Macn 202 Management Acc 202 Own Notes

MACN 202 Management Accounting: Financila Management Section. Notes Page |1 OWN Research to STILl:.............................................................................................................................................5 QUESTIONS:...............................................................................................................................................................6 Reconcilliation of Absorbtion profit to absorbtion profit(pg 142 viggio)..................................................................6 (GP%) GROSS PROFIT Percentage % RATIO: = Gross Profit/TURNOVER | =% ANSWER |.................................10 QUESTIONS CURRENT PLACE...............................................................................................................................10 To scan in/do still:....................................................................................................................................................11 Rem: Notes special things to remember..................................................................................................................12 2-TERMS:(vig ch 1+2)..............................................................................................................................................14 Intro:....................................................................................................................................................................14 the production point of indifference, :...............................................................................................................14 analysis of the companies cost structure: ........................................................................................................14 Capital structure ..............................................................................................................................................14 annuity: ...........................................................................................................................................................14 over-trading......................................................................................................................................................14 Cost Objects:........................................................................................................................................................14 Direct and Indirect Costs......................................................................................................................................15 inventory valuation:(note)................................................................................................................................15 DIRECT COSTS : ...............................................................................................................................................15 INDIRECT COSTS :.............................................................................................................................................15 Categories of manufacturing costs. – with direct/indirect costs........................................................................15 DIRECT MATERIALS :.........................................................................................................................................15 INDIRECT MATERIALS :......................................................................................................................................15 DIRECT LABOUR :..............................................................................................................................................15 INDIRECT LABOUR ..........................................................................................................................................15 DIRECT EXPENSE :............................................................................................................................................15 PRIME COST .....................................................................................................................................................16 MANUFACTURING OVERHEAD :.........................................................................................................................16 COST ALLOCATIONS :........................................................................................................................................16 TOTAL MANUFATURING COST :.........................................................................................................................16 Period and Product Costs..................................................................................................................................16 PRODUCT COSTS :............................................................................................................................................16 PERIOD COSTS :................................................................................................................................................16 Relevant and Irrelevant Costs:.............................................................................................................................16 RELEVANT COSTS AND REVENUES :.................................................................................................................16 IRRELEVANT COSTS AND REVENUES: ..............................................................................................................16 Avoidable or Unavoidable costs:..........................................................................................................................17 AVOIDABLE=....................................................................................................................................................17 UNAVOIDABLE..................................................................................................................................................17 Opportunity Costs:...............................................................................................................................................17 -Incremental /or Differential- and Marginal Costs.................................................................................................17 INCREMENTAL or DIFFERENTIAL COSTS :..........................................................................................................17 MARGINAL COSTS :...........................................................................................................................................17 Job Costing and Process Costing systems:............................................................................................................17 JOB COSTING SYSTEMS:....................................................................................................................................17 PROCESS COSTING SYSTEMS:...........................................................................................................................17 ABSORPTION COSTING AND VARIABLE COSTING:and STANDARD COSTING.........................................................17 inventory valuation:(note)................................................................................................................................17 IAS 2 on INVENTORIES States the Following.:...................................................................................................17 Absorbtion costing :..........................................................................................................................................18 Cost Absorbtion Rate :......................................................................................................................................18 Fully Integrated Absorbtion costing System ( or “full” absorb. costing system)................................................18 Variable Costing (or Marginal or Direct Costing)...............................................................................................19 Direct Costing...................................................................................................................................................19 Marginal Costing...............................................................................................................................................19

MACN 202 Management Accounting: Financila Management Section. Notes Page |2 Standard Costing:.............................................................................................................................................19 Sunk Costs:..........................................................................................................................................................19 SUNK COSTS : ..................................................................................................................................................19 Responsibility Accounting :..................................................................................................................................20 RESPONSIBILITY ACCOUNTING :........................................................................................................................20 PROFIT CENTRE :..............................................................................................................................................20 COST CENTRE:..................................................................................................................................................20 INVESTMENT CENTRE:......................................................................................................................................20 Maintaining a cost database:................................................................................................................................20 Fixed and Variable Production Overheads : and Cost Behaviour of......................................................................20 VARIABLE COSTS :............................................................................................................................................20 FIXED PRODUCTION COSTS :............................................................................................................................21 SEMI-FIXED (or STEP-FIXED COSTS) : ...............................................................................................................22 SEMI-VARIABLE (or MIXED COSTS) :..................................................................................................................22 Relevant Range....................................................................................................................................................22 Relevant Range: ..............................................................................................................................................22 Selling Costs.........................................................................................................................................................22 Selling Costs :...................................................................................................................................................22 Conversion Costs:.................................................................................................................................................23 Conversion Costs :............................................................................................................................................23 HIGH-LOW COST ANALYSIS:..............................................................................................................................23 contribution:.....................................................................................................................................................23 budget:.............................................................................................................................................................23 “Standard Hours Produced”:.............................................................................................................................23 “Standard PROFIT STATEMENT”: ......................................................................................................................23 STATIC BUDGET ...............................................................................................................................................23 FLEXED BUDGET ..............................................................................................................................................24 BILL OF MATERIALS ..........................................................................................................................................24 STANDARD COST CARD ...................................................................................................................................24 Formulas..................................................................................................................................................................25 SHARES................................................................................................................................................................25 ANNUITY:..............................................................................................................................................................26 loan: periodic payment of a loan..........................................................................................................................27 Perpetuity:...............................................................................................................................................................27 MARKET VALUE OF A COMPANY:..........................................................................................................................28 market Value of Convertible debentures or preference shares............................................................................28 chapter 11 relevant costs......................................................................................................................................29 Context of relevant costs:....................................................................................................................................29 terms:...................................................................................................................................................................29 adding a new product...........................................................................................................................................29 Dropping a product or division.............................................................................................................................30 Make or buy decision............................................................................................................................................30 special orders.......................................................................................................................................................31 IMPortant : use the relevant costing decision model as an aid in choosing amoung competing alternatives.......31 Chapter 6 Financial and Business Analysis..............................................................................................................35 financial vs mngmnt Accountants viewpoint............................................................................................................35 Financial accountant:...........................................................................................................................................35 Management Accountant:....................................................................................................................................35 Business Risk vs Financial risk..............................................................................................................................35

MACN 202 Management Accounting: Financila Management Section. Notes Page |3 The Business Model:.............................................................................................................................................36 STAGE 2: Company assets................................................................................................................................37 STAGE 3: Income Statement. ...........................................................................................................................38 BUSINESS RISK, operating leverage and gross profit %........................................................................................38 Business risk:....................................................................................................................................................38 fundamentals of finance risk....................................................................................................................................40 debt advantage & disadvantage..........................................................................................................................40 the cash flow statement:.........................................................................................................................................40 financial statement analysis:...................................................................................................................................40 RATIOS.....................................................................................................................................................................41 margin of safety:..................................................................................................................................................41 key ratios for cvp.................................................................................................................................................41 (PV ratio) Profit Volume ratio: ( or also called ‘contribution RATIO or margin %’ )............................................41 profit ratio.........................................................................................................................................................41 (B/E sales) break-even sales revenue:( not a ratio)..........................................................................................41 break-even sales volume:( not a ratio).............................................................................................................42 margin of safety ratio ......................................................................................................................................42 OTHER TYPES:...................................................................................................................................................42 Business Risk assesment......................................................................................................................................42 business risk ratios (there are 8 of ).....................................................................................................................42 business risk ratios (there are 3 of ).....................................................................................................................42 Contribution : High – Low method to get it from the income statement...........................................................42 OPERATING LEVERAGE: = CONTRIBUTION/EBIT (Earnings Before Interest and Tax) | =Decimal Answer | low=1,5 high=3 |..............................................................................................................................................42 (GP%) GROSS PROFIT Percentage % RATIO: = Gross Profit/TURNOVER | =% ANSWER |.................................43 return on operating assets: earnings before interest and tax/ Operating Assets *100/1 | = % answer...........43 net profit percentage % ratio= net profit after tax/turnover * 100/1 |%=answer|...........................................44 Roe : return on equity = earnings after tax/total shareholders funds *100/1 |% =answer|..............................44 increase in Turnover or sales growth – as a ratio =new-old/old |=%answer |...................................................44 b/E point = fixed costs/pv ratio % (contribution margin) | =% answer |..........................................................44 debtor turnover................................................................................................................................................44 Stock turnover .................................................................................................................................................44 For financial ratios note that the ratio for debt-equity: you do USE debt=ONLY long term debt + bank overdraft NOT creditors at all!!!!!!!!....................................................................................................................................44 chapter 1 : the meaning of financial management..................................................................................................45 special things to remember in exam:...................................................................................................................45 The financial operations of a company:...................................................................................................................45 Business Risk vs Financial risk..............................................................................................................................45 The Investment decision: (also called Capital Budgeting)....................................................................................46 finance Decision (also called Capital Structure)...................................................................................................48 WACC : weighted average cost of capital. also called the discount rate used in evaluation of future investments......................................................................................................................................................48 VALUATION OF A COMPANY:.................................................................................................................................51 chapter 2 Present & Future value of money............................................................................................................53 introduction:............................................................................................................................................................53 future value:............................................................................................................................................................53 Present value: (PV)..................................................................................................................................................54 shares : present value of shares...........................................................................................................................54 .............................................................................................................................................................................54 Return on Shares- return on investment:.............................................................................................................57

MACN 202 Management Accounting: Financila Management Section. Notes Page |4 Debt : Present value of debt:................................................................................................................................57 Market value of debentures.....................................................................................................................................59 annuity:...................................................................................................................................................................59 loan: periodic payment of a loan..........................................................................................................................61 Perpetuity:...............................................................................................................................................................61 MARKET VALUE OF A COMPANY:..........................................................................................................................62 Issue costs............................................................................................................................................................62 How To Determine Growth Rate:..........................................................................................................................62 miller & Modigliani market value of company......................................................................................................63 ...............................................................................................................................................................................63 chapter 3 capital structure and the cost of capital (Managerial finance-vigario).....................................................64 things to remember:............................................................................................................................................64 Introduction:.........................................................................................................................................................64 debt advantage & disadvantage..........................................................................................................................64 FINANCIAL GEARING:............................................................................................................................................66 Advantages & Disadvantages of Fin. Gearing...................................................................................................66 debt as part of the capital structure.....................................................................................................................67 WACC weighted average cost of capital. also called the discount rate used in evaluation of future investments. 68 traditional Capital Structure Theory:.................................................................................................................70 Determining the optimal Debt: Equity ratio and the target WACC....................................................................71 MARKET VALUE OF A COMPANY:.......................................................................................................................71 Miller & Modigliani Theory: (pick the main points from below and write facts below each other –re do to make some common facts plain)...................................................................................................................................72 The arbitrage process : for the miller-modigliani theory. (pick the main points from below and write facts below each other –re do to make some common facts plain)...........................................................................72 optimal capital structure......................................................................................................................................73 Generally:.........................................................................................................................................................73 Should all companies have debt in their structure?..........................................................................................73 Cost of capital : (in %)......................................................................................................................................74 Cost of equity capital (in %)..............................................................................................................................74 Cost of debentures..........................................................................................................................................74 Cost of irredeemable debentures :...................................................................................................................74 Cost of debentures/ or preference shares with conversion options : (you want the %)...................................74 Cost of retained earnings :...............................................................................................................................75 Issue costs........................................................................................................................................................75 Cost of preference shares.................................................................................................................................75 WACC, as calculated from the optimal capital structure parts.........................................................................75 addendum to chapter :Alternative method of determining growth for calculating share market value etc... . .75

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OWN RESEARCH TO STILL: 1) Appropriate Target rate of WACC debt : EQUITY ratio FOR VARIOUS types COMPANIES ie “TARGET WACC”?.

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QUESTIONS: (1) See page 19 vigario – no ii roman figures at bottom –is there a printing error 'budget' should read 'actual" (i) Same place no -4- last sentence – how is no fixed cost carried to balance sheet, or where are fixed costs ever carried to balance sheet??? By not going and subtracting over/under recovery or how? (2) Semi-variable NOT the same as mixed costs – vigio and drury books different. (3) Google search for different learning curves for different industries/ mnftr. Types e.g. electr.etc. (4) See page 224 viggio- how does example work- not include fixed costs? Why? Also is answer 268 or -268? (5) Pg 246-example1- what means 'Other Costs are 20% VAR WITH PRODUCTION UNITS."? (6) Differential cost driver ???? what's this mean? (7) Absorption costing : (i) The IAS statement on inventories states that ALL overheads,eg management salaries and depreciation and administration MUST BE INCLUDED IN COST OF INVENTORIES on page 1 ch 1.But PAGE 27 CH2 it says any costs that come after PRESENT CONDITION should not be included eg: selling costs. BUT WE learn to do a COST OF SALES analysis in the INCOME statement where SALARIES ARE NOT INCLUED nor admin nor depreciation, but opening and closing inventory is included in the calculation.SO how do you use the figure above to do this calc. which needs opening - closing inventories + purchases ? where does one get these figures then, or where do you use the IAS inventory rate then? ( the rest of income statement has salaries, depreciation etc- you cannot charge it twice/double!! In income statement.!!) I MEAN : DOES ONE SUBTTRACT/ADJUST THE COSTS CHARGED TO CLOSING STOCK --OUT OF THE NORMAL SALARIES & OVERHEADS IN THE INCOME STATEMENT SO IT DOSNT GET SUBTRACTED TWICE? (ii) WHO MAY USE LIFO method of stock valuation?? (iii)STEP COST ALLOCATION METHOD This tequnique does account for inter-service dept. cost allocation. The method used here is to allocate the cost for the service dept. which services the greatest no. of other service depts. first. Or if you get a situation where some service depts. service each other,as in example here, then first to be allocated is the one with highest cost. SO WHICH GOES FIRST IF ONE GETS BOTH TYPES AT SAME TIME? (8) METHOD OF DOING OVERHEAD ACCOUNT AND OVER/UNDER RECOVERY INCOME STATEMENT. (i) Overhead account CONTRA WIP account. : All estimated/charged overheads to CR , Actual overheads to DR , Balancing amount as Over/Under recovery to Income Statement. (ii) REM: ???????just remember the over/under recover amount that goes to income statement or comes from this account , WILL NOT INCLUDE ANY OVER/UNDER RECOVERY FOR CLOSING STOCK????????? SO FOR (8) WHAT IS THE ANSWER TO BETWEEN ????? QUEST. MARKS. YES/NO ? HOW 7) RECONCILLIATION of BUDGET to ACTUAL PROFIT. a) When a STANDARD COSTING SYSTEM is used, the under/over recovery is shown as : i) Volume Variance (difference between budget –actual) ii) AND Expenditure Variance. (difference between budget –actual) EXAMPLE: Example 1 on left and 2 on right are completely different exercises, both are Reconcilliations.The one on the right seems the more correct one.-includes units- but not sure if both are equally correct- ASK. 8) Is marketing costs part of mnftring overheads for absorbtion costing? Delivery costs, packaging, etc? 9) On page 52 viggio, why does it say contribution instead of gross profit,3rd row from bottom far left, because fixed manufacturing costs do and must get included in the the box above- to calc gross profit! 10)

Next Qusetion – read the yellow carefully –there are 2 questions here!

RECONCILLIATION OF ABSORBTION PROFIT TO ABSORBTION PROFIT(PG 142 VIGGIO) 1) METHOD :Whether it is a year to year or month to month recon . for the 1 company or whatever : a) No units on left needed. b) Start with 1st profit AFTER over/under adjustment, end with last profit after over/under adjustment. c) Add any Variable Non-mnftr costs (eg:selling costs) subtracted before for net profit.(yes or no or what – not shown in exercise) d) Any non-mnftr fixed costs : Add them back in.{or maybe ; not sure but do other one rather- it seems you want to see the gross profit somewhere)) if different you must do a separate item line to recon it : just

MACN 202 Management Accounting: Financila Management Section. Notes Page |7 subtract one from the other then put difference in recon ( highly unlikely to happen anyway!) what do you do? And dothey want to see the gross profit for both somewhere or not? e) 1st :Do opposite to over/under to bring to first period gross profit( if added in income stat, -then subtract it and visa-versa) f) Now you have next periods Gross Profit. g) Now add/minus previous months over/under- same as you would in income stat,(not add if subtracted etc but add again – you are going toward getting NEXT PERIODS NET PROFIT now as if it is a normal income stat.) h) Now add next periods Variable and Fixed non-mnftr overheads in. Next question: Part (a) For a Variable Standard Costing recon, in the” Volume Variance Part” at top top,,(ask : 1-but what do you do with closing stock – or 2- opening stock with different fixed cost to this year?) you will also leave out fixedmnftring costs here, because you don’t do a special “Overheads Volume –variance subtraction” in the expenditure section below, because you don’t have any fixed costs in the closing stock to wheedle out (if the numbers are right it could cause a error, If You don’t do all this I think) Part (b) And for same issue as above : what do you do wuth the variable and fixed manufacturing costs whem yopu get a closing stock for this year, or also Opening stock for this year from last year with different fixed costs to this year.????? 11) For high –low costing, book vig and drury say you use activities as the one to choose for the HIGH-LOW method- not price, but in test for last question in the 2nd CVP test, the memorandum uses the price to choose the high + low one?? Which do we use? 12) What do you do with a closing stock in the budget – if you are doing a recon for budget to actual profit in absorption or variable or standard costing?????? How do you handle this closing stock in the recon itself. 13) What does ‘full costing mean?test 3 14) What does constant price level terms mean? In test 3 15) In job costing for manufacturing accounts : where do you get wages from? (ALL WRITTEN OUT?) a) You must pay taxes on all all wages in WIP, as asset or asset increase, esp. in closing stock- how does that work?ie add the wages then subtract them again fior profit, but for plain retail they only use wages as tax deductable( must a storemans wages go to closing inventory?) but for mnftring it is not tax deductable. 16) For overhead account; for 1st month could you CR transfer wages to WIP before any DR it all- so you have a CR but not a DR in WIP? 17) For fixed costs in variable costing, must fixed go to cost of sales before gross profit or NOT?????/VERY IMPORTANT: ie in vigg textbook it does both! See drury exercise 7.16: here it is NOT included –fixed costs in cost of sales- also this was a test question and we got marked wrong for having fixed costs in cost of salesBUT in Viggio pg 137 he DOES put fixed costs in Cost of Sales! So what do we do???? 18) Do you get a fully integrated STANDARD absorbtion costing system? 19) What for mat does one do the profit statements and income statements for variable costing, and also absorbtion – drury and viggario each have 2 or 3 methods each , so 6 or more methods. I mean with cost of sales , or using ccontribution as a heading or putting some stuff at the top first then others below- general mixup each has his own method – spo what is a standard accepted format one should use consistently???BIG MESS!!!!!!!also with including fixed mnftring costs in variable cost of sales figure - or not - etc etc. |

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| 9) For reciprocal allocation (algebra method) of allocating costs to production depts., what happens if you get a fraction at the end – like R0.345543 - how do you allocate these last fractions between depts.? On page 35 viggio at bottom of page.35 viggio 10) RECON OF PROFITS or also overheads : start at Budget and end at Actual.( or maybe any way you want?) 11) For a JOB COSTING system , part of fully integrated absorbtion costing ,on page 49 viggio , what is contra for "JOB 1-5" accounts, ie:where does "Job completed" on cr side get posted to? Do these acc's go to trial balance and Fin Stats? Where in fin stats do they go? 12) Fully integrated absorbtion : do you use budget or actual overheads for closing stock ?- if budget , then if over/under –recovery is for all of production (incl closing stock) then why is it only added to sold production – this will give a wrong value for 1-closing stock and 2-profit.OR is the overheads charged to incomplete jobs already "actual' and not "budget"? a) TRY PUT sales as only 1 for example pg 130 vig ? then this all becomes clear! (see pg 129 2nd paragraph from bottom for rule to use budget.. in closing stock only!Also?? before it was said one could use actual or budget) b) Fully integrated absorbtion :On page 130 vig highlighted : if over –recovery is for all of production (incl closing stock) then why is it only added to sold production – this will give a wrong value for 1-closing stock and 2-profit.OR is the overheads charged to incomplete jobs already "actual' and not "budget"? c) Over/Under recovery is only applied to sales,not closing stock, but at the full total for closing stock +sales , so there is a mistake where sales takes ov/und recovery away from closing stock and visa versa, and Opening stock dilutes it all a bit too wrongly.(say sales was only 1, then apply this to any example) d) Pg 150 viggio blu highlight,: for variable costing , if asked for the GROSS PFOFIT, or COST OF SALES BREAKDOWN, do you include fixed mnft costs or EXCLUDE them then?????

Chapter 9 standard costing :

a) Pg 345 vig – bottom o page, how do they get Standard = R165 000, shouldn’t it be 1.875X 110000?

b) If you have closing stock in a budget ,how do you do the recon for : sales variance: is it mnftr profit less ‘sales variable costs” or [contribution less closing stock less fixed mnftrcosts] .-before you div by units and X by difference in sales volume.? c) From variable &

Chapter 6 Ratios & business risk. 2) DOES return on operating assets include long term loans to others? Or exclude it? 3) Is wages a fixed or variable cost???? 4) In the book fin mngmnt b viggio, ch 6 , he uses 3 different ways to calc. the Operational Assets : in pg 236 for 4.3 it says at bottom- average over year,on pg227 it says we must use the beginning value,and only use average if question asks for it, in solution for practice question it Just gets Average of fixed assets, but for current assets it uses the year end one? Then in appendix it uses end of year for fixed and for current LESS investing fixed assets(less investments) 5) For gross profit % ratio : on page 234 it says it is trading profit after cost of sales(so without subtracting all admin &other expenses), but on pg 225 it says it is EBIT – so after all expenses& other fixed costs eg rent! So which is it 6) The profitability ratIO’S – is this Net profit + gross profit ratio , or just GP% ratio?- and which GP% ratio is it: Ebit or after cost of sales???? On pg 236 it says the profitability ratio is EBIT/Turnover EXACTLY!!!

MACN 202 Management Accounting: Financila Management Section. Notes Page |9 7) What is EPS- how do you work it out? is it declared dividends or is it total net profit divided by the number of shares issued? 8) Check all ratios and ask how you work each one out- some are weird and done different 2 ways in same chapter.

Chapter 3 cost of capital and capital structure

1) (See yellow why amount-how can amount make a difference????). THE IMPORTANT QUESTION IN THE LONG TERM FINANCING DECISION is: whether the cost of capital for a company is dependant on its financial structure. If long term debt does affect the cost of capital, then the company should minimize its cost of capital by borrowing an “amount” of debt capital that will give the company its lowest cost of capital. 2) ?Definition: Financial Structrure: : it seems like all 3 of: Total Assets & Issued Shares & Total Debt.? What does it mean?exactly? 3) The key ratio is interest cover- how many times interest is covered by profit.

CHAPTER 1-3: financial management to Capital structure & Cost of capital. 1) For calculating WACC, for the debt part, do you include bank overdrafts. And do you include any other creditors like massive supplier credit or so. 2) What is yellow? : EQUITY = includes all of : Retained income + Non-Distributable + Distributable Reseves + Share Premium + Any form of debt that has a conversion option to Ordinary Shares. +??Share issue expenses pg7 note top?? 3) For the method of calculating the WACC using the market value method : 1-how does it work, 2see yellow below Market Value of Equity: simply the net profit per year – not the dividends ,not the PV of anything, or anything else.if they give you dividends&Ke, then 100/ke X dividends=answer! (????This answer is called the present value of future cash flows in the book [PG7 vig] because it is the profit before part of it is paid as dividends I think!???? Is it the book value of capital employed-ie DEBT+EQUITY- or is it something else? what is the logic behind this? ALSO , WHY BRING IT ALL TO PRESENT VALUE- YOUR EVENTUAL DEBT REPAYMENTS AND ) 4) ????VALUE OF ORDINARY SHARES = Value of Company –less- Value of Debt .????how does this work, see book pg11 vig fin.mngmnt.- isn’t it the other way around- the value of the company = value of ordinary shares less value of debt???

5) See page 35 vig finance question is highlighter

6) Ask pg 35 at the highlighter 7) Page 36- ask if this is a printing error at the top- it looks like one for sure a) See bottom of page it also seems wrong- not sure! 8) On pg 59 in solution when given a market rate for debentures & one for loans, it uses the debentures one even though it is higher than the loan one. But in chapter 2 there is an exercise where a market rate of debt is used to go and calculate the debentures Market value. When do you use which ??

budgets 9) Pg 308/9 vig see green- july material and production is astuff up – looks like it is wrong- it seems the figures on pg 308 in working capital’ of twinmate must be ignored for finished production&raw materials – if you use them youy get wromg answer. Also he forgot the purchases for actual production for june.t

ratios

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Contribution : High – Low method to get it from the income statement.

You can get VARIABLE COSTS : by: given 2 years figures – then change in turnover Minus change in EBIT. You can get CONTRIBUTION Margin by: change in EBIT / change in TURNOVER. You can get CONTRIBUTION by : then use this % from contribution margin to MULTIPLY by any TURNOVER = Contribution . 1. Note: For contribution, a. If given both Revenue AND Turnover figures in an exam one above the other (revenue PROBABLY INCLUDES “Other Income” and turnover is from normal operations) , you don’t use you do not use REVENUE, you use TURNOVER , I THINK – just check with lecturer on this. 11) For the operating leverage : is it ebit/ turnover or ebit over revenue ( if revenue includes other income eg: rent or interest but turnover is from operations )

(GP%) GROSS PROFIT PERCENTAGE % RATIO: = GROSS PROFIT/TURNOVER

| =%

ANSWER | 12) Remember for the GP% ratio , it is turnover , not revenue, so if there are figures for both use turnover because GP% is for “operations”, not including “other income “ like rent or dividends (I THINK-CHECK WITH LECTURER) 13) Note: not the following headings below: i)

The Profitablility sure – just check)

ratios

are: 1-net profit%, 2-GP%, 3-sales growth, 4-profitability ratio.(not

ii) The liquidity ratios are: NOT SURE- check up (I think 1-debt2-liquidity3-acid-4times interest earned iii) Times interest earned ratio is also called the ‘gearing ratio’( I think – check)

QUESTIONS CURRENT PLACE

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TO SCAN IN/DO STILL: (1) Pg 53/54 example 1 of absorbtion costing. (2) Go through all the 'accountant will recomend ' stuff and summarise well : pg 199 vig top,175/176 vig,180 vig bottom, (3) Scan pg 177 for abc costing + opdrag page before (4) Scan Pg 181 for format of a "costing statement " (5) Limiting factors calculations for abc costing : pg 186 + 187 vig scan + re-study (6) See page 194 vig and put it all together with the rest of the verbal abc vs absorbtion costing notes in abc costing chapeter in notes.(get 1 good answer to learn – not 100's) (7) CHAPTER 4 variable costing: pg 144 to end of book- do the last 2 headings didn’t finish. (8) Learning curves: scan in some good examples and the text out of textbook to explain better- your explain is not very clear esp. example 1 page 218 viggio (9) Fully integ absorb- get examples & exaplain rught pg 35 vig (10) In RECONCILLIATIONS: do a over/under recovery of fixed overheads for Fully Integrated Absorbtion Costing (11) Get all the examples of relevant costing& practice exercises , as well as budgets & all execrcises & any other major work –related chapters where you mght qickly have to have a look at the methods in exercise if you get a very difficult opdrag.

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REM: NOTES SPECIAL THINGS TO REMEMBER I) (1)SEE PAGE 244 in Viggario book for Quest. + Answers. II) (3)REM: if they ask :the company gets an order for an extra 100 units, what will a profitable price be for this –it means ONLY FOR THE LAST 100 – not all units,ie the differential/ price.

III) If asked to get the profit for extra hundred(not just 'last' –but 'extra') DONT FORGET TO LEAVE OUT FIXED COSTS PER UNIT in your calculations!!!!! It is supposedly already paid by the first few –see pg 244 viggio. IE:IN MANAGEMENT ACC. IF FIXED COSTS ARE GIVEN IN A BUDGET AS A PER UNIT WORKED OUT COST – IT MEANS THAT THE TOTAL FIXED COSTS HAS ALREADY BEEN DIVIDED UP BETWEEN THE NUMBER OF UNITS IN THAT BUDGET- ANY EXTRA UNITS WOULD NOT SIMPLY INCUR THESE COSTS WITHOUT IT BEING STATED HOW-IE: IF PRODUCTION WOULD THEN AN EXTRA MONTHS RENT UP ETC.SO YOU IGNORE THESE FIXED COSTS FOR ANY EXTRA UNITS PRODUCED.unless told otherwise. 2) REM: NOTE: if you have to find out the fixed costs for a very large units- ONLY first convert variable costs to single/per unit(because lecturer/book/everyone does this) ,but do not first convert total costs and fixed costs to :per unit- use straight from large amounts because otherwise any- 0.33333 so R0.33 -recurRing fractions will give you wrong ANSWERS.(becuase you cannot get all the recurring parts in) 3) If asked to redraft a budget for a learning curve question, do a full total profit/ costs/fixed/var/ budget and also a per unit one next to it ,just to show, not just a per unit one even if the first budget was not even shown on paper. a) Also , if they say fixed costs of R50 each for 300 units, thyen for an extra 100 units the fixed costs will not apply, it has already been paid.- so leave fixed out in any calc. for the last 100 units. SEMESTER 2 ONWARDS: 1) How many decimals do we round off to? 2) Rounding off: For an answer above .5 round up / down for below 0.5.This is how viggario does it for all CVP/costs/ and calculating variable costs per unit from variable costs per all produced etc.(to get his clean answers! Without .3333 etc everywhere!) 3)

EXCELLENT EXAMPLE of the difference between Variable and Absorbtion costing where the profit is different in 2 years with same costs&price.

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 13 3)

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2-TERMS:(VIG CH 1+2) The Correct Method To Adopt When Looking At Product Decision-Making Is As Follows: 1.1. Identify the main or flag-ship product that the company manufactures. 1.2. Maximise the profit on the main product by maximising production ,sales and contribution. 1.3. Sell other products manufactured by the company only if there is spare capacity. 1.4. Sell other products at a price higher than variable cost. 1.5. One can only Max contribution( using Variable costing) per limiting factor, not max profitability by using ABC or Absorption costing unless you work it out from the start {incl. total activities/total cost drivers=to get cost driver rate} for each price & production level.) 1) COST RECOVERY RATE.: the rate or basis eg machine hours. at which costs are recovered to a specific eg production dept. 2) BASIS : the rate/basis is the measurement used to allocate costs eg: labour hours or machine hours. 3) COST PLUS BASIS :means you work out the final figure by starting with the cost price and then adding a certain amount or % to it. 4) LIMITING FACTORS OF PRODUCTION: like a bottleneck at the machine dept – because machines only produce a maximum amount each , or one cannot get more than a certain amount of some raw input product per month etc

INTRO: 1) Management accounting is primarily concerned with producing budgets, setting performance standards, and evaluating performance 2) Acc sys used for measure costs for profit measurement,inventory valuation ,decision making,performance measurement, control.

THE PRODUCTION POINT OF INDIFFERENCE, : Where the total cost of a capital-intensive company = the total cost of a labour-intensive company.

ANALYSIS OF THE COMPANIES COST STRUCTURE: Its fixed costs and contribution per unit.

CAPITAL STRUCTURE means whether the company is using equity or debt and what combination of the 2 and interest rates etc etc.

ANNUITY: The Receipt or Payment of a fixed amount over a number of years or periods. ANNUITY DUE: if payment is made at the beginning of each period, it is called this REGULAR /ORDINARY /DEFERRED ANNUITY : if payment is made at the end of the period.

OVER-TRADING Means the company is selling too mush on credit and debtors are taking too long to pay- too many debtors and too long to pay. This means it is taking chances with it’s selling on credit policy and over doing it.

COST OBJECTS: 1. COST OBJECT :Definition: ANY ACTIVITY for which a SEPARATE MEASUREMENT of COSTS is desired. a) Eg; cost of a product , of rendering a service to a bank customer ,of operating a particular sales territory or dept. The Cost Collection System works as such ; it accumulates costs-by assign into categories-eg labour,materials ,overheads.( or by fixed & variable).THEN assigns these costs to cost objects.

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 15

DIRECT AND INDIRECT COSTS INVENTORY VALUATION:(NOTE) IAS 2 : INTERNATIONAL STATEMENT ON INVENTORIES states that : Firstly, closing stock – work completed but unsold- (??? What About inventories & work in progress???) must be valued at the lower of cost and net realisable value.Inventories are valued at : all costs incurred in bringing to current state – ONLY manufacturing direct and indirect costs-The Costs of conversion of inventories include costs directly related to the units of production,such as direct labour.They also include a systematic allocation of fixed & variable overheads that are incurred in converting material into finished goods.Fixed production overheads are those indirect costs of production that remain relatively constant regardless of the volume of production, such as depreciation ,maintenance of factory buildings and equipment,and the cost of factory management and administration. However FIXED OVERHEADS are only allocated at the normal production capacity(over anumber of seasons or periods under normal circumstances,taking into account the loss of activity relating to planned maintenance) .If idle plant /low production inventory costs are ONLY allocated at normal prod. Capacity Levels.BUT in periods of abnormally high production, the amount of fixed averheads allocated to each product unit is decreased so inventories are not valued at below cost. As a result of this accounting definition ,the valuation of stock is carried out on a FIFO or weighted average basis.LIFO is strictly prohibited.

DIRECT COSTS : Costs that can be specifically and exclusively identified with a particular cost object. . .. Eg:wood in a desk, maintenance labour in -(cost object maintenance dept)-but NOT Maint.Labour in a –(cost object desk produced).The more direct cost and less indirect costs =the more accurate the estimate.

INDIRECT COSTS : Costs that cannot be identified specifically and exclusively with a particular cost object, but can only be identified with a a number of depts.. /cost objects.

CATEGORIES OF MANUFACTURING COSTS. – WITH DIRECT/INDIRECT COSTS. Direct Materials Direct Labour Prime Cost Manufacturing Overhead Total Manufacturing Cost

Xx Xx Xx Xx Xx

i) In manufacturing organisations traditional product costs accumulated as follows – ( developed esp. from/for ext. accounting requirements.

DIRECT MATERIALS : Cost of all materials that can be identified with a specific product.eg wood for desk is, but maintenance materials on machine to produce with is not,that is an indirect materials cost.

INDIRECT MATERIALS : cannot be identified with any one product, eg:because used for all.eg maintenance materials spares.

DIRECT LABOUR : can be specifically traced to or identified with product eg:labour assemble product

INDIRECT LABOUR can not be specifically traced to or identified with product eg:labour maintenance of many different product lines machines.

DIRECT EXPENSE : NOT labour/materials/overheads/ can be specifically traced to or identified with product eg hiring of machine to produce a specific quantity of a product is a direct expense. (other than /not labour/materials-in this context) anything else in this category would be classed as 'OVERHEADS' –see below.

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PRIME COST = Direct materials+Direct Labour +Direct Expenses.

MANUFACTURING OVERHEAD : All manufacturing costs exept : Direct materials+Direct Labour +Direct Expenses eg:rent of factory.

COST ALLOCATIONS : process of assigning indirect costs(overheads) to products- using surrogate ,not direct measures.ALSO – the assigning of eg: rent between mnftring and / non-mnftring depts.

TOTAL MANUFATURING COST : Direct materials+Direct Labour +Direct Expenses+Mnfctring overheads

PERIOD AND PRODUCT COSTS. 1) Because of external fin acc rules in most countries that require that for inventory evaluation ONLY MANUFACTURING COSTS /or RETAILER = PURCHASE COSTS + FREIGHT IN -should be included in the calculation of product costs AS WELL AS ONLY costs related directly to the units of production- accountants therefore classify costs as product costs and period costs. a) BECAUSE OF THIS ONLY the FIFO or weidghted average methods may be used to calc. inventory- NOT L.I.F.O.-ie. Costs must relate directly to units of production. REASONS CITED FOR THIS: b) Inventories represent a future probable inflow of revenue , period costs(overheads) do not c) Many non-manufacturing costs are NOT incurred when the product is being stored-thus inappropriate to include them in inventory valuation. INTERNATIONAL STATEMENT ON INVENTORIES states that :Inventories are valued at : all costs incurred in bringing to current state – ????ONLY manufacturing direct and indirect costs- ie:COSTS OF CONVERSION ???????YES OR NO. Includes systematic allocation of fixed & variable overheads. However FIXED OVERHEADS are only allocated at the normal production capacity.If idle plant /low production inventory costs are ONLY allocated at normal prod. Capacity Levels.BUT in periods of abnormally high production, the amount of fixed averheads allocated to each product unit is decreased so inventories are not valued at below cost.

PRODUCT COSTS : costs identified with goods purchased or produced for resale.-in mnftring is costs attached to product for inventory valuation of finished goods ,work in progress, matched against sales for recording profits. ONLY MANUFACTURING OVERHEADS may be INCLUDED as part of absorbtion costing in the valuation of closing stock.Variable costing would treat it as a period cost and write it off in period it occoured.(IFRS/etc) =recorded as an ASSET until sold ,then as an expense.(when you 'write out' last inventory count and write in new inventory in the profit & loss statement at year end I THINK? ) ! Product costs= TOTAL MANUFACTURING COSTS =direct labour+dir.material+direct expenses +Mnftring overheads( from last section) NOT eg: distribution+telephone for telesales .as per book exactly: Admin Overheads or selling overheads may never be assosiated with production.

PERIOD COSTS : costs treated as expenses in the period in which they occoured, BUT NOT included in the cost calc. of inventory valuation.(or /sales/work in progress.)recorded as an expense ONLY,never as an asset! Period costs= eg: sales expenses+ admin +distribution expenses.

RELEVANT AND IRRELEVANT COSTS: RELEVANT COSTS AND REVENUES : Those Future costs and Revenues that will be changed by any specific decision relating to production volume or selling volume.eg: material costs change if choose to produce more

IRRELEVANT COSTS AND REVENUES: Those Future costs and Revenues that will NOT be changed by any specific decision relating to production volume or selling volume.. Eg: rent for factory will not change if higher production or selling volume.

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AVOIDABLE OR UNAVOIDABLE COSTS: AVOIDABLE= relevant costs (sometimes used in place of other name)

UNAVOIDABLE irrelevant costs (sometimes used in place of other name)

OPPORTUNITY COSTS: 1) OPPORTUNITY COST =The cost of a foregone opportunity in favour of having chosen another one :eg . if the cost of selling a new product is to stop selling another one , the opportunity cost is the rvenue one used to receive from the old one.

-INCREMENTAL /OR DIFFERENTIAL- AND MARGINAL COSTS INCREMENTAL OR DIFFERENTIAL COSTS : Accountants use this : means the different in total costs for ALL THE EXTRA PRODUCTS WHEREBY the PRODUCTION HAS BEEN INCREASED.

MARGINAL COSTS : Economists use this : means difference in costs for ONLY ONE extra product –ie. For each separate new whereby production has been increased.

product

JOB COSTING AND PROCESS COSTING SYSTEMS: JOB COSTING SYSTEMS: Relates to a costing system where all the costs associated with each job could be different for each job completed and , so direct materials and labour are allocated at actual cost and fixed overheads are allocated on a pre-determined cost rate for each separate job.This is also known as a fully integrated absorption costing system. eg. In constructiion industry –where each house could be unique and have a completely different set of costs to other houses.

PROCESS COSTING SYSTEMS: The method used to value stock in mnftring where at end of period some of the closing stock is partially manufactured-not all finished yet.

ABSORPTION COSTING AND VARIABLE COSTING:AND STANDARD COSTING. INVENTORY VALUATION:(NOTE) IAS 2 ON INVENTORIES STATES THE FOLLOWING.: IAS 2 : INTERNATIONAL STATEMENT ON INVENTORIES states that : Firstly, closing stock – work completed but unsold- (??? What About inventories & work in progress???) must be valued at the lower of cost and net realisable value.Inventories are valued at : all costs incurred in bringing to current state – ONLY manufacturing direct and indirect costs-The Costs of conversion of inventories include costs directly related to the units of production,such as direct labour.They also include a systematic allocation of fixed & variable overheads that are incurred in converting material into finished goods.Fixed production overheads are those indirect costs of production that remain relatively constant regardless of the volume of production, such as depreciation ,maintenance of factory buildings and equipment,and the cost of factory management and administration. However FIXED OVERHEADS are only allocated at the normal production capacity(over anumber of seasons or periods under normal circumstances,taking into account the loss of activity relating to planned maintenance) .If idle plant /low production inventory costs are ONLY allocated at normal prod. Capacity Levels.BUT in periods of abnormally high production, the amount of fixed averheads allocated to each product unit is decreased so inventories are not valued at below cost.

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 18 Variable Production overheads are those indirect costs of production that vary directly,or nearly directly,with the volume of production,such as indirect materials and indirect labour. As a result of this accounting definition ,the valuation of stock is carried out on a FIFO or weighted average basis.LIFO is strictly prohibited. Cost accounting grew out of the need that financial accountants have for financial information ,and gathers and analyses costs for the purposes of :product costing,job costing,stock valuation.

ABSORBTION COSTING : IN EXAM, OR REAL LIFE, AS SOON AS ONE GETS AN INCOME STATEMENT OR FIGURES PREPARED USING ABSORBTION COSTING, ONE MUST QUICKLY CALCULATE THE SAME FIGURES USING VARIABLE COSTING – OR YOU WILL NOT BE ABLE TO DO PROPER COMPARISONS AND WORK THINGS OUT! Due to fixed costs being in there- always take them out and convert to CONTRIBUTION .. Method used to VALUE CLOSING STOCK that includes ALL MANUFACTURING COSTS-VARIABLE AND FIXED-NOT any NON-MNFTRING COSTS AT ALL!!!!!! ((WHICH DOES/can INCL. RENT AND MAINTENANCE per book)– The fixed cost element can be determined by budget or by actual,and is added to all variable mnftring costs(eg direct material) to get the total per unit product cost for inventory valuation per the IAS definition ( which says ALL MNFTRING COSTS must be included in Inventory Valuation incl. fixed mnftring costs eg: Maintenance etc.) .ONLY Financial Accounting uses it. NOTE: every time production volume changes ,the cost per unit will change because fixed costs get divided by a larger /or smaller number now.So it is an inconvenient method requiring constant raising of under/over recovery charges to balance the figures.The 2 reasons for this is: 1-Actual volume is different to budget volume. 2-Actual manufacturing overhead being different to budget overhead. That is why Management Accounting uses a different method –: called "Variable Costing". FOR ABSORBTION COSTING THRE ARE 2 WAYS OF VALUING STOCK:1-BUDGET AND 2ACTUALVARIABLE PLUS FIXED COST OF PRODUCTION. But for variable costing ther are also these 2 ways , exept there it is only VARIABLE COSTS OF PRODUCTION, not fixed and variable in the stock valuation(per book vigario pg14-concl. ALSO, FOR ABSORBTION COSTING THERE ARE 3 POSSIBLE WAYS OF PRESENTING THE INFORMATION IN THE FINANCIAL STATEMENTS. 1-FULLY INTEGRATED ABSORBTION COSTING (BUDGET COST) 2-NON-INTEGRATED ABSORBTION COSTING (BUDGET COST) 3-ACTUAL COST ABSORBTION COSTING. (all exactly per vig. Pg 14 book!) IS ABSORBTION COSTING ACCEPTABLE:? NO, because it will distort true company profits due to showing fixed costs as closing inventory costs –you cannot compare 2 periods properly,or budget properly if you use include rent at a pre-determined rate eh R300 per product it will not be accurate if production rises or falls.- it will eg show excessive profits when stock holding is rising ? per book vig pg14. HOW DO YOU MAKE IT ACCEPTABLE: You explain on any budget that the Per Unit cost can vary by the TOTAL FIXED COSTS AMOUNT included in the costing eg R500 –at any level above or below the no. of units that the budget was calculated at. However ,for calculating costs of products in a Job Costing environment, where the costs are used to quote on future jobs eg: Printers , when using absorbtion costing, one must remember that one company allocates fixed costs differently to another one,and there is no right or wrong method to allocate fixed costs really, ie some allocate all overheads, some only admin + management , some only maintenance and depreciation etc.

COST ABSORBTION RATE : the cost rate at which a group of costs or fixed costs or overheads are charged to a specific product eg: machine hours divided between no. of products.(it is used by fin . accountants to calculate absorbtion costing system.

FULLY INTEGRATED ABSORBTION COSTING SYSTEM ( OR “FULL” ABSORB. COSTING SYSTEM) If the fixed element is pre-determined .So when fixed elements eg: rent+maintenance ,are pre-calculated in the previous years as a per unit cost, from per average normal production levels,so eg R1000 rent /

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 19 500products made per mnth= R2 rent per product ;and these amounts are added to normal vriable costseg direct material, to get a (estimated/ avg)total cost per product unit . (NOTE: not all fixed costs need to be allocated as such ONLY mnftring costs MUST BE(WHICH DOES INCL. RENT AND MAINTENANCE per book), other fixed costs eg admin and computer,marketing costs(more 'sales costs' types get left out)can be left out and the system would still be called Fully Integrated absorbtion Costing) ONLY where the fixed cost element is predetermined though and not based on actual fixed costs ,which is another type of absorbtion costing.The actual amount will differ from the allocated amount though and OVER or UNDER recovery of fixed overhead will occour, which must be balanced by a BALANCING AMOUNT known as the over/under –recovered fixed overhead.This amount is included by 'raising a charge' (possibly it's very own ledger account-CRJ/CPjournal) and including it in the Cost of sales breakdown in Income statement for Gross Profit calc. Do NOT ASSUME every company uses fully integrated abs.cost. to allocate costs in order to arrive at the cost of a product.Only companies that have a JOB COSTING environment , require a pre-determined FIXED COST to allocate to FUTURE production.Very few companies will allocate costs to production and service depts. , followed by re-allocation from service depts. to production depts. However , when using absorbtion costing, one must remember that one comapny allocates fixed costs differently to another one,and there is no right or wrong method to allocate fixed costs really, ie some allocate all overheads, some only admin + management , some only maintenance and depreciation etc.

VARIABLE COSTING (OR MARGINAL OR DIRECT COSTING) IN EXAM, OR REAL LIFE, AS SOON AS ONE GETS AN INCOME STATEMENT OR FIGURES PREPARED USING ABSORBTION COSTING, ONE MUST QUICKLY CACULATE THE SAME FIGURES USING VARIABLE COSTING – OR YOU WILL NOT BE ABLE TO DO PRPER COMPARISONS AND WORK THINGS OUT! Due to fixed costs being in there- always take them out and convert to CONTRIBUTION .. The method used to VALUE CLOSING STOCK using variable manufacturing costs only- fixed costs are written off as period costs.(as per book- fixed mnfrtring costs are charged to the Income statement as an expense for the period.So closing stock is valued on manufacturing variable costs only. Ie: the valuation excludes all mnfring fixed costs.The System is representative of managerial accounting for decision making. Variable costing is consistent with CVP analysis,ie fixed costs are treated as period costs.(per book exactly) FOR VARIABLE COSTING ,THERE ARE 2 WAYS OF VALUING STOCK – 1-BUDGET OR 2-ACTUAL.

DIRECT COSTING. MARGINAL COSTING. STANDARD COSTING: Another method of VALUEING CLOSING STOCK – but at a pre-determined rate for BOTH VARIABLE AND FIXED COSTS. STANDARD VARIABLE COSTING: (a) when only pre-determined variable costs are used. STANDARD FIXED COSTING: (b) when only pre-determined fixed costs are used.

SUNK COSTS: SUNK COSTS : These are COSTS created by a decision in the PAST that cannot be changed by any future decision – or which has a zero value when making future decision: eg:depreciation,or money spent on material that is no longer required/ or sellable.-OR buy a car for 10000, when you sell it the 10000 is sunk cost because selling price depends on what the buyer will pay –it can be above or below 10000 .

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RESPONSIBILITY ACCOUNTING : RESPONSIBILITY ACCOUNTING : accounting for a RESPONSIBILITY UNIT -an organisation unit or part of a business for which a manager is reponsible.Revenues & Costs so deviations from performance budget can be attributed to resposible individual.

PROFIT CENTRE : same as above :Accountability for profitability of assets placed under a managers control.

COST CENTRE: SAME AS above but AREA or DEPT. for which a manager is responsible.

INVESTMENT CENTRE: term defines accountability for profit generation AS WELL AS choices in what will or will not be purchased by way of capital expenditure in running a business.

MAINTAINING A COST DATABASE: 1) Database to be maintained so relevant cost info can be extracted easily. 2) Need eg: By products, responsibility centres,depts.,distribution channels, + categ. of expense eg direct labour + categ. of cost behaviour eg fixed and variable. 3) For cost control and performance measurement: a) Reports by resposibility centre per week/ etc b) Future reports for eg: possible price changes. c) Standards costs stored & used to evaluate

FIXED AND VARIABLE PRODUCTION OVERHEADS : AND COST BEHAVIOUR OF a) Measurements of volume needed to :patients seen-one more patient/day?=costs/revenue/(or units sold ? reduce price to sell more?,or units produced ,guests booked etc)

VARIABLE COSTS : vary directly or very nearly directly according to incr./decr. in volume(eg:of production).See chart below : total variable costs are linear/direct and Unit var. cost is constant.

UNITS vs VARIABLE COSTS GRAPH

TOTAL Variable Cost

5000 4000 3000 2000 1000 0

0 0

1000 100

2000

200

3000

300

ActivityLevel

5000 4000

400

500

UNIT Variable Cost

Variable Costs:(b)Per Unit (cost =R10 per unit)

VARIABLECOSTS: (a)TOTAL

40 30 20 10 0

10 0

10 100

10 200

10 300

10 400

ActivityLevel (unitsofoutput)

10 500

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PROFIT vs VARIABLE COSTS GRAPH.

FIXED PRODUCTION COSTS : basicaly stay constant regardless of volume of production –OVER a specific period of time- (before inflation pushes up input prices etc),but also called ‘long term variable costs’ because over the long term ALL costs are seen a variable-due to inflation etc. eg:rent, municipal rates

UNITS vs FIXED COSTS GRAPH

FIXED COSTS:(b) unit (supposed hyperbolic!)

50

0 0

100

200

300

ActivityLevel (no.ofunits)

400

500

Unit Fixed Cost

Total Fixed Costs

FIXEDCOSTS:(a) Total

1000 500 0 0

2

4

ActivityLevel : Output -no ofunitsproduced

6

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PROFIT vs FIXED COSTS GRAPH

SEMI-FIXED (OR STEP-FIXED COSTS) : They are fixed in (Relevant Ranges )at specific activity levels :eg at 100 – 5000 products ,-within a specific time period (same as fixed –to exclude inflation etc)- but if production goes above that they change to the next level etc.– usually in steps-

Total Fixed Costs

STEPFIXEDCOSTS 300 250 200 150 100 50 0 0

100

200

300

400

500

ActivityLevel

SEMI-VARIABLE (OR MIXED COSTS) : These include both a FIXED and a VARIABLE component eg:maintenance = fixed cost + a variable cost according to amount of activity ; or sales rep. costs =salary + commission per amount of sales. Eg rent= rent +10%gross revenue

RELEVANT RANGE RELEVANT RANGE: A limited level of activity under which costs are analysed as either fixed or variable,eg for production of 1-1000 units, over that another costing structure is used,or another range.

SELLING COSTS SELLING COSTS : relate to sales, written off in period incurred. Eg :commission costs,etc.

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CONVERSION COSTS: CONVERSION COSTS : All costs other than Direct Material costs that are incurred in manufacturing a product.The word conversion is normally associated with process costing and refers to all costs exept direct material directly related to the manufacturing process. ADMINISTRATION Costs: Administration Costs: treated as a manufacturing overhead only if relate to work being carried out in mnftring process – but in most instances they are written off as a period cost- not mnftr. Cost. Eg: cost of accountant= period cost , cost of person who records all manufacturing processes number produced, materials used etc only in mnftring = manftring admin cost .

HIGH-LOW COST ANALYSIS: REFERS TO ANALYSIS OF SEMI-VARIABLE COSTS where the var. & fixed. Elements are calc. by analysing incr. in cost in comparison to incr. in prod. Volume.

CONTRIBUTION: CONTRIBUTION is the SELLING PRICE of a product LESS all VARIABLE COSTS.The term used by Management accountants to describe the incremental profit that a company will make as the company sells one more unit of production.(DOES NOT include FIXED COSTS, ONLY SELLING PRICE – VARIABLE COSTS = contribution, then after that ,CONTRIBUTION-FIXED COSTS=NET LOSS/PROFIT.) Variable costs would include selling,marketing,distribution costs etc,so ALLl variable costs,none are left out. Mngmn acc only concerned with contribution,not profit since incr. sales = incr.contribution where fixed costs stay constant. Means ' Profit contributed toward total profit of firm before fixed costs' so.This happens because fixed costs do not change , but production volume does, so once all fixed costs have been paid by current production volume, any increase in production volume above this results in a higher profit than before the fixed costs were paid for.Thus before fixed profit is paid for , PART OF THE CONTRIBUTION goes to fixed costs, but after the fixed cost is paid for, ALL OF THE CONTRIBUTION goes toward profit.

= -

SALES Variable Costs (incl.marketing,selling,distrib ution ie: ALL. CONTRIBUTION Fixed Costs

=

PROFIT

-

BUDGET: A budget is a quantitative analysis of a plan or corporate action.It is intended that production/sales etc be coordinated by various depts. to achieve expectations about future income/cash flows/fin pos , fin perf and supportin plans.

“STANDARD HOURS PRODUCED”: -“– is the time it takes to produce one product ,used as a common denominator to divide up costs into different products.

“STANDARD PROFIT STATEMENT”: This is an income statement , using pre-determined standard cost rates , showing what profit we can expect from a given sales volume.The volume is usually estimated from known sales and production capacity, but could also just mean the volume for the flexed budget, when using standard costing.

STATIC BUDGET The plain original realistic budget for the year drawn up at beginning of year.

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FLEXED BUDGET Standard Budget : The budget the is drawn up using the ACTUAL sales VOLUME, but with the original costs from the Original Budget, not the Actual Costs. This can then be compared to the actual Income statement to see what the difference in each cost was once converted to the actual sales level.

BILL OF MATERIALS A list of all the actual materials needed to manufacture a specific product. Does not include labour/overheads etc. like the ‘Standard Cost Card.’

STANDARD COST CARD Card with the costs of all the Inputs used to make 1 output product.(That should (actual) be used to produce a product.)1 card is kept for each different product made. (-historical cost -not a goal type cost).Nowdays on computer.

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FORMULAS 1)

Future Value FORMULA : FV= PV(1+i)n a) b) c) d)

2) 3)

Where FV= future value PV= present value I = interest rate – in DECIMALS eg for 15% Use 0.15 NOT 15% n= number of years/periods

Present Value Formula : PV = FV/(1+i)n PV of DEBT Formulas :There are 2 possible situations & formulas here: a) For “Perpetuity Type ” Loan :PRESENT VALUE (PV) formula of Debt : PV= Cash-Flow/Kd this is where the loan is indefinite/infinite with no repayment date specified. The answer is not fixed- it changes if looked at from a PV or FV.

b)

For “Repayment Time Specified ”Loan : (PV) formula of Debt : PV= Cash-Flow /(1+Kd)n here you must work out the PV with this formula for every year of the loan individually,

and then add up all the answers to get the total.- but you still only use the current market interest rate for Kd. c) Where i) Cash-Flow = the FV – ie money that is to flow in the future- the Future Value =this is the interest in Rands OR/AND the capital repayments that will be paid back in the future. ii) Kd = the interest rate charged for debt- if tax is deductable then first deduct the tax % from the rate before you use it. Interest After Tax = interest rate X [100% - tax rate% ]%. This Kd is the current market value of debt , not at the actual interest rate actually being paid back by company, but at the lowest you could get today instead- even if it is.

SHARES a)

STATIC DIVIDENDS FORMULA(no growth ) i)

There are 2 Ways this can get calculated: depending on if the shares are to be held “for ever” or to be “sold” after a specific time. The difference is for the “for ever” one it works similar to the ‘perpetuity’ formula = [ Do/Ke ] and the second works similar to the Present Value formula [ like =FV/(1+i) ] (1) PERPETUITY Type FORMULA: where the share is to held for an indefinite period ie: ‘in perpetuity’. (a)

Ex-Dividend formula: Value =

Do

/Ke X Number of shares

: means

if the shareholder receives a dividend today that dividend is EXCLUDED (b)

Cum-Dividend formula: Value = Dividend + (Do/Ke X TOTAL number of shares.) means if the shareholder receives a dividend today then that

dividend is INCLUDED in the calculation of value of share (you just add the dividend to answer-simple) (c) Remember: you can ALSO get the PV of an ANSWER from this formula if it only will occour in eg 3 yrs time. : say that for the next 2 years the share price will fluctuate ( or grow etc) but in 3 years time it will start to remain the same from there on- static. If you are looking for the value of the share today, you must first calculate the PV of the next 2 years separately using another method ( directly or using growth formula below etc.) THEN you can calculate the value of the 3rd year onwards using the above formula and bring this to PV by substituting your FV you got in the for it to bring it to PV. : ie: [Do/Ke] = FV , so PV today = [D0/Ke ] / (1+i)n ……where we would use ‘Ke’ for ‘i’ here.! (2) “TO BE SOLD “ Type PRESENT VALUE FORMULA :

where the shares are to be sold after a specific

period of time :now it’s a PV calculation.

(a)

Ex-Dividend formula: Value =

Do

/(1+Ke)n X Number of shares :

means if the shareholder receives a dividend today that dividend is EXCLUDED You use this formula once for each separate year to come, so for 3 years you must do the calc. 3 times and add the answers up to get the total. (b)

Cum-Dividend formula: Value = Dividend + (Do/(1+Ke)n X TOTAL number of shares.) means if the shareholder receives a dividend today

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 26 then that dividend is INCLUDED in the calculation of value of share (you just add the dividend to answer-simple) (c) Remember you could do the above calc. for years 3 & 4 but do years 1&2 with another formula for eg.”growth” and just add the answers up to get the total.( say there was growth for first 2 yrs then no growth for 2 yrs.)

b)

GROWTH / FALLING DIVIDENDS (growth or getting less)

i)

PERPETUITY Type FORMULA: (a)

ii)

where the share is to held for an indefinite period ie: ‘in perpetuity’. Do not use year 0

dividends, only end year 1

Ex-Dividend formula: Value =

D1

/Ke - g X Number of shares :

means if the shareholder receives a dividend today that dividend is EXCLUDED (b) Cum-Dividend formula: if they ask for cum-dividend then (probably) just add the dividend you are receiving to the answer per share. “TO BE SOLD “ Type PRESENT VALUE FORMULA : where the shares are to be sold after a specific period of time :now it’s a PV calculation.

(a)

Ex-Dividend Formula : Value =

D1

/(1+Ke )n X Number of shares

: (ie cash flow/for this one you MUST work each year out separately using the PV formula given here. To accommodate the growth (g) in dividends each year you cannot do it with the formula, you must manually increase the dividends each year, then work out the Present Value for each separate year using the above formula .THE SELLING PRICE AT THE END OF THE PERIOD MUST BE INCLUDED IN THE final year PV calculation.(ie just add it to the final year dividends and get the PV of the total, no need to do a separate calculation!)Then add all the years up to get the present value of the shareholding. (b) Cum-Dividend Formula: Cum-Dividend: probably just add the dividend you are receiving to the answer (c) Remember:you might have to work out the PV for only 2 years using this formula, then switch to another formula if question says there will be no more growth from the 3rd year onward : that new answer then gets in turn brought to P.V. iii)

2) Debt : Present value of debt: 2. There are 2 possible situations & formulas here: a. For “Perpetuity Type ” Loan :PRESENT VALUE (PV) formula of Debt : PV= Cash-Flow/Kd this is where the loan is indefinite/infinite with no repayment date specified. The answer is not fixed- it changes if looked at from a PV or FV.

b.

For “Repayment Time Specified ”Loan : (PV) formula of Debt : PV= Cash-Flow/(1+Kd)n here you must work out the PV with this formula for every year of the loan individually, and then add up all the answers to get the total.- but you still only use the current market interest rate for Kd.

ANNUITY: 3) Future Value FORMULA for ORDINARY/DEFERRED/REGULAR ANNUITY. :

– 1 / i] (1+i) a) I = Constant Amount invested each year b) c) d)

FVa =

future value of the annuity. i = interest rate – in DECIMALS eg for 15% Use 0.15 NOT 15% n= number of years/periods

4) Future Value FORMULA for ANNUITY DUE :

a) I = Constant Amount invested each year b) c) d)

FVa = I x [ (1+i)n

FVa =

FVa= I x [ {(1+i)n – 1 }/ i] (1+i)

future value of the annuity. i = interest rate – in DECIMALS eg for 15% Use 0.15 NOT 15% n= number of years/periods

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 27 5) Present Value FORMULA for Regular ANNUITY :

PVa= I x [ {1 – 1/ (1+i)n } / i]

DO A SCAN) a) I = Constant Amount invested each year b) c) d) e)

PVa =

present value of the annuity. i = interest rate – in DECIMALS eg for 15% Use 0.15 NOT 15% n= number of years/periods

This is

where the payments are at the end of the year.

6) Present Value FORMULA for ANNUITY DUE :

1](

PVa= I x [ ({1 – 1/ (1+i)n } / i) +

DO A SCAN)

a) I = Constant Amount invested each year b) FVa = future value of the annuity. c) i = interest rate – in DECIMALS eg for 15% Use 0.15 NOT 15% d) n= number of years/periods e) This one is where payments are at the beginning of the year.-annuity due.

LOAN: PERIODIC PAYMENT OF A LOAN 1) CHANGING the Present Value FORMULA for Regular ANNUITY to MAKE I THE SUBJECT

below: a)

PVa= I x [ {1 – 1/ (1+i)n } / i] PVa i) Becomes : I = / [ {1 – 1/ (1+i)n } / i] PVa X i ii) Or: I = / [ {1 – 1/ (1+i)n } / i] : this formula is easier to use than the one above for manual calculations – the /I is just changed mathematicaly to go on top as “X PVa “

iii)

Where:

(1) I = Constant Amount invested each year (2) PVa = present value of the annuity. (3) i = interest rate – in DECIMALS eg for 15% Use 0.15 NOT 15% (4) n= number of years/periods

PERPETUITY: 1) A Perpetuity is a normal Annuity but with an infinite life. 2) You only work it out by using a special formula: 3) PRESENT VALUE of a PERPETUITY FORMULA : a)

PVp =

PVp= I/i

Present Value of a Perpetuity.

b) I = Constant Amount invested each year c) d)

i = interest rate – in DECIMALS eg for 15% Use 0.15 NOT 15% This one is where payments are at the end of the year.- I think- it does not say in the book what it is. Also it does not say what the formula for at begin of year (annuity due) is.

4) PRESENT VALUE of a -growing- PERPETUITY FORMULA :

growth in decimals eg 0.08

PVp= I/i-g where g=

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 28

MARKET VALUE OF A COMPANY: 1)

The Market Value of a Company : there are 2 formuals :Formula 1:

V0

= MVe +

MVd

a) The Market Value of a Company Formula : is simply the Market Value of Equity ( ie the PV valuation of the shares) PLUS the Market Value OF all Debt (ie PV valuation of debt) ,these valuations of debt and equity above must be done using the “FV of cash flows” at “current market rates” to get the Present Value of all future cash flows. 2)

The Market Value of a Company : there are 2 formulas :Formula 2 : Y /WACC = Dividends(Do) + DebtInterest Paid in Cash/WACC (AFTER TAX)

V0 =

MARKET VALUE OF CONVERTIBLE DEBENTURES OR PREFERENCE SHARES. 1) The Valuation of Convertibles is carried out in 2 steps: a) At the option date, compare the value of each option and choose the option with the highest value. b) Calculate the value of future cash flows and the terminal value of the option chosen, back to year 0. (date at which the you want to know the value – not date of option but date today) 2) If You Convert From One Type Of Security To Another, (Eg: Debentures To Shares, Or Pref. Shares To Debentures). Use The Current Type’s Ke Or Kd To Bring The “Future Market Value Fv” At Date Of Conversion To Todays Present value- NOT the Kd or Ke of what it will be when its converted. So: if you are going to choose to convert to ordinary shares at the date of the option in say 3 years , from debentures , then there is one complication : TO GET THE Present Value OF THE MARKET VALUE OF THE NEW ORDINARY SHARES today in order to add it to the PV of any cash flows up to the date of conversion = Market Value of DEBENTURES, TOU MUST USE THE DEBENTURE Kd (LESS TAX), AND NOT THE ORDINARY SHARE Ke at which the FV market value of the shares were worked out

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 29

CHAPTER 11 RELEVANT COSTS CONTEXT OF RELEVANT COSTS: 1) Management accounting is primarily concerned with producing budgets, setting performance standards, and evaluating performance. 2) Relevant costs Requires an understanding of: 1) Special Orders: A special order is one that will not affect a companies current sales to its regular customers (often as an export). It is usually sold at below full cost – by using contribution to work out an extra low price, because overheads are covered by sales to normal customers. { {Note : Be careful : even doing this for export can cause the goods to re-appear on the local market at lower price than you usually even sell at.} a) 2 Alternative Decisions: is about comparing a capital–intensive business to a labour intensive-business. b) Limiting Factors: always look out for when assessing any exam question: eg: production bottlenecks/raw material supply problems ie:quotas.

TERMS: 1) Relevant Cost: i) a future cash flow arising as a direct consequence of the decision under review.-ONLY RELEVANT COSTS should be considered in decision making , because it is assumed that in the long run future profits would be maximized if the ‘cash profits’ of the company, ie: the cash earned from sales minus the cash expenditures incurred to sell the goods, are also maximized. ii) COSTS WHICH ARE NOT RELEVANT INCLUDE: (1) Past sunk costs, or money already spent. (2) Future spending already committed by separate decisions. (3) Costs which are not of a cash nature eg: depreciation (4) Absorbed overheads (only cash overheads incurred are relevant to a decision) iii) The relevant cost of a unit of production is usually the variable cost of that unit plus (or minus) any change in the total expenditure of fixed costs. 2) Differential cost a) A differential cost is the difference in cost of alternative choices. If Option A costs an extra R300 Option B costs an extra R360, the cost differential is R60, with Option B being more expensive. A differential cost is the difference between the relevant costs of each option. 3) Incremental cost a) The differential cost of an extra unit of production is the extra cost required to make that unit, ie it is the difference in cost between making the unit and not making it. This type of cost is also called incremental cost. Incremental costs are relevant costs. 4) Opportunity cost a) An opportunity cost is the benefit foregone by selecting one alternative in preference to the most profitable alternative. If, for example, a company is currently making a cash-flow of R100 000 from the use of a machine and it now has an opportunity of investing in a new machine, the choices are: i) Continue with the existing machine ii) Replace with the new machine iii) Sell existing machine (opportunity cost) 5) Sunk costs a) A sunk cost in decision-making terms is a past expenditure incurred as a result of past decisions,which: i) Has been charged as a cost of sale in a previous accounting period OR ii) Will be charged in a future accounting period, although the expenditure has already been incurred (or the expenditure decision irrevocably taken). An example of this type of cost is depreciation. if the fixed asset has been purchased, depreciation may be charged for several years but the cost is a sunk cost about which nothing can now be done.

ADDING A NEW PRODUCT Following factors are to be considered: 1- working capital :cash to be invested in stock and debtors , as well as 2incremental admin.costs, 3-advertising ,4-incremental marketing costs, etc.

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 30

DROPPING A PRODUCT OR DIVISION 1) Following factors are to be considered: i) Production capacity taken up by product : (1) Under-utilisation condition of capacity : if it at least contributes to fixed costs it should not be dropped. (2) Operating At Full Capacity: strong consideration should be given to an alternative product if it has a higher ‘Contribution’ . ii) Long term prospects for recovery of demand iii) Market competition iv) The cash break-even point /CHART (1) The cash break-even point is only a short term solution where the long term prospects for recovery are good. (2) Where the CVP chart shows the profit break even point below which a company is said to be making a loss, (3) the CASH BREAK-EVEN CHART is an analysis based on the receivable cash from sales minus the outflow of all cash payable.It ignores all NON-CASH OUTLAYS and takes account of time lags in accounts receivable and payable. Eg depreciation could make a difference between the 2 chart types. So if cash outflows are low the company could SAFELY continue to operate at a financial actual loss without big risk of INSOLVENCY.

MAKE OR BUY DECISION 1) Includes outsourcing a service (eg: IT Dept functions. ) 2) Qualitative as well as Quantitative aspects must be considered: a) QUALITATIVE ASPECTS: i) Consideration of competitiors economies of scale ii) Consideration of inhibited future expansion due to the tying up of available capacity. iii) Reduction in dependence on outside supplier iv) Internal quality control, rather than relying on outside companies quality control dept. v) Risk of destroying long term relationships with suppliers which may prove to be harmful and disruptive. vi) Technology change often makes internal production more costly than purchasing from outside. b) QUANTITATIVE ASPECTS : i) This means the Actual numbers involved : see example below.

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 31

SPECIAL ORDERS 1) A special order is one that will not affect a companies current sales to its regular customers (often as an export). It is usually sold at below full cost – by using contribution to work out an extra low price, because overheads are covered by sales to normal customers. { {Note : Be careful : even doing this for export can cause the goods to re-appear on the local market at lower price than you usually even sell at.} 2) The following qualitative aspects must be considered for special orders: a) The effect of selling at lower prices to use excess capacity: the buyer might undersell you to your normal customers. b) One might have to use normal customers capacity to fulfill a large order and loose normal sales. c) The special order may be packaged in a different brand so as not to compete with the normal sales, or sold on a foreign market. d) Price must cover variable costs, special shipping& production costs and some contribution. e) Opportunity cost of tying up the plant must be considered. f) Effect on commissions paid to company staff. g) Accommodation of sales to existing customers h) Future long term contracts from company requesting a special order price. i) Market factors: how will the special order affect our competitiors attitude to pricing. 3) Example:

IMPORTANT : USE THE RELEVANT COSTING DECISION MODEL AS AN AID IN CHOOSING AMOUNG COMPETING ALTERNATIVES. 1) Remember when you work out a no. of products,round off DOWN. Ie: as 3.7 of product A : you bring this down to 3 : because you normally cannot produce the extra o.3 with limited resources, you must usually bring it down to the number below, not above. 2) LABOUR VS CAPITAL INTENSIVE EVALUATION: To Evaluate by Normal Method: a) first calc. the fixed costs, then evaluate how long it will take to break even. b) Next calc. indifference point: fixed+variable x X = fixed + variable x X. c) Draw a graph to see which is more profitable ABOVE the indifference point. d) To evaluate a decision with limiting factors, choose the one which maximizes profit on the basis of contribution per limiting factor. 3) LIMITING FACTORS EVALUATION: How To Evaluate Management Accounting Information For All Questions And In Particular Where There Is A Limiting Factor a) Step1-5 Simplified: 1-sort variable/fixed costs+ work out totals.2-do contribution VS limiting factors(bottlenecks). Step 1 Sort out the information given by evaluating fixed costs and variable costs, both budget and actual. Virtually all questions require an analysis of the cost structure. Have headings, eg fixed costs, variable costs, high / low, absorption costing, variable costing. You will invariably be given information on a variable costing or absorption costing basis that requires you to sift through the information and show the costs as variable costs or fixed costs. Step 2

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 32 Identify maximum production capacity for machinery or labour and show whether there is a limiting factor. Headings should read “Potential limiting factor — machine hours”, (or labour hours or material, etc). You must also conclude whether there is a limiting factor for each cost analysed. Step 3 When there is a limiting factor, you must determine the contribution per unit, followed by the cost per limiting factor. Step 4 Do the budget. Step 5 Evaluate possible alternative information that may change the contribution per unit determined in Step 3 above.

NOTE :EXAMPLE OF CONTRIBUTION PER LIMITING FACTOR WHERE BUYING IN IS A PROBLEM. This is often a problem for students . Where there is an option to buy in , the correct method is to calc. the contribution per limiting factor.Method is shown here:

4) 2 Alternative Decisions: is about comparing a capital–intensive business to a labour intensive-business. 5) When evaluating a business decision or when answering an examination question that requires an opinion on how a business should be structured you should consider the following: a) BUSINESS COST STRUCTURE Business is about maximising contribution and minimising ‘overheads’.The goal should be lower fixed costs to be able to generate a positive contribution or profit faster.When starting a company it is therefore better to start small and not ‘too flashy’ in order to minimise the fixed costs. If the business does not work, your losses will be restricted to the fixed costs. Low fixed costs, however, tend to go hand in hand with high variable costs. The contribution per unit for new companies will normally tend to be relatively low. b) FIRST MILESTONE The first objective of a business should be to break even. If a company cannot break even in the short to medium-term, it is probably a bad investment. You should therefore always determine the break even point and the margin of safety. Companies with a low fixed cost structure or low overheads be less risky than companies with high fixed costs. In an examination question asking for advice how a company is performing, focus your answer on an analysis of the companies cost structure, ie its fixed costs and contribution per unit. c) MEDIUM /LONG TERM OBJECTIVE: Once a company has established itself and has passed the break-even point, the company will look to changing its cost structure so that the contribution per unit increases. Invariably, this means moving from a ‘low fixed cost, high variable cost’ cost structure to a ‘high fixed cost, low variable cost’ cost structure. It therefore becomes important at this point to determine the Production Point Of Indifference, ie where the total cost of a capital-intensive company = the total cost of a labour-intensive company d) LONG-TERM OBJECTIVE The long-term objective should be to maximise return on investment. Companies should therefore aim at increasing sales and reducing variable costs. In the long-term, a company will aim at minimising the variable costs of production, and therefore maximise contribution. Targeting fixed costs is counter-productive. Fixed costs are the engine-room of the company and represent the manufacturing assets that generate sales profit. If the overheads are too high, it is because the sales are too low. Target sales, and the costs will look after themselves. Most companies, when faced with difficult times, tend to target fixed costs such as salaries and the infrastructure of the company, which often leads to a slow death. It is better to target variable costs which will increase contribution and sales rather than a cost reduction. Always focus on sales. d) EXAMPLE: NOTE: the examples below are very simple, to get the idea of all the angles, incl. multiple limiting factors at the same time where you must use ‘linear programming’ to solve it, you must go through examples in the book.

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 33 The example below evaluates two production options, high fixed costs, low variable costs vs. the option of low fixed costs and high variable costs. In examinations, you must focus on the overall discussion. 1- Effects of different cost structure 2 -Break-even point 3 -Point of indifference 4 -Long-term cost structure

EXAMPLE B: A BIT MORE DIFFICULT: CHOOSE BETWEEN 1-IMPORTING & 2-LIMITING FACTOR.

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 34

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 35

CHAPTER 6 FINANCIAL AND BUSINESS ANALYSIS (Re-do from return on operating assets-no time) 1) Financial & Management accountants are often called upon to evaluate a company and see how well a certain division or particular company is performing. The skills required for such an analysis are considerable and the techniques of establishing such a value differ from business to business. 2) It must look through the spectacles of a Fin. As well as a Mangmnt. Accountant, each of which have different spectacles.

FINANCIAL VS MNGMNT ACCOUNTANTS VIEWPOINT. FINANCIAL ACCOUNTANT: 1) He is interested in analyzing the info from point of view of various stakeholders and from a historical perspective. 2) MOST IMPORTANT INPUTS: Financial statements 3) PRINCIPLE TOOLS: a) Comparative Fin. Statement Analysis. b) Ratio Analysis. 4) IGNORED: (as a result the ratios and returns might have no bearing on current economic status, particularly in times of rising inflation. a) Inflation b) CURRENT MARKET Values of EQUITY + DEBT + ASSETS. 5) MAJOR LIMITATIONS OF FIN. ACC. DATA. a) Inflation: ratios/assessments based on historical value distort the analysis. Often eg in SA with high inflation book value is often a fraction of real value. So if returns 5 years ago were 10% on investment, even if it decreased to 5 % today it may seem that it has increased to 20% because the assets are at old book value but income is at new inflation changed market value: ie income/assets=…. b) Current market values of equity + debt + assets. : old book values distorts all ratios .(etc) c) Non-Monetary Items: Fin Stat. often fail to show value of non-monetary items eg: management, breadth of product range, technology, trademarks, brands, patents, goodwill etc. Hence problem of using ratios alone to value a firm. d) Market Forces: next years market, labour union militancy, foreign exchange factors, competitors, substitute products etc. e) Accounting Policies: comparing different companies could be meaningless because eg depreciation, stock valuation policies are different. ( as well as firms being structured differently as well)

MANAGEMENT ACCOUNTANT: 1) MOST IMPORTANT INPUTS/criterion: The Present Value of Future Cash flows. a) This means the CURRENT MARKET VALUES of investments such as EQUITY, DEBT, ASSETS are assessed at current market value, not book value. 2) PRINCIPLE TOOLS(some) : a) Financial risk and b) Business risk of the firm- 2 separate attributes assessed separately which have an effect on each other.

BUSINESS RISK VS FINANCIAL RISK. 1) Definition : BUSINESS RISK: = ’ Ke ‘ the risk that relates to the daily running of the operating activities of the company. a) The Business Risk is: Measured and Affected by:

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 36 (1) NATURE of business activities of company (2) OPERATING LEVERAGE of firm (3) PHYSICAL STATE OF FIXED ASSETS (4) POLITICAL CONSIDERATIONS (5) PRODUCT SUBSTITUTES available (6) COMPETITION (7) MANAGEMENT (8) FUTURE PROSPECTS BY PRODUCT & VOLUME (9) FUTURE PROSPECTS for the INDUSTRY IN GENERAL. b) To assess: 1-Current Market Value , or 2-Future prospects , or 3-Viability we assess ALL of the business risk factors above.eg ratios may be very, very, good but substitute product/physical state etc. may easily wipe out the company. c) What can go wrong with a business: eg: i) No demand ii) Competitors undercut iii) Unable secure raw materials iv) Machinery used is inefficient v) You experience employee problems. vi) Debtors do not pay on time. 2) Definition: FINANCIAL RISK: =’ Kd’ the risk that “relates to the borrowing of long-term and short-term debt.” The company becomes liable for : (1) Monthly Interest repayments (2) Capital Repayments. b) The Financial Risk is : that funds will be available to pay i) Interest ii) Capital Repayments iii) Default Risk – this third risk can be avoided by using Equity Finance. c) Financial Gearing : the object of this financial risk is that it is hoped that the cost of debt is lower than returns offered by the assets purchased with borrowed funds - thus increasing returns to shareholders. d) Evaluating Financial Risk : it is important to consider ‘Business Risk’ as well to evaluate financial risk itself because a company with high business risk should borrow limited amounts of cash, but with less business risk the capacity to take on financial risk is increased. 3) If ever given a question in exam , and company has any form of debt, then a) Ke = Business Risk + Financial Risk b) If there is no debt in the structure then Ke= Business risk only. 4) Companies can be classified in terms of their business risk: HIGH RISK Mining Chemical Speciality Products Technology

MEDIUM RISK Restaurant Security Building

LOW RISK Supermarket (retail) Household Products Banking Clothing(??? Not sure – check up)- not high fashion, but plain.

High Fashion(I think)-

THE BUSINESS MODEL: 1) ?As per book it is : the idea to produce product + get dividends or re-invest+incr.equity worth + finance bank collateral interst payments or liquidation? KEY ANALYSIS RATIOS (AND OTHER TOOLS) OF THE 4 STAGES OF A BUSINESS MODEL STAGE 1: CAPITAL STAGE 2: ASSET STAGE 3 INCOME STAGE 4 CASH FLOW STRUCTURE STRUCTURE STATEMENT STAT. 1 -Return on Operating 1- Key ones: 1-Current Ratio 1-Debt: Assets a) Gross Profit 2-Acid Test ratio 1) Times interest earned. 2 –Debtors Analysis Percentage 2) Debt to equity 3-Cash Flow Stat.asset b) Increase in 3-Debtors Collection

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 37 replacement 2-Equity: 3Price Earnings ratio 4Dividend Payout 5Dividend Yield

Turnover c) Operating Leverage 2-Less important ones: a) Net profit percentage b) Profitability c)Return on Equity d)Earnings per Share e)Dividends Per Share

4-Stock Turnover

2) THE BUSINESS MODEL CAN BE BROKEN DOWN INTO 4 STAGES: STAGE 1: CAPITAL STRUCTURE (means using equity or debt) (1) Equity Providers: require 1-Dividends or 2-Capital appreciation (latter means shares become worth more by declaring less dividends and reinvesting instead) (2) Debt Capital Providers: require 1-Interest and 2- Capital Repayments. ii) Analysis & Ratios: (1) Debt: (a) Times interest earned (b) Debt to equity (2) Equity: (a) Price Earnings ratio (b) Dividend Payout (c) Dividend Yield iii) Requirements of capital structure: (1) Dividends (2) Interest (3) Capital repayment iv) Note: For debt repayments profit must be converted to cash. Also, the cash flow statement is the most important aspect of a company because cash is king, and payments,salaries etc. must be in cash. Many companies can show a profit by applying questionable but acceptable accounting standards, but cash flow statement shows up problems here.

STAGE 2: COMPANY ASSETS v) Operating Assets: The following are all part of operating assets: (1) Fixed assets: (a) Machinery (b) Equipment (c) Buildings (2) Current Assets: (a) Debtors (b) Stock (c) Cash (3) Current liabilities: (you are what???? Why is this part of operating assets see page 216 ‘vig finance’???) (a) Creditors vi) Requirements of Operating Assets: (1) Capital Replacement (2) Asset Maintenance. vii) The fixed assets purchased with equity/debt finance is invested to purchase fixed assets& daily working capital.The assets generate the profit and cash flow to run a viable going concern. These assets represent the infrastructure of the company ie the ‘Operating Assets’. viii) Important consideration for viability of firm is 1-physical state of assets + 2-cash provision for replacement & 3-cash provision for further investment. ix) Analysis & Ratios: (1) Return on Operating Assets (2) Debtors Analysis (3) Cash Flow Statement : for asset replacement.

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 38

STAGE 3: INCOME STATEMENT. i)

Should be the most important fin stat. of firm because it is the ‘engine room’ of the company, but sadly it is not because of ‘fair value’ which means the adjustments to income stat. that must be made to bring it to market values(which are these if not stock? - book says Below gross profit?).Because these revaluations are mostly very suspect and result in non cash flow adjustments which are questionable and make the profit questionable at best.The turnover to gross profit is the most valuable, the sections below are,as per textbook, questionable due to ‘fair value’ adjustments’.But somewhere else in book it says the last section has a limited value(exept profit- the dividends/tax/retentions are worthwile) ii) There are 3 sections in the income statement/SCI, (1) Operating Costs = valuable info (2) Infrastructure Costs(admin costs to profit) =noise (3) Financing (interest,tax,dividends,retentions for asset repace/growth) = valuable info.(exept net profit!) iii) Analysis & Ratios (1) Key ones: (a) Gross Profit Percentage (b) Increase in Turnover (c) Operating Leverage (2) Less important ones: (a) Net profit percentage (b) Profitability (c) Return on Equity (d) Earnings per share (e) Dividends per share. b) STAGE 4: Cash Flow Statement. i) Most important financial analysis tool.(by far) ii) Its not polluted by fair value adj and shows where cash comes and goes to.The cash flow statement is the company blueprint, all other ratios and analysis are simply commentaries. iii) Cash is King iv) The only place it can be manipulated is if debtors are sold as debtor finance- take care check here. (often bad quality ones are kept while good quality ones are sold) v) The Debtors adj. in it shows 1-debtor control & 2-quality of sales/turnover.( companies manipulate fin.stats. here by doubtful payer sales) vi) Analysis & Ratios: (1) Current ratio (2) Acid Test ratio (3) Debtors Collection (4) Stock Turnover

BUSINESS RISK, OPERATING LEVERAGE AND GROSS PROFIT % BUSINESS RISK: 1) If company has high business risk it is prudent to limit its exposure to financial risk because: 2) HIGH BUSINESS RISK+ HIGH FINANCIAL RISK = HIGH EXPOSURE TO BANKRUPTCY. 3) High Business risk : HIGH OPERATING RISK = HIGH POTENTIAL RETURNS + HIGH BANKRUPTCY RISK 4) Low Business Risk: LOW OPERATING RISK = LOW POTENTIAL RETURNS + LOW BANKRUPTCY RISK

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 39 HIGH BUSINESS RISK: 1) PROFILE OF COMPANY WITH HIGH BUSINESS RISK: a) CAPITAL INTENSIVE (likely less labour intensive) b) ALSO CALLED: “HIGHLY GEARED” or “HIGH OPERATING LEVERAGE” companies c) Accounting Perspective: (1) CAPITAL INTENSIVE (2) High Fixed costs( so high B/E point=drop in sales is dangerous ,also so high operating leverage) (3) High Contribution (and Ratio) (4) High Operating Leverage (5) High Profit/Volume Ratio (6) High Break-Even Point (7) Low Variable Costs (‘Relatively’) (8) Potential for significant Profits above Break-Even point d) Risk/Returns Perspective: i) High Risk ii) High Required Return iii) High Potential Profit iv) Volatile Dividends Payment v) Volatile Dividend Yield vi) Volatile P/E Price/Earnings ratio e) Examples: i) Mining ii) Oil & Gas Producers iii) Telecommunications f) Pay particular attention: i) To: state of fixed assets, AS: they’re highly machine intensive and profits are dependant on state&life of assets. ii) To: Ability to convert turnover into cash AS:in order to lower its business risk! and remain solvent. Debtors & level of current asset investment in Stock are therefore important. g) Notes: Negative:Such companies usually have very high fixed costs,ie: high operating leverage as per textbook (?due to presumably low var.costs I think?).So they have a High B/E point, so a drop in sales could bankrupt them.Eg mines have a high fixed cost-(wages?) etc.- but low variable costs-ore is free etc.-, so increase in Price or Volume of ore=vast increase in profits.Positive : high profit potential past B/E point. a) Diagram of High Contribution & High earning potential above B/E point.

LOW BUSINESS RISK 2) PROFILE OF COMPANY WITH LOW BUSINESS RISK a) NON-CAPITAL INTENSIVE (likely MORE Labour intensive) b) ALSO CALLED: “LOW OPERATING LEVERAGE” companies c) Accounting Perspective: (1) NON-CAPITAL INTENSIVE (2) Relatively Low Fixed costs(so low B/E point=drop in sales not dangerous, also so low operating leverage) (3) Low Contribution (and Ratio) (4) Low Operating Leverage (5) Low Profit/Volume Ratio (6) Low Break-Even Point (7) High Variable Costs (8) Stable Profit. d) Risk/Returns Perspective: i) Low Risk ii) Low Required Return iii) Stable Profit iv) Stable Dividends Payment v) Stable Dividend Yield vi) Stable P/E Price/Earnings ratio e) Examples: i) Household Goods ii) Personal Goods iii) Retailers iv) Food producers f) Pay Particular Attention : i) To: Debtor Levels and Stock analysis AS: are important , But Only if and where cash flow is poor, although most of these companies sell for cash. Also state of fixed assets are not very important, as investment in fixed assets is usually small. g) Notes: Positive:Have relatively low fixed costs ie: low operating leverage (?presumably due to high var.costs?)So little danger of bankruptcy if sales drop. Negative: high variable costs& low contribution ratio. Eg: P&Pay- low fixed costs=rent&depreciation, high var.costs = goods for sales.So profit is normally increased by increasing no. of selling points(shops) or increasing sales- because markup and contribution is usually low. h) Diagram of Low Contribution & Stable / (Lowish) earning potential above B/E point.

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 40

FUNDAMENTALS OF FINANCE RISK DEBT ADVANTAGE & DISADVANTAGE 1) THE DEBT ADVANTAGE = a) debt financing is tax deductable, therefore debt is considered cheaper than equity eg if tax rate is 40% , then: (interest rate*( {100-40=60%} after tax)=effective interest rate.) b) financial gearing improves shareholder return.(you get 36% profit after adding old +new profit, without investing anything-very good.as long -as it is above the required Ke-) 2) THE DEBT DISADVANTAGE= the financial risk of the company increases as the company takes on debt finance. a) Ke = return that shareholders expect, equal to the level of “business risk” +”financial risk”. Note: Ke is always = business risk + financial risk.So if there is no financial risk then…… b) Ke –the required return- will no doubt increase when firm takes on finance risk because there is now more risk involved and high risk=high returns.

THE CASH FLOW STATEMENT: 1) Net profit :Where cash from operations after working capital changes is negative or much less than profit ,the company Is in severe trouble.So even if profit is improving this figure is the big one- the engine room. 2) Working capital changes :must all increase in same proportion to turnover change up or down. But creditors up +debtors up(debtor days) + inventories up is bad- so it goes with (1) 3) Interest expense /dividends &taxes: look at the times interest earned ratio. And how much of interest payment is from CASH generated from operations( not just from profit) lots of tax should not be paid from little CASH from operations. And Dividends should be low for low CASH from operations – not just right for ‘profit’.(in case profit is from some weird adjustments) 4) Purchase of equipment: is there enough CASH to pay, or is too much debt being taken on with the rest of the figures looked at 5) Financing Activities: should it be more from equity or from debt , how much did each put in? look at other figures to see if lots of debt is good here.

FINANCIAL STATEMENT ANALYSIS: 1) OTHER USEFULL INFORMATION a) Comparative financial statements (over 5-10 yrs) b) Comparative Industry figures c) Inflation adjusted indexed financial statements d) Ratio analysis e) Business risk f) Financial risk- assessed on market values, not book values g) Accounting policy details h) Business activity info i) Full financial accounts j) Future strategy&investment plans k) Inflation l) Labour union aggressive/ labour disputes m) Management record n) Management-staff relationships

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 41 o) Share price movement data. 2) OVERVIEW a) Nature of business: eg it is a retailer i) so = low business risk etc ii) I expect: high or low :fixed costs, contribution,operating leverage,business risk iii) Sales on credit or cash( cash flow risk tra-la-la) b) Future business prospects Qty+products c) Future business prospects industry d) Competitiors e) Operating assets replacement policy+condition(if value increases or lots sold&bought then good replacement policy) f) ALL THE REST OF BUSINESS RISK + viable concern + acquisitions or other points of interest. -----------------------------------------------------------------------------------g) Aquisitions: are they cheap with good profitability?? Yes or no h) Viable going concern –low long term debt /current liabilities more than current assets/ futire prospects / + a general summary of all conditions 3) CONCLUSION a) Negative Assessment: i) Poor cash flow ii) High debt iii) High interest cost (relative) per annum iv) Debtors far too high and take too long to pay v) Creditors are too high b) Positive features: i) Sales increased substantially ii) Profit is up iii) Earnings per share is increased(not say ‘up) c) Overall: i) Company is/not a good investment, in my opinion(depends on question) although profit is up the negative cash flow is a serious problem, I would not advise to invest until company improves cash flow and improves/decreses long term debt

RATIOS MARGIN OF SAFETY: a) Difference between : Budgeted Sales Volume MINUS Break-Even Sales Volume. b) Sometimes Expressed as % of Budgeteted Volume or Budgeted Revenue.

KEY RATIOS FOR CVP (PV RATIO) PROFIT VOLUME RATIO: ( OR ALSO CALLED ‘CONTRIBUTION RATIO OR MARGIN %’ ) %

= Contribution / Sales. =0.abxy or ( * 100/1= ab.xy %) TO 4 decimal places OR to 2 decimal places for

PROFIT RATIO =Profit / Sales =0.abcd or ( * 100/1= ab.cd %) TO 4 decimal places OR to 2 decimal places for %

(B/E SALES) BREAK-EVEN SALES REVENUE:( NOT A RATIO) =Fixed Expenses / PV Ratio

= Rands ,2 decimal cents.

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 42 REM: FIXED expenses is NEVER just the totals that do not change –you must FIRST CHECK EVERY TOTAL eg: labour-MATERIALS-OVERHEADS ETC FOR THE FIXED PART AND VAR. PART BEFORE you calc. the total fixed costs.

BREAK-EVEN SALES VOLUME:( NOT A RATIO) =Fixed Expenses / Contribution per unit. = units (round- off downwards only –ie: per unit)

MARGIN OF SAFETY RATIO Sales - (B\E Sales revenue) / Sales =answer as % OR decimal =0.XXXX or ( * 100/1= XX.YY %) TO 4 decimal places OR to 2 decimal places for % {sales means budget sales revenue. –but could also be actual... depends on needs)

OTHER TYPES: 1.1. contribution ratio = marginal contribution/marginal sales 1.2. variable cost ratio = marginal variable costs / marginal sales

BUSINESS RISK ASSESMENT BUSINESS RISK RATIOS (THERE ARE 8 OF ) BUSINESS RISK RATIOS (THERE ARE 3 OF ) CONTRIBUTION : HIGH – LOW METHOD TO GET IT FROM THE INCOME STATEMENT. You can get VARIABLE COSTS : by: given 2 years figures – then change in turnover Minus change in EBIT. You can get CONTRIBUTION Margin by: change in EBIT / change in TURNOVER. You can get CONTRIBUTION by : then use this % from contribution margin to MULTIPLY by any TURNOVER = Contribution . 3. Note: For contribution, a. If given both Revenue AND Turnover figures in an exam one above the other (revenue PROBABLY INCLUDES “Other Income” and turnover is from normal operations) , you don’t use you do not use REVENUE, you use TURNOVER , I THINK – just check with lecturer on this. b. For EBIT - remember not to use ‘net profit’, but to use EBIT instead here.

OPERATING LEVERAGE: = CONTRIBUTION/EBIT ANSWER |LOW=1,5 HIGH=3 |

(EARNINGS BEFORE INTEREST AND TAX)

| =DECIMAL

1) A high operating leverage eg: 3 means i. CONTRIBUTION (ratio) is HIGH AND ii. CAPITAL INTENSIVE (PROBABLY) iii. BUSINESS RISK & ?OPERATING RISK? is high as it is Captal Intensive with HIGH FIXED COSTS. iv. B/E POINT is HIGH probably (because of probably high fixed costs) v. FIXED COSTS is probably HIGH 2) A low operating leverage eg: 1,5 means: i. CONTRIBUTION (ratio) is LOW AND ii. LABOUR INTENSIVE (PROBABLY) iii. ?BUSINESS RISK &? OPERATING RISK is low as it is Labour Intensive with LOW FIXED COSTS. iv. B/E POINT is LOW probably (because of probably low fixed costs) v. FIXED COSTS is probably LOW 3) The ratio trends toward 1-the absolute minimum- this would be very low(no fixed costs basicly). This ratio is very useful when evaluating companies because it helps us asses comparative operating risk in terms of operating fixed costs. So the fixed costs will be in the EBIT, and thus even if it has a high contribution, but somehow a low fixed costs, we will quickly see if there is a maybe a low risk, where usually a high contribution margin means it is a high risk company because there are then usually high fixed costs and this will in turn bring down the EBIT and make for a HIGH answer which of course means a high business risk and high operating risk.

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 43 4) Another way to see the light this ratio provides is to work out the cost structure (variable/fixed cost structure) – and a high fixed/low variable will mean a high ratio&low risk , but a low fixed /high variable will probable mean a low ratio&low risk.

(GP%) GROSS PROFIT PERCENTAGE % RATIO: = GROSS PROFIT/TURNOVER

| =%

ANSWER | 14) Remember it is turnover , not revenue, so if there are figures for both use turnover because GP% is for “operations”, not including “other income “ like rent or dividends (I THINK-CHECK WITH LECTURER) 15) Most important business risk assessment when operating leverage and B/E information are not available. 16) HOW IT WORKS: a) if turnover increases by 500, by how much will GP% increase :ANSWER by the contribution. (unless you were operating at a loss before turnover increased!) b) the contribution ratio must be higher than the GP% ALLWAYS unless fixed costs are = 0! 17) FINANCIAL ANAYSIS: a) If turnover increases: THE more capital intensive it gets (high fixed,low var.), the greater an increase in GP% for an increase in turnover ,and greater the drop in GP% for a drop in turnover % . So if for capital intensive business, we would expect the GP% to increase quite substantially if turnover increases. nIf it does not then it shows the company has not performed as well as it should have(might have been going at a loss before the increase, or maybe fixed costs were slaphappily increased as well, or contribution decreased) b) If GP% increases : ALL WE SAY IS THAT THE PROFITABILITY OF THE COMPANY HAS Improved c) WHAT negative factors could cause GP% to go up less when Turnover% increases a lot: i) Selling price drop (most common reason) ii) Var. cost increase (next most common reason) iii) Fixed cost increase.

RETURN ON OPERATING ASSETS: EARNINGS BEFORE INTEREST AND TAX/ OPERATING ASSETS *100/1 | = % ANSWER 1) 2) 3) 4) 5)

Use gross profit before interest. From ALL(not other income) Use (fixed assets – long term investments) + ALL current assets, Exclude “long term investments” in the “fixed costs” section. Current assets include all bank + debtors + inventory. Use value at beginning of period for assets, unless question specifically states “average asset value” the begin+end/2 a) When they do the average of 2 years, they sometimes take average of fixed assets but add it to the current assets without getting an average of the current assets , only of fixed assets? It seems you do not have to , but may sometimes do it this way to balance some kind of oddities. 6) Interest is a cost of finance just like dividends are a cost of finance, thus both are excluded from the calculation 7) This ratio can be got from Profitability ratio X Operating asset Turnover ratio = this Ratio

RE_DO THE SUB RATIOS BELOW-no time For each of these ratios + the rest also check whether they should use ‘turnover ‘ or ‘revenue’ ie: including “other income” or only “income from operations”. 8) Use gross profit before interest. From ALL(not other income) 9) Use fixed assets+current assets 10) Use value at beginning of period for assets, unless question specifically states “average asset value” the begin+end/2 11) Interest is a cost of finance just like dividends are a cost of finance, thus both are excluded from the calculation 12) Note ; this ratio is equal to the: GP% (profitability ratio) x operating asset turnover ratio answer.

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 44 13) It shows the return for Business + Financial risk. 14) FINANCIAL ANAYSIS: i) Important ratio ii) 15 % is very low so it means that not efficient OR that there is an opportunity to increase profit (sales) without investing more in assets for a while. iii) It shows how well the company is performing in terms of the investment in assets has been returning a profit((efficient etc), as long as assets did not deteriorate too much. iv) BEWARE, one thing to watch out for is if the company has been running down it’s operating assets and allowing the asset base to deteriorate, then the ratio will increase significantly.Therfore one must check this first SUB-RATIO -OPERATING ASSET TURNOVER = TURNOVER/OPERATING ASSETS END/2)] | DECIMAL ANSWER | 40C PER RAND IS VERY LOW

[FA+CA FOR YEAR AVERAGE(B-

1) An answer of 0.39 means that you get a profit of about 40 c per rand , which is very low. This means there is underutilized capacity or over-investment in fixed assets, one of the two. SUB-RATIO – PROFITABILITY RATIO: = EBIT / TURNOVER An answer of 0.39 means that you get a profit of about 40 c per rand , which is very low. This means there is underutilized capacity or over-investment in fixed assets, one of the two.

NET PROFIT PERCENTAGE % RATIO= NET PROFIT AFTER TAX/TURNOVER * 100/1 | %=ANSWER| 2) Not very important ratio 3) The difference between GP% ratio and is is just interest- which could be from debt .used instead of equity. 4) This ratio could also be calc. as net profit before tax/turnover – it does not matter , as long as we are consistent in our comparisons.

EQUITY = EARNINGS AFTER TAX/TOTAL SHAREHOLDERS FUNDS *100/1 |

ROE : RETURN ON % =ANSWER|

1) Total shareholders funds = includes ordinary shares + share premium + all reserves + retained earnings BUT EXCLUDES PREFERENCE SHARES. 2) It means the firm has managed to give the shareholders a higher/lower profit per rand invested.

INCREASE IN TURNOVER OR SALES GROWTH – AS A RATIO =NEW-OLD/OLD |=%ANSWER | 1) ALLWAYS SAY: I expect a substantial increase in cash flow and increase in profity 2) Note; Business Risk will INCREASE where a increase in turnover does not result in an increase in CASH FLOW.

B/E POINT = FIXED COSTS/PV RATIO % (CONTRIBUTION MARGIN) | =% ANSWER | 1) Say has improved or got worse every year. Less means an IMPROVEMENT IN BASIC PROFITABILITY of the company

DEBTOR TURNOVER STOCK TURNOVER Note: not the following headings below: The Profitablility check)

ratios

are: 1-net profit%, 2-GP%, 3-sales growth, 4-profitability ratio.(not sure – just

The liquidity ratios are: NOT SURE- check up (I think 1-debt2-liquidity3-acid-4times interest earned Times interest earned ratio is also called the ‘gearing ratio’( I think – check) Financial ratios:

FOR FINANCIAL RATIOS NOTE THAT THE RATIO FOR DEBTEQUITY: YOU DO USE DEBT=ONLY LONG TERM DEBT + BANK OVERDRAFT NOT CREDITORS AT ALL!!!!!!!! Must finish all these to end of chapter, because did not have enough time to finish . ALSO do Z-score + A score + financial assessment template etc.

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 45

CHAPTER 1 : THE MEANING OF FINANCIAL MANAGEMENT SPECIAL THINGS TO REMEMBER IN EXAM: 1) In exam, if asked to calculate the value of ordinary shares, always multiply final answer by total no. of shares to get the total company value, UNLESS they specifically ask for the value of just 1 share.(each) 2) Remember to add the new investment to the grand total you work out to figure out the new amounts allowed from the Target ke:kd percentages.for a new investment evaluation if it fits in the target ke or kd thing..- don’t forget it.!

THE FINANCIAL OPERATIONS OF A COMPANY: This diagram highlights the issues covered in the textbook (vig-fin.manag.)

1) WHEN WE LOOK AT THE FINANCIAL OPERATIONS OF A COMPANY:, we are interested in only 2 things.: a) FINANCE DECISION. : refers to the source of funds ie: either debt or equity. b) INVESTMENT DECISION. : also called “Capital Budgeting” (where the required inputs are WACC and future cash flows) refers to the purchase of an asset/s for the sole purpose of increasing shareholder wealth, if the future cash flows are greater than the required return then the asset should be purchased .The Shareholders wealth comes only from either: i) Dividends ii) Shares Appreciation : Increase in the Value of the Company.(shares) (1) Valuations: this is needed to measure the increase in Value of the Company. 2) In “Finance” as such you must always deal with market values of debt (kd) and of equity (ke) and never with book values.

BUSINESS RISK VS FINANCIAL RISK. 5) Definition : BUSINESS RISK: = ’ Ke ‘ the risk that relates to the daily running of the operating activities of the company. a) The Business Risk is: Measured and Affected by:

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 46 (1) NATURE of business activities of company (2) OPERATING LEVERAGE of firm (3) PHYSICAL STATE OF FIXED ASSETS (4) POLITICAL CONSIDERATIONS (5) PRODUCT SUBSTITUTES available (6) COMPETITION (7) MANAGEMENT (8) FUTURE PROSPECTS BY PRODUCT & VOLUME (9) FUTURE PROSPECTS for the INDUSTRY IN GENERAL. b) To assess: 1-Current Market Value , or 2-Future prospects , or 3-Viability we assess ALL of the business risk factors above.eg ratios may be very, very, good but substitute product/physical state etc. may easily wipe out the company. c) What can go wrong with a business: eg: i) No demand ii) Competitors undercut iii) Unable secure raw materials iv) Machinery used is inefficient v) You experience employee problems. vi) Debtors do not pay on time. 6) Definition: FINANCIAL RISK: =’ Kd’ the risk that “relates to the borrowing of long-term and short-term debt.” The company becomes liable for : (1) Monthly Interest repayments (2) Capital Repayments. b) The Financial Risk is : that funds will be available to pay i) Interest ii) Capital Repayments iii) Default Risk – this third risk can be avoided by using Equity Finance. c) Financial Gearing : the object of this financial risk is that it is hoped that the cost of debt is lower than returns offered by the assets purchased with borrowed funds - thus increasing returns to shareholders. d) Evaluating Financial Risk : it is important to consider ‘Business Risk’ as well to evaluate financial risk itself because a company with high business risk should borrow limited amounts of cash, but with less business risk the capacity to take on financial risk is increased. 7) If ever given a question in exam , and company has any form of debt, then a) Ke = Business Risk + Financial Risk b) If there is no debt in the structure then Ke= Business risk only. 8) Companies can be classified in terms of their business risk: HIGH RISK Mining Chemical Speciality Products Technology

MEDIUM RISK Restaurant Security Building

LOW RISK Supermarket (retail) Household Products Banking Clothing(??? Not sure – check up)

High Fashion(I think)

THE INVESTMENT DECISION: (ALSO CALLED CAPITAL BUDGETING) 1) The value of any investment, or valuation of a company is ALLWAYS measured as the Net Present Value (NPV) of the Future Cash Flows. a) So what you do is calculate the PV of each future cash flow separately 1 by 1 by using the WACC % , and add them together to get the NPV of all future cash flows. If the answer is negative then it means you will get less return over the full period than the WACC, if it is Zero OR Positive then it means The Project can be accepted because it will be profitable. If it is zero it means you will get EXACTLY the WACC% of profit. If Positive then you will get more ???(how much more is the “FV of positive amount using WACC % over full term“ less FV of total cash flow.??? 2) In order to evaluate an investment decision we need to know the following: a) WACC / discount rate : to see if total return is above or below required return(WACC) b) Relevant Cash flows incl. Tax payments. : to compute the profit

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 47

3)

4) 5)

6)

c) TAX RATE : to see how much of the interest PAID is cancelled out by TAX reduction. d) How the project will be funded ??: the WACC will not be affected by the finance method chosen but FUTURE funding of other projects will be affected by choice e) Present Value :The value of any investment or valuation of a project is ALLWAYS the Net Present Value of the Future Cash Flows. ALLWAYS use the Market Value method to calc. the WACC to see how much debt or equity you can still use. NEVER use another method.For equity use formula value=D1/(ke-g). ,and for debt use the market value method. Remember also for equity you only use the answer from formula, don’t add any Share Premium or Retained Earnings or Reserves of any kinds. Remember to add the new investment to the grand total you work out to figure out the new amounts allowed from the Target ke:kd percentages.- don’t forget it.! All the Market values of Preference dividends(not less tax) + Debentures(less tax) + Long term loan(less tax) get worked out separately and added one by one to the market value of Equity to get the grand total before you divide it up in the ke:kd target percentages. a) Debentures: Use the formula for PV of Future cash Flows to infinity , and remember to subtract the TAX from both “top D1” and “bottom kd” before you calculate the formula.So here the Yearly interest in rands is the D1 at the top(less tax deduction), and the Current market interest rate for similar type of debentures is the Kd at the bottom.: formula for PV of Future cash Flows to infinity = D1/(kd-g) b) Preference Shares : Pref.Dividends are not tax deductable so do not deduct tax here from D1 or Kd. Use the formula for formula for PV of Future cash Flows to infinity = D1/(kd-g) c) Long Term Loan : see method for calculating the “market value of WACC” and use the same method as for debt in that method (PV of each year’s interest in Rands +PV of each capital repayment, added together). Don’t forget to deduct tax above&below in PV calc-ie from interest paid in rands and from Current market rate for interest used at bottom in PV formula. DONT deduct TAX from the LOAN CAPITAL AMOUNT REPAYMENTS, only the other 2. How to calculate whether a company should invest in a project: see this scan example below:

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 48

FINANCE DECISION (ALSO CALLED CAPITAL STRUCTURE) 5) Finance decision : refers to the source of funds ie: either debt or equity. 6) In “Finance” as such you must always deal with market values of debt (kd) and of equity (ke) and never with book values. 7) Method: a) First calculate the “target WACC“ b) Debt or Equity : then decide how investments should be financed : by debt or equity.

WACC : WEIGHTED AVERAGE COST OF CAPITAL.

ALSO CALLED THE DISCOUNT RATE USED IN EVALUATION

OF FUTURE INVESTMENTS.

c) WACC is the minimum return a company needs to fully compensate the debt providers as well as the equity providers, basicly the ”specially worked out” mathematical “average” of the debt interest and equity dividends to be paid out yearly in return for the capital used to finance the company. d) It is also called the ‘appropriate discount rate used in the evaluation of future investments’. e) Note: i) EQUITY = incl. Retained income + Non-Distributable + Distributable Reseves + Share Premium + Any form of debt that has a conversion option to Ordinary Shares.+??Share issue expenses pg7 note top?? ii) DEBT=Lease + Pref.Shares + Mortgage Bonds + Debentures + Long term loans + any form of finance with NO option to convert to ordinary shares. f) If asked to calculate the WACC for investment decisions, it means work out the “TARGET WACC”. g) METHOD to Cal. WACC: i) WACC % = [Ke X % DEBT] + [Kd X % EQUITY] (1) Add all the Debt + Equity used by company. Then calc the % of debt in the total and the % of equity in the total. (2) Use the % calculated above and the actual Ke & Kd worked out below to calculate : WACC % = [Ke X % DEBT] + [Kd X % EQUITY] ii) Kd =DEBT: (1) Pref Shares & Long Term loan & Debentures are all debt. (2) Pref Shares dividends ARE NOT TAX DEDUCTABLE, but Debentures&Loans interest repayments are tax deductable. (3) TAX :To Deduct Tax from the % interest payable for debt, you say “quoted interest percent” X [100tax rate]/100 = The Effective tax rate. (but never use this method to work out anything wit profit, because once you remove tax like this you cannot go work out tax for the remainder in your next calc. anymore because it is already out % wise, any attempt to do this results in major errors- do not ever use this rate where tax must come out afterwards in your sum.)

(4) Add the % of each type of debt AFTER it’s OWN specific tax deduction in the weighted ratio it is to the total debt, to get your debt average %. (a) Eg: Say Pref shares = R 100@9% before tax, & Debentures = R400@20% & Long term loan = R500@ 12% , Then you say Total debt = 100+400+500 =1000. So [100/1000 X 9] + [400/1000 X {20X60%} ] + [500/1000 X {12X60%} ] = 0.9+4.8+3.6= 9.3% effective debt interest. iii) Ke =EQUITY : (1) Just get the Ke . iv) In order to calculate the WACC one can use 1 of 3 methods. (1) BOOK VALUE Method: (a) Use the book values of equity and debt to work out WACC, exactly as they appear in the books of the company on that date. (b) This method is wrong – you cannot actually take the book values to get WACC, you must use market values. (c) EQUITY = incl. Retained income + Non-Distributable + Distributable Reseves + Share Premium + Any form of debt that has a conversion option to Ordinary Shares.+?? Share issue expenses pg7 note top?? (d) DEBT=Lease + Pref.Shares + Mortgage Bonds + Debentures + Long term loans + any form of finance with NO option to convert to ordinary shares.

(e) (2) MARKET VALUE Method:

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 49

(1) Market Value Method Formula=: (2) This is the most correct of all 3 methods to use. It recognizes 1- the Value of equity&debt is at current market rates & 2- The Discount Rates (interest÷nds) are at Current market rates and not at historical rates. (3) Remember for calculating the market value of equity you never include Distributable or Nondistributable reserves, or Share Premium, or retained Earnings in your calculations. So you will not add these reserves or retained earnings etc. later on either, you only use the value you get from the formula as your equity, nothing else. (4) CALCULATING :Interest (Kd) & Dividend (Ke) Rates : (5) CALCULATING : Market Value of Equity and Debt: Market Value of Equity: Formula for Present Value of all Future Dividends to Infinity: = D1/(ke-g) use this formula to get the market value of equity.It is a weird formula but it is the prescribed formula for working out the market value for ordinary shares, or for preference shares or any other type of shares. D1= dividend in one years time Ke= shareholders required return g= growth to infinity (NOTE if g= 0 or not given, then just put it as g=0 in the calculation.) (D0 =dividend today) Market Value of Debt: for each year to come, work out the interest payable for that year at the actual interest rate to be used that year.(not necessarily the current market interest rates and also the Capital repayments(repayment of original amount loaned) that must take place that year. Add these two together to get the total repayable that year and then work out the PV for that amount using THIS TIME THE CURRENT MARKET VALUE of interest on debt (as opposed to /not the other interest % used to calc. amounts used above) . Add all the years of the loans repayment&interest PV’s to get the present value of future cash flows of debt interest at the current market discount rate= the Answer. (i) Eg: for a loan of 1000000 repayable in 4 yrs at 10% per year where the “current market value” of debt is 14 %: 100000 100000 100000 100000 + 1,000,000 (1+0.14) (1+0.14)2 (1+0.14)3 (1+0.14)4 =87719 + =76947 + =67497 + =651288(do this step in 2 part s like in book for exam markers to get it.)

=883451 ANSWER WACC : = ‘market kd’ X debt/total debt+equity + market ke X equity/total debt+equity . = WACC (b) Debentures: Use the formula for PV of Future cash Flows to infinity , and remember to subtract the TAX from both “top D1” and “bottom kd” before you calculate the formula.So here the Yearly interest in rands is the D1 at the top(less tax deduction), and the Current market interest rate for similar type of debentures is the Kd at the bottom.: formula for PV of Future cash Flows to infinity = D1/(kd-g) (c) Preference Shares : Pref.Dividends are not tax deductable so do not deduct tax here from D1 or Kd. Use the formula for formula for PV of Future cash Flows to infinity = D1/(kd-g) (b) Long Term Loan : see method for calculating the “market value of WACC” and use the same method as for debt in that method (PV of each year’s interest in Rands +PV of each capital repayment, added together). Don’t forget to deduct tax above&below in PV calcie from interest paid in rands and from Current market rate for interest used at bottom in PV formula. DONT deduct TAX from the LOAN CAPITAL AMOUNT REPAYMENTS, only the other 2 Example: from book, Also for a loan of 1000000 repayable in 4 yrs at 10% per year where the “current market value” of debt is 14 %: (i)

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 50

(3) TARGET WACC Method: (a) This method uses the target RATIO of Debt:Equity of the company to calculate the TARGET WACC , which is done using current market Kd (interest rates) and current market Ke (shareholders required return). (b) So use the target ratio of ke : kd at todays interest rates & Ke rates to get your answer for the target WACC. This resultant WACC is then the appropriate rate to use in all investment decisions. (c) It seems 40: 60 is the proper ratio for debt: equity to use for all companies, but I am not sure? – must find out /research!. (d) If you have no target WACC you can use the firms current capital structure (debt : equity ratio) AT MARKET VALUES , if it seems to be at the optimal level. (e) WACC of holding company : neither the target WACC or actual WACC of holding company is used for a subsidiary, each companies individual WACC is used by itself for any calculations because each industry is different / has different risks etc. 5)

CHOOSING THE METHOD OF FINANCING : a) In deciding how to finance a project you must always work with MARKET VALUES, and NEVER with BOOK VALUES. b) If the Company has worked out a target WACC then it must simply at all times move towards the target. c) Note: a company always tends to finance a project entirely by debt or equity. The logic here is that new projects are normally for a small amount relative to the total value of debt and equity, and the method of finance will not have a big effect on financial risk. d) If the target WACC is 40 : 60 , and at the present moment the ratio is eg: 883451:2000000 = 30:70 then the company can take on more debt in order to move closer to the ratio. i)

METHOD:

(3) Add new investment required + current debt + current equity = new “Total Financing.” (4) Then find max debt and max equity parts of this new total by calc. it from the target debt:equity % the company has decided on.You just minus the new investment amount required from any of the latter max figures calculated , to see how much would be allowed to fit in to each. (5) See example below for method:.

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 51

VALUATION OF A COMPANY: 3) VALUE= Present value of Future Cash Flows : this is simply stated the Concept Of Value Used In All Calculations of company or share value. 4) ????VALUE OF ORDINARY SHARES = Value of Company –less- Value of Debt .????how does this work, see book pg11 vig fin.mngmnt. 5) ORDINARY SHARES VALUE: To calculate the value of the companies shares today, in order to calculate the price you wish to sell them at, you use the formula for “PV of Future Dividends to Infinity”. 6) PREFERENCE SHARES VALUE : use the same formula as below. 7) Formula for (PV) Present Value of all Future Dividends to Infinity: = D1/(ke-g) (can be used for ordinary or preference shares or debentures: anything with dividends it seems) a) D1= dividend in one years time i) For Debentures :Remember to deduct tax from the D1 value of interest in Rands actually paid each year before you use it in the formula. b) Ke= shareholders required return (in decimals eg: 0.2) i) For Ordinary Shares: remember that for calculating the Market value of equity you do NOT include the distributable&non-distributable reserves or share premium or anything else in equity- only the Ordinary shares values. ii) For Debentures : ke will be called kd instead, and one must first remember to deduct tax from the D1 value of interest in Rands actually paid each year as well as from the the kd interest percentage before you use it: ie if debenture interest = 10% and tax = 30 % then the rate to use for this formula will be : 10 X 70% = 7% . iii) For Preference Shares : ke will of course be called kd instead, but one does not deduct tax from preference dividends, because it is not tax deductable. c) g= growth to infinity (in decimals eg: 0.04) (NOTE if g= 0 or not given, then just put it as g=0 in the calculation.) d) (D0 =dividend today) 8) In exam, if asked to calculate the value of ordinary shares, always multiply final answer by total no. of shares to get the total company value, UNLESS they specifically ask for the value of just 1 share.(each) 7) Debentures: Use the formula for PV of Future cash Flows to infinity , and remember to subtract the TAX from both “top D1” and “bottom kd” before you calculate the formula.So here the Yearly interest in rands is the D1 at the top(less tax deduction), and the Current market interest rate for similar type of debentures is the Kd at the bottom.: formula for PV of Future cash Flows to infinity = D1/(kd-g) 8) Preference Shares : This is just Non-Tax deductable form of “debt”. Pref.Dividends are not tax deductable so do not deduct tax here from D1 or Kd. Use the formula for formula for PV of Future cash Flows to infinity = D1/(kd-g) 9) Long Term Loan : see method for calculating the “market value of WACC” and use the same method as for debt in that method (PV of each year’s interest in Rands +PV of each capital repayment, added together). Don’t forget to deduct tax above&below in PV calc-ie from interest paid in rands and from Current market rate

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 52 for interest used at bottom in PV formula. DONT deduct TAX from the LOAN CAPITAL AMOUNT REPAYMENTS, only the other 2

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 53

CHAPTER 2 PRESENT & FUTURE VALUE OF MONEY. INTRODUCTION: 1) Time value of Money is an essential concept in the understanding of finance. 2) BANK OVERDRAFT : is not seen as debt unless a part of it IS ACTUALLY being used as a form of long term financing/debt THEN that part used as such should be accounted for as ‘debt’ in the debt: equity ratio. 3) DEFERRED TAXATION: DEFERRED TAX IS NOT included as tax when calculating the capital structure of a company, because the timing of tax payments is accounted for when evaluating the project investment decision. You just ignore it outright. This will only really apply when calculating the WACC at ‘book value’ method- so ignore it always when you do this. 4) THE ‘CURRENT MARKET VALUE’ TO USE AS THE Ke OF Kd WHEN DOING ALL THE CALCULATIONS :where “actual todays market values” instead of the interest rate being paid today due to previous years dealings, is as follows: a) First Choice: if the same type of security’s current interest rates are given.Use that one, even if it is higher than other securities in same class eg if you have got debentures and ‘loans’ are cheaper than ‘debentures at current rates, you still only use debentures rates. b) Second Choice: if only a similar and not the same type of security’s market rates are given , then use tah one: eg if you got debentures and only current rates for loans are given then use the loans rates as your current market rates for debentures. 5)

FUTURE VALUE: 7)

Future Value FORMULA : FV= PV(1+i)n

a) Where FV= future value b) PV= present value c) I = interest rate – in DECIMALS eg for 15% Use 0.15 NOT 15% d) n= number of years/periods 8) COMPOUND INTEREST : The future value of an investment over 3 years FV=PV(1+i) (1+i) 1+i) = PV(1+i) X (1+i) X (1+i), that is what PV(1+i)n means : to the power of n means all this. So it basicly is the interest gained in year 1 and 2 etc reinvested and this is called compound interest.

9) FUTURE VALUE TABLES : the future value table can be used instead of using a calculator.It basicly works like this : it gives you a “Factor” for each year from 1 ,2,3,4 etc. upwards in a column for each percentage rate. So for 10% interest you go to the 10% column , go down it to the year number you want, take the ‘Factor” from there and multiply it by the Present Value to get the answer you want. (the ‘factor’ =(1+i)n ) 10) SOLVING FOR i . (INTEREST RATE). : if a question asks you to find the interest rate if given the ONLY the : PV & FV & n : what happens is you get stuck at the point of FV/PV = (1+i)n after working out the formula backwards, there seems to be no mathematical solution to solve this, so the only way to do it is to start trying to substitute different values for i in the formula FV/PV = (1+i)n until you hit on the right one OR one can use the Future Values Table and look across, (not down), the 3 year row till you get the FV/PV . To use the calculator all you have to remember is to put the PV as a “–“ and FV as “+” (or visa versa-works same) or the calculator will not do it-it says “error”. 11) SOLVING FOR n (NO. OF YEARS) : if a question asks you to find the number of years if given ony { i & PV & FV } , you do the same as above : go as far as you can with the formula, then either try different values till you hit the right one or use the FV table. The calculator also just needs a PV as “+” or FV as “-“

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 54 12) Using MONTHS, WEEKS OR QUARTERLY instead of YEARS in the FORMULA : if the interest is compounded

monthly, weekly or quarterly then you have to simply have more periods for ‘n’ in the formula and divide up the interest rate to a lower figure by : a) Interest rate : divide the yearly interest rate by the number of periods in the year eg : for months by 12, or for quarters by 4 : this will give you the interest rate per period to put in the formula above. b) Number of Periods: here you multiply the number of years by the number of periods in each year to get the (higher) figure to put in the formula. So for months X 12 , or for quarters X 4 etc.

PRESENT VALUE: (PV) 13) Present Value Formula : PV = FV/(1+i)n 14) Present Value calculations are the inverse of future value calculations. 15) Remember that in all finance calculations the value of a project or company or Investment is always the Present value of Future Cash Flows. 16) The present value factors are the inverse of the future value factors, so on the future value table, the PV ‘Factor’ will simply be 1/FV factor , and the other way around too – the inverse of the PV table value for “PV FACTOR” ie 1/’PV factor’ is ALSO = to the FV Factor : so it works both ways,and back again,and again, etc. 17) To CREATE A PV TABLE easy way :To solve for some problems eg solve for i or n, you should create a PV table to make it easier. The easy way to create one is: a) Eg for the 10% column i) for row 1 : 1/ (1+0.1) = 1/1.1 = 0.909 . ii) for row 2 :just leave the previous answer on the calculator and then divide it by 1.1 again to get next “row 2” answer : iii) for row 3 = year 3 : just leave the previous answer on the calculator and then divide it by 1.1 again to get next “row 3” answer : iv) continue as for last one. 18) MULTIPLE FUTURE PAYMENTS: a) To calculate the PV of multiple future payments you must do each one individually, then add them up. Watch out for begin of first year receipts with zero interest .Remember to evaluate multiple future payments in different years against each other one can convert them with these formulas to any common year ie year 5 or 6 or 7 etc, but very often it is most convenient to convert them all to PV present value. – even if the first payment for some of them is only in 3 or 4 years from now you can still convert it to PV to compare it to other investment options. 19) Solving for n or I : works same as for “PV” above.

SHARES : PRESENT VALUE OF SHARES The diagram shows the formula in the special notation:

1) The Value of an Investment or Project or Company or Company Shares is the “Present Value of Future Cash Flows”.If you are valuing a share and if the share pays regular dividends, then there are 2 scenarios : static or growing dividends. There is a formula for each: 2) BANK OVERDRAFT : is not seen as debt unless a part of it IS ACTUALLY being used as a form of long term financing/debt THEN that part used as such should be accounted for as ‘debt’ in the debt: equity ratio. 3) 3) DEFERRED TAXATION: DEFERRED TAX IS NOT included as tax when calculating the capital structure of a company, because the timing of tax payments is accounted for when evaluating the

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 55 project investment decision. You just ignore it outright. This will only really apply to WACC using ‘book value method”- so always ignore deferred tax here. a) STATIC DIVIDENDS (no growth ) i) There are 2 Ways this can get calculated: depending on if the shares are to be held “for ever” or to be “sold” after a specific time. The difference is for the “for ever” one it works similar to the ‘perpetuity’ formula = [ Do/Ke ] and the second works similar to the Present Value formula [ like =FV/(1+i) ] (1) PERPETUITY Type FORMULA: where the share is to held for an indefinite period ie: ‘in perpetuity’. (a)

Ex-Dividend formula: Value =

Do

/Ke X Number of shares

: means

if the shareholder receives a dividend today that dividend is EXCLUDED (b)

Cum-Dividend formula: Value = Dividend + (Do/Ke X TOTAL number of shares.) means if the shareholder receives a dividend today then that

dividend is INCLUDED in the calculation of value of share (you just add the dividend to answer-simple) (c) Remember: you can ALSO get the PV of an ANSWER from this formula if it only will occour in eg 3 yrs time. : say that for the next 2 years the share price will fluctuate ( or grow etc) but in 3 years time it will start to remain the same from there on- static. If you are looking for the value of the share today, you must first calculate the PV of the next 2 years separately using another method ( directly or using growth formula below etc.) THEN you can calculate the value of the 3rd year onwards using the above formula and bring this to PV by substituting your FV you gott in the above formula to bring it to PV. : ie: [Do/Ke] = FV , so PV today = [D0/Ke ] / (1+i)n ……where we would use ‘Ke’ for ‘i’ here.! (2) “TO BE SOLD “ Type PRESENT VALUE FORMULA : period of time :now it’s a PV calculation.

(a)

Ex-Dividend formula: Value =

Do

where the shares are to be sold after a specific

/(1+Ke)n X Number of shares :

means if the shareholder receives a dividend today that dividend is EXCLUDED You use this formula once for each separate year to come, so for 3 years you must do the calc. 3 times and add the answers up to get the total. (b)

Cum-Dividend formula: Value = Dividend + (Do/(1+Ke)n X TOTAL number of shares.) means if the shareholder receives a dividend today

then that dividend is INCLUDED in the calculation of value of share (you just add the dividend to answer-simple) (c) Remember you could do the above calc. for years 3 & 4 but do years 1&2 with another formula for eg.”growth” and just add the answers up to get the total.( say there was growth for first 2 yrs then no growth for 2 yrs.) ii)

Where:

(a) Do = Current Dividends or Year 0 dividends, per share. ( “D”=dividends “0” =Year 0) (b) Ke = Shareholders Required return or Discount Rate. –use in DECIMALS eg for 15% Use 0.15 NOT 15% (K = latin e=Equity) (‘Ke is the same as i in the PV formula’-as per book vertabim) (c) n = number of years (only in the ‘To Be Sold” formula) iii) When: the question is silent as to Cum- or Ex-Dividends you must use Ex-dividends. Another reason for doing an ex-dividend valuation (unless otherwise asked) is that PV assumes that the first cash flow will take place at the end of the period. b) GROWTH / FALLING DIVIDENDS (growth or getting less) i) Cum-Dividend or Ex-Dividend : the book says nothing about this for this type but it probably works exactly the same as for static dividends. If it is Cum-Dividends then you probably just have to add the dividend you receive today to the answer! ii) There are also 2 types of formula for this one- the Perpetuity type and the “To Be Sold Soon” one. iii) Do not use year 0 dividends, only end year 1 dividends!!!!

iv) PERPETUITY Type FORMULA: dividends, only end year 1

where the share is to held for an indefinite period ie: ‘in perpetuity’. Do not use year 0

D1

(a) Ex-Dividend formula: Value = /Ke - g X Number of shares : (b) Cum-Dividend formula: if they ask for cum-dividend then (probably) just add the dividend you are receiving to the answer per share. (c) Remember: you can get the PV of an answer from this formula if it only will occour in eg 3 yrs time. : say that for the next 2 years the share price will fluctuate ( or grow etc) but in

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 56 3 years time it will start to remain the same from there on- say at 5% growth. If you are looking for the value of the share today, you must first calculate the PV of the next 2 years separately using another method ( directly or using growth formula below etc.) THEN you can calculate the value of the 3rd year onwards using the above formula and bring this to PV by substituting your FV you get into the PV formula again to bring it to PV. : ie: [D1/Ke – g] = FV , so PV today = [D1/Ke – n …… where we would use ‘Ke’ for ‘i’ here.! g] / (1+i) v) “TO BE SOLD “ Type PRESENT VALUE FORMULA : where the shares are to be sold after a specific period of time :now it’s a PV calculation. DO NOT USE

(a)

(b) (c)

(d)

(e)

Where:

g

HERE!

And remember to use D1 and not D0. D1 n (1+Ke )

Ex-Dividend Formula : Value =

/ X Number of shares : (ie cash flow/for this one you MUST work each year out separately using the PV formula given here. To accommodate the growth (g) in dividends each year you cannot do it with the formula, you must manually increase the dividends each year, then work out the Present Value for each separate year using the above formula .THE SELLING PRICE AT THE END OF THE PERIOD MUST BE INCLUDED IN THE final year PV calculation.(ie just add it to the final year dividends and get the PV of the total, no need to do a separate calculation!)Then add all the years up to get the present value of the shareholding. Cum-Dividend Formula: Cum-Dividend: probably just add the dividend you are receiving to the answer This is an Odd-one out: You have to be very careful here : there are 2 odd things to watch for: (i) For this one you DO NOT USE g , you just use the PV formula ALONE: so here you must work each year out separately 1 by 1, and for each year just increase the dividend MANUALLY. (ii) How you work this out depends on the VANTAGE POINT of the person: who is working it out. You might have to use the other ‘perpetuity type’ formula even if it dos’nt look like it; because: So if you are selling in 3 years time at 500 each, with a dividend growth of 5% ,you say work out the PV today of all 3 years to come (all 3 dividends to be paid + the selling price you will get) = your valuation from your vantage point. BUT if the person who is buying them from you wants to work out the value of the same shares at the exact same point in time in 3 years time, he will use a completely different formula for the same thing AND WILL ALSO ALLWAYS GET A DIFFERENT ANSWER: You see, HE only uses the ‘perpetuity type ’ formula –because he has no plans to sell the share yet and the NOTE: (3+1= 4th) years dividend to be paid out (his first one) and (ke-g) as the dividend(as per perpetuity formula).Remember to use the dividend from 1 year ahead of when he buysnot the dividend on the date of ‘year 3’ when he gets the shares( ie D1 NOT D0 ) Anyway ,so his valuation could very well be higher than the sellers and , on paper at least, he could make a profit if he were to sell it on the spot there and then when he receives it! See example on pg 27/28 Vig-Finance. Remember : D1 means: if you get 2 odd payments in Year 1 and 2, then from year 3 a dividend of 400 growing at 5 %, it means that year 3 =400 is D1 , because year 2 is Y0 for the 400 onwards part and the 400 is Y1. Then on top of it year 2 is = n in the formula for PV if you want to bring the whole part from year 3 : the 400-onwards answer: down to PV-because For D1 you take year 2 of course. Watch out for this one in questions; it catches you easy. Remember:you might have to work out the PV for only 2 years using this formula, then switch to another formula if question says there will be no more growth from the 3rd year onward : say that for the next 2 years the share price will fluctuate ( or grow etc) but in 3 years time it will start to remain the same from there on- say at 5%. (or visa versa). If you are looking for the value of the share today using all this info., you must first calculate the PV of the next 2 years separately using this PV method THEN you can calculate the value of the 3rd year onwards using the ‘perpetuity –non-growth’ formula and bring the answer to PV by substituting your answer as the FV in the PV formula to bring it to PV. : ie: [D1/Ke – g] = FV , so PV today = [D1/Ke – g] / (1+i)n ……where we would use ‘Ke’ for ‘i’ here.! See pg 28/29 in vig.-finance.

(f) D1 = DO NOT USE YEAR 0 DIVIDENDS! ONLY USE end of year 1 dividends! D1 means Current Dividends or Year 1 dividends, per share. ( “D”=dividends “1” =Year 1 ie -end of year 1-)So for the ‘Static/No-Growth’ one we use year 0 but for this one we use the dividends you will get at end of year 1: Remember this! ‘ (g) Ke = Shareholders Required return or Discount Rate. –use in DECIMALS eg for 15% Use 0.15 NOT 15% (K = latin e=Equity) (‘Ke is the same as i in the PV formula’-as per book vertabim)

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 57 (h) n = number of years (only in the ‘To Be Sold” formula) (i) g = Growth in annual dividends. : use in DECIMALS eg for 15% Use 0.15 NOT 15% (rem 8% =o.O8 not o.8.) 4) How To Determine Growth Rate: a) Method most used: get average of growth rate over a few years., or make an estimate based on unknown information.Finance is not an exact science and we at times need to estimate inputs that are not necessarily 100% correct. b) Alternatively: calc. growth rate based on ROE-return on assets. Problem with this is ROE is at historical values, not market values. c) Or Alternatively : use Future rate of Investment and Return from that investment: i) The future rate of investment and the return on that investment are the factors which generate future dividends, but then the criterion is that a constant proportion of cash earnings per share is reinvested in projects which produce an average rate of return. d)

FORMULA : G= br

,then to get the answer to % multiply by 100.

e) f) The book value of total capital employed is the “TOTAL EQUITIES & LIABILITIES” section on the balance sheet. It may be calculated as the balance at the beginning of the financial year, or the average assets employed over the year, ie beginning asset value plus end of year asset value divided by 2. g) ASSUMPTIONS: this formula only works subject to the following being true: i) ) retained earnings must be the only source of investment capital ii) a constant proportion of earnings must be reinvested each year iii) the reinvested earnings must generate a constant annual rate of return.

RETURN ON SHARES- RETURN ON INVESTMENT: 1)

THE RETURN TO SHAREHOLDERS FORMULA :IS CALCULATED by DIVIDENDS / CURRENT MARKET VALUE of shares, not book value.?????????????????

DEBT : PRESENT VALUE OF DEBT: 4. Definition: “Any form of finance that is not an ordinary share or does not have an option to convert to ordinary shares”. There are however certain Grey Areas / types of debt which are partly debt and partly share equity. 5. Types of Debt and Taxability a. Long Term Loans : Interest is Tax Deductable b. Debentures : Interest is Tax Deductable c. Mortgage Bonds : Interest is Tax Deductable d. Preference Shares: Dividends After Tax e. Lease. : ????? 6. BANK OVERDRAFT : is not seen as debt unless a part of it IS ACTUALLY being used as a form of long term financing/debt THEN that part used as such should be accounted for as ‘debt’ in the debt: equity ratio. 7. 3) DEFERRED TAXATION: DEFERRED TAX IS NOT included as tax when calculating the capital structure of a company, because the timing of tax payments is accounted for when evaluating the project investment decision. You just ignore it outright. This will only. 8. Rem: In your calculations you only ever use the cost of similar debt today AFTER tax, at market cost- not ever the actual interest rate being charged for the loan. This principle is you go borrow elsewhere at cheap rates to pay off the more expensive debt. 9. Tax: you always deduct tax first from the interest rate to get the actual interest rate charged = interest rate X [100% - tax rate% ]%

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 58 10. Note: a funny thing is if a company is paying 20% interest on a loan which appears on the balance sheet at 100, but the current market interest on debt rate is lower eg: 15% so they are dof and should only be paying this, not 20%, then you say : quote “ in real terms the company has more debt than is shown in the balance sheet” the reason for this is that if you were to put 20% (same market rate) in the formula below as Kd instead of 15% (lower market rate) as Kd your answer as to the “Market Value” of the debt would be EXACTLY 100., but if you use 15% as Kd then the answer would always be MORE than 100, but if you use 25% (higher market rate) the Market Value will always be lower! 11. Note: The formulas below are ONLY to work out the MARKET VALUE of the debt amount today. So basicly what would that debt be worth if the bank somehow could ‘sell’ the loan to someone else- I think. It is weird figures they get from this formula though !-note!

12. a.

There are 2 possible situations & formulas here: For “Perpetuity Type ” Loan :PRESENT VALUE (PV) formula of Debt : PV= Cash-Flow/Kd this is where the loan is indefinite/infinite with no repayment date specified. The answer is not fixed- it changes if looked at from a PV or FV. The cash flow at top as well as the Kd at bottom are both AFTER tax, so tax must first be deducted from BOTH.

i. Using the “Perpetuity” formula BUT ONLY FROM a year in the FUTURE: 1. If they said that from year 2 the interest paid will remain the same, you can use the ‘perpetuity type’ debt formula to calculate the ‘market value’ at that time-ie in 2 years. But then you must bring that Future value to the Present Value using the normal PV formula. So a ‘market value‘ can be changed to it’s Present Value using the PV formula. ii. An ‘ EQUIVALENT MARKET VALUE‘ can be changed to it’s Present Value using the PV formula. 1. As said above , the answer to the ‘perpetuity’ formula must be changed to its PV using the PV formula if it was worked out for a year in the future only. So a ‘market value’ is not a fixed thing, it changes as soon as you want to know its value in another year- whether past or future. b.

For “Repayment Time Specified ”Loan : (PV) formula of Debt : PV= Cash-Flow/(1+Kd)n here you must work out the PV with this formula for every year of the loan individually, and then add up all the answers to get the total.- but you still only use the current market interest rate for Kd. The cash flow at top as well as the Kd at bottom are both AFTER tax, so tax must first be deducted from BOTH.

c. Where i. Cash-Flow = the FV – ie money that is to flow in the future- the Future Value =this is the interest in Rands OR/AND the capital repayments that will be paid back in the future. ii. Kd = the interest rate charged for debt- if tax is deductable then first deduct the tax % from the rate before you use it. Interest After Tax = interest rate X [100% - tax rate% ]%. This Kd is the current market value of debt , not at the actual interest rate actually being paid back by company, but at the lowest you could get today instead. iii. To calculate the PV of Debt : you only ever : 1. Get value of future cash flows: what is the company actually paying back each year: a. For an indefinite/INFINITE/ “perpetuity” loan : If they state the interest rate used to pay back the loan then calculate the interest payment in rands: this is your “FV of Cash Flow” and ONLY use the “perpetuity” type formula above, not the other one. b. If loan is Repayable in 3 years : you must include the amount of the repayment as a cash flow for the year it is paid back. So that year would be ‘interest+capital’= ‘cash flow’ in formula. For multiple repayments each repayment must be added as a cash flow in it’s specific year/month etc-.and only use the “Repayment time specified” type formula above. iv. To calculate the Kd: You only ever use the “current market value” of debt today, so this Kd is the current market value of debt , not at the actual interest rate actually being paid back by company, but at the lowest you could get today instead. The logic is you go lend today at the lower rate and pay the other loan back. d. Note: to get year 1 + 2 + 3 PV using above formula DO AN ANNUITY( PMT) on the calculator, not a PV calculation! e. Preference Shares: to value pref. shares you use the exact same method as for debt here.Remember-no tax to deduct!Dont!

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 59 f. Debenture : treated exactly same as debt, also DO deduct tax g. You are paying interest For 2 Years at 15% and thereafter at 25% : i. Do the first 2 years using the “temporary” PV formula then from year 2 on using the “perpetuity” formula, but then it must be PV’d. ii. Using the “Perpetuity” formula BUT ONLY FROM a year in the FUTURE: 1. If they said that from year 2 the interest paid will remain the same, you can use the ‘perpetuity type’ debt formula to calculate the ‘market value’ at that time-ie in 2 years. But then you must bring that Future value to the Present Value using the normal PV formula. So a ‘market value‘ can be changed to it’s Present Value using the PV formula. h. To evaluate a 3 different debenture options: work them out 1 by 1 and get a Market VALUE for each option, then compare. Usually you get the market value at the time in the future when the options become a actual option eg in 2 years time one may choose between 3 options- not todays PV. i. ‘Conversions’ : If a debenture will have a new value in the future due to its being ‘converted’ when it falls due to debentures with a different/same interest rate, then you take it as if it were the same debentures as the originals- not a different one completely. So is asked for the present value of these debenture you MUST include the future value of the debentures in eg 2 years, and use the PV formula to change it to Present Value – and add this to the PV value of each year up to then=total PV Market Value. (eg if there are 3 options when the debentures fall due then ( as a result of choosing one of the above options) then the highest choice will be the FV market value it will have in the future-to be added to in between years values to get total) pg 32 33 viggio –fin mngmnt. j. Show all calculations in a simple way, even if you use a intere 129 465 calculator. Eg: st X Where the calculation is second part(bold ) by calculator 3.60 from formula 5 capita l

1000 X 0.56 7

567

1032

MARKET VALUE OF DEBENTURES. 1)

FORMULA FOR MARKET VALUE OF Redeemable DEBENTURES: MV= i/(1+Kd) n + i/

(1+Kd)

n

+ i/(1+Kd) n + R/(1+Kd)n

a) The market value of debentures is calculated -exactly- the same as market value of debt. It is just the PV of future cash flows –incl. interest & capital repayments. 2)

FORMULA FOR MARKET VALUE OF ‘perpetual’ Irredeemable DEBENTURES: MV= i(1-T)/Kd here you must work out the PV with this formula for every year of the loan individually, and then add up all the answers to get the total.- but you still only use the current market interest rate for Kd. The cash flow at top as well as the Kd at bottom are both AFTER tax, so tax must first be deducted from BOTH.

ANNUITY: 5) An annuity refers to a stream of EQUAL payments of a fixed amount over a number of years or periods. Eg 1000 invested every year for 10 years is called a 10 year annuity investment.

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 60 6) BEGINNING / or END OF THE YEAR : the timing of the investment can take place at begin or end of year. Each one has a different formula a) “ANNUITY DUE “: for the FV at beginning of year (.: For the FV ,not the PV, the only difference between the 2 is that for beginning of year annuity due all you have to do is multiply the Ordinary Annuity-end yearby (1+i) to get the -begin year- “annuity due”, but this does not work for the PV of the annuity due- see the formulas below. b) “ORDINARY or REGULAR or DEFERRED ANNUITY” : at end of year. 7) Future Value FORMULA for ORDINARY/DEFERRED/REGULAR ANNUITY. :

– 1 / i] (1+i) a) I = Constant Amount invested each year b) c) d)

FVa = I x [ (1+i)n

FVa =

future value of the annuity. i = interest rate – in DECIMALS eg for 15% Use 0.15 NOT 15% n= number of years/periods

e) Doing the above formula manually :

8) Future Value FORMULA for ANNUITY DUE :

a) I = Constant Amount invested each year b) c) d)

FVa= I x [ {(1+i)n – 1 }/ i] (1+i)

FVa =

future value of the annuity. i = interest rate – in DECIMALS eg for 15% Use 0.15 NOT 15% n= number of years/periods

e) Doing the above formula manually :

9) Present Value FORMULA for Regular ANNUITY :

PVa= I x [ {1 – 1/ (1+i)n } / i]

DO A SCAN) a) I = Constant Amount invested each year b) c) d) e)

PVa =

present value of the annuity. i = interest rate – in DECIMALS eg for 15% Use 0.15 NOT 15% n= number of years/periods

This is

where the payments are at the end of the year.

10) Present Value FORMULA for ANNUITY DUE :

(

DO A SCAN)

PVa= I x [ ( {1 – 1/ (1+i)n } +1 ) / i]

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 61

a) I = Constant Amount invested each year b) FVa = future value of the annuity. c) i = interest rate – in DECIMALS eg for 15% Use 0.15 NOT 15% d) n= number of years/periods e) This one is where payments are at the beginning of the year.-annuity due.

LOAN: PERIODIC PAYMENT OF A LOAN 2) The Periodic Repayments of a loan can be calculated by using the “Present Value formula for a Regular Annuity” by making the I the subject of the formula as follows: 3) CHANGING the Present Value FORMULA for Regular ANNUITY to MAKE I THE SUBJECT

below: a)

PVa= I x [ {1 – 1/ (1+i)n } / i] PVa i) Becomes : I = / [ {1 – 1/ (1+i)n } / i] PVa X i ii) Or: I = / [ {1 – 1/ (1+i)n } / i] : this formula is easier to use than the one above for manual calculations – the /I is just changed mathematicaly to go on top as “X PVa “

iii)

Where:

(1) I = Constant Amount invested each year (2) PVa = present value of the annuity. (3) i = interest rate – in DECIMALS eg for 15% Use 0.15 NOT 15% (4) n= number of years/periods 4) Where there are monthly instead of yearly payments you have to divide i/12 and multiply nX12 . 5) Where the interest is compounded monthly but the loan repayments are made once per year, I tried to get the answer by using the effective interest rate over a year and then just leaving out the compounded part and sticking to the years as the n , then you get the right answer it seems .But if you just go work out the monthly repayments and multiply by 12 it wont work because you are reducing the original loan monthly (too soon) and not yearly so your interest payable will not compute properly.(you might be able to otherwise use the other method for multiple cash flows aver a period.-not sure) 6) To use The P.V. tables instead: a) Just get the PVa annuity factor from the table by going to the relevant ‘interest’ column and ‘periods’ row. b) Then, since I= PVa/factor as in the above formulas, you just divide the PVa ‘Loan Amount’ by the factor you read off the table.

PERPETUITY: 5) A Perpetuity is a normal Annuity but with an infinite life. 6) You only work it out by using a special formula: 7) PRESENT VALUE of a PERPETUITY FORMULA : a)

PVp =

PVp= I/i

Present Value of a Perpetuity.

b) I = Constant Amount invested each year c) d)

i = interest rate – in DECIMALS eg for 15% Use 0.15 NOT 15% This one is where payments are at the end of the year.- I think- it does not say in the book what it is. Also it does not say what the formula for at begin of year (annuity due) is.

8) PRESENT VALUE of a -growing- PERPETUITY FORMULA :

g=growth and

PVp=

D1

/i - g where

D1 is the same as I above but indicates the payment received at the end of the first year, NOT at the beginning of the first year : so it will normally be the given payment with the first years growth added ie; not 100 but 100X 5% growth = 105! 9) Remember : D1 means: if you get 2 odd payments in Year 1 and 2, then from year 3 a dividend of 400 growing at 5 %, it means that year 3 =400 is D1 , because year 2 is Y0 for the 400 onwards part and the 400 is Y1. Then on top of it year 2 is = n in the formula for PV if you want to bring the whole part from year 3 : the

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 62 400-onwards answer: down to PV-because For D1 you take year 2 of course. Watch out for this one in questions; it catches you easy.

MARKET VALUE OF A COMPANY: 3)

The Market Value of a Company : there are 2 formuals :Formula 1:

V0

= MVe +

MVd a) The Market Value of a Company Formula : is simply the Market Value of Equity ( ie the PV valuation of the shares) PLUS the Market Value OF all Debt (ie PV valuation of debt) ,these valuations of debt and equity above must be done using the “FV of cash flows” at “current market rates” to get the Present Value of all future cash flows. 4)

The Market Value of a Company : there are 2 formuals :Formula 2 :Dividends(Do) + Debt Interest Paid in Cash /WACC

a) This is simply a mathematical formula that will work as well as the above reason , for some mathematical reason. 5) MAXIMUM MARKET VALUE OF A COMPANY: Fact:The market value that minimizes WACC , maximizes the Market Value of the company, and thus Maximises the market value of the equity capital (shares) , because of the way & formulas one uses to calculate the “Market Value of a Company “ namely the fact that ‘current market values of interest=Kd ’ and ‘shareholders required return= Ke ’ are used, plays the prominent role here.

ISSUE COSTS 1) Any issue cost from any form of financing where the company incurs a cost in issuing a form of finance, is NOT EVER added to the cost of equity or cost of debt finance( share issue costs & debenture issue costs) , INSTEAD these costs are supposed to be included as part of the cost of the project being financed. So if investment cost= 200; and issue costs = 10 then actually; investment cost= 210. 2) HOWEVER, where it is deemed as desirable to issue costs in determining the Market Value or (Market dividend from it) then the cost per share must be deducted from the market value of the share.

HOW TO DETERMINE GROWTH RATE: a) Method most used: get average of growth rate over a few years., or make an estimate based on unknown information.Finance is not an exact science and we at times need to estimate inputs that are not necessarily 100% correct. b) Alternatively: calc. growth rate based on ROE-return on assets. Problem with this is ROE is at historical values, not market values. c) Or Alternatively : use Future rate of Investment and Return from that investment: i) The future rate of investment and the return on that investment are the factors which generate future dividends, but then the criterion is that a constant proportion of cash earnings per share is reinvested in projects which produce an average rate of return. d)

FORMULA : G= br

,then to get the answer to % multiply by 100.

e) f) The book value of total capital employed is the “TOTAL EQUITIES & LIABILITIES” section on the balance sheet. It may be calculated as the balance at the beginning of the financial year, or the average assets employed over the year, ie beginning asset value plus end of year asset value divided by 2. g) ASSUMPTIONS: this formula only works subject to the following being true: i) ) retained earnings must be the only source of investment capital ii) a constant proportion of earnings must be reinvested each year iii) the reinvested earnings must generate a constant annual rate of return.

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 63

MILLER & MODIGLIANI MARKET VALUE OF COMPANY 1)

Formula = dividend + interest/WACC : all done at market values and interest etc to be after tax of course. a) This seems to be the only formula they use for moglidani ,- not the other one.

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 64

CHAPTER 3 CAPITAL STRUCTURE AND THE COST OF CAPITAL (MANAGERIAL FINANCEVIGARIO) THINGS TO REMEMBER: 1) ALSO REMEMBER interest is calculated on the “LOAN” or “INVESTMENT”, not on the PROFIT. For any debt advantage /disadvantage calculations.

INTRODUCTION: Definition: Capital Structure: Refers to long term financing of the company. So either debt or equity financing. The question is : should a company have debt as part of its ‘capital structure’. ?Definition: Financial Structrure: : it seems like all 3 of: Total Assets & equity=Issued Shares & Total Debt.?

DEBT ADVANTAGE & DISADVANTAGE 6) THE DEBT ADVANTAGE = 2 of : being; a) ALL FORMS OF DEBT FINANCING, OTHER THAN PREFERENCE SHARES, ARE TAX DEDUCTABLE. THEREFORE DEBT IS CONSIDERED CHEAPER THAN EQUITY i) The Effective rate of Interest is : for a Tax rate of 30% : (interest rate*(100-tax% {=70% after tax}) eg: 25%INTEREST RATE * 70% after tax =17.5% effective interest rate.[if a tax rate of 30%] BUT NEVER USE THIS METHOD TO WORK OUT ANYTHING, DO IT MANUALLY AS IN THE METHOD BELOW.THIS METHOD JUST BRINGS WRONG ANSWERS, BECAUSE ONCE YOU REMOVE TAX LIKE THIS YOU CANNOT GO WORK OUT TAX FOR THE REMAINDER IN YOUR NEXT CALC. ANYMORE BECAUSE IT IS ALREADY OUT % WISE, ANY ATTEMPT TO DO THIS RESULTS IN MAJOR ERRORS- DO NOT EVER USE THIS RATE WHERE TAX MUST COME OUT AFTERWARDS IN YOUR SUM. ii) Note : in this example below the 15 % from using the above formula will never get you your answers you want here. COMPARISONS : If Asked to do a comparison between equity & debt financing ONLY do a full sum to compare the figures, just using % above won’t work- but if asked which is cheaper-tax or equity- you can do the ‘after tax’ calculations and then .You must always put the following headings in for any At the bottom of sum put the following headings/TOTALS in exam: b) 1-Shareholders Investment : c) 2-Expected Return Ke= (actual return in other words) d) 3-Required Return Ke= (Ke of shareholders) i)

b) FINANCIAL GEARING IMPROVES SHAREHOLDER RETURN. i) You get a return of some profit for putting absolutely no investment in of your own money, as long as it is above the required ‘Ke’ =required shareholders return or cost of equity. (you get 36% profit after adding old +new profit, without investing anything-very good.as long -as it is above the required Ke-which is the shareholders required return.)

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 65 ii) Example: do any calculation is this way exactly – and remember to add in the : ‘old’ profit they normally get .so always get ALL profit and ALL equity from ALL investments of the company (not just this project) to work out the Shareholders Return =Tot.profit/Tot.equity. ALSO REMEMBER interest is calculated on the “LOAN” or “INVESTMENT”, not on the PROFIT.

iii) c) CREATES WEALTH (PER “ECONOMICS –money supply) d) CHEAPER THAN EQUITY e) PROMOTES GROWTH IN COMPANY. 10) THE DEBT DISADVANTAGE : (4 of ) b) THE ‘FINANCIAL RISK’ OF THE COMPANY INCREASES AS THE COMPANY TAKES ON DEBT FINANCE. Ie i) Capital Repayments ii) Interest Repayments c) THE HIGHER RETURN EXPECTED BY THE SHAREHOLDERS IN RETURN FOR ADDITIONAL FINANCIAL RISK COULD WIPE OUT THE BENEFITS OF CHEAP DEBT FINANCE. ie : “Ke“ :–the required return-Ke- by the shareholders will no doubt – is expected to in other words- to increase when firm takes on extra ‘finance risk’ because there is now more risk involved and thus the shareholders will require a higher return to compensate i) Ke = Ke = return that shareholders expect, which is derived from the level of “business risk” +”financial risk”. Note: Ke is always = business risk + financial risk. So if there is no financial risk then there is only business risk left.… d) FINANCIAL RISK= Kd e) LOOSE KNEE CAPS IF NOT PAID. FOR A COMPARATIVE: sum you must always : at the bottom put the following headings: 1-Shareholders Investment : 2-Expected Return Ke= (actual return in other words) 3-Required Return Ke= (Ke of shareholders) EXAMPLE : The book uses the same example as used in 1(b)i above.

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 66

f)

FINANCIAL GEARING: 1) Financial gearing describes the proportion of debt compared to equity financing. 2) High financial gearing means heavy reliance on debt financing and Low financial gearing means it is heavily reliant on equity financing. 3) With high financial gearing will show a greater Earnings per Share in times of increased profit. 4) In an Economic downturn highly geared companies will do worse than those with low-gearing due to interest (and capital) that must be repaid. 5) High financial gearing implies increased risk- and those with increased risk do well in good times and show below average in bad times. 6) (See yellow why amount-how can amount make a difference????). THE IMPORTANT QUESTION IN THE LONG TERM FINANCING DECISION is: whether the cost of capital for a company is dependant on its financial structure. If long term debt does affect the cost of capital, then the company should minimize its cost of capital by borrowing an “amount” of debt capital that will give the company its lowest cost of capital. 7) If you work out the EPS for companies with 1-low gearing , and 2-medium gearing , and 3-high gearing (but equity stays at eg 2 million, just the makeup of the equity is different for each of low/medium/high) for 4 different profit levels , you end up finding out that the high gearing company cannot make the interest payments in bad profit years, but does the BEST in good profit years, and visa versa for the others in corresponding proportion to their levels.see example pg 43 viggio-finance.

ADVANTAGES & DISADVANTAGES OF FIN. GEARING. ADVANTAGES 1-Interest is Tax Deductable (exept for preference shares) 2-Higher Net return –ie: Fin. Gearing increases Shareholders return. 3-Creates Wealth 4-Promotes Growth in company 5-Cheaper than Equity.

DISADVANTAGES 1-Fixed Annual Interest 2-Repayment of Capital 3-Financial Risk (kd) 4-Loose knee caps if not paid.

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 67

DEBT AS PART OF THE CAPITAL STRUCTURE 1) The question we need to answer in this sub-section is : SHOULD A COMPANY TAKE ON DEBT, AND IF SO, HOW MUCH? 2) There are 2 schools of thought on whether there is any advantage in debt financing. a) TRADITIONAL THEORY: it is acceptable and will lower overall cost of finance of the company as long as they do not take on too much debt. (free money-if profit covers interest) b) MILLER & MODIGLIANI THEORY: states that debt finance brings with it EXTRA financial risk such that the cost of equity = Ke will increase, leaving WACC equal to the cost of business risk.

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 68

WACC WEIGHTED AVERAGE COST OF CAPITAL.

ALSO CALLED THE DISCOUNT RATE USED IN EVALUATION OF

FUTURE INVESTMENTS.

1) WACC is the return a company needs to fully compensate the debt providers as well as the equity providers. 2) It is also called the ‘appropriate discount rate used in the evaluation of future investments’. 3) METHOD: Add the long term debt + Equity used Divide the company up e) Note: i) EQUITY = incl. Retained income + Non-Distributable + Distributable Reseves + Share Premium + Any form of debt that has a conversion option to Ordinary Shares.+??Share issue expenses pg7 note top?? ii) DEBT =Lease + Pref.Shares + Mortgage Bonds + Debentures + Long term loans + any form of finance with NO option to convert to ordinary shares. f) If asked to calculate the WACC for investment decisions, it means work out the “TARGET WACC”. h) METHOD to Cal. WACC: i) WACC % = [Ke X % DEBT] + [Kd X % EQUITY] (1) Add all the Debt + Equity used by company. Then calc the % of debt in the total and the % of equity in the total. (2) Use the % calculated above and the actual Ke & Kd worked out below to calculate : WACC % = [Ke X % DEBT] + [Kd X % EQUITY] ii) Kd =DEBT: (1) Pref Shares & Long Term loan & Debentures are all debt. (2) Pref Shares dividends ARE NOT TAX DEDUCTABLE, but Debentures&Loans interest repayments are tax deductable. (3) TAX :To Deduct Tax from the % interest payable for debt, you say “quoted interest percent” X [100tax rate]/100 = The Effective tax rate. (but never use this method to work out anything wit profit, because once you remove tax like this you cannot go work out tax for the remainder in your next calc. anymore because it is already out % wise, any attempt to do this results in major errors- do not ever use this rate where tax must come out afterwards in your sum.)

(4) Add the % of each type of debt AFTER it’s OWN specific tax deduction in the weighted ratio it is to the total debt, to get your debt average %. (a) Eg: Say Pref shares = R 100@9% before tax, & Debentures = R400@20% & Long term loan = R500@ 12% , Then you say Total debt = 100+400+500 =1000. So [100/1000 X 9] + [400/1000 X {20X60%} ] + [500/1000 X {12X60%} ] = 0.9+4.8+3.6= 9.3% effective debt interest. iii) Ke =EQUITY : (1) Just get the Ke . iv) In order to calculate the WACC one can use 1 of 3 methods. (1) BOOK VALUE Method: (a) Use the book values of equity and debt to work out WACC, exactly as they appear in the books of the company on that date. (i) EQUITY INCLUDES : add all: Ordinary shares + Reserves + Retained earnings + Share premium = Book Value of Equity. (ii) DEBT INCLUDES : plain book value of any debt. This must not be calculated using any PV formulas- use the value in liability accounts only. (iii) To get the kd and ke : 1. Kd : the interest rate (not market rates but book value rates) 2. Ke: shareholders required return (b) This method is wrong/has little value – you cannot actually take the book values to get WACC, you must use market values. (2) MARKET VALUE Method:

(1) Market Value Method Formula=: (2) This is the most correct of all 3 methods to use. It recognizes 1- the Value of equity&debt is at current market rates & 2- The Discount Rates (interest÷nds) are at Current market rates and not at historical rates. (3) Remember for calculating the market value of equity you never include Distributable or Nondistributable reserves, or Share Premium, or retained Earnings in your calculations. So you will

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 69

not add these reserves or retained earnings etc. later on either, you only use the value you get from the formula as your equity, nothing else. (4) CALCULATING :Interest (Kd) & Dividend (Ke) Rates : (5) CALCULATING : Market Value of Equity and Debt: Market Value of Equity: Formula for Present Value of all Future Dividends to Infinity: = D1/(ke-g) use this formula to get the market value of equity.It is a weird formula but it is the prescribed formula for working out the market value for ordinary shares, or for preference shares or any other type of shares. D1= dividend in one years time Ke= shareholders required return g= growth to infinity (NOTE if g= 0 or not given, then just put it as g=0 in the calculation.) (D0 =dividend today) Market Value of Debt: for each year to come, work out the interest payable for that year at the actual interest rate to be used that year.(not necessarily the current market interest rates and also the Capital repayments(repayment of original amount loaned) that must take place that year. Add these two together to get the total repayable that year and then work out the PV for that amount using THIS TIME THE CURRENT MARKET VALUE of interest on debt (as opposed to /not the other interest % used to calc. amounts used above) . Add all the years of the loans repayment&interest PV’s to get the present value of future cash flows of debt interest at the current market discount rate= the Answer. (i) Eg: for a loan of 1000000 repayable in 4 yrs at 10% per year where the “current market value” of debt is 14 %: 100000 100000 100000 100000 + 1,000,000 (1+0.14) (1+0.14)2 (1+0.14)3 (1+0.14)4 =87719 + =76947 + =67497 + =651288(do this step in 2 part s like in book for exam markers to get it.)

=883451 ANSWER WACC : = ‘market kd’ X debt/total debt+equity + market ke X equity/total debt+equity . = WACC (b) Debentures: Use the formula for PV of Future cash Flows to infinity , and remember to subtract the TAX from both “top D1” and “bottom kd” before you calculate the formula.So here the Yearly interest in rands is the D1 at the top(less tax deduction), and the Current market interest rate for similar type of debentures is the Kd at the bottom.: formula for PV of Future cash Flows to infinity = D1/(kd-g) (c) Preference Shares : Pref.Dividends are not tax deductable so do not deduct tax here from D1 or Kd. Use the formula for formula for PV of Future cash Flows to infinity = D1/(kd-g) (b) Long Term Loan : see method for calculating the “market value of WACC” and use the same method as for debt in that method (PV of each year’s interest in Rands +PV of each capital repayment, added together). Don’t forget to deduct tax above&below in PV calcie from interest paid in rands and from Current market rate for interest used at bottom in PV formula. DONT deduct TAX from the LOAN CAPITAL AMOUNT REPAYMENTS, only the other 2 Example: from book, Also for a loan of 1000000 repayable in 4 yrs at 10% per year where the “current market value” of debt is 14 %: (i)

(6) TARGET WACC Method:

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 70 (a) This method uses the target RATIO of Debt:Equity of the company to calculate the TARGET WACC , which is done using current market Kd (interest rates) and current market Ke (shareholders required return). (b) So use the target ratio of ke : kd at todays interest rates & Ke rates to get your answer for the target WACC. This resultant WACC is then the appropriate rate to use in all investment decisions. (c) It seems 40: 60 is the proper ratio for debt: equity to use for all companies, but I am not sure? – must find out /research!. (d) If you have no target WACC you can use the firms current capital structure (debt : equity ratio) AT MARKET VALUES , if it seems to be at the optimal level. (e) WACC of holding company : neither the target WACC or actual WACC of holding company is used for a subsidiary, each companies individual WACC is used by itself for any calculations because each industry is different / has different risks etc.

TRADITIONAL CAPITAL STRUCTURE THEORY: 1) Also called the Generally – Believed theory. 2) Also says the company cannot maximize shareholders wealth unless the optimal WACC is achieved. 3) Assumes an optimal capital structure does exist and depends on level of gearing.As the level of debt is increased up to the ‘optimal WACC level’ the WACC falls because it is tax deductable where equity is not. But after the “optimal WACC level” is reached then any further increase in the debt will increase the risk of the firm and then shareholders will demand a higher yield = ‘Ke’. 4) This first diagram below illustrates the case where the equity starts to increase only when the debt reaches a certain level ( middle circle). It is cheaper than equity to get more debt till the increase in required Ke of shareholders renders any marginal increase in debt too expensive.(Probably exactly where the financial risk is just bordering on too high fo the firm to comfortably and completely safely carry!) a) The second ‘alternative’ diagram below shows the case where the Ke –required return of shareholders starts to increase as soon the company gets ANY debt. The same process will basicy occour as in diagram 1 albeit all a bit quicker. b) As long as there is a “Initial Dip” in the WACC line, the theory can be described as “the Traditional type” . But Where there is NO “Initial Dip” in WACC then it is classed as a “Millar & Moglidiani Theory” type.

Alternative Case:

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DETERMINING THE OPTIMAL DEBT: EQUITY RATIO AND THE TARGET WACC. 1) The Target WACC should always be the possible : ie on the above graphs this would be where the WACC line dips to its lowest point in the middle, not at the point where it equals Ke (Equity requirement) 2) You work both out in one shot by: you can either draw up a diagram as shown above and the target WACC and target Debt:Equity ratio will simply be the point where the WACC line dips the lowest of all. a) Or you can work it out mathematicly by: i) List all possible debt: equity ratios from 0: 100 to 100 : 0 in ‘20%’ increments but including “50%’. ii) Then find out from shareholders and debt providers what their Ke and Kd will be for each specific level of debt: equity listed above. iii) Now just work out the WACC at each level using the above figures: Your target WACC will be the LOWEST WACC you get and target debt : equity ratio will simply be the one that applies to the LOWEST WACC. 3) Fact:The market value that minimizes WACC , maximizes the Market Value of the company, and thus Maximises the market value of the equity capital (shares) , because of the way & formulas one uses to calculate the “Market Value of a Company “ namely the fact that ‘current market values of interest=Kd ’ and ‘shareholders required return= Ke ’ are used, plays the prominent role here.

MARKET VALUE OF A COMPANY: 6)

The Market Value of a Company : there are 2 formuals :Formula 1:

V0

= MVe +

MVd (AFTER TAX)

a) The Market Value of a Company Formula : is simply the Market Value of Equity ( ie the PV valuation of the shares) PLUS the Market Value OF all Debt (ie PV valuation of debt) ,these valuations of debt and equity above must be done using the “FV of cash flows” at “current market rates” to get the Present Value of all future cash flows. 7)

The Market Value of a Company : there are 2 formulas :Formula 2 : Y /WACC = Dividends(Do) + DebtInterest Paid in Cash/WACC (AFTER TAX)

V0 =

a) This is simply a mathematical formula that will work as well as the above reason , for some mathematical reason. 8) MAXIMUM MARKET VALUE OF A COMPANY: Fact:The market value that minimizes WACC , maximizes the Market Value of the company, and thus Maximises the market value of the equity capital (shares) , because of the way & formulas one uses to calculate the “Market Value of a Company “ namely the fact that ‘current market values of interest=Kd ’ and ‘shareholders required return= Ke ’ are used, plays the prominent role here.

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MILLER & MODIGLIANI THEORY:

(PICK THE MAIN POINTS FROM BELOW AND WRITE FACTS BELOW EACH OTHER –RE DO TO MAKE

SOME COMMON FACTS PLAIN)

1) In 1958 Miller & Modigliani proposed that there is no optimal capital structure , because the advantage of debt directly counteracted by an increase in Ke, such that the WACC would always equal business risk. Millar & Mogidliani however made certain assumptions: a) All Investors are rational b) Capital Markets are Perfect c) Relevant Information is freely available to everybody. d) All Investors have the same expectation about the future e) There are no transaction costs f) There is no taxation, or there is no distinction between company and personal tax g) Firms can be classed into business risk or operating risk classes. h) Individuals and firms can borrow at the same rate, and personal gearing is assumed to be a perfect substitute for company gearing. 2) As per this theory, no optimal level of gearing exists –so there is NO Optimal debt: equity ratio for a company! 3) Miller and Modigliani argued that the cost of capital is independent of the capital structure, and hence the value of the firm is independent of the proportion of debt to total capitalisation. As debt financing increases, the initial effect would be to lower the WACC, thus increasing the value of the firm. The model, however, argues that increased gearing results in shareholders requiring an increased return to equate the increased risk. The change in the required equity return will just offset any possible saving or loss on the interest change. As gearing increases, the WACC will remain constant, therefore no optimal level of capital gearing exists. 4) The equilibrium factor in the Miller and Modigliani theory is the arbitrage process. The arbitrage process takes place where two firms of identical income and risk exist, and where one of the firms has a temporafily higher value due to the different debt : equity ratios of the two firms. The investors would arbitrage in order to bring equalise the values of the companies. 5) As per this theory, the ONLY formula you use to work out the value of a firm is : V0 = Y/WACC = Dividends(Do) + DebtInterest Paid in Cash

/WACC

(AFTER TAX)

a) Where i) Vo= market value of the firm ii) Y= dividend + interest iii) Ko= WACC 6) Diagram of this theory: here the WACC line will ALLWAYS = the equity.

THE ARBITRAGE PROCESS : FOR THE MILLER-MODIGLIANI THEORY.

(PICK THE MAIN POINTS FROM BELOW AND WRITE

FACTS BELOW EACH OTHER –RE DO TO MAKE SOME COMMON FACTS PLAIN)

1) The arbitrage process is a term used to describe how an investor of a company that has both debt and equity finance will only be satisfied if he is receiving a return (Ke) that fully compensates him for financial risk. If he is not adequately compensated, he will invest in an all-equity financed company and increase his return by taking on personal financial risk by borrowing at a cost equal to the corporate borrowing rate. a) However this theory seldom if ever applies to the real world and is just a applied science theory.

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 73

2)

3) 4) 5)

6)

b) ThisIf the Ke of a company is not high enough to fully compensate shareholders for their risk as stated above , then as per moglidani theory states they are not necessarily operating in a traditional system, but there is a temporary imbalance in the levels of Ke and now the shareholders must slowly go through the ‘arbitration’ process to ensure their ke increases or else they rather Borrow Personally in the SAME equity to debt ratio the company was borrowing in(the equity they take out/sell :to: personal debt to go borrow now), invest in a different ALL EQUITY company to get a higher return as explained above. c) Because market value of shares= Do/ke , if the Ke is too low after acquiring debt then the shareholders have allowed their value of their investment to rise by not doing arbitrage, so the value of the shares are “OVERVALUED” and must drop by having the market value drop. d) Theory states this pressure will cause the balance in all companies to slowly self correct. Calculating The Correct Value For A Companys Shares : which has debt &equity ,where the Ke is Below that what it should be after comparing to a similar company with only equity, no debt. do this: a) First work out the market value of company using Mv = dividend + interest / WACC ( less tax , and at market values) b) Second take MV – debt value = equity value. (mv means market value) c) third work out what the shareholders Ke should be to be correct : MVequity = Do/Ke so Ke= Do/ MV equity Exam question: always do a full sum to show how much you borrow and what your new profit and new return on investment will be for any arbitrage question where the investor is advised to sell and borrow personally …. (scan an example still) Definition: equilibrium cost of equity: means the Kd which the shareholder should have in order to be in equilibrium( the right one) Note: for this theory it is assumed that Ke (and probably market cost of debt as well) will be exactly the same for businesses in the same class which have identical business risk, due to all the assumptions that the theory has(see assumptions above). So: if in a question the WACC (not Ke) is different for 2 businesses but they are in same class & have same business risk, then it is definitely working according to a traditional system and not the former theory because one must have taken on debt without the exact compensating change in Ke by the shareholders, which would cause the WACC difference between them.(even if the 2 Ke’s are different, they are not in different in perfectly compensating ratio – thus it’s a traditional, not mogidliani. a) To calc. which shareholders do better use dividends/’market’ value of shares=return, not book value- to check any complicated questions. REMEMBER: if you must calculate the equilibrium market value or share value or debt value of a company you have to use ‘market values’ not book values , for the Ke or Kd or WACC (for market value of firm)at bottom of formula. So if there are 2 companies then the HIGHEST WACC available on the market is the one you use to value the company : using formula ‘dividends’+’debt interest payments’/WACC , and same story for other stuff.

7) 8) See example pg 49 viggio for a compex question as relating to this- very intricate- must read it carefully to fully understand this.

OPTIMAL CAPITAL STRUCTURE 1) Definition: Capital Structure : means debt –equity ratio. Optimal Capital Structure means calculated Target debt – equity ratio worked out from lowest WACC possible. If the target D-E ratio is not being stuck to then the company is seen as being in “Temporary Disequilibrium” and must move towards the target. Either the a) “Debt Capacity is Underutilised” = ratio is imbalanced toward equity b) Or “Company has too much debt” = ratio is imbalanced toward debt. (it can be acceptable for a temporary time )

GENERALLY: 1) BANK OVERDRAFT : is not seen as debt unless a part of it IS ACTUALLY being used as a form of long term financing/debt THEN that part used as such should be accounted for as ‘debt’ in the debt: equity ratio. 2) 3) DEFERRED TAXATION: DEFERRED TAX IS NOT included as tax when calculating the capital structure of a company, because the timing of tax payments is accounted for when evaluating the project investment decision. You just ignore it outright. This will only.

SHOULD ALL COMPANIES HAVE DEBT IN THEIR STRUCTURE? 1) Individuals & companies should be as debt free as possible.Debt will always increase the shareholders risk .Even in a world that is not like Miller/Moglidani WACC “will never decrease below business risk-per viggio vertabim” 2) Debt:

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 74 a) Lease b) Mortgage loan c) Long-term loan (not short term loans/overdraft/supplier credit) d) Debenture e) Pref. Share 3) Equity: a) Ordinary shares b) Reseves c) Retained income d) Share issue costs

COST OF CAPITAL : (IN %) 1) To evaluate an investment project you need a discount rate. 2) The discount rate must reflect the risk of the project. 3) The target WACC rate is the correct discount rate to use as it reflects the capital structure of the firm and return required by shareholders after allowing for risk. 4) If you have no target WACC you can use the firms current capital structure (debt : equity ratio) AT MARKET VALUES , if it seems to be at the optimal level. 5) There are 3 assumptions behind the use of a firms current WACC as the discount rate in investment appraisal. a) The firms will retain it’s existing proportion of debt: equity (ie current=target) b) The Project is marginal (small in comparison to total capital value of firm- most project are indeed small) c) The project has the same ‘risk’ as other projects of the firm- if it has more/less then an appropriate riskadjusted rate must be used.

COST OF EQUITY CAPITAL (IN %) 1) You just use the standard formulas for calculating the Market Value of Shares by using the discounted PV of future cash flows. Then you just change each formula around so Ke becomes the subject and use this to work out the Ke % which is your “cost of equity capital) 2) How To Determine Growth Rate: a) Method most used: get average of growth rate over a few years., or make an estimate based on unknown information.Finance is not an exact science and we at times need to estimate inputs that are not necessarily 100% correct. b) Alternatively: calc. growth rate based on ROE-return on assets. Problem with this is ROE is at historical values, not market values.Cost of debt capital : redeemable debentures :

COST OF DEBENTURES 1)

FORMULA FOR MARKET VALUE OF DEBENTURES: MV= i/(1+Kd) n + i/(1+Kd)

(1+Kd)

n

+ R/(1+Kd)

n

n

+ i/

a) The market value of debentures is calculated -exactly- the same as market value of debt. It is just the PV of future cash flows –incl. interest & capital repayments.

COST OF IRREDEEMABLE DEBENTURES : 2)

FORMULA FOR MARKET VALUE OF ‘perpetual’ Irredeemable DEBENTURES: MV= i(1-T)/Kd here you must work out the PV with this formula for every year of the loan individually, and then add up all the answers to get the total.- but you still only use the current market interest rate for Kd. The cash flow at top as well as the Kd at bottom are both AFTER tax, so tax must first be deducted from BOTH.

a) The market value of debentures is calculated -exactly- the same as market value of debt. It is just the PV of future cash flows –incl. interest & capital repayments.

COST OF DEBENTURES/ OR PREFERENCE SHARES WITH CONVERSION OPTIONS : (YOU WANT THE %) 3) The Valuation of Convertibles is carried out in 2 steps: a) At the option date, compare the value of each option and choose the option with the highest value. b) Calculate the value of future cash flows and the terminal value of the option chosen, back to year 0. (date at which the you want to know the value – not date of option but date today) 4) If you convert from one type of security to another, (eg: debentures to shares, or pref. shares to debentures). Use the current type’s Ke or Kd To bring the “future market value FV” at date of conversion to todays Present value- NOT the Kd or Ke of what it will be when its converted. So: if you are going to choose to convert to

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 75 ordinary shares at the date of the option in say 3 years , from debentures , then there is one complication : TO GET THE Present Value OF THE MARKET VALUE OF THE NEW ORDINARY SHARES today in order to add it to the PV of any cash flows up to the date of conversion = Market Value of DEBENTURES, TOU MUST USE THE DEBENTURE Kd (LESS TAX), AND NOT THE ORDINARY SHARE Ke at which the FV market value of the shares were worked out.

COST OF RETAINED EARNINGS : As the retained earnings form part of shareholders capital, the required return for retained earnings is exactly the same as that for Share Capital- ie equity capital. Just use the same result you get for ‘cost of equity capital’

ISSUE COSTS 3) Any issue cost from any form of financing where the company incurs a cost in issuing a form of finance, is NOT EVER added to the cost of equity or cost of debt finance( share issue costs & debenture issue costs) , INSTEAD these costs are supposed to be included as part of the cost of the project being financed. So if investment cost= 200; and issue costs = 10 then actually; investment cost= 210. 4) HOWEVER, where it is deemed as desirable to issue costs in determining the Market Value or (Market dividend from it) then the cost per share must be deducted from the market value of the share. IE: Final Answer minus the Issue cost.

COST OF PREFERENCE SHARES 1) Pref shares carry a fixed commitment and in the event of liquidation they take precedence over common equity shareholders. 2) No tax is deductable from pref shares so no adjustment is made for tax. 3) You use exactly the same formula for pref shares as for the current market value of debt. Ie MV= D/Yield ( or PVp= D0/i )

WACC, AS CALCULATED FROM THE OPTIMAL CAPITAL STRUCTURE PARTS. 1) WACC of holding company : is not used for a subsidiary, each companies individual WACC is used for any calculations because each industry is different / has different risks etc. 2) Use the target WACC at current Market values ,to base any new investment decisions on. 3) See WACC in headings above. 4) You can just calculate all debentures+loans+equity of all sorts in one go in a table, instead of first doing equity then debt separately: as a shortcut! See example below

ADDENDUM TO CHAPTER :ALTERNATIVE METHOD OF DETERMINING GROWTH FOR CALCULATING SHARE MARKET VALUE ETC.. 1) Or alternatively : use Future rate of Investment and Return from that investment: a) The future rate of investment and the return on that investment are the factors which generate future dividends, but then the criterion is that a constant proportion of cash earnings per share is reinvested in projects which produce an average rate of return. b)

FORMULA : G= br

,then to get the answer to % multiply by 100.

c) d) The book value of total capital employed is the “TOTAL EQUITIES & LIABILITIES” section on the balance sheet. It may be calculated as the balance at the beginning of the financial year, or the average assets employed over the year, ie beginning asset value plus end of year asset value divided by 2.

MACN 202 Management Accounting: Financila Management Section. Notes P a g e | 76 e) ASSUMPTIONS: this formula only works subject to the following being true: i) ) retained earnings must be the only source of investment capital ii) a constant proportion of earnings must be reinvested each year iii) the reinvested earnings must generate a constant annual rate of return.