases and salesa) In the cash accountb) In the trading accountSOLUTION SAN LIO 41
  42. 42. VALUE ADDED TAX ACCOUNTJan 2010 -VAT paid 16,000 Jan 1 2010 B/F 16000VAT on purchases * 37,500 VAT Sales * 55,500March 31 2010 C/D 18,000 0 71,500 71,500*Purchases ksh 250,000*15%= Ksh 37,500*Sales 115% = 425,500 ? 100% = 425,500*100/115= 370,000Thus: VAT = 425,500-370,000= Ksh 55,500 SAN LIO 42
  43. 43. CASH ACCOUNTDR Sales cash Ksh 425,500CR Purchases cash Ksh 287,500TRADING ACCOUNTDR Purchases (net of VAT)= Ksh 250,000CR Sales (net of VAT) Ksh 370,000NOTEWhen sales made on credit the company’s liability to pay VAT arises once the invoice is issued. SAN LIO 43
  44. 44. This may mean that VAT is actually paid out to the government before the cash is received from customersOn the other hand VAT on credit purchases may be set off against output VAT as soon as liability is entered into the books and before payments to the creditors are made. ( it is not necessary to wait until the debt is settled) SAN LIO 44
  45. 45. PROJECTS WITH UNEQUAL LIVES when choosing between mutually exclusive projects, we must first determine if they can be repeated, and if so, we must take this into account when we estimate the projects’ profitability. If a company is choosing between two mutually exclusive alternatives with significantly different lives, an adjustment may be necessaryILLUSTRATION We may illustrate this by assuming a company that wishes to invest in TWO mutually exclusive projects SAN LIO 45
  46. 46.  Lets call these projects A and B as follows PROJECT A is a SIX year period projectCASH FLOWS ARE AS FOLLOWS:YR0 KSH -40,000YR1 KSH 8,000YR2 KSH 14,000YR3 KSH 13,000YR4 KSH 12,000YR5 KSH 11,000YR6 KSH 10,000 SAN LIO 46
  47. 47. PROJECT B is a THREE year projectCASH FLOWS ARE AS FOLLOWSYR0 KSH-20,000YR1 KSH 7,000YR2 KSH 13,000YR3 KSH 12,000The COST of capital of the company is 12%IF we were to do the NPV of the two projects, we can conclude as follows: SAN LIO 47
  48. 48. NPV PROJECTS A AND BYR CF DF PVYR0 KSH -40,000 1 -40,000YR1 KSH 8,000 0.8929 7,143.20YR2 KSH 14,000 0.7972 11,160.80YR3 KSH 13,000 0.7118 9,253.40YR4 KSH 12,000 0.6355 7,626.00YR5 KSH 11,000 0.5674 6,241.40YR6 KSH 10,00 0.5066 5,066.00 NPV (A) 6,490.80 SAN LIO 48
  49. 49. BYR CF DF PV(KSH)YR0 KSH-20,000 1 -20,000YR1 KSH 7,000 0.8929 6,250.30YR2 KSH 13,000 0.7972 10,363.60YR3 KSH 12,000 0.7118 8,541.60NPV (B) 5,155.50Thus from this analysis the company will choose project A since it has the higher NPVIRR of A =17.5% AND of B = 25.2% SAN LIO 49
  50. 50. BUTAlthough the analysis suggests that Project A should be selected, this analysis is incomplete, and the decision to choose Project A is actually incorrect.If we choose Project B, we will have an opportunity to make a similar investment in three years, and if cost and revenue conditions remain at the SAME, this second investment will also be profitable.However, if we choose Project A, we will not have this second investment opportunity. SAN LIO 50
  51. 51. THE COMMON LIFE APPROACHTherefore, to make a proper comparison of Projects A and B, we could apply the replacement chain (common life) approachThis involves finding the NPV of Project B over a six-year period, and then comparing this extended NPV with the NPV of Project C over the same six years.The NPV for Project A as calculated is already over the six-year common life. SAN LIO 51
  52. 52. For Project B, however, we must add in a second project to extend the overall life of the combined projects to six years.Here we assume (1) that Project B’s costs and annual cash inflows will not change if the project is repeated in three years and (2) that the COY’s cost of capital will remain at 12% THUS YRS 4-5 &6 = CFs Ksh 7,000, 13,000 and 12,000 respectively SAN LIO 52
  53. 53. NPV OF B ON COMMON LIFEYR0 KSH-20,000 1 -20,000YR1 KSH 7,000 0.8929 6,250.30YR2 KSH 13,000 0.7972 10,363.60YR3 KSH -8,000* 0.7118 -5,694.40YR4 KSH 7,000 0.6355 4,448.50YR5 KSH 13,000 0.5674 7,376.20YR6 KSH 12,000 0.5066 6,079.20NPV(B-COMMON LIFE APPROACH) 8,823.40* (12,000-20,000). B is selected. SAN LIO 53
  54. 54. EXPANSION AND STRATEGIC OPTIONS Strategic management is the formal and structured process by which an organization establishes a position of strategic leadership. Strategic leadership is about the achievement of sustained comparative advantage over the competition Thus strategy is knowing the business you propose to carry out Kenneth Andrew (1971) defined strategy as the pattern of major objectives; purposes or goals and essential policies or plans for achieving those goals, stated in such a way as to define what business the company is in or is to be in and the kind of company it is or is to be SAN LIO 54
  55. 55.  Kenichi Ohmae (1983) defined strategy as the way in which a corporation endeavours to differentiate itself positively from its competitors, using its relative strengths to better satisfy customer needs. I define strategy as being different!. Your talents are unique, and they indeed can be implemented in a unique way. SO, how does a business move from here? Capital budgeting-identify projects SOURCES of capital-capital structure decisions Cash flow management- CASH is CRITICAL Strategy management- stay ahead SAN LIO 55
  56. 56. CAPITAL STRUCTURE OF A FIRMDefined as the proportionate re-alignment of a companys different funding sources, including debt, equity and other hybrid instruments such as convertible bonds. Capital structure can fairly easily be measured by the ratio of long-term debt to total capital.At the beginning of trade, a coy should have a balanced capital structureThis means assets should be financed/funded by the appropriate types of finance SAN LIO 56
  57. 57. NOTE: Balance sheet shows assets and how they are financed- IAS 1 guides on full disclosureLong-term sources of finance e.g. equity capital and debentures should cover all investment in fixed assetsBut with sufficient excess to make a significant contribution towards funding current assets SAN LIO 57
  58. 58. This so in order that we can achieve the ideal WORKING CAPITAL RATIO of 2:1 i.e. half the value of current assets should be financed by long-term capital and the remainder by short term sources e.g. creditorsEven within the long-term sources of funds, a satisfactory relationship should be created between various types available- whether it is shares or loans SAN LIO 58
  59. 59. The optimum structure depends on such factors as the nature of the trade undertaken, the likely stability of profits (product lines, markets etc)Lets assume this ideal structure is established as at the beginning of tradeOn day one of trade, the financial structure established at the outset begins to be affected by the results of trading as well as passage of time namely: SAN LIO 59
  60. 60. The initial investment increased by the amounts of profits earned and retained in the business and is reduced by lossesPassage of time means long-term loans being paid gets closer to the end of their term and may be classified as current liabilities The rate at which debtors pay and creditors are paid affect the balance between current assets and current liabilities SAN LIO 60
  61. 61. Credit purchases of additional stock needed to expand a successful coy and credit sales also affect the balance between current assets and current liabilitiesIn the long-run, success may encourage the acquisition of extra production capacity which must be funded by appropriate type of finance to maintain the structure SAN LIO 61
  62. 62. Flows of resources take place with trading, and these have an impact on the enterpriseThe impact may be beneficial or detrimental i.e. may lead to success or failureManagers are paid to manage this structure and desirable balance of financing business activities SAN LIO 62
  63. 63. PRACTICAL ASPECTSThe value of a firm is the present value of its expected future cash flows (FCFs) discounted at its Weighted Average Cost of Capital(WACC)WACC depend on such factors as : The percentage of debt and equity (Wd and We) The cost of debt (rd) The cost of stock(rs) The corporate tax rate(T)THIS MEANSWACC= Wd(1-T)rd+ We*rs SAN LIO 63
  64. 64. The implication of this is that the only way any DECESION can change a firm’s value is by affecting its: Free cash flows The cost of capitalWHY?Because:V(Value of the firm)= ∑ FCFt (1+WACC)t SAN LIO 64
  65. 65. Debt increases the cost of stock rs- this is because the fixed claim of debt-holders makes the residual claim of stockholders become less certain, hence increasing the cost of stockDebt reduces the taxes a company will pay- this because companies deduct interest expenses when calculating taxable income. Notice the sharing of the company’s ‘spoils’ is between the debt-holders, investors and the government. This reduction in taxes reduces the after-tax cost of DEBT SAN LIO 65
  66. 66.  The risk of bankruptcy increases the cost of debt rd- this is because with higher bankruptcy risk, debt- holders will insist on a higher expected return- and this effectively increases pre-tax cost of debt The risk of bankruptcy REDUCES Free Cash Flow- this is because : as risk of bankruptcy increases, some customers will certainly opt to buy from another more stable company –which reduces sales. This scenario effectively DECREASES Net Operating Profit after Tax (NOPAT)-thereby reducing FCF SAN LIO 66
  67. 67.  Bankruptcy threat also negatively affects the productivity of workers and managers and this again reduces NOPAT and FCF Bankruptcy threat also makes suppliers tighten their credit levels –which reduces payables causing net operating working capital to increase and therefore reducing FCF. These events effectively reduces the value of the firmBankruptcy threat AFFECTS agency costs- this is because: SAN LIO 67
  68. 68.  When business is performing well, managers may waste cash flow on unnecessary expenditures e.g. expensive cars. This is purely an agency cost (CALLED THE AGENCY PROBLEM). Threat of bankruptcy and possible take-over bids reduces this wasteful spending and this INCREASES FCF The other effect is that in times of threats, managers may reject risky but would be profitable projects because to the manager- the company is his only investment BUT shareholders may be well diversified and therefore willing to take on risk projects which promise higher returns (CALLED THE UNDERINVESTMENT PROBLEM) SAN LIO 68
  69. 69. BUSINESS AND FINACIAL RISK Business risk is the risk a firm’s common shareholders would encounter if the firm had no debt. Note that the greater the use of debt, the greater the concentration of risk on the stockholders, and the higher the cost of common equity. Business risk arises from uncertainty in projections of an entity’s cash flows- which simply means uncertainty about the entity’s operating profit as well as its capital (investment)requirements The return on INVESTED capital (ROIC) puts these two aspects together to measure business risk SAN LIO 69
  70. 70. ROIC= NOPAT = EBIT(1-T) Capital Capital= Net Income to common stockholders + After tax interest payments CapitalNOTE :CAPITAL= FIRM’S DEBT + EQUITYAnd it means the required amount of operating capital accordingly SAN LIO 70
  71. 71.  Business risk depends on the following factors: Demand variability- the more stable the demand is, the lower the firm’s business risk Sales price variability- the more reliable output prices are, the lower the firm’s business risk Input cost variability- the more stable the input costs the lower the business risk Ability to change output prices when output costs changes- the greater the ability to adjust and match output prices with input costs the lower the business risk SAN LIO 71
  72. 72.  Ability to develop new products in a cost effective and timely fashion- the faster the possibilities to develop new products as older ones become obsolete the lower the business risk Foreign risk exposure- if a firm engages in the production of overseas products, it is subject to exchange rate fluctuations. The faster the fluctuations the higher the business risk Political and economic stability- the less the stability, the higher the business risk SAN LIO 72
  73. 73. The extent to which costs are fixed- the harder it is for the firm to vary its costs (they are fixed) the higher the business risk.NOTE: This scenario is known as OPERATING LEVERAGE SAN LIO 73
  74. 74. FINANCIAL RISKThis is the additional risk that the common stockholders have to content with because of a decision to FINANCE USING DEBTNote that normally, stockholders would be exposed to a risk inherent in the firm’s operations- this is basically the business risk being the uncertainty inherent in the projections of future ROIC (ROCE)Where an entity uses debt (financial leverage), this increases risk to the common stockholdersFinancial experts call this risk CONCENTRATION- SAN LIO 74
  75. 75. CALLED SO because the debt-holders who receive a fixed interest payments BEAR NONE of the business riskIn CONCLUSION- financing with debt increases the common stock-holders expected rate of return on an investment projectDebt also increases the common stockholder’s risk in an investment project accordinglyBut typically, FINANCIAL LEVERAGE increases expected ROE (Return On Equity) but also INCREASES RISK SAN LIO 75
  76. 76. It is important to appreciate how a trade-off between the two should be managed since they affect the VALUE of the firm. SAN LIO 76
  77. 77. OPERATING LEVERAGEThis term is used in business to mean-that- other things constant, a relatively small change in sales results in a large change in EBIT (Earnings Before Interest and Tax)The higher a firm’s fixed costs, the higher is its operating leverageNote that other things constant, the higher the firm’s operating leverage, the higher is its business risk- simply because the said firm can not vary its costs as DEMAND changes. SAN LIO 77
  78. 78.  Operating leverage aspect can be use well illustrated by break-even analysisREVENUE +VE EBIT -VE EBIT SALES BREAK-EVEN EBIT=0 SAN LIO 78
  79. 79. High operating leverage Low operatingleverage SAN LIO 79
  80. 80. MODIGLIANI AND MILLER-NO TAXES Assumptions of the theory of these two gentlemen There are no brokerage costs There are no taxes There are bankruptcy costs Investors can borrow at the same rate as corporations All investors have the same information as management about the firm’s investment opportunities EBIT is not affected by the use of debt SAN LIO 80
  81. 81. The argument of this theory is that if all these assumptions hold: then a firm’s VALUE is not affected by its CAPITAL STRUCTURETHUSVL= VU=SL+DWHEREVL= The value of a levered firmVU= The value of an identical but unlevered firmSL= The value of the levered firm’s stockD= The value the levered firm’s Debt SAN LIO 81
  82. 82. Thus if MM CAPITAL STRUCTURE THEORY assumptions are correct- then it would not matter how a firm finances its operations and therefore CAPITAL STRUCTURE DECISIONS would be irrelevant.The moral of this theory therefore is the fact that- it tells us when capital decisions would be irrelevant and thus helps financial experts deal with what is required for capital structure decisions to remain relevant and hence determining a firm’s VALUE SAN LIO 82
  83. 83. MM THE EFFECT OF CORPORATE TAXES This followed a relaxation of the assumption-no taxes and means corporations will factor in taxation Interest payments are expenses deductible (DIVIDEND IS NOT)and therefore interest payment reduces the amount of taxes paid by a corporation This subsequently means that if corporations pay less taxes to the government, then more of its cash flow is made available to its investors (i.e. the tax deductibility of the interest payments shield a firm’s pre-tax income) SAN LIO 83
  84. 84. THUSMM tax shield formulaVL= VU + PV OF TAX SHIELDAccording to MM, the PV of the tax shield = Corporation tax T*the amount of debt DTHUSVL= VU+TDWHEREVL=Value of the levered firmVU=Value of the unlevered firm SAN LIO 84
  85. 85. MILLER: CORPORATE & PERSONAL TAXESThis theory of Miller, without Modigliani, brings in the aspects of personal taxesHe separated income as follows: Income from bonds- which is basically interest and which is taxed at rates (Td) Income from stocks which is basically dividends as well as capital gains- and that CAPITAL gains are taxed at a LOWER effective rate (Ts) than returns on debt (dividend tax is withheld in Kenya)(IF stock is held until the owner dies no taxes paid) SAN LIO 85
  86. 86. He argued that due to these tax implications: Investors are willing to accept comparatively low BEFORE tax returns on stocks relative to the BEFORE tax returns on bonds (WHY?) Remember risk- and how it affects required rate of returnThe point is: The more favourable tax treatment of income from stock lowers the required rate of return on stocks and therefore favouring equity financing SAN LIO 86
  87. 87. The deductibility of interest on the other hand favors the use of debt financingAccording to Miller, the net impact of both corporate and personal taxes can be measured by the equation:VL=VU + 1- (1-Tc)(1-Ts) *D (1-Td) SAN LIO 87
  88. 88. WHERETc= Corporate Tax rateTs= personal tax on income from stocksTd= tax rate on income from debt accordinglyNOTEMiller’s argument is that the marginal tax rates on stock and debt balance out such that the entire bracket portion of the equation equals ZEROThusVL=VU SAN LIO 88
  89. 89. However, experts still believe that there is a tax advantage to debtEXAMPLEIf we assume a Tc 40%, Td=30% and Ts=12%Then the advantage of debt financing isVL= VU+ 1 – (1-0.4)(1-0.12) *D (1-0.30) VL = VU+0.25D SAN LIO 89
  90. 90. THE TRADE-OFF THEORYMM theory assumes no bankruptcy costsThe truth is that bankruptcy can be quite costly because this exercise leads to extremely high legal and other accounting expensesCustomers , suppliers and employees are also lostEntities may also be forced to realise assets for less than they would be worth in normal business operationsIt should noted that most fixed assets are illiquid as they are made to meet the specific company’s needs SAN LIO 90
  91. 91. When there is huge debt in the capital structure bankruptcy gets more complicated- particularly if debt is utilised to purchase fixed assets which would otherwise not sell in bankruptcyIt is these developments that led to the development of the so called TRADE-OFF THEROY LEVERAGEEntities simply trade-off the benefits of DEBT FINANCING (favourable corporate tax treatment) AGAINST the higher interest rates and bankruptcy costs SAN LIO 91
  92. 92. Thus according to this theory,VL= VU + Value of any side effects which include:The tax shiedThe expected costs due to bankruptcy and financial distress SAN LIO 92
  93. 93. THE SIGNALING THEORY MM assumed symmetric information i.e. investors have the same information about a firm’s prospects as its managers But the truth is that managers have better information about the firm than the firm’s investors This is what is known as Asymmetric information and it does in fact affect the optimal capital structure SUMMARY A firm with positive prospects would AVOID selling stock/shares and GO FOR DEBT FINANCE to avoid EPS dilution SAN LIO 93
  94. 94.  Thus debt offering is taken as a positive SIGNAL On the other hand- a firm with negative prospects would go for stock/shares sell- which would mean bringing in new investors to share the losses Thus the announcement of stock offering is taken as a SIGNAL that the firm’s prospects as seen by its management are not goodWHATS UP WITH STOCK? We are looking at future prospects of a firm SAN LIO 94
  95. 95. A firm with better prospects would not sell shares- because it wants to avoid EPS dilution- hence it will go for debt financing- and make the ‘kill’ for its existing shareholdersA firm with poor future prospects on the other hand will sell stocks-and avoid debt- since it may not even repay the debt in the future- and thus invites others to share in the lossesIN SUMMARY SAN LIO 95
  96. 96. Since issuing stock sends the wrong signals, and thereby depressing the stock price even when the company’s prospects are bright,A firm should maintain a BORROWIN CAPACITY that can be used when good investment opportunities come alongThis simply means in normal circumstances, firms should use MORE EQUITY and LESS DEBT SAN LIO 96
  97. 97. ASYMMETRIC SITUATIONThis drives an entity to raise capital in a PECKING ORDER thus:Raise capital internally by reinvesting its net income as well as selling its short-term marketable securitiesIssue debt- is a good signalIssue preferred stock- is a good signalOnly as a last resort will the managers issue common stock SAN LIO 97
  98. 98. SUMMARYEstimating the optimal capital structure of a firm should involve the following STEPS namely: Estimate the interest rate the entity will pay Estimate the cost of equity Estimate the weighted average cost of capital Estimate the free cash flows and their present value, which basically is the value of the firm Deduct the value of the debt to find the shareholders wealth- which is MAXIMIZED SAN LIO 98
  99. 99. GENERALLY-FIRMS CONSIDER: Sales stability- stable sales will allow for taking more debt Asset structure- assets that are suitable as security for debt encourage firms to heavily go for debt Operational leverage- firms with less operating leverage can employ financial leverage since it will have less business risk Growth- encourages reliance on external capital sources Profitability- the higher the return on investment, the less the debt SAN LIO 99
  100. 100.  Taxes- the higher the firm’s taxes, the greater the advantage for debt finance Control- debt may be a better option where control is a factor Management attitudes- this is about management judgement on capital structure. Conservative managers use less debt Lender and rating agency attitudes- these will influence capital structure accordingly Market conditions- stock & bond market conditions, when they cant sell, debt becomes the choice SAN LIO 100
  101. 101. The firm’s internal conditions- a firm with better future prospects would rather go for debt finance until the higher expected earnings are realised- BECAUSE THESE MAKE THE STOCK PRICE BETTERFinancial flexibility- the more the profitable investment opportunities, the more it is likely to have a flexible capital structureWHILE MAKING CAPITAL DECISIONS. SAN LIO 101

×