DAMAT HOTEL

and
BUSINESS COLLEGE
Financial Management
Module

“A Journey towards Excellence”

Module Introduction

Dear learners! First of all, we would like to say well come to the course financial management I.
This module is prepared in the way to make you learn the fundamentals of financial management.
Finance is so indispensable to businesses that it is some times referred to as the "life blood" of any
organization. Regardless of whether they are big or small, governmental or non governmental,
businesses without finance is said to be "wingless bird".
Financial management can be defined as the management of capital sources and uses so as to attain
the desired goals of the firm (i.e. maximization of shareholders’ wealth).
One of the career opportunities for accounting graduates is being employed in governmental,
nongovernmental called together not for profit organizations or in a profit making business
organization that operate only with the existence of finance. For these organizations to achieve their
objectives, they need to utilize their resources in an effective and efficient manner, the core point in
financial management. Therefore, you are expected to have a profound knowledge of financial
management that enables you to know the financial position and operating results and make right
decision at the right time for the organization in which you are employed or the one that you consult,
by applying the knowledge you acquired in this course. Hence, you are required to know the basic
decisions involved in financial management: the investment, financing and assets management
decisions, as financial statements prepared by an accountant might not reveal the actual financial
health of a business enterprise and hence, the financial statement must be analyzed by forming
relations between the items, called ratio analysis. You are also advised to know the basic concept of
time value of money, and to advise the organization with regard to when and where to invest, in
which form to invest i.e. whether to invest in stocks, bonds or other instruments and how to value
bonds, stocks, retained earning, make good capital budgeting decisions so that the company will be
in a position to choose the most profitable investment portfolio.
To pursue the purpose of the course, the module is organized into five chapters with their respective
sections and sub sections. The first chapter is an introduction to financial management. Chapter two
is devoted to financial analysis and planning. It discusses the need for financial analysis, approaches
to financial analysis and interpretation, financial planning process and techniques for determining
the financial requirements. The third chapter deals with the Cost of Capital, which in detail discusses
about concepts and components of cost of capital. Chapter four deals with capital budgeting that
specifically discusses about techniques to choose among a given investment option and at last,
chapter five deals with Financing Decisions.
To facilitate your study, most sections in every chapter are made to include illustrative examples
and activities. You also find model examination questions at the end of each chapter and their
respective answer keys. Please, do not look at the answers before you try by yourself.

Module Objectives
After thoroughly studying the entire course, you will be able to:
 Understand the concept of finance and financial management
 Analyze the financial statement and tell its weaknesses and strengths
 Determine the external fund required for your business or business in which you are working
 Demonstrate the concept of cost of capital
 Describe the bond and stock valuation techniques
 Make right decision to choose the best investment alternative
 Describe the concepts of Financing Decisions
Brief contents

Chapter One: An Overview of Financial Management

Chapter Two: Financial Analysis and Planning

Chapter Three: The Cost of Capital

Chapter Four: Investment Decision Making/ Capital Budgeting Decision

Chapter Five: Financing Decisions

 CHAPTER ONE

FINANCIAL MANAGEMENT AN OVERVIEW

Contents of the Chapter

 Aims and objectives
 Introduction
1.1. Finance and Related Disciplines
1.1.1. Finance and Economics
1.1.2. Finance and Accounting
1.1.3. Finance and Other Disciplines
1.2. Scope of financial management
1.2.1. Traditional Approach
1.2.2 Modern Approach.
1.3. Important Decision in Financial Decision
1.4. Key Activities of the Financial Manager
1.5. Objectives of Financial Management
1.6. Profit and Wealth Maximization
1.6.1. Profit Maximizations Decision Criterion
1.6.2. Wealth Maximization Decision Criterion
1.7. Agency Relationships
1.7.1. Stock Holders versus Managers
1.7.2. Stock Holders versus Creditors
Chapter summary
Model Examination Questions
  Aims and Objectives
At the end of this chapter the students should be able to:
 Define finance and describe its major areas – Financial services and managerial finance/
corporate finance/ financial management.
 Differentiate financial management form the closely related disciplines of economics and
accounting.
 Describe the two approaches to the scope of financial management – traditional and
modern approaches and identify the key activities of the financial manager.
 Explain why wealth maximization rather than profit maximization is the goal of financial
management.
 Introduction
Finance may be defined as the art and science of managing money. The major areas of finance
are: (1) Financial services and (2) managerial finance/ corporate finance/ financial management.
While financial service is concerned with design and delivery of advice and financial products to
individuals, businesses and governments within the areas of banking and related institutions,
Personal financial planning, investments, real estate, and insurance and so on. Financial
management is concerned with the duties of the financial mangers in the business firm. Financial
managers actively manage the financial affairs of any type of business namely, financial and non
financial, private and public, large and small, profit seeking and not- for- profit. They perform
such varied tasks as budgeting financial forecasting, cash management, credit administration,
investment analysis, funds management and so on. In recent years, the changing regulatory and
economic environments coupled with the globalization of business activities have increased the
complexity as well as the importance of the financial managers’ duties.
Management: - in all business areas and organizational activities are the acts of getting people together to
accomplish desired goals and objectives. Management comprises planning, organizing, staffing, leading, or
directing, and controlling an organization (a group of one or more people or entities) or effort for the
purpose of accomplishing a goal. Re-sourcing encompasses the deployment and manipulation of human
resources, financial resources, technological resources, and natural resources. Because organizations can
be viewed as systems, management can also be defined as human action, including design, to facilitate the
production of useful outcomes from a system. This view opens the opportunity to ‘manage’ oneself, a pre-
requisite to attempting to manage others.

Financial management: financial management can be defined as the management of capital

sources and their uses so as to attain the desired goal of the firm (i.e. maximization of share holders’
wealth). Financial management involves sourcing of funds, making appropriate investments and
promulgating the best mix of financial and dividends in relation to the value of the firm. Note:
capital sources means items found on the right-hand side of the balance sheet i.e. liabilities and
owners’ equity whereas uses of capital means items found on the left hand side of the balance sheet
i.e. assets.

As a result, the financial management function has become more demanding and complex. This
chapter provides an overview of financial management function and it is organized into the
following sections: -
 Relationship finance and related disciplines.
 Scope of financial management.
 Important decision in financial management.
 Key activities of the financial manager.
 Goal / objectives of financial management.
 Profit maximization and wealth maximization.
1.1. Finance and Related Disciplines

Dear students! What is the relationship between finance and Accounting?

What is the scope of financial management? And what is the most important
financial management decisions that finance managers can decide?

Financial management as an integral part of overall management is not a totally independent area.
It draws heavily on related disciplines and fields of study, such as economics, accounting,
marketing, production and quantitative methods. Although these disciplines are interrelated, there
are key differences among them. In this section we discuss these relationships.
1.1.1. Finance and Economics
The relevance of economics to financial management can be described in the light of the two broad
areas of economics: Macro -Economics and Micro- Economics.
Macroeconomics - is concerned with the overall institutional environment in which the firm
operates. It looks at the economy as a whole. Macroeconomics is concerned with the institutional
structure of the banking system, money and capital markets, financial intermediaries, monetary,
credit and fiscal policies and economic policies dealing with, and controlling level of activity with
in an economy. Since business firms operate in the macro economic environment, it is important
for financial managers to understand the broad economic environment specifically, they should:
(1) recognize and understand how monetary policy affects the cost and availability of funds; (2)
be versed in fiscal policy and its effects on the economy; (3) be ware of the various financial
institutions / financing outlets; (4) understand the consequences of various levels of economic
activity and changes in economic policy for their decision environment.
Microeconomics: - Deals with the economic decisions of individuals and organizations. It
concerns itself with the determination of optimal operating strategies. In other words, the theories
of Microeconomics provide for effective operations of business firms. They are concerned with
defining actions that will permit the firms to achieve success. The concepts and theories of
microeconomics relevant to financial management are, for instance, those involving (1) supply
and demand relationships and profit maximization strategies (2) issues related to the mix of
productive factors; optimal’ sales level and product pricing strategies (3) measurement of utility
preference, risk and the determination of value 4) the rationale of depreciating assets.
Thus, knowledge of economics is necessary for a financial manager to understand both the
financial environment and the decision theories which underline contemporary financial
management. A basic knowledge of economics therefore, necessary to understand both the
environment and the decision techniques of financial management.

 Activity 1.1
1. Describe the close relationship between finance and economics and explain why the finance
manager should possess a basic knowledge of economics? What is the primary economic principle
used in managerial finance?
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1.1.2. Finance and Accounting
Conceptually speaking, the relationship between finance and accounting has two dimensions (i)
they are closely related to the extent that accounting is an important input in financial decision
making and (ii) there are key differences in view point between them. Accounting function is a
necessary input in to the finance function. That is accounting is a sub function of finance.
Accounting generates information/ data relating to operations/ activities of the firm. The end
product of accounting constitutes financial statements such as the balance sheet, the income
statement, and the changes in financial position/ sources and uses of funds statement/ cash flow
statement. The information contained in these statements and reports assists financial managers in
assessing past performance and future directions of the firm and in meeting legal obligation such
as payment of taxes and so on. Thus, accounting and finance are functionally closely related. But
there are two key differences between finance and accounting.
1.Treatment of Funds: The view point of accounting relating to the funds of the firm is different
from that of finance. The measurement of funds (income and expense) in accounting is based on
accrual principle / system. Revenue is recognized at the point of sale and not when collected.
Similarly, expenses are recognized when they are incurred rather than when actively paid. But the
view point of finance relating to the treatment of funds is based on cash flow. The revenues are
recognized only when actually received in cash (i.e. cash inflow) and expenses are recognized on
actual payment (cash out flow). This is so because the financial manager is concerned with
maintaining solvency of the firm by providing the cash flows necessary to satisfy its obligations
and acquiring and financing the assets needed to achieve the goals of the firm.
2. Decision making: - Finance and accounting also differ in respect of their purpose. The purpose
of accounting is collection and presentation of financial data. It provides consistently developed
and easily interpreted data on the past, present and future operations of the firm. The primary focus
of the function of accountants is on collection and presentation of data while the financial
manager’s major responsibility relates to financial planning, Controlling and decision -making.
Thus, in a sense, finance begins where accounting ends.

 Activity 1.2
1. What are the major differences between accounting and finance with respect to
i. Emphasis on cash flows of the financial manager?
 ii. Emphasis on accounting profit?
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1.1.3. Finance and Other Disciplines

Apart from economics and accounting; finance is also being used for day to day decision. On
supportive disciplines such as marketing, production and quantitative methods. For example,
financial mangers should consider the impact of new product development and promotion plans
made in marketing area since their plans will require capital outlays and have an impact on the
projected cash flows: -
The marketing, production and quantitative methods are, thus, only indirectly related to day today
decision making by financial managers and are supportive in nature while economics and
accounting are the primary disciplines on which the financial managers draws substantially.
1.2. Scope of Financial Management
The approach to the scope and functions of financial management is divided, for purposes of
exposition into two broad categories: a) the traditional approach and (b) the modern approach.
1.2.1. Traditional Approach: - The traditional approach to the scope of financial management
refers to its subject-matter, in academic literature in the initial stages of its evolution as a separate
branch of an academic study.
1.2.2. Modern Approach: - The modern approach views the term financial management in abroad
sense and provides a conceptual and analytical framework for financial decision making.
According to it, the finance function covers both acquiring of funds as well as their allocations.
Thus, apart from the issues involved in acquiring external funds, the main concern of financial
management is the efficient and wise allocation of funds to various uses. It is viewed as an integral
part of the over all management. The main contents of this approach are:-
 What is the total volume of funds an enterprise should commit?
 What specific assets should an enterprise acquire?
 How should the funds required be financed?
1.3. Important Decision in Financial Management
1. Investment Decision: This decision is called capital budgeting decision. It generally answers
the question that what assets should the firm owns, investment decision or capital budgeting
involves the decision of allocation of capital or commitment of funds to long- term assets that
would yield benefits in the future.
2. Financing Decision: - The second major decision involved in financial management is the
financing decision. The investment decision is broadly concerned with the asset mix or the
composition of the assets of the firm. The concern of the financing decision is with the financing
mix or capital structure, or leverage. The term capital structure refers to the proportion of debt
(fixed – interest source of financing) and equity capital (variable – dividend securities/ source of
funds). The financing decision of a firm relates to the choice of the proportion of these sources to
finance the investment requirements.
3. Dividend Policy Decision: - The third major decision area of financial management is the
decision relating to the dividend policy. The dividend decision should be analyzed in relation to
the financing decision of a firm. Two alternatives are available in dealing with the profits of a firm:
1. They can be distributed to the shareholders in the form of dividends or
2. They can be retained in the business it self.
The decision as to which course should be followed depends largely on a significant element in
the dividend decision, the dividend payout ratio that is what portion of net profits should be paid
out to shareholders. The final decision will depend up on the preference of the shareholders and
investment opportunities available within the firm. The second major aspect of the dividend
decision is the factors determining dividend policy on a firm in practice.
4. Asset Management Decision: After the assets are acquired the need to be managed effectively.
The financial manager is charged with the varying degree of operating responsibility over existing
assets.

 Activity1.3
1. What are the major types of financial management decisions that business firms make? And
Identify their difference
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1.4. Key Activities of the Financial Manager: The primary activities of a financial manager are
(1) performing financial analysis and planning (2) making investment decision, and (3) making
financial decisions.
1.5. Objectives of Financial Management: To make wise decisions a clear understanding of the
objectives which are sought to be achieved is necessary. The objective provides a framework for
optimum financial decision-making. The term objective is used in the sense of a goal or decision
criterion for the four decisions involved in financial management. The financial manager uses the
overall company’s goal of shareholders’ wealth maximization which is reflected through the
increased dividend per share, and the appreciations of the prices of shares in formulating the
financial policies and evaluating alternative course of actions. In order to do so, this overall goal
of wealth maximization needs to be related to take the following specific objectives of financial
management in account. These are:
 Financial management aims at determining how large the business firm should be and how fast
should it grow?
 Financial management aims at determining the best percentage composition of the firm’s assets
(asset portfolio decision of related to capital uses)
 Financial management aims at determining the best percentage composition of the firm’s
combined liabilities and equity decisions related to capital sources.

 Activity 1.4
1. What is the primary goal the firm? Discuss how to measure achievement of this goal.
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1.6. Profit and Wealth Maximization

 Dear students! What are the goals of financial management? Which goal can
be considered as an appropriate goal of the firm? Why?

1.6.1. Profit Maximizations as a Decision Criterion

Profit maximization is considered as the goal of financial management, in this approach, actions
that increase profits should be undertaken and actions that decrease profits are avoided. Thus, the
investment, financing and dividend decisions also be noted that the term objective provides a
normative framework decision should be oriented to the maximization or profit. The term profits
are used in two senses. In one sense it is used as an owner – oriented. In this concept it refers to
the amount and share of national income that is paid to the owners of business. The second way is
operational concept i.e. profitability, this concept signifies economic efficiency i.e. profitability
refers to the situation where output exceeds input and, the value credited by the use of resources
is greater than the input resources. Thus, in the entire decisions one test is used i.e. select asset,
projects and decision that are profitable and reject those which are not profitable.
Profit maximization criterion is criticized on several grounds. Firstly; the reasons for the
opposition that are based on misapprehensions about the workability and fairness of the private
enterprise itself. Secondly, profit maximization suffers from the difficulty of applying this criterion
in the actual real world situations. We shall now discuss some of the limitations of profit
maximization objective of financial management.
1. Ambiguity: The term profit maximization as a criterion for financial derision is vague and
ambiguous concept it lacks precise connotation. The term’ is amenable to different
interpretations by different people. For example, profit may be long-term or short term, it may
be total profit or rate of profit, it can be net profit before tax or net profit after tax, it may be
return on total capital employed or shareholder’s equity and so on.
2. Timing of Benefits: - Another technical objection to the profit maximization criterion is that
it ignores the differences in the time pattern of the benefits received from investment proposals
or course of action when the profitability is worked out, the bigger the better principle is
adopted as the decision is based on the total benefits received over the working life of the asset,
irrespective of when they were received
3. Quality of Benefits: Another important technical limitation of profit maximization is that it
ignores the quality aspects of benefits which are associated with the financial course of action.
The term, quality means the degree of certainty associated with which benefits can be expected.
Therefore, the more certain the expected return, the higher the quality of benefits. As against
this, the more uncertain or fluctuating the expected benefits, the lower the quality of benefits.
The profit maximization criterion is not appropriate and suitable as an operational objective. It
is unsuitable and inappropriate as an operational objective of investment, financing, and
dividend decisions of a firm. It is vague and ambiguous. It ignores important dimensions of
financial analysis viz risk and time value of money.
An appropriate operational decision criterion for financial management should poses
the following quality.
A. It should be precise and exact.
 B. It should be based on the bigger the better principle.
C. It should consider both quantities and quality dimensions of benefits.
D. It should consider time value of money
1.6.2. Wealth Maximization as a Decision Criterion
Wealth maximization decision criterion is also known as value maximization or net present –
worth maximization is widely accepted as an appropriate operational decision criterion for
financial management decision. It removes the technical limitations of profit maximization
criterion and it pokes the three requirements of a suitable operational objective of financial courses
of action. These three features are exactness, quality of benefits, and the time value of money.
1. Exactness: The value of an asset should be determined in terms of returns it can produce. Thus,
the worth of a course of action should be valued in terms of the returns less the cost of
undertaking the particular course of action is the exactness in computing the benefits associated
with the course of action. The wealth maximization criterion is based on cash flows generated
and not on accounting profits. The computation of cash inflows and cash outflows is precise.
As against this, the computation of accounting is not exact.
2. Quality, Quantity, Benefits and Time Value of Money: The second feature of wealth
maximization criterion is that it considers both the quality and quantity dimensions of benefits.
Moreover, it also incorporates the time value of money. As stated earlier, the quality of benefits
refers to certainty with which benefits are received in future. The more certain the expected
cash flows, the better the quality of benefits and higher value. To the contrary, the less certain
the flows, the lower the quality and hence, value of benefits. It should also benefit that money
has time value. It should also be noted that benefits received in earlier years should be valued
highly than benefits received later.
The operational implication of uncertainty and timing dimension of the benefits associated with
financial decision is that adjustments need to be made in the cash flow pattern. It should be made
to incorporate risk and to make an allowance for differences in timing of benefits. Net present
value maximization is superior to the profit maximization as on operational objective.
Note, Profit maximization as the objective of financial management; it aims at improving
profitability, maintaining the stability and reducing losses and inefficiencies.
 Activity 1.5
1. What are the differences between shareholder wealth maximization and
profit maximization?
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1.7.AGENCY RELATIONSHIPS

It has long been recognized that managers may have personal goals that compete with shareholder
wealth maximization. Managers are empowered by the owners of the firm—the shareholders—to
make decisions and that create a potential conflict of interest known as agency theory. An agency
relationship arises whenever one or more individuals, called principals, hire another individual or
organization, called an agent, to perform some service and delegate decision-making authority to
that agent. In financial management, the primary agency relationships are those between (1)
stockholders and managers and (2) managers and debt holders.
1.7.1. Stockholders Versus Managers
A potential agency problem arises whenever the manager of a firm owns less than 100 percent of
the firm’s common stock. In most large corporations, potential agency conflicts are important,
because large firms’ managers generally own only a small percentage of the stock. In this situation,
shareholder wealth maximization could take a back seat to any number of conflicting managerial
goals. For example, people have argued that some managers’ primary goal seems to be to
maximize the size of their firms. By creating a large, rapidly growing firm, managers (1) increase
their job security, because a hostile takeover is less likely; (2) increase their own power, status,
and salaries; and (3) create more opportunities for their lower- and middle-level managers.
Furthermore, since the managers of most large firms own only a small percentage of the stock, it
has been argued that they have a big appetite for salaries and perquisites, and that they generously
contribute corporate dollars to their favorite charities because they get the glory but outside
stockholders bear the cost.
Managers can be encouraged to act in stockholders’ best interests through incentives that reward
them for good performance but punish them for poor performance. Some specific mechanisms
used to motivate managers to act in shareholders’ best interests include (1) managerial
compensation, (2) direct intervention by shareholders, (3) the threat of firing, and (4) the threat of
takeover.
1. Managerial compensation. Managers obviously must be compensated, and the structure of the
compensation package can and should be designed to meet two primary objectives: (a) to attract
and retain able managers and (b) to align managers’ actions as closely as possible with the
maximization.
Different companies follow different compensation practices, but a typical senior executive’s
compensation is structured in three parts: (a) a specified annual salary, which is necessary to meet
living expenses; (b) a bonus paid at the end of the year, which depends on the company’s
profitability during the year; and (c) options to buy stock, or actual shares of stock, which reward
the executive for long-term performance. Managers are more likely to focus on maximizing stock
prices if they are themselves large shareholders. Often, companies grant senior managers
performance shares, where the executive receives a number of shares dependent upon the
company’s actual performance and the executive’s continued service. Most large corporations also
provide executive stock options, which allow managers to purchase stock at some future time at
a given price. Obviously, a manager who has an option to buy, say, 10,000 shares of stock at a
price of Birr10 during the next 5 years will have an incentive to help raise the stock’s value to an
amount greater than Birr10.
2. Direct intervention by shareholders. Years ago most stock was owned by individuals, but
today the majority is owned by institutional investors such as insurance companies, pension funds,
and mutual funds. Therefore, the institutional money managers have the clout, if they choose to
use it, to exercise considerable influence over most firms’ operations.
3. The threat of firing. Until recently, the probability of a large firm’s management being ousted
by its stockholders was so remote that it posed little threat. This situation existed because the shares
of most firms were so widely distributed, and management’s control over the voting mechanism
was so strong, that it was almost impossible for dissident stockholders to get the votes needed to
overthrow a management team. However, as noted above, that situation is changing.
4. The threat of takeovers. Hostile takeovers (when management does not want the firm to be
taken over) are most likely to occur when a firm’s stock is undervalued relative to its potential
because of poor management. In a hostile takeover, the managers of the acquired firm are generally
fired, and any who manage to stay on lose status and authority. Thus, managers have a strong
incentive to take actions designed to maximize stock prices. In the words of one company
president, “If you want to keep your job, don’t let your stock sell at a bargain price.”
1.7.2. Stockholders (Through Managers) Versus Creditors
In addition to conflicts between stockholders and managers, there can also be conflicts between
creditors and stockholders. Creditors have a claim on part of the firm’s earnings stream for
payment of interest and principal on the debt, and they have a claim on the firm’s assets in the
event of bankruptcy. However, stockholders have control (through the managers) of decisions that
affect the profitability and risk of the firm. Creditors lend funds at rates that are based on (1) the
riskiness of the firm’s existing assets, (2) expectations concerning the riskiness of future asset
additions, (3) the firm’s existing capital structure (that is, the amount of debt financing used), and
(4) expectations concerning future capital structure decisions. These are the primary determinants
of the riskiness of a firm’s cash flows, hence the safety of its debt issues. Now suppose
stockholders, acting through management, because a firm to take on a large new project that is far
riskier than was anticipated by the creditors.
This increased risk will cause the required rate of return on the firm’s debt to increase, and that
will cause the value of the outstanding debt to fall. If the risky project is successful, all the benefits
go to the stockholders, because creditors’ returns are fixed at the old, low-risk rate. However, if
the project is unsuccessful, the bondholders may have to share in the losses. From the stock-
holders’ point of view, this amounts to a game of “heads I win, tails you lose,” which is obviously
not good for the creditors.
Can and should stockholders, through their managers/agents, try to expropriate wealth from
creditors? In general, the answer is no, for unethical behavior is penalized in the business world.
First, creditors attempt to protect themselves against stockholders by placing restrictive covenants
in debt agreements.
Moreover, if creditors perceive that a firm’s managers are trying to take advantage of them, they
will either refuse to deal further with the firm or else will charge a higher-than-normal interest rate
to compensate for the risk of possible exploitation. Thus, firms that deal unfairly with creditors
either lose access to the debt markets or are saddled with high interest rates and restrictive
covenants, all of which are detrimental to shareholders.
 Activity 1.6
2. What are agency problems and how do they come about? How to overcome agency
problems?
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Summary
This chapter provides an introduction to some of the basic concepts underlying financial
management. So, we stressed the following points.
Financial management is concerned with acquiring, financing and managing assets to achieve
a desired goal.
The Financial process involves four broad decision areas: (1) Long-term investment decisions,
(2) Long-term financing decisions, (3) Asset management decision, and (4) dividend decision.
Financial decisions involve a risk-return trade off in which higher expected returns are
accompanied by higher risk. The financial manager determines the appropriate risk-return
trade off to maximize the value of the firm’s stock.
Financial managers are responsible for obtaining and using funds in away that will maximize
the value of the firm.
The primary goal of management in a publicly trade firm should be to maximize stockholders’
wealth, and this means maximizing the price of the firm’s stock.
Model Examination Questions
Choose the Best Answer
1. The only viable goal of financial management is
A. Profit maximization B. Wealth maximization
C. Sales maximization D. Assets maximization
2. Basic objective of financial management is
A. Maximization of profits B. Maximization of share holder’s wealth
C. Ensuring financial discipline in the organization D. None of the above
3. Finance function involves
A. Procurement of finance only B. Expenditure of funds only
C. Safe custody of funds only D. Procurement and effective utilization of fiancé
4. The goal of profit maximization takes in to consideration
A. Risk related to uncertainty of returns B. Timing of expected returns
C. Efficient management of every business D. None of the above
5. Financial management is mainly concerned with
A. Arrangement of funds
B. All aspects auguring and utilizing means of financial resources for firm's activities
C. Efficient management of every business
D. None of above
Answers to Model Examination Questions

1. B 2. B 3. D 4. C 5. B
 CHAPTER TWO

FINANCIAL ANALYSIS AND PLANNING

Contents of the Chapter
 Aims and objectives
 Introduction
Contents
2.1. Sources of Financial Information
2.2. Financial Analysis
2.2.1. The Need for Financial Analysis
2.2.2. Methods / Domains of Financial Analysis
2.2.2.1. Ratio Analysis
2.2.2.2. Horizontal (trend) Analysis
2.2.2.3. Vertical (Static) Analysis
2.2.3. Benchmarks for Comparisons
2.2.4. Types of Financial Ratios
2.2.4.1. Liquidity Ratio
2.2.4.2. Activity Ratio
2.2.4.3. Leverage Ratio
2.2.4.4. Profitability Ratio
2.2.5. Limitations of Ratio Analysis
2.2.6. Common Size and Index Analysis
2.2.6.1. Statement of Items as Percentage of Totals
2.2.6.2. Statement of Items as Indexes Relative to a base year
2.2.7. Du Pont Analysis
2.3. Financial Planning
2.3.1. The Planning Process
2.3.2. Sales Forecasting
2.3.3. Techniques of Determining External Financial Requirements
2.3.3.1. Percent – of –sales Method of Financial Forecasting
2.3.3.2. Formula Methods for Forecasting (AFN)
 Chapter Summary
  Model Examination Questions

 Aims and Objectives

This Chapter aims at presenting the financial statements, importance, objectives, uses, meaning of
financial analysis, and techniques of financial statement analysis.
At the end of this unit, students will be able to:
 Understand the financial statements
 List the users of financial Statements
 Identify the techniques of financial analysis and apply to real business world
 Identify the techniques for forecasting external resources required
 Introduction
The essence of managing risk is making good decisions. Correct decision making depends on
accurate information and proper analysis. Financial statements are summaries of the operating,
investment, and financing activities that provide information for these decisions. But the
information is not enough by them selves and need to be analyzed. Financial analysis is a tool of
financial management. It consists of the evaluation of the financial condition and operating results
of a business firm, an industry, or even the economy, and the forecasting of its future condition
and performance. This Chapter discusses common financial information and performance
measures frequently used by owners and lenders to evaluate financial health and make risk
management decisions. By conducting regular checkups on financial condition and performance,
you are more likely to treat causes rather than address only symptoms of problems.
2.1. Sources of Financial Information
Financial statements help assess the financial well-being of the overall operation. Information
about the financial results of each enterprise and physical asset is important for management
decisions, but by themselves are inadequate for some decisions because they do not describe the
whole business. An understanding of the overall financial situation requires three key financial
documents: the balance sheet, the income statement and the cash flow statement.
1. The Balance Sheet
The balance sheet shows the financial position of a firm at a particular point of time. It also shows how
the assets of a firm are financed. A completed balance sheet shows information such as the total value
of assets, total indebtedness, equity, available cash and value of liquid assets. This information can
then be analyzed to determine the business' current ratio, its borrowing capacity and opportunities
to attract equity capital.
2. Income Statement
Usually income statements are prepared on an annual basis. An income statement often provides
a better measure of the operation's performance and profitability. It shows the operating results of
a firm, flows of revenue and expenses. It focuses on residual earning available to owners after all
financial and operating costs are deducted, claims of government are satisfied.
3. Cash Flow Statement
Reports the sources and uses of the operation’s cash resources. Such statements not only show the
change in the operation's cash resources throughout the year, but also when the cash was received
or spent. An understanding of the timing of cash receipts and expenditures is critical in managing
the whole operation.
2.2. Financial Analysis

 Dear students! What does financial statement analysis mean? What are the
advantages of financial statement analysis? What methods will be used for analyzing
the financial statement?

Financial analysis is the assessment of firm's past, present, and anticipated future financial condition.
It is the base for intelligent decision making and starting point for planning the future courses of
events for the firm. Its objectives are to determine the firm's financial strength and to identify its
weaknesses. The focus of financial analysis is on key figures in the financial statements and the
significant relationships that exist between them.
2.2.1. The Need for Financial Analysis
The following stakeholders are interested in financial statement analysis to make their respective
decision at right time.
The following are interested in financial statements analysis
1. Investors: Investors fall into two categories, existing and potential. Some seek a takeover,
leading to majority control and shareholding. This usually occurs when a company is losing public
confidence resulting in low market value. Often considered as hostile takeovers, the investors tend
to restructure the business and control it completely, issue shares or sell it off in the open market.
The other category consists of short and long-term investors, both interested in increasing their
wealth with the minimal effort. This may be through either earning dividends or trading shares in
the stock exchange.
2.Lenders: These may supply funds to the organization on short and/or long-term basis. There are
several financial institutions and individuals willing to lend to progressive companies but few to
support those with lower earning levels. The loan carries a charge of interest payable annually
or as agreed, on the principle or compounded principle, over the period that the loan has been
issued.
3.The Management: The managers are entrusted with the financial resources contributed by
owners and other suppliers of funds for effective utilization. In their pursuit to make the company
achieve its objectives, the managers should use relevant financial information to make right
decision at the right time.
4.Suppliers: Suppliers of products and services to the company would like their investments -
sales made on credit terms - received with surety. A creditor would be reluctant to trade any
further if s/he is not guaranteed a timely payment against the issued invoice.
5.Employees: Many would consider employees the least affected of all when it comes to analyzing
the company's accounts. Think again. The employees will be first to feel the change in
circumstances as they may be promoted, demoted or fired. They would be very much interested
in finding out if the company exhibits any points in their favor, mainly job security and facilities.
6.Government bodies: As a rule, Companies House requires each company, private or public, to
submit their financial statements and accounts annually. The list of registered companies and
their most recent accounts are published in the Companies House official publication, which
informs the public of their performance for the year or period ended. In addition, the government
has the responsibility to ensure that the information is not delusive and the rights of the public
are protected. Furthermore, it bears the responsibility of prosecuting any offender of the law,
including corporate and consumer law.
7.Competitors: It may seem odd, but existing competitors and new entrants have to consider the
likelihood of their success or failure in trying to conquer the market. Their primary interest lies
in the business ratios of efficiency/productivity and cash, debtor and credit management. For the
industry, it acts as a comparative for better performance of firms and companies of varying sizes.
 They also help in establishing a trend of the industry that is normally a guide to new entrants to
study, analyze and perform.
2.2.2. Methods/ Domains of Financial Analysis

2.2.2.1.Ratio Analysis

Probably, the most widely used financial analysis technique is ratio analysis, the analysis of
relationships between two or more line items on the financial statements.
A ratio: Is the mathematical relationship between two quantities in the financial Statement.
Ratio analysis: is essentially concerned with the calculation of relationships which, after proper
identification and interpretation, may provide information about the operations and state of affairs
of a business enterprise. The analysis is used to provide indicators of past performance in terms of
critical success factors of a business. This assistance in decision-making reduces reliance on
guesswork and intuition, and establishes a basis for sound judgment.
2.2.2.2.Horizontal (Trend) Analysis

Horizontal Analysis expresses financial data from two or more accounting periods in terms of a
single designated base period; it compares data in each succeeding period with the amount for the
preceding period. For example, current to past or expected future for the same company.
2.2.2.3. Vertical (Static) Analysis
In vertical analysis, all the data in a particular financial statement are presented as a percentage of
a single designated line item in that statement. For example, we might report income statement
items as percentage of net sales, balance sheet items as a percentage of total assets; and items in
the statement of cash flows as a fraction or percentage of the change in cash.
2.2.3. Benchmarks for Evaluation
What is more important in ratio analysis is the through understanding and the interpretation of the
ratio values. To answers the questions as; it is too high or too low? Is good or bad? A meaningful
standard or basis for comparison is needed.
We will calculate a number of ratios. But what shall we do with them? How do you interpret them?
How do you decide whether the Company is healthy or risky? There are three approaches:
Compare the ratios to the rule of thumb, use Cross-sectional analysis or time series analysis.
Comparing a company's ratios to the rule of thumb has the virtue of simplicity but has little to
recommend it conceptually. The appropriate value of ratios for a company depends too much on
the analyst's perspectives and on the Company's specific circumstances for rules of thumb to be
very useful. The most positive thing to be said in their support is that, over the years, Companies
confirming to these rules of thumb tend to go bankrupt somewhat less frequently than those that
do not.
Cross-Sectional Analysis- involves the comparison of different firm's financial ratios at the same
point in time. The typical business is interested in how well it has performed in relation to its
competitors. Often, the firm's performance will be compared to that of the industry leader, and the
firm may uncover major operating deficiencies, if any, which, if changed, will increase efficiency.
Another popular type of comparison is to industry averages; the comparison of a particular ratio
to the standard is made to isolate any deviations from the norm. Too high or too low values reflect
symptoms of a problem. Comparing a Company's ratios to industry ratios provide a useful feel for
how the Company measures up to its Competitors. But, it is still true that company specific
differences can result in entirely justifiable deviations from industry norms. There is also no
guarantee that the industry as a whole knows what it is doing.
Time-Series Analysis – is applied when a financial analyst evaluates performance of a firm over
time. The firm's present or recent ratios are compared with its own past ratios.
Comparing of current to past performance allows the firm to determine whether it is progressing
as planned.

 Activity 2.1
1. Who are the users of financial statements and for what purpose do they use it?
___________________________________________________________________________
___________________________________________________________________________
2. Discuss the basis with which you compare your company's ratios
___________________________________________________________________________
___________________________________________________________________________

2.2.4. Types of Financial Ratios

 Dear students! Do you know the classifications of financial ratios?

Give your answers in writing before beading the following section.
There are five basic categories of financial ratios. Each represents important aspects of the firm's
financial conditions. The categories consist of liquidity, activity, leverage, profitability and market
value ratios. Each category is explained by using an example set of financial ratios for Lakomenza
Company.
Exercise 2.1

Dear Students! Let us use the financial statements of Lakomenza Company, shown below to
investigate and explain ratio analysis.
Lakomenza Company, Income Statements
Variables 2001 2000
Sales 3,074,000 2,567,000
Less Cost of Goods Sold 2,088,000 1,711,000
Gross Profit 986,000 856,000
Less Operating Expenses
Selling Expenses 100,000 108,000
General and Adm. Expenses 468,000 445,000
Total Operating Expenses 568,000 553,000
Operating Profit 418,000 303,000
Less Interest Expenses 93,000 91,000
Net Profit Before Tax 325,000 212,000
Less Profit Tax (at 29%) 94,250 61,480
Net Income After Tax 230,750 150,520
Less Preferred Stock Dividends 10,000 10,000
Earning Available to Common Shareholders 220,750 140,520
EPS 2.90 1.81

Lakomenza, Balance Sheets

2001 2000
Assets
Current Assets
Cash 363,000 288,000
Marketable Securities 68,000 51,000
Accounts Receivables 503,000 365,000
Inventories 289,000 300,000
 Total Current Assets 1,223,000 1,004,000
Gross Fixed Assets (at cost)
Land and Buildings 2,072,000 1,903,000
Machinery and Equipment 1,866,000 1,693,000
Furniture and Fixture 358,000 316,000
Vehicles 275,000 314,000
Others 98,000 96,000
Total Fixed Assets 4,669,000 4,322,000
Less Acc. Depreciation 2,295,000 2,056,000
Net Fixed Assets 2,374,000 2,266,000
Total Assets 3,597,000 3,270,000
Liabilities and Owners' Equity
Current Liabilities
Accounts Payable 382,000 270,000
Notes Payable 79,000 99,000
Accruals 159,000 114,000
Total Current Liabilities 620,000 483,000
Long-Term Debts 1,023,000 967,000
Total Liabilities 1,643,000 1,450,000
Shareholder's Equity
Preferred Stock –Cumulative, 2000 Share issued and Outstanding 200,000 200,000
Common Stock, Shares issued and Outstanding in 2001, 76,262; in 191,000 190,000
2000, 76,244

Paid- in Capita in Excess of Par on Common Stock 428,000 418,000

Retained Earnings 1,135,000 1,012,000
Total Stockholders' Equity 1,954,000 1,820,000
Total Liabilities and Stockholders' Equity 3,597,000 3,270,000

2.2.4.1. Liquidity Ratios

Liquidity refers to, the ability of a firm to meet its short-term financial obligations when and as
they fall due.
Liquidity ratios provide the basis for answering the questions: Does the firm have sufficient cash
and near cash assets to pay its bills on time?
Current liabilities represent the firm's maturing financial obligations. The firm's ability to repay
these obligations when due depends largely on whether it has sufficient cash together with other
assets that can be converted into cash before the current liabilities mature. The firm's current assets
are the primary source of funds needed to repay current and maturing financial obligations. Thus,
the current ratio is the logical measure of liquidity. Lack of liquidity implies inability to meet its
current obligations leading to lack of credibility among suppliers and creditors.

 Dear students! What are the basic measures of liquidity of the companies?

A. Current Ratio: - Measures a firm’s ability to satisfy or cover the claims of short term creditors
by using only current assets. That is, it measures a firm’s short-term solvency or liquidity.
The current ratio is calculated by dividing current assets to current liabilities.

Current Assets
Current Ratio = Current Liabilities

Therefore, the current ratio for Lakomenza Company is

For 2001 = 1,223,000 = 1.97
620,000
The unit of measurement is either birr or times. So, we could say that Lakomenza has Birr 1.97 in
current assets for every 1 birr in current liabilities, or, we could say that Lakomenza has its current
liabilities covered 1.97 times over. Current assets get converted in to cash through the operating
cycle and provide the funds needed to pay current liabilities. An ideal current ratio is 2:1or more.
This is because even if the value of the firm's current assets is reduced by half, it can still meet its
obligations.
However, between two firms with the same current ratio, the one with the higher proportion of
current assets in the form of cash and account receivables is more liquid than the one with those
in the form of inventories.
A very high current ratio than the Standard may indicate: excessive cash due to poor cash
management, excessive accounts receivable due to poor credit management, excessive inventories
due to poor inventory management, or a firm is not making full use of its current borrowing
capacity. A very Low current ratio than the Standard may indicate: difficulty in paying its short
term obligations, under stocking that may cause customer dissatisfaction.
B. Quick (Acid-test) Ratio: This ratio measures the short term liquidity by removing the least
liquid assets such as:
- Inventories: are excluded because they are not easily and readily convertible into cash and more
over, losses are most likely to occur in the event of selling inventories. Because inventories are
generally the least liquid of the firm's assets, it may be desirable to remove them from the
numerator of the current ratio, thus obtaining a more refined liquidity measure.
- Prepaid Expenses such as; prepaid rent, prepaid insurance, and prepaid advertising, pre paid
supplies are excluded because they are not available to pay off current debts.
Acid-Test Ratio is computed as follows.

Current assets  Inventories

Quick/Acid test Ratio = Current Liabilities

For 2001, Quick Ration for Lakomenza Company will be: 1,223,000- 289,000 = 1.51
620,000
Interpretation: Lakomenza has 1birr and 51 cents in quick assets for every birr current liabilities.
As a very high or very low acid test ratio is assign of some problem, a moderately high ratio is
required by the firm.

 Activity 2.2
1. What is Liquidity and what does Liquidity ratio measures?
____________________________________________________________________________
____________________________________________________________________________
2. Compute the current and acid-test ratio of Lakomenza Company for the year 2000
2.2.4.2. Activity Ratios

 Dear students! In the previous discussions, you have seen the Liquidity ratios. Now,
You are going to see the Activity ratios.
So, What do you think the activity ratio measures?
What ratios are included under this category?

Activity ratios are also known as assets management or turnover ratios. Turnover ratios measure
the degree to which assets are efficiently employed in the firm. These ratios indicate how well the
firm manages its assets. They provide the basis for assessing how the firm is efficiently or
intensively using its assets to generate sales. These ratios are called turnover ratios because they
show the speed with which assets are being converted into sales.
Measure of liquidity alone is generally inadequate because differences in the composition of a
firm's current assets affect the "true" liquidity of a firm i.e. Overall liquidity ratios generally do
not give an adequate picture of company’s real liquidity due to differences in the kinds of current
assets and liabilities the company holds. Thus, it is necessary to evaluate the activity ratio.
Let us see the case of ABC and XYZ café having different compositions of current assets but equal
in total amount.
Exercise 2.2 ABC Café XYZ Café
(Birr) (Birr)
Cash 0 7,000
Marketable Security 0 17,000
A/R 0 5,000
Inventories 35,000 6,000
Total Current Asset 35,000 35,000
Current Liabilities 0 6,000
A/P 14,000 2,000
N/P 0 4,000
Accruals 0 2,000
Total Current Liability 14,000 14,000

The two cafeterias have the same liquidity (current ratio) but their composition is different.
CR = CA CR= CA
CL CL

=35,000 = 2.5 times =35,000 = 2.5 times

14,000 14, 000

Where: CR is current ratio, CA is current assets, CL is current liability, A/R is accounts

receivables, N/R is notes receivable and A/P is accounts payable.
When you see the two cafes, their current ratios are the same, but XYZ café is more liquid than
ABC café. This differences cause the activity ratio showing the composition of each assets than
the current ratio making activity ratio more important in showing a 'true" liquidity position than
current ratio.
Although generalization can be misleading in ratio analysis, generally, high turnover ratios usually
associated with good assets management and lower turnover ratios with poor assets management.
The major activity ratios are the following.
A. Inventory Turnover Ratio
The inventory turnover ratio measures the effectiveness or efficiency with which a firm is
managing its investments in inventories is reflected in the number of times that its inventories are
turned over (replaced) during the year. It is a rough measure of how many times per year the
inventory level is replaced or turned over.
Inventory Turnover = Cost of Goods Sold
Average Inventories

For the year of Lakomenza Company for 2001= 2,088,000/294,500*= 7.09 times
Interpretation: - Lakomenza's inventory is sold out or turned over 7.09 times per year.
In general, a high inventory turnover ratio is better than a low ratio.
An inventory turnover significantly higher than the industry average indicates: Superior selling
practice, improved profitability as less money is tied-up in inventory.
B. Average Age of Inventory
The number of days inventory is kept before it is sold to customers. It is calculated by dividing the
number of days in the year to the inventory turnover.

No days in year / 365days

Inventory Turnover
Average Age of Inventory =
Therefore, the Average Age of Inventory for Lakomenza Company for the
Year 2001 is:
365 days = 51 days
7.09
This tells us that, roughly speaking, inventory remain in stock for 51 days on average before it is
sold.

The longer period indicates that, Lakomenza is keeping much inventory in its custody and, the
company is expected to reassess its marketing mechanisms that can boost its sales because, the
lengthening of the holding periods shows a greater risk of obsolescence and high holding costs.
C. Accounts Receivable Turnover Ratio: - Measures the liquidity of firm’s accounts receivable.
That is, it indicates how many times or how rapidly accounts receivable is converted into cash
during a year. The accounts receivable turnover is a comparison of the size of the company’s sales
and its uncollected bills from customers. This ratio tells how successful the firm is in its collection.
If the company is having difficulty in collecting its money, it has large receivable balance and low
ratio.

Receivable Turnover = Net Sales

Average Account Receivables

The accounts receivable turnover for Lakomenza Company for the year 2001 is computed as under.
Accounts receivable turnover ratio = 3,074,000 = 7.08
434,000*
Average Accounts Receivable is the accounts receivable of the year 2000 plus that of the year
2001 and dividing the result by two.
So, 434 = 503,000 + 365,000/ 2 = 434,000*
Interpretation: Lakomenza Company collected its outstanding credit accounts and re-loaned the
money 7.08 times during the year.
Reasonably high accounts receivable turnover is preferable.
 A ratio substantially lower than the industry average may suggest that a Company has:
 More liberal credit policy (i.e. longer time credit period), poor credit selection, and
inadequate collection effort or policy.
 A ratio substantially higher than the industry average may suggest that a firm has;
 More restrictive credit policy (i.e. short term credit period), more liberal cash discount offers
(i.e. larger discount and sale increase), more restrictive credit selection.
D. Average Collection Period: Shows how long it takes for account receivables to be cleared
(collected). The average collection period represents the number of days for which credit sales are
locked in with debtors (accounts receivables).
Assuming 365 days in a year, average collection period is calculated as follows.

365days
Average Collection period = Re ceivable Turnover
The average Collection period for Lakomenza Company for the year 2001 will be:
365 days/7.08 =51 days or
Average collection period = Average accounts receivables* 365 days/Sales
434,000* 365 days/3,074,000* = 51 days
The higher average collection period is an indication of reluctant collection policy where much of
the firm’s cash is tied up in the form of accounts receivables, whereas, the lower the average
collection period than the standard is also an indication of very aggressive collection policy which
could result in the reduction of sales revenue.
E. Average Payment Period
The average Payment Period/ Average Age of accounts Payable shows, the time it takes to pay to
its suppliers.

The Average Payment Period = Accounts Payable

Average purchase per day

Purchase is estimated as a given percentage of cost of goods sold. Assume purchases were 70% of
the cost of goods sold in 2001.

So, Average Payment Period = 382,000 = 95 days

2,088,000 x .70/365

This shows that, on average, the firm pays its suppliers in 95 days. The longer these days, the more
the credit financing the firm obtains from its suppliers.
F. Fixed Asset Turnover
Measures the efficiency with which the firm has been using its fixed assets to generate revenue.
The Fixed Assets Turnover for Lakomenza Company for the year 2001 is calculated as follows.

Fixed assert turnover = Net sales

Average Net Fixed Asset

Fixed Assets Turnover = 3,074,000 = 1.29

2,374,000*
This means that, Lakomenza Company has generated birr 1.29 in net sales for every birr invested
in fixed assets.
Other things being equal, a ratio substantially below the industry average shows; underutilization
of available fixed assets (i.e. presence of idle capacity) relative to the industry, possibility to
expand activity level without requiring additional capital investment, over investment in fixed
assets, low sales or both. Helps the financial manager to reject funds requested by production
managers for new capital investments.
Other things being equal, a ratio higher than the industry average requires the firm to make
additional capital investment to operate a higher level of activity. It also shows firm's efficiency in
managing and utilizing fixed assets.
G. Total Asset Turnover- Measures a firm’s efficiency in management its total assets to
generate sales.

Total Assets Turnover = Net sales

Net total assets

The Total Assets Turnover for Lakomenza Company for the year 2001 is as follows.
3,074,000 = 0.85
3,597,000
Interpretation: - Lakomenza Company generates birr 0.85 (85 cents) in net sales for every birr
invested in total assets.
A high ratio suggests greater efficiency in using assets to produce sales where as, a low ratio
suggests that Lakomenza is not generating a sufficient volume of sales for the size of its investment
in assets.
Caution- with respect to the use of this ratio, caution is needed as the calculations use historical
cost of fixed assets. Because, of inflation and historically based book values of assets, firms with
newer assets will tend to have lower turnovers than those firms with older assets having lower
book values. The difference in these turnovers results from more costly assets than from differing
operating efficiencies. Therefore, the financial manager should be cautious when using these ratios
for cross-sectional comparisons.
 Activity 2.3
1. What are the major types of activity ratios?
______________________________________________________________________________
______________________________________________________________________________
2. Calculate and interpret all the activity ratios for Lakomenza Company for the year 2000.
______________________________________________________________________________
______________________________________________________________________________
2.2.4.3. Leverage Ratios

 Dear learners! Until now, you were learning about liquidity and activity ratios.
Now you are going to see the leverage ratios. So, what is leverage ratio?
What are the major types of ratios included under this ratio? How each ratio is to
be computed?

Leverage ratios are also called solvency ratio. Solvency is a firm’s ability to pay long term debt as
they come due. Leverage shows the degree of ineptness of firm.
There are two types of debt measurement tools. These are:
A. Financial Leverage Ratio: These ratios examine balance sheet ratios and determine the extent
to which borrowed funds have been used to finance the firm. It is the relationship of borrowed
funds and owner capital.
B. Coverage Ratio: These ratios measure the risk of debt and calculated by income statement
ratios designed to determine the number of times fixed charges are covered by operating
profits. Hence, they are computed from information available in the income statement. It
measures the relationship between what is normally available from operations of the firm’s
and the claims of outsiders. The claims include loan principal and interest, lease payment and
preferred stock dividends.
A.1, Debt Ratio: Shows the percentage of assets financed through debt. It is calculated as:

Debt ratio = Total Liability

Total Assets

The debt ratio for Lakomenza Company for the year 2001 is as follows:
= 1,643 = 0.457 or 45.7 %
3,597
This indicates that the firm has financed 45.7 % of its assets with debt. Higher ratio shows more
of a firm’s assets are provided by creditors relative to owners indicating that, the firm may face
some difficulty in raising additional debt as creditors may require a higher rate of return (interest
rate) for taking high-risk. Creditors prefer moderate or low debt ratio, because low debt ratio
provides creditors more protection in case a firm experiences financial problems.

A.2. Debt -Equity Ratio: express the relationship between the amount of a firm’s total assets
financed by creditors (debt) and owners (equity). Thus, this ratio reflects the relative claims of
creditors and shareholders against the asset of the firm.

Debt -equity ratio = Total Liability

Stockholders' Equity

The Debt- Equity Ratio for Lakomenza Company for the year 2001 is indicated as follows.
Debt- Equity ratio = 1,643,000 = 0.84 or 84 %
1,954,000
Interpretation: lenders’ contribution is 0.84 times of stock holders’ contributions.
B. 1. Times Interest Earned Ratio: Measures the ability of a firm to pay interest on a timely
basis.

Times Interest Earned Ratio =Earning Before Interest and Tax

Interest Expense

The times interest earned ratio for Lakomenza Company for the year 2001 is:
418,000 = 4.5 times
93,000
This ratio shows the fact that earnings of Lakomenza Company can decline 4.5 times without
causing financial losses to the Company, and creating an inability to meet the interest cost.
B.2.Coverage Ratio: The problem with the times interest eared ratio is that, it is based on earning
before interest and tax, which is not really a measure of cash available to pay interest. One major
reason is that, depreciation, a non cash expense has been deducted from earning before Interest
and Tax (EBIT). Since interest is a cash outflow, one way to define the cash coverage ratio is as
follows:

Cash Coverage Ratio= EBIT + Depreciation

Interest

(Depreciation for 2000 and 2001 is 223,000 and 239,000 respectively).

So, Cash coverage ratio for Lakomenza Company for the year 2001 is
418,000 + 239,000 = 7.07 times
93, 000

This ratio indicates the extent to which earnings may fall with out causing any problem to the firm
regarding the payment of the interest charges.

 Activity 2.4
1. What does leverage ratio mean and what it measures?
___________________________________________________________________________
___________________________________________________________________________
2. Why cash coverage ratio is more important than times interest earned ratio?
___________________________________________________________________________
___________________________________________________________________________
3. Compute the leverage ratio of Lakomenza Company for the year 2000
2.2.4.4. Profitability Ratios:

 Dear Students! What does profitability mean? What are the basic types of
Profitability ratios?

Profitability is the ability of a business to earn profit over a period of time. Profitability ratios
are used to measure management effectiveness. Besides management of the company, creditors
and owners are also interested in the profitability of the company. Creditors want to get interest
and repayment of principal regularly. Owners want to get a required rate of return on their
investment. These ratios include:
A. Gross Profit Margin
B. Operating Profit Margin
C. Net Profit Margin
D. Return on Investment (ROI)
E. Return on Equity (ROE)
F. Earnings Per Share (EPS)
A. Gross Profit Margin: This ratio computes the margin earned by the firm after incurring
manufacturing or purchasing costs. It indicates management effectiveness in pricing policy,
generating sales and controlling production costs. It is calculated as:

Gross Profit Margin = Gross Profit

Net Sales

The gross profit margin for Lakomenza Company for the year 2001 is:
Gross Profit Margin = 986,000 = 32.08 %
3,074,000
Interpretation: Lakomenza company profit is 32 cents for each birr of sales.
A high gross profit margin ratio is a sign of good management. A gross profit margin ratio may
increase by: Higher sales price, CGS remaining constant, lower CGS, sales prices remains
constant. Whereas, a low gross profit margin may reflect higher CGS due to the firm’s inability to
purchase raw materials at favorable terms, inefficient utilization of plant and machinery, or over
investment in plant and machinery, resulting higher cost of production.
B. Operating Profit Margin: This ratio is calculated by dividing the net operating profits by net
sales. The net operating profit is obtained by deducting depreciation from the gross operating
profit. The operating profit is calculated as:

Operating Profit Margin = Operating Profit

Net Sales

The operating profit margin of Lakomenza Company for the year 2001 is:
418,000 = 13.60
3,074,000
Interpretation: Lakomenza Company generates around 14 cents operating profit for each of birr
sales.

C. Net Profit Margin: This ratio is one of the very important ratios and measures the
profitableness of sales. It is calculated by dividing the net profit to sales. The net profit is obtained
by subtracting operating expenses and income taxes from the gross profit. Generally, non operating
incomes and expenses are excluded for calculating this ratio. This ratio measures the ability of the
firm to turn each birr of sales in to net profit. A high net profit margin is a welcome feature to a
firm and it enables the firm to accelerate its profits at a faster rate than a firm with a low profit
margin. It is calculated as:

Net Profit Margin = Net Income

Net Sales

The net profit margin for Lakomenza Company for the year 2001 is:
230,750 = 7.5 %
3,074,000
This means that Lakomenza Company has acquired 7.5 cents profit from each birr of sales.
D. Return on Investment (ROI): The return on investment also referred to as Return on Assets
measures the overall effectiveness of management in generating profit with its available assets, i.e.
how profitably the firm has used its assets. Income is earned by using the assets of a business
productively. The more efficient the production, the more profitable is the business.
The return on assets is calculated as:
 Return on Assets (ROA) = Net Income
Total Assets

The return on assets for Lakomenza Company for the year 2001 is:
230,750 = 6.4 %
3,597,000

Interpretation: Lakomenza Company generates little more than 6 cents for every birr invested in
assets.

E. Return on Equity: The shareholders of a company may Comprise Equity share and preferred
share holders. Preferred shareholders are the shareholders who have a priority in receiving
dividends (and in return of capital at the time of widening up of the Company). The rate of dividend
divided on the preferred shares is fixed. But the ordinary or common share holders are the residual
claimants of the profits and ultimate beneficiaries of the Company. The rate of dividends on these
shares is not fixed. When the company earns profit it may distribute all or part of the profits as
dividends to the equity shareholders or retain them in the business it self. But the profit after taxes
and after preference shares dividend payments presents the return as equity of the shareholders.
The Return on equity is calculated as:

ROE = Net Income

Stockholders Equity

The Return on equity of Lakomenza Company for the year 2001 is:
230,750 = 11.8%
1,954,000
Interpretation: Lakomenza generates around12 cents for every birr in shareholder’s equity.
F. Earning per Share (EPS): EPS is another measure of profitability of a firm from the point of
view of the ordinary shareholders. It reveals the profit available to each ordinary share. It is
calculated by dividing the profits available to ordinary shareholders (i.e. profit after tax minus
preference dividend) by the number of outstanding equity shares.
The earning per share is calculated as follows:
 EPS = Earning Available for Common Stockholders
Number of Shares of Common Stock Outstanding

Therefore, the earning per share of Lakomenza Company for the year 2001 is:
EPS = 220,750 = birr 2.90 per share
76,262 shares
Interpretation: Lakomenza Company earns birr 2.90 for each common shares outstanding.

 Activity 2.5
1. Describe the major types of profitability ratios
______________________________________________________________________________
______________________________________________________________________________
3. Calculate the profitability ratios of Lakomenza for the year 2000
______________________________________________________________________________
______________________________________________________________________________
Market Value Ratio:

 Dear Students! What are the major types of market value ratios?

Market value or valuation ratios are the most significant measures of a firm's performance, since
they measure the performance of the firm's common stocks in the capital market. This is known as
the market value of equity and reflects the risk and return associated with the firm's stocks.
These measures are based, in part, on information that is not necessarily contained in financial
statements – the market price per share of the stock. Obviously, these measures can only be
calculated directly for publicly traded companies.
The following are the important valuation ratios:
A. Price- Earnings (P/E) Ratio: The price earnings ratio is an indicator of the firm's growth
prospects, risk characteristics, shareholders orientation corporate reputation, and the firm's level
of liquidity.
The P/E ratio can be calculated as:

P/E Ratio = Market Price per Share

Earning per Share

The price per share could be the price of the share on a particular day or the average price for a
certain period.
Assume that Lakomenza Company's common stock at the end of 2001 was selling at birr 32.25,
using its EPS of birr 2.90, the P/E ratio at the end of 2001 is:
= 32.25/ 2.90 = 11.10
This figure indicates that, investors were paying birr 11.10 for each 1.00 of earnings.
Though not a true measure of profitability, the P/E ratio is commonly used to assess the owners'
appraisal of shares value. The P/E ratio represents the amount investors are willing to pay for each
birr of the firm's earnings. The level of P/E ratio indicates the degree of confidence (or Certainty)
that investors have in the firm's future performance. The higher the P/E ratio, the greater the
investor confidence on the firm's future. It is a means of standardizing stock prices to facilitate
comparison among companies with different earnings.
B. Market Value to Book Value (Market-to-Book) Ratios
The market value to book value ratio is a measure of the firm's contributing to wealth creation in
the society. It is calculated as:

Market-Book Ratio = Market Value pre Share

Book Value per Share

The book value per share can be calculated as:

Book value per share = Total Stockholders Equity

No. of Common Shares Outstanding

Book Value per Share for 2001 = 1,954,000 = 25.62

76,262
Therefore, the Market-Book Ratio for Lakomenza Company for the year 2001 is:
32.25 = 1.26
25.62
The market –to-book value ratio is a relative measure of how the growth option for a company is
being valued via-a vis- its physical assets. The greater the expected growth and value placed on
such, the greater this ratio.

 Activity 2.6

1. What are the major market value ratios?

___________________________________________________________________________
___________________________________________________________________________
2. Calculate the market value ratios for Lakomenza Company for the year 2000
______________________________________________________________________________
______________________________________________________________________________
2.2.5. Limitations of Ratio Analysis
While ratio analysis can provide useful information concerning a company’s operations and
financial condition, it does have limitations that necessitate care and judgments. Some potential
problems are listed below:
1. Many large firms operate different divisions in different industries, and for such companies it
is difficult to develop a meaningful set of industry averages. Therefore, ratio analysis is more
useful for small, narrowly focused firms than for large, multi divisional ones.
2. Most firms want to be better than average, so merely attaining average performance is not
necessarily good as a target for high-level performance, it is best to focus on the industry leader’
ratios. Benchmarking helps in this regard.
3. Inflation may have badly distorted firm’s balance sheets - recorded values are often substantially
different from “true” values. Further, because inflation affects both depreciation charges and
inventory costs, profits are also affected. Thus, a ratio analysis for one firm over time, or a
comparative analysis of firms of different ages, must be interpreted with judgment.
4. Seasonal factors can also distort a ratio analysis. For example, the inventory turnover ratio for a
food processor will be radically different if the balance sheet figure used for inventory is the
one just before versus just after the close of the coming season.
5. Firms can employ “window dressing” techniques to make their financial statements look stronger.
6. Different accounting practices can distort comparisons. As noted earlier, inventory valuation and
depreciation methods can affect financial statements and thus distort comparisons among firms.
Also, if one firm leases a substantial amount of its productive equipment, then its assets may
 appear on the balance sheet. At the same time, the ability associated with the lease obligation
may not be shown as a debt. Therefore, leasing can artificially improve both the turnover and
the debt ratios.
7. It is difficult to generalize about whether a particular ratio is “good” or “bad”. For example, a
high current ratio may indicate a strong liquidity position, which is good or excessive cash,
which is bad (because excess cash in the bank is a non-earning asset).
Similarly, a high fixed asset turnover ratio may denote either that a firm uses its assets efficiently
or that it is undercapitalized and cannot afford to buy enough assets.
8. A firm may have some ratios that look “good” and other that look “bad”, making it difficult to
tell whether the company is, on balance, strong or weak. However, statistical procedures can be
used to analyze the net effects of a set of ratios. Many banks and other lending organizations
use discriminate analysis, a statistical technique, to analyze firm’s financial ratios, and then
classify the firms according to their probability of getting into financial trouble.
9. Effective use of financial ratios requires that the financial statements upon which they are based
are accurate. Due to fraud, financial statements are not always accurate; hence information
based on reported data can be misleading. Ratio analysis is useful, but analysts should be aware
of these problems and make adjustments as necessary.

 Activity 2.7
1. Discuss the major limitations of ratio analysis?
_______________________________________________________________________________
_______________________________________________________________________________

2. Which of these limitations might observe in the organization in which you work or around you?
2.2.6. Common size and Index Analysis

 Dear students! What we mean when we say vertical and horizontal analysis?

It is often useful to express balance sheet and income statement items as percentages. The
percentages can be related to totals, such as total assets or total sales, or to some base year. Called
Common size analysis and Index analysis, respectively, the evaluation of trends in financial
statements percentages over time affords the analyst insight in to the underlying improvement or
deterioration in financial condition and performance. While a good portion of this insight is
revealed on the analysis of financial ratios, a broader understanding of the trends is possible
when the analysis is extended to include the foregoing considerations.
To illustrate these two types of analysis, let us use the balance sheet and income statements of
TOSSA Electronics Corporation for the year 1999 through 2001 E.C.
Exercise 2.3 the following table illustrates the balance sheet and income statement for TOSSA
Electronics Corporation. You are required to analyze it using vertical and horizontal analysis
methods of the financial statement.
 Table 1
TOSSA Electronic Corporation Balance Sheet

Items 1999 2000 2001

Assets
Cash 2,507,000 4,749,000 11,310,000
Accounts Receivables 70,360,000 72,934,000 85,147,000
Inventory 77,380,000 86,100,000 91,378,000
Other Current Assets 6,316,000 5,637,000 6,082,000
Total Current Assets 156,563,000 169,420,000 193,917,000
Fixed Assets (Net) 79,187,000 91,868,000 94,652,000
Other Long-Term Assets 4,695,000 5,017,000 5,899,000
Total Assets 240,445,000 266,305,000 294,468,000
Liabilities and Shareholders' Equity
Accounts Payable 35,661,000 31,857,000 37,460,000
Notes Payable 20,501,000 25,623,000 14,680,000
Other Current Liabilities 11,054,000 7,330,000 8,132,000
Total Current Liabilities 67,216,000 64,810,000 60,272,000
Long -Term Debt 888,000 979,000 1,276,000
Total Liabilities 68,104,000 65,789,000 61,548,000
Preferred Stock 0 0 0
Common Stock 12,650,000 25,649,000 26,038,000
Additional Paid in Capital 36,134,000 33,297,000 45,883,000
Retained Earnings 123,557,000 141,570,000 160,999,000
Shareholders' Equity 172,341,000 200,516,000 132,920,000
Total Liabilities and Equity 240,445,000 266,305,000 294,468,000
 Table 2
TOSSA Electronic Corporation Income Statement

Items Year
1999 2000 2001
Sales 323,780,000 347,322,000 375,088,000
Cost of Goods Sold 148,127,000 161,478,000 184,507,000
Gross Profit 175,653,000 185,844,000 190,581,000
Selling Expenses 79,399,000 98,628,000 103,975,000
General and Adm. Expenses 43,573,000 45,667,000 45,275,000
Total Expenses 122,972,000 144,295,000 149,250,000
Earning Before Interest and Tax 52,681,000 41,549,000 41,331,000
Other Income 1,757,000 4,204,000 2,963,000
Earning Before Tax 54,438,000 45,753,000 44,294,000
Taxes 28,853,000 22,650,000 20,413,000
Earning After Tax 25,585,000 23,103,000 23,881,000
 Solutions to exercise 2.3
Table 3
TOSSA Corporation Common size Balance Sheet
Year
Items 1999 2000 2001
Assets
Cash 1.00 1.80 3.80
Accounts Receivables 29.30 27.40 28.90
Inventory 32.20 32.30 31.00
Other Current Assets 2.60 2.10 2.10
Total Current Assets 65.10 63.60 65.90
Fixed Assets (Net) 32.90 34.50 32.10
Other Long-Term Assets 2.00 1.90 2.00
Total Assets 100.00 100.00 100.00
Liabilities and Shareholders' Equity
Accounts Payable 14.80 12.00 12.70
Notes Payable 8.50 9.60 5.00
Other Current Liabilities 4.60 2.80 2.80
Total Current Liabilities 28.00 24.30 20.50
Long-Term Debt 0.40 .40 .40
Total Liabilities 28.30 24.70 20.90
Preferred Stock 0 0 0
Common Stock 5.30 9.60 8.80
Additional Paid in Capital 15.00 12.50 15.60
Retained Earnings 51.40 53.20 54.70
Shareholders' Equity 71.70 75.30 79.10
Total Liabilities and Equity 100.00 100.00 100.00
 Table 4
TOSSA Electronic Corporation Common size Income Statement
Items Year
1999 2000 2001
Sales 100.00 100.00 100.00
Cost of goods sold 45.70 46.50 49.20
Gross Profit 54.30 53.50 50.80
Selling Expenses 24.50 28.40 27.70
General and Adm. Expenses 13.50 13.10 12.10
Total Expenses 38.00 41.50 39.80
Earning Before Interest and Tax 16.30 12.00 11.00
Other Income .50 1.20 .80
Earning Before Tax 16.80 13.20 11.80
Taxes 8.90 6.50 5.40
Earning After Tax 7.90 6.70 6.40

2.2.6.1. Statement Items as Percentage of Totals

In Common size analysis, we express the various components of a balance sheet as percentages of
the total assets of the company. In addition, this can be done for the income statements, but here
items are related to sales. The expression of individual financial items as percentage of totals
usually permits insights not possible from a review of raw figures by themselves.
In the table for TOSSA Company we can see that, over the three years the percentage of current
assets increased and that this was particularly true for cash. In addition we see that account
receivables showed a decrease from the year 1999 to 2000 and showed a relative increase from the
year 2000 to 2001. On the liability and shareholders' equity side, of the balance sheets, the debt of
the company declined on a relative basis from 1999 to 2001. The accounts payable increased
substantially 1999 to the year 2001.
The Common size income statement on table 4 shows the gross profit margin is constantly
decreasing from the year 1999 to 2001. When this is combined with the fluctuating selling
expenses and constantly decreasing general and administrative expenses, the end result gives the
constantly decreasing net profit margin.
 Table 5
TOSSA Electronic Indexed Balance Sheet

Year
Items 1999 2000 2001
Assets
Cash 100.00 189.40 451.10
Accounts Receivables 100.00 103.70 121.00
Inventory 100.00 111.30 118.10
Other Current Assets 100.00 89.20 96.30
Total Current Assets 100.00 108.20 123.90
Fixed Assets (Net) 100.00 116.00 119.50
Other Long-Term Assets 100.00 106.90 125.60
Total Assets 100.00 110.80 122.50
Liabilities and Shareholders' Equity
Accounts Payable 100.00 89.30 105.00
Notes Payable 100.00 125.00 71.60
Other Current Liabilities 100.00 66.30 73.60
Total Current Liabilities 100.00 96.40 89.70
Long-Term Debt 100.00 110.20 143.70
Total Liabilities 100.00 96.60 90.40
Preferred Stock 0.00 0.00 0.00
Common Stock 100.00 202.80 205.80
Additional Paid in Capital 100.00 92.10 127.00
Retained Earnings 100.00 114.60 130.30
Shareholders' Equity 100.00 116.30 135.20
Total Liabilities and Equity 100.00 110.80 122.50
 Table 6
TOSSA Electronic Indexed Income Statement

Items Year
1999 2000 2001
Sales 100.00 107.30 115.80
Cost of Goods Sold 100.00 109.00 124.60
Gross Profit 100.00 105.80 108.50
Selling Expenses 100.00 124.20 131.00
General and Adm. Expenses 100.00 104.80 103.90
Total Expenses 100.00 117.30 121.40
Earning Before Interest and Tax 100.00 78.90 78.50
Other Income 100.00 239.30 168.60
Earning Before Tax 100.00 84.00 81.40
Taxes 100.00 78.50 70.70
Earning After Tax 100.00 90.30 93.30

2.2.6.2. Statement of Items as Indexes Relative to a Base Year

The common size balance sheets and income statements can be supplemented by the expression
of items as trends from the base year. For TOSSA electronic Corporation, the base year is 1999
and all the financial statement items are 100.00 for that year. Items for the two subsequent years
are expressed as an index relative to that year. If the statement item were birr 22,500 compared
with birr 15,000 in the base year, the index would be 150. Table 5 and 6 are an indexed balance
sheet and an income statement. In table 5, the increase in cash is apparent. Note also the large
increase in cash and inventories are also increasing from the base year to 2001. There is also a
sizable increase in fixed assets.
On the liability side of the balance sheet, we note the fluctuating trend in accounts payable, notes
payable and other current liabilities which resulted in constantly decreasing total current liabilities.
Where as there is an increasing trend in long term debt from base year to the year 2001 the
aggregate effect of which is the decreasing trend in total liability from base year to the 2001.
The common stock and retained earning shows an increasing trend from the base year to the year
2001 which resulted in the increase in total liability and equity from the base year to the year 2001.

When we consider the indexed income statement in table 6 we see the increase in sales, cost of
goods sold and gross profits from the base year to the year 2001. Earning before taxation and taxes
are decreasing from the base year to the final year. Finally, the earnings after taxation show the
fluctuating trend.

 Activity 2.8
1. What are the differences between vertical and horizontal analysis?
______________________________________________________________________________
______________________________________________________________________________
2.2.7. DuPont Analysis

 Dear learners! Have you heard the word DuPont analysis before? If so, answer in
writing before you read the following section.

DuPont analysis (also known as the DuPont identity, DuPont equation, DuPont Model or the

DuPont Method) is an expression which breaks ROE (Return on Equity) into three parts. The
name comes from the DuPont Corporation that started using this formula in the 1920s.

The DuPont Model developed in 1914 by F. Donaldson Brown of chemical company DuPont de
Nemours & DuPont Corporation. It is a set of financial ratios and key figures relating to the Return
on Investment (ROI). It is a technique that can be used to analyze the profitability of a company
using traditional performance figures. It integrates elements of the Income Statement with those
of the Balance Sheet.
ROI = Net Profit Margin x Total Assets Turnover
The DuPont Model

Activity 2.9
1. Draw the DuPont Model Using the information on financial ratios of Lakomenza Company.
______________________________________________________________________________
______________________________________________________________________________
2.3 .Financial Planning

 Dear learners! What does financial planning mean and why it is needed?

Forecasting in financial management is needed when the firm is ready to estimate its future
financial needs. Forecasting uses past data as a base and then planned and expected circumstances
are incorporated in order to estimate the future financial requirements.
2.3.1. Steps in Planning Process
The basic steps involved in predicting those financial needs are the following.
Step1: Project the firm's sales revenues and expenses over the planning period.
Step2: Estimate the levels of investment in current and fixed assets that are necessary to support
the projected sales.
Step3: Determine the firm's financial needs throughout the planning period.
2.3.2. Ingredients of Financial Planning
Assumptions- The user needs to specify some assumptions as to the future. The financial plan
should explicitly specify the environment in which the firm expects to operate over the life of
the plan. A plan that is prepared under one assumption or a set of assumptions will be different
from a plan prepared under another assumption. Among the more important assumptions that
will have to be made are the level interest rate and the firm's tax rate.
Sales Forecast- almost all financial plans require a sales forecast. Most other values in the
financial plan will be calculated based on the sales forecast.
Performance Statements- a financial plan will have a forecasted balance sheets, income
statement, and statement of cash flows. These are called pro forma statements.
Assets Requirements – the plan should state the planed investments and the changes in the
firm's assets.
Financial Requirements- the plan should also describe the necessary financing arrangements
needed to finance the planned investments. Financing policy issues such as debt policy, debt-
equity ratio, and dividend should be discussed.
2.3.2.1. Sales Forecasting
The most important element in financial planning is the sales forecast. Because such forecast are
critical for production scheduling, for plant design, for financial planning, and so on, the entire
management team participate in its preparation. Companies must project the state of the national
economy, economic conditions within their own geographic areas, and conditions in the product
markets they serve. Further, they must consider their own pricing strategies, credit policies,
advertising programs, capacity limitations, and the like. If sales forecast is off, the consequence
can be series. First, if the market expands more than the firm has expected, and geared up for, the
company will not be able to meet its customers' needs. Orders will back up, delivery times will
lengthen, repair and installations will be harder to schedule and customer dissatisfaction will
increase. On the other hand, if its projections are overly optimistic, the firm could end up with too
much plant, equipment and inventory. This could mean, low turnover ratios, high cost for
depreciation and storage, and, possibly write offs of obsolete inventory and equipment. Therefore,
accurate sales forecast is critical to the well-being of the firm.

 Activity 2.10
1. What are the ingredients that should be considered when developing sales forecast?
______________________________________________________________________________
______________________________________________________________________________
2. Explain why accurate sales forecast is critical.
______________________________________________________________________________
______________________________________________________________________________

2.3.3. Techniques of Determining External Financial Requirements

 Dear Learners! What techniques are used for financial planning?

2.3.3.1. Percent-of-Sales Method of Financial Forecasting

When constructing a financial forecast, the sales forecast is used traditionally to estimate various
expenses, assets, and liabilities. The most widely used method for making these projections is the
percent-of-sales method, in which the various expenses, assets, and liabilities for a future period
are estimated as a percentage of sales. These percentages, together with the projected sales, are
then used to construct pro forma (planned of projected) balance sheets.
The calculations for a pro forma balance sheet are as follows:
1. Express balance sheet items that vary directly with sales. That means multiply those balance
sheet items that vary directly with sales by (1 + sales growth rate).
2. Multiply the income statement items by (1+ Sales Growth Rate). Thus, we are assuming that
each income statement item increases at the same rate as sales, which means that we are
assuming constant returns to scale.
3. Where no percentage applies (such as for long-term debt, common stock, and capital surplus),
simply insert the figures from the present balance sheet in the column for the future period.
4. Compute the projected retained earnings as follows:
 Projected Retained Earnings = Present Retained Earnings + Projected Net Income – Cash
Dividends Paid.
(You will need to know the percentage of sales that constitutes net income and
the dividend payout ratio).
5. Sum the asset accounts to obtain a total projected assets figure. Then add the projected
liabilities and equity accounts to determine the total financing provided. Since liability plus
equity must balance the assets when totaled, any difference is a shortfall, which is the amount
of external financing needed.
2.3.3.2. Formula Method for Forecasting AFN
A simple forecasting formula provides a short cut to projecting additional funds needed (AFN)
and can be used to clarify the relationship between sales growth and financial requirements, as
well as the influence of other relevant variables on (AFN).
Additional
Fund = [Required Increase] – [Spontaneous Increase] - [Increase in Retained]
`Needed in Assets in liabilities Earnings
AFN = A*/S (S) - L*/S (S) - MS1 (1-d)
Where
AFN= Additional or External Fund Needed
A*/S= Assets that increase spontaneously with sales as a percentage of sales
L*/S= Liabilities that increase spontaneously with sales as a percentage of sales
S1= Total sales Projected for next year
S = Change in sales = S1- So
M= Profit margin or rate of profit per a birr of sales
D= Percentage of earnings paid out in dividends or Dividend Payout Ratio
Exercise 2.4
KOSPI Products Company is a highly capital intensive Manufacturing Company, whose June 30,
2001 balance sheet and summary of income statement are given below. KOSPI operated its fixed
assets at full capacity in 2001 to support its birr 400,000 of sales and it had no unnecessary current
assets. Its profit margin on sales was 10 percent, and it paid out 60 percent of its net income to
stockholders as dividends. If KOSPI's sales increase to birr 600,000 in 2002, what will be its pro
forma June 30 2002 balance sheet, and how much additional financing will the company required
during 2002?
KOSPI Product Company Balance sheet on June 30, 2001 (In Thousands of Birr)
Cash …………………….. 10 Accounts Payable ……………..…..... 40
Accounts Receivables……90 Notes Payable ………………………..10
Inventories……………... 200 Accrued Wages and Taxes…………. 50
Total Current Assets…. 300 Total Current Liabilities…................ 100
Net Fixed Assets ……….300 Mortgage Bonds…….…………....... 150
Total Assets…………... 600 Common Stock….……………...….. 50
Retained Earnings……………...…. 300
Total Liabilities and Equity……….. 600
KOSPI Product Company Income Statement for 2001 (In Thousands of Birr)
Sales ………………………………………………….… 400
Total Costs……………………………………………... 333
Taxable Income………………………………………….. 67
Taxes (40%)…………………………………………… 27
Net income…………………………………………….… 40
Dividends…………………………………………………24
Additions to retained earnings…………………………… 16
Solutions to Exercise 2.4
The Projected Balance Sheet Method
The first task is to identify those balance sheet items that vary directly and proportionately with
sales; those are called spontaneous assets. Because KOSPI has been operating at full capacity (it
has no excess manufacturing capacity), each assets item, including plant and equipment, must
increase if the higher level of sales is to be attained. More cash will be needed for transactions;
receivables will be higher, as sales increase by 50% (from 400,000 to 600,000) and credit policy
is assumed unchanged; additional inventory must be stocked; and new fixed assets must be added.
If KOSPI assets are to increase, its liabilities and/or equity must likewise rise: the balance sheet
must balance and any increase in assets must be financed in some manner. Some of the required
funds will come spontaneously from routine business transactions, whereas, other funds must be
raised from outside sources. Spontaneously generated funds will come from such sources as
accounts payable and accruals, which are assumed to increase spontaneously and proportionately
with sales. As sales increase, so will KOSPI's purchase and larger purchase will automatically
result in higher level of accounts payable. Similarly, because a higher level of operations will
require more labor, accrued wages will increase, and, assuming profit margins are maintained, an
increase in profits will pull up accrued taxes. Retained earnings will also increase but not in direct
proportion to the increase in sales. Neither notes payable, mortgage bonds, nor common stocks
will increase spontaneously with sales, so management must obtain funds from these sources by
taking some specific planned action. The spontaneous assets include: cash, accounts receivable,
inventories and net fixed assets. Similarly, accounts payable, accrued wages and taxes are the
spontaneous liabilities. No other balance sheet items are spontaneous, but all entries in the income
statement are assumed (for simplicity) to vary directly and spontaneously with sales.
2002 Projections
Balance Sheet Items As of June 30 1st approximation 2nd approximations
2001 Includes financings
Cash 10 15 15
Accounts Receivables 90 135 135
Inventories 200 300 300
Total Current Assets 300 450 450
Net Fixed Assets 300 450 450
Total Assets 600 900 900
Accounts Payable 40 60 60
Notes Payable 10 10a 15d
Accrued Wages & Taxes 50 75 75
Total Current Liabilities 100 145 150
Mortgage Bonds 150 150a 300e
Common Stocks 50 50a 126f
Retained Earnings 300 324b 324
Total Liability and Equity 600 669 900
Additional Fund Needed 231c
 Income Statement Items For the year ended June 30 2001 Forecasted 2002
Sales 400 600
Total Costs 333 500
Taxable Income 67 100
Taxes (40%) 27 40
Net Income 40 60
Dividends 24 36
Additions to Retained Earnings 16 24
Foot Notes
a
This account does not increase with sales, so for the first- appropriation projection, the 2001 balance is carried foreword. Latter decisions could
change the figure shown
b
2001 retained earnings plus 2002addition=birr 300,000+24,000= birr 324,000
c
AFN is a balancing item found by subtracting projected total liabilities and equity from projected total assets
d
Birr 5,000 of the new notes payable has been added to the first approximation balance. This is the maximum addition based on the limitation on total
current liabilities
e
Birr 150,000 of new bonds has been added to the first approximations balance. This is the maximum additional debt due to total liabilities limitations
f
The addition to common equity is determined as a residual ;it is that amount of AFN that still remains after the additions to notes payable and
mortgage bonds

We will begin our analysis by constructing first- approximation projected financial statements for
June 2002, proceeding as follows.

Step 1: Project balance sheet and income statement items: spontaneous assets, liabilities and all
the income statement items are multiplied by (1+g) or 1.50 and items such as notes payable that does
not vary directly with sale is simply carried forward from column one to column two to develop the
first approximation balance sheet. We also carry forward figures for mortgage bonds and for
common stock from 2001 to 2002.
Step 2: Project cumulative retained earnings: we next combine the additions to retained earnings
estimate for 2002 and the June 30 2001 balance sheet figures to obtain June 30 2002 projected
retained earnings. KOSPI will have a net income of birr 60,000 in the year 2002. If the firm
continues to pay out 60 percent of its income as dividend, the dividend payment will be birr 36,000,
leaving birr 60,000- 36,000 = birr 24,000 of new retained earnings. Thus, the 2002 balance sheet
account retained earnings is projected to be birr 300,000 + 24,000 = 324,000.
Step 3: Calculations of Additional Fund Needed (AFN): Next, we sum the balance sheet asset
accounts obtaining a projected total assets figure of birr 900,000, and we also sum the projected
liability and equity items to obtain birr 669,000. At this point, the 2002 balance sheet does not
balance. Thus, we have a shortfall, or additional funds needed (AFN) of birr 231,000.
Raising the Additional Funds Needed
Additions could use short-term bank loans (notes payable), mortgage bonds, common stock, or a
combination of these securities to make up the shortfall. It would make this choice on the relative
costs of these different types of securities, subject to certain constraints. Assume here KOSPI has
a contractual agreement with its bondholders to keep debt at or below 50 percent of total assets
and also to keep the current ratio at a level of 3.0 or greater. These provisions restrict the financing
choices as follows.
A. Restrictions to Additional Debt
Maximum Debt Permitted = 0.5 x Total assets
= 0.5 x 900,000 = 450,000
Less: debt already projected for June 2002:
Current liabilities 145,000
Mortgage bonds 150,000 = 295,000
Maximum additional current liabilities 155,000
B. Restrictions on Additional Current Liabilities
Maximum current liabilities = Current assets ÷ 3.0
= 450,000 ÷ 3 = 150,000
Current liabilities already projected…………….. 145,000
Maximum additional current liabilities……….…… 5,000

C. Common Equity Requirements

Total additional funds needed………………. 231,000
Maximum additional debt permitted…………155,000
Common Equity funds required……………… 76,000
Here is a summary of its projected non spontaneous external financings:

Short-term debt (notes payable) ………………… 5,000

Long-term debt……………………………....… 150,000
New Common stock…………………………….. 76,000
Total ……………..…………………………….. 231,000
The Formula Method for Forecasting AFN

AFN = A*/S (S) - L*/S (S) - MS1 (1-d)

= 1.5 (200,000) - 0.225 (200,000) – 0.1(600,000) (0.4)
= 300,000 – 45,000- 24,000 = 231,000
Chapter Summary
The Primary purpose of this chapter was to discuss the techniques used by the stockholders when
they analyze the basic financial statement. Financial statement analysis is the assessment and
interpretation of the basic financial statement (income statement, balance sheet and statement of
cash flow) items to show the financial condition and results of operation of a firm. The financial
statement analysis generally begins with calculations of different ratios such as liquidity, assets
management, debt management, profitability and market value ratios. In addition to calculating
these ratios, trend analysis is used as it reveals whether the firm's financial position is improving
or deteriorating over time. Regardless of showing the financial condition and operation ratios have
some limitations and therefore, it is advisable to take these limitations while using ratio for
evaluating financial performance. Firms project their financial statements and determine their
capital requirements. A firm can determine the additional fund needed by estimating the amount
of new assets to support the forecasted level of sales and then subtracting from that amount both
the spontaneous funds that will be generated from operations and the additions to retained earnings.
Model Examination Questions
A. Short Answer Questions
1. Explain the need for performance evaluation
2. Explain the different types of ratio analysis
3. Are liquidity ratios sufficient to show the "True" liquidity of the firm? Why?
4. Discuss the major problems that could be faced in financial ratio analysis.
B. Workout Questions
1. The only current asset possessed by a firm are: Cash birr 105,000, Inventories birr 560,000 and
Accounts Receivable birr 420,000. If the current ratio for the firm is 2:1, determine its current
liabilities and calculate the firm's quick ratio
2. At the close of the year a company has inventory of birr 150,000 and cost of goods sold for birr
975,000. If the company's turnover ratio is 5, determine the opening balance of the inventory
3. Assume that the industry average of fixed asset turnover of MAM Manufacturing Company is
2.50 times and the total asset turnover is 2 times. Net sales for the year is 250,000 and 95% of
the total assets of the organization is fixed. Assume further that the production manager
requests additional fund for the purchase of fixed assets that he thinks could increase the
profitability of the company. Given no impact of depreciation, and if you are the financial
manager of MAM Manufacturing Company, what should be your reaction towards this
proposal? Why?
4. Complete the following financial statements of Omega Company on the basis of the ratios
given below.
Omega Company
Profit and loss account
For the year ended June 30 2001
Sales 2,000,000
Cost of Goods Sold 600,000
Gross Profit 1,400,000
Operating Expenses 1,190,000
Earning Before Interest and Tax -
Debenture Interest 10,000
Income Tax -
Net Profit -
 Omega Company
Balance sheet
For the year ended June 30 2001
Assets Liabilities
Cash - Sundry creditors 60,000
Stocks - 10% Debentures -
Debtors 35,000 Total liabilities -
Total Current Assets - Reserve and Surplus -
Fixed Assets - Share Capital -
Total Assets - Total Liability and Equity -
Additional Information
A. Net Profit to Sale…………….. 5% D. Inventory Turnover …………. 15 times
B. Current Ratio………………… 1.5 E. Share Capital to Reserve…….. 4:1
C. Return on Net Worth ……….. 20 % F. Tax Rate…………………….. 50 %
Multiple Choice Questions
1. Travel Air emerging regional air line, earns 6 percent on total assets but has a turnover on
equity of 24 percent. What percent of the air line’s assets are financed with debt?
A. 30 % C. 75 %
B. 25 % D. 70 %
2. Chara Company has current ratio of 2.2 times, acid test ratio of 1.4 times and inventories of
birr 55,000. What will be its current assets?
A. 90,000 C. 155,000
B. 151,250 D. 68,750
3. Which of the following ratio indicate the most liquidity position of the company?
A. Liquidity ratio C. Profitability ratio
B. Activity ratio D. Dent management ratio
4. Which of these are concerned with financial statement analysis to assure the protection of
the rights of the public?
A. Investors C managers
B. Government D. All of the foregoing
5. The implication of high fixed assets turnover ratio relative to industry average is:
A. presence of idle capacity
B. Possibility to expand activities without requiring additional capital investment
C. Under investment in fixed assets
D. Presence of low sales volume
6. The starting point for financial forecasting is
A. Estimating sales revenue and expenses
B. Estimating level of investment in assets
C. Estimating the additional fund needed
D. None of the foregoing
Answers to Model Examination Questions
Answer to Discussion Questions
1. Refer to section 2.2.1 3. Refer to section 2.2.4.2
2. Refer to section 2.2.4 4. Refer to section 2.2.5
Workout Questions
1. Cash = 105, inventories = 560,000, Accounts Receivables = 420,000. Therefore, the
total current assets are 1,085,000. As current ratio 2:1, the current liabilities are
1,085,000/2 = 542,500
The quick ratio = Current assets- inventory/ current liabilities
= 1,085,000- 560,000/542,500 = 0.97
2. Closing inventory = 150,000, cost of goods sold = 975,000 inventory turnover = 5 times
ITO = cost of goods sold/ average inventory, while the average inventory = beginning
inventory + ending inventory/ 2
5 = 975,000/ 150,000 + beginning inventory/2 and denoting beginning inventory by X we have
1,950,000 = 750,000 + 5X
Hence, the beginning inventory is 1,950,000- 750,000 = 5X implying that beginning
inventory will be birr 240,000.
3. TATO = net sales/ total assets = 250,000/ total assets = 2 times
So the total assets = 250,000/2 = 125,000 and we are given that 95 % of these assets are fixed.
Hence, the fixed assets = 95 % (125,000) = 118,750
So, the fixed assets turnover = 250,000/ 118,750 = 2.10
 When we compare the industry average (2.50) with the actual result (2.10), the implication is
that, MITU Manufacturing Company has less FATO than the industry. This further indicates
that it is under utilizing its existing fixed assets to generate sales. So no need of purchasing
additional fixed assets to boost sales revenue. Hence, the proposal should be rejected.
4. Calculation of ratios for Omega Company
 Net income = 5 % (2,000,000) = 100,000
 Let X be income before taxation so, (X- 50% * X= 100,000)
So, the income before taxation is birr 200,000 implying that income tax is birr 100,000
 Current ratio= 1.50, as current liabilities are birr 60,000, total current assets will be
1.50x 60,000 = birr 90,000
Inventory turnover ratio= 15 times = Cost of goods sold/ closing inventory= 15
As cost of goods sold is birr 600,000, closing inventory will be 600,000/15= 40,000
Out of the total current assets of birr 90,000, stock is birr 40,000 and the debtors are
birr 35,000. Therefore, the remaining balance is cash.
Hence, cash= 90,000- 75,000 = 15,000
Return on net worth = Net profit/ net worth= 20 % and as net profit is birr 100,000. Hence,
the net worth is birr 500,000.
 Share to reserve ratio is 4:1 and as share capital + reserve = net worth= 500,000
Hence, share capital is birr 400,000 and reserve is birr 100,000.
 As total liabilities and equity 660,000 is equal to total assets, the fixed assets portion is
the difference of total assets and current assets (660,000- 90,000) = 570,000
Omega Company, Income Statement, for June 30, 2001
Sales 2,000,000
Cost of Goods Sold 600,000
Gross Profit 1,400,000
Operating Expenses 1,190,000
Earning Before Interest and Tax 210,000
Debenture Interest 10,000
Income Tax 100,000
Net Profit 100,000

Omega Company, Balance Sheet, for June 30, 2001

Assets Liabilities
Cash 15,000 Sundry creditors 60,000
Stocks 40,000 10% Debentures 100,000
Debtors 35,000 Total liabilities 160,000
Total Current Assets 90,000 Reserve and Surplus 100,00
Fixed Assets 570,000 Share Capital 400,000
Total Assets 660,000 Total Liability and Equity 660,000

Multiple choice questions

1. C 2. B 3. B 4. B 5. C 6. A
 CHAPTER THREE

COST OF CAPITAL

Contents of the Chapter

 Aims and Objectives
 Introduction
3.1. Cost of Capital: An Overview of Cost of Capital
3.1.1. What Impacts the Cost of Capital?
3.1.2. Significance of Cost of Capital
3.1.3. Capital Structure
3.1.4. Major Types of Cost of Capital (Sources of Capital)
3.1.5. The Specific Cost of Capital
3.1.5.1. The Cost of Debt ( kd)
3.1.5.2. Cost of Preferred Stock (kp)
3.1.5.3. The Cost Common Stock (ks) (Cost of Internal Equity)
3.1.5.4. The Cost of Equity From new Common Stock ( kn)
3.1.5.5. Cost of Retained Earnings (Kr)
3.1.6. The Weighted Average Cost of Capital (WACC)
3.1.7. The Marginal Cost of Capital (MCC)
Chapter Objectives: - At the end of this chapter learners are expected to:
 Define cost of capital and understand the basic concepts underlying it
 Determine the cost of debt, preferred stock, common stocks (internal and External Equity)
 Learn about the methods of calculating the component of costs of capital and the weighted
average cost of capital (WACC) and discuss the alternative weighting schemes.
Introduction
3.1.An Overview of Cost of Capital

In pervious section, we have seen the important concept that the expected return on an investment
should be a function of “market risk” embedded in that investment risk – return tradeoff. The firm
must earn a minimum rate of return to cover the cost of generating funds to finance investments;
otherwise, no one will be willing to buy the firms bonds, preferred stock, and common stock. This
point of reference, the firms required rate of return, is called the cost of capital.
The cost of capital is the required rate of return that a firm must achieve in order to cover the cost
of generating funds in the market place. Based on the evaluations of risky ness of each firm,
investor will supply new funds to a firm only if it pays them the required rate of return to
compensate them for taking the risk of investing in the firm’s bonds and stocks. If indeed, the cost
of capital is the required rate of return that the firm must pay to generate funds, it becomes a
guideline for measuring the profitability’s of different investments. When there are differences in
the degree of risk between the firm and its divisions, a risk – adjusted discount rate approach should
be used to determine their profitability.
As firms usually use more than one type of financing, cost of capital is thus a weighted average of
the specific costs of the several sources. we ought always to use the weighted average cost of
capital, and not an individual cost of funds, as our discount rate for investment decisions. When
we compute a firms weighted average cost of capital, we are simply calculating the average of its
costs of money from all investors, those being creditors and stock holders.

 Activity3.1
1. Define the term cost of capital and what is the role of cost capital in a
firm’s investment and financing decisions?
______________________________________________________________________________
______________________________________________________________________________

3.1.1. What Impacts the Cost of Capital?

1. Risky ness of earnings.
2. The debt to equity mix of the firm.
3. Financial soundness of the firm.
4. Interest rate levels in US/ global market place.
Note: - The cost capital becomes a guideline for measuring the profit abilities of different
investments. Another way to think of the cost of capital is as the opportunity cost of funds, since
this represents the opportunity cost for investing in assets with the same risk as the firm. When
investors are shopping for places in which to invest their funds, they have an opportunity cost. The
firm, given its risky ness, must strive to earn the investors opportunity cost. If the firm does not
achieve the return investors expect (i.e. the investors opportunity cost), investors will not invest in
the firms debt and equity. As a result, the firms value (both their debt & equity) will decline.
3.1.2. Significance of Cost of Capital
Cost of capital is useful as a standard for:-
 Evaluating investment decisions
 Designing a firms debt policy, and
 Appraising the financial performance of top management
3.1.3. Capital Structure
 It is the mixture of long term sources of funds used by affirm.
 The primary objective of capital structure decision is to mix the market value of long term
sources of bonds.
 The mix is called optimal capital structure which minimize the firms overall cost of capital
3.1.4. Major Types of Cost of Capital (Sources of Capital)
The major sources capital is:-
1. Specific cost of capital.
a Cost of Debt (Kd).
b Cost of Preferred Stock (Kp).
c Cost of Common Stock (Ks).
d Cost of Retrained Earnings (Kr).
2. Weighted Average Cost of Capital (WACC)
3. Marginal Cost of Capital (MCC)
3.1.5. The Specific Cost of Capital: A firm’s capital is supplied by its creditors and owners. Firms
raise capital by borrowing it (issuing bonds to investors or promissory notes to banks) or by issuing
preferred or common stock. The overall cost of a firms capital depends on the return demanded by
each of these suppliers is called the specific cost of capital. In the following section, we estimate
the cost of debt capital (kd), the cost of capital raised though a preferred stock issue (kp), and the
cost of equity capital supplied by common stock holders, (ks) for internal equity and kn for external
equity.
3.1.5.1. The Cost Debt (kd)
When a firm borrows money at a stated rate of interest, determining the cost of debt, kd, is
relatively straight forward. The lenders cost of capital is the required rate of return on either a
company’s new bonds or promissory note. The firm’s cost of debt when it borrows money by
issuing bonds is the interest rate demanded by the bond investor. When borrowing money from an
individual or financial institution, the interest rate on the loan is the firm’s cost of debt. The cost
of debt to the borrower: the firms cost of debt is the investors required rate of return on debt
adjusted for tax and flotation costs.
This is because interest on debt is a tax –deductible expenses; it reduces the firm's taxable income
by the amount of deductible interest. The interest deduction, therefore, reduces taxes by an amount
equal to the product of the deductible interest and the firm’s tax rate. Flotation costs which are
costs incurred in issuing debt securities – increases the cost of debt. Thus, the after tax cost of debt,
kd, is computed as follows:
Where
(1  T )
kd  Ki
(1  F ) T = Corporate tax rate
F= Flotation cost as a percentage of value of debt
Ki = investor required rate of return before tax
If there is no flotation costs, the Kd can be computed using the formula
kd  ki(1  T )
Example 1:- Assume that MULU Co. is to issue long term notes, investors will pay Br, 1000 per
note when they are issued if the annual interest payment by the firm is Br 100.The firm’s tax rates
is 45%, and flotation costs are 2%.calculate the cost of this debt.
Given Required Solution
ki(1  T )
I = Br 100 Kd =? kd= = 4.4%
 8%(1  45)
M = Br 1000
T = 45%
Note: - The before tax cost of debt can be found by determining the internal rate of return (or yield
to maturity) on bond cash flows as discussed before. However, the following short cut formula
may be used for a approximating the yield to maturity on a bond.

( M  Vb)
Ki  I 
N

M  Vb)
2

Where
I= Annual interest payment in dollars
M = Par value usually $ 1000 per bond
Vb= Value or net proceeds form the sale of a bond
N = Term of the bond
Example 2: - A Br 1,000 Par value bond with market price of Br 970 and a coupon interest rate of
10% while flotation costs for the issue would be approximately 5%, the bond matures in 10 years
and the corporate tax is 40%. Compute the cost of the bond.

Given Required Solution

( M  Vb )
M = Br 1000 Kd = ? Ki = I 
n
n = 10 ______ ________
M  Vb
i = 10%
2
( Br1000  Br 921.5)
I = MxKc = 0.1X Br 1000 = Br 100 Br 100+
10
1000  Br 921.5
Vb = Np = Br 970 – (0.05 X Br 970) Br
2
107.85
= Br 921.50 = Br
Br 960.75
= 11.23%but Kd  Ki (1  T )
11.23 (1-0.40)
= 0.1123X 0.60 = 6.74%

 Activity 3.2
1. Why is cost of debt normally less than the cost of equity?
______________________________________________________________________________
______________________________________________________________________________
3.1.5.2. Cost of Preferred Stock (kp)
The cost of preferred stock (kp) is the rate of return investors require on a company’s new preferred
stock plus the cost of issuing the stock. Therefore, to calculate kp; a firm’s managers must estimate
the rate of return that preferred stock holders would demand and add in the cost of the stock issue.
Because preferred stock investors normally buy preferred stock to obtain the stream of constant
preferred stock dividends associated with the preferred stock issue, their return on investment can
normally be measured by dividing the amount of the firm’s expected preferred stock dividend by
the price of the shares. The cost of issuing the new securities known as flotation cost includes
investment bankers’ fees and commissions, and attorneys' fees. These costs must be deducted form
the preferred stock price paid by investors to obtain the net price received by the firm. The
following equation shows how to estimate the cost of preferred stock.
 DP Or
Kp  DP
KP
If Kp  flotation cost exists
Pp  F

Where:-
Kp = The cost of the preferred stock issue; the expected return
Dp = The amount of the expected preferred stock dividend
Pp = the current price of the preferred stock
F = the flotation costs per share
Example 1: - Suppose that Midrock Company has preferred stock that pays Br 13 dividend per
share and sells for Br 100 per share in the market. Compute the cost of preferred stock.
DP Br 13
Kp = = = 13%
Pp Br 100

Example 2; - Suppose Ellis industries has issued preferred stock that has been paying annual
dividends of $ 2.50 and is expected to continue to do so indefinitely. The current price of Ellis
preferred stock is $ 22 a share and the flotation cost is $ 2 per share. Compute the cost of the
preferred stock.

Given Required Solution

( DP) $2.50
DP = $ 2.50 Kp =? Kp = =
( Pp  F ) $22  2
Pp = $ 22 a share = 0.125 or 12.5%
F = $ 2 a share

Note: - There is not tax adjustments in the cost of preferred stock calculation unlike interest
payments on debt, firms may not deduct preferred stock dividends on their tax returns. The
dividends are paid out of after tax profits. Moreover, the cost of preferred stock higher than the
after tax cost of debt, kd because a company’s bond holders and bankers have a prior claim on the
earnings of the firm and its assets in the event of liquidation. Preferred stock holders, as the result,
take a greater risk than bond holders or bankers and demand a correspondingly greater rate of
return.
3.1.5.3. The Cost of Common Stock (ks) (Cost of Internal Equity)
The cost of common stock equity, ks is the rate at which investors discount the expected dividends
of the firm to determine its share value. Two techniques for measuring the cost of common stock
equity capital are available. One uses the constant growth valuation model (Gordon growth
model); the other uses the capital asset pricing (CAPM).
i. Using the Constant Growth Valuation Model (the Gordon Growth Model)
Using the Gordon growth model, the cost of common stock, Ks is computed as follows:-
D1
Po 
Ks  g
Where Po= Value of common stock
D1 = Dividend to be received in 1 year
Ks = Investors required rate of return
g = rate of growth
Solving the model for ks results in the formula for the cost of common stock
D1 Do(1  g )
Ks  + g or Ks 
Po Po
Example: - Suppose that IBM industries common stock is selling for $ 40 a share. A next year's
common stock dividend is expected to be$4.20 and the dividend is expected to grow at a rate of
5% per year indefinitely. Compute the expected rate of return on IBM’s common stock.
Given Required Solution
D1 $ 420
Po  $40 Ks =? Ks  +g= g
Po 540
D1 = $4.20 0.105 + 0.5 = 0.155 or 15.5%
g = 5%
ii. The Capital Asset Pricing Model (CAPM) Approach to Estimating (ks): a firm may pay
dividends that grow at changing rate; it may pay dividends that grow at changing rate; it may pay
no dividends at all for the managers of the firm may believe that market risk is the relevant risk.
In such cases, the firm may chose to use the capital asset pricing model (CAPM) to calculate the
rate of return that investors require for holding company’s common stock according to the degree
of non diversifiable risk present in the stock. The CAPM formula for the cost of common stock is:

Where:-
Ks = the required rate of return from the company’s common stock equity
B = Beta coefficient which is an index of systematic risk
rf = Risk free rate
rm = Return on the market portfolio
Example:- Suppose BATU industries has a beta of 1.39, the risk free rate as measured by the rate
on short term U.S. Treasury bill is 3% and the expected rate of return on the overall stock market
is 12%. Given those market conditions find the required rate of return for BATU’S common Stock.
Given Required Solution
B= 1.39 Ks = Ks = rf + b (rm-rf)
rf = 3% = 3% + 1.39 (12%-3%)
rm= 12% = 3% + 1.39 (9%)
0.1551 or 15.5%

3.1.5.4. The Cost of Equity from new Common Stock ( kn): The cost incurred by a company
when new common stock s is sold at the cost of equity from new common stock (Kn) .Capital from
existing stock holders is internal equity capital, i.e. the firm already has these funds. In contrast,
capital from issuing new stock is external equity capital. The firm is trying to raise new funds from
outside source. New stock some times finance a capital budgeting project the cost of this capital
includes not only stockholders’ expected returns on their investment but also flotation costs
incurred to issue new securities. flotation costs makes the cost of using funds supplied by new
stock holders slightly higher than using retained earnings supplied by the existing stockholders
.
To estimate the cost of using fund supplied by new stockholders, we use a variation of the dividend
growth model that includes flotation costs.

D1
Kn 
( po  f )  g

Kn = the cost of new common stock equity

Po = price of one share of the common stock
D1 = the amount of the common stock dividend expected to be paid in one year
F = the flotation cost per share
g = the expected constant growth rate of the company’s common stock dividends
Example: Assume again that IBM industries anticipated dividend next year is $4.20 a share, its
growth rate is 5% a year and its existing common stock is selling for $40 a share. New shares of
stock can be Sold to the public for the same price but to do so IBM pay its investment bankers 5%
of the stock’s selling price or $2 per share. Given these condition s compute IBM’s new common
equity.
Given Required Solution
D1
D1 = $ 4.20 Kn =? Kn  g
( Po  F )
$4.20 $4.20
Po = $ 40   5%  5%  16.05%
$40  $2 $38
F= $ 2, g= 5%

 Activity3. 3
1. When a company issues new securities? How do flotation costs affect the cost of raising that capital?
_____________________________________________________________________________________
_____________________________________________________________________________________
3.1.5.5. Cost of Retained Earnings (Kr)
The cost of retained earnings, Kr, is closely related to the cost of existing common stock since the
cost of equity obtained by retained earnings is the same as the rate of return investors require on
the firm’s common stock. There fore

Ks = Kr

3.1.6. The Weighted Average Cost of Capital (WACC)

 Dear students! How does one calculate the weighed average cost of capital?
A firm’s weighted average cost of capital (WACC) is a composite of the individual costs of
financing, weighted by the percentage of financing provided by each source. Therefore, a firm’s
WACC is a function of (1) the individual costs of capital and (2) the makeup of the capital structure
– the percentage of funds provided by long term debt, preferred stock and common stock. Thus,
the computation of the cost of capital requires three things.
1) Compute the cost of capital for each and every source of financing used by the firm.
2) Determine the weight percentage of each financing in the capital structure of the firm.
3) Calculate the firm’s weighted average cost of capital (WACC) using the values in (1) & (2)
Example: Assume that IBM industries finance its assets through a mixture of capital sources, as
shown on its balance sheet.
Total Br 1.000,000
Long and short term debt Br 400,000
Preferred stock Br 100,000
Common equity Br 500,000
Total liability and equity Br 1,000,000
And the IBM’s cost of capital were, Kd = 6%, Kp = 12.5% and Ks= 15.5% compute the weighted
average cost of capital;
Solution Ko = ∑% of total capital structure * cost of capital for each
Supplied by each type of capital source of capital
W
= Wd * kd + p* kP + Ws * Ks + Wr * Kr where

Wd =% of total capital supplied by debt

Wp = % of total capital supplied by preferred stock
Ws = % of total capital supplied by common stock
Wr = % of total capital supplied by retained earnings
Source (a) Market value (b) Weight ( c ) Cost (d) Weighted costs e=( cxd)
Long and short term Br 400,000 40% 6% 2.4%
debt
Preferred stock Br 100,000 10% 12.5% 1.25%
Common equity Br 500,000 50% 15.5% 7.75%
Total Br 1,000,000 100% 11.40%

The weighted average cost of capital (WACC) is 11.40%

 Activity3.4
Distinguish between specific costs and weighted average cost of capital? What is the rationale for
computing after tax weighted average cost of capital?
______________________________________________________________________________
______________________________________________________________________________

3.1.7. The Marginal Cost of Capital (MCC)

Because external equity capital has a higher cost than retained earnings due to flotation costs the
weighted cost of capital increases for each dollar of new financing. There fore lower cost of capital
sources is used first. In fact, the firms cost of capital is a function of the size it’s total investment.
A schedule or graph relating the firm’s costs of capital to the level of new financing is called the
weighted marginal cost of capital (WMCC). Such a schedule is used to determine the discount
rate to be used in the firm’s capital budgeting process. The steps to be followed in calculating the
firm’s marginal cost of capital are:
1. Determine the cost and percentage of financing to be used for each source of capital (debt,
preferred stock, common stock equity).
2. Compute the break even points on the MCC curve where the weighted cost will in increase
Breakeven point = maximum amount of the lower cost source of capital
Percentage of financing provided by the source
3. Calculate the weighted cost of capital over the range of total financing between break points.
4. Construct a MCC schedule or graph that shows the weighted costs of capital for each, level of
total new financing. This schedule will be used in conjunction with the firm’s available
investment opportunities (IOs) in order to select the investments. As long as a profit’s IRR is
greater than the marginal cost of new financing, the project should be accepted. Also the point
at which the IRR intersects the MCC gives the optimal capital budget.
Example: LULA company is considering three investment Proposals whose initial costs
and internal rates of return are given below ‘
Company Initial cost ($) Internal rate of Rerun (IRR) (% )
A 100,000 19
B 125,000 15
C 225,000 12

The company finances all expansion with 40% debt, and 60% equity capital. The after tax cost is
8% for the first $ 100,000 after which the cost will be 10 percent. Retained earnings in the amount
of $ 150,000 available, and the common stock holders’ required rate of rectum is 18%. If the new
stock is issued, the cost will be 22%.
Calculate
A) the dollar amounts at which break occur and
B) Calculate the weighted cost of capital in each of the intervals between the breaks.
C) Graph the firm’s weighted marginal cost of capital MCC) schedule and investment
opportunities schedule (IOS)
D) Decide which projects should be selected and calculate the total amount of the optimal
capital budget.
Solution
a) Breaks (increase) in the weighted marginal cost capital will occur as follow
For debt
Debt
$100,000  $250.000
Debt total assets 
0.4
For common stock Retain earning
$150,000  $250.000
Equity assets 
0.6
The debt break is caused by exhausting the lower cost of debt, while the common stock break is
caused by using up retained earnings.
b) The weighted cost of capital in each interval between the breaks is computed as follows with
$ 0-$ 250,000 total financing
Source of capital weight cost weighted cost
Debt 0.4 8% 3.2%
10.8%
Common stock 0.6 18%
14.0%
With over $ 250, 000 total financing

Source of capital weight cost weighted cost

Debt 0.4 10% 4%
Common stock 0.6 22% 13.2%
K= 17.2%
c) See fig (d) below
d) Accepts projects A and B for a total of $ 225,000, which is the optimal budget

20
B 17.2% MCC
16

12 IOS

C
8

100 200 225 300 400 500

New financing (thousand dollars)

 Activity 3.5
1. What is a marginal cost of capital (MCC) schedule?
______________________________________________________________________________
______________________________________________________________________________

Chapter Summary
To find a firm’s overall cost of capital, a firm must estimate how much each source of capital costs.
The after tax cost of debt (kd) is the market’s required rate of return on the firm’s debt, advised for
the tax saving realized when interest payments are deducted from taxable income. The before tax
cost of debt, ki is multiplied by one minus the tax rate (I - T) to arrive at the firm’s after tax cost of
debt.
The cost of preferred stock, kp is the investor’s required rate of return on that security. The
cost of common stock, Ks is the opportunity cost of new retained earnings, the required
rate of return on the firm’s common stock. The cost of new commons tock, kn (external
equity) the required rate of return on the firm’s common stock, adjusted for the flotation
costs incurred when new common stock is sold in the market.
The weighted average cost of capital (WACC), is the over all average cost of funds
considering each of the component capital costs and the weight of each of those
components in the firm’s capital structure. To estimate WACC, we multiply the individual
source’s cost of capital times its percentage of the firm’s capital structure and then add the
results.
A firm’s WACC changes as the cost of debt or equity increases as more capital is raised. Financial
mangers calculate the break points in the capital budget size at which the MCC will change. There
will always be an equity break point, BPe and there may be one or more debt break points. Financial
mangers then calculate the MCC up to break even points and plot the MCC values on graph
showing how the cost of capital changes as capital budget size changes.
Model Examination Questions
1. Find the yield to maturity on a semiannual coupon bond given that the bond price is $988
having at the coupon rate of 8%. The bond has a face value of$1000, and there are 25 years
remaining until maturity.
A) 7.22% B) 8.11% C) 8.81% D) 9.41%
2. Find the price of a semiannual coupon bond given that the coupon rate 5%, the
face value of the bond is$1000. The current market required rate of return is6%, and
there are 4 years remaining until maturity.
A) $964.9 B) $968.54 C) $971.17 D) $977.05
3. Find the price for a stock given that the next dividend is $4.5 per share, the
required return is 10.5%, and the growth rate in dividends is 4.8% per year.
A) $73.15 B) $78.95 C) $83.88 D) $86.17
4. Find the dividend growth rate for a stock given that the current dividend is $3.62 per share, the
required return is 4.5%, and the stock price is $122.06 per share.
A) 0.92% B) 1.49% C) 1.86% D) 2.41%
5. Find the Expected Return on Stock i given that the Expected Return on the Market Portfolio
is 11.5%, the Risk-Free Rate is 4.8%, and the Beta for Stock i is 2.8.
A) 22.02% B) 23.02% C) 23.56% D) 23.98%
Workout Questions
1. A common stock just paid a dividend of Br 2. The dividend is expected to grow at 8% for three
years, and then it will grow at 4% in perpetuity. What is the stock worth (super normal growth)?
2. If a share currently pays Br 1.50 annual dividends, is expected to grow at a rate of 5% per year
and has a required return of 14% what should its share price be?
3. Smith. Inc. has a bond outstanding with 16 Years remaining to maturity, a $ 1000 face value,
and a coupon rate of 8% paid semiannually. If the current market price is $ 880, what is the yield
to maturity (YTM) on the bonds?
4. The Simma products corporations have the following capital structure, which it considers optimal:
Bonds, 7% (at par) Br 300,000
Preferred stock,Br.5 240,000
Common stock 360,000
Retained earnings 300,000
1,200,000
Additional Information:
 Dividends on common stock are currently Br 3 per share and are expected to grow at
constant rate of 6%.
 Market price of common stock is Br 40 and the preferred stock is selling at Br50.
 Flotation cost on new issues of common stock is 10%.
 The interest on bonds is paid annually and the company’s tax rate is 40%.
Calculate: (a) the cost of bonds (b) the cost of preferred stock (c) the cost of retained earnings
(d) the cost of new common stock (e) the weighed average cost of capital.
5 Find the dividend growth rate for a stock given that the current dividend is $5.72 per
share, the required return is 11.7%, and the stock price is $135.01 per share.
Answers for Model Examination Questions
Multiple Choice Questions
1. B 2.A 3.B 4. B 5.C
Workout Questions
Solutions: - 1
 D N  1
C  (1  g1)T   
P 1   +  Ks  g 2 
Ks  g1  1  Ks )T  (1  r ) N

Br 2 X (1.08)  (1.08)3   Br 2(1.08)3(1.04) 

 
P 1   +  0.12  0.04 
0.12  0.08  (1.12)3  (1.12)3

Br 54 X 1  0.8966  ( Br 32.75) 
P + 1  
 (1.12)3 
Br 5.58  Br 23.31
P

Br 28.89

Solution:- 2
Given: Required Solution
D1
Do = Br 1.50 Po=? Po=
Ks  g
Ks= 14%
= 1.50 (1  0.05) =
1.575
g = 5% = Br 17.50
0.14  0.05 0.09

Solution:-3
Given: Required
M = $ 1,000 YTM =?
Vb = $ 880
n = 16
Kc = 8 %
I= KC*M
 Solution
$ 1000 * 0.08 /2
I = $ 40.00
( M  Vb)
YTM  I 
N
M  Vb
2

 $40  (1000  $880).50 (1  0.05)

16

$1000  880
2
= 10.23%

Solution:-4
(A) Since the bonds are selling at par, the before-tax cost of debt (Ki) is the same as the coupon
rate, that is, 7%.therefore, theafter tax cost of bonds is
Kd = Ki (1-t)
= 7% (1-0.4)
4.2%
(B) The cost of preferred stock is:
Dp Br 5
KP    10%
P Br 50
(C) The cost of retained earnings is
D1 (1  g )  Br 3 (1  0.06)  Br 3.18
D1 Br 3.18
Ks  +g= + 6%
Po Br 40
= 7.95%+ 6% = 13.95%
(D) The cost of new common stock is
D1
Ks  +g
Po(1  f )
Br 3.18
+ 6% = 8.83% + 6% = 14.83%
Br 40(1  0.1)
(E) The weighted average cost of capital is computed as follows:
Source of Capital
Capital structure Percentage Cost Weighted cost
Bonds Br 300 25% 4.2% 1.05%
Preferred stock 240 20% 10% 2.00%
Common stock 360 30% 13.95% 4.185%
Retained earnings 300 25% 14.83% 3.708%
Br 1,200 100% WACC 10.943%

Solution 5
PoKs  Do 135.01 (0.117)  5.72
g = = 0.0716 = 7.16 %.
Do  Po 5.72  135..1
 CHAPTER FOUR
INVESTMENT DECISION /CAPITAL BUDGETING
Contents of the Chapter
 Aims and Objectives
 Introduction
4.1. Capital Budgeting Defined
4.2. Importance of Capital Budgeting
4.3. Components of Capital Budgeting.
4.4. Capital Budgeting Decision Practices
4.5. Classification of Investment Projects
4.6. Capital Budgeting Decision Methods
4.6.1. The Pay back Period (PBP)
4.6.2. The Accounting Rate of Return (ARR)
4.6.3. Discounted Pay back Period (DPBP)
4.6.4. Net Present Value (NPV)
4.6.5. Internal Rate of Return (IRR)
4.6.6 The Modified Internal Rate of Return (MIRR)
4.6.7. Conflicting Rankings between the NPV and the IRR Methods
4.6.8. Profitability Index (PI)
4.6.9. Capital Rationing
Chapter Summary
Model Examination Questions
Chapter Objectives: - At the end of this chapter, learners are expected to:
 Understand of the importance of capital budgeting in decision making.
 Explain of the different types of investment project.
 Introduce to the economic evaluation of investment proposal.
 Explain the mechanics, advantages and disadvantages of the different investment decision
criteria.
 Describe the capital budgeting techniques to be used for mutually exclusive projects in
times of capital rationing.
  Use the capital budgeting criteria-the non discounted and discounted methods to evaluate
the worth of the projects.
 Identify the type of investment projects.
 Introduction
Business firms regularly make decisions involving capital goods purchases such as equipment and
structures. Capital goods are business assets with an expected use of more than only one year.
The fixed asset account on a firm’s Balance sheet represents its net investment or capital
expenditure in capital goods. Capital goods represent a major portion of the total assets of today’s
firms.
An investment in capital goods requires an outlay of funds by the firm in exchange for expected
future benefits over a period greater than one year. The proper goal in making capital investment
decision should be maximization of the long-term market value of the firm. Managers attempt to
maximize value by selecting capital investments in which the value created by the project’s future
cash flows exceeds the recurred cash outlay. Capital budgeting is the process of planning,
analyzing, selecting, and managing capital investments.
Capital budgeting may involve other investments besides the long term investments in capital
goods. Many other long term investments led them selves to capital budgeting analysis. Such
commitments include outlays for advertising campaigns, research and development (R&D),
employee education and training programs, leasing contracts, and mergers and acquisition. The
focus of our treatment of capital budgeting centers on the decision to acquire capital goods namely
fixed assets used for a firms operation. However, firms can use similar procedures and processes
to analyze various capital expenditures. Capital budgeting analysis also helps annalists to evaluate
existing projects and operations and to decide if a firm should continue to fund certain projects.
4.1. Capital Budgeting Defined
Capital budgeting refers to the process we use to make decisions concerning investments in the
long-term assets of the firm. There are typically two types of investment decisions: (1) Selection
decisions concerning proposed projects (for example, investments in the long term assets such as
property, plant and equipment or resource commitments in the form of new product development
market research, refunding of long-term debt, introduction of computer, etc); and (2) replacement
decisions for example replacement of existing facilities with new facilities. The general idea is that
the capital or long term funds raised by the firms are used to invest in assets that will enable the
firm to generate revenues several years in to the future. Often the funds raised to invest in such
assets are not unrestricted or infinitely available; thus the firm must budget how these funds are
invested.
4.2.Importance of Capital Budgeting

 Dear students! Why are capital budgeting decisions so important to the success of
the firm?

Capital budgeting decisions are important to a firm for three major reasons.
1. Size of outlay. Although a tactical investment decision generally involves a relatively small
amounts of funds, strategic investment decision may require large sum of money that directly
affect the firm’s future course of development. Corporate mangers continually face vexing
problem of deciding where to commit the firm’s resources.
2. Effect on future direction: The future success of a business largely depends on the investment
decision that corporate mangers make today. Investment decision may result in a major
departure from what the company has been doing in the past. Though making capital
investments, firms acquire the long lived fixed assets that generate the firms' future cash flows
and determine its level of profitability. Thus, these decisions greatly influence of firms ability
to achieve its financial objectives.
3. Difficulty to reverse; capital investment decisions often commit funds for lengthy periods
rendering such decisions difficult or costly to reverse. Therefore, capital investments are not
only vital to firms’ development but also have the capacity to lock in periods there by reducing
the firm’s flexibility.
Capital budgeting decisions are especially critical in small businesses because they often make
few capital expenditures and often have little margin for error. Making a poor decision may tie up
large amounts of funds for expended periods in fixed assets whole generating little, if any, value
to the company.
Proper capital budgeting analysis is critical to a firms' successful performance because sound
capital investment decisions can improve cash flows and lead to higher stock process. Yet, poor
Decisions can lead to financial distress and even to bankrupt. In summary making the right capital
budgeting decisions is essential to achieving the goal of maximizing share holder wealth.
Activity 4.1
1. What is capital Budgeting?
______________________________________________________________________________
______________________________________________________________________________
2. Why capital budgeting decisions are important to the success of affirm?
______________________________________________________________________________
______________________________________________________________________________

4.3. Components of Capital Budgeting.

The incremental (or relevant) after tax cash flows that occur with an investment projects are the
ones that are measured. In general, the cash flows of a project fall in to the following three
categories.
1. The initial investment
2. The incremental (relevant) cash inflows over the life of the project; and
3. The terminal cash flow
1. Initial Investment (I)
It includes the cash required to acquire the new equipment or build the new plant less any cash
proceeds from the disposal of the replaced equipment only changes that occur at beginning of the
project are included as part of the initial investment outlay. Any additional working capital needed
or no longer needed in a future period is accounted for as cash out flow or cash inflow during that
period. And it can be determined as follows:

Initial investment = Cost of asset +Installation cost + working - proceeds form sale of old
assets + taxes on Sale of old assets

Example XYZ Corporation is considering the purchase of a new machine for Birr 500,000 which
will be depreciated on a straight line basis over five years with no salvage value. In order to put
this machine in operating order, it is necessary to pay installation charges of Birr 100, 000. The
new machine will replace on. Birr 480, 000 that is depreciated on a straight line basis (with no
salvage value) over its 8 years life. The old machine can be sold for Birr 510.000. To a scrap dealer.
The company is in the 40 % tax bracket. The machine will require an increase in WIP inventory
of Br 10, 000 compute the initial investment.
Solution: The key calculation of the initial investment is the taxes on the sale of the old machine.
Basically there are three possibilities:
1. The asset is sold for more than its book value (tax gain)
2. The asset is sold for its book valve (no tax gain or loss)
3. The assets is sold for less than its book value (tax loss)
From the given example, the total gain which is the difference between the selling price and the
book value is Br 210.000 (Br 510,000- Br 300,000) The tax on this Br 210.000 total gain is Br
84,000 (40% X Br 210,000).
Initial investment = purchase price + Installation cost + Increased - proceeds
investment from sale old asset
= Br 500,000 + Br 100,000 + Br 10, 000 – Br 510, 000 + Br 84,000
= Br 184,000.
2. Incremental (Relevant) Cash Inflows
Incremental or operating cash inflows are those cash inflows that the project generates after it is
in operation. For example cash flows that follow a change in sales or expenses are operating cash
flows. Those operating cash flows incremental to the project under consideration are the relevant
to our capital budgeting analysis. Incremental operating cash flows also include tax changes,
including those due to changes in depreciation expense, opportunity cost and externalities.
Incremental after tax cash inflows can be computed using the following formula.

After – tax incremental cash inflows = (increase in revenues) (1-tax rate)

- (Increase in cash) (1-tax rates)
+ (increase in depreciation) (tax rate expense)

The computation of relevant or incremental cash inflows after taxes involves two basic steps.
1. Compute the after tax cash flows of each proposal by adding back any non cash charges which
are deducted as expenses on the firms' income statement, to net profits.
After – tax cash inflows = net profits after tax + depreciation
2. Subtract the cash inflows after taxes resulting form the use of the old asset from the cash
inflows generated by the new asset to obtain the relevant cash inflows after taxes.
Example; - Gibe Corporation has provided its revenue and cash operating costs (excluding
depreciation) for the old and the new machine as follows.

Annual
Cash operating Net profit before
Revenue Costs Depreciation and taxes

Old machine Br.300, 000 Br 140.000 Br 160,000

New Machine Br 360, 000 Br 120, 000 Br 240,000

Complete the after tax incremental cash inflows.

After – tax incremental cash inflows = (increase in revenue) (1- Tax rate)
- (increase in cash charges) (1- Tax rate) + (increase in depreciation expenses) (Tax rate)
= (1,360, 000-300,000) (1-40%) – (120,000-140,000) (1-0.4) + (240,000- 160,000) (0.4)
= 36,000 – (-12,000) + 32.000 = 80,000.

 Activity 4.2
Moha Soft Drink Company is contemplating the replacement of one of its bottling machines
with new one that will increase revenue from Br50, 000to Br62, 000 per year and reduce cash
operating costs from Br24, 000 to Br 20,000 per year. The new machine will cost Br96, 000 and
have an estimated life of 10years with no salvage value. The firm uses straight line depreciation
and is subject to a 40% tax rate. The old machine has fully depreciated and has no salvage value.
What are the incremental cash inflows generated by the replacement?
______________________________________________________________________________
______________________________________________________________________________

3. Terminal Cash Flow (shut down cash flow)

Cash flows associated with the net cash generated from the sale of the assets; tax effects from the
termination of the asset and the release of net working capital.
If a project is expected to have a positive salvage value at the end of its useful life, there will be a
positive incremental cash flow at that time. However, this salvage value incremental cash flow
must be adjusted for tax effects.
4.4. Capital Budgeting Decision Practices

 Dear students! How capital budgeting decisions be practiced?

Financial managers apply two decision practices when selecting capital budgeting projects: accept
/reject and ranking. The accept / reject decision focuses on the question of whether the proposed
project would add value to the firm or earn a rate of return that is acceptable to the company. The
ranking decision lists competing projects in order of desire ability to choose the best one.
The accept / reject decision determines whether the project is acceptable in light of the firms
financial objectives. That is, if a project meets the firms' basic risk and return requirements (cost
and benefit requirements), it will be accepted, If not it will be rejected.
Ranking compares perfects to a standard measure and orders the projects based on how well they
meet the measure. If, for instance, the standard is how quickly the project payoff the initial
investment, then the project that pays off the investment most rapidly would be ranked first. The
project that paid off most slowly would be ranked last.
4.5. Classification of Investment Projects
Investment projects can be classified in to three categories on the basis of how they influence the
investment decision process; independent projects mutually exclusive projects and contingent
projects.
1.An Independent Project is one the acceptance or rejection does not directly eliminate other
projects from consideration or affect the likelihood of their selection. For example, management
may want to introduce a new product line and at the same time may want to replace a machine
which is currently producing a different product. These two projects can be considered
independently of each other if there are sufficient resources to adopt both, provided they meet the
firm's investment criteria. These projects can be evaluated independently and a decision made to
accept or reject them depending up on whether they add value to the firm.
2. Mutually Exclusive Projects are those projects that can not be perused simultaneously i.e. the
acceptance of one prevents the acceptance of the alternate proposal. Therefore, mutually exclusive
projects involve, either decision – alternative proposals can not be perused simultaneously. For
example, a firm may own a block of land which is large enough to establish a shoe manufacturing
business or a steel fabrication plant. It show manufacturing is chosen the alternative of steel
fabrication is eliminated mutually exclusive projects can be evaluated separately to select the one
which yields the highest net present value (NPV) to the firm. The early identification of mutually
exclusive alternative is crucial for a logical screening of investments. Otherwise, a lot of hard work
and resources can be wasted if two decision in dependently investigates, develop and initiate
projects which are later recognized to be mutually exclusive
3.A Contingent Project is one the acceptance or rejection of which is dependent on the decision
to accept or reject one or more other projects. Contingent projects may be complementary or
substitutes. For example, the decision to start a pharmacy may be contingent up on a decision to
establish a doctors’ Surgery in an adjacent building. In this case the projects are complementary
to each other.

 Activity 4.3
What is the primary purpose of independent projects and mutually exclusive projects?
How do they differ form one another?
______________________________________________________________________________
______________________________________________________________________________
Stages in Capital Budgeting Process
The capital budgeting process has four major stages
1. Finding projects
2. Estimating the incremental cash flows associated with projects
3. Evaluating and selecting projects
4. Implementing and monitoring projects
This chapter focuses on stage 3- how to evaluate and choose investment projects. It is assumed
that the firm has found projects in which to invest and has estimated the projects cash flows
effectively.
4.6. Capital Budgeting Decision Methods

 Dear students! Identify the major capital budgeting techniques with their merits and
Demerits.

The capital budgeting techniques are of two types. They are the non-discounted methods
(traditional approach) and the discounted methods (Modern approach). Each of these methods is
discussed below.
 Capital budgeting methods

Discounting methods
Non discounting methods
- Discounted Payback Period (DPBP) -
Payback Period (PBP)
- Net Present Value (NPV) - Accounting Rate of Return- (ARR)
-Internal Rate of Return (IRR)
- Modified Internal Rate of Return (MIRR)
- Profitability Index (PI)
Note - Capital Budgeting techniques are usually used only for projects with large cash outlays.
Small investment decisions are usually made by the “seat of the pants”
Non Discounting Methods
4.6.1. The Payback Period) (PBP)
The payback period is the number of years needed to recover the initial investment of a project. It
is the number of years required for an investment’s cumulative cash flows to equal its net
investment. Thus, payback period can be looked up on as the length of time required for a project
to break even on its net investment i.e. the number of time period it will take before the cash
inflows of a proposed project equal the amount of the initial project investment (a cash out flow).
How to Calculate the Payback Period: To calculate the payback period, simply add up a projects
projected positive cash flows, one period at a time, until the sum equals the amount of the project’s
initial investment. That number of time periods it takes for the positive cash flows to equal the
amount of the initial investment is the payback period.
Decision Rule;- To apply the payback decision method, firms must first decide what payback time
period is acceptable for long term projects and the calculated payback period should be less than
some pre-specified (decided) number of periods. The rationale behind the shorter the payback
period, the less risky the project and the greater the liquidity.
Methods of Calculation of Payback Period (PBP)
 On the basis of uniform cash in flow (annuity form)
 On the basis of non uniform cash inflow (non annuity form)
Uniform cash inflows:-
PBP = Net initial investment
Uniform in crease in annual cash flows
Non uniform
Unresolved Cost at full re cov ery
cash inflows: the start of the Year
PBP Year before full Re cov ry 
Cash flow during the year
Example: An investment has a net investment of Br 12,000 and annual cash flows of Br. 4, 000
for five years. If the project has a maximum desired payback period of 4 years, compute the
payback period and what would be the decision rule?
Solution: - Sine the investment has uniform cash inflows
The PBP = Net initial investment
Uniform increase in annual cash flows
= Br 12, 000 = 3 years
4.0
Decision Rule: - Accept the project because the calculated payback period is less than the specified
payback period.
Example 2: Compute the payback period for the following cash flows, assuming a net investment
of Br 20, 000
Year(t) 0 1 2 3 4 5
Yearly cash flows(Br) 0 8,000 6,000 4,000 2,000 2,000
What would be the decision rule if the specified PBP be three years?
Solution: - the investments cash flows are not uniform (in annuity form), the cumulative cash
flows are used in computing the payback period in the following table.
Year 0 1 2 3 4 5
Yearly cash flows 0 8,000 6,000 4,000 2,000 2,000
Cumulative cash flows 0 8000 14,000 18,000 20,000 22,000

The payback period is 4 years because four years are required before the cumulative cash flows
equal the project net investment. And the decision rule is to reject the project be cause the
calculated payback period is greater than the pre specified payback period.
 Example: 3 BAKO Company is considering investing in a project that has the following cash
flows.
Year(t) 0 1 2 3 4 5
Expected after-tax net cash flows (CF (5000) 800 900 1,500 1,200 3,200
t) (
Br)

Required: compute, (a) The PBP and (b) What would be the decision rule if the company specified
the PBP to be 3. 5 years?

Solution
Year Cash flow Cumulative CF
(+ ) or ( -)
0 (5000) Br (5000) Br (5,000)
1 800 800 (4,200)
2 900 1700 (3,300)
3 1500 3200 (1,800)
4 1200 4400 (600)
5 3,000 7,600 2,600
 Number of year 
  +  Amount of investment remaining to be recaptured
Pay back period = before re covery
   Total cash flow during the pay back period 
 
of original investment

Br 600
 4 Years   4.19 Years
Br 3700

The above table shows that payback period is between four years and five years.
(b) The decision rule is to reject the project because the calculated payback period is greater than
the specified payback period.

Advantage and disadvantages of the payback period

Advantages Disadvantages
- It is easy to use and understand - It does not recognize the time value of money
- Adjusts for uncertainty of later cash flows - It ignores the impact of cash inflows received
-Biased to ward liquidity after the payback period
- Handles investment risk effectively - Biased against long term projects such
as research and development and new projects.
 Activity 4.4
1. Compute the payback period for the following cash inflows assuming an
Investment of Br 3700.

Year 0 1 2 3 4
Cash flow (3,700) 1,000 2,000 1,500 1,000
______________________________________________________________________________
______________________________________________________________________________

4.6.2. The Accounting Rate of Return (ARR)

Finding the average rate of return involves a simple accounting technique that determines the
profitability of a project. This method of capital budgeting is perhaps the oldest technique used in
business. The basic idea is to compare net earnings (after tax profits) against initial cost of a project
by adding all future net earnings together and dividing the sum by the average investment.
Decision Rule: - a project is acceptable if its average accounting return exceeds a target average
accounting return other wise it will be rejected.
Since income and investment can be measured in various ways there can be a very large number
of measures for ARR. The measures that are employed commonly in practice are;
1. ARR= Average in come after tax
Initial investment
2. ARR = Average income after tax
Average investment
3. ARR = Average in come after tax before interest
Initial investment
4. ARR= Average income after tax before interest
Average in vestment
5. ARR= Total income after tax but before
Deprecation – initial investment
(Initial investment ) X years
2
Example: - suppose the net earnings for the next four years are estimated to be Br 10, 000, Br 15,
000, Br 20, 000 and Br 30, 000, respectively. If the initial investment is Br 100, 000, find the
average rate of return.
Solution: - The accounting rate of return can be calculated as follows
1. Average net earnings= Br 10, 000 + Br 15, 000 + Br 20,000 + Br 30,000
4 years
Br 75,000
= Br 18,750
4
2. Average investment = Br 100,000/ 2 =Br 50, 000
Br 18,750 X 100
3. ARR= =38 %
Br 50,000
Advantages and Disadvantages of ARR
Advantages
1. It is simple to calculate.
2. It is based on accounting information, which is readily available, and familiar to
business man.
3. It considers benefits over the entire life of the Project.
4. Since it is based on accounting measures, which can be readily obtained from
financial accounting system of the firm, it facilities post auditing of capital
expenditures.
5. While income data for the entire life of the project is normally required for
calculating the ARR, one can make do even if the complete income data is not
available.
Disadvantages
1. Not a true rate of return, time value of money is ignored
2. Uses an arbitrary bench mark cut off rate
3. Based on accounting (book) values not cash flows and market value

 Activity: 4.5
1. Why the ARR is not recommended for financial analysis?
______________________________________________________________________________
______________________________________________________________________________
2 The McDonald is a fast food restaurant chain potential franchisees are given the following
revenue and cost information
Building and equipment ------------------ Br 980,000
Annual revenue --------------------------- Br 1,040,000
Annual Cash operating costs -------------Br 760,000
The building and equipment have a useful life of 20 years. The straight – line method for
depreciation is used. The income tax is 40%. Based on this information, compute.
(a) The payback period (PBP)
(b) The accounting rate of return (ARR)
______________________________________________________________________________
______________________________________________________________________________
The Discounted Methods (Modern Approaches)
4.6.3. Discounted Payback Period (DPBP)
Out of the serious shortcomings of the payback period method is that it does not consider time
value of money. There is a variation of the payback period, the discounted payback period that
tries to do away with this serious shortcoming by discounting the cash flows before aggregating
them. The discounted payback period is the length of time it takes for the discounted cash flows
equal to the amount of initial investment.
 Number of years 
   PV of investment to be capitured 
Discounted payback period (DPBP) =  before full re cov ery  +  
 of original investmetn  PV of total cash flow during year of pay 
 
Example: Satcon Construction Company is considering investing in a project that has the
following cash flows.

Year (t) 0 1 2 3 4 5

Expected cash flow (in Birr) (5000) 800 900 1500 1200 3200

And the required rate to purchase the asset is 12% .Compute the discounted payback period
Solution; - the cash flow time line for the asset is:-
- -1 2- 3- 4- 5-

(Br 5, 000) 800 900 1,500 1,200 3200

714.29

17.47

1,067.67
762.62

1815.77

We can use the present values of the future cash flows to compute the discounted payback. To do
so, we simply apply the concept of the traditional payback to the present values of the future cash
flows.

Year Cash flow PV of CF Cumulative PV

0 Br (5, 000) (5,00) Br (5,000)
1 800 714. 29 (4285. 71)
2 900 717. 47 (4284.71)
3 1500 1,067.67 (2,500.57)
4 1,200 762.62 (1,737.95)
5 3,200 1,815.77 77.82
 Number of years 
   PV of investment to be capitured 
That’s DPB is =  before full re cov ery  +  
 of original investmetn  PV of total cash flow during year of pay 
 
4 + Br 1, 737.95
Br. 1, 815. 77
= 4. 96 years
Decision rule: A project is acceptable if its payback less than its life. In this case, 4.96
Years are less than five years, so, the project is acceptable
Problems with Discounted Payback Period:
 The discounted payback period solves the time value problem, but it still ignores the cash flows
beyond the payback period.
 You may reject projects that have large cash flows in the outlying years that make it very
profitable.
 Any measure of payback can lead to focus on short run profits at the expense of larger long-
term profits.

 Activity 4.6
Assume that Honey land Hotel investing in a new coffee machine that will cost $10,000.The
machine is expected to provide cost saving each year as shown in the following table.

Year (t) 0 1 2 3 4 5
Expected cash flow (in dollar) (10,000) 2000 2500 3000 3500 4000

If the required rate of return is 12%, what would be the discounted payback period for the machine?
______________________________________________________________________________
______________________________________________________________________________
4.6.4. Net Present Value (NPV)
The project selection method that is most consistent with the goal of owner wealth maximization
is the net present value method. It is the sum of the present values of the net investments i.e. it is
the difference between the present value of the cash flows (the benefits) and the cost of the
investment (ICo)
NPV= the sum of the present value (PV) of after tax cash flows – initial investment
 CF 1   CF 2   CF 3   CF 4   CFn 
  +   +   +   + …………. +   - Ico
 (1  k )1  (1  k ) 2   (1  k )3   (1  k ) 4   (1  k ) n 
= CF1 (PVIFk,1) + CF2 (PVIFk,2) + CF3 (PVIFk, 3 ) + CF4 (PVIFk4) + …(CFNk, n) – Ico.
Where
CF = cash inflow per period
K = Discount rate
ICO= Initial cash outlay (initial investment)
K = Investors required rate of return
Decision rule:
For Independent Projects: Accept the project if the NPV > 0
Reject the project if the NPV < 0
For Mutually Exclusive Projects: choose projects with the highest NPV.
Example A project has a net investment of Br 5, 000 and a cash flow of Br800, Br900, Br 500,
Br1200 and Br 3, 200 for period 1,2,3,4, and 5 .Compute the NPV and comment on the decision
rule.
Solution:-
 CF 1 CF 2 CF 3 CF 4 CF 5 
NPV =       - Ico
 (1  K ) (1  K )2 (1  K )3 (1  K )4 (1  K )5 

 800 Br 900 Br 500 Br 1200 Br 1200 Br 3200 

=        Br 5,000
 ( F  12)1 (1.12)2 (1.12)3 (1.12)4 (1.12)5 (1.12)5 
= Br 77.82
The result of this computation is the same as the cash flow time line diagram as follows.
- -1 2- 3- 4- 5-

(5,000)
(Br 5, 000) 800 900 1,500 1,200 3200
12 %
714.29
12% 12%
714.29 12%
717.47

762.62 Decision rule: - Accept the project since the NPV > 0 i.e. Br 77. 82>0 and the positive
NPV of Br 77.82 indicates that the projects rate of return is greater than the
1,815.77
required 12% but how much greater? The NPV criterion does not provide a direct
answer. Rather, the positive NPV indicates that the profits over and above the cash flows needed
to earn 12% have a present value of Br 77. 82.
 Investment initial cost CF1 CF2
A Br 10, 000 0 Br 14,400
B Br 10,000 Br 10,000 Br 2, 400

Example 2.Given the following cash flow, and investors required rate of return (K) is 10%

Compute the NPV if,

(a) Project A and project B are independent projects.
(b) Project A and project B are mutually exclusive.
(C) Comment on the Decision rule.
Solution

( A) NPV  n CFt - ICo B) n CFt - ICo

 t  1 (1  k )t  t  1 (1  k )t
t=1 t=1
 CF1 CF 2   CF1 CF 2 
=    - ICo    - ICo
 (1  K )1 (1  K )2   (1  K )1 (1  K )2 
 Br 0 Br 14,400  Br 10,000 Br 2400
=    - Br 10,000  Br (1.1)2  (1.1)2  Br 10,000
 (1.1)1 (1.1)2   
= Br 1,901 Br 1,074

C) - if projects are independent; accept both projects since their NPV is greater than zero.
- If projects are mutually exclusive; accept project A since it has the highest NPV
Advantages and Disadvantages of NPV
Advantages

Time value of money is considered

Direct measure of the benefit

It is an objective method of selecting and evaluating of the project.
Disadvantages
 The NPV is expressed in absolute terms rather than relative terms and hence does not
factor is the scale of investment.
 The NPV does not consider the life of the project.
 Activity 4.7
1. Adidas Company is considering two investment project proposals, project X and project Y
Br 5,000. The finance department estimates that the project will generate the following cash
flows.
Year 0 1 2 3 4
Project
X (5,000) 2,000 3,000 500 0
Y (5000) 2000 2000 1, 000 2000

Assume that the required rate of return is 10% and the two projects are independent projects, what
would be the decision Rule?
______________________________________________________________________________
______________________________________________________________________________

4.6.5. Internal Rate of Return (IRR)

The internal rate of return (IRR) is the estimated rate of return for a proposed project given the
projects incremental cash flows. Just like the NPV method, the IRR method considers all cash
flows for a project and adjusts for the time value of money. However, the IRR results are expressed
as a parentage, not a dollar figure. In short, the internal rate of return (IRR) of an investment
proposal is defined as the discount rate that produces a Zero NPV.
n
CFt
NPV =  (1  IRR )t - ICo = 0

t 1
 CF 1 CF 2 CF 3 CF 4 CFn 
=      .... 
(1  IRR )n 
- ICo= 0
 (1  IRR )1 (1  IRR )2 (1  IRR )3 (1  IRR )4
Where
NPV= Net present value of the project proposal
IRR = Internal rate of return
CF= Cash flow
ICO = Initial cash outlay
As in the case of the payback criterion, different procedures are available for computing
investments IRR depending on whether or not its cash flows are in annuity form.
i. When the Cash Flows are in Annuity Form: when the cash flows of an investment are in
annuity form, its IRR can be computed very easily when cash flows are in annuity form IRR is
found by dividing the value of one cash flow in to the net investment and then locating the resulting
quotient in the present value annuity table.
Example, A project required a net investment of Br 100, 000 produced 16 annual cash flows of
Br 14, 000 each, required a 10 percent rate of return, and had a NPV of Br 9, 536. Compute the
IRR.
Solution
Steps
1. Identify the closest rates of return
2. Compute the Net resent Value (NPV) for each of these two closest rates.
3. Compute the sum of the absolute values of the NPV obtained in step 2
4. Dived the sum obtained in Step3 in to the NPV of the smaller discount rate.
Step 1; Br 100, 000
Table value IRR
Br 14, 000 = 7.143
7.379 11%
6.974 12%
Steps 2; (NPV, 11%) = Br 14, 000 (7.379) – Br 100,000 = Br 3,306
(NPV, 12%) = Br 14,000 (6,974) – Br 100,000 = Br 2. 364
The project’s IRR occurs between the two discount rates that produce changes in the sign of the
NPV coefficients. In this example the NPV is positive at 11 percent and negative at 12%. There
fore, the projects IRR is between these two rates.
Steps3. Compute the sum of the absolute values of the NPVs obtained in steps2.
Br 3, 306 + Br 2, 364= Br 5, 670
Steps 4; Divide the sum obtained in steps 3 in to the NPV of the smaller discount rate identified
in step1. Then add the resulting quotient to the smaller discount rate.
Br 3,306
= IRR  11% Br 3,306 IRR  11% 
Br 5,670
Br 5,680 = 11% 0.58%
= 11  0.58%
= 11.58%
ii. When the cash flows are of mixed stream
Example: project X has the following cash flows
Cash flows
Initial
Investment year1 Year2 year3 Year4
Project X (Br 5, 000) Br 2000 Br 3000 Br 5000 Br 0=
And project X’s Cost of capital is 6%. Calculate the IRR for project X and comment on the decision
rule.
First, we insert project Xs cash flows and the times they occur in to the equation.
 Br 2,000   Br 3,000  Br 5,000
 (1  K )1  +  (1  K )2  +  (1  K )3  - Br 5,000
     
Next, we try various discount rates until we find the value of k those results in a NPV of zero. Let’s
begin with the discount rate of 5%
 Br 2,000   Br 3,000  Br 5,000  Br 2000  Br 3,000  Br 5,000
=  +  +  -Br 5, 000  + +  -Br 5,000
 (1  05)1   (1  05)2   (1  05)3   (1  05)1   (1  05)2   (1  05)3 

Br 1, 904.76+ Br 2,721.09+Br 431.92- Br 5000 = Br 57.77

These are close but not quite zero and let’s try second time using the discount rate of 6%
Br 2000 Br 2000 Br 5000 Br 2000 Br 2000 Br 5000
= + + -- Br 5,000 + + - Br 5000
(1.06)1 (1.06)2 (1.06)3 (1.06)1 (1.06)2 (1.06)3
= Br 1, 886 .79 + Br 2,669.99+Br 419.81 –Br5000
= - Br 23.41
This is close enough for our purpose. We conclude the IRR for the project X is slightly less than
6 percent. Although calculating IRR by trial and error is time consuming the guess does not have
to be made entirely in the dark. Remember that the discount rate and NPV are inversely related
when an IRR quests is too high, the resulting NPV will be too low when an IRR guess is too low,
the NPV will be too high.
Note; - we could estimate the IRR more accurately through more trial and error. However,
carryings, the IRR computation to several decimal points may give a false sense of accuracy as in
the case in which the cash flow estimates are in error.
Decision rule
If the IRR of a project is greater than the firms cost of capital (the Hurdle rule) accept the
project, if IRR is less than the cost of capital, reject the project
Advantages and Disadvantages of IRR
Advantages: - A number of surveys have shown that in practice the IRR method is more popular
than the NPV approach. The reason may be that the IRR is straightforward like the ARR but it
1. Recognizes the time value of money
2. Recognizes income over the whole life of the project
3. The percentage return allows a sound basis for ranking projects
Disadvantages
1. It often gives unrealistic rates of return:
Suppose the cut-off rate (cost of capital) is 11% and the IRR is calculated as 40%, does this mean
that management should immediately accept the project because its IRR is 40%? The answer is
no! An IRR 40% assumes rate a firm has the opportunity to reinvest future cash flows at 40%
2. Give different rates of return.

 Activity 4.8
1. A company is considering an investment with predicted annual cash flows for the next 3
years of Br 1, 000, Br 4,000 and Br 5,000 respectively. The initial investment is Br 7,650. If the
cut off rate is 11%, is the project acceptable?
______________________________________________________________________________
______________________________________________________________________________

Note: cut of rate, cost of rate, required rate of return, and hurdle rule have similar meaning.
Which Method is better: the NPV or the IRR?
The NPV is superior to the IRR method for at least two reasons.
1. Reinvestment of Cash flows: The NPV method assumes that the projects cash in flows are
reinvested to earn the hurdle rate; the IRR assumes that the cash inflows are reinvested to
earn the IRR of the two NPV’s assumption is more realistic in most situations since the IRR
can be very high on some projects.
2. Multiple Solutions for the IRR: It is possible for the IRR to have more than one solution. If
the cash flow experience a sign change (eg. Positive cash flow in one year, negative in the
next), the IRR method will have more than one solution. In other words, there will be more
than one percentage member that will cause the present value benefits to equal the present
value cash flows. When this occurs, we simply do not use the IRR method to evaluate the
 project since no one value of the IRR is theoretically superior to the others. The NPV method
does not have this problem.
4.6.6 The Modified Internal Rate of Return (MIRR)
The modified internal rate of return (MIRR) is an attempt to overcome the above two deficiencies
in the IRR method. The person conducting the analysis can choose whatever rate he or she wants
for investing the cash inflows for the remainder of the projects life.
For example, if the analyst chooses to use the hurdle rate for the reinvestment purposes, the MIRR
techniques calculates the present value of the cash out flows ( i.e. PVC) the future value of the
cash inflows ( to the end of the project’s life) and then solves for the discount rate that will equate
the PVC and the FVB . In this way the two problems mentioned previously are overcome;
1. The cash inflows are assumed to be reinvested at reasonable rate chosen by the analyst.
2. There is only one solution to the technique.
In general the modified internal rate of return (MIRR) has a significant advantage over the regular
IRR. MIRR assumes that cash flows from all projects are reinvested at the cost of capital, while
the regular IRR assumes that the cash flows form each project are reinvested at the project’s own
IRR. Since reinvestment at the cost of capital is generally more correct, the modified IRR is better
indicator of a projects true profitability. Algebraically it can be expressed as:

FVC
MIRR = n -1
PVC
Where
MIRR = Modified internal rate of return
FVC = Future value of the cash inflows
PVC = Present value of the cash out flows
Example: Assume that we are evaluating a project that has a cost of Br 30,000 after tax cash
inflows of Br 10,000 per year for four years and a hurdle rate of 10%. Computer the MIRR and
comment on the decision rule
Solution
Since the cash inflows are assumed to be received at the end of each year, the cash inflows would
be reinvested as shown below Notice that the 1st year’s cash inflow is assumed to be reinvested for
three years, so we multiply time the feature value factor for 10%. The second year’s cash flow is
assumed to be reinvested for two year. Year 3‘s cash inflow is invested for 1 year and year 4’s
 cash inflow is received at the end of the 4th year. So, it is not available for reinvestment it concedes
with the end of the projects life.

Year Years reinvested Cash inflow Future value factor of 10% Future value
1 3 Br 10,000 1,331 Br 13,310
2 2 10,000 1,210 Br 12,100
3 1 10,000 1,100 Br 11,000
4 0 10,000 1,000 Br10,000
Total Br 46,410

Now, the only question remaining is: if we invest Br 30,000 in an account to day and receive the
equivalent of Br 46, 410 in four years what rate would be earned on the investment? We can
illustrate the calculation using time line as shown

1 2 3 4

Cash flows (30,000) 10,000 10, 000 10, 000 10,000

K=10% 11,000
K=10%
12, 100

K= 10%
13,310
Terminal value
(TV) 46,410
MIRR = 11.53%
PV of TV = 30,000
NPV =0

4.6.7. Conflicting Rankings between the NPV and the IRR Methods
As long as proposed capital budgeting projects are in dependent both the NPV and IRR methods
will produce the same accept / reject indication that is a project that has a positive NPV will also
have an IRR that is greater than the discount rate (hurdle rate). As a result the project will be
acceptable based on both the NPV and IRR values. However, when mutually exclusive projects
are considered and ranked, a conflict occasionally arises. For instance, one project may have a
higher NPV than another project but a lower IRR.
Example: GEDA company own a piece of land that can be used in different ways on the one
hand this land has mineral beneath it that could be mined, So GEDA could invest in mining
equipment and reap the benefits retrieving and selling the minerals. On the other hand, the land
has perfect soil conditions for growing grapes that could be used to make wine, so the company
could use it to support vinegar. Clearly, these two uses are mutually exclusive .The mine can not
be dug if there is a vineyard and the vineyard can not be planned if the mine is dug. The acceptance
of one project means that the other must be rejected
Example 2: Now let’s suppose that GEDA finance department has estimated the cash flows
associated with each use of the land. The estimates are as follows.

Time Cash flows for the mining project Cash flows for the vineyard project
To (Br 736,369) ( Br 736,369)
T1 Br. 500,000 0
T2 300,000 0
T3 100,000 0
T4 20,000 50,000
T5 5,000 200,000
T6 5,000 500,000
T7 5,000 500,000
T8 5,000 500,000

Required: Which project should GEDA choose? If the required rate of return be 10%?
Solution: Note that although the initial outlays for the two projects are the same the incremental
cash flows associated with the project differ in amount and timing. The mining projects generate
its greatest cash flows early in the life of the project where as the vineyard projects generate its
greatest positive cash flows later. The differences in the projects cash flow timing have
considerable effects on the NPV and IRR for each venture. The NPV and IRR results for each
project given its cash flow are summarized as follows.
NPV IRR
Mining project Br 65, 727, 39 6.05%
Vineyard and project be 194,035.65 14.0%
The NPV and IRR results show that the vineyard project has a higher NPV than the mining project
but the mining project has a higher IRR than the vineyard project GEDA faced with the conflict
between NPV and IRR results because the projects are mutually exclusive, the firm can accept
only one.
In the cases of conflict among mutually executive projects the one with the highest NPV should
be chosen because NPV indicates the dollar amount of value that will be added to the firm if the
project is undertaken. In our example, GEDA should choose the vineyard project if its primary
financial goal is to maximize firm value. Algebraically it is computed as:

FVC Br 46,410
MIRR = n -1 = 4 = 11.53%
PV Br 30,000
Decision rule: since the MIRR (11.53%) is greater than the hurdle rule (10%) so we have to
accept the project
Activity 4.9
1. What advantages does the MIRR have over the regular IRR for making capital budgeting
decisions?
______________________________________________________________________________
______________________________________________________________________________
4.6.8. Profitability Index (PI)
The Profitability Index (PI): Sometimes called benefit cost ratio method compares the present
value of future cash inflows with the initial investment on a relative basis Therefore; the PI is the
ratio of the present value of cash flows (PVCF) to the initial investment of the project. This index
is used as a means of ranking profits in descending order of attractiveness.

PVCF
PI 
Inifial investemtn
Decision rule
In this method, a project with PI greater than 1 is accepted but a project is rejected when its PI is
less than 1.
Note that the PI method is closely related to the NPV approach .In fact if the net present value of
the project is positive, the PI will be greater than 1. On the other hand if the NPV is negative the
project will have PI of less than 1. The same conclusion is reached, there fore, whether the NPV
or PI is used. In other words, if the NPV of the cash flows exceeds the initial investment there are
a positive net present value and a PI greater Ethan 1 indicating that the project is acceptable.
Example: Zuma Co. is considering a project with annual predicted cash flows of $ 5, 000, $3,000
and $ 4,000 respectively for three years. The initial investment is $ 10,000 using the PI method
and a discount rate of 12%, determine the PI if the project is acceptable.
Solution to determine the PI, the present value of the cash flows should be divided by the initials
cost.
CF1 CF 2 CF 3
PVCF = + +
(1  K )1 (1  K )2 (1  K )3
$5000 $3000 $4000
= + + , PVCF= $9,704
(1.12)1 (1.12)2 (1.12)3
Initial investment (Io) = $ 10,000
PVIF $ 9,704
PI = = = 0.0704. Since the PI value is less than 1, the project is rejected
(IO ) $10,000

 Activity 4.10
1. Do the NPV and PI methods give the same answers in terms of accepting or
rejecting projects? Discuss:
1.1. Which method is superior NPV or pay back period? Why?
1.2.Which method is superior NPV or IRR?
______________________________________________________________________________
______________________________________________________________________________
4.6.9. Capital Rationing
Capital rationing refers to the situation where a budget constraint is imposed and the firm may not
invest in all acceptable projects. Given the set of projects that are acceptable, what subsets of
projects should the firm select? In this situation the firm is still trying to maximize shareholders
wealth. So, it should invest in that group of projects that collectively has the largest net present
value. How do we identify that best group? That is, what investment criterion will identify this
group?
If capital rationing is imposed, then financial managers should seek the combination of projects
that maximizes the value of the firm with in the capital budget limit. If the firm decides to impose
a capital constraint an investment projects, the appropriate decision criterion is to select the set of
projects that will result in the highest net present value subject to the capital constraint.
Example: - consider a firm with a budget constraint of Br 1,000, 000 and five projects available
to it, as given below.
Project Initial Profitability Net present
Outlay index Value
A Br. 400,000 2.4 Br 560,000
B Br. 400, 000 2.3 320,000
C 1,600, 000 1.7 1,200,000
D 600,000 1.3 180,000
E 600,000 1.2 120,000
Were there is no capital constraints, all projects were acceptable. However, due to capital
constraint we have to ration the available capital.
Case1.Indivisible Projects: If the projects are indivisible, the firm can not invest in a portion
project. A project is either taken in full (100%), if not, it is dropped in such a case when projects
are indivisible, there is no guide line to be followed in picking the sets of project that will maximize
the total NPV of the firm .Thus we are left with trial and error. therefore, try different combinations
of the alternative projects without surpassing the capital constraint which will maximize overall
NPV and that mix of projects is the optimal mix. From the given example higher total net present
value is provided by the combination of projects be selected from the sets of projects available.
Case2 Divisible Projects: If projects are divisible that means an investor can invest in any portion
of a project. In such case of project divisibility the selection of the best projects is straight forward.
It is to allot the available capital starting from the project with the highest profitability index (not
necessarily the project with highest NPV)
Project Initial out NPV PI Ranking
A 200,000 280,000 2.4 1st
B 200,000 260,000 2.3 2nd
C 600,000 420,000 1.7 3rd
Total 1,000,000 960,000

Note: - project C is not fully taken. This is because the amount of money left after project A and
B are taken is only Br 600,000 but project C requires Br 800,000. Thus, just the amount that is
available, which is Br 600.000 is invested in project C which is 75% of the total. The NPV is
expected to be proportionate to the amount of investment in C thus equals 75% of Br 560,000.
 Activity 4.11
1. What is the meaning of the term “capital rationing”?
___________________________________________________________________________________
___________________________________________________________________________________
2. What are some common reasons for capital rationing with in a firm?
___________________________________________________________________________________
___________________________________________________________________________________
3. What is the preferred method for choosing among indivisible projects under capital constraints?
Explain in why?
___________________________________________________________________________________
___________________________________________________________________________________
Chapter Summary
This chapter focused on the capital investments and cash flow analysis. The key point of the
chapter is as follows.
Capital budgeting is the process of planning, analyzing, selecting and managing capital
investments. Capital budgeting decisions are crucial to a firm’s welfare because they often
involve large expenditures, have a long-term impact on performance, and are not easily
reversed once started, and are vital to a firm’s ability to achieve its financial objectives.
The capital budgeting process requires identifying project proposals, estimating project cash
flows, evaluating, selecting, implementing projects, and monitoring performance results.
Capital budgeting analysis uses only a project’s incremental after tax cash flows. Cash flows
from accepting projects can be both direct (the purchase price of equipment and installation
costs) and indirect (change in net working capital, opportunity costs. Projects relevant cash
flows consists of three components: initial investment, operating cash flows, and terminal cash
flow.
Financial managers use many different techniques to evaluate the economic attractiveness of
making capital investments because each method provides additional information about the
project.
Discounted cash flow (DCF) methods (NPV, PI, IRR and MIRR) are superior to the pay back
methods (PBP, DPB) because the latter techniques use time value of money principle to
discount all project cash flows and offer project estimates past recovery of the initial estimate.
For single, independent projects with conventional cash flows, the four DCF methods give the
same accept-reject signal when firms do not face a capital constraint.
Conflicting rankings may occur among the DCF methods when comparing mutually exclusive
projects with differing initial investments (size or scale) and cash flow patterns. And when
conflicts occur due to size or timing differences, the NPV is the preferred ranking method
because it enables management to choose from among mutually exclusive investments with
the objective of maximizing the firm’s value and therefore, shareholder wealth.
Capital rationing, due to market or management imposed constraints, may not allow a firm to
undertake all acceptable projects. When projects are indivisible, the preferred method to
maximize shareholder wealth is to choose that combination of projects offering the highest
NPV with in the limits imposed by the constraints.
 Model Examination Questions
Multiple Choice Questions

1. Find the NPV of the project with the following cash flows if the cost of capital is 14%.

0 1 2 3 4 5 6 7 8
$- $ 500 $0 $0 $ 200 $ 100 $ 400 $ 400 $ 400
1,100
A) $528.82 B) $537.81 C) $540.35 D) $549.972
2. Find the Payback Period for the project with the following cash flows.
0 1 2 3 4
$ - 1,500 $ 500 $ 100 $100 $ 900

A) 3.53 years B) 3.89 years C) 5.11 years D) 6.35 years

3. Find the IRR of the project with the following cash flows.

0 1 2 3 4 5 6 7
$ - 1,500 $0 $40 0 $0 $0 $0 $0 $ 1200

A) 1.13% B) 3.96% C) 6.12% D) 8.16%

4. Assume that Limu Cofeee Plant is considering a new labor saving machine that will cost
Br10; 000.the machine is expected to provide cost savings each year as shown in
the following table.
0 1 2 3 4 5
Br10,000 Br 2000 Br 2,500 Br 3,000 Br 3,500 Br 4000

If the enterprise’s required rate of return be 12%, then which of the following is not true?
A) The payback Period is3.7143 years B) The discounted payback Period is 3.7143 years
C) The MIRR is greater than the cost of capital. D) NPV>0
5. Refer to the above question what would be the profitability index?
A) Greater than one B) less than one C) equal to one D) A and B
 Workout Questions
1. MATADORE Associates are considering the purchase of a new machine for Br 300, 000
mean while, they are planning to sell their old machine for Br 60, 000. The old machine was
purchased 3years ago and its book value is Br 46,200. Both machines have a depreciation life
of 5 years. Delivery expenses are Br 6000, and installation expenses are Br 10, 000. Using
tax rates of 34% for ordinary income, calculate the initial cost of buying the new equipment.
2. Sara and Associates have estimated the earning before interest and tax (EBIT) of their firm
under two conditions as follows

Year EBIT with EBIT with new

Old equipment Equipment
1 Br 150,000 Br 210,000
2 190, 00 290,000
3 340,000 380,000
4 450,000 490.000
5 550,000 710,000

The old equipment was purchased 2 years ago for Br 500, 000. New equipment can be purchased
for Br 710,000. Both pieces of Equipment have a depreciation life of 5 years. Using a tax rate of
34% calculate the incremental cash flow of replacing the old equipment and explain your findings
in your own words.
3. Sunshine Construction Company is considering a capital investment for which the initial outlay
is Br 20, 000. Net annual cash inflows (before taxes) are predicted to be Br 4, 000 for 10 years.
Straight- line depreciation is to be used, with an estimated salvage value of zero. Ignore income
taxes. Compute the
A. Pay back period (PBP)
B. Accounting Rate of Return (ARR)
C. Net present Value (NPV) assuming the cost of capital (before tax) of 12 percent; and
D. Internal rate of return
4. You are a financial analyst for Dire Electronics Company. The director of capital budgeting has
asked you to analyze two proposed capital investments, projects X and Y. Each project has a cost
of Br 10,000and the cost of capital for each project is 12 percent. The projects’ expected net cash
flows are as follows
Expected net cash flows
Year project X Project y
0 Br 10,000 Br 10,000
1 6,500 3,500
2 3,000 3,500
3 3,000 3,500
4 1,000 3,500

A. Calculate each project’s pay back period (PBP), Net present value (NPV), Internal rate of
return (IRR) and the modified internal rate of return (MIRR)
B. Which project or projects should be accepted if they are independent?
C. Which project should be accepted if they are mutually exclusive?
D. How might a change in the cost of capital produce conflict between the NPV and the IRR
rankings of these two projects? Would this conflict exist if it were 5%
E. Way does the conflict exists?
Answers for Model Examination Questions
Multiple Choice Questions
1. B 2. B 3. A 4. B 5. A
Workout Questions
Solutions 1
Cost of equipment (new) ------------------------- Br 300, 000
Delivery Expenses ----------------------------------- Br 6,000
Installation --------------------------------------------Br 10, 000
Sale of old machine --------------------------------------Br (60,000)
Tax on the sale of old machine Br 4, 692
Cost of buying the new equipment Br260, 000
 Tax = 34% of recaptured depreciation and Recaptured depreciation = Selling price – book
value: = Br 60, 000 – 46, 200 = Br 13, 800. Therefore, the tax on the sale of the old machine is
34% X 13, 800 = Br 4, 692.
Solution 2
Year New deprecation Old Additional Additional
Depreciation Depreciation Tax benefit at 34%
1 Br 142,000 Br. 95.000 Br 47.000 Br15, 980
2 227,000 75,000 152, 200 51,748
3 134,900 70,000 64,900 22,066
4 106,500 0 106,500 36,210
5 99,400 0 99,400 33,796
Incremental cash flow = Additional EBIT + Additional tax benefit
Year Incremental cash flow
1 Br 75,980
2 151,748
3 62,066
4 76,210
5 193,796
Note: - This computation is similar to the formula used to compute incremental cash flow
Solution 3
A). since the cash flows are uniform (in annuity form) then payback period
(PBP) = Initial investment = Br 20, 000
Annual cash flows Br, 4,000 PBP = 5 years
B) Accounting rate of return (ARR) = Net income
Initial investment
Depreciation = Br 20, 000 = Br 2, 000/ year
10 Years
ARR = (Br 4,000 – Br 2,000/ year = 0.10
Br 20, 000
t
C) Net percent value (NPV) =  CFt/ (1+K) t -ICo which means
NPV = PV of cash inflows (discounted at the cost of capital (12%)
 CF 1 CF 2 CF 3 CF 4 CF 5 
NPV =      .....CF  - Ico
 (1  K ) (1  K )2 (1  K )3 (1  K )4 ( 4 K )5 

NPV = 4,000 + 4,000 + 4,000 + --------------------- 4,000 – Br. 20,000

(1.12)1 (1.12) 2 (1.12) 3 (1.12) 10
= Br 4,000 * (PVI F12 % 10) – Br 20,000 = Br 4,000 (5.6502) – Br 20, 000
= Br 2, 600.80
(D) Internal rate of return (IRR) is the rate which equates the amount invested with the present
value of cash flows generated by the project: Br 20, 000 = Br 44, 000 (PVIFAr 10)
Using the short cut formula Br 4, 000 15% and 16%
LRPV- SRPV *(HR – LR)
IRR = LR + LRPV – HRPV
= 15% + (5.0188 – 5.00
5.0188 – 4. 8332 * (16%- 15%) = 15% + 0.0188 X 1%
0.1856
= 15% + 0.101 % = 15.101%
Solution 4
A) To determine the pay back period construct the cumulative cash flows for each project.

Project Cumulative cash flows

0 1 2 3 4
Project X (Br 10, 000) (3,500) (500) 2,500 3,500
project Y (Br 10, 000) (6,5000) (3,000) 5,00 4,000

PBPx = 2 + Br 500 = 2.17 years PBPy = 2 + Br 3,000 = 2.86 years

Br 3000 Br 3,500

NPY x = CF1/ (1+k) 1 + CF2/ (1+k) 2+ CF3/ (1+k) 3 + CF4/ (1+k) 4 - ICo
Br 6,500 + 3,000 + 3,000 + 1,000
1 2 3
(1.12) (1.12) (1.12) (1.12)4 - Br 190,000

NPVY = (Br 3,500 + Br 3,500 + 3, 500 + 3500 - Br 10,000

(1.12)1 (1.12)2 (1.12) 3 (1.12) 4

= Br 630.72

MIRR: - To solve for each projects IRR, find the discount rates which equates each NPV to Zero

IRR x = 18.0%
IRRy = 15.0%

MIR:- to obtain each projects MIRR begin by finding each projects terminal value (FVCF) cash
flows
TVx = Br6, 500 (1.12)3 + Br 3,000 (1.12)2 + Br 3,000 ( 1.12)1 + Br 1,000 ( 1.12)0 = Br. 17,255.23
 FVCF  1 17,255.23  1
=
PVCF 10,000
= 14.61%
3 2
TVy (FVCFy) = Br 3,500 (1.12) Br 3500 (1.12) 2 + Br
3500 (1.12)1 + 3500
= Br 16, 727.65

FVCF  1 Br16,727.65  1
MIRRy =
PVCF Br10,000

= 13.73%
B. The following table summarizes the project rankings by each method
Project Which
Ranks higher
Pay back X
NPV X
IRR X
MIRR X
Note that all methods rank project X over project. In addition both projects are acceptable under
the NPV, IRR, and MIRR criteria. Thus, both projects should be accepted if they are independent.
(C) Inthiscase, we choose the project with the higher NPV at K =- 12% or project X
(D) If the firms cost of capital is less than 6% a conflict exists because NPVy > NPVx, but IRRx
> IRRy. Therefore that when K = 5% the MIRRx = 10.64% and MIRRy – 10.83 hence the modified
IRR (MIRR) ranks the projects correctly even if k is to the lest of the over point.
(e) The basic cause of the conflict is differing reinvestment rate assumptions between NPV and
IRR. NPV assumes that caws lows can be reinvested at the cost of capital while IRR assumes re –
investment at the (Generally) high IRR makes early cash flows especially valuable and hence short
– term projects look better under IRR
 CHAPTER FIVE
LONG-TERM FINANCING
Contents of the Chapter
 Unit Objective
 Introduction
 Contents
5.1. Bonds
5.1.1. Types of Bonds
5.1.2. Advantages and Disadvantages of Bonds
5.2. Stocks
5.2.1. Preferred Stocks
5.2.1.1. Features of Preferred Stocks
5.2.1.2. Advantages and Disadvantages of Preferred Stocks
5.2.2. Common Stocks
5.2.2.1. Characteristics of Common Stocks
5.2.2.2. Advantages and Disadvantages of Common Stocks
5.2.3. Other Types of Stocks
5.2.4. Stock Issuance
5.3. Investment Banking
5.3.1. Functions of Investment Banking
5.4. Term Loans
 Unit summary
 Model Examination Questions
Unit Objectives
This unit discusses issues pertaining to long-term financing instruments. It also presents the
different instruments as: bonds, stocks, investment banking and term loans.
After learning this unit students will be able to:
 Identify the different types of bonds
 Identify the basic types of stocks
 Distinguish the advantages and disadvantages of preferred and common stocks
 Define investment banking
 Describe the functions of investment banking
 Describe the term loans
 Introduction
In order to establish, manage and expand businesses, capital is crucial. Thus, one major challenge
encountered by most entrepreneurs, notwithstanding the scope of operations, is the question of
sourcing capital. Companies require capital at various stages of their operations – to start up a
venture; expansion; for growth; and so on. This challenge becomes more apparent in view of the
fact that business owners do not just need capital, but are also concerned about the level of risk
associated with raising the capital, as well as with maintaining control of their businesses.
In choosing a source of capital, the entrepreneur can select from any of the two broad means of
financing – equity financing or debt financing. If the entrepreneur chooses to source capital
through equity financing, he would not assume the risk of high interest rates but would have to
involve other persons in the control of his business. If he opts for debt financing, although the
entrepreneur would maintain control of the business, he would be liable to pay interest on the
capital. This means that the entrepreneur has to carefully appraise and balance the risk involved in
debt financing vis-à-vis the question of control of his business before making an informed financial
decision.
5.1. Bonds

 Dear learners! What do you think are bonds? What are the different types of
Bonds? What are the advantages and disadvantages of issuing bonds?

A bond is a long-term promissory note that promises to pay the bondholder a predetermined, fixed
amount of interest each year until maturity. A bond is issued by a business or governmental unit;
it is a contract under which a borrower agrees to make payments of interest and principal, on
specific dates, to the holder of the bond. A bond issue is generally advertised, offered to the general
public, and typically sold to many different investors.
Dear Students! in chapter four, you have seen the basic bond terminologies. Now let us see the
different types of bonds.
5.1.1. Types of Bonds

 Dear learners! What are the major types of bonds?

A. Debentures
A debenture is simply a document that either creates a debt or acknowledges it. The term is used
for a medium to long-term instrument used by all forms of registered companies to borrow money.
Debenture-holders are creditors of the company and therefore, are not members of the company.
They have no voting rights regarding the company’s decisions and the interest the company pays
to them is a charge against profit in the company’s financial statements. A debenture is specie of
personal property and the holder can transfer it freely. As a bearer instrument, any person in
possession of it can make a claim for payment. Debentures may be secured by a fixed or floating
charge, or may be unsecured. Debentures secured by a fixed charged have priority over other types
of debentures; followed by debentures secured by a floating charge; while an unsecured debenture
holder is like an ordinary creditor with no special protection. However, unsecured debentures
usually attract higher interest rates.
B. Income Bonds: An income bond requires interest payments only if earned, and failure to meet
these interest payments can not lead to bankruptcy. In this sense, income bonds are more like
preferred stock than bonds. They are generally issued during the reorganization of the firm facing
financial difficulties. The maturity of the income bond is usually much more than that of other
bonds to relieve pressure associated with the repayment of the principal. While interest payment
may be passed, unpaid interest is generally allowed to accumulate for some period and must be
paid before the payment of any common stock dividends.
C. Mortgage Bonds: A mortgage bond is a bond secured by a lien on real property. Typically,
the value of the real property is greater than that of the mortgage bonds issued. This provides the
mortgage bondholders with a margin of safety in the event the market value of the secured property
declines.
D. Junk Bonds: Junk bonds are bonds issued by firms with sound financial stories that were facing
severe financial problems and suffering from poor credit ratings. The major participants in this
market are new firms that do not have an established record of performance.
E. Zero and Very Low Coupon Bonds: are bonds that allow the issuing firm to issue bonds at a
substantial discount from their face value with a zero or very low coupon. The investor receives a
large part (or all on the zero coupon bonds) of the return from the appreciation of the bond. 5.1.2.
Advantages and Disadvantages of Bonds
Advantages
 Bond is generally less expensive that other forms of financing because (a) investors view debt
as a relatively safe investment alternative and demand lower rate of return (b) interest expenses
are tax deductible.
 Bond holders do not participate in extraordinary profit; the payments are limited to interest.
 Bondholders do not have voting right.
 Flotation costs on bonds are generally lower that those on common stocks.
Disadvantages
 Bond (other than income bonds) results in interest payments that, if not met can force the firm
in to bankruptcy.
 Debt (other than income bonds) produces fixed charges, increasing the firm's financial
leverage. Although this may not be a disadvantage to all firms' it certainly is for some firms
with unstable earning streams.
 Debt must be repaid at maturity and thus at some point involves a major cash out flow.
 The typically restrictive nature of indenture covenants may limit the firm's future financial
flexibility.

 Activity 5.1
1. What are bonds? Why organizations or government issue bonds?
______________________________________________________________________________
______________________________________________________________________________
2. What are the major types of bonds?
______________________________________________________________________________
______________________________________________________________________________
3. What are the advantages and disadvantages of bond issue?
______________________________________________________________________________
______________________________________________________________________________
5.2. Stocks

 Dear Learners! What are stocks and why they are issued?

There are many different types of stocks which can be invested in based upon your financial
position, your risk comfort level, and your investment goals. In order to determine which type to
invest in, you have to first determine what you want the stock to do for you. Do you plan to hold
the security long-term, or are you a day trader? Are you looking for capital gains in your
investments or is income your main objective? How you answer these questions will give you a
good idea of which type of stock you should be considering for your portfolio.
A company’s stock offerings generally fall into one of two categories: common stock or preferred
stock.
5.2.1. Preferred Stock
Is a security which has characteristics of both bonds and common stock and is commonly referred
to "hybrid" security. Preferred stock is similar to common stock in that it has no fixed maturity
date, the nonpayment of dividends does not bring on bankruptcy , and dividends are not deductible
for tax purpose. On the other hand, preferred stock is similar to bonds in that dividends are limited
in amount. The dividends on preferred stock are usually a fixed percentage of the par, or face,
value. Thus, like bonds, shares are sensitive to interest rate fluctuations. Prices go up when interest
rates go down, and vice versa. Preferred dividends are not a contractual obligation of the issuer,
however. Although, they are payable before common stock dividends, they can be skipped
altogether if corporate earnings are low and if the issuer goes bankrupt.
5.2.1.1. Features of Preferred Stock
Although each issue of preferred stock is unique, several characteristics are common to almost all
issue. These traits include the ability to issue multiple classes of preferred stock, the claim on assets
and income, and the cumulative and protective features.
A. Multiple Classes
If a company desires, it can issue more that one classes of preferred stock, and each class can
have different characteristics. In fact, it is quite common for firms that issue preferred stock to
issue more than one class. Preferred stocks can be further differentiated by the fact that some are
convertible to common stocks while others are not, and they have varying priority status with
respect to assets in the events of bankruptcy.
B. Claim on Assets and Income
Preferred stocks have priority over common stock with respect to claims on assets in the case of
bankruptcy. The preferred stock claim is honored after bond and before that of common stocks.
Preferred stock also has a claim on income prior to common stock. That is, the firm must pay its
preferred stock dividends before it pays common stock dividends. Thus in term of risk, preferred
stock is safer than common stock because it has a priority claim on assets and income. However,
it is riskier than long-term debt because its claims on assets and income come after those of bonds.
C. Cumulative Feature
Most preferred stock carries a cumulative feature that requires all past unpaid preferred stock
dividends be paid before any common stock dividends are declared. The purpose is to provide
some degree of protection for the preferred stock shareholders. Without a cumulative feature there
would be no reason why preferred stock dividends would not be omitted or passed when common
stock dividends were passed. Because preferred stock does not have the dividend enforcement
power of interest from bonds, the cumulative feature is necessary to protect the rights of preferred
stockholders.
5.2.1.2. Advantages and Disadvantages
Because preferred stock is a hybrid of bonds and common stock, it offers the firm several
advantages and disadvantages by comparison with bonds and common stocks.
Advantages
 Preferred stock does not have any default risk to the issuer. That is, the non payment of
dividends does not force the firm in to bankruptcy, as does the non payment of interest on debt.
 Preferred stockholders' do not have voting rights except in the case of financial distress.
Therefore, the issuance of preferred stock does not create a challenge to the owners of the firm.
 The dividend payments are generally limited to a stated amount. Preferred stock does not
participate in excess earnings, as does common stock.
 Although preferred stock does not carry specified maturity, the inclusion of call features and
sinking funds provides the ability to replace the issue if interest rates decline.
Disadvantages
 Because preferred stock is riskier than bonds and its dividend is not tax deductible, its cost is
higher than that of bonds.
 Although preferred stock dividends can be omitted, their cumulative nature makes their
payment almost mandatory.
5.2.2. Common Stocks
Common stock involves ownership in a corporation. In effect, bond holders and preferred
stockholders can be viewed as creditors, while the common stock holders are the true owners of
the firm. Common stock does not have a maturity date, but exists as long as the firm does. Nor
does the common stock have an upper limit on its dividend payments. Dividend payments must be
declared by the firm's board of directors before they are issued. In the event of bankruptcy, the
common stockholders, as owners of the corporation, can not exercise claims on assets until the
bondholders and preferred stockholders have been satisfied.
5.2.2.1. Characteristics of Common Stocks
A. Claim on Income
As the owners of the corporation, the common stockholders have the right to the residual income
after bondholders and preferred stockholders have been paid. This income may be paid directly to
the shareholders in the form of dividends or retained and reinvested in the firm.
B. Claim on Assets
Just as the common stock has the residual claim on income, it also has a residual claim on assets
in the case of liquidation. Only after the claim of debt holders and preferred stockholders have
been satisfied do the claims of common stockholders receive attention. Unfortunately, when
bankruptcy does occur, the claims of common stockholders generally go unsatisfied. In effect, this
residual claim on assets adds to the risk of common stock.
C. Voting Right
The common stockholders are entitled to elect the board of directors and are in general the only
security holders given a vote. Common stockholders not only have the right to elect the board of
directors, they also must approve any change in the corporate charter.
D. Limited Liability
Although the common stockholders are the actual owners of the corporation, their liability in the
case of bankruptcy is limited to the amount of their investment. The advantage is that, investor
who might not otherwise invest their funds in the firm become willing to do so. This limited
liability feature aids the firm in raising funds.
5.2.2.2. Advantages and Disadvantages of Common Stocks
Advantages
 The firm is legally not obligated to pay common stock dividends. Thus, in times of financial
distress, there need not be a cash outflow associated with common stock, while there must be
with bonds.
 Because common stock has no maturity date, the firm does not have a cash outflow associated
with its redemption.
 By issuing common stock, the firm increases its financial base and thus its future borrowing
capacity. Conversely, issuing debt increases the financial base of the firm but cuts the firm's
borrowing capacity.
Disadvantages
 Because dividends are not tax deductible, as are interest payments, and flotation costs on equity
are larger than those on debt, common stock has a higher cost than debt.
 The issuance of new common stock may result in change in the ownership and control of the
firm. Although the owners have a preemptive right to retain their proportionate control, they
may not have the funds to do so. If this is the case, the original owners may see their control
diluted by the issuance of new stock.
5.2.3. Other Types of Stocks

 Dear Learners! What are the other types of stocks other than common and
preferred stocks?

Listed below are several types of stocks which are commonly traded in the securities market:
1.Blue Chip Stocks: are stocks of well-established companies that have stable earnings and no
extensive liabilities. They have a track record of paying regular dividends, and are valued by
investors seeking relative safety and stability.
2.Income Stocks: generate most of their returns in dividends, and the dividends-unlike the
dividends of preferred stock or the interest payments of bonds-will, in many cases, grow
continuously year after year as the companies' earnings grow. These companies have a high
dividend payout ratio because there are few opportunities to invest the money in the business
that would yield a higher return on stockholders' equity. Hence, many of these companies are
already very large, and are also considered to be blue-chip companies, such as General Electric.
3.Growth Stocks: are stocks of companies that reinvest most of their earnings into their
businesses, because it can yield a higher return on stockholders' equity, and ultimately, a higher
return to stockholders, in the form of capital gains, than if the money were paid out as dividends.
Typically, these companies have high P/E ratios because investors expect high growth rates for
the near future. Note, however, that growth stocks are risky. If a growth-oriented company
doesn't grow as fast as anticipated, then its price will drop as investors lower its future prospects
with the result that the P/E ratio declines. So even if earnings remain stable, the stock price will
decline.
4.Speculative Stocks: are the stocks of companies that have little or no earnings, or widely varying
earnings, but hold great potential for appreciation because they are tapping into a new market,
are operating under new management, or are developing a potentially very lucrative product that
could cause the stock price to zoom upward if the company is successful.
5.Tech Stocks: are the stocks of technology companies, which make computer equipment,
communication devices, and other technological devices. The stocks of most tech companies are
either considered growth stock or speculative stock; some are considered blue-chip, such as Intel
or Microsoft. However, there is considerable risk in tech companies because research and
development efforts are hard to evaluate, and since technology is continually evolving, it can
quickly change the fortunes of many companies, especially when old products are displaced by
new products.
5.2.4. Stock Issuance
Companies can decide to make the transition from the private market to the public market for
several reasons. When a company "goes public," its first offering of stock is called an Initial Public
Offering or IPO. Once a company is public it can also decide to issue more stock. Stocks consist
of two markets: primary and secondary. The primary market - also called "issuance market" - is
the one in which a security is first issued. Companies use the primary market to raise capital. By
issuing securities, they can divide major capital outlays into small units. If a company decides to
issue securities in order to raise short- or long-term capital, it enters the money or capital market
as an issuer. Companies can issue different kinds of securities: shares, bonds, warrants etc.
In a first step, securities such as shares and bonds are placed directly with investors or indirectly
via banks with no involvement of a stock exchange to begin with. The most important kind of
placement and the one that is most common is firm-deal underwriting of the issue by the bank or
banking group.
Secondary Market
The secondary market is the market in which securities are traded on the stock market.

In the secondary market, companies are not in search of capital; instead, you as an investor deal
with other buyers and sellers of securities. This is where actual stock-exchange trading takes place.
All traded securities are public and available to everyone.

 Activity 5.2
1. What are the major types of stocks?
_________________________________________________________________________
_________________________________________________________________________
2. What are the characteristic features of common and preferred stocks?
_________________________________________________________________________
_________________________________________________________________________
3. Preferred stock is said to be a hybrid type of long-term financing. Discuss the reason
_________________________________________________________________________
_________________________________________________________________________
 5.3.Investment Banking

 Dear learners! What is investment banking? What are the basic functions of
Investment banking?

The investment banker is a financial specialist involved as an intermediary in the merchandising of

securities. He/she act as a "middle person" by facilitating the flow of savings from those economic
units that want to invest to those units that want to raise funds. We use the term investment banker
to refer both to a given individual and to the organization for which such a person works, variously
known as investment banking firm or an investment banking house. Although these firms are called
investment bankers, they perform no depository or lending functions. The activities of commercial
banking and investment banking were separated by the banking act of 1933.
5.3.1. Functions of Investment Banking
The investment banking performs three basic functions: (1) underwriting, (2) distributing, and (3)
advising.
A. Underwriting: The term underwriting is borrowed from the field of insurance. It means
"assuming a risk". The investment banker assures the risk of selling security issue at a satisfactory
price. A satisfactory price is the one that will generate a profit for the investment banking house.
The process goes
The investment banker and its syndicate will buy the security issue from the corporation in the need
of funds. The syndicate is a group of other investment bankers who are invited to help buy and sell
the issue. The managing house is the investment banking firm that organized the business because
its corporate client decided to raise external funds. On a specific day, the firm that is raising capital
is presented a check in exchange for the securities behind the issued. At this point, the investment
banking firm syndicate owns the securities. The corporation has its cash and can proceed to use it.
The firm is now immune from the possibility that the security markets might turn sour. If the price
of the newly issued securities falls below that paid to the firm by the syndicate, the syndicate will
suffer a loss. The syndicate, of course, hopes that the opposite situation will result. Its objective is
to sell the new issue to the investing public at a price per security greater than its cost.
B. Distributing: once the syndicate owns the securities, it must get them in to the hands of the
ultimate investors. This is the distribution or selling function of investment banking. The syndicate
can properly be viewed as the security wholesaler, and the dealer organization can be viewed as the
security retailer.
C. Advising: The investment banker is an expert in the issuance and marketing of securities. A
sound investment banking house will be aware of prevailing market conditions and can relate those
conditions to the particular type security that should be sold at a given time. Business conditions
may be pointing to future increase in interest rates. The investment banker might advise the firm to
issue its bonds in the timely fashion to avoid the higher yields that are forthcoming. The banker can
analyze the firm's capital structure and make recommendations as to what general source of capital
should be issued. In many instances, the firm will invite its investment banker to sit on the board of
directors. This permits the banker to observe corporate activity and make recommendations on a
regular basis.
Distribution Methods
There are several methods to the corporation for placing new security offering in the hands of final
investors. The investment banker's role is different in each of these.
1. Negotiated Purchase
In a negotiated underwriting, the firm that needs funds makes contact with an investment banker,
and deliberations concerning the new issue begin. If all goes well, a method is negotiated for
determining the price the investment banker and the syndicate will pay for the securities. For
example, the agreement might state the syndicate will pay birr 2 less than the closing price of the
firm's common stock on the day before the offering date of the new stock issue. The negotiated
purchase is the most prevalent method of securities distribution in the private sector. It is generally
thought to be the most profitable technique as far as investment bankers are concerned.
2. Competitive Bid Purchase
The method by which the underwriting group is determined distinguishes the competitive bid
purchase from the negotiated purchase. In a competitive underwriting, several underwriting groups
bid for the right to purchase the new issue from the corporation that is raising funds. The firm does
not directly select the investment banker. The investment banker that underwrites and distributes the
issue is chosen by the auction process. The syndicate willing to pay the greater birr amount per new
security will the competitive bid.
3. Commission or Best- Efforts Basis
Here the investment banker acts as an agent rather than as principal in the distribution process. The
securities are not underwritten. The investment banker attempts to sell the issue in return for a fixed
commission on each security actually sold. Unsold securities are returned to the corporation. This
agreement is typically used for more speculative issues. The issuing firm may smaller or less
established than the investment banker, this distribution method is less costly to the issuer than a
negotiated or competitive bid purchase. On the other hand, the investment banker only has to give it
his or her "best effort".
4. Privileged Subscription
Occasionally, the firm may feel that a distinct market already exists for its new securities. When a
new issue is marketed to a definite and select group of investors, it is called a privileged subscription.
Three target markets are typically involved: (1) current stockholders, (2) employees, or (3)
customers. Of these, distribution directed at, current stockholders are the most prevalent. In a
privileged subscription, the investment banker may act only as a selling agent. It is also possible that
the issuing firm and the investment banker might sign a standby agreement, which would obligate
the investment banker to underwrite the securities that are not accepted by the privileged investors.
5. Direct Sale
In a direct sale, the issuing firm sells the securities directly to the investing public with out involving
an investment banker. Even among established corporate giants this procedure is relatively rare.
5.4.Term Loans
So far, we have been dealing with bonds, stocks, long-term financing instruments which may be
sold to many investors through public offerings. Term loans are long term debt where the borrowers
negotiate directly with the financial institutions for examples banks, an insurance company, or a
pension fund. This type of financing is, therefore, called direct financing. A term loan is a contract
under which a borrower agrees to make payments of interest and principal, on specific dates, to the
lender. Although the maturities of term loans vary, most are for periods in the 3 to 15 years range.
Term loans have three basic advantages over publicly issued securities: Speed, flexibility, and low
issuance costs. Because they are negotiated directly between the lender and the borrower, formal
documentation is minimized. The key provisions of a term loan can be worked out much more
quickly than can those for public issue and it is not necessary for a term loan to go through the SEC
registration procedures. A further advantage of term loan over the publicly held debt securities has
to do with further flexibility: if a bond issue is held by many different bondholders, it is virtually
impossible to obtain permission to alter the terms of the agreement, even though new economic
conditions may make such changes desirable. With term loans, the borrower can generally sit down
with the lender and work out mutually agreeable modifications to the contract.

 Activity 5.3
1. What are the basic functions of investment banking?
____________________________________________________________________________
____________________________________________________________________________
2. What are the mechanisms of offering securities to the final investors?
____________________________________________________________________________
____________________________________________________________________________
Chapter Summary
This chapter deals with the long term financing instruments such as bonds, stocks, investment
banking and term loans. Bonds and stocks are securities that are issued to the large public whereas,
term loans and investment banking those who need fund and who need to invest fund will be brought
together by the financial institutions.
Model Examination Questions
A. Discussion Questions
1. Discuss the different types of bonds
2. Discuss the major advantages and disadvantages of bonds?
3. What are the major different between bonds and preferred stocks?
4. Describe the two types of security markets?
5. What is the difference between term loans and bonds?
6. Describe investment banking
B. Multiple Choice Questions
1. Bond type whose none payments does not lead to bankruptcy is
A. Debentures C. Junk bonds
B. Income bonds D. Mortgage bonds
2. Which is not the advantage of issuing bonds?
A. Less floating costs C. Results in payment of fixed charges
B. Absence of voting right D. non participation of bondholders in extraordinary profits
3. Which of the following is the common characteristic of that hybrid securities share with
bonds?
A. Absence of fixed maturity date
B. Non payment of dividends does not result in bankruptcy
C. Dividends are not tax deductible
D. Dividends are limited in amount
4. Stocks of companies that have no or little earnings are:
A. Growth stocks C. Tech stocks
B. Speculative stocks D. Income stocks
5. Which is not a distribution method of investment banking?
A. Negotiated purchase C. Privileged subscription
B. Competitive bid purchase D. Underwriting
6. Market where securities are first issued is
A. Primary market C. Secondary market
B. Issuance market D. Both A and B are answers
Answers to Model Examination Questions
Discussion Questions
1. Refer section 6.1.1 4. Refer section 6.2.4
2. Refer section 6.1.2 5. Refer section 6.4
3. Refer section 6.2.1 6. Refer section 6.3
Multiple choice questions
1. B 2. C 3. D 4. B 5. D 6. D
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