FINANCIAL MANAGEMENT 314

INDIVIDUAL ASSIGNMENT
DUE DATE: 27 OCTOBER 2015

1) The capital structure of a business basically refers to the certain levels of equity and debt
that an entity uses to finance their assets. There are 4 main theories that could help
determine the capital structure of Oceana Group Limited.
The first theory is the Miller and Modigliani (M&M) which assumes the following:
At any level of debt, the cost of debt is constant and the debt is risk- free.
There are no information and transaction costs hence there are perfectly
efficient capital markets whereby every individual has all the information
related to the market.
Individuals are able to borrow and lend at the same rate as business do.
There are no income taxes
Future earnings are agreed upon and market participants have similar
expectations

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Taking these assumptions into consideration, the M&M theory states that due to the
increasing levels of debt finance, a companys weighted average cost of capital remains
constant. This is because as debt increases, the shareholders expect a higher return and
thus this increase in cost is set off against the cheaper debt in the capital structure. The
M&M theory therefore proposes that a companys market value is not determined by the
level of debt or its capital structure. Later, this model takes out the assumption of no taxes
which would mean that the market value of the business will remain the same with the
exception of a tax shield on interest that is paid on its debt. Financial distress costs as well
as agency costs are taken into consideration at this point in time (Fouche, 2014).
Nevertheless, the second theory is the trade-off theory. This assumes that there is a range
of capital structures whereby if the entitys capital structure stays within the range, the
value of the firm will be maximised. Management therefore tries to set off the costs of
financial distress and agency costs with the tax advantages of debt. However, with regards
to the WACC, it assumes that as debt increases the WACC falls slightly but as soon as
debt reaches a certain point, shareholders become aware of the increased risk and
therefore demand a higher return, thus causing the WACC to gradually increase (Fouche,
2014).
Moving onto the third is the pecking order theory. This is whereby an entity does not
require an optimal capital structure and sources of finance are chosen based on
managements preference. It usually results in sourcing finances internally as a first
choice and then only resorting to external financing once the internal financing funds
have been depleted. Management is also considered to have more knowledge about the
entity and its future prospects than investors do (Fouche, 2014).
Lastly, the debt signalling theory is basically based on the same premise as the peckingorder theory but if management believes that shares are undervalued, they would rather
obtain finances through debt rather than issuing new shares. These actions by
management then indicate to investors whether or not they should buy or sell their shares.
Therefore, the signalling theory basically states that a firms debt can be used as a signal
of the stocks performance (Fouche, 2014).
However, with regards to Oceana Group Limited, it can be concluded that they make use
of the signalling theory and somewhat the pecking order theory. This is mainly supported
by the debt/equity ratio which had an increase from 2011 to 2012. The increase in
debt/equity ratio indicates that Oceana had an overall increase in the amount of debt that
they took out in 2012. Since debt was increased, we can conclude that the signalling
theory can be applied, as debt was used as the companys first choice in terms of
financing. The most probable reason for debt being the companys first choice is because
of the interest cover ratio. This ratio has increased substantially over the past few years
especially from 2011 to 2012. This therefore indicates that it is becoming easier for
Oceana to pay their interest expenses on their outstanding debt, which could potentially
indicate that they are able to take out more debt since they would be capable of repaying
the interest on them.
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With regards to the pecking order theory is does not apply, because when a company
needs financing, debt is their second option, which comes after the retained earnings and
equity capital have been depleted and when looking at Oceana, they increased their debt
hence that being their first option. Oceanas capital structure can however indicate that it
could be pecking order theory because it also states that management knows best about
the company and therefore if management thought that their shares are undervalued, they
would have preferred to take debt out rather than issue shares. The M&M theory does not
apply as well because Oceanas WACC increased substantially whilst the M&M theory
states that the WACC remains constant overtime.
2a) Cost of equity using the Capital Asset Pricing Model:
Ke = Rf + (Rm - Rf)
= 7.41% + 0.1325 (6%)
=8.205%
b) Cost of equity using the Growth Model:
Therefore:
Ke = [D1/Mp] + g
= [255.85 (1+11%) / 8619] +11%
= 14.29497041%
= 14.29%

3) The Price/Earnings Ratio indicates the number of years it would take the shareholder to
regain their initial investment at the current earnings level. The Price/Earnings Ratio has
continuously increased throughout the years from 8.78 in 2008 to 11.64 in 2012. This
therefore shows an increase in the confidence that the market shows in the company because
the market is more willing to pay for the earnings of the company. The market hence believes
in the firm's ability to increase its earnings because it reflects the companys ability to grow.
4) The DuPont Analysis enables us to evaluate the performance of Oceana Group Ltd, for its
2011 and 2012 financial year. Oceanas generated a return on equity of 24.53% in 2011,
which increased to 28.01% in 2012.

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The Financial leverage which is indicated by the assets/equity ratio was 1.48 times in 2011
and increased to 1.57 times in 2012. This indicates that Oceanas financial leverage stayed
relatively constant.
Nevertheless, Oceanas return on assets increased by 1.27% (17.89%-16.62%) which was
caused by an increase in the profit margin of 0.44% (9.55%-9.11%). This however, can be
proven to be true because 2012 showed higher amounts of both net profit and sales leading to
a higher profit margin and thus, a higher return on assets. An increase in the Return on assets
was also caused due to an increase in the Groups asset turnover from 1.82 in 2011 to 1.87
times in 2012. This is also because both sales increased by a larger amount than total assets.
In conclusion, the return on equity increased due to an increase in both return on assets and
the assets/equity ratio.
5) The discounted free cash flow method is a capital budgeting technique that is used
whereby the future cash flows of the project are discounted in order to determine a present
value of that can be used to evaluate the project. There are two main factors that are focused
on. These are the cash flows, and the discount rate which is known as the weighted average
cost of capital (WACC). Below is a list of certain aspects that affect the cash flow.
According to Exhibit 1:
An increase in the inventory days would negatively affect the cash flow as more
money is tied up in the merchandise.
The working capital increases substantially, this would therefore indicate an outflow
of cash and hence a decrease in the cash flow.
Short-term borrowings would represent a cash inflow, however when paying back the
principle amount, it would then reflect a cash outflow.
Acquisition of the V&A cold store facility is a cash outflow.
An increase in the hake quota from 1% to 3.3% represents a cash inflow as it would
result in an increase in the quantity of hakes they would be able to sell.
Transfer of South Coast lobster fishing rights was not obtained. This could represent
an opportunity cost of the amount of sales that could have been achieved if the
lobsters were caught and sold, therefore representing a cash outflow.
Transfer of horse mackerel fishing rights which resulted in a 34.7% share in the South
African horse mackerel industry, has a positive impact on the cash flow, and hence
would be considered as an inflow.

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According to Exhibit 2:
An increase in net income from R333.2 million to R443.8 million has a positive
impact on the cash flow and hence is considered as an inflow.
A revenue jump to 27% is a cash inflow and hence has a positive impact on the cash
flow of Oceana.
Increase in canned fish quota would be a cash outflow as more canned fish would be
able to be imported.
According to Exhibit 3:
The total debt/cash flow ratio indicates a decrease in the cash flow because as can be
seen by the debt/equity ratio, debt has increased and hence an overall increase in debt
would lead to a decrease in the cash flow when the debt/cash flow ratio is looked at.
6) If the lobster fishing rights to Oceana did not take place, there are certain financial and
strategic implications
Financial:
Inventory would decrease which means that supply would fall.
A decrease in supply would in turn lead to a decrease in profits and hence result in
fewer earnings.
Their market share in the Lobster fishing market would decrease.
Strategic:
Move away from the lobster market and rather focus on catering for canned food
market on a wider scale.
Offer a wider variety of other seafood other than lobsters, in order to make up for the
loss in revenue they would have gained if they had obtained the rights.
Form a partnership with another company in order to gain access to the rights.

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Reference List
FOUCHE, J, 2014. Financial Management, Turning theory into practice. Cape Town:
Oxford.

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