DEPARTMENT OF ECONOMICS,

BENUE STATE UNIVERSITY, MAKURDI

ECO: 213 PRINCIPLES OF FINANCE LECTURE NOTES
INTRODUCTION
Finance is the life blood of business. Before discussing the nature and scope of financial
management, the meaning of "finance" has to be explained. In fact, the term "finance" has to be
understood clearly as it has different meanings and interpretations in various contexts. The time
and extent of the availability of finance in any organization indicates the health of a concern.
Every organization, may it be a company, firm, college, school, bank or university, requires
finance for running its day-to-day affairs. As every organization faces stiff competition, it
requires financing not only for survival but also for strengthening itself. Finance is said to be the
circulatory system of the economy, making possible the required cooperation between the
innumerable units of activity.
DEFINITION OF FINANCE
There are so many definitions of the term "finance". Finance is defined by Webster's Third
International Dictionary as a system that includes the circulation of money, the granting of
credit, the making of investments, and the provision of banking services. This definition gives an
indication of the fact that finance is a system by itself and thus a broad field of activities at the
center of economic operations or social activities with economic implications. The Oxford
English Dictionary defines finance as a system that includes lending money, setting debts,
paying ransoms, managing money, and providing capital for investment.
The Encyclopedia of Banking and Finance classified finance into three (3) categories, which are:
1. To raise money necessary to organize, re-organize, or expand an enterprise whether by sale
of stock bond, etc.
2. Finance is a general term that denotes the theory and practice of monetary credit, banking
and promotion of operation in the most comprehensive sense, it includes money, credit,
banking, securities investment; speculation, foreign exchange, promotion, under writing
brokerage trust etc.
3. Defines finance as rising money and administration of revenues and expenditure by the
government.

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 Christy and Roden (1973) defined finance as a study of the nature and use of means of payment.
Gitman (2000) defined finance as the act and science of managing money. Finance is the
process, institution, and instrument involved in the transfer of money among individuals,
organizations, and governments. Also, finance is simply a set of activities dealing with the
management of funds. Finance is also the science and art of determining if the funds of an
organization are properly used.
FUNCTIONS OF FINANCE
1. Funding Raising: Financing involves the sourcing of funds from external organizations such
as banks' capital markets, non-bank loan institutions and also from internal sources for
internal use.
2. Allocation of Funds: It is concerned with allocating financial resources and different uses.
Different uses of funds are associated with risk and return. As such, the cost/risks and returns
need to be weighed before allocating resources. This implies that resources should be
allocated to uses that have high possible returns and low possible risks.
3. Management of Flow of Funds: This involves minimizing the outflow of funds and
maximizing the inflow of funds.
GOALS OF FINANCE
i. Establish a business plan
ii. Obtain necessary resources for the accomplishment of a business plan
iii. To plan the period of time necessary for accomplishing the business plan.
In general, the major goal of finance is to maximize a shareholder commitment to an
organization.
TYPES OF FINANCE
Personal Finance
Personal finance is the cornerstone of financial planning for individuals and households. It
involves managing one’s income, expenses, savings, and investments to achieve financial
stability and goals. This type of finance encompasses a variety of activities such as budgeting,
saving for emergencies, planning for retirement, and making strategic investments to grow
wealth over time. Personal finance also includes managing debt and credit responsibly,
understanding insurance needs, and planning for major life events like buying a home, funding
education, or healthcare expenses. Key to personal finance is the development of good financial

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habits, such as living within one’s means, regular saving, and investing wisely. Individuals often
use tools and services like financial advisors, budgeting apps, and investment platforms to
navigate their financial journeys. Effective personal finance management not only provides a
cushion against financial uncertainties but also enables individuals to take advantage of
opportunities and achieve their long-term financial goals.
Corporate Finance
Corporate finance deals with the financial decisions and strategies of businesses. Its primary
objective is to maximize shareholder value through long-term and short-term financial planning
and the implementation of various financial strategies. This includes managing the company’s
capital structure—balancing debt and equity to fund operations and growth. Corporate finance
involves activities such as capital budgeting, where companies evaluate and select investment
projects that will generate future returns. It also encompasses working capital management to
ensure the firm has sufficient liquidity to meet its short-term obligations. Additionally, corporate
finance handles mergers and acquisitions, determining the financial viability and strategic
benefits of combining with or purchasing other companies. Risk management is another critical
aspect, where companies identify, assess, and mitigate financial risks. Financial managers and
analysts in this field use tools and techniques such as financial modelling, forecasting, and
valuation to make informed decisions that align with the company’s strategic goals and enhance
its market value.
Public Finance
Public finance pertains to the financial management of governments and public institutions. It
involves the collection of revenue, primarily through taxation, and the allocation of these funds
to various public expenditures to provide essential services such as education, healthcare, and
infrastructure. Public finance aims to achieve economic stability, equitable distribution of
resources, and the efficient delivery of public services. It encompasses budget formulation and
implementation, where governments plan their spending to align with economic priorities and
social goals. Managing public debt is another critical aspect, where governments borrow funds to
cover deficits or invest in long-term projects while ensuring debt levels remain sustainable.
Public finance also includes fiscal policy, where governments adjust spending and tax policies to
influence the economy, aiming to stimulate growth or curb inflation. Economists and public
administrators in this field analyze the impacts of these financial policies and decisions to ensure

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they promote the well-being of the society while maintaining fiscal discipline and economic
stability.

FINANCIAL MANAGEMENT
Making daily financial decisions and exercising control in households, cooperative organizations,
non-profit business organizations, and government is a dynamic act and science. It is a
managerial activity that is concerned with planning, providing, and controlling the financial
resources at the disposal of an organization. It is thus a very important aspect of finance, although
it is not easy to separate it from other financial activities. However, an attempt to limit the areas
of financial management can be made if one agrees with the fact that financial management itself
requires simultaneous consideration of 3 key financial decisions, namely: i. investment decision,
ii financing decision, and iii dividend/share decisions. Generally, financial management can be
discussed in the following key areas:
(i) Estimating the C a p i t a l r e q u i r e m e n t s of t h e concern . The financial manager
should exercise maximum care in estimating the financial requirements of his firm. To do this
most effectively, he will have to use long-range planning techniques. This is because every
business enterprise requires funds not only for long-term purposes for investment in fixed assets,
but also for the short term so as to have sufficient working capital. He can only do his job
properly if he can prepare budgets for various activities to estimate the financial requirements of
his enterprise. Carelessness in this regard is sure to result in either a deficiency or a surplus of
funds. If his concern is suffering because of insufficient capital, it cannot successfully meet its
commitments on time. However, if it has acquired excess capital, the task of managing such
excess capital may not only prove very costly but also tempt the management to spend
extravagantly.
(ii) Determining the C a p i t a l S t r u c t u r e of t h e E n t e r p r i s e . The capital structure
of an enterprise refers to the kind and proportion of different securities. The financial manager
can decide the kind and proportion of various sources of capital only after the requirement for
capital funds has been decided. The decisions regarding an ideal mix of equity and debt, as well
as short-term and long-term debt ratios, will have to be taken in the light of the cost of raising
finance from various sources, the period for which the funds are required, and so on. Care should
be taken to raise sufficient long-term capital in order to finance the fixed assets as well as the

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extension programme of the enterprise in such a wise manner as to strike an ideal balance
between the own funds and the loan funds of the enterprise.
(iii) Finalizing the choice as to the sources of finance. The capital structure finalized by the
management decides the final choice between the various sources of finance. The important
sources are share-holders, debenture-holders, banks and other financial institutions, public
deposits, and so on. The final choice actually depends upon a careful evaluation of the costs and
other conditions involved in these sources. For instance, although public deposits carry a higher
rate of interest than debentures, certain enterprises prefer them to debentures as they do not
involve the creation of any charge on any of the company's assets. Likewise, companies that are
not willing to dilute ownership may prefer other sources instead of investors in their share capital.
(iv) Deciding the pattern of investment of funds. The financial manager must prudently
invest the funds procured in various assets in such a judicious manner as to optimize the return on
investment without jeopardizing the long-term survival of the enterprise. Two critical techniques
— (i) Capital Budgeting and (ii) Opportunity Cost Analysis — can help him finalize the
investment of long-term funds by assisting him in making a careful assessment of various
alternatives. A portion of the long-term funds of the enterprise should be earmarked for
investment in the company's working capital as well. He can take proper decisions regarding the
investment of funds only when he succeeds in striking an ideal balance between the conflicting
principles of safety, profitability, and liquidity. He should not attach all his importance only to
the canon of profitability. This is particularly because of the fact that the company's solvency will
be in jeopardy if a major portion of its funds are locked up in highly profitable but totally unsafe
projects.
(v) Distribution of Surplus judiciously. The Financial Manager should decide the extent of
the surplus that is to be retained for ploughing back and the extent of the surplus to be distributed
as a dividend to shareholders. Since decisions pertaining to the disposal of surplus constitute a
very important area of financial management, he must carefully evaluate such influencing factors
as: (a) the trend of earnings of the company; (a) the trend of the market price of its shares; (c) the
extent of funds required for meeting the self-financing needs of the company; (d) the future
prospects; (e) the cash flow position, etc.
Financial Manager

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 Financial managers go by different names depending on the nature, size, and structure of
the organization; we can see names like finance controller, director of finance, and general
manager of finance in many other organizations. A financial manager is referred to as a person in
charge of the financial and finance department of an organization, usually a member of the board
of directors. The functions of a financial manager pervade (cover) all the departments of an
organization in that he has to make key decisions affecting the operation of these departments as
far as finances are concerned.
The ability of a financial manager to perform his numerous functions depends on how he
organizes his department and his ability to communicate with other departments. The
organization of the finance department tends to reflect the management style of the financial
manager. Its management style is in turn determined by
i. His level of confidence in his subordinate
ii. His value system
iii. His leadership tendencies
The value system of a manager refers to how he looks at the participation of other people in the
decision-making process. His level of confidence in his subordinate will determine whether he
will delegate some of his functions to his subordinate and trust them to exercise such functions
effectively and efficiently. This in turn influences the leadership style of the financial manager.
The functions of a financial manager have consistently broadened from a traditional role to a
more dynamic approach. Such traditional functions (roles) include:
i. Providing means of payment for an organization
ii. Management of a firm’s cash position,
iii. Keeping accurate financial records
iv. Preparation of financial report.
The modern functions of a financial manager have been expanded to include an analytical
aspect of an organization's finances. Thus, they include the following:
1) Forecasting of Cash Flow. This is necessary for the successful day to day operations of the
business so that it can discharge its obligations as and when they rise. In fact, it involves
matching of cash inflows against outflows and the manager must forecast the sources and
timing of inflows from customers and use them to pay the liability.

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2) Raising Funds: The Financial Manager has to plan for the mobilization of funds from
different sources so that the requisite amount of funds is made available to the business
enterprise to meet its requirements for the short term, medium term, and long term.
3) Managing the Flow of Internal Funds: Here, the manager has to keep track of the surplus in
various bank accounts of the organization and ensure that they are properly utilized to meet the
requirements of the business. This will ensure liquidity position o f the company is
maintained intact with the minimum amount of external borrowings.
4) To Facilitate Cost Control: The Financial Manager is generally the first person to recognize
when the costs of the supplies or production processes are exceeding the standard costs or
budgeted figures. Consequently, he can make recommendations to the top management for
controlling the costs.
5) To Facilitate Pricing of Products, Product Lines, and Services: The Financial Manager can
supply important information about cost changes and costs at varying levels of production and
the profit margins needed to carry on the business successfully. In fact, the financial manager
provides tools for the analysis of information in pricing decisions and contributes to the
formulation of pricing policies jointly with the marketing manager.
6) Forecasting Profits: The financial manager is usually responsible for collecting the relevant
data to make forecasts of profit levels in the future.
7) Measuring Required Return: The acceptance or rejection of an investment proposal depends
on whether the expected return from the proposed investment is equal to or more than the
required return. An investment project is accepted if the expected return is equal to or greater
than the required return. The determination of the required rate of return is the responsibility of
the financial manager and is a part of the financing decision.
8) Managing Assets: The function of asset management is centered on the decision-making role
of the financial manager. Finance personnel meet with other officers of the firm and participate
in making decisions affecting the current and future utilization of the firm's resources. As an
example, managers may discuss the total amount of assets needed by the firm to carry out its
operations. They will determine the composition or mix of assets that will help the firm best
achieve its goals. They will identify ways to use existing assets more effectively and reduce
waste and unwarranted expenses. The decision-making role crosses liquidity and profitability

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 lines. Converting the idle equipment into cash improves liquidity. Reducing costs improves
profitability.
9) Managing Funds: In the management of funds, the financial manager acts as a specialized staff
officer to the Chief Executive of the company. The manager is responsible for having sufficient
funds for the firm to conduct its business and pay its bills. Money must be located to finance
receivables and inventories, to make arrangements for the purchase of assets, and to identify the
sources of long-term financing. Cash must be available to pay dividends declared by the board of
directors. The management of funds has both liquidity and profitability aspects.
10. Budget Preparation: The financial manager also prepares a financial plan that allocates
resources based on projected revenues, i.e., expected inflows of the company.
11. Formulation of Dividend Policy: the financial manager also formulate a set of guidelines that the
organization was to determine how much of its earning it will pay to shareholders and how much
it will play back into the company.
12. Financial Planning and Control: This involves participating in product pricing. The
determination of the unit cost of production is done by the accounting method and this is under
the control of the financial manager. Thus, pricing of products also attracts the attention of the
financial manager since his objective is to maximize revenue against cost.
SOURCES OF FUNDS
Sources of funds refer to the various ways through which a business can obtain the necessary capital to
finance its operations, growth, and investment activities. Understanding the different sources of funds is
crucial for effective financial management and strategic planning. These sources can be broadly
categorized based on period, ownership and sources of generation
A. Based on Period
1. Long-term Sources:
Long-term sources of funds fulfil the needs of any business for a long period that is for a period
exceeding 5 years. Long-term funds are generally used for purchasing fixed assets. Examples of
long-term sources of funds are shares, debentures, bonds, long-term loans from banks, etc.
2. Medium-term Sources:
The funds which are required for more than one year but less than five years. These include
public deposits, borrowing from banks, lease financing, etc.

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3. Short-term Sources:
The funds which are required for less than one year is termed short-term sources of fund. These
kinds of funds are easily available and are easy to repay also. For Example, short-term loans
from commercial banks, trade credit, factoring and commercial paper.
B. Based on Ownership
1. Owner’s Funds:
As the name suggests, owner’s funds are those which are provided to the firm by its owners. The
owner can be a sole trader, a shareholder of the company, or a partner. The owners not only
invest capital but also reinvest profits in the organization. The owner does not have to refund the
invested amount during the lifetime of the organization. The investment made by the owners
decides their control over the management. Issue of equity shares and retained earnings are the
two most important sources of the owner’s fund.
2. Borrowed Funds:
As the name suggests, it is a fund which is borrowed from different financial institutions or
raised through the issue of bonds and debentures. These sources provide a firm with different
sources of funds for a fixed period and come with a fixed amount of interest, which a company
has to pay whether it is making a profit or not. Usually, the borrowed funds are provided to the
firms by keeping some fixed assets as security. So this source of funds is a bit riskier as
compared to the owner’s fund. For Example, public deposits, loans from a bank, debentures
bonds, etc.
C. Based on the Source of Generation
1. Internal Sources:
Every business organization has some funds which are kept aside for future uncertainties and
needs. When the funds are generated internally, then they are said to be internal sources of funds.
Internal sources of funds have their own merits and demerits. The biggest advantage of internal
sources is that these are a permanent source of funds that could be easily availed, and does not
involve any explicit cost as it belongs to the business enterprises only. However, internal funds
lead to various risks to the firm and can accomplish only the limited needs of the firm. For
example, equity share capital, retained earnings, etc.

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2. External Sources:
When a large amount of funds is required by a business enterprise, then it opts for external
financing. Therefore, external sources of finance are the sources that are obtained from outside
the business. The cost of raising funds from external sources is more than the cost from internal
sources. Sometimes, an organization has to mortgage its assets as security. For example, lease
financing, debt factoring, preference shares, Commercial papers, etc.
Some of the examples of sources of funds are explained below;
i. Shares
Shares represent ownership in a company. When a company issues shares, it sells parts of its
equity to investors. Shares can be of two main types:
 Equity Shares (Common Stock): These shares give shareholders ownership rights in the
company. Equity shareholders have voting rights and receive dividends, but they are last
to be paid in case of liquidation. They benefit from the company’s growth as they can see
their share value increase.
 Preference Shares (Preferred Stock): These shares provide holders with preferential
treatment in receiving dividends and during liquidation, but typically don’t come with
voting rights. Preference shareholders receive fixed dividends before equity shareholders.
ii. Debentures
Debentures are a type of long-term debt instrument that companies use to borrow money. They
are unsecured, meaning they are not backed by any collateral. Investors lend money to the
company in exchange for periodic interest payments and the return of the principal amount at the
end of the term. Debentures are typically used when companies need to raise substantial amounts
of capital and can offer a fixed or floating rate of interest.
iii. Bonds
Bonds are debt securities similar to debentures but often secured against the company’s assets.
They are issued to raise capital and require the issuer to pay periodic interest (coupons) and
repay the principal amount at maturity. Bonds can be issued by corporations, municipalities, and
governments. They come in various types, such as:
 Government Bonds: Issued by the government and considered low-risk.
 Corporate Bonds: Issued by companies and carry higher risk compared to government
bonds but potentially offer higher returns.

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  Municipal Bonds: Issued by local governments or municipalities and often have tax
advantages.
iv. Bank Loans
Bank Loans are a common method of funding where businesses borrow a lump sum from a
bank, which must be repaid over time with interest. Bank loans can be:
 Short-term Loans: Typically used for immediate needs and are to be repaid within a
year.
 Long-term Loans: Used for significant investments and have longer repayment periods,
often several years.
v. Public Deposit
Public Deposits are funds raised directly from the public, where individuals and institutions
invest their money with a company for a fixed term at a specified interest rate. It’s a form of
unsecured borrowing by companies. Public deposits are often attractive to investors due to higher
interest rates compared to bank savings accounts. They are regulated to protect investors and
ensure companies are solvent enough to repay these deposits.
vi. Lease Financing
Lease Financing involves acquiring the use of an asset through a leasing agreement rather than
purchasing it outright. There are two main types of leases:
 Operating Lease: Short-term leasing where the asset is returned to the lessor at the end
of the lease term. The lessor retains ownership and responsibility for maintenance.
 Finance Lease: Long-term leasing where the lessee has most of the ownership benefits,
including maintenance responsibilities and the option to purchase the asset at the end of
the lease term.
Leasing is useful for companies that need assets but want to avoid the large upfront costs
associated with purchasing.
vii. Trade Credit
Trade Credit is a credit extended by suppliers allowing businesses to purchase goods or services
and pay for them at a later date. It’s a common and convenient financing method for managing
short-term working capital needs. Trade credit is interest-free if paid within the agreed period
and helps companies maintain cash flow.

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viii. Debt Factoring
Debt Factoring involves selling a company's accounts receivable to a factoring company at a
discount. The factoring company advances a percentage of the receivables' value to the business
and assumes the responsibility of collecting the debt. This provides immediate cash flow to the
company and transfers the risk of default on the receivables to the factor.
ix. Hire Purchase
Hire Purchase is a financing method where businesses acquire an asset by making an initial
down payment and subsequent periodic payments. Ownership of the asset transfers to the buyer
once all payments have been made. It’s commonly used for acquiring expensive equipment or
vehicles. Unlike leasing, the buyer becomes the owner of the asset after the final payment.
x. Tax deferment
Tax deferment allows individuals and businesses to delay paying taxes on income or gains until a
future date, effectively providing a temporary source of funds. This strategy frees up money that
would otherwise be used to pay taxes, enabling it to be invested or used immediately, and
enhancing cash flow.
x. Retained Earnings
Retained Earnings are the profits that a company has earned and retained in the business rather
than distributing them as dividends to shareholders. These funds are reinvested into the business
for growth, development, or as a reserve for future needs. Retained earnings are a cost-effective
source of financing since they do not involve incurring debt or diluting ownership through
issuing shares.
TIME VALUE OF MONEY (TVM)
1. Introduction to Time Value of Money (TVM)
The Time Value of Money (TVM) is a fundamental financial principle that recognizes the idea
that a specific amount of money has different values at different points in time due to its
potential earning capacity. This concept is vital in finance because it underpins the valuation of
investments, financial planning, and decision-making.
2. Core Concepts of TVM
 Present Value (PV): The current value of a future amount of money, discounted at a
specific interest rate.

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  Future Value (FV): The value of a current amount of money at a future date,
compounded at a specific interest rate.
 Interest Rate (r): The percentage rate at which money grows over time.
 Compounding: The process where the value of an investment increases because the
earnings on an investment, both capital gains and interest, earn interest as time passes.
 Discounting: The process of determining the present value of a future amount.
 Annuity: An annuity is a series of recurring cash payments that occur at regular intervals, such
as rent on an apartment, a monthly mortgage loan payment, or monthly auto loan payments. In
ordinary annuities, payments are made at the end of each period. With annuities due, they're
scheduled at the beginning of the period.
3. Key Formulas in TVM
1. Future Value of a Single Sum (Compounding):
n
FV =PV∗(1+r )
Where;
FV: Future Value
PV: Present Value
r: Interest rate per period
n: Number of periods
Example. Calculate the future value of ₦10,000 invested for 5 years at an annual interest rate of
6%.
Solution:
FV = 10,000.00 X (1+0.06)5
FV = 10,000.00 X 1.065
FV = 10,000.00 X 1.3382
FV = 13,382.26
2. Present Value of a Single Sum (Discounting):

Where;
FV: Future Value
PV: Present Value

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 r: Interest rate per period
n: Number of periods
Example: Determine the present value of a ₦5,000 payment to be received 5 years from now,
assuming a discount rate of 6% per annum.
Solution:
PV = 5,000.00/1.3382
PV = 3,736.92
3. Present Value of an Annuity

Example: Calculate the present value of a ₦500 annual payment received for 20 years at a
discount rate of 6%.
Solution:
PV = 500 X {1-(1+0.06)-20}/0.06
PV = 500 X (1-1.06-20)/0.06
PV = 500 X 1 – 0.312
PV = 500 X 0.688/0.06
PV = 500 X 11. 47
PV = ₦5, 733. 33
4. Future value of an annuity

Example: You plan to save ₦200 monthly in an account paying 4% annual interest
compounded monthly. What will be the value in 5 years?
PMT = 200
R = 0.04/12 = 0.0033
n = 5 X 12 = 60
FV = 200 X (1 + 0.0033)60/0.0033 = ₦13,243.66
CAPITAL BUDGETING
Capital budgeting is a managerial technique of planning capital expenditure in consonance with
the overall objectives of the firm. It is the process by which organizations evaluate potential

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major investments or expenditures. Capital budgeting is a double-edged tool that analyzes
investment opportunities and the cost of capital simultaneously while evaluating the
worthwhileness of a project. A wide range of criteria have been suggested to judge the
worthwhileness of investment projects. Capital projects need to be thoroughly evaluated as to
their costs and benefits. The costs of capital projects include the initial investment at the
inception of the project. The installed capacity is generally determined by the initial investment
made in land, building, plant and machinery, equipment, furniture, fixtures, and so on.
Investment Evaluation Criteria
The investment begins with the assembling of investment proposals from different departments
of a firm. The departmental head will have innumerable alternative projects available to meet his
requirements. He has to select the best alternative from among the conflicting proposals. This
selection is made after estimating the return on the projects and comparing the same with the cost
of capital. The investment proposal that gives the highest net marginal return will be chosen. The
following are the steps involved in the evaluation of an investment:
i. Identification of potential investment opportunities.
ii. Evaluation and analysis of the opportunities.
iii. Application of a decision rule for making the choice
Features required by capital budgeting criteria
A sound appraisal technique should be used to measure the economic worth of an investment
project. Thus, features that must be had by sound investment evaluation criteria include:
 It should consider all cash flows to determine the true profitability of the project.
 It should provide an objective and unambiguous way of separating good projects from
bad projects.
 It should help rank projects according to their true profitability.
 It should recognize the fact that bigger cash flows are preferable to smaller ones, and
early cash flows are preferable to later ones.
 It should help to choose among mutually exclusive projects the project which maximizes
the shareholders' wealth.
 It should be a criterion that is applicable to any conceivable investment project
independent of others.
Techniques of Capital Budgeting

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They are classify into two, Discounted and non-discounted criteria
Discounted Cash Flow (DCF) Criteria
• Net present value (NPV)
• Internal rate of return (IRR)
• Profitability index (PI)
Non-discounted Cash Flow Criteria
• Pay-back period
• Accounting rate of return (ARR).
Non-discounted Cash Flow Criteria
1. Pay Back Period (PBP): This is the period (usually expressed in years) it takes for the
original cost of the project to be recovered from the earnings of the project. Earnings here
could also be referred to as cash flows.
Decision Rule for Pay-Back Period
1. The payback period is used by comparing the calculated payback period with the
organization’s targeted payback period. A project will be rejected unless its payback period is
less than the organization’s payback period.
2. For mutually exclusive projects, the project with the shorter payback period will be
selected, provided the payback period of that project is less than the organization’s targeted
payback period.

For project with equal cash flows, the payback period is mathematically expressed as:
PBP = Net Investment ¿ ¿
1. Suppose that a project require a net investment of N 25,000 and yields an annual cash flow of
N 6,250
Calculate the project payback period.
25000
PBP = = 4years
6,250
Therefore, the payback period of the project is 4 years.
2. Suppose Asor and sons Ltd wishes to invest in a project which requires a net investment of N
72,000 and yields an annual cash flow of N 20,000 calculate the payback period.
Soln

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 72000
PBP = = 3 years
20000
= 3 x 20,000 = 60,000
= 72,000 - 60,000
= N 12,000
N 12,000 of the Net investment is remaining to be recovered in the fourth (4 th) year. But the cash
flow in the 4th year is N 20,000. The time required to recover N 12,000 in the 4th year will be
12,000 12months
= x = 7.2
20,000 1
= 8 months
N:B round up every figure after decimal point in payback period calculation.
∴ Payback period = 3yrs 8months
3. Projects with unequal cash flows
Maria, who just received a cash award of N 100,000 for being the best student in ECO 213 is
considering investing in poultry business, the cash flow associated with project are as follows;
Year 1 2 3 4 5
Cf(N) 20,000 50,000 30,000 20,000 15000
Required:
i. Calculate the payback period of this project
ii. If Maria’s preference is for a project whose payback period is not more than 4yrs should she
accept this project or not.
Soln

(i)Year C.f Netcf

1 20,000 20,000
2 50,000 70,000
3 30,000 100,000
Thus, PBP = 3years
(ii) She should accept the project because the actual payback period is less than her
targeted payback period.
Assignment

17
 (i) Suppose Mercy and Sons Ltd, wishes to invest in a project which requires a Net
investment of N 120,000 and the company’s annual cash flow are as follows:
Year 1 2 3 4 5 6
Cf(N 45,000 22,000 20,000 13,000 13,000 13,000
)
Calculate the payback period for the project.
(ii) Consider the project with the following cash flows and indicate on which project
to accept for implementation.
Year Project A Project B Project C
0 (50,000) (50,000) (50,000)
1 3000 20000 10,000
2 10000 20000 10,000
3 20,000 20000 10000
4 20000 20000 10000
5 25,000 20000 10000
Advantage of Payback Period
I. It is very easy to calculate
II. It make use of actual cash flows instead of accounting cash flows
III. It provides a clear indication of the time required to convert at is key investment into a safe
one
Disadvantages
I. It does not take into consideration cash flows after the payback period
II. It does not recognize the time value of money
III. It does not take risk and uncertainties into consideration.
2. Accounting Rate of Return
This is the rate of return on the amount of capital invested various definitions exist for
accounting rate of return, however the most widely used is given as
Average Annual profit
ARR =
Average Investment
Where:
Average annual profit = Average annual profit after tax

18
 opening Investment + Net Book Value(NBV )
Average investment =
2
Decision Rule for ARR
I. For independent project, accept a project if the project’s ARR is equal to or greater than
the ARR set by management i.e targeted ARR, otherwise reject it.
II. For mutually exclusive projects
a. Select the project with the highest ARR
b. Ensure that the project selected has an ARR that is equal to or greater than the ARR set by
Management.
Illustration 1
1. Jacob Plc is to undertake a project requiring a Net investment of N 100,000 on the plant and
machineries. The project is to last for 5 years at the end of which the plant and machineries
will have a Net book value of N 20,000 annual profit after tax.
Year PAT (Profit After Tax)
1 24,000
2 28,000
3 22,000
4 36,000
5 42,000
Required;
i. Calculate the ARR of the project
ii. Assuming the company’s targeted ARR is 0.5, will the project be accepted.
Soln
24,000+28,000+22,000+36,000+ 42,000
Average annual profit =
5
= 30,400
100,000+20,000
Average investment = = 60,000
2
30,400
ARR = = 0.51
60,000
ii. The project will be accepted because the actual ARR is greater than the targeted ARR.
Assignment

19
 Eunice Oggah Nig. Ltd is considering selecting from two projects, A & B that have the following
information:

Project A Project B
Cost of project N 100,000 N 150,000
Life of project 4years 4years
Residual value N 5000 N 15,000
Estimated profit before tax
Year 1 N 35,000 N 40,000
Year 2 N 50,000 N 52,000
Year 3 N 56,000 N 60,000
Year 4 N 60,000 N 80,000
Assuming a tax rate of 35% and company’s target rate of return of 0.2, using the ARR criterion,
which of the projects should the company select?
Advantages of ARR
I. It is simple to calculate
II. Unlike the payback period, it considers the entire cash flows over the entire life span of the
project
III. It uses readily available accounting data
IV. It could be used to compare performance of many companies
Disadvantages
I. It suffers from definition problems in the sense that it can be calculated in several ways.
II. It takes no account of the time value of money
III. There are no rules for setting the minimum acceptable ARR by the management
IV. It ignores risk and management of risk.
Disco unted Cash Flow (DCF) Criteria
1. Net Present Value (NPV)
NPV is the value obtained by first discounting all future cash flows from a capital investment at
the chosen interest rate and then subtracting them from the initial cost of the project.
Mathematically, the NPV is given as:

20
 A1 A2 A3 An
NPV = + ……. -C0
(1+r ) ( 1+ r ) ² ( 1+ r ) ³ C 1+r

C0 = total cost of project

A = Yearly cash flows (Annual)
Decision Rule
1. If the NPV is positive the project should be accepted
2. For mutually exclusive projects, the project with the highest NPV should be accepted
Illustration: Damsel Nig Plc is considering investing in a project costing N 180, 000 with an
expected interest rate of 15% the estimated cash flows are given as follows.
Year 1 2 3 4
Cf(N) 90,000 110,000 60,000 40,000
Required:
i. Calculate the NPV of the project
ii. Decide on whether the project should be accepted or not
Soln
90,000 110,000 60,000 40,000
i. NPV = + + -180,000
1+ 0.15 ( 1+ 0.15 ) ² ( 1+ 0.15 ) ³ (1+0.15)⁴

90,000 110,000 60,000 40,000

= + + -180,000
1.15 ( 1.15 ) ² ( 1.15 ) ³ (1.15)⁴

90,000 110,000 60,000 40,000

= + + - N180, 000
1.15 1.3225 1.520875 1.74900625

= 78, 26087+83,175.80+39, 45097+22,870.13 - N180, 000

= 223,757.77 – 180000 = N 43757.77

iii. The project should be accepted because the NPV is positive.
Advantages of NPV
I. It recognizes the time value of money
II. It makes use of actual cash flows as against the use of accounting profit

21
III. It makes use of all the cash flows associated with the project unlike PBP that leaves out
other. Cash flows after actual investment have been recovered
IV. It is more useful than other techniques in ranking projects when there is scarcity of resources
(financial resources)
Disadvantages
I. It assumes that all cash flows are certain
II. It does not take risks and uncertainties into consideration
III. It rely on the correct estimation of interest rate.
2. Internal Rates of Return (IRR)
IRR is the rate of return that equates the present value of future cash flows to initial outlay (cost)
of the investment. It is the rate at which the Net present value is equal to zero (0)
Decision Rule
I. If the IRR exceeds the firm’s target rate of return, the project should be accepted.
II. For mutually exclusive projects, we select the project with a higher IRR provided the IRR of
that project is higher than the required rate of return.
N: B. The calculation process of IRR is similar to NPV except that the interest rate (PV) is equal
to the C0 (total cost of project)
3. Profitability Index
This is the value of the present value of future cash flows divided by initial cost of investment.

A1 A2 A3 An
PI = + +=…….
(1+r ) ( 1+ r ) ² ( 1+ r ) ³ (1+r )n
C0
PV
∴ PI =
C₀
Decision Rule
1. Accept the project that has the PI greater than one(1)
2. For mutually exclusive projects, the project with the highest PI and greater than one (1)
should be accepted.
RISK ANALYSIS IN CAPITAL BUDGETING

22
Risk analysis in capital budgeting is essential for understanding the uncertainties and potential
variations in a project's future cash flows. Effective risk assessment helps in making informed
decisions by evaluating the impact of different risk factors on a project's viability and
profitability. This process involves identifying, quantifying, and managing the risks associated
with capital investments.
Risk Analysis Techniques in Capital Budgeting
Sensitivity Analysis
Definition of sensitivity analysis is a modeling and risk assessment procedure in which changes
are made to significant variables in order to determine the effect of these changes on the planned
outcome. Particular attention is thereafter paid to variables identifies as being of special
significance"
Sensitivity analysis put in simple terms is a modeling technique which is used in Capital
Budgeting decisions which is used to study the impact of changes in the variables on the
outcome of the project. In a project, several variables like weighted average cost of capital,
consumer demand, price of the product, cost price per unit etc. operate simultaneously. The
changes in these variables impact the outcome of the project. It therefore becomes very difficult
to assess change in which variable impacts the project outcome in a significant way. In
Sensitivity Analysis, the project outcome is studied after taking into change in only one
variable. The more sensitive is the NPV, the more critical is that variable. So, Sensitivity
analysis is a way of finding impact in the project's NPV (or IRR) for a given change in one of the
variables.
Steps involved in Sensitivity Analysis
Sensitivity Analysis is conducted by following the steps as below:
1. Finding variables, which have an influence on the NPV (or IRR) of the project
2. Establishing mathematical relationship between the variables.
3. Analysis the effect of the change in each of the variables on the NPV (or IRR) of the
project
ILLUSTRATION
X ltd is considering it new product with the following details
S/NO PARTICULARS FIGURES
1 Initial capital cost ₦400

23
 2 Annual unit sales 5
3 Selling price per unit ₦100
4 Variables cost per unit ₦50
5 Fixed cost per year ₦400
6 Discount rate 6%
Required
1. Calculate the NPV of the project
2. Compute the impact on the project’s NPV of a 10% percent adverse variance in in the selling
price per unit. Which variable is having maximum effect? Consider life of the project as 3
years.
SOLUTION
1.
PARTICULARS AMOUNT (₦)
A Selling Price Per Unit (A) 100
B Variable Cost Per Unit (B) 50
C Contribution Per Unit (C = A-B) 50
D Number of Units Sold Per Year 5
E Total Contribution (E = C x D) 250
F Fixed Cost Per Year 50
G Net Cash Inflow Per Year (G = E - F) 200
Calculation of Net Present Value (NPV) of the project
Year Year Cash Flow (₦) Discounting @ 6% Present Value (₦)
0 (400.00) 1.000 (400.00)
1 200.00 1.06 188.60
2 200.00 1.12 178.00
3 200.00 1.19 168.00
Net Present Value (188.60 + 178 + 168) - 400= 134.60

2. Assume that there is 50% variance in the selling price per unit and recalculate the NPV.

PARTICULARS AMOUNT (₦)

24
 A Selling Price Per Unit (A) 90
B Variable Cost Per Unit (B) 50
C Contribution Per Unit (C = A-B) 40
D Number of Units Sold Per Year 5
E Total Contribution (E = C x D) 200
F Fixed Cost Per Year 50
G Net Cash Inflow Per Year (G = E - F) 150
Calculation of Net Present Value (NPV) of the project
Year Year Cash Flow (₦) Discounting @ 6% Present Value (₦)
0 (400.00) 1.000 (400.00)
1 150.00 1.06 141.51
2 150.00 1.12 133.92
3 150.00 1.19 126.05
Net Present Value (141.51 + 133.92 + 126.05) - 400= 1.48
Student should compute the impact on the project’s NPV of a 10% percent adverse variance in
each variable and find out which variable has the maximum effect on the NPV.
Scenario analysis
Although sensitivity analysis is probably the most widely used risk analysis technique, it does
have limitations. Therefore, we need to extend sensitivity analysis to deal with the probability
distributions of the inputs. In addition, it would be useful to vary more than one variable at a time
so we could see the combined effects of changes in the variables. Scenario analysis provides
answer to these situations of extensions. This analysis brings in the probabilities of changes in
key variables and also allows us to change more than one variable at a time. This analysis begins
with base case or most likely set of values for the input variables. Then, go for worst case
scenario (low unit sales, low sale price, high variable cost and so on) and best case scenario.
Alternatively scenarios analysis is possible where some factors are changed positively and some
factors are changed negatively. So, in a nutshell Scenario analysis examine the risk of
investment, to analyse the impact of alternative combinations of variables, on the project's NPV
(or IRR).
Example

25
Ahura Company Limited is attempting to evaluate two mutually exclusive projects; A and B
each requiring a net investment of N 10, 000 and both having most likely annual cash inflow of
N 20,000 per year for the next 15 years. The company’s cost of capital is 10%. In order to obtain
some insight into the riskiness of these projects, management has made pessimistic of the annual
cash flows associated with values for each project are given below:
Ahura Company Limited project A and B
NET Investment Cash Project A Project B
Estimate
N 10,000 N 10,000

Worse case N 1,500 N0

Base case N 2000 N 2000

Best Case N 2,500 N 4,000

i. Calculate the net present value associated with cash estimate given for each project.
ii. Comment on your results in (1) above
Structure should calculate, the NPV using the formula below. The formula is used when the
annual CF are even.
1 1
NPV = CF ( − ¿ - C0
r r (1+ r)∩
Where
CF = cash flows
r = cost of capital
n = numbr of years
C0 = Initial investment
Project A
1 1
Pessimistic = NPV = 1,500 ( − ) – 10.000
0.1 0.1 ( 1.1 ) .⁵
1 1
= 1,500 ( − ) - 10,000
0.2 0.42
= 1,500 ( 10 – 2.38) - 10,000
= 1,500 (7.62) – 10,000

26
= 11,430 – 10,000
(Students should practice the rest of the NPV).
The result = are presented in the table below;
The NPV’s for projects A and B
Project A Project B

Pessimistic 1,430 10,000

Most likely 5,240 5,240

Optimistic 9050 20,480

ii. From the result as summarized in the table above, project A is less risky than project B and
depending on the company’s attitude towards risk, it may choose either. If the is a risk averter,
it will take project A thereby eliminating the possibility of less. Rut if it is a risk-takers, it may
undertake project B due to the possibility of receiving a return with a high NPV.
3. Certainty Equivalent
This is another method of dealing with risk in investment, business, or project evaluation.
It is done by reducing the forecast cash flows to some conservative level. For example, if the
earnest, according to his best estimate, expects a cash flow of N 60,000, he may apply an
intuitive correction factor and may work with N 50,000 to be on the safer side. The certainty

equivalent approach may be defined as: NPV = ℇ

∝ tAt
- Co
(1+1)τ
∝tAt ∝tAt ∝tAt ∝tAt
= + + ------- - Co
(1+r )¹ (1+r )² (1+r )³ (1+r )ⁿ
Where ∝t = risk adjusted factor/certainty equivalent coefficient/sensitivity equivalent
At = cash flow at time t r=interest rate
C0 = Net investment
certainity cash flow
∝t =
Risky cash flow
Illustration: 1. Assuming Emmanuel Nig Ltd expected a risky cash flow of N 80,000 and
considers a certainty cash flow of N 60,000; calculate the company’s certainty equivalent
coefficient

27
 60000
∝t = = 0.75
80000
Assignmegt: Barnabas Nig. Plc wishes to carry out an investment worth N 50,000, with an
interest rate of 10% and the investment has the following cash flows and certainty equivalent
values for 4 years. Calculate the RANPV. Should the project be accepted?
Year 1 2 3 4
Cf 3000 2000 1000 2000
∝t 0.9 0.70 0.50 0.30

4. Probability Approach
Probabilities are used to access the risks involved in a project more accurately. A probability of
an outcome may be defined as a measure of someone’s opinion about the likelihood that an event
will occur. If an event is certain to occur, we say that its probability of occurrence is 1. The
expected value of return on a project can be estimated by assigning probability to outcomes. The
risk-adjusted cash flow can be found by multiplying the possible cash flows by their respective
probabilities.
Illustration
An investor, Amase Nig Plc, has estimated the possible net cash flows of projects A and B and
the associated probabilities for the period of 5 years. Both projects have a discount rate of 10%
and a net investment of N500 each. The possible cash flows and their probabilities are
represented in the table below:
Year Project A Project B
Cf(A) Prob RACF Cf(N) Prob RACF
1 4000 0.10 400 12000 6.10 1200
2 5000 0.20 1000 10,000 0.15 1500
3 6000 0.40 2400 8000 0.50 400
4 7000 0.20 1400 6000 0.15 900
5 8000 0.10 800 4000 0.10 400
Required
1. Calculate the risk adjusted cash flows
2. Calculate the risk adjusted NPV
3. Which project is preferable – project A

28
Solution
(i) Risk adjusted cash flow = cash flow x probability
(ii) RA.NPV =
10 A₁ A₂ A₃ A₄ A₅
r= = 0.10 + +¿ + + - C0
100 1+ r ( 1+ r ) ² ( 1+ r ) ³ (1+r )⁴ (1+r )⁵
Project A
400 1000 2400 1400 800
RA.NPV = + + + +¿ - 500
1+ 0.1 ¿¿ (1+0.1)³ (1+0.1)⁴ (1+0.1)⁵
400 1000 2400 1400 800
= + + + +¿ - 500
1.1 1.21 1.331 1.4641 1.61051
= (363.64+826.45+1803.16+956.22) - 500
= 3,949.47 - 500
= 3449.47.
(Students should calculate for project B and answer question 3 in class)
.
COST OF CAPITAL
The term "cost of capital" refers to the minimum rate of return a firm must earn on its
investments. This is in consonance with the firm’s overall objective of wealth maximization. The
cost of capital is a complex, controversial, but significant concept in financial management.
The following definitions give clarity management.
Hamption J.: The cost of capital may be defined as "the rate of return the firm requires from
investment in order to increase the value of the firm in the market place."
James C. Van Horne: The cost of capital is "a cut-off rate for the allocation of capital to
projects." It is the rate of return on a project that will leave the market price unchanged.
Soloman Ezra: "Cost of Capital is the minimum required rate of earnings or the cut-off rate of
capital expenditure".
According to the definitions above, the cost of capital is the minimum rate of return that a firm is
expected to earn on its investments in order to maintain the market value of its shares.
Importance of Cost of Capital:
The cost of capital is very important in financial management and plays a crucial role in the
following areas:
i . Investment decisions: The cost of capital is used for discounting cash flows under the Net

29
Present Value method for investment proposals. So, it is a very useful investment decision.
ii. Capital structure decisions: An optimal capital structure is one in which the firm's value is
maximized, and the cost of capital is the lowest. So, the cost of capital is crucial in designing an
optimal capital structure.
iii. Evaluation of final Performance: he cost of capital is used to evaluate the financial
performance of top management. Actual profitability is compared to the expected and actual cost
of capital, and if profit is greater than the cost of capital, the performance may be said to be
satisfactory.
iv. Other financial decisions: the cost of capital is also useful in making such other financial
decisions as dividend policy, capitalization of profits, making rights issues, etc.
Computation of Cost of Capital:
The computation of the cost capital of a firm involves the following calculation of the cost of
various types of capital, such as debt, preferred capital, equity, and retained earnings.
A. The Cost of Debentures:
The capital structure of a firm normally includes debt capital. Debt may be in the form of
debentures, bonds, term loans from financial institutions and banks, etc. The amount of interest
payable for issuing a debenture is considered to be the cost of the debenture or debt capital (K d).
The cost of debt capital is much cheaper than the cost of capital raised from other sources,
because interest paid on debt capital is tax deductible.
The cost of debenture is calculated in the following ways:
(i) When the debentures are issued and redeemable at par: Kd = r (1 – t)
Where Kd = Cost of debenture
r = Fixed interest rate
t = Tax rate
(ii) When the debentures are issued at a premium or discount but redeemable at par
Kd = I/NP (1 – t)
Where, Kd = Cost of debenture
I = Annual interest payment
t = Tax rate
Np = Net proceeds from the issue of debenture.

30
(iii) When the debentures are redeemable at a premium or discount and are redeemable after ‘n’
period:
I (1−t )+1/n (R−P)
Kd=
1 /2(R+ P)
where Kd = Cost of debenture .
I = Annual interest payment
t = Tax rate
P = Net proceeds from the issue of debentures
R = Redeemable value of debenture at the time of maturity
Illustration 1:
(a) A company issues 100,000, 15% Debentures of 100 each. The company is in a 40% tax
bracket. You are required to compute the cost of debt after tax if debentures are issued at (i) par,
(ii) 10% discount, and (iii) 10% premium.
(b) If brokerage is paid at 5%, what will be the cost of debentures if the issue is at par?
I
(1−t ) X 100
(a) Cost of Debenture, Kd = NP
15,000
(1−0.4)X 100=0.09
i. Issued at par: Kd = 100,000 X100=9%
15 , 000
(1−0 .4 ) X 100=0. 10 X 100=10%
ii. Issued at discount rate of 10%: Kd = 90 , 000
15,000
(1−0.4) X 100=0.08 X 100=8 %
iii. Issued at 10% premium: Kd = 110,000
(b) If brokerage is paid at 5% and debenture are issued at par
15 ,000
(1−0.4) X 100=0.09 X 100=9%
Kd = 100,000−5,000
Illustration 2:
TYONA Ltd. has issued 12% Debentures with a face value of 100 each. The floating charge of
the issue is 5% of the face value. The interest is payable annually, and the debentures are
redeemable at a premium of 10% after 10 years.
What will be the cost of debentures if the tax is 50%?
Solution

31
 I (1−t )+1/n (R−P)
Kd= X 100
Cost of Debenture: 1 /2(R+ P)
Here, I=12. t=50% or 0.5, P=100-5=95, n=10 years, R=100+10% of 100=110
12(1−0 .5 )+1/10(110−95 ) 6+1 .5
Kd= X 100= X 100=0. 073 X 100=7 .3
1/2(110+95 ) 102 .5
B. Cost of Preference Share Capital:
For preference shares, the dividend rate can be considered as their cost, since it is this amount
that the company wants to pay against the preference shares. Like with debentures, the issue
expenses or the discount/premium on issue and redemption are also to be taken into account.
S (i) The cost of preference shares (KP) = DP / NP
Where, DP = Preference dividend per share
NP = Net proceeds from the issue of preference shares.
(ii) If the preference shares are redeemable after a period of ‘n’, the cost of preference shares
(KP) will be:
D+1/n( R−P)
K p= X 100
1/2( R+P )
Where P = Net proceeds from the issue of preference shares
R = Net amount required for redemption of preference shares
D= Annual dividend amount.
The cost of preference shares has no tax advantage because their dividend is not allowed as a
deduction from income for income tax purposes. The students should note that both in the case
of debt and preference shares, the cost of capital is computed with reference to the obligations
incurred and proceeds received. The net proceeds received must be taken into account while
computing the cost of capital.
Illustration 3:
A company issues 10% preference shares with a face value of 100 each. Floatation costs are
estimated at 5% of the expected sale price. What will be the cost of preference share capital (K P)
if preference shares are issued (i). at par, (ii) at a 10% premium, and (iii) at a 5% discount?
Ignore dividend tax.
Solution:
Cost of preference share capital (KP) = D/P x 100

32
(i) When preference shares are issued at par i.e 100 per share,
10
K p= X 100=10 .5 %
95
Here, D=10% of 100=10, P=100-5% of 100=95
(ii) When preference shares are issued at 10% premium (i.e at ₦110 per share)
10
K p= X 100=9 .56 %
104 . 5
Here, D = 10% of 100 =10, P = 110-5% of 110=104.50
(iii) When preference shares are issued at 5% discount (i.e at ₦95 per share)
10
K p= X 100=11.08 %
90. 25
Here, D = 10% of 100 =10, P = 95-5% of 95=90.25
Illustration 4:
Ruby Ltd. issues 12%. Preference Shares of ₦100 each at par redeemable after 10 years at 10%
premium. What will be the cost of preference share capital?
Solution
D+1/n( R−P)
K p= X 100
Cost of preference share: 1/2( R+P )
Here; D = 12% of 100=12, R = 110(at 10% premium), P=100 (at par), n=15 years
12+1/10(110−100 ) 13
K p= X 100= X 100=12. 38 %
1/2(110+100 ) 105
Illustration 5:
A company issues 12% redeemable preference shares of 100 each at a 5% premium, redeemable
after 15 years at a 10% premium. If the floatation cost of each share is 2, what is the value of K P
(cost of preference share) to the company?
D+1/n( R−P)
K p= X 100
1/2( R+P )
Here; D = 12% of 100=12, R=110(at a 10% premium), P=100+5% of 100-2=103, n =15 years.
12+1/10(110−103 ) 12 . 47
K p= X 100= X 100=11. 71 %
1/2(110+103 ) 106 . 50
C. Cost of Equity or Ordinary Shares:

33
The funds required for a project may be raised by the issue of equity shares, which are of a
permanent nature. These funds do not need to be repayable during the lifetime of the
organization. Calculation of the cost of equity shares is complicated because, unlike debt and
preference shares, there is no fixed rate of interest or dividend payment. The cost of equity shares
is calculated by considering the earnings of the company, the market value of the shares, the
dividend per share, and the growth rate of dividends or earnings.
(i) Dividend/Price Ratio Method:
An investor buys equity shares of a particular company as he expects a certain return (i.e., a
dividend). The expected rate of dividend per share based on the current market price per share is
the cost of equity share capital. Thus, the cost of equity share capital is computed on the basis of
the present value of the expected future stream of dividends.
Thus, the cost of equity share capital (Ke) is measured by:
Ke = where D = Dividend per share
P = Current market price per share.
If dividends are expected to grow at a constant rate of ‘g’ then cost of equity share capital
D
Ke= + g×100
(Ke) will be P
This method is suitable for those entities whose growth rate in dividends is relatively stable. But
this method ignores the capital appreciation in the value of shares. A company that declares a
higher amount of dividends out of a given amount of earnings will be valued higher than a
company that earns the same amount of profits but uses a large portion of it to fund its expansion
program.
Illustration 6:
AHIR Company’s shares are currently quoted in market at ₦ 60. It pays a dividend of ₦3 per
share and investors expect a growth rate of 10% per year.
You are required to calculate:
(i) The company’s cost of equity capital.
Solution
D
Ke= + g×100
Cost of Equity Capital: P

34
 3
Ke= +0 . 10×100=0 . 05×0 . 10×100=15 %
(i) 60
Illustration 7:
The current market price of a share is ₦100. The firm needs ₦100,000 for expansion and the
new shares can be sold at only ₦95. The expected dividend at the end of the current year is
₦4.75 per share with a growth rate of 6%.
Calculate the cost of capital of new equity.
Solution:
D
Ke= + g×100
We know, cost of Equity Capital P
(i) When current market price of share (P) = Rs. 100
4 . 75
Ke= +6 %×100
100
= 0.0475 + 0.06¿ 100 = 10.75%.
4 . 75
Ke= +0. 06×100
(ii) Cost of new Equity Capital = 95 = 11%.
Illustration 8:
A company’s share is currently quoted in the market at ₦20. The company pays a dividend of ₦2
per share. You are required to calculate (a) Cost of equity capital of the company.
Solution:
Cost of equity share capital (Ke) = D/P +g ¿ 100 = ₦2/₦20 + 5%¿ 100 = 15%
Illustration 9:
Green Diesel Ltd. has its equity shares of Rs. 10 each quoted in a stock exchange at a market
price of Rs. 28. A constant expected annual growth rate of 6% and a dividend of Rs. 1.80 per
share has been paid for the current year.
Calculate the cost of equity share capital.
Solution:
D0 (1 + g)/ P0 + g ¿ 100 = 1.80 (1 + .06)/ 28 + 0.06 ¿ 100
= 0.0681 + 0.06¿ 100 = 12.81%
(ii) Earnings/Price Ratio Method:

35
This method takes into consideration the earnings per share (EPS) and the market price of a
share. Thus, the cost of equity share capital will be based upon the expected rate of earnings of a
company. The argument is that each investor expects a certain amount of earnings, whether
distributed or not, from the company whose shares he invests.
If the earnings are not distributed as dividends, they are kept in the retained earnings and cause
future growth in the earnings of the company as well as an increase in the market price of the
share.
Thus, the cost of equity capital (Ke) is measured by:
Ke = E/P where E = Current earnings per share
P = Market price per share.
If the future earnings per share will grow at a constant rate ‘g’ then cost of equity share capital
(Ke) will be
Ke = E/P+ g¿ 100
This method is similar to dividend/price method. But it ignores the factor of capital appreciation
or depreciation in the market value of shares. Adjustment of Floatation Cost There are costs
associated with floating shares in the market, which include brokerage, underwriting
commission, etc. paid to brokers, underwriters, etc. This adjustment is to be made with the
current market price of the share at the time of computing the cost of equity share capital since
the full market value per share cannot be realized. So the market price per share will be adjusted
by (1 – f) where ‘f’ stands for the rate of floatation cost.
Thus, using the Earnings growth model the cost of equity share capital will be:
Ke = E / P (1 – f) + g ¿ 100
Illustration 10:
The share capital of a company is represented by 10,000 Equity Shares of ₦10 each, fully paid.
The current market price of the share is ₦40. Earnings available to the equity shareholders
amount to ₦60,000 at the end of a period.
Calculate the cost of equity share capital using Earning/Price ratio.
Solution
Cost of Equity Capital Ke = E/P
60 , 000
=
E= Earnings per share10 , 000 ₦6, P = ₦40

36
 6
×100=15 %
Ke = 40
Illustration 11:
A company plans to issue 10,000 new Equity Shares of ₦10 each to raise additional capital. The
cost of floatation is expected to be 5%. Its current market price per share is ₦40.
If the earnings per share is ₦7.25, find out the cost of new equity.
Solution:
E
×100
Cost of New equity Ke = P (1−f )
Where; E=7.25, P=40, t=5% or 0.05
7 .25 7 .25
Ke= ×100= ×100=19 %
40 (1−0 . 05) 38
D. Cost of Retained Earnings:
The profits retained by a company for using in the expansion of the business also entail cost.
When earnings are retained in the business, shareholders are forced to forego dividends. The
dividends forgone by the equity shareholders are, in fact, an opportunity cost. Thus retained
earnings involve opportunity cost.
If earnings are not retained they are passed on to the equity shareholders who, in turn, invest the
same in new equity shares and earn a return on it. In such a case, the cost of retained earnings
(Kr) would be adjusted by the personal tax rate and applicable brokerage, commission etc. if any.
Therefore Kr = Ke(1-t)(1-f)¿ 100
D
Ke= +g
Where P , t = Shareholders personal tax rate, f = rate of floatation cost.
Many accountants consider the cost of retained earnings as the same as that of the cost of equity
share capital. However, if the cost of equity share capital i9 computed on the basis of dividend
growth model (i.e., D/P + g), a separate cost of retained earnings need not be computed since the
cost of retained earnings is automatically included in the cost of equity share capital. Therefore,
Kr = Ke = D/P + g.
Illustration 12:

37
It is given that the cost of equity of a company is 20%, marginal tax rate of the shareholders is
30% and the Broker’s Commission is 2% of the investment in share. The company proposes to
utilize its retained earnings to the extent of Rs. 6,00,000.
Find out the cost of retained earnings.
Kr = Ke(1-t)(1-f)¿ 100
= 0.20(1-0.30)(1-0.02) ¿ 100
=0.1372¿ 100 = 13.72%
Here; Ke = 20% or 0.20, t = 30% or 0.30, f = 2% or 0.02
E. Overall or Weighted Average Cost of Capital:
A firm may procure long-term funds from various sources like equity share capital, preference
share capital, debentures, term loans, retained earnings etc. at different costs depending on the
risk perceived by the investors.
When all these costs of different forms of long-term funds are weighted by their relative
proportions to get overall cost of capital it is termed as weighted average cost of capital. It is also
known as composite cost of capital. While taking financial decisions, the weighted or composite
cost of capital is considered.
The weighted average cost of capital is used by an enterprise because of the following
reasons:
(i) It is useful in taking capital budgeting/investment decisions.
(ii) It recognises the various sources of finance from which the investment proposal derives its
life-blood (i.e., finance).
(iii) It indicates an optimum combination of various sources of finance for the enhancement of
the market value of the firm.
(iv) It provides a basis for comparison among projects as a standard or cut-off rate.
Computation of Weighted Average Cost of Capital:
Computation of Weighted Average cost of capital is made in the following ways:
(i) The specific cost of each source of funds (i.e., cost of equity, preference shares, debts,
retained earnings etc.) is to be calculated.
(ii) Weights (i.e., proportion of each, source of fund in the capital structure) are to be computed
and assigned to each type of funds. This implies multiplication of each source of capital by
appropriate weights.

38
Generally, the-following weights are assigned:
(a) Book values of various sources of funds
(b) Market values of various sources of capital
(c) Marginal book values of various sources of capital.
Book values of weights are based on the values reflected by the balance sheet of a concern,
prepared under historical basis and ignoring price level changes. Most of the financial analysts
prefer to use market value as the weights to calculate the weighted average cost of capital as it
reflects the current cost of capital.
But the determination of market value involves some difficulties for which the measurement of
cost of capital becomes very difficult.
(iii) Add all the weighted component costs to obtain the firm’s weighted average cost of capital.
Therefore, weighted average cost of capital (Ko) is to be calculated by using the following
formula:
Ko = K1w1 + K2w2 + …………
Where K1, K2 ……….. are component costs and W1, W2 ………….. are weights.
Illustration 13:
Jamuna Ltd has the following capital structure and, after tax, costs for the different sources of
fund used:
Source Amount (₦) After-tax Cost
Equity share capital 600,000 13%
Preference share capital 300,000 8%
Debentures 240,000 5%
Retained Earnings 60,000 9%
You are required to calculate the Weighted Average Cost of Capital

Solution
Source Amount (₦) Proportion After-tax Weighted Cost
Cost
Equity share capital 600,000 0.50 13% 0.065
Preference share capital 300,000 0.25 8% 0.02
Debentures 240,000 0.20 5% 0.01

39
 Retained Earnings 60,000 0.05 9% 0.0045
Total 1,200,000 1 0.0995
Therefore, the weighted cost KO = 0.0995¿ 100=9.95%

FINANCING DECISION
A business faces 4 major issues when selecting an appropriate source of finance, these are
I. Can the finance be raised from internal sources?
II. Can the finance be raised from external sources? If the finance is to be raised from
external sources, should it be debt or equity?
III. If the external source be debt or equity, where should it be raised from, and in which
form?
IV. What should be the financing mix if the finance should be raised from internal and
external sources what ratio should be internal or external.
The company needs to consider the amount held in current cash balance and short-term
investments and how much of this would be needed to support the existing operation. If spare
cash existed, it would be the most obvious source of finance for the project. If the required cash
cannot be provided in this way, then the company will consider its future cash flow. In this case,
a cash budget needs to be prepared. If the company’s projected cash flow is not sufficient to fund
the new project, then it could consider tightening its control and working capital to improve its
cash position. This involves pressuring debtors for early settlement and lengthening the payment
period to creditors. In doing all these, certain factors need to be considered. These are:
Cost of Finance: Debt finance is typically treated as a separate chapter from equity finance.This
is because debt finance is safer from a lender's point of view. Interest has to be paid before
dividends in the event of liquidation, and debt finance is paid off before equity. This makes debt
a safer investment than equity, and hence, debt investors demand a lower rate of return than
equity investors. Debt interest is also tax deductible, making it cheaper for a tax-paying
company. Arrangement costs are usually lower on debt financing than on equity financing.
Current Capital Bearing of the Business: Debt financing is attractive due to its cheap cost. Its
disadvantage is that interest has to be paid. If too much is borrowed, the company may not be
able to meet interest and principal payments, and liquidation may follow. The level of the

40
company’s borrowing is usually measured by the capital gearing ratio, and companies must make
sure that the ratio is not too high. The company's gearing ratio is the ratio of debt finance to
Debt Finance
equity finance. gearing ratio =
Equity Finance
Security Available: Many lenders will require assets to be pledged as security against loans. In
addition, good equity assets such as land and buildings provide equity for borrowing in the
absence of good asset security. Further borrowing may not be an option.
Business Risk: This refers to the volatility of operating profit. Companies with high operating
profit should avoid high levels of borrowing. High-risk ventures are normally financed by equity
finance as there is no legal obligation to pay equity dividends.
Operating Gearing refers to the ratio of the company’s operating costs that are fixed as opposed
to variables. It is the proportion of the company’s fixed costs to its variable costs. The higher the
proportion, the higher the operating gearing. Companies with high operating gearing tend to have
higher operating profits. This is because fixed costs remain the same, no matter the volume of
sales. Thus, if sales increase, operating profit increases by a large percentage, and if sales fall,
operating profit falls by a higher percentage, i.e. vice versa.
¿ cost
ratio =
variable cost
Voting Control: A large issue of shares to new investors could alter the voting control of the
business. If the founding owners own over 50% of the equity, they may be reluctant to sell new
shares to outside investors as their voting control at the annual general meeting may be lost.
The Current State of the Equity/Stock Market: When share prices are falling, many
companies will be hesitant to sell new shares, and vice versa.
FINANCIAL RATIO
A ratio creates a mathematical relationship between certain elements or variables on a financial
statement. A ratio is a calculation in which two values are compared to one another. Financial
ratio analysis is a financial analysis that uses ratio calculation to access the performance of an
organization. In general, there are four basic categories of financial ratios; these are:
1. Liquidity ratio
2. Leverage ratio
3. Profitability ratio
4. Share holder ratio

41
1. Liquidity Ratio: It is a measure of how well a business is able to pay its debts. The most
commonly used liquidity ratio is:
current Assests
i. Current Ratio: Current ratio =
current liabilities
A ratio greater than I means that the firm has more current assets than current liabilities. The
higher the current ratio, the greater the firm’s ability to meet its current obligations, which
are:
- Payment of interest
- Payment of dividends
- Payments of taxes
- Payments of salaries
However, firms with a lower current ratio may be doing well, while firms with a high current
ratio may not be doing well. This is because the current ratio is a test of quantity and not
quality. It does not assess the quality of assets and liabilities because they are not subject to
depreciation and must be paid, but current assets include doubtful and slow-paying debtors.
Because the firm's ability to pay bills is impaired, too much reliance on the current ratio
should be avoided. Further investigation into the quality of current assets should be carried
out. However, the current ratio is a quick measure of the firm’s liquidity.
i. Working Capital Ratio:
current Assets
Working capital ratio = Current ratio the higher the firm’s working
current liabilities
capital, the greater the firm’s ability to meet its current obligation.
ii. Quick Ratio:
Quick assets ( current assets )−inventories
Quick ratio =
current liabilities
If quick ratio≥ 1, the better the financial position of the firm.
Cash
iii.Cash Ratio: cash ratio =
current liabilities
Cash = cash at hand + cash at bank.
If cash ratio ≥ 1, the better the financial position of the firm.
2. Leverage Ratio:

42
 Total liabilities
Leverage ratio = '
share holde r s equity
A lower leverage ratio is considered to be a satisfactory financial condition of the firm.
Profitability Ratio
A company should earn a profit to survive and grow over a long period of time. The percentage
at which a company makes gain or incurs losses is the basis by which one compares one year’s
performance with another. Therefore, the financial manager should continually evaluate the
efficiency of the company in terms of profit.
Profitability ratios are calculated to measure the operating efficiency of a company. There are
two types of profitability ratio, i.e.,
1. Profitability ratio in relations to sales
2. Profitability ratio in relations to investment.
(1) The measures of profitability ratio in relation to sales are:
Gross Profit
1. Gross Profit margin Ratio =
Sales
The gross profit margin ratio reflects the efficiency with which management produces each unit
of product. This ratio indicates the average spread between the cost of goods sold and the sales
revenue. A high gross profit margin implies that the firm is able to produced at a lower cost. It is
a sign of good management. The gross profit margin ratio may increase due to any of the
following factors:
i. Higher sales prices
ii. Lower costs of goods sold
iii. A combination or variation in sales prices and cost. The variation is known as margin
widening.
Net profit
2. Net Profit Margin ratio: (NPM) =
Sales
The NPM Ratio establishes a relationship between net profit and sales and indicates
management’s efficiency in manufacturing, administration, and sales. If the net margin ratios are
inadequate, the firm will fail to achieve satisfactory returns on shareholders’ funds. It also
indicates the firm’s capacity to withstand adverse economic conditions. A firm with a high net
profit margin ratio will be better placed to survive in the face of falling market prices and rising

43
costs of products. It would really be different for a firm with a low net profit margin to withstand
those adverse conditions.
Operating Expense Ratio: This explains the changes in the profit margin ratio. This ratio is
calculated by dividing operating expenses by sales (the sum of cost of goods sold, selling
expenses, and general and administrative expenses).
Operating Expenses
Operating expenses ratio =
Sales
Unlike gross profit margin ratio, and net profit margin ratio, a high operating expenses ratio is
rather unfavorable.
(2). Profitability Ratio in Relations to Investment
It is measured by
Net profit
1. Return on assets ratio =
Assets
This indicates how well a company is able to leverage its asset to generate earnings from its
activities.
2. Return on owner’s equity ratio:
Net profit
=
shareholder ' s Equity
This measures how well a company is able to leverage its shareholder’s equity to generate
earnings from its activities.
Shareholder Ratios
1. Earnings per share ratio =
Net Income Available ¿ shareholders ¿
Number of shares outstanding
2. Dividends per share ratio =
Dividends paid ¿ shareholders ¿
Number of shares outstanding
dividends
3. Dividends payout ratio =
earnings
Dividends per share
4. Dividends yield ratio =
market price per share
5. Retention Ratio (plongh back) ratio
Earinings−Dividends
=
Earnings

44
For all this earnings, the higher the better
Financial Statement
There are three most important financial statements. They are;
1. Balance sheet
2. Profit and loss account (Income Statement)
3. Statement of changes in financial position
1. Balance Sheet
A balance sheet is a financial statement that presents a summary statement of the firm's financial
position at a given period of time. The statement balances the firm's assets (what the firm owns)
and liabilities (what the firm owes). Assets represent things of value that a company owns and
has in its possession, or something that will be received and can be measured objectively. They
are also called the resources of the business. Some examples of assets include receivables,
equipment, property, and inventory. Assets have value because a business can use or exchange
them to produce the services or products of the business.
Liabilities are the debts owed by a business to others—creditors, suppliers, tax authorities,
employees, etc. They are obligations that must be paid under certain conditions and time frames.
A business incurs many of its liabilities by purchasing items on credit to fund its business
operations.
A company's equity represents retained earnings and funds contributed by its owners or
shareholders (capital) who accept the uncertainty that comes with ownership risk in exchange for
what they hope will be a good return on their investment. A sample of balance sheet is presented
below.
JOE’S ZIK AND SONS LTD BALANCE SHEET AS AT 31ST DECEMBER, 2018
Assets N N
Current Assets
Cash at hand 10,000
Cash at hand 2,000
Inventories 5,000
Total Current Assets 17,000
Fixed Assets:
Equipment 82,000
Building 73,000
Land 70,000
Plant and machinery 138,000

45
 Total fixed Assets 363,000
Total Assets 380,000
Liabilities
Current Liabilities
Account payable 45000
Taxes payable 10,000
Dividends payable 87,000
Total Current Liabilities 142,000
Long term Liabilities
Long term loans 108,000
Debentures 100,000
Retained earnings 30,000
Total Long Term Liabilities 238,000
Total Liabilities 380,000

Contents of a Balance Sheet

Assets: Assets, as earlier stated, are what the company owns. They are grouped into tangible and
intangible assets and current and long-term (fixed) assets.
Tangible assets are properties that can be touched and seen, such as buildings, machinery, cars,
trucks, computers, and the likes. Tangible assets all have a value, which is set by their purchase
prices. Tangible assets are properties that do not have a physical presence and cannot be seen or
touched. They include things like intellectual property, copyright, patents, and goodwill. The
financial measurement of an intangible asset is somewhat subjective because it is usually based
on a preserved value rather than a purchase price.
Current assets are those that are cash or have a one-year business cycle. A business cycle is the
length of time required to produce or acquire a product, sell the product, and receive payment for
the product. A long-term asset is one that cannot be converted into cash within a single business
and has a service life of at least three years.
Liabilities: are debts to a company. Like assets, liabilities can either be long-term or short-term.
Short-term liabilities are those that will come due and will be paid within the next year, e.g.,
income taxes yet to be paid. Long-term liabilities are those that are payable over a period of time
greater than the accounting period. They include debentures, bonds, and secured long-term loans
from financial institutions.
2. Income Statements (Profit and Loss Statement)

46
An income statement reports a company's performance in generating a profit during a particular
period of time. It has three sections: revenue, cost of sales, and operating expenses. A sample of
an income statement is presented below.

ATE AND SONS LTD INCOME STATEMENT FOR THE YEAR ENDED DECEMBER,
31, 2018

₦ ₦

Total revenue 1,000,000 1,000,000

Less Cost of Goods Sold 426,200
Gross Profit 573,800

Less Expenses
Accounting and legal fees 11,700
Advertising 15,000
Depreciation 38,000
Electricity 2,700
Insurance 15,200
Interest and bank charges 27,300
Postage 1,500
Printing and stationery 8,700
Professional memberships 1,800
Rent for premises 74,300
Repairs and maintenance 21,100
Training 6,900
Vehicle operating costs 20,000

47
 Wages and salaries 223,500
Workers compensation 6,500
All other expenses 14,100
Less Total Expenses 488,300
Net Profit 85,500

Contents of Income Statement

Revenues (Earnings):- This section reports the sources of a company’s revenue for the financial
period and to total revenue.
Cost of Sales: Apart from companies which provide strictly processional services like
advertising, medical services, legal services, etc., companies incur the cost of raw materials,
labour, overhead, etc., which are the costs of production. This cost is deducted from the total
gross sales to calculate a company’s gross profit.
Gross profit: The net of revenues and cost of sales is gross profit
Interest Expenses: charges on a company’s borrowed money.
Taxes: Taxes are compulsory levy imposed on a firm by the government.
Net Profit: It is also called profit after taxes. This is the amount of profit a company has
available to reinvest and distributes to shareholders as dividends.
3 Statement of Changes in Financial position
This is a statement that reconciles changes that occur during the financial year to the amount on
the balance sheet and income statement. The balance sheet gives a summary of the firm's
resources and obligations at a point in time; the profit and loss account. It reflects the results of
the business operations by summarizing revenue and expenses during a period of time. Both
these statements fail to explain the changes in assets, liabilities, and owner equity.
It is intended to be summarized:
i. Changes in assets and liabilities resulting from financial and investment transactions during the
period, as well as those changes that resulted due to changes in owners’ equity
ii. The way in which the firm used its financial resources during the period. The most commonly
used forms of the statement of changes in financial position are called the "statement of sources
and uses of funds." They are simply called the "funds flow statement," "sources and uses of
capital statement," "cash flow statement," or "statement of sources and uses of each. The fund
flow statement summarises the differences between current assets and current liabilities, while

48
the cash flow statement summarizes the flow of cash in a firm. To get a better insight into the
changes that take place within a period of time, however, a firm may prepare a comprehensive,
all-inclusive, statement of changes in financial position, incorporating the analysis of the firm’s
cash and working capital positions. Thus, three common statements could be prepared:
i. Changes in the firms working capital position
ii. Changes in the firms cash position
iii. Changes in the firm total financial position.
The analysis of changes in financial position begins with an analysis of balance sheet
changes over a desired period of times. It can be illustrated below

ABUA and Co-balance sheet changes December 31, 2009-Dec 31 2010

Assets 2009 2010 Change
Cash 54 135 +81
Debtor 0,750 8,235 + 1,485
Stock(inventory). 10,125 22,080 + 12,555
Total current assets 16,929 31,080 + 14,121
Fixed assets (net) 2,970 0,075 + 3,105
Other assets 945 1,890 + 945
Total assets 20,844 39,015 + 18,171
Liabilities and Net worth
Bank borrowing 3,510 8,664 + 5,154
Creditors 2,835 6,615 + 3,780
Provision for taxes 270 975 + 702
Accrued expenses 810 2,700 + 1,890
Total current liabilities 7,425 18,951 11,526
Long term debt 1,944 1,404 -540
Total liabilities 9,369 20,355 10,986
Paid up shares capital 8,370 8,370 -
Reserves and surplus 3,105 10,320 + 7, 185
Total funds 20,844 39,015 + 18,171
The data in the table above can be recasted in a simple format of statement of changes in
financial position.
ABUA AND CO-STATEMENT OF CHANGES IN FINANCIAL POSITION SOURCES:
Increase in current liabilities:
Bank borrowings 5,154

49
Creditors 3,780
Provision for taxes 702
Accrued expenses 1,890
Total 11,526
Increase in shareholder’s
equity reserved/ retained earrings) 7,185
18,711
Uses
Increase in current assets:
Cash 81
Debtors 1,485
Stock (inventory) 12,555
Total 14,121
Increase in fixed assets 3,105
Increase in other assets 945
Decrease in long-term debt 540
18,711

A simple statement of changes in a firm working capital can be illustrated below.

Abu Company Funds Flow Statement
Source N
Funds from operations 120,000
Sale of machine 30,000
Issuance of debentures 100,000
Issuance of ordinary shares 100,000
Fund provided 350,000

Uses
Purchase of long term investments 80,000
Payment of loans 90,000
Payment of cash dividend 60,000
Increase in working capital 120,000
350,000
Abua& Co Cash Flow Statement
Source N
Cash from operations 18,000
Sale of plant 36,000
Institutional loan 8,000
Issuance of equity shares 55,000
Cash provided 180,000
Uses
Purchase of land and building 50,000
Purchase of plant and machinery 70,000
Payment of cash dividend 40,000

50
Increase in cash 20,000
Total 180,000

DIVIDEND AND SHARE REPURCHASING DECISION

In every business unit, the amount of profit earned (or loss incurred) during a financial year is
ascertained and distributed among its owners. In the case of a proprietary concern, the whole
amount of profit or loss so ascertained is added to the proprietor’s capital, and whatever amount
is withdrawn by him is termed "drawings" and is deducted from his capital. Similarly, in the case
of a partnership firm, the profit or loss is distributed among the partners in their agreed profit
sharing ratio and included in their capital. Whatever amount is withdrawn by the partners is
deducted from their respective capitals as drawings. In the case of a company, however, it is
dealt with differently.
First of all, we work out the operating profits (called PBIT – Profit before interest and tax). Then
subtract the amount of interest on loans to arrive at the profit before tax (PBT).Then we deduct
the amount of tax on the company’s profits as per the rules and ascertain the profit after tax
(PAT). This is the amount of profit that is available for distribution among the shareholders. As a
matter of practice and financial prudence, the whole amount of profit earned by the company is
never distributed to the shareholders. A substantial part of it is retained to meet the company’s
future financial needs. The amount of profits so retained is called "retained earnings", and the
amount of profit distributed to the shareholders is called "dividend". It may be noted that the
dividend paid to preference shareholders is called the "preference dividend" and the dividend
paid to equity shareholders is called the "equity dividend."
Factors Affecting Dividend and Share Repurchasing Decisions
The dividend to preference shareholders is paid at a fixed rate and paid on a priority basis, i.e.,
before making payment to equity shareholders. The real issue involved in the dividend decision
by the management of any company is the dividend to be paid to equity shareholders. Such a
decision is guided by the following factors:
1. Financial needs of the company: While deciding the amount of dividend to be paid, the
management must take into account the financial needs for the normal growth of its business,
expansion activities, the repayment of long-term debt, etc. Even otherwise, the company must
retain a part of profits for long-term solvency and to meet future contingencies.

51
2. Liquidity requirement: The payment of a dividend involves the outflow of cash. At times, a
company may have high profits but not much cash. In such a case, it may not declare a high
dividend rate.Even otherwise, the liquidity requirement for ensuring timely payment of all dues
and debts has to be kept in view while determining the rate of dividend. Such a consideration is
of greater importance in the case of a growing concern whose liquidity needs may be large on
account of its expansion activities and growing working capital requirements, and therefore, they
would prefer a low payout.
3. Access to capital market: A company that, by virtue of its record of profitability and timely
repayment of debt, has better access to the capital markets, i.e., it can successfully raise funds by
issuing shares and debentures through the capital market, may pay higher dividends. But, if a
company does not have easy access to the capital markets because of its weak financial position
or low profitability record, it cannot afford to pay high dividends. However, when the capital
market conditions are unfavorable, most companies should adopt a conservative dividend policy.
4. Expectations of shareholders: Rather than a higher dividend rate, equity shareholders
typically anticipate capital appreciation.But, some shareholders, like retired people or employees,
do look forward to dividends as a source of their regular income. As a result, companies cannot
ignore such a segment and pay a low dividend or skip it even when profits are high.A reasonable
payout is always welcome. In fact, companies that skip payment of dividends or pay too low a
rate of dividends as a matter of practice are rated low in the capital market as the shareholders
suspect their management’s intentions.
5. Tax policy: In our country, dividends have been taxable in the hands of shareholders since
1976. Hence, companies prefer to pay a low amount of dividends and issue bonus shares to
shareholders from time to time as these are not taxable until they are sold. If these are sold after
12 months, the sale proceeds are regarded as a long-term capital gain and taxed at a lower rate.
However, of late, the government has changed its policy on the taxation of dividends. Dividends
are not taxable in the hands of shareholders. But the company has to pay some additional tax
(12.5%) on the distributed part of its profits. So, companies have now become liberal in the
matter of dividend distribution.
6. Investment opportunities and growth prospects: When a company has adequate profitable
investment opportunities and growth prospects, it may prefer to retain more profits and pay a
lower rate of dividends so as to better serve the shareholders in the long run. Of course, in the

52
absence of such possibilities, companies prefer the payment of higher dividends and avoid idle
cash with them.
7. Legal constraints: Sometimes, the government prescribes certain limits on the dividend
payout, which have to be kept in view while deciding on the rate of dividend to be paid.
Similarly, at times, the long-term fund providers may put some restrictions on the dividend
payout as part of their agreement. The companies have to adhere to such limits. In any case,
company law has provided certain rules to be followed while deciding on the amount to be
distributed as a dividend. For example, capital profits are not normally used for the distribution
of dividends; a banking company has to transfer a certain percentage of profit to a statutory
reserve which is not available for the payment of dividends, and so on. These have to be duly
abided by while determining the amount to be distributed as a dividend.

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