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A simple explanation of a Section 12J investment

on Thursday, 18 January 2018.

A simple explanation of a Section 12J investment

 

Please note this article was sponsored by Fairtree Capital

The main points:

  1. A taxpayer can make an investment in a Section 12J company and this investment is 100% tax deductible if held for a period of 5 years or longer.
  2. If the taxpayer is an individual with a marginal tax rate of 45% or a trust, the taxpayer can invest R1 million and will effectively be paying R550 000 (R1 million - R450 000) for the investment since the full investment amount is tax deductible in the year of investment (provided the taxpayer has taxable income of R450 000 or more).
  3. A company (excluding a SBC which will be taxed at different rates) can invest R1 million and effectively be paying R720 000 (R1 million - R280 000) for the investment since the full investment amount is tax deductible in the year of investment (provided the company has taxable income of R280 000 or more).
  4. When the section 12J investment is realised in the future, the base for the capital gain will be 0 due to the initial benefit of 100% tax deductibility.

What is a Section 12J company?

The government has identified small and medium-sized entities (SMEs) as a major contributor to future economic growth. One factor that hampers the growth of SMEs is a lack of access to equity funding.

In order to alleviate this problem the government has added Section 12J to the South African Income Tax Act as a catalyst for equity funding for SMEs. Section 12J provides a marketing vehicle to venture capital companies (VCCs) due to the tax incentive.

A Venture Capital Company (VCC) is a company that accepts investments from any taxpayer (individual, trust or company). The VCC manages the collective investment and make investments in SMEs.

The VCC will issue a certificate to the taxpayer for the amount of the investment. The taxpayer is then allowed to deduct their full investment against their taxable income in the relevant tax year.

The tax benefit which arises from Section 12J is thus an incentive for taxpayers to invest indirectly in SMEs.

Who are allowed to invest in a Section 12J Company?

Any taxpayer qualifies to invest in an approved VCC.

Are there any other tax implications?

As with any other investment on realisation the taxpayer will be liable for capital gains tax (CGT). However if the investor utilised the Section 12J deduction when they purchased the shares, the base cost will be reduced to zero on realisation. Therefore the capital gains tax liability is higher than it would have been for the same investment where the Section 12J deduction was not applied.

Taking the CGT into account, is an investment in a Section 12J company still beneficial?

Below is a comparison of a traditional investment in listed shares versus an investment in a Section 12J company. For both investments the following are assumed:  a 10% annual growth in value, a 5 year investment term, an individual tax payer with the maximum marginal tax rate of 45% and all other factors are constant.

 
Investment in listed shares
Investment in a Section 12J Company
Initial investment amount

1,000,000.00

1,000,000.00

With growth in capital year 1

1,100,000.00

1,100,000.00

With growth in capital year 2

1,210,000.00

1,210,000.00

With growth in capital year 3

1,331,000.00

1,331,000.00

With growth in capital year 4

1,464,100.00

1,464,100.00

With growth in capital year 5

1,610,510.00

1,610,510.00

     

Value on realisation

1,610,510.00

1,610,510.00

     
Capital gain tax implications:
   
     

Base cost

1,000,000.00

0.00

Realisation

1,610,510.00

1,610,510.00

Capital gain

610,510.00

1,610,510.00

     

Inclusion in taxable income @ 40%

244,204.00

644,204.00

Tax on capital gain @ 45%

109,891.80

289,891.80

     
Net rate of return over 5 year period
   
     

Net gain

500,618.20

320,618.20

Initial section 12J deduction adjusted for inflation of 6% per year

 

602,201.51

Total gain on investment

500,618.20

922,819.71

     

Net rate of return over 5 year period

0.50

0.92

 

 



The Section 12J investment has a net rate of return that is 42% higher than the traditional investment. Therefore even with the reduced base cost it is still beneficial.



We interviewed Fairtree Capital to find out more about their Section 12J company: Fairtree Capital Hospitality 

Fairtree Banner

Who is Fairtree Capital?

Fairtree Capital is an African investment manager that manages alternative and long only investment portfolios across all global asset classes for institutional clients and high net worth individuals. Based in Cape Town, South Africa, our firm commitment to a consistent investment philosophy has continued to deliver high-quality returns to investors since the inception of our first fund in 2003.

How does the Fairtree Capital Hospitality Section 12J company fit into Fairtree Capital?

Fairtree Capital Hospitality (Pty) Ltd is managed by Fairtree Capital.

Tell us more about Fairtree Capital Hospitality

The Company focusses on leveraged acquisitions of a diversified portfolio of hospitality properties with positive cash flows and significant capital appreciation potential which are positioned to benefit from the growth in the South African tourism industry.

The company’s focus will be in the hotel industry, where various opportunities exist given supply constraints, a weak South African currency and strong growth in the tourism market. The members of the board use their expertise, in association with its hotel management affiliates, to reposition and restructure properties for growth and to capitalise on the changing accommodation market with strong focus on new technology. The company will develop its investments into efficiently structured real estate investments, which operate at optimum capacity and then look to realise these investments at maximum value. The company’s primary focus area is South Africa with some international exposure.

Fairtree Hospitality will invest in Qualifying Companies operating in the hospitality industry with the following features:

  • Exciting business models;
  • Potential for expansion or capacity growth;vi
  • Defensible market positions;
  • Attractive entry prices and
  • Opportunities to add value

Who is the management team of the Fairtree Capital Hospitality company?

Kobus Nel - CA(SA), CFA - Director

Experience:

CA Articles : PricewaterhouseCoopers

Corporate finance team : Sanlam Ltd

Founder and Fund manager : Fairtree Capital

Joe Bester - CA(SA) - Director

Experience:

CA Articles : PricewaterhouseCoopers

Ma-Afrika Group : Financial manager and CFO

Ma-Afrika Hotels : COO

Christiaan Rossouw - Equity Analyst

Experience:

Realgrowth Property Development (Internship) : Financial Analyst

Allan Gray : Investment Consultant

What is the minimum investment that an investor can make?

R500 000

What is the expected annual return on the investment?

The expected return is CPI + 10% to 15%

Until when are you accepting investments in the company?

This tranche of the investments closes 01 March 2018, however if our target investment amount is reached before then, it may close sooner.

When will the investor receive their investment certificate for tax purposes?

As soon as the investment is made.

When will the investment be realised?

The investment will be locked in for a period of 6 years after which liquidation possibilities will be discussed with investors who would like to realise their investment.

What is the Corporate Service Fee that Fairtree Hospitality Company charge?

1% (Excluding VAT) on gross assets calculated as at each valuation date. The gross asset value of the Company will be calculated by using the sum of the gross initial value of the acquisitions of Investments made by the Company. For purposes of calculating the corporate services fee, the gross asset value of the Company will be escalated annually on 1 March by CPI + 2%. Where an Investment was acquired within the preceding year, this increase will be applied on a pro rata basis.

How risky are these investments?

The Fairtree Capital Hospitality Company is a Real Estate Private Equity vehicle and has a significantly lower risk profile than traditional Venture Capital Investments. The Company will be investing in established, profitable hospitality properties. The fact that there is significant underlying value in the physical properties, get investors tangible and secure underlying assets. 

Furthermore, the Directors will also be invested personally in the assets that the Company acquires. The Company is not a Venture Capital Company per its traditional definition, but is benefitting substantially by making use of the fact that Hospitality Property specifically falls within the ambit of the Section 12J Venture Capital Company requirements. 

How well regulated is the company?

The Company is a registered Venture Capital Company under Section 12J of the Income Tax Act. In order to obtain this registration, the Company had to acquire an FSB license and register with SARS. The Company is thus regulated by the FSB and by SARS specifically for the compliance with the Section 12J requirements.

What legislation does the company fall under?

The Company is structured as a Venture Capital Company and is regulated primarily by the The Companies Act, the FSB and SARS.

Where can an investor get more information on the company?

www.fairtreehospitality.com

Who can an investor contact for questions or to arrange to make an investment?

Joe Bester - This email address is being protected from spambots. You need JavaScript enabled to view it. or 

Christiaan Rossouw - This email address is being protected from spambots. You need JavaScript enabled to view it.

Please also feel free to post your comments or questions below and CH Consulting will route the questions to Fairtree Capital.

Further tax advice on the Section 12J investments

Please contact us at CH Consulting https://www.chconsulting.co.za/contact

Author: Chris Herbst - CH Consulting

How is crypto currency such as Bitcoin taxed in South Africa?

on Friday, 01 December 2017.

How is crypto currency such as Bitcoin taxed in South Africa?

 

 

Please note that the information below is an opinion and cannot be used to rely on as formal tax advice. In order to  obtain formal tax advice regarding your tax situation, please contact us directly for a consultation.

For the lazy reader I start with a summary:

  1. It is my opinion that Bitcoin will be classified as an asset for tax purposes in the current ambit of the income tax act.
  2. It is my opinion that the gains made on the sale of Bitcoin will be taxed as trading income (except in the unlikely case where it was held as a long term investment where it will be taxed as capital gains).
  3. See the example at the end of the article.

 

The View of SARS

 

SARS has not given their interpretation for the specific tax treatment of cryptocurrency yet. There is a common misconception that this means that no tax has to be paid on cryptocurrency gains. This is not the case, as the income tax act does make provision for gains on cryptocurrency albeit not directly. According to an article published by IOL, in Personal Finance, SARS has made their current position clear “Transactions or speculation in Bitcoin is subject to the general principles of South African tax law and taxed accordingly” (https://www.iol.co.za/personal-finance/youre-liable-for-tax-on-bitcoin-gains-11508366).

For the rest of this article I will refer to Bitcoin as an example, since this is a well known cryptocurrency. Where I use the term Bitcoin I also refer to other forms of cryptocurrency unless explicitly indicated otherwise.

 

The nature of Bitcoin - Currency vs Asset

 

In order to assess how Bitcoin fits into the South African Income tax act a first consideration should be to assess the nature of Bitcoin. 

Bitcoin cannot be classified as a currency since it is not related to a specific country. Section 24I of the income tax act defines local currency as “currency of the Republic” and foreign currency as: “any currency which is not local currency”. It is thus clear that Bitcoin is not local or foreign currency and therefore not currency.

The next logical consideration would be to assess Bitcoin as an asset (similar to for example shares). 

Paragraph one of the the eight schedule of the income tax act defines an asset as:

“property of whatever nature, whether movable or immovable, corporeal or incorporeal, excluding any currency, but including any coin made mainly from gold or platinum and a right or interest of whatever nature to or in such property”

Section 1 of the income tax act defines trading stock as:

“anything produced, manufactured, constructed, assembled, purchased or in any other manner acquired by a taxpayer for the purposes of manufacture, sale or exchange by the taxpayer or on behalf of the taxpayer “

Trading stock is also classified as an asset. 

It is therefore in my opinion clear that Bitcoin will be classified as an asset for tax purposes in the current ambit of the income tax act and in the majority of the cases as trading stock when it is traded in a speculative manner.

 

Capital gain vs trading income

 

The next question that arises is whether the Bitcoin (asset) will be taxed as a capital gain or as normal trading income when you sell the Bitcoin.

The income tax act is clear on this area as it is well established.

If an asset is held as a long term investment it will be taxed as a capital gain and if the asset is for short term trading (speculative) purposes it will be regarded as trading income.

It can be complex exercise to determine the intention of a taxpayer as to whether the asset was purchased as a long term investment or for trading purposes.  This article will not focus on the complexities of determining the long term or trading nature of the asset. In the current Bitcoin environment I am of the opinion that most of the parties buying and selling Bitcoin is doing this for trading purposes. As soon as you buy low and sell high or even only sell high you are providing an indication that you do not have a set investment period.

 

Conclusion

 

It is therefore in my opinion clear that the gains made on the sale of Bitcoin will be taxed as trading income (except in the unlikely case where it was held as a long term investment where it will be taxed as capital gains).

In simple terms, the amount you sell the Bitcoin for, less the amount you paid for the Bitcoin will be added to your normal taxable income.

 

Example

 

An illustration by example:

Example:

Mr Nakamoto works as an plumber and earns R500 000 salary per year. In addition to this Mr Nakamoto buy and sell Bitcoin. 

In the relevant year Mr Nakamoto did the following Bitcoin trades:

  1. Bought Bitcoin for R100 000 and sold this in the same year for R150 000
  2. Bought Bitcoin for R60 000 and sold this in the same year for R170 000

Thus the total gain Mr Nakamoto made is R50 000 (R150 000 - R100 000) + R110 000 (R170 000 - R60 000) = R160 000.

The R160 000 should be added to his salary of R500 000. Thus his taxable income will be R660 000 (R500 000 + R160 000).

Please note that exchange gains can also play a role, but will not be discussed in this article.

Author: Chris Herbst, CH Consulting

Provisional Tax Estimate - The Risk of using the Basic Amount

on Sunday, 06 August 2017. Posted in General, Tax

Provisional Tax Estimate - The Risk of using the Basic Amount

Many tax practitioners have reverted to the easy option of using the basic amount as an estimate for the first-period provisional tax estimate. Many tax professionals are also under the incorrect impression that this is within the ambit of the income tax act to use the basic amount as a first period estimate.

The actual purpose of the basic amount is twofold:
1. It serves as the minimum estimate.
2. It is used as a limit to calculate underestimation penalties if the taxpayer's assessed income it below R1 million.

A brief examination of the income tax law will substantiate statements one and two above:

Paragraph 19 of the Fourth Schedule of the Income Tax Act 58 of 1962:

19. (1)(a) Every provisional taxpayer (other than a company) shall, during every period within which provisional tax is or may be payable by that provisional taxpayer as provided in this Part, submit to the Commisioner (unless the Commissioner direct otherwise) a return of an estimate of the total taxable income which will be derived by the taxpayer in respect of the year of assessment in respect of which provisional tax is or may be payable by the taxpayer: Provided that such estimate will not include any retirement fund lump sum benefit, retirement fund lump sum withdrawal benefit or any severance benefit received by or accrued to or to be received by or accrue to the taxpayer during the relevant year of assessment.

(b) Every company which is a provisional taxpayer shall, during every period within which provisional tax is or may be payable by it as provided in this Part submit to the Commissioner (unless the Commission directs otherwise) a return of an estimate of the total taxable income which will be derived by the company in respect of the year of assessment in respect of which provisional tax is or may be payable by the company.

(c) The amount of any estimate so submitted by a provisional taxpayer (other than a company) during the period referred to in paragraph 21(1)(a), or by a company (as a provisional taxpayer) during the period referred to in paragraph 23(a), shall not be less than the basic amount applicable to the estimate in question, as contemplated in item (d), unless the circumstances of the case justify the submission of an estimate of a lower amount.

It is clear that the basic amount serves as a minimum estimate when
paragraph (a), (b) and (c) are read together.

An important point to note is that paragraph (c) does not absolve the taxpayer of the obligation to estimate the taxable income and instead fall back on the basic amount.

Paragraph 20 of the Fourth Schedule of the Income Tax Act 58 of 1962:

20. (1) If the actual taxable income, as finally determined under this Act, for the year of assessment in respect of which the final or last estimate of his or her taxable income is submitted in terms of paragraph 19(1)(a) by a provisional taxpayer other than a company, or the estimate of its taxable income in respect of the period contemplated in paragraph 23 (b) is submitted in terms of paragraph 19(1)(b) by a company which is a provisional taxpayer, in respect of any year of assessment is--

(a) more than R1 million and such estimate is less than 80 per cent of the amount of the actual taxable income for such year of assessment, a penalty, which is deemed to be a percentage based penalty imposed under Chapter 15 of the Tax Administration Act, equal to 20 per cent of the difference between--

(i) the amount of normal tax, calculated at the rates applicable in respect of such year of assessment and after taking into account any amount of a rebate deductible in terms of this Act in the determination of normal tax payable, in respect of a taxable income equal to 80 per cent of such actual taxable income; and

(ii) the amount of employees' tax and provisional tax in respect of such year of assessment paid by the end of the year of assessment;

(b) R1 million or less and the estimate is less than 90 per cent of the amount of such actual taxable income and is also less than the basic amount applicable to the estimate in question, as contemplated in paragraph 19(1)(d), the taxpayer shall, subject to the provisions of subparagraphs (2), (2B) and (2C), be liable to pay to the Commissioner, in addition to the normal tax payable in respect of his or her taxable income for such year of assessment, a penalty, which is deemed to be a percentage based penalty imposed under Chapter 15 of the Tax Administration Act, equal to 20 per cent of the difference between--

(i) the lesser of--

(a)(a) the amount of normal tax, calculated at the rates applicable in respect of such year of assessment and after taking into account any amount of a rebate deductible in terms of this Act in the determination of normal tax payable, in respect of a taxable income equal to 90 per cent of such actual taxable income; and

(b)(b) the amount of normal tax calculated in respect of taxable income equal to such basic amount, at the rates applicable in respect of such year of assessment and after taking into account any amount of a rebate deductible in terms of this Act in the determination of normal tax payable; and

(ii) the amount of employees' tax and provisional tax in respect of such year of assessment paid by the end of the year of assessment...

It is evident from paragraph 20 that the basic amount is used as a limit when calculating the understatement penalty for taxpayers where the assessed taxable income was below R1 million.

It is tempting to use the basic amount as a default estimate for the first-period provisional tax estimate. However, risk is involved in doing so.

Let us take a situation where the taxpayer had a basic amount of R900 000 and thus based his / her taxable income estimate for the first provisional tax period on this amount. If the actual assessed income is R1 200 000 paragraph 20(a) will apply (since actual taxable income above R1 000 000). Thus the basic amount will not be used as a limit to calculate an underestimation penalty.

The taxpayer's estimate was less than R960 000 (80% of R1 200 000) and therefore according to paragraph 20(a), an understatement penalty will be issued. The fact that the taxpayer's basic amount was used will not be a justification to avoid the penalty, however, if the taxpayer can provide another legitimate reason SARS may remit the penalty.

The conclusion is that the taxpayer should estimate taxable income and not rely on the basic amount as a default. The basic amount was not intended for this purpose and SARS does not accept it as such.

 Author: Chris Herbst - CH Consulting

Contact us for tax consulting: https://www.chconsulting.co.za/contact

 

Tax and small business owner remuneration

on Saturday, 08 April 2017. Posted in General, Consulting, Tax

The tax consequences of profit extraction by directors of owner managed companies.

Tax and small business owner remuneration

 

Introduction

A question that we often receive from directors is how to compensate yourself if the company is owner managed. In other words a business where the owners are the directors and have discretion in how they are going to structure their own remuneration, or how they are going to extract the profit from the company.  Let us explore three possible scenarios.

1. Building up a loan account

We often find that the owners draw money at will and build up a loan account with the company. Some directors are under the impression that this method attracts no tax. They are wrong. 

The first factor to consider here is the interest rate that the company is charging the director. In most cases this is 0%. In normal circumstances a company would charge an interest rate to someone it lends money to. Thus in this case the 0% or lower than market related interest rate is directly attributed to the fact that the director is a connected person to the company. In other words the director is receiving a benefit due to his / her employment or connection with the company. This  equates to remuneration and as you know remuneration is taxable. 

The way the income tax act deals with this situation is by a concept called a deemed dividend. The logic behind this is that the interest free \ low interest loan to the director is (substance over form) the same as a dividend. At the tax year end the balance of the director’s debit (owing to the company) loan account is used to calculated the deemed dividend. The difference between the interest rate that the company charged the director and the official interest rate (repo rate plus 1%) is used to calculated the amount of interest that “should” have been charged were the director not  a connected person. The balance times the interest rate that “should” have been charged is now deemed a dividend and off course dividend tax (currently 20%) is payable on this amount.

Let me illustrate by way of an example:

Director A of company ABC has a loan account debit balance with the company at year end of R100 000. The company did not charge any interest to the director. The current repo rate is 7% and thus the official interest rate is 8% (7% + 1%). 

Thus the deemed dividend is R8 000.00 (R100 000 x 8%) and the dividend witholding tax on that is  R1 600.00 (R8 000.00 x 20%).

Some directors might think that this is not a bad deal R1 600.00 on R100 000 cash withdrawn from the company. They are again wrong. Remember since the loan is of a capital nature it does not get deducted on the income statement as for example a salary, thus it does not decrease your taxable income. So in effect you can argue that the company pays 28% income tax on the R100 000 (since this would have been deductible if it was a salary. Already you are at R28 000 (R100 000 x 28%) plus R1 600.00 deemed dividend which is R29 600. Again the director might think that this is better than a normal dividend of R72 000 (the after tax profit R100 000 - R28 000) which would have resulted in R14 400 witholding tax (R100 000 x 20%) plus the R28 000 income tax which would which would have resulted in a total of R42 400.

In the loan account situation your total tax was R29 600 at an effective tax rate of 29.6% (R29 600 / R100 000) and in the dividend situation your total tax was R42 400 at an effective tax rate of 42.4% (R42 400 / R100 000). Well that might seem that the loan account is the better option, but the differentiating factor is that the same deemed dividend will be charged on the same R100 000 (plus interest from previous year) in the next year. In other words your effective tax rate in the loan account situation keeps on growing each year that the loan has its balance outstanding. Effectively the director is being taxed multiple times on the same initial R100 000.

2. Paying a dividend

This was basically covered in the previous section. If the director declares a dividend to him / herself the effective tax rate is 42.4%. Simply due to the fact that the company pays 28% tax on the profit and the director pays 20% dividend tax on the dividend allocated from after tax profit.  

An example:

The company has R100 000 taxable income (which the director would like to allocate to him \ herself. Thus the company pays R28 000 income tax and the after tax profit is R72 000 (R100 000 - R28 000). The company can declare a dividend on the after tax profit to the director which results in R14 400 dividend witholding tax (R72 000 x 20%). In other words the company and director paid a total tax of R42 400 (R28 000 plus R14 400) which is an effective percentage of 42.4 (R42 400 / R100 000).

3. Paying a salary

The director can also pay him \ herself a salary. For some reason many directors are under the impression that this is the least tax efficient. In many cases this is actually the most tax efficient.

The tax rate off course varies based on the total salary that the director receives from the company. However the effective tax rate is less than 42.4% (as with the dividend) for a total annual salary of up to R5 961 949 (based on the 2018 individual tax rate table, a corporate income tax rate of 28% and a dividend witholding tax rate of 20%).

Conclusion

Many factors have been left out for simplification in the discussion above. My advice would be to always contact a tax professional to evaluate your specific situation. If I had to make a rule of thumb, I would say it is simple, if your company’s taxable profit that you would like to extract is less than R5 961 950 (for 2018 tax year) extract the profit by way of a salary, if it is more than R5 961 950 (for 2018 tax year), extract the R5 961 950 as a salary and the amount above that as a dividend. What about loan accounts? I would say, stay away!

Contact us for assistance: https://www.chconsulting.co.za/contact

 Author: Chris Herbst

Business Valuations

on Monday, 16 January 2017.

BUSINESS VALUATIONS: THE ART OF THE SCIENCE - PART 2

Business Valuations

We will address the following two questions we ended part 1 with: 

1. The influence of our fair rate of return/discount rate ( 15% in example ) has on the valuation, or how we determine the correct rate.

2. How long we assume the company will exist (three years in the example).

In plain language the rate of return or discount rate is the rate that a rational investor will expect to earn if he / she would invest their money in your business or in our example in Company A. Off course in many valuations there is not an actual investor wanting to invest in the business, however we still use this logic. To determine the fair rate of return we use the Capital Asset Pricing Model (CAPM) : 

E(Ri) = Rf + Beta(RPm) + RPu

where:

  • E(Ri) is required return on security i
  • Rf is the risk-free rate
  • Beta is the influence the general market risk has on the specific company
  • RPm is the general market risk premium
  • RPu is the premium due to company specific risk

This may seem complicated, but fear not, I will explain.

The risk-free rate (Rf) is the rate of return an investor can expect when investing in an investment that carries no risk (all investments actually do have risk, thus we are talking hypothetically). Usually a valuator use the 10 year government bond rate for this. Let’s say in our example the 10 year government bond rate is 8%. You can find the actual bond rates for South Africa at: https://www.resbank.co.za/Research/Rates/Pages/CurrentMarketRates.aspx

The general market risk premium is the added return for additional general risk in the market. This is where the judgement of the valuator plays a role - this can be a subjective consideration. For example if the economic forecasts (say based on political events etc.) is bleak the risk for the investor is greater. Thus the investor would expect more return to compensate for the additional risk. Let’s say we add 5% return for general market risk.

However the general market risk may not have the same influence on all industries or types of businesses. This is where the Beta variable plays a role. It may be that when economic conditions are bad it is actually good for some businesses and bad for others. For example, if the economic conditions are bad people may be under financial stress and shop more at Shoprite (low cost grocery store) and less at Woolworths (high-end grocery store). So in this case bad economic conditions my be good for Shoprite and bad for Woolworths. The Beta variable can have a value between -1 and 1. With a value of -1 it means that whatever the general market risk premium is, it is has the opposite effect on the business. If the market risk premium is 3% then it actually lowers the rate the investor will expect (E(Ri)) by 3%, since -1 x 3% = - 3%. Intuitively it means say bad economic conditions are good for the specific company (Shoprite in example above). On the other end of the scale a Beta of 1 will add the full impact of the market risk premium to the business. The Beta value can also be anything else between -1 and 1. For example 0 would mean the market risk  premium has no influence on the business. The decision on which Beta to use is again one where the valuator will use professional judgement, experience and if available comparable market data. Let’s say in our example the Beta is 0.6.

Lastly the company specific risk (RPu) is the what it says, the risk specific to this company. There may be a number of risk factors specific to a company, for example an inexperienced management team may cause the investor to take on more risk and thus expect for return. Let’s say in our case the company specific risk is 4%.

Now, to calculate our example’s required return / fair rate of return:

E(Ri) = 8% + 0.6 (5%) + 4% = 15%

If you now refer back to Part 1 of our example it will be clear that a higher rate of return will make the value of the business smaller because we discount each future profit back to present value by dividing with (1 + rate of return) to the power of the relevant number of years.

Which brings us to our second question - how long the company will exist or the window period. We can expect the business to exist a certain number of years - again this is based on professional judgement and can be a subjective decision. In many cases there is no clear reason to expect that the business will only exist a certain number of years, but it may be that you are working with a clear exit strategy of say 5 years. Normally I would select 10, 15 or 20 years as a window period. In our example we used 3 years for simplicity. 

Author: Chris Herbst