CHAPTER 15: METHODS OF FINANCING A BUSINESS SUGGESTED SOLUTIONS SOLUTION TO MULTIPLE CHOICE QUESTIONS 15.1 15.2 15.3 15.4 15.5
(d) (a) (b) (b) (a)
15.6 15.7 15.8 15.9 15.10
(b) (b) (d) (e) (c)
END OF CHAPTER QUESTIONS
15.1 If the Balance Sheet may be considered to be a list of all the assets of a company, this is “balanced” by a list of who has ownership rights over those assets (share holders and debt holders). This tends to be an accounting perspective on the information in the Balance Sheet. From a finance perspective, the assets of a company reflect all the decisions, which have been made by the financial manager with regard to wealth creating assets in which the company has invested. The equity and liabilities reflect all the decisions, which have been made by the financial manager as to the sources of finance, which will be used to acquire those assets.
15.2 It is now well understood that the objective of business is to create wealth by adding value. Stated differently, assets, which have the capacity to create wealth, are acquired. The wealth created must be at least equal to the return required by the investors (normally divided into equity investors and debt holders – because each has a different risk profile). Since it is intuitive that projects which do not meet the target required rate of return will not be undertaken by the business, this decision (the investment decision) must be made before considering the sources of finance which will be used.
15.3 The primary source of wealth creation is the acquisition of assets, which will generate profits and thus grow the capital invested. A secondary, but significant method of increasing shareholder wealth is to use borrowed funds, pay the after tax cost of those funds (interest), and retain any return which is excess of this cost. This is known as levering the profits of the shareholders through the use of debt. At the same time however, increasing the use of debt causes additional risk for shareholders. Finding the ideal proportion of debt to equity is finding that proportion where the benefits of additional leverage are optimised against the cost of the risk caused by additional debt. It is a “notional” mix which every financial manager strives to achieve.
15.4 The two primary ways of raising finance are through the issue of shares (which may be of different classes – offering differing risks and returns) and through the issue of debt instruments (which also may be of different types, for example short or long term, secured or unsecured). The main equity issue will be ordinary shares. Shareholders are considered to be “residual” investors, in that they receive “what is left”, once all other forms of finance have received their return. Thus is a company does very well, ordinary shareholders will receive large residual benefits, but if the company does badly, shareholders may receive nothing – they bear the ultimate risk.
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15.5 Financing Shareholder Equity Debt
Capital Structure
Cost of Capital
50% 50% 100%
10.50% 20.00%
Weighted Cost of Capital 5.25% 10.00% 15.25%
Cost of Debt equals the after tax cost 15% x (1 - 30%) = 10.50% The project offers a return of 18%, which is lower than the required rate of return for equity shareholders of 20%. However, as 50% of the funds are financed at a real cost to the company of only 10.5%, the weighted average cost of all the funding is 15.25% and the project should be accepted. Note that as a result of leverage, the project achieving a return of 18%, exceeds the required rate of return by 2.75%, this “excess” or “residue” accrues to the equity holders and will create additional wealth for them.
15.6 Some significant implications of using debt in addition to equity financing, when previously only equity financing was used are:
The weighted average cost of capital will be lower than the cost of equity Projects, which were previously unacceptable, may now be acceptable Fixed costs will increase as a result of the annual interest payable The interest payable will be deductible for the purpose of calculating taxable income Equity holders may require a higher return as a result of the risks of taking on debt
15.7 Trade Creditors: This is a form of short term loan resulting from suppliers who are prepared to wait for a defined period (usually 60 to 90 days) before receiving payment for goods or services supplied.
Bank Overdrafts: Banks are prepared to allows short term credit, particularly to businesses which experience cyclical cash flows as a result of seasonal supply and demand patterns or other factors which cause variability is cash flows.
Money Market Instruments: Funds can be obtained through short term loans, bill of exchange, letters of credit and other instruments which are available from intermediaries such as merchant banks.
15.8 Factoring is the process of handing accounts receivable (debtors) to a third party for collection, in return for a fee or commission based on the debts to be collected. The cash is paid over immediately. It is thus a source of immediate cash financing for a company which sells on credit.
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15.9 Loan R 700,000 Term 4 years PVA factor (16%:4years) R -250,163 Annual loan repayment
Rate
16% 2.7982 (R700 000/2.7982)
TERM LOAN AMORTISATION YEAR 0 1 2 3 4
LOAN REPAYMENT R0 -R 250,163 -R 250,163 -R 250,163 -R 250,163
INTEREST PORTION R0 R 112,000 R 89,894 R 64,251 R 34,505
PRINCIPAL REMAINING PORTION BALANCE R0 R 700,000 -R 138,163 R 561,837 -R 160,269 R 401,569 -R 185,912 R 215,657 -R 215,657 R0
15.10
Long Term Loan Mortgage Loan Secured Debentures Unsecured Debentures Redeemable Preference Shares
15.11 Leasing, notably long term leasing, also known as a capital lease, creates the obligation to meet regular payments. These payments are in reality repayments of the capital amount of the lease and interest payments. Investors and analysts, reviewing the balance sheet of a company consider the lease obligation to be almost identical to a long term loan in terms of the obligations and risks which the lease creates. When determining the capital structure of a company, for the purpose of assessing its financial risk, all lease obligations are seen as a use of debt for financing. The decision for the financial manager is therefore not whether to buy an item or not – that is the investment decision which is made using the principles of investment decision appraisal. Only once that decision has been made, are the financing alternatives considered – one of which is leasing, because it may have cost/benefit advantages over a standard long term loan.
15.12 All projects are considered only on the basis of meeting the hurdle rate of the company. This hurdle rate is determined by calculating the weighted average marginal cost of capital, using the target capital structure of debt to equity, which is considered optimal. The fact that a particular project will be financed by new debt is not relevant to the decision. This is a sometimes subtle, but very significant point to note. The reason for this is that new debt for a particular project is used only because, at that particular moment, additional debt is required in order to keep the target capital structure in the correct proportion. The next project, for example, may be financed from equity. For practical reasons, finance is raised in a type of step-wise process as the company grows. If for example a project with an IRR of 14% is accepted because the particular financing for that project is at an after tax rate of 10%, the possibility is that the next project, being financed by equity at say 20% may be rejected even if its IRR is higher than (14%), but lower than 20%. The net effect is that less profitable projects would be accepted on this basis than more profitable projects – clearly an illogical approach to wealth creation.
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15.13
ACUTE, OBTUSE AND JUDICIOUS LTD
The most obvious similarity between the three companies is that they have identical non- current and current asset investments. Each company has invested R110 000 in assets and is using R10 000 in short term liability financing (most probably trade creditors). The most obvious difference between the three companies is that Acute Ltd is financed 100% by equity, Judicious is using a 50% equity, 50% debt mix, while Obtuse Ltd is very heavily geared with only 5% equity against 95% debt. From a financing perspective, the shareholders of Acute Ltd have the least financial risk, although they may be missing some additional return, which could be generated through borrowing and levering their return on equity upwards. Judicious Ltd is making using of the leverage potential. This results in the lenders being reasonably comfortable as their loan is protected by the shareholders funds – the company would have to destroy value of 50% of the total company, before the debt holders would suffer any loss of capital. The shareholders on the other hand, enjoy the benefit of potential leverage, although the risk is heightened as a result of the commitment to meet the annual fixed cost of interest burden. Obtuse Ltd seems to have lost its way. Both the shareholders and the debt holders are likely to be extremely concerned. If the company has a bad year, and loses 5% of its asset value, the shareholders will have no more interest in the company and will have lost all their funds. The debt holders will then become the owners and risk bearers of the business – this is not what they intended, else they would have purchased shares in the first instance. Obtuse desperately needs to change its capital structure with an injection of funds from shareholders – if they can find any that would be willing.
15.14
A COMPANY LEASING DECISION Lease Payment Lease Period Interest rate Cost of Asset 1-tax rate Tax rate Wear & Tear Allowance After tax cost of debt
R 47,000 3 18% R 150,000 60% 40% 33.33% 10.80%
per year years, payable in advance Capital repayable at the end of the period
Tax payable at the end of each year Straight line - no scrap value 18% x .6 (say 11% for use of Tables)
BORROW AND PURCHASE ALTERNATIVE 1
2
3
4
40% of (Col3+Col4)
6
7
8
YEAR
LOAN PAYMENTs
INTEREST
DEPRECIATION
TAX SHIELD
CASH OUTFLOW
P V FACTOR 11%
PRESENT VALUE
0 1 2 3
0 -27,000 -27,000 -177,000
27,000 27,000 27,000
50,000 50,000 50,000
30,800 30,800 30,800
3,800 3,800 -146,200
0.9009 0.8116 0.7312
3,423 3,084 -106,901
NET PRESENT COST OF BORROWING AND PURCHASING
-100,394
LEASE ALTERNATIVE YEAR
0 1 2 3
LEASE PAYMENT
-47,000 -47,000 -47,000
TAX SHIELD
CASH OUTFLOW
PRESENT VALUE
1 0.9009 0.8116 0.7312
-47,000 -25,405 -22,887 13,747
NET PRESENT COST OF LEASING
-81,546
18,800 18,800 18,800
-47,000 -28,200 -28,200 18,800
P V FACTOR 11%
CONCLUSION: LEASE THE ASSET AS LEASING HAS A LOWER NET PRESENT COST
The most important uncertainty is the scrap value of the asset at the end of the period, which would accrue to the company it purchased rather than leased. It would have to be around R25 000 after tax for the decision to be marginal (R100 394 – R81 546) / .7312
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15.15
GADJET LTD
(a)
GADJET LTD ALL EQUITY Financing Shareholder Equity 12% Secured Debentures
Assets Budgeted Profit before interest and tax Interest Profit before tax Tax Net Profit attributable to shareholders Return on Equity Return on Assets before interest and tax Return on Assets before interest after tax
(b)
EQUITY AND DEBT
R 400,000 R0 R 400,000
R 250,000 R 150,000 R 400,000
R 400,000 R 400,000
R 400,000 R 400,000
R 80,000 R0 R 80,000 R 24,000 R 56,000
R 80,000 R 18,000 R 62,000 R 18,600 R 43,400
14.00% 20.00% 14.00%
17.36% 20.00% 14.00%
12.00% Interest 30.00% Tax
The all equity financing option has less risk, as there is no obligation to meet the fixed costs of interest of R18 000 each year. However, it does not make use of the potential for leverage. Based on the budget, a return on assets of 20% is forecast. The after tax cost of debt is only 8.4% (12% x .7), thus offering the shareholders who are prepared to select the mix of debt and equity, the opportunity to lever their return on equity up from 14% after tax to 17 .4%. Given that the proportion of long term debt is still relatively low at 37.5% (150/400) this seems like a more attractive option with a relatively small additional risk. It is worth noting that shareholders that invest in the company if the debt and equity option is selected will require a higher return on their investment than those who opt for the all equity option will. The selection of the most attractive alternative is therefore always subject to the appetite for risk of the investor.
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15.16
READY AND STEADY LTD
(a) and (c)
READY AND STEADY LTD READY LTD Financing Shareholder Equity 12% Secured Debentures Assets OperatingProfit before interest Interest Net Profit attributable to shareholders Return on Equity (b)
STEADY LTD
R 500,000 R0 R 500,000
R 250,000 R 250,000 R 500,000
R 500,000 R 500,000
R 500,000 R 500,000
R 75,000 R0 R 75,000
R 75,000 R 30,000 R 45,000
15.00%
18.00%
12.00%
Interest ASSUMED
15.00% ROA
The interest rate of debt was not given in the question. Tax is ignored, therefore reducing the impact of the tax shield which would be there for share holders. Assuming an interest rate of 12%, there is clearly a leverage effect for shareholders who have invested into Steady Ltd. As the funds earned 15%, and for half of those funds, only 12% needs to be paid, the additional 3% earned on those funds accrues to the ordinary shareholders, levering their return from 15% (Return on all assets), to 18% (Return on the capital provided by shareholders)
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15.17
ADEPT LTD
(a) DIFFERENTIAL CASH FLOWS Capital outlay After tax lease cost W&T Tax shield foregone CASH FLOWS 14% PRESENT VALUE FACTOR PRESENT VALUES NPV LEASING
0 160,000
160,000 1.0000 160,000 -330
1
2
3
4
5
-37,100 -9,600 -46,700 0.8772 -40,965
-37,100 -9,600 -46,700 0.7695 -35,936
-37,100 -9,600 -46,700 0.6750 -31,523
-37,100 -9,600 -46,700 0.5921 -27,651
-37,100 -9,600 -46,700 0.5194 -24,256
PV@14% 0.8772 0.7695 0.6750 0.5921 0.5194
EXPLANATION: If borrow and purchase, the present value of all the cash flows is R160 000 when discounted at the after tax cost of debt. This is compared to the effect if leasing is selected, namely that the after tax cost of leasing of R37 100 would be paid and the company would forfeit the tax shied of R9 600 which would have been a cash flow if purchased (20% x R160 000 x 30%). The net effect is that it is marginally advantageous to borrow and purchase (leasing has a negative net present value when compared in this way against borrowing and buying. (b)
Should borrow and buy – see the more detailed (considerably longer method) which shows the cash flows for each decision (rather than just the incremental cash flows). Note that the difference (net present cost) is only R325 (see R330 above – rounding errors). This is thus a very marginal decision ie qualitative factors should also be considered. ADEPT LTD TERM LOAN AMORTISATION YEAR
0 1 2 3 4 5
LOAN REPAYMENT
0 -53,501 -53,501 -53,501 -53,501 -53,501
INTEREST PORTION
0 32,000 27,700 22,540 16,347 8,917
PRINCIPAL PORTION
0 -21,501 -25,801 -30,961 -37,153 -44,584
REMAINING BALANCE
160,000 138,499 112,698 81,737 44,584 0
loan repayment
-R 53,500.75
Lease Payment
53,000
Interest rate Cost of Asset 1-tax rate Tax rate Wear & Tear Allowance After tax cost of debt
20% 160,000 70% 30% 20% 14.00%
BORROW AND PURCHASE ALTERNATIVE YEAR 0 1 2 3 4 5
LOAN REPAYMENT 0 -53,501 -53,501 -53,501 -53,501 -53,501
INTEREST
DEPRECIATI TAX SHIELD ON
CASH OUTFLOW
P V FACTOR 14%
PRESENT VALUE
0 32,000 32,000 19,200 -34,301 0.8772 27,700 32,000 17,910 -35,591 0.7695 22,540 32,000 16,362 -37,139 0.6750 16,347 32,000 14,504 -38,997 0.5921 8,917 32,000 12,275 -41,226 0.5194 NET PRESENT COST OF BORROWING AND PURCHASING
-30,089 -27,387 -25,069 -23,090 -21,413 -127,047
LEASE ALTERNATIVE YEAR 0 1 2 3 4 5
LEASE PAYMENT -53,000 -53,000 -53,000 -53,000 -53,000
TAX SHIELD
CASH OUTFLOW
P V FACTOR 14%
15,900 -37,100 0.8772 15,900 -37,100 0.7695 15,900 -37,100 0.6750 15,900 -37,100 0.5921 15,900 -37,100 0.5194 NET PRESENT COST OF LEASING
PRESENT VALUE -32,544 -28,548 -25,043 -21,967 -19,270 -127,372
CONCLUSION: BORROW AND PURCHASE - LOWER NET PRESENT COST: A VERY MARGINAL DECISION
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15.18
VENTAIR LTD
(a) to (d) VENTAIR LTD TERM LOAN AMORTISATION YEAR
LOAN REPAYMENT
0 1 2 3 4 5
0 -86,340 -86,340 -86,340 -86,340 -86,340
INTEREST PORTION
0 48,600 41,807 33,791 24,332 13,171
PRINCIPAL PORTION
0 -37,740 -44,533 -52,549 -62,008 -73,170
REMAINING BALANCE
270,000 232,260 187,727 135,178 73,170 0
loan repayment
-R 86,340.02
Lease Payment
80,000
Interest rate Cost of Asset 1-tax rate Tax rate Wear & Tear Allowance After tax cost of debt
18% 270,000 70% 30% 20% 12.60%
BORROW AND PURCHASE ALTERNATIVE YEAR
LOAN REPAYMENT
0 1 2 3 4 5
0 -86,340 -86,340 -86,340 -86,340 -86,340
INTEREST 0 48,600 41,807 33,791 24,332 13,171
DEPRECIATION
TAX SHIELD
CASH OUTFLOW
P V FACTOR 13%
54,000 30,780 -55,560 0.8850 54,000 28,742 -57,598 0.7831 54,000 26,337 -60,003 0.6931 54,000 23,500 -62,840 0.6133 54,000 20,151 -66,189 0.5428 NET PRESENT COST OF BORROWING AND PURCHASING
PRESENT VALUE -49,171 -45,105 -41,588 -38,540 -35,927 -210,331
LEASE ALTERNATIVE YEAR 0 1 2 3 4 5
LEASE PAYMENT -80,000 -80,000 -80,000 -80,000 -80,000
TAX SHIELD
CASH OUTFLOW
P V FACTOR 13%
24,000 -56,000 0.8850 24,000 -56,000 0.7831 24,000 -56,000 0.6931 24,000 -56,000 0.6133 24,000 -56,000 0.5428 NET PRESENT COST OF LEASING
PRESENT VALUE -49,560 -43,854 -38,814 -34,345 -30,397 -196,969
CONCLUSION: LEASE THE MACHINE AS LEASING HAS A LOWER NET PRESENT COST
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15.19
KABOUTER HOUTKLIMRAME (PTY) LTD
(a) KABOUTER HOUTRAME (PTY) LTD TERM LOAN AMORTISATION YEAR 0 1 2 3 4 5
LOAN REPAYMENT 0 -167,190 -167,190 -167,190 -167,190 -167,190
INTEREST PORTION 0 100,000 86,562 70,436 51,086 27,865
loan repayment
PRINCIPAL PORTION
REMAINING BALANCE
0 -67,190 -80,628 -96,753 -116,104 -139,325
R -167,189.85
LEASE PAY
150,000
RATE COST TAX 1-TAX W&T AfTax COD
20% 500,000 70% 30% 20% 14.00%
500,000 432,810 352,182 255,429 139,325 0
(b) BORROW AND PURCHASE ALTERNATIVE LOAN INTERE DEPRECIA YEAR REPAYME TAX SHIELD ST TION NT 0 1 2 3 4 5
CASH OUTFLOW
P V FACTOR PRESENT 14% VALUE
0 0 -167,190 100,000 100,000 60,000 -107,190 0.8772 -167,190 86,562 100,000 55,969 -111,221 0.7695 -167,190 70,436 100,000 51,131 -116,059 0.6750 -167,190 51,086 100,000 45,326 -121,864 0.5921 -167,190 27,865 100,000 38,359 -128,830 0.5194 NET PRESENT COST OF BORROWING AND PURCHASING
-94,026 -85,581 -78,336 -72,153 -66,910 -397,008
LEASE ALTERNATIVE YEAR 0 1 2 3 4 5
(c)
LEASE PAYME NT -150,000 -150,000 -150,000 -150,000 -150,000
TAX SHIELD
CASH P V FACTOR OUTFLOW 14%
45,000 -105,000 0.8772 45,000 -105,000 0.7695 45,000 -105,000 0.6750 45,000 -105,000 0.5921 45,000 -105,000 0.5194 NET PRESENT COST OF LEASING
PRESENT VALUE -92,105 -80,794 -70,872 -62,168 -54,534 -360,474
On the basis of the quantitative calculations, the machine should rather be leased as there is a net advantage in costs of R36 534 (R397 008 – R360 474). Decisions such as these are based on the information provided, so this needs to be carefully checked. For example there must be no inflationary clause in the lease agreement, or any other hidden costs. Another significant point in all leasing agreements is the fact that ownership is never transferred to the lessee. In this case, the assumption was made that the asset will have a zero scrap value after 5 years. This is just a convenient and prudent assumption. Assuming the asset does have a scrap value after 5 years (or it could continue being used – thus generating further income), then the borrow and purchase alternative can look more attractive. The difference in the net present cost is R36 534. A rough way of using sensitivity for scrap value is to see what amount (in 5 years time) would make the difference. The amount is R36534/.5194, which is around R70 000. If there is a significant chance that the asset could be scrapped and more than R70 000 received after tax, this should be considered.
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15.20
ALJOH ALIMINIUM LTD
(a) ALJOH ALIMINIUM TERM LOAN AMORTISATION YEAR
LOAN REPAYMENT
0 1 2 3 4
INTEREST PORTION
0 -113,569 -113,569 -113,569 -113,569
PRINCIPAL PORTION
0 36,000 28,243 19,710 10,324
R -113,569.49
loan repayment REMAINING BALANCE
0 -77,569 -85,326 -93,859 -103,245
LEASE PAY
360,000 282,431 197,104 103,245 0
105,000
RATE
10%
COST
360,000
TAX
60%
1-TAX
40%
W&T
25%
AfTax COD
6.00%
(b) BORROW AND PURCHASE ALTERNATIVE YEAR
0 1 2 3 4 4
LOAN REPAYMENT
INTEREST
DEPRECIATIO N
TAX SHIELD
CASH OUTFLOW
P V FACTOR 6%
PRESENT VALUE
0 0 -113,569 36,000 90,000 50,400 -63,169 0.9434 -113,569 28,243 90,000 47,297 -66,272 0.8900 -113,569 19,710 90,000 43,884 -69,685 0.8396 -113,569 10,324 90,000 40,130 -73,440 0.7921 Profit on Disposal 60,000 0.7921 NET PRESENT COST OF BORROWING AND PURCHASING
-59,594 -58,982 -58,509 -58,171 47,526 -187,731
(c)
LEASE ALTERNATIVE YEAR
0 1 2 3 4
LEASE PAYMENT
-105,000 -105,000 -105,000 -105,000
TAX SHIELD
CASH OUTFLOW
P V FACTOR 6%
42,000 -63,000 0.9434 42,000 -63,000 0.8900 42,000 -63,000 0.8396 42,000 -63,000 0.7921 NET PRESENT COST OF LEASING
PRESENT VALUE
-59,434 -56,070 -52,896 -49,902 -218,302
CONCLUSION: BORROW AND PURCHASE - LOWER NET PRESENT COST
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