Finance

for Non-financial Managers

Day 3

Justin Spencer-Young

Copyright

Day 3 - Agenda

  Business Growth   Working capital management   Capital budgeting   Discount rates   Sources of capital   Cost of capital

The Business Objective

“The objectives of every business are to

endure and grow”

Erik Beinhocker, The Origin of Wealth

To Endure and Grow

Debt

Profitability

Growth

Value

Use of Debt A BUNGEARED GEARED

Equity 1000 600Debt (12%) 400

1000 1000

EBIT (OPERATING PROFIT) 200 200Less: Interest 0 48Profit Before Tax 200 152Tax (30%) 60 45.6Profit After Tax 140 106.4

Return on Assets 20% 20%

Return on Equity 14% 18%

Interest Paid 48Tax saved 14.4Real cost of debt 33.6Real rate of interest 8.4%

BOTH EXAMPLES HAVE THE SAME ASSET BASE

RETURN TO SHAREHOLDERS HAS BEEN "GEARED UP"

Capital Structure and Share Price

Impact of Capital Structure on Share price

6000

6500

7000

7500

8000

8500

9000

0% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65%

Debt to total capital

Sh

are p

ric

e

Share price

Worldwide Annualized Real Equity Returns and Risk Premiums relative to Bills 1900 - 2000

Operating Leverage:

Sales % change Variable Fixed Total costs Profit % change

1,000 920 0 920 80

900 -10% 828 0 828 72 -10%

1,100 +10% 1,012 0 1,012 88 +10%

Variable" 1,000 520 400 920 80

900 -10% 468 400 868 32 -60%

1,100 +10% 572 400 972 128 +60%

Semi-fixed" 1,000 0 920 920 80

900 -10% 0 920 920 -20 -125%

1,100 +10% 0 920 920 180 +125%

Fixed"

Operating Leverage & Financial Leverage

Sales Variable Fixed Total costs EBIT Interest PBT Int cover % ∆ Sales % ∆ EBIT % ∆ PBT

1,000 920 0 -920 80 - 27 53 3

900 828 0 -828 72 -27 45 2.7 -10% -10% -15%

1,100 1,012 0 -1,012 88 -27 61 3.3 +10% +10% +15%

Variable" 1,000 520 400 -920 80 -27 53 3

900 468 400 -868 32 -27 5 1.2 -10% -60% -91%

1,100 572 400 -972 128 -27 101 4.7 +10% +60% +91%

Semi-fixed" Fixed" 1,000 0 920 -920 80 -27 53 3

900 0 920 -920 -20 -27 -47 -0.7 -10% -125% -189%

1,100 0 920 -920 180 -27 153 6.7 +10% +125% +189%

Turnover is Vanity

Profit is Sanity

Cashflow is Reality

What if you are a supplier to:

Selling to Pick n’ Pay

100,000 100,000 100,000 100,000 100,000 200,000 300,000 400,000 500,000 500,000 500,000 500,000

100,000 200,000 300,000 300,000 300,000 400,000 600,000 900,000

1,200,000 1,400,000 1,500,000 1,500,000

0 0 0

100,000 100,000 100,000 100,000 100,000 200,000 300,000 400,000 500,000

1 2 3 4 5 6 7 8 9 10 11 12

40,000 40,000 40,000 40,000 40,000 80,000

120,000 160,000 200,000 200,000 200,000 200,000

(60,000) (60,000) (60,000) (60,000) (60,000) (120,000) (180,000) (240,000) (300,000) (300,000) (300,000) (300,000)

(60,000) (120,000) (180,000) (140,000) (100,000) (120,000) (200,000) (340,000) (440,000) (440,000) (340,000) (140,000)

Month I/S

Sales I/S

Profit B/S

Debtors C/F In

C/F Out

C/F Bal

Managing Cash Flow

A growing business eats cash!!"

Working Capital Management & Growth   What is growth?

  More revenue?   More capacity?   More people?   More profit?

  Can we grow too fast?

  Growing bankrupt!!

Sustainable Growth

 Definition  The maximum net asset growth rate that can

be achieved without the need for external funding

 Constant Debt/Equity ratio  Formula

SGR = Retained Earnings1 / Equity0

Required Growth > Sustainable Growth

1.  Increase profit margin 2.  Improved working capital management 3.  Reduce dividends 4.  Increase leverage 5.  New equity 6.  Merge

Sustainable Growth > Required Growth

1.  Ignore the problem 2.  Pay dividends 3.  Grow by acquisition 4.  Share buy back

Sustainable growth example Anglo Plats

Sustainable growth rate 3.57% (RE2002 / E2001) Actual Growth rate 11.11% (NA2002 / NA2001)

Debt funding will be required in 2002

2001" 2002"

A Quick Estimate of Debt Capacity Example

Step 1 NOPAT = R 100 M i* = 7% pa M = 2 years

Step 2 Total Debt < NOPAT / (i* +1/M)

< 100 / (.07 + 1/2)

< 100 / (.07 + .5)

< 100 / (.57)

< R 175 M

Anglo Plats A Quick Estimate of Debt Capacity

R 000 000’s (M=1.5 years; i=10% after tax)

Dec 2001 Dec 2002 Debt Capacity < 5 791 8 027 (.1+.66) (.1+.66)

< 7 620 10 562 Actual Debt Nil 1 360

Nedbank Financial Planning

Dec 2003 Dec 2004 Sustainable Growth Rate 5.4% (RE1 / E0 ) (974 / 17 976) Actual Growth Rate 8.3% (NA1 / NA0 ) (30 386 / 28 062)

Leverage will increase in 2004 unless new equity is raised which was the case with the R 5.15 billion rights issue in February 2004

Nedbank A Quick Estimate of Debt Capacity

R 000 000’s (M=5 years; i=10% after tax)

Dec 2003 Dec 2004 Debt Capacity < (1 225) 2 086 (.1+.2) (.1+.2)

< Nil 6 953 Actual Debt 10 086 7 482

Over-borrowed in 2003 and 2004 hence the February 2004

R 5.15 billion rights issue to fund growth instead of more debt

Capital Budgeting

  Budgets for new equipment   Budgets for new projects   Budgets for new businesses

  Business plan

  How do well ‘sell’ our plan to management?

Capital Budgeting…cont

 Economic life cycle (time)  Project risk (hurdle rate or ROI)  Forecast of future cash flows  Per unit return or contribution (Payback)  Capital outlay

Discounted cash flow

 Capital outlay  Forecast  Hurdle rate or risk  Time line  External influences

 Interest rate  Exchange rates  Utilisation

DCF graph Rands

+

-

Time

Initial capex expense

Profits over time

Net Present Value (NPV)

Present -200

Year 1 100

Year 2 120

Year 3 130

Year 4 150

83.30

83.28

75.27

72.30

114.15 = NPV Discount rate = 20%

A positive NPV implies that we will make a return on investment that is higher than the discount rate. At what discount rate will the NPV = 0?

Discount rates & expected returns

Gov bonds

5% Cash 7%

JSE equity 13%

Private equity

35% SME 25%

Lotto

99.9%

Government bonds are considered to be Risk Free JSE equity on average returns 6% above the Rf rate