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By Wayne Ford

The word "accounting" is derived from the concept of "accountability" - somebody has to "account" to somebody else for her actions, or for the results of her actions.

People who manage assets are usually not the people who own the assets, and managers are thus required to "account" to the owners - or the representatives of the owners - regarding their "stewardship" of the owners' assets.

Modern finance and accounting is based on the "double-entry" system, which originated in Venice in the 15th century. In those days international trade was extremely dangerous. Intelligent merchants therefore took to hiring other adventurers, entrusting them with shiploads of trade goods or caravans of camels, and sending them off on voyages often lasting several years. When the captains returned (if they returned) they had to "account" to the owners regarding what they had done with the goods entrusted to them, and what they had brought back.

Borrowing money to finance projects or working capital is called "Gearing" or "Leverage". A "highly geared" entity is one which has a high ratio of debt to equity, i.e. it is heavily borrowed or heavily in debt. A "lightly geared" or "lightly leveraged" entity is an organisation which has not borrowed much capital, and has chosen to use owners' equity as its primary source of finance.

Being heavily geared has certain risks, in that loans and interest have to be repaid to the lenders irrespective of profitability or cashflow, whereas shareholders' only get paid if profits are made. If you are in serious debt and your cashflow fails then you could be forced into bankruptcy, and may lose everything.

Gearing is not necessarily a negative factor, as the "cost" to the company of borrowed money is generally cheaper than that of shareholders' funds, and the interest paid on loans is tax deductible, while dividends are not (because dividends are paid out of after-tax profits). A company with too little gearing is probably missing out on a profit opportunity. Consequently, if your business has stable cash flows with which to meet the planned finance interest and loan repayments then you can sustain a higher gearing ratio, and pay less for your financing, whereas if your business generates unpredictable and volatile cash flows then borrowing money is a serious risk, as you cannot be sure that you will have cash on hand to meet your installments, even if you are very profitable.

It is possible to earn a risk-free return - investing in a government bond such as an R153 will pay a specified fixed amount of interest and a full redemption of the capital value of the bond at the end of the investment period, absolutely guaranteed and totally risk free. The rate of interest you can earn on such an investment is around 8% p.a. before tax.

Because it is possible to earn a return risk-free, any project which involves risk will need to reward the investor by offering a rate higher than the risk-free rate. How much higher depends on how much more risky the project, and this cannot be accurately calculated - an educated guess is usually the best you will be able to achieve.

The internal rate of return (IRR) on the project must at least exceed the cost of finance - if the IRR used in evaluating the project is lower than the cost of finance, the project will automatically yield a negative return.

If other projects of equivalent risk are available, the IRR for evaluating this project must be at least as great as the return you could earn on the alternative project, to ensure your decision results in the best project being selected and undertaken. This is not necessarily limited only to other investment projects - if you have a large amount of debt on which to pay 16% interest, and the proposed project is only likely to yield 16%, then it may be a better idea to use whatever spare cash is available to pay off the debt, as the "saving" of the interest paid will be the full 16% and "risk free", while the return of 16% will attract taxation and may not necessarily be achieved in the first place.

Your minimum IRR must exceed the greater of the risk-free rate, the internal cost of capital, and the rates of return of other "investment" opportunities. Your IRR must also incorporate a "premium" to compensate for the degree of risk and uncertainty which you will be facing by undertaking this project instead of simply paying off debt or investing in risk-free opportunities such as government bonds.

The higher the perceived risk, the more risk-compensation is required. In practice, you would try to compare the perceived risk profile of the project under consideration against the perceived risk profile of the alternatives, be they a risk-free government bond or debt-repayment, or some other risky capex project, and if the project under consideration is more risky or has a greater potential for failure, you need to add extra "risk compensation points". If you are called upon to make a decision on a large-scale, high-value project, and you are not sure how to calculate an accurate discount rate, rather spend a few thousand Rand and hire an objective expert to assist you.

Learn more about the Finance for Non-Financial Managers Training Course here.