CORPORATE FINANCE

1. OVERVIEW OF FINANCIAL MANAGEMENT

 Financial Management is an essential part of the economic and non economic activities
which leads to decide the efficient procurement and utilization of finance with profitable
manner. In the olden days the subject Financial Management was a part of accountancy
with the traditional approaches. Now a days it has been enlarged with innovative and multi
dimensional a function in the field of business and it has developed as corporate finance,
business finance, financial economics, financial mathematics and financial engineering.

 it is an integral part of overall management and understanding the basic concept about the
financial management becomes an essential part for the students of economics, commerce
and management .Hence in this course we look closer the role of financial management in
business world and its scopes of applications.

Nature and Scope of Financial Management

To have a good understanding of the nature and area applications of financial

management, you need to understand first what finance is. Literally, finance means
the money used in day-to-day activities of an individual or a business for exchange of
goods and services. But here our focus rather should be to consider finance as a
separate and distinct field of study comprises facts, theories, concepts, principles,
techniques and practices related with raising and utilizing of funds (money) by
individuals, businesses, and governments.

Finance is a dynamic field of study affects the decisions of all individuals and
organizations that earn or raise money and spend or invest it. Its area of applications
is to what extent concerned with the processes, institutions, markets, and instruments
involved in the transfer of funds of how, where, by whom, why, and through what
money is transferred among and between individuals, businesses, and governments. It
also comprises principles and techniques, used to manage money. Hence, finance is
both an art and science of managing money.

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 Though finance had ceded itself as distinct field of study, it is an integral part of the
firm’s overall management and its theories, concepts, and techniques are drawn from
related disciplines such as; Economics , Accounting , Marketing , Production
management, Mathematics, and Human resource management. Thus scope of
financial management ranges or extent of matters being dealt with the above fields
studies providing financial decision making.

Definition and Functions of Financial Management

 Financial management is an area of financial decision-making, harmonizing

individual motives and enterprise goals that is responsible for obtaining and
effectively utilizing the funds necessary for efficient operations. Traditionally,
financial management was viewed as a field of study limited to only raising of
money in which, the scope and role of financial management was considered in a
very narrow sense of procurement of funds from external sources. Internal financial
decision makings as cash and credit management, inventory control, capital
budgeting were ignored.

 However, in contemporary approach financial management viewed in a broad sense

at corporate finance level. Corporate finance is defined much more broadly to
include any business decisions made by a firm that affect its overall financial
management decisions. Accordingly in modern approach, financial management
provides a conceptual and analytical framework for the three major financial
decision making functions of a firm;

 Investment Decisions/Capital Budgeting/

 Financing Decisions/Capital Structure/
 Dividend Decisions/Profit Allocation Decisions/

1. Investment decisions also called capital budgeting or Asset-Mix decision is the

process of planning and managing a firm’s long-term investments. Capital budgeting
decision is concerned with long-term assets and their compositions. Measurement of
investment proposals is the major exercise of capital budgeting decision. It evaluates

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 the business risk composition of the firm where risk and uncertainty of a certain
project proposal is evaluated against a certain established standards. In capital
budgeting, the financial manager tries to identify investment opportunities that are
worth more to the firm than they cost to acquire; Means that the value of the cash
flow generated by an asset exceeds the cost of that asset.

When the investment is made on long-term assets it is considered as capital

budgeting while the other is working capital. Example capital budgeting is deciding
whether or not to purchase a new machine for the production line. Whereas Example
of working capital management is determining whether to pay cash for a purchase or
use the credit offered by the supplier.

2. Financing decisions is known as firm’s capital structure or Capital-Mix is concern of

financial manager obtains and manages the long-term financing sources to its long-
term investments. A financial structure is the mixture of long-term debt and equity the
firm uses to finance its operations. The financial manager has two concerns in this
area; First, how much should the firm borrow? Second, what are the least expensive
sources of funds for the firm? i.e. The decision to issue additional shares of stock or
determining how much debt should be assumed to fund a project.

3. Dividend decisions also known as profit allocation decisions or working capital

management an emphasis managing the firm’s a day-to-day activity that ensures the
firm has sufficient resources to continue its operations and avoid costly interruptions
and whether the firm should distribute all profits, or retain them, or distribute a
portion and retain the balance. Like the debt-equity policy, the dividend policy should
be optimum one that maximized the market value of firm’s shares.

There are tradeoffs on the dividend decisions and financing decisions of a firm. On
the one hand, paying out more dividends will make the firm to be perceived strong
and healthy by investors; on the other hand, it will affect the future growth of the
firm. So the dividend decision of a firm should be analyzed in relation to its financing
decisions and In summary, the scope of financial management confined with
investing, financing, and dividend policy designing decisions and the financial

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 manager’s role includes both acquiring of funds from external sources and allocating
of the funds efficiently within the firm thereby making internal decisions.

The Goal of Financial Management

 Assuming that we restrict ourselves to for-profit businesses, the goal of financial

management is;

1. To make money(profit Maximization) or

2. Add value for the owners (wealth maximization).

 This goal is a little vague, of course, so we examine some different ways of

formulating it in order to come up with a more precise definition. Such a definition is
important because it leads to an objective basis for making and evaluating financial
decisions.
 If we were to consider possible financial goals, we might come up with some ideas
like: Survive, Avoid financial distress and bankruptcy, Beat the competition,
Maximize sales or market share, Minimize costs, Maximize profits Maintain steady
earnings growth and etc. These are only a few of the goals we could list and these
could be achieved both in short term and in the long-term objectives.
Thus objectives of financial management may be broadly divided into two parts
namely:

1. Profit maximization (Short-Term Objectives):-is firm’s short-term objective by

which a function of maximizing revenue and /or minimizing costs.

If a firm is able to maximize its revenues for a given level of costs or minimizing costs
for a given level of revenues, it is considered to be efficient. In the economic theory, the
behavior of firm is analyzed in terms of profit maximization.

While maximizing profit, a firm either produces maximum output for a given amount
of output, or uses minimum input for producing a given output. Profit maximization
would probably be the most commonly cited goal, but even this is not a very precise
objective. First, do we mean something like accounting net income or earnings per
share? These accounting numbers may have little to do with what is good or bad for
the firm.

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 Second As a famous economist once remarked, in the long run, we’re all dead! More
to the point, this goal doesn’t tell us what the appropriate trade-off is between current
and future profits

2. Wealth maximization: also known as value maximization or net present

worth maximization is almost universally accepted as an appropriate operational
decision criterion for financial management decisions. It is the primary goal of
financial management maximizes the current value per share of the existing stock this
is because they have been hired to represent the interests of the current shareholders.
It removes the technical limitations of profit maximization criterion. Its operational
features satisfy all the three requirements of a suitable operational objective of
financial courses of action; exactness, quality of benefits and the time value of
money.

Given the goal financial management maximizes the value of the stock, an obvious
question comes up is what the appropriate goal is when the firm has no traded stock?
Corporations are certainly not the only type of business; and the stock in many
corporations rarely changes hands, so it’s difficult to say what the value per share is at
any given time. As long as we are dealing with for-profit businesses, only a slight
modification is needed. The total value of the stock in a corporation is simply equal to
the value of the owners’ equity.

Finally, the goal o financial management does not imply that the financial manager
should take illegal or unethical actions in the hope of increasing the value of the equity in
the firm. What we mean is that the financial manager best serves the owners of the
business by identifying goods and services that add value to the firm because they are
desired and valued in the free marketplace. Thus wealth maximization means
maximization of the value of a firm.

The Components of the Financial Environment

Financial managers must understand not only the internal environment, but also the
financial environment and markets within which the firm operates, where capital

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 required is raised, where the financial instruments are traded, and how stock prices
are determined.

Accordingly the financial environment consists the following components;

1. Financial Institutions 3. Financial Markets

2. Financial Instruments and

1. Financial Institutions:-are financial intermediaries, which are specialized financial

firms, which facilitate the transfer of funds from savers to demanders who have
productive investment opportunities.

• They accept savings from customers and lend this money to other customers or
they invest it.

• The key participants in financial transactions of financial institutions are

individuals, businesses, and government and foreigners.

2. Financial Instruments:-are ownership interests, or a contractual right to receive or

obligation to deliver cash or other financial asses.

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 • They are claims by lenders against income or wealth of borrowers, represented
usually by a certificate, created in the lending of money, and eventually
devastated upon returning of money.

• i.e. loans and borrowing contracts, promissory notes, commercial papers, treasury
bills, bonds, and stocks.

• Under normal circumstances, two parties are involved in any financial instrument
the buyers (holders) and sellers (issuers).

3. Financial Markets - are the place where financial securities are traded.

• Unlike financial institutions, are places in which suppliers and demanders of

funds meet directly to exchange financial securities and valuable commodities
like gold, diamond, silver are exchanged at efficient market prices?

• In economics, financial markets are a mechanism that allows people to easily buy
and sell financial securities, valuable commodities, and other fungible items.

• They may or may not have a particular physical existence.

2. IFRS BASED FINANCIAL STATEMENT ANALYSIS

FINANCIAL ANALYSIS

1. SOURCES OF FINANCIAL INFORMATION

A firm has to accumulate financial data for management decision making. Accounting system is
the source of this financial data. In providing information to the user, the accounting system has
to perform accumulation, measurement, and communication of information.
A firm communicates financial information to the users through financial statements and reports.
In this regard three major final statements are prepared for the purpose of external reporting.
These are: the Balance Sheet, the Income Statement and the Statement of Changes in Financial
position. The Income Statement provides detailed view of the flow of revenue and expenses over
the most recent period. The focus of this financial statement is the residual earnings available to
owners after all financing and operating costs are deducted and the claims of government have
been satisfied. This statement also shows the amount of dividends or reinvested to finance future
operations.

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The balance sheet shows the status of the firm at a point of time. It shows the total asset of the
firm and how these assets are financed. The financing portion of the balance sheet, usually, is
funded between contribution by owners and firm's creditors.

Finally, the statement of changes in financial position restates the information presented in the
income statement and balance sheet. The statement responds to the question of sources and
application (uses) of funds over the reporting period.

2. Users of Financial Analysis

Financial analysis is the process of identifying the financial strength and weakness of the firm by
properly establishing relationships among or between the items of the balance sheet and the
income statement. Financial analysis can be used by the management of the firm or by external
parties, such as, shareholders, (owners), creditors, lenders, investors, etc. The nature of this
analysis (the method and the extent of coverage) will differ depending on the purpose. Hence, the
users of the final analysis are those who are the users of the accounting information presented in
the financial statement.

3. Methods of Financial Analysis

Analysis of accounting data involves comparisons. An absolute statement of reporting net
income or net loss, (for example; a report saying that 'company y is earning 2 million
birr'), is by itself not sufficient. It should be compared with items of balance sheet or
income statement. If the values of the measurement are compared with the values of other
time, we call it longitudinal or horizontal or trend analysis. This system compares
accounting data over a period of time and it must be distinguished from that of latitudinal
or vertical or static analysis, which refers to the review of financial information for only
one accounting period. We have a number of methods to analyze a given financial
statement over time or for a single accounting period. Some of these are:
I. Ratio Analysis III. Common Size Analysis
II. Index Analysis IV. Trend Analysis

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 Ratio Analysis
Ratio analysis is a power full tool of financial analysis. A ratio is defined as the indicated quotient
of two mathematical expressions and as the relationship between two or more items. In financial
analysis a ratio is used as yardstick to evaluate financial performances.
A ratio analysis involves comparison. A single ratio in itself does not indicate favorable or
unfavorable conditions performances of a firm. It should be compared with some standards.
Standards of comparison may be obtained from:
 Ratio calculated from the past financial statement of the firm,
 Ratio developed from the Performa financial statements,
 Ratio of the most successful and profitable firm in the industry,
 Ratio of the industry to which the firm belongs.
Dozens of ratios can be computed from a single set of financial statement. Each analysis tends to
have a set of favorable ratios which might be relevant to the particular type of investigation. For
our discussion, the following different and commonly used ratios will be considered under four
major categories. These categories are:

Liquidity Ratios:
This ratio includes:
 Current ratio  Quick or Acid test ratio

Asset Management ratios:

This ratio includes:
 Receivable turn over  Inventory turn over
 Daily sales Outstanding  Fixed Asset turn over
(DSO)/Average collection  Total Asset turn over
period

Debt Management Ratios:

It includes:
 Ratio of debt to total equity  Fixed charge coverage ratio
 Ratio of times interest earned

Profitability ratios:
Ratios in this group are:
 Profit margin ratio  Return on investment (Assets)

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  Return on Equity

I. LIQUIDITY RATIOS
Liquidity is extremely essential for a firm to be able to meet its obligation as they become due.
Liquidity ratio, therefore, measures the ability of a firm to meet is current obligation. Analysis of
liquidity demands preparation of cash budget and cash flow statements; but liquidity ratios can be
calculated, by establishing relationship between current liabilities and current assets.

A firm should not suffer from lack of liquidity or should not be too liquid. Lack of liquidity
produces loss of confidence in face of creditors, greater court law suits, bad credit rating, etc. and
very high degree liquidity is also bad, as idle asset earn nothing, which means, the firms, current
fund is tied unnecessarily by current assets.

Current Ratio
It is the most important ratio among liquidity ratios. It is essentially an attempt to measure and
compare the current assets with current liabilities. This ratio is extensively used by financial
analysts, bankers, credit institution with the view to find out whether the current liabilities, which
are required to be met in the short run, are adequately covered by current assets which may be
expected to be realized over a similar period of time.

THE BALANCE SHEET

The left-hand side of Allied’s year-end 2001 and 2000 balance sheets, which are given
in Table 2-1, shows the firm’s assets, while the right-hand side shows the liabilities and
equity, or the claims against these assets. The assets are listed in order of their “liquidity,”
or the length of time it typically takes to convert them to cash. The claims are listed in the
order in which they must be paid: Accounts payable must generally be paid within 30
days, notes payable within 90days, and so on, down to the stockholders’ equity accounts,
which represent ownership and need never be “paid off.”
Table 1 Allied Food Products: December 31 Balance Sheets (Millions of Dollars)

ASSETS 2000 2001 LIABILITIES AND EQUITY 2000 2001

Cash and marketable $80 $10 Accounts payable $30 $60
securities
Accounts receivable 315 375 Notes payable 60 110
Inventories 415 615 Accruals 130 140
Total current assets $810 $1,000 Total current liabilities 220 310

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Net plant and equipment 870 1,000 Long-term bonds1 580 754
Total debt $800 $1,064
Preferred stock (400,000 shares) 40 40
Common stock (50,000,000 shares) 130 130
Retained earnings 710 766
Total common equity $840 $896
Total assets $1,680 $2,000 Total liabilities and equity $1,680 $2,000

Table 2 Allied Food Products: Income Statements for Years Ending December 31
(Millions of Dollars, Except for Per-Share Data)

2000 2001
Net sales $2850.0 $3,000
Operating costs excluding depreciation and amortization 2497.0 2,616.2
Earnings before interest, taxes, depreciation, and amortization (EBITDA) $353.0 $383.8
Depreciation 90.0 100
Amortization 0.0 0.0
Depreciation and amortization 90.0 $100
Earnings before interest and taxes (EBIT, or operating income) 263.0 283.8
Less interest 60 88.0
Earnings before taxes (EBT) 203.0 195.8
Taxes (40%) 81.2 78.3
Net income before preferred dividends b 121.80 117.5
Preferred dividends 4.0 4.0
Net income 117.80 $113.5
Common dividends 53.0 $57.5
Addition to retained earnings 64.80 $56.0
Per-share data:
Common stock price 26.00 23.00
Earnings per share (EPS) a 2.36 2.27
Dividends per share (DPS) a 1.06 1.15
Book value per share (BVPS) a 16.80 17.92
Cash flow per share (CFPS) a 4.16 4.27

a
There are 50,000,000 shares of common stock outstanding. Note that EPS is based on earnings
after preferred dividends — that is, on net income available to common stockholders.
Calculations of EPS, DPS, BVPS, and CFPS for 2001 are as follows:

The bonds have a sinking fund requirement of $20 million a year. Sinking funds will be discussed
later, but in brief, a sinking fund simply involves the repayment of long-term debt. Thus, Allied
was required to pay off $20 million of its mortgage bonds during 2001. The current portion of the
long-term debt is included in notes payable here, although in a more detailed balance sheet it
would be shown as a separate item under current liabilities.

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The current ratio for Allied would be:

Industry average: 4.2 times

Allied’s current ratio is well below the average for its industry, 4.2, so its liquidity position is
relatively weak. Still, since current assets are scheduled to be converted to cash in the near future,
it is highly probable that they could be liquidated at close to their stated value. With a current
ratio of 3.2, Allied could liquidate current assets at only 31 percent of book value and still pay off
current creditors in full.
Note:
1. A relatively higher degree of current ratio is considered as an indicator that the firm is
liquid and has the ability to pay its current obligations when they due. Usually, 2:1 or
more is found to be satisfactory. This is an arbitrary figure, those having more than 2:1
may suffer from lack of liquidity than less than 2:1, because liquidity ratio is a quality
ratio, not of quantity of assets or liabilities.
2. Generally a quick ratio of 1:1 is considered to be sound. This ratio should be treated
carefully as inventors and others are not totally non-liquid. Generally; - Liquidity ratio
should be subject to qualitative tests. The major elements of current assets; such as
inventories, receivables, prepayments, etc., should be assessed carefully.
- Liquidity ratios are also subject to other influences of financial forces which can improve or
deteriorate the ratio. It may also be affected by movement of receivables, inventories, investment
on fixed asset, etc.

Quick or Acid test Ratio

Since current ratio includes inventories which might not be easily realizable, financial analysts
have developed another indicator for liquidity. This is a more refined measure of liquidity; it

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establishes a relationship between quick or liquid assets and current liabilities. An asset is liquid
if it can be converted into cash immediately or reasonably soon without a loss of value.

Cash is the most liquid asset. Receivables and securities are relatively liquid. Inventories and
prepaid expenses considered to be less liquid. They need some more time to be converted into
cash and have a tendency to fluctuate in value.

Industry average =2.1 times

Inventories are typically the least liquid of a firm’s current assets; hence they are the assets on
which losses are most likely to occur in the event of liquidation. Therefore, a measure of the
firm’s ability to pay off short-term obligations without relying on the sale of inventories is
important.
The industry average quick ratio is 2.1, so Allied’s 1.2 ratio is low in comparison with other firms
in its industry. Still, if the accounts receivable can be collected, the company can pay off its
current liabilities without having to liquidate its inventory.

II. ASSET MANAGEMENT RATIO

The second group of ratios, the asset management ratios, measures how effectively the firm
is managing its assets. These ratios are designed to answer this question: Does the total
amount of each type of asset as reported on the balance sheet seem reasonable, too high, or
too low in view of current and projected sales levels? When they acquire assets, Allied and
other companies must borrow or obtain capital from other sources. If a firm has too many
assets, its cost of capital will be too high; hence its profits will be depressed. On the other
hand, if assets are too low, profitable sales will be lost. Ratios that analyze the different types
of assets are described in this section.

1. Inventory Turnover Ratio

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Industry average = 9.0 times

As a rough approximation, each item of Allied’s inventory is sold out and restocked, or “turned
over,” 4.9 times per year. “Turnover” is a term that originated many years ago with the old
Yankee peddler, who would load up his wagon with goods, then go off on his route to peddle his
wares. The merchandise was called “working capital” because it was what he actually sold, or
“turned over,” to produce his profits, whereas his “turnover” was the number of trips he took each
year. Annual sales divided by inventory equaled turnover, or trips per year. If he made 10 trips
per year, stocked 100 pans, and made a gross profit of $5 per pan, his annual gross profit would
be (100)($5)(10) =$5,000. If he went faster and made 20 trips per year, his gross profit would
double, other things held constant. So, his turnover directly affected his profits.

2. Days Sales Outstanding (DSO)

Days sales outstanding (DSO), also called the “average collection period” (ACP), is used to
appraise accounts receivable, and it is calculated by dividing accounts receivable by average daily
sales to find the number of days’ sales that are tied up in receivables. Thus, the DSO represents
the average length of time that the firm must wait after making a sale before receiving cash,
which is the average collection period. Allied has 46 days sales outstanding, well above the
36-day industry average:

Note that in this calculation we used a 365-day year. Other analysts use a 360-day year for this
calculation. If Allied had calculated its DSO using a 360- day year, its DSO would have been
reduced slightly to 45 days.

3. Fixed Assets Turnover Ratio

The fixed assets turnover ratio measures how effectively the firm uses its plant and equipment.
It is the ratio of sales to net fixed assets:

Industry average =3.0 times

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Allied’s ratio of 3.0 times is equal to the industry average, indicating that the firm is using its
fixed assets about as intensively as are other firms in its industry. Therefore, allied seems to have
about the right amount of fixed assets in relation to other firms.

4. Total Assets Turnover Ratio

The final asset management ratio, the total assets turnover ratio, measures the turnover of the
entire firm’s assets; it is calculated by dividing sales by total assets:

Industry average =1.8 times.

Allied’s ratio is somewhat below the industry average, indicating that the company is not
generating a sufficient volume of business given its total assets investment. Sales should be
increased, some assets should be disposed of, or a combination of these steps should be taken.

III. DEBT MANAGEMENT RATIO

Short term creditors, such as, bankers, suppliers of raw materials, etc., are interested with the
firm's current debt paying ability. This will be known by liquidity ratios. On the other hand, long
term creditors, like bond holders, financial institutions, etc., are more concerned with firm's long
term financial strength. In fact, a firm should be strong both in the short run and in the long run.

To judge the long run financial position of the firm, leverage, or capital structure ratios are
calculated. These ratios show the mix of funds provided by owners and creditors. As a general
rule, there should be an appropriate mix of funds in the capital structure of a firm. The manner in
which assets have been financed has a number of implications:
(i) Debt is more risky from the firm’s point of view. The firm has legal obligation to pay to its
bond holders at stipulated time interest and principal, irrespective of the year's performance.
If it fails, an action may be taken on firm's assets.
(ii) Highly burdened or highly geared firms will find difficulty in raising additional funds from
creditors and owners in the future. Always the owners' equity is assumed as margin of safety
for the investment by creditors. If the base is thin, the creditor's risk will be high.
Leverage ratios are many, but all these ratios indicate more or less the same thing: the extent of
which the firm has relied on debt in financing its assets. It may be calculated from balance sheet
items to determine the proportion of debt in total financing or from income statement items to

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know the extent to which operating profits are sufficient to cover fixed charges. Some of these
ratios are:

1. Financial Leverage
The extent to which a firm uses debt financing, or financial leverage, has three important
implications:
1. By raising funds through debt, stockholders can maintain control of a firm while limiting
their investment.
2. Creditors look to the equity, or owner-supplied funds, to provide a margin of safety, so
the higher the proportion of the total capital that was provided by stockholders, the less
the risk faced by creditors.
3. If the firm earns more on investments financed with borrowed funds than it pays in
interest, the return on the owners’ capital is magnified, or “leveraged.”
To understand better how financial leverage affects risk and return, consider Table 3-1. Here we
analyze two companies that are identical except for the way they are financed. Firm U (for
“unleveraged”) has no debt, whereas Firm L (for “leveraged”) is financed with half equity and
half debt that costs 15 percent. Both companies have $100 of assets and $100 of sales, and their
expected operating income (also called earnings before interest and taxes, or EBIT) is $30. Thus,
both firms expect to earn $30, before taxes, on their assets. Of course, things could turn out badly,
in which case EBIT would be lower.
Table 3 Effects of Financial Leverage on Stockholders’ Returns
Firm U (Unleveraged)

Current Assets $50 Debt $0

Fixed Assets 50 Common Equity $100
Total Assets $100 Total liabilities and $100
equity

Expected conditions Bad conditions

Sales $100.00 $82.50
Operating costs 70.00 80.00
Operating income (EBIT) $30.00 2.50
Interest 0.00 0.00
Earnings before taxes (EBT) $30.00 2.50

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 Taxes (40%) 12.00 1.00
Net income (NI) 18.00 1.50
18% 1.5%

Firm L (Leveraged)

Current Assets $50 Debt $50

Fixed Assets 50 Common Equity $50
Total Assets $100 Total liabilities and $100
equity

Expected conditions Bad conditions

Sales $100.00 $82.50
Operating costs 70.00 80.00
Operating income (EBIT) $30.00 2.50
Interest (15%) 7.50 7.5
Earnings before taxes (EBT) $22.5 ($5.00)
Taxes (40%) 9.00 (2.00)
Net income (NI) 13.50 (3.00)
27.00% (6.00%)

2. Debt Ratio
The ratio of total debt to total assets, generally called the debt ratio, measures the percentage of
funds provided by creditors:

Industry average = 40.0%.

Total debt includes both current liabilities and long-term debt. Creditors prefer low debt ratios
because the lower the ratio, the greater the cushion against creditors’ losses in the event of

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liquidation. Stockholders, on the other hand, may want more leverage because it magnifies
expected earnings.
Allied’s debt ratio is 53.2 percent, which means that its creditors have supplied more than half the
total financing. Nevertheless, the fact that Allied’s debt ratio exceeds the industry average raises a
red flag and may make it costly for Allied to borrow additional funds without first raising more
equity capital. Creditors may be reluctant to lend the firm more money, and management would
probably be subjecting the firm to the risk of bankruptcy if it sought to increase the debt ratio any
further by borrowing additional funds.

3. Times-Interest-Earned (TIE) Ratio

The times-interest-earned (TIE) ratio is determined by dividing earnings before interest and
taxes (EBIT in Table 2-2) by the interest charges:

Times
Industry average = 6.0 times.
The TIE ratio measures the extent to which operating income can decline before the firm is
unable to meet its annual interest costs. Failure to meet this obligation can bring legal action by
the firm’s creditors, possibly resulting in bankruptcy. Note that earnings before interest and taxes,
rather than net income, are used in the numerator. Because interest is paid with pre-tax dollars,
the firm’s ability to pay current interest is not affected by taxes.
Allied’s interest is covered 3.2 times. Since the industry average is 6 times, Allied is covering its
interest charges by a relatively low margin of safety. Thus, the TIE ratio reinforces the conclusion
from our analysis of the debt ratio that Allied would face difficulties if it attempted to borrow
additional funds.

4. EBITDA COVERAGE RATIO

The TIE ratio is useful for assessing a company’s ability to meet interest charges on its debt, but
this ratio has two shortcomings:
1) Interest is not the only fixed financial charge — companies must also reduce debt on
schedule, and many firms lease assets and thus must make lease payments. If they fail to
repay debt or meet lease payments, they can be forced into bankruptcy.

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 2) EBIT does not represent all the cash flow available to service debt, especially if a firm
has high depreciation and/or amortization charges. To account for these deficiencies,
bankers and others have developed the EBITDA coverage ratio, expressed as follows:

Industry average = 4.3 times.

Allied had $283.8 million of operating income (EBIT), presumably all cash. Noncash charges of
$100 million for depreciation and amortization (the DA part of EBITDA) were deducted in the
calculation of EBIT, so they must be added back to find the cash flow available to service debt.
Also, lease payments of $28 million were deducted before getting the $283.8 million of EBIT.9
that $28 million was available to meet financial charges, hence it must be added back, bringing
the total available to cover fixed financial charges to $411.8 million. Fixed financial charges
consisted of $88 million of interest, $20 million of sinking fund payments, and $28 million for
lease payments, for a total of $136 million.10 Therefore, Allied covered its fixed financial
charges by 3.0 times. However, if operating income declines, the coverage will fall, and operating
income certainly can decline. Moreover, Allied’s ratio is well below the industry average, so
again, the company seems to have a relatively high level of debt.

IV. PROFITABILITY RATIOS

Profitability is the net result of a number of policies and decisions. The ratios examined thus
far provide useful clues as to the effectiveness of a firm’s operations, but the profitability
ratios show the combined effects of liquidity, asset management, and debt on operating
results.

1. PROFIT MARGIN ON SALES

The profit margin on sales, calculated by dividing net income by sales, gives the profit per
dollar of sales:

19
Industry average= 5.0%.

Allied’s profit margin is below the industry average of 5 percent. This sub-par result occurs
because costs are too high. High costs, in turn, generally occur because of inefficient operations.
However, Allied’s low profit margin is also a result of its heavy use of debt. Recall that net
income is income after interest. Therefore, if two firms have identical operations in the sense that
their sales, operating costs, and EBIT are the same, but if one firm uses more debt than the other,
it will have higher interest charges. Those interest charges will pull net income down, and since
sales are constant, the result will be a relatively low profit margin. In such a case, the low profit
margin would not indicate an operating problem, just a difference in financing strategies. Thus,
the firm with the low profit margin might end up with a higher rate of return on its stockholders’
investment due to its use of financial leverage. We will see exactly how profit margins and the
use of debt interact to affect stockholder returns shortly, when we examine the Du Pont model.

2. BASIC EARNING POWER (BEP)

The basic earning power (BEP) ratio is calculated by dividing earnings before interest and taxes
(EBIT) by total assets:

Industry average =17.2%.

This ratio shows the raw earning power of the firm’s assets, before the influence of taxes and
leverage, and it is useful for comparing firms with different tax situations and different degrees of
financial leverage. Because of its low turnover ratios and low profit margin on sales, Allied is not
earning as high a return on its assets as is the average food-processing company.

3. RETURN ON TOTAL ASSETS

The ratio of net income to total assets measures the return on total assets (ROA) after interest and
taxes:

20
Industry average = 9.0%.

Allied’s 5.7 percent return is well below the 9 percent average for the industry. This low return
results from
1) The company’s low basic earning power plus
2) High interest costs resulting from its above-average use of debt, both of which cause its
net income to be relatively low.

4. RETURN ON COMMON EQUITY

Ultimately, the most important, or “bottom line,” accounting ratio is the ratio of net income to
common equity, which measures the return on common equity (ROE):

Industry average= 15.0%.

Stockholders invest to get a return on their money, and this ratio tells how well they are doing in
an accounting sense. Allied’s 12.7 percent return is below the 15 percent industry average, but not
as far below as the return on total assets. This somewhat better result is due to the company’s
greater use of debt, a point that is analyzed in detail later in the chapter.

V. MARKET VALUE RATIOS

A final group of ratios, the market value ratios, relates the firm’s stock price to its earnings, cash
flow, and book value per share. These ratios give management an indication of what investors
think of the company’s past performance and future prospects. If the liquidity, asset management,
debt management, and profitability ratios all look good, then the market value ratios will be high,
and the stock price will probably be as high as can be expected.

1. PRICE/EARNINGS RATIO

21
The price/earnings (P/E) ratio shows how much investor is willing to pay per dollar of reported
profits. Allied’s stock sells for $23, so with an EPS of $2.27 its P/E ratio is 10.1:

=10.1 times

Industry average=12.5 times.

As we will see later, P/E ratios are higher for firms with strong growth prospects, other things
held constant, but they are lower for riskier firms. Since Allied’s P/E ratio is below the average
for other food processors, this suggests that the company is regarded as being somewhat riskier
than most, as having poorer growth prospects, or both.

2. PRICE/CASH FLOW RATIO

In some industries, stock price is tied more closely to cash flow rather than net income.
Consequently, investors often look at the price/cash flow ratio:

Industry average =6.8 times

The calculation for cash flow per share was shown in earlier, but just to refresh your memory,
cash flow per share is calculated as net income plus depreciation and amortization divided by
common shares outstanding.
Allied’s price/cash flow ratio is also below the industry average, once again suggesting that its
growth prospects are below average, its risk is above average, or both.

3. MARKET/BOOK RATIO

The ratio of a stock’s market price to its book value gives another indication of how investors
regard the company. Companies with relatively high rates of return on equity generally sell at
higher multiples of book value than those with low returns. First, we find Allied’s book value per
share:

22
Now we divide the market price per share by the book value to get a market/book (M/B) ratio of
1.3 times:

Industry average =1.7 times

Investors are willing to pay less for a dollar of Allied’s book value than for one of an average
food-processing company.
Since M/B ratios typically exceed 1.0, this means that investors are willing to pay more for stocks
than their accounting book values. This situation occurs primarily because asset values, as
reported by accountants on corporate balance sheets, do not reflect either inflation or “goodwill.”
Thus, assets purchased years ago at preinflation prices are carried at their original costs, even
though inflation might have caused their actual values to rise substantially, and successful going
concerns have a value greater than their historical costs. If a company earns a low rate of return
on its assets, then its M/B ratio will be relatively low versus an average company.

TYING THE RAT I O S TOGETHER: THE DU PONT CHART AND

EQUATION
The chart depicted in Figure 1 is called a modified Du Pont chart because that company’s
managers developed this approach for evaluating performance. Working from the bottom up, the
left-hand side of the chart develops the profit margin on sales. The various expense items are
listed and then summed to obtain Allied’s total cost, which is subtracted from sales to obtain the
company’s net income. When we divide net income by sales, we find that 3.8 percent of each
sales dollar is left over for stockholders. If the profit margin is low or trending down, one can
examine the individual expense items to identify and then correct problems.
The right-hand side of Figure 3-2 lists the various categories of assets, totals them, and then
divides sales by total assets to find the number of times Allied “turns its assets over” each year.
The company’s total assets turnover ratio is 1.5 times.

23
The profit margin times the total assets turnover is called the Du Pont equation, and it gives the
rate of return on assets (ROA):
……Equation 1

Figure 1 Modified Du Pont Chart for Allied Food Products (Millions of Dollars)

Allied made 3.8 percent, or 3.8 cents, on each dollar of sales, and assets were “turned over” 1.5
times during the year. Therefore, the company earned a return of 5.7 percent on its assets.
If the company were financed only with common equity, the rate of return on assets (ROA) and
the return on equity (ROE) would be the same because total assets would equal common equity:

This equality holds if and only if Total assets =Common equity, that is, if the company uses no
debt. Allied does use debt, so its common equity is less than total assets. Therefore, the return to
the common stockholders (ROE) must be greater than the ROA of 5.7 percent. Specifically, the

24
rate of return on asset (ROA) can be multiplied by the equity multiplier, which is the ratio of
assets to common equity:

Firms that use a large amount of debt financing (more leverage) will necessarily have a high
equity multiplier—the more the debt, the less the equity, hence the higher the equity multiplier.
For example, if a firm has $1,000 of assets and is financed with $800, or 80 percent debt, then its
equity will be $200, and its equity multiplier will be $1,000/$200=5. Had it used only $200 of
debt, then its equity would have been $800, and its equity multiplier would have been only
$1,000/$800=1.25.2
Allied’s return on equity (ROE) depends on its ROA and its use of leverage: 3

……………… Equation 2

Now we can combine Equations 1 and 2 to form the Extended Du Pont Equation, which shows
how the profit margin, the assets turnover ratio, and the equity multiplier combine to determine
the ROE:

For Allied, we have

ROE = (3.8%) (1.5) (2.23)
=12.7%.
The 12.7 percent rate of return could, of course, be calculated directly: both Sales and Total assets
cancel, leaving Net income/Common equity=$113.5/ $896 = 12.7%. However, the Du Pont
2
Expressed algebraically,

Here D is debt, E is equity, A is total assets, and A/E is the equity multiplier. This equation ignores
preferred stock.
3
Note that we could also find the ROE by “grossing up” the ROA, that is, by dividing the ROA by the
common equity fraction: ROE =ROA/Equity fraction =5.7%/0.448 =12.7%. The two procedures are
algebraically equivalent.

25
equation shows how the profit margin, the total assets turnover, and the use of debt interact to
determine the return on equity.4
Allied’s management can use the Du Pont system to analyze ways of improving performance.
Focusing on the left, or “profit margin,” side of its modified Du Pont chart, Allied’s marketing
people can study the effects of raising sales prices (or lowering them to increase volume), of
moving into new products or markets with higher margins, and so on. The company’s cost
accountants can study various expense items and, working with engineers, purchasing agents, and
other operating personnel, seek ways to hold down costs. On the “turnover” side, Allied’s
financial analysts, working with both production and marketing people, can investigate ways to
reduce the investment in various types of assets. At the same time, the treasury staff can analyze
the effects of alternative financing strategies, seeking to hold down interest expense and the risk
of debt while still using leverage to increase the rate of return on equity.

As a result of such an analysis, Ellen Jackson, Allied’s president, recently announced a series of
moves designed to cut operating costs by more than 20 percent per year. Jackson and Allied’s
other executives have a strong incentive for improving the company’s financial performance,
because their compensation is based to a large extent on how well the company does. Allied’s
executives receive a salary that is sufficient to cover their living costs, but their compensation
package also includes “performance shares” that will be awarded if and only if the company
meets or exceeds target levels for earnings and the stock price. These target levels are based on
Allied’s performance relative to other food companies. So, if Allied does well, then Jackson and
the other executives —and the stockholders—will also do well. But if things deteriorate, Jackson
could be looking for a new job.

INDEX ANALYSIS
Index analysis supports the traditional ratio analysis. In index analysis, the items in the financial
statements are expressed as an index relative to the base year. All items in the base year are
assumed to be 100%. Usually, this analysis is most appropriate for Income Statement items.

COMMON SIZE ANALYSIS

Another method of financial analysis is a common size statement analysis. A common size
statement expresses each item in the balance sheet as percentage of total asset (net) and each item

26
in income statement as percentage of total sales (net). When statements are expressed in terms of
percentages of total assets and total sales, these statements are called common size statements. In
recent times, attention is given to common size statements analysis.

TREND ANALYSIS
In financial analysis, the direction of change over a period of years is given importance. Trend
analysis indicates the direction of changes and usually, the use of index number is advocated.
Hence, to produce an index analysis, select the base year and calculate the change percentage in
each item of the year in relation to the base year. The method is usually called trend percentage
method. Trend analysis, sometimes called time series analysis, it is used to evaluate performances
over a period of years. This type of analysis looks for three points:
A. Important trends in the firm's data
B. Shifts in trends over years
C. Data outlier (i.e., values that debates from the visual fit line).

SIGNIFICANCE AND LIMITATION OF RATIO ANALYSIS

A. Significance
Financial ratio analysis is essentially an attempt the develop meaning full relationship between
individual items or group of items in the balance sheet or income statement. In some situations,
this analysis may be in terms of one group of items vis-a-vis another group; or, alternatively, and
combinations of groups of items to an individual item or vice-versa.
A purpose full financial ratio analysis could lead to highlight management issues and problems,
and this will aid the management in identifying alternative courses of action to respond to such
issues and problems. Such problems could possibility be:
 To compare different firms is the same  To compare performances is different
industry times
 To know whether the firm's financial  Whether the profitability of the firm is
position is basically sound. satisfactory?
 To compare different industries  Whether the firm's credit policy in
 Whether the capital structure (mix) of a relation to sales or purchase is sound?
firm is in proper proportion?  Whether the firm is credit worthy?
Some ratios are more important in one kind of analysis while others in other kind of analysis. For
example, the credit analyst usually selects few important ratios. He/she may use current or quick
ratios to judge the firm’s liquidity or debt-paying ability in the short run similarly, in security

27
analysis; the major emphasis is on long term profitability. Hence, besides analyzing profitability
ratio, a close look should be made on asset utilization and leverage ratios. The ratio of a firm in
itself does not reveal anything. The ratios should be compared with the ratio of similar firms
and/or industry.

B. Limitations
No financial ratio analysis, however sound, can be meaning full unless the questions sought to be
answered are clearly formulated. Besides, one must remember that financial statements prepared
for external reporting purpose and on which financial ratios are calculated, don't provide any
worthwhile answer in relation to several matters which are crucial in responding such questions.
Some of the problems in the application of ratio analysis are:
(i) Difficulty to decide the proper basis of comparison. The problem of standards of
comparison is usually an important case. And impossible to compile an industry wide
averages or ratios that serves as a useful standard to measure all firms.
(ii) The standard of comparison does not consider the different technological, social, market,
etc., conditions of firms.
(iii) The change in the general price level makes the analysis invalid (problem of inflation)
(iv) The greatest constraint to meaning full analysis comes from different accounting
treatments reflected in annual financial statements; such differences as in:
 depreciation methods  asset and liability classification
 methods of inventory valuation in to current and non current
 capitalization and amortization  treatment of intangible assets
of expenditures  Use of different accounting
 cost classification periods, etc.
(v) The ratios calculated at a point of time are less informative and are defective as they
suffer from short run changes.
(vi) The ratios are calculated from past data and are not representative of the current which
cannot be used as indicator of the future.
Hence, we can't totally relay on financial analysis as they are defective in various groups.
However, the limitations mentioned above are substantially reduced:
(i) If the analysis is related to an enterprise over a period of time. This avoids problems of
procedural differences and absorbed common problems like market, technology and
social differences.
(ii) If the analysis is limited to a few well chosen ratios designed to answer specific
questions.

28
 (iii) If the results are counter checked by way of comparison against similar norms in
business.
(iv) If the ratios are interrelated with each other with view to developing insights regarding
profitability, financial conditions, etc.
(v) If ratios are interpreted in the perspectives of social, economical, technological, etc.,
development of the society in which the firm operates.

3. TIME VALUE OF MONEY

BASIC TIME VALUE CONCEPTS:
In accounting and finance, the phrase time value of money indicates a relation-ship
between time and money—that a birr/ dollar received today is worth more than a birr/
dollar promised at some time in the future. Why? Because of the opportunity to invest
today’s birr/ dollar and receive interest on the investment. Yet, when deciding among
investment or borrowing alternatives, it is essential to be able to compare today’s birr/
dollar and tomorrow’s birr/ dollar. Investors do that by using the concept of present
value, which has many applications in accounting and finance.

As a simple example of this concept of present value, assume that you are trying to sell
your car and you receive offers from three prospective buyers.

Buyer A offers you $8,000 to be paid immediately now. Buyer B offers you $8,200 to be
paid one year from now. Buyer C offers the highest price, $9,200, but the offer provides
that payment will be made in five years. Assuming that the offers by B and C involve no
credit risk and that money may be invested at 5% interest compounded annually, which
offer would you accept? You should accept the offer of $8,000 to be received
immediately. If you were to invest $8,000 today, even at the modest rate of interest of
5%, your investment would be $8,400 in one year and $10,210.25 in five years.

This example suggests that the timing of cash receipts and payments has an important
effect on the economic worth and the accounting values of both assets and liabilities.
Consequently, investment and borrowing decisions should be made only after a careful
analysis of the relative present values of the prospective cash inflows and outflows.

4.1 Simple and Compound interest

29
Interest is the fee charged for the use of money for a specified time period. Because the
concept of economic earnings is periodic, we typically think of return on investment in
terms of a rate of return per year.

Simple interest is the return on a principal amount for one time period. Simple interest
is computed on the amount of the principal only i.e. the interest does not earn a
return/interest. The following equation expresses simple interest:

Where p = principal
i = rate of interest for a single period
n = number of periods
To illustrate, Barstow Electric Co. borrows $10,000 for 3 years with a simple interest rate
of 8% per year. It computes the total interest it will pay as follows:

Interest = p x i x n = $10,000 x .08 x 3 = $2,400

If Barstow borrows $10,000 for 3 months at 8%, the interest is computed as follows:

Interest = $10,000 x .08 x 3/12 = $200

Compound Interest is the return on a principal amount for two or more time periods,
assuming that the interest for each time period is added to the principal amount at the end
of each period and earns interest in all subsequent periods.

For example, assume that Vasquez Company deposits $10,000 in National Bank, where it
will earn compound interest of 9% per year compounded annually. The total compounded
interest after three years would be:

Compound interest calculation Compound interest Accumulated year-end balance

Year 1 $10,000 × .09 900 10,900
Year 2 $10,900.00 × .09 981 $11,881
Year 3 $11,881.00 × .09 1,069.29 $12,950.29
Total compound interest = 2,950.29

30
4.2 FUTURE AND PRESENT VALUES OF A SINGLE AMOUNT

Many business and investment decisions involve a single amount of money that either
exists now or will in the future. Single-sum problems are generally classified into one of
the following two categories.

i. Computing the unknown future value of a known single sum of money that is
invested now for a certain number of periods at a certain interest rate.
ii. Computing the unknown present value of a known single sum of money in the
future that is discounted for a certain number of periods at a certain interest rate.

Future Value of a Single Sum

The accumulated amount of a single amount invested at compound interest may be

computed period by period by a serious of multiplications.

Where FV = future value

PV = present value (principal or single sum)

i = the rate of interest for each period
n = the number of periods that interest is to be compounded
To illustrate, Bruegger Co. wants to determine the future value of $50,000 invested for 5
years compounded annually at an interest rate of 11%.

Using the future value formula, Bruegger solves this investment problem as follows.

= FV = $50,000 (1+.11)5 FV = $50,000 (1.68506)

FV = $84,253
Throughout the discussion of compound interest, note the intentional use of the term
periods instead of years. Interest is generally expressed in terms of an annual rate.
However, many business circumstances dictate a compounding period of less than one
year. In such circumstances, a company must convert the annual interest rate to
correspond to the length of the period.

31
To convert the “annual interest rate” into the “compounding period interest rate,” a
company divides the annual rate by the number of compounding periods per year.

In addition, companies determine the number of periods by multiplying the number of

years involved by the number of compounding periods per year.

To illustrate, assume that Commonwealth Edison Company deposited $250 million in an

account with Northern Trust Bank at the beginning of 2010 as a commitment towards a
power plant to be completed December 31, 2013. How much will the company have on
deposit at the end of 4 years if interest is 10%, compounded semiannually?

Given: PV = 250,000,000 i = 10/2 = 5% n=4*2=8

FV = $250,000,000 (1+.05)8

FV = $250,000,000 (1.47746 FV = $369,365,000

Note that how often interest is compounded can substantially affect the rate of return.
When the compounding frequency is greater than once a year, the effective interest rate
will always exceed the stated rate.

The formula for calculating the effective rate, in situations where the compounding
frequency (n) is greater than once a year, is as follows.

To illustrate, if the stated annual rate is 8% compounded quarterly, the effective annual
rate is:

= .0824 = 8.24 %

Present Value of a Single Sum

The present value is the amount needed to invest now, to produce a known future value.
The present value is always a smaller amount than the known future value, due to earned
and accumulated interest. In determining the future value, a company moves forward in
time using a process of accumulation. In determining present value, it moves backward in
time using a process of discounting.

32
The following formula is used to determine the present value of 1 (present value factor):

Where PVFn,i = present value factor for n periods at i interest rate

To illustrate, what is the present value of $84,253 to be received or paid in 5 years

discounted at 11% compounded annually?

= .59345 Hence, the PV of $84,253 is computed: 84,253 * .593 = $50,000

Illustration 2: For example, assume that your rich uncle decides to give you $2,000 for a
trip to Europe when you graduate from college 3 years from now. He proposes to finance
the trip by investing a sum of money now at 8% interest compound annually that will
provide you with $2,000 upon your graduation.

Required: Determine the sum of money that your uncle has to invest now.

Solution: Present value = $2,000 (PVF3, 8%)

= $1,587.66

Example—Computation of the Number of Periods:

The Village of Somonauk wants to accumulate $70,000 for the construction of a

veteran’s monument in the town square. At the beginning of the current year, the Village
deposited $47,811 in a memorial fund that earns 10% interest compounded annually.
How many years will it take to accumulate $70,000 in the memorial fund?

Given: Future value = 70,000 Present value = 47,811

i = 10% n =? FV = PV (1+i) n` 70,000 = 47,811 (1+.1) n

70,000 = 47,811(FVFn, 10%)

FVFn, 10% = FVFn, 10% = 1.46410

33
Using the future value factor of 1.46410, refer to table factor (future value factor of 1)
and read down the 10% column to find that factor in the period row. Thus, it will take 4
years for the $47,811 to accumulate to $70,000 if invested at 10% interest compounded
annually.

Example—Computation of the Interest Rate:

Advanced Design Co. needs $1,409,870 for basic research 5 years from now. The
company currently has $800,000 to invest for that purpose. At what rate of interest must
it invest the $800,000 to fund basic research projects of $1,409,870, 5 years from now?

Given: FV = 1,409,870 PV = 800,000

n=5 i =? FV = PV (1+i) n

1,409,870 = 800,000 (1+i) 5 1,409,870 = 800,000 (FVF5, i)

FVF5, i = FVF5, i = 1.76234

Using the future value factor of 1.76234, refer to table factor (future value factor of 1)and
read across the 5 period row to find that factor in the interest rate column. Thus, the
company must invest the $800,000 at 12% to accumulate $1,409,870 in 5 years.

ANNUITIES
Annuity is refers to the periodic deposits, receipts, withdrawals, or payments (called
rents); with interest at a stated rate compounded at the time that each rent is paid or
received.

Conditions of an annuity:

1. The periodic rents are equal in amount.

2. The time period between rents is constant.
3. The interest rate per time period remains constant.
4. The interest is compounded at the end of each time period.

34
Types of annuities:

 Ordinary annuity (annuity in  Annuity due (annuity in advance)

arrears)  Deferred annuity
 Ordinary annuity (annuity in arrears)

Ordinary annuity is an annuity in which rents are received or paid at the end of each
period.

Amount of ordinary annuity

The total amount of an ordinary annuity is determined at the time the final rent is made. It
consists of the sum of the equal periodic rents and compounded interest on the rents
immediately after the final rent. Because an ordinary annuity consists of rents deposited
at the end of the period, those rents earn no interest during the period i.e. periodic rents of
an ordinary annuity earn interest in subsequent periods, however the final rent do not earn
interest because the total amount is determined immediately at the time the final rent is
made. Hence, when computing the future value of an ordinary annuity, the number of
compounding periods will always be one less than the number of rents.

The formula used to determine the amount of ordinary annuity is as follows:

Where: AOAn, i = Amount of ordinary annuity for n number of periods at i rate of

interest

R = Periodic rent n = number of periods i = interest

Example:

Assume that AK Electronics deposits $75,000 at the end of each 6-month period for the
next 3 years, to accumulate enough money to meet debts that mature in 3 years. What is
the future value that the company will have on deposit at the end of 3 years if the l
interest rate is 10% compounded annually?

Solution: Given: R = 75,000 n=6 i = 5%

35
 = 75,000 (6.80191) = 510,143.25

 Annuity due (annuity in advance)

Annuity due is an annuity in which rents are received or paid at the beginning of each
period.

Amount of annuity due

The amount of an annuity due is the total amount on deposit one period after the final
rent. Annuity due assumes periodic rents occur at the beginning of each period. This
means an annuity due will accumulate interest during the first period, and the final rent
also earns interest because the amount on deposit is determined one period after the final
rent. If rents occur at the end of a period (ordinary annuity), in determining the future
value of an annuity there will be one less interest period than if the rents occur at the
beginning of the period (annuity due).

The formula used to determine the amount of an annuity due is as follows:

AADn, i = (AOAFn+1 i.e. Amount of annuity due for n number of periods at i

rate of interest = Rent multiplied by Amount of ordinary annuity for one more periods
(n+1) minus 1. Or

AADn, i = AOAFn,i (1+i) * R

Example: Miss Sue plans to deposit $800 a year on each birthday of her son, Howard.
She makes the first deposit on his tenth birthday, at 6% interest compounded annually.
Sue wants to know the amount she will have accumulated for college expenses by her
son’s eighteenth birthday (assume no deposit on the eighteenth birthday).

Solution: Given: R = 800 i = 6% n=8

AAD8, 6% = (AOAF9, 6% *R OR AAD8, 6% = AOAF8, 6% (1+i) *R

= *R = *R

36
 = 11.49132 *R = 9.89747 (1+.06)*R

= 10.49132*800 = 10.49132*800

= 8,393.05 = 8,393.05

Example Computation of Rent

Assume that you plan to accumulate $14,000 for a down payment on a condominium
apartment 5 years from now. For the next 5 years, you earn an annual return of 8%
compounded semiannually. How much should you deposit at the end of each 6-month
period?

Solution: Given: AOA10, 4% = 14,000 n = 10 i = 4% R =?

14,000 = R (12.00611)

14,000 = 12.00611R R = 1,166.07

Example- Computation of the Number of Periodic Rents

Suppose that a company’s goal is to accumulate $117,332 by making periodic deposits of

$20,000 at the end of each year, which will earn 8% compounded annually while
accumulating. How many deposits must it make?

Solution: Given: AOAn, 8% = 117,332 R = 20,000 i = 8% n =?

117,332 = 20,000 (AOAFn, 8%)

AOAFn, 8% = AOAFn, 8% = 5.86660

Use table factor for future amount of ordinary annuity and read down the 8% column to
find 5.86660. Thus, the company must make five deposits of $20,000 each.

 Deferred annuity

37
Deferred annuity is an arrangement/annuity in which rents does not begin until two or
more periods have expired, or rents remains on deposit for two or more periods beyond
the final rent.

Amount of deferred annuity

The amount of deferred annuity is total amount of ordinary annuity remains on deposit
for two or more periods beyond the final rent. When the amount of an ordinary annuity
continues to earn interest for one additional period, we have an annuity due situation;
when the amount of an ordinary annuity continues to earn interest for more than one
additional period, we have a deferred annuity situation.

The amount of deferred annuity may be computed by two different ways.

o Amount of ordinary annuity for all periods (including the period of deferral) and
subtract from this the amount of the ordinary annuity for the deferral period when
rents were not made, but interest continued to accumulate.

ADA = AOAn+d, i AOAd, i

Where; ADA = Amount of deferred annuity

AOAn, i = Amount of ordinary annuity for all periods (including the period of deferral)

AOAd, i = Amount of the ordinary annuity for the deferral period when rents were not
made

o The amount of a deferred annuity may also be computed by multiplying the

amount of the ordinary annuity by the amount of 1 for the period of deferral to
accrue compound interest.
ADA = AOAn, i (1+i) d

Where; AOAn, i = Amount of the ordinary annuity

(1+i) d = Amount of 1 for the period of deferral/ compounded interest for the deferred
periods

38
Example: Mr. Adams will deposit $30,000 in a 12% fund at the end of each year,
beginning December 31, 2012 up to December 31, 2018. What amount will be in the fund
as of December 31, 2022?

Solution: Given: R = 30,000 i = 12% n=7 d=4

ADA = AOAn+d, i AOAd, i

= 30,000 (20.654583) – (4.779328)

= 619,637.50 – 143,379.85 = 476,257.65 Or

ADA = AOAn, i (1+i) d

= (1+.12)4 =30,000 (10.089012) (1.573519)

= 302,670.36 (1.573519) = 476,257.55

N.B: The 0.10 Cents difference is resulted from rounding error.

Present value of ordinary annuity

The present value of an ordinary annuity is the present value of a series of equal rents, to
receive/pay at the end of each period. The present value of an ordinary annuity falls one
period before the final rent. Hence, all rents have a discount/present value.

The formula used to determine the present value of an ordinary annuity is as follows:

Example: On January 1, year 1, ZTE Co. has outstanding a $500,000 noninterest bearing
debt, payable $100,000 a year for five years starting on December 31, year 1.What is the
present value of this debt on January 1, year 1, if 8% compounded annually is considered
a fair rate of interest?

Solution: Given: R = 100,000 n=5 i = 8%

39
 = 100,000 (3.992710) = 399,271

Present value of annuity due

The present value of an annuity due is the present value of a series of equal rents, to
receive/pay at the beginning of each period. The present value of an annuity due falls on
the date the first rent is deposited or withdrawn. Hence, the first rent does not have a
discount/present value.

The present value of an annuity due is computed by:

PVADn, i = (PVOAFn-1, i + 1)*R

Where: PVADn, i = Present value of annuity due for n number of periods at i interest rate

PVOAFn-1, i = Present value of ordinary annuity factor of 1 birr for one period less (n-1)
at i interest rate

Example: On January 1, 2012, Hadiya supermarket rents satellite cameras for 4 years
with annual rental payments of Birr 150,000 to be made at the beginning of each year. If
the relevant annual interest rate is 11%, what is the present value of the rental obligations
on January 1, 2012?

Solution: Given: R = 150,000 n=4 i = 11%

PVADn, i = (PVOAFn-1, i + 1)*R

PVADn, i = +1 = 2.44371 + 1 = 3.44371 * 150,000

= 516,556.5

40
Present value of deferred annuity

When periodic rents are postponed for more than one period, the present value of such an
annuity on some date prior to the first rent may be computed by using two different
methods as follows:

(1) Discount the present value of the ordinary annuity portion at compound interest for
the periods the annuity is deferred i.e.

PVDA =

(2) Determine the present value of an ordinary annuity equal to the total number of
periods involved (including the periods of deferrals) and subtract from this the present
value of the “missing” ordinary annuity for rents equal in number to the number of
periods the annuity is deferred i.e.

PVDA = PVOAn+d, i – PVOAd, i

Example: Assume that Jedi Co. wants to know the amount at time period 0 that would
pay a debt of five payments of $100,000 each, payments starting at the end of year 4, and
interest compounded at 8% per time period.

Solution:
Given: R = 100,000 n=5 d=3 i = 8%
PVDA =?

= =

= = = $316,954

41
4. RISK AND RETURN
DEFINITION OF RISK AND RETURN
RETURN: is the total gain or loss experienced on behalf of the owner of an investment
over a given period of time. It is calculated by dividing the asset’s change in value plus
any cash distributions during the period by its beginning of period investment value.

R = Pt – Pt-1 + Ct
Where, R = actual, expected, or required rate of return
Pt = price (value) of asset at time t.
Pt-1 = price (value) of asset at time t -1.
Ct = cash flow received from 5the asset investment in time period t-1 to t.
 The return R, reflects the combined effect of changes in value, Pt – Pt-1 or capital gain
and cash flow C, or yield realized over the period t, the beginning value P t-1, and the
ending value Pt, are not necessarily realized values.
Example: Alpha Company wishes to determine the actual rate of return on two of its
video machines, X and Y. X was purchased exactly one year ago for $20,000 and
currently has a market value of $21,500. During the year it generated $800 of after-tax
cash receipts. Y was purchased four years ago, and its value at the beginning and end of
the year just ended declined from $12,000 to $11,800. During the year it generated
$1,700 of after tax cash receipts.
Required: what is the annual rate of return on asset X and asset Y?
Solution:
Risk: is the probability or likelihood that actual results (rates of return) deviates from
expected returns. It is the variability of returns associated with a given investment. The
word risk is usually used interchangeably with uncertainty.

Behavioral assumptions (risk preferences)

Some assumptions are needed to describe the way in which financial managers evaluate
risky projects. There are three attitudes towards risk.

42
1) Risk indifferent (neutral): the attitude towards risk in which no change is required
for an increase in risk. The risk neutral investor does not consider risk, and he would
always prefer investment with higher return.
2) Risk averse: the attitude in which an increased return would be required for an
increase in risk. Because managers with this attitude shy away from risk, they require
higher returns to compensate them for taking greater risk.
 Investors chose investments which have equal rates of return with the lowest risk.

3) Risk seeking (risk lover): is the attitude towards risk in which a decreased return
would be accepted for an increase in risk. Because, they enjoy risk, managers of this
attitude are willing to give up some returns to take more risk. Investors like
investment with higher risky irrespective of the rates of return.
 In general, managers are assumed to be risk averse, i.e. they accept additional risk
only if coupled with an appropriate increase in expected return.
 Managerial risk aversion provides two criteria that can be used to rank risky projects:
A) If two projects have the same expected return, the manager will prefer the one
with the lesser amount of risk.
B) If two projects have the same degree of risk, the manager will prefer the one with
the higher expected return.

MEASURING RISK AND RETURN

Measures of risk for a single asset
Risk (uncertainty) has to do with the future. So to measure risk, we use data from a
probability distribution. Probability distribution lists the set of possible returns that can
occur at a specific time and their associated probabilities of occurrence. Because the
possible returns are mutually exclusive, the probabilities sum to 1 or 100%. Probability
distributions are prepared based on past data, industry trends and ratios, and forecasts of
the general economy of the country.
 From a probability distribution, the following measures are obtained.
1) Expected rate of return 3) Coefficient of variation.
2) Standard deviation or variance
 Under conditions of risk a separate probability distribution is used for each year.

43
1) Expected rate of return (R)
 Expected rate of return is the return expected to be realized from an investment.
 It is the mean value of the probability distribution of possible returns.
 It is the sum of the probability distribution of each out come (return) and its
associated probability. Where, ri = possible return in year i.
Pi = probability of occurrence of ri.
N = number of possible returns.
Or, R = p1r1 + p2r2……+ pnrn where, p1,p2…. pn = is the probability of the ith out
come.
r1, r2..... rn = is the ith possible outcome (return).
Example: Mr. X is considering the possible rates of return (dividend yield plus capital
gain or loss) that he might earn next year on a $10,000investment in the stock of either
Alpha Company or Beta Company. The rates of return probability distributions for the
two companies are shown here under:
State of the economy Probability of the state Rate of return if the state occurs
Alpha company Beta company
Boom 0.35 20% 24%
Normal 0.40 15% 12%
recession 0.25 5% 8%
Required: compute the expected rate of return on each company’s stock.
Solution:
2) Standard deviation ( )
 Standard deviation is the most common statistical indicator of an asset’s risk (stand
alone risk).
 It measures the dispersion of the probability distribution around its expected value.
 It measures the variability of a set of observations.

Standard deviation ( ) =

Example: suppose we have security “L” with the distribution of possible returns shown
below. (Assume one year holding period).
Probability distribution of possible returns
Probability of occurrence 0.10 0.15 0.05 0.20 0.15 0.20 0.10 0.05

44
Possible return -8% 0 5% 6% 9% 14% 18% 28%

Required: determine:
A) Expected rate of return (R).
B) Standard deviation ( ).
Solution:
Possible outcome (ri) ri - R (ri – R)2 pi Pi(ri – R)2

 The larger standard deviation indicates a greater variation of returns and thus a
greater chance that the expected return will not be realized.
 The larger the Standard deviation ( ), the higher the risk, because Standard deviation
( ) is a measure of total risk.
3) Coefficient of Variation(CV)
 Coefficient of Variation (CV) is a measure of relative dispersion that is useful in
comparing the risk of assets with deferring expected returns.
 It shows the risk per unit of return and it provides a more meaningful basis for
comparison when the expected returns on two alternatives are not the same.

Coefficient of Variation (CV) =

Example: given the following information about two assets which one of lesser risk?
Asset X Asset Y
Expected return (R) 12% 20%
Standard deviation ( ) 9% 10%
Required: determine Coefficient of Variation (CV) for each of the assets and show
which one is riskier.
Solution:
Asset…….would be preferred as it gives a lower amount of risk per unit of a return. If
the firm was to compare the assets solely on the basis of Standard deviation, it would

45
prefer asset X. however, comparing the Coefficient of Variation (CV) of the assets shows
that management would be making a serious error in choosing X over Y.

PORTFOLIO RISK AND RETURN

PORTFOLIO: is a collection or a group of investment assets. If you hold only one asset,
you suffer a loss if the return turns out to be very low. If you hold two assets, the chance
of suffering a loss is reduced and returns on both assets must be low for you to suffer a
loss.

By diversifying, or investing in multiple assets that do not move proportionately in

the same direction at the same time, you reduce your risk.
 It is the total portfolio risk and return that is important. The risk and return of
individual assets should not be analyzed in isolation; rather they should be analyzed
in terms of how they affect the risk and return of the portfolio in which they are
included.
 The goal of the financial manager should be to create an efficient portfolio, one that
maximizes return for a given level of risk or minimizes risk for a given level of risk.
Expected return on a portfolio (rp)
 Expected return on a portfolio is the average of the returns of the assets weighted by
the proportion of the portfolio devoted to each asset.
 For a portfolio of securities, the expected return r p, is
Where, the expected return for security i.
rp =
= the proportion of funds invested in
security i.
n = the total number of securities in the
portfolio.

Example: consider a portfolio of three stocks A, B, and C, with expected returns of 16%,
12%, and 20% respectively. The portfolio consists of 50% stock A, 25% stock B, and
25% stock C.
Required: what is the expected return on this portfolio?

46
Solution:
Portfolio risk ( )
Unlike the expected return, the portfolio risk, as measured by its standard deviation, is
not a weighted average of the standard deviations of the assets making up the
portfolio. A portfolio’s standard deviation depends not only on the risk of the
individual securities, or assets, but also on the correlations between their returns.
Correlation (co-movement): refers to the association of movement between two
numbers.
It measures the degree of linear relationship to which two variables, such as returns
on two assets, move together. Correlation takes on numerical values that range from
+1 to -1. While the positive or negative sign indicates the direction of the co-
movement and the absolute value of the correlation indicates the relative strength of
the association. The closer the correlation coefficient is to +1 or -1, the stronger the
association.
 If the variables move together, they arte positively correlated (a positive correlation
coefficient).
 If the variables move in opposite direction, they are negatively correlated (a negative
correlation).
 A correlation of 0.0 indicates that no relationship between the variables, that is they
are unrelated.
 A correlation of +1.0 indicates that the variables move up and down together, the
relative magnitude of the movements is exactly the same (perfect positive
correlation).
 If correlation is between 0.0 and +1.0, the returns usually move up and down
together, but not all the time. The closer the correlation is to 0.0, the lesser the two
sets of returns move together.
 A correlation of -1.0 implies that they move exactly opposite to each other. (Perfect
negative correlation).

Example: consider a portfolio of two investment ventures under three deferent economic
climates.

47
State of the economy Probability of the Rate of return
state X Y
Bad 0.2 0% -10%
Average 0.6 10% 10%
Good 0.2 20% 40%

Required: Calculate CorrXY.

SOLUTION:

EXAMPLE: suppose we want to measure the standard deviation for the portfolio for our
previous example.

Possible out come pi ri - R (ri – R)2 pi (ri – R)2

Security A
r1 = -20% 0.5 -0.20 - 0.25 = 0.45 0.2025 0.10125
r2 = 70% 0.5 0.7 – 0.25 = 0.45 0.2025 0.10125
2
A = 0.2025
A = 0.45= 45%
Security B
r1 = 30% 0.5 0.3 – 0.2 = 0.1 0.01 0.005
r2 = 10% 0.5 0.1 – 0.2 = 0.1 0.01 0.005
2
B = 0.01
B = 0.10= 10%
 The weighted average of the individual is simply = (0.2 X 45%) + (0.8 X 10%) =
17%, however, this is not the of the overall portfolio.
 The returns for a portfolio consisting of 20% security A and 80% security B are:
shown in our previous example.
State Probability Return on portfolio
Recession 0.50 20%
Boom 0.50 22%
Since rp = 21%, then the standard deviation of the portfolio is:

48
 The portfolio ( ) is less than the weighted average of the individual security’s
standard deviation, 17%. Due to the weighted average of the individual ignores the
relationship, or covariance, between the returns of the two securities

COVARIANCE OF RETURNS
 Covariance measures how closely security returns move together. The covariance
between possible returns for securities J and K,
 When we consider two assets in the portfolio, we are concerned with the co-
movement of security movement.
 It measures the co-movement of security movement.
 It can be positive Covariance, negative Covariance, zero Covariance, and non-
Covariance.

= rJK

Where, rJK = the expected correlation between possible returns J and k.

The standard deviation for security J, and
The standard deviation for security K
The standard deviation of a portfolio ( ) is:

Where, n = the total number of securities in the portfolio

The proportion of funds in security j

= The proportion of funds in security k
The covariance between possible returns for security j&k

Example: suppose that you want to measure the of a two security portfolio, A&B.
security A&B in the portfolio has a of 11% and 19% respectively. The expected
correlation between the two securities is 0.30. if you invest 20% and 80% of your funds
in security A& B respectively.

49
Required: Determine the

Given: WA = 20% = 11%

WB = 80% = 19%

rAB = 0.30

Solution: =

= 16%

TYPES OF RISK: SYSTEMATIC AND UNSYSTEMATIC

 The total risk of a portfolio, measured by its standard deviation, declines as more
assets are added to the portfolio. Adding more assets to the portfolio can eliminate
some of the risk, but not all of it.
 The total risk can be divided in to two parts. These are:
1) Diversifiable (unsystematic or company-specific) risk
 It is the portion of an asset’s risk that is attributable to firm-specific, random causes,
such as strikes, lawsuits, product development new patent, regulatory actions, and
loss of a key account.
 It is avoidable or diversifiable risk, because these events occur some what
independently, they can be largely diversified away so that negative events affecting
one firm can be offset by positive events for other firms.
 They are irrelevant risks (called unique risk).
2) Non-diversifiable (systematic or market) risk
 It is attributable to market factors (such as war, inflation, international incidents,
impact of monetary and fiscal policies, and political events) that affect all firms. This
risk can not be eliminated through diversification. It is unavoidable risk. They are
relevant risks.

Total security risk = non-diversifiable risk + diversifiable risk

50
 Because non-diversifiable risks remain, whether or not a portfolio is formed, the only
relevant risk is non-diversifiable risk. That is, the only risk a well diversified portfolio
has the non-diversifiable risk. Therefore, the contribution of any asset to the riskiness
of a portfolio is its non-diversifiable risk.
RISK AND REQUIRED RATE OF RETURN
Required rate of return: is the minimum expected rate of return that would induce
an investor to acquire it. There is a direct relationship between an asset’s risk and its
expected rate of return.
 As we have seen in this chapter, the standard deviation is a measure of total risk.
However, the market doesn’t pay for the unsystematic risk, but for the systematic risk
as measured by beta.
 The beta of a portfolio is simply a weighted average of the betas of securities
comprising the portfolio. It is a measure of systematic risk in the portfolio.
 The CAPM (Capital asset pricing model) can be applied, like for individual securities,
to portfolios to determine their expected returns.
 To determine the expected return for a portfolio under CAPM, we do have two
alternatives.
The 1st alternative: to determine the expected return for individual securities and take
their weighted average to get the portfolio expected return.
The 2nd alternative: to determine the weighted average of the betas of the securities
making up the portfolio and insert their portfolio beta in the CAPM formula.
Example: consider a two security portfolio consisting of securities A and B with
betas of 1.3 and 0.7 respectively. Suppose that the expected return on treasury
securities is 6% and the expected return on the market portfolio is 12%. Assume you
invested 30% of your fund in security A and 70% of your fund in security B.
Required: determine the expected return on the portfolio using two alternatives.
 According to the CAPM, the required rate of return of a security is influenced by risk
free rate and a premium to compensate for the security risk.
Alternative 1: first determine individual securities expected return.
Expected return for security A = Rf + BA (Rm – Rf) compensation for risk
Market risk premium

51
 Where, Rf = the risk-free rate of return, which is generally measured by the
return on Treasury bill.
 Treasury bills offer risk-free rate, as they do not have risk of default. The government
guarantees them.
BA = the beta coefficient for asset A (security A)
Rm = the expected rate of return on the market portfolio (a portfolio that contains all
risky financial assets (example stocks, bonds, options) and all risky real states
(example precious metals, jewelry, real estate, stamp collections).
RA = Rf + BA (Rm - Rf)
= 6% + 1.3 (12% - 6%) = 13.8%
Expected return for security B (RB) = Rf + BB (Rm – Rf)
= 6% + 0.7 (12% - 6%) = 10.2%
 Thus, the expected return for the portfolio (rp) is:
E(rp) = WARA + WBRB = (0.3 X 13.8%) + (0.7 X 10.2%) = 11.28%
Alternative 2: we need to compute the beta of the portfolio first
Bp = , where, BP =beta of the portfolio
Wi = the proportion of funds invested in security
i, and
Bi = the beta of security i.
Bp = WABA + WBBB = (0.3 X 1.3) + (0.7 X 0.7) = 0.88
E(rp) = Rf +Bp (Rm - Rf) = 6% + 0.88 (12% - 6%) = 11.28% this is the same
as that obtained using alternative 1.
Example: the following information relates to the amount of investment and the beta
for six company stocks.
stock Amount invested Beta
A Birr 10,000 1.40
B 10,000 0.80
C 10,000 0.60
D 10,000 1.80
E 5,000 1.05
F 5,000 0.90
Required:

52
1) Determine the Beta of the portfolio comprising these six stocks
2) If the risk-free rate is 8% and the expected return on the market portfolio is 14%,
what will be the portfolio’s expected return?
Solution:
1) First we need to determine the proportion of funds invested in each stock.
Stock Amount invested Weights
A
B
C
D
E
F
Total
 The Beta of the portfolio is simply the weighted average of the Betas of the stocks in
the portfolio. Thus, Bp is:

RISK AND RETURN- DIVERSIFICATION

The principle of diversification

 Diversification results from combining securities whose returns are less than perfectly
correlated in order to reducing portfolio risk.
 As noted before, the portfolio expected return is simply a weighted average of the
individual security expected return, no matter the number of securities in the
portfolio. Thus, diversification will not systematically affect the portfolio return, but
it will reduce the variability (standard deviation) of returns.
 In general, the less the correlation among security returns, the greater the impact of
diversification on reducing variability. This is true no matter how risky the securities
of the portfolio are when considered in isolation.

 The figure shown that when we spread our investment across many different assets,
our portfolio risk will be reduced assuming that the securities return is less than
perfectly correlated.

53
 The area that is labeled “diversifiable risk” is the part that can be eliminated by
diversification. As we add more and more securities in our portfolio, the portfolio
risk decreases up to a point. This point is a minimum level of risk that can not be
eliminated by diversification. This minimum level of risk is labeled “non-
diversifiable risk” in the figure.

Diversification and unsystematic risk

Holding a portfolio of assets could eliminate some or all of the unsystematic risk.
Unsystematic risk is essentially eliminated by diversification, so a portfolio with
many assets has almost no unsystematic risk.
Diversification and systematic risk
Unlike unsystematic risk, systematic risk cannot be eliminated by diversification. A
systematic risk affects all assets. As a result, a systematic risk cannot be eliminated
regardless of the number of securities in the portfolio. Thus, for a well diversified
portfolio, the unsystematic risk is negligible. For such a portfolio, essentially all of
the risk is systematic.

5. THE COST OF CAPITAL

Capital is a necessary factor of production, and like any other factor, it has a cost. This
cost is equal to the marginal investor’s required return on the security in question. With
this in mind, we now consider the process of estimating the cost of capital.

The cost of capital is the return that must be provided for the use of an investor’s funds.
If the funds are borrowed, the cost is related to the interest that must be paid on the loan.
If the funds are equity, the cost is the return that investors expect, both from the stock’s
price appreciation and dividends. From the investor’s point of view, the cost of capital is
the same as the required rate of return.

The required rate of return on an investment and its value are intertwined. If you buy a
bond, you expect to receive interest and the repayment of the principal in the future. The
price you pay reflects your required rate of return. What determines your required rate?
Your opportunity cost—the return you could have received on an investment with similar

54
risk. Suppose that after you buy this bond, market interest rates increase. Your own
required rate of return also rises. When your required rate of return increases, the value of
your bond’s future interest and principal fall since the discount rate—the rate you use to
translate future cash flows into today’s value—increases. The discount rate increases
because it is a reflection of market interest rates.

THE LOGIC OF THE WEIGHTED AVERAGE COST OF CAPITAL

It is possible to finance a firm entirely with common equity. In that case, the cost of
capital used to analyze capital budgeting decisions should be the company’s required
return on equity. However, most firms raise a substantial portion of their capital as debt,
and many also use preferred stock. For these firms, the cost of capital must reflect the
average cost of the various sources of funds used, not just the costs of equity.

BASIC DEFINITIONS
The items on the right side of a firm’s balance sheet—various types of debt, preferred
stock, and common equity—are called capital components. Any increase in total assets
must be financed by an increase in one or more of these capital components.

The cost of each component is called the component cost of that particular type of capital;
for example, if a firm can borrow money at 10 percent, its component cost of debt is 10
percent. Throughout this section, we concentrate on these three major capital
components: debt, preferred stock, and common equity. The following symbols identify
the cost of each:

interest rate on the firm’s new debt before-tax component cost of debt.

after-tax component cost of debt, where is the firm’s marginal tax rate.

is the debt cost used to calculate the weighted average cost of capital.

component cost of preferred stock.

component cost of common equity. It is defined there as the rate of return investors
require on a firm’s common stock. Equity capital is raised in two ways: (1) by

55
 retaining earnings (internal equity) or (2) by issuing new common stock (external
equity).

the weighted average cost of capital. If a firm raises new capital to finance
asset expansion, and if it is to keep its capital structure in balance (that is, if it
is to keep the same percentage of debt, preferred stock, and common equity
funds), then it must raise part of its new funds as debt, part as preferred stock,
and part as common equity (with equity coming either from retained earnings
or by issuing new common stock).

These definitions and concepts are explained in detail in the remainder of this section.

COST OF DEBT,
Most firms use long-term debts to finance their long term investments. However, it is also
possible to use short term debt to finance long term investments. This is very risky
because there is a mismatch in the maturity of the debt instrument and the maturity of the
investments. As a result, the short term debts need to be roll over when they come due.
Such financing technique is usually not used by a well-managed firm. As a result we will
focus solely on long term debts as financing option.

It is important to note that the cost of debt is not simply the coupon rate of the debt
instrument. Since the cost of capital represents an opportunity cost, the cost of debt is
represented by the yield to maturity (YTM) to be realized by investors of the firm’s debt
in the current market. This is because investors bid the price of the debt instrument up or
down depending on the coupon rate in relation to the market interest rate they can earn in
alternative investment of equal risk.

If coupon rate market interest rate, sold at premium

If coupon rate market interest rate, sold at par

If coupon rate market interest rate, sold at discount

As a result, investors always earn the market interest rate regardless of the stated coupon
rate. In order to determine the cost of debt , we need to solve the following equation.

56
, assuming a semi-annual coupon bond.

If you look at the equation carefully, you will realize that solving for the yield to maturity
will simply give you for the debt instrument.

It is also important to note that the cost of debt is not a true representation of the
firm’s cost of issuing a debt instrument. This is because interest payments on debt
instruments are tax deductible. In effect, the government pays part of the cost of debt
because interest is tax deductible. As a result, it is more important for the firm to look at
the after-tax cost of debt rather than the before–tax cost of debt.

The after-tax cost of debt, , is used to calculate the weighted average cost of
capital, and it is the interest rate on debt, , less the tax savings that result because
interest is deductible. This is the same as multiplied by ,, where is the
firm’s marginal tax rate:

Example 1. Suppose ABC Inc. has marginal tax rate of 28% and the bond issued has a
YTM of 9%. What is ABC’s (after-tax) cost of debt?

The reason for using the after-tax cost of debt in calculating the weighted average cost of
capital is as follows. The value of the firm’s stock, which we want to maximize, depends
on after-tax cash flows. Because interest is a deductible expense, it produces tax savings
that reduce the net cost of debt, making the after-tax cost of debt less than the before-tax
cost. We are concerned with after-tax cash flows, and since cash flows and rates of return

57
should be placed on a comparable basis, we adjust the interest rate downward to take
account of the preferential tax treatment of debt.

Note that the cost of debt is the interest rate on new debt, not that on already outstanding
debt; in other words, we are interested in the marginal cost of debt. Our primary concern
with the cost of capital is to use it for capital budgeting decisions—for example, would a
new machine earn a return greater than the cost of the capital needed to acquire the
machine? The rate at which the firm has borrowed in the past is irrelevant—we need the
cost of new capital. Strictly speaking, the after tax cost of debt should reflect the
expected cost of debt.

The situation presented above has a very naïve view of the firm’s tax environment, i.e. it
assumes that the firm remains in the same tax bracket for the life of the debt instruments.
However, this is not necessarily the case for the following reasons.

I. A firm’s tax bracket is based on its taxable income. It is possible for the firm to be
in the next tax bracket if its taxable income increased to a certain level.
II. The tax structure could be altered by the government anytime during the debt’s
lifetime.

The technique of determining the cost of debt is a very simple one which does not take in
to consideration some of the problems a financial manager will encounter in the real
world. The following are some of the scenarios that complicate the computation of the
cost of capital.

1. Interest payment schedule is not known or fixed when the decision is made.
2. Mixture of fixed and variable rates debt instruments.
3. Mixture of straight and convertible debt instruments.
4. Debt instruments with and without sinking fund.

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 COST OF PREFERRED STOCK,
Unlike a debt instrument, the dividends from preferred stock are not tax deductible. As a
result, a firm cannot adjust the cost of preferred stock for tax benefits. Similarly, there are
certain situations in the real world that makes the computation of the cost of preferred
stock more complicated that the one presented below. The following are some of those
situations:

I. Dividends are cumulative III. Sinking fund provisions

II. Callable features
The simplified situation assumes that dividends are paid on time, and the preferred stock
is going to be around as long as the firm that issues it is around.

The component cost of preferred stock used to calculate the weighted average cost of
capital, , is the preferred dividend, , divided by the current price of the preferred
stock, .

………Equation 1

Example 2. ABC Inc. has preferred stock that pays a $10 dividend per share and sells
for $97.50 per share in the open market. What is ABC Inc.’s cost of
preferred stock ?

COST OF COMMON EQUITY

The costs of debt and preferred stock are based on the returns investors require on these
securities. Similarly, the cost of common equity is based on the rate of return investors
require on a company’s common stock. Note, though, that new common equity is raised
in two ways: (1) by retaining some of the current year’s earnings and (2) by issuing new
common stock. As we shall see, equity raised by issuing stock has a somewhat higher
cost than equity raised as retained earnings due to the flotation costs involved with new
stock issues. We use the symbol to designate the cost of retained earnings and to
designate the cost of common equity raised by issuing new stock, or external equity.

59
Determining the cost of common equity is more complicated than determining the cost of
either debt or preferred stock because unlike the other two instruments, common equity is
not a fixed income “security”.

COST OF RETAINED EARNINGS,

A corporation’s management might misguidedly think that retained earnings are “free”
because they represent money that is “left over” after paying dividends. While it is true
that no direct costs are associated with capital raised as retained earnings, this capital still
has a cost. The reason we must assign a cost of capital to retained earnings involves the
opportunity cost principle. The firm’s after-tax earnings belong to its stockholders.
Bondholders are compensated

by interest payments, and preferred stockholders by preferred dividends. All earnings

remaining after interest and preferred dividends belong to the common stockholders, and
these earnings serve to compensate stockholders for the use of their capital. Management
may either pay out earnings in the form of dividends or else retain earnings and reinvest
them in the business. If management decides to retain earnings, there is an opportunity
cost involved— stockholders could have received the earnings as dividends and invested
this money in other stocks, in bonds, in real estate, or in anything else.

Thus, the firm should earn on its retained earnings at least as much as the stockholders
themselves could earn on alternative investments of comparable risk.

Since shareholders are the owners of the firm, they are entitled to the firm’s earnings. If
the firm pays out all its earnings as dividends, the firm will be classified as a no growth
firm. However, it is possible for the firm to retain part of those earnings as and use them
for the firm than issuing new common stocks.

If the firm retained part of its earnings for new projects, that means the shareholders
“need” to give up that money. In order to do so, they will demand compensation from the
firm for using that money. As a result, the cost of retained earnings simply
represents a shareholder’s expected return from the firm’s common stock.

60
There are three ways of estimating the cost of retained earnings:

A. Capital Asset Pricing Model (CAPM)

B. Dividend growth model, and
C. Bond-yield-plus-risk-premium approach

A. Capital Asset Pricing Model (CAPM)

One approach to estimating the cost of common equity is to use the Capital Asset Pricing
Model (CAPM) proceeding as follows: , where

Step 1. Estimate the risk-free rate, , generally taken to be either the

government Treasury bond rate or the short-term (30-day) Treasury bill
rate.
Step 2. Estimate the stock’s beta coefficient, , and use it as an index of the
stock’s risk. The signifies the company’s beta.
Step 3. Estimate the expected rate of return on the market, or on an “average”
stock, .
Step 4. Substitute the preceding values into the CAPM equation to estimate the
required rate of return on the stock in question:

The above equation shows that the CAPM estimate of begins with the risk-
free rate, , to which is added a risk premium set equal to the risk premium on an
average stock, , scaled up or down to reflect the particular stock’s risk as
measured by its beta coefficient.

Example 3. To illustrate the CAPM approach, assume that , ,

and for a given stock. This stock’s is calculated as follows:

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Had been , indicating that the stock was riskier than average, its would have
been

For an average stock when is 8 percent and the market risk premium is 5 percent,

Example 4. Suppose the return on a 30 year T-bond is currently 6%, and the financial
analyst of Microsoft has estimated the return on a market portfolio to be
10% and the beta for Microsoft is 0.85. What is the cost of retained earnings
for Microsoft using CAPM?

It should be noted that although the CAPM approach appears to yield an accurate, precise
estimate of , there are actually several problems with it. First, if a firm’s stockholders
are not well diversified, they may be concerned with stand-alone risk rather than just
market risk. In that case, the firm’s true investment risk would not be measured by its
beta, and the CAPM procedure would understate the correct value of .

Further, even if the CAPM method is valid, it is hard to obtain correct estimates of the
inputs required to make it operational because

1. there is controversy about whether to use long-term or short-term Treasury

yields for ,
2. it is hard to estimate the beta that investors expect the company to have in
the future, and
3. it is difficult to estimate the market risk premium.

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 B. Dividend growth model
The dividend growth model ( or is known as the discounted cash flow (DCF) approach,
uses the time value of money to determine the cost of retained earnings. Recall that both
the price and the expected rate of return on a share of common stock depend, on the
dividends expected on the stock:

Here is the current price of the stock; is the dividend expected to be paid at the end
of Year ; and is the required rate of return. If dividends are expected to grow at a
constant rate, then,

We can solve for to obtain the required rate of return on common equity, which, for
the marginal investor, is also equal to the expected rate of return:

Thus, investors expect to receive a dividend yield, , plus a capital gain ,g. This method

of estimating the cost of equity is called the discounted cash flow, or DCF, method.
Based on the above formula the cost of retained earnings using the dividend
growth model is made up of two components: dividend yield and growth rate. Since
the dividend yield of a stock is easy to compute, the problem with estimating the cost of
retained earnings comes primarily with estimating the growth rate of the dividends.

C. BOND-YIELD-PLUS-RISK-PREMIUM APPROACH
Analysts who do not have confidence in the CAPM often use a subjective, ad hoc
procedure to estimate a firm’s cost of common equity: they simply add a judgmental
risk premium of 3 to 5 percentage points to the interest rate on the firm’s own long-
term debt. It is logical to think that firms with risky, low-rated, and consequently

63
 high-interest-rate debt will also have risky, high-cost equity, and the procedure of
basing the cost of equity on a readily observable debt cost utilizes this logic.

For example, if an extremely strong firm such as BellSouth had bonds that yielded 8
percent, its cost of equity might be estimated as follows:

The bonds of a riskier company such as Continental Airlines might carry a yield of 12
percent, making its estimated cost of equity 16 percent:

Because the 4 percent risk premium is a judgmental estimate, the estimated value of is
also judgmental.

Example 5. Epsilon Company’s last annual dividend was $4 per share and both earnings
and dividends are expected to grow at a constant rate of 8%. The stock now
sells for $ 50 per share. The company’s beta coefficient is 1.5. The return of
a market portfolio is 12%, and the risk-free is 8%. The company’s A-rated
bonds are yielding 12%.
Calculate the cost of retained earnings using:

a. Capital Asset Pricing Model (CAPM)

b. Dividend growth model, and
c. Bond-yield-plus-risk-premium approach
Solution

a. Capital Asset Pricing Model (CAPM)

b. Dividend growth model

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 c. Bond-yield-plus-risk-premium approach

Based on the above example we realized that we do not always get a consensus answer
for the cost of retained earnings using different method. Hence, it is key to note that a
financial manger should use his or her caution when determining the cost of retained
earnings.

COST OF NEW COMMON STOCK,

Companies generally hire an investment banker to assist them when they issue common
stock, preferred stock, or bonds. In return for a fee, the investment banker helps the
company structure the terms and set a price for the issue, and then sells the issue to
investors. The banker’s fees are often referred to as flotation costs, and the total cost of
capital should reflect both the required return paid to investors and the flotation fees paid
to the investment banker.

“How Much Does It Cost to Raise External Capital?,” flotation costs are often
substantial, and they vary depending on the size and risk of the issuing firm and on the
type of capital raised. So far, we have ignored flotation costs when estimating the
component costs of capital, but some would argue that these costs should be included in a
complete analysis of the cost of capital. The counter-argument is that flotation costs are
not high enough to worry about because (1) most equity comes from retained earnings,
(2) most debt is raised in private placements and hence involves no flotation costs, and
(3) preferred stock is rarely used.

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 Step 1. The old stockholders expect the firm to pay a stream of dividends, , that
will be derived from existing assets with a per-share value of . New
investors will likewise expect to receive the same stream of dividends, but
the funds available to invest in assets will be less than because of
flotation costs. For new investors to receive their expected dividend
stream without impairing the stream of the old investors, the new funds
obtained from the sale of stock must be invested at a return high enough to
provide a dividend stream whose present value is equal to the net price the
firm will receive:

Here is the dividend stream to new (and old) stockholders, and is

the cost of new outside equity.

Step 2. When growth is constant, the above equation reduces to

Step 3. The above equation can be rearranged as

Here F is the percentage flotation cost required to sell the new stock, so is the
net price per share received by the company.

Example 6. From an earlier example, we know the upcoming dividend for

ABC Inc. is $0.576 per share and stock price is $18.43 per share.
In addition, we also know the growth rate of dividend is 10% .
given this information, what is ABC’s cost of new common stock
if the floatation cost is set at 5%?

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 =13.29%

Since retained earnings is a cheaper source of common equity than new common stocks,
a firm usually exhausts its retained earnings before issuing new common stocks. The
difference between the cost of retained earnings and the cost of new common stocks is
known as the floatation cost adjustment:

What is ABC’s floatation cost adjustment?

Example 7. Armon brothers Inc. is attempting to evaluate the costs of internal and
external common equity. The company’s stock is currently selling for
$62.5 per share. The company expects to pay a dividend of $5.42 per share
at the end of the year, and it is expected to grow at 5% a year from now
on. Suppose the company expects to net $57.5 per share on a new share
after floatation costs.
A. What is the firm’s floatation cost?

B. What is the firm’s cost internal equity (or retained earnings)?

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C. What is the firm’s cost external equity (or new common stocks)?

D. What is ABC’s floatation cost adjustment?

COMPOSITE, OR WEIGHTED AVERAGE, COST OF CAPITAL, WACC

Each firm has an optimal capital structure, defined as that mix of debt, preferred, and
common equity that causes its stock price to be maximized. Therefore, a value-
maximizing firm will determine its optimal capital structure, use it as a target, and then
raise new capital in a manner designed to keep the actual capital structure on target over
time. In this chapter, we assume that the firm has identified its optimal capital structure,
that it uses this optimum as the target, and that it finances so as to remain on target. How
the target is established will be examined in financial management II course.

Weighted average cost of capital, WACC, is computed as follows:

Here, , and are the weights used for debt, preferred, and common equity,
respectively.
The target proportions of debt, preferred stock, and common equity, along with the costs
of those components, are used to calculate the firm’s weighted average cost of capital,
WACC.

Example 8. Suppose that a firm has a target capital structure calling for 45 percent
debt, 2 percent preferred stock, and 53 percent common equity (retained earnings plus

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common stock). Its before tax cost of debt, , is 10 percent; its after-tax cost of debt
; its cost of preferred stock, , is 10.3 percent; its cost of
common equity, , is 13.4 percent; its marginal tax rate is 40 percent; and all of its new
equity will come from retained earnings. We calculate the firm’s weighted average cost
of capital, WACC, as follows:

Every dollar of new capital that the firm obtains consists of 45 cents of debt with an after-
tax cost of 6 percent, 2 cents of preferred stock with a cost of 10.3 percent, and 53 cents
of common equity (all from additions to retained earnings) with a cost of 13.4 percent.
The average cost of each whole dollar, WACC, is 10 percent.

The weights could be based either on the accounting values shown on the firm’s balance
sheet (book values) or on the market values of the different securities. Theoretically, the
weights should be based on market values, but if a firm’s book value weights are
reasonably close to its market value weights, book value weights can be used as a proxy
for market value weights. This point is discussed further latter, but in the remainder of
this section, we shall assume that the firm’s market values are reasonably close to its
book values, and we will use book value capital structure weights.

Note that when calculating the firm’s target capital structure, total debt includes both
long-term debt and bank debt (notes payable). Recall that investor-supplied capital does
not include other current liabilities such as accounts payable and accruals.

Example 9. Suppose the cost of debt is 8%, cost of preferred stock is 10%, and the
cost of new common stock is 12% for Microsoft, which is facing a 35% tax bracket.
What is Microsoft’s WACC if it decides to raise its capital with 20% debt,35% preferred
stocks, and 45% common stocks?

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 Example 10. Valie enterprises, inc. has compiled the following information regarding
its financing:
Type of capital Book Value Market Value After-tax cost
Long-term debt $3,000,000 $2,800,000 4.8%
Preferred stock $102,000 $150,000 9.0%
Common stock $1,108,000 $2,500,000 13.0%
$4,210,000 $5,450,000

A. What is weighted average cost of capital using the book values?

B. What is weighted average cost of capital using the market values?

The marginal cost of capital (MCC)

From the graph above, you will realize that the WACC is a straight line, which means
that it is assumed that the cost of raising capital remains constant regardless of the amount
of capital raised. However, this is not usually the case. The cost of the different forms of
capital increases (or jumps) if the amount of capital the firm is trying to raise exceeds
certain level. In this case, we need to look at the marginal cost of capital that looks at the
weighted average cost of capital a firm faces for raising each additional dollar.

As we have discussed earlier, retained earnings represent a cheaper source of capital

than new common stocks. As a result, a firm will exhaust its retained earnings before it

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issues new common stocks. In this case, we know the WACC of the firm will jump when it
switches from retained earnings to new common stocks. A firm needs to determine when
the WACC will jump to the higher level i.e. the break even point. In addition,the costs of
issuing debts and preferred stocks increase as the firm issues more and more of such
securities. As a result, the firm’s MCC schedule will experience several more jumps when
the costs of issuing debts and preferred stocks increase.

How do we determine a firm’s MCC schedule? In other words, how do we determine

when the break points (or jumps) will take place in a frim’s (MCC) schedule? We will
ilustrate this with an example.

Example 11. Suppose the cost of debt is 8%, cost of preferred stock stock is 10%, and
the cost of retained earnings is 11% and cost of new common stock is 12% for
Microsoft,which is facing a 35% tax bracket. Microsof decides to raise its capital with 20%
debt,35% prefereed stocks and, and 45% with common equity. Suppose microsoft is
expected to have total earnings of $300 million that it plans to pay 40% of it as dividend
payments. What is the break point of the MCC?
First we know Microsoft will first exhaust its retained earnings before using the more
costly new common stock. As a result, we can determine the microsoft’s WACC when its
source of equity is only retaine earnings and when its source of equity is only new common
stock as follow;

In addition,we know that Microsoft has total earnings of $300 million and it plans on
retaining 60% of it. Given the information, we know Microsofrt’s retained earnings is

Since we know that 45% of Microsoft’s capital will be raised with equity (either retained
earnings or new common stocks),the total of money microsoft can raise without issuing
new common stocks is;

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In this case , if microsoft has to raise more than $400M,it will have to issue new common
stocks. In other words, Microsoft’s MCC schedule will experience a jump at $400
million.

The graph below shows the MCC schedule of Microsfot:

In the above example, we have shown how we can determine the break point or
jump in Microsoft’s MCC schedule when it exhausted its retained earnings and
need to issue new common stocks to raise capital. However, we also know that
the costs of debt and preferred stock will also rise as Microsoft issues more and
more debts and preferred stocks. As a result, Microsoft’s MCC schedule will
experience several jumps as it raises more and more capital.

Example 12. Film works Inc. currently considering several investments. It finances all
its expansion with 40% debt and 60% equity capital. The after-tax cost of
debt is 8% for the first $100,000, after which the cost will be 10%.
Filmworks Inc. currently has $120,000 of retained earnings available. The
cost of retained earnings will be 18%. If the firm decides to issue new
common stocks (after exhausted the retained earnings), the cost will be
22%.
a) Where will be the break points will occur for Filmworks Inc. MCC schedule?
b) What is the weighted average cost of capital in each of the intervals?
c) Plot Filmworks Inc. MCC schedule using the information in a) and b).
d) How would the situation change if Filmworks Inc. has $150,000 of retained
earnings?
Solution:

a) Where will be the break points will occur for Filmworks Inc. MCC schedule?
We know there will be two break points in Filmworks Inc. MCC schedule:

(1) When all retained earnings is exhausted and new common stocks have to
be issued, and
(2) When all the low-cost debts (i.e. 8%) is exhausted and the high cost of
debts have to be issued. It is all important to note that at this point in time,
we do not know which break point will take place first.
Break point “1”: when retained earnings is exhausted

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 Break point “2”: when low-cost debt is exhausted

b) What is the weighted average cost of capital in each of the intervals?

I. For financing between $0 and $200,000
In this range, Filmworks will be using retained earnings and the low-cost debt. The
WACC for this range will be:

II. For financing between $200,000 and $250,000

In this range, the firm will be using new common stock (because it has exhausted its
retained earnings) and the low-cost debt. The WACC then be:

III. For financing beyond $250,000

In this range, the firm will be using new common stocks and the high c-cost debt. In this
case the WACC will be:

c) Plot Filmworks Inc. MCC schedule using the information in a) and b).

d) How would the situation change if Filmworks Inc. has $150,000 of retained
earnings?
With the new level of retained earnings, it will affect the break point where
Filmworks will exhaust its retained earnings.

In this situation, we can see that Filmworks will exhaust its retained earnings and
low-cost debt at the same time. As a result, Filmworks Inc. MCC schedule will
look as follows:

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 6. Capital budgeting /investment decision making

The investment decisions of a firm are generally known as the capital budgeting, or
capital expenditure decisions. A capital budgeting decisions may be defined as the firm’s
decisions to invest its current funds most efficiently in the long-term assets in anticipation
of an expected flow of benefits over a series years. The long term assets are those that
affect the firm’s operations beyond the one year period.
The following are the features of investment decisions:
- The exchange of current funds for future benefits.
- The funds are invested in long-term assets.
- The future benefits will occur to the firms over a series of years.
In the investment analysis, it is cash flow, which is important, not the accounting profit.
The firm’s value will increase if investments are profitable & add to shareholder’s
wealth.
Importance of capital budgeting
- They influence the firm’s growth in the long-run.
- They affect the risk of the firm.
- They involve commitment of large amounts of funds.
- They are irreversible, or reversible at substantial loss.
- They are among the most difficult decisions to make.
Project classifications
1. Expansion of existing 3. Replacement &
business. modernization
2. Expansion of new business.
 A Co. may add capacity to its existing product line to expand existing operations.
 Expansion of a new business requires invest in new product & anew kind of
production activity within the firm.
 The main objective of modernization & replacement is to improve operating
efficiency & reduce costs.
Yet another useful way to classify invest is as follows.

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 1. Mutually exclusive investments: serve the same purpose & compete with each
other. If one investment under taken, others will have to be excluded.
2. Independent investments: serve different purposes & do not compete with each
other.
3. Contingent invests: are dependent projects; the choice of one investment
necessitates under taking one or more other investments.
Capital budgeting processes
The following steps are Capital budgeting processes
1. Identification of various investments proposals: The capital budgeting may have
various investment proposals. The proposal for the investment opportunities may be
defined from the top management or may be even from the lower rank. The heads of
various departments analyses the various investment decisions, and will select proposals
submitted to the planning committee of competent authority.
2. Screening or matching the proposals: The planning committee wills analyses the
various proposals and screenings. The selected proposals are considered with the
available resources of the concern. Here resources referred as the financial part of the
proposal. This reduces the gap between the resources and the investment cost.
3. Evaluation: After screening, the proposals are evaluated with the help of various
methods, such as payback period proposal, net discovered present value method,
accounting rate of return and risk analysis. Each method of evaluation used in detail in
the later part of this chapter. The proposals are evaluated by.
(a) Independent proposals (c) Partially exclusive proposals.
(b) Contingent of dependent proposals
Independent proposals are not compared with another proposal and the same may be
accepted or rejected. Whereas, higher proposals acceptance depends upon the other one
or more proposals. For example, the expansion of plant machinery leads to constructing
of new building, additional manpower etc. Mutually exclusive projects are those which
competed with other proposals and to implement the proposals after considering the risk
and return, market demand etc.
4. Fixing property: After the evolution, the planning committee will predict which
proposals will give more profit or economic consideration. If the projects or proposals are

75
not suitable for the concern’s financial condition, the projects are rejected without
considering other nature of the proposals.
5. Final approval: The planning committee approves the final proposals, with the help of
the following:
(a) Profitability (c) Financial violability
(b) Economic constituents (d) Market conditions.
The planning committee prepares the cost estimation and submits to the management.
6. Implementing: The competent authority spends the money and implements the
proposals. While implementing the proposals, assign responsibilities to the proposals,
assign responsibilities for completing it, within the time allotted and reduce the cost for
this purpose. The network techniques used such as PERT and CPM. It helps the
management for monitoring and containing the implementation of the proposals.
7. Performance review of feedback: The final stage of capital budgeting is actual results
compared with the standard results. The adverse or unfavorable results identified and
removing the various difficulties of the project. This is helpful for the future of the
proposals.
Capital Budgeting Evaluation Techniques
Three steps are involved in the evaluation of an investment
1. Estimation of cash flows. 3. Application of a decision rule for
2. Estimation of the RRR(cost of making the choice.
capital)
There are two project evaluation techniques

1. The traditional criteria (technique)

They are called the traditional techniques because they do not consider the time value of
money concepts in ranking investments proposals. Two methods are included under the
traditional technique, namely the payback period & the accounting rate of return.
a) The payback period: the payback period is the number of years that is required
for 5the business firm to recover from the project the amount of the initial
investment in total. If the cash flows from the project are in annuity form, the

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 payback period can easily be determined by dividing the initial investment by the
annual cash flow in the annuity.

That is, payback period (in years) =

When the cash flows from the project are not in an annuity, the payback period is
computed as follows: payback period = year before full recovery

To illustrate the computation of the payback period when the cash flows from the project
is an annuity form, suppose the project requires an initial investment of 24,000 birr & the
annual after-tax cash flows of 6,000 birr for five years. The payback period is, therefore,

Payback period = 24000/6000 = 4 years

This to mean that the initial investment amount of this particular project will be
recovered with in the first four years of the project life (i.e. 6000 for four years is 24,
000).

To illustrate the computation of the payback period when the cash flows from the project
are not in an annuity form, assume the project requires an initial investment of 60,000
birr. The after-tax cash flows from the project are 8,000 birr during year 1, 15,000 birr
during year 2, 22,000 birr during year 3, 20,000 birr during year 4, & year 5 each. Here,
the cash flows are not uniform. In this case, we first need to compute the cumulative.

Year annual cash flow cumulative cash flow

1 8,000 8,000
2 15,000 23,000
3 22,000 45,000
4 20,000 65,000*
5 20,000 85,000
Looking at the cumulative cash flows, the cumulative cash flows at the end of year 3,
which is 45,000, is less than the initial investment whereas the cumulative cash flows at
end of year 4 that is 65,000 is slightly greater than the initial investment. This implies that

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the payback period for this project is greater than 3 years but less than 4 years. The exact
payback period can be computed as follows:

Payback period = 3 years + (15,000/20,000) years = 3 years +0.75 years= 3.75 years,
or = 3 years + (0.75) (12 months) =3 years & 9 months.

This is true if the cash flows of 20,000 birr during year four are uniformly distributed
over the entire year. Otherwise, the payback period is different from 3 years & 9 months.
For instance, if the cash flow of 20,000 birr is expected to occur only once at the end of
year 4, the payback period will be 4 years.

As a general rule, the shorter the payback period required, the better the project. Thus, the
project is accepted if it’s payback period is less or equal to the period required by the
management of the business firm. If two projects are mutually exclusive (i.e. if the
acceptance of one project precludes the acceptance of the other), a project with the
shorter payback period selected even if both of them fulfill the acceptance criteria. On the
other hand, if two projects are independent (i.e. the cash flows of one of the project do
not influence the cash flows of the other), both the projects can be accepted as long as
their payback periods are less than the planned payback period.

Advantages of payback period:

The payback period is an easy & an in expensive method to evaluate & rank project
alternatives.
Disadvantages of payback period:
1. It ignores the cash flows beyond the computed payback period though they are
important for acceptance or rejection decisions.
2. It ignores the time value of money which is an important variable that
demands consideration in evaluating the desirability of a given project.
b) The accounting rate of return (ARR): is the rate of return that is calculated by
dividing the projects expected annual net profit by the average investment outlays.
The average investment outlay, on the other hand, is computed by dividing the
sum of original cost of the project & the salvage value of return (ARR) can be
expressed with the algebraic equation as follows.

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 ARR =

To illustrate the accounting rate of return consider the project that has the original
investment of 70,000birr, the life of 4 years, & the salvage value of 6,000 birr at the end
of year 4. The straight line method of depreciation is used. Income before depreciation &
taxes are 40,000 birr for year 1, 42,000 birr for year 2, 36,000 birr for year 3, & 50,000
birr for year 4. Determine the accounting rate of return if income tax rate on the project is
40%. To compute the accounting rate of return (ARR) for this project, first we have to
determine the average investment & the annual depreciation amount.
Average investment = (70,000+6,000)/2 = 38,000 birr
Annual depreciation = (70,000-6,000)/4 = 16,000 birr

To compute the new profit for each year during the four years.

Year 1 Year 2 Year 3 Year 4

Income before depn. & taxes 40,000 42,000 36,000 50,000

Less: annual depreciation 16,000 16,000 16,000 16,000
Income before taxes 24,000 26,000 20,000 34,000
Less: income taxes (40%) 9,600 10,400 8,000 13,600

Then we compute the average net profit during the four years. That is:
Average net profit = (14,400+15,600+12,000+20,400)/4 =15,600 birr

Hence, ARR = = 0.41or41%

This is to mean that an average of 1 birr invested in this project, there is an average return
of 41% in the form of net profit per year over the entire four years of the life of the
project. The accounting rate of return method project evaluation, like the payback period
method, ignores the timing of cash flows or the time value of money. Moreover, the
accounting rate of return ignores the fluctuation of cash flows over the life of the project
as it assumes an average cash flows every during the project’s life.

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2. The Discounting cash flow (DCF) criteria (techniques)

The Discounting cash flow (DCF) techniques are other methods of evaluating & ranking
investment project proposals. These techniques employ the time value of money concept;
unlike the traditional methods. Four DCF techniques are discussed in the section that
follows.

a) The discounting payback period: is defined as the number of years that

is required to recover the amount of money invested in a project at the beginning after
discounting the future cash flows to their present values. Discounting payback period in
computed in the same manner as that of the regular payback period except the
discounted cash flows are used in the case of the former one. The expected future cash
flows are discounted by the project’s cost of capital. To illustrate the computation of the
discounted payback period, suppose that a given capital budgeting alternative is
expected to have an initial of 30,000 birr & the life of 5 years. The after-tax cash flows
from the project during years 1,2,3,4 & 5 are 15,000 birr, 18,000 birr, 12,000 birr,
20,000 birr, & 22,000 birr respectively. The cost of capital (the4 required rate of return)
is %. What is the discounted payback period for this project? To this question, first we
have to compute the discounted cash flows & the cumulative cash flows for each year
which help buys to locate the discounted payback period for this project. Hence, the
discounted cash flows & the cumulative cash flows year by year are show as follows.

Year cash flows discount factor present value cumulative CF

1 15,000 0.909 13,635 13,635
2 18,000 0.826 14,868 28,503
3 12,000 0.751 9,012
4 20,000 0.683 13,660
5 22,000 0.621 13,662
As you can see from the cumulative discounted cash flows the discounted payback period
for project is b/n 2 & 3 years. This is because the cumulative discounted cash flow at the
end of year 2 is less than the initial investment of 30,000 birr & the cumulative
discounted cash flows at the end of year 3 is greater than the same initial net investment.
The exact payback period (discounted) can be computed as:

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Discounted payback period =2 years+ (1,497/9,012) years =2 years+0.17 years = 2.17
years

= or 2 years + (0.17)(12 months) = 2 years & 2 months.

It requires the project a period of 2 years & 2 months to recover its initial net investment
taking the time value money into account. This is true only if the cash flows assumed to
occur uniformly throughout the year. But the cash flows are discounted back to their
present cash equivalents by considering that the cash flows are occurring at the end of
every year. Hence, the project needs to wait for one more years after year 2 in order to
recover the remaining present value equivalent amount of 1,497 birr at the end of year 2.
Therefore, the discounted payback period of this project is 3 years instead.

b) The net present value(NPV) method: is an investment project proposals

evaluating & ranking method using the net present value, w/c is the difference
b/n the present values of future cash inflows& the present values of future cash
out flows, discounted at the given cost of capital, or opportunity cost of capital.
In order to use this method properly, the following procedures are followed.
1. Find the present values of each cash flow, including both inflows & out flows
using the cost of capital of the project for discounting.
2. Sum the discounted cash outflows & the discounted cash outflows separately.
3. Obtain the difference b/n the sum of the cash inflows & the sum of cash out flows.

In all the cash out flows for the project occur at time zero, i.e. at the beginning 9of year 1,
the present value of the cash outflows is the same as to the net investment amount.

Decision rule for the net present value (NPV) Method

If the projects are independent, the projects with positive net present values are the ones
whose implementation maximizes the wealth of shareholders. Hence, such projects
should be accepted for implementation. If the projects, on the other hand, are mutually
exclusive, the one with the higher positive NPV should be accepted leading to the
rejection of the projects with the lower positive NPV. Projects with negative NPV should
not be considered for acceptance in the first place.

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The rational for the net present value method is that a NPV of zero signifies that the cash
flows of the project are just sufficient to repay the invested capital & to provide the
required rate of return, no more no less. If the project has a positive NPV, it is generating
more cash than needed to service its debts & to provide the require rate of return to the
shareholders, & this excess cash accrues solely to the firm’s shareholders. Therefore, if
the firm takes on a project with a positive NPV, the wealth of the shareholders will
improved as indicated above.

To illustrate the NPV as a method of project proposals ranking assume that a given
project is expected to have an initial investment & project life of 40,000 & 5 years
respectively. The annual after-tax cash flow is estimated at 12,000 birr for each one of the
five years. Using the required rate of return of 10%,

What is the NPV of the project? How do you judge the acceptability of this project?

In order to answer this question, it is wise to identify the cash inflows& cash out flows. In
the case of this project, there are annuity cash inflows of 12,000 every year for five years
& single cash outflows of 40,000 at time zero. The present value of the annuity cash
outflows is:

Present value of annuity = 12,000(annuity factor)

The annuity factor given the period of 5 years& discount rate of 10% is3.791 substituting
the factor I the equation above.

PVA = 12,000(3.791) = 45,492 birr

Present value of cash flows = 40,000 birr

Hence, the net present value (NPV) = PV of inflows less PV of out flows

=45,492-40,000 = 5,492 birr

Since the project makes the net present value (NPV) of positive 5,492 birr, it should be
accepted.

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Consequently, the wealth of the shareholders would increase by 5,492 birr in total as the
result of accepting & running this project. Thus, the project can be judged as an
acceptable one. To further illustrate the NPV method, consider the following mutually
exclusive project alternatives, together with their cash flows.
Alternative Year 0 Year 1 Year 2 Year 3 year 4 Year 5
A (80,000) 20,000 25,000 25,000 30,000 20,000
B (100,000) 25,000 20,000 30,000 35,000 40,000

The required rate of return on both projects is 12%. Then, evaluate these projects using
the net present value method.
The evaluation of these two projects requires the computation of the net present values
for both projects. As you can see the cash flows from both projects are not in annuity
forms. The cash flows are irregular for both projects. Hence, we need to discount each of
the cash flows individually. Then the individual discounted cash flows are added. The
cash outflows at time zero will be deducted from the sum of the discounted cash inflows
in order to get the net present value of the project. The net present value (NPV) for
project A is:
Year cash flows discount factor (12%) present values
1 20,000 0.893 17,860
2 25,000 0.797 19,925
3 25,000 0.712 17,800
4 30,000 0.636 19,080
5 25,000 0.567 11,340
PV of cash inflows (sum) 86,005
PV of cash outflows 80,000
Net present value (NPV) 6,005 birr

The net present value (NPV) for project B is:

Year cash flows discount factor (12%) present values
1 25,000 0.893 22,325
2 20,000 0.797 15,940
3 30,000 0.712 21,360

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4 35,000 0.636 22,260
5 40,000 0.567 22,680
PV of cash inflows (sum) 104,565
PV of cash outflows 100,000
Net present value (NPV) 4,565 birr
Since the two projects are mutually exclusive, the one with the higher NPV has to be
accepted. Thus, project A is selected as its NPV is higher than that of project B. Had the
two project been independent of one another, both of them would be accepted because
both projects have positive net present values (NPVs).

c) The Internal rate of Return (IRR): is the discount rate which equates the
present value the expected cash flows with the initial investment outlays. In
other words, IRR is a method of ranking investment projects proposals using
the rate of return on an asset (investment). At IRR, the sum of the present
values of all cash inflows is equal to the sum of the present values of all cash
out flows. That is:
PV (cash inflows) =PV (cash out flows). Hence, the net present value of
any project at a discount rate that is equal to the IRR is zero.

Computing the internal rate of return

1. Uniform cash inflows over the life of the project:
In this case, the present value table of an annuity can be used to calculate the IRR since
the cash inflows are in annuity form. The following steps can be followed to calculate
IRR for constant cash inflows.
Step 1: find the critical value of discount factor

Discount factor =

Step 2: find the IRR by looking along the appropriate line (year) of the present value of
annuity table until the column which contains the critical discount factor (i.e. the discount
factor computed under step 1) is located.

To illustrate the calculation of IRR when the cash flows are in an annuity form, assume
that a project has a net investment of 26,030 birr & annual net cash inflows of 5000 birr

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for seven years. What is the IRR of this project? In order to answer this question, we need
to follow the two steps discussed above.
Step 1computes the critical discount factor. That is

Discount factor = =5.206

Step 2 after determining the critical discount facto, we look for the value that is equal to
this factor in the present value of annuity table across the line corresponding of 7 years
(i.e. n=7). The discount factor of 5.206 appears in the 8% column on the line/row of 7
years. Therefore, the IRR IS 8%.

2. Fluctuating cash inflow over the life of the project

When the cash inflows from the project are not in annuity form, IRR is calculated
through an interactive process or through “trial & error”. It may be difficult to identify
from which discount rate to start. A good first guess can be made by estimating the
discount factor.
In general, the following procedures are used to calculate the IRR of the non-uniform net
cash flows.
Step 1: find the critical value of discount factor. In fact, if the fluctuations I the cash
inflows is very large, the estimated discount factor doesn’t help you much in locating the
IRR in the present value of annuity table.

Estimated discount factor =

Step 2: look at the present value of annuity table to obtain the nearest discount rate for
the estimated discount factor determined in step 1.
Step 3: calculate the NPV using the discount rate identified in step 2.
Step 4: If the resulting NPV is positive, choose the higher discount rate & repeat the
procedure. Choose the lower discount rate if the NPV is negative, & repeat the same
procedure until you find the discount rate that equates the NPV to zero.
To illustrate the IRR computation under fluctuating cash inflows from the project assume
a project that has an initial investment of 40,000 birr & the following net cash inflows;
Year 1, 15,000 birr; Year 4, 15,000 birr; and
Year 2, 10,000 birr; Year 5, 15,000 birr.

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 Year 3, 10,000 birr;
What is the IRR of this project?
In order to estimate the discount factor, you need to give weight to the cash flows over
the life of the project. Larger weights should be given to the cash flows towards the
beginning of the life of the project than to the cash flows that occur towards the end of
the project life.
Hence,
Year weights cash flow x weights
1 5 75,000
2 4 40,000
3 3 30, 000
4 2 30,000
5 1 15,000
15 190,000

Average net cash flow = =12,667

Estimated discount factor = = 3.158

By looking up in the present value table for annuity, the approximate the discount factor
of 3.158 online 5(n=5) is 18%. Thus, the starting point of the iterative process is 18%.
The NPV of the project using the discount rate of 18% is:
NPV
=(15,000)(0.847)+(10,000)(0.718)+(10,000)(0.609)+(15,000)(0.516)+(15,000)(0.437)-
40,000 =270
Since the NPV computed using a discount rate of 18% is positive, are have to take a
discount rate higher than 18% in search for the NPV of zero. So the second guess can be
19%. The NPV of the project using the discount rate of 19% is:
NPV
=(15,000)(0.840)+(10,000)(0.706)+(10,000)(0.593)+(15,000)(0.499)+(15,000)(419)-
40,000 =-640

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As per the above calculations, NPV is negative when the discount rate of19 % is used &
positive when the discount rate of 18% is used. Thus, the IRR for this project falls b/n 18
& 19%. If the exact IRR is needed, the interpolation method it can be used. That is:
Step 1: obtain the NPV of the smaller rate by the absolute sum & add the resulting
quotient to the smaller rate, or divide the NPV of the larger rate by the absolute sum &
subtract the resulting quotient from the larger rate.
Step 2: divide the NPV of the smaller rate by the absolute sum & add the resulting
quotient to the smaller rate, or divide the NPV of the larger rate by the absolute sum &
subtract the resulting quotient from the larger rate.
By following the above two steps, the exact IRR for this project is thus:
The absolute sum of the NPVs =|270|+|-640| = 270+640 =910
Then, dividing the NPV of the smaller rate by the absolute sum, you get 270/910 = 0.30
to the nearest two digits after the decimal point, & add this figure to the smaller rate.
IRR = 18%+0.30% = 18.30%
Or you can divide the NPV of the larger rate by the absolute sum, & you get:
-640/910-0.70 t0 the nearest two digits after the decimal point, & subtract this
figure from the larger rate to obtain the exact IRR.
IRR = 19%-0.70% = 18%
In both cases, you arrive at the same IRR value of 18.3%
The rational for the IRR method is that the IRR on a project is its expected rate of return.
If the IRR of a given investment project exceeds the cost of the funds used for financing
the project(cost of capital), there is the remaining surplus after paying for the capital, &
this surplus adds up on the wealth of the shareholders of the firm. Therefore, selecting the
project with the IRR less than the cost of capital imposes an unnecessary cost on current
shareholders. The return from the project will to cover even the cost of capital.

Decision rule for IRR

A project whose IRR is greater than its cost of capital, or required rate of return (RRR) is
accepted & whose IRR is less than the RRR of the project is rejected.
d) Profitability index (PI): is the ratio of the present value of the expected net
cash flow of the project & its initial investment outlay.

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 PI = PV/IO
Where, PV = Present value of expected net cash flows
IO = initial investment outlay
PI = profitability index
Profitability index provides or measure of profitability in a more readily understandable
terms. It simply converts the NPV criteria into a relative measure.
NPV VS PI
The NPV & the PI criteria reach the same acceptance-rejection decisions for independent
projects. The PI is greater than 1 if the NPV of the project is positive. However, in the
case of mutually exclusive projects, NPV & PI will result in different acceptance-
rejection decisions. One advantage of NPV in this case is that it reflects the absolute size
of alternative investment proposals. PI does not reflect difference in investment size.
Therefore, the NPV is more appropriate for mutually exclusive projects than PI.
Consider the following two mutually exclusive projects.
PV of cash flows initial investment NPV PI

Project A 200 100 100 2.0

Project B 3000 2000 1000 1.50

From the above example Project A is accepted using PI B/C its PI is greater than that of
Project B. however, NPV of the project B is greater than that of Project A. Thus, even
though the PI of a project is a very useful tool, it should not be used as a decision rule
when mutually exclusive projects of different size are being considered.
NPV Vs IRR
The NPV & IRR project ranking techniques lead to the same acceptance-rejection
decisions for independent projects. However, these methods may lead to different
decisions when it is impossible to undertake all investment opportunities. In other words,
when investment opportunities are mutually exclusive, NPV & IRR may result in
contradicting decisions. If this is the case, which one of the two methods should be used
to select b/n among the mutually exclusive projects? What are the reasons for the
difference b/n the two methods? Let us first discuss the reasons for the difference. These
reasons can be classified into two. These are:

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 1. Difference in the size of investment
All investments do not usually require the same amount of initial outlay. One investment
may have larger initial investment than its alternatives. In this case, NPV leads to better
investment decision b/c it ensures that the firm will reach the optimal scale of investment.
NPV automatically examines & compares the incremental cash flows against the cost of
capital. The IRR criteria ignore this important aspect of an investment decision b/c the
return is expressed in a percentage.
To illustrate, the difference b/n the NPV & IRR as project ranking techniques consider
the following mutually exclusive projects, project A & project B.
012 345
Project A (50,000) 17,000 17,000 17,000 17,000 17,000
Project B (32,000) 12,000 12,000 12,000 12,000 12,000
The required rate of return for this project is 8%. Which one of these two projects should
be selected? From the above illustrative example, we can see that the lives of both
projects are the same. However, the initial investment of project A is greater than that of
project B. Thus; one can learn that there is a difference in the size or scale of investment.
In order to identify the project to be selected, the NPV & IRR for both projects have to be
calculated. Since the cash flows for both projects are in an annuity form, the IRR can be
easily determined from the present value table of annuity after determining the discount

factors. Therefore, the discount factor for project A = = 2.941

Looking in the present value table of annuity in the raw of 5 years, the discount factor of
2.941 corresponds to 20.8%.

The discount factor for project A = = 2.667

Looking in the present value of annuity table across the 5 year (n=5) row, the discount
factor of 2.667 corresponds to 25.5% &
The NPV of project A = (17,000) (the discount factors of annuity at the required rate of
8%)-50,000
= (17,000) (3.993)-50,000 = 17,881 birr
The NPV of project B = (12,000) (the discount factors of annuity at the required rate of
8%)-50,000

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= (12,000) (3.993)-50,000 =15,916 birr
The above calculations indicate that both projects are acceptable if they are independent
projects. However, those projects are mutually exclusive. As a result, IRR ranks project B
first, but NPV ranks project A first. Thus, there is a paradox b/n the two methods. in
order to clarify such paradoxical result, it is advisable involved. Then the internal rate of
return (cross over rate) is determined on the incremental cash flows & additional
investment. Additional investment is the difference b/n the investment outlays of the two
projects. Cross over rate is the discount rate at which the NPV profiles of the two projects
cross,& thus, at which the projects’ NPVs are equal. Thus, the internal rate of return on
incremental cash flows is the same as the cross over rate. The cross over rate for the
illustration under consideration is calculated in the same, procedures as IRR for the
project, i.e.
Discount factor = 18,000/5,000 = 3.600
From the present value of annuity table, the discount factor of 3.600 corresponds to the
12% column. Thus, the cross over rate is 12%. The cross over rate indicates that indicates
that the NPV gives priority to projects A at discount rates below cross over rate of 12%,
but IRR supports project B for a discount rate above the cross over rate.
Since the cost of capital is 8%, the incremental cash flow represents a profitable
opportunity. Therefore, the larger project which incorporates these additional cash flows
should be accepted. If the cross over rate is less than the cost of capital (IRR), the project
with the smaller investment should be selected b/c the additional commitment of
resources will not be compensated.
Therefore, by examining & comparing the incremental cash flows against the cost of
capital, the NPV method ensures that the firm will reach the optimal scale or size of
investment.
2. Difference in timing of cash flows
The NPV & the IRR can still give contradictory ranking even when initial investment
outlays are the same b/c of the difference in the timing of the cash flows. Most of the
cash flows one project may occur in the early years & most of the cash flows from the
other project may occur during the later years. The critical issue is that “how useful is the
project if it generates cash flows sooner than later?” so, which method should be sued?

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Basically, the cash flows that occur sooner are better than the cash flows that occur later
b/c early cash flows can be reinvested. In fact, we cannot use the scale of investment
project argument discussed earlier to justify the preference of NPV & IRR. However, we
can still use the same incremental cash flow technique. So, how can we justify the use of
NPV as a project ranking & evaluating method when differences in the scale of
investment do not exist?
In order to justify the superiority of NPV rule over that of the IRR, we need to consider
the reinvestment rate assumption of early cash flows. According to the reinvestment rate
assumption, NPV method implicitly assumes that the cost of capital (RRR) is the rate of
which cash flows can be reinvested, whereas the IRR method assumes that the business
firm has the opportunity to reinvest at the IRR. Which assumption do you think is better?
The best assumption is the one that considers the reinvestment of cash flows at the cost of
capital, i.e. NPV method, the IRR method incorrectly penalizes the receipts of more
distant years by using high discount rate (IRR) B/C IRR is greater than required rate of
return (RRR). Thus, the best reinvestment rate assumption is the cost of capital which is
consistent with NPV method.
To illustrate, let us assume that project A & project B have the same initial investments,
10,000 birr. The RRR is for the firm 10%.

Year project A project B

0 (10,000) (10,000)
1 - 6,000
2 13,924 7,200
IRR 18% 20%
NPV 1,501 1,401
Which project should be selected?
IRR singles that project B is better than project A; whereas NPV signals that project A is
better than project B. Since NPV method is the superior top the IRR method in selecting
b/n two mutually exclusive projects, project A is selected. Project A will provide the most
wealth to the shareholders. To prove the soundness of this decision, we can calculate the
terminal value of each project using future value technique. Thus, terminal value of:
Project A = 13,924 birr

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Project B = 7,200 birr + (6,000) (1.1) birr =13,200 birr
Since the terminal value of project A is greater than the terminal value of project B, the
former project is selected which is in line with the NPV decision rules.
Projects with unequal lives
Earlier in this chapter, we assumed that mutually exclusive projects have equal lives. But
there are many situations in which alternative investment have unequal lives. The most
common example of such situation is unequal replacement decision. Since it is not
appropriate to compare projects of unequal lives adjustment must be made. Even though
there are different methods (approaches) of dealing with mutually exclusive alternatives
with different lives, there of them are introduced in this chapter.
1. The replacement chain approach
Replacement chain, which is called common life approach, is the method of comparing
projects of unequal lives which assumes that each project can be repeated as many times
as necessary to reach a common life span. Then, the NPV or the other method is used to
evaluate the project.
To illustrate the comparison off projects with unequal lives consider two mutually
exclusive projects whose cash flows are summarized below. The discount rate for both
projects is 10%.
012 345 6
Project A (40,000) 10,000 12,000 15,000 11,000 9,000
11,000
Project B (30,000) 12,000 14,000 13,000 - -
-
Two projects are incomparable. Thus, according to replacement chain approach, project
B will be repeated in the three years. Assuming that cash flow & the discount rates will
not change. Thus, if project B is repeated, its year 4, years 5, & year 6 cash flows are
12,000 birr, 14,000 birr, & 13,000 birr respectively. In this way, the two projects have the
same life. If project B is repeated, its cash flows will be:
0 1 2 3 4 5 6

Project B (30,000) 12,000 14,000 13,000 12,000 14,000 13,000

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The present value computation of the repeated project B requires a two-step process.
These are:

Step 1: you compute the present values at t=0 for project B & at t=3 for the repeated
project B.
present values at time zero(t=0)=(12,000)(0.909)+ (14,000)(0.826)+
(13,000)(0.751)=32,235 birr
present values at time three(t=3)=(12,000)(0.909)+ (14,000)(0.826)+
(13,000)(0.751)=32,235 birr
Step 2: discount the present value of repeated project B at time three (t=3) to the present
values at time zero (t=0). That is, present value of repeated project B at time zero =
(32,235) (0.751) = 24,208 birr
Then, add the present value of the first three years cash flows to the present value of the
repeated project after three years. That is:
Total present value = 32,235+24,208 = 56,443 birr. Hence, the NPV of the repeated
project B =56,443-30,000 = 26,443 birr
The NPV of project A is calculated as follows.
Year cash flows discount factor present value
1 10,000 0.909 9,090
2 12,000 0.826 9,912
3 15,000 0.751 11,265
4 11,000 0.683 7,513
5 9,000 0.621 5,589
6 11,000 0.564 10,204

PV of cash inflows (sum 49,573)

PV of cash outflow 40,000
NPV of project A9,573 birr
Therefore, using the NPV method for project comparison of the two projects, project B
should be selected. Under the replacement chain approach of comparing projects with
unequal lives, the least common factor of the projects lives is used to find the common
useful life. For instance, if the life of project A is 5 years & that of project B is 3 years,

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project A is repeated 3 times & project B is repeated 5 times b/c the least common factor
for the two project lives(i.e.3 & 5) is 15 years.
2. Equivalent Annual Annuity(EAA) Method
This method enables us to calculate the annual payments a project would provide if it
were an annuity. When comparing projects of unequal lives, the one with higher
equivalent annual annuity should be chosen. Three steps are followed under this method:
Step 1: find each project’s NPV over its initial life. The NPV for the above projects are
as follows:
Project A = 9,573 birr (as computed before)
Project B = (12,000) (0.909) + (14,000) (0.826) + (13,000) (0.751) =32,235 birr
Step 2: find the equivalent annual annuity that has the same present value as the
project’s N
Equivalent annual annuity can be calculated as follows.
Project A NPV = PV of cash flows – PV of initial outlays.
9,573 = PV of cash flows – 40,000
9,573 + 40,000 = PV of cash flows
PV of cash flows=49,573. By looking up in the present value of annuity table at n=6 &
I=10%, the discount factor is 4,355. As you know PV of cash flows = cash flow x
discount factor.49, 573= (4.355) (x)
Where, x is the equivalent annual annuity.
X= 49,573/4.355 = 11,383 birr
For project B NPV = PV of cash flows – PV of initial outlays
2,235 = PV of cash flows – 30,000
2,235 + 30,000 = PV of cash flows
PV of cash flows=32,235. By looking up in the present value of annuity table for the
discount that corresponds to n=3 & I=10% is 2.487. Hence
2.487(y) 32,235 where, y is represents the equivalent annual annuity amount for the
project. Solving for y we get. Y = 32,235/2.487 = 12,961 birr
Step 3: the project with the higher equivalent annual annuity will always have the higher
NPV when extended out to any common life. Therefore, project B‘s equivalent annual
annuity (EAA) is larger than project A’s, project B would be chosen.

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7. LEVERAGE IN BUSINESS
Meaning of leverage
 In business, leverage is the use of fixed costs in an attempt to increase or (lever up)
profitability. These fixed costs could be fixed operating costs (e.g. depreciation) or
fixed financing costs (e.g. interest) or in most cases both.
 It is the use of fixed costs with the intent of magnifying the returns of the firm.
 Leverage magnifies profit as sales increases, and magnifies loses as sales drops.
Types of leverage
1) Operating leverage: it is the use of fixed operating costs in the production activities
or operations of the firm.
 It is the use of fixed operating costs to magnify the effects of changes in sales on the
firm’s profits before interest and taxes (PBIT).
Degree of operating leverage (DOL)
 Degree of operating leverage is the numerical measure of the firm’s operating
leverage. It quantifies the responsiveness of operating income to changes in the level
of income.
 It is the variability of operating income (PBIT), due to the use of fixed operating
costs. It is the percentage change in operating profit (PBIT) as a result of percentage
change in sales.
DOL =

Where,
DOL = Degree of operating leverage
PBIT = profit before interest and taxes (operating
profit).
Q = sales (units to be sold).
DOL = =
 This ratio answers the following types of questions. If sales increases by 10%, by
what percentage will operate profit increase, given a certain degree of operating
leverage?
Example: if DOL = 2, then a 10% increase in the level of sales will increase operating
profits by 20%.
 A large DOL indicates that small change in the level of sales will produce large
changes in the level of operating profit.
 A firm with relatively high leverage level will experience more variability in
operating income if sales changes, thus, a higher level of leverage can be associated
with higher level of risk. Due to that decreases in sales results in a larger increase in
lose if the use of leverage is increase.

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 Illustration: assume Lakew Company has the following income statement for the
current year ended December 31, 2003.
Lakew Company
Income statement
For the year ended December 31, 2003
Sales (in units)…………………………………………………………1, 000
Sales revenue……………………………………………………..birr 10,000
Less: variable operating costs…………………………………………..5,000
Fixed operating costs……………………………………………2, 500
PBIT (Operating income)………………………………………….birr 2,500
Less: interest……………………………………………………………...500
Profit before tax……………………………………………………birr 2,000
Less: tax (40%)…………………………………………………………...800
Profit after tax……………………………………………………...birr 1,200
Ato Lakew is the owner manager of the company, and he is planning to increase the sales volume
to 1,500 units in the year 2004. He assumed the selling price per unit (SPU), VCU and the total
fixed costs would remain the same as they were in the year2003.
Projected operating leverage for the year 2004,
Sales (in units)………………………………………………………...1, 500
Sales revenue……………………………………………………..birr 15,000
Less: variable operating costs (1, 5000 x 5)……………………………7,500
Fixed operating costs……………………………………………2, 500
PBIT (profit before interest and tax)……………………………….birr 5,000

DOL = = == == =2
This indicates that as the company’s sales increases from 1,000 to 1,500, its PBIT will
increase from birr 2,500 to birr 5,000. Or a 50% change in sales results in a 100%
increase in PBIT.
DOL = 1, what does it imply? There is no fixed operating cost employed and there will
be 1% change in PBIT for a 1% change in sales.
Example:
Given amount percentage of sales
Sales…………………………………..birr 80,000………………….100%
Less: variable costs………………………..32,000…………………...40%
Contribution margin…………………birr 48, 000…………………….60%
Less: fixed costs………………………….38, 000
Net operating income……………… birr 10,000
Required:
1) Compute the company’s DOL.
2) Using the DOL, estimate the impact on net income of a 5% change in sales.
3) Verify your estimate from the above by constructing a new contribution; forget
income statement for the company and assuming a 5% increase in sales.

 When operating leverage exists, an increase in sales results in a more than

proportional increase in operating profits and vice versa.
Alternative method of determining DOL

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 DOL =

DOL = where, Q = the level of sales

P = the SPU
V = the VCU
F = the total fixed costs.
Example: A certain firm is able to sell a unit of product for birr 5, each unit has a variable
cost of birr 3, and the fixed costs of operation are birr 1,000. What is the firm’s DOL a5t
1,000 units of sales?
Solution:

 The number……indicates that if the firm increases sales by 10%, operating profits or
PBIT will rise by 20%. This increase is easily verified, for 1,000 units of sales, the
level of operating profit is birr 1,000.
Total Revenue = birr 5 x 1,000 = birr 5,000.
Total cost = birr (3 x 1,000) + birr 1,000 = birr 4,000.
 Operating profit = birr 1,000.
 If sales are increased by 10%, what would be the level of operating profit becomes?
Increase in sales level = 1.1 x 1,000 = 1,100 units.
Total revenue = birr 5 x 1,100 = birr 5,500.
Total cost = birr (3 x 1,100) + 1,000 = birr 4,300
 Operating profit = birr 1,200
The greater the fixed costs, the smaller the denominator in the ratio, and hence the
larger the degree of operating leverage.
Firms with larger amounts of fixed costs have to sell a larger level of units in order to
spread out these fixed costs, such firms have higher degrees of operating leverage.
Substitution of fixed operating costs for variable operating costs and its effect on
operating leverage:
 Operating leverage is affected when the firm substitutes fixed operating costs for
variable operating costs (e.g. substituting equipment for labor). This may increase
degree of operating leverage (DOL) because fixed operating costs in a form of
equipment depreciation, have increased.
Example: by using the earlier example, the firm’s product sold for birr 5, and fixed and
variable operating costs were birr 1,000 and birr 3 per unit respectively. Suppose the firm
increase fixed costs to birr 1,500 but reduces variable operating costs from birr 3 to birr
2.50 per unit.
Solution: DOL = = 2.5
 The higher the fixed operating costs, the higher the DOL will be. The DOL has
increased from 2 to 2.5. I.e. if the firm were to increase sales by 10%, operating profit
would increase by 25%.
Operating leverage and risk
 Operating profits will rise and fall more rapidly for a firm with a higher degree of
operating leverage (high operating fixed costs).

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 How operating leverage affects the level of risk associated with airlines and retailing
businesses?
 Airlines industry has a large DOL because of depreciation on plans and equipments
are so huge, i.e. high fixed costs.
 Retailing business has few fixed operating costs (example rent for a building) and
many variable operating costs, as a result, they have a low degree of operating
leverage.
 Business (operating risk) is the variability of earnings before interest and tax.
Variability of earnings before interest and tax is due to variability of sales or
variability of expenses (fixed and variable expenses). Or operating risk is the
variability of EBIT caused by the use of operating leverage.
 Firms with high DOL (i.e. relatively large foxed operating costs) are generally riskier
than firms with lower DOL (i.e. relatively lower fixed operating costs).
 The DOL shows how increase or decrease in the level of fixed operating costs will
affect the firm’s operating profits. Management needs to be aware of that an increase
in fixed operating costs may increase:
 Changes in operating profits as sales changes.
 The level of sales necessary for the firm to be profitable, and
 The level of business risk.
2) FINANCIAL LEVERAGE
 Financial leverage is the use of fixed costs in the financing of the firm’s assets such as
interest costs and preferred stock dividends.
 It is the use of fixed financing costs to magnify the effects of changes in operating
profit on the firm’s earnings per share (EPS).
 The two fixed financing costs are:
a) Interest on debt financing, and
b) Preferred stock dividends – these costs must be paid regardless of the amount of
PBIT available to pay them.
Degree of financial leverage
 The Degree of Financial Leverage (DFL), like the DOL, is a measure of
responsiveness.
 It measures the responsiveness of EPS (Earning per share) to changes in operating
profits.
 It is the numerical measure of the firm’s financial leverage.
DFL =
Illustration: assume Nile Company has earned profit before interest and tax of birr
10,000 in the current year. It has an interest cost of birr 2,000 on its outstanding debt and
600 shares of birr 4 (annual preferred stock dividend per share) preferred stock
outstanding. The firm is in the 40% tax bracket. Nile Company’s financial manager, Mr.
Abel, wants to see the effects of changes in operating profits on the company’s EPS.
Particularly, he is interested to see the effects of increase or decrease the current
operating profit by 40%.
Preferred stock dividend = birr 4 x 600 = birr 2,400
Common stock outstanding = 1,000 shares.

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The EPS (earning per share) for various levels of PBIT for Nile company:
40% decrease in PBIT current year PBIT 40% increase in PBIT
PBIT………………………birr 6,000…….………………birr 10,000………………birr 14,000
Less: interest…………………...2,000………………………….2, 000……………………2,000
Profit before tax………………..4,000………………………….8, 000………………….12, 000
Less: tax (40%)…………………1,600…………………………3, 200…………………....4,800
Net profits after tax……………..2,400…………………………4,800…………………….7, 200
Less: preferred stock dividends...2,400…………………………2,400……………………..2,400
Earnings available for
common stock holders………….birr 0…………………….birr 2,400……………........birr 4,800

EPS……………………… = birr 0… = birr 2.40………

Br4.80
(1) When PBIT increases from birr 10,000 to birr 14,000, EPS increases from birr 2.4 to
birr 4.8.
 Increase (change) in EPS = birr 4.8 – birr 2.4 = birr 2.4.
 Percentage increase (change) in EPS = x 100 = 100%
 So, when PBIT increases by 40%, EPS will increase by 100%.
(2) When PBIT decreases from birr 10,000 to birr 6,000, EPS will decrease from birr 2.4
to Br 0.
 Decrease (changes) in EPS = birr 0 – birr 2.4 = -birr 2.4.
 Percentage decrease in EPS = x 100 = -100%.
Similarly, a 40% decrease in PBIT results in a 100% decrease in EPS.
(3) What is the DFL for Nile Company?
DFL = = DFL = = 2.5
 The numerical value of DFL 2.5 means that a 40% change in the firm’s operating
profit results in a 100% change (i.e. 2.5 x40% = 100%) in earnings per share.
Alternative formula:
DFL = where, I = interest

PD = annual preferred stock dividend

T = Tax rate
Example: if PBIT = birr 10,000, I = birr 2,000, PD = birr 2,400, and I = 40%

DFL =

DFL =

DFL = = 2.50

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Financial leverage and risk
 The use of financial leverage increases the owner’s rate of return. When the firm’s
degree of financial leverage (DFL) increases, its financial risk also increases.
 Financial risk is the risk to a firm that it is unable to cover required financial
obligations as they become due. The penalty for not meeting financial obligations is
bankruptcy.
 Financial risk is the variability of EPS (earning per share) caused by the use of
financial leverage. It is unavoidable risk if the firm decides to not to use any debt in
its capital structure.
3) TOTAL (COMBINED) LEVERAGE AND EFFECTS OF LEVERAGE
 The combined effect, or total leverage can be defined as the potential use of fixed
costs, both fixed operating costs and fixed financial costs, to magnify the effect of
changes in sales on the firm’s EPS (Earning per share).
 It is viewed as the total impact of the foxed costs in the operating and financial
structure of the firm.
Degree of total leverage (DTL)
Degree of combined or total leverage (DTL) is the numerical measure of the firm’s
total leverage.
It is the percentage change in EPS divided by the percentage change in sales.
DTL = DTL = DOL X DFL
 Whenever, the percentage change in EPS resulting from a given percentage
change in sales is greater than the percentage change in sales, combined or
total leverage exists. I.e. as long as DTL is greater than 1, there is total
leverage effect.
To apply the above formula of DTL, we use the following changes and tables, in this
table, a 50% increase in sales in a 60% increase in operating profits. In return, a 60%
increase in operating profits result in a 300% increase in EPS. Or,
50% increase in sales………60% increase in operating profit………………300% increase in EPS.

Table: the total leverage effect: 50%

Sales (in units)……………………………………………………….20, 000………………………………..30, 000
Sales revenue……………………………………………………..100,000………………………………..150, 000
Less: variable operating costs……………………………….40, 000…………………………………60, 000
Fixed operating costs……………………………………10, 000………………………………….10, 000
PBIT………………………………………………………………………50, 000…………………………………80, 000
60%
Less: interest……………………………………………………….20, 000……………………………………20,000
Profit before tax………………………………………………….30, 000……………………………………60,000
Less: tax (40%)…………………………………………………….12, 000……………………………………24,000
Profit after tax (PTA)…………………………………………..18, 000……………………………………36,000
Less: preferred stock dividend…………………………….12, 000……………………………………12,000
Earnings available for common stock holders……….6, 000……………………………………24,000

EPS (earning per share)…………………………………. = 1.20…………………… = 4.80

+ 300%

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%age change in PBIT = = 60%, and
%age change in Q =

%age change in EPS = = 300%.

Alternative methods of determining DTL
DTL =

Example:
 Q (sales quantity) = 20,000
 P (SPU) = Birr 5
 VC(VCU) = Birr 2
 FC = Birr 10,000
 Interest = birr 20,000
 Annual preferred stock dividend = birr 12,000
 Tax rate (T) = 40%.
Required: determine the DTL.
Solution: DTL =

DTL =

DTL =

DTL =

DTL = =6
 Degree of Total Leverage of a firm is the product of the firm’s degree of operating
leverage (DOL) and degree of financial leverage (DFL).
 DTL = DOL X DFL DTL = 1.2 X 5 = 6.0
 A numerical value DTL 6 means that a 50% increase in firm’s sales results in a 300%
(6 x 50% =300%) increase in EPS (Earning per share) or vice versa.
Total leverage and risk
The use of operating leverage increases business risk because the firm must now meet
higher fixed costs to be profitable. The use of financial leverage increases financial risk
because the firm must now meet costs (especialy interest and preferred stock dividend
payments) associated with debt and preferred astock financing.

It is generally not wise to use a large amount of both financial and operating leverages.
Any firm that has substantial amoun of fixed equipment and is financed with borrowed

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 funds has both operating and financial leverages. The use of both sources of leverages
will certainly increase the risk exposure of the firm.

Effect of leverage on return on equity(ROE) and earning per share (EPS)

Both return on equity (ROE) and earning per share (EPS) decline as more debt is used.

1) The financial leverage will have a favorable impact on EPS and ROE only when the
firm’s return on investment (ROI) exceeds the interest cost of debt.
Example: the firm is paying 15% on debt and earning a return of 24% on funds
employed.
2) The financial leverage will have unfavorable impact on EPS and ROE only when the
firm’s return on investment (ROI) is less than the interest cost of debt.
Example: the firm is paying 15% on debt and earning a return of 12% on funds
employed. The shareholders will have to meet the deficit 3%, as a result, EPS and
ROE decline.
3) If the rate of return on assets were just equal to the cost of debt, the financial leverage
will have impact on the shareholders return. EPS and ROE would be the same under
all plans.
 Effect of leverage on return on equity(ROE) and earning per share (EPS)
Favorable…………………………………………….ROE> i
Unfavorable………………………………………….ROE< i
Neutral……………………………………………….ROE = i.

8. INTRODUCTION TO FINANCIAL INSTITUTIONS

Meaning and Nature of Financial Institutions

 Financial institutions (e.g., commercial and savings banks, credit unions, insurance
companies, mutual funds) perform the essential function of channeling funds from those
with surplus funds (suppliers of funds) to those with shortage of funds (users of funds).
 Financial institutions are business organizations that act as mobilizers and depositors of
savings, and as purveyors of credit or finance.
 Financial institutions provide various types of financial services in an economy. Financial
intermediaries are a special group of financial institutions that obtain funds by issuing
claims to market participants and use these funds to purchase financial assets.

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 Financial system defined as the collection of markets, institutions, laws, regulations, and
techniques through which bonds, stocks, and other securities are traded, interest rates are
determined, and financial services are produced and delivered around the world.

Types of Financial Institutions

Financial institutions can be classified as depository and non-depository institutions.

Depository institutions
Depository institutions accept deposits from surplus units and provide credit to deficit
units through loans and purchases of securities.
Depository institutions include commercial banks, savings and loan associations, and
credit unions.
 Commercial Banks: are the most dominant depository institutions in the economies of
most major countries. They serve surplus units by offering a wide variety of deposit
accounts, and they transfer deposited funds to deficit units by providing direct loans or
purchasing debt securities.
Commercial banks serve both the private and public sectors, as their deposit and lending
services are utilized by households, businesses, and government agencies.
Their major assets are loans and their major liabilities are deposits.
 Saving and Loan Associations: are the major sources of mortgage loans to finance the
purchase of homes and in fact the basic motivation behind the creation of Saving and Loan
Associations was the providing of funds for financing the purchase of a home.
Saving and Loan Associations are either mutually owned or have corporate stock
ownership.
 Credit Unions: Credit unions differ from commercial banks and savings institutions in
that they
o Are non-profit and
o Restrict their business to the credit union members, who share a common bond (such as a
common employer or union)
They are the smallest of the depository institutions and many in number.
Credit unions are really cooperative, self-help associations of individuals.
Non-depository institutions

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 Non-depository institutions generate funds from sources other than deposit. They raise
funds by offering legal contracts, selling shares to the public, borrowing in the money
market and issuing long term debt.
Non-depository institutions include finance companies, mutual funds, pension funds,
insurance companies, investment banks.
 Finance companies: financial intermediaries that make loans to both individuals and
businesses. Unlike depository institutions, finance companies do not accept deposits but
instead rely on short and long term debt for funding.
 Mutual funds: mutual funds (one type of investment companies) are financial
intermediaries that sell shares to the public and invest the proceeds in a diversified
portfolio of securities.
The distinct feature of mutual funds is that persons owning shares in the fund have a right
to sell them back to the fund at their current asset value whenever they wish to do so.
Mutual shares are not traded in secondary markets.
 Pension funds: are financial institutions that offer savings plans through which fund
participants accumulate savings during their working years before withdrawing them
during their retirement years. Funds originally invested in and accumulated in a pension
fund are exempt from current taxation.
The employers also contribute to this fund to undertake their social obligation and to
ensure the welfare of their ex-employees.
There are two basic and widely used types of pension plans:
i. Defined benefit plan i. ii. Defined contribution plan
 Insurance companies: are financial institutions that protect individuals and corporations
(policy holders) from adverse events.
Insurance companies provide insurance policies, which are legally binding contracts for
which the policy holder (owner) pays insurance premiums.
Insurance companies can be divided into 2
i. Life insurance i. ii. Property and casualty insurance
 Investment bank: investment banking involves the raising of debt and equity securities
for corporations or governments. This includes the origination, underwriting, and
distribution of issues of new securities.

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 Investment banking also includes corporate finance activities such as advising on mergers
and acquisitions, as well as advising on restructuring of existing corporations.

Functions of Financial Institutions

The great importance of the financial system in our daily lives can be illustrated by
reviewing the different functions that it performs. The global financial system has seven
basic economic functions that create a need for money and capital market.
i. Savings Function
 The global system of financial markets and institutions provide a conduit for the public’s
savings.
 Bonds, stocks, and other financial claims sold in the money and capital markets provide a
profitable, relatively low risk outlet for the public’s savings, which flow through the
financial markets into investment so that more goods and services can be produced (i.e.,
productivity will rise), increasing the worlds standard of living.
 When savings decline, investment and living standards begin to fall in those nations where
savings are in short supply.
ii. Wealth Function
 While current savings represent a flow of funds, accumulated savings built up over time
represent a stock of assets that we often refer to as wealth.
 For those businesses and individuals choosing to save, the financial instruments sold in the
money and capital markets provide an excellent way to store wealth (i.e., preserve the
value of assets we hold) until funds are needed for spending.
 Although we might choose to store our wealth in “things” (e.g., automobiles), such items
are subject to depreciation and often carry great risk loss. However, bonds, stocks, and
other financial instruments do not wear out over time and usually generate income;
moreover, their risk of loss often is much less than for many other forms of stored wealth.
iii. Liquidity Function
For wealth stored in financial instruments, the global financial market place provides a
means of converting those instruments into cash with little risk of loss.
The world’s financial markets provide liquidity (immediately spendable cash) for savers
who hold financial instruments but in need of money.

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 In modern societies, money consists mainly of currency and a deposit held in banks,
credit unions, and other depository institutions and is the only financial instrument
possessing perfect liquidity.
iv. Credit Function
In addition to providing liquidity and facilitating the flow of savings into investment to
build wealth, the global financial markets furnish credit to finance consumption and
investment spending.
Credit consists of a loan of funds in return for promise of future payment.
v. Payments Function
The global financial system also provides a mechanism for making payments for
purchases of goods and services.
Certain financial assets-including currency, non-interest bearing checking accounts
(referred to as demand deposits), and interest bearing checking accounts (referred to as
negotiable order of withdrawal or NOW accounts)-still serve as a popular medium of
exchange in making payments all over the globe.
Also high on the payments list are plastic debt and credit cards issued by banks, credit
unions, and retail stores. Indeed, electronic means of payments are growing rapidly today,
while checks and other paper-based means of payment are declining in volume.
vi. Risk Protection Function
The financial markets offer businesses, consumers, and governments’ protection against
life, health, property, and income risks. This is accomplished, first of all, by the sale of
insurance policies.
The financial system permits individuals and institutions to engage in both risk sharing
and risk reduction.
Risk sharing occurs when an individual or institution transfers risk exposure to someone
willing to accept that risk (such as an insurance company).
Risk reduction usually takes place when we diversify our wealth across a wide variety of
different assets so that our overall losses are likely to be more limited.
vii. Policy Function

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 In recent decades, the financial markets have been the principal channel through which
government has carried out its policy of attempting to stabilize the economy and avoid
inflation.
By manipulating interest rates and the availability of credit, government can affect the
borrowing and spending plans of the public, impacting the growth of jobs, production, and
prices. This task of economic stabilization has been given largely to central banks.

Role of Financial Institutions

 Financial institutions are needed to resolve the problems caused by market imperfections.
 They accept funds from surplus unit and channel the funds to deficit unit.
 It reduces information and transaction costs of financial market transactions.

Money and Characteristics of a Developed Money Market

 Any financial asset that is generally accepted in payment for purchase of goods and
services is money.
 Money is a coin or paper notes every one accepted as a medium of exchange for goods
and services.
 The most important financial asset in the economy is money – one of the oldest and most
useful inventions in the history of the world.
 Metallic coins served as money for many centuries until paper notes ( currency) first
appeared in china during tang dynasty over a thousand years ago ( 618-907 C.E.) and in
Sweden in 1661.
 The federal government of the United States did not issue paper money until 1861.
 The money market is the mechanism through which holders of temporary cash surpluses
meet holders of temporary cash deficits.
 The money markets, short term debt instruments ( those with an original maturity of one
year or less) are issued by economic units that require short term funds and are purchased by
economic units that have excess short term funds.
 A variety of money market securities are issued by corporations and government units to
obtain short term funds. These securities include:
 Treasury bills  Federal funds

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  Repurchase agreements  Negotiable certificates of deposits
 Commercial paper  Bankers acceptance
A. Treasury Bills: short term obligations issued by the government.
B. Federal Funds: short term funds transferred between financial institutions usually for no
more than one day.
C. Repurchase Agreements: agreements involving the sale of securities by one party to
another with a promise to repurchase the securities at a specified date and price.
D. Commercial Paper: short term unsecured promissory notes issued by a company to raise
short tern cash.
E. Negotiable Certificates of Deposits: bank-issued time deposit that specifies an interest
rate and maturity date and is negotiable (saleable on a secondary market).
F. Bankers Acceptance: time drafts payable to a seller of goods, with payment guaranteed
by a bank.

Characteristics of a developed money market

Money markets and money market instrument (securities) have three basic characteristics:

1. Money market instruments are generally sold in large denominations ( often in units of $
1 million to $ 10 million)
2. Money market instruments have low default risk
3. Money market securities must have an original maturity of one year or less.

9. FINANCIAL INSTITUTIONS IN THE FINANCIAL SYSTEM

 Financial institutions are business organizations that act as mobilisers and depositories of
savings, and as purveyors of credit or finance.
 They also provide various financial services to the community. They differ from non
financial business organizations in respect of their wares, i.e., while the former deal in financial
assets such as deposits, loans, securities and so on.
And the latter deal in real assets such as machinery, equipment, stocks of goods, real estate and
so on.

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 The activities of different financial institutions may be either specialized or they may
over lap; quite often they overlap.
 Financial institutions provide various types of financial services in an economy. Financial
intermediaries are a special group of financial institutions that obtain funds by issuing claims to
market participants and use these funds to purchase financial assets.

Classification of Financial Institutions

 Financial institutions may be grouped in a variety of different ways. One of the most
important distinctions is
1. Depository institutions:
 Commercial banks  Saving banks and
 Savings and loan  Credit unions
associations
Depository institutions derive the bulk of their loanable funds from deposit accounts sold to the
public.

2. Contractual institutions:
 Insurance companies  Pension funds

Contractual institutions attract funds by offering legal contracts to protect the saver against risk
(such as insurance policy).

3. Investment institutions
 Mutual funds and  Real estate investment trusts

Investment institutions sell shares to the public and invest the proceeds in stocks, bonds and
other assets in the hope of providing higher returns to their shareholders.

3.2 Portfolios of Financial Institutions

 The management of financial institution is called on daily to make portfolio decisions.
I.e. deciding what financial assets to buy or sell.
 A number of factors affect these critical decisions. For example, the relative rate of return
and risk attached to different financial assets will affect the compositions of each financial
institution’s portfolio

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 If the management is interested in maximizing profits and has minimal aversion to risk, it
will tend to pursue the highest yielding financial assets available, such as corporate bonds and
stocks.
 A more risk adverse institution on the other hand, is likely to surrender some yield in
return for the greater safety available from acquiring gov’t bonds and high quality money
market instruments.
 The cost, volatility, and maturity of incoming funds provided by surplus –budget units
also have a significant impact on the financial assets acquired by financial institutions.
Commercial banks,for instance, derive a substantial portion of their funds from checking
accounts ,which are relatively in expensive but highly volatile. Such an institution will tend to
concentrate its lending activities in short and medium term loans to avoid an embarrassing
shortage of cash (liquidity).
 On the other hand, a financial institution such as a pension fund, which receives a stable
and predictable in flow of savings, is largely freed from concern over short term liquidity needs.
It is able to invest heavily in long term financial assets.
 Decisions on what financial assets to acquire and what financial assets to issue to the
public are also influenced by the size of the individual financial institution.
 Larger institutions frequently can take advantage of greater diversification in their
sources and uses of funds. This means that the overall risk of a portfolio of financial assets can
be reduced by acquiring financial assets from many different borrowers.
 Similarly, a larger financial institution can contact a borrower range of savers and achieve
greater stability in its incoming flows of funds.
 At the same time, through economies of scale (size), larger financial institutions can often
sell financial services at lower cost per unit and pass those cost savings along to their customers.
 Finally, regulations and competition, two external forces, play major roles in shaping the
financial assets acquired and issued by financial institutions.
 Because they hold the bulk of the public’s savings and are so crucial to economic growth,
financial intermediaries are among the most heavily regulated of all business firms.
o Commercial banks are prohibited from investing in low quality or highly volatile loans
and securities in many countries.

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o Insurance companies and pension funds must restrict asset purchases to those a” prudent
person” would most likely choose. Such regulations are designed primarily to ensure the safety
of the public’s funds.

MAJOR DEPOSITORY INSTITUTIONS

 Depository institutions are financial intermediaries that acquire the

bulk of their funds by offering their liabilities to the public mostly in the form of deposits.
Once they raise funds through deposits and other funding sources, depository institutions
both make direct loans to various entities and invest in securities.
 All depository institutions accept deposit. The major difference
among these types of institutions lies in how they are owned and in the sources and uses of
funds.
 The income of depository institutions is derived from two sources:
 The income generated from the loans they make and The
securities they purchase
 Fee income
 Depository institutions are highly regulated because of the vital
role that they play in the country’s financial system.
 Demand deposit accounts are the principal means that individuals
and business entities use for making payments and
 Gov’t monetary policy is implemented through the banking
system.
 Because of uncertainty about the timing and /or the amount of the
cash outlays, a depository institution must be prepared to have sufficient cash to satisfy
withdrawals of funds by depositors and to provide loans to customers.

Commercial Banks

 The dominant privately owned financial institution in the economies of most

major countries is the commercial bank. This institution offers the public both deposit and
credit services, as well as a growing list of newer and more innovative services, such as
investment advice.

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  Commercial banks are the financial department stores of the financial system.
They offer a wider array of financial services than any other form of institution; meeting the
credit, payments, savings needs of individuals, businesses and governments.

Uses of Funds by Commercial Banks

1. Cash and Due from Banks(primary reserves)

o All commercial banks hold a substantial part of their assets in primary reserves,
consisting of cash and deposits due from other banks.
2. Security Holdings and Secondary reserves
o Commercial banks hold securities acquired in the open market as a long term
investment and also as a secondary reserve to help meet short run cash needs. For many
banks, municipal securities (bonds and notes issued by state, city and other local
governments) represent the largest portion of security investments. In addition to municipal
securities, investment in treasury obligations (including bills, notes and bonds) are also
assets of banks.
o Under existing regulations, commercial banks are forbidden to purchase corporate
stock. However, banks do hold small amounts of corporate stock as collateral for loans.
3. Loans
o The principal business of commercial banks is to make loans to qualified
borrowers. Loans are among the highest yielding assets a bank can add to its portfolio, and
they provide the largest portion of operating revenue.

The Sources of Funds for Banks include: deposits, non deposit borrowing, common stock
and retained earnings. Banks are highly leveraged financial institutions. The bulk of
commercial bank funds (80% or more) come from deposits. Equity capital (net worth)
supplied by a bank’s stockholders provides only a minor portion (about 6% on average) of
total funds for most banks today.

DEPOSITS

There are several types of deposit accounts. Some of these include:

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 1. Demand Deposit, also called Checking Accounts, is the principal means of
making payments because they are safer than cash and widely accepted. Demand deposits
pay no interest and can be withdrawn up on demand.
2. Savings Deposits pay interest, typically below market interest rates, do not have a
specific maturity, and usually can be withdrawn up on demand.
3. Time Deposits, also called certificates of deposit, have a fixed maturity date and
offer the highest interest rates a bank can pay.

NON DEPOSIT BORROWING

 Non deposit borrowing include borrowing reserves in the federal funds market,
borrowing from the federal reserve bank, and borrowing by the issuance of instruments in
the money and bond markets.
1. Reserve Requirements and Borrowing in the Federal Funds Market:
o A bank cannot invest birr 1 for every birr 1 it obtains in deposit.
o All banks must maintain a specified percentage of their deposits in a non interest
bearing account at the federal reserve bank or as cash in the bank’s vault (i.e, currency on
hand).
o As a practical matter, banks hold most of their reserves in the form of deposits
with the Federal Reserve banks. Vault cash holdings are kept to a minimum because
insurance rates increase significantly when large amounts of vault cash are held on bank
premises and no interest is earned on these cash holdings.
 Each bank’s legal reserves may be divided into two categories:
Required Reserves and Excess Reserves
o Required Reserves are equal to the legal reserve requirement ratio times the
volume of deposits subject to reserve requirements.
o Excess Reserves equal to the difference between the total legal reserves actually
held by a bank (actual reserves) and the amount of its required reserves.

BORROWING FROM THE FEDERAL RESERVE BANK:

 The Federal Reserve Bank is the bankers’ bank or the bank of last resort. Banks
temporarily short of funds can borrow from the Federal Reserve Bank. Collateral is

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necessary to borrow and the Federal Reserve Bank establishes (and periodically changes)
the type of collateral that is eligible.

Equity Capital

 Banks can raise funds by issuing common stock. They can also use their retained
profits. However, banks highly rely on borrowings rather than equity capital.

Regulation

 Commercial banks do have a vital role in the financial system of a country and
hence they are highly regulated and supervised.
 The regulations cover the following areas:
o Ceilings imposed on the interest rates that can be paid on deposit accounts.
o Geographical restrictions on branch banking
o Permissible activities for commercial banks
o Capital requirements for commercial banks

NON BANK THRIFT INSTITUTIONS

 Many non bank financial institutions are becoming increasingly like commercial
banks and are competing for many of the same customers.
A. Savings and Loan Associations(S and Ls)
 Are among the largest of all thrift institutions, accepting deposits and extending
loans and other services primarily to household customers. S and Ls emphasize longer term
loans to individuals and families. They are the major sources of mortgage loans to finance
the purchase of homes.
 Competition from commercial banks coupled with unstable interest rates and
many failures have forced S and Ls to diversify their operations.
 The acceptable list of investments now includes
 Consumer loans such as loans for home improvement, loans for automobile, loans
for education and loans for credit cards
 Non consumer loans, such as commercial, corporate, business or agricultural
loans

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  Municipal securities
 Savings and loan associations are not permitted to invest in junk bonds (highly
risky bonds).

Sources of Funds for S and Ls

 The sources of funds for S and Ls consist of passbook savings accounts, time
deposits and negotiable order of withdrawal accounts. S and Ls can also raise funds in the
money market (example: they can use repurchase agreement market, borrow in the federal
funds market) and the bond market.
B. Saving Banks
 Saving banks are similar to S and Ls although they are much older than S and Ls.
These institutions play an active role in the residential mortgage market, as do savings and
loan associations, but are more diversified in their investments: purchasing corporate bonds
and common stock, treasury and government agency securities, making consumer loans and
investing in commercial mortgage.

Sources of Funds for saving banks

 The principal source of funds for saving banks is deposits. Saving banks
offer the same types of deposit accounts as S and Ls.
C. Credit Unions
 Credit unions are institutions established to provide credit to individuals
who share common bond such as working in the same organization, belonging to the same
association or neighborhood. They are the smallest of depository institutions even though
they are many in number. The members of credit union provide the funds primarily in the
form of saving accounts.
 Credit unions are exclusively household oriented intermediaries offering
their deposit and credit services to individuals and families.
 Their rapid growth stems mainly from being able to offer low loan rates and
high deposit interest rates to their customers and from their relatively low operating costs.
 Credit unions are cooperative, self help associations of individuals rather
than profit motivated financial institutions.

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  Saving deposits and loans are offered only to members of each association
and not to the general public. Credit unions began early in the twentieth century and are the
newest of the depository institutions.

NON DEPOSITORY FINANCIAL INSTITUTIONS

 Non depository institutions include contractual institutions and investment

institutions. They raise funds by offering legal contracts, selling shares to the public,
borrowing in the money market and issuing long term debt.
a. Contractual Institutions
1. Insurance Companies
 Insurance companies provide insurance policies, which are legally binding
contracts for which the policy holder pays insurance premiums. According to the insurance
contract, insurance companies promise to pay specific sums contingent on the occurrence of
future events, such as death or automobile accident. Thus, insurance companies are risk
bearers.
 Insurance companies can be divided into two:
o Life insurance
o Property and casualty insurance
 Life insurance companies today insure policy holders against three
basic kinds of risks:
o Premature death
o The danger of living too long and outlasting one’s accumulated
assets and
o Serious illness or accident
 Life insurance companies invest the bulk of their funds in long
term securities. Such as bonds, stocks and mortgage, thus, helping to fund real capital
investment by business and government.
2. Pension Funds
 Pension funds are established to provide income to retired
persons in the economy. The fund is raised through the contribution of employees who are
supposed to be the beneficiaries up on retirement. The employers also contribute to this fund

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to undertake their social obligation and to ensure the welfare of their ex employees. Those
funds are then invested in different securities.
 The major roles of pension funds are:
 It provides sustaining security to the society
 It helps in maintaining consumer market
 It becomes the source of finance for government based
investments.
 It serves the role of national economy stabilization by
investing on government bonds.
 There are two basic and widely used types of pension plans:
o Defined benefit plans and
o Defined contribution plans
 In a defined benefit plan, the plan sponsor agrees to make specified birr
payments annually to qualifying employees beginning at retirement (and some payments to
beneficiaries in case of death before retirement). These payments typically occur monthly.
 In a defined contribution plan, however, the plan sponsor is responsible
only for making specified contributions into the plan on behalf of the qualifying
participants, not specified payments to the employee after retirement.
 The amount contribution is typically either a percentage of the employee’s
salary and / or a percentage of the employer’s profits. The payments that will be made to
qualifying participants up on retirement depend on the investment performance of the funds
in which the assets are invested and are not guaranteed by the plan sponsor.
b. Investment Institutions
1. Mutual Funds
 Mutual funds are financial intermediaries that sell shares to the public and
invest the proceeds in a diversified portfolio of securities. They are a kind of financial
institution that combine the money of its shareholders and invest those funds in a wide
variety of stocks, bonds and money market instruments.
 The distinct feature of mutual funds is that persons owning shares in the
funds have a right to sell them back to the fund at their current asset value whenever they

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 wish to do so. The fund is obligated to redeem the shares it issues, and mutual shares are
not traded in secondary markets.
 The importance of these institutions in the financial system is that they
provide an easy way for individuals to invest in a diversified portfolio of financial assets.
Thus, mutual funds provide the investor with professional management of funds and
diversification of investment risk.
2. Investment Banks
 Investment banks involve in the raising of debt and equity securities for
corporations or governments. This includes the origination, underwriting and distribution of
issues of new securities. Investment banking also includes corporate finance activities such
as advising on mergers and acquisitions, as well as advising on the restructuring of existing
corporations.
 The major source of fund for investment banks is the repurchase agreement
(securities sold under agreement to repurchase). The other major source of funds is
securities sold short for future delivery.
 Investment banking firms include some of the best known names in the
financial world are :
 Morgan Stanley  Merrill lynch
 Goldman Sachs

10. INTEREST RATES IN THE FINANCIAL SYSTEM

Introduction
 Interest movements have a direct influence on the market values of debt
securities. Such as money market securities, bonds and mortgages and have an indirect
influence on equity security values. Thus, participants in financial markets attempt to anticipate
interest rate movements when restructuring their positions.
 Interest movements also affect the value of most financial institutions. The cost of
funds to depository institutions and the interest received on some loans by financial institutions
are affected by interest rate movements. Thus, managers of financial institutions attempt to

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anticipate interest rate movements so that they can capitalize on favorable movements or
reduce their institution’s exposure to unfavorable movements.

THE THEORY OF INTEREST RATE

 There is not one interest rate in any economy for there are thousands of different
interest rates in the financial system. Even securities issued by the same borrower will often
carry a variety of interest rates.
 There are four most influential theories of the determination of the interest rate.
These are:
o Classical theory o Loanable funds theory
o Liquidity preference theory o Rational expectations theory
a. Classical Theory of Interest Rates
 One of the oldest theories concerning the determinants of the pure or risk free
interest rate is the classical theory of interest rates, developed during the 19 th and early 20th
centuries by a number of British economists and elaborated on by Irving Fisher (1930) and
others more recently.
 The classical theory argues that the rate of interest is determined by two forces.
 The supply of savings, derived mainly from households.
 The demand for investment capital, coming mainly from the business sector.

Saving by Households

 Most saving in modern economies is carried out by individuals and families. For
these households saving is simply abstinence from consumption spending.
 In making the decision on the timing and amount of saving to be done,
households typically consider several factors:
 The size of current and long term(permanent) income
 The desired saving target and
 Set aside in the form of savings
 Generally, the volume of household saving rises with income. Higher income
families and individuals tend to save more and consume less relative to their total income than
families and with lower income.

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  Although income levels probably dominate saving decisions, interest rates also
play an important role. Interest rates affect an individual’s choice between current consumption
and saving for future consumption.
 The classical theory of interest assumes that individuals have a definite time
preference for current over future consumption. The only way to encourage an individual or
family to consume less now and save more is to offer a higher rate of interest on current
savings. The classical theory considers the payment of interest a reward for waiting.

Investment by Business sector

 Businesses require huge amounts of funds each year for investment on equipment,
machinery, inventories and to support the construction of new buildings and other physical
facilities. The maximum that a firm will invest depends on the rate of interest, which is the cost
of loans. The firms demand for borrowing is negatively related to the interest rate. If the rate is
high, only limited borrowing and investment declines. At a low rate more projects offer a
profit, and the firm wants to borrow more.

Limitations of the Classical theory of Interest

The classical theory sheds considerable light on the factors affecting interest rates.
However, it has some serious limitations.

 The central problem is that the theory ignores several factors other than saving
and investment which affect interest rates. For example, commercial banks have the power to
create money by making loans to the public.
o When borrowers repay their bank loans, money is destroyed. The amount of
money created or destroyed affects the total amount of credit available in the financial market
place.
 In addition, the classical theory assumes that interest rates are the principal
determinants of the quantity of savings available. Today, economists recognize that income is
far more important in determining the volume of saving.
 Finally, the classical theory contends that the demand for borrowed funds comes
principally from business sector. Today, however, both consumers and governments are
important borrowers, significantly affecting credit availability and cost.

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 b. Liquidity Preference theory of Interest Rates
 The liquidity preference theory, originally developed by John Maynard Keynes,
analyzes the equilibrium level of the interest rate through the interaction of the supply of
money and the public’s aggregate demand for holding money. In the theory of liquidity
preference, only two outlets for investor funds are considered- bonds and money.
 For Keynes, money is equivalent to currency and demand deposits, which pay
little or no interest but are liquid and may be used for immediate transactions. Bonds include
long term, interest paying financial assets that are not liquid and that pose some risk because
their prices vary inversely with the interest rate level. Bonds may be liabilities of governments
or firms.
 Keynes observed that the public demands money for three different purposes
(motives).
 The transaction motive: represents the demand for money in order to purchase
goods and services. Because inflows and outflows of money are not perfectly synchronized in
timing or amount. So, households, businesses and governments must keep some money simply
to meet daily expenses.
 Precautionary motive: some money also must be held as a reserve for future
emergencies and to cover extra ordinary expenses. This precautionary motive arises because
we live in a world of uncertainty and cannot predict exactly what expenses or opportunities
will arise in the future.
 Speculative motive: the third motive for holding money stems from uncertainty
about the future prices of bonds.
 The total demand for money in the economy is simply the sum of transactions,
precautionary and speculative demands.
 Although money pays no interest, the demand for money is a negative function of
the interest rate.
 At a low rate, people hold a lot of money because they do not lose much interest
by doing so and because the risk of a rise in rates (and a fall in the value of bonds) may be
large. With a high interest rate, people desire to hold bonds rather than money, because the cost
of liquidity is substantial in terms of lost interest payments and because a decline in the interest
rate would lead to gains in the bonds’ values.

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  For Keynes, the supply of money is fully under the control of the central bank.
The money supply is not affected by the level of the interest rate. Liquidity preference theory
illustrates how central banks can influence interest rates in the financial markets, at least in the
short term. For example, if higher interest rates are desired, the central bank can contract the
size of the money supply and interest rates will tend to rise (assuming the demand for money is
unchanged). If the demand for money is increasing, the central bank may be able to bring about
higher interest rates by ensuring that the money supply grows more slowly than money
demand. In contrast, if the central bank expands the money supply, interest rates may decline
in the short term (provided the demand for money does not increase).

Limitations of the liquidity Preference theory

 Like the classical theory of interest, liquidity preference theory has limitations.
 It is a short term approach to interest rate determination unless modified because
it assumes that income remains stable. In the longer term, interest rates are affected by changes
in the level of income and by inflationary expectations. Indeed, it is impossible to have a stable
equilibrium interest rate without also reaching an equilibrium level of income, saving and
investment in the economy.
 Also, liquidity preference considers only the supply and demand for the stock of
money, where as business, consumer and government demands for credit clearly have an
impact on the cost of credit. A more comprehensive view of interest rates is needed that
considers the important roles played by all actors in the financial system.
c. The Loanable Funds Theory of Interest
 A view that overcomes many of the limitations of earlier theories is the loanable
funds theory. It is the most popular interest rate theory among practitioners and those who
follow interest rates “on the street.”
 The loanable funds theory argues that the risk free interest rate is determined by
the inter play of two forces: the demand for and supply of credit(loanable funds)
 The demand for loanable funds consists of credit demands from domestic
businesses, consumers, governments and borrowing in the domestic market by foreigners.

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  The supply of loanable funds stems from domestic savings, dishoarding of money
balances, money creation by the banking system and lending in the domestic market by foreign
individuals and institutions.

Total Demand for Loanable funds

 The total demand for loanable funds is the sum of domestic consumer business,
government credit demands and foreign credit demands. Higher rates of interest lead to some
businesses, consumers and governments to curtail their borrowing plans. Lower rates of
interest bring forth more credit demand. However, the demand for loanable funds does not
determine the rate of interest by itself. The supply of loanable funds must be added to complete
the picture.

Total Supply of Loanable funds

 The total supply of loanable funds includes domestic saving, foreign lending,
dishoarding of money and new credit created by the domestic banking system.
d. The Rational Expectations theory of Interest
 In recent years, a fourth major theory about the forces determining interest rates
has appeared: the rational expectations theory of interest rates. This theory builds on a growing
body of research evidence that the money and capital markets are highly efficient institutions
in digesting new information affecting interest rates and security prices. For example, when
new information appears about investment, saving or the money supply, investors begin
immediately to translate that new information into decisions to borrow or lend funds.
 This expectations theory assumes that businesses and individuals are rational
agents who attempt to make optimal use of the resources at their disposal in order to maximize
their returns. Moreover, a rational agent will tend to make unbiased forecasts of future asset
prices, interest rates and other variables.
 Knowledge of past interest rates – for example, those that prevailed yesterday or
last month will not be a reliable forecast of where those rates are likely to be in the future.
Indeed, the rational expectations theory suggests that, in the absence of new information, the
optimal forecast of next period’s interest rate would probably be equal to the current period’s
interest rate because there is no particular reason for the next period’s interest rate to be either

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higher or lower than today’s interest rate until new information causes market participants to
revise their expectations. Old news will not affect today’s interest rates because those rates
already have impounded the old news.
 Interest rates will change only if entirely new and unexpected information
appears. For example, if government announces for several weeks running that it must borrow
an additional $ 10 billion next month, interest rates probably reacted to that information the
first time it appeared.
 How do we know which direction rates will move? Clearly, the path interest rates
take depends on what market participants expected to begin with.
 The rational expectation theory is a modification over the loanable funds theory.
The rational expectations theory considers on the determination of interest rates not only the
actual demand and supply but also the expected demand for and supply of loanable funds.
 The rational expectations theory argues that forecasting interest rates requires
knowledge of the public’s current set of expectations. Indeed, to be a consistently correct
interest rate forecaster under the rational expectations theory you must know:
 What market participants expect to happen and
 What new information will arrive in the market before that information actually
arrives. That is a tall order!
 Nevertheless, the rational expectations view is still in the development stage. One
key problem is that we do not know very much about how the public forms its expectations –
what data are used, what weights are applied to individual bits of data and how fast people
learn from their forecasting mistakes.
 Moreover, several characteristics of real world markets seem at odds with the
assumptions of the expectations theory. For example, the cost of gathering and analyzing
information relevant to the pricing of assets is not always negligible.

11. FINANCIAL MARKETS IN THE FINANCIAL SYSTEM

 In order to finance their operations as well as expand, businesses must invest
capital in amounts that are beyond their capacity to save in any reasonable period of time.
Similarly, governments must borrow large amounts of money to provide the goods and
services that the people demand of them. The financial markets permit both businesses and

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governments to raise the needed funds by selling securities. Simultaneously, investors with
excess funds are able to invest and earn a return, enhancing their welfare.
 A financial market, like any market, is just a way of bringing buyers and sellers to
gather. In financial markets, it is financial assets such as debt and equity securities are bought
and sold. Financial markets differ in detail, however. The most important differences concern
the types of securities that are traded, how trading is conducted and who the buyers and sellers
are.

Primary versus Secondary Markets

 Financial markets function as both primary and secondary markets for securities.
The term primary market refers to the original sale of securities by governments and
corporations. The secondary markets are those in which these securities are bought and sold
after the original sale. Equities are, of course, issued solely by corporations. Debt securit ies are
issued by both governments and corporations.

Primary Market

 A primary market is one in which a borrower issues new securities in exchange

for cash from an investor (buyer). The issuers of these new securities receive cash from the
buyers of these new securities, who in turn receive financial claims that previously did not
exist. If the issuer is selling securities for the first time, these are referred to as initial public
offerings (IPO).
 In general, the primary market involves the distribution to investors of newly
issued securities by central gov’ts and corporations. The participants in the market place that
work with issuers to distribute newly issued securities are called investment bankers.
Investment bankers perform one or more of three functions:
 Advising the issuer on the terms and timing of the offering
 Buying the securities from the issuer and
 Distributing the issue to investors
 Once the original buyers sell the securities, they traded in the secondary markets.
Outstanding securities may trade repeatedly in the secondary market, but the original issuer
will be unaffected in the sense that they receive no additional cash from these transactions.

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 The Underwriting Process

 Underwriting means act of guaranteeing a specific price to the initial issuer of

securities. Underwriting securities can be undertaken in various ways including the bought deal
for the underwriting of bonds, the auction process for both stocks and bonds, and rifhts offering
for underwriting common stock.

Auction Process

 This method, the issuer announces the terms of the issue, and interested parties
submit bids for the entire issue. It is more commonly referred to as a competitive bidding
underwriting. For instance, suppose that a public utility wishes o issue 20 million birr of bonds.
Various underwriters will form syndicates and bid on the issue. The syndicate that bids the
lowest yield (i.e. the lowest cost to the issuer) wins the entire 20 million birr bond issue and
then re offers to the public.

Secondary Market

 A secondary market transaction involves one owner or creditor selling to another.

It is therefore, the secondary markets that provide the means for transferring ownership of
corporate securities. Although a corporation is only directly involved in a primary market
transaction (when it sells securities to raise cash), the secondary markets are still critical to
large corporations. The reason is that investors are much more willing to purchase securities in
a primary market transaction when they know that those securities can later be resold if
desired.
 Thus, the existence of well functioning secondary markets, where investors come
together to trade existing securities, assures the purchase of primary securities that they can
quickly sell their securities if the need arises. Of course, such sales may involve a loss because
there are no guarantees in the financial markets.
 The key distinction between primary and secondary markets is that, in the
secondary market, the issuer of the assets does not receive funds from the buyer. Rather, the
existing issue changes hands in the secondary market, and funds flow from the buyer of the
asset to the seller.

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 Money Market

 The money market, like all financial markets, provides a channel for the exchange
of financial assets for money. However, it differs from other parts of the financial system in its
emphasis upon loans to meet purely short term cash needs. The money market is the
mechanism through which holders of temporary cash surplus meet holders of temporary cash
deficits.
 It is designed, on the one hand, to meet the short run cash requirements of
corporations, financial institutions, and gov’ts, providing a mechanism for granting loans as
short as overnight and as long as one year to maturity. At the same time, the money market
provides an investment outlet for those units (principally corporations, financial institutions
and gov’ts) that hold surplus cash for short periods of time and wish to earn at least some
return on temporary idle funds.
 The essential function of the money market is to bring these two groups in to
contact in order to make borrowing and lending possible.

Types of money Market Instruments

1. Treasury Bills
 Treasury bills are issued by the treasury department of the gov’t and backed by
full faith and credit of the gov’t. As a result, treasury bills carry no risk of default. The market
for treasury bills is the most liquid in the world.
 A treasury bill is a discount security. Such security does not make periodic
interest payments. The security holder receives interest instead at the maturity date, when the
amount received is the face value (maturity value or par value) which is larger than the
purchase price. For example, assume an investor purchases a 182 day treasury bill that has a
face value of birr 100,000 for birr 90,000. By holding the bill until maturity date, the investor
will receive birr 100,000; the difference of birr 4000 between the proceeds received at maturity
and the amount paid to purchase the bill represents the interest.
2. Commercial Paper
 Commercial paper is a short term unsecured promissory note that is issued in the
open market and represents the obligation of the issuing corporation. The issuance of

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commercial paper is an alternative to bank borrowing for large corporations (non financial and
financial) with strong credit ratings.
 Commercial paper, like treasury bills, is a discount instrument. Despite the fact
that the commercial paper market is larger than markets for other money markets instruments.
Secondary trading activity is much smaller.
 The yield on commercial paper is higher than treasury bills for the same maturity.
There are three reasons: first, unlike treasury bills, the investor in commercial paper is exposed
to credit risk. Second, interest on treasury bills is exempted from tax; however, interest on
commercial paper is taxable. To offset this tax advantage, commercial paper should offer
higher yield. Third, commercial paper is less liquid than treasury bills.
3. Bankers’ Acceptances
 A banker’s acceptance is a vehicle created to facilitate commercial trade
transactions. The instrument is called a banker’s acceptance because a bank accepts the
ultimate responsibility to repay a loan to its holder.
 Bankers’ acceptances are sold on a discounted basis just as treasury bills and
commercial paper. The major investors in banker’s acceptance are money market mutual funds
and municipal entities.
 Investing in banker’s acceptance exposes the investor to credit risk. This is the
risk that neither the borrower nor the accepting bank will be able to pay the principal due at the
maturity date. Bankers’ acceptances have higher yields than treasury bills. The higher yield
relative to treasury bills also includes a premium for relative illiquidity.
4. Certificate of Deposits( CDs)
 A certificate of deposit is a financial asset issued by a bank or thrift that indicates
a specified sum of money has been deposited at the issuing depository institution. Certificates
of deposits are issued by banks and thrifts to raise funds for financing their business activities.
A certificate of deposit bears a maturity date and a specified interest rate and can be issued in
any denomination.
 A certificate of deposit may be non negotiable or negotiable. In the former case,
the initial depositor waits until the maturity date of the certificate of deposit to obtain the funds.
If the depositor chooses to withdraw funds prior to the maturity date, an early withdrawal
penalty is imposed.

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  In contrast, a negotiable certificate of deposit allows the initial depositor (or any
subsequent owner of the CD) to sell the CD in the open market prior to the maturity date.
 Unlike treasury bills, commercial paper and bankers acceptance, yields on CDs
are quoted on an interest bearing basis.
5. Repurchase Agreements
 A repurchase agreement is the sale of a security with a commitment by the seller
to buy the security back from the purchaser at a specified price at a designated future date.
Basically, a repurchase agreement is a collateralized loan, where the collateral is a security.
When the term of the loan is one day, it is called “overnight repo”, a loan for more than one
day is called a “term repo”.
6. Federal Funds
 As it is explained in the earlier chapter 3, depository institutions are required to
maintain reserves. The reserves are deposits at the Federal Reserve Bank, which are called
federal funds.
 No interest is earned on federal funds. Consequently, a depository institution that
maintains federal funds in excess of the amount required incurs an opportunity cost- the loss of
interest income that could be earned on the excess reserves.

Equity Market

 Equity security is a certificate of ownership in a corporation- residual claim

against both the assets and the earnings of a business firm. All corporate stock represents an
ownership interest in a corporation, conferring on the holder a number of important rights and
privileges as well as risks.
1. Common Stock
 The most important form of corporate stock is common stock. Like all forms of
equity, common stock represents a residual claim against the assets of the issuing firm,
entitling the owner to a share in the net earnings of the firm when it is profitable and to share
in the net market value (after all debts are paid) of the company’s assets if it is liquidated.
 By owning common stock the investor is subject to the full risks of ownership,
which means that the business may fall to unacceptable levels.
2. Preferred Stock

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  The other major form of stock issued today is preferred stock. Each share of
preferred stock carries a stated annual dividend expressed as a percent of the stock’s par value.
 Preferred stock holders have a prior claim over the firm’s assets and earnings
relative to the claims of common stock holders.

Where Stocks Trading Occur?

 The four major types of markets on which stocks are traded referred to as follows:
 First market - trading on exchanges of stocks listed on an exchange
 Second market – trading in the OTC market of stocks not listed on an exchange
 Third market – trading in the OTC market of stocks listed on an exchange
 Fourth market – private transactions between institutional investors who deal
directly with each other without utilizing the services of a broker – dealer intermediary.

Debt Market

 Equity (stocks) and debt (notes, bonds and mortgages) instruments with maturities
of more than one year trade in capital markets. Bonds are long term debt obligations issued by
corporations and gov’t units. Proceeds from a bond issue are used to raise funds to support long
term operations of the issuer (example, for capital expenditure projects).

Bond Markets

 Bond markets are markets in which bonds are issued and traded. They are used to
assist in the transfer of funds from individuals, corporations and gov’t units with excess funds
to corporations and gov’t units in need of long term debt funding.
 Bond markets are traditionally classified into three types:
1. Treasury notes and bonds 3. Corporate bonds
2. Municipal bonds and
1. Treasury Notes and Bonds
 Treasury notes and bonds (T-notes and T-bonds) are issued by the treasury
department of the gov’t and are used to finance the gov’t deficits or expenditures. Like T-bills,
T-notes and T- bonds are backed by the full faith and credit of the gov’t and are, therefore,
default risk free.

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  As a result, T-notes and bonds pay relatively low rates of interest (yield to
maturity) to investors. T-notes and bonds, however, are not completely risk free. Given their
longer maturity (i.e. duration), these instruments experience wider price fluctuations than do
money market instruments as interest rates change( and thus are subject to interest risk).
 Further, many of the older issued bonds and notes may be less liquid than newly
issued bonds and notes. T-notes have original maturities from 2 to 10 years, while T-bonds
have original maturities from over 10 to 30 years.
2. Municipal Bonds
 Municipal bonds also called ‘munis’ are securities issued by state and local gov’ts
to funds either temporary imbalances between operating expenditures and receipts or to finance
long term capital outlays for activities such as school construction, public utility construction
or transportation systems. Tax receipts or revenues generated from a project are the source of
repayment on municipal bonds. Municipal bonds are attractive to household investors since
interest payments on municipal bonds are exempt from federal income taxes.
 As a result, the interest borrowing cost to state or local gov’t is lower, because
investors are willing to accept lower interest rates on municipal bonds relative to comparable
taxable bonds such as corporate bonds.
3. Corporate Bonds
 Corporate bonds are all long term bonds issued by corporations. There are two
secondary markets in corporate bonds:
 The exchange market (e.g. the NYSE) and
 The Over the counter (OTC) market

Types of Markets in Which Securities are Traded

1. Organized exchanges
 Stock exchanges are formal organizations, approved, and regulated by the
securities and commission (SEC). These exchanges are physical locations where members
assemble to trade. Stocks that are traded on an exchange are said to be listed stocks. That is,
these stocks are individually approved for trading on the exchange by the exchange. The
trading mechanism on exchanges is the auction system, which results from the presence of
many competing buyers and sellers assembled in one place.

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  In the united states, there are two national stock exchanges:
 The New York stock exchange (NYSE)
 The American stock exchange (AMEX or ASE), also called the curb.
2. The OTC Market
 The OTC market is called the market for unlisted stocks. It results from
geographically dispersed traders or market- makers linked to one another via
telecommunication systems. That is, there is no trading floor. This trading mechanism is a
negotiated system where by individual buyers negotiate with individual sellers.
 The large majority of securities bought and sold around the globe, especially debt
securities are traded over the counter and not on organized exchanges. All money market
instruments are traded in the OTC markets, as are the large majority of gov’t bonds and
corporate bonds. While most common stocks are traded on the exchanges, estimated one
quarter to one third of all stocks are traded OTC market.
 The US OTC market is regulated by a code of ethics established by the National
Association of Security Dealers (Self-regulatory Organization), a private organization that
encourages ethical behavior among its members.
 Trading firms or their employees who break NASD’s regulations may be fined,
suspended, or thrown out of the organization. One of the most important contributions of
NASD has been the development of NASDAQ (the National Association of Security Dealers
Automated Quotations System).
 NASDAQ displays bid and ask prices for OTC – traded securities on video
screens connected electronically to a central computer system.
 All NASD member firms trading in a particular stock report their bid-ask price
quotations immediately to NASDAQ. This nationwide communications network allows
dealers, brokers, and customers to determine instantly the terms currently offered by major
securities dealers.
3. The Third Market
 The market for securities listed on a stock exchange but traded over the counter is
known as the third market. Broker and dealer firms not member of an organized exchange are
active in this market. The original purpose of the third market was to supply large blocks of
shares to institutional investors, especially mutual funds and pension funds.

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  The third market provides additional competition for the organized exchanges,
especially the NYSE. Moreover, along with the other OTC markets, the third market has been
a catalyst in reducing brokerage fees and promoting trading efficiency.
4. The Fourth Market
 It is not necessary for two parties to a transaction to use an intermediary. That is,
the services of a broker or a dealer are not required to execute a trade. The direct trading of
stocks between two customers without the use of a broker is called the fourth market. This
market grew for the same reasons as the third market – the excessively high minimum
commissions established by the exchanges.

12. Regulation of Financial Markets and Institutions

 The financial markets play an important role in many economies and governments
around the world have long deemed it necessity to regulate certain aspects of those
markets. Because of difference in culture and history, different countries regulate
financial markets and financial institutions in different ways, emphasizing some forms
of regulation more than others.

Differences also exist in the system of regulation and different countries adopt different system
of regulation to regulate financial markets.

THE ROLE OF THE GOVERNMENT

o In their regulatory capacities, governments have greatly influenced the development and
evolution of financial markets and institutions.
o Governments in most developed economies have created elaborate systems of regulation for
financial markets, in part because the markets themselves are complex and in part because
financial markets important to the general economies in which they operate.
o It is important to realize that governments, markets and institutions tend to be having
interactively to affect one another’s actions in a certain ways.

PURPOSE AND FORMS OF REGULATION

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 Justification for regulation

The three justifications for regulations are;

o The protection of investors

o Ensuring the markets are fair, efficient and transparent
o The reduction of systematic risk

 The three justifications for regulation are closely related and, in some respects, overlap; many
of the requirements that help to ensure fair, efficient and transparent markets also provide
investor protection and help to reduce systematic risk. Similarly, many of the measures that
reduce systematic risk provide protection for investors.

The protection of investors

 Investors should be protected from miss leading, insider trading, and the misuse of client
assets. Full disclosure of information material to investor’s decision in the most important
means for ensuring investors protection.
 Investors are thereby better able to assess the potential risks and rewards of their investments.
Disclosure requirements, accounting and auditing standards should be in place and they should
be of high and internationally acceptable quality.
 Unless investors are accorded sufficient protections they will not have faith in the system. This
lack of faith will be detrimental to build a vibrant and robust capital markets.

To sum up, regulation helps to;

a) Solve moral hazard problem- taking up unexpected activities by corporate (borrowers) after
mobilizing funds from the public affecting investor’s interests. Disclosures requirements are
good in this regard.
b) Avoid market failures due to asymmetric information. This is because of lack of proper
information for investors with regarded to direction of the market may give disincentives to
stay in the market and they might move out of the market.

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c) Limit opportunities for agents to act against the interests of their shareholders.
Agents/managers having special information may use for their own advantage at the expense of
shareholders affecting corporate governance. Thus, regulations such as laws against insider
trading could reduce the magnitude of the problem.
d) Regulate investment bankers because, if they are left free, to get more business they may join
hands with the corporate to defraud investor. Regulation such as code of conduct for
investment bankers are help full to this end.

Ensuring that markets are fair, efficient and transparent

 The fairness of the markets is closely linked to investor protection and in particular to the
prevention of improper trading practices. Market structures should not unduly favor some
market users over others, regulations should detect, deter and penalize market manipulations
and other unfair trading practices.
 In an efficient market the dissemination of relevant information is timely and wide spread and
is reflected in the price of securities. The process of regulation should promote market
efficiency.
 Transparency may be defined as the degree to which information about trading (both for pre-
trade and post –trade information) is made publicly available on a real –time basis. Pre-trade
information concerns the posting firm bids and offers as a means to enable investors to know
with some degree of certainty, whether at what price they can deal. Post-trade information
related to the prices and the volume of all individual transactions actually concluded.
Regulation should ensure the highest levels of transparency.

The reduction of systematic risk

Although regulators cannot be expected to prevent the financial failure of markets

intermediaries, regulation should aim to reduce the risk of failure. Where financial failure
nonetheless does occur, regulations should seek to reduce the impact of that failure. Market
intermediaries should, therefore, be subject to adequate and ongoing capital and other
prudential requirements.

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 Risk taking is essential to an active market and regulation should not un necessary stifle
legitimate risk taking ,rather, regulators should promote and allow for the effective
management of risk and ensure that capital and other prudential requirements are sufficient to
address appropriate risk taking ,allow the absorption of some losses and check excessive risk
taking .

Instability may result from events in ones own jurisdiction or in another jurisdiction or occur
across several jurisdictions. So, regulators should try to facilitate stability domestically and
globally through cooperation and information sharing.

FORMS OF REGULATIONS

 DISCLOSURE REGULATION

 This is the form of regulation that requires issuers of securities to make public a large amount
of financial information to actual and potential investors. The standard justification for
disclosure rules is that the managers of the issuing firm have more information about the
financial health and future of the firm than investors who own or are considering the purchase
of the firm’s securities. The cause of market failure here, if indeed it occurs, is commonly
described as systematic information. This is referred to as agency problem, in the sense that the
firm’s managers who act as agents for investors may act in their own interests to the
disadvantage of the investors.
 The advocates of disclosure rules say that in the absence of the rules the investors,
comparatively limited knowledge about the firm would allow the agents to engage in such
practices.
 It is interesting to note that several prominent economists deny the need and justification for
disclosure rules they argue that the securities market would, without governmental assistance
get all the information necessary for fair pricing of new as well as existing securities.

 FINANCIAL ACTIVITY REGULATION

It consists of rules about traders of securities and trading on financial markets. A prime
example of this form of regulation is the set of rules against trading by insiders who are

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 corporate officers and others in positions to know more about a firm’s prospects than the
general investing public.

The second example of this type of regulation would be rules regarding the structure and
operation of exchanges where securities are traded. The argument supporting these rules rests
of the possibilities that members of exchanges may be able, under certain circumstances, to
collude and defraud the general investing public.

 REGULATION OF FINANCIAL INSTITUTIONS

This is the form of governmental monitoring that restricts these institutions’ activities in the
vital areas of lending, borrowing and funding. The justification for this form of government
regulation is that financial firms have a special role to play in a modern economy. Financial
institutions help households and firms to save, they also facilitate the complex payments
among many elements of the economy. And in the case of commercial banks they serve as
conduits for the government’s monetary policy.

Thus, it is often argued that the failure of these financial institutions would disturb the
economy in a severe way.

 REGULATION OF FOREIGN PARTICIPANTS

This is that form of governmental activities that limits the roles foreign firm can have in
domestic markets and their ownership or control of financial institutions.

 REGULATIONS OF ECONOMIC ACTIVITY

Authorities use banking and monetary regulation to control changes in a countries money
supply, which is thought to control of financial institutions.

SYSTEMS OF REGULATION

Financial institutions, markets and their products are regulated through three major systems of
regulations.

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1). FEDERAL/CENTRAL REGULATION

This type of regulation involves the control of the market at the national level through
legislation or through the creation of government agencies to administer and over see the
legislations. Naturally, the sensitivity of securities market failure and the special role of
depository institutions in monetary policy place them under federal control.

Depository institutions in many countries including Ethiopia are regulated by respective central
banks.

Security markets are on the other hand regulated by the respective country such as the
Securities and Exchange Commission (SEC) of the USA.

2). SELF REGULATION ORGANIZATIONS (SRO)

Self regulation amounts to a situation where members involved in a financial activity come
together and set a code of rules and regulations to abide by in the conduct of their activity.

SROs are said to be cost effective and stable from political interference. Since SROs follows
their own rules and procedures, they are insulated from government pressure, which makes the
system more stable and long lasting.

As far as self regulation is concerned, stock exchanges take the first step through their listing
requirements. Stock exchanges employ quantitative or qualitative listing requirements to screen
out participants in the market.

Establishing government regulatory agencies involves a heavy burden and expense in terms of
money, time and man power. It also exerts considerable pressure on taxpayers, because
running such government agencies requires raising funds from the public.

Hence, Self Regulatory Organizations can generally be considered as cost effective and stable
which makes them an ideal mechanism for regulation.

3). MARKET REGULATION

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This approach is also referred to as market action and is in line with the laissez faire approach,
which tells us that the market will take care of itself. In fact what is meant by market action is
that a market should be able to regulate itself. This is especially with regard to disclosure
regulation.

Proponents of this approach contend that there is no justifications for disclosure regulation by
government assistance get all the information necessary for a fair pricing of new as well as
existing securities through its power to under price the securities of firms that do not provide
all necessary data.

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