MBA Accounting

• The income approach is the most appropriate method for valuing an on-going company.
• An investment in any asset is worth no more than the present value of its expected future cashflow, which can be in the form of earnings, dividends or free cashflow to equity.
• The most common method used by analysts is single period capitalisation method (SPCM) (some finance text books call it the Gordon growth model for discounting back future dividends).
• SPCM converts the single period of income into value by dividing it with a capitalisation rate.
• This method relies on two assumptions: A stable annual financial return, which can be a proxy for every year in perpetuity; and a constant growth rate, which is a proxy for the annual compound growth rate in perpetuity.

Value of a company        

Cashflow  (1+g)                                                                                R – g

 where Cashflow can be in the form of dividend per share (DPS) or free cashflow per share g refers to the future growth rate of cash flow R refers to the required rate of return for an investor Capitalisation rate = R - g

Illustration:

• Company A provided a DPS of 50 sen last year. Let us assume that we expect the company’s DPS to grow at 8% (g = 8%). The value of a company is equal to RM10.80 if an investor’s required rate of return (R) is equal to 13%. 

         Value of company A =           RM0.50 x (1 + 0.08) = RM10.80                                               0.13 -0.08                                            

• The computed value of RM10.80 is the intrinsic value for Company A. We will rate it a “buy” if the current price is lower than RM10.80.

PER = Market price/Earnings per share (EPS)

• If Company A’s PER is 10 times against the industry’s 15 times, we can conclude that company A is undervalued.

For example, Company A is a holding company. It has a subsidiary, Company B, which is also listed on the exchange. The RNAV will use the market value instead of the book value of Company B to determine the overall revised market value of Company A’s assets. This figure will provide a more reflective value for Company A compared with its historical book value. Among the three approaches, the value indicated by the income approach is more appropriate and will have the greatest influence in valuing an operating company.

FIXED INCOME SECURITIES:

The holders of the fixed income securities are creditors of the company rather than shareholders:

Have no rights in the company beyond the payment of a fixed interest on their loans and repayment of the loans in accordance with the terms on which they were issued.

Fixed income securities may be secured or unsecured, with the secured fixed income securities ranking before the unsecured.

The two (2) principal types of fixed income securities are debentures and loan stocks.

DEBENTURES/DEBENTURE STOCKS

A debenture is similar to a mortgage;

It is a long-term loan secured on certain fixed or floating assets of a company;

A debenture stock is a debenture issued as a fixed-interest stock;

Such securities are issued under trust deeds, and in the event of the borrower defaulting on the interest or capital repayment, the debenture holder has the right to appoint a receiver to sell the company’s assets and secure repayment of the loan;

LOAN STOCKS

A loan stock is a security issued by a company in respect of a loan made by investors;

Loan stocks may be secured, unsecured, convertible or non-convertible, but are often unsecured, unlike debentures;

Unsecured loan stocks

carry higher risk than debentures, and in the event of a winding-up, unsecured loan stock holders rank alongside all other unsecured creditors.

Convertible loan stocks

carry the right to convert into ordinary shares of the company on pre-arranged terms and within a limited period. The objective of issuing a convertible loan stock is to obtain fixed interest finance at a relatively low rate of interest and at the same time make it attractive to potential holders by the offer of equity participation at a later date.

NOTES

These are also fixed income securities with a maturity date, and may or may not be redeemable.

BONDS

Like debentures, bonds are fixed income securities issued to lenders of long-term loans, and with a maturity date.

SHARE CAPITAL:

A share is a security which represents a portion of the owner’s capital in a business. Shareholders are the owners of the business. They share in the success or failure of the business. This can be measured by the amount of dividends that they receive and by the price of the share, quoted on the stock market. (In the U.S., shares are referred to as common stock.)

There are several types of share capital:

(1) ORDINARY Share Capital

· Also known as equity shares, this is the risk capital of a company;

· Ordinary shares give holders the rights of ownership in the company, such as the right to share in the profits, the right to vote in general meeting and to elect and dismiss directors;

· Obligations of ownership are also conferred and this may result in the loss of an investor’s money if the company is unsuccessful;

· Ordinary shares usually form the bulk of a company’s capital and have no special rights over other shares and

· In the event of liquidation, ordinary shares rank after all other liabilities of the company.

(2) PREFERENCE Shares

·  Shares which carry the right to dividend (normally fixed) which ranks for payment before that of ordinary shareholders;

·  Preference shares may be preferred also as regards distribution of assets upon dissolution of the company;

·  Generally carry no voting rights, but voting rights may be made contingent upon failure to pay dividends on preference shares for a certain period of time

·  There are several types of preference shares which are as follows.

(a) Participating preference shares

are entitled to participate in the profits beyond the fixed dividends, by way of an additional fluctuating dividend if the company is successful.

(b) Cumulative preference shares

are preference shares which, apart from having a preferential right to receive a fixed dividend ahead of ordinary shares, also carry the right of any arrears of the preference dividends which may have built up.

 © Non-cumulative preference shares

are preference shares which are not entitled to any arrears in dividends.

(d) Redeemable preference shares

may be redeemed by the company at a stated redemption price on advance notice of a period of time. It is usual to set a redemption price above the par value to compensate the owner for the involuntary loss of his investment.

(e) Convertible preference shares

are preference shares which carry the right to be made convertible, at the option of the holder, into another class of shares, normally into ordinary shares.

Sources Of Short-term finance

Description

Bank Overdrafts

• Simplest and most flexible type of short term finance for most business;

• Given a maximum limit;

• Interest is charged only on those utilized;

• Unutilized amount might be charged a small % of commitment fee;

• This facility is given on top of what the owner has in his/her current account;

• Generally about 2%-5% above the lender bank’s base lending rate. Premium spread like 0.25% to 0.75% are given by the lender bank to their high valued customers;

• Flexible because the borrower can reduce his overdraft as and when he wants by merely banking into his current account which has the overdrawn amount;

• The main disadvantages are this type of facility is repayable on demand and normally the borrower need to provide security/collateral for the overdraft facility.

Short-term loans

• Fixed amount and have a fixed period of time to repay the loan;

• Interest rate is fixed;

• Duration from few months to few years;

• Repayments either in installments or bullet type meaning one lump sum repayment;

• Interest is charge on the amount borrowed;

• Like bank overdraft, need to provide security or collateral for the lender bank;

• Advantage - the company does not need to pay back immediately especially when they embark on medium to long term projects/investments. So it is more secure than bank overdraft;

• Disadvantage - the interest rate is fixed. Un-conducive particularly when interest rates trends are moving downward;

Revolving Credit

• Borrowing for a short period of time say ninety days but renewable when expiry date is due;

• Has the feature of both short-term and medium-term loans as the borrower can keep repaying and borrowing for a few years

Bridging loans

• Normally applies to property based or project financing

• Loans are given for a specified period of time and coincides with the date the funds to repay. For example, in a housing project, a bridging loan of $XXmillion is repayable when the house owners commence to pay the housing developer.

Debt Factoring

• The lender bank or finance company takes over the company’s trade debts in return for a commission;

• Services offered include debt collection and administration, credit insurance and finance provision;

• Debt collection and administration includes taking over all the trade debts and manages the collection of debts for a fee/commission;

• Credit insurance is the paying in advance certain portion of the face value of the debts say 85%. Two types: recourse and non-recourse factoring arrangement. Recourse means that in the event of bad debts, the company will absorb it whilst non-recourse is that the factoring company will absorb the bad debts but will charge a higher commission for doing so;

• Finance provision is similar to recourse factoring.

Invoice discounting

• Similar to factoring. The lender will advance a percentage of the trade debt;

• The collection and management of the trade debt is done by the company and not the lending institution;
• The borrower to repay amount advanced plus interest charged.

Trade credits

• Credit extended by the supplier of goods and/ services;

• Normally for a period of 30 to 90 days;

• Credit term given by suppliers will depend on the company’s financial position and whether discount is taken or not;

• Interest free unless if supplier offers discount and borrower did not pay to enjoy the discount benefit;

• Therefore, the “cheapest” source of finance but should be handled properly otherwise company’s reputation might be ruined if it overstretch the credit term given by the suppliers.

A Cost Unit

Is the quantitative unit of product or service in relation to which costs can be ascertained.

Examples:

Jobs, contracts, kilowatt hours, cost per patient day

Cost Centre

Is “a location, person or item of equipment ( or group of these) in respect of which costs may be ascertained and related to cost units’

In a business, it is divided into sections called cost centre where costs are accumulated.

Example of Classification of Cost centre:

Production cost centre:

- where production takes place like machining and assembling department.

Service Cost Centre:

- which provides services to other cost centre like stores, production planning, store and maintenance.

Process Cost Centre:

- where a specific process or a continuous sequence of operations take place like refining process.

(1) By Nature

Based on nature of major costs like material, labour and other expenses.

Material can be sub-classified into:

Raw material, semi-finished materials, components, consumables, maintenance materials

Labour can be sub-classified into:

Maintenance, supervision, clerical and others

Other expenses can be sub-classified into:

Rent, water, electricity and depreciation

(2) By Function:

Costs are classified by function to which they relate.

They are:

Production Costs:

All costs involved in the acquiring of raw materials to the delivery of finished goods to the warehouse.

For example, production overheads, direct materials, direct labour and direct costs.

Administration Costs

All costs involved in the general administration including managing the operations of the organization

For example:

Depreciation, Electricity and Audit fee

Marketing Costs

Costs incurred in securing orders, selling, advertising, promoting, distributing of the finished products

For example:

Salesmen salaries, commission and incentives

Samples, cost of advertisement, trade fairs, warehouse rent, transport costs and others

Finance Costs

Relate to the financing the activities of the business.

For example:

Overdraft interest, fixed term loan interest and commitment fees

Research Costs

Costs incurred in seeking new or improved ideas, designs, process/methods and new products

For example:

Cost of salaries of researches personnel, laboratory maintenance and cost of feasibility

Development Costs

Costs incurred in developing new or improved ideas, methods/process or new products so that production can take place.

For example:

Cost of tests/trail runs

4) Based on Time

Categorized into two types:

Historical or Sunk Costs:

- costs that have already been incurred. For example like cost of fixed assets

Future Costs:

- costs that needs to be predetermined like standard cost.

(5) By Cost Units

A cost unit consist of material, labor and other expenses. In turn they are analysed into direct and indirect costs. Direct costs are charged directly to a cost unit whilst indirect costs relate to more than one cost unit. Unlike direct cost, indirect cost cannot be charged to a cost unit.

Example of direct costs: direct material, direct labour and direct expenses

Example of indirect costs: indirect materials, indirect labour and indirect expenses/overheads.

(6) By Controllability

Categorized into two types:

Controllable or Managed Costs:

- costs that are influenced by the decisions or actions of a manager like shut down costs -retrenchment wages

Uncontrollable Costs:

- costs that are not influenced by the decisions or actions of a manager like increased price increase of raw materials.

(7) By Normality

Costs can be categorized into:

Normal costs are those costs that management expects to incur and is within a normal range for example: loss due to evaporation

while

Abnormal costs are those that are not expected to recur or one that is smaller or larger than expected for example lost production due to plant breakdown.

(8) Product Or Period Costs

Product costs are costs incurred in the manufacturing of the goods.

These costs comprise all cost of production whether it is direct or indirect which can be assigned to the goods produced.

Period costs related to costs that cannot be assigned to the goods produced and are incurred during the period and are charged as that year’s expense in the profit and loss account.

9) Relevant and Non-Relevant Costs

Refer to earlier article on relevant and non-relevant costs