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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.
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