NATIONAL OPEN UNIVERSITY OF NIGREIA

SCHOOL OF MANAGEMENT SCIENCES

COURSECODE: PSM 825

COURSE TITLE: FINANCIAL MANAGEMENT IN GOVERNMENT

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PSM 825: FINANCIAL MANAGEMENT IN GOVERNMENT

COURSE GUIDE

NATIONAL OPEN UNIVERSITY OF NIGERIA

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INTRODUCTION

PSM 825: Financial Management in Public Sector is a first semester year one three
credit units and 600 level core course. The course material is prepared for all
students who are taking courses in financial management. The course is a useful
material to you in your academic pursuit as well as in your work place as managers
and administrators.

The course will expose you to understanding many of the concepts, theories and
formulas in financial management as they affects government
institutions/establishments. It will assist you to be able to apply these concepts,
theories and formulas to the task you perform as financial manager in the corporate
business setting and government establishments.

The course consists of 21 units, which include course guide, Introduction of

Financial Management; The Nigerian Financial System; The Capital Market
Operation; Sources of Finance; Right Issue; Investment Decision under Certainty;
Investment Decision under Uncertainty; Leasing; Cost of Capital; Working Capital
Management; Budget and Budgetary Control in the Organization; Variance
Analysis; Cost – Volume Profit Analysis; Public Sector Financial management;
Techniques and tools for achieving efficiency management of government finance

This course guide tells you briefly what the course is all about, what course,
material you will be using and how you can work your way through these
materials. It suggest some general guidelines for the amount of time you are likely
to spend on each unit of the course in order to complete it successfully.

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It also gives you some guidance on your tutor-marked assignments, which will be
made available in the assignment files. There are regular tutorial classes that are
linked to the course. You are advised to attend these sessions.

WHATYOU WILLLEARN IN THIS COURSE

PSM 825: Financial Management in Government introduces you to various

techniques, guide, principles, practices, forms and methods of financial
management in government.

COURSE AIMS

The main aim of the course is to expose you to the meaning and application of
Public Financial Management. The course also aims at pointing out techniques of
Public Financial Management. It also aims to help you develop skills in the
business/government settings. You can also apply the principles to your job as
Financial Managers in both public and private sectors.

COURSE OBJECTIVES
To achieve the aims set out, the course sets overall objectives. Each unit also has
specific objectives. The unit objectives are always included at the beginning of the
unit, you should read them before you start working through the unit. You may
want to referrer to them during your study of the unit to check your progress.
You should always look at the unit objectives after completing a unit. In doing so,
you will be sure that you have followed the instructions in the unit.

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Below are the wider objectives of the course as a whole. By meeting these
objectives, you should have achieved the aims of the course as a whole. On
successful completion of the course, you should be able to:

1. Explaining the nature of Financial Management.

2. Enumerating the values of Financial Management to civil servants.
3. Evaluating and providing practical applications of Financial Management
principles.
4. Evaluating and expatiating on the value of Budgeting and the budgetary
process.
5. Stating and explaining the various processes of appraising investment
projects in the public sector.
6. Evaluating the process and concept of working capital management.
7. Evaluating the various process and politics of financial bill and budget in the
government.
8. Discussing the financial control and reporting functions of the financial
manager in the public sector.
9. Evaluating the dichotomy of agency function and problem of the financial
manager in the public sector.
10. Describing the total flow of financial resources in the public service.

WORKING THROUGH THECOURSE

To complete this course, you are required to read the study units, read textbooks
and read other materials provided by the National Open University of Nigeria
(NOUN). Each unit contains self-assessment exercises, and at a point in the course,
you are required to submit assignments for assessment purposes. At the end of the

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course, is a final examination. The course should take you about 17-18 weeks in
total to complete.

Below you will find listed all the components of the course, what you have to do,
and how you should allocate your time to each unit in order to complete the course
successfully on time.

Below are the lists of all the components of the course:

COURSE MATERIALS

Major components of the course are:

a. Course guide
b. Study units
c. Textbooks
d. Assignment guide

STUDY UNITS

There are six modules (twenty one units) in this course which should be studied
carefully. They are as follows:

Module 1

Unit 1: The meaning and nature of Financial Management

Unit 2: Evolution and Development of Nigerian Financial System

Unit 3: Regulatory and structure of Nigerian Financial System

Unit 4: The Development of Nigerian Capital Market

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Unit 5: The Capital Market Operations

Module 2

Unit 1: Sources of Finance

Unit 2: Right Issue

Module 3

Unit 1: Traditional methods of Investment Appraisal

Unit 2: Scientific Methods of Investment Appraisal

Unit 3: Investment Decision under condition of Uncertainty

Unit 4: Leasing

Module 4

Unit 1: Cost of Capital

Unit 2: Weighted Average Cost of Capital

Unit 3: Working Capital Management

Unit 4: Management of Working Capital Components

Unit 5: The Meaning and Nature of Budget

Unit 6: Budgetary Control in the Organization

Module 5

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Unit 1: Variance Analysis

Unit 2: Cost – Volume Profit Analysis

Module 6

Unit 1: Public Sector Financial management

Unit 2: Techniques and tools for achieving efficiency management of government

finance

The first module deals with the theory of finance, the Nigerian financial market,
and the capital market operation

The second module examines sources of finance and right issue

The third model deals with investment decision under certainty, investment
decision uncertainty and leasing.

The fourth module examines cost of capital, working capital management and
budget and budgetary control in an organization.

Module five deals with variance analysis and cost volume profit analysis

The sixth module is the last segment, it examines public sector financial
management and technique and tools for achieving efficiency in management of
government finance.

TEXTBOOKS AND REFERENCES

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 1) Akinde, M.A.O (2006). Fundamentals and Practice of Business Finance.
Lagos: Abioudun-Kinson Nigeria Ltd
2) Frank, W and Alan, S (2002). Business Accounting. London: Pitman
Publishing
3) Mohammed, S.R (2003). Theory and Practice of Auding. Lagos: Abioudun-
Kinson Nigeria Ltd
4) Okijo, Y (2000). Financial Management. Lagos: Laco Publishers
5) Oye, A (2005). Financial Management. Third edition. Lagos: El-Toda
Ventures Ltd
6) Robert, O.I (1999). Financial Management Made Simple. Lagos: ROI
Publishers
7) Terry, L (2003). Management Accounting. London:Gulidfold and King’s
Lynn

THE ASSIGNMENT FILE

There are many assignments in this course and you are expected to do all of them
by following the schedule prescribed for them in terms of when to attempt them
and submit same for grading by your tutor.

TUTOR–MARKED ASSIGNMENT (TMAs)

In doing the tutor-marked assignment, you are to apply your transfer knowledge
and what you have learnt in the contents of the study units. These numerous
assignments are expected to be turned into our tutor for grading. They constitute
30% of the total score for the course.

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FINALEXAMINATION AND GRADING

At the end of the course, you will write the final examination. It will attract the
remaining 70%. This makes the total final scores to be 100%.

COURSE MARKING SCHEME

Total Course Marking Scheme

ASSESSMENT MARKS
Assignment 1-9 Nine assignments, six best six marks
of the nine count @ 5% each = 30%
of the course marks
Final Examination 70% of overall course marks
Total 100% of course marks

COURSE OVERVIEW

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This table brings together the units, the number of weeks you should take to
complete them and the assignments that follow them.

Unit Title of Work Weeks Assessment

activity (end of unit)
Course Guide
Module 1
1 The meaning and nature of Financial 1 Assignment 1
Management
2 Evolution and Development of Nigerian 1 Assignment 2
Financial System
3 Regulatory and structure of Nigerian 1 Assignment 3
Financial System
4 The Development of Nigerian Capital 1 Assignment 4
Market
5 The Capital Market Operations 1 Assignment 5
Module 2
1 Sources of Finance 1 Assignment 6
2 Right Issue 1 Assignment 7
Module 3
1 Traditional methods of Investment 1 Assignment 8
Appraisal
2 Scientific Methods of Investment 1 Assignment 9
Appraisal
3 Investment Decision under condition of 1 Assignment 10
Uncertainty

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 4 Leasing 1 Assignment 11
Module 4
1 Cost of Capital 1 Assignment 12
2 Weighted Average Cost of Capital 1 Assignment 13
3 Working Capital Management 1 Assignment 14
4 Management of Working Capital 1 Assignment 15
Components
5 The Meaning and Nature of Budget 1 Assignment 16
6 Budgetary Control in the Organization 1 Assignment 17
Module 5
1 Variance Analysis 1 Assignment 18
2 Cost – Volume Profit Analysis 1 Assignment 19
Module 6
1 Public Sector Financial management 1 Assignment 20
2 Techniques and tools for achieving 1 Assignment 21
efficiency management of government
finance
Total 21

HOW TO GET MOST FROM THIS COURSE

In distance learning, the study units replace the university lecturer. This is one of
the great advantages of distance learning. You can read and work through specially
designed study material at your own pace, and at a time and place that suits you
best. Think of it as reading the lecture that a lecturer might set you some reading to
do, the unit will tell you when to read your other materials. Just as a lecturer might

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give you an in-class exercise, your study units provide exercise for you to do at
appropriate points.

Each of the study units follows a common format. The first item is an introduction
to the subject matter of the unit, and how a particular unit is integrated with the
other units and the course as a whole.

Next is a set of learning objectives. These objectives let you know what you should
be able to do by the time you have completed the unit. You should use these
objectives to guide your study. When you have finished the unit, you must go back
and check whether you have achieved the objectives. If you make a habit of doing
this, you will significantly improve your chances of passing the course.

The main body of the unit guides you through the required reading from other
sources. This will usually be either from a reading section of some other sources.

Self-tests are interspersed throughout the end of units. Working through these tests
will help you to achieve the objectives of the unit and prepare you for the
assignments and the examination. You should do each self-test as you come to it in
the study unit. There will also be numerous examples given in the study units,
work through these when you come to them too.

The following is a practical strategy for working through the course. If you run into
any trouble, telephone your tutor. Remember that your tutor’s job is to help you.
When you need help, do not hesitate to call ans ask your tutor to provide it.

(i) Read this course guide thoroughly.

(ii) Organise a study schedule. Refer to the course overview for more details.
Nate the time you are expected to spend on each unit and how the

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 assignments relate to the units. Important information e.g. details of your
tutorials, and the date of the first day of the semester will be made
available. You need to gather all this information in one place, such as
your diary or a wall calendar. Whatever method you chose to use, you
should decide on and write in your own dates for working on each unit.
(iii) Once you have created your own study schedule, do everything you can
to stick to it. The major reason that students fail is that they get behind
with their coursework. If you get into difficulties with your schedule,
please let your tutor know before it is too late for help.
(iv) Turn to unit 1 and read the introduction and the objectives for the unit
(v) Assemble the study materials. Information about what you need for a unit
is given in the “Overview” at the beginning of each unit. You will always
need both the study unit you are working on and one of your references,
on your desk at the same time.
(vi) Work through the unit. The content of the unit itself has been arranged to
provide a sequence for you to follow. As you work through the units, you
will be instructed to read sections from your other sources. Use the unit
to guide your reading.
(vii) Well before the relevant date, check your assignment file and make sure
you attend the next required assignment. Keep in mind that you will learn
a lot by doing the assignments carefully. They have been designed to
help you meet the objectives of the course and, therefore, will help you
pass the exam. Submit all assignments not later than the due date.
(viii) Review of the objectives for each study unit confirms that you have
achieved them. If you feel unsure about any of the objectives, review the
study material or consult your tutor.

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 (ix) When you are confident that you have achieved a unit’s objectives, you
can then start on the next unit. Proceed unit by unit through the course
and try to face your study so that you keep yourself on schedule.
(x) When you have submitted an assignment to your tutor for making, do not
wait for its return before starting on the next unit. Keep to your schedule.
When the assignment is returned, pay particular attention to your tutor’s
comments, both on the tutor-marked assignment form and also written on
the assignment. Consult your tutor as soon as possible if you have
questions or problems.
(xi) After completing the last unit, review the course and prepare yourself for
the final examination. Check that you have achieved the unit objectives
(listed at the beginning of each unit) and the course objectives (listed in
the Course Guide).

FACILITATORS/TUTORS AND TUTORIALS

There are 17 hours of tutorials provided in support of this course. You will be
notified of the dates, times and location of these tutorials, together with the names
and phone numbers of your tutor, as soon as you are allocated a tutorial group

Your tutor will mark and comment on your assignments, keep a close watch on
your progress and on any difficulties you might encounter and provide assistance
to you during the course. You must mail your tutor-marked assignments to your
tutor well before the due date (at least two working days are required). They will
be marked by your tutor and returned to you as soon as possible. Do not hesitate to
contact your tutor by telephone, e-mail, or discussion board if you need help. The
following might be circumstances in which you would find help necessary.

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CONTACTYOUR TUTOR IF:

- You do not understand any part of the study units or the assigned readings
- You have difficulty with the self-test or exercise
- You have a question or problem with an assignment with your tutor’s
comment on an assignment or with the grading of an assignment

You should try your best to attend the tutorials. This is the only chance to have
face-to-face contact with your tutor and to ask questions which are answered
instantly. You can raise any problem encountered in the course of your study. To
gain the maximum benefit from your tutorials, prepare a question list before
attending them. You will learn a lot from participating in discussions actively

SUMMARY

As earlier stated above, this course expose you to the meaning and application of
Public Financial Management. The course also aims at pointing out techniques of
Public Financial Management. It also aims to help you develop skills in the
business/government settings. You can also apply the principles to your job as
Financial Managers in both public and private sectors.

We hope you will enjoy your acquaintances with the National Open University of
Nigeria (NOUN). We wish you every success in the future.

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 NATIONAL OPEN UNIVERSITY OF NIGERIA
SCHOOL OF MANAGEMENT SCIENCES
14/16, AHMADU BELLO WAY, VICTORIAL ISLAND, LAGOS

COURSE DEVELOPMENT

COURSECODE: PSM 825

COURSE TITILE: FINANCIAL MANAGEMENT IN GOVERNMENT

COURSE DEVELOPER/WRITER: J.S. KEHINDE, Ph.D, ACA

DEPARTMENT AF ACCOUNTING AND FINANCE
LAGOS STATE UNIVERSITY, OJO

COURSE EDITOR: DR (MRS) A.O. FAGBEMI

NATIONAL OPEN UNIVERSITY OF NIGERIA
14/16 AHMADU BELLO WAY, VICTORIAL ISLAND, LAGOS

PROGRAMMELEADER: DR. C.I.OKEKE

NATIONAL OPEN UNIVERSITY OF NIGERIA
14/16 AHMADU BELLO WAY, VICTORIAL ISLAND, LAGOS

COURSECOORDINATOR: MRS. IBEME, NWAMAKA P

NATIONAL OPEN UNIVERSITY OF NIGERIA
14/16 AHMADU BELLO WAY, VICTORIAL ISLAND, LAGOS

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 MODULE 1

Unit 1: THE MEANING AND NATURE OF FINANCIAL MANAGEMENT

1.0 Introduction
2.0 Objectives
3.0 Main contents
3.1 Financial Management
3.2 Functions of the Financial Manager/Roles of Financial
Management
3.3 Objectives of Financial Management
3.4 Agency problem in financial management
4.0 Summary
5.0 Conclusion
6.0 Tutor-Marked Assignments
7.0 References/Further Reading

1.0 Introduction

In this unit, we will attempt to explain financial management. The unit will also
explain the functions of the financial manager/roles of financial management.
It examines the objectives of financial management. It further discusses agency
problem in financial management.

2.0 Objectives
At the end of this unit, you should be able to:

1. Define Financial Management

2. Discuss the functions and objectives of financial management
3. Explain the agency problem in financial management

3.0 Main content

The world over, the issues of raising and utilizing of fund have been the heart
beat of all financial managers both in the corporate world and in the public

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sector. The profitable utilization of this scarce resource (fund) by various
sectors has become more important as cost of fund rises on a daily basis.
Thus, the financial manager must do all that is possible to generate returns
that will not only be sufficient to meet the cost of fund but also enough to
satisfy the wealth maximization objective of the firm. This being the age long
prime purpose of establishing a firm. Raising finance for corporate bodies, thus
becomes important and of highest importance.

3.1 Financial Management

“Finance is the management of money”, it is the management of money and

investment or borrows(ing) or raise(ing) of money for purchase of investment or
to provide money for a project. Finance is the heart-beat of all corporate bodies.
Thus management of finance has become relevant in modern business
organizations. The financial effective management rules the finance world
today, as the survival instinct of corporate organization continues to be an
important factor.

Financial management is the process of planning and controlling of the

financial resources of a firm. It includes the acquisition, allocation and
management of firms’ financial resources. It has today been identified with the
totality of how the firm raises finance, where the firm sources funds, the cost of
such funds, the alternative method(s) of utilizing such funds and the final
benefits accruing from using such funds.

To the financial manager, the cost and benefit of capital remain the most
important factor, since the primary objective of the firm is to maximize the
shareholders’ wealth i.e. the present value of equity holding. The shareholders’
wealth is affected by:

1. The volume or quantity of future cash flows

2. The timing of future cash flow

3. The risk attached to the future cash flow.

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Today, the firm does not exist to maximize the shareholders’ wealth alone as
this is gradually becoming a narrow (one-sided) objective of the firm, on the
broader aspect is the maximization of the stakeholders’ wealth. This is so since
the firm exists for the benefits of all its stakeholders such as the shareholders,
the management, the employees, the creditors, the government, and the public
at large, who are public observers of firms’ performances and potential
stockholders.
Self-Assessment Exercise (SAE) 1

Explain the concept “Financial Management”

3.2 Functions of the Financial Manager/Roles of Financial Management

1. Financial Decision: This is the effective management of the capital

structure of the business. The financial manager must ensure maximum
mixture of debt and equity in financing the firm, so as to ensure maximum
returns to the shareholders. The maximum mix of finance of debt and equity
must be established to maximize the returns of shareholders.

2. Investment Decision: The financial manager should select the most

profitable investment portfolio that will reduce to the bearest minimum the risk
of the organization not maximizing stockholders’ wealth.

3. Dividend Decision: The financial manager must select the best dividend
policy per time, the timing dividend, the forms of dividend to be paid, the
methods of payment, the amount to be paid etc. The fund(s) to use is an
important factor to be considered by the financial Manager. As dividend can be
paid either in cash (cash dividend), or by share allocation (stock dividend).

The amount to be retained by the firm for future finances must also be
considered. Since retained earnings is the cheapest source of fund to the firm,
and a bird in hand is worth more than ten in the bush. Thus, cash dividend
will mean more to some section/segment of investors than the retained
earnings which still remains an integral part of the shareholders wealth. Thus,

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the financial manager must be able to draw the border line between amount to
be declared as well as retained for future use.

4. Acquisition Decision: The financial manager must be interested in the

organizations internal and external growth. The growth of corporate
organization can be varied, either by way of merger or acquisition, by backward
integration or forward integration etc.

5. Working Capital Management (Treasury Management): It is the

totality of management of cash, debtor prepayments, stocks creditors, short
term loans accruals, etc. to ensure the profitability of the firm’s operation. It is
the management of current asset and liabilities of firm, which is fast becoming
important in the face of high cost of capital. In modern financial world, efficient
management of the working capital will ensure maximum utilization of scarce
financial resource and ipso facto maximization of the shareholder’s wealth.

6. Financial Control and Reporting: Financial control and reporting is an

important function of the financial manager. He must be able to present a lucid
yet concise financial report that provides management with required
information necessary to take financial decision.

3.3 Objectives of Financial Management

The major objective of management is to maximize the shareholders’ wealth.

The shareholders’ wealth is the present value of future cash flows or present
value of future dividends payable to the shareholders infinitely.

The Shareholders wealth maximization is gradually becoming the single and

narrow objective of firms pursued by financial managers making it the most
fashionable objective of the firm.

This is being achieved through a combination of goals such as:

1. Increase in the market share of the firm

2. Increase in reported profits

3. Continuous survival of the business

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 4. Provision of valued services to customers

5. Ensuring public acceptability of the firm and its products/services

coupled with both social acceptability and legal acceptability.

3.4 Agency Problem in Financial Management

The financial manager is acting as agent for the shareholders of the firm. Thus,
the financial manager is an agent of the shareholders in administering the firm
for attainment of its objective i.e maximization of shareholders’ wealth. Thus,
an agent-principal relationship exists between them. At the same time, the
financial manager stands between the shareholders and the creditors of the
organization, thus an agency relationship existing between the financial
manager and the creditors of the firm.

These agent-principal relationships can cause problem as the financial

manager’s objective or goal might be different from the shareholders’ goals and
that of the creditors might be different from that of the financial manger. For
example, while the shareholders may be pursuing a huge dividend payment
(aim), the financial manager might be pursuing a high retained earning policy.
On the other hand, while the creditors are pursuing quick debt recovery policy
the financial manager may be pursuing high fund re-investment policy.

Thus, the financial manager must strike a balance between all these opposing
negating goals to ensure the sustainable survival of the firm.

In solving the problem therefore:

1. The financial manager must ensure provision of adequate information of

both the creditors and the shareholders.

2. The shareholders can be appointed as directors so as to ensure active

participation in the firm’s activities.

3. The shareholders must have personal knowledge of who the financial

managers are, and at the same time financial managers must have

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 adequate knowledge of who the shareholders are especially of their
varying interests.

4. The financial manager must strike a balance between organizational

goals and the creditors’ interests so as not to operate against the object
clause of firm, otherwise its activities will be declared ultra vires.

5. The financial manager must prevent utilization of short term fund to

finance long term project and vice versa that may breach trust between
the creditors and the firm.

Self-Assessment Exercise (SAE) 2

Briefly discuss the functions and roles of financial management.

4.0 Summary

In this unit, we examined the definitions of financial management. It outlined the major
functions and roles of financial management in an organisation. We also discussed the
problems of financial management.

5.0 Conclusion

Financial management is the process of planning and controlling of the

financial resources of a firm. It includes the acquisition, allocation and
management of firms’ financial resources. The major objective of management
is to maximize the shareholders’ wealth. The shareholders’ wealth is the
present value of future cash flows or present value of future dividends payable
to the shareholders infinitely.

6.0 Tutor-Marked Assignments (TMAs)

1. Explain the concept “Financial Management”

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2. Distinguish between Financial management as an activity and as an academic
discipline?

3. What are the roles of financial managers in an organisation?

7.0 References/Further Reading

Akinde, M.A.O (2006). Fundamentals and Practice of Business Finance. Lagos:

Abioudun-Kinson Nigeria Ltd

Frank, W and Alan, S (2002). Business Accounting. London: Pitman Publishing

Mohammed, S.R (2003). Theory and Practice of Auding. Lagos: Abioudun-Kinson

Nigeria Ltd

Okijo, Y (2000). Financial Management. Lagos: Laco Publishers

Oye, A (2005). Financial Management. Third edition. Lagos: El-Toda Ventures Ltd

Robert, O.I (1999). Financial Management Made Simple. Lagos: ROI Publishers

Terry, L (2003). Management Accounting. London:Gulidfold and King’s Lynn

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 MODULE 1
Unit 2: EVOLUTION AND DEVELOPMENT OF NIGERIAN FINANCIAL
SYSTEM
1.0 Introduction

2.0 Objectives

3.0 Main Contents

3.1 Evolution of the financial system

3.2 The history of the Nigerian financial system

4.0 Summary

5.0 Conclusion

6.0 Tutor-Marked Assignments

1.0 Introduction

In the last unit, we examined the meaning and the functions of financial
management. In this unit, we shall examine the evolution and development of
the Nigerian financial management authorities.

2.0 Objectives

In this unit, our main objectives include:

1. To explain the evolution of financial system

2. To discuss the history of the Nigerian financial system

3.0 Main Contents

The financial system is the totality of institutions, bodies, rules and regulations
governing the flow of financial resources within the economy.

The Nigeria financial system is described as the framework of:

1. Laws and regulations

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2. Financial institutions

3. Practices which direct the flow of financial resources within the economy.

Broadly speaking, “A financial system consists of a network of financial links

between economic units a web of debentures and shares. The financial system
is a superstructure created on the basis of the real wealth of the economy
“Jack revel (1975).

3.1 Evolution of the Financial System

The financial system as it is today developed from the effort of individuals who
productively engage in trade; exchanging goods for goods in what was
primordially denoted as barter, trade by barter evolve the present financial
system. The process succeeds as long as the buyer and seller of equivalent
goods exist. However, with ever increasing volume of activities and the need to
exchange a variety of commodities (of the seller) for a single product and vice
versa, the barter system soon became not only cumbersome but also
inadequate on the one hand, surplus units could not preserve their surplus in
the most convenient form and on the other hand deficit units could not obtain
resource they require in the most convenient form on the other hand.

The poor performance of the barter system soon paved the way for the usage of
gold as a means of exchange. As gold soon became means of exchange good for
good; the higher the quantity of gold you possess the better your capacity to
trade. Gold a commodity in itself soon became what could be exchanged for
other forms of goods and services. Several values exist for several forms of gold
and with these value equivalent amount of goods and services were exchanged.

The gold system was sustained for a long period of time. In England, precious
metals and coins were used almost exclusively as money until the middle of the
seventeenth century. However, in 1640, Charles I appropriated £130,000 worth
of gold held for merchants in the tower of London.

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Thereafter, gold and silver bullion plates were kept in the strong rooms of the
goldsmiths. Eventually receipts for these deposits were accepted in exchange
for goods and so withdrawal of the actual gold and silver became unnecessary.

This was the origin of the bank note and paper currency which soon began
forming an increasing proportion of British money. The paper from which notes
are made is comparatively worthless. However people who receive note are
confident that other too will accept them. The evolution of money in its present
form was the next stage and with money came the need for financial assets and
claims in the form we have them today. The creation of financial assets and
claims was facilitated by the emergence of financial intermediaries, which
perform the crucial function of matching the needs of surplus units with those
of the deficit units. These functions were performed in the form of financial
markets-notably the money market and the capital markets.

The financial institutions, consisting of the money market and the capital
market stand as the major subject of financial system mostly in a developed
economy where the governments play only a little role in the financial
intermediation. However, in a developing nation like Nigeria, the financial
system cannot function without the activities of the government, which makes
for a great player in the financial system. Most times in a nation like ours,
financial intermediation remains at the subsidiary level because non financial
activities are done in Cash rather than through other more articulated means
which avoid the risk of Cash and the cumbersomeness of money.

3.2 The History of the Nigerian Financial System

The history of the financial system in Nigeria could be broadly divided into two
parts namely: the colonial era and the post Colonial era. The post colonial era
could be subdivided into the foundation (or the phase two of the system), the
government intervention (or the phase three) the stabilization Era (or the phase
four).

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The Colonial Era

This era witnessed the initial development of the financial system in the nation.
This era witnessed a period in which the Nigeria financial system remained a
subject of the British financial system. The same rule that governs the British
system operates in Nigeria, primarily edicts and ordinances were used in the
nation; most operating laws were British laws.

The Second Phase (The Financial System Foundation)

The emergence of solid foundation for the Nigerian financial system did not
come until after 1960 when Nigeria became an independent nation. Thus with
the political independence, the Bank of England ceased to be the apex Bank for
the Central Bank. Most operating laws were enacted as laws within the
independent era and the Republican era of 1963.

Most already existing areas of the system received enabling laws, such that the
following laws became operative.

1. Income Tax Management Act 1961

2. Companies Income Tax Act 1961

3. Income Tax Rent Act 1963

4. Lagos Stock Exchange Act 1961

5. Trustee Investment Act 1962

6. Exchange Control Act 1962

7. NPF Act 1961

8. Banking Act 1961

The above laws provided the requisite framework from development of Nigeria
modern financial, system. They provide the basic foundation for the operation
of the financial system. The laws allow for the co-existence of the private and
public sector of the economy which remain inter-independent and the

28
establishment of some regulatory financial institution like the Nigeria
Industrial and Development Bank (NIDB).

The Third Phase: (Government Intervention) 1997

This period witnessed the transformation of the Nigerian financial system. The
major influencing factor of this period is the transition of the major revenue
source to the nation. The transition from agricultural based economy to
dependence on petroleum product, impact greatly on the financial system; the
need to indigenize the industry and the financial sector also come in to focus.
The period witnessed the oil boom era and its emergence impact on the
economy.

This period witnessed the enactment of the following laws:

1. The Capital Gains Tax Act 1967

2. The Companies Act 1968

3. The Companies Income Tax 1979

4. The indigenization Acts 1972

5. The indigenization of Banking and Financial institution 1974

This period also witnessed the birth of several government parastatals such as
industrial and Agricultural Development Corporations in the states, the Federal
Mortgage Bank, other regulatory machineries such as the capital Issue
commission and the Securities and Exchange Commission were also
established. The role of the government in financial intermediation (e.g. in
granting building loans and car loans and handling its own pensions and
gratuity schemes) were also increased. This era witnessed increasing
participation of the government in financial activities either as intermediaries,
regulatory body or direct participant in financial activities. The capital market
benefited a great deal from the development in this era although not as direct
objective of the government but as a bye product (side effect) of the

29
development e.g. the indigenization Decrees led to the going public of the
hitherto private limited liability companies.

The Fourth Phase (The Stabilization Era)

This period commenced from 1979 to date, the period witnessed a lot of
conservative laws being enacted. The downturn in international oil price
witnessed around this period impacted negatively on the Nigerian economy and
Ipso factor the Nigerian financial system. Austerity measures were introduced
to curb the excesses in the economy. The period witnessed the deregulation of
the Nigerian economy when all facet of the Nigerian economy witnessed
deregulation, the banking sector and all other aspects of the financial sector
were also deregulated, including the foreign exchange system. The money
market and the industrial sector were all either partially deregulated or fully
deregulated. This period witnessed what could be called an artificial growth in
the economy, a period of growth without development.

The deregulation of financial sector culminated in the indiscriminate licensing

of Banks and Financial Houses and the proliferation of Banks and other
financial institutions with little or no supervision or control. The result was the
distress in the banking sector witnessed between 1993 and 1995; several
banks became distressed and eventually liquidated due to unscrupulous bank
workers perpetrating sharp practices.

Currently, the financial system is witnessing modification of existing rules and

regulations, more strict control measures are being introduced to the system
and rules and regulations that will guarantee dependability and sustainability
growth are being enacted. Thus, the financial system is a conglomerate of
various institutions, markets, and operators that interact within an economy to
provide financial services. Such services may include resource mobilization and
allocation; financial intermediation and facilitation of foreign exchange
transactions to enhance international trade. The financial system plays a great
role in problems of economic growth and development of a nation. It is the mid-

30
wife of industrial growth of a nation. Over the years the Nigerian financial
system have been undergoing continuous revolution and hence re-positioning
the nation for development growth.
Self-Assessment Exercise (SAE) 1

Explain various stages in the history of Nigerian financial system

4.0 Summary

The unit examined the evolution of financial system. It discussed the major stages in the
evolution of Nigerian financial system. It also examined the various stages in the
development of the Nigerian financial system.

5.0 Conclusion

In this unit, you have leant the nature and evolution of Nigerian financial system. The
unit shows the major development in Nigeria and their functions.

6.0 Tutor-Marked Assignments

1. Explain the evolution of the financial system

2. Briefly explain the stages in the evolution of Nigerian financial system

3. Differentiate between financial system and financial market

7.0 References/Further Reading

Akinde, M.A.O (2006). Fundamentals and Practice of Business Finance. Lagos:

Abioudun-Kinson Nigeria Ltd

Frank, W and Alan, S (2002). Business Accounting. London: Pitman Publishing

Mohammed, S.R (2003). Theory and Practice of Auding. Lagos: Abioudun-Kinson

Nigeria Ltd

31
Okijo, Y (2000). Financial Management. Lagos: Laco Publishers

Oye, A (2005). Financial Management. Third edition. Lagos: El-Toda Ventures Ltd

Robert, O.I (1999). Financial Management Made Simple. Lagos: ROI Publishers

Terry, L (2003). Management Accounting. London: Gulidfold and King’s Lynn

32
 MODULE 1
Unit 3: REGULATORY ANS STRUCTURE OF NIGERIAN FINANCIAL SYSTEM
1.0 Introduction

2.0 Objectives

3.0 Main Contents

3.1 The structure of the Nigerian financial system

3.2 Nigeria financial system regulatory authority

3.3 Financial market

4.0 Summary

5.0 Conclusion

6.0 Tutor-Marked Assignments

1.0 Introduction

In the last unit, we examined the meaning and the functions of financial
management, the evolution and development of Nigerian financial market. In
this unit, we shall examine the regulatory and the structure of financial
management system in Nigeria.

3.3 The structure of the Nigerian financial system

3.4 Nigeria financial system regulatory authority

3.5 Financial market

OBJECTIVE

1. Explain the structure of the Nigerian financial system

2. Understand the functions of regulatory agencies in Nigeria financial
system

33
3.1 Nigeria Financial System Regulatory Authorities

A. The Central Bank of Nigeria

The Central Bank of Nigeria (CBN) came into existence by the CBN Act 1958
which became operative in 1959. The CBN remains the apex regulatory body of
the financial system.

The CBN is responsible for monitoring activities of the Banks (Commercial

Banks, Community Bank etc). The Central Bank of Nigeria is the Banker and
Financial adviser to the Federal Government of Nigeria. The CBN is regarded as
the lender of last resort to the Banks.

Thus, it promotes growth and stability in the financial sector. In 1991 the CBN
assumed the highest controlling authority over the financial institutions by
virtue of Decree 25 of 1991. Also it needs to be stated that in the recent years
the power of the CBN have been grossly increased to enhance efficiency in the
financial sector.

B. The Nigerian Deposit Insurance Corporation (NDIC)

The Nigerian Deposit Insurance Corporations (NDIC) was established by Decree

No 22 of 15th June 1988. It effectively began operations in February 1989. It
provides deposit insurance and related services for the banks, that is, it
provides insurance for deposit with banks in order to promote confidence in the
banking industry. The NDIC is empowered to peruse the books and affairs of
insured banks and other deposit taking financial institutions. Licensed banks
are mandated to pay 15/16 of one percent of their total deposit liabilities as
insurance premium to the NDIC. The depositor’s claim is limited to N 50,000 in
case of banks liquidation. In recent years the CBN and the NDIC have
intensified efforts to ensure that distress in the banking industry is reduced to
the bearest minimum. In 1997 the NDIC became autonomous by the
amendment of the 1988 NDIC decree. It reports now to the Federal Ministry of
Finance.
34
C. The Securities and Exchange Commission (SEC)

The Securities and Exchange Commission (SEC) was established by the SEC
Act of 27th September 1979 (originally known as the capital Issues
commission), which was latter reviewed and enacted by the SEC Degree of
1988, which was established as the apex body in charge of the Capital Market.
Its major function is to regulate activities at the Capital Market and also
promote confidence in the working of the system. It aims at improving public
confidence and participation in the system. It also influences the pricing of
shares and the volume of such shares that could be issued. Additionally it
licenses dealers in securities investment advisers and market places, such as
stock exchange branches with intention of maintaining proper standard of
conduct and professionalism in the securities business.

The company and Allied Matters Decree 1990 further enlarged the
responsibility of the SEC to include approval and regulation of mergers and
acquisitions and the authorization of the establishment of the trustees.
However, with the advent of deregulation, the function of pricing of stock has
been transferred to the issuing house. However, with the advent of
deregulation, the function of pricing of stock has been transferred to the
issuing house. However, the SEC retains the power to maintain surveillance
over the market to enhance efficiency.

In 1993 the SEC issued directives for the establishment of other stock
exchange in other states of the nation in compliance with the deregulation
principle; this was followed by the promulgation of the Nigerian Investment
Promotion Commission Decree No 16 and the Foreign Exchange Monitoring
and Miscellaneous Provisions Decree No 17 also in 1995.

D. The Federal Ministry of Finance

The Federal Ministry of Finance is the Apex Government parastatal controlling

the Fiscal Operations of the Federal Government. The CBN and the FMF prior
to 1991 jointly awarded Bank licenses. However, with the 1991 reform, this

35
responsibility was transferred to the CBN, the CBN now reports to the
presidency through the FMF.

E. National Insurance Commission (NIC)

The national Insurance Commission established by the Insurance Special

Supervision, Fund (Amendment) Decree No 62 of 1992 is charged with the
duties of ensuring effective Administration, Supervision, regulation and
controlling of insurance business. In Nigeria they issue standard of
performance for insurance companies. It also ensures protection of policy
holders and the establishment of a bureau to which complaints are made by
members of the public.

To ensure efficiency and effectiveness of the insurance companies the NIC was
established to take over the supervisory and regulatory role of FMF over the
insurance business.

F. The Federal Mortgage Bank of Nigeria (FMBN)

The FMBN was established to provide banking and advisory services and
research activities pertaining to housing. In 1990 the National housing policy
was adopted and subsequently Decree 3 of January 1991 was promulgated
which empowered the Federal Mortgage Bank of Nigeria to license and regulate
primary mortgage institutions in Nigeria; it thus becomes the Apex regulatory
body for the Mortgage Finance industry. In 1993 a new institution called
federal Mortgage Finance was established to carry out the finance function of
the FMBN, however, the FMBN still retains its regulatory authority. The FMBN
following the recent government directive is now placed under the CBN.

3.5 Financial Market

The Financial Market exists for the purpose of mobilization and intermediation
of funds; that is, through the financial market, funds are transmitted from the
surplus sector of the economy to the deficit unit of the economy. The funds
mobilized might be a short term fund or a long term depending on the nature of
institutions involved and the method of transaction. Funds traded can either
36
be a short term fund long term fund, or medium term fund. The operations of
the financial market involve the commercial banks, the merchant banks, the
development banks, financial houses and individuals. The Financial markets
are generally categorized into two namely: the money market and the Capital
market.
Self-Assessment Exercise (SAE) 1

Mention and explain at least four of the regulatory authorities of the Nigerian
financial system

3.2 The Structure of the Nigerian Financial System

The Nigerian Financial System consists of the regulatory and supervisory

authorities and the banks and non-bank financial institutions.

The regulatory and supervisory authorities include:

1. The Federal Ministry of Finance (FMF)

2. The Central Bank OF Nigeria (CBN)

3. Nigeria Deposit Insurance Corporation (NDIC)

4. Securities and Exchange Commission (SEC)

5. National Insurance Commission (SEC)

6. Federal Mortgage Bank of Nigeria (FMBN)

7. The National Board for Community Bank (NBCB)

The central Bank of Nigeria (CBN) remains the Apex regulatory body, for the
money market. The CBN regulates exclusively the activities of the financial
institutions and specialized financial institutions such as the Nigerian
Industrial Development Bank (NIDB), The Nigerian Bank for Commerce and
Industry (NBIC) and the Nigeria Agricultural and Cooperative Bank (NACB).

The Capital Market is solely regulated by the Securities and Exchange

Commission (SEC) acting as the highest regulatory authority while the stock

37
market activities is being carried out by the Nigerian stock exchange, with
branches in Lagos (Lagos Stock Exchange), and Abuja (Abuja Stock Exchange).

Operators in the Capital Market are the issuing houses, and the stock
brokerage firms and the registrars.

In 1997, the CBN Decree No 24. of 1991 was modified such that with effect
from 1997 the CBN reports directly to the presidency through the Federal
Ministry of Finance. Also by the same token with effect from 1st January 1997,
the CBN assumed the highest controlling authority over commercial bank and
other banking institutions in Nigeria. Thus the CBN now regulates and control
the activities of the Commercial Banks, Peoples Banks, Community Banks,
Mortgage Banks, Finance Houses, Discount Houses, Bureaux de Change and
Development Banks.

4.0 Summary

The unit examined the structure of the Nigerian financial system and the
regulatory authorities in the Nigerian financial system.

5.0 Conclusion

In this unit, you have leant the structure of Nigerian financial system. The unit shows the
major regulatory agencies in Nigeria and their functions.

6.0 Tutor-Marked Assignments

1. State and explain the actors in Nigeria financial markets

2. Differentiate between financial system and financial market

7.0 References/Further Reading

Akinde, M.A.O (2006). Fundamentals and Practice of Business Finance. Lagos:

Abioudun-Kinson Nigeria Ltd

38
Frank, W and Alan, S (2002). Business Accounting. London: Pitman Publishing

Mohammed, S.R (2003). Theory and Practice of Auding. Lagos: Abioudun-Kinson

Nigeria Ltd

Okijo, Y (2000). Financial Management. Lagos: Laco Publishers

Oye, A (2005). Financial Management. Third edition. Lagos: El-Toda Ventures Ltd

Robert, O.I (1999). Financial Management Made Simple. Lagos: ROI Publishers

Terry, L (2003). Management Accounting. London:Gulidfold and King’s Lynn

39
 MODULE 1

Units 4: THE DEVELOPMENT OF NIGERIA CAPITAL MARKET

1.0 Introduction

2.0 Objectives

3.0 Main Contents

3.1 Evolution of the Nigerian capital market

3.2 Characteristics of the capital market

4.0 Summary

5.0 Conclusion

6.0 Tutor-Marked Assignments

7.0 References/Further Reading

1.0 Introduction

In this unit, we discuss the evolution of Nigerian financial market. You will learn about
the characteristics of the capital market and the factors influencing activities in
the capital market. The unit explain the opportunities in the Nigerian financial
market. Also, we shall discuss the functions of the Nigerian financial market.
2.0 Objectives

1. To explain the meaning of capital market

2. To examine the characteristics of the capital market

3. To discuss the function of Nigerian capital market

40
3.0 Main Content

The capital market is the market where long term funds are being raised. It
mobilizes surplus funds from the surplus unit of economy for usage by the
deficit unit of the economy. Instruments traded in the capital market are of
long term in nature. The capital market aside from providing a forum or fund
mobilization, also help in development of investment opportunities, willing
investors can come to the market to buy investment instrument being offered
at the capital market. The growth of the capital market also makes for the
growth of the national economy. The capital market as a whole is a complex
arrangement of institutions and mechanism where medium and long term
funds are pooled and made available to organization, government, and
individuals.

The development of the capital market stems from the realization that
household, corporate and institutional savings can be mobilized and
channelled for investment purpose thereby reducing the clamour for foreign
sources of fund which often times have political and economic strings attached
thereon. The possibility of mobilizing funds domestically through the capital
market induces expansion and growth by the firms through forward and
backward integration which are made possible cheaply.

The growth of any nation economically is measured by the value of its

accumulated wealth and its growth through savings and investment. The
capital market provides funds for such development. The growth rate of capital
market depicts the growth in investment and the productive sector of the
economy at large.

3.1 Evolution of the Nigerian Capital Market

The need to raise funds domestically informed the coming together of some
eminent Nigerian and British national in the corporate world as exists in
Nigeria. They jointly agree on seeking the formation of a forum that will enable
fund on the long term bases to be raised locally, Until then, most times

41
operating firms, borrow fund from the banks (mostly on short term basis) most
of which have foreign nationality ownership. This desire for a capital market
informed the appointment of a committee to advice the Federal Government on
ways and means of establishing a stock market in Nigeria. This committee was
formerly set up by the Federal ministry for Industry in May 1958. The
Committee reported favourably in 1959 on the benefit of such a market. It also
made the following recommendations among others.

1. The creation of facilities for dealing in shares

2. Measures to encourage savings and issue of securities of government and

other organization.

3. The establishment of rules regulating transfers

Thus in 1960 The Nigeria Stock Exchange was first incorporated as the Lagos
Stock Exchange on 15th September as a non profit making private limited
liability company. It actually began operations on 5th June 1961 with an
authorized share capital.

3.2 Characteristics of the Capital Market

The capital market represents the forum for mobilizing long term financial
instrument. The major feature of the capital market involves.

1. Instrument traded in the capital market are intermediate and long term
in maturity, involving both debt and equity.

2. The available financial instruments in the capital market come from five
general categories of users; individuals and household business and
financial corporations; the federal governments; state and local
government and foreign borrowers.

3. The supply of new funds are mainly channelled through financial

institution from the same five sources of fund.

4. The scope of the market covers both long term financial instrument and
medium term financial instruments.

42
5. The long term financial instruments are normally open for trading among
investors in the counter and organized exchange market rather than the
raising of new funds in the primary market.

Factors Influencing Activities in the Capital Market

The activities in the capital market have been mostly influenced by the
government stock holding. Most times government stocks are rigid stocks that
are rarely being traded. However the largest percentage of stock in the capital
market are government stock, thus activities in the capital market are
hampered. However, with the current trend of government divestment and a
gradual withdrawal from participating in investment, it is hopeful that
government stock being sold would stimulate activities in the capital market.

The activities of various institutional investors also impact negatively on the

growth of stock market, since most institutional investors e.g pension fund,
insurances companies, unit trust etc buy stock for almost permanent holding
without necessarily trading in them; this reduces the volume of activities in the
capital market.

However, with the current development and growth in the capital market most
of the problems are being solved. Most especially with the realization that
holding stock for the sake of dividend does not benefit the holder rather trading
them provide the best yield. It is thus hopeful that volume of activities in the
stock market would be on the increase.
Self-Assessment Exercise (SAE) 1

Trace the evolution of Nigerian capital market

4.0 Summary

This unit explains the evolution of the Nigerian Capital Market, characteristics of
the Capital Market and the functions of the Nigerian Capital Market. In the

43
unit, we examine the factors influencing activities in the capital market and
requirements for listing on the NSE

5.0 Conclusion

The development of the capital market stems from the realization that
household, corporate and institutional savings can be mobilized and
channelled for investment purpose thereby reducing the clamour for foreign
sources of fund which often times have political and economic strings attached
thereon.

6.0 Tutor-Marked Assignments (TMAs)

1. Explain the Factors Influencing Activities in the Capital Market

2. List and explain the Characteristics of the Capital Market

7.0 References/Further Reading

Akinde, M.A.O (2006). Fundamentals and Practice of Business Finance. Lagos:

Abioudun-Kinson Nigeria Ltd

Frank, W and Alan, S (2002). Business Accounting. London: Pitman Publishing

Mohammed, S.R (2003). Theory and Practice of Auding. Lagos: Abioudun-Kinson

Nigeria Ltd

Okijo, Y (2000). Financial Management. Lagos: Laco Publishers

Oye, A (2005). Financial Management. Third edition. Lagos: El-Toda Ventures Ltd

Robert, O.I (1999). Financial Management Made Simple. Lagos: ROI Publishers

Terry, L (2003). Management Accounting. London:Gulidfold and King’s Lynn

44
 MODULE 1

Units 5: THE CAPITAL MARKET OPERATIONS

1.0 Introduction

2.0 Objectives

3.0 Main Contents

3.1 Opportunities in the stock market

3.2 Functions of the Nigerian capital market

4.0 Summary

5.0 Conclusion

6.0 Tutor-Marked Assignments

7.0 References/Further Reading

1.1 Introduction

In the last unit we discussed, the evolution and the characteristics of the
capital market in Nigeria, in this unit, we shall discuss the capital market
operation by examining the opportunities in the Nigerian stock exchange and
the functions of the Nigerian capital market.

2.0 Objectives

The objectives of this unit include:

1. To examine the functions of Nigerian Capital market

2. To discuss the roles and benefits of the central securities clearing system

3. To examine the techniques of going public

3.0 Opportunities in the stock market

45
3.1 Opportunities in the Stock Market

Professor Wilson Herbert has outlined some of the major benefits and
opportunities open to investors through active participation in the capital
market as follows:

1. Increased access to sources of funds and growth.

2. The capital market provides huge sources of external fund to the firm
who operates in the capital market. It enhances both the internal and
external growth of the organization. The ability to raise additional capital
is ordinarily easier and more successful where the firm is quoted at the
stock exchange.

Organizations can grow through both internal and external methods. The
internal methods occur through internal organic process while the
external occurs through acquisition of other firms. The stock exchange
listing facilitates the latter process.

Status Symbol

The stock exchange listing facilitates the possibility of a firm obtaining loan
and other financial facilities from the Banking institutions more easily than the
unlisted firms. The stock exchange listing enhances public confidence in the
firm and hence can facilitate the giving of loans to them. Through stock
exchange listing, a firm can seek fund internationally, it is possible for a firm to
be quoted in another country’s capital market. Currently the UBA is quoted in
the American capital market being the second firm in the whole West African
region to obtain such status.

Flexibility of Capital Structure

The availability of the stock exchange finance gives a firm more flexible capital
structure. The debt equity structure of the company becomes easy to alter as
and when deemed fit, the firm can decide to increase equity by issuing more
shares and thus reducing risk and vice-versa as the need arises.

46
Realization of Wealth

Investment conversion becomes very easy with the existence of the capital
market, the investors can at will dispose of their holdings in a firm for cash or
to purchase the equity of other firms. The more the firm grows, the better will
be the value of it shares, investors can realize more value from their initial
investment than when first invested and such benefit could be reaped through
the stock market. Going public, offers investors the opportunity to convert their
securities holdings into cash and in the process increase their wealth.

3.2 Functions of the Nigerian Capital Market

The following are the functions of the Nigerian Capital market

1. The capital market acts as financial intermediary that refocuses

funds from tile surplus sector to tile deficit sector.

2. The Capital market provides corporate organization individuals the

opportunities to raise new funds

3. The capital market provides a market for existing securities and

hence helps in proper valuation of both new and existing classes of
stock.

Nigerian Securities and Exchange Commission (SEC)

The Nigeria Securities and Exchange Commission (SEC) came in to

existence by virtue of the SEC Decree of 1979 which became effective from
1st April 1978 majorly to protect the interest of investors and to oversee
an orderly development of the capital market. The commission is the apex
regulatory body for the Nigerian capital market.

Functions of the Nigerian Securities and Exchange Commission (SEC)

The Major functions of the SEC include the following:

I. Registers all securities proposed to be offered for sale or for

subscription by the public or to be offered privately with the

47
 intention that the securities shall be held ultimately by others than
to those to whom the offers were made or registered Stock exchange
and securities dealers as stated by the Okigbo’s committee on SEC.

2. Determine the amount and the time at which securities of a

company are to be sold to the public.

3. Maintain surveillance over securities market to ensure orderly, fair,

and equitable dealings in securities.

4. Registers stock exchange branches, registrars, investments advisers,

securities dealers and their agents and control and supervises their
activities with a view to maintain in standards of conduct and
professionalism in the securities business.

5. Protects the integrity of the securities market against abuses arising

from the practice of insider trading.

6. Acting as regulating or apex organization for the Nigerian stock

Exchange and its branches to which it would be at liberty to
delegate powers.

7. Create the necessary atmosphere for the orderly growth and

development of the capital market. The SEC is also to undertake
such other activities as are necessary for giving full effect to the
provisions of the SEC decree.

The Central Securities Clearing System (CSCS)

The Central Securities Clearing system (CSCS) rests on the concept which
provide an integrated central depository, clearing (electronic/book entry
transfer of shares from seller to buyer and settlement (Payment for bought
securities) for all stock market transactions. Established in 1992
(stemming from the 1989 conference of the Federation of International
Stock Exchange of which the Nigerian stock exchange is a member) the
Nigerian Stock Exchange endorsed the establishment of CSCS, following

48
the recommendation of a group of 10 private companies which conducted
a research on the operation of the financial market.

Clearing settlement and delivery of transactions on the exchange are done

electronically by the Central securities Clearing System (CSCS). THE CSCS a
subsidiary of the Nigerian Stock Exchange was established as part of the effort
to make the Nigerian Stock Market more efficient and investor – friendly, the
CSCS also offers the custodian services. Transaction cycle currently has been
reduced to four days (T +3) in the CSCS. The CSCS also help eliminate the
bottlenecks between registrars and company Executives in issuing new
certificates to investors.

Stock Market Legislations

Transactions in the stock market are guided by the following legislation these
among others are:

Companies and Allied Matters Act 1990

Investment and Securities Act of 1999

Nigerian Investment Promotion Commission Act of 1995

Foreign Exchange (Miscellaneous Provisions) Act of 1995

Trustees Investment Act of 1990

Pricing Of Issues

The new issues (stock) prices are determined by issuing houses stock/ brokers.
The prices of existing issues in the secondary market are determined by
stockbrokers only. The prices in the stock exchange daily quoted on the stock
exchange financial list.

Benefits of the Central Securities Clearing System

The CSCS though a new system in Nigeria yet holds a great future benefit for
all categories of people dealing with the stock exchange from the investor to the

49
quoted company, to the capital market system itself and to the operating stock
broking firms.

Benefit to the Investor

1) The persistent problem of stolen share certificate will no longer be

relevant no certificates will be issued any longer

2) Speculation becomes easier and minimum risk is involved since

transaction should be concluded within 5 days (now 3 days with the ATS
installed).

Benefit to the Quoted Company

1. There is a great cost reduction since huge money expended in

production and distribution of shares-certificates is now eliminated.

2. The huge manpower formerly concentrated in issuing and signing

share certificates can now be concentrated in doing other jobs.

3. There is rapid increase in trading on companies share certificate.

4. Rapid increase in company capitalization and net worth are being

experienced.

Benefits to the Capital Market

1. The market now witness more transparency.

2. There is improvement in investors’ confidence in the Capital market

system.

3. Turnover in the market has been on the increase.

4. It becomes easy to attract foreign investors.

5. The market's liquidity and vibrancy would be given a boost.

Benefits to the Stock Broking Firms

1. Prompt inter-banks money and stock settlement remain on the

increase.

50
2. Problems of certificate delivery have been eliminated.

3. The stock brokerage firms’ efficiency has been improved.

4. The stock brokerage firms’ operational cost has been reduced

drastically.

Nigerian Stock Exchange (NSE)

The Nigerian Stock Exchange was established in 1960 as the Lagos Stock
exchange, In 1977 it became the Nigerian Stock exchange with branches
established in Kaduna (in 1978), Port Harcourt (in February 1990) in
Ibadan (August 1990) and Abuja area office (in 1999) operations started in
the Lagos Stock exchange in 1961 with 19 securities stated for trading. The
Nigerian Stock Exchange was established a company limited by guarantee.
The emergence of the NSE ended the existence of the Trust Deed
Arrangement which existed before the NSE trough which government
stocks were marketed.

The stock exchange is a market for capital mobilization through which

funds can be raised by public companies and government stock. The stock
exchange primarily is the forum for trading in existing securities of quoted
companies. The facility for trading in existing securities remove the
restrictions that would have prevented individuals from investing their
savings in securities, through this the stock exchange see to the efficient
allocation of available capital funds to diverse uses in the economy. It also
acts as vehicle for broadening the share ownership base of companies, thus
creating wealth in the nation.

Objectives of the Nigerian Stock Exchange

The Nigerian Stock Exchange at inception was set up to achieve the

following objective:

1. To mobilize savings for economic growth.

51
2. To ensure diversion of capital from less productive sectors (like real
estate) to more productive industrial sector.

3. To augment the banking system and ensure the dependence of

government on taxation for economic development.

4. To ensure decentralization of ownership of assess and creation of a

healthy private sector.

5. To avoid or minimize excessive concentration of economic power in

government hands.

6. To avoid or minimize excessive concentration of economic power in the

hands of a small private group.

7. To encourage even distribution of wealth

8. To facilitate co-operation between indigenous and foreign investors in

fostering economic development.

Functions of the Nigerian Stock Exchange

The NSE is saddled with the responsibility of rendering the following

functions:

1. It provides a forum for trading in both existing and new securities e.g..
stocks and debenture.

2. It provides the surplus sector with the opportunities of investing such

funds in profitable ventures.

3 It encourages inflow of funds from the international communities by

enhancing inflow of funds for investment.

4 It provides a means of securing long term funds for commerce and

industrial development

5. It helps in stock pricing by ensuring that the existing new stock and
new stock of similar nature are traded at fair price acceptable to all
parties.

52
6. It facilitates the determination of listing requirement for new s as well
as secondary trading activities by dealers

7. To facilitate provision of information through the daily official list on

securities and performances of participants in the capital market.

It should be stated that the activities of the stock exchange is being controlled
by the Central Bank of Nigeria (CBN); The NSE submit periodic report to the
Governor of the CBN. CBN analysis of the activities of the NSE is majorly on
the gilt-edged securities and industrial stocks and shares. It is also concern
with the number of listed securities and their price.

Requirements for Listing on the NSE

1. The company willing to be listed must have five (5) years successful
trading.

2. The company willing to be listed on the stock exchange must have not
less than N125, 000.00 or 25% of its issued share capital subscribed to
by the public.

3. The company should be a limited liability company (or a public limited

company).

4. The company must submit a duly audited account; such adult must
have been carried out not less than 9 months before submission date.

5. It must submit quarterly and half yearly financial statement to the

exchange after being listed.

6. The company must have at least five hundred shareholders.

However it was discovered that the above criteria may be too difficult to
comply with by small companies willing to go public. As such the rules were
relaxed; this led to the formation of the second-tier Securities

Second-Tier Securities Market (SSM)

53
The second-tier securities market (SSM) is the market in securities of
companies that could not satisfy the requirement for the stock exchange,
that is companies who could not have a full listing however the SSM is still
regulated by the stock exchange.

The following are the requirements for listing in the SSM.

1. The Company should have traded for at least 3 years however the size
of the company is not relevant.

2. The company must be willing to offer at least 10% of her shares for sale
which nominal value should be at least N50,000, also no single
shareholder should own more than 75% of the equity of the company.

3. The total number of shareholders should be at least 100. The company

must equally be willing to sign an undertaking with the stock exchange.

4. The company can only raise a maximum amount of N5 million.

A flat rate is usually levied on such company by the stock exchange

usually this is less than the amount levied on the company quoted fully
on the exchange.

5. Only authorized dealing member of the exchange can trade the shares of
the company.

Advantages of Public Quotation

l. The company can raise funds from the issue of the company shares.

2. The company is regarded as a less risky company than those not

quoted on the exchange.

3. The quoted company most times enjoy fair treatment when

negotiating for loan from banks and other institutions.

4. The quoted company can enjoy the possibility of growth extra

expansion that the unquoted company due to access to greater and
cheaper sources of funds.

54
5. Quoted companies normally enjoy certain boosted status, which can
promote greater customer patronage.

Disadvantages of Public Quotation

The quotation cost could be very expensive to some companies since all the
cost would be borne by the company.

1. The possible dilution of ownership structure remains a problem to

quoted companies.

2. The stringent rules and regulation that may be complied with is a

problem.

3. The quoted company now becomes a public corporate citizen more

information on the company must be made public thus eroding the
secrecy of the firm.

4. The stock exchange listing does impose some administrative cost on

the quoted companies; this might be an extra burden.

Techniques of Going Public

The firm willing to go public must take note of the several possible method of
going public. These are:

1. Offer by Prospectus: Or direct offer: This is a process used when a firm

is willing to raise new fund from the public. It involves public issue of
prospectus; the issued prospectus must comply with the stock exchange
issuing requirements as stipulated by the Companies and Allied Matter Decree
1990 and other rules and regulations governing the operation of the NSE. The
prospectus and the accompanying application form must be published in a
national daily. The copy of such prospectus is made available to the public
through brokers and bankers of the issue.

2. Offer for Sale by Tender: Offer for sale by tender is a method commonly
used when the value of shares to be quoted are not quite known. The issuing
company may not be able to sell all issued shares if the price is too high. Thus,

55
offer for sale by tender is normally being used. This entails a process whereby
the issuing company fixes a minimum price at which the share could be sold
and the call for tender for the shares by the public. The stated price is the
minimum possible share price the public can quote for the share. The share is
being allotted to the highest subscriber bidder for the shares. This is known as
the striking price.

3. Offer for Sale: This process is almost similar to offer for sale by tender:
In this case the new issue (or shares) is being bought by another firm or
merchant bank that is sponsoring the issued shares. He now re-offers the
shares to the public for subscription. The issues are most times publicly
advertised in the dailies for subscribers by the public. Thereafter the allotment
follows due to possibly lower than expected subscription or higher than needed
subscription. There may arise the need for under writing of the share issue

4. Stock Exchange Introduction: This does not involve issuing of shares

(either new shares or existing); A company willing to have quotation on the
exchange may have it shares quoted. This only occurs where shares in large
companies operating in the same industry are already quote by the exchange.
The purpose of this introduction is to improve upon the goodwill of the
company to the public.

5. Private Placement: In this case the company shares are not offered to
the public for purchase. The issuing house only look privately for willing buyers
of the shares. Most times financial institutions are the buyers of such shares.

6. Right Issue: This is a method of raising new fund through the exchange.
In this case however the shares are only made available to existing
shareholders of the firm who can buy the shares at a price higher than the
book value but lower than the market price of the share. Normally the right
issue price is lower then the offer for sales price.

Under Writers and the Under Writing Concept

56
The concept of underwriting is to provide securities for companies willing to
issue shares. The concept enable the issuing company to still be able to
raise the needed amount in case of (under subscription) for its shares i.e.
(the quantity of shares purchased by the public being less than the total
shares issued). The underwriters are financial institutions which agree to
purchase securities which are unsubscribed for by the investing public for
an underwriting commission

The underwriter helps restore confidence in the company in case of under

subscribing if the price is too high, making it too outrageous for the
investing public to buy. In order to save the plan and the investing purpose
of the issuing company from collapse or failure, the under writer purchases
the unsubscribed shares for a commission, the purpose is to re-sell such
shares at a future date. Most times it is only offer for sale that are
underwritten, private placement of shares already have buyer so there is no
need for underwriting. The underwriter most times is the issuing company's
merchant bank.

The Primary Market: It is a market where new issues are being traded. The
mode of offer for the securities traded in this market includes offer for
subscription, rights issues offer for sale and private placements.

The Secondary Market: The secondary market is the market for trading in
existing securities. This consists of stock exchanges and over the counter
markets where securities are bought and sold after their issuance in the
primary market.

The Unit Trust Scheme: This is a system whereby financial resources of

small willing investors are pooled together in order to purchase several
shares to achieve maximum returns with minimum risks through efficient
portfolio diversification. Unit trust schemes normally ensure low-cost and
high profitability in investment portfolio diversification. The CAMD'1990

57
provided for procedure of establishing a unit trust. The first of such trust
was established in December 1990.

Capital Market Instrument

1. Ordinary Shares: The ordinary share is a unit of capital ownership in

a firm in terms of equity investment by the shareholders. The ordinary
shares do attract returns at the end of the trading period (normally 12
months. It accords its holders right of ownership in the asset of the firm. The
ordinary shareholder can vote in the AGM (Annual General Meeting) of the
firm. Currently in a public company no single individual is allowed to own
more than 10% of the total issued shares of the firm. The ordinary share is
assets (a financial asset) that are traded at will. Normally dividends can be
paid as return to holders of ordinary shares. There exist also the preference
shares.

2. Preference Shares: The preference shares are debt instruments in a

firm. The holders of preference share are not owners of the firm since they
cannot vote in the AGM of their firm. Preference share attract fixed dividend
or interest e.g. 10% preference share of N100,000 will attract a finance
interest of N1 0 0 , 0 0 0 . However, the preference share is also regarded as
shares in firm depending on the nature of the preference share. There are
several forms of preference shares. There is the cumulative preference share,
participating preference share convertible preference share, redeemable
preference shares etc.
3. Debentures: These are long term debt securities normally offered for
public subscription. They generally attract a fixed rate of return called
interest. Most times Debentures are securities in a particular asset of the
firm in such case tagged secured debenture. An unsecured debenture is one
not secured on any particular asset of the firm. Debentures are mostly sold
either at premium or at discount.

58
4. Development Loan Stock: These are financial instruments that allow
the government to borrow money for a long period of time up to 25 years,
bearing interest and capital repayment, thereon.
Self-Assessment Exercise (SAE) 1
Explain the various benefits of the Central Securities Clearing System
4.0 Summary

This unit explains the evolution of the Nigerian Capital Market, characteristics of
the Capital Market and the functions of the Nigerian Capital Market. In the
unit, we examine the factors influencing activities in the capital market and
requirements for listing on the NSE

5.0 Conclusion

The development of the capital market stems from the realization that
household, corporate and institutional savings can be mobilized and
channelled for investment purpose thereby reducing the clamour for foreign
sources of fund which often times have political and economic strings attached
thereon. The activities in the capital market have been mostly influenced by the
government stock holding. Most times government stocks are rigid stocks that
are rarely being traded.

6.0 Tutor-Marked Assignments (TMAs)

1. Explain the various benefits of the Central Securities Clearing System

2. Discuss the Factors Influencing Activities in the Capital Market

7.0 References/Further Reading

Akinde, M.A.O (2006). Fundamentals and Practice of Business Finance. Lagos:

Abioudun-Kinson Nigeria Ltd

Frank, W and Alan, S (2002). Business Accounting. London: Pitman Publishing

59
Mohammed, S.R (2003). Theory and Practice of Auding. Lagos: Abioudun-Kinson
Nigeria Ltd

Okijo, Y (2000). Financial Management. Lagos: Laco Publishers

Oye, A (2005). Financial Management. Third edition. Lagos: El-Toda Ventures Ltd

Robert, O.I (1999). Financial Management Made Simple. Lagos: ROI Publishers

Terry, L (2003). Management Accounting. London:Gulidfold and King’s Lynn

60
 MODULE 2

Unit 1: SOURCES OF FINANCE

1.0 Introduction

2.0 Objectives

3.0 Main Contents

3.1 Factors to Consider Before Granting Bank Borrowing:

3.2 Ways of raising 0rdinary shares

4.0 Summary

5.0 Conclusion

6.0 Tutor-Marked Assignments

7.0 References/Further Reading

1.0 Introduction

In the last module, we discussed the meaning and nature of financial management, we
also explained the nature and function of capital market operation in Nigeria, in unit, we
shall discuss source of finance and various ways of raising ordinary share.

2.0 Objectives

At the end of this unit, you should be able to:

1. Explain the various sources of finance

2. Examine the various ways of raising ordinary shares

61
3.0 Main Contents

3.1 Source of finance

Source of finance can therefore be conveniently classified into three groups:

 Short term sources - These are finance sources up to one year.

 Medium term sources - These are finance sources between 1 to 5 years
duration.
 Long term sources - These are finance sources from 5 years and above.

A Short Term Sources

These are financing sources up to one-year duration (i.e. they are repayable
within one year). It is suitable for funding shortages in working capital. They
should not, if it can be avoided, be used to finance a long-term investment. A
company that funds long term project with short term funds may be forced to
renegotiate a long-term loan under unfavourable condition or to sell the asset,
which is needed for the continuation of the business. In addition, where short
term sources are recalled by the holders, a company might find itself in a
position of technical or legal bankruptcy. The main methods of obtaining short-
term funds arc:

1. Borrowing from friends and relations

2. Borrowing from co-operatives
3. Trade credits (i.e. Suppliers) - The use of credit from suppliers is a
major source of finance. It is a facility granted to a company by a
supplier since the system allows the company to pay at a later date. The
cost of cash discount is depicted as follows:

Cost of Cash Discount (i.e. Implied cost) = % Discount X 365

100% - %Discount CN - CD
Where:

CN = Maximum payment period

62
 CD = Maximum discount period

4. Accruals - These are deferred payment on items like salaries and wages,
rent, tax. Accruals are amount owing on services rendered to firms for
which payments have not been made. The amount owed is a source of
finance. E.g. wages, tax payable etc.
5. Bank borrowing -This usually takes two forms namely: Bank overdraft
(E.g. Drawings Against unclear Effect Facility) and Bank loan facility.
Bank rate is negotiable with Central Bank of Nigeria requirements and
the cost to the company is calculated as follows:

Cost of the overdraft = Interest payment X 365 .

Total sum utilized Period of Loans
Factors to Consider Before Granting Bank Borrowing:

- The purpose for which the advance is required

- The Amount of the advance
- The Repayment term of the advance
- The Term of payment (i.e. how could the advance be paid?)
- The Collateral security of the advance
- Does the Character or record of the customer justify the advance?
- What is the Capital structure of the borrowing company?
- How Credible/Credit-worthy are the owners of the business?

Documents to be Requested Before Granting Bank Borrowing

a. Application requesting for the loans.

b. Memorandum of Association

c. Articles of Association

d. Names, Address & Particulars of the Directors

e. List of directors' shareholding.

f. Boards Resolution

63
g. Certificate of Incorporation

h. Collateral Security including personal guarantee of the Managing Director.

i. Audited Account of the company.

j. Management Accounts & Reports of the company.

k. Cash flow projection of the company.

l. Acceptance of the offer letter (by affixing company seal & two directors or a
director & secretary must sign on behalf of the company).

6. Speeding up payment from Trade debtors (Customers) - This depends

on the availability of sound credit control and reminder system.

7. Debt Factoring - A factor is an agent that manages trade debts.

Factoring involves turning over the responsibility for collecting a firm's
debt to specialist institution. A factor agent usually offers three main
services namely:

- Taking over the management of clients sales ledgers.

- Insuring their clients against the risk of bad debts.
- Providing finance by means of advances against the security of trade
debtors.

8. Bill of Exchange - This is a form of short term finance used in trade

financing. A bill of exchange is one method of settlement in a trade
between a seller and a buyer. A bill of exchange takes two forms:

 Trade Bills - These are bills of exchange in which the buyer

acknowledges it by writing accepted across it and signing it.
 Bank bills - These are bills or exchange drawn on a bank, which will
accept them. This is known as acceptance credit.

9. Invoice Discounting - This is similar to factoring except that only the

financing service is used meaning that the copies of company's invoices
sent to customers are discounted with a financial institution and the

64
 trading company still collects the debt as agents for the financial
institution and remits the cash on receipt to the account open for that
purpose.

10. Commercial paper - This is a short term and an unsecured money

market instrument used to invest company's surplus. Large companies
with good credit rating can raise short-term funds by issuing commercial
notes, which arc then purchased by investors in the money market. The
financial institution does not guarantee the notes but assists in finding
investors to buy them. The investors effectively lend directly to the
company issuing the notes. The financial institution charges commission
for the service.

B Medium Term Sources

These are financing sources between 1 to 5 years duration.

1. Medium Term loans: These are usually issued for a definite period when
compared with overdraft. This is a negotiated loan between a financial
institution and a company between 1-5 years, usually at a fixed rate of
interest. Medium Term Loans in form of bank lending can be secured or
unsecured. Unsecured lending is not common and is only available to
credit worthy companies. Secured lending requires heavy collateral
securities and proper evaluation of credit worthiness of all customers are
also considered.
2. Hire purchase agreement: This is in form of a credit sales agreement by
which the owner of the assets or supplier grant the purchaser the right to
take possession of the assets but ownership will not pass until all the hire
purchase payment has been paid. The purchaser will pay the hire
purchase payment over an agreed period. No form of collateral is required.
It is normally reflected in the balance sheet of the borrower. It reduces the
gearing ratio and increases ability to raise further finance. It also attracts
capital allowance.

65
3. Lease: A lease is a contractual agreement between the owner of an asset
(lessor) and the user of the asset (lessee) granting the user or lessee the
exclusive right to use the asset for an agreed period in return for the
payment of rent. The main advantage of lending to a lessee is the use of
an asset without having to buy. This conserves an organization's funds.
There are two major types of lease:
 Finance leases (or full payment leases/ capital leases): The finance
lease is non-cancellable. The lessee is responsible for the upkeep,
insurance and maintenance of the leased asset. Finance lease is an
example of off-balance sheet financing. It is off balance sheet because
sources of financing fixed asset are not shown as liabilities on the
balance sheet.
 Operating leases: With operating lease, the owner (lessor) is
responsible for the upkeep, insurance, servicing and maintenance of
the leased asset
4. Sales and leaseback: This is an arrangement by which a firm sells its
assets to a financial institution for cash and the financial institution
immediately leases it back to the firm.
5. Venture capital: This is a major source of capital for SMEs and
collapsed businesses. The provider of finance might decide to participate
in the company instead of allowing the client to run the business himself.
The participation might be in the form of equity or debenture stock.
Small companies normally require this type of finance because of their
inadequate collateral securities and poor management skills and talents.
It is otherwise known as business angel.
6. Project finance: This requires evaluation of the company and its project.
The project itself serves as a collateral security for the fund. It is a risky
source of finance if the project fails. However, the financial institution
should request for additional collateral security.

66
C Long Term Sources

These are financing sources of 5 years and more duration.

1. Loan Stock/Debentures: This is long-term debt finance raised by a

company for which interest is paid usually at a fixed rate. The company
must pay the interest whether it makes profit or not. Loan stock also has
a nominal value of ₦100. Debentures are a form of loan stock that is
legally defined as the written acknowledgement of a debt incurred by a
company usually given under company seal and containing provisions as
to the payment of interest and eventual repayment of principal.

Loan stock and debentures are often secured. The security can take the
form of fixed charge (usually on a specific asset/ property). Floating
charges (charge on certain asset of the company e.g. stock/property).
Floating charges can crystallize to a specific security if the company
defaults in meeting its obligations under the terms of loan/debenture.
Loan stock/debentures also are unsecured. However only high credit-
worthy companies can issue unsecured loan stock. The interest on
unsecured loan stock is usually higher than that of a secured loan stock.
Loan stock and debentures are usually redeemable, irredeemable and
convertible. The interest payments on loan stock/ debentures are
allowable for corporation tax.

The higher the loan stock/debentures in a company's capital structure,

the higher the gearing or leverage. Gearing or leverage increases financial
risk of a company since interest must be paid irrespective of profitability.

2. Preference Shares: The holders of preference shares are entitled to a

fixed percentage dividend before ordinary shareholders can be paid
any dividend. Preference shares are a form of hybrid security between
ordinary shares and debentures. These are often issued as an
alternative to debt when the company pays no tax. Preference shares
can be redeemable or irredeemable.

67
 3. Ordinary Shares: Ordinary shareholders are the owners of the firm.
They exercise control over the firm through their voting rights. A firm
contemplating on raising funds through ordinary shares will incur
floatation cost/issue cost.

Ways of Raising Ordinary Shares

 Public Subscription (Stock Exchange Introduction): This is an

invitation to the public at large so as to invite them to subscribe for
share in the company. The public issue must comply with CAMA 1990.
This is also known as Initial Public Offering (IPO).

Techniques of Conversion

 Conversion Price (CP): It is the nominal value of convertible security

that can be converted into one ordinary share. It represents the effective
price of ordinary shares paid for on conversion. CP can be derived as
follows:

Conversion Price = Market Value/Nominal value of Convertible security

Number of ordinary shares issued on conversion
 Conversion Rate (CR): It is the number of convertible security that
could be exchanged for new ordinary shares or security. It is expressed
as follows:

Conversion Rate= Number of ordinary shares issued on conversion

Market value/nominal value of converted security

 Conversion Value (CV): It is the market value of ordinary shares into

which unit of stock or convertible security will be converted. This is
expressed as follows:

Conversion Value = Conversion Rate X Market Value per share

68
 Cost of option to convert: At the point of conversion, the holder of such
security has two options i.e. to convert and not to convert. The cost of
option is derived as follows:

Cost of option = Actual price of convertible security - Conversion price

Conversion Rate
 Conversion Premium/Discount: This is the difference between the
conversion price and market price.

NOTE:

i) Where conversion price is greater than (>) market price of share, it is

equal to discount.
ii) Conversion premium/discount could be presented in form of yield i.e.

Conversion Yield is known as: Premium/Discount X 100

Conversion Price 1

 Bonus/Script/Capitalization issue: This is issued to existing

shareholders by whom further shares are credited as fully paid-up out of
the company’s reserves in proportion to existing holdings. This is known
as capitalization of reserves.
 Offer for sale: This is where a company issues its shares for public
subscription through an issuing house in which the sales proceeds go to
the existing shareholders not the company. Simply put, offer for sale is
the sale of existing shares by existing shareholders but not a fresh issue
of shares. This method was used by Daar Communication Plc and all the
proceeds were paid directly into Daar Holding Plc for the existing
shareholders of the company.
 Offer for Sale by Tender: This is when a company’s share is being
issued out by a company to the public asking the price that all intending
shareholders can subscribe. This is referred to as striking price and the

69
 stock exchange will ensure that all shares are taken up at the striking
price.

4. Retained Earnings: This is a part of a company’s profit not paid out as

ordinary dividend. It is also a source of financing. It is a cheap source of
raising finance as compared to share issue because no issue cost is involved.
Raising funds through retained earnings avoid dilution of control since there
is no share issue to outsiders. Retained earnings are an important source of
financing for companies that do not have access to the capital markets.

Self-Assessment Exercise (SAE) 1

Briefly explain the three major sources of finance

4.0 Summary

In this unit, we examined the three major sources of finance and the prerequisites for
each source. We also discussed the process of raising shares at the capital
market.

5.0 Conclusion

The business organisation must ensure that their business is finance using the
cheapest and the most convenience sources the government and its
department must also finance their activity at the lowest cost for the highest
effectiveness. It is therefore of value to consider the various sources of finance
to the business organisation
6.0 Tutor-Marked Assignments

1. Explain the various ways of raising ordinary shares

2. Discuss the techniques of Conversion

70
7.0 References/Further Reading

Akinde, M.A.O (2006). Fundamentals and Practice of Business Finance. Lagos:

Abioudun-Kinson Nigeria Ltd

Frank, W and Alan, S (2002). Business Accounting. London: Pitman Publishing

Mohammed, S.R (2003). Theory and Practice of Auding. Lagos: Abioudun-Kinson

Nigeria Ltd

Okijo, Y (2000). Financial Management. Lagos: Laco Publishers

Oye, A (2005). Financial Management. Third edition. Lagos: El-Toda Ventures Ltd

Robert, O.I (1999). Financial Management Made Simple. Lagos: ROI Publishers

Terry, L (2003). Management Accounting. London: Gulidfold and King’s Lynn

71
 MODULE 2

UNIT 2: RIGHTS ISSUE

1.0 Introduction

2.0 Objectives

3.0 Main Contents

3.1 The meaning of right issue

3.2 Factors to be considered when setting The Price of a Right
3.3 Theoretical Right issue
4.0 Summary

5.0 Conclusion

6.0 Tutor-Marked Assignments

7.0 References/Further Reading

1.0 Introduction
In module one you have leant the meaning of financial management and the regulatory
agencies in Nigerian financial system. In this unit, you will learn the meaning of right
issue and the factors to be considered when setting the price of a right issue.
2.0 Objectives

At the end of this unit, you should be able to:

1. Explain the meaning of right issue

2. Discuss the factor to be considered setting the price of a right issue

72
3.0 Main Contents

3.1 The meaning of right issue

A right issue is an issue of new shares to existing shareholders in proportion to
the number of shares already held by each shareholder. This enables existing
shareholders to subscribe cash for shares in proportion to their existing
holdings. The price at which the new shares are issued by the company is
always below the current market price of the shares so as to encourage the
existing shareholders to take up the issue.

Options open to shareholders when a right issue is made (i.e. Premptive

rights of existing shareholders)

1. Subscribe for the new shares: If the shareholders have sufficient cash
resources to buy the new shares and they feel that the company will use
the money so raised to finance a profitable investment opportunity, then
they should take up all the rights.
The new shares are acquired without the need to pay stamp duty or
brokerage commission provided it is the original shareholder that takes
up the rights.
2. Sell part and buy part: If the shareholders feel the new shares are worth
having but they lack the cash to pay for them, they can sell sufficient
part of the rights to enable them to take up the balance.
3. Sell the rights: If the shareholders are not happy about the rights issue
they should sell the rights. Usually, the rights are sold via a broker who
will charge brokerage commission.
4. Do nothing at all: If the amount payable for the new shares has not
been received by a stipulated deadline, the company will sell the new
shares in the market. The shareholders will receive the sales proceeds of
the new shares less the rights price and any expenses.

73
3.2 Factors to be considered when setting the Price of A Right Issue

a) The existing/ current share price

b) Current price of comparable stocks
c) The reasons for the issue
d) The size of the issue and ability of the shareholders to subscribe
e) Any current government controls

3.3 Definition of Rights issue terms

Theoretical Ex-right price/value: This is the new market price that arises as
a result of an adjustment to allow for rebate price of the new shares. This can
be calculated as:

Theoretical Ex-right price/value= Total Investment in all new shares

Total number of shares after the rights
OR

(Market Value of old shares Theoretical value or the new shares)

Total number of shares after the rights
OR

(Number of shares in issue X market price)+(Number of rights shares X price

of right shares)
Total number of shares in issue after the rights

Theoretical Nil price or The value of the rights: When the right issues are
made usually at a rebate price, automatically again will occur to shareholders.
This gain is called Nil price and is calculated as follows:

Theoretical Nil price/value= (Theoretical Ex-right price/value minus Right

issue price)

 Placement issue: This is an arrangement whereby a new issue of shares is

not offered to the general public but is placed to a number of institutions
such as Pension fund, Insurance Company etc.

74
  Conversion of shares: The conversion of other securities into ordinary
shares.

Theoretical Right issue

Example1

Today’s ltd has 80million ordinary share of N4.00 each and has recently
decided to raise further capital through a 1 for 4 right issue just before the
issues was announced the market price of the ordinary share was N5.00 and
the right was put at N4.80

Required

A) Compute the theoretical ex-rights value of the and the theoretical nil
paid value of the right
B) Advice an existing shareholder of 5000 ordinary share of the possible
course of action available to him in respect of his entitlement
Solution N

(i) 4 existing share at N5 20

1 right issue at N4.8 4.80
24.80

Theoretical ex- right value = 24.80 = N4.96

5
Theoretical Nil-paid value
= Theoretical ex- right value – Right price

= N4.96 – N4.8
= N0.16

(ii) The course of actions available to the holder of 5000 shares are

a) Sell all the right

b) A mixture of sell and buy(take the right )

Sell all the right

75
 Proceed of sales (5000/4) 1250 x 0.16 = 200

Value of the original investment 5000 x 4.96 = 24800

25000
Subscribe fully

Value of investment 6250 X 4.96 = 31000

Less

Cost of investment 1250 x 4.80 = 6000

25000
Mixture of buy and sell

Let us assume that the shareholder sold a units of the shares

Cash received will be N0.16x

Total number of shares remaining will be 1250 – X

Cost of the remain share = (1250 - X) 4.80

Total value of the right 0.16X

Therefore

0.16X = 4.80(1250 – X)

4.96X = 6000

X = 6000 = 1210
4.96
The right to be taken the shareholder does not want a change in the cash
position is 1250 – 1210 = 40

Therefore he should sell 1210 shares and subscribe for 40 shares

Self-Assessment Exercise (SAE) 1

Explain the options open to shareholders when a right issue is made

76
4.0 Summary
In this unit, we examined the meaning of right issue. It gives some examples of
theoretical right issue. The unit also outlined the factor to be considered setting the price
of a right issue.
5.0 Conclusion
A right issue is an issue of new shares to existing shareholders in proportion to
the number of shares already held by each shareholder. This enables existing
shareholders to subscribe cash for shares in proportion to their existing
holdings.
6.0 Tutor-Marked Assignments (TMAs)

1. Explain the meaning of right issue

2. Discuss the factor to be considered setting the price of a right issue

7.0 References/Further Reading

Akinde, M.A.O (2006). Fundamentals and Practice of Business Finance. Lagos:

Abioudun-Kinson Nigeria Ltd

Frank, W and Alan, S (2002). Business Accounting. London: Pitman Publishing

Mohammed, S.R (2003). Theory and Practice of Auding. Lagos: Abioudun-Kinson

Nigeria Ltd

Okijo, Y (2000). Financial Management. Lagos: Laco Publishers

Oye, A (2005). Financial Management. Third edition. Lagos: El-Toda Ventures Ltd

Robert, O.I (1999). Financial Management Made Simple. Lagos: ROI Publishers

Terry, L (2003). Management Accounting. London:Gulidfold and King’s Lynn

77
 MODULE 3

Unit 1: TRADITIONAL METHODS OF INVESTMENT APPRAISAL

1.0 Introduction

2.0 Objectives

3.0 Main Contents

3.1 The meaning of payback period

3.2 The advantages and disadvantages of payback period
3.3 Average return on investment
4.0 Summary

5.0 Conclusion

6.0 Tutor-Marked Assignments

7.0 References/Further Reading

1.0 Introduction

The Payback period method:

The principle behind the Pay back method has more regard for liquidity than
profitability. It is a measure of liquidity over cost. (or initial outlay).

Advantages of Pay Back Period

1. It is easy to understand and estimate.

2. It is liquidity based; rather than profitability, thus seems more

acceptable where liquidity stands as the main factor to be
considered.

3. It is less forecast biased sensitive, unlike other investment criterion

used.

4. It is suitable for use in an unstable economic environment

78
Disadvantages of Pay Back Period

1. It disregards the time value of money.

2. It disregards all cash inflows which occur after the payback period.

3. It is not an objective criterion for decision-making

4. If it is not properly applied (Invoked). It may lead to wrong decision-

making

5. It is highly subjective in nature.

Illustration 1

Two projects A and B with the following relevant information

A outlay = 200,000

Inflows year 1 = 60,000 Year2 = 80,000, Year 3 = 80,000 Year 4 =100,000.

Project B: outlay = 200,000

Inflows Year 1 = 80,000 Year 2 = 80,000 Year 3 = 40,000 Year 4 = 60,000

Year 5 = 60,000

Compute the payback period.

Project A Cash flow Cumulative

Y0 (200,000) (200,000)
Y1 60,000 140,000
Y2 80,000 60,000
Y3 80,000
Y4 100,000

Actual payback 2 years + 60,000

80,000 yrs

2yrs + 0.75 yrs

79
 2.75 years.
Project A Cash flow Cumulative

Y0 (200,000) (200,000)

Y1 80,000 120,000
Y2 80,000 40,000
Y3 40,000

Y4 60,000
Y4 60,000

N.B Where there is equal annual cash inflow or where the stream of cash
inflow is the same over the life span of the project, then the pay back
formula becomes

I
= Cn

I= Initial cash outlay

Annual cash inflow
In the above fisher's interception model, Project A intercept pro at remaking
project B more preferable.

N.B In the above illustration, the payback period of project A is cumbersome

to ascertain from the tabulated computation. This is largely due to the fact
that the streams of cash inflows are the same over period of the project's life.
Thus, a formula will help to allay this uncertainty, in the case where the
streams of cash inflows are not the same over the life span of project.

Pay back period = L + I - CFL

A (L+1)

Where L = the last complete year in which cumulative net cash are less than
the initial investment (outlay)

I = initial cash outlay (investment)

80
CFL = Cumulative cash inflow at period L

A (L+I) Actual cash inflows at the period immediately after period by

applying the above formula, we have to identity the last period with
negative cumulative flows i.e.-(60,000) for Yr2: -It -is discovered that at
the end of this Yr2 (2nd year) N 140,000 out of the N200;000 has been
realized. Meaning that the remaining N60,000 difference has to be
accounted for in the 3rd year say mid of the Yr3.

Average Return on Investment

It is otherwise known as the average accounting rate of return (ARR). It is

used in measuring the rate of return to investment..

The formula used is as follows:

ARR = Average profit

Average investment
Where:

Average profit (AP) = Total Profit Generated

No of years

Average investment = Initial cash outlay - S

2

Illustration 2

Mary & Co. invested N2, 000,000 in a certain investment yielding the
following capital inflow after tax:

Year 1 100,000

Year 2 200,000

Year 3 50,000

Year 4 40,000

81
Given that the life span of the investment is 4 years and having 10%
interest rate per annum for the life of the asset, you are required to
compute the average Return on Investment (R.O.I)

Solution

Total profit 100,000 + 200,000 + 50,000 + 40,000

`= 390,000
4

= 97500

Oshogwemoh

Average investment = 300.000 = 50,0

R.O.1 = 97500

150,000 = 0.65

R.O.1 = 65%
4.0 Summary

The various methods of appraising investment project was covered, this is meant to be a
guide to manager in decision making

5.0 Conclusion:

The students can use the internal rate of return, the net present value the probability index
and the accounting rate of return to make decide profitability of investment project and be
able to identify those the form can engage in and those they will not accept based on their
profitability or otherwise.

6.0 Tutor-Marked Assignments (TMAs)

82
1. Explain the merits and demerits of payback period

2. Identify the major features of Investment Appraisal Method

7.0 References/Further reading

Akinde, M.A.O (2006). Fundamentals and Practice of Business Finance. Lagos:

Abioudun-Kinson Nigeria Ltd

Frank, W and Alan, S (2002). Business Accounting. London: Pitman Publishing

Mohammed, S.R (2003). Theory and Practice of Auding. Lagos: Abioudun-Kinson

Nigeria Ltd

Okijo, Y (2000). Financial Management. Lagos: Laco Publishers

Oye, A (2005). Financial Management. Third edition. Lagos: El-Toda Ventures Ltd

Robert, O.I (1999). Financial Management Made Simple. Lagos: ROI Publishers

Terry, L (2003). Management Accounting. London:Gulidfold and King’s Lynn

83
 MODULE 3

Unit 2: SCIENTIFIC METHODS OF INVESTMENT APPRAISAL

1.0 Introduction

2.0 Objectives

3.0 Main Contents

3.1 Investment Appraisal Method

3.2 Net Present Value Method

4.0 Summary

5.0 Conclusion

6.0 Tutor-Marked Assignments

7.0 References/Further Reading

1.0 Introduction

The financial manager in the private and public organisations must

decide which investment opportunity must be accepted among available
opportunities. The risk and return factor on such investments must be
given adequate thought. To successfully accomplish these, the financial
manager will have to appraise available investment opportunities to
ensure making the right decision.
2.0 Objectives
By the end of this study, you will be able to:
1. Explain the investment appraisal method
2. Identify the problems associated with Net Present Value Method

84
3.0 Main Contents

3.1 Investment Appraisal Method

There are two groups of investment appraisal methods. The first group
involves considering the time value of money, while the second method
does not give any cognizance to the time value of money. The methods are:

1. The payback period

2. Average annual rate of return on investment.
3. The net present value method.
4. The internal rate of return method.
5. Profitability index (Benefit-cost ratio) method
6. The net tern final value method.

The payback period method and the average annual rate of return on
investment (or Accounting Rate of Return) method fall under the
traditional method of investment appraisal because they do not consider
the time value of money. The remaining methods give cognizance to the
time value of money. They are equally called the scientific method of
investment appraisal.

Time Value of Money

The net present value and the Internal Rate of Return (IRR) incorporate
time value of money. The time value of money concept states that the
value of N1 today will not be the same in a year's time, due to depreciation
in the real value of naira. In order words, what a naira can buy today in a
year’s time an amount above a naira would be required to purchase that
same article. Thus a naira invested today should yield an amount over
and above the naira invested. Devaluation of money allows for this.
However in a relatively stable economy, the interest rate could be taking
to account for devaluation in naira. The interest rate per naira is the

85
compensation for the loss of value by the naira amount. Hence the
interest rate is used for discounting.

Money and Real Interest Rate

The scientific method assumes therefore that the interest rate used is the
real interest rate and not the money interest rate. The real interest rate is
the after tax interest rate while the money interest rate is the before tax
interest rate. The scientific method makes use of the real interest rate
asking for granted that inflation rate will be equal the tax rate. Since
normally the value of good should only be inflated by the tax paid thereon.

For example the money interest rate is 20% and the tax rate is 30% the
real interest rate will be (1-0.30) (20%) (0.70) (20%) = (14%).

Self-Assessment Exercise (SAE) 1

Explain the two groups of investment appraisal methods.

3.2 Net Present Value Method

The net present value method is the total present value of a project which
should be greater than the initial capital outlay of the project before such
project could be accepted. The decision rule is that:

Total present value > capital outlay: accept the project

Total present value < capital outlay: reject the project

Illustration 1

A company wishes to invest N40,000 in a project which has a 6 year life

span. With Net cash inflow as follows:

Year 1 100,000

Year 2 20,000

Year 3 50,000

Year 4 60,000

86
Year 5 100,000

Year 6 100,000.

The interest rate of 10% is acceptable for the project acceptability should
this project be accepted?

SOLUTION:

Time Cash Flow DCF (10%) FV

Year 0 400,000 1 (400,000)
Year 1 100,000 0.909 90900
Year 2 200,000 0.826 165200
Year 3 50,000 0.75 1 37550
Year 4 60,000 0.683 40980
Year 5 100,000 0.621 62100
Year 6 100, 000 0.564 56400
NPV 53130
DECISION RULE

Since the present value, is more than the initial outlay we will
accept the project.

INTERNAL RATE RETURN

The internal rate of return is the interest rate or rate of return which
produces a cumulative present value that is equal to the initial outlay.
t P
P0 = ∑ (1+ r)t
n-1

t t
∑ Rn (1+r) -n ∑ Cn (1+r) -n
n-1 n-1

Where r = internal rate of return. The internal rate of return method helps
to strike the point where the present value of inflows equals the initial
outlay. That is NPV= Cumulative present value-Initial outlay =0

87
LINEAR INTERPOLATION

Using the principle of similar triangle, a formula could be obtained for the
internal rate of return. This method entails deriving two Net Present Values
(NPVs) from two interest rates applied. One of the two NPVs must be
negative and the other positive. These Net present values and the
associated interest rates can now be used to secure the internal rate of
return. It is otherwise known as Linear Interpolation Method.

VP
IRR = R 0 + (RN - RP)
(V p + V N)

OR
RN - VN
(Rn – R p )
VP + V N

IRR = LR + [ NPVp ] (HR-LR) Recommended for examination

purposes.

NPVp-NPVN

Source : the author

Where

RP =Interest rate of positive net present value

RH = Interest rate of negative net present value

VP = Positive Net present value

VN = Negative Net Present Value.

| | = Means absolute term, which is addition of both positive NPV and negative
NPV.

LR = The rate that produce positive NPV

88
HR= The rate that produce negative NPV

NPVP = Positive NPV

NPVN = Negative NPV

ILLUSTRATION 2

A company wishes to invest a sum of N350,000 in a project view the

following net cash inflows for 5 years.

Year 1 200,000

Year 2 100,000

Year 3 100,000

Year 4 40,000

Year 5 10,000

The acceptable interest rate is 10%.

You are required to compute

1) The Net present value

2) Internal rate of return for the project

SOLUTION
Time Cash Flow DCF PV DCF PV
(10%) (16%)
Year 0 (350,000) 1 (350,000) 1 (350,000)

Year 1 200,000 0.909 181800 0.862 172400

Year 2 100,000 0.826 82600 0.743 74300

Year 3 100,000 0.751 75100 0.641 64100
Year 4 40,000 0.683 27320 0.552 22080

Year 5 10,000 0.620 6200 0.476 4760

23020 (12360)

89
2. To compute IRP

Rp + Vp (RN - Rp)
(Vp + VN)

10% + 23020 (16-10)

[23020 + 12360]

10% + 3.90 = 13.90

OR

16 - 12360 (16-10)
[23020 + 12360]

16-2.096

=13.90

PROBLEM WITH NPV

There are several problems inhibiting the usage of NPV as a method of

project evaluation.

1. Multiple Internal Rates of Return:

This is a situation whereby a negative inflow occurs during the project's

life. While the Net present value of the project is still positive in this
case multiple internal rates of return will exist thus making our result
ambiguous.

2. The Re-investment Rate Problem of the IRR and NPV

The internal rate of return assumes that cash inflows are re-invested at
the internal rate of return margin.

90
 On the other hand the Net present value (NPV) principle assumes that
inflows of cash are reinvested at the NPV rate. This can yield a different
final result.

Two projects with the same internal rate of return of 20%

Project Price Cash inflow (yr1) Cash inflow (yr2)

A 75 15 19

B 75 60 36

The company reinvested at a rate of 3% per annum.

Project 1

Yr 1 15 x 1.03 = 15.45

Yr 2 inflow = 19.00
34.45
Project 2

Yr 1 60 x 1.03 = 61.8

Yr 2 inflow = 36.0
97.8
3. Independency of Project (3): The Net present value principle (NPV)
assumes that project A is different from project B, project B is different
from project C etc.
NPV

B
A

A B

91
In the above, project B must always be preferred to A. However, this may not
always hold. In a situation of Non-independence where a project is assumed
to be the best now turns out to be false off.

Advantages of NPV

1. It considers the time value of money unlike the payback period

2. It considers the cash inflows both during and after the period i.e. over
the project's entire life.

Disadvantages of NPV

1. It is cumbersome and difficult to compute.

2. It is not suitable for project with different cash inflows

Net Terminal Value (NTV)

The net terminal value is a compounded value of the net present value of the
life of an asset or project obtained by compounding all the cash flows to the
end year of the life span of the project.

Illustration 4

A project with cash flow of 250 and having inflow of

Year 1 60

Year 2 120

Year 3 80

Year 4 80

The rate of interest for the project being 10%, compute the net terminal
value of the project.

92
Solution

There are two methods in solving the above problem.

Method I

-250 (1.1)4 + 60 (1.1)3 + 120 (1.1)2 + 80(1.1)' + 80(1.1)°

- 250 (1.4641) + 60 (1.331) + 120 (1.21) + 80 (1.1) 80 (1)

- 366.025 + 79.86 + 145.2 + 88 + 80

= 27.035

= 27.

Methods 2

Using the NPV method:

Time Cash flow Df (10%) PV

Year 0 (250) 1 (250)

Year 1 60 0.909 54.54

Year 2 120 0.826 99.12

Year 80 0.751 60.08

3
Year 4 80 0.683 54.64

18.38

NTV = 18.38 (1.1)4 = 26.91

= 27

Profitability Index or the Benefit Cost Ratio

This is the ratio of present value of project life to the initial capital outlay.

Profitability index (P.T) = PV

Outlay
Or

93
Profitability index = NPV
Outlay

Illustration 5

From Illustration 4, compute the profitability index of the project.

P.T = 268.38

250 = 1.07352

Illustration 6

ABC Ltd is planning to replace two of his machine with a new model because of
the maintenance cost of N 5,000. One of the two old machines is considered to
be expensive. The old machines are being depreciated over a period of 10 years
on a straight line basis. The estimated scrap value after 10 years is N900.00 for
each machine while the current market value is estimated at N1, 500.00 each.
The annual operating costs for each of the old machine are as follows:

Materials 90,000

Barbar- 1 operator for 2,000 hrs 2,025

Variable expenses 1387

Maintenance (excluding any compulsory expenditure) 3,000

Fixed expenses: Depreciation 135

Fixed Factory overhead 4,050

94
The new machine has an estimated life of 8 years and will cost N 100,000
made up of ex-showroom price of N87,000.00 and installation cost of
13,000.00. The scrap value after 8 years is estimated at N4,500.00 the
operating costs of the new machine are estimated as follows:

N
Materials 162,000
Labour -3 operators at 1,800 hrs 3,900
Variable expenses 2,274
Fixed expenses:
- Depreciation 11,938
Fixed Factory overhead 7,800
Maintenance 4,500
24238
The company's cost of capital is 10% and projects are evaluated on basis of
rate of returns. In addition to satisfying the profitability test, projects are
also required to satisfy a financial viability test by meeting 5 year pay-back
condition.

You are required to:

a. Advise management on the profitability of the proposal by applying a

discounted cash flow technique to calculate the internal rate of
return.
b. Subject proposal to a financial viability test, and
c. Comment very briefly on two other factors that could influence the
decision of management in respect of this proposal.
d. (Assume that residual value is received on the last day of the
machine’s working life and ignore taxation).

95
Present value of N1 for 8 years
Annuity
Ordinary
At 10% 5.335
0.4665

At 20% 3.837
0.2326
(ICAN MAY 1985 Q.1)
Answer
a. Operating Cost –Old
Machines

Materials N (90,000 x 2) 180,000

Labour, N (2025 x 2) 4,050

Variable expenses N(1387 x 2) 2,774

Maintenance 6,000
Total 192,824
Operating Cost-Proposed
Machine
Material 162,000
Labour 3,900
Variable expenses 2,271
Maintenance 4,500
Total 172,674

Savings per annum if new machine is bought

= N(192,824 - 172,674)

= N20,150

Internal Rate of Return

96
NPV AT 10%

Initial Outlay = N(100,000 – 3,000) 97,000

NPV of savings = 20150 x 5.333 107,500.25

NPV of scrap value = 4500 x 0.46645 2,099.25

NPV 12,599.50
NPV at 20%
Initial Outlay (100,000 - 3000) (97,000)
NPV of savings = 20,150 x 3.837 77,316
NPV of scrap value = 4t,500 x 0.2326 1,046.70
NPV (18,637,75)

IRR = 10% + [ 12599.5 ] 20% - 10%

12599.5 + 18637.75

= 10% + 4%

= 14%
Financial Viability Test
Y r. Cash Flow Cumulative Cash flow
0 -97,000 97,000
1 20,150 76,850
2 20,150 56,700
3 20,150 36,550
4 20,150 16,400
5 20,150 3,750
6 20,150 +23,900
7 20,150 +44,050
8 20,150 +64,200
9 4,500 +63,700
Payback period= 4 year + 16400 x 12 months)
20150

97
 = 4 years + 9.767 months

= 4 years, 10 months.

Two other factors that can influence the decision of management in respect
of this proposal are:

(i) Taxation: The timing of taxation should especially take capital

allowance into consideration. In this type of investment appraisal as this will
affect the cash flows from the project.

(ii) Inflation: In an inflationary situation, the existing techniques for

investment appraisal (NPV, IRR) are inadequate unless certain.

Adjustments are made, because real purchasing power is constantly being

eroded. Unless this erosion is taken into account company will find that
‘profitable' investment could actually turn out to be seriously unprofitable.

Self-Assessment Exercise (SAE) 2

Discuss the problems associated with Net Present Value Method

4.0 Summary

The various methods of appraising investment project was covered, this is meant to be a
guide to manager in decision making

5.1 Conclusion:

The students can use the internal rate of return, the net present value the probability index
and the accounting rate of return to make decide profitability of investment project and be
able to identify those the form can engage in and those they will not accept based on their
profitability or otherwise.

98
6.0 Tutor-Marked Assignments (TMAs)

1. Explain the merits and demerits of payback period

2. Identify the major features of Investment Appraisal Method

7.0 References/Further reading

Akinde, M.A.O (2006). Fundamentals and Practice of Business Finance. Lagos:

Abioudun-Kinson Nigeria Ltd

Frank, W and Alan, S (2002). Business Accounting. London: Pitman Publishing

Mohammed, S.R (2003). Theory and Practice of Auding. Lagos: Abioudun-Kinson

Nigeria Ltd

Okijo, Y (2000). Financial Management. Lagos: Laco Publishers

Oye, A (2005). Financial Management. Third edition. Lagos: El-Toda Ventures Ltd

Robert, O.I (1999). Financial Management Made Simple. Lagos: ROI Publishers

Terry, L (2003). Management Accounting. London:Gulidfold and King’s Lynn

MODULE 3

Unit 3: INVESTMENT DECISION UNDER CONDITION OF UNCERTAINTY

99
1.0 Introduction

2.0 Objectives

3.0 Main Contents

3.1 Risks in Investment Decision

3.2 Expected Net Present Value/Expected Value Method

3.3 Sensitivity Analysis

4.0 Summary

5.0 Conclusion

6.0 Tutor-Marked Assignments

7.0 References/Further Reading

1.0 Introduction
Making investment decision many at times involve making several estimate due
to uncertainty and risk in economic environment. Most time, it is not always
easy to make decision with absolutism on the result of a particular venture due
to uncertainty and risky economic environment. Thus, uncertain estimates
will be given cognizance by the financial manager, to allow for variability in
returns.

Where the possible outcome can be determined, as well as possible probability

of return, with good sense of accuracy, it mean that situation of uncertainty is
in place. However, outcome or return cannot be estimated when a risky
situation is in place. In risky situation, there is no solution to problems that
may exist.
2.0 Objectives

100
At the end of this unit, you should be able to:

1. know the risks in investment decision

2. to understand the meaning and nature of Expected Net Present
Value/Expected Value Method
3. explain sensitivity analysis

3.0 Main Contents

3.1 Risks in Investment Decision

Where possible outcome or return cannot be estimated with probability of

occurrence, a risky situation is said to be in place. Under risk, the financial
manager might not be able to proffer any reasonable solution to the problem on
hand. In fact, there is no decision rule in such a case.

Methods used under Risk and Uncertainty

1. Payback period method.

2. Finite horizon method.

3. Expected value method/Expected net present value.

4. Standard Deviation & variance method.

5. Risk premium method.

6. Sensitivity analysis method.

7. Decision tree method.

8. Simulation.

9. Certainty equivalent.

10. Capital asset pricing model (CAPM).

11. Portfolio theory.

3.2 Expected Net Present Value/Expected Value Method

101
Under this condition, the probability of occurrence of an event is already
known. Where fair probability of occurrence is attached, the result obtained is
a product of the various probabilities observed and the possible return on the
investment.

Illustration

A project has an initial capital outlay of N30,000, generating return 30,000 in

year one, 40,000 in year two, 60,000 in year three with a probability of 0.3 in
year 1, 0.30 in year 2 and 0.4 in year 3, and interest rate of 10% per annum.

Should project be undertaken?

Cash Expected Present

Time Probability DF (10%)
Flow Cash Flow Values PV
Y0 (30,000) 1 1 1 (30,000
Y1 30,000 0.3 9,000 0.909 8,181
Y2 40,000 0.3 12,000 0.826 9,912
Y3 60,000 0.4 24,000 0.751 18,024
Expected
6117
NPV
Decision rule: Undertake the project, since it has positive NPV
Self-Assessment Exercise (SAE) 1

Explain various methods used under Risk and Uncertainty

3.3 Sensitivity Analysis

The sensitivity analysis measures the margin of safety. It measures the least
price for which a product can be sold that will not result into loss. It is the
margin of safety beyond which stock must not go down else, will result into
loss. In the production section, it is known as the `buffer stock'. In sales it is
the least price that may be offered without making loss. In project appraisal,
sensitivity margin can be calculated as shown below.
Sensitivity margin = NPV
APV of measured variables
102
APV = Accumulated present value.

Illustration 2

Omotesho & Co. plans to invest the sum of ₦750,000 in a project which has a
life span of 5 years and generating 20,000 units of koko-product annually.
The selling price is ₦50 per unit of Koko, and a variable cost of ₦30 per unit
of the product. Annual fixed cost amounts to N150, 000, and the associated
cost of capital is put at 15%.

Required:

(1) Should Omotesho & Co invest in the project?

(2) Compute the sensitivity analysis of the project.

Solution:

Annual contribution (20,000 x 20) 400,000

Less: Fixed Cost (150,000)

Annual Net Cash Flow 250,000

Year initial outlay 750,000

Year 1-5 cash flow at 15% (3.35 x 837,500

250,000)

NPV
87,500

Computation of sensitive analysis

1. Contribution
S.M (sensitivity margin) NPV = 87,500

103
 APV of Contribution. 3.35 x
400,000

= 6.53%

This simply implies that sales volume can be comfortably reduced by

6.53% without resulting into loss.

2. Selling Price
S.M = 87,500

S.M = 87,500
3.35(20,000 x 50)

= 2.612%

This shows the maximum percentage decrease possible in selling-price,

i.e. should selling price fall by 2.612% or more, the project will not be
profitable.

3. Variable Cost

S.M (of variable cost) = 87500 = 4.35%

3.35 x (20,000 x 30)
This shows the maximum percentage increase possible on variable cost.

4. Fixed Cost

S.M = 87500 =
17.41%
3.35 x 150,000

= 17.41%

This shows the maximum percentage increase that is possible in fixed cost.

5. Outlay 87,500 = 0.1167 x 100%

750,000

104
 = 11.67%

6. Project Life

To calculate the sensitivity margin for the project life, the assumption
is that the project’s life could be reduced more than 5yrs, without any
effect on the profitability of the project.

Project Inflow = N250,000

Cost of project (initial outlay) = 750,000

A{1 – (1+ r)-n } - Outlay = 0
r

250,000{1- (1.15)-n} – 750,000

0.15

1- (1.15)-n = 750,000 x 0.15 = 112,500 = 0.45

250,000 250,000

1 – 0.45 = (1.15)-n

(1.15)-n = 0.55

ILLUSTRATION 3

Risi Ltd A. novelty Toll Company is considering whether to produce a new toll
called spymen and a special machine having no other use would be required
which would cost N2,000.

The company’s cost of capital is 5%. The direct cost of a spyman is expected to
be N1 and whatever the number sold, the price will be N2. The demand for the
toll is not likely to last more than three years. The sales in each year are highly
uncertain.

The directors of the company have estimated the various possible levels of
demand in each of these demands as in the table below. Because the nature
of the products, the level of demand achieved in any one year is independent
of that obtained in any other year.

105
 Year 2 Year 3
Year 1 Sales in
Probability Sales in Probability Sales
Probability Units
Units in Units
0.2 500 0.2 250 0.2 100
0.2 1,000 0.3 500 0.2 250
0.4 2,000 0.3 750 0.3 500
0.1 2,500 0.1 1,000 0.3 750
0.1 3,000 0.1 2,000 - -

The preliminary design studies for the `spyman' have already bee completed
at a cost of N1,000. If the project is rejected, they could be sold for N250.

Required

(a) Calculate the project's expected net present value.

(b) Would you necessarily recommend acceptance if this value were

positive? Specially, how would your conclusion be affected if the
company were:

(i) One-man firm with no other project available except to invest at

its cost of capital, and the N2,000 required to 100 finance the
project was the entrepreneur's life-time saving

(ii) A very large company undertaking many large projects.

(ICAN May 1986).

Answer
Year 1 Year 2 Year 3
Prob. Unit Expect Prob. Unit Expect Prob. Unit Expected
ed ed Units

106
 Units Units

0.2 500 100 0.2 250 50 0.2 100 20

0.2 1,000 200 0.3 500 150 0.2 250 50
0.4 2,000 800 0.3 750 225 0.3 500 150
0.1 2,500 250 0.1 1,000 100 0.3 750 225
0.1 3,000 300 0.1 2,000 200 __ -___ - _ -___
1.0 1650 1.0 725 1.0 445

Yr1 Yr2 Yr3

N N N
Sales value 3,300 1,450 890
Less direct cost 1,650 725 445
Cash flow 1,650 725 445

Note: Sales value = Expected Unit X N2

Direct Cost = Expected Unit X N 1

Project's Net Present Value

Yr Discount Factor PV
Cash Flow
@5%
0 -2000 1 -2000
1 +1650 0.9524 +1571.45
2 +725 0.9070 +657.58
3 +445 0.8638 +384.39
N613.43

(b) If the Net present value of this project is positive but not more than
N250 it will not necessarily be recommended since the company can
realize N250 now if the project is not undertaken. If any case, the
company will also consider the correlation of this project's cash flow
to the cash from other investments of the company.

i) If the company is a one-man with no other project available

except to invest at its cost of capital, and the N2,000 required

107
 to finance the project was the entrepreneur's life-time saving, it
would be advisable to carry out a sensitivity analysis of the
projects variable (Nos of years for the product's demand, sales
price, direct cost) to see how the adverse changes in those
variables will affect the project's net present value before
investing on this project, else, putting the amount on a deposit
account with the bank may be a better alternative.
ii) If the company is a very large company undertaking many
large projects, the company may only need to decide on
whether the project is positively or negatively correlate with the
other project of the company before investing in it. If negatively
correlated, the company, to balance other project's risk may
want to undertake the project. Also, if the project is very
important to the achievement of cash flow from other profitable
projects, the company may not need to look at this project in
isolation but in conjunction with those projects

4.0 Summary

This unit explains the risks involved in investment decision. It examines the various
methods used under Risk and Uncertainty with practical examples. The unit
also explain sensitivity analysis in investment decision

5.0Conclusion

The student will be able to use the sensitivity analysis, expected net presnt value method
and the decision tree method in decision making analysis and for management use.

6.0 Tutor-Marked Assignments

108
1. Explain the importance of Sensitivity Analysis

2. Discuss the various methods used under risk and uncertainty

7.0 References/Further Reading

Akinde, M.A.O (2006). Fundamentals and Practice of Business Finance. Lagos:

Abioudun-Kinson Nigeria Ltd

Frank, W and Alan, S (2002). Business Accounting. London: Pitman Publishing

Mohammed, S.R (2003). Theory and Practice of Auding. Lagos: Abioudun-Kinson

Nigeria Ltd

Okijo, Y (2000). Financial Management. Lagos: Laco Publishers

Oye, A (2005). Financial Management. Third edition. Lagos: El-Toda Ventures Ltd

Robert, O.I (1999). Financial Management Made Simple. Lagos: ROI Publishers

Terry, L (2003). Management Accounting. London:Gulidfold and King’s Lynn

MODULE 3

109
UNIT 4: LEASING

1.0 Introduction

2.0 Objectives

3.0 Main Contents

3.1 The Meaning of Leasing

3.2 Types of Leasing Agreement

3.3 Advantages and Disadvantages of Leasing

3.4 Process in Lease Finance Calculations

4.0 Summary

5.0 Conclusion

6.0 Tutor-Marked Assignments

7.0 References/Further Reading

1.0 Introduction
In the last two units, we have discussed investment decision under condition of certainty
and uncertainty. In this unit, we shall discuss the meaning, types, merits and demerits of
leasing.

2.0 Objectives
By the end of this study, you will be able to:
1. To understand the meaning and types of leasing agreement
2. To know the merits and demerits of Leasing
3. To understand the process in Lease Finance Calculations
110
3.0 Main Contents

3.1 The Meaning of Leasing

Leasing is a contractual agreement between two people, where the right to

use the asset is transferred by the owner (the Lessor) to the (Lessee) for an
agreed period of time and for a consideration called "Lease rental".

The lease rental usually is paid at an agreed time either monthly, quarterly,
half-yearly or annually. The cash flow and profit generation of the leasing
must be considered when fixing the periodic lease rental payment. There is
the primary lease agreement and the secondary lease agreement.

The primary lease agreement entails payment of both the asset cost and the
profit thereon for a period of 4 years to 5 years.

The secondary lease is a perpetual lease agreement with a nominal lease

rental being paid.

Lease rental could be paid up-front in which case more rental is paid at the
initial life of the asset and less rental paid at the later life of the asset.
Where the lessor pay less rental at the initial life of the asset and higher
rental toward the end of the asset's life is known as BACK-ENDED lease.

3.2 Types of Leasing Agreement

Finance Leasing and the Operating Leasing are the two major types of
leasing agreement.

Finance Lease

Finance lease is mostly undertaken by banks and non bank financial

institutions. Finance lease is equally known as "Capital on full payout
lease" It relies on the proceeds from the lease rentals in the primary lease
period to recover both the industrial and trade margins.

The aggregation of the primary lease rental covers either the initial capital
outlay or cost of the asset and some amount of rents or returns on the

111
investments. The secondary lease rental account majorly for return on the
leased asset. The risk on the asset and cost of maintenance remains the
function of the leasee. He claims the capital allowance on the asset. Infact
the right of ownership after the payment of the primary lease rental is
transferred to the lessee.

All insurance cover on the asset is done by the lessee. The secondary lease
period rental payment non-time account for only the recovery of the assets
salvage value on the asset leased.

Operating Lease

In operating lease the asset cost is not wholly amortized during the primary
lease period; the lessor while giving the lessee the use of the asset retains
practically all risk, obligations, and ownership (in regard like early
obsolescence, appreciation in value) of the asset.

This occur where the owner of the asset sells the asset to a leasing company
transferring the ownership right to the leasing company however retain the
usage of the asset for a payment of lease rental to the new owner (the
lessor).
Self-Assessment Exercise (SAE) 1

Explain the major types of leasing agreement

3.3 Advantages and Disadvantages of Leasing

Advantages of Leasing

Purchase Price: The initial capital outlay which is natural in purchase of

asset is avoided in leasing. Such huge amount can be invested in some other
profitable investment. Leasing thus provides liquidity for the business
organization.

Off-Balance Sheet Financing: Leasing being an off-balance sheet financing

(operating leasing presents a strong but cheap means of financing to the

112
business organization). The business can make use of the asset without
necessarily buying it.

Where an asset is needed for a few time period it will make no sense buying
such an asset where leasing can be done. Leasing thus provide opportunity
to use an asset for a few period without having to incur huge purchase cost
and thus scraping the asset just after a few period. This account for while
why conglomerates lease vehicle rather than out rightly purchase them.

Illiquidity: Most times investor may not be liquid enough to take bank loan,
for asset purchase but by leasing such asset could be easily acquired.

Risk Transfer: The risk of obsolescence involved in dynamic assets is easily

transferred to the lessor in the leasing agreement under an operating leasing
agreement. This enables the lessee to cancel his agree in case the asset
becomes obsolete.

Disadvantages of Leasing

Loss of Claim on Depreciation: The capital allowance is normally claimed

by the lessor in operating leasing rather than such benefit accruing to the
use the asset.

Ownership Right: The ownership right in operating leasing belongs to the

Lessor; hence the user/Lessee will not have full authority on the asset(s).

3.4 Process in Lease Finance Calculations

Three cases are available under leasing decision. For the Financial Manager,
they are:

1. Obtain a loan to finance the purchase of the asset.

2. Purchase the asset from company purse.

3. Lease the asset.

Decision Criterion (Where the company is in a taxable position.

113
Step 1: Compute tax benefit on the interest on loan and tax benefit
capital allowance.

Tax benefit on Interest = Tax rate X Interest on loan

Step 2: Compute the cash repayment using amortization method. Cash
repayment =
Loan or r(Loan)
1 – ( 1 + r)n 1(1 + r)-n
r

Step 3: Multiply the annual repayment by number of years total cash

repayment.

Step 4: Deduct tax benefit on interest and capital allowance from annual
cash repayment to get real annual cash paid.

Step 5: Compute the present value of net cash repayment.

CASE 2: Leasing

Follow the first 5 steps above.

Leasing Or Buying Decision

Step 6: Compare the present value of net cash repayment and loan with
present value of net cash repayment and leasing.

Step 7: Accept the method that yields the least cost.

ILLUSTRATION 1

David Kenny Plc. have just secured a profitable investment opportunity

using an asset with initial capital outlay of N2 million with a zero residual
value after 6 years.

The Financial Manager of the Company is considering the method of finance

to adopt. Two opportunities are available.

1) The usage of loan with a 20% interest, with a constant annual

repayment.

114
2) Finance by leasing from a leasing company at an annual rental
N600,000.00

Capital allowance on the asset is 20% straight line over 6 years. The
company income tax is 35%. The company cost of capital is 13%.

Required:

Advice the company on which of the two options to select where the,
company is in a taxable position.

Answer

1. Prepare an amortization schedule for the loan in order to identify the

annual repayment and tax savings on the interest.

Step 1: 1 – (1 + r)-n = 1 – (1.20)-6

r 0.20 = 3.3255

Therefore, annual repayment = ₦2,000,000 = ₦601,413

3.325
Year payment
1. 601413
2. 601413
3. 601413
4. 601413
5. 601413
6. 601413

Capital Allowance = ₦2,000,000 = ₦333,333.

6

Repayment Schedule
Year Capital Annual Cash Interest Capital Balance

115
 B/F Paid 20% Repaid
1. 2,000,00 1,798,58
601,413 400,000 201,413
0 7
2. 1,798,58 1,556,89
601,413 359,717 241,695.6
7 1
3. 1,556,891. 1,266,85
601,413 311,378 290,035
4 7
4. 1,266,85
601,413 253,371 348,042 918,815
7
5. 918,815 601,413 183,763 501,170 501,165
6. 501,165 601,413 100,233 501,180 NIL

Time Saving on Saving on Capital Total Benefit

Interest Allowance
Yr1. 140,000 116,667 256,667
Yr2. 125,900 116,667 242,567
Yr3. 108,982 116,667 225,650
Yr4. 88,680 116,667 205,347
Yr5. 64,317 116,667 180,984
Yr6. 35,082 116,667 151,749

NB: Saving on interest = 20% of capital balance multiply by 35% capital

balance saving on capital allowance = capital allowance multiply by 5%.

OPTION 2
NCF DCF PV

116
 Year

Item lease rental 0-5 600,000 4.5172 2710200

Tax saving in rental 1-6 210,000 3.998 (839580)
Tax saving on capital 2-
116,667 3.5376 (412721)
allowance 7

1457899

Advice: It will be advisable for the company to lease the asset than for loan to
purchase the asset.

Illustration 2

Assuming from the above that the company is in a non-taxable position.

Answer

Note: Where the company is in a non-taxable position then there shall be no

tax benefit on both capital and interest on loan or lease.

Loan will be: 601413 @ 3.998 = 2404450

Lease Rental amount 600,000 @ 4.5172 = 2710320

In the above case it will be better for the company to take loan for the
purchase of the asset.
Self-Assessment Exercise (SAE) 1

Explain the major challenges of leasing

4.0 Summary

In this unit, you have learnt the meaning of leasing, the major types of leasing agreement.
We have also explained the merits and demits of leasing and the Process in Lease
Finance Calculations

117
5.0 Conclusion

In this unit you have studied the various methods used in calculating lease finance and
the adaptability of leasing technique to business finance of assets .

6.0 Tutor-Marked Assignments

1. Explain the major types of leasing agreement you know

2. Discuss the major challenges of leasing

7.0 References/Further Reading

Akinde, M.A.O (2006). Fundamentals and Practice of Business Finance. Lagos:

Abioudun-Kinson Nigeria Ltd

Frank, W and Alan, S (2002). Business Accounting. London: Pitman Publishing

Mohammed, S.R (2003). Theory and Practice of Auding. Lagos: Abioudun-Kinson

Nigeria Ltd

Okijo, Y (2000). Financial Management. Lagos: Laco Publishers

Oye, A (2005). Financial Management. Third edition. Lagos: El-Toda Ventures Ltd

Robert, O.I (1999). Financial Management Made Simple. Lagos: ROI Publishers

Terry, L (2003). Management Accounting. London:Gulidfold and King’s Lynn

118
 MODULE 4
Unit 1: COST OF CAPITAL

1.0 Introduction

2.0 Objectives

3.0 Main Contents

3.1 Cost of Capital

3.2 Types of Cost

3.3 Cost of Preference Share.

4.0 Summary

5.0 Conclusion

6.0 Tutor-Marked Assignments

7.0 References/Further Reading

1.0 Introduction

In the last unit, we looked at the meaning of leasing, various types. We also examined the
merits and demerits of leasing and the process in lease finance calculation. In this unit,
we shall examine cost of capital, its usage and various types.
2.0 Objectives

In this unit, you will be able to;

1. Understand the meaning of cost of capital and its usefulness

2. To examine the opportunity Cost of Capital

119
3.0 Main Contents

3.1 Cost of Capital

It is the minimum required rate of return on investment. It is the present value

of future stream of Net Cash flow on investment.

It is also the minimum value per share in the capital market.

The usefulness of Cost of Capital

1. It is an important tool in capital budgeting decision.

2. It is a useful measurement of the firm's financial performance

3. It is a tool of financial decision making.

4. It can be used in selecting source of finance; as cost of capital the market

is known the Financial Manager can select a cheap source of fund.

5. It is also important in dividend policy formulation and working capital

management

3.2 Types of Cost

Future Cost: Are expected cost associated with investment.

They are those costs used in appraising investment opportunities when

matched with future benefits or expected returns on the investment, it will
produce the net return on such investment. Future cost of fund is also used as
discounting factor.

Historical Cost: These are past financial expenditures used in securing a

future benefit. It is the sacrificing of present consumption (in investment) for
future consumption benefit

Explicit Cost: The explicit cost of capital is that cost of capital that equates
the present value of future incremental cash inflow with present value of future
incremental cash outflow. That is, the cost of debt, equity etc.

120
Opportunity Cost of Capital/Explicit Cost of Capital: It is the cost of
alternative project forgone for the purpose of investing in the selected projects.
Explicit cost of capital becomes relevant only when there are several possible
investment opportunities to be selected from.

VALUATION OF SECURITIES

Debt (Irredeemable debenture)

The cost of Debt is the internal rate of return on Debt; that is the cost at which
the present value of incremental cash inflow equals the present market value
(or purchase cost) of the asset.

N0 = 1(1 + r)-1 + (1 + r)-2 + I(1 + r)-3

N0 = EIn(1 + r)-n

I = 1 or 1 = I

Where N0 = Net cash inflow in year zero

I = Cash inflow in year 1 to year n

N = Number of years

R = Interest rate

Note: This is the cost of irredeemable Debt e.g. irredeemable debenture.

Illustration I

Kemi-Alabi purchased a 15% irredeemable debenture for N100 ex-interest.

Compute the cost of debt.
Answer: Cost of Debt = 15
100 = 0.15

Cost Of Redeemable Debt: (e.g. Debenture)

The cost of redeemable debt is calculated using the internal rate of return
method. This represents the discount rate that equates the current market
value (ex-interest) of the debenture with the present value of associated future

121
cash inflows. These are the interest payable annually plus the redemption
value in the year of redemption.

i=1
VRD = ___I__ + ___I__ + ___I__ + ___R__
(1 + r)1 (1 + r)2 (1 + r)3 (1 + r)n

Where R(1 + r)-1 = Present value of redemption value

VRD = Value of redeemable debenture

R = Interest rate

I = Interest recovered

Illustration: 1

Kolade bought a 12% redeemable debenture, redeemable at par in 10 year’s

time. The current market value of the debenture is N80, associated tax is
40%. What is the cost of the redeemable debenture?

Answer

Yr 0 Current market value = N80 (outflow)

Yr 1 - 10 Interest net of tax = N12 (1- 0.4) = N 7.20

Yr.10 Redemption value= N100 (i.e. at par) (inflow)

Time NCF NCF PV DCF at PV

10% 13%
Yr 0 80 1 (80) 1 (80)

Yr 1- 7.20 6.144 44.24 5.426 39.067

10 29
Yr 10 100 0.38 38.00 0.29
_
2.24 (11.933)
By interpolation,

IRR =

122
 10 + __2.24___ (13 – 10)
(2.24 + 11.931)

= 10.47%

Self-Assessment Exercise (SAE) 1

Explain the major usefulness of cost of capital

3.3 Cost of Preference Share.

Irredeemable preference share/redeemable preference share

Preference share is assumed to be debt in nature because a preference

shareholder is entitled to fix Dividend like the Debenture holder that earn fix
interest rate. Thus in computing the cost of preference shareholder same
method used in Debenture cost calculation is used.

Cost of irredeemable preference share will be.

Cost of irredeemable preference share:

No = D (1 + Kp)-1 + D (1 + kp)-2 + D (1 + kp)-3

Where No = Net cash inflow in year zero

Kp = Rate of return on preference share

D = Dividend received

R = Number of year.

Redeemable preference share

VRP = ___I__ + ___I__ + ___I__ + ___I__
(1 + kp)1 (1 +kp)2 (1 + kp)3 (1 + kp)n

Note: This can only be solved by using interpolation i.e. the internal rate of
return method.

123
Cost of Equity (Ordinary Share)

The ordinary share are irredeemable, they earn dividend however the
dividend can be growing dividend; that is, where the Dividend grows, at a
particular rate annually.
KE = D
P
Where KE = Cost of equity

D = Dividend

P = Market value

G = Growth rate.

Cost of Equity with Issuing or Floatation Cost

KE = D__
P-X

Where D = Dividend

KE = Cost of equity

X = Flotation or issuing cost.

Illustration

The issue price of- a share is N30 and issue cost are 30k per share. New
shareholders expect constant annual dividend of 50 kobo. What is the cost
of equity?

KE = 0.5 = 0.50
30 – 0.3 29.7 = 0.0168 = 1.682%
Dividend Growth Model

No shareholder in real life expect a constant dividend for a long time his
investment. Thus most times the dividend is assumed to increase or grow
annually.
MV (Ex-div) = Do(I+g) + D(I+g)2 + D (1 +g)n
(I + ke) (I+ke)2(I+ke)n
124
Most time a constant dividend increase for perpetuity is assumed.
MV = D0(I +g)
Ke-g
KE = D(I +g) + g
MV
KE = d +g
MV

Where

D = D(I+g) = Dividend in year I

KE = Cost of share

MV = Market value.

Growth Calculation

g= (n-1) Latest Dividend

Earliest Dividend

Gordon Model of Dividend Growth Calculation

g = rb

b = retention rate

r = return on capital employed rate

i.e return rate on capital employed

EPS = Earning per share

APS Asset per share
b = EPS - DPS
EPS
rb = (EPS – DPS X EPS ) = EPS - DPS
(EPS APS) APS

125
4.0Summary

The method of calculating the various cost of financial assets was discussed which
include ordinary share debenture and other bond. the various techniques of those
appraisals and their market value was also discussed

5.0 Conclusion

The student will be able to apply the knowledge gained to making market decision on
when to use a means of finance and when not to use it it will be of value in deciding
whether to go for finance by equity or debt

6.0 Tutor-Marked Assignments

1. Explain the meaning and various types of cost

2. Identify the Importance of Cost of Preference Share.

7.0 References/Further Reading

Akinde, M.A.O (2006). Fundamentals and Practice of Business Finance. Lagos:

Abioudun-Kinson Nigeria Ltd

Frank, W and Alan, S (2002). Business Accounting. London: Pitman Publishing

Mohammed, S.R (2003). Theory and Practice of Auding. Lagos: Abioudun-Kinson

Nigeria Ltd

Okijo, Y (2000). Financial Management. Lagos: Laco Publishers

Oye, A (2005). Financial Management. Third edition. Lagos: El-Toda Ventures Ltd

Robert, O.I (1999). Financial Management Made Simple. Lagos: ROI Publishers

Terry, L (2003). Management Accounting. London:Gulidfold and King’s Lynn

126
 MODULE 4
UNIT 2: WEIGHTED AVERAGE COST OF CAPITAL

1.0 Introduction

2.0 Objectives

3.0 Main Contents

3.1 Weighted Average Cost of Capital

3.2 Importance of Weighted Average Cost of Capital

4.0 Summary

5.0 Conclusion

6.0 Tutor-Marked Assignments

7.0 References/Further Reading

1.0 Introduction

In the last unit, we examine the cost of capital, types and the cost of preference
share. In this unit, we shall examine Weighted Average Cost of Capital.

2.0 Objectives

The objectives of this unit include:

1. To examine the importance of Weighted Average Cost of Capital

2. To understand the short Comings of Weighted Average Cost of Capital

127
3.0 Main Content

3.1 Weighted Average Cost of Capital (WACC)

The weighted average cost of capital is the minimum average cost of capital of
all sources of finance of a firm.

It is the minimum rate of return any project should yield to make it acceptable.
It is computed by calculating the weighted average all the capital element in a
capital structure.

The market value and not the book value is used in the compute, weighted
average cost of capital.

Importance of Weighted Average Cost of Capital (WACC)

1. The weighted average cost capital (WACC) is used in appraising a future

project not a historical project.

2. The weighted average cost of capital (WACC) is important it makes use of

market value which considers both the systematic risk and the
unsystematic risk.

Short Comings of Weighted Average Cost of Capital

1. Risk: There is the assumption that the new project appraised is of the
same class of risk (both financial and operating risk) as the existing
project; however where the new project not of the same class of risk then
using the WACC will produce an invalid result.

2. Sources of finance difficulties.

(i) The Bank overdraft has a variable interest rate this makes the
WACC based on the cost of Bank overdraft amp The ambiguity is
compounded by the nature Bank overdraft which is payable on
demand.

(ii) Convertible Securities: The option to convert and not to convert

makes the WACC computed based on the convertible securities

128
 difficult to rely upon; because the converted security cost will
be different from the cost of the unconverted security.

(iii) Cost of unquoted securities: Non listed or unquoted securities

cost are normally difficult to measure.

(iv) Constant Dividend Growth Rate: In reality the dividend growth

rate might not be constant. Thus the WACC based on the
constant dividend growth rate might be unrealistic

(v) Constant tax rate: It is wrongly assumed for the purpose of

convenience that the tax rate will be constant. This might not
be true in reality. Thus the WACC might present an incorrect
and unreliable cost of capital.

Illustration 1

Sunspring Plc, issued N4,000,000 15% debenture stock redeemable at par

in six (6) year’s time and have a current market value of N108 cum int. The
company's equity capital has N7,000,000 ordinary share of N1 each and
retained earning of N1,500,000. The current market value of the ordinary
share is N4.25 cum dividend.

The company has N2,000,000 of 9% preference share, currently priced at

70 kobo per share. Equity dividend for the current period is N 1,750,000
the project dividend growth rate is 7% per annum. Corporate tax rate is
45%. Dividend on ordinary share is about to be paid, debenture interest are
due but unpaid. The preference share dividend have been paid. Sunspring
Plc., needs your advice on the appropriate cost of capital to use in
appraising the investment projects.

ANSWER

Step 1: Compute the cost of each component of capital.

(1) Cost of equity

Market value of share = N4.25 (given)

129
 Dividend per share = 1,750,000

7,000,000 = 0.25

Market value ex div = 4.25 - 0.25 = 4

:. MV = N4 x 7,000,01 = N28,000,00

Cost of equity = D (1+g) + g = 1,750,000 (1.07) + 0.07

M.V 28,000,000 = 0.1368

(2) Cost of Preference share

= 0.09

0.70 = 0.1285

(3) 15% Debenture: Cost

Market value = N108 (Cum-Int)

Market value ex-Int. = 108 - 15 = 93

Interest = 15%, Tax = 35%

Interest (Net of taxes) N15 x (1 – 0.45) = N8.25

Years = 6 years
Time NCF DCF PV DCF 7% PV
10%
Yr0 93 1 (93) 1 (93)
Yrl-6 8.25 35.93 35.89 4.77 39.35
Yr 6 100 0.56 56 0.67 67
(1.07) 13.35

C = 10 + 13.35
13.35+1.07 (10-7)

C = 12.77% OR 0.1277

130
WACC
Capital Item Market value weigh Cost WACC
Ordinary share 28,000,000 0.846 0.1368 0.1157
9% Preference share 1,400,000 0.042 0.1285 0.0054
15% Debenture 3,720,000 0.112 0.1277 0.0143
33,120,000 0.1354

Note: Weight is the market value per source (i.e per capital item by the total
market value (i.e total capital source).
Self-Assessment Exercise (SAE) 1

Discuss the short-comings of Weighted Average Cost of Capital

4.0Summary

The method of calculating the various cost of financial assets was discussed which
include ordinary share debenture and other bond. the various techniques of those
appraisals and their market value was also discussed

5.0 Conclusion

The student will be able to apply the knowledge gained to making market decision on
when to use a means of finance and when not to use it it will be of value in deciding
whether to go for finance by equity or debt

6.0 Tutor-Marked Assignments

1. Explain the importance of Weighted Average Cost of capital

2. Identify the shortcomings of Weighed Average Cost of Capital.

7.0 References/Further Reading

Akinde, M.A.O (2006). Fundamentals and Practice of Business Finance. Lagos:

Abioudun-Kinson Nigeria Ltd

131
Frank, W and Alan, S (2002). Business Accounting. London: Pitman Publishing

Mohammed, S.R (2003). Theory and Practice of Auding. Lagos: Abioudun-Kinson

Nigeria Ltd

Okijo, Y (2000). Financial Management. Lagos: Laco Publishers

132
 MODULE 4
UNIT 3: WORKING CAPITAL MANAGEMENT

1.0 Introduction

2.0 Objectives

3.0 Main Contents

4.0 Summary

5.0 Conclusion

6.0 Tutor-Marked Assignments

7.0 References/Further Reading

1.0 Introduction

The working capital is the required fund necessary for the day to day
running of the business. It includes Cash, Inventory, Accounts receivable,
Prepayment, (which constitute application of fund) accounts payable,
accruals, etc. (which constitute sources of term fund).

The working capital constitutes the short term investment decision of the
organization. It is the short term sources and application of fund the cost
of these short term sources of fund are very important to an organization.
It is the current assets circulating or floating capital. It changes form in the
production and trading process. E.g. Cash is used to purchase raw
materials (Inventory). These are being used up in the production process to
yield finished goods (stock). The stocks are sold for cash or on credit
(yielding) account receivables; sometimes inventories (raw material) are
obtained on credit (Account payable).

133
2.0 Objectives

After study this unit, you should be able to:

1. Understand factors affecting working capital

2. Financing Working Capital

3.0 Main Contents

3.1 Working Capital Concepts

The Gross concept: It is the totality of the current assets of the business
which include accounts receivable, cash, short dated securities (short term
investment), bill receivable and Stock (or inventory). The gross concept
advocates that a firm should posses working capital just adequate and
sufficient to meet the firm's operating cycle. It ensures that excess
investment in cash is avoided, since excess investment in cash results in
excess liquidity resulting to high cost of income. Thus it is called
optimal level of Investment in current assets; excess investment in current
asset is avoided.

Secondly, this emphasizes available source of fund - such that such fun are
called up as at when needed. Excess investment in current asset is thus
avoided.

The Net Concept: This emphasises continuous liquidity of the firm. The
concept advocates a finance of Working Capital by a permanent source of
funds e.g shares, debentures, long term debts, preference shares, retained
earning etc. The Net concept advocates the efficient mix of long term and
short term sources of funding Working Capital.

There exists no rule as to the exact Working Capital level a firm should
hold and there exists no rule as to how current asset should be financed.

3.2 Factors Affecting Working Capital

134
1. The fluctuations necessitated by seasonal sales, change in taste and
fashion etc.

2. The operating cycle affect the working capital, a long term operating
cycle would result into capital tie down and hence increased cost of
working capital.

3. The nature of the business also determines the level and extent of
working capital the business will have.

4. The variability in stock purchase due to the firm speculators

purchase is another factor affecting working capital.

5. The growth stage of the firm is another factor. A new growing firm will
require a high level of Working Capital and the Working Capital cycle
will be short and rapid.

6. The credit policy of' a firm can impact either negatively or positively
upon its working capital. A liberal credit term will result in capital
tie-up but a high level sales, and hence high level, while a tight credit
policy may reduce sales but improve liquidity. Profitability may be low
with high credit policy. Thus, the firm must strike a balance between
liquidity and profitability.

7. Another factor affecting the working capital of a firm is the extent to

which short term funds (cash) are used to finance long term
investment.

8. An efficient operating cost will contribute to the working capital

efficiency of a firm.

3.3 Operating Cycle

It is the total period of converting raw materials into cash and returning
the cash into raw materials. This actually involves converting the raw

135
materials to work in progress and the work in progress to finished good and
the finished goods into sales and finally the sales to cash.

Cash

Sales (debts)
Raw materials

Work in Progress
Finished Goods

The operating cycle is the total period it will take to convert raw materials
into cash as above.

To maintain an uninterrupted operating cycle, cash must be maintained

Liquidity is the most important factor for operating cycle.

Operating Cycle Length

To determine the length of operating cycle the total period of cash

component of the operating cycle must be determined.

1. Inventory

Raw materials conversion period = Raw materials x 360

Raw materials consumption

Raw materials conversion RMI x 360 (0r 365)

RMC

2. Work In Progress

Work in progress conversion period (WIPCP) =

136
 = Work in Progress Inventory
Cost of Production

= WIPI X 360( or 365)

Cost of production

3. Finished Goods

Finished good conversion period (FGI) X 360 (or 365)

Cost of good sold

4. Book Debts Conversion Period (BDCP)

(Debt repayment period)

= Book debt inventory or Debtor x 360(or 365)

Credit sales Credit sales

5. Payable Different Period

(Credit Repayment Period)

Creditors
Credit purchase x 360(or 365)

The information below is extracted from the records of Kunle Plc.

1998 1999 2000

137
 Stock: Raw material 100,000 140,000 160,000

Work in progress 78,000 90,000 100,000

Finished goods 90, 000 128,000 160,000

Purchases 500,000 700,000 800,000

Cost of goods sold 800,000 900,000 980,000

Sales 800,000 1,900,000 1,200,000

Debtor 170,000 200,000 280,000

Trade creditors 90,000 100,000 120,000

Assume a 365 days year.

Compute: The operating cycle of the business.

Solution
1998 1999 2000
Days taken can be computed as (Days) (Days) (Days)
below.
1998 1999 2000
Raw material x 365
Purchases 73 73 73
1-2 Trade creditor x 365
Purchases 65.7 52.1 54.75
3-4 Word in progress x 365
Cost of sales 35.59 36.5 37.24
4-5 Finished goods x 365
Cost f sales 41.06 51.91 59.59
5-6 Debtors x 365
Sales 68.94 66.97 85.17
(Total length of days) 284.29 280.48 309.75

138
Self-Assessment Exercise (SAE) 1

Explain the major factors affecting working capital

3.4 Financing Working Capital

In financing working capital the risk return trading must be considered

That is, the cost of fund and return from usage of that fund must be given
a considerate attention, to ensure profitability and liquidity. Financing
method must equally be flexible to accommodate constant change involved
in working capital management. Thus there are three major methods of
financing working capital namely:

1. Long Term Financing: This involves using fund from long term
securities.

2. Short Term Financing: This involves using fund from short term
securities.

3. Spontaneous Financing: This involve utilization of short term

unnegotiated financing source e.g. credit from creditors.
4.0 Summary

In this unit, we examined the working capital concepts, the factors affecting working
capital. It outlined the factors Influencing Credit Control Policy, and the factors
to be considered in granting Credit to a Specific Customer.

5.0 Conclusion

The student will be able to determine the various levels of optimal combination of current
assets and current liabilities for the benefit of the organisation.

6.0 Tutor-Marked Assignments (TMAs)

139
1. Explain the working capital concepts

2. Discuss the factors affecting working capital in Nigeria

7.0 References/Further Reading

Akinsulire, O (2005). Financial Management, 3rd edition. Lagos: Ceemol Nigeria Ltd

Brigham, C and Houston, D (1999). Fundamentals of Financial. Florida: the Dryden

Press

Lucey, T (2002). Costing. London: Thomson Learning

Pandy, L.M (2004). Financial Management. New Delhi: Vikas Publishing

House

140
 MODULE 4
UNIT 4: MANAGEMENT OF WORKING CAPITAL COMPONENTS

1.0 Introduction

2.0 Objectives

3.0 Main Contents

4.0 Summary

5.0 Conclusion

6.0 Tutor-Marked Assignments

7.0 References/Further Reading

1.0 Introduction

Working capital is the life blood of an organization, it consists the liquidity

flow as different from the profitability of the organization. A profitable but
illiquid business could be forced to close down. This unit examine the
components of working capital management.
2.0 Objectives
3. Management of Working Capital Components
4. Factors Influencing Credit Control Policy

3.0 Main contents

3.1 Management of Working Capital Components

Cash Management

Cash is the most liquid assets of the company; it is used as a medium of

exchange in business activities. Sales represent inflow of cash, while

141
purchase brings about outflow of cash. It is used to meet daily components
of organization obligations. Cash management involves three major stages
namely: Cash planning, Cash flow management and maintaining optimal
cash level.

Cash planning entails analyzing the organizational cash needed and

estimating inflow and outflow of cash. The purpose is to avoid carrying
excess cash or running into cash shortages.

Managing the cash flow involves evolving method of maximizing cash

outflow. Keeping optimal cash level, no surplus cash or shortage of cash
exist.

Cash Planning

This is a process of estimating current and future cash needs for the
organization and making appropriate effort to attain these. The singular
purpose of cash planning is to avoid excess liquid and low shortage of cash.

Cash Budgeting and Financing

Cash budgeting entails estimating relative inflow and outflow throughout the
life of the asset. The cash budget could be long term or share term capital. A
cash budget that goes beyond a year will be termed long term budget.

Financial Management Question

Kay Nig Ltd. produced the following information covering November, December,
January, February, and March 2011. The information is stated below:

142
 NOV DEC JAN FEB MAR
N N N N N
Sales 150,000 200,000 200,000 300,000 400,000
Expenses 10,000 12,000 12,000 13,000 15,000
Wages 15,000 16,000 18,000 20,000 25,000
Loan repay 10,000 10,000 10,000 10,000 10,000
Purchases 150,000 160,000 180,000 200,000 250,000
Rental income (Rec’d)10,000 12,000 18000 20,000 25,000

Additional Information:

Before preparing the cash budget, your enquiry revealed the following:

1. Payment for sales is 50% cash sales and 50% credit sales. The credit
sales are paid for in two equal installments a month after sales.

2. Purchases are paid for 40% in the month of purchases and the
remaining are paid in two equal installments a month after purchase.

The management of Dr. Kay Nig Ltd. has requested you to prepare a cash
budget for the firm covering January, February and March, 2011.

143
SOLUTION

CASH
BUDGET

144
 January February March
N N N
Sales 187,500 250,000 325,000
Rental Income 18,000 20,000 25,000
205,500 270,000 350,000
Payment
Purchases (165,000) (182,000) (214,000)
Expenses ( 12,000) ( 13,000) ( 15,000)
Wages (18,000) ( 20,000) ( 25,000)
Loan repayment ( 10,000) ( 10.000) ( 10,000)
205,000 225,000 264,000
Balance 500 45,000 86,000
205,500 270,000 350,000

WORKINGS
SALES
NOV DEC JAN FEB MAR
N N N N N
75,000 37,500 37,500
------ 100,000 50,000 50,000

145
 PURCHASES
NOV DEC JAN FEB MAR
N N N N N
60,000 45,000 45,000 ------- -------
-------- 64,000 48,000 48,000 -------
-------- -------- 72,000 54,000 54,000
-------- -------- --------- 80,000 60,000
-------- -------- --------- -------- 100,000
60,000 109,000 165,000 182,000 214,000

Managing the Cash Flows

This is a process of ensuring adequate cash collection period and the

disbursement of the same. The purpose is to ensure accelerated cash
collections and decelerated cash disbursements.

3.6 Cash Management Techniques

1. Accelerated Cash Collections: This is a method of ensuring reduction

in time lag or gap between the time customer enjoys a service or buys a
product and the time the customer receives the bill and settles it, and the
time cash becomes available for maintaining the operating cycle.

A cash collection method could either be centralized or decentralized system

or the lock- box system. The lock-box system entails establishing various
collections centres taking into account customer location and the volume of
remittances.

2. Optimal Cash Level: This is determined through the use of Economic

Order Quantity. It is used to determine the optimal cash level.

Formula: EOQ = 2DO

C
D = Cash need or cash demand

146
 O = Cost of cash investment

C = Cost of carrying cash

Illustration 2

Mary James Plc operates a centralized collection system. It takes 6 days to

receive mail remittance and another 3 days for processing mail. Mary James
Plc daily collection amount to N600,000. Mary James Plc currently is thinking
about the introduction of Lock - Box System. By this same time mailing is
expected to fall by two days while the processing time is also expected to drop
by two days. Interest of' 22% is expected to be paid by PEPZIM BANK PLC.

Required:

a) Find the fall in cash balance expected to result from adopting the lock-
box.

b) What is the opportunity cost of the present centralized system?

c) Should the lock-box system be established.

If its annual cost is N100,000?

Answer

a. Reduction in cash balances

= Time saved X Daily Average Collection

= 2 x 600,000 = N 1,200,000

(b) Opportunity Cost: Interest Rate X Reduction in Daily Cash Balance

= 0.22 X 1200,000 = N 264,000

(c) Cost of lock Box System = N100,000

The new system should be adopted since the lock box system cost less
than the opportunity cost.

That's lock box system = N100,000

147
 Opportunity Cost = N264,000

Illustration 3

Kolawale Plc required ₦100,000 annually for raw material purchases. This
cost is equally available for lending at a cost of 30% annually. N200
transaction cost will be required to secure the cash required; Kolawale Cash
flow follows an annuity.

Required:

(l) Compute the optimal cash conversion size for Kolawale Plc.

(2) Compute total cost of holding cash in hand during this period.

(3) How often (in days) will cash conversion be made, assume a 30 days
month.

Answer

(a) Using the EOQ Method = (OCL) = 2DO

Optimal Cash level C

Where D = Cash demand

O = Holding cost
C = Carry cost

(Carrying cost) all in capital letter

Cost in naira = ₦100,000 x 0.30 = N30,000

Cost x I

Cash Demand (year) = N100,000

Carrying cost = ₦30,000 x 1 = ₦0.025

₦100,000 12
Carrying cost = 0.025

148
OCL = 2 x ₦100,000 x ₦200 = ₦40,000
₦0.025

b. The cost of holding cash during the period is the opportunity cost of
not investing cash.
030 x 100,000 x 30 = ₦2,500
360

C. Number of order = ₦100,000 = 2.5 times

₦40,000

The number of days = 360

2.5

= 144days.
Motives for Holding Cash

Organization should hold cash for three purposes as follows:

 Transactionary Motives

The business organization holds cash for the purpose of conducting its
day to day activities such as for the purchase of raw materials, payment
of wages and salaries, maintenance of machine etc.

 Precautionary Motives

The business organization holds cash to meet unexpected contingencies.

This acts as a `buffer' to meet unexpected needs for cash.

 Speculative Motives

Corporate organization may hold cash for the purpose of investing in

business opportunities that may surface suddenly.

Inventory Management

Inventory is stock. It includes raw materials, work in progress and finished

goods ready for sales. It is the most illiquid component of the working
capital. Thus a company willing to estimate its liquid must deduct the

149
inventory or stock portion of the current asset before it against the current
liability to obtain the quick asset ratio or the acid out Ratio.

Working Capital Ratio = Current Asset

Current liability

Acid test ratio = Current Asset - Stock

Current Liabilities

The firm must decide what quantity of stock is needed, at what point should
order be made and at what price and what is the cost of stock out; can we
reduce stock costs? These questions will help the financial manager to work
out a proper stock management policy.

It is imperative to know that the firm can pile up stock in order to eliminate
cost in production runs, sometimes they do keep large stock to reduce the
time lag between when an inventory is needed and when t is fully bought.

Optimum Level Of Stock

The economic order quantity (E.O.Q provides the firm with the most profitable
form of obtaining the Optimum level of raw material.

E.O.Q = 2DO
C
Where D = Annual demand

O = Ordering cost

C = Carry cost.

Ordering Cost: This is cost associated with placing new order such as
invoices cost, book-keeping of inventory, cost of stationary, transportation
cost, inspection handling cost etc.

Carrying Cost: Is the cost incurred to hold the stock. To protect the stock,
such cost includes, storage cost, insurance, depreciation, cost of obsolescence
and deterioration cost.

150
Minimum Stock Level: (Margin of safety or buffer stock) It is the level to
which stock should not fall before new order is place it is the stock's margin
of safety. It constitutes the firms buffer stock.

Minimum Stock Level: Re-order level - (Normal consumption X Average

reorder period).

Maximum Stock Level: This is the highest level stock must not rise above. It
is the level above which stock should not rise.

Maximum Stock Level =

Reorder Level - (Min consumption x minimum reorder period) + Reorder

quantity.

ROL - (Min consumption x min reorder period) + ROQ.

Creditors: (Account Payable)

This is a source of fund to the firm. It constitute the cheapest source of fund
to the firm, however, the firm must design a proper method of settling the
creditors. This will enhance continuous and repeated purchase. Creditors
include the accounts payable where the credit is on overdraft, then the cost of
the overdraft must be considered and compared with cost of alternative
financing.

Debtors: (Account Relievable)

The Debtor includes accounts receivable. It is very important to the firm due
to the fact that such debtor could impact negatively on the liquidity of the
firm. Liquidity of the firm accounts for the viability of such firm’s security.
The debtor is a tied down capital, this capital tied down would impact
negatively on the firm's ability to finance other current assets.

Thus the firm must establish a flexible credit policy. Sometimes the credit
Policy of a firm might be rigid depending on the nature of the business, the
Current Asset Stock and the preference for liquidity over profitability.

151
Thus the Credit Policy of the firm should be flexible enough to boost
profitability of the firm. It is also important to consider liquidity as the daily
activities of the firm need cash realized from sale to meet the needs for
finance for the moment.

3.6 Factors Influencing Credit Control Policy

1. Policy of the competitors: The Credit Control Policy of the competitors

is of utmost important in deciding a company Credit policy; since Credit
Policy have direct impact on sales such that the higher the credit granted
the higher the sales; Thus a competitor offering a hot credit facility {say 90
days} will be considered to have more sales than a company with less
credit facility (say 30 days).

2. Nature of Product: A company with a unique product, without

substitute will not need to consider any credit policy. A monopoly will not
consider any credit facility nor have any credit policy.

3. Trade-Off between Profits on Sales and Cost of Having Debtors Plus

Bad Debts: Increased profits anticipated from increased sales coming in
a result of credit facility should be compared with cost of bad debt and
maintenance cost of a wage credit control department before deciding
on a particular credit policy.

4. Customers Risk Category: The customers risk category should be

considered in grating credit facility. Customer with poor record of credit
repayment will have less chance of obtaining credit facility compare compared
with a customer with good record of credit repayment.

5. Cost of Debt Factoring and Invoice Discounting: The cost involved

in debt factoring and invoice discounting should be given congruence in
granting credit facilities. Where the cost of factoring is too high, it
becomes difficult therefore, to grant credit facilities.

152
6. Cost of Working Capital: The financial cost of working capital
should be considered. The increased working capital required should be
considered in term of cost involved and risk thereon.

Factors to be considered in Granting Credit to a Specific Customer

1. Trade Reference: One or more companies which the customer has

dealt with in business before will be asked to give a reference on the
Customer.

2. Bank reference or bank's opinion: A bank may also be asked to

comment on the financial standing of its customers.

3. Published information: e.g. annual accounts of the particular

customer can be analysed to determine its liquidity and profitability
position.

4. Salesmen’s Opinion: The opinion of the salesmen should be

considered when granting credit facility to a customer since they are
more close to the customer than others.

5. Customers Past Credit Record: An emanation of how will the

customer has paid in the past might give some insight as to how well
he will perform in the future.

Self-Assessment Exercise (SAE) 2

Explain the factors influencing credit control policy

4.0 Summary

In this unit, we examined the working capital management components, the factors
affecting working capital. It outlined the factors Influencing Credit Control Policy,
and the factors to be considered in granting Credit to a Specific Customer.

5.0 Conclusion

153
The student will be able to determine the various factors Influencing Credit Control
Policy and the factors to be considered in Granting Credit to a Specific
Customer

6.0 Tutor-Marked Assignments (TMAs)

1. Explain the management of working capital components

2. Explain the factors Influencing Credit Control Policy

3. Briefly examine the factors to be considered in Granting Credit to a
Specific Customer

7.0 References/Further Reading

Akinsulire, O (2005). Financial Management, 3rd edition. Lagos: Ceemol Nigeria Ltd

Brigham, C and Houston, D (1999). Fundamentals of Financial. Florida: the Dryden

Press

Lucey, T (2002). Costing. London: Thomson Learning

Pandy, L.M (2004). Financial Management. New Delhi: Vikas Publishing

House

154
 MODULE 4
UNIT 5: MEANING AND NATURE OF BUDGET
1.0 Introduction

2.0 Objectives

3.0 Main Contents

3.1 The Meaning of Budget

3.2 Types and purpose of budget in an organisation

4.0 Summary

5.0 Conclusion

6.0 Tutor-Marked Assignments

1.0 Introduction

In the last unit, we discussed the working capital concepts, factors affecting
working capital, financing working capital, and the factors to be considered
in Granting Credit to a Specific Customer. In this unit, we shall examine
budget and budgetary control in an organisation
2.0 Objectives

The objectives of this unit include:

1. To discuss the meaning and various types of budget

2. To examine the purpose of budget in an organisation

3.0 Main Contents

3.1 The Meaning of Budget

155
Steiner (1979) define budget as “integrating methods to translate plans into
current action” Budget is a quantitative financial plan of the firm covering a
stated period of time. They are guides to action. The plan or standard set would
be assigned quantitative value and the actual performance would be compared
to the standard set. They are used as a control to performance. There are
various budget that could be set, thing include the sales and other income
budget, expense and cost budgets, cash budgets, production and material
budgets, human resources budget, etc

The whole of these budgets fused together from the master budget of the firm
for a given period of time.

Organizational Goal and Budget

There is a kin relationship between organizational goal and budget, normally

the goals are broken down into short various organization object that would be
attained within a given period of time are expressed in term of the budget. The
budget is purely the quantitative and financial expression of the organizational
goal or objective.

For example let us assume the organization aims at attaining certain income or
return level. The process could be graphically represented as below:

Organizational Goal
(Income Goal)

Sales Budget Plan Income Plan Other income

budgets

Expenses and Cost

Budget

Purpose of Budgets

156
(1) Budgets improve planning: The budget are designed to improve on
planning process, the goals expressed financial plan would constitute the
budget.

(2) Budgets Assist in coordinating operation: The operation of the

organization would lack coordination if there is no written down
quantified financial plan. Budget help in shaping t operation of the firm
without a budget, operation remain within a direction.

(3) Budgets Assist Management Control over Performance.

Without a budget the performance measurement could be vague. The

standard for measuring performance is the budget. The extent of success
and failure are better measured by the means of a budget. The standard
set in the budget is compared with actual performance.

(4) It also assists in achieving the organizational objectives without a clear

budget the objective of the organization would not be attained.

(5) Budgets assist in effective utilization of the organization resources.

(6) Budgets help in minimizing waste and hence increase profitability.

Type of Budget

There are three major type of budget, these are:

1. Operation budget.

2. Financial budget

3. Capital budget.

Operational Budget
Operation budget is the quantitative plan of the firm operation. This include:

1. Production budget

2. Material/Inventory purchase budget.

3. Sales budget.

157
Financial Budgets

This relate to budgeted financial statements expected by management to be

reported at the end of the period. The management set standard to be achieved
of each financial resources of the organization. These budgets include:

1. Cash flow budget

2. Profit and loss budget

3. Cash budget

4. Balance sheet budget

The cash flow budget is a standard statement of sources, and application of

those fund. The organization sets the expected cash for the period and the
source of those fund are also stated. The expected application of funds is also
stated. This forms a standard of operation that will be compared with the
actual report at the end of the period. The purpose of such budget is to serve
as a guide for operation.

Cash budget remains the most important of all financial budgets. The cash
budget is simply an estimation of expected cash that will be needed ration. This
for the firms activity for the year. The purpose of the budget is to assist
management in realizing needed cash and sources of such cash for the year.

The profit and loss budget is simply an estimation of income and revenue to
the firm in the year in view. The balance sheet budget is an estimation of the
position or state of affairs of the firm for the year in view. The purpose of such
budget is to guide the operational standard of the firm.

Capital budgets

The capital budget is the quantitative financial plan of the firm in acquisition of
tangible assets or investment or long-term projects it is mostly asset base
budget. The purpose is to estimate possible project the firm can undertake.

Zero-Base Budgeting (ZBB)

158
Peter A. Pybirr (1977) have defined zero base budgeting as: “A planning and the
process which require each manager to justify his entire budget request is
detail from scratch hence zero-base and shift the burden of proof to each
manager to justify why he should spend any money a all the approach requires
that all activities; he analyzed as decision packages” which are evaluated by
systematic analysis and ranked in order of importance”.

Zero-base budgeting is a budgeting process which de that cost benefit analysis

of each expenditure to be included in a budget is done. Where the cost is
greater than the benefit, such expenditure will be rejected. Each manager is
expected to defend the expenditure incurred in a particular year. The purpose
of this budget is to ensure that only those expenditure whose benefit will justify
the cost are the only one that would be incurred. The purpose is that the
benefit from expenditure is paramount and of the highest import unlike the
traditional budgeting system that have a classes of expenditure which are
normally included in the budget without evaluation of their benefit e.g
administration expenses.

In Zero-base budget each expenditure is evaluated separately and accounted

separately unlike the traditional budget that has classes of expenditure e.g.
administration expenses, operational expenses etc In zero-base budget such
classes of expenditure do not exist.

However the zero-base budget follows the same process of development as the
traditional budget. The plan and the overall objectives of the firm must be
evaluated, strategic plan must be developed. Thereafter the budget headings
are created that is, the activities are grouped in such a way to allow for
decision making process. The grouping may include grouping into cost centre,
a particular product, project, or service etc.

The next step is to develop the alternative ways of achieving the set objective.
The best of the alternative process is then accepted and re sources are
committed to the pursuit of the course.

159
Advantages of Zero- Base Budgeting.

1. It enhance careful evaluation of each expenditure head or cost and

relating them to benefit for maximizing the usage of the firm resources.

2. It ensures that utilization of resources is linked with result. The

target of the zero-base budget is result.

3. It is a decision making process in allocating the scarce resource of

the organization.

4. It is a great cost saving device for the firm.

Problem of Budgeting

1. It may be too stereo type for operation in a dynamic environment

Budget are sometime rigid and may not lend itself to require change
in a dynamic period.

2. It is always a cumbersome process and difficult to operate small

organization with low level of resources.

3. Budget requires the cooperation and support of all levels of st this

may be difficult in a loose system.

4. Forecast and plan used in budget are pure estimate that may be
inaccurate and sometime not realistic under cent tin situation.

5. Budgeting require huge cost that a small firm might not be to afford.

6. The problem evaluation, monitoring and follow-up procedure remain

a task in budgeting process.

Self-Assessment Exercise (SAE) 1

Explain various types of budget you know

4.0 Summary

160
The unit examined the meaning of budgeting and its various types. We have explained
the importance of budgeting in an organisation..
5.0 Conclusion

There is a kin relationship between organizational goal and budget, normally

the goals are broken down into short various organization object that would be
attained within a given period of time are expressed in term of the budget. The
budget is purely the quantitative and financial expression of the organizational
goal or objective.

6.0 Tutor-Marked Assignments

1. Explain the importance of budgeting in an organisation

2. Explain the advantages and disadvantages of Zero based budgeting

7.0 References/Further Reading

Akinsulire, O (2005). Financial Management, 3rd edition. Lagos: Ceemol Nigeria Ltd

Brigham, C and Houston, D (1999). Fundamentals of Financial. Florida: the Dryden

Press

Lucey, T (2002). Costing. London: Thomson Learning

Pandy, L.M (2004). Financial Management. New Delhi: Vikas Publishing

House

161
 MODULE 4
UNIT 6: BUDGETARY CONTROL IN THE ORGANISATIONS
1.0 Introduction

2.0 Objectives

3.0 Main Contents

3.1 The Meaning of Control

3.2 Budgetary Control Method

4.0 Summary

5.0 Conclusion

6.0 Tutor-Marked Assignments

1.0 Introduction

In the last unit, we discussed the meaning, nature and types of budget in an
organisation. In this unit, we shall examine budget and budgetary control
in an organisation
2.0 Objectives

The objectives of this unit include:

3. To understand the meaning of control and its various types

4. To examine budgetary control methods
3.0 Main Contents

3.1 The Meaning of Control

Control is a process of comparing performance with standard set and

measuring deviation thereby enhancing future standard setting. It is a process

162
of obtaining feedback from organization activities. Every organization must set
objective to be achieved and within a specific period of time. To this objective,
resources of the organization are normally committed. Feedback from the
system is always obtained by comparing actual performances with standard set
deviation are measured. Reasons for this deviation are sorted and corrected so
that future performance could he better than the previous years, significance of
deviation is measured and controlled is made and control led to ensure that
performance conforms to plans.

Process of Control

There are several process involved in control these include:

1. Objective setting

2. Establishing standards

3. Monitoring the performance

4. Measuring performances against standards

5. Obtaining feedback

6. Evaluating performances

7. Taking corrective action.

Types of Control

Control could be classified according to usage, it can also be classified

according to level of authority in an organization.

Control according to usage could be classified as below:

(1) Control to standardize performance

(2) Control to conserve assets or asset control

(3) Control to standardize quality and quality control

(4) Control to limit authority without top management’s approval

(5) Control to measure performances.

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Control could also be classified according to level of management authorities
and position in the organization. In this regard control would be classified as:

1. Strategic control or top management control.

2. Management control or middle management control.

3. Operations control or day-to-day control of performance by staff.

4. Profitability control.

Method of Control

There are several forms of activities in the organization to each of these

activities techniques of control can be adopted. These include:

(I) Budgetary control method.

(2) Audit control method.

(3) Network analysis method

(4) The Grant chart method.

3.2 Budgetary Control Method

Budgetary control entails the process of using budgeting as a means of control

of financial activities in an organization.

The organization transmutes the plan into a financial or quantitative form that
covers a period time normally a financial year. The budget is the standard of
performance expected during the year, the actual performance at the end of the
year could now be compared to standard set, and deviation could be monitored
and corrected in future budget.

Audit Control: This entails the usage of internal control system of the
organization to ensure control of activities, the safety physical of assets, cash,
and other assets include what Audit control is aimed at.

Network Analysis: The net work analysis is the process of ensuring that the
job or events are completed within a reasonable time and at the least cost.

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Thus Net work analysis ensures cost and time control of an event or job to be
done.

Budgeting and Budgetary Control

The process of ensuring success in an organization entails evolving the goals of

the organization from the organization vision.

The goals and objectives of the organization state where the organization is
going and what it aims at, achieving goals are normally long term and broad in
nature while the objective are short term and concise in nature. Budgets are
set to achieve the various objectives of the firm; sales budget is set to achieve
the market (or sale) objective.

Cash budget is set to achieve the level of liquidity required by the organization.
Various other expenses budget are set to ensure that the targeted profit
objective is attained etc.
Self-Assessment Exercise (SAE) 1

Explain the meaning of control and its various types

4.0 Summary

The unit examined the meaning of control and its various types. We have explained
budget and budgetary control, and the major problems of budgeting.
6.0 Conclusion

Every organization must set objective to be achieved and within a specific

period of time. Control is a process of comparing performance with standard
set and measuring deviation thereby enhancing future standard setting. It is a
process of obtaining feedback from organization activities.
6.0 Tutor-Marked Assignments

1. Explain the concept “Control”

165
2. Briefly explain the budgetary control methods in Nigeria
7.0 References/Further Reading

Akinsulire, O (2005). Financial Management, 3rd edition. Lagos: Ceemol Nigeria Ltd

Brigham, C and Houston, D (1999). Fundamentals of Financial. Florida: the Dryden

Press

Lucey, T (2002). Costing. London: Thomson Learning

Pandy, L.M (2004). Financial Management. New Delhi: Vikas Publishing

House

166
 MODULE 5
UNITS 1: VARIANCE ANALYSIS

1.0 Introduction

2.0 Objectives

3.0 Main Contents

3.1 Variance Analysis

3.2 How to determine favourable and adverse variance

4.0 Summary

5.0 Conclusion

6.0 Tutor-Marked Assignments

7.0 References/Further Reading

1.0 Introduction

In the last module, we discussed cost of capital, working capital management and budget
and budgetary control in organisations. In this module, we shall examine variance
analysis and how to determine favourable and adverse variance.

2.0 Objectives

The objectives of this unit include:

1. understand the meaning of variance analysis

2. to know how to determine favourable and adverse variance

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3.0 Main Content

3.1 Variance Analysis

The Basic tool of budgetary control is Variance analysis. Variance analysis is

the process of comparing budgeted item of revenue or expenditure with the
actual performance. The purpose is to evaluate deviation either a favourable
deviation or adverse. Corrective actions are taken to improve upon the
performance in the coming year.

There are basically two type of variance namely:

(1) Cost variance

(2) Sale Variance

Cost Variance relates to manufacturing and non-manufacturing cost variance.

This could be subdivided into:

I. Material cost variance

2. Labour cost variance

3. Overhead cost variance.

Sale Variance refers to the comparison of budgeted sales with actual sales.

1. Material cost variances: The comparison of budgeted or stand material

cost with actual material cost.

2. Labour cost variance is the comparison of budgeted labour cost with the
actual labour cost.

3. Overhead cost variance is the comparison of budgeted overhead cost with

the actual overhead cost. Material labour and overhead are vital elements
of cost to an organization in determining the unit price of product or
services

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Material Cost Variance

Material cost variance = (Budgeted material cost - actual material cost).

Budgeted material cost = SQ x SP

Actual material cost = AQ x AP

Material cost variance = (SQ x SP) – (AQ x AP)

Where SQ = Standard quantity

SP = Standard price

AP = Actual price

AQ = Actual quantity

Material Mixture Variance

(Budgeted Material Units – Actual Material Units) X Budget Price

Material Yield variance

(Budgeted Yield - Actual Yield) X Budgeted Yield Price.

Example 1

Standard price of material = N5 per unit

Actual price of material = N6 per unit

Standard quantity = 100 units

Actual quantity = 80 units

Find the material cost variance

Solution

Material cost variance = (100 x 5) – (80 x 6)

MCV = 500 – 480

= N20

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N20 is a surplus because it is reduction over the standard cost, which will
affect the unit price of the product positively. To maximize profit material cost
needs to be minimized.

Labour Cost Variance

1. Labour Cost Variance (LCV) = Budgeted Labour Cost – Actual Labour

Cost.

2. Labour Rate Variance (LRV) = Budgeted Actual rate x Actual Hours

3. Labour Efficiency Variance (LEV) = Budgeted Hours – Actual Hours for

actual output.

Example 2

The following are extracted from the records of JNNY & SONS Ltd.

Standard labour hours = 100 hours

Standard labour rate = N10/hrs

Actual labour hours = 800 hrs

Actual labour rate = N12 per hr.

You are required to calculate the labour cost variance.

Solution

LCV = 1000(10) - 800(12)

LCV = 10,000 – 9,600

LVC = 400 F

The above variance is favourable because the actual labour cost is less than
the budgeted labour cost. This will help the organization to maximize profit and
maximize sales as the reduction in labour cost will also reduce the unit price of
product or service.

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Overhead Cost Variance

Overhead cost variance = (Budgeted Variable Overhead + Fixed Overhead) –

(Actual Variable Overhead + Fixed Overhead).

OCV = (BVO + BFO) – (AVO + AFO)

Where overhead cost is only variable.

Overhead, OCV = BVO – AVO

Where overhead cost is only fixed.

Where:

OCV = Overhead Cost Variance

BVO = Budgeted Variable Overhead

AVO = Actual Variable Overhead

BFO = Budgeted Fixed Overhead

AFO = Actual Fixed Overhead

Example 3

The following are the standard and actual overhead cost of a firm:

Budgeted variable overhead cost N150,000

Budgeted Fixed Overhead Cost = N50,000

Actual Variable Overhead Cost N135,000

Actual Fixed Overhead cost N75,000

Solution

TOCV = (BVO + BFO) – (AVO + AFO)

= (150,000 + 50,000) – (135,000 + 75,000)

= 200,000 – 210,000

= N10,000A

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The variance is a adverse because there is an increment of N10,000 in actual
overhead. This will affect the pricing of the organization and reduce the profit
margin of the product.

Sales Variance

Sales variance = Budgeted sales – Actual sales

Budgeted sales = SQS x SP

Actual sales = AWS x AP

Sales variance = (SQS X SP) – (AQS x AP)

Where:

SQS = Standard quantity to be sold

SP = Standard selling price per unit

AQS = Actual Quantity sold

AP = Actual selling price per unit.

Example 4

The following are extracted from the books of Mrs. James a seller of electric
cooker.

Standard sales quantity 600 units

Standard sales price N350 per units

Actual sales quantity 750 units

Actual sales price N320 per unit.

You are required to determine whether the sales variance is favourable or

adverse.

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Solution

SV = (SQS X SP) – (AQS X AP)

= (600 x 350) – (750 x 320)

= 210,000 - 240,000

= N30, 000 F

The variance is favourable because for an organization to maximize profit

it needs to increase it sales. The increment of N30000 sales over the
budgeted sales will help the seller to maximize profit.

Self-Assessment Exercise (SAE) 1

Explain two types of variance you know

3.2 How to determine favourable and adverse variance

l. In cost variances (material, labour and overhead), there is favourable

variance when the actual cost is less than the budgeted cost. In
contrast, there is an adverse variance when the actual cost is greater
than budgeted cost.

2. In sales variance there is favourable variance when the actual sales is

greater than the budgeted sales. On the other hand, there is adverse
variance, if the actual sales are less than the budgeted sales. However
in a situation where the budgeted cost or sales equal to the actual cost
or sales, there is no variance. It must be noted that the above variance
calculated can be broken down into parts that can be calculated
separately and derive the same answers as shown above. Nevertheless,
these are treated under Management Accounting.

Self Test Exercise

I. Professor Sunny established a factory where canned juices are

produced. He act as the chairman of the company and has the
managers Running the company. At the end of 2002 financial year,

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 Professor Sunny wants to know the extent the actual performance of
the company deviated from the budgeted performance.

The managers presented the following information to him.

Budgeted material quantity 80000 units

Budgeted sales quantity 200000 units

Budgeted labour rate N30 per hour

Budgeted material price per unit N15 per unit

Budgeted labour hours 5000 hours

Budgeted sales price N50/unit

Budgeted fixed overhead N1,200,000

Budgeted variable overhead N2,500,000

Actual material quantity 70000 units

Actual sales quantity 190000 units

Actual labour rate N24 per hr

Actual labour hours 4800 hrs

Actual material price per unit N25 per unit

Actual sales price N55 / unit

Actual variable overhead N2,800,000

Actual fixed overhead N1,200,000

Assuming you are the budget officer.

You are required to calculate the

(1) Material cost variance

(ii) Labour cost variance

(iii) Overhead cost variance and

174
(iv) Sales variance, and show which ones are favourable or adverse

2. A company manufacturing a special type of wall files 12” X 8” x ½ “ uses a

system of standard costing. The standard mix of the compound used for
making the tiles is:

2400 units of material A at N300 per unit

1000 units of material B at N600 per unit

1600 units of material C at N720 per unit.

This compound should produce 240000sq. It is of the wall files of ½” thickness.

During a period in which 2000,000,000 files of the standard size were
produced; the material usage was:

1400,000 units of materials A at N320 per unit

600,000 units of materials B at N640 per unit

1000,000 units of material C at 760 per unit.

Compute the following

a. Material price variance

b. Material mixture variance

c. Material cost variance

3. ABC Ltd. Manufactures a product called Kunde. A standard cost system

is in operation and the relevant information is as follows:

Standard rate = N50 per hour

Standard time = 4 hours per product.

During the period the production work unveiled that 800 units had been
produced of Kunde in 1840 hours. The wage rate paid had been N60 per hour.

You are required to compute:

175
a. The labour rate (usage) variance

b. The labour efficiency variance

c. Labour variance.

Self-Assessment Exercise (SAE) 2

Discuss the various ways of determining the favourable and adverse variance

4.0 Summary

This unit explains the meaning of variance analysis and the major factors in determining
favourable and adverse variance

5.0 Conclusion

The various types of variances was covered, the cost variance and sales variances were
equally covered. The reason for the variances and how to apply them for management
decision making was also covered for the student benefit in work place.

6.0 Tutor-Marked Assignments (TMAs)

1. Differentiate between cost variance and sale variance

2. Explain the meaning of Overhead Cost Variance

7.0 References/Further Reading

Akinsulire, O (2005). Financial Management, 3rd edition. Lagos: Ceemol Nigeria Ltd

Brigham, C and Houston, D (1999). Fundamentals of Financial. Florida: the Dryden

Press

Lucey, T (2002). Costing. London: Thomson Learning

Pandy, L.M (2004). Financial Management. New Delhi: Vikas Publishing

House

176
 MODULE 5

UNITS 2: COST - VOLUME PROFIT ANALYSIS

1.0 Introduction

2.0 Objectives

3.0 Main Contents

4.0 Summary

5.0 Conclusion

6.0 Tutor-Marked Assignments

7.0 References/Further Reading

1.0 Introduction
In the last unit, we discussed variance analysis and how to determine favourable and
adverse variance. In this unit, we examine cost-volume profit analysis, the assumptions of
cost volume profit analysis and limitations of cost volume profit analysis.

2.0 Objectives

At the end of this unit, you should be able to:

1. Explain the meaning and elements of cost

2. Calculate Cost Volume Profit Analysis

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3.0 Main Contents

3.1 What is Cost?

It is the amount of expenditure (actual or notional) incurred on or attributable

to, a given thing. Cost is any value or amount of an attribute or product or
service per unit.

It is the per unit measurement of value of an attribute, service, a product or

activity. Costs are most time historical in nature. The quantity and price are
two attributes of cost. Every cost is a variance of unit and price.

They are some time's called direct cost.

Most times costs are measured for planning purposes. In a firm, planning as
expressed by the budget of the organization is a variance of many components
of which cost is of utmost importance. Planning rests on good costing system;
such that if the costing system is vague then the resultant price or financial
plan or budget from such system would be at best vague and highly unreliable.

Elements of Cost

This is the primary classification of costs according to the factors upon which
expenditure is incurred. This include materials cost, labour cost (wages) and
overhead cost.

Nature of cost

Cost can be classified according to the nature of concurrence. Cost

classifications according to nature delimit cost into either a fixed cost or a
variable cost.

Fixed cost

These are costs which tend to remain constant with variation in volumes of
output. Fixed cost primarily depends on the effusion of time. It does not vary
directly with volume of production. They are sometimes referred to as period
cost.

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Variable Cost: These are costs that vary directly with volume of output.

They are some times called direct cost.

Cost centre

This is a location, person, or item of equipment (or group of these) for which
cost may be ascertained and used for the purpose of cost control.

Historical Cost

This is the ascertainment of costs after they have been incurred. They are
based on historical data.

Future Cost

These are cost ascertained based on forecast of future activities and events.

Cost Unit

This is a unit of quantity of product, service or attribute in relation to which

costs may be ascertained or expressed.

Cost Apportionment

This is the allotment of proportion for items of cost to cost centres and cost
units.

Cost Allocation

This is the process of assigning indirect or common cost to different

departments, processes or products.

Direct costs are allocated to the department or cost centre where they are
incurred occur, however, indirect cost or common cost have to be apportioned
to various cost centres. Examples of such cost include human resources
department cost, office overhead cost etc.

Costs are normally allocated for various purposes. These include tax purpose,
financial reporting purpose, third party reimbursement, decision making and
control purposes.

179
Several organizations have evolved methods or steps in cost allocation.
However, an effective cost allocation steps would require the following.

1. Definition of the cost objects: The cost objects relates to ascertainment of

whether a department or unit will be classified as cost centre or cost unit to
which cost can be allocated.

2. Cost accumulation: The total cost that would be distributable to the

available cost centres have to be determined. The organization would decide
what constitute a direct and indirect cost for easy allocation and the
organization must ensure that ascertained costs are not counted twice.

Cost Control: It is the practice of regulating the cost of operating an

undertaking. The purpose is to reduce cost of operation. i.e. an attempt to keep
cost at a reduced level enhancing the profit of the firm..

Price: It is the cost to a purchaser of any articles or service expressed in

monetary terms. It is the money rate used to calculate cost, normally it is a
unit of money used to establish a cost of product or service or an attribute.

3.2 Cost Volume Profit Analysis

This is an analytical tool applied by management in forecasting and

determining future level of activities such as level of sales required at a given
level of profit, e.t.c. it is one of the techniques used by management in its
planning activities.

The ability to separate cost into fixed and variable cost makes possible several
manipulation of various cost variables to predict the future level of activities.
Using the techniques, it is possible to predetermine a future level of profit, it
can be used to determine sales units, sales value when total cost is known and
divisible into fixed and variable cost.
The basic formula derived as follows:

SP = TC + Λ

SP = QP

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TC = FC + VC
Where
SP- Selling price
Q- Quantity
P- Price per unit
TC- Total cost
VC – QV Variable cost
FC - Fixed cost
Λ - Profit
SP – TC
PQ – QV + FC + Λ
Collect like terms
PQ – QV = FC + Λ
Q (P-V) = FC + Λ
Q = FC + Λ
P-V
Note: (P- V = is contribution margin (CMR)

Possible Calculation

(1) Break- even point in Unit.

To calculate the break-even point, this will occur where profit equal zero
(i.e Λ = 0)

From the above if Λ = 0

Then Q= FC or FC
P–V CMR
OR
Q =FC
I – VC
SP
(2) To compute the break-even point in naira value, multiply the Q by P
(Price)

Sale value = FC x P

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 I–V
P
(3) To compute the level of sales in unit to attain a desired
predetermined profit.

Q= FC + Λ or FC + Λ
CM P
(4) The value of sales to attain a desired/predetermined profit

FC + ΛP
CM

Assumptions of Cost Volume Profit Analysis

(1) Variable cost per unit must be known and must remain constant
irrespective of the volume of production

(2) The technological level is expected to remain static.

(3) It is assumed that all unit produced are sold such that products
must equal sales.

(4) All factors of production are quantifiable and are expected available
at all time.

(5) The inflated profit level is assumed to be constant.

Limitations of Cost Volume Profit Analysis

(1) The assumption of constant variable cost might not hold quantity and
cash discount.

(2) Technical development cannot be constant in a dynamic technological

world.

(3) There are sex oral qualitative factors influencing production and sales
which may not be quantifiable in monetary value.

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Break Even Point Diagram

Total Sales

Profit
Total Cost
Variable cost

Example

Kolawole Plc. is a manufacturing company having in 1996 the total fixed cost
to be N1, 200,000 the variable cost being N2,000,000 and sales for the year
equal N4,000,000.

Compute the break even point in Nara value

Solution

B.E.P (N) FC .
I - V/P

This is: 1,200,000 .

1 - 2,000,000/4,000,000 = N2, 400,000
Example 2

Ojo and Co is a manufacturing firm with the budget given below for the year
ending 28th February 2000

Budgeted sales N1, 000,000

Budgeted Variable Cost N 500,000

Budgeted Fixed Cost N 200,000

Compute the break-even point in naira

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B.E.P (N) FC .
I - V/P

200,000 - 200,000
1- 500,000 0.5
1000,000
= N400, 000

Self-Assessment Exercise (SAE) 1

1. List and explain the major element of cost

4.0Summary

The relationship between the cost and volume of products was examined in the study the
economics order quantity was equally examined it also seek to help determine the best
time to buy a particular quantity and when not to order. The contribution margin was also
covered.

5.0 Conclusion

The student will be able to use the knowledge of cost volume analysis in decision making
process. It will be of value to making decision on units of a raw material to order and at
what price.

6.0 Tutor-Marked Assignments

1. Explain the basic assumptions of Cost Volume Profit Analysis

2. Discuss the Limitations of Cost Volume Profit Analysis

184
7.0 Reference/further readings

Akinsulire, O (2005). Financial Management, 3rd edition. Lagos: Ceemol Nigeria Ltd

Brigham, C and Houston, D (1999). Fundamentals of Financial. Florida: the Dryden

Press

Lucey, T (2002). Costing. London: Thomson Learning

Pandy, L.M (2004). Financial Management. New Delhi: Vikas Publishing

House

185
 MODULE 6

Unit 1: PUBLIC SECTOR FINANCIAL MANAGEMENT

1.0 Introduction

2.0 Objectives

3.0 Main Contents

4.0 Summary

5.0 Conclusion

6.0 Tutor-Marked Assignments

7.0 References/Further Reading

1.0 Introduction
Finance is an important aspect of government’s business at all levels. It is a
very prominent position in organizations, be they private or public. Indeed, of
the many factors that do affect organizational performances, none is greater
than finance. Finance is the engine room of all organizations; It is the lifeblood
of any organization. It is likened to air in the body of human beings without
which, no human being can survive. It keeps the administrative machinery of
any organization on its wheels. No organization can function effectively without
finance. Indeed, it is the life elixir of any organization (Idahosa and
Nchuchuwe, 2005). Management scholars see it as the most significant asset in
any organization. As Bhagwan and Bhushan (2006) put it, the success of any
administration depends upon the availability of finance.

Almost everything government does requires finance. The best policies and

plans will come to naught unless funds are available to pay for the personnel

186
and materials/equipments required. Every administrative act has its financial

implications. Nothing can be done without the expenditure of money, at the

very minimum for buying stationeries or for the payment of the salary and

wages of the officials or employees who perform one duty or the other.

Unavailable financial resources set a limit on administrative activity as a whole

and on each of its separate parts. It is therefore not too surprising that Lloyed

George remarked that “Government is finance” (cited in Tonwe, 2008). This

according to Bhagwan and Bhushan (2006) is quite correct because the

governmental machinery will come to a halt unless funds are available to pay

the personnel and purchase the equipments and materials required.

2.0 Objectives

By the end of this study, you will be able to:

1. Explain financial management and control in the public service

2. The importance of budget to government

3. Discuss the procedures in government budget

3.0 Main Contents

3.1 Financial Management and Control Framework In Public Service

Financial management and control is the bedrock of government management

and its framework should provide the principal source of reference for guiding

managers and their financial advisers in the efficient, effective and proper use

of public resources.

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It is the premise of this study that the status of financial management and

control has diminished in recent years because of unclear communications and

a lack of accountability by those responsible for exercising it. The

commendable objectives of recent management reforms, such as improved

stewardship and accountability, will be much more difficult to achieve without

clear, comprehensive and coherent financial management and control

frameworks in government departments and agencies.

A model framework for financial management and control is outlined as that

which is consistent with the objectives of the most recent management reforms,

notably those related to modern comptrollership and the management

accountability framework.

It is possible to extract a financial management and control framework from

the management reforms and expert commentaries of the last few years, and

this is the subject of the rest of this study.

Let’s start with the definition of comptrollership submitted by the Society of

Management Accountants to the Independent Review Panel on Modern

Comptrollership:

…the process of acquiring resources and using them effectively and

efficiently in the accomplishment of an organization’s purposes and

objectives

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This definition focuses on what preoccupies most government managers,

namely, getting the resources they need to get the job done, and being able to

account to stakeholders on how well they used approved resources in

accordance with stakeholders’ expectations. I say this because in my view

‘accomplishment of an organization’s purposes and objectives’ includes staying

within the bounds of a legal mandate and meeting the stated values of the

organization with respect to ethics, and applicable rules.

Given the above interpretation, I suggest that the purpose of a governmental or

departmental/agency financial management and control framework is: To

facilitate and set the boundary lines for the planning, use and accounting of

resources. The phrase ‘and set the boundary lines’ establishes that an

Financial management and control framework facilitates the resource

management cycle (from planning to external reporting) within the rules,

values, and performance expectations of the organization’s stakeholders.

Financial planning and control in public sector involves the process of financial

planning. Budgeting and control of budget in the public sector or government

sector.

Financial control in the public sector is aimed at ensuring accountability, strict

utilization of public fund. A meritorious discharge of duty in the public service

enhances prudent expenditure of public funds.

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Financial planning entails the establishment of a financial plan and budget.

The budget is a legal document stating the projected revenue and expenditure

of the government for a fiscal period normally a year spanning from January to

December (Kehinde and Abiola, 2006).

The budget states the various revenue expenditure, it states the sources of

those revenue and amount expected from each, such bases are the government

forecast. The revenue is matched with expenditure. Government expenditure is

basically divided into the recurrent expenditure and capital expenditure.

Recurrent expenditures are those expenditure on government consumption

activities like payment and settling of other consumption spending of the

government.

The capital expenditure is that which is spent on capital project, it is that fund

expended on capital varieties e.g road construction, electricity generation,

government housing estate etc. They are money spent on investment that

would generate future income to the government. Where they do not generate

direct income to the government, they generate utility to the nation (Kehide and

Abiola ( 2006).

3.2 Importance of Budget to Government

a. It represents a legal and economic document that guides government

activities and operations.
b. It projects the policy operation of the government. It is the translation of
government policy to action. It is the policy document of the government.

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 c. It represents government allocation of the national resources.
d. It provides the basis for control of government financial activities.
e. It is a measure of government performance. It provides a basic means of
measuring government performances.
f. It serves as a basic tool for decision making in the private sector since
government budget provides the direction of the private sector, budget as a
tool for planning their affairs and determining their policy.
g. It is a basic tool for a community government plans and activities to the
nation as a basic tool of performance.

3.3 Government Budget Procedure

Presidents in Council. This is the first process in government budgeting and

planning. The president and all the ministers come together to determine the

government policies and strategy for the year. The president and all his

ministers decide what must be done sometimes as part of government

programme. Thereafter each ministry and departments prepare their

department budget based on the objective of the government for the year.

Call Circulars: The ministry of finance requests for the various ministries

budget through call circulars, which the ministry of finance budget and

planning sector put together for the president consideration.

The ministry of finance’s budget department proposal put the various

department proposals together to form the budget.

Budget Committee: The ministry of finance then set up a budget committee

members consists of a director from the ministry (most times the Director of

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budgeting and planning). A Director from the Office of the Accountant General

of the Federation, Ministry of establishment, ministry of works and housing.

The committee looks at the call circulars submitted by each ministry to ensure

that they comply with laid down rules and regulation. When the call circular

requires they are to be return for necessary amendment.

Thereafter the President in Council considers the budget proposal and sends it

to the National Assembly for Legislative approval.

Section 81(1) of the 1999 constitution in regard to the budget process, states

that the president shall cause to be prepared and laid before each house of the

National Assembly at any time in each financial year, estimates of the revenues

and expenditure of the federation for the next following year. Thus, base on

the requirement of this section, the proposed budget will be sent to the

National Assembly for approval.

The National Assembly: The National Assembly is divided into the upper

house (the senate) and the lower house (or House of Representatives). The

proposed budget becomes the annual financial bill that must be passed into

law as a legal document of government financial activities.

The financial bill passes through the formal law making process. Hence the bill

will be passed to the house of representatives for consideration, and this will go

to the senate where it will pass through the same process and thereafter the

president assent. This process includes the following,

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The First Reading. A copy of the bill is given to each member of the house for

personal digestion and consideration. The committee stage: After the first

reading the bill will be considered by the various standing committee of the

house. This is called the committee stage. Each committee express its opinion

on the bill.

The Second Reading: After the committee stage, the houses meet to consider

the report of the committee. It should be noted that any minister including the

president could be called upon either at committee stage or the second reading

to answer question on any part of the bill. The house after the second reading,

leaves to consider the bill again.

The Final Reading: The house meet for the final reading of the bill and each

member can still express his opinion and recommendation, as the bill could be

amended as deemed fit by the House. Thereafter the bill is given final house

approval.

The House: The House of Representatives will be the first to consider the bill,

thereafter passing it to the senate which consider it and append the final

senate approval.

The President Assent: The bill is thereafter passed to the president for final

approval. The president approval is the final in passing the bill which becomes

the financial appropriation for the year. However, where the president refuse

to approve, then the provisions of section 59(4) of the constitution August hold

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which states that “which the president refuse to approve the bill sent to him by

the National Assembly within thirty days the bill shall be represented to the

National Assembly. Sitting at a joint meeting and if passed by two third (2/3)

majority of the members of both houses, the bill shall become law and the

approval of the president shall be ignored.

3.4 Factors Influencing Government Budget

1) The personality of the personnel involved in the budget matters. The

skill, knowledge and wisdom of the personnel involved counts in

government budget.

2) The resources of the nation matters; whether or not he nation is looking

for financial resources to execute the budget will court in the budget

implementation.

3) The availability of fund to execute the budget matters. No matter how

progressive a budget might be it will fail if there is no fund to execute it.

a. Global trend

4) Where the revenue generation of the nation is subject to extended

influence like inflation in the world market and other external influence,

the budget projection might be difficult.

5) Continuity in government August influence budget projectiles. Where

the government policy is unstable this will negatively affect the budget.

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 6) Global Peace: Since all nations are dependent on each other, political

situation in a nation August influence the budget of another nation since

no nation operations independent. The revenue generation of the nation

could be impaired e.g September 11th World Trade disaster in the United

States of America (USA).

Self-Assessment Exercise (SAE) 1

Explain the importance of budget to government

4.0 Summary

In this unit, you have learnt of the budgetary process in the government. The value of
government budget and the approval process of the government budget

5.0 Conclusion

The unit provide the guide that works the student through the government budget and the
process of it approval. Thus, it will be a useful tool to enhancing the ability of the student
preparing the budget in the government department.

6.0 Tutor-Marked Assignments

1. Discuss the factors influencing government budget in Nigeria

2. Explain the procedures in government budgeting in Nigeria

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7.0 References/Further Reading

Tonwe, D.A (2008), Public Administration: An Introduction, Lagos: Amfitop

Books.

Kehinde J (2011), Strategy Financial Management, Lagos: Rakson Nigeria Ltd

Idahosa, S. A. and Nchuchuwe, F.F (2005), “Local Government Finances in

Nigeria: Issues in Generation, Utilization, Accountability and Service

Delivery”, Nigerian Journal of Policy and Development, Vol 4, pp100 -132.

Bhagwan, V. and Bhushan, V. (2006), Public Administration, New Delhi: S.

Chand and Company Ltd.

196
 MODULE 6

Unit 2: TECHNIQUES AND TOOLS FOR ACHIEVING EFFICIENT

MANAGEMENT OF GOVERNMENT FINANCE

1.0 Introduction

2.0 Objectives

3.0 Main Contents

4.0 Summary

5.0 Conclusion

6.0 Tutor-Marked Assignments

7.0 References/Further Reading

1.0 Introduction

In the last unit, you have leant the nature of financial management and control in the
public sector and the importance of budget to government. In this unit, you will learn the
techniques and tools for achieving efficient management of government finance

2.0 Objectives

The objectives of this unit include Understand the tools for efficient management of
government finance

(1)To know various approaches to budget implementation in Nigeria

(2)To understand the Pillars of a Financial Management and Control
Framework

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3.0 Main Contents
3.1 Techniques and Tools for Achieving Efficient Management Of
Government Finance

Finance and its prudent management are the bedrock of effective functioning of

government. No one can doubt the need for efficient financial management in

any modern system. According to Tonwe (2004), governments require finance

to perform their statutory provisions which border on provision of services and

bringing about development in their delimited areas. Availability of adequate

fund, coupled with efficient financial management constitutes the required

catalyst necessary for timely execution and completion of development projects

by local government.

In recent time, lack of funds has often been attributed as the major problem

which had hindered effective and successful execution and completion of many

public projects. However, experience has shown the contrary that poor finance

management, rather than inadequate finance is the bane of governments’

inability to achieve substantial development in their domain.

The aim of this section is to examine the various methods and techniques that

could be applied for effective and efficient finance management in the

government system. In other words, this chapter attempts to give decision

makers in government options to consider as they deal with the complex and

ever changing questions of financing for the local community.

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Financial management encompasses many aspects. When working in this field,

it is evident that many factors play a role and need to be considered. This guide

gives government officials quick access to a framework of ideas and suggestions

that work within the hierarchy of financial management.

The funds of the government councils are managed by the key officers of

respective councils. Financial management has to do with efficient use of

funds. It is a method of showing and ascertaining the financial position of

government or business from time to time.

Financial Management can be envisaged as consisting of a cycle of activities.

The aim of this cycle of activities is to ensure that resources are allocated and

monitored in such a way that they have the greatest beneficial impact on

overall service objectives.

In order to perform finance functions efficiently, the financial managers of the

government have to:

1. Set the financial objectives of the government.

2. Prepare plans of action and select policies for achieving the objective.

3. Develop financial plans and incorporate these into the overall plans of

the government.

4. Check the achievement of the objectives and evaluate deviations from the

plan.

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 5. Establish causes for deviations.

6. Take corrective action and/or redesign policy or revise the objectives to

start a new cycle

Traditionally, considerable importance is attached to what can be the money

factor in the functioning of organizations in both public and private sectors

(Adamolekun, 1983). One important issue of concern is usually the

management of available financial resources. Generally speaking, a number of

various approaches for efficient finance management are available. However,

the approach to be adapted must take into account the peculiar nature of the

project, its environment, purpose and the public it is meant to serve (Nwankwo,

2004). This is because if a “wrong” or “unpopular” approach is adapted for a

particular project, it can mar the project completely.

The different approaches that can be adapted for efficient financial

management of government level include the following:

3.2 The Use of Budget

The use of budget has been a long standing practice in government system.

Budgetary control is concerned with ensuring that the financial management

plan that has been agreed with the board of management is achieved. Control

is effected through monitoring expenditure before and after commitment to

prevent under expenditure or over expenditure. An effective use of the budget

is good for achieving efficient financial management. A budget is a plan of

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activity expressed in financial terms; such plans are often short term, typically

covering a period of one year. When approved, the budget becomes an

authority to raise the amount of revenue and incur the amount of expenditure

stated therein.

Adamolekun (1983) summarized the purpose of a budget thus:

(i) a short term financial plan;

(ii) a political document couched in figures;

(iii) a management tool used for both planning and control;

(iv) a device for ensuring continuous monitoring procedures, and reviewing

and evaluating

(v) performances with reference to previously established standards;

(vi) an agent to enable management to anticipate change and adapt to it;

(vii) an overall method for improving operation.

It is imperative to note that the budgetary process takes four distinct activities.
These are as follows: budget preparation, budget authorization, budget
execution and budget monitoring and evaluation. In many governmental
arrangements, the agencies or bodies responsible for each of these activities are
distinct, with varying degrees of autonomy and interdependence (Adamolekun,
1983).

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3.2 Approaches to Effective Budget Implementation

Rational Approach

The rational approach is a popular decision-making model. It is usually applied

where effective and efficient allocation of resources is needed. The rational
approach is generally known as

“The Modern Financial Resources Allocation and Control Model” within the
financial management circle. Using rational approach for proper financial
management entails the following:

1) Determination of available resources;

2) Determination of objectives for which the resources will be allocated;

3) Determination of the alternative courses of action for the achievement of

objectives;

4) Evaluation of the alternative courses of action for the achievement of

objective(s);

5) Establishment of decision criteria;

6) Allocation of resources;

7) Establishment of control measure and feedback mechanism necessary or

required

8) performance evaluation;

9) Adjustment of future plans and objectives for purposes of future

allocation.

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Incremental Approach

Many organizations adopt an incremental budgeting method to produce budget

estimates. Incremental approach to financial management involves
introduction of gradual changes or adjustment in the allocation and control of
financial resources of an organization in order to achieve the desired objectives.
Once a system of financial management and control are adopted, only minor or
gradual changes or adjustments are required in order to put the system into
perfect working condition (Nwakwo, 2004).

Incremental approach takes as its starting point the current year’s budget and
arrives at next year’s budget by a series of adjustments to this. The adjustment
process is sometimes referred to as rolling forward an existing budget.

Incremental method has some advantages. It is a relatively straight forward

process; only marginal changes to the existing budget need to be understood
and agreed, thereby minimizing the amount of time that need be spent on
budget preparation. Hence, it is a relatively inexpensive method of estimating a
budget. Additionally, it is easy to operate and allows some degree of flexibility
and discretion in the use and management of funds.

Zero-Based Budgeting (ZBB)

The Zero-base budgeting (ZBB) approach involves preparing a comprehensive

budget anew, that is, from a zero base. The novelty of ZBB is that each year an
organization should begin its budgetary process with a clean sheet of paper. In
other words, ZBB prepares something ‘fresh’.

It starts from zero or from the scratch. The construction of a new budget for
each service from basic principles is referred to as zero-based budgeting. This
approach has the effect of focusing attention on such issues as waste,
unnecessary performance, leasing versus purchasing of equipment, and so on.

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In Zero based budgeting individual cost centre managers are asked to estimate
the cost of providing various levels of services, which are then passed up
through the organizational hierarchy. At each level in the hierarchy, managers
are asked to decide upon the order of the decision packages as a way of
ensuring that spending is linked to priorities (Rose and Lawson, 1999).

One of the major strengths of ZBB is that there is a specific link between
budget and activity.

The budget process involves specifying objectives and considering cost-effective

methods of achieving these objectives. In this way, ZBB eliminates waste,
extravagancy, mismanagement of finances of a local government.

The major drawback of ZBB as a finance management tool is that it is time

demanding. In other words, it takes lot of time to construct a budget from zero
each year.

Planning-Programming and Budgeting System (PPBS)

As the name implies, the three main features of PPBS are planning,
programming and budgeting; the emphasis here is upon a programmatic
approach to both planning and budgeting.

PPBS is an approach to budgeting which is intended to provide a system that

relates expenditure at each stage of the budget to the purposes of that
expenditure.

The application of PPBS as a finance management tool allows for weighing the
alternatives, analysing of cost and benefits of any project or programme before
the commitment of financial resources to the project. A further advantage is
that programme budgeting looks beyond the immediate future and is
concerned with the long-term effects of activities.

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PPBS has a number of drawbacks. Technically speaking, PPBS requires
information on costs and benefits that is not readily available, and it is also a
time-consuming budgetary method.

Audit Alarm

Audit alarm is a precautionary method of alerting the appropriate authority or

the public about illegal financial transactions or misappropriations that August
lead to loss of funds or revenue meant for a project. Audit alarm can be raised
by a member of the executive or the general public. This is usually done at any
time irregularity is noticed in the management of funds meant for public use.
Whenever audit alarm is raised it usually attracts full-scale audit-exercise to
ascertain the magnitude of the fraud or irregularity. This method serves as a
precautionary warning to those entrusted with the responsibility of the
finances.

Auditing Approach

The regular audit method complements the good efforts of audit alarm. Audit is

more or less a practice which could be called a technique for ensuring a more

effective internal check on financial management. There should be regular and

independent examination of the books of accounts by appointed qualified

auditors to ensure that the statement of account as recorded represents a true

and fair-view of all the transactions as during the period under investigation.

Regular auditing of account would ensure sanity, prudence and probity in the

use and management of finances.

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3.3 The Pillars Of A Financial Management And Control Framework

The pillars of comptrollership advocated by the Independent Review Panel and

later by the Modern Comptrollership team at the Treasury Board Secretariat

can be summarized as follows:

1. Performance Information – financial and non-financial information

2. Risk Management

3. Control Systems

Each of these pillars fit well with the financial management and control

framework:

Linking financial and non-financial information

The key objective of this pillar is to link resources to results. In my view, the

reason why this objective has been so hard to achieve is because of a lack of

cost management, a critical element of financial management. Expressed in

simplest terms, cost management is a responsibility for managing the factors

that cause costs; specifically what causes the work (the activities in the MAF)

that consumes resources. When the factors that cause costs are understood

and managed, it is much easier to achieve sound resource management.

Factors that cause the costs of activities (resources consumed) August include

many things, such as: the volume of client demand; service standards (e.g.,

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accuracy and timeliness); the type of clients; and the complexity of governing

rules and systems. This is the non-financial information that needs to be

linked to the financial information in order to link resources to results. A good

cost management structure within the financial management and control

framework will provide clear cost policies and principles, costing

methodologies, and an activity dictionary that truly reflects the actual work

that is done to achieve results. It will also have a costing module in its financial

management and control system to enable expenditures to be linked to

activities, and the resulting activity costs to be assigned on a causal basis to

performance targets (outputs and outcomes in the MAF) and to other cost

objects, such as clients and services.

While the concepts in cost management are fairly straight forward, they appear

to be extremely hard to apply in the public sector. I believe one of the main

reasons for this is that an expenditure culture still exists. The primary interest

appears to be in how much has been spent by a department or program, rather

than what it costs to deliver its services and outputs.

In the federal government this culture will be difficult to change as long as

appropriations continue to be authorized and managed on an expenditure

rather than an accrual basis.

A good cost management framework not only enables the linking of resources

to results for accountability purposes, but also provides better information for

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planning, alternative service delivery analysis, pricing of services, and other

critical decisions.

Risk Management

This second pillar is clearly related to financial management and control,

particularly to control. This is because control is a function of risk. The only

reason for having controls is to guard against unacceptable things happening.

Thus, we have the FAA and TB policies and regulations. These only exist to

help alleviate the possibility of Ministers and public servants doing the wrong

things, such as misappropriating or overspending funds.

Financial management Controls are costly, and this is why they should be

subjected to risk management techniques before being implemented. A key

requirement is to size the risk.

Financial management and control also uses risk management to help in the

analysis of decisions, such as how to minimize the risk of unfavourable

downstream financial consequences. A good example of this would be where

the financial specialist, using life-cycle costing methods, is able to show that

the best acquisition price for a major capital acquisition August not in fact be

the least costly option over the long term.

It is important to remember that risk management is also to alleviate the risk of

opportunities being missed. This involves anticipating new technologies or new

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pieces of legislation to ensure that the organization will be ready to take

advantage of them as soon as they are available or take effect.

Control Systems

Financial management and control systems reflect mandatory controls such as

those required for expenditures and revenues under the FAA and TB policies,

and those that stem from risk management techniques where there is

discretion by the senior executive or a board of management to decide what

areas of management and accountability need protective or facilitative control

measures.

Protective controls are meant to protect public funds from being spent

improperly or imprudently and public assets from loss, theft and damage.

Facilitative controls are controls that enable the achievement of program

objectives. Expressed another way, protective controls are input-oriented and

facilitative controls are output oriented.

Protective control systems are exemplified by financial, appropriation and

commitment accounting systems as well as inventory and asset systems.

Because they are costly, these systems should be as efficient as possible, for

example, through the use of expert systems.

These systems can make the work associated with protective controls user-

friendly. They prompt the user to make selections from a menu on the

computer screen so that no essential control steps are missed. They also advise
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the user of the authority to consult with in the event that difficulties are

encountered.

Facilitative control systems are exemplified by financial planning and

forecasting systems, and integrated financial and non-financial performance

systems. They alert managers of the need to revise plans and take actions to

correct identified problems, or to take advantage of newly identified

opportunities.

Self-Assessment Exercise (SAE) 1

1. Explain the various ways of performing finance functions efficiently

4.0 Summary

Public sector financial management is crucial to a country’s economic

development. Issues such as extravagance, wastage, embezzlement, and
corrupt practices will affect the development of a country. As taxpayers, who
are the providers of funds, citizens expect their Government to provide value-
for-money services to them. Public officials and their offices are therefore
accountable for the efficient and effective management of funds provided by
these taxpayers to achieve the intended outcomes of the specified activities.

5.0 Conclusion

Given the rather elaborate constitutional, statutory, administrative and other

provisions put in place to ensure probity, accountability and transparency by
public functionaries, the popular belief of many people in this country and
abroad that there is a serious problem of accountability and transparency in
Nigeria is very instructive.

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6.0 Tutor-Marked Assignments

1. Explain the approaches to effective implementation of government budget

2. Discuss the Pillars of A Financial Management And Control Framework

7.0 References/Further Reading

Adamolekun, L. (1983), Public Administration: A Nigerian and Comparative

Perspective, Lagos: Longman Nigeria. Ltd.

Tonwe, D.A (2008), Public Administration: An Introduction, Lagos: Amfitop

Books.

Kehinde J and Abiola, S (2006), Financial Management and Strategy, Lagos:

Rackson Nigeria Ltd

Idahosa, S. A. and Nchuchuwe, F.F (2005), “Local Government Finances in

Nigeria: Issues in Generation, Utilization, Accountability and Service

Delivery”, Nigerian Journal of Policy and Development, Vol 4, pp100 -132.

Bhagwan, V. and Bhushan, V. (2006), Public Administration, New Delhi: S.

Chand and Company Ltd.

211