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 don't 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 don't hit
the P &L and vice versa
SAN LIO 1
2. These items are captured by the cash flow
statement accordingly
A cash flow layout is identified as follows:
SAN LIO 2
3. IAS 7
STANDARD LAYOUT OF THE CASH FLOW STATEMENT
Net cash flow from operating activities
▼ PLUS OR MINUS
Investing Activities
▼
Financing
▼ EQUALS
INCREASE OR DECREASE IN CASH OVER THE PERIOD
SAN LIO 3
4. NET CASH FLOW FROM OPRATING
ACTIVITIES
DIRECT METHOD
Cash from sales* xxxx
Less 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. INDIRECT METHOD-NOTE ONE
Operating profit xxxx
ADD: Depreciation xxx
ADD: loss on sale of fixed assets xxx
LESS: Profit on sale of fixed assets (xxx)
INCREASES IN STOCKS (XXX)
DECREASE IN STOCKS XXX
INCREASE IN DEBTORS (XXX)
DECREASE IN DEBTORS XXX
INCREASE IN CREDITORS XXX
DECREASE IN CREDITORS (XXX)
LESS TAXATION (XXX)
SAN LIO 5
6. =NET cash flow from operating activities
XXXX
NOTE TWO OF CASH FLOW
Usually changes in cash- BANK balance and
OD
MAY TAKE AN ILLUSTRATION
SAN LIO 6
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. 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
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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. Economic factors etc
THE 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. 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. 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. 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. Going public-disadvantages
Cost of reporting
Disclosures
Self-dealings-???
Inactive market/low price- fight for a market
share
Control- voting rights
LOANS AND DEBENTURES
These are interest bearing funds and could be
Short-term
SAN LIO 14
15. Medium-term
Long-term
NOTE
The way these are arranged is important.
Managers don't 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. Long-term loans are preferred
UNBALANCED FINANCIAL DEVELOPMENTS
Its top management’s job to maintain an
appropriate balance between:
Long-term
Medium-term
Short-term finance
SAN LIO 16
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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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
Sales
LESS Credit from suppliers=Creditors
Purchases of raw
=CASH OPERATING CYCLE IN DAYS
SAN LIO 27
28. Good to take an example at this stage on COC
SAN LIO 28
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. 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. 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. 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. 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. 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. PAYABLE S DEFERRAL PERIOD
= Payables*365 ( IN DAYS)
Purchases
OR
= 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. 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. 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. 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. 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. VAT transactions should be carefully analyzed for
cash budget purposes
EXAMPLE
Maarifa 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. 1. Prepare the company’s VAT account for the
first three months of 2010, showing the
balance due at 31 March 2010
2. Prepare a schedule showing the appropriate
numbers relating to purchases and sales
a) In the cash account
b) In the trading account
SOLUTION
SAN LIO 41
42. VALUE ADDED TAX ACCOUNT
Jan 2010 -VAT paid 16,000 Jan 1 2010 B/F 16000
VAT on purchases * 37,500 VAT Sales * 55,500
March 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= 370,000
Thus: VAT = 425,500-370,000= Ksh 55,500
SAN LIO 42
43. CASH ACCOUNT
DR Sales cash Ksh 425,500
CR Purchases cash Ksh 287,500
TRADING ACCOUNT
DR Purchases (net of VAT)= Ksh 250,000
CR Sales (net of VAT) Ksh 370,000
NOTE
When sales made on credit the company’s
liability to pay VAT arises once the invoice is
issued.
SAN LIO 43
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. 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 necessary
ILLUSTRATION
We may illustrate this by assuming a company that
wishes to invest in TWO mutually exclusive projects
SAN LIO 45
46. Lets call these projects A and B as follows
PROJECT A is a SIX year period project
CASH FLOWS ARE AS FOLLOWS:
YR0 KSH -40,000
YR1 KSH 8,000
YR2 KSH 14,000
YR3 KSH 13,000
YR4 KSH 12,000
YR5 KSH 11,000
YR6 KSH 10,000
SAN LIO 46
47. PROJECT B is a THREE year project
CASH FLOWS ARE AS FOLLOWS
YR0 KSH-20,000
YR1 KSH 7,000
YR2 KSH 13,000
YR3 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
49. B
YR CF DF PV(KSH)
YR0 KSH-20,000 1 -20,000
YR1 KSH 7,000 0.8929 6,250.30
YR2 KSH 13,000 0.7972 10,363.60
YR3 KSH 12,000 0.7118 8,541.60
NPV (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. 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. 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. 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. NPV OF B ON COMMON LIFE
YR0 KSH-20,000 1 -20,000
YR1 KSH 7,000 0.8929 6,250.30
YR2 KSH 13,000 0.7972 10,363.60
YR3 KSH -8,000* 0.7118 -5,694.40
YR4 KSH 7,000 0.6355 4,448.50
YR5 KSH 13,000 0.5674 7,376.20
YR6 KSH 12,000 0.5066 6,079.20
NPV(B-COMMON LIFE APPROACH) 8,823.40
* (12,000-20,000). B is selected.
SAN LIO 53
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. 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. CAPITAL STRUCTURE OF A FIRM
Defined as the proportionate re-alignment of a
company's 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. 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. 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. 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. 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. 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. 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. 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 MEANS
WACC= Wd(1-T)rd+ We*rs
SAN LIO 63
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 capital
WHY?
Because:
V(Value of the firm)= ∑ FCFt
(1+WACC)t
SAN LIO 64
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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. Operating leverage aspect can be use well illustrated by
break-even analysis
REVENUE
+VE EBIT
-VE EBIT
SALES
BREAK-EVEN EBIT=0
SAN LIO 78
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. The argument of this theory is that if all these
assumptions hold: then a firm’s VALUE is not
affected by its CAPITAL STRUCTURE
THUS
VL= VU=SL+D
WHERE
VL= The value of a levered firm
VU= The value of an identical but unlevered firm
SL= The value of the levered firm’s stock
D= The value the levered firm’s Debt
SAN LIO 81
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. 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. THUS
MM tax shield formula
VL= VU + PV OF TAX SHIELD
According to MM, the PV of the tax shield =
Corporation tax T*the amount of debt D
THUS
VL= VU+TD
WHERE
VL=Value of the levered firm
VU=Value of the unlevered firm
SAN LIO 84
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. 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. 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. WHERE
Tc= Corporate Tax rate
Ts= personal tax on income from stocks
Td= tax rate on income from debt accordingly
NOTE
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
Thus
VL=VU
SAN LIO 88
89. However, experts still believe that there is a
tax advantage to debt
EXAMPLE
If we assume a Tc 40%, Td=30% and Ts=12%
Then the advantage of debt financing is
VL= VU+ 1 – (1-0.4)(1-0.12) *D
(1-0.30)
VL = VU+0.25D
SAN LIO 89
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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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 structure
WHILE MAKING CAPITAL DECISIONS.
SAN LIO 101
