1. MNF2023 DISCUSSION CLASS 2010

2. CHAPTER 2 FINANCIAL STATEMENTS

3. FINANCIAL STATEMENT ANALYSIS

4. You will need to be familiar with income and balance sheet statements since some questions will test your knowledge in this regard. Questions 1-6 in your assignment 01 tested your knowledge on the income statement. Please work through the solutions in your tutorial and the statements above to become familiar with these calculations You need to know how to calculate Earnings per share (EPS), net profit after taxes, Dividends per share given the divided payout, ROE, etc You should expect both theory and calculations from this section. Below is some illustration of typical questions that could come from this section. Please work through them and compare with the provided answers.

5. FINANCIAL STATEMENT ANALYSIS(FSA) Slovo Corporation had pre-tax profits of R 1.2 million, an average tax rate of 35% and it paid preference share dividends of R 80 000. There were 80 000 shares outstanding and no interest expense. What was Slovo Corporation’s earning per share? (R8.75) (May/June 2009) A firm has fixed assets worth R1 000 000 and accounts payables worth R20 000. The firm owes R440 000 on a mortgage bond and has R120 000 in current assets. Its owners’ equity equals to …(R660 000) (May/June 2009) A firm with sales of R1 000 000, net profits after taxes of R30 000, total assets of R1 500 000 and total liabilities of R750 000 has a return on equity of …(4%) (May/June 2009) Similar questions in your guides, tutorial letters and prescribed textbook

6. (FSA) Statement of Retained Earnings You will need to know how to calculate the statement of retained earnings. Example format is provided above; A firm had as at year-end 2004 and 2005 retained earnings balances of R670 000 and R560 000 respectively. The firm paid R10 000 in dividends in 2005. The firm’s net profit after taxes for 2005 was … R670 000 + Net profit – Dividends paid = R560 000 R670 000 + NP – 10 000 = R560 000, so NP = - R100 000

7. FSA (Financial Ratios) At the end of 2007, Heaton Industries reported retained earnings of R675 000 and it had R172 500 worth of net income during the year. The previous year the company had reported R555 000 in retained earnings. If the company purchased no shares during 2007, how much dividends did it pay during 2007? (R52 500) Liquidity Ratios –Current Ratio –Quick Ratio Activity Ratios –Inventory Turnover –Average Age of Inventory –Average Collection Period –Average Payment Period –Total Asset Turnover –Price Earnings (P/E) Ratio –Market/Book (M/B) Ratio Financial Leverage Ratios Debt Ratio Profitability Ratios Common-Size Income Statements Gross Profit Margin Operating Profit Margin (OPM) Net Profit Margin (NPM) Earnings Per Share (EPS) Return on Total Assets (ROA) Return on Equity (ROE) Note: Work through ratio analysis. (Remember that formulae are not provided in the final exam so you will have to master them!)

8. EXAMPLES Minor Motors Information Practices questions on financial statement analysis Questions 1-6 Assignment 01 Semester 1 Solutions in tutorial letter 201/1/2010 Other Practice questions A firm has a current ratio of 0.5:1. In order for this firm to increase its current ratio, it must … –use cash to reduce accounts payable –use cash to reduce the long-term bonds outstanding –borrow short-term notes payable and use the cash generated to increase inventories –speed up the collection of accounts receivables and use the cash generated to increase inventories

9. If a firm’s return on equity (ROE) is above the industry average but its net profit margin and debt ratio are both below the industry average, which one of the following statements will be correct? –Its return on assets (ROA) must equal the industry average. –Its total assets turnover must be above the industry average. –Its total assets turnover must be below the industry average. –Its total assets turnover must equal the industry average. Practice questions (The Du Pont)

10. The DuPont system of analysis is used to dissect the firm’s financial statements and to assess its financial condition. It merges the income statement and balance sheet into two summary measures of profitability: ROA and ROE as shown in the equation below. A firm with a substandard return on total assets can improve its return on equity, all else equal, by … –increasing its total asset turnover –increasing its debt ratio –decreasing its debt ratio –decreasing its total asset turnover ( Answer increasing the debt ratio) Practice questions (The Du Pont)

12. The firm’s earnings that were available for ordinary shareholders for 2009 were … –-R224.00 – R195.00 – R302.40 – R516.00 Practice questions Sales revenue R 3060 Cost of goods sold R 1800 Account receivable R 500 Preference share dividends R 18 Interest expense R 126 Tax rate 40% Total operating expenses R 600 Ordinary shares outstanding 1000

13. Assignment 01, Questions 8-10 –Please note that Bad debts and depreciation are never included in the cash budget because they are considered non cash items. GENERAL FORMAT OF A CASH BUDGET

14. Actual SalesForecasted Sales MonthMayJuneJulyAugustSeptember Receipts (R)50 00060 00050 00030 00070 000 Cash sales (60%) a30 00036 00030 00018 00042 000 * Credit sales 1 month (25%) b12 50015 00012 500 7 500 * Credit sales 2 months (10%) c 5 000 6 000 5 000 Dividend income 5 000 Total receipts (A) (a+b+c)50 00041 50054 500 Purchases (70% of sales)35 00042 00035 00021 00049 000 * Payments cash (60%) d21 00012 60029 400 * Payment lagging 1 month (30%) e12 60010 500 6 300 * Payments lagging 2 months (10%) f 3 500 4 200 3 500 Fixed salary costs 6 000 Total payments (B) (d+e+f)43 10033 00045 200 Net cash (A-B) 6 900 8 200 9 300 Opening cash balance (July) 5 00011 90020 100 Closing cash balance11 90020 10029 400 Minimum cash requirement(15 000) Required financing/securities (3 100) 5 100 14 400

15. TIME VALUE FOR MONEY 1.Discuss the role of time value in finance 2.The concept of future value and present value, their calculation for single amounts 3.Find the future value and the present value of both an ordinary annuity and an annuity due, and the present value of a perpetuity. 4.Calculate both the future value and the present value of a mixed stream of cash flows. 5.Understand the effect that compounding interest more frequently than annually has on future value and the effective annual rate of interest. 6.Describe the procedures involved in (1) determining deposits needed to accumulate to a future sum, (2) loan amortization, (3) finding interest or growth rates, and (4) finding an unknown number of periods.

16. TIME VALUE FOR MONEY

17. Future Value of a Single Amount Jane Farber places R800 in a savings account paying 6% interest compounded annually. She wants to know how much money will be in the account at the end of five years. FV = R 800 X (1 + 0.06) 5 = 800 X 1.338 =R 1 070.40

18. Present Value of a Single Amount: Pam Valenti wishes to find the present value of $1,700 that will be received 8 years from now. Pam’s opportunity cost is 8%. PV = R 1 700/(1 + 0.08) 8 = 1 700/1.851 = 918.42 = R 1 700 X PVIF 8%, 8

19. Annuities (ordinary) Fran Abrams wishes to determine how much money she will have at the end of 5 years if he deposits (at the end of every year) R 1 000 into an account earning 7% annually. FVA = $1,000 (FVIFA,7%,5) = $1,000 (5.751) = $5,751

20. Annuities (Due) Fran Abrams now wishes to calculate the future value of an annuity due if he deposits (at the beginning of every year) R 1 000 in to an account earning 7% for 5 yrs FVA = $1,000(FVIFA,7%,5)(1+.07) = $1,000 (5.751) (1.07) = $6,154

21. Present Value of a Perpetuity A perpetuity is a special kind of annuity. With a perpetuity, the periodic annuity or cash flow stream continues forever. For example, how much would I have to deposit today in order to withdraw R1,000 each year forever if I can earn 8% on my deposit? PV=Annuity/interest rate PV= 1 000/0.08 = R12 500 FV of a Mixed Stream Calculate the FV of a mixed stream if the opportunity cost is 8%?

22. FV OF A MIXED STREAM

23. Compounding Interest More Frequently Than Annually Fred Moreno has found an institution that will pay him 8% annual interest, compounded quarterly. If he leaves R 100 in the account for 24 months (2 years), he will be paid 2% interest compounded over eight periods. 0 1 yr2yrs

24. Continuous Compounding Fred Moreno deposits R100 into an account paying 8% annual interest compounded continuously. Find the future value of this investment after 2 years of this investment? FV = R100 X e 0.08 X 2 = R100 X 2.7183 0.16 = R100 X 1.1735 = R117.35

25. Calculating payments (PMT) FVA = PMT X FVIFA Hence = PMT = FVA FVIFA Suppose you want to buy a house 5 years from now and you estimate that the down payment needed will be R30,000. How much would you need to deposit at the end of each year for the next 5 years to accumulate R30,000 if you can earn 6% on your deposits? PMT = 30 000/5.637 = 5 321.98

26. Interest or Growth Rates Find the rate of interest or growth for the following stream of cashflows? PVIF i, 5YRS = PV/FV = 1250/1520 = 0.822 = 5%

27. Finding Number of Periods Mrs Bates wishes to know the number of years it will take for her initial R 1 000 earning 8% per annum to grow to R 2 500 PVIF 8%, n = PV/FV = 1000/2500 = 0.400 or 12 Yrs Practice questions 11-15 of assignment 01, May/June 09, October/November 09.

28. Risk and Return Defining return = Cf+Pt-Pt-1 Pt-1 Game room wishes to determine the returns of its video machine Conqueror. It was purchased 1 year ago for R20,000 and currently has a market value of R21,500. During the year, it generated R800 worth of after-tax receipts. Return = Risk preferences Risk-averse Risk-indifferent Risk-seeking Choose the better of two investments, A and B. Each requires an initial outlay of R10,000 and each has a most likely annual rate of return of 15%. Management has made pessimistic and optimistic estimates of the returns associated with each.

29. Risk of a Single Asset

30. Expected Return Standard Deviation

31. Coefficient of Variation The coefficient of variation, CV, is a measure of relative dispersion that is useful in comparing risks of assets with differing expected returns. Review questions 6 (assignment 02, 17 and18 assignment 01.

32. Portfolio Return The return of a portfolio is a weighted average of the returns on the individual assets from which it is formed and can be calculated as shown in Equation 5.5. In the same way the beta of a portfolio will be calculated using this formula. In this case you calculate the weight/proportion of every asset in the portfolio, multiply it by its beta and find the total beta of that portfolio. You will also need to know the implication of beta values.

33. Basic Valuation Model Valuation of stocks and bonds is done In a similar manner. Practice question 4 assignment 2. For premium bonds, the current yield > YTM. For discount bonds, the current yield < YTM.

34. Calculating YTM, PV & FV A Par value company bond pays interest semiannually, the required stated annual return is 12% and it has 10 yrs to maturity. Calculate PV. Bond corporation issued R1000 par value bonds bearing a coupon rate of 12% and paying coupons semi annually. The bonds have 3yrs remaining to maturity and are priced at R940 per bond. What is the annual yield to maturity? Coupon=12%X1000=120/2 Periods N= 3X2= 6 FV= 1 000 PV= 940 compute I = 7.27X2 = 14.54%

35. Common Stock Valuation Stock Returns are derived from both dividends and capital gains, where the capital gain results from the appreciation of the stock’s market price due to the growth in the firm’s earnings. Mathematically, the expected return may be expressed as follows: E(r) = D 1 /P + g For example, if the firm’s $1 dividend on a $25 stock is expected to grow at 7%, the expected return is: E(r) = 1/25 +.07 = 11%

36. Basic Stock Valuation Equations

37. Constant Growth Model Lamar Company, a small cosmetics company, paid the following per share dividends: Lamar has just paid a dividend of R1.50 and expects dividends to grow according to the schedule below. Calculate the price of Lamar’s share. Practice question 19 of assignment 02. P 0 = R1.50/(0.15 – 0.07) = R18.75

38. Other Approaches (P/E) Multiples Some stocks pay no dividends—using P/E ratios are one way to evaluate a stock under these circumstances. The model may be written as: Question 12 assignment 01. P 0 = (EPS t+1 ) X (Industry Average P/E) For example, Lamar’s expected EPS is R2.60/share and the industry average P/E multiple or P/E ratio is 7, then P 0 = R2.60 X 7 = R18.20/share.

39. Working Capital Management Working Capital includes a firm’s current assets, which consist of cash and marketable securities in addition to accounts receivable and inventories. It also consists of current liabilities, including accounts payable (trade credit), notes payable (bank loans), and accrued liabilities. Net Working Capital is defined as total current assets less total current liabilities. Central to short-term financial management is an understanding of the firm’s cash conversion cycle.

40. Calculating the OC & CCC Reducing AAI or ACP or lengthening APP will reduce the cash conversion cycle, thus reducing the amount of resources the firm must commit to support operations. Permanent vs. Seasonal If a firm’s sales are constant, then its investment in operating assets should also be constant, and the firm will have only a permanent funding requirement. If sales are cyclical, then investment in operating assets will vary over time, leading to the need for seasonal funding requirements in addition to the permanent funding requirements for its minimum investment in operating assets.

41. Aggressive vs. Conservative Strategies Aggressive strategy the firm funds its seasonal requirement from short term debt while its permanent requirement from long term funds. Conservative strategy the firm funds both its seasonal and permanent requirements from long term debt. Apply the concepts and calculate the amount of financing required under each of the two methods of financing. Work through; Illustrations from Gitman chapter 14 and assignment 03 tutorial letter 101.

42. Ignore the $ Signs (example used only for illustration purposes) Changing Credit Standards Example Dodd Tool, a manufacturer of lathe tools, is currently selling a product for $10/unit. Sales (all on credit) for last year were 60,000 units. The variable cost per unit is $6. The firm’s total fixed costs are $120,000. Dodd is currently contemplating a relaxation of credit standards that is anticipated to increase sales 5% to 63,000 units. It is also anticipated that the ACP will increase from 30 to 45 days, and that bad debt expenses will increase from 1% of sales to 2% of sales. The opportunity cost of tying funds up in receivables is 15%. Given this information, should Dodd relax its credit standards?

43. Changing Credit Standards Example Additional Profit Contribution from Sales

44. Changing Credit Standards Example

45. Yes they should because they have a profit from the plan. Kindly note the positive and negative values and why they occur. When you relax credit standards you will expect to increase your sales but the marginal investment in accounts receivables will also increase and so will your bad debts. So you have to reconcile these effects.

46. Analyzing Credit Terms Taking the Cash Discount –If a firm intends to take a cash discount, it should pay on the last day of the discount period. –There is no cost associated with taking a cash discount. Giving Up the Cash Discount –If a firm chooses to give up the cash discount, it should pay on the final day of the credit period. –The cost of giving up a cash discount is the implied rate of interest paid to delay payment of an account payable for an additional number of days. – Note: If the cost of giving up the cash discount exceeds the required return on borrowed funds the company should take the cash discount. Attempt practice questions in your tutorials and study guides. Cost = % discount x 365________ 100% - %discount credit pd - discount pd

47. Sources of Short-Term Loans Method of Computing Interest –Once the nominal (stated) rate of interest is established, the method of computing interest is determined. –Interest can be paid either when a loan matures or in advance. –If interest is paid at maturity, the effective (true) rate of interest—assuming the loan is outstanding for exactly one year—may be computed as follows: Interest Borrowed amount

48. Sources of Short-Term Loans Method of Computing Interest –If the interest is paid in advance, it is deducted from the loan so that the borrower actually receives less money than requested. –Loans of this type are called discount loans. The effective rate of interest on a discount loan assuming it is outstanding for exactly one year may be computed as follows: Interest paid Amount borrowed – interest paid Review the practice examples in chapter 15 of your prescribed textbook.

49. IMPORTANT INFORMATION (Calculators) Ensure that your calculator is cleared before any new calculation(shift or 2 nd Function, clear all/CA. When you clear the HP10bII it should show a quick message (1- P-yr). If it does not, press; 1 Shift PMT and clear again until it indicates (1-P-yr) If you calculate an annuity due, remember to convert the calculator to begin mode and always change back to normal mode after you complete this kind of calculation In time value for money, interest is always quoted per annum e.g. 12% pa. Therefore when it is compounded more than once a year, remember to determine the interest per period and to increase the periods N (see study unit 5 study guide) You should ignore the input (CPT) key when using the HP10bII and just press for the required variable

50. IMPORTANT INFORMATION (Calculators) I have provided you the suggested solutions (Memo) for the May/June 09 exams posted under additional resources on myUNISA. Please work through the questions and check with the answers. But please, do not concentrate on this paper alone as the upcoming exam questions may differ. I have also provided you with the questions from last semester (Semester 2),2009 for both assignments 1 & 2. Although some of the questions are similar to your tutorial, I advise you to attempt them and compare with the answers I have provided in the slide that follows. The tutorial questions are posted under “additional resources on myUNISA. You have enough questions and pointers for this exam, in this presentation, your tutorial letters, the May/June 09 exam, the study guide and textbook. So, just practice....practice...practice!

51. PRACTICE QUESTIONS As part of your preparation we encourage you to attempt questions from assignments 01 and 02 for the Second semester’ 09. The suggested answers are provided here below: Assignment 01 semester 02 *The Zero denoted as an option implies that there was no correct solution for that question and students should just attempt it.......! Qn.Ans.Qn.Ans.Qn.Ans.Qn.Ans.Qn.Ans. 1. 2 2.23.14.15.3 6.27.18.49.010.2 11.012.413.114.215.4 16.117.218.219.120.3 Assignment 02 Semester 02 1.42.23.24.15.2 6.17.38.39.410.4 11.212.413. 0 14.215.4 16.117.118.119.420.2

52. EXAMINATION FORMAT The examination will consist of section A & B. Section A is 50 multiples choice questions accounting for 1 mark each, (totalling 50 marks) Section B will comprise 2 short answer questions totalling 20 marks (show all your working for this section). The whole paper will be marked out of 70 marks which will be adjusted to 90% to account for the exam mark. The exam duration is 2hours so budget your time sparingly so that you complete the exam on time. We recommend at most, 1 and a half hours to section A and 30 minutes to section B but you are welcome to follow a pattern which suits you. Both your assignments 01 and 02 contribute to the year mark of 10%. Each assignment accounts for 5% of the year mark so you are encouraged to submit both assignments.

53. GOOD LUCK WITH THE EXAM!!! KASOZI STEPHEN JASON AJH VAN DER WALT BUILDING RM 3-116 TEL: +27 12 429 4684 EMAIL: kasozjs@unisa.ac.za