CHAPTER 15: METHODS OF FINANCING A BUSINESS

SUGGESTED SOLUTIONS
SOLUTION TO MULTIPLE CHOICE QUESTIONS
15.1 (d) 15.6 (b)
15.2 (a) 15.7 (b)
15.3 (b) 15.8 (d)
15.4 (b) 15.9 (e)
15.5 (a) 15.10 (c)

END OF CHAPTER QUESTIONS

15.1
If the Balance Sheet may be considered to be a list of all the assets of a company, this is
“balanced” by a list of who has ownership rights over those assets (share holders and debt
holders). This tends to be an accounting perspective on the information in the Balance Sheet.
From a finance perspective, the assets of a company reflect all the decisions, which have
been made by the financial manager with regard to wealth creating assets in which the
company has invested. The equity and liabilities reflect all the decisions, which have been
made by the financial manager as to the sources of finance, which will be used to acquire
those assets.

15.2
It is now well understood that the objective of business is to create wealth by adding value.
Stated differently, assets, which have the capacity to create wealth, are acquired. The wealth
created must be at least equal to the return required by the investors (normally divided into
equity investors and debt holders – because each has a different risk profile). Since it is
intuitive that projects which do not meet the target required rate of return will not be
undertaken by the business, this decision (the investment decision) must be made before
considering the sources of finance which will be used.

15.3
The primary source of wealth creation is the acquisition of assets, which will generate profits
and thus grow the capital invested. A secondary, but significant method of increasing
shareholder wealth is to use borrowed funds, pay the after tax cost of those funds (interest),
and retain any return which is excess of this cost. This is known as levering the profits of the
shareholders through the use of debt. At the same time however, increasing the use of debt
causes additional risk for shareholders. Finding the ideal proportion of debt to equity is finding
that proportion where the benefits of additional leverage are optimised against the cost of the
risk caused by additional debt. It is a “notional” mix which every financial manager strives to
achieve.

15.4
The two primary ways of raising finance are through the issue of shares (which may be of
different classes – offering differing risks and returns) and through the issue of debt
instruments (which also may be of different types, for example short or long term, secured or
unsecured). The main equity issue will be ordinary shares. Shareholders are considered to be
“residual” investors, in that they receive “what is left”, once all other forms of finance have
received their return. Thus is a company does very well, ordinary shareholders will receive
large residual benefits, but if the company does badly, shareholders may receive nothing –
they bear the ultimate risk.

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 1

15.5
Weighted
Capital Cost of
Financing Cost of
Structure Capital
Capital
Shareholder Equity 50% 10.50% 5.25%
Debt 50% 20.00% 10.00%
100% 15.25%
Cost of Debt equals the after tax cost 15% x (1 - 30%) = 10.50%

The project offers a return of 18%, which is lower than the required rate of return for equity
shareholders of 20%. However, as 50% of the funds are financed at a real cost to the
company of only 10.5%, the weighted average cost of all the funding is 15.25% and the
project should be accepted. Note that as a result of leverage, the project achieving a return of
18%, exceeds the required rate of return by 2.75%, this “excess” or “residue” accrues to the
equity holders and will create additional wealth for them.

15.6
Some significant implications of using debt in addition to equity financing, when previously
only equity financing was used are:

 The weighted average cost of capital will be lower than the cost of equity
 Projects, which were previously unacceptable, may now be acceptable
 Fixed costs will increase as a result of the annual interest payable
 The interest payable will be deductible for the purpose of calculating taxable income
 Equity holders may require a higher return as a result of the risks of taking on debt

15.7
 Trade Creditors: This is a form of short term loan resulting from suppliers who are
prepared to wait for a defined period (usually 60 to 90 days) before receiving payment for
goods or services supplied.

 Bank Overdrafts: Banks are prepared to allows short term credit, particularly to
businesses which experience cyclical cash flows as a result of seasonal supply and
demand patterns or other factors which cause variability is cash flows.

 Money Market Instruments: Funds can be obtained through short term loans, bill of
exchange, letters of credit and other instruments which are available from intermediaries
such as merchant banks.

15.8
Factoring is the process of handing accounts receivable (debtors) to a third party for
collection, in return for a fee or commission based on the debts to be collected. The cash is
paid over immediately. It is thus a source of immediate cash financing for a company which
sells on credit.

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 2

15.9

Loan R 700,000 Rate 16%

Term 4 years
PVA factor (16%:4years) 2.7982
Annual loan repayment R -250,163 (R700 000/2.7982)
TERM LOAN AMORTISATION
LOAN INTEREST PRINCIPAL REMAINING
YEAR
REPAYMENT PORTION PORTION BALANCE
0 R0 R0 R0 R 700,000
1 -R 250,163 R 112,000 -R 138,163 R 561,837
2 -R 250,163 R 89,894 -R 160,269 R 401,569
3 -R 250,163 R 64,251 -R 185,912 R 215,657
4 -R 250,163 R 34,505 -R 215,657 R0
15.10
 Long Term Loan
 Mortgage Loan
 Secured Debentures
 Unsecured Debentures
 Redeemable Preference Shares

15.11
Leasing, notably long term leasing, also known as a capital lease, creates the obligation to
meet regular payments. These payments are in reality repayments of the capital amount of the
lease and interest payments. Investors and analysts, reviewing the balance sheet of a
company consider the lease obligation to be almost identical to a long term loan in terms of
the obligations and risks which the lease creates.
When determining the capital structure of a company, for the purpose of assessing its financial
risk, all lease obligations are seen as a use of debt for financing. The decision for the financial
manager is therefore not whether to buy an item or not – that is the investment decision which
is made using the principles of investment decision appraisal. Only once that decision has
been made, are the financing alternatives considered – one of which is leasing, because it
may have cost/benefit advantages over a standard long term loan.

15.12
All projects are considered only on the basis of meeting the hurdle rate of the company. This
hurdle rate is determined by calculating the weighted average marginal cost of capital, using
the target capital structure of debt to equity, which is considered optimal. The fact that a
particular project will be financed by new debt is not relevant to the decision. This is a
sometimes subtle, but very significant point to note.
The reason for this is that new debt for a particular project is used only because, at that
particular moment, additional debt is required in order to keep the target capital structure in
the correct proportion. The next project, for example, may be financed from equity. For
practical reasons, finance is raised in a type of step-wise process as the company grows.
If for example a project with an IRR of 14% is accepted because the particular financing for
that project is at an after tax rate of 10%, the possibility is that the next project, being financed
by equity at say 20% may be rejected even if its IRR is higher than (14%), but lower than 20%.
The net effect is that less profitable projects would be accepted on this basis than more
profitable projects – clearly an illogical approach to wealth creation.

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 3

15.13 ACUTE, OBTUSE AND JUDICIOUS LTD
The most obvious similarity between the three companies is that they have identical non- current and
current asset investments. Each company has invested R110 000 in assets and is using R10 000 in
short term liability financing (most probably trade creditors).
The most obvious difference between the three companies is that Acute Ltd is financed 100% by
equity, Judicious is using a 50% equity, 50% debt mix, while Obtuse Ltd is very heavily geared with
only 5% equity against 95% debt.
From a financing perspective, the shareholders of Acute Ltd have the least financial risk, although they
may be missing some additional return, which could be generated through borrowing and levering their
return on equity upwards.
Judicious Ltd is making using of the leverage potential. This results in the lenders being reasonably
comfortable as their loan is protected by the shareholders funds – the company would have to destroy
value of 50% of the total company, before the debt holders would suffer any loss of capital. The
shareholders on the other hand, enjoy the benefit of potential leverage, although the risk is heightened
as a result of the commitment to meet the annual fixed cost of interest burden.
Obtuse Ltd seems to have lost its way. Both the shareholders and the debt holders are likely to be
extremely concerned. If the company has a bad year, and loses 5% of its asset value, the
shareholders will have no more interest in the company and will have lost all their funds. The debt
holders will then become the owners and risk bearers of the business – this is not what they intended,
else they would have purchased shares in the first instance. Obtuse desperately needs to change its
capital structure with an injection of funds from shareholders – if they can find any that would be
willing.

15.14 A COMPANY LEASING DECISION

Lease Payment R 47,000 per year
Lease Period 3 years, payable in advance
Interest rate 18% Capital repayable at the end of the period
Cost of Asset R 150,000
1-tax rate 60%
Tax rate 40% Tax payable at the end of each year
Wear & Tear Allowance 33.33% Straight line - no scrap value
After tax cost of debt 10.80% 18% x .6 (say 11% for use of Tables)

BORROW AND PURCHASE ALTERNATIVE

40% of
1 2 3 4 6 7 8
(Col3+Col4)
CASH P V FACTOR
YEAR LOAN PAYMENTs INTEREST DEPRECIATION TAX SHIELD PRESENT VALUE
OUTFLOW 11%

0 0
1 -27,000 27,000 50,000 30,800 3,800 0.9009 3,423
2 -27,000 27,000 50,000 30,800 3,800 0.8116 3,084
3 -177,000 27,000 50,000 30,800 -146,200 0.7312 -106,901
NET PRESENT COST OF BORROWING AND PURCHASING -100,394

LEASE ALTERNATIVE

LEASE P V FACTOR PRESENT

YEAR TAX SHIELD CASH OUTFLOW
PAYMENT 11% VALUE

0 -47,000 -47,000 1 -47,000

1 -47,000 18,800 -28,200 0.9009 -25,405
2 -47,000 18,800 -28,200 0.8116 -22,887
3 18,800 18,800 0.7312 13,747
NET PRESENT COST OF LEASING -81,546

CONCLUSION: LEASE THE ASSET AS LEASING HAS A LOWER NET PRESENT COST
The most important uncertainty is the scrap value of the asset at the end of the period, which would
accrue to the company it purchased rather than leased. It would have to be around R25 000 after tax
for the decision to be marginal (R100 394 – R81 546) / .7312

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 4

15.15 GADJET LTD
(a)

GADJET LTD
ALL EQUITY
EQUITY AND DEBT
Financing
Shareholder Equity R 400,000 R 250,000 12.00% Interest
12% Secured Debentures R0 R 150,000 30.00% Tax
R 400,000 R 400,000

Assets R 400,000 R 400,000

R 400,000 R 400,000

Budgeted Profit before interest and tax R 80,000 R 80,000

Interest R0 R 18,000
Profit before tax R 80,000 R 62,000
Tax R 24,000 R 18,600
Net Profit attributable to shareholders R 56,000 R 43,400

Return on Equity 14.00% 17.36%

Return on Assets before interest and tax 20.00% 20.00%
Return on Assets before interest after tax 14.00% 14.00%

(b) The all equity financing option has less risk, as there is no obligation to meet the fixed costs of
interest of R18 000 each year. However, it does not make use of the potential for leverage.
Based on the budget, a return on assets of 20% is forecast. The after tax cost of debt is only
8.4% (12% x .7), thus offering the shareholders who are prepared to select the mix of debt
and equity, the opportunity to lever their return on equity up from 14% after tax to 17 .4%.
Given that the proportion of long term debt is still relatively low at 37.5% (150/400) this seems
like a more attractive option with a relatively small additional risk. It is worth noting that
shareholders that invest in the company if the debt and equity option is selected will require a
higher return on their investment than those who opt for the all equity option will. The selection
of the most attractive alternative is therefore always subject to the appetite for risk of the
investor.

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 5

15.16 READY AND STEADY LTD
(a) and (c)

READY AND STEADY LTD

READY STEADY
LTD LTD
Financing Interest
12.00%
Shareholder Equity R 500,000 R 250,000 ASSUMED

12% Secured Debentures R0 R 250,000 15.00% ROA

R 500,000 R 500,000
Assets R 500,000 R 500,000
R 500,000 R 500,000

OperatingProfit before interest R 75,000 R 75,000

Interest R0 R 30,000
Net Profit attributable to shareholders R 75,000 R 45,000
Return on Equity 15.00% 18.00%

(b) The interest rate of debt was not given in the question. Tax is ignored, therefore reducing the
impact of the tax shield which would be there for share holders.
Assuming an interest rate of 12%, there is clearly a leverage effect for shareholders who have
invested into Steady Ltd. As the funds earned 15%, and for half of those funds, only 12%
needs to be paid, the additional 3% earned on those funds accrues to the ordinary
shareholders, levering their return from 15% (Return on all assets), to 18% (Return on the
capital provided by shareholders)

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 6

15.17 ADEPT LTD
(a)
DIFFERENTIAL CASH FLOWS
0 1 2 3 4 5 PV@14%
Capital outlay 160,000 0.8772
After tax lease cost -37,100 -37,100 -37,100 -37,100 -37,100 0.7695
W&T Tax shield foregone -9,600 -9,600 -9,600 -9,600 -9,600 0.6750
CASH FLOWS 160,000 -46,700 -46,700 -46,700 -46,700 -46,700 0.5921
14% PRESENT VALUE FACTOR 1.0000 0.8772 0.7695 0.6750 0.5921 0.5194 0.5194
PRESENT VALUES 160,000 -40,965 -35,936 -31,523 -27,651 -24,256
NPV LEASING -330

EXPLANATION: If borrow and purchase, the present value of all the cash flows is R160 000 when
discounted at the after tax cost of debt. This is compared to the effect if leasing is selected, namely
that the after tax cost of leasing of R37 100 would be paid and the company would forfeit the tax shied
of R9 600 which would have been a cash flow if purchased (20% x R160 000 x 30%). The net effect is
that it is marginally advantageous to borrow and purchase (leasing has a negative net present value
when compared in this way against borrowing and buying.
(b) Should borrow and buy – see the more detailed (considerably longer method) which shows
the cash flows for each decision (rather than just the incremental cash flows). Note that the
difference (net present cost) is only R325 (see R330 above – rounding errors). This is thus a
very marginal decision ie qualitative factors should also be considered.

ADEPT LTD
TERM LOAN AMORTISATION loan repayment -R 53,500.75

LOAN INTEREST PRINCIPAL REMAINING

YEAR Lease Payment 53,000
REPAYMENT PORTION PORTION BALANCE

0 0 0 0 160,000 Interest rate 20%

1 -53,501 32,000 -21,501 138,499 Cost of Asset 160,000
2 -53,501 27,700 -25,801 112,698 1-tax rate 70%
3 -53,501 22,540 -30,961 81,737 Tax rate 30%
4 -53,501 16,347 -37,153 44,584 Wear & Tear Allowance 20%
5 -53,501 8,917 -44,584 0 After tax cost of debt 14.00%

BORROW AND PURCHASE ALTERNATIVE

LOAN DEPRECIATI CASH P V FACTOR PRESENT

YEAR INTEREST TAX SHIELD
REPAYMENT ON OUTFLOW 14% VALUE
0 0 0
1 -53,501 32,000 32,000 19,200 -34,301 0.8772 -30,089
2 -53,501 27,700 32,000 17,910 -35,591 0.7695 -27,387
3 -53,501 22,540 32,000 16,362 -37,139 0.6750 -25,069
4 -53,501 16,347 32,000 14,504 -38,997 0.5921 -23,090
5 -53,501 8,917 32,000 12,275 -41,226 0.5194 -21,413
NET PRESENT COST OF BORROWING AND PURCHASING -127,047

LEASE ALTERNATIVE

LEASE CASH P V FACTOR PRESENT

YEAR TAX SHIELD
PAYMENT OUTFLOW 14% VALUE

0
1 -53,000 15,900 -37,100 0.8772 -32,544
2 -53,000 15,900 -37,100 0.7695 -28,548
3 -53,000 15,900 -37,100 0.6750 -25,043
4 -53,000 15,900 -37,100 0.5921 -21,967
5 -53,000 15,900 -37,100 0.5194 -19,270
NET PRESENT COST OF LEASING -127,372

CONCLUSION: BORROW AND PURCHASE - LOWER NET PRESENT COST: A VERY MARGINAL DECISION

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 7

15.18 VENTAIR LTD
(a) to (d)

VENTAIR LTD
TERM LOAN AMORTISATION loan repayment -R 86,340.02
INTEREST REMAINING
YEAR LOAN REPAYMENT PRINCIPAL PORTION Lease Payment 80,000
PORTION BALANCE
0 0 0 0 270,000 Interest rate 18%
1 -86,340 48,600 -37,740 232,260 Cost of Asset 270,000
2 -86,340 41,807 -44,533 187,727 1-tax rate 70%
3 -86,340 33,791 -52,549 135,178 Tax rate 30%
4 -86,340 24,332 -62,008 73,170 Wear & Tear Allowance 20%
5 -86,340 13,171 -73,170 0 After tax cost of debt 12.60%
BORROW AND PURCHASE ALTERNATIVE

LOAN CASH P V FACTOR PRESENT

YEAR INTEREST DEPRECIATION TAX SHIELD
REPAYMENT OUTFLOW 13% VALUE
0 0 0
1 -86,340 48,600 54,000 30,780 -55,560 0.8850 -49,171
2 -86,340 41,807 54,000 28,742 -57,598 0.7831 -45,105
3 -86,340 33,791 54,000 26,337 -60,003 0.6931 -41,588
4 -86,340 24,332 54,000 23,500 -62,840 0.6133 -38,540
5 -86,340 13,171 54,000 20,151 -66,189 0.5428 -35,927
NET PRESENT COST OF BORROWING AND PURCHASING -210,331
LEASE ALTERNATIVE

LEASE CASH P V FACTOR PRESENT

YEAR TAX SHIELD
PAYMENT OUTFLOW 13% VALUE
0
1 -80,000 24,000 -56,000 0.8850 -49,560
2 -80,000 24,000 -56,000 0.7831 -43,854
3 -80,000 24,000 -56,000 0.6931 -38,814
4 -80,000 24,000 -56,000 0.6133 -34,345
5 -80,000 24,000 -56,000 0.5428 -30,397
NET PRESENT COST OF LEASING -196,969
CONCLUSION: LEASE THE MACHINE AS LEASING HAS A LOWER NET PRESENT COST

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 8

15.19 KABOUTER HOUTKLIMRAME (PTY) LTD
(a)

KABOUTER HOUTRAME (PTY) LTD

TERM LOAN AMORTISATION loan repayment R -167,189.85

LOAN INTEREST PRINCIPAL REMAINING

YEAR LEASE PAY 150,000
REPAYMENT PORTION PORTION BALANCE
0 0 0 0 500,000 RATE 20%
1 -167,190 100,000 -67,190 432,810 COST 500,000
2 -167,190 86,562 -80,628 352,182 TAX 70%
3 -167,190 70,436 -96,753 255,429 1-TAX 30%
4 -167,190 51,086 -116,104 139,325 W&T 20%
5 -167,190 27,865 -139,325 0 AfTax COD 14.00%
(b)

BORROW AND PURCHASE ALTERNATIVE

LOAN
INTERE DEPRECIA CASH P V FACTOR PRESENT
YEAR REPAYME TAX SHIELD
ST TION OUTFLOW 14% VALUE
NT
0 0 0
1 -167,190 100,000 100,000 60,000 -107,190 0.8772 -94,026
2 -167,190 86,562 100,000 55,969 -111,221 0.7695 -85,581
3 -167,190 70,436 100,000 51,131 -116,059 0.6750 -78,336
4 -167,190 51,086 100,000 45,326 -121,864 0.5921 -72,153
5 -167,190 27,865 100,000 38,359 -128,830 0.5194 -66,910
NET PRESENT COST OF BORROWING AND PURCHASING -397,008

LEASE ALTERNATIVE

LEASE
TAX CASH P V FACTOR PRESENT
YEAR PAYME
SHIELD OUTFLOW 14% VALUE
NT
0
1 -150,000 45,000 -105,000 0.8772 -92,105
2 -150,000 45,000 -105,000 0.7695 -80,794
3 -150,000 45,000 -105,000 0.6750 -70,872
4 -150,000 45,000 -105,000 0.5921 -62,168
5 -150,000 45,000 -105,000 0.5194 -54,534
NET PRESENT COST OF LEASING -360,474

(c) On the basis of the quantitative calculations, the machine should rather be leased as there is a
net advantage in costs of R36 534 (R397 008 – R360 474). Decisions such as these are
based on the information provided, so this needs to be carefully checked. For example there
must be no inflationary clause in the lease agreement, or any other hidden costs.
Another significant point in all leasing agreements is the fact that ownership is never
transferred to the lessee. In this case, the assumption was made that the asset will have a
zero scrap value after 5 years. This is just a convenient and prudent assumption. Assuming
the asset does have a scrap value after 5 years (or it could continue being used – thus
generating further income), then the borrow and purchase alternative can look more attractive.
The difference in the net present cost is R36 534. A rough way of using sensitivity for scrap
value is to see what amount (in 5 years time) would make the difference. The amount is
R36534/.5194, which is around R70 000. If there is a significant chance that the asset could
be scrapped and more than R70 000 received after tax, this should be considered.

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 9

15.20 ALJOH ALIMINIUM LTD
(a)

ALJOH ALIMINIUM
TERM LOAN AMORTISATION loan repayment R -113,569.49

LOAN INTEREST PRINCIPAL REMAINING

YEAR LEASE PAY 105,000
REPAYMENT PORTION PORTION BALANCE

0 0 0 0 360,000 RATE 10%

1 -113,569 36,000 -77,569 282,431 COST 360,000
2 -113,569 28,243 -85,326 197,104 TAX 60%
3 -113,569 19,710 -93,859 103,245 1-TAX 40%
4 -113,569 10,324 -103,245 0 W&T 25%
AfTax COD 6.00%

(b)
BORROW AND PURCHASE ALTERNATIVE

LOAN DEPRECIATIO TAX CASH P V FACTOR PRESENT

YEAR INTEREST
REPAYMENT N SHIELD OUTFLOW 6% VALUE

0 0 0
1 -113,569 36,000 90,000 50,400 -63,169 0.9434 -59,594
2 -113,569 28,243 90,000 47,297 -66,272 0.8900 -58,982
3 -113,569 19,710 90,000 43,884 -69,685 0.8396 -58,509
4 -113,569 10,324 90,000 40,130 -73,440 0.7921 -58,171
4 Profit on Disposal 60,000 0.7921 47,526
NET PRESENT COST OF BORROWING AND PURCHASING -187,731

(c)

LEASE ALTERNATIVE

LEASE CASH PRESENT

YEAR TAX SHIELD P V FACTOR 6%
PAYMENT OUTFLOW VALUE

0
1 -105,000 42,000 -63,000 0.9434 -59,434
2 -105,000 42,000 -63,000 0.8900 -56,070
3 -105,000 42,000 -63,000 0.8396 -52,896
4 -105,000 42,000 -63,000 0.7921 -49,902
NET PRESENT COST OF LEASING -218,302

CONCLUSION: BORROW AND PURCHASE - LOWER NET PRESENT COST

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 10