Corporate Finance Module

2010
UNIVERSITY OF LUSAKA (UNILUS)

Faculty of Accounting and Finance
CORPORATE FINANCE/FINANCIAL MANAGEMENT
STUDY MODULE
COURSE CODE: BSP320/ECF210/AFIN209
PROGRAMS: LONG DISTANCE/FULL-TIME/PART-TIME
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Table of Contents Page
Chapter 1: Introduction to corporate Finance [5]
Role of finance Managers……………………………………………………………………
Forms of Business Organizations…………………………………………………….
Goals of Corporation and agency Problem……………………………………
Corporate Governance issues………………………………………………………….
Financial Markets Operations……………………………………………………………
Chapter 2: Time Value of Money and Valuation Models [16]
Compounding and Discounting…………………………………………………………
Lumps Sum amounts, Annuities and perpetuities…………………………
Compounding interest more than once a year………………………………
Amortizations……………………………………………………………………………………………
Valuation Models for financial Securities…………………………………………
Bond Valuation and Yields……………………………………………………………………
Stock Valuation ………………………………………………………………………………………
Chapter 3: Risk and Return [38]
Risk and return relationship…………………………………………………………………
Measuring risk and expected return…………………………………………………..
Types of Risk and Capital Asset Pricing Model (CAPM)………………..
Efficient frontier and Capital market line (CML)……………………………….

Chapter 4: Capital budgeting or Investment Appraisal [51]
Techniques in Capital Budgeting; NPV, IRR, ARR, PI and Payback Period
Conflict of NPV vs. IRR………………………………………………………………………
Capital Rationing…………………………………………………………………………………
Inflation and Capital Budgeting………………………………………………………
Taxes and Capital allowances …………………………………………………………
Chapter 5: Cost of Capital, Capital Structure and Financial leverage [69]
Introduction……………………………………………………………………………………………
Cost of debt, Prefered Stock, equity and WACC…………………………
Financial Leverage and Capital structure……………………………………
Homemade Leverage…………………………………………………………………………
M&M I theory…………………………………………………………………………………………
M&M II theory…………………………………………………………………………………………
Chapter 6: Working Capital Management [80]
Working Capital cycle, investment and financing policies……………
Cash Management……………………………………………………………………………………
Marketable Securities………………………………………………………………………………
Credit Management…………………………………………………………………………………
Managing trade credit……………………………………………………………………………

Inventory Management………………………………………………………………………
Short-term sources of finance……………………………………………………………
Chapter 7: Efficient Market hypothesis Theory [102]
Introduction……………………………………………………………………………………………
Forms of market efficiency…………………………………………………………………
Analysis Techniques……………………………………………………………………………
Chapter 8: Dividend Policy [105]
Dividends and dividend payment………………………………………………………
Establishing a dividend policy……………………………………………………………
Alternatives to cash dividends……………………………………………………………
Chapter 9: Long-Term sources of Finance [109]
Equity financing………………………………………………………………………………………
Debt financing and debt instruments………………………………………………
Chapter 10: International Trade and Finance [123]
International trade documents……………………………………………………………
Foreign Exchange Markets and Risks………………………………………………
Hedging Tools and Purchasing power Parity…………………………………
Chapter 11: Financial Statement Analysis [133]
Common Size Analysis and Financial Ratios…………………………………
Review Questions………………………………………………………………………………………….…………… [141]

Key learning objectives for the course:
Upon completing this study module student should be able to:
1) Understanding the importance of corporate finance and its relevance in

organization
2) Know the important role that financial managers play in contributing to the
maximization of a firm’s value and shareholder wealth.
3) Understand how financial markets operate and how firms use these to raise
capital for investments.
4) Articulate the relevance of time value of money the various concepts that
underlie the topic and be able to use the various discounting and
compounding methods to evaluate cash flows and financial assets.
5) Understand the relationship between risk and return.
6) Appraise investments using capital budgeting methods learnt.
7) Articulate theories underlying cost of capital and capital structure and also
calculate various cost of capital including weighted average cost of capital.
8) Understand how to manage working capital components and able to

explain the different sources of short term and long term capital.
9) Understand how pricing of share works through market information
10) Determine an appropriate dividend policy for a give firm.
11) Understand risk factors affecting international trade and finance and how
to manage these risks
12) Analyze the performance of firms through financial analysis techniques.

CHAPTER 1
1.0 COPRORATE FINANCE
Introduction
Today Corporations are the main drivers of modern economies. Unlike other forms
of business organization, limited companies or firms especially those that are
public command most of the business transaction and trade around the world.
Due to the structure of most of these public limited companies (Plcs), the
ownership of the company is so diverse and separate from the management of
the company. Management usually makes decision on the best way to manage
the financial resources and other assets of the business on behalf of the
shareholders. Shareholders expect that management will always manage the
shareholders’ investment in such a way that they achieve the goals and
expectation of the owners of the company.
Corporate Finance involves understanding how Corporate Managers (Financial

Managers) will solve organizational problems to do with the following:
i. What long term investments should the business undertake? What assets to
invest in and line of business to be considered. Is it minining, retail trade or
transport etc?
ii. The other questions are with how to raise the required finance for the
business venture identified. Should a stock issue be made or should the
company borrow?
iii. Finally once the resources are secured how the day to day operation should
be managed prudently so that they add value to the shareholders
investments.

As mentioned earlier since owners (shareholders) are not involved in the daily
operations of the firm, these decisions are made by top management, which
includes the Financial Manager. Since prudent financial management is important
in planning for such investments, the financial manager’s role becomes critical.
The role of the Financial Manager
When share holders create a firm (corporation), their intention is to make a profit.
In the initial stage of setting up the firm shareholders, are involved in the day to day
management of the company. However, as the company grows shareholders will
in most cases employ managers to run the company on their behalf. Management
is engaged, to make decisions on behalf of the shareholders in line with
shareholder expectations. Finances play a critical role in the performance of a
company. The finance manager’s role is to plan for the acquisition of assets and
use of these assets, so as to increase the value (wealth) of the firm.
As the firm plans regarding the shareholders’ investments and ways of increasing
the value of the firm the finance Manager engages in making the following
financial decisions:
i. Investment Decisions:
These are decisions that have to do with the firm deciding on what
investments it wishes to make. It also includes determining what assets to
invest in. The decision making process involves selecting viable projects by
applying investment appraisal techniques depending on the nature of
business the firm is involved in (e.g. mining,retail,manufacturing or tourism).
ii. Financing Decisions:
These are decisions regarding, how the investment(s) selected will be
financed. Firms have three options regarding where they source finances.
They can source them internally by using retained earnings, borrowing from
the Debt capital market or Issuing stocks (Ordinary Shares).

The decision to use a specific source of finance is determined by the period
of investment (long-term of Short-term),use of funds for either Capital
investment or Working Capital requirements and desired capital structure
for a given firm. That is, the balance between equity and debt used in
financing the assets of the firm.
iii. Dividend Decisions
These decisions involve determining a dividend policy for the firm which
describes how the returns from the investment are distributed to
shareholders as dividends. The policy describes when and how much of the
profits are distributed as dividends including the mode of payment.
As the finance manager performs these functions the overriding goal is to ensure
that the firm’s value is maximized.
Forms of Business Organizations
Businesses across the world operate in three main forms which include: Sole
Proprietorship, Partnerships and Corporation (Companies or limited Companies).
i. Sole Proprietorship (Sole trader)

A sole trade business is a form of business owned by one individual. Going
into business as a sole trader is very easy and is common with very small
establishments. Most large companies present today started as sole
proprietorships.
Advantages of Sole proprietorship:
1. It is easily and inexpensively formed since there are no stringent
legal requirements and are usually subject to a few government
regulations.
2. The businesses pay small amounts of taxes and are nonexistent
in some cases.

Some limitations of sole proprietorship
1. It is in most cases difficult for a sole proprietorship to sources for

large sums of capital.
2. There is no limited liability with a proprietorship for business debts
and can lose assets beyond those invested in the business.
3. The life of a proprietorship is limited to the life of the individual who
created it.
ii. Partnerships
A partnership exists whenever two or more persons associate to conduct a
business with a view to make a profit. Partnerships operate under a
partnership agreement entered into by the partners. Where such an
agreement has not been signed the law is taken to apply. The major
advantage of a partnership is its low cost of formation. The limitations of
partnerships are:
1. Unlimited liability for the partners.
2. The limited life of the business as it is tied to the continued
relationship of the partners.
3. There is difficulty in transferring of ownership.
4. Difficulty in raising large capital amounts.
iii. Corporations(Limited Companies)

A corporation or Company is a legal entity or person created under law,
distinct from its owners and managers.
The separation gives the corporation three major advantages:
1. It has unlimited life and it continues beyond the original owners or
existing shareholders.
2. It permits easy transfer of ownership interest (shares).

3. It has limited liability meaning that the shareholders only stand to lose
what has been invested in the company in case of liquidation of the
company.
4. These three factors allow corporation to easily access large amounts
of capital.
The most preferred form of running a business is to organize it as a corporation

or limited company. The major thrusts are:
1. Limited liability reduces risk to investors and the lower the firm’s risk
the higher its value.
2. A firm’s value is dependent on its growth opportunities which in turn
are dependent on the firm’s ability to attract capital. Since
corporations can attract capital more easily than unincorporated
businesses they have superior growth rate.
3. The value of an asset also depends on its liquidity, which means the
ease of selling the asset and converting it to cash. Since an
investment in the stock (shares) of a corporation is much more liquid
than a similar investment in other businesses, this too means that the
corporation form of organization can enhance the value of a
business.
4. Corporation may in some instances be taxed at a lower rate or be
given tax holidays or other tax incentives. These incentives in most
cases may not be available for the other forms of businesses.

Goals of the Corporation
Decisions in corporations are not made in a vacuum but rather with some
objective in mind. Firms have different objectives such as profit maximization,
market share growth, and Sales maximization, minimize costs among others.
However, among all these the most important goal of the firm is to maximize
the wealth of shareholders which translates to maximizing of share prices.
Value creation occurs when we maximize the share price for current
shareholders.
Example 1.1
Goal statement by firms;
1. “Creating superior shareholder value is our top priority.” Associated Banc-

Corp 2006 Annual Report.
2. “The desire to increase shareholder value is what drives our actions.” Phillips
2006 Annual Report.
3. “FedEx’s main responsibility is to create shareholder value.” FedEx

Corporation, SEC Form Def 14A for the period ending 9/25/2006.
4. “… the Board of Directors plays a central role in the Company’s corporate

governance system; it has the power (and the duty) to direct Company
business, pursuing and fulfilling its primary and ultimate objective of
creating shareholder value.” Pirelli & C. S.p.A. Milan Annual Report 2006.
Wealth Maximization is superior because it takes account of current and future

profits and EPS; the timing, duration, and risk of profits and EPS; dividend
policy; and all other relevant factors. Thus, share price serves as a barometer
for business performance.
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On the other hand profit maximization has the short comings such as
increasing current profits while harming a firm (e.g., defer maintenance, issue
common stock to buy T-bills, etc.) It also ignores changes in the risk level of the
firm.
Now since the goals of shareholders may not represent the goals of managers
who run the firm, managers may not always act in the best interest of
shareholders. This creates conflict of interest.
The Agency Problem
This is defined as a potential conflict of interest between the principals

(Shareholders) and the agents (Managers).This is created when managers act
in contrast to the expectations of the shareholders regarding the objective of
wealth maximization. It is necessary for shareholders to put in place incentives
to ensure that managers maximize shareholder wealth.
Managerial Incentives to maximize shareholder wealth
To ensure that managers act in line with shareholder expectation agency costs
are incurred by firms. These costs take several forms:
i. Expenditure to monitor managerial actions. e.g external audits

ii. Expenditure to structure the organization so that the possibility of
undesirable managerial behavior will be limited.
iii. Opportunity costs associated with lost profits opportunities because the
organizational structure does not permit managers to take actions on as
timely basis as would if the managers were shareholders.
Mechanism applied to force managers to act in the shareholders best interest

include:
i. The threat of being fired.

ii. The threat of take over which takes the form a hostile takeover. When a new
firm takeover another company managers are usually replaced by these
appointed by the new board. Management would want to avoid a takeover
for fear of losing their jobs to competition.
iii. Structured Managerial Incentives, which include executive share options,
where executive, are given an opportunity to buy share in the future at some
discounted price and performance shares awarded on the basis of
performance using some criteria.
Corporate Governance Issues

Due to the structure of modern corporations’ conflicts arise as a result of
differences in perception and needs of shareholders, managers, society and
other stakeholders regarding how the corporation functions. The goal of
corporate governance is to:
o Eliminate or mitigate conflicts of interest particularly those between
managers and shareholders.
o Ensure that the assets of the company are used efficiently and
productively and in the best interest of its investors and other
stakeholders.
o Promote sustainability: Meeting the needs of the present without
compromising the ability of future generations to meet their own needs.
o Instill corporate Social Responsibility (CSR) by promoting a business
outlook that acknowledges a firm’s responsibilities to its stakeholders
and the natural environment.
Attributes of an effective corporate governance system are:
1. Delineation of rights of shareholders and other stakeholders;
2. Clearly define manager and director governance responsibilities to
stakeholders;
3. Identifiable and measurable accountabilities for the performance of
the responsibilities.
4. Fairness and equitable treatment in all dealings between managers,
directors and shareholders;
5. Complete transparency and accuracy in disclosure regarding
operations, performance, risk and financial position.
Attempt Review Question number 10
FINANCIAL MARKETS
In an economy there exist an interaction between the corporation, financial

intermediaries and lenders and borrowers. This occurs in the financial markets
and is there for the purpose of facilitating the raising of capital by corporation and
other businesses, which in turn lead to economic growth.
Unlike commodity markets where trading of physical goods is done, Financial

Markets are markets where financial assets, instruments or securities are traded.
These instruments facilitate the transfer of funds between units that need funds
and those that supply funds. The financial Markets that are found in any financial
System consist of a number of players. The markets bring together lenders,
borrowers (investors) and financial intermediaries (financial institutions).Financial
intermediaries are firms such as commercial banks, stock exchanges, investment
companies, insurance companies and pension funds. Borrowers and lenders of
funds include both individuals and firms.
Financial markets play an important role in the financial system because they
allow firms to raise capital for new investments.
Financial markets can further be subdivided into the following:
i. Primary Markets
These are markets in which newly issued securities are bought and sold for
the first time. Initial Public Offer (IPOs) is usually done in the primary market.
Firms raise capital through the primary market.
ii Secondary markets
These are markets in which existing, outstanding securities are bought and
sold. The company that first issued the securities does not participate in the
secondary market.
iii Capital Markets
Capital markets are markets for long-term debt and corporate stocks. New
York Stock Exchange (NYSE), London Stock Exchange, Lusaka Stock
Exchange (LuSE) etc
iv Money Markets
These are markets for debt securities with a maturity of less than one year
(short term).
v Spot Markets and Futures Markets
Spots markets are refers to buying and selling of assets on the spot at spot
prices, while futures markets refers to markets where assets are bought and
sold for delivery at some future date and at some agreed price.
Attempt reviews questions number 11, 12, 24 & 6
CHAPTER 2
2.0 TIME VALUE OF MONEY AND VALUATION:
Introduction
Time value of money has to do with trying to determine the value of cash flows
expected in the future. It is essential to note that the value of a dollar today is
worth more than a dollar received in the future.
This is due to the element of interest. To store the value of money interest is
charged to compensate for the opportunity cost or deferred consumption.
Hence in money terms a dollar in the future is equal to a dollar today plus
interest earned. By including the element of interest it is possible to compound
and discount values.
Future value and compound interest for lump sum
The future value of a sum today can be found by compounding or adding

interest to the present value. Interest can be added using simple interest or
compound interest.
Simple Interest is when interest is not reinvested, so interest is only earned on

the principle amount.
Compound Interest Is when interest is earned on interest invested over more

than one period.
Future Value (FV) Is the amount an investment is worth in the future invested
at some rate of interest over a given period of time.
Future value interest factors
(1+r)t or (FVIFr,t) form the tables. This is also known as a compound factor.
Present value and discounting for lump sums
Present Value (PV) Is the current value of a future cash flow discounted at
some discount rate over a given period of time. Discounting is the removal of
interest from a future value while compounding is the addition of interest.
Formulas:
Compounding: for a single period
i. FV=PV (1+r)
Compounding: for more than one period
t
ii. FV= PV (1+r)
Discounting: for a single period
iii.PV=FV/(1+r) or PV=FV * 1/(1+r)
Discounting: for more than one period
iv.PV=FV/ (1+r)t or PV=FV * 1/(1+r)t
t =Number of compounding or discounting periods these can

years,months,weeks,or days.
r = the rate of interest used to compound or discount values.
Present value interest factors
1/(1+r)t or (PVIFr,t) from the tables. This is also known as a discount factor.
Example 2.1
Invest $100 at a rate of interest of 10% for a period of two years using:
o Simple Interest
o Compound interest
o Compare your answer when you invest for one year only.
Solution:
Using simple interest:
$100 *0.1=$10 for year one interest earned
$100*0.1=$10 for year two interest earned
$100+$10+$10=$120 is the future value of $100.
Notice the interest is only earned on the principle.
Using Compound Interest:
FV=PV(1+r)t
2
=$100(1.1)
=$121
The future value will be more than the simple interest FV since interest is
reinvested. For one year the values will be equal since interest is not reinvested on
compound method.
Example 2.2
What is the present value of $300 received two years from now, discounted at
10%.
This requires discounting $300 to the present or today.
0 1 2 $300
PV
t
PV = FV*1/(1+r)
= 300(0.8264)
= $247.92
Example 2.3
What is the future value at the end of the fifth year of the following stream of cash
flows received at the end of each of the five years, if each is invested at 15%
Year 1 $300
2 $200
3 $150
4 $100
5 $200
300 200 150 100 200
FV = 300(1.7490) +200(1.5209) +150(1.3225) +100(1.1500) +200

= $1342.26
The future value can be picked from the tables for future values of a $1.
Compounding and discounting Annuities:
An annuity is a series of payments or receipts of an equal amount for a specified

number of periods. When the cash flows occur at the end of the period it is
known as an ordinary annuity or deferred annuity. When the cash flows are
made at the beginning of each period it is an annuity due.
Future value of an annuity:
FVa= a ((1+r) t – 1)/r or FVa = a (FVIFA r,t)
Where a = the equal annuity payment
FVa = future value of a annuity
Annuity Due:
FVa due = a (FVIFA r,t)*(1+r)1
Present Value of an annuity:
PVa = a (1- 1/(1+r)t)/r or PVa = a (PVIFA r,t)
Annuity Due:
PVa due = a (PVIFA r,t)*(1+r)1
Work out an annuity due like an ordinary annuity and then multiply by (1+r) 1.
Perpetuities
Perpetuity is a stream of equal cash flows that is expected to continue forever

(infinity). PV perpetuity = PMT/r, where PMT is the equal payment.
Example 2.4
A company offer annual payments of $100 at the end of each year for the next
three years. What is the present value of this annuity discounted at 10%.
PVannuity = a (PVIFA r,t) ,where; r=10% , t=3
PVa = 100(2.4869)
=$248.69
Example 2.5
Suppose the payment in were made at the beginning of each period instead
of at the end? This becomes an annuity due. The present value is then;
PV a due = a (PVIFA r,t) *(1+r) where; r=10% , t= 3
= 100(2.4869) *(1.1)
=$273.56
Example 2.6
Future Value of an annuity for $200 paid at the end of each year for 2 years is
found as follows; assuming interest is compounded semi annually at 10%
FVa = a (FVIFA r/m,t*m) where r=10% ,t= 2 years ; m=2 the rate will be 5% and
period will be 4 from the table.
FVa = $200(4.3101)
= $862.02
Example 2.7
The future value of an annuity due where $300 is paid at the beginning of each
year for 3 years at 12% is found by;
FVa due = a (FVIFA r,t) where r=12% ,t =3
= 300(3.3744)*(1.12)
= $1133.80
Example 2.8
Perpetuity has no time limit. The present value of $100 perpetuity discounted at
15% is;
PV pp = PMT/r, where r=15%, PMT is $100.
= 100/0.15 = $666.67
Determination of interest rates
How can we know the rate of interest being charged by a bank? This is possible
by solving for the rate using tables.
Example 2.9
1. A bank offers to lend you $1,000 if you sign a note to pay $ 1,610.50 at the end
of 5 years. What rate of interest is the bank charging you?
PV=$1000, FV=$1610.50 and t=5 ,r=?
PV= FV (PVIF r,t)
1000=1610.50(PVIF r,t)
1000/1610.5= (PVIF r,5)
0.620925178= (PVIF r, 5years)
From the table we look for the discount factor 0.6209 and look up the interest
rate we find 10%.
Attempt review question number
Find for an annuity the interest charged using the same concept.
Compounding Interest more than once a year
Effective Annual Rate (EAR)
The interest rate offered or stated by lending institutions known as Nominal or

Stated Interest rate or APR (Annual percentage Rate). When interest is
compounded more than once per annum (semi, quarterly, week, daily),
comparing such rates with those quoted per annum we need to find the Effective
annual Rate (EAR). EAR is the rate of interest actually being earned as opposed to
the stated rate.
m
EAR = (1+ r/m) – 1.0, where m is the number of compounding periods in a
year.
Example 2.10
What is the effective annual rate on a loan where interest is compounded

monthly and the nominal rate used is 12% per annum? M =12
12
EAR = (1+ 0.12/12) - 1 = 1.12682503-1
= 0.12682503 or 12.6%
The 12.6% is proof that when interest is compounded more than once per year
the effective interest is much higher than that quoted.
Discounting and compounding for periods shorter than a year
When discounting or compounding for periods shorter than one year divide the
rate of interest (r) with the number of periods (m) and multiply the time (t) with the
number of periods (m).
For lump sum amounts
t*m
FV = PV (1+ r/m)
Where m is the number of periods of compounding in a year.
t*m
PV = FV/(1+r/m)
For Annuities
FVa = a (FVIFA r/m,t*m)
PVa = a (PVIFA r/m,t*m)
Amortization
Amortizing a loan is paying off, liquidating a loan in equal installments at fixed

intervals over the life of the loan or obligation. The liquidation can be shown
through an amortization schedule.
Example 2.11
Prepare an amortization schedule for a $1,000 loan to be paid in 3 equal

installments at the end of each of the next 3 years. Interest is charged at a rate of
6% per annum.
Steps 1: find the annual installment (a) using annuity formula.
Steps 2: construct the amortization schedule.
PVa = a (PVIFA r,t) where r=6% ,t=3years PVa=$1000
1000=a (2.6730)
‘a = 374.11
AMORTIZATION SCHEDULE
Year Beginning Installment Interest Paid Principle Balance

Amount ($) ($) Paid ($) ($)
($)
1 1000.00 374.11 60.00 314.11 685.89
2 685.89 374.11 41.15 332.96 352.93
3 352.93 374.11 21.18 352.93 0
1,122.33 122.33 1,000.00
Always find the installment by applying the annuity formula.
VALUATION MODELS FOR FINANCIAL SECURITIES
The application of the discounted cash flow methods is important when it comes
to determining the value of financial assets. In particular it is used in valuing
Bonds, Stocks and other financial assets that are traded in by investors. The
process involves estimating the future cash flow streams from a given asset and
then discounting them at a rate to the present hence deriving the price or value of
the asset.
Bond Valuation
A bond is a long term debt instrument issued by governments or corporations. The
issuing party issues bond certificates in exchange for loan(debt) that will be
payable at some maturity date plus interest throughout the term of the bond at an
agreed rate.
Features of a Bond:
1. Par Value or Nominal Value: A bond has par value also known as face
value of the bond which represents the original amount borrowed by the
issuer of the bond. (‘Original price’).
2. Maturity Date: A bond has a maturity date which is the date on which the
par value is supposed to be repaid.
3. Coupon Interest Rate: This is rate of interest that the bond issuer promises
to pay on the bond. It is a percentage of the par value. E.g. $1000 par value
Bond with interest rate of 10%.
4. Coupon Payment: This is the monetary value of interest that is paid on the
bond at specified times or period yearly or semi annually or quarterly etc.
The coupon payment for a $1000 par value bond at 10% is $100.During the
term of the bond only interest is paid, while the principle is repaid at
maturity.
5. Maturity Period: this is time from when the bond is issued to the time it
matures. The maturity period of bonds varies from 5 year-10year and more.
6. Call Provision: This allows the issuers of the bond to call back the bond
before its maturity date. Usually there is a premium for calling a bond called
a Call premium.
Determining the Price or Value of a Bond
A bond provides two cash flow streams Interest (I) and Maturity value (par
value)(MV) at the end of the term.
t t
Value of Bond (Price) =∑ I*(1/1+kd) + MV(1/1+kd)
Or
Vb= I (PVIFA kd,t) + MV(PVIF kd,t)
Where I = the interest payment (Coupon)
MV= maturity value of the bond at maturity
kd= market interest rate applicable on bonds
t = number of years until the bond matures. This declines each year after the
bond is issued.
Example 2.12
Emma Bond: Par value $1000, coupon rate 10%, maturity 10years, market rate for
bonds 15%.
Find the value of the bond five years after it had been issued.
I=$1000*.1=$100,t=5years ,r=15%
Vb =100(PVIFA 15%, 5years) + 1000(PVIF 15%, 5years)
Vb = 100(3.3522) +1000(0.4972)
=335.22 +497.2
=$832.42
The time take is the time remaining before the bond matures and not the original
maturity of 10 years.
Bonds and Interest Rates
Bond prices in the market are affected by changes in the interest rates. The
following are the observation for prices when rates change up and down in the
market.
1. When the going rate of interest kd is equal to the coupon rate a bond will
sell at par value.
2. When the going rate of interest is above the coupon rate a bond will sell
below par value. Such a bond is called a discount Bond.
3. When the going rate of interest is below the coupon rate a bond will sell
above par value. Such a bond is called a Premium Bond.
4. An increase in interest rate will cause the price of an outstanding bond to
fall, while a decrease in rates will cause it to rise.
5. The market value of a bond will approach its par value as its maturity date
approaches.
Determining the interest rate on a bond Yield to Maturity (YTM)
Yield to Maturity (YTM) is the rate of return earned on a bond if it is held to maturity.
This return is important to investors who want to buy bonds in the market; they
would like to know how much they will earn from a bond if they bought it and held
it to maturity. This rate of return is what is compared to the rates on other bonds in
the market to determine whether it’s worthwhile to buy or not. When a bond is
selling at par the YTM (Total Yield) consist of interest yield only. If the bond sells
below or above par the YTM will consist interest yield and positive or negative
capital gains.
YTM (Total Yield %) = Interest Yield% + Capital Gains Yield%
Total Yield = I/P1 + (p1-p0)/P0
Where; I is the interest payment on the bond
P1 is the current market price of the bond
P0 is the original or par value of the bond
Capital Gains= Current Price – Par Value
Finding the YTM by formula:
YTM = [PMT + (MV-Vb)/N] / ({2Vb+MV}/3)
Where; MV is the maturity value or par value, Vb is the market price for the bond,N
is the time until the bond matures and PMT is the coupon payment.
When a bond is called it is possible to determine a Yield to Call (YTC). In this case
MV will be replaced with Call Price (CP).
Example 2.13
A company has a bond issued at par $1000 and 2 years after being issued the
bond is being sold for $1200.The coupon rate on the bonds is 10% and had a
maturity of 10 years. Find the YTM?
YTM = 100+ ((1000-1200)/8)/((2*1200)+1000)/3
= 75/1133.333 = 0.06617647 or 6.6%
Example 2.14
Suppose these bonds had a call provision and were called after 2 years. Find the
YTC if the call premium is 10% of par value.
Call price =1000*1.1= $1100
YTC = (100+ ( (1100-1000)/2))/((2*1000)+1100)/3
= 150/1033.33 = 0.14516129 or 14.5%
Current Yield (CY)
This is the return earned by the bond based on its current market price. It is found
by dividing the coupon with the bond current market price.
Current Yield = Coupon/Current Price
Example 2.15
if a bond issued at par was selling for $900 and paid a coupon of $100.Its current
yield will be
C Y = 100/900 = 11.11%
Bond Value for interest compounded more than once per annum:
When compounding occurs more than once per year the formulas are modified as
follows:
Vb= I/m (PVIFA kd/m,t*m) + MV(PVIF kd/m,t*m)
Where m = is the number of compounding periods.
Divide the interest rate kd by the number of periods of compounding and multiply
the time by the same number of compounding periods.
VALUATION OF STOCKS (SHARES)
Stocks can be grouped into two categories Common Stock and Preferred Stocks.
The general term used is equity.
Preferred Stocks:
Are hybrid types of stock as they have similarities with both common stock and
bonds. They pay a fixed dividend and are paid before common stock. Because of
their cumulative nature they can be omitted from payment without causing
bankruptcy. They do have a maturity date.
Vps= D/kps
Where D is the dividend on the preferred stock and k ps is the required rate of
return.
Common Stock:
Common stocks represent an interest in the ownership of a company. Shares

entitle shareholders to dividends but do not guarantee payment of dividend all the
time. Shares can also be sold at some future date at a higher price. This allows the
shareholder to earn Capital Gains. It is also possible to make capital losses if share
prices depreciate. The main cash flow streams from stocks are dividends and
capital gains resulting from selling the shares at a higher price.
Valuation of stocks
The value of a stock depends on whether the dividend is static (Zero growth);
growing from year to year at constant rate or growing at a non constant rate.
Hence the following models have been developed.
Zero Growth Model:
It assumes dividends remain the same throughout. Because the dividend payment
is infinite this becomes perpetuity.
P0= D/ks
Where P0 is the Price or value of the stock today and ks is the discount rate.
Constant Growth Model (Gordon’s model):
It is applicable to stock valuation when the dividend grows at a constant rate of

growth g.
P0= D0(1+g)/Ks-g = D1/ks-g
Where D0 is the dividend just paid and D 1 is the dividend paid at the end of year
one.
g is the constant growth rate and ks is the discount rate. Note; is Ks>g
Non Constant Growth Model:
This is a model that is applied when growth is not constant.
Example 2.16
Ks= 16%,
N = years for super normal growth 3 years
g1= growth rate during supernormal growth 30%
g2= constant growth after supernormal growth 10%
D0= last dividend that the company just paid=$1.82
Expected Rate of Return on a Constant Growth stock
Rate of return= Dividend yield + Capital Gains Yield
Ks = D1/P0 + g
Capital gains yield %= Capital Gain/Beginning Price
Or (P1-P0)/P0 * 100%; a yield is a percentage.
Examples 2.17
Valuation of Preferred Stock
Vps = Dps/kps
The required return on a preferred stock is 10% and a company pays dividends
of $8.125 per year. Find the value of the stock today.
Vps=8.125/0.10
= $81.25
Zero Growth in dividends stock
A stock pays a dividend of $1.82 per with zero growth, the required rate of
return is 16%. Find its market value today.
Po=D/ks
= 1.82/0.16
= $11.38
The rate of return ks can be found by making it the subject of the formula where
the price of the stock is given.
Constant Growth model (Gordon’s Model)
Dividends are assumed to grow at a constant rate of growth g.
A company pays a dividend that has a constant growth rate g of 10% per year and
the company most recent dividend payment was $1.82.The required rate of return
is 16%.Find the value of this stock in the market.
Po= Do (1+g)t/ks-g = D1/ks-g
G= growth rate
Ks= required rate of return
Do= recently paid dividend
D1= D0 (1+g)1 = 1.82(1.10) = $2.00
Po= 2.00/0.06
= $33.33
Non- Constant growth model
A company’s required rate of return is 16% and the dividend growth at a rate of
30% g1 for 3 years and then it dropped to a constant growth rate of 10% g 2
thereafter. The most recently paid dividend was D0= $1.82.
Where dividends grow a varying growth rates the following steps are required
to solve such a question.
Step 1 Find the PV of the dividend during the period of non constant growth by
first finding respective dividends for each year and then discounting those
cash flows.
Step 2 Find the price of the stock at the end of the non constant growth period,
at which point it has become a constant growth stock and then discount this
price back to the present.
Steps 3 finally add the two values found in step 2 and 3 to determine the value
of the stock today.
Steps 1 find the PV of dividends from year 1- 3
D1= 1.82(1.30)1 = 2.366

D2= 1.82(1.30)2 = 3.076
D3= 1.82(1.30)3 = 3.999
Present Values of the dividends are found by discounting each dividend to the
present.
1.366 (0.8621) = $2.040 D1
3.076(0.7422) = $2.286 D2
3.999(0.6407) = $2.562 D3
Total $6.888
‘g1 =30% ‘g2 =10% ∞
PV D1 D2 D3 D4
Step 2 Find the present values of the dividends expected from year 4 onwards.
P3= D4/ks-g
= 3.999(1.10)1/0.06
= $73.32
This is the price of the stock at the end of year 3,so we to discount back to the
present 3 years back.
PV of P3
$73.32(PVIF16%,3years)
= 73.32(0.6407)
= $46.98
Step 3 Find the price of the stock by adding the two components found in step
one and step two.
P0= $6.89+$46.98
= $53.87
This represents the value of the stock today in the market.
Yields on constant growth stock are determined as follows:
Expected Yield = Dividend Yield + Capital Gains Yield
= D1/Po + g ; g= Capital Gains Yield
Examples 2.18
1. A stock originally sold for $20 per share and now sells for $25.The dividend last
paid was $5.Find the Dividend yield and capital gains yield and total yield or
return.
Dividend yield = $5/$20 = 25%
Capital Gain = $25-$20 = $5
Capital Gains yield = $5/$20 =25%
Total Yield = 25%+25% =50%
Suppose the stock had a growth rate g of 5% this represent the capital gains
yield for such a stock.
Attempt Question number 5, 7, 9 a, b, 18 & 19
CHAPTER 3
3.0 RISK AND RETURN
Introduction
Risk is part of doing any business and it cannot be ignored. Different businesses or
ventures will be associated with different levels of risk. The risk level inherent in a
particular business is also responsible for the amount of return that investors will
demand.
Relationship between risk and Return
The expected return on any investment is dependent on the inherent level of risk
attached to that particular investment. Usually investors will demand more return
for taking on more risk. Hence the higher the risk the higher the return demanded
by investors. Only government securities or instruments are considered risk-free,
these include government bonds and treasury bills (T-Bills).Government are
known not to default, as they will eventually pay their debts or obligations.
Investor Attitude towards Risk
Investors are generally not comfortable with risk. This behavior is term risk
aversion. Risk aversion is the tendency by investor to avoid risk. However there are
those investors that are risk takers and are willing to take on more risk to make
more gain.Behavoiur towards risk is preferential hence some investor are risk
averse while others are risk takers.
Risk defined
Risk is the probability that the actual future returns from an investment may differ
from those expected. In other words it is exposure to loss. This is so because it
very difficult to predict the future accurately because there are so many factors to
consider that changes unexpectedly. e.g recent global recession. Because risk is
important for determining the return that investors demand and most investors are
risk averse (avoid risk), we need to measure it to be able to factor it in the
computation of returns appropriate for investors.
Measuring Risk
As there is a relationship between risk and return a need to measure or quantify

risk was required. Prof Markowitz developed a way of measuring risk using
statistical mathematics under his principle of portfolio selection (1952). He
suggested that investor could select efficient or optimal portfolios given risk level
and return. The following assumption were made under this principle
i. Investors are rational meaning that they are profit seeking and would
therefore wish to maximize return but that they are also risk averse.
ii. Every investment has a probability distribution of returns. Factors leading to

deviation in returns are states of economy, industry or company. The
probability that actual returns deviate from the expected returns represents
a risk.
In order to measure risk we need to understand the probability distribution of the
risk. A probability distribution is a list of all possible outcomes for an event or
outcome with a probability assigned to each outcome.
Example 3.1
A probability distribution for different states of an economy with probability

assigned and the returns under each state of the economy.
State of Economy Probability Returns of Stock Returns of Stock

A B
Boom 0.3 25% 19%
Normal 0.4 15% 12%
Recession 0.3 -10% 8%
Total Probability 1.0
Risk can be measured by looking at the variability in the probability distribution

with reference being made to the mean value or average (expected return).The
variability or spread, which is the risk is measured using the standard deviation.
The smaller the standard deviation the lesser the risk and the larger the standard
deviation the higher the risk. Before we can measure the standard deviation we
need to know the expected return or mean.
Expected Return
The expected return is the mean or average value of the probability distribution of
possible events. It’s the weighted average return on an investment.
Expected Return = ER= P1(R1)+P2(R2)+P3(R3)
Meaning summation of the product of the respective probabilities and the returns,
where Pi probability for a given state of economy and k i is the return on a given
stock.
Solution
Expected return for stock A
State of Economy Probability Returns of Stock A ER
Boom 0.3 25% 7.5%
Normal 0.4 15% 6%
Recession 0.3 -10% -3%
Total Probability 1.0 Expected Return 10.5%
The expected return =10.5%; this can be written as k=P 1(k1)+P2(k2)+P3(k3).
From here we go on and work the standard deviation of the stock or risk.
Standard Deviation
Standard deviation= s=√∑ (k-ki)2*P
Or standard deviation = √ P1 (R1-ER)2+P2(R2-ER)2+P3(R3-ER)2
Standard Deviation for stock A is calculated as follows:
R –ER (R-ER)2 (R-ER)2 P
25-10.5=14.5 210.25 (210.25)(0.3) = 63.075
15-10.5=4.5 20.25 (20.25)(0.4) = 8.100
-10-10.5=-20.5 420.25 (420.25)(0.3) = 125.075
Variance = = 196.25
Standard Deviation = = 14.00892573
Coefficient of Variation CV
This is the risk measured per unit of return, measured as the standard deviation
divided by the expected return.
CV= ; for stock A the CV = 14.00892573/10.5 = 1.334
This means that for this stock A an investor takes on 1.334 units of risk for every
extra 1.0 unit of return earned. This is useful especially where standard deviations
are equal or close and an investor needs to choose between two or more options
for investment.
Types of Risk
Every business has an inherent risk associated with it and this risk can be
classified into two categories.
i. Systematic Risk
This is the risk that affects the entire market or a large number of assets or stock. It
is known also as market risk. Because it affects the entire market it is difficult to
avoid or diversify out. It is hence called undiversifiable risk. This is the type of risk
that is important to an investor when determining their required rate of return.
ii. Unsystematic Risk
This is the risk that is unique or specific to an asset, stock, or individual

company.Because it is unique an investor is able to diversify this type of risk and
hence it is called diversifiable risk or specific risk. Total risk is a combination of the
two types of risk. The standard deviation measures total risk while systematic risk
is measured by the beta
Portfolio Selection and Diversification
Most investors tend to hold more than one investment. They hold what is known
as a portifolio.A portfolio is a group of assets or investment held by an investor. The
reason for holding a portfolio is to diversify the risk or reduce the level of exposure
to risk associated with holding a single investment.
Determining the risk in a portfolio requires knowing the portfolio expected return
and the correlation or covariance of the returns among the securities that make
the portfolio.
Portfolio expected return
Expected return for a portfolio ERp=WA*ERA+WB*ERB
Example 3.2
Let say you intend to hold a portfolio in which 50% of the funds are invested in A
and the other half in B.The ER for A and B respectively are 10.5% and 12.9%.Let us
assume that the calculated standard deviation for A and B are 14% and 4.32%.Find
portfolio expected return.
ERp= 0.5(10.5)+0.5(12.9) = 11.7%
Measuring Risk for a Portfolio
A number of factors affect the risk associated with holding a portfolio; one of them
is the way returns from investment move in relation to each other. Returns either
move positively or negatively in relation to each other. This is known as the
correlation (covariance). The covariance is measure as follows:
,
COV (Ra Rb) =∑P2(Ra-ERa)(Rb-ERb)
= 0.3(14.5)(6.1)+0.4(4.5)(-0.9)+0.3(-20.5)(-4.9)
= 55.05 or 0.5505
This means that the relationship between the returns of A and B is positive. This
will increase the risk for a portfolio.
To obtain the portfolio risk we need to compute the portfolio standard deviation
using the formula below.
∂p= √ WA2 x ∂A2 + WB2 x ∂B2 + 2 xWA x WB x COV (Ra,Rb)
Where;
W is percentage weights for amount invested in A and B
∂ is the standard deviation for A and B
,
COV (Ra Rb) is the covariance for A and B
Therefore the portfolio standard deviation for this example will be;
2 2 2 2
∂p = √ 0.5 (0.14) +0.5 (0.0432) +2(0.5)(0.5)(0.5505)
= 0.0049+0.00046656+0.27525
= 0.529732536
The correlation lies between +1 and -1. When it is 0 it means there is no relation
between the returns movement.
Diagram for the relationship between returns of A and returns of B in a

portfolio
Returns
Stock A returns
Stock B returns
Diagram 1 shows Positive Covariance or Correlation Coefficient
2.
Returns Stock A returns
Stock B returns
Diagram 2 shows Negative Covariance or Correlation Coefficient
Negative correlation between returns from two or more investment reduces the
overall risk for a portfolio, hence it is important to understand how return move
when selecting investments to add to a portfolio.
The Efficient Frontier
The Efficient Frontier represents all the dominant portfolios in risk/return space.
There is one portfolio (M) which can be considered the market portfolio if we
analyze all assets in the market. Hence, M would be a portfolio made up of assets
that correspond to the real relative weights of each asset in the market. Assume
you have several assets. With the help of the computer, you can calculate all
possible portfolio combinations for a portfolio. The Efficient Frontier will consist of
those portfolios with the highest return given the same level of risk or minimum
risk given the same return.
The Efficient Frontier Graph 1
Figure 1
The Efficient Frontier Graph 2
Figure 2
The Capital Market Line (CML)
What Does Capital Market Line (CML) Mean?
A line used in the capital asset pricing model that plots the rates of return for
efficient portfolios, depending on the risk-free rate of return and the level of risk
(standard deviation) for a particular portfolio.
The CML is derived by drawing a tangent line from the intercept point on the
efficient frontier to the point where the expected return equals the risk-free rate of
return. The CML is considered superior to the efficient frontier because it takes into
account the inclusion of a risk-free asset in the portfolio. The capital asset pricing
model (CAPM) demonstrates that the market portfolio is essentially the efficient
frontier. This is represented visually by the security market line (SML).
Graph for Capital Market Line (CML)
Capital Asset Pricing Model CAPM
Risk can also be measured in terms of the volatility of particular assets returns to
movements in the returns from the market as a whole. The coefficient that
measures this risk is known as a Beta β. It measures systematic risk or market risk.
The market stock is always assigned a β =1.All other stock will be compared to the
market stock β,and will have a beta which is above 1,below 1 or equal 1.Stocks
with beta above 1 have a higher risk, while those with a beta below 1 have less
risk. When the beta is equal 1 the risk is average and compares with the market.
β This means it moves in the same pattern as the market return. Average risk.
β This means that the returns move above the market return and riskier than
the market.
β This means that the returns move below the market return and less riskier
than the market.
The relationship between risk as measured by beta and required rate of return is
represented by security market line (SML) graphically.
Graph of the Security Market (SML)
Return(k) (SML)
Market premium or risk premium
Risk free rate
Rf
Risk
Rf = Risk free rate (treasury bill rate)
The CAPM formula represents this relationship as follows:
R=Rf + (ERm–Rf) β
The difference between the expected market return and risk free rate (ERm–Rf) is
known as the market premium. The interpretation of this formula is that the
expected return on an asset is equal to the risk free rate plus the risk premium
times the beta of that particular security. ERm is the expected return on the market
asset or stock.
Example 3.3
Using the CAPM it is possible to determine the required return on a given stock if
the beta is known and the risk premium is also know.
A stock has a beta of 1.2 and the risk premium for this stock is 6%.Given that T bills
offer 8% risk free return. What required rate of return will investors demand on this
stock?
R = Rf+(ERm-Rf)*β
= 8 + (6*1.2)
= 15.2%
When the risk is adjusted the return responds likewise. Suppose the beta was
increased to 2.0.
R = 8+ (6*2.0)
= 20%
The same would happen if the beta was reduced to 0.5.
R = 8+(6*0.5)
= 11%
Attempt Review Question number 4 b, 8d 25, 26, 27 & 28
CHAPTER 4
CAPITAL BUDGETING OR INVESTMENT APPRIASAL
Introduction
When firms decide to invest in projects they undertake an analysis to determine

how much will be required to invest in any given project and also whether the
project should be undertaken or not on the basis of its viability in terms of yielding
the expected returns for the investors. This process of evaluating projects or
investment is known as Capital Budgeting or Investment Appraisal. It is defined
as the process of planning expenditures on assets whose returns are expected to
extend beyond one year. When a firm invests in a project it is usually before a long
period when returns begin to flow in and these continue to flow in for several years
and large amounts of capital are required at the initial stage of investment.
The objective in investment appraisal or capital budgeting is to estimate these

future cash flows and initial investment and determine whether any such project
will be worth undertaking or not.
Capital Budgeting Process
The most common way of undertaking capital budgeting involves the following
steps:
 First management must estimate the expected cash flows from a given
project including the salvage or scrap value at the end of the project and
also the initial investment required. For example if you are building an
airport, how much do you need to invest? How much do you expect to
collect as cash flows from this investment?
 The risk of the projected cash flows must be estimated. This is done by
computing a probability distribution of the project returns or cashflows.Risk
is part of any business and predicting the future is not always correct, since
there are chances that the projections may be very different from the actual
cashflows.
 The risk level of the project enables the firm then to determine the
appropriate discount rate or required rate of return for that given project.
This rate also factors in the cost of money, inflation and other risks
associated with the project. The higher the risk for the project the higher the
return demanded.
 All future cash flows from the project are affected by time and these require
to be discounted to the present to determine their present value for more
realistic comparison with cost of the project.
 Finally the present value of the future cash flows and the initial cost are
compared. If the return exceeds the initial cost the project is accepted or
taken while if the cost exceeds the returns the project is rejected. This
follows the fact that only profitable projects can be able to add value to the
firm.
Examples of Projects for Capital Budgeting
Capital budgeting or investment appraisal is applied in varying projects which
include the following:
I. Replacement: A firm may require replacing a worn out or damaged

equipment used in production of profitable product ( maintenance). A
company may replace aging technology with new technology that is able to
reduce costs and is more efficient (Cost reduction).
II. Expansion of existing products or markets: For a company to increase its

output it will require to invest massively (e.g. Zambia Sugar or Lafarge). This
expansion can be locally or into new markets.
III. Safety or Environment projects: Recently global warming has taken
headlines in many developed economies. To protect the environment
investment in this area is needed. Companies have to comply with
government regulation to protect the environment and are forced to invest
in environmentally friendly technology.(eg car manufacturers, energy
companies etc).
Capital Budgeting Techniques
Investment projects are appraised using a combination of a number of

techniques. No one method is used in isolation to ensure that the correct decision
is made for a given project. The following are some of the methods used to
appraise projects:
 Net Present (NPV) method-(uses Cash flows)

 Pay Back period (discounted and non discounted)-(Uses Cash flows)
 Internal Rate of Return(IRR)-(Uses Cash flows)
 Accounting Rate of Return(ARR)-(Uses Accounting profits)
 Profitability Index (PI)-(Uses cash flows)
These methods can be further classified between discounted cash flows methods
meaning the cash flows are discounted at a given rate and non discounted cash
flow methods where the cash flows are not discounted.
Net Present Value (NPV) - This is a discounted cash flow method.
The NPV method compares the present value of future cash flows from a given
project with the initial cost of the project. The future cash flows are discounted first
at the firms cost of capital or required rate of return, so that they are compared at
their present value taking into consideration the time factor. The difference
between the cost and the present value of the future cash flows is the NPV.It can
be positive or negative.
Rejection/Acceptance Rule:
The rule is that we accept projects with positive NPVs and reject those with
negative NPVs. With mutually exclusive projects, select project with highest
NPV.
Advantages of NPV:
i. Takes account of time value of money.

ii. Uses cash flow, not accounting profit.
iii. Takes account of all relevant cash flows over life of project.
iv. Can take account of conventional and non-conventional cash flows, as well
as changes in discount rate during project
v. Gives absolute measure of project value.
Disadvantages of NPV:
i. Project cash flows may be difficult to estimate (but applies to all methods).
ii. Accepting all projects with positive NPV only possible in a perfect capital
market.
iii. Cost of capital may be difficult to find.
iv. Cost of capital may change over project life, rather than being constant.
Example 4.1
A firm expects the following stream of cash flows from its project of $500,000 per
annum for 5 years. The projects’ initial costs are $1.0 million and company’s cost of
capital is 10%. Determine whether the company should take this project or not
using NPV?
Solution
Year Cash flow($) DCF 10% Present Value
0 (1000, 000) 1.0000 (1,000,000)
1 500,000 0.9091 454,550
2 500,000 0.8264 413,200
3 500,000 0.7513 375,650
4 500,000 0.6830 341,500
5 500,000 0.6209 310,450
+NPV 895,350
The project yields a positive NPV hence the company should accept this project.
Note: when cash flows form an annuity you can use the present of annuity to
discount the five year cash flows. The result should be the same.
Year Cash flow ($) DCF 10% Present Value
0 (1000, 000) 1.0000 (1,000,000)
1-5 500,000 3.7908 1,895,400
----------
+NPV 895,400
Payback Period method- this can be a discounted or non discounted method
The pay back method measures the length of time the project takes to pay back
the initial cost for the project. The period is counted as 1 full year where the entire
cash flow is used to pay back towards the capital, while in the year a portion is
required to complete the full payment , this fraction is multiplied with 12months.
Acceptance/Rejection Rule:
Projects with shorter payback periods are accepted over those with longer
payback periods.
Advantages of payback period:
i. Simple concept to understand
ii. Easy to calculate (provided future cash flows have been calculated)
iii. Uses cash, not accounting profit
iv. Takes risk into account (in the sense that earlier cash flows are more
certain).
Disadvantages:
i. Considers cash flows within the payback period only; says nothing about
project as a whole
ii. Ignores size and timing of cash flows
iii. Ignores time value of money (although discounted payback can be used)
iv. It does not really take account of risk.
Example 4.2
Year Project A Project B
0 $(1000) $(1000)
1 400 600
2 400 400
3 400 200
4 400 nil
Payback 2.5 years 2 years
2.5 years is worked as follows 400+400=800 so we need only 200 out of 400
from year 3 to make $1000. 200/400=0.5
2+0.5=2.5 years. Or you can say 0.5*12months, which is 2 years, 6 months.
In a discounted model the cash flows will first be discounted to take into
account the time value of money this is more superior to the non discounted
method.
Internal Rate of Return (IRR)- This method uses discounted cash flows.
IRR is the rate of return that gives an NPV which is equal to Zero. This
means that to get an NPV of Zero the initial cost should exactly equal to the
present value of the future cash flows. In other words the project breaks
even. The IRR represent the minimum rate of return that a project would
yield. The process of computing the IRR involves linear interpolation or
extrapolation to obtain an approximate IRR value.
The way of obtaining IRR is to use the formula
IRR = A1 + NPV1 x (B2 - A1)
(NPV1 – NPV2)
A1= lower rate
B2= Higher rate
NPV1= Positive NPV
NPV2= Negative NPV
Using this method we need find two NPVs one positive and the other
negative and then proceed to use the formula to find the IRR.A negative NPV
is found by increasing the discount at which the cash flow are being
discounted , this reduces their present value creating a negative NPV since
now the cost exceeds the returns.
Accept /rejection Rule:
A firm should accept all projects that have an IRR which is greater than the
company’s cost of capital and reject those that have an IRR which is less
than the company’s cost of capital or required rate of return.
Advantages of IRR:
i. It is closely related to NPV and results in the same decision.

ii. Easy to understand and communicate.
Disadvantages of IRR:
i. A problem if applying IRR to projects with non-conventional cash

flows is that multiple IRRs may be found: again, NPV gives correct
selection advice.
ii. NPV can accommodate changes in discount rate during project,

but IRR ignores them.
iii. NPV method assumes that cash flows can be reinvested at a rate
equal to the cost of capital: IRR method assumes that cash flows
can be reinvested at rate equal to IRR.
Example 4.3
0 (1,500, 000) 1.0000 (1,500,000)
1-5 500,000 3.7908 1,895,400
----------
+NPV 395,400
Year Cash flow ($) DCF 32% Present Value
0 (1500, 000) 1.0000 (1,500,000)
1-5 500,000 2.3452 1,172,600
----------
-NPV (327,400)
IRR = 10 + 395,400 x (32-10)
(395,400 +327,400)
= 22.03%
Profitability Index (PI)
The profitability Index measures the cost benefit ratio of a project. The index is the
present value of the cash flows divided by the initial investment. Projects with
negative NPV has an Index below 1 while those with positive NPV have an index
which is above 1.In other words it measures the value created per dollar invested.
PI is similar to NPV rule. Because it is a ratio when evaluating projects it’s also
important to consider the actual monetary value than just rely on the ratio. A higher
ratio does not necessarily mean a better project.
Example 4.4
0 (1,500, 000) 1.0000 (1,500,000)
1-5 500,000 3.7908 1,895,400
----------
+NPV 395,400
The PI for this project is 395,400/1500000 = 0.2636
Advantages of PI
i. Closely related to NPV leading to identical decisions
ii. May be useful when available investment funds are limited
iii. Easy to understand and communicate.
Disadvantages of PI
i. May lead to incorrect decisions on comparison of mutually exclusive

projects. When in doubt use the NPV rule that show the actual cash value.
Accounting Rate of Return (ARR) – Uses accounting profit and losses
The accounting rate of return uses accounting profit or losses and not
cashflows.The difference between accounting profits and cash flows is the
accounting profits and losses include non cash items depreciation such.
Depreciation = initial cost - salvage value/project life or asset life
To convert cash flows to accounting profits we subtract depreciation.
To convert accounting profits to cash flows we add back depreciation.
ARR = the average accounting profits & losses/Average investment
ARR= (Sum of profits & (losses))/project life
(Initial cost + salvage value)/2
Accept/ Rejection Rule
If the company target rate is less than the computed accounting rate we accept
the project, otherwise reject the project.
Advantages of ARR
i. Easy to calculate
ii. Needed information will usually be available
Disadvantages of ARR
i. It does not reflect a true rate of return since it ignores the time value of
money.
ii. It is based on accounting numbers which are not cash flows.
Example 4.5
A company has the following profits from a project over a five year period;
$2000,$1500,$2200,$1200 and $4000. The initial investment is $20,000.The
company’s target accounting rate is 19%.Find the ARR.
ARR = Average account profits /average investment
Average profits = (2000+1500+2200+1200+4000)/5 = $2180
Average investment = initial cost +salvage value
= (20,000+0)/2 = $10000
ARR = $2180/$10,000 *100% = 21.8%
The project is acceptable since its ARR is above the company’s target of 19%.
Mutually exclusive and Independent Projects
When two projects are mutually exclusive it means that only one of them can be
selected. A decision to select one affects the decision the select the other project.
Independent projects can be selected simultaneously or at the same time. It
means that a decision to select one project does not affect the decision to select
the other.
IRR vs. NPV Conflict
Usually IRR and NPV result in the same decision for selecting projects. At times a
conflict arises where for two mutually exclusive projects IRR selects a different
project and NPV selects a different one.
Project 1 and project 2
NPV1 Project 1
NPV2 Project 2 Cross over rate
0 IRR1 IRR2 Discount rate
When NPV is used Project 1 is selected, while IRR rejects project 1 and selects
project 2.This is a conflict. To resolve this use the NPV rule and select the project
with the highest NPV.The point where the two lines cross is known as the cross
over-rate. It represents a point of indifference and the two NPVs are also equal. It
also means that at that point neither project is better than the other.
Unequal Lives of Projects
Two projects with unequal lives and mutually exclusive cannot be compared
adequately without making an adjustment for the difference in their lives.
Year Project X Project Y
0 (30,000) (30,000)
1 20,000 37,500
2 20,000 -
Project X is twice as long as project Y and in order to cope with this problem the
project cash flows must be repeated for enough years until both projects finish in
the same year. For example if one project has a life of 4 years and another a life of
3 years, year 12 would be the first time the projects both finish together. Hence the
cash flows for the first would be repeated three times and for the second four
times and discounting the cash flows would be carried out over 12 years. This can
shown as follows:
Year X Y
0 (30,000) (30,000)
1 20,000 37,500 + (30,000) the initial cost is repeated for Y
2 20,000 37,500
These cash flows can be now discounted and the NPVs will be comparable.
However this method is rather time consuming and a simpler method exists. It is
to discount the projects once only and to divide the NPV by the annuity rate that is
the sum of the discount rates over the life of the projects. This produces an
average figure known as an annualized equivalent that allows the project returns
to be compared fairly.
Year Discount Rate (5%) X Y
0 1.000 (30,000) (30,000)
1 0.952 19,040 37,500
2 0.907 18,140 -
1.859 7180 5700
Annualized equivalent for X = 7180/1.859 = $3,862
Annualized equivalent for Y= 5700/0.952 = $5,987
The 1.859 is found by summing 0.952+0.907=1.859
The first method used is known as Lowest Common Multiple, while the other is
known as Annualized Equivalent.
Capital Rationing
i. Arises when a firm has insufficient funds to invest in all projects with positive
NPV.
ii. Hard capital rationing arises when limitations are externally imposed.
iii. Soft capital rationing arises when limitations are internally imposed.
iv. Soft capital rationing is more common.
Hard capital rationing
Causes:
 Capital markets may be depressed.
 Investors may consider the company to be too risky to invest in.
 Issue costs may make a small issue of finance expensive.
Soft capital rationing
Arises if managers:
 want to avoid dilution of control (equity)

 want to avoid dilution of EPS (equity)
 wish to avoid fixed interest payments (debt)
 wish to follow policy of steady growth
 Believe restricting available funds will encourage better investment projects
(internal market for investment funds).
Impact of Inflation on cash flows
Inflation reduces the value of money over time and creates a gap between the real
value and nominal value of money. Hence even if the nominal value of money
increases, the rate of inflation reduces its real value. Cash flows represent the
actual money value received or paid. In an instance where there is no inflation this
is known as the real value of money. When inflation is factored in it is known as
the nominal value of money.
To compensate for inflation the real value of money =nominal value less inflation
(nominal value of money=real value (1+inflation rate)).In times of rising inflation
it is important to consider inflation in determining the value of an investment.
Taxes
Taxes are normal part of carrying on business in many economies. Taxes

represent relevant cash outflows that are spent by the business they should
always be considered when evaluating investment. Depending on the corporate
tax rate applicable the tax payable will be computed based on the taxable income
computed by removing non deductable (Non allowable) expenses from the profit.
Items such as depreciation are non allowable and are added back to the profit
figure for tax computation purposes by the tax authority. To provide some tax relief
capital allowances are given to companies according to the tax regulation. Capital
allowances are meant to reduce the taxable income thus reducing the amount of
tax paid.
Relevant Cash flows for decision making
When trying to evaluate a project the relevant cash flow question is always
important. Relevant cash for a project is a change in the firm’s overall future cash
flow that comes about as a direct consequence of the decision to take that project.
Because the relevant cash flow is defined in terms of change or increment to the
firm’s existing cashflow, they are called incremental cash flows associated with a
project. We conclude to say that relevant cash flows are incremental cash flows
from a project.
Sunk Costs
A sunk cost is a cost that has already been incurred and cannot be removed and
therefore should not be considered in an investment decision. It’s irrelevant to the
decision. For example when you buy a car and afterwards decide either sale or
convert it to taxi, it’s the incremental costs and benefits that will be important for
decision making. The cost of buying the car is a sunk cost.
Opportunity Costs
An opportunity cost represents the most valuable alternative that is given up if a

particular investment is undertaken. An opportunity cost should be considered as
a relevant cash flow for a project.
Hence in evaluating any project one has to consider, what are the relevant cash
flows to consider in making a decision?
Attempt Review Question number 9
CHAPTER 5
COST OF CAPITAL, CAPITAL STRUCTURE AND FINANCIAL LEVERAGE
To start a new business or to finance a particular business project a company

requires capital funds. These funds come at a cost and this is known as the Cost
of Capital. Capital comes in various forms which will include the following:
Types of Capital
 Common Share Capital or Common Stock or Equity
 Preferred Stock or Preference Shares
 Debt Capital or loans
 Retained Earnings
Each of these Capital carry a cost and that is the cost of that particular type of
capital. The cost of capital is what each provider of the capital demands as
compensation for using their funds. To the provider of the funds this is their
required rate of return.
Why is Cost of Capital important?
1. For value maximization of the firm.
2. Capital budgeting decisions
3. For other cost decisions.
Think of how you can explain each of the three points above with examples.
The form of capital that a firm uses in financing its business makes what is known
as its Capital structure. A company may use only one type of capital say Common
stock or it can use a combination of different capital.
COST OF DEBT
Debt is borrowed Capital (Loan) provided by a lender (creditor) in exchange for

interest payment. The interest paid on a debt at a given rate is the cost of debt
capital. Since interest expense is deductable under tax rules this creates a saving
for the company due to what is called the Tax Shield (1-Tax%).The tax shield
lowers the overall cost of debt, which is a benefit to the company.
The cost of debt is kd before tax. When we take into account the tax shield this
changes. Let’s say tax is 40%.The new cost of debt is Kd*(1-T),T is the tax rate.
Example 5.1
Debt cost is 10% and the tax rate is 40% for company tax, what is the after tax cost
of Debt?
Kd*(1-T) = 10*(1-0.4) = 6%
The cost has been reduced from 10% to 6% and this is the major advantage of
using debt for financing.
COST OF PREFERRED STOCK
Preference Shares are a hybrid form of equity, semi debt and semi equity in
nature. The dividend paid is fixed and is a percentage of the share price. e.g 10%
preference shares meaning your dividend is 10% of the price you paid for the
share.
Kp=Dp/Price of Share
Unlike interest on debt dividends on shares are not allowed as deductions for
expenses.
Example 5.2
A preferred stock pays a dividend of $11.70 and sells for $100.00. Find the Cost of
the preferred equity?
COST OF EQUITY
Equity is the capital supplied by ordinary share holders. These are the owners of
the company. Despite them being the owners they too require a return for the
amount they have invested, otherwise there is no reason to invest. Share holders
expected to gain from their investment in two ways, through share price increase
(Capital gains) and dividends paid by the company.
The two components form the cost of equity, which can be computed using the
following.
1. Ke= Rf + (ERm-Rf) *β. This cost of equity using the CAPM model.
2. Ke= D1/Po +g. This is cost of equity using the Dividend Growth model.
Example 5.3
Suppose for a Stock the risk free rate is Rf=8% ,expected market return ERm=14%
and the stock β 0.7.Find the Cost of this stock.
Ke= 8% +(14-8)%*0.7
= 12.2%
Example 5.4
A stocks expected dividend D1 = $1.43 and it has a growth rate g of 6.6%. The stock
sells for $25.54.What is the cost of equity using the Gordon’s model.
Ke= D1/P0 + g
= 1.43/25.54 +6.6 = 12.2%
Ensure that you multiple with 100% the first computation of the equation to convert
the decimal to percentage.
COST OF RETAINED EARNINGS
The retained earnings equally belong to share holders and are supposed to be
paid out as dividends. The cost to the shareholders is the opportunity cost of
forgoing dividends and this represent the cost of retained earnings. The cost of
retained earnings is the same as the cost of equity.
WEIGTHED AVERAGE COST OF CAPITAL (WACC)
When a company with a given target capital structure uses different forms of
capital in its capital structure, an average cost of the capitals will be computed.
This is called the weighted average cost of capital or WACC in short.
WACC= We(ke) + Wps(kps) + Wd(kd)(1-T)
W = weight of each form of capital used in the capital structure of the firm.
Example 5.5
Capital Structure for Company Z extracted from the Balance Sheet.
($) Weight
LT Debt 3,000,000 30%
Preferred Stock 1,000,000 10%
Common Stock 6,000,000 60%
Total 10,000,000 100%
Suppose a company has the following costs for each form of Capital.
Kd=10%; Kps=12%; Tax=40% and Ke=12.2%. Find the WACC for the company using
the above capital structure?
WACC= 0.6(12.2)+0.1(12)+0.3(10)(1-0.4)
= 10.32%
Book Value vs. Market Value for WACC
The book value of WACC is where the weights are based on the par values for the
Capital components of a firm’s capital structure as in the example above. Another
approach is finding WACC using market values to determine the weights instead
of book values. The Market values of common stock will also factor in the value of
retained earnings since the market price of share adjusts for all relevant
information which includes the profits made by the firm. When market values have
been given use these to find the WACC unless stated otherwise.
Determining weights using market values
Example 5.6
A company has 1million share outstanding with par value $2.0 and market price of
$2.50.Debt is valued at $1.5m market value,while preferred stock has a market
price of $1.50 and outstanding shares are 500,000.
Capital Structure at Market Value
Debt = 1,500,000
Pref. Stock 500,000*$1.5 = 750,000
Equity 1,000,000*$2.5 = 2,500,000
Total Capital 4,750,000
Weights will be Debt 31.6%, Pref. Stock 15.8% and Equity52.6%.These will be the
weights to use in the WACC equation.
In summary the cost of capital for any firm is important to know as this will be used
to discount project cash flows, and also determine whether the company will be
profitable in its ventures so as to increase the value of the firm.
FINANCIAL LEVERAGE AND CAPITAL STRUCTURE
When management of a company is planning on how much debt-equity ratio they

are making a capital structure decision. Activities undertaken by management
alter the capital structure (level of debt, equity funding the asset side of the
balance sheet) this is called capital restructuring. Such activities include selling
more stock to liquidate a portion of debt outstanding, this increase equity and
reduces debt ratio. The company may borrow to buy back some of its shares this
increases the debt ratio.
Companies can change their capital structure without affecting the assets of the
firm. However changing the capital structure does have an impact on the value of
the firm and the cost of capital.
What is the Optimal Capital Structure?
When a company is considering the best combination of equity versus debt to

include, the underlying question is which capital structure maximizes the value of
the firm or the value of the stock.
Capital structure and Cost of Capital
Under cost of capital, WACC was the weighted average cost of capital for the
combination of debt and equity capital used in the firm. When the WACC is
minimized this will maximize the cash flows of the firm and therefore maximize the
value of the firm. What is important to consider now is what happens to the WACC
when the capital structure of the firm changes. Therefore we can say that the
optimal capital structure is one that minimizes the WACC, this is also known as the
target capital structure.
Effects of Financial Leverage
Financial leverage refers to the extent to which a firm relies on debt to finance its
business. The more debt a firm uses the more financial leverage or gearing the
firm has. To consider the effect of financial leverage we show how it impacts
earnings per share (EPs) and return of Equity (ROE).
Example 5.7
Trans AM Corporation
Management has decided on the following proposal.
Current Proposed
Assets $8000,000 $8000,000
Debt $0 $4000,000
Equity $8000,000 $4000,000
Debt-Equity ratio 0 1
Share price $20 $20
Shares Outstanding 400,000 200,000
Interest 10% 10%
Current Capital structure
Recession Expected Expansion

EBIT $500,000 $1000,000 $1500,000
Interest 0 0 0
Net Income $500,000 $1000,000 $1500,000
ROE 6.25% 12.5% 18.75%
EPS $1.25 $2.50 $3.75
Proposed Capital Structure debt is $4000,000
EBIT $500,000 $1000,000 $1500,000

Interest $400,000 $400,000 $400,000
Net Income $100,000 $600,000 $1100,000
ROE 2.50% 15.0% 27.50%
EPS $0.50 $3.00 $5.50
From the above the following conclusions can be made:
1. The effect of financial leverage depends on the company’s EBIT.When EBIT

is high leverage is beneficial.
2. When profitability is high leverage increases the returns to shareholders as
measured by ROE and EPS.
3. Shareholders are exposed to more risk under the proposed capital structure
because EPS and ROCE are more sensitive to changes in EBIT.That is when
profit are not stable or there are losses this has a great negative impact on
the EPS and ROCE of a firm.
4. Because of the impact that financial leverage has on both the expected
return to stock holders and the riskiness of the stock, capital structure is an
important consideration.
Homemade leverage
Sometimes shareholders can employ personal borrowing to alter the degree of

financial leverage that they are exposed to this is known as homemade leverage.
Let us look at a shareholder who has $2000 worth of stock priced at $20, this
shareholder has 100 shares and Trans Am does implement the proposed capital
structure.How can this shareholder use homemade leverage to replicate the
proposed capital structure.
Proposed Capital Structure
Recession Expected Expansion

EPS $0.50 $3.00 $5.50
Earnings for 100 shares 50.00 300.00 550.00
Net Cost=100*20=$2000
EPS $1.25 $2.50 $3.75

Earnings for 200 shares 250 500 750
Less: interest on $2000@10% -200 -200 -200
Net Earnings $50 $300 $550
Net Cost=200 shares *$20-Amount borrowed=$4000-2000=$2000
It can be seen that by borrowing personally the share can earn the same returns
as in the proposed capital structure of Trans Am. This concept can also be applied
in reverse if Trans Am had borrowed to unlever the stock. So it would seem that
whether or not Trans Am changed its capital structure its irrelevant.
CAPITAL STRUCTURE AND COST OF CAPITAL
Franco Modigliani and Merton Miller in short known as M&M formulated the M&M
proposition I $ II.
M&M I
This is the proposition that the value of the firm is independent of the firm’s capital
structure. It explains that if we had two identical firms one with more debt than the
other the total value of the firms would be the same. This is the pie model ‘the size
of the pie does not depend on how it is sliced’.
M&M II
This is the proposition that a firm’s cost of equity capital is a positive linear function
of the firm’s capital structure.
Re=Ra+(Ra-Rd) *(D/E)
Ra is the WACC
Cost of Equity Re
.
WACC=Ra
Rd
Debt-Equity ratio (D/E)
What happens when there is tax included in the equation? We look at M&M
theory with tax factored in.
M&M I proposition with tax
When a company uses debt the interest expense is tax deductable and this
reduces the cost of debt. This relief is known as the tax shield (1-T).This second
theory implies that a firm’s WACC decreases as the firm relies more heavily on
debt financing.
1.0 WACC =E/V *Re+D/V*Rd*(1-T)
M&M II proposition with tax
This implies that a firms cost of equity,R e rises as the firm relies more heavily on
debt financing.
2.0 Re=Ru+(Ru-Rd)*D/E*(1-T)RU= is the cost of capital for unlevered firm (No Debt)
Re
Cost of Equity
Ru=10% Ru
WACC
Rd*(1-T)
Debt –Equity ratio
Attempt review question number 4 and 8
CHAPTER 6
WORKING CAPITAL MANAGEMENT
Introduction
Working capital constitutes a firms’ investment in currents assets such as, cash,
marketable securities, inventories and accounts recievables.Net working capital
refers to the difference between current assets and current liabilities.
Current assets are those assets that can be converted into cash within a period of
one year, these being cash, inventory, debtors and marketable securities. Current
liabilities are those obligations that are payable within one year.
Importance of working Capital management
i. Managing of working capital takes a large portion of the time of most

financial manager’s day to day activities because of its complexities.
ii. A large number of companies’ investment is tied up in working capital such

as inventory, material suppliers, and debtors and such require close
management to avoid huge losses.
iii. Small firms that do have large amounts of capital rely on working capital
investment for growth by reducing investment in fixed assets and opting to
lease or rent equipment and office space. For such firms management of
working capital is of crucial importance.
iv. As a firm grows in terms of sales revenues this can only be achieved by
considerable investment in its working capital to support the growth.
v. Working capital management affects the company’s risk, return, and share
price.
vi. Excessive levels can result in a substandard Return on Investment (ROI).
Working Capital Cycle
To understand the relationship between the various components of working

capital, we need to study the working capital cycle. This is also known as cash
cycle and refers to the length of time taken by a firm from the time of purchase of
raw material or inventory,coversion to finished goods, selling of the goods to
customers, collection of the cash and finally payment of cash for the purchase of
raw materials or inventory.
The working Capital Cycle can be analyzed as follows:
Working Capital Cycle or Cash Cycle = Inventory Period + Receivables Period –
Payables Period.
Operating Cycle = Inventory period + receivables period
Inventory Period
This is the length of time required to convert raw materials into finished goods and
sell these goods.
Inventory period (days) = (Average inventory/Cost of Sales)*365 days
The closing inventory can also be used in place of average inventory.
Receivables Period
This is the length of time required to covert debtors into cash or collect cash from
customers who still owe the firm.
Receivables period (days) = (Average debtors/Credit Sales or Sales)*365 days
Use sales figure when credit sales have not been given.
Payables Period
This is the length of time between purchase of raw material, stocks and labor and
the payment of cash for them. It is the time it takes to pay creditors.
Payables Period (Days) = (Average Creditors/cost of sales)*365 days
Closing yearend creditors can be used if no average creditors figure is given.
Example 6.1
A company financial statements show the following: creditor days 40, debtor days
30, and inventory days 42.Find the operating cycle and cash cycle?
Solution
Operating Cycle = 42+30=72 days
Cash cycle = 72- 40 = 32 days
These ratios can be computed from the financial, statement numbers in the
income statement and balance sheet. In an ideal situation all firms should have
the shortest possible cash cycle. The reason for this is that the longer cash cycles
will require more financing for the period before cash is collected from debtors.
The cash cycle can be shortened by reducing the inventory and debtor days and
extending the creditors days.
Working Capital Financing Policies
To achieve a certain level of sales forecast a firm has to ensure that it able to
finance its working capital adequately and manage it through the business cycles.
Assets held in a business can be classified under three categories namely:
 Temporary current assets or fluctuating, that tends to fluctuate with seasons

or business cycles.
 Permanent current assets that tend not to fluctuate with seasons. They
represent the minimum level of asset holding for a firm at its lowest point in
the business cycle.
 Fixed Assets or Noncurrent assets; these are assets of long term nature
such as building, land holdings, machinery and others. These also form part
of the permanent assets of a firm since they do not fluctuate with seasons.
Financing Policies are three fold; loose, tight and moderate policy.
1. The loose policy for financing working capital means a firm holds large
levels of current assets at any given point in time. This is represented by
policy A
2. The tight policy for working capital investment mean a firm holds minimum
levels of current assets at any point in time. This is represented by policy C
3. The moderate policy falls in between the two extremes of policy A and
B.This is represented by policy B.
Working Capital financing Policies
All assets held by a firm can be financed using long term financing or short term
finance. A firm is free to use an approach that it thinks is appropriate for its
business set up.
A firm can apply any three of the following:
a) Conservative Approach
This approach finances fixed assets and permanent current assets using long
term finance and only finances the temporary current assets with short term
finance.
Long-Term Financing Benefits
• Less worry in refinancing short-term obligations
• Less uncertainty regarding future interest costs
Long-Term Financing Risks
• Borrowing more than what is necessary
• Borrowing at a higher overall cost (usually)
Result
• Manager accepts less expected profits in exchange for taking less
risk.
b) Aggressive Approach
This approach finances all fixed assets and part of the permanent current assets
using long term finance and the other part of permanent current assets and
temporary current assets is financed by short term finance.
Short-Term Financing Benefits
• Financing long-term needs with a lower interest cost than short-term

debt
• Borrowing only what is necessary
Short-Term Financing Risks
• Refinancing short-term obligations in the future
• Uncertain future interest costs
Result
• Manager accepts greater expected profits in exchange for taking

greater risk.
c) Moderate ( Matching Approach)
This is an approach of financing where each asset would be offset with a

financing instrument of the same approximate maturity. Fixed assets and the non
seasonal portion of current assets are financed with long term debt and equity
(long term profitability of assets to cover the long term financing cost of the firm).
Seasonal needs are financed with short term loans (under normal operations
sufficient cash flow is expected to cover the short term financing cost).
CASH MANAGEMENT
Cash includes cash and other near cash assets such as marketable securities. It
is important that a firm holds adequate cash balances to enable it run operations
smoothly. Cash is required to settle obligations and other day to day transactions.
When cash is held idle it does not earn any returns, hence only an optimal amount
should be kept to reduce costs of holding cash and opportunity cost of returns not
earned by investing it elsewhere.
Reasons for holding Cash:
i. Transaction motive; cash is required for day to day operations of a firm such
as payment for salaries and other supplies.
ii. To meet compensation balances required by banks for loans provision and
services provided to customers. This cash will be kept as a minimum
balance on a checking account or bank account.
iii. Speculative motive; cash balance allows firms to take advantage of any
unexpected discounts or bargain purchases that may arise.
iv. Precautionary motives; cash balances are held for emergency situations
where cash flows fluctuate unexpectedly to cover any deficits.
Advantages of holding adequate cash balances
a) Trade discounts and cash discounts can only be taken advantage of if

adequate cash is held by a firm.
b) Holding adequate cash and near cash assets like marketable securities
can help a firm to maintain a good credit rating.
c) Acquisition of companies and other business opportunities requires

adequate cash balances to be held by a firm.
Cash flow Synchronization
To efficiently manage cash it is necessary for a firm to synchronize its cash inflows
with the cash outflows, so as to permit the holding of minimum optimal cash
balances.
Using Float
Float is the amount of funds that are tied up in cheques that have been written but
are still in the process and have not yet cleared. Float can be categorized into
disbursement float and collection float. Collection float is the amount cheques
collected from debtors and deposited and have not yet cleared through the bank
account. Disbursement float is the amount of cheques written to suppliers that
have not yet been cleared through the bank.
A firm can make use of float to improve its bank balance and can use this as a
short term means of financing. Float can be improved by collecting quickly and
slowing down payments.
What is the optimal Cash balance to keep?
The optimal level of cash should be the larger of:
i. The transaction balance required when cash management is efficient.
ii. The compensating balance requirements of commercial banks.
Marketable Securities
Marketable securities are securities that can be sold on short notice for close to
their quoted market prices. These include treasury bills, certificates of deposits and
other money market instruments.
Reasons for holding marketable securities:
 Marketable securities are a suitable substitute for holding cash. Holding

cash does not generate returns, hence a suitable alternative is to holding
cash in form of marketable securities that are able to earn returns.
 Marketable securities are temporary investment and can be used when;
i. A firm requires financing seasonal fluctuations. Surplus cash

invested in securities can be used to finance deficit periods.
ii. A firm needs to meet known financial obligation. For example to

meet a bond maturity payment cash can be kept insecurities to be
liquidated at the date of payment of the debt obligation.
iii. A firm issues long term securities such as shares, where large
amounts of capital are usually raised. Part of the funds can invested
in marketable securities and later sold off when cash is required.
What is the criterion for selecting marketable securities?
Securities have inherent risk and these needs to be considered when choosing a
security.
The types of risks:
i. Default Risk; the risk that the borrower will not pay interest or the principle.
When choosing securities this risk need to consider and securities with less
default security are most preferred.
ii. Interest Rate Risk; this is the risk to which investors are exposed due to
changing interest rates in the market. The less sensitive a security is to
fluctuations in interest rate the more constant the returns expected.
iii. Purchasing Power Risk (inflation Risk); this is the risk that inflation will
reduce the purchasing power of a given sum of investment. For investors to
earn a real return, securities should have returns higher that the rate of
inflation.
iv. Liquidity or marketability risk; is the risk that the security cannot be sold at a
reasonable price on short notice without significant loss in value. A good
security should be easily converted to cash with minimal loss in value.
Common Money market Securities
i. Treasury Bills (T-bills): Short-term, non-interest bearing obligations of the

Government issued at a discount and redeemed at maturity for full face
value.
ii. Treasury Bonds: Long-term (more than 10 years’ original maturity)

obligations of the Government.
iii. Repurchase Agreements (RPs; repos): Agreements to buy securities

(usually Treasury bills) and resell them at a higher price at a later date.
iv. Bankers’ Acceptances (BAs): Short-term promissory trade notes for which
a bank (by having “accepted” them) promises to pay the holder the face
amount at maturity.
v. Commercial Paper: Short-term, unsecured promissory notes, generally

issued by large corporations (unsecured IOUs).
vi. European Commercial Paper: See above, except maturities extend to one
year and more active secondary market.
vii. Negotiable Certificate of Deposit: A large-denomination investment in a

negotiable time deposit at a commercial bank or savings institution paying
a fixed or variable rate of interest for a specified period of time.
viii. Eurodollars: A US dollar-denominated deposit – generally in a bank located

outside the United States – not subject to US banking regulations.
Determining the Optimal Balance for Cash and Marketable Securities
Q* is the optimal (C*) cash balance to transfer or borrower at one time.
Total Cost = holding Costs + Transaction Costs
= (Average cash balance) (opportunity) + (number of transaction) (Cost per

transaction)
= (C/2) (k) + (T/C) (F)
C = amount of cash raised by selling securities or borrowing from a bank.
F = fixed cost of making a security trade or obtaining a loan.
T= total amount of net new cash needed for transaction over the entire period (one
year).
k= opportunity cost of holding cash
Q*= optimal cash to be raised by selling marketable securities or borrowing. It can

found using the EOQ model formula.
C*= √(2 (F) (T))/k
Example 6.2
A company requires to use $1.0 million annually. The opportunity costs of holing
cash are 12% and the fixed cost of making out a loan is $150. Determine the
optimal cash balance for the company?
F=$150;k=12% and T= $1,000,000
C*= (2)(1,000,000)(150)
0.12
= $50,000.00
The company will require sourcing $50,000 each time they source cash. This is the
amount that will minimize the cost of holding cash.
CREDIT MANAGEMENT
In today’s world of business advancing credit is considered as one way to attract

customers and create a good impression on your clients. The task of deciding
who to give credit is only one part of managing credit and a lot more other factors
need to be considered in making this decision. Good credit management is
important because poorly managed credit system results in losses due to bad
debt and in extreme cases may lead to bankruptcy.
How are accounts receivables (debtors) created?
Accounts receivables arise as sales are made on credit each day multiplied by the
number of days given for collection or payment of amounts due.
Example: If a company offers 10 days credit to its customers and makes on

average $100 of credit sales a day the accounts receivables created will be;
Accounts receivables = credit sales per day * length of collection period
= $100 x 10days =$1000
As the collection days vary and amounts of daily credit sales change the debtors
balances also change accordingly.
Managing Credit – The Credit Policy
To manage credit effectively a credit policy has to be in place for every firm. Credit
policies contain a set of decisions that includes a firm’s credit period, credit
standard, collection procedures and discounts offered.
Credit Period
A credit period is the length of time a company gives its customers to pay what
they owe the firm. A firm can give say 20, 30 or 60 days.
Credit Standards
Credit standards stipulate the minimum financial strength that an applicant must
demonstrate in order to be granted credit. Customers are evaluated using the five
‘Cs’ system (Character, Capacity, Capital, Collateral and Condition).
i. Character; which refers to the measure of the level of honesty and trust
worthiness that a customer exhibits. It is important to carry out background
check from past business contacts.
ii. Capacity; which measures the customer’s ability to pay. Customers should
not be granted credit for which they are not able to pay.
iii. Capital; which measures the general financial condition of a firm as

indicated by an analysis of its financial statements.
iv. Collateral; which is represented by the assets that customers may offer as
security in order to obtain credit.
v. Condition; which refers to general economic conditions and other
developments that might affect a customer’s ability to meet its obligations.
Collection Policy
The collection policy is those procedures that a firm follows to collect accounts
recievables.These are there to ensure that a firm has taken all means available
to collect the debts outstanding. The extreme being taking legal action.
Cash Discounts
Cash discounts are offered to customers when they make payment of the
amounts outstanding earlier than expected. For example an offer of 2/10, net 30
means that a discount of 2% is offered for payment within 10 days but full payment
should be made in 30 days.
Managing Accounts Payables
Accounts payable arise as a result of trade credit that the firm obtains from
suppliers. Accounts payable need to be settled at agreed dates to avoid sour
relationships with suppliers and legal action that may be taken for late payment or
failure to pay. On the other hand if a firm is also trading giving credit to its own
customers the credit period extended to these customers should be shorter than
the credit period given by suppliers. This is important to enable the firm collect
adequate cash for paying accounts payables.
Cost of trade credit
At times suppliers do give discounts for earlier payment and trade discounts.
These should be evaluated to weigh the cost and benefits.
(365/number of days beyond

Cost of trade credit = (1+ (Discount/1-Discount)
discount)
-1
Example 6.3
Find the cost of trade credit if terms are 1/10, net 30 and the account is paid on
th
A) The 20 day.
th
B) The 30 day.
(365/10)
For a = (1+(0.01/1-0.01)) -1 = 44.32%
(365/20)
For b = (1+(0.01/1-0.01)) -1 = 20.13%
The cost of credit is much lower when the company pays on the net day than any
day prior to the net day.
INVENTORY MANAGEMENT
Inventory forms an important part of a firm’s resources as it is the source of

revenue. Inventory is part of working capital and can be classified into three
categories:
 Raw materials
 Working in Progress (WIP)
 In- Transit inventory
 Finished Goods
The challenge for many firms is to determine the right quantity of inventory to hold.
Holding inventory cost money and it also ties up the much needed capital that a
firm has while no return is being earned.
The amount of inventory ordered and held is a factor of the level of demand
fluctuation and cost associated with holding inventory. To avoid stock outs firms
hold additional inventory known as safely stock in case the lead time demand
changes. The amount of stock to be ordered that ensures that the Total inventory
Cost are minimized is known as the economic order quantity (EOQ).
Inventory Costs
Costs associated with inventory can be classified as follows:
Carrying Costs
This is the cost of carrying inventories and they includes costs for storage,
opportunity cost of capital, depreciation cost, insurance and obsolescence.
Ordering Costs
This is the cost of placing and receiving a single order and these are fixed in
nature regardless of the size of the order
Optimal Inventory Order Quantity (EOQ)
Total Carrying Costs = (C) (P) (Q/2)
Where C is percentage cost of carrying inventory based on the unit price and Q/2
is average inventory held.
Total Ordering Cost = (F)(S/Q)
S is the total quantity per annum, S/Q gives the number of orders per year and F is
the fixed cost of ordering.
Total Inventory Costs = Totals carrying Costs + Total Ordering Costs
TIC = (C) (P)(Q/2) + (F)(S/Q)
The Economic Order Quantity (EOQ)
Q*= 2(F)(S)/(C)(P)

Example 6.4
A Firm requires 120,000units annually each cost $2,the cost per order is $150 and
carrying cost as a percentage of inventory is 0.217. Find the EOQ.
EOQ = 2($100)(120,000 units)/(0.217*$2)
= 7,432 units represent the optimal quantity to order each time.
Other considerations
Lead Time (LT)- The length of time between the placement of an order for an
inventory item and when the item is received in inventory.
Order point – The quantity to which inventory must fall in order to signal that an
order must be placed to replenish an item.
Order Point (OP) = Lead Time * Daily usage during lead time.
Just –In- Time (JIT) – An approach to inventory management and control in which
inventories are acquired and inserted in production at the exact times they are
needed.
Requirements of applying this approach:
 A very accurate production and inventory information systems.
 Highly efficient purchasing system.
 Reliable suppliers.
 Efficient inventory –handling system.

SHORT-TERM SOURCES OF FINANCE
Short–term sources of financing are those where the repayment is expected to

occur within a period of one year or less. The following are the different sources of
short term financing:
i. Bank Overdraft; this is a facility that allows a firm to overdraw its bank
account beyond the required minimum level.
ii. Letter of Credit; this is used for international transaction whereby the issuing
bank guarantees payment to a third party, provided the foreign goods are
delivered as agreed.
iii. Secured Loans; these are loans secured by assets pledged by the borrower
as security in case of failure to repay the loan. Loans can also be unsecured
depending on the relationship between the lender and the borrower.
iv. Trade Credit; this is most common form of short term spontaneous source of
financing and is arranged between two firms.
Attempt review question number 3

CHAPTER 7
THE EFFICIENT MARKET HYPOTHESIS (EMH) THEORY
Stock price prediction has been part of the capital market business for centuries
now and analysts are ever trying to perfect the game. This has led to financial
analysts coming up with models to try and determine the future movement in
stock prices (values) to provide stock trade information on which stocks are worth
buying or selling.
The value of a stock is affected by a number of market factors. This is information

is captured in the stock price and is actually what causes the rise and fall in stock
value over time. In an efficient market this information is captured more quickly
than in a less efficient market. In the stock market information relating to a stock’s
value and how quickly it is factored in the price makes a difference for dealers in
stocks and could mean the difference between a capital gain or capital loss.
Hence theories regarding stock price movements and market efficiency have
been an important part of financial analysts and stock dealers and brokers.
Random Walk and Efficient Market Hypothesis
This is the notion that stock price changes are random and unpredictable. The
argument is that stock prices follow a random walk since the ability to predict new
information about a stock is not possible. If we assume that the price of a stock
today has already taken into account all the market information it is also true that
any new information that an analysts might obtain will already have been
absorbed in the stock price; it is much more difficult for any one investor to beat
the market to information that may give them an advantage over other investor
regarding stock price movement, unless such information was provided by
insiders (insider dealing).This notion that stock prices already fully reflect all
available information about securities is known as Efficient Market Hypothesis
(EMH).

Form of the efficient Market Hypothesis
1. Weak Form
The weak form hypothesis asserts that stock prices already reflect all
information that can be derived by examining market trading data such as
the history of past prices, trading volumes or short interest. This form of
hypothesis implies that trend analysis is fruitless. Past price data are publicly
available and virtually costless to obtain. The weak form hypothesis holds
that if such data ever conveyed reliable signals about future performance all
investors already would have learned to exploit the signal.Utilmately,the
signal lose their value as they become widely known because a buy signal
for instance would result in an immediate price rise.
2. Semi-Strong
The semi strong hypothesis states that all publicly available information
regarding the future prospects of a firm already must be reflected in the
stock price. Such information includes in addition to past prices,
fundamental data on the firm’s product line, quality of management,
financial performance, and patents held sales forecasts and future strategic
plan for investments. Again if investors have access to such information
from publicly available sources one would expect it to be reflected in stock
prices.
3. Strong Form
The strong form of efficient market hypothesis states that stock prices reflect
all information relevant regarding a firm, even including information
available only to company insiders. This is an extreme version. It is true that
corporate officers have access to privileged information long before it
released to the public to enable them profit from trading on that information.

The Securities and Exchange Commission (SEC) prevents corporate officers
and related parties from trading using insider information since it is illegal
and criminal offence.
Technical Analysis
Technical analysis implies the search for recurrent and predictable patterns in
stock prices. Although the value of future economic prospects of a firm are well
understood by technical analyst they believe that such information is not
necessary for a successful trading strategy. They are sometime referred to as
chartist because of their reliance of charts and graph from which they try to pick
up trends that can be exploited.
The key to successful technical analysis is a sluggish response of stock prices to

fundamental supply and demand factors. Through this chartist identify support
levels and resistance levels which price levels that are difficult for stock prices fall
below or rise above. This information is used to determine when to sell a stock or
when to buy a stock.
Fundamental Analysis
Fundamental Analysis uses the financial statements (Income statement and

Balance sheet) of firms to determine the stock price. Fundamentalist usually start
with past earning and an examination of the company balance sheets. They
supplement this analysis with further detailed economic analysis that includes an
evaluation of the quality of the firm’s management; the firm’s standing within its
industry and the prospects for the industry as a whole. The idea is to obtain insight
into future performance of the firm not yet recognized by the rest of the market and
based on this information decide which stock to buy or sell.
Attempt review question number 30

CHAPTER 8
DIVIDENDS AND DIVIDEND POLICY
The term dividends refer to cash paid out of the earnings or profits made by the
firm. If a payment is made from other sources other than current or accumulated
profits the term distribution rather than dividends is used.
Cash dividends can be in several forms:
1. Regular Cash dividends
2. Extra dividends
3. Special dividends
4. Liquidating Dividends
Cash Dividends
These are the most common type of dividends and are paid out to owners of the
firm in the normal course of business at regular intervals. Extra dividend is what is
paid beyond the normal cash dividend hence the tern “extra”. Special dividends
are the unusual type and are one payment not to be repeated in the future.
Liquidating dividend are those paid when the entire or part of the business is sold
off or liquidated.
Dividend per share
Is the ratio of the dividend declared divided by the number of outstanding shares.

Example 8.1
A company declares K200, 000,000.00 dividend payment and has 200,000,000

shares outstanding.
Dividend per share = K200, 000,000/200,000,000 = K1 per share.
Establishing a dividend Policy
A dividend policy therefore is the time pattern of dividend payout. It answers the
question of whether the payout should be a large percent of its earning or a small;
percentage.
1. Residual Dividend Approach
This is a policy under which a firm pays dividends only after meeting its
investment needs while maintaining a desired debt equity ratio. In a residual
policy the firm first determines the amount funds to be generated without
selling new equity. Second the firm decides whether to pay dividends or not. If
funds needed for investment are less than funds generated, then dividend will
be paid out of whatever remains after reinvestment. This creates an unstable
dividend policy since in period where investment opportunities are many
dividends paid will be less or zero, while in those periods where there no
investment opportunities high dividends are paid.
2. Compromise Dividend Policy
In practice it is common for companies to apply a compromise dividend

policy. This policy has five main goals:
i. It avoids cutting back on positive NPV projects to pay dividends.
ii. It avoids dividends cuts.
iii. This policy avoids the need to sell equity.

iv. The policy maintains a target debt – equity ratio.
v. It also maintains a target dividend payout ratio.
A target payout ratio is a firm’s long term desired dividend to earnings ratio.
Alternative Forms to Cash Dividends
Stock Repurchase
A firm can repurchase its own stock as another way of paying out its earnings to
its shareholders. A stock repurchase has an effect on the EPs as it reduces the
number of outstanding share which causes the EPs to rise.
Stock Dividends and Stock Splits
Stock Dividend is a payment made by a firm to its owners in the form of stock
(bonus issue), diluting the value of each share outstanding. The dilution is caused
by the increase in the number of outstanding shares. The relative share holding of
each shareholder remains the same.
Stock Splits are essentially the same thing as a stock dividend except that a split
is expressed as ratio instead as a percentage. A split means each share is split to
create additional shares. For example in 4 for 1 stock split each old share is split
into 4 new shares.
Factors Affecting Dividends Payout Policy
There are factors affecting a company’s decision to pay dividends. Some factors
are external, while others are more company specific.
a) Taxation is an important factor in all investment decision because it is the

after tax return that is most relevant to investors. The various method or
system of tax has an impact on the dividends. Double taxation, split rate and
imputation tax system.

b) Flotation costs on new issues vs. retained earnings are important especially
for small firms. When the cost is high most firms will not pay dividend as this
will increase the cost of capital.
c) Restriction on dividend payments can also be a factor. Certain covenants

may restrict the amount of profits paid as dividends.
d) Clientele Effect which is the preference of the investors in relation to income.

Younger investor might prefer capital gains to regular dividends, while older
investors might prefer dividends to capital gains.
e) Signaling Effect is when firms use its dividend policy to signal investors
about how the company is really doing.

CHAPTER 9
LONG TERM SOURCES OF FINANCE
Long Term Capital is raised through what are termed capital markets. The major
sources of long term capital are equity (common and preferred) and debt.
EQUITY FINANCING
Public Issue
In a public issue securities are sold to hundreds, and often thousands, of investors
under a formal contract overseen by Securities and Exchange Commission and
stock exchange regulatory authorities. When a company issues securities to the
general public, it usually uses the services of an investment banker. The
investment Banker is a financial institution that underwrites (purchases at a fixed
price on a fixed date) new securities for resale. The investment banker receives an
underwriting spread when acting as a middleman in bringing together providers
and consumers of investment capital. Underwriting spread is the difference
between the price the investment bankers pay for the security and the price at
which the security is resold to the public. When a company issues stock for the
first time it known as an Initial Public Offer (IPO).
Three primary means companies use to offer securities to the general public:
• Traditional (firm commitment) underwriting
• Best efforts offering
• Shelf registration

Underwriting is bearing the risk of not being able to sell a security at the
established price by virtue of purchasing the security for resale to the public; also
known as firm commitment underwriting. If the security issue does not sell well,
either because of an adverse turn in the market or because it is overpriced, the
underwriter, not the company, takes the loss.
Underwriting Syndicate is a temporary combination of investment banking firms

formed to sell a new security issue.
Competitive-bid
The issuing company specifies the date that sealed bids will be received and
competing syndicates submit bids. The syndicate with the highest bid wins the
security issue.
Negotiated Offering
The issuing company selects an investment banking firm and works directly with
the firm to determine the essential features of the issue and together they discuss
and negotiate a price for the security and the timing of the issue. Depending on
the size of the issue, the investment banker may invite other firms to join in sharing
the risk and selling the issue. This is generally used in corporate stock and most
corporate bond issues.
Best Efforts Offering is a security offering in which the investment bankers agree
to use only their best efforts to sell the issuer’s securities. The investment bankers
do not commit to purchase any unsold securities.
Shelf Registration is a procedure that allows a company to register securities in

advance that it may want to sell and then put that registration ‘on the shelf’ until it
makes a sales offering; also called SEC Rule 415. These securities can then be
sold piecemeal whenever the company chooses.

• A firm with securities sitting “on the shelf” can require that investment
banking firms competitively bid for its underwriting business.
• This competition reduces underwriting spreads.
• The total fixed costs (legal and administrative) of successive public debt
issues are lower with a single shelf registration than with a series of
traditional registrations.
• The amount of “free” advice available from underwriters is less than before
shelf registration was an alternative to firms.
Rights Issue
The sale of new securities in which existing shareholders are given a preference in
purchasing these securities up to the proportion of common shares that they
already own. In a rights issue shareholders have options to exercise the rights and
subscribe for additional shares, sell the rights (they are transferable) or do nothing
and let the rights expire. The Directors in agreement with shareholders specify, the
number of rights required to subscribe for an additional share of stock, the
subscription price per share which is set at a discount to the market share price
and the expiration date of the offering.
Subscription Rights
The number of shares that a shareholder can buy depend on the number of rights
that shareholder owns and normally a rights issue is done in proportion of existing
shares. For example 2:4 rights issue mean a shareholder can buy 2 new shares for
every 4 shares they hold.

Example 9.1
A company has 1,000,000 shares outstanding and announces a 1:2 rights issue.
How many shares will be issued in the rights offering to existing shareholders?
Number of new shares = Outstanding Shares/2 shares required to buy one
= 1,000,000/2
= 500,000 new shares
The rights have a value which can be computed and since these can be sold lets
try and determine the value of a right.
Value of a Right
Value of right = Price of a share after rights issue - Subscription price
Example 9.2
A company under takes a rights issue and each share sells for K300 (subscription
price).This is 1:4 rights issue. Assuming the investor had only 4 shares he is entitled
to buy only 1 share. The market price of this share is K400.Determine the value of a
right?
Value of a share after rights issue = (4*K400+1*K300)/ 5 shares now owned
= K380
The share price has fallen from K400 to K380.
Value of right = K380-K300
= K80

Preemptive Right
The privilege of shareholders to maintain their proportional company ownership

by purchasing a proportionate share of any new issue of common stock, or
securities convertible into common stock.
Bonus Issue
These are shares issued without payment to holders of existing common stock.
They are issued because the price of existing shares has become too high. Bonus
is initiated by management with subsequent approval by shareholders. The
shareholders maintain their value but they have more share consequently the
value of each share is reduced by a bonus issue.
Example 9.3
A company has 1,000,000 share outstanding valued at K220 each. It carries on a

bonus issue of 1:1 meaning it issues 1,000,000 share in the bonus issued to
existing shareholders. The value of each share will drop to K110.
Total value of 2,000,000 share = K220,000,000
Each share = 220,000,000/2,000,000= K110 per share.
Private (or Direct) Placement
The sale of an entire issue of unregistered securities (usually bonds) directly to one
purchaser or a group of purchasers (usually financial intermediaries).
• Eliminates the underwriting function of the investment banker.
• The dominant private placement lender in this group is the life-insurance

category (pension funds and bank trust departments are very active as
well).

• Allows the firm to raise funds more quickly.
• Eliminates risks with respect to timing.
• Eliminates SEC regulation of the security.
• Terms can be tailored to meet the needs of the borrower.
Common Stock and Its Features
Common Stock securities represent a stake or ultimate ownership (and risk)

position in a corporation. A share has a Par Value /face value. It is merely a
recorded figure in the corporate charter and is of little economic consequence.
Stock should never be issued below par value as shareholders would be legally
liable for any discount from par if the firm is liquidated. Common stock that is
authorized without par value (no-par stock) is carried on the books at the original
market price or at some assigned (or stated) value. The difference between the
issuing price and the par or stated value is additional paid-in capital.
Rights of Common Shareholders
i. Right to Income – entitled to share in the earnings of the company only if cash
dividends are paid (via approval by the board of directors).
ii. Right to Purchase New Shares – the corporate charter of state statute may
provide current shareholders with a preemptive right, which requires that these
shareholders be first offered any new issue of common stock or an issue that
can be converted into common stock.
iii. Voting Rights – because the shareholders are owners of the firm, they are
entitled to elect the board of directors. There are two methods of voting: (1) in
person or (2) by proxy. A Proxy is a legal document giving one person(s)
authority to act for another.

Dividends are only payable after the firm has declared a dividend payment. The
amount of dividend is neither fixed nor tax deductible and it’s determined by the
firm’s management. Shareholders force a firm into liquidation if it has not paid
dividends.
Advantages of Issuing Common stock
a) Common stock does not obligate the firm to make fixed payments to stock
holders.
b) Common stock carries no fixed maturity date that is it never has to be repaid
as would debt.
c) The sale of common stock increases the credit worthiness of the firm and
provides capacity to raise new capital through debt.
Disadvantages of common stock
a) The sale of common stock extends voting rights and presents a dilution of
power for existing shareholders.
b) Common stock gives new owners the right to share in the income and
profits of the firm, unlike debt.
c) Floatation costs may be high for equity compared to debt or preferred stock.
d) Common stock dividends are not tax deductible like interest on debt.

Preferred Stock and Its Features
• Preferred Stock is a type of stock that promises a (usually) fixed dividend,

but at the discretion of the board of directors. Cumulative Dividends feature
is a requirement that all cumulative unpaid dividends on the preferred stock
be paid before a dividend may be paid on the common stock. For example,
if the board of directors omits a $6 preferred dividend for two years, it must
pay preferred shareholders $12 per share ($100 par value) before any
dividend can be paid to common shareholders. Participating Preferred
Stock allow the holder to participate in increasing dividends if the common
stockholders receive increasing dividends. Preferred stockholders have a
prior claim on income and an opportunity for additional return if the
dividends to common stockholders exceed a certain amount.
• Preferred stockholders are not normally given a voice in management

unless the company is unable to pay preferred stock dividends during a
specified period.
• If such a situation presents itself, the class of preferred stockholders would

be entitled to elect a specified number of directors.
• Any situation in which the company defaults under restrictions in the

agreement (similar to bond indenture) may lead to voting power for
preferred shareholders.
• Preferred shareholders cannot force the immediate repayment of

obligations (like debt obligations).
• Call Provision – almost all issues carry a call provision because of the infinite
maturity. It is often a cheaper method of retirement than open market
purchases, inviting tenders, or an exchange of securities.

• Sinking Fund – like bonds, many preferred issues provide for this method of
retirement.
• Conversion – certain issues are convertible into common stock at the option
of the preferred stockholder. Used most frequently in the acquisition of other
companies (the transaction is not taxable to the shareholders of the
acquired firm).
• Dividends on preferred stock are not tax deductable like debt interest and
this is a disadvantage for preferred stock.
DEBT FINANCING
Debt is generally referred to as capital that a firm borrows for a limited period of
time and repayable. The most important feature of debt is that it does not
constitute an ownership claim on the firm. Debt obligation is a contractual
agreement which usually stat the amount borrowed interest payable and dates at
which interest payment and capital repayments are due. On advantage for firms
that use debt is that the debt interest is tax deductable unlike dividends. The tax
shield reduces the overall cost of debt.
Types of Long-term Debt Instruments
Debentures
A debenture is a document issued by a company containing an acknowledgment

of debt. The term Bond is used interchangeably with debenture. Usually a
debenture carries a charge on the assets of the borrowing company. Debenture or
bonds have an Indenture. This is a legal agreement, also called the deed of trust,
between the corporation issuing bonds and the bondholders, establishing the
terms of the bond issue and naming the trustee.

Secured Bonds
A secured bond or debenture carries a charge on the assets of the borrowing firm
which can be Floating or Fixed Charge.
Floating Charge is a charge that does not specify the assets pledged on loan and
the company is free to sell these assets.
Fixed Charge is a charge where specific assets have been identified and pledged
as collateral and as such cannot be sold by the company.
Subordinated Debenture
A long-term, unsecured debt instrument with a lower claim on assets and income
than other classes of debt; known as junior debt. Subordinated debenture holders
rank behind debenture holders but ahead of preferred and common stockholders
in the event of liquidation. Frequently, the security is convertible into common
stock to lower the yield required by subordinated debenture holders (often less
than regular debentures).
Serial Bonds
An issue of bonds with different maturities, as distinguished from an issue where

all bonds have identical maturities (term bonds).For example, a $10 million issue
of serial bonds might have $500,000 of predetermined bonds maturing each year
for 20 years. Investors are able to choose the maturity that best fits their needs
(wider investor appeal).
Term Loan
Debt originally scheduled for repayment in more than 1 year, but generally in less
than 10 years. Features of term loan include the following:
i. Credit is extended under a formal loan arrangement.

ii. Usually payments that cover both interest and principal are made quarterly,
semiannually, or annually.
iii. The repayment schedule is geared to the borrower’s cash-flow ability and
may be amortized or have a balloon payment.
iv. The interest rate is higher than on a short-term loan to the same borrower
(25 to 50 basis points on a low risk borrower).
v. Interest rates are either (1) fixed or (2) variable depending on changing
market conditions – possibly with a floor or ceiling.
vi. Borrower is also required to pay legal expenses (loan agreement) and a
commitment fee (25 to 75 basis points) may be imposed on the unused
portion.
vii. The borrower can tailor a loan to their specific needs through direct
negotiation with the lender.
viii. Flexibility in terms of changing needs allows the borrower to revise the loan
more quickly and more easily.
ix. Term loan financing is more readily available over time making it a more
dependable source of financing than, say, the capital markets.
Revolving Credit Agreement
A formal, legal commitment to extend credit up to some maximum amount over a

stated period of time. Agreements are frequently for three years. The actual notes
are usually 90 days, but the company can renew them as per agreement. Most
useful when funding needs are uncertain. Many are set up so at maturity the
borrower has the option of converting into a term loan.
Lease Financing

Lease is a contract under which one party, the lessor (owner) of an asset, agrees
to grant the use of that asset to another, the lessee, in exchange for periodic rental
payments. Title to the assets will only pass to the lessee after the full payment of
the lease amount. In the books of the lessee the asset is recognized in the balance
sheet and a liability is recorded for the lease amount owed to the lessor. The
original intention in a finance lease is to own the asset.
Examples of familiar leases:
1. Apartment House
2. Office Buildings
3. Automobile and Heavy equipment
Operating Lease
An operating lease is an agreement for the rental of an asset and the lessee does
not intend to own the asset at the end of the day. The lease rentals are all charged
to the profit and loss account as an expense.
A lease agreement will include the following:
a) Advantage: Use of an asset without purchasing the asset
b) Obligation: Make periodic lease payments
c) Contract specifies who maintains the asset
i. Full-service lease – lessor pays maintenance
ii. Net lease – lessee pays maintenance costs
d) Cancelable or no cancelable lease? usually an operating lease (short-term,

cancellable) vs. financial lease (longer-term, no cancelable).

Sale and Leaseback
The sale of an asset with the agreement to immediately lease it back for an extended
period of time. The lessor realizes any residual value. There may be a tax advantage
as land is not depreciable, but the entire lease payment is a deductible expense. The
company selling the asset will enjoy a large cash inflow which it can use to invest in
another new asset.Lessors are usually insurance companies, institutional investors,
finance companies, and independent companies.
Derivative Security
A financial contract whose value derives in part from the value and characteristics of
one or more underlying assets (e.g., securities, commodities), interest rates, exchange
rates, or indices. Straight debt or equity cannot be exchanged for another asset, but
options are exchangeable. An option is part of the broader category of derivative
securities.
Convertible Security
A bond or a preferred stock that is convertible into a specified number of shares of

common stock at the option of the holder.
i. This provides the convertible holder a fixed return (interest or dividend) and the
option to exchange a bond or preferred stock for common stock.
ii. The option allows the company to sell convertible securities at a lower yield
than it would have to pay on a straight bond or preferred stock issue.
iii. Conversion Price – The price per share at which common stock will be
exchanged for a convertible security. It is equal to the face value of the
convertible security divided by the conversion ratio.Conversion Ratio – The
number of shares of common stock into which a convertible security can be
converted. It is equal to the face value of the convertible security divided by the
conversion price.

Warrants
A relatively long-term option to purchase common stock at a specified exercise

price over a specified period of time. Warrants are employed as “sweeteners” to
obtain a lower interest rate and to raise funds when the firm is considered a
marginal credit risk. Other uses include compensate underwriters and venture
capitalists when founding a company.
Warrant Features
The warrant contains provisions for:
i. The number of shares that can be purchased per warrant.
ii. The price at which the warrant can be exercised.
iii. The warrant expiration date.
Warrant holders are not entitled to any dividends nor do they have any voting
power. The exercise price is generally adjusted for any common stock dividends
and splits.
Venture Capital
Wealthy investors and financial institutions are the primary providers of funds for a
new enterprise (usually common stock).Venture capital is much more risky business
for investors. The risk here is the most start up firm have no track record and usually
in this arrangement the venture capitalist will have stake in the equity of the firm,
which is intended to be sold at a later date once the business has grown to a
significant level.
Attempt review question number 1 and 2

CHAPTER 10
INTERNATIONAL TRADE AND FINANCE
Large corporations usually have international operations with subsidiaries and

other trading partners located all across the globe. Some of the financial
considerations for international companies are foreign tax rates, exchange rates,
interest rate and other foreign government interventions. One of the major
problems in trading internationally is that sellers and buyers rarely meet and
concluding transaction is more complex.
Structure of International Trade Documents
In international trade, sellers often have difficulty obtaining thorough and accurate
credit information on potential buyers. Channels for legal settlement in cases of
default are more complicated and costly to pursue. Key documents are (1) an
order to pay (international trade draft), (2) a bill of lading, and (3) a letter of credit.
The international trade draft (bill of exchange) is a written statement by the

exporter ordering the importer to pay a specific amount of money at a specified
time.
Sight draft is payable on presentation to the party (drawee) to whom the draft is
addressed.
Time draft is payable at a specified future date after sight to the party (drawee) to
whom the draft is addressed.
• An unconditional order in writing signed by the drawer, the exporter.
• It specifies an exact amount of money that the drawee, the importer,

must pay.
• It specifies the future date when this amount must be paid.

• Upon presentation to the drawee, it is accepted.
• The acceptance can be by either the drawee or a bank.
• If the drawee accepts the draft, it is acknowledged in writing on the

back of the draft the obligation to pay the amount so many specified
days hence.
• It is then known as a trade draft (banker’s acceptance if a bank

accepts the draft).
Bill of Lading
A shipping document indicating the details of the shipment and delivery of goods
and their ownership. It serves as a receipt from the transportation company to the
exporter, showing that specified goods have been received. It serves as a contract
between the transportation company and the exporter to ship goods and deliver
them to a specific party at a specific destination. It serves as a document of title.
Letter of Credit
A promise from a third party (usually a bank) for payment in the event that certain
conditions are met. It is frequently used to guarantee payment of an obligation.
• A letter of credit is issued by a bank on behalf of the importer.
• The bank agrees to honor a draft drawn on the importer, provided the bill of
lading and other details are in order.
• The bank is essentially substituting its credit for that of the importer.

Countertrade
Generic term for barter and other forms of trade that involve the international sale
of goods or services that are paid for – in whole or in part – by the transfer of
goods or services from a foreign country.
• Used effectively when exchange restrictions exist or other difficulties

prevent payment in hard currencies.
• Quality, standardization of goods, and resale of goods that are delivered

are risks that arise with countertrade.
Forfaiting
The selling “without recourse” of medium- to long-term export receivables to a

financial institution, the forfeiter. A third party, usually a bank or governmental unit
guarantees the financing.
 The forfeiter assumes the credit risk and collects the amount owed from the
importer.
 Most useful when the importer is in a less-developed country or in an Eastern

European nation.
Foreign Exchange markets and Exchange Rates
The foreign exchange market is a market where one country’s currency is

traded for another’s. It forms one of the world’s largest financial markets.
Common currency traded are US dollar $, British Pound £, the Japanese Yen¥
and the Euro €.The market participants are commercial banks, investment
banks and currency bureau. Other participants include
i. Importers who pay for goods using foreign currencies.

ii. Exporters who receive foreign currency and may want to convert to
domestic currency.
iii. Portfolio managers who buy and sell foreign stocks and bonds
iv. Foreign exchange brokers who match buy and sell orders.
v. Traders who make a market in foreign currencies
vi. Speculators who try to profit from changes in exchange rates
Exchange Rates
An exchange rate is the price of one country’s currency expressed in terms of

another country’s currency. The exchange rate for US dollar to kwacha can be
expressed as K4, 980 (ask rate) or K5, 120 (Bid rate). This means that If you
wanted to buy a dollar, you would pay K5120 for each dollar and if you wanted
to sell US dollars you would sell them for K4980 each.
Cross rate
A cross rate is the exchange rate for a non US currency expressed in terms of
another non US currency. For example we can express the € Euro and Swiss
Franc SF as follows.
€ Per 1$ = 1.00
SF per 1$ = 1.00
Suppose the cross rate is quoted as:
€ Per SF = 0.40
If you had $100.These can be converted to Swiss franc at $100 *SF2 per $1 =
SF 200 or If you converted using the cross rate it will be SF200 *€4 per SF 1 =
€80.

Types of foreign exchange transaction
Spot Trade
An agreement to trade currencies based on the exchange rate today for

settlement within two business days. In a Spot trade the exchange rate used is
called the “Spot Rate” or Spot Exchange Rate.
Forward Rate
A forward trade is an agreement to exchange specific amount of currency at

some time in the future. The exchange rate used in the forward Trade is called
Forward Exchange Rate.
K 5,120 Spot Rate
K 5,720 Forward Rate
It can be seen that the forward rate for the dollar is more expensive than in the
spot rate. When the dollar is more expensive in the future than today it is term
selling at a premium relative to the kwacha while in the same sense the
kwacha is said to be trading at a discount relative to the dollar.
Exchange Rate Risks
This is the risk associated with fluctuations in foreign exchange rates relative to
the domestic currency. There are three main types of exposure relating to
exchange rates.
i. Short Run exposure which is the risk relating to day to day fluctuations
on exchange rates. For example If you are an exporter and you bill you
client 10 tons of Copper at $8000 per ton you expect $80,000 converted
at today’s rate say K4900 this invoice would be valued at K
392,000,000.Now since the client will pay in a 30 days the rate for a dollar
may go up or down. If the rate dropped to K4000, then value of the

invoice would be K320, 000,000.00.The exporter then suffers a loss due to
an exchange rate drop. This can be reduced using a forward exchange
agreement to lock the rate.
ii. Long Run Exposure which is the risk relating to unexpected changes in
the relative economic condition of the country of operation. For instance
if economic conditions in Zambia changed and the kwacha appreciated
over time to say K1, 000 against the dollar. Foreign based companies
would lose the cost advantage as their operating costs would rise as the
dollar weakens. Hedging long run exposure is difficult but a firm may try
to match foreign currency inflows and out flows. This means match sales
and labor costs from the same foreign country. Toyota has plants in the
US for US sells and employs labor and materials from the same country.
iii. Translation Exposure which is the risk relating the effects of having to
translate profits or accounting values from one currency into another
foreign currency. If a multinational company had a branch in Zambia
and had in its bank K2.0 billion. When this is converted at K4000 per
dollar, this translates to $500,000.The following month if the same
balance were maintained and translated at K5000, this would be only
$400,000. An exchange loss/Gain occurs due to translation of currencies.
This can apply to assets and other liabilities for the financial statements.
Political Risk
Finally another risk faced with international firm is political Risk. It refers to changes
in value that arise due a direct consequence of political action. Examples of these
include nationalization of companies, blocking of externalization of profits, fixing
exchange rates and exploitative tax regimes. Ways to hedge this is to form joint
venture with governments or local companies. Use local financing and skilled
manpower to win goodwill of government and communities.

Risk Management (Hedging Exposure)
Hedging is the term used to refer to methods use to reduce or eliminate risk
arising from price or rate fluctuations. Firms employ financial engineering by using
existing securities to create new ones that are then used to manage risk. These
are known as Derivatives. A derivative is a financial asset that represents a claim
to another financial asset. Corporations buy and sell derivatives as way of
managing risk. Price volatility occurs in interest rate, exchanges rate and
commodities.
Hedging techniques:
Forward Contracts
A forward contract is binding agreement signed between two parties calling for
the sale of an asset or product in the future at a price agreed today. In a forward
contract both the buyer and seller have an obligation to take and make delivery
respectively. The buyer or the seller stands to win or lose depending on how
prices move. It is a zero sum game.
Futures Contracts
A futures contract is in essence a forward contract however gains and losses are
realized daily. When a futures contract is bought for product say oil we profit if
prices rise today and the seller losses. The seller will pay and the transaction starts
again the following day. If prices fall the second day the seller wins and we lose so
we pay up. The resettlement feature in futures contracts is called marking to
market.

Swap Contracts
A swap contract is an agreement by two parties to exchange or swap specified

assets at specified intervals in the future. The distinguishing feature of swaps is
that they are like forward contract though in multiples.
i. Interest Rate Swap is a swap contract where two firms agree to exchange
payment of each other’s interest obligation. If a firm desiring a floating rate
can only obtain a fixed rate, while another firm desiring a fixed rate interest
can only obtain a floating rate. The two firms can enter into a swap contract
to accomplish their objectives.
ii. Currency Swap is a swap contract where two parties agree to exchange a
specific amount of one currency for a specific amount of another at specific
dates in the future. This is common among group subsidiaries of
multinational companies. One subsidiary can exchange one currency with
another subsidiary and this is a neat solution for hedging exchange rate
movements.
iii. Commodity Swap is a swap contract to exchange a fixed quantity of a

commodity at fixed times in the future. This is a way of reducing transaction
exposure. The commodities are priced using an average of daily price over
a given period. The average price eliminates huge fluctuation in price that
occurs on a daily basis.
Unlike futures and forward contracts swaps are not traded in organized markets
and these are mostly organized by swap dealers. Commercial banks are the major
swap dealers.

Option Contracts
An option is an agreement that gives the owner the right, but not the obligation to
buy or sell a specific asset at a specific price for a set period of time.
i. Put Option Is an option that gives the owner the right but not the obligation
to sell an asset.
ii. Call Option is an option that gives the owner the right but not the obligation
to buy an asset.
When the underlying asset is either bought or sold it is called exercising the option,
and the price agreed is called the strike or exercise price.
Purchasing Power Parity (PPP)
Purchasing power parity is the idea that the exchange rate adjusts to keep
purchasing power constant among currencies. Relative purchasing power parity
says that the change in the exchange rate is determined by the difference in the
inflation rates of two countries. For instance.
S0 = Spot exchange rate (foreign currency per dollar)
Et = expected exchange rate in t periods.
Hus= Inflation rate in the United sates
HFc = Foreign country inflation rate
The expected percentage change in the exchange rate over time is
(Et – S0)/S0 = hFC - hus
The expected exchange rate Et = S0 x (1 + ( hFC – hUS)

For example suppose US inflation is predicted to be 4 %.British inflation over the
coming year is expected to be 10% and the pound to dollar exchange rate is £0.50.
Expected exchange rate is = 0.50 x (1 + (0.1- 0.04)) = £0.53
CHAPTER 11

FINANCIAL STATEMENT ANALYSIS
The financial analysis of a company is a process of selecting, evaluating and

interpreting financial data along with other information in order to formulate an
assessment of the company’s present and future financial condition and
performance. We can use financial analysis to evaluate the efficiency of a
company’s operations, its ability to manage expenses, the effectiveness of its
credit policies and its creditworthiness.
1. Common size Analysis
This approach to financial analysis involves restating financial statement figures

using a reference point. For instance values in the income statement can stated as
a percentage of the sales. This enables analysts to identify trends and major
differences. The analyst can then compare these proportions across time and
across company’s industry.
Vertical Common Size Analysis is used to analyze patterns in profitability using

common-size income statements and patterns in investments and financing using
common size balance sheets.
Example 11.1

This example uses an extract from the financial statements of Procter & Gamble
and you are expected to have prior knowledge of financial statements and ratio
analysis from financial accounting.
Procter & Gamble Income Statement:

Procter & Gamble Balance Sheet:
Using common size analysis comparisons overtime in the percentage change will
reveal trends that will then be used in the evaluation of the financial performance

of the company. The balance sheet shows balance sheet figures as a percentage
of total assets.
Example 11.2
The balance sheet Common size Non Current Assets percentage for 2004 is
computed as follows:
14108/57048 =0.2473 or 24.7%
Example 11.3
The Income statement common size percentage of Cost of goods sold for 2003 is
computed as follows:
22141/43377 =0.5104 or 51%
2. Financial Ratio Analysis
Financial ratio is the use of financial accounting and other information to assess a
company’s financial performance and financial condition. There are a number of
various ratios used and can be categorized into the following:
i. Profitability Ratios
The profitability ratios analyze a company’s ability to manage its expenses to

generate profits from its sales.
ii. Liquidity Ratios
These are used to measure a company’s ability to meet its short term
immediate obligations.
iii. Activity Ratios (Efficiency)

These are used to evaluate a company’s effectiveness in putting its asset
investment to good use by generating sufficient sales.
iv. Gearing Ratios or Financial Leverage
These are used to measure a company’s debt obligation and its ability to
meet the interest payment.
v. Investment Ratios
These ratios measure the benefits generated by investments made by

shareholders in the company.
Profitability Analysis
Margins are a measure of profits as a percentage of sales. Mark up is a measure

of profit as a percentage of product cost. Ratios used include.
Gross Profit margin = (Gross Profit/Sales) x 100%

= $26,331/$51,407 = 51.2%
Operating profit Margin = (Operating Profit/Sales) x 100%
=$9,827/$51,407 = 19.1%
Net Profit margin = (Net Profit/Sales) x 100%
= $6,481/$51,407 = 18.2%
Return on Capital Employed (ROCE) = (Net profit/Capital Employed) x 100%
= $6,481/$43,706 =14.82%
Liquidity Analysis

Liquidity measures the company’s ability to generate cash and meet its immediate
obligations. These are the ratios used.
Current Ratio = Current Assets/Current Liabilities
= $17,115/$22,147=0.77
Quick (Acid test) = (Current Assets–Inventories)/Current

liabilities = $5,469+$423+$4,062/$22,147 =0.45
Activity or Asset Utilization Ratios
These ration analyses how well management is put assets to use in generating
sales.
Inventory Turnover = Cost of Sales/Inventory
= $25,076/$4,400 = 5.7 times
It measures how many times inventory is turned over.
Total Asset Turnover = Total Revenue/Total Assets
= $51,407/$57,048 = 0.90 times
It measure how much sales is generated per dollar invested in assets.
Working Capital Turnover = Total Revenue /Working Capital
Inventory Days = Inventory/Cost of Sales *365 days
= $4,400/$25,076 *365 = 64.05 days
It measures how long the firm takes to sell inventory.
Receivables Days = Debtors/Credit Sales *365 days

= $4,062/$51,407*365 =28.84 days
It measure how long debtors take to settles accounts.
Payables Days = Creditors/Purchases or Cost of Sales *365 days
= $3,617/$25,836*365 =51.1 days
It measures how the firm takes to pay its creditors.
Purchases = Costs of Sales +Closing inventory – Opening inventory
Gearing or Financial Leverage Ratios
These ratios measure to what extent the company is relying on debt to finance its
assets. The more debt a company uses the higher its financial risk. Financial risk
relates to the use of debt in the company’s capital structure.
Debt to Equity ratio = LT Debt/Equity Funds ( LT means long-term)
= $25,910/$17,278 =1.50
It measures the ration Lt Debt to shareholder equity.
Gearing Ratio = LT debt/Equity + LT Debt
= $25,910/$43,706 = 0.5928
It measures the amount of LT debt against total investment in assets.
Interest Cover Ratio = Profit before Interest/Interest payable
= $9,827/$629 =15.62
It measures how many times interests can be paid out of profit.
Investment Ratios

These ratios analyze the benefits generated from investment by shareholders.
Earnings per share (EPs) = Net income to shareholders/Number of shares

outstanding = $6,481-$131/2581 = $2.46 assume the company has
2581 shares outstanding.
Price Earnings Ratio = Market price per share/Earning per share
= $54.44/$2.46 = 22.13
Dividend Cover Ratio = Profit before dividend due to Shareholders/Dividends

payable = $6,481-$131/$2,408 = 2.63 times
Dividend Payout Ratio = Dividend paid to common Shareholders/Net income

attributable to shareholders = $2,408/$6,481-$131 = 37.92%
Limitations
Though using ratios is helpful in analyzing a company’s performance, however

ratios do not provide all the information that is required in making a conclusive
decision concerning the financial performance of a company. Hence ratios should
be used in conjunction with other qualitative information.
Recommended Reading Materials:
th
 Ross; Westerfield; Jordan Corporate Finance Fundamentals 8 edition.
th
 Essentials of investment Bodie ,Kane,Marcus 7 edition
 Lusaka Stock Exchange (LuSE) brochures and website.
 Corporate Finance a practical Approach CFA institute

th
 Van Horne Fundamentals of Financial Management 13 editon.
Review Questions:
Q1.
a) Longwe Mining Contractors is expanding operations to mining companies in its

locality. The company wishes to raise more funding through a rights issue for
K24 million. The company has currently 9,000 000 shares outstanding, and is
also listed on the Lusaka Stock Exchange. The Shares are current quoted at
K10 and the subscription price has been set at K8 per share.
Required:
i. Find the number of shares to be issued in rights offer?
ii. What is the new price of the shares after the rights issue?
iii. Determine the value of each right?

iv. How many shares would an investor buy if he held 3000 shares?
b) Briefly discuss both internal and external factors that influence a company’s
Dividend Policy.
c) A plant requires the use of 200,000 units of a component for its production. The
cost to the company is K5000 per unit. The cost per order is K80, 000 and the
carrying cost per unit is K500.
i. Determine the economical quantity to order using the EOQ model.
ii. What is the Total ordering Cost to the company?

iii. Find the Total inventory cost to the company.
Q2.
The Nasanga Sugar plant Company has been predominately a family business
with the family holding a large share of the company. Due to the need to expand
into other regional markets has held a meeting to decide on whether to finance its
K15 billion expansion program using debt finance or to use the common stock.
The company has a significant investment in fixed assets which can be used as
security for debt if need arises, however there are concerns that the expansion into
new market is a risky project and returns are likely to come through only in the
long-term. The family is eager to maintain their current shareholding but is willing
to reduce this for the common benefit of company growth.
Required:
i. Discuss the benefits and shortcomings of using Debt and equity finance for
Nasanga Sugar Plant.
ii. Which financing option would be most suitable for Nasanga Sugar and
why?
iii. What advantages would Nasanga obtain if it used convertible loan stock?
Q3.
A supplier has always offered gem traders 60days credit.Th supplier is now
facing debt collection problems and is considering offering all its clients 2%
cash discount for all invoices paid with 14 days of pucrchase.Gem Traders can
invest cash at an annual rate of 12%.
Required

a) Determine whether it’s economical for Gem Traders to take advantage of
the discount
b) Explain the importance of credit management in a firm and outline the

features of a good credit policy.
c) Marketable securities are an important tool in managing cash. Discuss

the risks to be considered when selecting marketable securities in which
to invest.
Q4.
a) Timber milling balance sheet shows the following capital structure for 2009
9% Debenture K4, 500,000
7% preferred Stock K1, 500,000
Common Stock (100,000 shares) K1, 000,000
Retained Earnings K2, 500,000
The debt was issued at K1000 par and is now quoted at K1,000.The company
has 15000 preference share outstanding with a market price of K90.The
company last dividend was K4 and is expected to grow at 5 percent yearly and
common stock is currently quoted at K65.The corporate tax rate is 35%.
i. Calculate the weighted average cost of capital (WACC) for Timber limited.
i. Discuss the MM Theory with tax in relation to WACC and Cost of equity.
ii. What is the direct and indirect cost of bankruptcy?

b) There are risks inherent in any business. The two types of risks to which
investors are exposed are Unsystematic and systematic risk. Differentiate
between the two risks and explain how an investor can minimize one of the
two risks? How is Total risk measured?
Q5.
a) Three years ago, your company issued some 15 year bonds with 11%
coupon rates and 10% call premium. You have called these bonds which
originally sold at their face value of K1000.
Compute the Total yield realized by the investors who purchased the bonds
when they were issued and comment on whether these investors would be
happy with the calling of the bonds?
b) Palabana Peanut Company issued new 20 year bonds on January 1,

1990.the bonds sold at par (K1000) and paid a 10 % coupon annually.
i. What was the YTM of the bonds on January 1, 1990?
ii. What was the bond’s price and current yield on January 1, 1995, five
years later assuming interest rates fell to 8%?
iii. On January 1 2005 these bonds sold for K850 in the market. What was
the YTM at that date?

Q6
a) Define a financial system and briefly explain how it operates and its role in
national economic development. In your opinion, what needs to be done to
enhance the efficiency and effectiveness of our financial system?
b) From your studies, what is corporate finance? Briefly explain what corporate
finance is concerned with and explain why it is argued that wealth
maximization provides a more meaningful objective than profit
maximization for the financial management function in business enterprises.
Q7
a) On August 20, 2010 Monde buys a house for K300 million, paying 20% down
payment and agreeing to pay the balance in 15 equal installments that
include principal and 15% interest compounded on declining balance.
Required:
What equal installment would leave a zero balance after the 15th
installment has been paid?
b) The Panono liquor Company is currently growing faster than the economy.
Expected growth of the company is 11% for the next 3 years; then it is
expected to settle down to a constant rate of 4% thereafter. The dividend
paid last year was K1.75 and investors require are turn on stock of similar
risk of 11%.
i. What is the present price of the stock?
ii. Suppose you want to hold the stock for one more year. What do you
expect the selling price to be one year hence?
Q8

c) Timber milling balance sheet shows the following capital structure for 2010
9% Debenture K4, 500,000
7% preferred Stock K1, 500,000
Common Stock K1, 000,000
The company last dividend was K4 and is expected to grow at 5 percent yearly
and common stock is currently quoted at K40.The corporate tax rate is 33%.
ii. Calculate the weighted average cost of capital (WACC) for Timber limited.
iii. Explain what is meant by cost of capital and weighted average cost of
capital and discuss the impact of tax on the cost of capital of a firm.
iv. Explain what is meant by capital structure of firm?
d) There are risks inherent in any business. The two types of risks to which
investors are exposed are Unsystematic and systematic risk. Differentiate
between the two risks and explain how an investor can minimize one of the
two risks? How is Total risk measured?
Q9
a) A student requires K5, 000,000 to clear an outstanding balance before

graduating in two (2) years time. How much should he invest now at 15%
compounded semi annually for him to have the required amount to pay the
school at the end of the two years?

b) A pension fund requires to pay an annual dividend to its equity share
holders of K200.the require rate of return on common stock is 11 percent.
Find the value of this stock today
c) A company is evaluating two projects. Project gold mine requires

K200million cash outlay, and Project Platinum also requires K200 million.
The company can only undertake one project as it applies capital rationing.
Each project will last 25 years and the cash flows for each year are as
follows.
Years Project gold mine Project platinum

1 K4, 000,000 K15, 000 000
2-25 K18, 000,000 K25, 000,000
The company’s cost of capital is currently 10%
i. Evaluate the two projects and advise the company about the viability
of the two projects.
ii. Explain the meaning of capital rationing and external and internal
factors that contribute to capital rationing.
iii. State three (3) advantages of using the NPV as a method for
investment appraisal.
Q10
Describe the agency problem and how it can solve and also explain the
significance of Corporate Governance?
Q11
What are financial intermediaries and what economic function do they
perform?

Q 12
Define money market, capital market, primary market and secondary market.
Q13
To help you reach your $1000 goal your father offers to give you $400 on
January 1 1988. You will get a part-time job and make 6 additional payments of
equal amounts each 6 months thereafter. If all this money is deposited in a
bank which pays 8 percent, compounded semiannually how large must your
payment be?
a) What is the effective annual rate being paid in question (4) above?
b) Which amount is worth more at 10 percent; $1000 in hand today or
$2000 due after 8 years?
c) Set up an amortization schedule for a $20000 loan to be repaid in equal
installments at the end of each of the next 3 years. The interest rate is 10
percent.
Q14
While you were a student at the Copperbelt University you borrowed $5000
at annual interest rate of 9 percent. If start to repay $75 per month, how long
will it take to repay the loan?
Q15
Find the amount to which $200 will grow under each of the following
conditions:
i. 12% compounded annually for 5 years
ii. 12 % compounded quarterly for 5 years
iii. 12% compounded monthly for 1 year
Q16
Define intrinsic value of stock? And describe the features of a bond?
Q17
If you buy a callable Bond and interest rates decline, will the value of your
bond rise by as much as it would have if the bond had not been callable?

Q18
The braswell company issued a new series of bonds on January 1, 1967.
The bonds were sold at par ($1000) have a 12 percent coupon and mature
in 30 years on December 31 1996.Coupon payments are made semi
annually on June 30 and December 31.
i. What is the YTM if Braswell bonds on January 1 1967?
ii. What is the price of the bond on January 1 1972, 5 years later if
interest fell to 10 percent?
iii. Find the current yield and capital gains yield on July 1 1987?
Q19
Supposing that Exxon sold an issue of bonds with a 10 year maturity $1000
par value, 12 percent coupon rate and semi-annual interest payments. Two
years after the bonds were issued the going rate of interest on bonds such
as these fell to 8 percent what would be the value of this bond then?
i. If after the 2 years the same bond in (Q19) above was sold for $ 1320,
calculate its yield to maturity (YTM).
Q20
What is NPV versus IRR conflict? And the meaning of cross over-rate. Also
distinguishes between mutually exclusive and independent projects.
Q21
A project Swift wing has an initial cost of $65000 and its expected net cash
flows are $15000 per year for 8 years. What is the project’s payback, NPV if
the cost of capital is 14 percent and the IRR of the project?
Q22
Ferrari engineering is considering including two pieces of equipment, a
truck and an overhead pulley system in this year’s capital budget. The

projects are not mutually exclusive. The cash outlay for the truck is $17350
and that for the pulley system is $24,225.00
The firm’s cost of capital is 15 percent. After tax cash flows including
depreciation are shown in dollars.
Year Truck Cash flows($) Pulley Cash flows($)
1 5,300 8,100
2 5,300 8,100
3 5,300 8,100
4 5,300 8,100
5 5,300 8,100
Calculate the IRR and NPV for each project and indicate the correct
accept/reject decision for each.
Q23
Why should firms not employ capital rationing?
Q24
Describe the structure of Lusaka Stock Exchange (LuSE) and the
operations.
Q25
Give that the beta for stock is 1.5 and treasury bill have a return of 6% in the
market, what is the return on this stock given that the market risk premium is
7%?
Q26
What does the beta of a stock measure? And distinguish between Non
Diversifiable risk and unsystematic risk.
Q27
What is the significance of correlation of returns in portfolio selection and
risk?

Q28
Given the following information about two stocks
Economic State Probability Stock A Returns Stock B Returns

Average 0.3 0.15 0.14
High 0.5 0.25 0.30
Low 0.2 0.10 0.12
Calculate the expected returns on stocks and compare their risk levels.
Which stock would you recommend?
Assuming that the stocks were part of a portfolio where one half of the
portfolio value was invested in each stock, what would be the portfolio
expected return?
Q29
What are derivate securities?
Q30
Explain the Efficient Market Hypothesis Theory.

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2010

UNIVERSITY OF LUSAKA (UNILUS)

CORPORATE FINANCE/FINANCIAL MANAGEMENT

COURSE CODE: BSP320/ECF210/AFIN209

PROGRAMS: LONG DISTANCE/FULL-TIME/PART-TIME

0|P a g e University of Lusaka

Chapter 1: Introduction to corporate Finance [5]

Role of finance Managers……………………………………………………………………

Forms of Business Organizations…………………………………………………….

Goals of Corporation and agency Problem……………………………………

Corporate Governance issues………………………………………………………….

Financial Markets Operations……………………………………………………………

Chapter 2: Time Value of Money and Valuation Models [16]

Compounding and Discounting…………………………………………………………

Lumps Sum amounts, Annuities and perpetuities…………………………

Compounding interest more than once a year………………………………

Valuation Models for financial Securities…………………………………………

Bond Valuation and Yields……………………………………………………………………

Stock Valuation ………………………………………………………………………………………

Chapter 3: Risk and Return [38]

Risk and return relationship…………………………………………………………………

Measuring risk and expected return…………………………………………………..

Types of Risk and Capital Asset Pricing Model (CAPM)………………..

Efficient frontier and Capital market line (CML)……………………………….

1|P a g e University of Lusaka

Techniques in Capital Budgeting; NPV, IRR, ARR, PI and Payback Period

Conflict of NPV vs. IRR………………………………………………………………………

Inflation and Capital Budgeting………………………………………………………

Taxes and Capital allowances …………………………………………………………

Chapter 5: Cost of Capital, Capital Structure and Financial leverage [69]

Cost of debt, Prefered Stock, equity and WACC…………………………

Financial Leverage and Capital structure……………………………………

Chapter 6: Working Capital Management [80]

Working Capital cycle, investment and financing policies……………

Managing trade credit……………………………………………………………………………

2|P a g e University of Lusaka

Short-term sources of finance……………………………………………………………

Chapter 7: Efficient Market hypothesis Theory [102]

Forms of market efficiency…………………………………………………………………

Chapter 8: Dividend Policy [105]

Dividends and dividend payment………………………………………………………

Establishing a dividend policy……………………………………………………………

Alternatives to cash dividends……………………………………………………………

Chapter 9: Long-Term sources of Finance [109]

Debt financing and debt instruments………………………………………………

Chapter 10: International Trade and Finance [123]

International trade documents……………………………………………………………

Foreign Exchange Markets and Risks………………………………………………

Hedging Tools and Purchasing power Parity…………………………………

Chapter 11: Financial Statement Analysis [133]

Common Size Analysis and Financial Ratios…………………………………

Review Questions………………………………………………………………………………………….…………… [141]

3|P a g e University of Lusaka

Upon completing this study module student should be able to:

1) Understanding the importance of corporate finance and its relevance in

5) Understand the relationship between risk and return.

6) Appraise investments using capital budgeting methods learnt.

8) Understand how to manage working capital components and able to

9) Understand how pricing of share works through market information