FMA205D: Financial Management II Study Guide (TUT Exam Notes)

This study guide is tailored for Tshwane University of Technology (TUT) students registered for FMA205D: Financial Management II, a core subject in the National Diploma: Internal Auditing. It is designed as an exam-focused companion covering key theory, calculations, and application areas that typically feature in tests, assignments, and past papers for FMA205D and similar South African modules such as FMA205D TUT exam notes, UNISA Financial Management II, and CUT Cost and Financial Management. The emphasis is on concepts required by internal auditing students: working capital, capital budgeting, cost of capital, capital structure, and dividend policy.

1. Core Principles of Financial Management II in the Internal Auditing Context

Financial Management II (FMA205D) at TUT builds on the basic tools learned in introductory financial management and accounting modules. For internal auditing students, the focus is not only on calculations, but also on how those figures influence risk assessment, internal controls, and assurance. Understanding the financial management decisions of an organisation allows internal auditors to evaluate whether management is acting in line with the entity’s objectives and risk appetite.

1.1 The Role of Financial Management in Internal Auditing

In the National Diploma: Internal Auditing, FMA205D links directly with modules such as Auditing II, Internal Control, and Risk Management. Financial management decisions affect:

Profitability and solvency – which auditors must evaluate when assessing going-concern risks.
Liquidity and working capital – key when testing cash management and credit policies.
Capital investment decisions – relevant for assessing whether major projects align with strategic goals and proper approvals.
Financing choices and capital structure – auditors evaluate whether entities comply with loan covenants and maintain sustainable debt levels.
Dividend policy – informs how profits are allocated between reinvestment and distribution, impacting long-term value and cash needs.

An internal auditor should be able to interpret financial ratios, understand capital budgeting techniques, and evaluate cost of capital assumptions used by management.

1.2 The Financial Management Environment

In South Africa, entities operate within a legal and regulatory framework that directly shapes financial decisions:

Companies Act 71 of 2008 – governs distributions, solvency and liquidity tests, and director responsibilities for financial decisions.
King IV Report on Corporate Governance – promotes integrated thinking, responsible capital allocation, and stakeholder-inclusive models.
JSE Listings Requirements (for listed firms) – impose disclosure requirements about capital structure, dividends, and financial risks.
Tax legislation (Income Tax Act) – influences optimal financing and investment decisions due to tax shields and incentive allowances.

For internal auditors in South African organisations (private, public, or SOEs), these frameworks shape the guidelines within which financial management techniques are applied. When reviewing investment proposals or financing plans, auditors must consider whether decisions are consistent with both organisational policies and statutory requirements.

1.3 Key Objectives of Financial Management

FMA205D emphasises maximisation of shareholder wealth rather than mere profit maximisation. This involves:

Time value of money – acknowledging that a rand received today is more valuable than a rand received in the future.
Risk–return trade-off – accepting higher risk only when compensated by higher expected returns.
Cash flow focus – using free cash flows, not just accounting profit, for investment decisions.
Long-term sustainability – ensuring that dividends and debt levels do not compromise future operations.

Students often encounter exam scenarios where they must decide between alternative projects or financing options. In such questions, stating explicitly that the decision aims to maximise the firm’s value (shareholder wealth) can earn theory marks, in addition to showing the workings.

1.4 The Internal Auditor’s Perspective

While financial managers make capital budgeting and financing decisions, internal auditors:

Evaluate the process used to make these decisions.
Test controls over budgeting, approval, and monitoring.
Assess assumptions in cash flow projections and cost of capital estimates.
Report weaknesses in financial policies, such as:
- Poor credit risk assessment leading to excessive bad debts.
- Weak inventory control causing overstocking or stock-outs.
- Inadequate project appraisal techniques.

In FMA205D exam questions targeted at internal auditing students, you may be asked to:

Compute a financial metric (e.g., NPV, WACC).
Interpret the result from an internal auditing perspective.
Identify possible control weaknesses in the financial management process.

An effective answer combines technical calculation with audit insight.

1.5 Time Value of Money Refresh (Essential Toolkit)

Before tackling later sections, revise core time value of money tools, which are frequently used across FMA205D topics:

Present Value (PV) of a future amount:

[
PV = \frac{FV}{(1 + r)^n}
]
Future Value (FV):

[
FV = PV \times (1 + r)^n
]
Present Value of an Annuity (PVA) (equal cash flows for n periods):

[
PVA = C \times \frac{1 – (1 + r)^{-n}}{r}
]
Present Value of a Perpetuity:

[
PV_{perp} = \frac{C}{r}
]

Examiners like to integrate TVM (time value of money) concepts into questions on capital budgeting, bond valuation, or equity valuation. Practise solving:

Lump sum PV/FV questions.
Annuities due vs ordinary annuities (where timing differs).
Mixed cash flow streams (requiring individual discounting).

For internal auditing students, understanding TVM is crucial when reviewing discounted cash flow (DCF) models used by management to justify investments.

2. Working Capital Management and Short-Term Financial Decisions

Working capital management is a major theme in FMA205D: Financial Management II and frequently appears in TUT exam papers and past questions. Internal auditors often focus here because poor working capital practices can lead to liquidity crises, fraud opportunities, and operational inefficiencies.

2.1 Concepts and Definitions

Working capital refers to the capital used in the day-to-day operations of a business.

Gross working capital: Total current assets.
Net working capital (NWC):

[
\text{NWC} = \text{Current Assets} – \text{Current Liabilities}
]

Common components:

Current Assets: Cash, bank, trade receivables (debtors), inventory (stock), short-term investments.
Current Liabilities: Trade payables (creditors), bank overdraft, short-term loans, accrued expenses.

A firm must balance liquidity (ability to meet short-term obligations) and profitability (earning returns on assets). Too much working capital reduces profitability (cash tied up in stock); too little increases liquidity risk.

2.2 Liquidity Ratios and Their Interpretation

Internal auditors and financial managers both use liquidity ratios to assess the short-term financial position of the entity.

Current Ratio:

[
\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}
]
- General rule of thumb: around 2:1, but optimal levels vary across industries.
- A very high ratio may indicate inefficient use of funds (e.g., excessive stockholding).
- A very low ratio may signal potential liquidity problems and risk of default.
Quick Ratio (Acid-Test Ratio):

[
\text{Quick Ratio} = \frac{\text{Current Assets} – \text{Inventory}}{\text{Current Liabilities}}
]
- Aimed at assessing ability to meet obligations using more liquid assets.
- Often targeted at 1:1 but should be interpreted in context.
Cash Ratio:

[
\text{Cash Ratio} = \frac{\text{Cash and Cash Equivalents}}{\text{Current Liabilities}}
]
- Stricter measure; useful in stress-testing scenarios.

Example:

A company has:

Cash: R30 000
Accounts Receivable: R70 000
Inventory: R100 000
Current Liabilities: R120 000

Then:

Current Ratio = (30 000 + 70 000 + 100 000) / 120 000 = 200 000 / 120 000 ≈ 1,67:1
Quick Ratio = (200 000 – 100 000) / 120 000 = 100 000 / 120 000 ≈ 0,83:1

Interpretation: Reasonable current ratio but weak quick ratio, suggesting overreliance on inventory. For exam answers, comment on implications for internal audit: e.g., “The internal audit function should review inventory management and credit policies to ensure liquidity risk is adequately controlled.”

2.3 The Working Capital Cycle (Cash Conversion Cycle)

The Working Capital Cycle (WCC) or Cash Conversion Cycle (CCC) measures how long cash is tied up in operations from paying suppliers to collecting from customers.

Key components:

Inventory Conversion Period (ICP):
[
ICP = \frac{\text{Average Inventory}}{\text{Cost of Sales per day}}
]
Receivables Collection Period (RCP)} or Debtors Days:
[
RCP = \frac{\text{Average Trade Receivables}}{\text{Credit Sales per day}}
]
Payables Deferral Period (PDP)} or Creditors Days:
[
PDP = \frac{\text{Average Trade Payables}}{\text{Credit Purchases per day}}
]
Working Capital Cycle:

[
WCC = ICP + RCP – PDP
]

Shorter WCC = quicker conversion back to cash → better liquidity.

Case Study Example:

ABC (Pty) Ltd, a manufacturing firm in Pretoria, reports:

Average Inventory = R300 000
Cost of Sales = R1 800 000 per year
Average Receivables = R200 000
Credit Sales = R2 400 000 per year
Average Payables = R150 000
Credit Purchases = R1 500 000 per year

Step-by-step:

Cost of Sales per day = 1 800 000 / 360 = R5 000 → ICP = 300 000 / 5 000 = 60 days
Credit Sales per day = 2 400 000 / 360 = R6 667 → RCP ≈ 200 000 / 6 667 ≈ 30 days
Credit Purchases per day = 1 500 000 / 360 = R4 167 → PDP ≈ 150 000 / 4 167 ≈ 36 days

Thus:

[
WCC = 60 + 30 – 36 = 54 \text{ days}
]

Internal audit angle: Evaluate whether a 54-day cycle is consistent with company policy and industry norms. If management’s target is 40 days, highlight weaknesses in inventory or receivables management and evaluate internal controls around procurement, storage, and credit approval.

2.4 Inventory Management Techniques

Inventory is often a large component of working capital and a common focus area in internal audit engagements. Key concepts:

Economic Order Quantity (EOQ): The optimal order size that minimises total inventory costs (ordering + holding costs).

[
EOQ = \sqrt{\frac{2DS}{H}}
]

Where:
- (D) = Annual demand (units)
- (S) = Ordering cost per order (R)
- (H) = Holding cost per unit per year (R)
Reorder Level (ROL):

[
ROL = \text{Lead Time Demand} + \text{Safety Stock}
]
Lead Time: Time between placing order and receiving inventory.

EOQ Example:

A firm uses 24 000 units per year of a component. Ordering cost is R300 per order and holding cost is R10 per unit per year.

[
EOQ = \sqrt{\frac{2 \times 24,000 \times 300}{10}} = \sqrt{\frac{14,400,000}{10}} = \sqrt{1,440,000} \approx 1,200 \text{ units}
]

Number of orders per year = 24 000 / 1 200 = 20 orders.

In FMA205D exams, you may be required to compute EOQ, total costs at EOQ, and compare with current ordering policy. From an internal auditing perspective, discuss:

Whether the business follows a systematic inventory policy.
Risks of stock-outs vs excessive holding costs.
Integration with ERP systems and authorisation of orders.

2.5 Receivables (Debtors) Management

Efficient receivables management aims to maximise sales while keeping bad debts, collection costs, and average collection period under control.

Key elements:

Credit Policy: Criteria for granting credit (e.g., credit checks, customer categories).
Credit Terms: Credit period, cash discounts (e.g., 2/10, net 30).
Collection Policy: Methods of following up overdue accounts.

When analysing credit policy changes, FMA205D questions often ask whether relaxing or tightening policy increases the value of the firm. You are typically given:

Incremental sales.
Contribution margin.
Change in bad debts.
Change in average collection period (affecting investment in receivables).
Required return on investment in receivables.

General steps:

Compute incremental contribution (incremental sales × contribution margin).
Compute incremental bad debts.
Compute opportunity cost of additional investment in receivables:

[
\Delta \text{Investment} = \frac{\Delta \text{Receivables}}{360} \times \text{Cost of Sales per day}
]

or more simply based on change in average collection period.
Evaluate net benefit or cost:

[
\text{Net Benefit} = \text{Incremental Contribution} – \text{Incremental Bad Debts} – \text{Opportunity Cost}
]
If Net Benefit > 0, the change is acceptable (other things equal).

Internal auditing implication: Auditors should verify that credit policy changes are supported by proper analysis and approved at the appropriate level, and that credit risk is monitored.

2.6 Cash Management

Cash management ensures the entity has enough cash to meet obligations, but not so much that returns are sacrificed. Common models:

Baumol Model – treats cash management like EOQ for inventory.
Miller–Orr Model – sets upper and lower control limits for cash balance, with a return point.

Although detailed derivations may be less emphasised in FMA205D at TUT than in some UNISA modules (such as DSF2601 or FAC2601), you must understand:

Reasons for holding cash (transaction, precautionary, speculative).
Techniques to speed up collections and delay payments within ethical and legal limits.
Internal controls over cash receipts and payments, including segregation of duties and bank reconciliations.

Internal audit connection: Cash is highly susceptible to fraud and error. Audit procedures include reviewing bank reconciliations, assessing controls over EFT payments, and testing the handling of petty cash and cash receipts.

2.7 Short-Term Financing

Short-term financing sources include:

Bank overdrafts.
Short-term bank loans.
Trade credit (spontaneous financing).
Commercial paper (for larger, high-credit-quality firms).

Key evaluation criteria:

Interest cost (explicit and implicit).
Flexibility and ease of access.
Security/collateral requirements.
Impact on bank covenants and credit ratings.

Cost of Trade Credit Example:

Supplier offers terms 2/10, net 30. If the firm does not take the 2% discount and instead pays on day 30, cost of not taking discount:

[
\text{Cost} = \frac{\text{Discount}}{1 – \text{Discount}} \times \frac{360}{\text{Credit Period} – \text{Discount Period}}
]

[
= \frac{0,02}{0,98} \times \frac{360}{30 – 10}
= 0,02041 \times 18 = 0,3674 = 36,74% \text{ per annum}
]

Internal audit relevance: Ignoring discounts may imply significant hidden financing cost. Auditors can recommend policies to ensure discounts are evaluated against alternative financing sources.

3. Capital Budgeting: Investment Decisions and Project Evaluation

Capital budgeting is a central component of FMA205D at TUT, and exam questions often require detailed calculations and clear recommendations. For internal auditing students, understanding capital budgeting is vital for evaluating the effectiveness, efficiency, and economy (the “3 Es”) of major capital projects.

3.1 Types of Capital Projects

Capital budgeting deals with long-term investments such as:

Expansion projects – increasing capacity, entering new markets.
Replacement projects – replacing old assets with new, more efficient ones.
Regulatory/safety projects – required by law (e.g., environmental compliance).
Strategic projects – acquisitions, research and development, IT systems.

Internal auditors review whether:

Projects support the organisation’s strategy.
Appropriate appraisal techniques are used.
Assumptions (sales forecasts, cost savings) are realistic.

3.2 Cash Flows in Capital Budgeting

Capital budgeting focuses on relevant cash flows, not accounting profit. Key concepts:

Initial Outlay (time 0): Purchase price, installation costs, initial working capital needs.
Operating Cash Flows (years 1–n): After-tax cash flows from operations (revenue – costs – taxes + depreciation tax shield).
Terminal Cash Flows (final year): Salvage value, recovery of working capital, terminal tax effects.

Operating Cash Flow (OCF) is often calculated as:

[
OCF = (R – C – \text{Dep}) \times (1 – t) + \text{Dep}
]

Where:

(R) = revenue
(C) = operating cash costs
Dep = depreciation
(t) = tax rate

The depreciation is added back because it is a non-cash expense.

Internal audit angle: Ensure that:

Cash flow forecasts are documented and supported.
Tax treatments are correctly considered.
Working capital effects are fully included.

3.3 Evaluation Techniques: NPV, IRR, PI, and Payback

3.3.1 Net Present Value (NPV)

NPV is the most theoretically sound method and heavily tested in FMA205D and similar modules at UNISA and CUT.

[
NPV = \sum_{t=0}^{n} \frac{CF_t}{(1 + k)^t}
]

Where:

(CF_t) = cash flow at time (t) (with (CF_0) normally negative)
(k) = cost of capital (discount rate)

Decision rule:

If NPV > 0, accept (project adds value).
If NPV < 0, reject.
If mutually exclusive projects, choose the highest positive NPV.

Example:

Project X requires R500 000 initial investment and yields:

Year 1: R200 000
Year 2: R250 000
Year 3: R200 000

Cost of capital = 12%.

[
NPV = \frac{-500,000}{(1+0)^0} + \frac{200,000}{1,12^1} + \frac{250,000}{1,12^2} + \frac{200,000}{1,12^3}
]

Compute:

Year 1 PV = 200 000 / 1,12 ≈ 178 571,43
Year 2 PV = 250 000 / (1,12^2) ≈ 250 000 / 1,2544 ≈ 199 904,49
Year 3 PV = 200 000 / (1,12^3) ≈ 200 000 / 1,404928 ≈ 142 391,09

Total PV of inflows ≈ 178 571,43 + 199 904,49 + 142 391,09 = 520 867,01

NPV ≈ 520 867,01 – 500 000 = R20 867,01 (approx)

Hence, accept Project X (positive NPV).

In exam solutions, show all steps clearly, label the discount factor, and round consistently.

3.3.2 Internal Rate of Return (IRR)

IRR is the discount rate at which NPV = 0. It can be found using:

Financial calculator.
Trial-and-error with interpolation.

Decision rule:

If IRR > required rate of return (cost of capital), accept.
If IRR < required rate, reject.

Limitation: For mutually exclusive projects or non-conventional cash flows (multiple sign changes), IRR can be misleading. For internal auditing purposes, note that management should not rely solely on IRR where NPV gives a conflicting signal.

3.3.3 Profitability Index (PI)

[
PI = \frac{\text{PV of future cash inflows}}{\text{Initial Investment}}
]

Decision rule:

If PI > 1, NPV > 0 (project acceptable).
Under capital rationing, rank projects using PI to maximise value per rand invested.

Example from above:

PV of inflows = R520 867,01
Initial investment = R500 000

[
PI = 520,867,01 / 500,000 ≈ 1,04
]

3.3.4 Payback and Discounted Payback Period

Payback Period: Time required to recover initial investment from undiscounted cash flows.

Decision rule in practice: Accept if payback < maximum acceptable period set by management.
Discounted Payback Period: Same idea but uses discounted cash flows.

These are easy to calculate and test in FMA205D, but they ignore cash flows after payback and time value of money (for simple payback). Internal auditors should view them as secondary indicators.

3.4 Capital Rationing and Project Selection

When resources (capital) are limited, firms cannot accept all positive NPV projects. Under single-period capital rationing, using PI is common:

Rank projects in descending order of PI.
Allocate budget to maximise total NPV.

Example:

Assume a capital budget of R800 000 and three independent projects:

Project	Initial Cost (R)	PV of Inflows (R)	PI
A	400 000	520 000	1,30
B	300 000	375 000	1,25
C	500 000	600 000	1,20

Ranking: A (1,30), B (1,25), C (1,20).

Selecting A (400k) + B (300k) uses R700 000 and yields total PV of R895 000.
Remaining R100 000 cannot fund C (requires 500k).

Total NPV of chosen projects = 895 000 – 700 000 = R195 000.

While capital rationing is often prominent in UNISA modules like FIN2601 and DSF2601, TUT’s FMA205D exams also test it as an application of NPV and PI. From an internal auditing perspective, auditors must confirm that project selection follows approved capital budgeting procedures and is not subject to bias or undue influence.

3.5 Risk Analysis in Capital Budgeting

Projects are risky because future cash flows are uncertain. Techniques include:

Sensitivity analysis – change one variable at a time (e.g., sales volume) and observe effect on NPV.
Scenario analysis – consider combinations of variables (best, worst, most likely scenarios).
Simulation – complex, requires software (less commonly tested).

Internal auditors may check:

Whether management considered downside risk.
If risk-adjusted discount rates or certainty equivalents were used.
Whether the risk analysis is documented and reviewed by appropriate committees.

You should be able to:

Compute NPVs under different scenarios.
Identify which variables have the greatest impact on NPV (key risk drivers).
Comment on risk mitigation measures (insurance, diversification, phased investments).

4. Cost of Capital and Capital Structure Decisions

Understanding cost of capital and capital structure is essential for correctly discounting project cash flows and evaluating financing decisions, both of which appear frequently in FMA205D TUT past papers, UNISA FIN2601, and CUT Financial Management modules. Internal auditors must understand these concepts to assess the adequacy of return targets and the prudence of leverage levels.

4.1 Components of Capital and Their Costs

Firms typically use a mix of:

Equity capital (ordinary shares, retained earnings).
Preference share capital.
Debt capital (debentures, bank loans).

Each source has its cost:

Cost of Debt (Kd):
- Based on after-tax interest rate, because interest is tax-deductible.
[
K_d = i(1 – t)
]

Where:
- (i) = nominal interest rate
- (t) = company tax rate
For redeemable debt, Kd is the yield to maturity adjusted for tax.
Cost of Preference Shares (Kp):

For irredeemable (perpetual) preference shares:

[
K_p = \frac{D_p}{P_0}
]

Where:
- (D_p) = annual preference dividend per share
- (P_0) = current market price per share
Note: Preference dividends are not tax-deductible for the company.
Cost of Equity (Ke):
Methods include:
- Dividend Growth Model (Gordon Growth Model):
  
  [
  K_e = \frac{D_1}{P_0} + g
  ]
  
  Where:
  - (D_1) = expected dividend next year
  - (P_0) = current share price
  - (g) = constant growth rate of dividends
- Capital Asset Pricing Model (CAPM):
  
  [
  K_e = R_f + \beta (R_m – R_f)
  ]
  
  Where:
  - (R_f) = risk-free rate
  - (R_m) = expected market return
  - (\beta) = beta coefficient of the share
In TUT FMA205D, the dividend growth model and basic CAPM often appear, similar to what is tested in UNISA’s INV2601.
Cost of Retained Earnings (Kr):

Typically considered equal to Ke, as retained earnings represent shareholders’ funds with an opportunity cost equal to the return they require.

4.2 Weighted Average Cost of Capital (WACC)

WACC is the overall average cost of capital, weighted by the market values of each component:

[
WACC = w_d K_d (1 – t) + w_p K_p + w_e K_e
]

Where:

(w_d, w_p, w_e) = weights of debt, preference equity, and ordinary equity respectively (based on market values).

The WACC is used as the discount rate in NPV calculations for projects with average risk.

Example:

XYZ Ltd has the following capital structure (market values):

Debentures: R1 200 000, cost of debt before tax 10%, tax rate 28%.
Preference shares: R600 000, cost 12%.
Ordinary shares: R2 200 000, cost 18%.

Total capital = 1 200 000 + 600 000 + 2 200 000 = R4 000 000.

Compute weights:

(w_d = 1 200 000 / 4 000 000 = 0,30)
(w_p = 600 000 / 4 000 000 = 0,15)
(w_e = 2 200 000 / 4 000 000 = 0,55)

After-tax cost of debt:

[
K_d(1 – t) = 10% \times (1 – 0,28) = 10% \times 0,72 = 7,2%
]

Thus:

[
WACC = 0,30(7,2%) + 0,15(12%) + 0,55(18%)
]

[
= 2,16% + 1,80% + 9,90% = 13,86%
]

So WACC ≈ 13,86%.

Internal auditing link: Auditors must check whether management uses appropriate weights (market vs book), correctly adjusts for tax, and uses the WACC consistently for investment appraisal and valuation.

4.3 Capital Structure: Debt vs Equity

Capital structure refers to the mix of debt and equity used to finance the firm. Common topics in FMA205D include:

Business risk vs financial risk.
Trading on equity (the impact of leverage on return on equity and EPS).
Modigliani and Miller (M&M) propositions (conceptual overview).

4.3.1 Business Risk and Financial Risk

Business risk: Variability in operating profit (EBIT) due to changes in revenues and operating costs; inherent in the business.
Financial risk: Additional variability in earnings to ordinary shareholders due to fixed financial obligations (interest and preference dividends).

Leveraging (using more debt) increases financial risk and potential returns to equity holders, but also increases the probability of financial distress.

4.3.2 Degree of Financial Leverage (DFL)

DFL measures sensitivity of EPS to changes in EBIT:

[
DFL = \frac{%\Delta EPS}{%\Delta EBIT}
]

Alternatively, at a particular level of output:

[
DFL = \frac{EBIT}{EBIT – I – \frac{D_p}{1 – t}}
]

Where:

(I) = interest
(D_p) = preference dividends

An increase in DFL indicates that a small change in EBIT leads to a larger change in EPS → higher financial risk.

Example Concept: For exam-type questions comparing two financing plans (A: more equity, less debt; B: more debt, less equity), you may be asked to calculate EPS at different EBIT levels and comment on the risk–return trade-off. This is also used in indifference point calculations (level of EBIT where EPS under two plans is equal).

4.4 Optimal Capital Structure and Theories

The aim is to find a capital structure that minimises WACC and maximises firm value. Theories:

Net Income (NI) Approach:
- Suggests that WACC can be lowered by using more debt (because debt is cheaper).
- Encourages high leverage, but ignores risk of financial distress.
Net Operating Income (NOI) Approach:
- Claims WACC is constant across all capital structures.
- Implies capital structure is irrelevant to firm value.
Modigliani and Miller (M&M):
- Without taxes: Capital structure is irrelevant; firm value depends only on operating income and business risk.
- With corporate taxes: Debt creates a tax shield (interest is tax-deductible), which increases firm value as leverage rises, but in real life, this is offset by bankruptcy costs, agency costs, and loss of financial flexibility.
Trade-Off Theory:
- There is an optimal debt level where the marginal tax benefit equals marginal cost of financial distress.
Pecking Order Theory:
- Firms prefer internal finance (retained earnings), then debt, and issue equity as a last resort, due to asymmetric information and issuance costs.

In exam answers, focus on definitions, implications, and simple diagrams (e.g., WACC vs leverage curve). For internal auditors, it is important to understand that management’s choice of capital structure affects risk profile, covenant compliance, and going-concern considerations.

4.5 Practical Considerations in South African Firms

Factors influencing capital structure decisions:

Tax environment – interest deductibility creates incentives for using debt.
Market conditions – availability and cost of bank loans, bond markets.
Company size and asset structure – larger firms with tangible assets have easier access to secured debt.
Management’s risk attitude – conservative vs aggressive financing.
Regulation – certain sectors (e.g., banks, insurers, SOEs) face regulatory capital requirements.

Internal auditors should examine:

Compliance with loan covenants (e.g., interest coverage ratios, gearing limits).
Monitoring of refinancing risk and debt maturity profiles.
Governance around decisions to issue new debt or equity.

5. Dividend Policy, Valuation, and Exam Strategy for FMA205D (TUT)

Dividend policy is another core area in FMA205D: Financial Management II and related South African modules (e.g., UNISA FIN2601, MNG2602, CUT Corporate Finance). For internal auditors, dividends influence retained earnings, which in turn affects financing needs and long-term growth capacity.

5.1 Dividend Policy Concepts

Dividend policy refers to the allocation of earnings between dividends paid to shareholders and retained earnings reinvested in the business.

Common dividend policies:

Constant Payout Ratio: Fixed percentage of earnings each year.
Stable (Constant) Dividend per Share: Fixed amount per share, possibly with occasional adjustments.
Low Regular Dividend plus Extras: Pay low fixed dividend and add “extras” in good years.
Residual Dividend Policy: Dividends equal earnings left after funding all positive NPV investment opportunities.

Factors influencing dividend decisions:

Legal constraints (Companies Act’s solvency and liquidity test).
Liquidity position and access to capital markets.
Shareholder preferences (income vs capital gains).
Control considerations (issuing new equity may dilute control).
Tax considerations (differential tax treatment of dividends vs capital gains).

Internal auditing focus: Evaluate whether dividend declarations are properly authorised, compliant with solvency and liquidity tests, and consistent with the entity’s financial strategy.

5.2 Dividend Relevance and Irrelevance Theories

Dividend Irrelevance Theory (M&M):
- In perfect markets, dividend policy does not affect firm value; investors are indifferent between dividends and capital gains.
- Assumes no taxes, no flotation costs, no information asymmetry.
Dividend Relevance Theories:
- Walter’s Model and Gordon’s Model argue that dividend policy does affect value, especially when:
  - Internal rate of return on new investments > or < required return.
  - Investors have preferences for current income.
- Bird-in-the-Hand Theory: Investors prefer certain dividends today over uncertain capital gains in the future.
- Signalling Theory: Dividend changes convey information about management’s expectations of future earnings.
- Clientele Effect: Different groups of investors prefer different dividend policies.

For exam purposes, be able to explain the assumptions and state whether dividend policy is seen as relevant or irrelevant under each model. From an internal auditing perspective, understand that abrupt or unjustified dividend changes may indicate earnings management or pressure from controlling shareholders.

5.3 Share Valuation Models and Dividend Policy

Valuation of ordinary shares frequently appears in FMA205D exams, often combined with dividend growth assumptions.

5.3.1 Zero-Growth Dividend Model

For a share with constant dividend (D) and required return (K_e):

[
P_0 = \frac{D}{K_e}
]

Example:

Dividend = R3 per share per year.
Required return = 12%.

[
P_0 = 3 / 0,12 = R25
]

5.3.2 Constant-Growth Dividend Model (Gordon Growth)

[
P_0 = \frac{D_1}{K_e – g}
]

Where: (D_1 = D_0(1 + g)).

Example:

Last dividend (D0) = R2,50.
Dividend growth rate = 6% per year.
Required return (Ke) = 14%.

Then:

[
D_1 = 2,50 \times 1,06 = R2,65
]

[
P_0 = \frac{2,65}{0,14 – 0,06} = \frac{2,65}{0,08} = R33,125
]

These models tie directly to dividend policy: higher expected growth and stable dividend patterns can increase share value. Internal auditors may review whether dividend forecasts used in valuations are realistic and supported by earnings projections.

5.4 Share Repurchases and Their Implications

Share repurchases (buy-backs) are an alternative to cash dividends. A company may decide to repurchase its own shares for reasons such as:

Returning surplus cash to shareholders.
Signalling confidence in future prospects.
Adjusting capital structure (reducing equity, increasing leverage).
Providing shares for employee share schemes.

Internal auditors must verify that share repurchases:

Are authorised by shareholders and the board.
Comply with Companies Act requirements and JSE rules (if listed).
Do not unfairly benefit certain shareholders at the expense of others.

From a valuation standpoint, share repurchases can change EPS and per-share metrics, but do not automatically create value; value increases only if the repurchase price is below intrinsic value.

5.5 Exam Strategy and Typical Question Types for FMA205D (TUT)

To succeed in FMA205D: Financial Management II as part of the National Diploma: Internal Auditing at TUT, students must combine calculation skills, theoretical understanding, and internal auditing perspective. Many concepts overlap with topics in UNISA modules like FIN2601, FAC2601, INV2601, MNG2602, and CUT Corporate and Financial Management, so online resources and past papers for those courses can also be useful for practice.

5.5.1 Typical Question Types

Calculation Questions (Long Format) – 20 to 40 marks:
- NPV, IRR, PI, payback.
- WACC calculation with multiple capital components.
- EOQ, working capital cycle, receivables policy evaluation.
- Share valuation using dividend models or P/E ratios.
Combined Calculation and Interpretation:
- Compute financial metrics and then interpret results from an internal auditing viewpoint.
- Example: “Calculate the NPV of Project A and comment on whether, as an internal auditor, you would consider the capital budgeting process sound.”
Theory/Discussion Questions – 10 to 20 marks:
- Compare NPV and IRR; discuss advantages and limitations.
- Explain factors influencing capital structure.
- Evaluate dividend relevance theories.
- Discuss the role of internal auditors in assessing working capital management.
Integrated Case Studies:
- A scenario describing a company’s financing, investment, and working capital situation.
- Requirements may include ratio analysis, risk identification, and proposal of control improvements.

5.5.2 Exam Preparation Tips

Master Core Formulas:
Create a formula sheet for:
- Time value of money (PV, FV, annuities).
- NPV, IRR basics.
- WACC and cost of capital components.
- Liquidity and working capital ratios.
- EOQ and inventory metrics.
- Dividend valuation models.
Practise applying them under timed conditions.
Understand, Don’t Memorise Mechanically:
- Learn why each formula is used.
- Be able to explain in words the meaning of NPV, WACC, leverage, and dividend policy.
Show All Workings Clearly:
- Layout calculations step-by-step.
- Label discount factors, WACC components, and intermediate figures.
- Even if the final answer is slightly off, method marks can be substantial.
Integrate Internal Audit Perspective:
- For every financial management area, ask:
  - What could go wrong (risk)?
  - What controls should be in place?
  - What should an internal auditor test or review?
- In discussion questions, referencing internal control, risk management, and governance often scores extra marks for auditing students.
Practise Past Papers:
- Use TUT’s past exam papers for FMA205D and tutorial letters.
- Supplement with similar questions from UNISA FIN2601, FAC2601, INV2601 and CUT finance modules, as many topics overlap.
Time Management in the Exam:
- Allocate time according to marks (e.g., 1 mark ≈ 1 minute).
- Start with questions you are most confident with to build momentum.
- Ensure you leave time for short theory questions, which are easy marks if approached with concise, structured answers.

5.5.3 Answering Theory Questions Effectively

For written questions:

Define key terms first (1–2 marks).
Explain the concept or theory (3–6 marks).
Apply to a practical or internal auditing context (3–6 marks).
Use headings or bullet points to structure your answer logically.

Example: “Discuss the advantages and disadvantages of using NPV as a capital budgeting technique.”

Structure:

Define NPV.
List and briefly explain advantages (time value of money, cash flow focus, value maximisation).
List and explain disadvantages (complexity, need for accurate discount rate, assumptions).
Summarise: Why NPV is generally preferred and how internal auditors can evaluate its use.

5.6 Linking FMA205D Content Across the Internal Auditing Curriculum

Finally, recognise how FMA205D reinforces and is reinforced by other subjects in the Tshwane University of Technology (TUT): National Diploma: Internal Auditing:

Internal Auditing II and III: Use financial management concepts to assess risk areas, review financial controls, and evaluate budgeting and forecasting processes.
Financial Accounting II: Provides the financial statements and disclosures that underpin ratio analysis, cash flow assessments, and performance evaluation.
Taxation: Influences the cost of capital (tax shields), investment decisions (capital allowances), and dividend decisions (tax treatment of distributions).
Risk Management: Financial risks (interest rate risk, liquidity risk, credit risk) are directly connected to capital structure, working capital, and investment policies studied in FMA205D.

Understanding these linkages strengthens your ability to think holistically as an internal auditor: not just computing numbers, but understanding what they mean for control design, assurance, and corporate governance.

This comprehensive guide, aligned with FMA205D: Financial Management II at Tshwane University of Technology (TUT) and contextualised for the National Diploma: Internal Auditing, provides the conceptual and computational foundation necessary for success in examinations and in professional internal auditing practice within South African organisations.