001_2012_4_e-1

�� 2010 University of South Africa

All rights reserved

Printed and published by the University of South Africa Muckleneuk, Pretoria

FIN2601E/1/2012-2018

98769170

InDesign

2

(iii) FIN2601/1/2012-2018

��

3page

INTRODUCTION iv

PURPOSE OF THIS MODULE iv

FREQUENTLY ASKED QUESTIONS iv

USE OF ICONS vii

TOPIC 1: INTRODUCTION TO MANAGERIAL FINANCE 1

STUDY UNIT 1: THE ROLE AND ENVIRONMENT OF MANAGERIAL FINANCE 3

STUDY UNIT 2: FINANCIAL STATEMENTS AND ANALYSIS 9

TOPIC 2: IMPORTANT FINANCIAL CONCEPTS 15

STUDY UNIT 3: TIME VALUE OF MONEY 17

STUDY UNIT 4: RISK AND RETURN 23

STUDY UNIT 5: INTEREST RATES AND BOND VALUATION 31

STUDY UNIT 6: STOCK VALUATION 37

ANNEXURE 1: Financial Tables 45

(iv)

��

4Welcome to the world of finance. As we enter the period after the global financial crisis of 2008 – 2009, the challenge of financial management is greater than ever. We have seen tremendous changes in the financial markets and systems in South Africa and globally in recent years.

5These changes should be reflected in the way we teach the financial management module. In this second-year module, we attempt to give you a foundation in finance and equip you with the tools that you will need to tackle the later modules in this discipline. Our approach is intended to give you a firm grasp of the underlying principles of financial management. This means that it is not sufficient to simply substitute figures in a formula and crunch numbers without understanding the context and meaning of the answers.

6We hope that this module will contribute to your understanding of financial management.

1 PURPOSE OF THIS MODULE7This module will be useful to students who are following or plan to follow a career in finance and other finance-related disciplines such as investments, banking and risk man-agement. It is designed to equip students with knowledge of the fundamental principles of financial management theory and practice.

8Students credited with this module should be able to

� demonstrate an understanding of the markets and environment within which financial management is practised

� apply financial management concepts and principles relating to financial state-ment analysis

� apply techniques relating to the time-value of money to value financial instruments within a risk-return framework

2 FREQUENTLY ASKED QUESTIONS9The prescribed book

10Do I have to buy a prescribed book or can I just use the study guide?

11You should buy the prescribed book as soon as possible after you have registered for the module Financial Management (FIN2601). Bookstores could run out of stock, which may cause an unnecessary delay in your studies. You should study the chapters of the prescribed book as indicated in the study guide.

12Make sure that you purchase an access kit for the MyFinanceLab website. The kit includes your access code.

(v) FIN2601/1/2012-2018

13I cannot get hold of the edition of the prescribed book specified in Tutorial Letter 101. May I use another edition?

14The study guide for Financial Management (FIN2601) was developed in a way that permits the use of any edition (including the “brief editions”) of the prescribed book: Gitman, LJ. 2010. Principles of managerial finance: Global and Southern African perspectives. Cape Town: Pearson/ Prentice Hall South Africa.

15I can buy a second-hand prescribed book, but it is not the same edition as the one prescribed in Tutorial Letter 101.Can I use it or will I be at a disadvantage if I use an earlier edition?

16You will not be at any disadvantage if you use an earlier edition of the prescribed book. As indicated above, the study guide for Financial Management (FIN2601) was developed in a way that permits the use of any edition. However, you will still need to purchase the access kit for the MyFinanceLab website.

17My local bookstore does not have any copies of the prescribed book. Can you provide me with the details of bookstores that may have the book in stock?

18The list of official booksellers appears in the Unisa booklet entitled University of South Africa: Services and procedures. The booksellers do not inform us of their stock levels and we cannot at any particular point in time say where you will be able to buy a particular prescribed book.

19May I use any alternative books?

20We strongly recommend the use of the prescribed book. You are welcome to consult additional reading material, but the examination paper is based on the prescribed book.

21Which specific pages do I need to study and which can I leave out?

22The chapters you should study are indicated in your study guide. The study guide will indicate if any pages may be left out.

23Could you highlight the most important aspects of each chapter?

24Some students are inclined to study only the “most important aspects”. This may prove to be disastrous in the examination. All aspects of the prescribed chapters should be regarded as important for the examination.

25Study guide and tutorial letters

26I have lost my study guide. Could you please mail or fax me a copy?

27Please order replacement copies of study guides from the Despatch Department (tel: 012 429 4104). We do not mail or fax copies of study guides to students.

28

(vi)

29I have lost one of my tutorial letters. Could you please mail or fax me a copy?

30Please order replacement copies of tutorial letters from the Despatch Department (tel: 012 429 4104).We do not mail or fax copies of tutorial letters to students. Alternatively download the tutorial letter from the myUnisa website.

31Assignments

32My assignment is late because …. May I submit it at a later date?

33It is your responsibility to ensure that your assignment reaches Unisa’s Muckleneuk Campus on or before the closing date. Please do not call us to request an extension for the submission of an assignment. Multiple-choice assignments are marked (by a mark-reading device) on a fixed date as specified in advance in the planning schedule of the Assignments Section. Hence multiple-choice assignments submitted after the closing date will not be marked.

34Calculators

35Are we allowed to use a calculator? Yes. In fact we would like to encourage you to use a financial calculator. We recommend the HP10BII calculator only.

36Are we allowed to use a programmable calculator in the examination? No.

37Group discussion classes

38Is it compulsory to attend the group discussion classes?No.

39Where will the group discussion classes take place?

40Details of the group discussion classes appear in the tutorial letter. You will be advised via SMS and the details will also be posted on the myUnisa forum.

41Supplementary books and videos

42Are there any supplementary books that I can use? No supplementary books are prescribed.

43Is there a workbook available that could help me prepare for the examination? Yes. Marx, J. (1996). Financial management workbook. Johannesburg: Heinemann. Contact one of the official booksellers if you are interested in obtaining a copy.

44Examination

45Are any previous examination papers available?

46Yes. These are posted on the myUnisa website.

(vii) FIN2601/1/2012-2018

47What will the format of the examination paper be? The examination paper consists of 40 multiple-choice questions (worth 1 mark each) and one or two long questions (worth 30 marks). The total mark is 70 and the duration of the paper two hours.

48Will the examination paper contain any theory questions or will there only be cal-culations and interpretations?

49Most of the questions involve calculations and interpretations.

50Will I be provided with all the financial tables (containing the present and future value factors) or should I memorise them?

51The financial tables will be provided as an annexure to the examination paper.

52Will all the equations be provided as an annexure to the examination paper?

53No equations will be provided. You have to know all the equations and be able to apply them in the examination.

54Can you give me any “tips” on the examination?

55No “tips” are provided to students.

56I am going overseas weeks before the examination results are due to be released. Could you please tell me what mark I received for this paper?

57No results are released prior to the dates set by the Examination Section. Please do not call the Department of Finance and Risk Management and Banking to request your results.

3 USE OF ICONS58The following icons are used in this study guide. An explanation of each icon is provided below:

Learning outcomes. The learning outcomes indicate what aspects of the particular topic or study unit you have to master (i.e. know and understand).

Assessment criteria. The assessment criteria indicate on what as-pects of the particular topic or study unit you will be tested/exam-ined and demonstrate that you have mastered the study material (i.e. competence).

Key concepts. Attention is drawn to certain keywords or concepts that you will come across in the topic or study unit.

(viii)

Overview. The overview provides the background to a particular topic or study unit.

Activity. These self-assessment activities should be performed in order to develop a deeper understanding of the learning material.

Feedback. Feedback is provided on the self-assessment activities.

Read. This icon will direct you to read certain sections of the pre-scribed book for background information.

Study. The Study icon indicates which sections of the prescribed book you need to study (i.e. learn, understand and practise).

Assessment. When you see the Assessment icon you will be re-quired to test your knowledge, understanding, and application of the material you have just studied.

Summary. This section provides a brief summary of what was covered in a particular study unit and what can be expected in the following study unit(s).

Checklist. After completion of a particular study unit, you should confirm that all learning outcomes were in fact achieved and that you comply with the assessment criteria.

1 FIN2601

TOPIC 1

INTRODUCTION TO MANAGERIAL FINANCE

1AIMS

The aims of this topic are to(1) provide an overview of the financial managerial function of an enterprise(2) characterise the operating environment of the enterprise(3) review the analysis of financial statements and the relevance of such statements to the

business

INTRODUCTION59Topic 1 is divided into the following two study units (SUs):

60SU 1: The role and environment of managerial finance

61SU 2: Financial statements and analysis

62Since each study unit has its own particular objective, we shall now deal with each of them separately.

3 FIN2601

Study unit 1

THE ROLE AND ENVIRONMENT OF MANAGERIAL FINANCE

TUTORIAL MATTERStudy chapter 1 in your prescribed book.

CONTENTS64Tutorial matter

65Learning outcomes

66Overview

67Self-assessment

68Activity

69Key concepts

70Summary

71Checklist

LEARNING OUTCOMES

After working through this study unit you should

� be able to define the functions of a finance manager

� be able to discuss the legal forms of business organisation

� be able to describe the managerial finance function and its relationship to economics and accounting

� be able to explain the goal of the enterprise and finance-related concepts such as corporate governance and the agency problem

� understand financial institutions and the role they play in managerial finance

� be able to discuss business taxes and their importance in financial decisions

1ASSESSMENT CRITERIA

Financial management is central to the operations of any business entity. Students will be expected to discuss the activities of a finance manager. They will also be expected to discuss, in detail, agency relationships; conflicts that may arise between shareholders and managers and between shareholders and the providers of debt. A demonstrable understanding of the financial markets and its operations will be expected.

4

OVERVIEW

This study unit introduces you to the field of finance and career opportunities in both financial services and managerial finance. The three basic legal forms of business (sole proprietorship, partnership and company), their strengths and weaknesses, and the relationship between the major parties in a company are described. The managerial finance function is defined and differentiated from economics and accounting. This is followed by a summary of the three key activities of the financial manager: finan-cial analysis and planning, investment decisions and financing decisions. The financial manager’s goals (maximising and preserving shareholder wealth) and the role of eth-ics in meeting these goals are then discussed. The agency problem is also reviewed.

This study unit also presents a broad overview of the operating environment of the en-terprise. It focuses on the financial environment in which the enterprise interacts with institutions, financial markets and the government. The role of domestic and international financial markets, the money market and capital markets is explained with reference to the fundraising activities of the enterprise. This is followed by a description of the characteristics of debt and equity securities, and the securities exchanges where these securities are traded.

The concepts of interest rates, required return, risk-return trade-offs and the term struc-ture of interest rates (which reveals the economic environment in which the enterprise operates) are integral to an understanding of securities and markets. The study unit con-cludes with a discussion of the impact of taxation on the enterprise’s financial activities.

SELF-ASSESSMENT

(1) Managerial finance …

(1) involves tasks such as budgeting, financial forecasting, cash management and funds procurement.

(2) involves the design and delivery of advice and financial products.(3) recognises funds on an accrual basis.(4) devotes most of its attention to the collection and presentation of financial data.

(2) The primary emphasis of the financial manager is the use of …

(1) accrued earnings.(2) cash flow.(3) organograms.(4) profit incentives.

(3) Which one of the following is not a key activity of the financial manager?

(1) making financing decisions(2) financial analysis and planning(3) managerial financial accounting

(4) making investment decisions

(4) Which of the following legal forms of business organisation is most expensive to organise?

(1) sole proprietorships(2) partnerships

5 FIN2601

(3) corporations(4) limited partnerships

(5) Which of the following is not an agency cost?

(1) bonding and structuring expenses(2) cost of goods sold(3) monitoring expenditures(4) opportunity costs

(6) The … is created by a financial relationship between suppliers and demanders of short-term funds.

(1) stock market(2) capital market(3) financial market(4) money market

(7) The Johannesburg Securities Exchange is an example of a …

(1) primary market only.(2) secondary market only.(3) primary and secondary market.(4) money market.

(8) The tax deductibility of expenses … their after-tax cost.

(1) increases(2) reduces(3) has no effect on(4) has an undermined effect on

(9) A corporate bond …

(1) will always be awarded an AAA rating.(2) represents the long-term funds provided by the enterprise’s shareholders.(3) will always be issued as a secured bond.(4) is a debt instrument indicating the amount borrowed and how the amount will

be repaid under clearly defined terms.

(10) Which one of the following statements about the difference between ordinary shares and preference shares is correct?

(1) The claims of preference shareholders must be satisfied before the board of direc-tors declares any dividends payable to ordinary shareholders.

(2) Ordinary shareholders are given preference over preference shareholders in the liquidation of assets as a result of bankruptcy.

(3) Preference shares are super-voting shares whilst ordinary shares are non-voting shares.

(4) Preference shareholders are sometimes referred to as residual owners.

6

2FEEDBACK ABOUT THE SELF-ASSESSMENT

Question 1 Answer 1

Question 2 Answer 2

Question 3 Answer 3

Question 4 Answer 3

Question 5 Answer 2

Question 6 Answer 4

Question 7 Answer 2

Question 8 Answer 2

Question 9 Answer 4

Question 10 Answer 1

ACTIVITY

Use the Internet to study about the following concepts within the South African context

� financial markets and operation (the Johannesburg Stock Exchange)

� business formsComplete the scheduled online tests/quizzes on chapter 1 on the MyFinanceLab website.

KEY CONCEPTS

� The scope of financial management

� Financing, investment and dividend decisions

� The agency problem

� Business forms

� Primary activities of a financial manager

� Goal of the enterprise

� Corporate governance

� Economic value added (EVA)

� Ethics

� Primary market

� Secondary market

� Capital market

� Debt capital

� Bond

� Stock

� Public offering

� Capital gains

� London interbank offered rate (LIBOR)

� Market interest rates

7 FIN2601

� Nominal or quoted interest rate

SUMMARY

This study unit provided an overview of financial management and its role in maximising the value of an enterprise’s ordinary share. The study unit looked at the role of the finance manager. It also examined the interlinkage between finance and other key line functions in an organisation. This study unit also discussed agency relationships; conflicts that may arise between shareholders and managers and between shareholders and the provid-ers of debt. The study unit also examined the operating environment of the enterprise.

CHECKLIST

Did you read the chapter in full in order to gain an overall impres-sion of the content?

Have you completed the activity?

Have you completed the assessment?

Have you studied the contents of this chapter?

Have you achieved the learning outcome?

Would you be able to meet the stated assessment criteria?

Have you discussed any challenges with this study unit with fellow students (personally or via the discussion forum at myUnisa), your tutor or lecturer?

Did you establish whether any additional resources are available from myUnisa?

9 FIN2601

Study unit 2

FINANCIAL STATEMENTS AND ANALYSIS



74Learning outcomes

75Overview

76Self-assessment

77Activity

78Key concepts

79Summary

80Checklist

LEARNING OUTCOMES


� be able to review the contents of key financial statements

� understand who uses financial ratios and why

� be able to discuss the relationship between debt and financial leverage

� be able to use ratios to analyse an enterprise’s profitability and its market value

� be able to use a summary of financial ratios and the DuPont system of analysis to perform a complete ratio analysis


Students should be able to construct the various forms of the financial statements. They should be able to interpret the financial performance of an enterprise by merely inspect-ing the financial statements as well as through the use of ratios. Students should be able to benchmark financial performance and draw comparisons between companies in the same industries. They should understand the limitations of ratio analysis.

81

10

OVERVIEW

This study unit examines four key components of the shareholders’ report: the state-ment of comprehensive income, statement of financial position, statement of retained earnings, and statement of cash flows. On the statement of comprehensive income and statement of financial position, the major accounts/balances are reviewed for the stu-dent. The rules for consolidating a company’s foreign and domestic financial state-ments (FASB No. 52) are described. Following the financial statement coverage the study unit covers the evaluation of financial statements using the technique of ra-tio analysis. Prospective shareholders and creditors use ratio analysis and the enter-prise’s own management to measure the enterprise’s operating and financial health.

Three types of comparative analysis are defined: cross-sectional analysis, time series analysis and combined analysis. The ratios are divided into five basic categories: liquid-ity, activity, debt, profitability and market. Each ratio is defined and calculated using the financial statements of the Bartlett Company. A brief explanation of the implications of deviation from industry standard ratios is offered, with a complete (cross-sectional and time series) ratio analysis of Bartlett Company ending the chapter. The DuPont system of analysis is also integrated into the example. The importance of understanding financial statements is highlighted through discussions of how such knowledge will help the student be a more efficient business manager and more effectively make personal financial decisions.

3SELF-ASSESSMENT

(1) The notes to financial performance are an important part of the shareholder’s report because they …

(1) are the primary communication from management to the enterprise’s owners.(2) provide information on the accounting policies, procedures, calculations and

transactions underlying entries in the financial statements.(3) indicate whether the auditors have certified the statements as a fair representa-

tion of the financial affairs of the enterprise.(4) explain to what extent the generally accepted accounting principles (GAAP)

were adhered to.

(2) Which of the following statements are correct?

(a) The financial statements of an enterprise consist of the income statement, the balance sheet, the statement of retained earnings and the cash budget.

(b) The income statement measures the profitability of the enterprise.(c) The balance statement measures only the value of the assets of the enterprise.(1) a(2) b(3) a, b(4) b, c

(3) An enterprise has fixed assets worth R900 000 and current assets worth R180 000. The enterprise owes R440 000 on a mortgage bond and money owed to creditors amount to R10 000. Owners’ equity equals …

(1) R630 000.(2) R640 000.(3) R1 170 000.(4) R1 180 000.

11 FIN2601

(4) Siyaya Corporation had sales worth R20 000 for the year. The inventory at the beginning of the year was worth R10 000, and at the end of the year it was worth R14 000. The enterprise purchased goods worth R15 000 during the year. The gross profit equals …

(1) R9 000.(2) R11 000.(3) R14 000.(4) R15 000.

(5) The income statement consists of …

(1) assets, liabilities and shareholders’ equity.(2) sales, cost of goods sold and operating expenses.(3) cash flow from operating, financing and investment activities.(4) net income earned, cash dividends paid and change in retained earnings.

(6) The … of a business enterprise is measured by its ability to satisfy its short-term obligations as they become due.

(1) activity(2) liquidity(3) debt(4) profitability

(7) The three summary ratios basic to the DuPont system of analysis are …

(1) net profit margin, total asset turnover and return on investment.(2) net profit margin, total asset turnover and return on equity.(3) net profit margin, total asset turnover and equity multiplier.(4) net profit margin, financial leverage multiplier and return on equity.

(8) An enterprise with total asset turnover lower than the industry standard may have …

(1) excessive debt.(2) excessive cost of goods sold.(3) insufficient sales.(4) insufficient fixed assets.

(9) An enterprise with sales of R 1 000 000, net profit after taxes of R30 000, total assets of R1 500 000 and total liabilities of R750 000 has a return on equity of …

(1) 20 per cent.(2) 15 per cent.(3) 3 per cent.(4) 4 per cent.

(10) An increase in financial leverage will result in … in the return on equity.

(1) an increase(2) a decrease(3) no change(4) an undetermined change

82

12


Question 1 Answer 2

Question 2 Answer 2

Question 3 Answer 1

Question 4 Answer 1

Question 5 Answer 2

Question 6 Answer 2

Question 7 Answer 3

Question 8 Answer 3

Question 9 Answer 4

Question 10 Answer 1

ACTIVITY

� Collect at least five different set of company financial statements from newspapers or company reports. These must be from the same industry.

� Analyse the way they are constructed.

� Perform ratio analysis and interpret the results.

� Complete the scheduled online tests/quizzes on chapter 2 on the MyFinanceLab website.

KEY CONCEPTS

� Shareholders’ report

� Income statement

� Balance sheet

� Current assets

� Retained earnings

� Ordinary income

� Current liabilities

� Statement of cash flows

� DuPont system of analysis

� Modified DuPont formula

� Leverage

� Return on equity (ROE)

� Price-earnings ratio (P/E)

� Financial leverage multiplier (FLM)

� Cross-sectional analysis

� Time series analysis

� Net working capital

� Quick ratio

13 FIN2601

� Total asset turnover

� Common size income statement

SUMMARY

This study unit examined the key components of the shareholders report. This was fol-lowed by the use of ratios to interpret the financial statements. The student was also introduced to how to draw a comparison in financial performance whether longitudinal, time series or cross-sectional.

CHECKLIST









14

83

15 FIN2601

TOPIC 2

IMPORTANT FINANCIAL CONCEPTS

4AIMS

The aims of this topic are to(1) explain the two fundamental principles of financial management: the time value of

money and risk versus return(2) apply the above principles in valuation of bonds and shares

INTRODUCTION84Topic 2 is divided into the following four study units (SUs):

85SU 3: Time value of money

86SU 4: Risk and return

87SU 5: Interest rates and bond valuation

88SU 6: Stock valuation

89Since each study unit has its own particular objective, we shall now deal with each of them separately.

16

90

17 FIN2601

Study unit 3

TIME VALUE OF MONEY



92Learning outcomes

93Overview

94Self-assessment

95Activity

96Key concepts

97Summary

98Checklist

LEARNING OUTCOMES


� be able to discuss the role of time value in finance and use computational tools in analysis

� understand the concepts of future value and present value

� be able to calculate the future value of both an ordinary annuity and an annuity due, the present value of a perpetuity and the future value of a mixed-stream cash flow

� understand the effect that compounding interest more frequently than annually has on future value and on the effective annual rate of interest

� be able to draw up a loan amortisation and determine an implied growth rate


Students will be expected to use discuss the concept of time value. They will be expected to apply the theory of compound interest and use computational tools in analysis. Fur-ther they will be expected to solve routine problems in the time value of money involving present value and future value.

18

OVERVIEW

This study unit introduces an important financial concept: the time value of money. The PV and FV of a sum, as well as the present and future values of an annuity, are explained. Special applications of the concepts include intra-year compounding, mixed cash flow streams, mixed cash flows with an embedded annuity, perpetuities, deposits to accumu-late a future sum, as well as loan repayment. Numerous business and personal financial applications are used as examples. The study unit drives home the need to understand time value of money at the professional level because funding for new assets and pro-grammes must be justified using these techniques. Decisions in a student’s personal life should also be acceptable on the basis of applying time-value-of-money techniques to anticipated cash flows.

The timing of cash flows has important economic consequences because enterprises and individuals have many opportunities to earn positive rates of return on invested funds. A time line depicts the investment cash flows (both positive and negative) on a horizontal line with time zero at the left end and future periods shown from left to right.

Future value (FV), the value of a present amount at a future date, is calculated by apply-ing compound interest over a specific time period. Present value (PV) represents the rand value today of a future amount, or the amount you would invest today of a future amount, or the amount you would invest today at a given interest rate for a specified time period to equal the future amount. Financial managers prefer present value to future value because they typically make decisions at time zero, before the start of the project.

Financial tables present future value and present value interest factors arranged in columns and rows, with a row for each period (years) and a column for each interest rate shown in the table. The interest factor for k% in year n is found at the intersection of row n and column k. Time value calculations can also be performed on a financial calculator. Use of a calculator greatly enhances the mathematical process in terms of speed and accuracy. It is important that the user understands the conceptual aspects of the solution model before using a calculator. The recommended calculator for this module is the HP10BII.

5SELF-ASSESSMENT

(1) R10 000 is invested in a savings account at 20% per annum compound interest for ten years. What is the end value of the investment?

(1) R61 740(2) R61 920(3) R62 290(4) R62 470

(2) You have invested R 3 600 per year (at the end of each year) for ten successive years in a savings account at 15% per annum compound interest. Which one of the following is closest to the end value in the savings account?

(1) R73 094,40(2) R74 390,60(3) R83 094,40(4) R93 940,60

19 FIN2601

(3) R10 000 is invested in a savings account for ten years at 20% compound interest, but the interest is calculated semi-annually. What is the end value of the investment?

(1) R27 670(2) R47 860(3) R67 270(4) R87 410

(4) You will receive an amount of R1 700 eight (8) years from now. However, if you could receive the amount right now and invest it, you would be able to earn 8% interest per annum on the amount. What would the amount be worth if you could receive it now instead of waiting eight years?

(1) R819(2) R918(3) R1 564(4) R1 700

(5) Which one of the following represents most closely the present value of R25 000 received annually for ten successive years using a discount of 17%?

(1) R29 250(2) R207 500(3) R116 475(4) R292 500

(6) What amount should be invested annually (at the end of each year) for five successive years at 12% per annum compound interest in order to yield approximately R25 000?

(1) R3 935,15(2) R4 199,72(3) R4 167,58(4) R4 400,00

(7) What is the interest or growth rate of the following stream of cash flows?

2010 R1 5172009 R1 3122008 R1 2102007 R1 080

(1) 6%(2) 8%(3) 10%(4) 12%


Question 1 Answer 2 Using equation Using tablesFVn = (1 + i)n FVn = PV × FVIFi,n

= R10 000 × (1 + 0,20)10 = R10 000 × 6,192 = R10 000 × 6,192 = R61 920 =R61920

20

Calculator solution Input Function 10 000 PV 10 n 20 i FV Solution is R61 917,36

Question 2 Answer 1 Using tables Calculator solution FVAn = PMT × (FVIFAi,n) Input Function = R3 600 × 20,304 3 600 PMT = R73 094,40 10 n 15 i FV Solution is R73 093, 39

Question 3 Answer 3 Using equation Calculator solution FVn = PV × (1 + i/m )m×n Input Function = R10 000 × (1 +0,2/2)10×2 10 000 PV = R10 000 × (1.1)20 10 × 2 = 20 n = R10 000 × 6,727 20/2 = 10 i = R67 270 FV Solution is R67 250

Question 4 Answer 2 Using tables Calculator solution PV = FVn × (PVIFAi,n) Input Function = R1 700 × 0,540 1 700 FV = R918 8 n 8 i PV Solution is R918,46

Question 5 Answer 3 Using tables Calculator solution PVA = PMT × (PVIFi,n) Input Function = R25 000 × 4,569 25 000 PMT = R116 475 10 n 17 i PV Solution is R116 465, 09

Question 6 Answer 1 Using tables Calculator solution PMT = FVA Input Function(FVIFAi,n) 25 000 FV= R25 000 5 n 6,353 12 i = R3 935,15 PMT Solution is R3 935,24

21 FIN2601

Question 7 Answer 4 Using tables Calculator solution PV = R1080 Input Function FV R1517 +/- 1080 PV = 6,711 1517 FV PVIFk,3 = 12% 3 n I Solution is 11,99

ACTIVITY

(1) Familiarise yourself with the HP10BII financial calculator by performing the future value and present value calculations.

(2) Listen to the podcast on the HP10BII calculator on the subject website.(3) Complete the scheduled online tests and quizzes on chapter 4 on the MyFinanceLab

website.

KEY CONCEPTS

� Time line

� Principal

� Nominal annual rate

� Compound interest

� Annuity

� Annuity due

� Future value

� Effective annual rate

� Ordinary annuity

� Present value

� Discounting cash flows

� Perpetuity

� Loan amortisation

SUMMARY

This study unit covered the various aspects of the time value of money. It introduced the tools of computational analysis that would be used in the latter study units.

99

22

CHECKLIST









23 FIN2601

Study unit 4

RISK AND RETURN



101Learning outcomes

102Overview

103Self-assessment

104Activity

105Key concepts

106Summary

107Checklist

LEARNING OUTCOMES

After working through this study unit you should be able to

� define risk

� define and calculate return

� distinguish between risk preference behaviours

� assess risk by means of sensitivity analysis and probability distributions

� calculate the standard deviation (s) and coefficient of variation

� calculate the return on a portfolio

� calculate the standard deviation (s) of a portfolio’s returns

� describe correlation and diversification, and their influence on the risk and return of a portfolio

� describe the link between risk and return according to the capital asset pricing model (CAPM)

� calculate and interpret beta (β)

� calculate the required rate of return of an asset using the capital asset pricing model (CAPM)


Financial management is central to the operations of any business entity. Students will be expected to discuss the activities of a finance manager. They will also be expected to

24

discuss, in detail, agency relationships; conflicts that may arise between shareholders and managers and between shareholders and the providers of debt.

OVERVIEW

This study unit focuses on the fundamentals of the risk and return relationship of as-sets and their valuation. For the single asset held in isolation, risk is measured with the probability distribution and its associated statistics: the mean, the standard deviation, and the coefficient of variation. The concept of diversification is examined by measur-ing the risk of a portfolio of assets that are perfectly positively correlated, perfectly negatively correlated, and those that are uncorrelated. The capital asset pricing model (CAPM) is then presented as a valuation tool for securities and as a general explana-tion of the risk-return trade-off involved in all types of financial transactions. This study unit highlights the importance of understanding the relationship of risk and return when making professional and personal decisions.

RISK

Risk is defined as the chance of financial loss, as measured by the variability of expected returns associated with a given asset. A decision maker should evaluate an investment by measuring the chance of loss (or risk) and comparing the expected risk with the ex-pected return. Some assets are considered to be risk free, the most common example being South African government bonds.

RETURN

The return on an investment (total gain or loss) is the change in value plus any cash dis-tributions over a defined time period. It is expressed as a percentage of the investment over the period. Make sure that you understand the formula for the return for any asset.Realised return requires the asset to be purchased and sold during the time periods in which the return is measured. Unrealised return is the return that could have been realised if the asset had been purchased and sold during the time period in which the return was measured.

RISK PREFERENCE BEHAVIOURS

A risk-averse financial manager requires an increase in return for a given increase in risk. A risk-indifferent manager requires no change in return for an increase in risk. A risk-seeking manager accepts a decrease in return for a given increase in risk. Most financial managers are risk-averse.

SENSITIVITY ANALYSIS AND PROBABILITY DISTRIBUTIONS

Sensitivity analysis evaluates asset risk by using more than one possible set of returns to obtain a sense of the variability of outcomes. The range is found by subtracting the pessimistic outcome from the optimistic outcome. The larger the range, the greater the variability of risk associated with the asset.The decision maker can obtain an estimate of project risk by viewing a plot of the prob-ability distribution that relates probabilities to expected returns and shows the extent of

25 FIN2601

distribution of returns. The more dispersed the distribution is, the greater the variability or risk associated with the return stream.

A bar chart is a probability distribution for a small number of outcomes, while a continu-ous probability distribution considers all possible outcomes over the relevant range.

STANDARD DEVIATION AND COEFFICIENT OF VARIATION

The standard deviation of a distribution of asset returns is an absolute measure of dis-persion of risk about the mean or expected value. A higher standard deviation indicates a greater project risk. In case of a larger standard deviation, the distribution is more dispersed and the outcomes have a higher variability – resulting in higher risk. The coef-ficient of variation is another indicator of asset risk, and measures relative dispersion. It is calculated by dividing the standard deviation by the expected value. The coefficient of variation may be a better basis than the standard deviation for comparing risk of assets with differing expected returns.

ANALYSING RISK AND RETURN WITHIN A PORTFOLIO

Assets should be evaluated in a portfolio context because the risk of the entire portfolio is a function of the risk of the individual assets. The risk of an asset cannot be viewed independently but should rather be viewed in the light of its overall effect on the port-folio’s risk. As long as we assume the conditions underlying the CAPM, the portfolio rules apply to investors and not to enterprises.

An efficient portfolio is one that maximises return for a given risk level or minimises the risk for a given level of return. The return of a portfolio is the weighted average of returns on the individual component assets.

The standard deviation of a portfolio is not the weighted average of component standard deviations: the risk of the portfolio as measured by the standard deviation will be smaller. It is calculated by applying the standard deviation formula to the portfolio assets.The correlation between asset returns is important when evaluating the effect of a new asset on the portfolio’s overall risk. Returns on different assets moving in the same direction are positively correlated, while those moving in opposite directions are negatively cor-related. Assets with a high positive correlation increase the variability of portfolio returns; assets with a high negative correlation reduce the variability of portfolio returns. When negatively correlated assets are brought together through diversification, the variability of the expected return from the resulting combination may be less than the variability or risk of the individual assets. When one asset has high returns, the other’s returns are low (and vice versa). Therefore the result of diversification is to reduce risk by providing a pattern of stable returns.

Diversification of risk in the asset selection process allows the investor to reduce overall risk by combining negatively correlated assets so that the risk of the portfolio is less than the risk of the individual assets in it. Even if assets are not negatively correlated, the lower the positive correlated between them, the lower the result-ing risk.

THE CAPITAL ASSET PRICING MODEL (CAPM) AND BETA

The total risk of a security is the combination of no diversifiable risk and diversifiable risk. Diversifiable risk refers to the portion of an asset’s risk attributable to enterprise-specific,

26

random events( strikes, litigation, loss of key contracts, etc) that can be eliminated by diversification. Non-diversifiable risk is attributable to market factors affecting all enter-prises (war, inflation, political events, etc). Some people argue that non-diversifiable risk is the only relevant risk because diversifiable risk can be eliminated by correlated assets.Beta measures non-diversifiable risk. It is an index of the degree of movement of an asset’s return in response to a change in the market return. The beta coefficient for an asset can be found by plotting the asset’s historical returns relative to the returns for the market. By using statistical techniques, the characteristic line is then matched to data points. The slope of this line is beta. Beta coefficients for actively traded shares are published in the Value Line Investment Survey and brokerage reports. The beta of a portfolio is calculated by finding the weighted average of the betas of the individual component assets.

The equation for the capital asset pricing model is:

Kj= R

f + [b

j × (k

m – R

f)]

Where:K

j = the required (or expected) return on asset

j

Rf = the rate of return required on a risk-free security

Bj = the beta coefficient or index of non-diversifiable (relevant) risk for asset

j

Km

= the required return on the market portfolio of assets (the market return)

PRACTICAL APPLICATIONS OF RISK AND RETURN CONCEPTS

Risk and return concepts come into consideration when dealing with related issues such as the leverage and capital structure of the enterprise. Risk is perceived as financial risk and business risk. The concept of leverage (both financial and operating) is used to de-scribe these types of risk. In ascertaining the optimal capital structure of the enterprise, the concepts of standard deviation, coefficient of variation and probabilities are crucial in determining expected values and in measuring risk.

7SELF-ASSESSMENT

(1) Risk may be defined as the …

(1) chance of financial loss.(2) variability of returns associated with a given asset.(3) uncertainty concerning a potential loss.(4) All of the above.

(2) A tank container (purchased a year ago for R120 000) currently has a market value of R145 000. During the year it generated R4 800 in after-tax cash receipts. What is the container’s rate of return?

(1) 4,0%(2) 13,9%(3) 16,8%(4) 24,8%

(3) If a financial manager’s required rate of return increases for an increase in risk, then he or she is a …

(1) risk-taking manager.(2) risk-indifferent manager.(3) risk-averse manager.(4) risk-control manager.

27 FIN2601

(4) What is the expected rate of return if the following probabilities and associated rates of return exist?

Pr

Rate of return0,25 20%0,50 15%0,25 10%

(1) 6,00%(2) 11,25%(3) 13,50%(4) 15,00%

(5) What is the standard deviation(s) for the returns of an asset as depicted below?

Pr Rate of return0,40 35%0,30 10%0,30 -20%

(1) 21,66%(2) 22,78%(3) 25,00%(4) 34,20%

(6) Nsukuzonke Ltd has invested in an asset. The expected return (k) is 18%. Risk estimates indicate that the standard deviation is 21%. The coefficient of variation, (CV) of the asset is closest to…

(1) 0,85.(2) 1,17.(3) 1,50.(4) 3,00.

(7) Investec is considering investing in Spur shares. The risk-free rate of return (Rf) is 14%. The beta of the share is 0.8% and the market rate of return (km ) is 20%. The required rate of return (kj) is closest to …

(1) 14,0%.(2) 15,2%.(3) 16,0%.(4) 18,8%.

(8) The returns of Ikhwezi Corporation’s shares have a standard deviation (σ) of 1.8% and a coefficient of variation (CV) of 0.09. The risk-free rate of return (Rf) is 12%. The beta of the share is 1.6% and the market rate of return (km ) is 17%. The required rate of return (kj) is closest to ….

(1) 13,5%.(2) 15,2%.(3) 19,2%.(4) 20,0%.

108

28


Question 1 Answer 4

Question 2 Answer 4

Question 3 Answer 3

Question 4 Answer 4

�

�

��

� ��

� � × Pr

= (0.20 × 0.25) + (0.15 × 0.50) + (0.10 × 0.25) = 0.15 = 15%

Question 5 Answer 2

��

�

� ��

�

� � ��

�

�

��

� ��

� � × Pr

= (0.35 × 0.40) + (0.10 × 0.30) + (–0.20 × 0.30) = 0.14 + 0.03 – 0.06 = 0.11 = 11% σk = �[ (0.35–0.11)2 × 0.4 + (0.01 – 0.11)2 × 0.30 + (–0.20 -0.11)2 × 0.30] = �0,0519 = 0.2278 = 22, 78%

Question 6 Answer 2 CV= σk / k = 0.21/ 0.18 = 1.1666 = 1.17

Question 7 Answer 4

Question 8 Answer 4

ACTIVITY

(1) Investigate the returns of your bank over the last three (3) years.

29 FIN2601

(2) After working through this study unit, complete the scheduled online test and quiz on the MyFinanceLab website.

KEY CONCEPTS

� Portfolio

� Risk

� Return

� Risk-averse

� Sensitivity analysis

� Probability

� Risk-seeking

� Range

� Standard deviation

� Normal probability distribution

� Efficient portfolio

� Uncorrelated

� Capital asset pricing model (CAPM)

� Coefficient of variation

� Beta coefficient (β)

� Security market line (SML)

� Non-diversifiable risk

� Market return

� Efficient market

SUMMARY

This study unit covered the concept of risk and return. This unit utilised the concepts of statistics to explain financial measures such as risk and return. Concepts such as standard deviation, risk, probability and coefficient of variation were covered. It is important for financial managers to analyse investment and financing strategies within a risk return framework.

CHECKLIST






30




31 FIN2601

Study unit 5

INTEREST RATES AND BOND VALUATION




111Overview

112Self-assessment

113Activity

114Key concepts

115Summary

116Checklist

LEARNING OUTCOMES


� be able to describe interest rate fundamentals, the term structure of interest rates and risk premiums

� understand the key inputs and the basic model used in the valuation process

� be able to apply the basic valuation model to bonds and describe the impact of required return and time-to-maturity on bond values

� be able to explain yield-to-maturity (YTM), its calculation and the procedure used to value bonds that pay interest semi-annually


Students will be expected to discuss the main theories of the term structure. They will also be expected to distinguish between the nominal rate and real rate of interest. It will also be expected of students to familiarise themselves with the bond market, specifically, the type of bonds and the features of these bonds. Further they will be expected to apply the basic valuation model in the determination of the bond price or the yield of the bond.

117

32

OVERVIEW

This study unit begins with a thorough discussion of interest rates and yield curves, and their relationship to required returns. Features of the major types of bond issues are pre-sented along with their legal issues, risk characteristics and indenture convents. The study unit then introduces students to the important concept of valuation and demonstrates the impact of cash flows, timing and risk on value. It explains models for valuing bonds and the calculation of yield-to-maturity using either the trial-and-error approach or the approximate yield formula. Students learn how interest rates may affect their ability to borrow and expand business operations or assets under personal control.

VALUATION

Valuation is the process that links risk and return in order to determine the worth of as-sets. A financial manager should understand the valuation process in order to judge the value of benefits received from bonds.

KEY INPUTS IN THE VALUATION PROCESS

The three key inputs in the valuation process are as follows1. cash flows – the cash generated from ownership of the asset2. timing – the time period(s) in which cash flows are received3. required return – the interest rate used to discount the future cash flows to a present value (the selection of the required return allows the level of risk to be ad justed: the higher the risk, the higher the required return)

THE BASIC BOND VALUATION FORMULA

��

� ��

�

� ��

� � ��

� � � ��

where:B

0 = value of bond that pays annual interest

I = interest or coupon paymentn = years to maturitym = par value / face valuek

d = required return on bond

In order to find the value of bonds paying interest semi-annually, the basic bond valuation equation should be adjusted to account for the more frequent payment of interest as follows:

� The annual interest should be converted to semi-annual interest by dividing it by two.

� The number of years to maturity should be multiplied by two.

� The required return should be converted to a semi-annual rate by dividing it by two.

� �

� ��

�

� ��

��

� � � ��

33 FIN2601

A bond sells at a discount when the required return exceeds the coupon rate. It sells at a premium when the required return is less than the coupon rate. A bond sells at par when the required rate of return equals the coupon rate.

YIELD-TO-MATURITY (YTM)

The yield-to-maturity (YTM) on a bond is the rate investors earn if they buy the bond at a specific price and hold it until maturity. The trial-and-error approach to calculating YTM requires finding the value of the bond at various rates to determine the rate causing the calculated bond value equal its current value. The procedure to calculate YTM is analogous to that of calculating the internal rate of return (IRR). Many calculators are programmed to calculate the internal rate of return (IRR). You can also use this feature to calculate the YTM, since the YTM and IRR are determined in the same way.

9SELF-ASSESSMENT

(1) In the valuation process, the … is used to incorporate risk in the analysis.

(1) standard deviation (σ)(2) coefficient of variation (CV)(3) discount rate(4) interest rate

(2) Muntu Zondo acquired an asset that is expected to generate cash flows of R2 200, R0, R4 400 and R11 00 at the end of years one, two, three and four respectively. Muntu’s required rate of return is 18%. The value of the asset equals …

(1) R10 219,00.(2) R14 432,00.(3) R17 600,00.(4) R31 154,20.

(3) The theory suggesting that for any given issuer, long-term interest rates tend to be higher than short-term rates is called …

(1) the expectation hypothesis.(2) the liquidity preference theory.(3) the market segmentation theory.(4) None of the above.

(4) An enterprise has an issue of R1 000 par value bonds with a nine per cent stated interest rate outstanding. The issue pays interest annually and has 20 years remain-ing to its maturity date. If bonds of similar risk are currently earning 11 per cent, the enterprise’s bond will sell for … today.

(1) R1 000(2) R716,67(3) R840,67(4) R1 123,33

(5) What is the yield-to-maturity, to the nearest per cent, for a bond whose current price is R908, has a coupon rate of 11%, has R1 000 par value, on which interest is paid annually and which has eight years to maturity?

(1) 11 per cent

34

(2) 2 12 per cent(3) 3 13 per cent(4) 4 14 per cent

(6) ABC Corp issued bonds bearing a coupon rate of 12 per cent, pay coupons semi-annually, have three years remaining to maturity and are currently priced at R940 per bond. What is the yield-to-maturity (YTM)?

(1) 12,00%(2) 13,99%(3) 14,54%(4) 15,25%

(7) Renaissance Investments has a required rate of return of 15%. It is considering invest-ing in Orange Cell debentures, which will be issued at a par value of R1 000 with a coupon interest rate of 12% (paid annually) and a maturity period of ten years. The value of the debentures is approximately …

(1) R247,00.(2) R602,28.(3) R849,28.(4) R1 000,00.


Question 1 Answer 3

Question 2 Answer 3

Question 3 Answer 2

Question 4 Answer 3

Question 5 Answer 3

Question 6 Answer 3

Question 7 Answer 3

ACTIVITY

� Use the Internet to study about the concepts bond market and the bond issuance within the South African context.

� Complete the scheduled online tests and quiz on chapter 6 on the MyFinanceLab website.

118

35 FIN2601

KEY CONCEPTS

� Valuation

� Floatation

� Discount

� Premium

� Real rate

� Nominal rate

� Interest rate risk

� Yield-to-maturity (YTM)

� Par value

� Face value

� Coupon

� Market segmentation

� Expectations

SUMMARY

This study unit covered the concepts of interest rates and valuation of bonds. Bonds rep-

resent debt capital and hence are a critical component of the financing of an enterprise.

CHECKLIST









36

119

37 FIN2601

Study unit 6

STOCK VALUATION

TUTORIAL MATTER

Study chapter 7 in your prescribed book.



122Overview

123Self-assessment

124Activity

125Key concepts

126Summary

127Checklist

LEARNING OUTCOMES


� be able to differentiate between debt and equity capital

� understand the concept of market efficiency and basic ordinary share valuation

using zero growth, constant growth and variable growth models

� be able to discuss the free cash flow valuation model and the book value, liquidation

value and price/earnings (P/E) multiple approaches

� be able to explain the relationships among financial decisions, return, risk and the

enterprise’s value.


Students will be expected to discuss the process of listing shares and differentiate be-tween preference and ordinary equity. Further they will be expected to value shares of enterprises that are at various stages of growth.

38

OVERVIEW

This study unit continues on the valuation process introduced in study unit 5 for bonds. Models for valuing preference and ordinary share are presented. For ordinary shares, the zero growth, constant growth, and variable growth models are examined. The relation-ship between share valuation and efficient markets is presented. The role of venture capitalists and investment bankers is also discussed. The free cash flow model is explained and compared with the dividend discount models. Other approaches to ordinary share valuation and their shortcomings are explained.

The chapter ends with a discussion of the interrelationship between financial decisions, expected return, risk, and an enterprise’s value. Share valuation from the perspective of the one’s professional life is contrasted with share valuation from a personal perspective.

EFFICIENT MARKET HYPOTHESIS

In an efficient market, investors would buy an asset if the expected return exceeds the current return – thereby increasing its price (market value) and decreasing the expected return until expected and required returns are equal.According to the efficient market hypothesis (EMH)

� share prices are in equilibrium (fairly priced with expected returns equal to required returns)

� share prices fully reflect all the available public information and will react quickly to new information

� investors should therefore not waste time searching for mispriced (overvalued or undervalued) shares

The efficient market hypothesis is generally accepted as being reasonable for shares traded on major exchanges (this is supported by research on the subject). The zero growth model of ordinary share valuation assumes a constant, non-growing dividend stream. The share is valued as perpetuity and discounted at a rate k

s.

ORDINARY SHARE VALUATION

The constant growth model of ordinary share valuation (also called the Gordon model) assumes that dividends will grow at a constant rate (g). The share is valued as the present value of the constantly growing cash flow stream.

The variable growth model of ordinary share valuation assumes that dividends grow at a variable rate. The share with a single shift in the growth rate is valued as the present value of the dividend stream during the initial growth phase plus the present value of the share price at the end of the initial growth phase.

Book value is the value of the share in the event that all assets are liquidated for their book value and the proceeds remaining after paying all liabilities are divided among the ordinary shareholders.

Liquidation value is the actual amount each ordinary shareholder would expect to receive if the enterprise’s assets are sold, creditors and preference shareholders are paid, and any remaining money is divided among the ordinary shareholders. Price-earnings multiples are another way to estimate ordinary share value. The share value is estimated by multi-plying expected earnings per share by the average price/earnings ratio for the industry.

39 FIN2601

Both the book value approach and liquidation value approach ignore the earning power of an enterprise’s assets and lack a relationship to the enterprise’s value in the marketplace. The price/earnings multiples approach is considered the best approach to valuation, since it considers expected earnings. The P/E ratio also has the strongest theoretical roots. One divided by the P/E ratio can be viewed as the rate at which investors discount the enterprise’s earnings. If the projected earnings per share (EPS) are assumed to be earned indefinitely, the P/E multiple approach can be regarded as a method of finding the pres-ent value of a perpetuity of projected EPS at a rate equal to the P/E ratio.

THE BASIC ORDINARY SHARE VALUATION FORMULA

��

��

��

� � � �where:P

0 = value of ordinary share

Dn = per-share dividend expected at the end of year n

ks = required return on an ordinary share.

The equation can be simplified somewhat by redefining each year’s dividend (Dn)

in terms

of anticipated growth – zero growth, constant growth and variable growth.

ZERO GROWTH MODEL

This assumes a constant dividend stream, that is:

D1 = D

2 = D

3 = D

4 =… = D�

Hence simplifying the basic ordinary share valuation formula this reduces to:

��

��

�

CONSTANT GROWTH MODEL

This assumes that dividends grow at a constant rate of (1 + g) where g is however lessthan the required rate of return k

s .The basic equation simplifies to:

��

��

��

where :g is the growth rateD

1 = D

0(1 + g) or

D1 = expected dividend

D0 = ex-dividend (the just paid dividend)

VARIABLE GROWTH VALUATION MODEL

This model is used to value shares with dividend that exhibit at least two cycles of growth, for instance where the dividends are initially stagnant (hence zero growth) and then be-

40

gin to grow at a constant rate (constant growth). Under this scenario, the valuation will be split into two, by first using the zero growth model for the years that the cash flows exhibit stagnation and then apply the constant growth model for those years where the dividends are growing.

11SELF-ASSESSMENT

(1) Which of the following is not typically a feature of preferred stock?

(1) Most preferred stock is non-cumulative(2) Most preferred stock is cumulative(3) Preferred stock is generally callable(4) Preferred stock is typically convertible

(2) You are planning to purchase the stock of B & B Inc. and you expect it to pay a dividend of R3 in one year, R4,25 in two years and R6 in three years. You expect the stock to sell for R100 in three years. If your required return for purchasing the stock is 12 per cent, how much would you pay for the stock?

(1) R75,45(2) R77,24(3) R81.52(4) R85.66

(3) ABS Corporation’s ordinary share is expected to pay a dividend of R3 forever and currently sells for R21,42. What is the required rate of return?

(1) 10%(2) 12%(3) 13%(4) 14%

(4) Bongani Corporation’s common stock currently sells for R180 per share. Bongani just paid a dividend of R10,18 and dividends are expected to grow at a constant rate of 6% forever. If the required rate of return is 12%, what will Bongani Corporation’s stock sell for one year from now?

(1) R180,00(2) R187,04(3) R195,40(4) R190,80

(5) Citizen Bank is expected to pay an annual dividend of 90 cents per share indefinitely and the required rate of return equals18%.The value of the share equals …

(1) R 0,16.(2) R 5,00.(3) R10,62.(4) R16,20.

(6) The constant rate of dividend growth for RA Investments is 8%.The enterprise is ex-pected to pay an annual dividend (D1) of R2,50 next year. The required rate of return (ks) equals 18%. The value of the share (P0) equals …

41 FIN2601

(1) R 9,62.(2) R13,89.(3) R25,00.(4) R31,25.

(7) I&J Ltd is expected to have earnings per share of R2,50 next year. The average price/earnings ratio for enterprises in the food sector is 18. The value of the enterprise’s share is closest to …

(1) R7,20.(2) R13,89.(3) R20,50.(4) R45,00.

(8) Khula Ltd has a beta (β) of 1,2, while the market return equals 18% and the risk free rate of return equals 12%.The enterprise is expected to pay a dividend (D1) of R8,64 next year. The enterprise’s share is worth …

(1) R10,37.(2) R45,00.(3) R48,00.(4) R72,00.


Question 1 Answer 1

Question 2 Answer 3

Ordinary basic share valuation model

��

��

��

� � � � = 3/(1+0.12) + 4.25/(1+0.120)2 + 106/(1+0.12)3

= R81.52

Question 3 Answer 4

Zero growth valuation model Ks = D1/ P= 3/21.42 = 14%

Question 4 Answer 3

Constant growth valuation model

Question 5 Answer 2

42

Zero growth valuation model

Question 6 Answer 3

Question 7 Answer 4

Question 8 Answer 2

ACTIVITY

� Analyse a recent initial public offering (IPO) and determine the growth path of the share.

� After working through this study unit, attempt the scheduled online tests and quizzes on chapter 7 on the MyFinanceLab website.

KEY CONCEPTS

� Constant growth model

� Gordon model

� Variable growth model

� Zero growth model

� Price/Earnings multiple approach

� Perpetuity

� Book value per share

� Market value per share

� Preference shares

� Common stock

� Free cash flow valuation model

� Efficient market hypothesis

SUMMARY

This study unit covered the concepts of determining the fair value of equity stock. It reviewed four models of valuing equity: basic valuation model, zero growth valuation model, constant growth valuation model and variable growth valuation model. The issue of efficient markets was also explored.

CHECKLIST



43 FIN2601







44

128

45 FIN2601

Appendix 1

Financial Tables

INTEREST TABLES129Table 1: Future-value interest factors for R1 compounded at k per cent for n periods

130

132

133

* FVIF > 99999

134

131

��

��

��

��

��

��

� �

��

��

��

��

��

��

��

��

��

��

��

��

� �

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

� �

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

� �

� �

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

� �

� �

46

135Table 2: Future-value interest factors for a R1 annuity compounded at k per cent for n periods

136

137

138

* FVIFA > 99999

139

�

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

� �

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

� �

� �

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

� �

� �

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

� �

� �

� �

�

47 FIN2601

140Table 3: Present-value interest factors for R1 discounted at k per cent for n periods

141

142

143

144

* PVIF = .000 when rounded to three decimal places

145

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

� �

� �

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

� �

� �

� �

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

� �

� �

� �

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

� �

� �

� �

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

� �

� �

� �

� �

48

146Table 4: Present-value interest factors for a R1 annuity discounted at k per cent for n periods

147

149

� �

148

�

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

��

49 FIN2601

001_2012_4_e-1

Documents

nancial management module

study unit

nancial management concepts

nancial markets

study guide

value nancial instruments

global nancial crisis

principles of managerial