Chapter one

1. An Overview of Financial Management

1.1. The nature and scope of financial management
1. 1.1. Introduction
To start any business we need capital/finance. Capital is the amount of money required to start a
business. The mobilization of finance is an important task for an entrepreneur because;
 Finance is one of the significant factors which determine the nature
and size of any enterprise.
 Finance is required to acquire various fixed assets and current
assets.
This is to be noted that identification of sources of finance is critical as it avoids the financial
hardships of an enterprise.

1.1.2. Meaning of finance

Finance is the study/ management of money. Finance is the science of managing financial
resources i.e. the best use of available financial sources. It is basically concerned with the nature,
creation, behavior, regulation and problems of money. It focuses on how the individuals,
businessmen, investors, government and financial institutions deal.

1.1.3. Classifications of Finance

The finance is classified into three categories

I. Personal finance

II. Public finance

III. Business finance

Personal finance: - This deals with the mobilization of funds from own sources. Here funds may
imply cash and non-cash items also.

Public finance: - This kind of finance deals with the mobilization or administration of public
funds. It includes the aspects relating to the securing the funds by the government from public
through various methods viz. taxes, borrowings from public and foreign markets.

Business finance: - Financial management actually concerned with business finance. Business
finance is pertaining to the mobilization of funds by various business enterprises. Business
finance is a broad term includes both commerce and industry. It applies to all the financial
activities of trade and auxiliaries of trade such as banking, insurances, mercantile agencies,
service organizations, and the manufacturing enterprises.
 1.1.4. Meaning of Financial Management
Financial management is one major area of study under finance. It deals with decisions made by
a business firm that affect its finances. Financial management is sometimes called corporate
finance, business finance, and managerial finance.

Financial management can also be defined as a decision making process concerned with
planning for raising, and utilizing funds in a manner that achieves the goal of a firm.

There are many specified business functions performed by a business unit. These include
marketing, production, human resource management, and financial management. Financial
management is one of the important functions of a firm. It is a specified business function that
deals with the management of capital sources and uses of a firm. Capital resources of a business
firm is obtained from two sources, i.e.

 resource owned and sacrificed by the firm (internal fund) and

 Resource borrowed and invested (external funds) by the firm.

1.1.5. Scope of Financial Management

The scope of financial management refers to the range or extent of matters being dealt with in
financial management.

Traditionally, financial management was viewed as a field of study limited to only raising of
money. Under the traditional approach, the scope and role of financial management was
considered in a very narrow sense of procurement of funds from external sources. The subject of
finance was limited to the discussion of only financial institutions, financial instruments, and the
legal and accounting relationships between a firm and its external sources of funds. Internal
financial decision makings as cash and credit management, inventory control, capital budgeting
were ignored. Simply stating, the old approach treated financial management in a narrow sense
and the financial manager as a less important person in the overall corporate management.

However, the modern or contemporary approach views financial management in a broad sense.
Corporate finance is defined much more broadly to include any business decisions made by a
firm that affect its finance. According to the modern approach, financial management provides a
conceptual and analytical framework for the three major financial decision making functions of a
firm. Accordingly, the scope of managerial finance involves the solution to investing, financing,
and dividend policy problems of a firm. Besides, unlike the old approach, here, the financial
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 increased globalization of business has expanded the scope of financial management further
to include financial decisions pertaining to the international financial environment.

1.2. Financial Markets and Institutions

1.2.2. Financial Institutions

Financial institutions are financial intermediaries, which are specialized financial firms that
facilitate the transfer of funds from savers to demanders of capital. They accept savings from
customers and lend this money to other customers or they invest it. In many instances, they pay
savers interest on deposited funds. In some cases, they impose service charges on customers for
the services they render. For example, many financial institutions impose service charges on
current accounts.

The key participants in financial transactions of financial institutions are individuals, businesses,
and government. By accepting the savings from these parties, financial institutions transfer again
to individuals, business firms, and governments. Since financial institutions are generally large,
they gain economies of scale in the transfer of money between savers and demanders. By pooling
risks, they help individual savers to diversify their risk.

The major classes of financial institutions include commercial banks, savings and loan
associations, mutual savings banks, credit unions, pension funds and life insurance companies.
Among these, commercial banks are by far the most common financial institutions in many
countries worldwide. In Ethiopia too, commercial banks are the major institutions that handle the
savings and borrowing transactions of individuals, businesses, and governments.

1.2.3. CASH FLOWS TO AND FROM THE FIRM

Suppose we start with the firm selling shares of stock and borrowing money to raise cash. Cash
flows to the firm from the financial markets. The firm invests the cash in current and fixed
assets. These assets generate cash some of which goes to pay corporate taxes. After taxes are
paid, some of this cash flow is reinvested in the firm. The rest goes back to the financial markets
as cash paid to creditors and shareholders.
Financial Markets

Financial markets are markets in which financial instruments are bought and sold by suppliers
and demanders of funds. They, unlike financial institutions, are places in which suppliers and
demanders of funds meet directly to transact business.

Functions of Financial Markets

Generally, financial markets play three important roles in functioning of corporate finance.

1. They assist the capital formation process. Financial markets serve as a way through
which firms can obtain the capital they need for their operations and investment.
 2. Financial markets serve as resale markets for financial instruments. They create
continuous liquid markets where firms can obtain the capital they need from individuals
and other businesses easily.
3. They play a role in setting the prices of securities. The price of a financial instrument is
determined through the interaction of demand and supply of the security in the financial
markets.
A financial market, like any market, is just a way of bringing buyers and sellers together. In
financial markets, it is debt and equity securities that 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. Some of these differences
are discussed next.
1.2.4. Primary versus secondary markets
Financial markets function as both primary and secondary markets for debt and equity securities.
This is based on whether the securities are new issues or have been outstanding in the market
place.

The term primary market refers to the original sale of securities by governments and
corporations. They are financial marketers in which firms raise capital by issuing new securities.
The secondary markets are those in which these securities are bought and sold after the original
sale. A secondary market transaction involves one owner or creditor selling to another.
Therefore, the secondary markets provide the means for transferring ownership of corporate
securities. They are financial markets in which existing and already outstanding securities are
traded among investors. Here the issuing corporation does not raise new finance
1.2.5. Money markets vs. Capital markets
This is based on the maturity dates of securities

Money Markets - are financial markets in which securities traded have maturities of one-year or
less. Examples of securities traded here include treasury bills, commercial papers, and short –
term promissory notes and so on.
Capital Markets - are financial markets in which securities of long-term funds are traded. Major
securities traded in capital markets include bonds, preferred and common stocks.

1.3. Financial Management Decisions

As the preceding discussion suggests, the financial manager must be concerned with three basic
types of questions. We consider these in greater detail next.
Capital Budgeting The first question concerns the firm’s long-term investments. The process of
planning and managing a firm’s long-term investments is called capital budgeting.
In capital budgeting, the financial manager tries to identify investment opportunities that are
worth more to the firm than they cost to acquire. Loosely speaking, this means that the value of
the cash flow generated by an asset exceeds the cost of that asset.
The types of investment opportunities that would typically be considered depend in part on the
nature of the firm’s business.
Regardless of the specific nature of an opportunity under consideration, financial managers must
be concerned not only with how much cash they expect to receive, but also with when they
expect to receive it and how likely they are to receive it. Evaluating the size, timing, and risk of
future cash flows is the essence of capital budgeting.
Capital Structure The second question for the financial manager concerns ways in which the
firm obtains and manages the long-term financing it needs to support its long-term investments.
A firm’s capital structure (or financial structure) is the specific 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? That is, what mixture of debt and equity is best?
The mixture chosen will affect both the risk and the value of the firm. Second, what are the least
expensive sources of funds for the firm?
The firm’s capital structure determines what percentage of the firm’s cash flow goes to creditors
and what percentage goes to shareholders. Firms have a great deal of flexibility in choosing a
financial structure. The question of whether one structure is better than any other for a particular
firm is the heart of the capital structure issue.
In addition to deciding on the financing mix, the financial manager has to decide exactly how
and where to raise the money. The expenses associated with raising long-term financing can be
considerable, so different possibilities must be carefully evaluated. Also, corporations borrow
money from a variety of lenders in a number of different, and sometimes exotic, ways. Choosing
among lenders and among loan types is another job handled by the financial manager.
Working Capital Management The third question concerns working capital management.
The term working capital refers to a firm’s short-term assets, such as inventory, and its short-
term liabilities, such as money owed to suppliers. Managing the firm’s working capital is a day-
to-day activity that ensures that the firm has sufficient resources to continue its operations and
avoid costly interruptions. This involves a number of activities related to the firm’s receipt and
disbursement of cash.
Some questions about working capital that must be answered are the following: (1) How much
cash and inventory should we keep on hand? (2) Should we sell on credit? If so, what terms will
we offer, and to whom will we extend them? (3) How will we obtain any needed short-term
financing? Will we purchase on credit, or will we borrow in the short term and pay cash? If we
borrow in the short term, how and where should we do it? These are just a small sample of the
issues that arise in managing a firm’s working capital.

1.4. Goal of the firm

1.4.2. Possible goals
If we were to consider possible financial goals, we might come up with some ideas like the
following:
Survive.
Avoid financial distress and bankruptcy.
Beat the competition.
Maximize sales or market share.
Minimize costs.
Maximize profits.
Maintain steady earnings growth.

1.4.3. The goal of the firm and financial management

The goal of financial management

The financial manager in a corporation makes decisions for the stockholders of the firm.
Given this, instead of listing possible goals for the financial manager, we really need to answer a
more fundamental question: From the stockholders’ point of view, what is a good financial
management decision? Good decisions increase the value of the stock, and poor decisions
decrease the value of the stock. The goal of financial management is to maximize the current
value per share of the existing stock
The goal of maximizing the value of the stock avoids the problems associated with the different
goals we listed earlier. There is no ambiguity in the criterion, and there is no short-run versus
long-run issue. We explicitly mean that our goal is to maximize the current stock value.
Because the goal of financial management is to maximize the value of the stock, we need to learn
how to identify investments and financing arrangements that favorably impact the value of the
stock.
1.5. Basic Forms of Business Organization
We examine the three different legal forms of business organization—sole proprietorship,
partnership, and corporation—to see why this is so. Each form has distinct advantages and
disadvantages for the life of the business, the ability of the business to raise cash, and taxes. A
key observation is that as a firm grows, the advantages of the corporate form may come to
outweigh the disadvantages.
SOLE PROPRIETORSHIP
A sole proprietorship is a business owned by one person. This is the simplest type of business
to start and is the least regulated form of organization.
The owner of a sole proprietorship keeps all the profits. That’s the good news. The bad news is
that the owner has unlimited liability for business debts. This means that creditors can look
beyond business assets to the proprietor’s personal assets for payment. Similarly, there is no
distinction between personal and business income, so all business income is taxed as personal
income.
The life of a sole proprietorship is limited to the owner’s life span, and the amount of equity that
can be raised is limited to the amount of the proprietor’s personal wealth. This limitation often
means that the business is unable to exploit new opportunities because of insufficient capital.
Ownership of a sole proprietorship may be difficult to transfer because this transfer requires the
sale of the entire business to a new owner.
PARTNERSHIP
A partnership is similar to a proprietorship except that there are two or more owners (partners).
In a general partnership, all the partners share in gains or losses, and all have unlimited liability
for all partnership debts, not just some particular share. The way partnership gains (and losses)
are divided is described in the partnership agreement. This agreement can be an informal oral
agreement, such as “let’s start a lawn mowing business,” or a lengthy, formal written document.
In a limited partnership, one or more general partners will run the business and have unlimited
liability, but there will be one or more limited partners who will not actively participate in the
business. A limited partner’s liability for business debts is limited to the amount that partner
contributes to the partnership. This form of organization is common in real estate ventures, for
example.
The advantages and disadvantages of a partnership are basically the same as those of a
proprietorship. Partnerships based on a relatively informal agreement are easy and inexpensive to
form. General partners have unlimited liability for partnership debts, and the partnership
terminates when a general partner wishes to sell out or dies. All income is taxed as personal
income to the partners, and the amount of equity that can be raised is limited to the partners’
combined wealth. Ownership of a general partnership is not easily transferred because a transfer
requires that a new partnership be formed. A limited partner’s interest can be sold without
dissolving the partnership, but finding a buyer may be difficult.
Because a partner in a general partnership can be held responsible for all partnership debts,
having a written agreement is very important. Failure to spell out the rights and duties of the
partners frequently leads to misunderstandings later on. Also, if you are a limited partner, you
must not become deeply involved in business decisions unless you are willing to assume the
obligations of a general partner. The reason is that if things go badly, you may be deemed to be a
general partner even though you say you are a limited partner.
Based on our discussion, the primary disadvantages of sole proprietorships and partnerships as
forms of business organization are (1) unlimited liability for business debts on the part of the
owners, (2) limited life of the business, and (3) difficulty of transferring ownership.
These three disadvantages add up to a single, central problem: the ability of such businesses to
grow can be seriously limited by an inability to raise cash for investment.
CORPORATION
A corporation is a legal “person,” separate and distinct from its owners, and it has many of the
rights, duties, and privileges of an actual person. Corporations can borrow money and own
property, can sue and be sued, and can enter into contracts. A corporation can even be a general
partner or a limited partner in a partnership, and a corporation can own stock in another
corporation.
Not surprisingly, starting a corporation is somewhat more complicated than starting the other
forms of business organization. Forming a corporation involves preparing articles of
incorporation (or a charter) and a set of bylaws. The articles of incorporation must contain a
number of things, including the corporation’s name, its intended life (which can be forever), its
business purpose, and the number of shares that can be issued. This information must normally
be supplied to the state in which the firm will be incorporated. For most legal purposes, the
corporation is a “resident” of that state.
The bylaws are rules describing how the corporation regulates its existence. For example, the
bylaws describe how directors are elected. These bylaws may be a simple statement of a few
rules and procedures, or they may be quite extensive for a large corporation. The bylaws may be
amended or extended from time to time by the stockholders.
In a large corporation, the stockholders and the managers are usually separate groups.
The stockholders elect the board of directors, who then select the managers. Managers are
charged with running the corporation’s affairs in the stockholders’ interests. In principle,
stockholders control the corporation because they elect the directors.
As a result of the separation of ownership and management, the corporate form has several
advantages. Ownership (represented by shares of stock) can be readily transferred, and the life of
the corporation is therefore not limited. The corporation borrows money in its own name. As a
result, the stockholders in a corporation have limited liability for corporate debts. The most they
can lose is what they have invested.
The relative ease of transferring ownership, the limited liability for business debts, and the
unlimited life of the business are why the corporate form is superior for raising cash.
If a corporation needs new equity, for example, it can sell new shares of stock and attract new
investors.
The number of owners can be huge; larger corporations have many thousands or even millions of
stockholders.
The corporate form has a significant disadvantage. Because a corporation is a legal person, it
must pay taxes. Moreover, money paid out to stockholders in the form of dividends is taxed
again as income to those stockholders. This is double taxation, meaning that corporate profits are
taxed twice: at the corporate level when they are earned and again at the personal level when
they are paid out.
As the discussion in this section illustrates, the need of large businesses for outside investors and
creditors is such that the corporate form will generally be the best for such fi rms. We focus on
corporations in the chapters ahead. Also, a few important financial management issues, such as
dividend policy, are unique to corporations. However, businesses of all types and sizes need
financial management, so the majority of the subjects we discuss bear on any form of business.
 Chapter Two
Financial Statement Analysis

Introduction
In the previous accounting courses you have learned that financial statements report both on a
firm’s financial position and financial performance. The four basic financial statements present
about different aspects of financial conditions, operating results, and cash flows. The balance
sheet shows a firm’s assets and claims against assets at a particular point in time – time. The
income statement, on its part, reports the results of the firm’s operations over a period of time.
Similarly, the statements of retained earnings and cash flows show the change in retained
earnings and cash between two balance sheet dates.

However, financial statements by themselves do not give a complete picture about a company’s
financial condition, operating results, and cash flows. Neither can a real value of financial
statements could be derived in themselves alone. Therefore, to predict the future and to help
anticipate future conditions, financial statements should be analyzed further. This analysis helps
to identify current strengths and weakness of the firm. It facilitates planning the future, and helps
to control the firm’s financial activities better. To have all this benefits, however, a finance
person should perform a financial analysis.

2.1. Meaning and Objectives of Financial Analysis

Financial analysis refers to analysis of financial statements and it is a process of evaluating the
relationships among component parts of financial statements.

The focus of financial analysis is on key figure in the financial statements and the significant
relationships that exist between them. Financial analysis is used by several groups of users like
managers, credit analysts, and investors.

The analysis of financial statements is designed to reveal the relative strengths and weakness of a
firm. This could be achieved by comparing the analysis with other companies in the same
industry, and by showing whether the firm’s position has been improving or deteriorating over
time. Financial analysis helps users obtain a better understanding of the firm’s financial
conditions and performance. It also helps users understand the numbers presented in the financial
statements and serve as a basis for financial decisions.

The main objective of financial analysis is to reveal the fact and relationships among the
managerial expectations and the efficiency of the business unit. The financial strengths and
weaknesses, its credit worthiness can also be known through such analysis. The safety of funds
invested in the firm, the adequacy or otherwise of its earnings, the ability to meet its obligations
etc. can also be examined through an analysis of their financial statements.

Of course, the financial analysis reveals only what has happened in the past. But, we can predict
future basing on past.

The management of the business unit is concerned; analysis can be used as a means of self-
evaluation. Through analysis the banker can assess the liquidity positions of the client firm and a
creditor can determine the credit worthiness. Analysis of financial statements helps an investor in
knowing the safety of his funds and the possible returns on the same. The bond holders can know
whether the income generated by the firm would provide sufficient margin to pay interest as well
as principal on maturity. The employees and trade unions can know how the firm stands in
relation to labor and its welfare. The analysis provides a basis to the government relating to
licensing controls, price fixation, ceiling of profits, dividend freeze, tax subsidy and other
concessions.

2.2. Tools and Techniques of Financial Analysis

A number of methods can be used in order to get a better understanding about a firm’s financial
status and operating results. The most frequently used techniques in analyzing financial
statements are:

i) Ratio Analysis – is a mathematical relationship among money amounts in the

financial statements. They standardize financial data by converting money figures in
the financial statements. Ratios are usually stated in terms of times or percentages.
Like any other financial analysis, a ratio analysis helps us draw meaningful
conclusions and interpretations about a firm’s financial condition and performance.
ii) Common Size Analysis – expresses individual financial statement accounts as a
percentage of a base amount. A common size status expresses each item in the
balance sheet as a percentage of total assets and each item of the income statement as
a percentage of total sales. When items in financial statements are expressed as
percentages of total assets and total sales, these statements are called common size
statements.
iii) Trend Analysis: making a comparative study of the financial statements for several
years. It Evaluates the performance of a firm by comparing its current year ratios
against the past years ratios. Also it is known as the time serious analysis. Trend
analysis Gives an indication the direction of changes and reflect whether the firm
financial has improved, declined or remain constant over time. More importantly
understand the reason why ratios have changed.
iv) Industry/cross-sectional analysis: comparing ratios of one firm against other firms
in the same industry at the same point time. This type of comparison indicates the
relative financial position and performance of the firm.
2.3. Ratio Analysis

2.3.1. Meaning of Ratio and Ratio Analysis

The term, ‘ratio’, refers to the numerical or quantitative relationship between items or variables.
It shows an arithmetical relationship between two figures. It is also defined as “the indicated
quotient of two mathematical expressions” and as “the relationship between two or more things”.
The relationship between two accounting figures expressed mathematically is known as
‘financial ratio’ or ‘accounting ratio’ or simply as a ratio. These ratios are generally expressed in
three ways. It may be a quotient obtained by dividing one value by another. For example, if the
current assets of a business on a particular date are Birr 200, 000 and its current liabilities Birr
100, 000 the resulting ratio would be Birr 200, 000 divided by 100, 000 i.e., 2:1. The ratio can be
expressed as a percentage as well. Taking the same particulars, it may be stated that the current
assets are 200% of the current liabilities. Sometimes ratios are expressed as so many ‘times’ or
‘fraction’: for example, the current assets may be stated as being double the current liabilities or
current liabilities was half of current assets.

Ratio analysis is the process of computing, determining and interpreting the relationship between
the component items of financial statements.

2.3.2. Importance of Ratio Analysis

Ratio analysis is an extremely useful and the most widely used tool of financial analysis. It
makes for easy understanding of financial statements. It facilitates intra-and inter-firm
comparison. Ratios act as an index of the efficiency of the enterprise. A study of the trend of
strategic ratios helps the management in planning and forecasting. Ratios help the management
in carrying out its functions of coordination, control and communication. The analysis of ratios
may reveal maladjustments in planning, organizing, coordinating and monitoring different
activities of an organization. It will help to identify the specific weak areas, causes thereof and
type of remedial actions called for. A purposeful ratio analysis helps in identifying problems
such as the following and in finding out suitable course of action.

(a) Whether the financial condition of the firm is basically sound,

(b) Whether the capital structure of the firm is appropriate,

(c) Whether the profitability of the enterprise is satisfactory,

(d) Whether the credit policy of the firm is sound, and

(e) Whether the firm is credit worthy.

In short, through the technique of ratio analysis the firm’s solvency both long and short term
efficiency and profitability can be assessed.

2.3.3. Classification of Ratios

There are several key ratios that reveal about the financial strengths and weaknesses of a firm.

The most important and commonly adopted classification of ratios is on the basis of the purpose
or function which the ratios are expected to perform. Such ratios are also called ‘functional
ratios’. They include liquidity ratios, asset management ratios, debt management ratios,
marketability ratios and profitability ratios. In fact, the entire ratio analysis can be discussed in
relation to the orientation of the functional basis of ratio classification.

2.3.3.1. Short term solvency or Liquidity measures

Liquidity ratios measure the ability of a firm to meet its immediate obligations and reflect the
short – term financial strength or solvency of a firm. In other words, liquidity ratios measure a
firm’s ability to pay its current liabilities as they mature by using current assets.

The liquidity ratios or short-term solvency ratios establish a relationship between cash and
current assets to current liabilities. A firm’s liquidity should neither be too low nor too high but
should be adequate. Low liquidity implies the firm’s inability to meet its obligations. This will
result in bad credit rating, loss of the creditors’ confidence or even technical insolvency
ultimately resulting in the closure of the firm. A very high liquidity position is also bad; it means
the firm’s current assets are too large in proportion to maturity obligations. It is obvious that idle
assets earn nothing to the firm; and in situations of high liquidity, the firm’s funds will be
unnecessarily tied up in current assets, which, if released, can be used to generate profits to the
firm. Therefore, every firm should strike a balance between liquidity and lack of liquidity.

Current assets include cash and those assets, which in the normal course of business get
converted into cash within a year or the accounting periods: e.g., cash, marketable-securities,
debtors, stock, etc. Prepaid expenses should also be included in the current assets because they
represent the payments which have been made by the firm for the near future.

Current liabilities are those liabilities or obligations which are to be paid within a year. They
include creditors, bills payable, accrued expenses, bank overdraft, income tax liability and long
term debt maturing in the current year.

There are two commonly used liquidity ratios: the current ratio and the quick ratio.

The following financial statements pertain to Zebra Share Company. We will perform the
necessary ratio analyses using them, and then evaluate and interpret each analysis.
 Zebra Share Company

Comparative Balance Sheet

December 31, 2001 and 2002

(In thousands of Birrs)

Assets 2002 2001

Current assets:

Cash 9,000 7,000

Marketable securities 3,000 2,000

Accounts receivable (net) 20,700 18,300

Inventories 24,900 23,700

Total current assets 57,600 51,000

Fixed assets:

Land and buildings 33,000 27,000

Plant and equipment 130,500 120,000

Total fixed assets 163,500 147,000

Less: accumulated depreciation 67,200 61,200

Net fixed assets 96,300 85,800

Total assets 153,900 136,800

Liabilities and stockholders’ equity

Current liabilities:

Accounts payable 20,100 17,100

Notes payable 14,700 13,200

Taxes payable 3,300 3,000

Total current liabilities 38,100 33,300

 Long-term debt:

Mortgage bonds –5% 60,000 60,000

Total liabilities 98,100 93,300

Stockholders’ equity:

Preferred stock –5% (Br. 100 par) 6,000 -

Common stock (Br. 10 par) 33,000 30,000

Capital in excess of par value 7,500 4,500

Retained earnings 9,300 9,000

Total stockholders’ equity 55,800 43,500

Total liabilities and stockholders’ equity 153,900 136,800

Zebra Share Company

Income Statement

For the Year Ended December 31, 2002

________________________________________________________________________

Net sales Br. 196,200,000

Cost of goods sold 159,600,000

Gross profit Br. 36,600,000

Operating expenses* 26,100,000

Earnings before interest and taxes (EBIT) Br. 10,500,000

Interest expense 3,000,000

Earnings before taxes (EBT) Br. 7,500,000

Income taxes 3,600,00

Net income Br. 3,900,000

* Included in operating expenses are Br. 6,000,000 depreciation and Br. 2,700,000 lease
payment.

Zebra Share Company

Statement of Retained Earnings

For the Year Ended December 31, 2002

Retained earnings at beginning of year Br. 9,000,000

Add: Net income 3,900,000

Sub-total Br. 12,900,000

Less: Cash dividends

Preferred Br. 300,000

Common 3,300,000

Sub-total Br. 3,600,000

Retained earnings at end of year Br. 9,300,000

i) Current ratio – measures the ability of a firm to satisfy or cover the claims of short-term
creditors by using only current assets. This ratio relates current assets to current liabilities. The
current ratio is an important and most commonly used ratio to measure the short-term financial
strength or solvency of the firm. It indicates how many rupees of current assets are available for
one rupee of current liability. The current ratio, in a way, provides a margin of safety to the
(short-term) creditors.

Current ratio = Current assets

Current liabilities

Zebra’s current ratio (for 2002) = Br. 57,600 = 1.51 times

Br. 38,100

Interpretation: Zebra has Br. 1.51 in current assets available for every 1 Br. in current
liabilities.

Relatively high current ratio is interpreted as an indication that the firm is liquid and in good
position to meet its current obligations. Conversely, relatively low current ratio is interpreted as
an indication that the firm may not be able to easily meet its current obligations. A reasonably
higher current ratio as compared to other firms in the same industry indicates higher liquidity
position. A very high current ratio, however, may indicate excessive inventories and accounts
receivable, or a firm is not making full use of its current borrowing capacity.

ii) Quick ratio (Acid – test ratio) - measures the short-term liquidity by removing the least liquid
current assets such as inventories. Inventories are removed because they are not readily or easily
convertible into cash. Thus, the quick ratio measures a firm’s ability to pay its current liabilities
by using its most liquid assets into cash. Similarly, prepaid expenses, which cannot be converted
into cash and be available to pay off current liabilities, should also be excluded from liquid
assets.

Quick ratio = Current assets – Inventory

Current liabilities

Zebra’s quick ratio (for 2002) = Br. 57,600 – Br. 24,900 = 0.86 times

Br. 38,100

Interpretation: Zebra has Br. 0.86 in quick assets available for every one birr in current
liabilities.

Like the current ratio, the quick ratio reflects the firm’s ability to pay its short-term obligations,
and the higher the quick ratio the more liquid the firm’s position. But the quick ratio is more
detailed and penetrating test of a firm’s liquidity position as it considers only the quick asset. The
current ratio, on the other hand, is a crude measure of the firm’s liquidity position as it takes into
account all current assets without distinction.

Quick ratio is a more refined and vigorous measure of the firm’s liquidity. It is widely accepted
as the best test for the liquidity of a firm. Generally, a quick ratio of 1:1 is considered to be
satisfactory.

2.3.3/2. Asset Management /Activity or turnover measures

Activity ratios indicate the efficiency with which the firm manages and used its assets. That is
why these activity ratios are also known as ‘efficiency ratios’. They are also called ‘turnover
ratios’ because they indicate the speed with which assets are being converted or turned over into
sales and cost of goods sold. Thus the activity or turnover ratio measures the relationship
between sales on one side and various assets on the other. A proper balance between sales and
different assets generally indicates the efficient management and use of the assets.

Activity ratios measure the degree of efficiency a firm displays in using its assets. Activity ratios
are also called asset management ratios, or asset utilization ratios. Generally, high turnover ratios
are associated with good asset management and low turnover ratios with poor asset management.
The following are some of the important activity ratios or turnover ratios:

a) Total assets turnover – indicates the amount of net sales generated from each birr of total
tangible assets. It is a measure of the firm’s management efficiency in managing its assets.
This ratio measures the overall performance and efficiency of the business enterprise. It points
out the extent of efficiency in the use of assets by the firm. Normally, the value of sales should
be considered to be twice that of the assets. A lower ratio than this indicates that the assets are
lying idle while a higher ratio may mean that there is overtrading.
Total assets turnover = Net Sales
Total assets

Zebra’s total assets turnover = Br. 196,200 = 1.27X

Br. 153, 900

Interpretation: Zebra Share Company generated Br. 1.27 in net sales for every one birr invested
in total assets.
b) Inventory turnover – measures how many times per year the inventory level is sold (turned
over). This ratio indicates the efficiency of the firm’s inventory management.

Generally, a high inventory turnover is an index of good inventory management and a low
inventory turnover indicates an inefficient inventory management. Low stock turnover implies
the maintenance of excessive stocks which are not warranted by production and sales activities.
It also may be taken as an indication of slow moving or non-moving and obsolete inventory. A
too high inventory turnover also is not good. It may be the result of a very low level of stocks
which may result in frequent stock-outs. The stock turnover should be neither too high nor too
low.

Inventory turnover = Cost of goods sold

Inventory

For Zebra Company (2002) = Br. 159,600 = 6.41times

Br. 24,900

Interpretation: Zebra’s inventory is on the average sold out 6.41 times per year.

In computing the inventory turnover, it is preferable to use cost of goods sold in the numerator
rather than sales. But when cost of goods sold data is not available, we can apply sales.

c) Accounts Receivable turnover – measures how efficiently a firm’s accounts receivable is

being managed. It indicates how many times or how rapidly accounts receivable are converted
into cash during a year.

Accounts receivable turnover = Net sales

 Accounts receivable

Zebra’s accounts receivable turnover (for 2002) = Br. 196,200 = 9.48 times

Br. 20,700

Interpretation: Zebra’s accounts receivable get converted into cash 9.48 times a year.

In general, a reasonably higher accounts receivable turnover ratio is preferable. A ratio

substantially lower than the industry average may suggest that a firm has more liberal credit
policy, more restrictive cash discount offers, poor credit selection or inadequate cash collection
efforts.

There are alternate ways to calculate accounts receivable value like average receivables and
ending receivables. Though many analysts prefer the first, in our case we have used the ending
balances. In computing the accounts receivable turnover ratio, if available, only credit sales
should be used in the numerator as accounts receivable arises only from credit sales.

d) Fixed assets turnover – measures how efficiently a firm uses it fixed assets. It shows how
many birrs of sales are generated from one birr of fixed assets

Fixed assets turnover = Net sales___

Net fixed assets

Zebra’s fixed assets turnover = Br. 196,200 = 2.04X

Br. 96,300

Interpretation: Zebra generated Br. 2.04 in net sales for every birr invested in fixed assets.

A fixed assets turnover ratio substantially lower than other similar firms indicates
underutilization of fixed assets, i.e., idle capacity, excessive investment in fixed assets, or low
sales levels. This suggests to the firm possibility of increasing outputs without additional
investment in fixed assets.

The fixed assets turnover may be deceptively low or high. This is because the book values of
fixed assets may be considerably affected by cost of assets, time elapsed since their acquisition,
or method of depreciation used.

e) Days sales outstanding (DSO) or Average Collection Period (ACP), It seeks to measure the
average number of days it takes for a firm to collect its accounts receivable. In other words, it
indicates how many days a firm’s sales are outstanding in accounts receivable.

Days sales outstanding = 365 days

 Accounts receivable turnover

Zebra’s days sales outstanding = 365 days = 39 days

9.48

Interpretation: Zebra’s credit customers on the average are paying their bills in almost 39 days.
If Zebra’s credit period is less than 39 days, some corrective actions should be taken to improve
the collection period.

The average collection period of a firm is directly affected by the accounts receivable turnover
ratio. The average collection period and the receivables’ turnover are interrelated. The
receivables turnover can be calculated by dividing days in the year by the average collection
period.

The average collection period indicates the rigidity or slowness of their collectability. The
shorter the period, the better the quality of debtors, since the shorter collection period implies
prompt payment by debtors. The firm’s average collection period should be compared with the
firm’s credit terms and policy to judge its credit and collection policy. An excessively long
collection period implies a too liberal and inefficient credit and collection performance while a
too low period indicates a very restrictive or strict credit and collection policy. The firm’s
average collection period should be reasonable and not totally different from that of the
industry’s average. Generally, a reasonably short-collection period is preferable.

2.3.3.3. Profitability measures

Profitability means the ability to make profits. Profitability ratios are calculated to measure the
profitability of the firm and its operating efficiency. These ratios measure the earning power of a
firm with respect to given level of sales, total assets, and owner’s equity. The following ratios are
among the many measures of a firm’s profitability.

1) Profit Margin – shows the percentage of each birr of net sales remaining after deducting
all expenses.

Profit margin = Net income

Net Sales

Zebra’s profit margin = Br. 3,900 = 2%

Br. 196,200
Interpretation: Zebra generated 2 cents in profits for every one birr in net sales.

The net profit margin ratio is affected generally by factor as sales volume, pricing strategy as
well as the amount of all costs and expenses of a firm.

2) Return on investment (assets) – measures how profitably a firm has used its investment
in total assets. This Return on Assets ratio measures the profitability of the total assets (or
investment) of a firm.

Return on investment = Net income

Total assets

Zebra’s return on investment = Br. 3,900 = 2.53 %

Br. 153,900

Interpretation: Zebra earned more than 2 cents of profits for each birr in assets.

Generally, a high return on investment is sought by firms. This can be achieved by increasing
sales levels, increasing sales relative to costs, reducing costs relative to sales, or efficiently
utilizing assets.

3) Return on equity – indicates the rate of return earned by a firm’s stockholders on investments
made by themselves.

Return on equity = Net income___

Stockholders’ equity

Zebra’s return on equity = Br. 3,900 = 6.99%

Br. 55,800

Interpretation: Zebra earned almost 7 cents of profit for each birr in owner’s equity

We can also use the following alternative way to calculate return on equity.

Return on equity = Return on investment

1 – Debt ratio

A high return on equity may indicate that a firm is more risky due to higher debt balance. On the
contrary, a low ratio may indicate greater owner’s capital contribution as compared to debt
contribution. Generally, the higher the return on equity, the better off the owners.
2.3.3..4. Long term solvency measures

These ratios are also known as ‘long term solvency ratios’ or ‘capital gearing ratios.’ Leverage
ratios are also called debt management or utilization ratios. They measure the extent to which a
firm is financed with debt, or the firm’s ability to generate sufficient income to meet its debt
obligations. While there are many leverage ratios, we will look at only the following.

i) Debt to total assets (Debt) Ratio – measures the percentage of total funds provided by debt.

Debt ratio = Total liabilities

Total assets

Zebra’s debt ratio = Br. 98,100 = 64%

Br. 153,900

Interpretation: At the end of 2002, 64% of Zebra’s total assets was financed by debt and 36%
(100% - 64%) was financed by equity sources.

A high debt ratio implies that a firm has liberally used debt sources to finance its assets.
Conversely, a low ratio implies the firm has funded its assets mainly with equity sources. Debt
ratio reflects the capital structure of a firm. The higher the debt ratio, the more the firm’s
financial risk.

ii) Times – interest earned or interest coverage ratio – measures a firm’s ability to pay its
interest obligations.

Times interest earned = Earnings before interest and taxes (EBIT)

Interest expense

Zebra’s times interest earned = Br. 10,500 = 3.50X

Br. 3,000

Interpretation: Zebra has operating income 3.5 times larger than the interest expense.

The times interest earned ratio implicitly assumes a firm’s operating income (EBIT) is available
to meet its interest obligations. However, earnings before interest and taxes is an income concept
and not a direct measure of cash. Hence, this ratio provides only an indirect measure of the
firm’s ability to meet its interest payments.

A higher coverage ratio is desirable from the point of view of creditors. But too high a ratio
indicates that the firm is very conservative in using debt. On the other hand, a low coverage ratio
indicates excessive use of debt or inefficient operations.

iii) Fixed charges coverage – measures the ability of a firm to meet all fixed obligations rather
than interest payments alone. Fixed payment obligations include loan interest and principal, lease
payments, and preferred stock dividends.

Fixed charges coverage = Income before fixed charges and taxes

Fixed charges

For Zebra Company, the other fixed charge payment in addition to interest is lease payment.
Therefore,

Zebra’s fixed charges coverage = Br. 10,500 + Br. 2,700 = 2.32X

Br. 3,000 + Br. 2,700

Interpretation: the fixed charges (interest and lease payments) of Zebra Share Company are
safely covered 2.32 times.

Like times interest earned, generally, a reasonably high fixed charges coverage ratio is desirable.
The fixed charges coverage ratio is required because failure of the firm to meet any financial
obligation will endanger the position of a firm.

2.3.3.5. Market value Ratios/measures

Market value ratios are used primarily for investment decisions and long range planning. They
include:

i) Earnings per share (EPS) – expresses the profits earned on each share of a firm’s common
stock outstanding. It does not reflect how much is paid as dividends.

Earnings per share = Net income – Preferred stock dividend

Number of common shares outstanding

Zebra’s Eps for 2002 = Br. 3,900 – Br. 300 = Br. 1.09

Br. 33,000  Br. 10

Interpretation: Zebra’s common stockholders earned Br. 1.09 per share in 2002.
ii) Dividends Per Share (DPS) – represents the amount of cash dividends a firm paid on each
share of its common stock outstanding.

Dividends Per Share = Total cash dividends on common shares

Number of common shares outstanding

Zebra’s DPs for 2002 = Br. 3,300 _ = Br. 1.00

Br. 33,000  Br. 10

Interpretation: Zebra distributed Br. 1 per share in dividends.

iii) Dividend pay-out (pay-out) ratio – shows the percentage of earnings paid to stockholders.

Dividends pay-out = Total dividends to common stockholders

Total earnings to common stockholders

Zebra’s pay-out ratio = Br. 1.00 = Br. 3,300 = 92%

Br. 1.09 Br. 3,600

Interpretation: Zebra paid nearly 92% of its earnings in cash dividends

2.3.4. Limitations of Ratio Analysis

Even though ratio analysis can provide useful information about a firm’s financial conditions and
operations, it has the following problems and limitations.

1. Generally, any single financial ratio does not provide sufficient information by itself.

2. Sometimes a comparison of ratios between different firms is difficult. One reason could be a
single firm may have different divisions operating in different industries. Another reason could
be the financial statements may not be dated at the same point in time.

3. The financial statements of firms are not always reliable, particularly, when they are not
audited.

4. Different accounting principles and methods employed by different companies can distort
comparisons.

5. Inflation badly distorts comparison of ratios of a firm over time.

6. Seasonal factors inherent in a business can also lead us to deceptive conclusion. For example,
the inventory turnover ratio for a stationery materials selling company will be different at
different time periods of a year.
 Chapter 3

3. Time value of money

3.1 INTRODUCTION

Many decisions in finance involve choices of receiving or paying cash at different time periods.
As you recall from the discussions of the second unit, the goal of a firm is wealth maximization.
This goal recognizes the difference in the value of equal cash flows received at different time
periods. So the concept of the time value of money is that money received now is generally
better than the same amount of money received some time later. This is because there is an
opportunity to invest the money we have now and earn a return on it. For example, if you have
Br. 1,000 today, you could save it in a bank and earn interest.

The time value of money is a very important concept in financial management. It has many
applications in financial decisions like loan settlements, investing in bonds and stocks of other
entities, acquisition of plant and equipment. Therefore, understanding the time value of money
concept is essential for a financial manager to achieve the wealth maximization goal of a firm.

The first basic point in the concept of the time value of money is to understand the meaning of
interest. Interest is the cost of using money (capital) over a specified time period. There are two
basic types of interest: simple interest and compound. Simple interest can be understood in two
different ways. One is that simple interest is an interest computed for just a period. If interest is
computed for one period only, the interest is always simple interest. Another way to understand
simple interest is that it is an interest computed for two or more periods whereby only the
principal (original) value would earn interest. In simple interest the previously earned interests
do not produce another interest.
Compound interest, on the other hand, is an interest computed for a minimum of two periods
whereby the previous interests produce another interest for subsequent or next periods. Here both
the principal and previous interests bring additional interest.

Though we have discussed both simple and compound interest, in financial management we are
largely interested on compound interest. So in the sections that follow we shall discuss the
concepts and techniques of the time value of money in the context of compound interest.

3.2 FUTURE VALUE

To understand future value, we need to understand compounding first. Compounding is a

mathematical process of determining the value of a cash flow or cash flows at the final period.
The cash flow(s) could be a single cash flow, an annuity or uneven cash flows. Future value (FV)
is the amount to which a cash flow or cash flows will grow over a given period of time when
compounded at a given interest rate. Future value is always a direct result of the compounding
process.

3.2.1 Future Value of a Single Amount

This is the amount to which a specified single cash flow will grow over a given period of time
when compounded at a given interest rate. The formula for computing future value of a single
cash flow is given as:

FVn = PV (1 + i)n
Where:
FVn = Future value at the end of n periods
PV = Present Value, or the principal amount
i = Interest rate per period
n= Number of periods
Or
FVn = PV (FVIFi,n)
Where:
(FVIFi, n) = The future value interest factor for i and n
The future value interest factor for i and n is defined as (1 + i)n and it is the future value of 1 Birr
for n periods at a rate of i percent per period.

Example: Hana deposited Br. 1,800 in her savings account in Meskerem 1990. Her account
earns 6 percent compounded annually. How much will she have in Meskerem 1997?

To solve this problem, let’s identify the given items: PV = Br, 1,800; i = 6%; n = 7 (Meskerem
1990 – Meskerem 1997).
FVn = PV (1 + i)n
= Br. 1,800 (1.06)7
= Br. 2,706.53

The (FVIFi,n) can be found by using a scientific calculator or using interest tables given at the
end of this material. From the first table by looking down the first column to period 7, and then
looking across that row to the 6% column, we see that FVIF6%,7 = 1.5036. Then, the value of
Br. 1,800 after 7 years is found as follows:
FVn = PV (FVIFi,n)
FV7 = Br. 1,800 (FVIF6%, 7)
= Br. 1,800 (1.5036) = Br. 2,706.48

3.2.2 Future Value of an Annuity

An annuity is a series of equal periodic rents (receipts, payments, withdrawals, deposits) made at
fixed intervals for a specified number of periods. For a series of cash flows to be an annuity four
conditions should be fulfilled. First, the cash flows must be equal. Second, the interval between
any two cash flows must be fixed. Third, the interest rate applied for each period must be
constant. Last but not least, interest should be compounded during each period. If any one of
these conditions is missing, the cash flows cannot be an annuity.

Basically, there are two types of annuities namely ordinary annuity and annuity due. Broadly
speaking, however, annuities are classified into three types:
i) ordinary annuity,
ii) annuity due, and
iii) deferred annuity
i) Future value of an Ordinary Annuity – An ordinary annuity is an annuity for which the cash
flows occur at the end of each period. Therefore, the future value of an ordinary annuity is the
amount computed at the period when exactly the final (n th) cash flow is made. Graphically,
future value of an ordinary annuity can be represented as follows:

0 1 2 ------------------ n

PMT1 PMT2 ---------------PMTn

The future value is computed at point n where PMTn is made.

 (1  i )  1
n

 

 i 
FVAn = PMT
Where:
FVAn = Future value of an ordinary annuity
PMT = Periodic payments
i = Interest rate per period
n = Number of periods
Or
FVAn = PMT (FVIFAi,n)
Where:
(FVIFAi, n) = the future value interest factor for an annuity
(1  i ) n  1
= i
Example: You need to accumulate Br. 25,000 to acquire a car. To do so, you plan to make equal
monthly deposits for 5 years. The first payment is made a month from today, in a bank account
which pays 12 percent interest, compounded monthly. How much should you deposit every
month to reach your goal?

Given: FVAn = Br. 25,000; i = 12%  12 = 1%; n = 5 x 12 = 60 months; PMT = ?

FVAn = PMT (FVIFAi, n)
 Br. 25,000 = PMT (FVIFA, %, 60)
 Br. 25,000 = PMT (81.670)
 PMT = Br. 25,000/81.670
  PMT = Br. 306.11

ii) Future value of an Annuity Due. An annuity due is an annuity for which the payments occur
at the beginning of each period. Therefore, the future value of an annuity due is computed
exactly one period after the final payment is made. Graphically, this can be depicted as:
0 1 2 --------------------- n

PMT1 PMT2 PMT3 ----------------------- PMTn + 1

The future value of an annuity due is computed at point n where PMTn + 1 is made
FVAn (Annuity due) = PMT (FVIFAi, n) (1 + i)
Or
 (1  i ) n  1
 
i
= PMT   ( 1 + i)

Example: Assume that pervious example except that the first payment is made today instead of a
month from today. How much should your monthly deposit be to accumulate Br. 25,000 after 60
months?

FVAn (Annuity due) = PMT (FVIFAi, n) (1 + i)

 Br. 25,000 = PMT (FVIFAi, n) (1 + i)
 Br. 25,000 = PMT (81.670) (1.01)
 PMT = Br. 25,000/82.487
 PMT = Br. 303.08

iii) Future value of Deferred Annuity is an annuity for which the amount is computed two or
more period after the final payment is made.
0 1 2 ------------------n --------------n + x

PMT1 PMT2 PMTn

The future value of a deferred annuity is computed at point n + x

FVAn (Deferred annuity) = PMT (FVIFAi, n) (1 + i)x
  (1  i ) n  1
 
i
= PMT   (1 + i)x

Where x = The number of periods after the final payment; and X  2.

Example: Henock has a savings account which he had been depositing Br. 3,000 every year on
January 1, starting in 1990. His account earns 10% interest compounded annually. The last
deposit Hencok made was on January 1, 1999. How much money will he have on December 31,
2003? (No deposits are made after 1999 January).

Jan.
1990 1991 1992 93 94 95 96 97 98 99 2000 2001 02 03 2004
3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000

The future value is computed on December 31, 2003 (or January 1, 2004).
Given: PMT = Br. 3,000; i = 10%; n = 10; x = 5
FVAn (Deferred annuity) = PMT (FVIFAi, n) (1 + i)x
= Br. 3,000 (FVIFA 10%, 10) (1.10)5
= Br. 3,000 (15.937) (1.6105)
= Br. 76, 999.62

3.2.3 Future Value of Uneven Cash Flows

Uneven cash flow stream is a series of cash flows in which the amount varies from one period to
another. The future value of an uneven cash flow stream is computed by summing up the future
value of each payment.

Example: Find the future value of Br. 1,000, Br. 3,000, Br. 4000, Br. 1200, and Br. 900
deposited at the end of every year starting year 1 through year 5. The appropriate interest rate is
8% compounded annually. Assume the future value is computed at the end of year 5.
0 1 2 3 4 5

1,000 3,000 4,000 1,200 900

FVIF8%, 4 Br. 1,000 (1,3605) = Br. 1,360.50
FVIF8%, 3 Br. 3,000 (1.2597) = 3,779.10
FVIF8%,2 Br. 4,000 (1.1664) = 4,665.60
 FVIF8%, 1 Br. 1,200 (1.0800) = 1,296.00
Br. 900 (1.0000) = 900.00
FV = Br. 12,001.20

3.3 PRESENT VALUE

Present value is the exact reversal of future value. It is the value today of a single cash flow, an
annuity or uneven cash flows. In other words, a present value is the amount of money that should
be invested today at a given interest rate over a specified period so that we can have the future
value. The process of computing the present value is called discounting.
3.3.1 Present Value of a Single Amount

It is the amount that should be invested now at a given interest rate in order to equal the future
value of a single amount.
n
FVn  1 
 FVn  
PV = 1  i   1 i 
n

Where:
PV = Present Value
FVn = Future value at the end of n periods
i = Interest rate per period
n = Number of periods
Or
PV = FVn (PVIFi, n)
Where:
(PVIFi, n) = The present value interest factor for i and n = 1/ (1 + i)n

Example: Zelalem PLC owes Br. 50,000 to ALWAYS Co. at the end of 5 years. ALWAYS Co.
could earn 12% on its money. How much should ALWAYS Co. accept from Zelalem PLC as of
today?

Given: FV5 = Br. 50,000; n = 5 years; i = 12%; PV = ?

PV = FV5 (PVIF12%, 5)
= Br. 50,000 (0.5674) = Br. 28,370
3.3.2 Present Value of an Annuity

i) Present value of an Ordinary Annuity is a single amount of money that should be invested
now at a given interest rate in order to provide for an annuity for a certain number of future
periods.
 1 
1  1  i n  1  1  i  n 
   PMT  
 i   i 
 
PVAn = PMT   = PMT (PVIFAi, n)
Where:
PVAn = The present value of an ordinary annuity
(PVIFAi, n) = The present value interest factor for an annuity
1  1  i 
n

= i
Example: Ato Mengesha retired as general manager of Tirusew Foods Company. But he is
currently involved in a consulting contract for Br. 35,000 per year for the next 10 years. What is
the present value of Mengesha’s consulting contract if his opportunity costs is 10%?

Given: PMT = Br. 35,000; n = 10 years; i = 10%; PVAn = ?

PVA10 = Br. 35,000 (PVIFA10%, 10)
= Br. 35,000 (6.1446) = Br. 215,061. This means if the required rate of return is
10%, receiving Br. 35,000 per year for the next 10 years is equal to receiving Br. 215,061 today.

ii) Present value of an Annuity Due – is the present value computed where exactly the first
payment is to be made. Graphically, this is shown below:

0 1 2 3 ---------------- n

PMT1 PMT2 PMTn

The present value of an annuity due is computed at point 1 while the present value of an ordinary
annuity is computed at point 0.
 1  (1  i )  n 
 
i
PVAn = (Annuity due) = PMT   (1 + i) = PMT (PVIFAi, n) (1 + i)

Example: Ruth Corporation bought a new machine and agreed to pay for it in equal installments
of Br. 5,000 for 10years. The first payment is made on the date of purchase, and the prevailing
interest rate that applies for the transaction is 8%. Compute the purchase price of the machinery.

Given: PMT = Br. 5,000; n = 10 years; i = 8%; PVAn (Annuity due) = ?

PVA (Annuity due) = Br. 5,000 (PVIFA 8%, 10) (1.08)
= Br. 5,000 (6.7101) (1.08) = Br. 36,234.54. So the cost of the
machinery for Ruth is Br. 36,234.54. We have identified the case as an annuity due rather than
ordinary annuity because the first payment is made today, not after one period.

iii) Present value of a Deferred Annuity is computed two or more periods before the first
payment is made.
1  (1  i )  n 
 
i
PVAn (Deferred annuity) = PMT   (1 + i)-x = PMT (PVIFAi, n) (1 + i)-x

Where x is the number of periods between the date when he first payment is made and the date
the present value is computed.

Example: Sefa Chartered Accountants has developed and copyrighted an accounting software
program. Sefa agreed to sell the copyright to Steel company for 6 annual payments of Br. 5,000
each. The payments are to begin 5 years from today. If the annual interest rate is 8%, what is the
present value of the six payments?

0 1 2 3 4 5 6 7 8 9 10

PVAn = ? 5,000 5,000 5,000 5,000 5,000 5,000

X

Given: n = 6; PMT = Br. 5,000; X = 4; PVA6 (Deferred annuity) = ?

i = 8% PVA6 (Deferred annuity) = Br. 5,000 (PVIFA8%, 6) (1.08)-4
= Br. 5,000 (4.6229) (0.7350) = Br. 16,989.16
3.3.3 Present Value of Uneven Cash Flows

The present value of an uneven cash flow stream is found by summing the present values of
individual cash flows of the stream.

Example: Suppose you are given the following cash flow stream where the appropriate interest
rate is 12% compounded annually. What is the present value of the cash flows?

Year 1 2 3
Cash flow Br. 400 Br. 100 Br.300
Br. 400 (0.8929) PVIF12%, 1
= Br. 357.16
Br. 100 (0.7972) PVIF12%, 2
= Br. 79.72
Br. 300 (0.7118) PVIF12%, 3
= Br. 213.54
Br. 650.42

3.3.4 Present Value of a Perpetuity

A perpetuity is an annuity with an indefinite cash flows. In a perpetuity payments are made
continuously forever. The present value of a perpetuity is found by using the following formula:
PV (Perpetuity) = Payment = PMT
Interest rate i
Example: What is the present value of a perpetuity of Br. 7,000 per year if the appropriate
discount rate is 7%?

Given: PMT = Br. 7,000; i = 7%;, PV (Perpetuity) = ?

 PV (Perpetuity) = PMT = Br. 7,000 = Br. 100,000. This means that
i 7%
receiving Br. 7,000 every year forever is equal to receiving Br. 100,000 now.

Chapter four (keep on reading assignment)

Chapter Five
The cost of capital
Introduction

As you well understand, two parties are involved in a financial asset under normal
circumstances. One is the party issuing the financial asset. Another is the one that buys or invests
on the financial asset. When we were discussing about valuation, we emphasized on the investor.
That is, how much is the maximum price the investor would pay for the financial asset? To
decide on this, the investor would discount the expected future cash flows. The discounting is
done based on the investor’s required rate of return.

The rate of return required by the investor should definitely be provided by some other party.
The party which should provide the investor its required rate of return is the issuing party. For
example, if the required rate of return by an investor on a given bond is 10%, the issuing
company should provide this 10% to the investor. This required rate of return that should be met
by the issuing company becomes its cost. This is a cost on the capital the issuing company wants
to raise.
Therefore, the required rate of return on investments in financial assets by the investor is the cost
of capital for the company issued the financial assets. But, generally, the cost of capital for the
issuing company is higher than the required rate of return by the investor. This is because when
the issuing company issues a financial asset, it must incur some costs. These costs incurred by
the issuer in relation to issuance of financial assets are called flotation costs. Examples include
advertising costs, commissions paid to those selling the financial assets, cost of printing
documents, costs of registration with government agencies, discounts to encourage the sale of
securities, and so on.

5.1Meaning of the Cost of Capital

The cost of capital is the minimum rate of return that a firm must earn in order to satisfy the
overall rate of return required by its investors. It is also the minimum rate of return a firm must
earn on its invested capital to maintain the value of the firm unchanged. The second definition
considers the cost of capital as a break even rate.

If a firm’s actual rate of return exceeds its cost of capital, the value of the firm would increase. If
on the other hand, the cost of capital is not earned, the firm’s market value will decrease. So the
cost of capital is the rate of return that is just sufficient to leave the price of the firm’s common
stock unchanged.

The cost of capital serves as a discount rate when a firm evaluates an investment proposal.
Suppose a firm is considering investment on a plant. The finance required for this investment is
to be raised by selling a common stock issue. Now, after raising capital, the firm is expected to
provide required rate of return to those who invest on the common stock. This in effect is the
firm’s cost of capital. So to decide to invest on the plant, the minimum rate of return from the
investment at least should be equal to the required rate of return by the common stockholders. If
the required rate of return by the firm’s common stockholders is 13%, then the firm should earn a
minimum of 13% on its investment on the plant. The 13% minimum rate of return that should be
earned by the firm is, therefore, its cost of capital.

5.2Measuring the Specific Cost of Capital

The cost of capital for any particular capital source or security issue is called the specific cost of
capital. It is also called individual cost of capital or component cost of capital.

Each type of capital contained the capital structure of a firm include:

1. Debt

2. Preferred stock

3. Common stock
 4. Retained earnings

Two important points you should bear in mind about the specific cost of capital. One is that it is
computed on an after-tax basis. Meaning, if there would be any tax implication on the individual
source of capital, it should be considered. In almost all circumstances, the tax implication is only
on debt sources of finance. The second point is that the specific cost of capital is expressed as an
annual percentage or rate like 6%, 9%, or 10%. The cost of capital is not stated in terms of birrs.

5.2.1 The Cost of Debt

This is the minimum rate of return required by suppliers of debt. The relevant specific cost of
debt is the after-tax cost of new debt. Generally, debt is the cheapest source of finance to a firm
and, hence, the cost of debt is the lowest specific cost of capital. There are two basic
explanations for this. First, debt suppliers, generally, assume the lowest risk among all suppliers
of capital. They receive interest payments before preferred and common dividends are paid.
Since they assume the smallest risk, their return is the lowest. Their lowest return would be the
lowest cost of capital to the firm. Second, raising capital through debt sources entails interest
expense. The interest expense in turn reduces the firm’s income which ultimately would cause
tax payment to be reduced. So raising money in the form of debt results in the smallest tax
burden, and finally, the firm’s cost of debt would be the lowest.

Debt sources of finance may take several forms like bonds, promissory notes, bank loans. Here,
for our convenience we consider bond issue to illustrate the cost of debt.

Computing the cost of new bond issue involves three steps:

i) Determine the net proceeds from the sale of each bond

NPd = Pd – f

Where:

NPd = The net proceeds from the sale of each bond

Pd = The market price of the bond

f = Flotation costs

ii) Compute the effective before tax cost of the bond using the following approximation formula:
 Pn  NPd
I
n
Pn  NPd
Kd = 2
Where:

Kd = The effective before tax cost of debt

I = Annual interest payment

Pn = The par value of the bond

n = Length of the holding period of the bond in years.

iii) Compute the after-tax cost of debt

Kdt = Kd (1 – t)

Where:

Kdt = the after-tax cost of debt

t = the marginal tax rate

Example: Currently, Abyssinia Industrial Group is planning to sell 15-year, Br. 1,000 par-value
bonds that carry a 12% annual coupon interest rate. As a result of lower current interest rates,
Abyssinia bonds can be sold for Br. 1,010 each. Flotation costs of Br. 30 per bond will be
incurred in the process of issuing the bonds. The firm’s marginal tax rate is 40%.

Required: Calculate the after tax cost of Abyssinia’s new bond issue:

Solution:

Given: Pn = Br. 1,000; I = Br. 120 (Br. 1,000 x 12%); n = 15; Pd = Br. 1,010; f = Br. 30;

t = 40%; Kdt =?

Then apply the three steps:

i) NPd = Br. 1,010 – Br. 30 = Br. 980

 Br.1,000  Br.980
Br.120 
15  12.26%
Br.1,000  Br.980
ii) Kd = 2

iii) Kdt = 12.26% (1 – 40%) = 7.36%

Therefore, the after – tax cost of Abyssinia’s new bond issue is 7.36%. That is, Abyssinia should
be able to earn a minimum of 7.36% to satisfy bondholders. Otherwise, the firm’s value will
decline.

5.2.2 The Cost of Preferred Stock

The cost of preferred stock is the minimum rate of return a firm must earn in order to satisfy the
required rate of return of the firm’s preferred stock investors. It is also the minimum rate of
return a firm’s preferred stock investors require if they are to purchase the firm’s preferred stock.

When a firm raises capital by issuing new preferred stock, it is expected to pay fixed amount of
dividends to the preferred stockholders. So it is the dividend payment that is the cost of the
preferred stock to the firm stated as an annual rate.

The cost of a new preferred stock issue can be computed by following two steps:

i) Determine the net proceeds from the sale of each preferred stock.

NPpf = Ppf – f

Where:

NPpf = Net proceeds from the sale of each preferred stock

Ppf = Market price of the preferred stock

f = Flotation costs

ii) Compute the cost of preferred stock issue

Kps = Dps__

NPpf

Where:

Kps = the cost of preferred stock

DPs = the per share annual dividend on the preferred stock

Example: Sefa Computer Systems Company has just issued preferred stock. The stock has 12%
annual dividend and Br. 100 par value and was sold at 102% of the par value. In addition,
flotation costs of Br. 2.50 per share must be paid. Calculate the cost of the preferred stock.

Solution:

Given: Pps = Br. 102 (Br. 100 x 102%); Dps = Br. 12 (Br 100 x 12%); f = Br. 2.50;

Kps =?

Then apply the two steps:

i) NPpf = Br. 102 – Br. 2.50 = Br. 99.50

ii) Kps = Br. 12 =12.06%

Br. 99.50

Therefore, Sefa Company should be able to earn a minimum of 12.06% on any investment
financed by the new preferred stock issue. Otherwise, the firm’s value will decrease.

5.2.3 The Cost of Common Stock

The cost of common stock is the minimum rate of return that a firm must earn for its common
stockholders in order to maintain the value of the firm. A firm does not make explicit
commitment to pay dividends to common stockholders. However, when common stockholders
invest their money in a corporation, they expect returns in the form of dividends. Therefore,
common stocks implicitly involve a return in terms of the dividends expected by investors and
hence, they carry cost.

Generally, common stock dividends are paid after interest and preferred dividends are paid. As a
result, common stock investors assume the maximum risk in corporate investment. They
compensate the maximum risk by requiring the highest return. This highest return expected by
common stockholders make common stock the most expensive source of capital.

The cost of common stock can be computed using the constant growth valuation model.

Ks = D1 + g

NPo

Where:

Ks = the cost of new common stock issue

 D1 = the expected dividend payment at the end of the next year

NPo = Net proceeds from the sale of each common stock

g = the expected annual dividends growth rate

The net proceeds from the sale of each common stock (NPo) is computed as follows:

NPo = Po – f

Where:

Po = the current market price of the common stock

f = flotation costs

Example: An issue of common stock is sold to investors for Br. 20 per share. The issuing
corporation incurs a selling expense of Br. 1 per share. The current dividend is Br. 1.50 per share
and it is expected to grow at 6% annual rate. Compute the specific cost of this common stock
issue.

Solution

Given: Po = Br. 20; Do = Br. 1.50; g = 6%; f = Br. 1; Ks =?

Then apply the two steps:

i) NPo = Br. 20 – Br. 1 = Br. 19

ii) Ks = D1 + g = Br. 1.50 (1.06) = 14.37%

Npo Br. 19

Therefore, the firm should be able to earn a minimum return of 14.37% on investments that are
financed by the new common stock issue.

D1 = Do (1+g), where Do is the most recent dividend. Similarly D2 = D1 (1+g) and so on.

D1= the expected dividend at the end of next year.

5.2.4 The Cost of Retained Earnings

Retained earnings represent profits available for common stockholders that the corporation
chooses to reinvest in itself rather than payout as dividends. Retained earnings are not securities
like stocks and bonds and hence do not have market price that can be used to compute costs of
capital.
The cost of retained earnings is the rate of return a corporation’s common stockholders expect
the corporation to earn on their reinvested earnings, at least equal to the rate earned on the
outstanding common stock. Therefore, the specific cost of capital of retained earnings is equated
with the specific cost of common stock. However, flotation costs are not involved in the case of
retained earnings.

Computing the cost of retained earnings involves just a single procedure of applying the
following formula:

Kr = D1 + g

Po

Where:

Kr = the cost of retained earnings

D1 = the expected dividends payment at the end of next year

Po = the current market price of the firm’s common stock

g = the expected annual dividend growth rate.

Example: Zeila Auto Spare Parts Manufacturing Company expects to pay a common stock
dividend of Br. 2.50 per share during the next 12 months. The firm’s current common stock price
is Br. 50 per share and the expected dividend growth rate is 7%. A flotation cost of Br. 3 is
involved to sale a share of common stock.

Required: Compute the cost of retained earnings

Solution

Given: Po = Br. 50; D1 = Br. 2.50; g = 7%; Kr =?

Then apply the formula:

Kr = D1+ g = Br. 2.50 + 7% = 12%

Po Br. 50

5.3Weighted Average Cost Of Capital (WACC)

In the previous section we have seen how to compute the cost of capital for each individual
source of capital. The specific cost of capital is used in evaluating an investment proposal to be
financed by a particular capital source. Practically, however, investments are financed by two or
more sources of capital. In such a situation, we cannot make use of the individual cost of capital.
Rather we should use the average cost of capital employed by the firm.
The firm’s capital structure is composed of debt, preferred stock, common stock, and retained
earnings. Each capital source accounts to some portion of the total finance. But the percentage
contribution of one source is usually different from another. So we must compute the weighted
average cost of capital rather than the simple average.

The weighted average cost of capital (WACC) is the weighted average of the individual costs of
debt, preferred stock and common equity (common stock and retained earnings). It is also called
the composite cost of capital.

If the weights of the component capital sources are all given, the weighted average cost of capital
can be computed as:

WACC = WdKdt + WpsKps + WceKs

Where:

WACC = the weighted average cost of capital

Wd = The weight of debt

Wps = the weight of preferred stock

Wce = the weight of common equity

Kdt = the after – tax cost of debt

Kps = the cost of preferred stock

Ks = the cost of common equity

The WACC is found by weighting the cost of each specific type of capital by its proportion in
the firm’s capital structure. Weights of the individual capital sources can be calculated based on
their book value or market value.

To illustrate the computation of the WACC, look at the following example.

Muna Tools Manufacturing Company’s financial manager wants to compute the firm’s weighted
average cost of capital. The book and market values of the amounts as well as specific after-tax
costs are shown in the following table for each source of capital.

Source of capital Book value Market value Specific cost

Debt Br. 1,050,000 Br. 1,000,000 5.3%

 125,000

Preferred stock 84,000 1,375,000 12.0

Common equity 966,000 Br. 2,500,000 16.0

Total Br. 2,100,000

Required: Calculate the firm’s weighted average cost of capital using:

1) book value weights

2) market value weights

Solution:

1) Total book value = Br. 2,100,000

Wd = Br. 1,050,000 = 0.5; Wps = Br. 84,000__ = 0.04; Wce = Br. 966,000 = 0.46

Br. 2,100,000 Br. 2,100,000 Br. 2,100,000

WACC = WdKdt + WpsKps + WceKs

= 0.5 (5.3%) + 0.04 (12.0%) + 0.46 (16.0%)

= 2.65% + 0.48% + 7.36%

= 10.49%

The minimum rate of return on all projects should be 10.49%. Meaning, Muna should accept all
projects so long as they earn a return greater than or equal to 10.49%

2) Total Market value = Br. 2,500,000

Wd = Br. 1,000,000 = 0.4; Wps = Br. 125,000 = 0.05; Wce = Br. 1,375,000 = 0.55

Br. 2,500,000 Br. 2,500,000 Br. 2,500,000

WACC = 0.4 (5.3%) + 0.05 (12.0%) + 0.55 (16.0%)

= 2.12% + 0.60% + 8.80%

= 11.52%

If the market value weights are used, Muna should accept all projects with a minimum rate of
return of 11.52%
 Chapter Six
Capital Budgeting /Investment Decisions

6.1Introduction
The success of a business unit depends upon the investment of resource in such a way that bring
in benefits or best possible returns from any investment. The investment in general means an
expenditure in cash or its equivalent during one or more time periods in anticipation of enjoying
a net cash inflows or its equivalent in some future time period or periods.

The investment in any project will bring in desired profits or benefits in future. If the financial
resources were in abundance, it would be possible to accept several investment proposals which
satisfy the norms of approval or acceptability. Since, we are sure that resources are limited, a
choice has to be made among the various investment proposals by evaluating their comparative
merit. This would help us to select the relatively superior proposals keeping in view the limited
available resources. For this purpose, we have to develop some evaluating techniques for the
appraisal of investment proposals.

6.2 Importance of Investment Decisions

The terms in financial management like investment decisions, investment projects, and
investment proposals are generally associated with application of long-term resources. What is
long-term? There is no hard and fast rule to define it, but by common practice and accordance
with the financing policies, practices and regulations of the financial institutions and banks a
period of ten years and above may be treated as long period. The decisions related to long-term
investment is also known as capital budgeting techniques. It is important because of the
following reasons:

1) The investment decisions are the vehicles of a company to reach the desired destiny of
the company. An appropriate decision would yield spectacular results whereas a wrong
decision may upset the whole financial plan and endanger the very survival of the firm.
Even firm may be forced into bankruptcy.

2) Capital budgeting techniques involve huge amounts of funds and imply permanent
commitment. Once you invest in the form of fixed assets it is not easy to reverse the
decision unless you incur heavy loss.

3) A capital expenditure decision has its effect over a long period of time span and
inevitably affects the company’s future cost.

4) Investment decision are among the firm’s most difficult decisions. They are the
predictors of future events which are difficult to predict. It is a complex problem
investment. The cash flow uncertainty is caused by economic, political, social and
technological forces.

6.3 Types of Investment Proposals

The long-term funds are required for the following purposes:
Expansion: A company adds capacity to its existing product lines to expand existing operations.
For example, a manufacturing unit producing one hundred thousand units per year. If it intends
to double the output by two hundred thousands, this will obviously increase the need for funds
for acquiring fixed and current assets.

Diversification: Sometimes the management of a company may decide to add new product line
to the existing product lines. Philips, a famous company for radio and electric bulbs etc.
diversified into production of other electrical appliances and television sets.

Replacements: Machines used in production may either wear out or may be rendered obsolete on
account of new technology. The productive capacity of the enterprise and its competitive ability
may be adversely affected. Extra funds are required for modernization or renovation of the entire
plant. The investment obviously is going to be long terms.

Research and Development: There has been an increased realization that the efficiency of
production and the total operations can be improved by application of new and more
sophisticated techniques of production and management. To acquire the technology huge funds
are needed.

The useful way of classifying investments is as under

1. Accept - Reject Decisions

2. Mutually Exclusive Decisions

3. Capital Rationing

Accept-Reject Decisions

Under this, if a project is accepted, the firm is going to invest, otherwise it is not going to invest
its funds. In general, the project proposals that yield a rate of return greater than the certain
required rate of return or cost of capital are accepted and others are rejected. By applying this
criteria more than one independent projects are accepted subject to availability of funds. Various
appraisal techniques are used to evaluate each project.

Mutually Exclusive Decisions

These are the projects which compete with each other in such a way that the acceptance of one
will exclude the acceptance of the other one. The alternatives are mutually exclusive one may be
chosen.

Capital Rationing
We are aware that the financial resources are limited. But, a large number of investment
proposals compete for those limited funds. The firm, therefore ration them. The firm allocates
funds to projects in a manner that it maximizes long-run returns. Thus, capital rationing refers to
the situation in which the firm has more acceptable investments, requiring a greater amount of
finance than is available with the firm. It is concerned with the selection of a group of investment
proposals out of making investment proposals acceptable under the accept-reject decision. The
projects are ranked as per their merits of acceptance basing on certain predetermined criteria.

6.4Data Required for Investment Decisions

Initial Investment: The total amount of cash required to buy various assets like land, buildings,
plant, machinery, equipment, etc. and there installation expenses have to be estimated. In
addition to fixed cost, the cost of maintaining stocks, contingency reserves to cover the cost of
supporting the additional receivables. Benefit of credit from suppliers will have the effect of
reducing the quantum of additional working capital required.

Subsequent Investment: The cost of maintenance, replacement and updating are to be treated as
outflows during the period in which they are expected to be incurred.

Economic Life of the project: The economic life of a project is to be distinguished from the life
of an individual assets. The building may have life of fifty years, plant may have ten years, and
some equipments may have five years only. The economic life of the project is determined by
the duration of the “earnings flow” generated by the project.

The economic life may end:

a) The cost of replacement becomes uneconomical in relation to the likely benefits.

b) When the viability is adversely affected due to obsolescence.

c) When maintenance costs exceed the disposable value, and

d) When the development of new technology necessitates new investment

Salvage Values: Sometimes the plant assets may have value for the enterprise at the end of the
life of the project or there may be some anticipated sales value of the plant. Such amount is to be
treated as an inflow at the end of the life of the project.

Annual Cash Flows: The calculation of annual cash flows in investment appraisal plays a key
role. The computation of cash flows is a simple task. The following areas are to be considered.

Sales revenue: This is going to be the function of sales any wrong calculation in this regard will
bear impact on the investment opportunity. Care has to be taken to forecast accurately and the
additional revenue generated by the investment should be taken into account. The investment
must also result into the reduction of operating cost either by modernization or replacement
models where the savings benefit or cash flows will increase. In simple terms annual cash flow is
equivalent to net profit after tax plus deprecation. Procedurally,

ACF = Sales – (Operating expenses + Non-operating expense + Tax) + Depreciation

Ex: The following is the information related to ABC Ltd. The company has been asked to
compute the annual cash flows.

Machine A Machine B

Birrs Birrs

Cost of machine 15, 000 24, 000

Estimated life in years 5 years 6 years

Estimated income 1, 000 1, 500

Estimated material cost 800 900

Estimated supervision cost 1, 200 1, 600

Estimated maintenance cost 500 1, 000

Estimated savings in wages 9, 000 12, 000

Additional Information

1. Depreciation may be charged on straight line method

2. The tax rate may be assumed 50% and

3. Calculate Annual cash flows.

Machine A Machine B

Birrs Birrs

Income: 1, 000 1, 500

Savings in wages 9, 000 12, 000

Total income / sales 10, 000 13, 000

Cost: material costs 800 900

Maintenance 500 1, 000

 Supervision 1, 200 1, 600

2, 500 3, 500

Profit before Depreciation & Tax 7, 500 10, 000

Depreciation 3, 000 4, 000

Profit Before tax 4, 500 6, 000

Tax @ 50% 2, 250 3, 000

Profit after tax (Net profit) 2, 250 3, 000

Add back depreciation 3, 000 4, 000

Annual cash flows 5, 250 7, 000

6.5Capital Budgeting Process

Capital budgeting is a difficult process to the investment of available funds. The benefit will
attained only in the near future but, the future is uncertain. However, the following steps
followed for capital budgeting, then the process may be easier are.

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 department analyze 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 will analyze 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

(b) Contingent of dependent proposals

(c) Partially exclusive proposals.

Independent proposals are not compared with another proposals 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 evaluation, the planning committee will predict which proposals
will give more profit or economic consideration. If the projects or proposals are 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

(b) Economic constituents

(c) Financial violability

(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. 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.

6.6 Project Appraisal Methods

There are two important methods of evaluating the investment proposals

Traditional methods (non -discounted methods)

 Payback period

 Accounting rate of return

Discounted cash flow method (modern methods)

 Net present value

 Profitability Index method / Benefit cost Ratio

 Internal Rate of Return

Pay Back Period:

This is one of the widely used methods for evaluating the investment proposals. Under this
method the focus is on the recovery of original investment at the earliest possible. It determines
the number of years to recoup the original cash out flow, disregarding the salvage value and
interest. This method does not take into account the cash inflows that are received after the
payback period. There are two methods in use to calculate the payback period

1) Where annual cash flows are not consistent vary from year to year

2) Where the annual cash flow are uniform

1. Unequal cash flows

B
P=E+ C

Where, P stands for payback period.

E stands for number of years immediately preceding the year of final recovery.

B stands for the balance amount still to be recovered.

C stand for cash flow during the year of final recovery.

Ex: The following is the information related to a company

Project A Project B

Year Cash flow $ Year Cash flow $

0 -700 0 -700

1 100 1 400

2 200 2 300

3 300 3 200

4 400 4 100
 5 500 5 0

Calculate payback period

Project A Cumulative Project B Cumulative

Year Cash flow cash flow Year Cash flow Cash flow

0 -700 -700 0 -700 -700

1 100 -600 1 400 -300

2 200 -400 2 300 0

3 300 -100 3 200 200

4 400 300 4 100 300

5 500 800 5 0 -

B
P=E+ C

100
= 3 + 400

= 3.25 year

B
P=E+ C

=2+0

= 2 years

Uniform cash flows:

Where the annual cash flows are uniform

Original Investment
PB = Annual cash flows
Shorter is the payback period better is the product

Accept/Reject criteria

If the actual pay-back period is less than the predetermined pay-back period, the project would
be accepted. If not, it would be rejected.

EX: A project requires an investment of $ 100, 000, it will generate annual cash flow of $25,000
per year. Calculate the payback period.

Original Investment
PB = Annual cash flows

100,000
= 25,000

= 4 years

Accounting Rate of Return

This method is based on the financial accounting practices of the company working out the
annual profits. Here, instead of taking the annual cash flows, we take the annual profits into
account. The net annual profits are calculated after deducting depreciation and taxes. The
average of annual profits thus derived is worked out on the basis of the period

Average annual profits after taxes

 100
ARR = Average investment over the life of project

1
Average investment = Net working capital + Salvage value + 2 (Initial cost of plant – salvage
value)

Net working capital = current assets – current liabilities

Total of annual profits

Average profits = Number of years

Accept/Reject criteria

If the actual accounting rate of return is more than the predetermined required rate of return, the
project would be accepted. If not it would be rejected.

Ex: Initial investments of plant $ 10, 000

Installation costs $ 1, 000

 Salvage value $ 1, 000

Net Working capital $ 2, 000

Life of plant 5 years

Annual profit per year $ 2, 500

Calculate ARR

12,500
Average profit = 2, 500 x 5 = 5 = 2, 500

1
Average investment = Wc + Sal.V. + 2 (Cost + Inst. Charges – Salv. Val)

1
= 2, 000 + 1, 000 + 2 (10, 000 + 1, 000 – 1, 000)

1
= 3, 000 + 2 (10, 000)

= 3, 000 + 5, 000

= 8, 000

2,500
ARR = 8,000 x 100

= 31.25%

The ARR is compared to the predetermined rate. The project will be accepted if the actual ARR
is higher than the desired ARR. Otherwise it will be rejected.

Discounted cash flow techniques:

This concept is based on the time value of money. The flow of income is spread over a few
years. The real value of Birr in your hand today is better than value of birr you earn after a year.
The future income, therefore, has to be discounted in order to be associated with the current out
flow of funds in the investment. Two methods of appraisal of investment project are based on
this concept. These are net present value and internal rate of return method.

Net Present Value

Net present value may be defined as the total of present value of the cash proceeds in each year
minus the total of present values of cash outflows in the beginning.

Net present value method is one of the modern methods for evaluating the project proposals. In
this method cash inflows are considered with the time value of the money. Net present value
describes as the summation of the present value of cash inflow and present value of cash
outflow. Net present value is the difference between the total present value of future cash inflows
and the total present value of future cash outflows.

Accept/Reject criteria

If the present value of cash inflows is more than the present value of cash outflows, it would be
accepted. If not, it would be rejected.
n
CFt Sn  Wn
 (1  K ) t

(1  K ) n
 Co
NPV =

Where; NPV = Net present value

CFt = Cash inflows at different periods

Wn = Working capital adjustments

Co = Cash outflow in the beginning

K = Cost of capital

Sn = Salvage value at the end

Decision Rule; The decision rule here is; to accept a project if the NPV is positive and reject if it
is negative

NPV > Zero Accept

NPV = Zero Indifference

NPV < Zero Reject

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 lower positive NPV. Projects with
negative NPV should not be considered for acceptance in the first place.

NPV of zero imply that the cash flows of the project are just sufficient to repay the invested
capital and to provide the required rate of return, no more, no less.

EX: ABC PLC is considering to invest in a cement project. It has on hand $180, 000. It is
expected that the project may work for seven years and likely to generate the following annual
cash flows. Calculate the Net present value.

Year ACF

1 30,000

2 50,000

3 60,000

4 65,000

5 40,000

6 30,000

7 16,000

The cost of capital is 8%

Solution: Year ACF PV factor Present value

1 30, 000 .926 27, 780

2 50, 000 .857 42, 850

3 60, 000 .794 47, 640

4 65, 000 .735 47, 775

5 40, 000 .681 27, 240

6 30, 000 .630 18, 900

7 16, 000 .583 9, 328

221, 513

- Original investment 180, 000

 Net present value 41, 513

I. The above problem the NPV is greater than zero hence, it may be accepted. You have already
learned in financial accounting to calculate the time value of money and the usage of present
value tables. Hence, you may directly use the present value factors from tables.

1 1

Present value of birr 1 = (1  r ) (1  .10)1
n

The present value of 1 Birr @ 10 cost after one year .909

two year .826

three .751

Profitability Index Method / Benefit Cost Ratio B/C Ratio

Profitability index method is the relationship between the present values of net cash inflows and
the present value of cash outflows. It can be worked out either in unitary or in percentage terms.
The formula is

Present va lue of cash inflows

Profitability Index = Pr esent value of cash outflows

PI > 1 Accept

PI = 1 indifference

PI < 1 reject

Higher the profitability index more is the project preferred.

From the above example we can calculate the profitability index as below

Present value of cash out flows $ 180, 000

Present value of cash inflows $ 221, 513

221,513
: - PI = 180,000

Internal Rate of Return (IRR)

The internal rate of return is also known as yield on investment, marginal efficiency of capital,
marginal productivity of capital, rate of return, time adjusted rate of return and so on. Internal
rate of return is nothing but the rate of interest which equates the present value of future earnings
with the present value of present investment. Therefore, IR depends entirely on the initial outlay
and the cash proceeds of the project which is being evaluated for acceptance or rejection. The
computation of IRR is difficult one; you have to start equating the two values i.e., present value
of future earnings and present value of investment. It is possible through trial and error method.

IRR can be calculated basing on the payback period where annual cash flows are uniform, in
case the annual cash inflows are different for the periods, the fake payback period is calculate
then adopt trial and error procedure.

Accept/Reject criteria

If the present value of the sum total of the compounded reinvested cash flows is greater than the
present value of the outflows, the proposed project is accepted. If not it would be rejected.

PB  DFr
r
IRR = DFrL  DFrH

Where; PB = Payback period

DFr = Discount Factor for interest

DFrL = Discount Factor for lower interest rate

DFrH = Discount Factor for higher interest rate

r = either of the two interest rates used

Or

NPVL
R
IRR = LRD + PV

Where; IRR = Internal Rate of Return

LRD = Lower Rate of Discount

NPVL = Net present value at lower rate of discount

(i.e., difference between present values of cash)

PV = The difference in present values at lower and higher discount values at lower.

R = The difference between two rates of discount.

Ex: Nissan Plc. has $100, 000 on hand. This amount is invested in a project, where the annual
benefits after taxes are as below. It would like to know the rate of return earned by the company
at the end of the life of the project.
 Year ACFS

1 $ 40, 000

2 35, 000

3 30, 000

4 25, 000

5 20, 000

Solution

At Discount Factor 20% At Discount Factor 10%

Year ACFS PV Factor PV in $ PV Factor PV in $

1 40, 000 .833 33, 300 .909 36, 400

2 35, 000 .694 24, 300 .826 28, 900

3 30, 000 .579 17, 400 .751 22, 500

4 25, 000 .482 12, 100 .683 17, 100

5 20, 000 .402 8, 000 .621 12, 400

95, 100 117, 300

NPVL
R
IRR = LRD + PV

17,300
 10
= 10 + 22, 200

= 17.8