UNIVERSITY OF NAIROBI SCHOOL OF BUSINESS

DFI 501: FINANCIAL MANAGEMENT

UNIVERSITY OF NAIROBI SCHOOL OF BUSINESS DEPARTMENT OF FINANCE AND ACCOUNTING DFI 501: FINANCIAL MANAGEMENT COURSE OUTLINE: MAY-AUGUST 2009

PRE-REQUISITE: DAC 501: FINANCIAL ACCOUNTING INSTRUCTORS: Kamasara V.O. and Lisiolo Lishenga COURSE OBJECTIVE Finance continues to advance rapidly both in the theory and in its real-world applications. As management struggle to create value within the corporate setting, financial management as a discipline is assuming a greater strategic focus. Conflicting stakeholder interests, informational and financial signaling implications, the globalization of finance, the growth of e-commerce, the emergence of strategic alliances, the rise of outsourcing and the advent of the virtual corporation now permeate and pose challenges to the field of financial decision-making. The primary objective of this course is to introduce students to the fundamental principles of financial management and the role of finance in the success of the business. Emphasis will be placed on the theories and models of finance and their application in financial decision making by individuals and business enterprises. COURSE CONDUCT AND EVALUATION: The course will be conducted by way of lectures and class discussions. Students are expected to acquire at least one copy of the recommended texts at the beginning of the course. An acquaintance of the material to be covered prior to the lectures enhances appreciation of the subject matter during the lecture. This will then be enhanced when student revises in light of lecture. Students should expect, and constantly practice on, quantitative questions. Students will be evaluated as follows: Quizzes Tests Final Exam Total 20% 30 50 100%

READING MATERIALS:

1) Brealey, R.A; Myers, S.C et al (20007): Principles of Corporate Finance, Mc Graw Hill. 2) Van Horne, J.C (2007): Financial management and Policy, 12th edition, Prentice hall. 3) Ross, S.A; Westerfield, R.W et al (2007): Principles and Applications of Corporate Finance, Mc Graw Hill/Irwin. 4) Gitman L.J (2006): Principles of Managerial Finance, 11th Edition, Pearson Addison-Wesley. 5) Pandey I.M (2005): Financial Management, 9th Edition, Vikas Publishing House, India. 6) Other reading materials to be assigned in class. COURSE CONTENT 1. Fundamental Concepts of Financial Management An Overview of Financial Management The Nature of Financial Markets Agency Theory and Corporate Governance Risk and Return 2. Valuation of Securities The Concept of Valuation Time Value of Money Valuation of Bonds Valuation of Stocks Corporate Valuation 3. Investment Decisions Basics of Capital Budgeting Cash flow Determination Capital Budgeting Techniques Uncertainty in Capital Budgeting Capital Rationing 4. Cost of Capital Cost of Component Sources of Capital WACC and MCC 5. Financial Planning and Forecasting. Analyzing Financial Performance Approaches to Financial Planning Cash Budgets

6. Financing Decisions Capital Structure Decision Dividend decision 7. Working Capital Management Issues in Working Capital Management Management of Cash and Short Term Financing Management of Accounts Receivables Management of Inventory Management of Accounts Payables

LECTURE ONE: OVERVIEW OF FINANCIAL MANAGEMENT 1.0 Introduction

This lecture discusses the objectives and scope of financial management, the factors that shape the operating environment of financial managers, and the owner/manager agency problem and possible solutions to the problem

Objectives At the end of this lecture students should be able to: 1. Define finance and discuss the scope and decision areas in financial management. 2. Describe the environments that impact on financial management decision. 3. Discuss the goals of financial management. 4. Explain the shareholder/management (agency) conflicts and possible solutions.

1.1 Scope of Finance

We begin the study of finance by taking a broad overview of it as an academic discipline as well as a professional practice. It will become clear that the field of finance is dynamic in its orientation and pervasive in its impact on the lives of almost every economic person. The discipline borrows and interfaces with many other academic disciplines and offers diverse and varied career opportunities. 1.1.1 DEFINITION OF FINANCIAL MANAGEMENT Financial management can be defined as the art and science of managing money. Every organization and individual who has an objective must decide from where to source for money, in what assets to invest the money, and how to manage its assets in the most efficient way. Finance is concerned with the process, institutions, markets, and instruments involved in the transfer money among and between individuals, businesses and the government. 5

1.1.2 WHY STUDY FINANCE All managers in a firm work with finance personnel to justify manpower requirements, negotiate operating budgets, deal with performance appraisals, and sell proposals based on their financial merits. Clearly, those managers who understand the theories, concepts, and practices of financial management will perform their responsibility efficiently and will also justify their needs for financing. Career opportunities in finance are many and diverse. Proficiency in financial management could enable one work as financial analyst, investment analyst, project finance manager, treasurer, and credit manager, pension fund manger, to mention but a few. Although this course focuses on profit making organizations, the decision-making principles are just as relevant for public, non-profit making organizations and even individuals. 1.1.3 DECISION FUNCTIONS OF FINANCE MANAGER Financial management is concerned with the acquisition, financing and management of assets with the goal f maximizing shareholders wealth. These three broad decisions functions of financial managements are briefly discussed below. The Investment Decision This is one the most important decision contributing to value creation. It entails the decision of the amount of assets to be held and the composition of the assets (asset structure). The Financing Decision The function involves deciding on the optimal capital structure (the proportion of debt and share capital) to be employed by the firm. The long term sources of financing which form the capital structure of the firm comprise basically three components: debt capital, preference share capital, and ordinary share capital. These components each have different costs and it is the responsibility of the finance manager to ensure the firms overall cost of financing is as low as possible. The financing decision encompasses the dividend decision of the firm. The value of dividends paid to shareholders must be balanced against the opportunity cost of retained earnings lost as a means of equity financing.

The Asset management decision The asset acquired must be managed effectively. The task requires an analysis of the risk and return of the various assets in order to ensure firms assets are held in efficient combinations. While the responsibility of managing fixed assets may reside with the operating managers, the financial manager will have to devote considerable attention to the management of current assets and liabilities (working capital management).

1.2 Financial Management Environments

The environments that impacts on the functions of a financial manager can be broadly viewed in terms of social, political, economic, and legal contexts. Although all four environments affect a finance managers functions and decisions, the political and social dynamics are driven by events on which the manager has little or no influence. Consequently, in this section we restrict the discussion only to aspects of the legal and economic environment, namely the various types of business organizations, the tax legislation, and the financial system (market institutions and intermediaries). 1.2.1 BUSINESS ORGANISATIONS The three basic forms of business organizations are a proprietorship, a partnership and a corporation (limited liability companies) Sole Proprietorship A proprietorship is an organization in which a single person owns the business, holds title to all the assets and is personally responsible for all liabilities. The main virtue of a proprietorship is that it can be easily established and is subject to minimum government regulation and supervision. The proprietorships shortcomings include the owners unlimited liability for the all business debts, the limitations in raising capital, and the difficulty in transferring ownership. The proprietorship pays no separate income taxes. Rather the income or losses from the proprietorship are included on the owners personal tax return.

Partnership A partnership is similar to a proprietorship, except that it is owned by two or more persons. The profit of the partnership is taxed on the individual partners after sharing. A potential advantage of a partnership compared to a proprietorship is that a greater amount of capital can be raised. In a general partnership each partner is personally responsible for the obligations of the business. A formal agreement (partnership deed) is necessary to set forth the privileges and duties of each partner, the distribution of profits, capital contributions, procedures for admitting new partners and modalities of reconstitutions of the partners in the event of death or withdrawal of a partner. In a limited partnership, limited partners contribute capital and their liability is confined to that amount of capital. There must be however, at least one general partner in the partnership who manages the firm and his liability is unlimited. Corporation A corporation is an artificial entity created by law. A corporation is empowered to own assets, to incur liabilities, engage in certain specified activities, and to sue and be sued. The principal features of this form of business organization are that the owners liability is limited; there is ease of transfer of ownership through sale of shares; the corporation has unlimited life apart from its owners and; the corporation has the ability to raise large amounts of capital. A possible disadvantage is that corporation profits are subject to double taxation. A minor disadvantage is the difficulties and expenses encountered in the formation. Corporation are owned by shareholders whose ownership is evidenced by ordinary stocks shareholders expect earn a return by receiving a dividend or gain through increasing share pries. Corporations are formed under the provisions of the Companies Act (CAP486). A Board of Directors, elected by the owners, has ultimate authority in guiding the corporate affairs and in making strategic policy decisions. The directors appoint the executive officers (often referred to as management) of the company, who run the company on a day-to-day basis and implement the policies established by the directors. The chief executive officer (CEO) is responsible for managing day-to-day operations and carrying out the policies

established by the board. The CEO is required to report periodically to the firm's directors. Figure 1.1 Strengths 1. Owner receives all 1. Can raise more 1. proprietorship Owners have profits (as well as losses) capital than a sole limited liability which guarantees they cannot lose more than they invest. 2.Low organizational costs 2. Borrowing power 2. enhanced owners 3. Not taxed separately: 3. proprietors return. 4. A high degree independence More rather income included on brainpower managerial skills of 4. Not are taxed 4. Endless life of firm The (does not depend on taxed life of owners) separately. partners of profits 5. A degree of secrecy is achievable 5. Can hire of from professional managers (separation ownership control) 6. There is ease of 6. Can raise funds more easily dissolution by Growth is not more restricted by lack of funds. (can see shares) available 3. Ownership (shares) and is readily transferable Strengths and weaknesses of the basic forms of business organizations Sole proprietorship Partnership Corporation

after receiving share

Weaknesses 1. owner has unlimited 1.Owners have 1. Taxes generally liability higher due to double on and liability total wealth can unlimited be taken to satisfy debts

and may have to taxationcover the debts of dividends other partners corporate profits

2.

Limited tends

fund to

raising 2.

Partnership on

is 2. More expensive the to organize

ability growth

inhibit dissolved of a partner

death or withdrawal Difficult to 3. Subject to greater

3. proprietor must be a jack- 3. of-all-trades 4.Difficult to motivate

liquidate or transfer regulation partnership interest 4. Lacks secrecy, because stockholders receive report must financial

employees career prospects

5. Continuity dependent on presence of proprietor

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1.2.2 TAX ENVIRONMENT Taxation by central and local government has profound influence on the behavior of business and their owners. Tax considerations are especially important in financial management. Let us also appreciate that tax laws are so numerous and complex and their impact so profound that firms require the input of a tax expert in many decisions. Ordinary income tax. The income of all business organizations is liable to tax by the government. As we noted before the income of proprietorships and partnerships added to that of its owners and taxed at graduated rates for individuals. How much tax is charged depends on the personal tax status of the owners. A corporations taxable income is found by deducting all allowable expenses from the revenue. The taxable income is then subject to the corporate tax rate to determine the amount of tax liability (The current corporate tax rate in Kenya is 30%). Capital allowance and tax credit. Capital allowance is allowable in place of depreciation and is granted to businesses engaged in investment activities and that operate fixed asset. Tax credits are reduction in tax liability granted by the government to a taxpayer. Capital allowances and tax credits lower the purchase price of capital assets and a major consideration in investment decisions. The government grants the allowance and credits for the purpose of stimulating economic development. Interest Vs dividends Interest paid on outstanding corporate debt is a tax-deductible expense. However dividends paid to shareholders are not tax deductible. Thus, for a profitable company, the use of debt (bonds) in its financing mix results in significant tax advantage relative to the use of share capital. Capital gains tax. This is the tax levied on the gain (or loss) on the sale of fixed assets. The capital gains tax rate is usually lower than the ordinary income tax rate (Capital gains tax is currently suspended in Kenya). 1.2.3 FINANCIAL SYSTEM The primary role of the financial system in the economy is to facilitate in the transformation of saving into investments. The financial system provides the principal means by which a person who has saved money out of current income can transfer their

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savings to someone else who has productive investments opportunities and is in need of money to finance them. This transfer of money results in the creation of a financial asset for the saver and a financial liability for the borrower. Consequently, the financial system provides the means for risk transfer and risk sharing among the market participants. Figure 1.2 illustrates the instruments used in financial system, the way they flow and the main participants in the system.

Figure 1.2

The financial system comprises of financial markets, financial

institutions that intermediate, the financial instruments that represent claims, and the savers and demanders of funds who are the government, individuals and businesses. Funds Funds Loans

Deposit /shares

Financial institutions Banks, insurance companies, Pension funds Saccos etc

Suppliers of funds (Savers) Business, Government Households

Funds

Private placement Securities Securities

Funds

Demanders of funds (Investors) Business, Government Households

Funds Securities

Financial markets Primary v Secondary Money v Capital

Funds

Securities

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Financial assets Financial assets are divided into three general classes; money, debt and shares. Money is issued by government as currency notes and coins and by some commercial banks through their checking accounts. The issuer of debt promises to pay the creditor a specific amount of money at a future date whereas the company that issues shares is selling ownership rights in the company to the shareholder. Savers and demanders of funds The key suppliers and demanders of funds are individuals, businesses, and governments. The savings of individuals provide financial institutions with a large portion of their funds. Individuals are not only suppliers of funds, but also demand funds from financial institutions in the form of loans. Individuals as a group are the net suppliers for financial institutions: They save more money than they borrow. Business firms also deposit some of their funds in financial institutions, primarily in checking accounts with various commercial banks. Firms, like individuals, also borrow funds from these institutions. As a group, business firms are net demanders of funds: borrowing more money than they save. Governments maintain deposits of temporarily idle funds, certain tax payments, and Social Security payments in commercial banks. Although governments do not borrow funds directly from financial institutions, by selling their securities to various institutions, they indirectly borrow from them. The government is typically a net demander of funds (budget deficits). Financial Intermediaries Financial intermediaries facilitate the indirect transfer of money from savers to lenders. Intermediaries confer the following advantages to those who consume their services. 1. Flexibility and liquidity Intermediaries provide a large sum of money to a borrower by pooling the savings several investors. They also engage in maturity transformation of assets and claims, providing investors with financial assets which maybe liquid money at the same time as they are making long-term loans. 2. Diversification By sourcing funds from savers with diverse characteristics the intermediary is able to provide relatively low risk capital to investors.

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3. 4.

Convenience By dealing with an intermediary a person gets a variety of financials services provided at one point in time and place. Expertise Because of continuous engagement in financial transactions the intermediary accumulates expertise that can be availed to customers.

The major financial institutions in Kenya economy are commercial banks, savings and loans, credit unions, savings banks, life insurance companies, pension funds, and mutual funds. These institutions attract funds from individuals, businesses, and governments, combine them, and make loans available to individuals and businesses. A brief description of the major financial institutions follows. Institution Commercial bank Description Accepts both demand (checking) and time (saving) deposits. Also offers negotiable order of withdrawal (NOW), and money market deposit accounts. Commercial banks also make loans directly to borrowers or through the financial markets. Saving and loan These are similar to a commercial bank except chat it may not hold demand (checking) deposits. They obtain funds from savings, negotiable order of withdrawal (NOW) accounts, and money market deposit accounts. They lend primarily to individuals and businesses in the form of real estate mortgage loans. Credit union Commonly known as Savings co-operative societies (Saccos), credit unions deal primarily in transfer of funds between members. Membership in credit unions is generally based on some common bond, such as working for a given employer. Credit unions accept members savings deposits, NOW account deposits, and money
market account deposits and lend funds to members, typically to finance automobile or appliance purchase, or home improvements.

Savings banks

These are similar to a savings and loan in that it holds savings, NOW, and money market deposit accounts. Savings banks lend or invest funds through financial markets, although some mortgage loans are made to individuals.

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Life insurance Company It is the largest type of financial intermediary handling individual savings. It receives premium payments and invests them to accumulate funds to cover future benefit payments. It lends funds to individual, businesses, and governments, typically through the financial markets. Pension fund Pension funds are set up so that employees can receive income after retirement. Often employers match the contribution of their employees. The majority of funds is lent or invested via the financial market. Mutual fund Pools funds from the sale of shares and uses them to acquire bonds and stocks of business and governmental units. Mutual funds create a professionally managed portfolio of securities to achieve a specified investment objective, such as liquidity with a high return. Hundreds of funds, with a variety of investment objectives exist. Money market mutual funds provide competitive returns with very high liquidity. Unit trusts Unit trusts are investment funds which are open ended, that is, the size of the fund and number of shares or units issued depends on the level of demand from the investor. More units are issued as and when investors subscribe, additional money to the fund. The value of this unit is based on the market value of the investment held by the trust. Unit trust provides 2 main services to individual investors. (a) Opportunity to invest in relatively will diversified portfolio of the management services are reflected in the purchase price of the units. In order to safeguard the interest of the unit holders, trustees are appointed under the terms of the trust deed. A management company will also be appointed with responsibility both for (b) The expertise of professional investment managers. The cost

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marketing and selling the units and investing the funds subscribed. Financial Markets Financial markets provide a forum in which suppliers of funds and demanders of funds can transact business directly. Whereas the loans and investments of intermediaries are made without the direct knowledge of the suppliers of funds (savers), suppliers in the financial markets know where their funds are being lent or invested. It is important to understand the following distinctions in the market. Money versus Capital markets. The two key financial markers are the money market and the capital market. Transactions in the money market take place in short-term debt instruments, or marketable securities, such as Treasury bills, commercial paper, and negotiable certificates of deposit. The market brings together government units, households, businesses and financial institutions who have temporary idle funds, and those in need of temporary or seasonal financing. Long-term securitiesbonds and stocksare traded in the capital market. The main actor in the capital markets is the securities exchanges, which provide the market place in which demanders can raise long-term funds and investors can maintain liquidity by being able to sell securities easily. The Nairobi Stock Exchange (NSE) was established in 1954 and is one of the most active stock markets in sub-Saharan Africa. It currently (2005) has 48 companies listed and 20 brokerage company members. Private placements versus Public offerings. To raise money, firms can use either private placements or public offerings. Private placement involves the sale of a new security issue, typically bonds or preferred stock, directly to an investor or group of investors, such as an insurance company or pension fund. However, most firms raise money through a public offering of securities, which is the nonexclusive sale of either bonds or stocks to the general public, Primary market versus Secondary market. All securities, whether in the money or capital market, are initially issued in the primary market (Initial public offerings ( IPOs) and seasoned equity offerings (SEOs)). This is the only market in which the corporate or government issuer is directly involved in the transaction and receives direct benefit from

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the issue. That is, the company actually receives the proceeds from the sale of securities. Once the securities begin to trade in the stock exchange, between savers and investors, they become part of a secondary market. The primary market is the one which new securities are sold; the secondary market can be viewed as used, or pre-owned, securities market.

1.3 The Goal of the Firm in Market Economy

A market economy is one in which goods and services are bought and sold at prices determined in free competitive markets. Business firms are the principal agents charged with the task of producing as efficiently as possible the goods and services the society needs. Given this broad goal of efficiency, what standard or benchmark should financial management practice be measured? In sum, what is the goal of the firm from a financial management perspective?

1.3.1

PROFIT MAXIMIZATION

Microeconomic theory of the firm is founded on profit maximization as the principal decision criterion: markets managers of firms direct their efforts toward areas of attractive profit potential using market prices as their signals. Choices and actions that increase the firms profit are undertaken while those that decrease profits are avoided. To maximize profits the firm must maximize output for a given set of scarce resources, or equivalently, minimize the cost of producing a given output. Applying Profit-Maximization Criterion in Financial Management Financial management is concerned with the efficient use of one economic resource, namely, capital funds. The goal of profit maximization in many cases serves as the basic decision criterion for the financial manager but needs transformation before it can provide the financial manger with an operationally useful guideline. As a benchmark to be aimed at in practice, profit maximization has at least four shortcomings: it does not take account of risk; it does not take account of time value of money; it is ambiguous and sometimes arbitrary in its measurement; and it does not incorporate the impact of nonquantifiable events.

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Uncertainty (Risk) The microeconomic theory of the firm assumes away the problem of uncertainty: When, as is normal, future profits are uncertain, the criteria of maximizing profits loses meaning as for it is no longer clear what is to be maximized. When faced with uncertainty (risk), most investors providing capital are risk averse. A good decision criterion must take into consideration such risk. Timing Another major shortcoming of simple profit maximization criterion is that it does not take into account of the fact that the timing of benefits expected from investments varies widely. Simply aggregating the cash flows over time and picking the alternative with the highest cash flows would be misleading because money has time value. This is the idea that since money can be put to work to earn a return, cash flows in early years of a projects life are valued more highly than equivalent cash flows in later years. Therefore the profit maximization criterion must be adjusted to account for timing of cash flows and the time value of money. Subjectivity and ambiguity A third difficulty with profit maximization concerns the subjectivity and ambiguity surrounding the measurement of the profit figure. The accounting profit is a function of many, some subjective, choices of accounting standards and methods with the result that profit figure produced from a given data base could vary widely. Qualitative information Finally many events relevant to the firms may not be captured by the profit number. Such events include the death of a CEO, political development, and dividend policy changes. The profit figure is simply not responsive to events that affect the value of the investment in the firm. In contrast, the price of the firms share (which measures wealth of the shareholders of the company) will adjust rapidly to incorporate the likely impact of such events long before they are their effects are seen in profits. 1.3.2 VALUE MAXIMIZATION Because of the reasons stated above, Value-maximization has replaced profitmaximization as the operational goal of the firm. By measuring benefits in terms of cash flows value maximization avoids much of the ambiguity of profits. By discounting cash flows over time using the concepts of compound interest, Value maximization takes account of both risk and the time value of money. By using the market price as a measure

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of value the value maximization criterion ensures that (in an efficient market) its metric is all encompassing of all relevant information qualitative and quantitative, micro and macro. Let us note here that value maximization is with respect to the interests of the providers of capital, who ultimately are the owners of the firm. the maximization of owners wealth is the principal goal to be aimed at by the financial manager. In many cases the wealth of owners will be represented by the market value of the firms shares - that is the reason why maximization of shareholders wealth has become synonymous with maximizing the price of the companys stock. The market price of a firms stocks represent the judgment of all market participants as to the values of that firm - it takes into account present and expected future profits, the timing, duration and risk of these earnings, the dividend policy of the firm; and other factors that bear on the viability and health of the firm. Management must focus on creating value for shareholders. This requires Management to judge alternative investments, financing and assets management strategies in terms of their effects on shareholders value (share prices). 1.3.3 AGENCY CONFLICTS AND WEALTH MAXIMIZATION Two difficulties complicate the achievement of the goal of shareholder wealth maximization in modern corporations. These are caused by the agency relationships in a firm, and the requirements of corporate social responsibility. I.3.3.1 Agency Problem

In modern corporations, control (vested in management) is divided from ownership (vested in shareholders). This separation is the cause of myriad conflicts of interests between management and owners. During the past years a body of financial theory, the agency theory, has emerged dealing with the conflict between shareholders and the resolution of these conflicts. The genesis of the conflict is the opportunistic behavior of management, which makes them place their (management) interest above that of shareholders. Consequently, shareholders wealth maximization goal is sacrificed. For instance, they may grant themselves excessive salaries, consume large amounts of perquisites, engage in empire

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building, and make sub-optimal investment decisions (retaining profits and investing in negative NPV projects rather distributing profits as dividends). Mechanism to Align Shareholder/Management Interests In order to ensure that managers act in the best interests of the shareholders several mechanisms may be employed. The most common measures are discussed below. (i). Monitoring Shareholders design mechanism to monitor management actions to ensure their interests are not hurt. Monitoring of management by shareholders themselves is, however, complicated for the following reasons: It is impossible for a shareholder without exception expertise to know to what extend management have under performed management can even conceal alliaceous frauds they have committed form shareholders and throughout. Underperformance may result from extraneous circumstances beyond management control. For example, changes in world prices of important inputs (oil) could escalate costs, or changing tastes may make demand for a companys product to evaporate (i.e. cigars and pipe tobacco). Shareholders are obligated to contract with external parties in order to effectively monitor management. Some of the monitoring arrangements include the following: Hiring auditors- who report annually to shareholders at the Annual General Meeting (AGM) on the managements stewardship of the company. Board of directors- a properly constituted board plays the oversight role on management for the shareholders Bonding insurance. Taking fidelity insurance whereby the firm is compensated if the insured management commits an infringement. (ii). Executive compensations schemes

Appropriate compensation schemes should be designed to address managements aversion to risk and their obsession with short-term decision horizon. Such schemes include; Stock options that make managers part owners help align interest of management

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and shareholders

(iii).

Cash and stock bonus pegged to performance. Shareholder-activism

The threat of bad publicity by disgruntled shareholders who can confront management and create dissent among other stockholders, if the grievance is founded. can act as a deterrent to managerialsm. (iv). Legal sanctions

Corporate boards and management also face legal liability for their acts of commission and omission which betray their fiduciary duty to shareholders. (v). Corporate takeover market (market for corporate control)

The possibility of an outside takeover of the company can be a powerful deterrent to mismanagement. Management of firms that under-perform become target for take-over bids. If a takeover bid succeed incumbent management teams vacate their positions to replaced by new management teams

(vi).

Market for executive labor.

In an efficient labor market, executives who under perform will lose their jobs and this may adversely affect their reputational capital. They will find it hard to secure similar positions in other companies. On the other hand managers who maximize shareholders wealth can keep their jobs. Inefficient managers will thus be driven out of the executive labor market or be forced to take less rigorous jobs.

1.3.3.2.

Social Responsibility and Ethics

It has been argued that the unbridled pursuit of shareholders wealth maximization makes companies unscrupulous, anti social, enhances wealth inequalities and harms the environment. The proponents of this position argue that maximizing shareholders wealth

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should not be pursued without regard to a firms corporate social responsibility. The argument goes that the interest of stakeholders other than just shareholders should be taken care of. The other stakeholders include creditors, employees, consumers, communities in which the firm operates and others. The firm will protect the consumer; pay fair wages to employees while maintaining safe working conditions, support education and be sensitive to the environment concerns such as clean air and water. A firm must also conduct itself ethically (high moral standards) in its commercial transactions. Being socially responsible and ethical cost money and may detract from the pursuit of shareholders wealth maximization. So the question frequently posed is: is ethical behavior and corporate social responsibility inconsistent with shareholder wealth maximization? Scholars and practitioners concur that, in the long run, the firm has no choice but to act in socially responsible ways. It is argued that the corporations very survival depend on it being socially responsible. The implementation of a pro-active ethics ad corporate social responsibility (CSR) program is believed to enhance corporate value. Such a program can reduce potential litigation costs, maintain a positive corporate image, build shareholder confidence, and gain the loyalty, commitment and respect of firms stakeholders. Such actions conserve firms cash flows and reduce perceived risk, thus positively effecting firm share price. It becomes evident that behavior that is ethical and socially responsible helps achieve firms goal of owner wealth maximization. The existence of non- financial objectives do not negate financial objectives, but they do mean that the simple theory of corporate finance, that the objective of the firm is to maximize the wealth of the share holders is too simplistic. It may be necessary to sacrifice financial objectives in order to be a responsible corporate citizen.

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REVIEW QUESTIONS 1. 2. 3. What are the problems in the relationship between shareholders and management? Contrast the liability provisions of a sole proprietorship, a partnership, a limited partnership, and a corporation. Explain the relationship among the following: a) Authorized shores; b) Outstanding shares; c) Treasury stock, and d) Issued shares. 4. 5. 6. 7. 8. 9. 10. What are the key differences between debt capital and equity capital? Differentiate between standard debt provisions and restrictive covenants included in a bond indenture. What is the Euro currency market? What is the London Inter-bank Offered Rate (LIBOR)? Distinguish between a Eurobond and a foreign bond. What is the agency problem? What are agency costs? For what three basic reasons is profit maximization inconsistent with wealth maximization? Describe the role of corporate ethics and social responsibility. Reconcile the need for ethics and social responsibility with shareholder wealth maximization. 11. 12. 13. What are the three key activities of a financial manager? Relate them to the firms balance sheet. Describe the field of managerial finance. Why is the study of finance important to all professionals and managers? What are the principal functions: 1. Financial markets and, 2. Financial intermediaries in a financial system?

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PROBLEMS QUESTION ONE Makau Munyao has invested sh.25 million in Mbooni Ltd. The firm has recently been declared bankrupt and has Sh.60 million in unpaid debts. Explain the nature of payments if any, by Mr. Munyao in each of the following situations: a) b) c) Mbooni Ltd. is a sole proprietorship owned by Mr. Munyao Mbooni Ltd. is a 50-50 partnership of Mr. Munyao and Mr. Mutiso. Mbooni Ltd is a corporation.

QUESTION TWO For each of the following situations explain the agency conflict inherent, the cost the firm might incur, and the likely remedies: a) b) c) d) The front desk receptionist routinely takes extra 20 minutes of lunch on his personal errands. Division managers are padding cost estimates in order to show short term efficiency gains. The firms CEO has secret talks with a competitor about the possibility of a merger in which she would become CEO of the combined firms. A branch manager lays off experienced full-time employees and replaces them with temporary workers to lower employment costs. The managers bonus is based on profitability of the branch. QUESTION THREE Unity Trading Companys charter authorities issuance of Sh.2,000,000 ordinary hours. Currently, 1,400,000 shares are outstanding and 100,000 shares are being held as treasury stock. The firm wishes to raise sh.48,000,000 for plant expansion. The sale of new ordinary shares will net the firm sh.60 per share.

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a) b) c)

Determine maximum member of ordinary shares the firm can issue without shareholders approval. Will the firm be able to raise needed funds without further authorization. What must the firm do to get authorization to issue more than the shares as determined in (a) above.

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LECTURE TWO: THE TIME VALUE OF MONEY 2.0 INTRODUCTION

In this lecture you will be provided with compounding and discounting skills required in making many financial decisions. Because you can earn interest on money you have, a shilling today would grow to more than a shilling later. Our goal in this lesson is to evaluate the trade-off between money held today and money promised at some future point in time. Objectives At the end of this lecture you should be able to: 1. Discuss the role of time value in finance 2. Explain the concept of future value and perform compounding calculations. 3. Explain the concept of present value and perform discounting calculations. 4. Apply the mathematics schedules, of and finance to accumulate a future sum, preparing loan amortization determining interest or growth rates.

2.1 THE TIME VALUE OF MONEY

Time value of money is one of the most important concepts in finance. The techniques and skills you learn in this lesson will be essential in handling many of the financial decision situations in latter lessons, so you should pay particular care to the material 26

presented. Time value computations will be necessary in many and diverse decision situations, such as financial structure decisions, lease versus purchase of capital assets choices, bond refinancing decisions, valuation of securities , cost of capital, among others. The concept of time value of money is based on the fact that, in general, a shilling received today is more valuable than a shilling to be received at future point in time (a bird in hand is worth two in the bush). This concept recognizes that the passage of time affects the value of money: A shilling in ones possession today is more valuable than a shilling to be received in future because, first, the shilling in hand can be put to immediate productive use, and, secondly, a shilling in hand is free from the uncertainties of future expectations (It is a sure shilling). 2.1.1 Time value Concepts We begin the lesson by considering two views of time value: Future value (FV) Present value (PV)

Financial values and decisions can be assessed by using either future value (FV) or present value (PV) techniques. These techniques result in the same decisions, but adopt different approaches to the decision. Future value techniques measure cash flow at the some future point in time typically at the end of a projects life. The Future Value (FV), or terminal value, is the value at some time in future of a present sum of money, or a series of payments or receipts. In other words the FV refers to the amount of money an investment will grow to over some period of time at some given interest rate. Present value techniques measure each cash flows at the start of a projects life (time zero).The Present Value (PV) is the current value of a future amount of money, or a series of future payments or receipts. Present value is just like cash in hand today. To illustrate the two concepts of time value, a time line could be employed. A time line is a horizontal line on which time zero appears at the left most end and future periods are marked from left to right. Figure 2.1 depicts cash flows occurring over time and the associated future values and present values.

27

Because money has time value, all of the cash flows associated with an investment must be measures at the same point in time. Typically the point is chosen is either at the end or the beginning of the investments life. FV techniques use compounding to find the future value of each cash flow at the given future date and the sums those values to find the value of cash flows. Alternatively the PV techniques use discounting to find the PV of each cash flow at time zero and then sums these values to find the total value of the cash flows. Although FV and PV techniques result in the same decisions, since financial managers make decisions in the present, they tend to rely primarily on PV techniques.

FIGURE 2.1Time line depicts an investment's cash flows covering five periods, and FV and PV concepts. The timeline represents the case where an initial investment of Sh. 100,000 at time zero is followed by cash inflows for the next five years of Sh.30,000, Sh. 50,000, Sh.40,000, Sh030,000, and Sh.20,000 respectively

FV

-100,000 0 1

30,000 2

50,000 3

40,000 4

30,000 5

20,000

PV

2.2 FUTURE VALUE OF A SINGLE AMOUNT

The question of whether or not interest is earned on the preceding years interest earnings needs to be addressed first. Two forms of treatment of interest are possible. In the case of

28

Simple interest, interest is paid (earned) only on the original amount (principal) borrowed. In the case of Compound interest, interest is paid (earned) on any previous interest earned as well as on the principal borrowed (lent). Compound interest is crucial to the understanding of the mathematics of finance. In most situations involving the time value of money compounding of interest is assumed. The future value of present amount is found by applying compound interest over a specified period of time The Equation for finding future values of a single amount is derived as follows: Let FVn = future value at the end of period n PV (Po) =Initial principal, or present value k= annual rate of interest n = number of periods the money is left on deposit.

The future value (FV), or compound value, of a present amount, Po, is found as follows. At end of Year 1, FV1 =Po (1+k) At end of Year 2, FV2=FV1 (1+k) = Po(1+k) (1+k) = Po (1+k)1 = Po ( 1+k)2

At end of Year 3, FV3 = FV2 (1+k) = Po ( 1+k) ( 1+k) (1+k) = Po (1+k)3 A general equation for the future value at end of n periods can therefore be formulated as, FVn = Po ( 1+k)n . Take note Equation (2-1) is the basic relationship in the timevalue-of-money formulations. All other equations and relationships we shall discuss later derive from this equation Example 1 Jane deposited Sh.800,000 in a saving account paying 6% interest compounded annually and would like to know the money the account after 3, 6,7, and 10 years. Solution At the end of 3 years, FV3 = 800,000 ( 1+0.06)3 = Sh.952,813 29 (2-1)

At the end of 6 years, FV6 = 800,000 ( 1+0.06)6 = Sh. 103,9534 At the end of 7 years, FV7 = 800,000 ( 1+0.06)7 = Sh. 1,202,904 At the end of 10 years, FV10 = 800,000 ( 1+0.06)10 = Sh. 1,432,678 2.2.1 Using Tables to Find Future Values

Unless you have financial calculator at hand, solving for future values using Equation 2.1 can be quite time consuming because you will have to raise (1+k) to the nth power. Luckily, there are published tables available giving values of (1+k)n for various values of k and n. Appendix A at the back of this manual contains a set of these interest rate tables. Appendix A table A-1 gives the future value interest factors. These factors are the multipliers used to calculate at a specified interest rate the future values of a present amount as of a given date. The future value interest factor for an initial investment of Sh.1 compounded at k percent for n periods is referred to as FVIFk n. Future value interest factors = FVIFk n. = (1+k)n . We can, consequently, rewrite Equation 2.1 as follows. FVn = Po * FVIFk,n (2.3) (2.2)

The FVIF for an initial principal of Sh.1 compounded at k percent for n periods can be found in Appendix Table A-1 by looking for the intersection of the nth row an the k % column. A future value interest factor is the multiplier used to calculate at the specified rate the future value of a present amount as of a given date. Example 2 We refer to Example 1 where Jane wanted to find out the amount in her account at future dates given prevailing interest rate of 6%. Solution Using Table A-1 we find the relevant factors by looking at the intersection of k-column, and n-row, and multiply by initial deposit. FV after 3 years will be, 800,000*FVIF 6%,3yrs = 800,000*1.191 = Sh.952,800 FV after 6 years will be 800,000 * FVIF 6%,6yrs = 800,000*1.419 =Sh.1,135,200 FV after 8 years will be, 800,000 * FVIF 6%,8yrs = 800,000*1.594 =Sh.1,275,200 FV after 10yearswill be, 800,000 * FVIF 6%,10yrs = 800,000*1.791 =Sh.1,432,800

30

Example What is the value of Janes deposit after six years assuming the following annual interest rates; 3%, 5%, 8%, 10%, and 15%. FV with 3% rate is 800,000*FVIF3%,6yrs=800,000 x 1.194=Sh.955,200 FV with 5% rate is 800,000*FVIF5%,6yrs=800,000 x 1.340=Sh.1,072,000 FV with 8% rate is 800,000*FVIF8%,6yrs=800,000 x 1.587=Sh.1,269,600 FV with 10% rate is 800,000*FVIF10%,6yrs=800,000 x 1.772=Sh.1,417,600 FV with 15% rate is 800,000*FVIF15%,6yrs=800,000 x 2.313=Sh.1,850,400 A Graphic View of Future Value Figure 2.1 Influence of time and interest rates on the FVIFs. 30 25 FV of 1/= 20 15 10 5% 5 1 0 2 4 6 8 10 12 Periods Future values are normally stated at the end of the given period. Figure 2.1 graphically illustrates the relationships between interest rate, the time periods, and the future value interest factors. The relationships can be summed as follows: 14 16 18 0% 20 5% 200 150 100

31

1. The higher the interest rate, the higher the future value of Sh.1. 2. The longer the period of time, the higher the future value of Sh.1. 3. When the interest rate is zero there is no growth and the future value equals the present value of Sh.1. 2.2.2 Compounding More Frequently.

Interest is often compounded more frequently than once a year. Financial institutions compound interest semi-annually, quarterly, monthly, weekly, daily or even continuously. Semi Annual Compounding This involves the compounding of interest over two periods of six months each within a year. Instead of stated interest rate being paid once a year one half of the stated interest is paid twice a year.. Example Jane decided to invest Sh.100,000 in savings account paying 8% interest compounded semi annually. If she leaves the money in the account for 2 years how much will she have at the end of the two years? She will be paid 4% interest for each 6-months period. Thus her money will amount to. FV4 Or Using tables = 100,000 x FVIF 4%,4periods Quarterly Compounding This involves compounding of interest over four periods of three months each at one fourth of stated annual interest rate. Example Suppose Jane found an institution that will pay her 8% interest compounded quarterly. How much will she have in the account at the end of 2 years? FV8 = 100,000(1+.08/4)4*2=100,000(1+.02)8 =100,000 x 1.1716 = 117,160 Or, =100,000*1.17 = Sh.117,000 = 100,000 ( 1+.08/2)2*2 =100,000(1+.04)4 =Sh.116,990

32

Using tables 100,000 x FVIF 2%,8periods = 100,000*1.172 = 117,200 As shown by the calculations in the two preceding examples of semi-annual and quarterly compounding, the more frequently interest is compounded ,the greater the rate of growth of an initial deposit. This holds for any interest rate and any period. General Equation for Compounding more Frequently than Once a Year. Let; m = the number of times per year interest is compounded n= number of years deposit is held. k= annual interest rate.
m*n

FV

n,k

k = P 0 1 + m

(2.4)

Continuous Compounding. This involves compounding of interest an infinite number of times per year, at intervals of microseconds - the smallest time period imaginable. In this case m approaches infinity and through calculus the Future Value equation 2.1 would become, FVn (continuous compounding) = Po * e k x n (2.5) Where e is the exponential function, which has a value of 2.7183. The FVIFk,n (continuous compounding) is therefore ekn , which can be found on calculators. Example If Jane deposited her 100,000/= in an institution that pays 8% compounded continuously, what would be the amount on the account after 2 years? Amount = 100,000 x 2.718.08*2 = 100,000 x 2.7180.16 =100,000*1.1735 =117,350 Nominal Rate versus Effective Annual Rate (EAR) of Interest. When interest is compounded more frequently than once annually, then the actual interest earned or paid would be higher than the nominal or stated interest rate. The nominal (stated, or quoted) annual rates is the contractual annual rate of interest charged by a lender or promised by a borrower.

33

The Effective annual rate (EAR) is the annual rate of interest actually paid or earned. The EAR is best viewed as the interest rate expressed as if it were compounded once per year. The effective annual rate reflects the impact of compounding frequency, whereas the nominal annual rate does not. At times ,interest rates may be quoted in ways that mislead borrowers and investors regarding the real interest burden or return they are contracting. To correctly assess the interest involved one should go beyond the stated rate and work out the effective annual rate and compare with the stated annual rates. We can calculate the EAR by the following equation

k EAR = 1 + 1 m
Example

(2.6)

Where m is the frequency of compounding per year, and k is the stated annual rate. Jane wishes to find the effective annual rate associated with 8% nominal annual rate when interest is compounded (1) annually, (2) semi annually, and (3) quarterly Solution Using the above equations; 1. Annual compounding EAR = (1 + 0.08 )1 -1 = ( 1+0.08)1-1 = 8%

2. Semi annual compounding EAR = ( 1+ 0.08/2 )2 1 = ( 1+0.04 )2-1 = 8.16% 3. Quarterly EAR = ( 1 + 0.08/4)4 1 = ( 1 + 0.02)4 1 = 8.24%. From the foregoing answers, we can note two points:

34

Take note 1) The effective annual rate increases with increasing compounding frequency. 2) The nominal and effective rates are equivalent for annual compounding.

2.3 FUTURE VALUE OF AN ANNUITY.

An annuity is a series of payments or receipts of equal amounts (i.e. a pensioner receiving Sh.100,000 per year for ten years after his retirement). The two basic types of annuities are the ordinary annuity and the annuity due. An ordinary annuity is an annuity where the cash flow occurs at the end of each period. In an annuity due the cash flows occur at the beginning of each period. This means that cash flows are sooner received with an annuity due than for a similar ordinary annuity. Consequently, the future value of an annuity due is higher than that of an ordinary annuity because the annuity dues cash flows earn interest for one more year. 2.3.1 Finding the Future Value of an Ordinary Annuity. The determination of the future value of an ordinary annuity can be illustrated using the following example. Example John wishes to determine how much money he will have at end of 5 years if he deposits Sh.100,000 annually at the end of the 5 years into an account paying 7% annual interest. The following time line and Table 2.2 depicts the situation faced by John. 131100 122500 114500 107000 100000

35

575100 0 1 100,000 2 100,000 3 100,000 4 100,000 5 100,000

Table 2.2 Future value of a Sh.100,000 5-year ordinary annuity compounded at 7% End of Amount year (1) 1 2 3 4 5 deposited (2) 100000 100000 100000 100000 100000 Number years companied (3) 4 3 2 1 0 1.311 1.225 1.145 1.070 4.751 1.000 5.751 100000 Sh.575100 FVIFA and the FV after 5 years of Future value interest factor (FVIF) from discount tables (4) Future value at end of year (5) (2) *(4) 131100 122500 114500 107000

Using Tables to Find Future Value of an Ordinary Annuity Annuity calculations can be simplified by using an interest table. The value of an annuity is founding by multiplying the annuity with an appropriate multiplier called the future value interest factor for an annuity (FVIFA) which expresses the value at the end of a given number of periods of an annuity of Sh.1 per period invested at a stated interest rate. The formula for the future value interest factor for an annuity when interest is compounded annually at k percent for n periods (years) is ;

FVIFA

k ,n

= (1+ k )
t =1

t 1

[(1+ k ) 1]
n

(2.7)

36

The future value interest factor for an n-year, k%, ordinary annuity (FVIFA) can also be found by adding the sum of the first n-1 FVIFs to 1.000,as follows; FVIFAk,n = 1.000 +
n 1 t =1

FVIF

k ,t

Applying the future value interest factor of an annuity, the future value of an annuity is determined using the following expression. The future value of an annuity (PMT) can be found by,
FVAn = PMT x (FVIFAk, n) (2.8)

Where FVAn is the future value of an n-period annuity, PMT is the periodic payment or cash flow, and FVIFAk,n is the future value interest factor of an annuity. The value FVIFAk,n can be accessed in appropriate annuity tables using k and n. The Table A-2 gives the PVIFA for an ordinary annuity given the appropriate k percent and n-periods.
Example

Using Table A-2, the appropriate FVIFA at 7%, for 5 years is 5.751 Thus future value of Johns Sh.100,000 5-year annuity is FVA = 100,000 x 5.751 = Sh.575,100
Activity

Find the future value of an annuity of Sh.100,000, a) at 12% for 7 years b) at 18% for 4 years c) at 9% for 15 years d) at 20% for 50 years e) at 35% for 2 years

2.3.2 Finding Value of an Annuity Due.

37

We can demonstrate the calculation of the future value of an annuity due by using the preceding example, only that now John makes the deposits at the beginning of the year rather than at the end. John wants to find now much money he will have at the end of five years if he deposits Sh.100,000 annually at the beginning of each of the next 5 years.

Solution The Time line and Table below shows the future value of a Sh.100,000 5-year annuity

due compounded at 7%.

Timeline

140,300 131,100 122,500 114,500 107,000

615,400

0
100,000 Table Beginning of year deposit

1
100,000

2
100,000

100,000 100,000

No of years interest compounded

FVIF

FV at the end of the year 5

1 2 3 4 5

5 4 3 2 1

1.403 1.311 1.225 1.145 1.070

140300 131100 122500 114500 107000

Sh.615,400

Using Tables to Find Future Value of an Annuity Due

38

A simple conversion can be applied to use the FVIFA (ordinary annuity)in Table A-2 with annuities due. The Conversion is represented by Equation 2.6 below.
FVIFk,n(annuity due) = FVIFk,n(ordinary annuity) x ( 1 +k) (2.6)

The conversion is necessary because each cash flow of the annuity due earns interest for 1 more year than an ordinary annuity.
Example

Using the expression above, we can calculate the future value of the preceding annuity due as follows. FVIFA7%,5yrs (annuity due) = FVIFA7%,5yrs(ordinary) x ( 1 + k) = 5.751 x (1+.07) = 5.751 x 1.07 =6 .154 Therefore future value of the annuity due = 100, 000 x 6.154 = Sh.615, 400. Because the annuity dues cash flows occur at the beginning of the period rather than at the end, its future value is greater than that of a similar ordinary annuity..
2.3.3 Finding unknown Interest Rate

A situation may arise in which we know the future value of a present sum as well as the number of time periods involved but do not know the compound interest rate implicit in the situation. The following example illustrates how the interest rate can be determined.
Example

Suppose you are offered an opportunity to invest Sh.100000 today with an assurance of receiving exactly Sh.300,000 in eight years. The interest rate implicit in this question can be found by rearranging Equation 2.1 as follows. FV8 = P0 (FVIF k, 8 ) 300,000 = 100,000 (FVIFKk,8) FVIFk, 8 = 300,000 / 100,000 = 3.000 Reading across the 8-period row in the FVIFs table (Table A-1) we find the factor that comes closest to our value of 3 is 3.059 and is found in the 15% column. Because 3.059

39

is slightly larger than 3 we conclude that the implicit interest rate is slightly less than 15 percent. To be more accurate, recognize that FVIFk,8 = (1+k)8 (1+k)8 = 3 (1+k) = 31/8 = 30.125 1+k = 1.1472 k = 0.1472 = 14.72%
2.3.4 Finding the Number of Compounding Periods.

We may need to know how long it will take for a shilling invested today to grow to a certain future value given a particular compound rate of interest.
Example

How long will it take Sh.1000 to grow to Sh.1900 if invested at compound annual interest of 10%. Using Equation 2.1 we rewrite it as: FVn = P0 (FVIFk%, n ) 1900 = 1000 ( FVIF10%, n) FVIF10%,n = 1.900 Reading down the 10% column in the FVIF table we look for the FVIF in that column that is closest to our calculated value 1.900. We see that 1.949 comes closest to 1.900 and that the number is in the 7-period row. Because 1.949 is a bit larger than 1.900 we conclude that the implicit compounding periods are slightly less than 7 periods. For accuracy, rewrite FVIF10%,n as ( 1+0.1)n and solve for n ( 1 + 0.1)n = 1.9

(1.1)

= 1.9

Using natural logarithms,

40

n ln1.1 = ln 1.9 n= (ln1.9)/ (ln 1.1) = 6.73 years

Rule of 72

Occasionally you may want to estimate how long a given sum must earn at a given annual rate to double the amount (or, what interest the principal must earn for a given number of periods for the principal to double); the rule of 72 can be used to make this estimate. 1. Numbers of years to double amount =
72 Annual interest rate
72 No of years amount is deposited.

2. The interest rate to double amount

Examples

At 2% interest it would take ~ 36 years (72/2) At 9% interest it would take ~ 8 years (72/9) If you keep money for 4 years you need to earn approximately 18% (72/4) to double it. If you keep money for 6 years you need to earn approximately 12% (72/6) to double it.

Activity

Using discount tables, test the accuracy of Rule 72

2.4 PRESENT VALUES

We may be interested in determining how much a given sum of money to be received at a future date is worth at present. To do this we use the concept of the present value. The present value (PV) is the current shilling value of a future amount i.e. the amount of money that would have to be invested today at a given interest rate to equal the future amount.

41

The process of finding present values is referred to as discounting. It is the inverse of compounding and seeks to answer the question. If I can earn k% on my money, what is the most I will be willing to pay now for an opportunity to receive FV(a future value) shillings n periods from now? The annual rate of return k% is referred to as the discount rate, required rate of return, cost of capital, or opportunity cost.
Example

Paul has an opportunity to receive Sh.30,000 one year from now. If he can earn 6% on his investments what is the most he should pay for this opportunity now? We are required to determine how much he needs to invest now at 6% in order to accumulate Sh.30,000 after one year. Let PV (or Po) equal this amount. PV (1+0.06) = 30,000 PV =
30,000 = 28,302 1.06

The PV of Sh.30,000 received one year from now is Sh.28,302.

Equation for Present Value

The PV of some future amount FVn to be received n periods from now assuming an opportunity cost k% is calculated by rearranging our basic future value equation 2.1, making (PV) the subject as follows.
n

P
=

PV

k ,n

FV (1+ k )

FV

(1+ k )

(2.8)

Example

Paul wishes to find PV of Sh.170,000 that he will receive 8 years from now. Pauls opportunity cost is 8% Substituting in Equation 2.7, PV8%,8yrs = 170,000/( 1 + 0.8)8 =170000/1.851 = Sh.91,842

42

Time line depicting the present value of a sum to be received 8 years from now.

PV=Sh.91,842

FV8 = Sh.170,000

2.4.1 Using Present Value Interest Factor (PVIF) Tables

The factor in Equation 2.8 denoted by

(1+ k )

, or (1+ K ) n

is called the present

value interest factor (PVIF). The PVIF is the multiplier used to calculate at a specified discount rate the present value of an amount to be received at a future date. The PVIFk,n is the present value of one shilling discounted at k% for n-periods. Therefore the present value (PV)of a future sum ( FVn) can be found by
PV = FVn x (PVIFk, n). Example (2.9)

In the preceding example the PV could be found by multiplying Sh.170,000 by the relevant PVIF. Table A-2 gives a factor of 0.540 for 8% and 8 years. PV = 170,000 x 0.540 = Sh.91,800.
Present Value Relationships PVIFs

1.00 0.75 0.5 0.25

0 2

0% 5% 15% 20%

0%

10

12

14

16

18

20

22

24

43

Periods

Remember that PV calculations assume that FV are measured at the end of the given period.
Take note The figure above shows that

1. The higher the discount rate the lower the PV. 2. The longer the period of time, the lower the PV 3.PVIFs cannot be greater than 1 nor less than zero.

Note that PVIFK,

1/FVIFk,n, thus given a table for FVIFs one can find

corresponding PVIFs.
2.4.2 Present Value of Cash Flow Streams

Two basic types of cash flow streams are possible: the mixed stream (unequal cash flows) and the annuity (uniform cash flows). A mixed stream cash flow reflects no particular pattern while an annuity is a pattern of equal periodic cash flows.
Present Value of a Mixed Stream

We determine the PV of each future amount and then add together all the individual PVs
Example

The following is a mixed stream of cash flows occurring at the end of year
Year Cash flow

Sh.000 1 2 3 4 5 400 800 500 400 300 44

If a firm has been offered the opportunity to receive the above amounts and if its required rate of return is 9% what is the most it should pay for this opportunities?
Table 2.4 PV of mixed stream of cash flows.

Year (n) 1 2 3 4 5

Cash flow 400,000 800,000 500,000 400,000 300,000

PVIF9%, n 0.917 0.842 0.775 0.708 0.650 PV

PV 366,800 673,600 386, 000 283,200 195,000

1,904,600

Present Value of an Annuity

The method for finding the PV of an annuity is similar for that of a mixed stream but can be simplified using present value interest factor of an annuity (PVIFA) tables. The present value interest factor of an annuity with endof-year cash flows that are discounted at k per cent for n periods is
1 1 = 1 k 1+k

PVIFAK,n

t =1

(1+ k )

(2.9)

Table A-3 provides the PVIFAk,n, which can be used in calculating the present value of

an annuity (PVA) as follows:

PVA = PMT* PVIFAk n Example (2.10)

Mark wants to find the PV of a 5- year annuity of Sh.700,000, assuming opportunity cost of 8%. The PVIFA at 8% for 5 years (PVIFA8%,5yrs) from Table A-3 is 3.993. Therefore, PVA = 3.993 X 700,000 = Sh.2,795,100

45

2.4.3 Present Value of Perpetuity

A perpetuity is an annuity with an infinite life never stops producing a cash flow at the end of each year forever. The PVIF for a perpetuity discounted at the rate k is
PVIFAk, Example = 1/k (2.11)

Rose wishes to determine the PV of a Sh.1000 perpetuity discounted at 10%. The present value of the perpetuity is 1000 x PVIFAk, = 1000 x 1/0.1= Sh.10,000. This implies that the receipt of Sh.1,000 for an indefinite period is worth only Sh .10,000 today if Rose can earn 10% on her investments (If she had Sh.10,000 and earned 10% interest on it each year, she could withdraw Sh.1000 annually without touching the initial Sh.10,000).
2.4.4 Deposits to Accumulate a Future Sum. It may be necessary to find out the periodic deposits that should lead to the built of a

needed sum of money in future. We can use the expression below, which is a rewriting of Equation 2.3.
PMT = FVAn/FVIFAk n (2.10)

Where PMT is the periodic deposit, FVAn is the future sum to be accumulated, and FVIFAk n is the future value interest factor of an n-year annuity discounted at k%.
Example

Jane needs to accumulate Sh. 5 million at the end of 5 years to make special purchase. She can make deposits in an account that pays 10% interest compounded annually. How much should she deposit in her account annually to accumulate this sum?
Solution PMT = FVAn/FVIFAk n Example
=

5,000,000/6.105

Sh.819,000

Suppose you want to buy a house in 5 years from now and estimate that the initial down payment of Sh. 2 million will be required at that time. You wish to make equal annual

46

end of year deposits in an account paying annual interest of 6%. Determine the size of the annual deposit. FVAN = PMT X FVIFAK, N PMT = FVAn/ FVIFAk n

PMT = 2,000,000/5.637= Sh.354,799 2.4.5. Amortizing a Loan

An important application of discounting and compounding concepts is in determining the payments required for an installment type loan. The distinguishing features of this loan is that it is repaid in equal periodic (monthly, quarterly, semiannually or annually) payments that include both interest and principal. Such arrangements are prevalent in mortgage loans, auto loans, consumer loans etc. Amortization Schedule. An amortization schedule is a table showing the timing of payment of interest and principal necessary to pay off a loan by maturity.
Example

Determine the equal end of the year payment necessary to amortize fully a Sh.600,000, 10% loan over 4 years. Assume payment is to be rendered (i) annually, (ii) semiannually.
Solution (i) Annual repayments

First compute the periodic payment PMT = PVAn /PVIFAk,n. Using tables we find the PVIFA10%,4yrs = 3.170, and we know that PVAn = Sh.600,000
PMT = 600,000/3.170 = Sh.189, 274 per year.

Table 2.4 Loan Amortization schedule Payments End of year Loan Beg. Of Interest Principal End of year

47

payment

year principal

principal.

[10%x (2)] (1) 1 2 3 4 189,274 189,274 189,274 189,274 (2) 600,000 470726 328525 172104 (3) 60,000 47,073 32,853 17,210

[ (1) (3) (4) 129,274 142,201 156,421 172,064

[ (2) (4)] (5) 470,726 328,525 172,104 -

(ii) Semi-annual repayments

For semi-annual repayments the number of periods, n, is 8 and the discount rate is 5%. Lets compute the periodic payment. PMT = PVAn /PVIFAk,n. Using tables we find the PVIFA5%,8periods =6.4632, and we know that PVAn = Sh.600,000
PMT = 600,000/6.4632 = Sh.92,833 per year.

Table 2.4 Loan Amortization schedule Payments End period (6months) of Loan payment Beg. year principal Of Interest Principal End period principal. of

[5%x (2)] (1) 1 2 3 4 5 6 92833 92,833 92,833 92,833 92,833 92,833 (2) 600,000 537,167 471,192 401, 918 329,181 252,807 (3) 30,000 26,858 23,559 20,096 16,459 12,481

[ (1) (3) (4) 62,833 65,975 69,274 72,737 76,374 80,192

[ (2) (4)] (5) 537,167 471,192 401918 329,181 252,807 172,615

48

7 8

92,833 92,833

172,615 88,413

8,631 4,421

84,202 88,412

88,413 -0-

2.4.6 Determining Interest or Growth Rate

It is often necessary to calculate the compound annual interest or growth rate implicit in a series of cash flows. We can use either PVIFs or FVIFs tables. Lets proceed by way of the following illustration.
Example

Roy wishes to find the rate of interest or growth rate of the following series of cash flows Year 2004 2003 2002 2001 2000
Solution

Cash flow (Sh.) 1,520,000 1,440,000 1,370,000 1,300,000 1,250,000

Using 2000 as base year, and noting that interest has been earned for 4 years, we proceed as follows: Divide amounts received in the earliest year by amount received in the latest year. 1,250,000/1,520,000 = 0.822. This is the PVIF k , 4 yrs . We read across row for 4

years for the interest rate corresponding to factor 0.822. In the row for 4 year in table of Table A-3 of PVIFs, the factor for 5% is .823, almost equal to 0.822. Therefore interest or growth rate is approximately 5%. Note that the

FVIF

k , 4 yrs

(1,520,000/1,250,000) is 1.216. . In the row for 4 year in table

of Table A-1 of FVIFs, the factor for 5% is 1.2155 almost equal to 1.216.We estimate the growth rate to be 5% as before.

49

REVIEW QUESTIONS 1. 2. 3. 4. 5. 6. 7.

Why does money have time value? List five different applications of time value of money. If, as an investor, you had a choice of daily, monthly, or quarterly compounding, which would you choose? Why? Describe the procedure used to amortize a loan into a series of equal annual payments. What is a loan amortization schedule? What is perpetuity? What is continuous compounding? What effect does frequency of compounding have on the effective annual rate (EAR)? Explain the difference between an ordinary annuity and an annuity due

PROBLEMS

2-1

Tom Mapesa has Sh.500,000 that he can deposit in any of three savings accounts for a 3 years period. Bank I compounds interest on an annual basis, Bank II compounds interest twice each year, and Bank III compounds interest each quarters. All the three Banks have a stated annual interest rate of 4%.

a) b) c) d)

Compute the amount in each bank account at the end of 3 years. What is the effective annual rate (EAR) that is earned from each bank? In which bank should Tom deposit his money? Bank IV is different from the others only in the sense that compounding is done continuously. What would be the amount at end of 3 years if it was deposited in Bank IV.

2.2.

Flo Waridi wishes to accumulate Sh.800,000 by the end of 5 years by making equal annual end-of-year deposits over the next 5 years. If Flo can earn 7% on her investments, how much must she deposit at the end of each year to meet this goal?

50

2-3

The East African Railways Ltd has outstanding an issue of 4 percent perpetual bonds and promises to pay Sh.2000 semiannually forever. If the market rate of interest for similar bonds is 9%,at what price should be perpetual bond sell currently.

2-4

Gina Watseka wants to take a holiday in Las Vegas 5 years from today. It is estimated that the trip will cost Sh. 600,000. a) Determine the periodic annual deposits in the account necessary to accumulate the required sh.600,000. Assume first deposit first deposit is made 1 year from today. b) c) How much will Gina have to deposit annually if the final deposit is made 1 year before the holiday. Suppose the cost of living increases 4 percent per year over the next 5 years. What would be the effective purchasing power in year 5 of your deposits calculated in part (a) above?

2-5

A Bank offers a loan of Sh.1,500,000. The terms of the loan require you to payback the loan in five equal annual installments of sh.416,100. interest on this loan. The first payment will be made a year from today. What it the effective annual rate of

2-6 a) Determine the equal annual end-off-year payments required each year over the life of the loans shown in the following table to repay them fully during the stated term in the loan. Loan A B C D Principal Sh. 120,000 600,000 750,000 40,000 Interest rate 8% 12 10 15 Term of loan 3 years 10 30 5

51

b) c) 2-7

Prepare a loan amortization schedule for each of the loans in (a). Explain why interest on the loan declines with the passage of time. An investment promises the following end-of-year cash flows Year 1 2 3 Cashflow Sh. 100,000 300,000 200,000

Assuming an interest rate of 10 per cent calculate the single amount that is equivalent in value to the cash flow stream. a) b) c) d) If received today If received at the end of year 1 If received at the end of year 2 If received at the end of year 3

Problems 2-8. If you invest Sh.12,000 today, how much will you have : a. In 6 years at 7%. b. In 15 years at 12 %. c. In 25 years at 10 %. d. In 25 years at 10 % compounded semi-annually.

2-9 How much would you have to invest today to get: a. Sh.12,000 in 6 years at 12%. b. Sh.8,000 in 5 years at 20% c. Sh.15,000 in 15 years at 8%. d. Sh.30,000 each year for 20 years at 6%. e. Sh.40, 000 each year for 40 years at 5%. 2-10 Brian Makamu borrows Sh.7,000,000 at 12% interest rate toward the purchase of a new house. His mortgage is for 30 years. How much will his annual payments be? a. b. How much interest will he pay over the life of the loan? How much should he be willing to pay to get out of a 12% mortgage and c. into a 10% mortgage with 30 years remaining on the mortgage?

52

2-11 Your younger sister, Susie, will start college in one years time. The college fees will amount to Sh.80,000 per year for four years payable at the beginning of each year. Anticipating Susies ambition, your parents started investing Sh.10,000 per year five years ago and will continue to do so for five more years. How much more will your parents have to invest for the next five years to have the necessary funds for Susies education.. Use 10% as the appropriate interest rate throughout the question. 2-12 You are the chairperson of the investment retirement fund for Actors Fund. You are asked to set up a fund of semi-annual payments to be compounded semi-annually to accumulate a sum of Sh.5,000,000 after 10 years at 8% annual rate (20 payments). The first payment into the fund is to take place 6 months from now, and the last payment is to take place at the end of the tenth year. a. Determine how much the semi-annual payment should be. On the day after the sixth payment is made ( the beginning of the fourth year), the interest rate goes up to 10% annual rate, and you can earn 10% on the funds that have accumulated as well as on all future payments into the fund. Interest is to be compounded semi-annually on all funds. b. Determine how much the revised semi-annual payments should be after this rate change (there are 14 semi-annual payments remaining). The next payment will be in the middle of the fourth year. 2-13 You can deposit Sh.100,000 into an account paying 9% annual interest either today or exactly 10 years from today. How much better off would you be at the end of 40 years if you decide to make the initial deposit today rather than 10 years from today. 2-14 Lumumba needs to have Sh.1,500,000 at the end of 5 years in order to fulfill his goal of purchasing a sports car. He is willing to invest the amount as a lump sum today but wonders what type of investment return he will need to earn. Figure out the annual compound rate of return needed in each of the following cases. Lumumba can invest Sh.1,020,000 today. a. Lumumba can invest Sh.815,000 today b. Lumumba can invest Sh.715,000 today c. 2-15 Lucas wishes to determine the future value at the end of two years 0f a Sh.150,000 deposit made today into an account paying a nominal interest rate of 12%. a. Find the future value of Lucas deposit assuming that interest rate is compounded: 1) Annually 2) Quarterly 3) Monthly 4) Continuously b. Using your findings in a demonstrate the relationship between compounding frequency and future value c. What is the maximum future value obtainable given the Sh.150,000 deposit, 2-year time period, and 12% nominal rate? Using your findings in a to explain. 2-16 Rita Wanda wishes to select the better of two ten-year annuities.

53

Annuity X is an ordinary annuity of Sh.250,000 per for 10 years. Annuity Y is an annuity due of Sh.220,000 per for ten years. a. Find the future value of both annuities assuming that Rita can earn (1) 10% annual interest, (2) 20% annual interest. b. Briefly explain the differences between the values 2-17 You plan to retire in exactly 20 years. Your goal is to create a fund that will allow you to draw Sh.200,000 per for 30 years between retirement and probable death. You will be able to earn 11% during the retirement period.. a. How large a fund will you need when you retire in 20 years to provide the 30-year Sh.200,000 annuity. b. How much would you need today as a lump sum to provide the amount calculated in a above if you earn only 9% during the 20 years preceding retirement? 2-18 While vacationing in Lamu Island Chris Musundi saw the vacation home of his dreams. It was listed with a sale price of Sh.20,000,000. The only catch is that Chris is 40and plans to continue working till he is 65. Chris expects property values to increase at the general rate of inflation. Chris can earn 9% annually and is willing to invest a fixed amount for the 25 years to fund the cash purchase of such a house when he retires. a. If inflation is expected to average 5% for the next 25 years what will Chris dream house cost when he retires/ b. How much must Chris invest at the end of each of the 25 years in order to have the cash purchase price of the house when he retires? c. If Chris invests at the beginning instead of at the end of teach of the 25 years, how much must he invest each year?

2-19 Rodgers Masengo just closed a Sh.2,000,000 business loan that is to be repaid in 3 equal end-of year repayments . The interest rate on the loan is 13%. Prepare an amortization schedule for the loan.

54

LECTURE 3: 3.0 INTRODUCTION

RISK AND RETURN

In this lecture we explain how risk and returns of an asset are measured and the trade-off between risk and return. We also introduce the portfolio theory, the diversification effect, and the concept of market efficiency.
Objectives At the end of this lecture you should be able to:

1. Explain the fundamentals of risk, return, and risk preferences. 2. Describe the procedures for measuring risk and return of single assets and portfolio of assets. 3. Show the effect of correlation and diversification on risk and return. 4. Discuss the meaning of beta and explain ther basics of the capital market pricing model (CAPM) and the security market line (SML).

Valuation and an understanding of the trade-off between risk and return form the foundation of shareholders wealth maximization. Each financial decision presents certain risk and return characteristics, and the unique combination of these characteristics impacts on the value of the firm. We shall consider risk and return as they relate to both single assets (arising share) and to a portfolio of assets.

3.1 FUNDAMENTALS OF RISK, RETURN AND PREFERENCES

55

3.1.1

Risk

The term risk is used interchangeably with the term uncertainty to refer to the variability of actual returns from those expected from a given asset. It is the chance of an unexpected financial loss (or gain). The greater the variability the higher risk. Different assets will have varying risk levels. For example, a government bond that guarantees its holder Sh 100 interest after 30 days has no risk it is risk free, because the return is certain. On the hand, a Sh.1000 investment in a certain companys shares which over the same period could earn from Sh.0 to Sh.200 is very risky due to the high variability of returns.

3.2.2 Return
The return on an asset is the total gain or loss experienced on an investment over a given period of time. It is commonly measured as the change in value plus any cash distribution during the period, expressed as a percentage of the beginning of the period investment value. The following equation captures the essence of this value.
kt = (Ct + [Pt Pt-1])/ Pt-1 (3.1)

Where kt = actual, expected, or required rate of return during period t Pt = Price (value) of asset at end of time period t Pt-1 = Price value of asset atend of time period t-1 Ct = Cash (flow) received from the asset investment in the time period t. t may be one day, one month, one year or 10 years. When it is one year kt represents an annual rate of return. The return could be positive or negative in the event of a loss.

3.2.3 Risk Preferences

The three basic risk preference behaviors among managers are risk-aversion, riskindifference and risk-seeking.
Risk-indifference, is the attitude toward risk in which no change in return would be

required for an increment risk

Risk-aversion is the attitude toward risk in which an increased return would be required

for an increase in risk. 56

Risk seeking is the attitude toward risk in which a decreased return would be accepted

for an increase in risk. Figure 3.1 graphically illustrates the three risk preferences.
Figure 3.1 shows the three risk preferences of risk aversion, risk seeking and risk indifference

Return Risk averse

Risk indifference

Risk seeking

Risk

Most managers and investors are risk-averse; for an increase in risk they require an, increase in returns. Consequently, managers and investors tend to be conservative rather than aggressive in accepting risk. Accordingly, unless specified otherwise, a risk averse financial behavior will be assumed in this lecture.

3.3 RISK AND RETURN OF A SINGLE ASSET

For risky securities the actual rate of return can be viewed as a random variable subject to a probability distribution (a set of possible values that a random variable can assume and their associated probabilities of occurrence). This probability distribution for normal

57

populations) can be summarized in terms of two parameters: (1) the expected return (mean), and (2) the standard deviation

3.3.1

Expected Return

The expected return is the weighted average of possible returns, with the weight being the probabilities of occurrences. The expected value of a return, k, is

k = (k i * Pr i )
n i =1

(3.2)

Where ki Pri n
Example

= return for the ith outcome = Probability of occurrence of the ith outcome = Number of outcomes considered.

Asset As return distribution is given in column 1 and 2 in the table below. Using the data in the two columns, the expected return and the standard deviations (risk) of the asset are computed in columns 3 and 4 in the same table. (1) Possible returns (2) Probability of occurrence (3) Expected return (4) Variance

Pr

k =

k * Pr
i

(k k ) Pr
2

0.10 0.02 0.04 0.09 0.14 0.20 0.28

0.05 0.10 0.20 0.30 0.20 0.10 0.05

0.005 0.002 0.008 0.027 0.028 0.020 0.014

0.0000018 0.0005476 0.0005832 0.0000048 0.0004232 0.0011236 0.0017298

= 1.00

= 0.094

= 0.004414

58

The expected return, k , is 9.4% as computed in column 3 above.

3.3.2

Standard Deviation

The risk of a return can be measured by the returns standard deviation or variance. The standard deviation is a statistical measure of the dispersion of a distribution around the expected value. It is the square root of the variance (the sum of squared deviations) of the distribution. The standard deviation is the most common statistical measure of an assets risk. The equation for determining the standard deviation (s.d.) is as follows

(k i k ) Pr
2

(3.3)

Using above preceding example we determine variance as in column 4 of the table.

3.3.3

= 0.004414

0.0664 = 6.64%.

The greater the standard deviation, the riskier the asset.

Coefficient of Variation

The standard deviation can sometimes be misleading in comparing the risk of investment alternatives if the alternatives differ in size. The coefficient of variation, CV, is a measure of relative dispersion that is useful in comparing the risk of assets with differing expected returns. The CV is a measure of risk that neutralizes the influence of size of the investment. The coefficient of variation (CV) is given by the formula,
CV = k k

(3.3)

The CV , thus, represents the amount of variation in the returns per unit of return. The higher the CV, the greater the risk. The real utility of the CV comes in comparing the risk of assets that have different expected returns.

59

Example

Consider investment opportunities A and B whose normal probability distributions of one-year return are as follows.
Characteristics Investment A Investment B

Expected return Standard deviation CV

0.08 0.06 0.75

0.24 0.08 0.33

Based solely on the standard deviation, Investment B would be riskier than A (A would be preferred). This would not be a rational investment decision because if one considers the coefficient of variation, which measures the relative dispersion of risk risk per unit of expected return it is evident that Investment B has the lower risk. B should therefore be preferred over A.

3.4

RISK AND RETURN IN A PORTFOLIO CONTEXT

A portfolio is a combination of two or more assets. The risk of any single proposed asset investment should not be viewed independently of other assets. New investment must be considered in light of their impact on the risk and return of the portfolio of asset held by an investor. The goal should be to create an efficient portfolio one that minimizes risk for a given level of return (or that maximizes returns for a given level of risk). We need to extend our analysis of risk and return to portfolios of assets. Indeed this is only necessary given that investors usually hold assets not singly but in combinations .

3.4.1

Portfolio Return

The expected return on a portfolio is the weighted average of the expected returns of the assets (securities) comprising that portfolio. The weights are equal to the proportions of total funds investor in each security (weight must sum up to 100%) The general formula for the expected return of a portfolio, kp, is

60

k
Where

= j =1 w j * k j
n

(3.5)

w , is the proportion in weight of total funds invested in security j; k

j

is the

expected return for security j; and n is the total number of different securities in the portfolio.

3.4.2

Standard Deviation of a portfolio

The standard deviation of a portfolio returns is found by applying the formula for the standard deviation of a single asset.. Specifically equation 3.2 would be applied, i.e.

(k i k ) Pr
2

(3.6)

Portfolio risk and co-variation

While the portfolio expected return is a weighted average of return on the individual assets, the portfolio s.d is not the simple weighed average of the standard deviations of the individual assets making up the portfolio. The difference is due to the covariance relationships between the returns on different assets comprising the portfolio, which affects risk without affecting returns.
Covariance (correlation)

Covariance (correlation) is a statistical measure of the degree to which two variables (i.e. securities return) move together over time. Positive correlation means that, on average, the returns of the two assets move in the same direction (i.e. when the returns of one asset increase (decrease) those of the other asset also increase (decrease)). Negatively correlation suggests the returns of the two assets move in opposite directions (i.e. when the returns of one asset increase (decrease) the returns of the other asset decrease (increase)). Zero correlation would imply that the two variables show no tendency to vary together.

61

The degree of correlation (co variation) is measured by a correlation coefficient, which ranges from +1 for perfectly positively correlated series to -1 for perfectly negatively correlated series. Uncorrelated series will have a coefficient of zero. The two figures below, Figure 3.2 and Figure 3.3 show the effect of correlation on risk.

Figure 3.2 A perfectly positively correlated returns of two assets M and N (no reduction in risk)

Return Return N

Time

62

Return

Figure 3.3 Perfectly Negatively Correlated returns of two assets , M and N (variability (risk) reduced to nil).

Time

Covariance (correlation) between the returns of assets provides for the possibility of eliminating some risk without reducing potential return. The result could be that a combination of individual risky assets could deliver a low risk portfolio as long as the individual assets returns do not move in lock step ( i.e. perfectly positively correlated).
Diversification

Diversification is the combining of assets (securities) in away that reduces risk (it depends on how the returns of the assets co-vary not on the number of assets in the basket). Diversification reduces risk because some of each individual securitys variability is offset by the variability in the opposite direction of other securities Benefits of diversification, in the form of risk reduction, occur as long as the security are not perfectively positively correlated. Combining assets with perfect positive correlation does not diversify risk. Combining assets with perfect negative correlation in returns confers the greatest diversification impact as it reduces risk to the minimum. Combining assets

63

with correlation coefficients between +1 to -1 will result in diversification benefits, whose magnitude depends on how far away the returns are from being perfectly positively correlated. To reduce overall risk, it is best to combine or add to the portfolio assets that have a negative or a low positive correlation. component assets x and y.
Correlation, Diversification, Risk and return

The calculation of portfolios sad can be found using the following formula:

Portfolio std. deviation =

w w COV ( R , R )
j =1 k =1 j k i j

Where n is the total number of different securities in the portfolio,

w and w
k

are the

proportions of total funds invested in securities k and j, and COV ( R j , Rk ) is the covariance between possible return for securities j and k. For a portfolio of two assets, X and Y, the portfolios standard deviation can be directly calculated from the standard deviations of both assets using the following formula.

wx +w
2 x 2 2
x

2 y

+ 2 wx wy COV ( R x , R y ) . Or, alternatively,

wx +w
2 x 2 2
x

2 y

+ 2 wx wy

xy

Where

w and w
x

are the proportion of funds invested in assets x and y, x and y

COV ( R x , R y ) is the

are the standard deviations of the returns of assets x and y,

64

covariance of the returns of assets x and y, and

xy

is the correlation coefficient between =

COV ( R x , R y )

the returns of component assets x and y. Note that

xy

The correlation coefficient takes values between -1, for perfectly negatively correlated returns, through 0 for uncorrelated returns, to +1 for perfectly positively correlated returns.
Example

Consider the following terms returns for three different assets A, B and C. Two portfolios are to be formed from the assets: (i) AB and (2) AC. The portfolios are formed by combining equal proportions of the component assets.
Asset A Asset B Asset C

8% 10% 12% 14% 10%

16 14% 12% 10% 8%

8% 10% 12% 14% 16%

Find expected returns of the two portfolios. Determine the Std. deviations of the two portfolios. Comment on the diversification impacts of the portfolios formed. The expected returns on the assets are as below.
A B
a

C
b

ri

k
% 8

pk
ri

k
%

pk
ri

k
% 8

pk
ri

0.2 0.2 0.2 0.2 0.2

Expected return

1.6 2.0 2.4 2.8 3.2

12

16 14 12 10 8

3.2 2.8 2.4 2.0 1.6

12

1.6 2.0 2.4 2.8 3.2

12

10 12 14 16

10 12 14 16

65

The standard deviations of the returns of the assets are similar as follows:
Asset A =
2 2 2 0 .2 (0.08 0.12) + 0.2 (0.10.12) + 0.2 (0.12 0.12)

+ 0.2 (0.14 0.12) + 0.2 (0.16 0.12)

2

(0.00032 + 0.00008+ 0+0.00008+0.00032)

=2.83%

Likewise the standard deviations of Asset B and C are 2.83%

Next we need to determine the covariance of returns of the assets being combined. We begin with portfolio AB.
COV (

R ,R )
a b

p ( R R )( R R )
ri a a b b

0.2(0.08-0.12) (0.16-0.12) 0.2(0.10-0.12)(0.14-0.12) 0.2(0,12-0.12)(0.12-0.12) 0.2(0.14-0.12)(0.10-0.12) 0.2(0.16-0.12)(0.08-0.12)

= = = =

-0.00032 -0.00008 -0.0000 -0.00008 -0.00032

-0.0008

Covariance of returns of portfolio AC =

p ( R R )( R R )
ri a a c c

66

0.2 0.08-0.12)(0.08-0.12) = 0.00032 0.2(0.10-0.12)(0.10-0.12) = 0.00008 0.2(0.12-0.12)(0.12-0.12) 0.2(0.14-0.12)(0.14-0.12) 0.2(0.16x0.12)(0.16-0.12) 0 0.000008 0.00032
0.0008 Expected returns of portfolio AB = 0.5x12+0.5x12=12% Standard deviation of returns of portfolio AB

pab

w a +w
2 2 2 a
x

2 b

+ 2 wa wb COV ( Ra , Rb)
2
x

pab

0.5 * 0.0283
=0

+ 0.5 * 0.0283 + 2 * 0.5 * 0.5 * 0.0008 =

Assets A and B are perfectly negatively correlated and combining them in a portfolio completely eliminates any variability (risk) in returns. The expected returns of portfolio AC= 0.5x12+0.5x12=12% Standard deviation of returns of portfolio AC =

pac

w a +w
2 2 2 a
x

2 c

+ 2 wa wc COV ( Ra , Rc )
2
x

pac

0.5 * 0.0283

+ 0.5 * 0.0283 + 2 * 0.5 * 0.5 * 0.0008

67

= (0.0008)
= 0.0283 =2.83%

Assets A and C are perfectly positively correlated (correlation coefficient of +1).Combining the two assets in a portfolio has no diversification effect as shown by the unchanged portfolio standard deviation of 2.83%. Most assets are positively correlated but with a correlation coefficient of less than +1. Combining them in a portfolio will result in diversification gains depending on how far from +1 the correlation coefficient is.

3.5 THE CAPITAL ASSET PRICING MODEL (CAPM)

One of the basic theories that links together risk and return for all marketable assets is the capital asset pricing model (CAPM) initially developed by Sharpe (1964) and Lintner (1965). A number of other economists subsequently tested, advanced, refined and extended its applicability (Black (`972), Merton (1973)).

3.5.1

Systematic Vs. Unsystematic Risk

The total risk of an asset can be decomposed into two basic components:
Total risk = non diversifiable risk + diversifiable risk

Unsystematic (Diversifiable) Risk

This is that part of total risk that can be diversified away by holding the investment in a suitably wide portfolio. Research has shown that on average, most of the reduction benefits of diversification can be gained by forming portfolios containing 15 -20 randomly selected securities. Diversifiable risk is the portion of total risk that is associated with random (idiosyncratic causes which can be eliminated through diversification. At the limit the market portfolio, comprising an appropriate portion of

68

each asset in the market has no undiversifiable risk The causes are firm-specific and include labour unrests, law suits, regulatory action, competition, loss of a key customer etc.
Non-diversifiable (Systematic) Risk

This is the risk inherent in the market as a whole and is attributable to market wide factors. This risk component is not diversifiable and must thus be accepted by any investor who chooses to hold the asset. Factors such as war, inflation, international incidents, government macroeconomic policies and political events account for nondiversifiable risk. Because any investor can costlessly create a portfolio of assets that will eliminate virtually all diversifiable risk, the only risk relevant in determination of the prices and
returns of an asset is its non-diversifiable risk. Interpretation

The CAPM links together non-diversifiable risk and the return for all assets. The model is concerned with: (1) how systematic risk is measured , and (2) how systematic risk affects required returns and share values. The CAPM theory includes the following propositions:
a. Investors require a return in excess of the risk-free rate to compensate them for

systematic risk.
b. Investors require no premium for bearing unsystematic risk because it can be

diversified away.
c. Because systematic risk varies between companies, investors will require a higher

return from investments where systematic risk is greater.

The Formula

The CAPM can be stated as follows.

69

R = R + (R R
i f i m

(3.7)

Where:

R
R

is the expected return from asset i. is the risk-free rate of return (return on the 91-day treasury bill is the return from the market as a whole: The market portfolio will ,

by definition be fully diversified as it comprises all marketable assets.

is the beta factor of asset i.. is the market premium

R R
m

The Beta Coefficient and the Market Premium

The beta coefficient,

, measures the non-diversifiable risk. It is an index of the degree

of volatility of asset is returns in terms of the volatility of the returns of the market portfolio (markets risk). The beta factor for the market portfolio is 1.0: the risk free asset will have a beta of 0. Assets that are riskier than the market will have betas > 1.0 while those which are less risky will have betas less than 1.0.
Example

ABC Ltd. wishes to determine the required return on asset Z which has a beta of 1.5. The risk-free rate of return is found to be 7%; the return on the market portfolio is 11%. Find the required rate of return on asset Z. Using the CAPM formula,

R = R + (R R
z f z m

= 7% + 1.5(11% - 7%) =7% + 6% = 13%

70

The markets risk premium of 4% (11% - 7%), when adjusted for asset Zs index of risk (beta) of 1.5 results in the assets risk premium of 6% (1.5 * 4%). That risk premium when added to 7% risk-free rate, results in a 13% required rate.
Security Market Line (SML)

When the CAPM is depicted graphically it is called the security market line (SML). In the graph, risk, as measured by beta, is plotted on the X-axis and the required return are shown on the Y-axis. Two points to note in graphing the SML are: (i) (ii) The risk-free asset has a beta of 0. The market portfolio has a beta of 1.The risk-return trade-off is clearly shown by the SML. For the preceding example ,the SML will appear as below
return

E(ri)

SML

rf 7%

0
(i)

beta

Figure 3.1 The figure show the Security Market Line with beta on the x-axis and expected return on the y-axis. Note that the market portfolio has a beta of 1 and the risk free asset of 0.

71

REVIEW QUESTIONS

1. 2. 3. 4. 5.

Define the terms return and risk as they relate to financial decision making. What is the coefficient of variation? When is it preferred over the standard deviation when company risk? What is an efficient portfolio? Why is the correlation between asset return important. What is the relationship of total risk, non diversifiable risk and diversifiable risk? Why is non diversifiable risk the only relevant risk in asset pricing? If corporate managers are risk averse, does this mean that they will not take risks? Explain.

PROBLEMS

3.1

Mbalamwezi Ltd must choose between two assets purchases: The annual rate of return and related probabilities for the assets are shown below: Project Rate of return -10% 10% 20% 30% 40% 45% 50% 60% 70% 80% 100% ABC Probability 0.01 0.04 0.05 0.10 0.15 0.30 0.15 0.10 0.05 0.04 0.01 Project XYZ Rate return 10% 15 20 25 30 35 40 45 50 Probability 0.05 0.10 0.10 0.15 0.20 0.15 0.10 0.10 0.05

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a)

For each projects, compute i) ii) iii) iv) The range of possible rates of return The expected value of return The standard deviation of returns The coefficient of variations.

b) c) 3-2

Construct a bar chart of each distributions of rates of return. Which project would you consider less risky? Why? The following data has been gathered in order to help in graphically estimating the betas of two assets A and B.

Actual return Year 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Market portfolio 6% 2 -13 -4 -8 16 10 15 8 13 Asset A 11% 8 -4 3 9 19 14 18 12 17 Asset B 16% 11 -10 3 -3 30 22 29 19 26

a)

On a set of market return (x-axis) asset return (y-axis) axes, use the data above to draw the characteristics line for asset A and for asset B (On the same set of axes).

b) c) 3.3

Use the characteristic lines from (a) to estimate the betas for assets A and B. Use the betas in (b) to comment on the relative risks of assets A and B. The risk free rate in the economy is currently 8%, with the market return at 12%. Asset A has a beta of 1.10 a) b) Draw the security market line (SML) Use CAPM to calculate the required return on asset A. Depict asset As position on the SML in (a)

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c)

Assume as a result of recent economic events the risk free rate and the market return have declined to 6% and 10% respectively. Draw the new SML on same axes as used before and show new position of asset A.

d) c)

Assume as a result of recent events, the market return has risen to 13%. Ignoring the shift in. Draw the new SML on same axes as before and show the new position for asset A.

3.5

A company is considering developing and raising two apartment complexes, WA and HA. The following estimate of cash flows has been generated for each apartment. WA HA Annual cash flows Probability 1,000.000 1,500,000 3,000.000 4,500.000 5,000.000 0.2 0.3 0.4 0.1

Probability 0.1 0.2 0.4 0.2 0.1

Annual cash flows 1,500.000 2,500.000 3,500.000 4,500.000

a) b) c) 3-6

Find the expected cash flows from each apartment complex. What is the coefficient of variation for each apartment complex Which apartment complex has more risk? The company in the preceding question will hold the apartments for 10 years. Either apartment would cost sh.10,000,000. The company uses risk adjusted discount rate when considering investments with coefficient of variation (CV) greater than 0.35. He estimates the cost of capital to be 12%. For projects with CV between 0.35 and 0.40, he adds 2% to the cost of capital and for projects with CV between 0.40 and 0.50 he adds 4%. The company would not consider an investment with a CV more than 0.50.

74

a) b) c)

Compute the risk adjusted net present values for WA and HA apartments. (Use cash flows from previous problem). Which investment should company accept if the investments are mutually are exclusive? If projects are not mutuality exclusive, and in the absence of capital positioning, how would your decision in (b) be affected.

3.6

Tobacco Company of Kenya (TCK) is a stable company with sales growth of about 5% per year in good or bad economic conditions. Because of this stability (correlation coefficient with economy of +0.3 and standard deviation of sales of about 5% from the mean) the management the company can absorb some small risky outfits, which could add quite a bit of a return with affecting companys risk. Two alternative outfits are being considered for acquisition (i.e. ABC and XYZ) TCK cost of capital is 10%. Probability 0.3 0.3 0.2 0.2 After tax cash flows for 10 years Sh 000 6000 10,000 16,000 25,000 Probability 0.2 0.2 0.2 0.3 0.1 After tax cash flows for 10 years Sh 000 (1,000) 3000 10,000 25,000 31,000

a) b) c) d) e) f)

What is the expected cash flow from each outfit. Which outfit has the lower coefficient of variation Compute the net present value of each outfit Which outfit would you pick based on NPV. Would you change your mind if you added the risk dimensions into the problem? Explain. If ABC had a correlation coefficient with the economy of 0.5 and XYZ had one of -0.1, which outfit would give you best portfolio effects for risk reduction? Which would give the highest potential return?

g)

What might be the effect of the acquisitions on the market value of TCK shares?

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LECTURE FOUR: VALUATION 4.1

LONG

TERM

SECURITIES

AND

INTRODUCTION

In lecture three we discussed two key finance concepts of risk and return. This lecture examines how the two concepts determine the value of long tem securities. Although we focus mainly on financial assets, the principles and methods discussed are just as relevant and applicable to the valuation of real assets.
Learning Objectives

At the end of this lecture you should be able to: 1. 2. 3. 4. Discuss the characteristic s of long term security instruments. Distinguish among the various valuation concepts. Describe the key inputs in, and the basic valuation model. Apply the basic valuation model to the valuation of bonds, preferred stock, and ordinary shares

4.2 CHARACTERISTICS OF LONG TERM SECURITIES

Long term securities are the claims held as evidence by those who have provided long term financing to a firm. They, typically, comprise bonds and debentures, preference shares, and ordinary shares.

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4.2.1

Bonds

A bond is a debt instrument indicating that a corporation or government has borrowed a certain amount of money and promises to repay it in the future under clearly defined terms. Corporate bonds are issued by corporations while the government issues government bonds. Bonds are usually issued with a maturity of 10-30 years and with a par or face value of Sh. 1000. The coupon interest rate on a bond represents the percentage of the bonds par value that will be paid annually (typically in 2 equal semi- annual payments) as interest. At maturity the bondholders are repaid the principal amount par value.
Legal Aspect of Corporate Bonds (Agency Problem)

In order to mitigate the agency problem, whereby management (and shareholders) of firms may be tempted to expropriate the wealth of bondholders, the law protects bondholders through indenture and the provision of a trustee.
I. Bond indenture

A bond indenture is a complex legal document stating the conditions under which a bond has been issued with the aim of protecting bondholders once they have lend to the issuer of the bond. It specifies the rights of the bondholders and the duties of the issuing corporation in the contract in which the corporation borrows from bondholders. Included in the indenture are the interest and principal payments, various standard and restrictive provisions, sinking-fund requirements and security (collateral) interest provisions. In the following sections we briefly discuss the contents of an indenture.
Standard provisions are provisions in a bond indenture specifying certain criteria of

satisfactory record keeping and general business maintenance on the part of the borrower. Normally, they do not place a burden on financially sound business. They typically require the borrower to: Maintain satisfactory accounting records (consistent with generally accepted accounting principles GAAPs, and international accounting standards - IASs)

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Periodically supply audited financial statements Pay taxes and other liabilities when due Maintain all facilities in good working order

Restrictive provisions These are contractual clauses that place operating and financial

constraints on the borrower. The most common restrictive covenants include: Require the borrower to maintain minimum level of liquidity (to insure against loan default and ultimate failure). Prohibit borrowers from discounting accounts receivable to generate cash. This could cause a long run cash shortage if proceeds are used to meet current obligations Impose fixed asset restrictions on the borrower (the liquidation or encumbrance of fixed assets could damage firms ability to repay the bonds). Constrain subsequent borrowing. Either additional debt is prohibited or is subordinated to the original loan (subsequent creditors have to wait until claims of senior or prior debt are satisfied). Limit the firms annual cash dividends payments to a specified amount or percentage. The violation of any standards or restrictive provision by the borrower gives the bondholders (through their trustee) the right to demand immediate repayment of the debt.
Sinking fund requirement

A sinking fund provides for the systematic retirement of bonds prior to their maturity. The corporation makes semi- annual or annual payments to a trustee who uses these funds to retire bonds by purchasing in the market, or sets up a fund that accumulates until maturity when the fund is applied in the liquidation of the bond.
Security collateral interest

The bond indenture identifies carry asset pledged as collateral. The protection of bond collateral is crucial to interests of bondholders.

78

II

Trustee

A trustee is a paid third party to a bond indenture (individual, corporation or commercial banks trust department) who is paid to act as a watchdog on behalf of the bondholders and is empowered to take specific actions if terms of indenture are violated. The provision for a trustee for a bond issue recognizes the fact that atomistic and diffuse bondholders, individually, may not have the capacity and incentive to ensure compliance with the terms of issue by effective monitoring of the issuer of bonds.
General Features of a Bond Issue

Three common features of a bond issue are conversion, call (redemption) and stock purchase warrants.
Conversion feature

This is a feature of convertible bonds that allows bondholders to change each bond into a stated number of shares of common stock (ordinary shares). Bondholders will exercise the option if the share price is greater than the conversion price (this feature is advantageous to the issuer because he does not have to give up immediate control as in issuing stock: to the holder it provides a possibility of a future speculative gain).
Call feature

The feature gives the issuer the opportunity to repurchase bonds prior to maturity at a stated call price that include a premium ( in most cases, the call price exceeds the par value by an amount equal to 1 years interest). The feature is advantageous to the issuer because when interest rates fall in the economy an issuer can call outstanding bonds and reissue a new bond at a lower interest rate but when interest rates rise the call option is not exercised.
Putable provision

In contrast to the call feature, the putable provision allows the investors the option of requiring the issuer to repurchase bonds at specified times prior to maturity. Investors will exercise this option when they need cash or when interest rates have risen since bonds were issued.
Stock purchase warrants

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Stock purchase warrants are instruments (sweeteners) attached to bonds that give the warrant holders the right to purchase a certain amount of a firms ordinary shares at a specific price over a certain period of time ( they enable firms to raise needed funds at slightly lower interest rates and less restrictive provisions).

4.2.2

Common Stock (Ordinary Shares)

The true owners of business forms are the ordinary shareholders. Sometimes referred to as residual owners, they receive what is left after satisfaction of all other claims. The fundamental aspects of ordinary shares are.
Ownership

The ordinary shares of a firm may be owned privately (family) or publicly with shares being traded in the stock exchange.
Par value

The par value of an ordinary share is relatively useless value, established in the firms corporate charter (memorandum). It is generally very low- Sh.5or less.
Pre-emptive rights

Allow shareholders to maintain their proportionate ownership in the corporation when new shares are issued. The feature maintains voting control and protects against dilution.
Rights offering

The firm grants rights to its shareholders to purchase additional shares at a price below market price, in direct proportion to their existing holding.
Authorized, outstanding and issued shares Authorized shares are the number of shares of common stock that the firms charter

(articles) allows without further shareholders approval.

Outstanding shares is the number of shares held by the public Issued shares are the number of share that has been put in circulation; they represent the

sum of outstanding and treasury stock.

Treasury stock is the number of shares of outstanding stock that have been repurchased

by the firm (not allowed by the Companies Act of Kenya Laws).

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Voting rights

Generally each ordinary share entitled the holder to one vote at the Annual General Meeting for the election of directors and on special issues.
Dividends

The payment of corporate dividends is at the discretion of the Board of Directors. Dividends are paid usually semi- annually (interim and final dividends). Dividends can be paid in cash, stock (bonus issues) and merchandise.

4.2.3
-

Preference Shares

These are a hybrid between debt and ordinary shares. Preference shares: Are promised a fixed periodic return which is stated as a % of par value Have preference over ordinary shares with respect to distribution of earnings Have preference over ordinary shares on the liquidation of asset - Do not have a voting right at the annual general meeting (AGM) of shareholders.

Preference shares may have several distinguishing features such as;

Cumulation

Most preferences shares are cumulative with respect to any dividend passed over. Dividend in arrears together with current dividends must be paid first before distribution is made to ordinary shareholders.
Callable (redeemable)

The issuer can retire outstanding stock within a certain period of time at a specific price.
Conversion

This feature allows holders to change each share into a stated number of ordinary shares.

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Summary of differences between debt and ordinary shares

Debt

Ordinary share

Voice in management Maturity Tax treatment

No Stated Interest is tax deductible

Yes Subordinate to debt None Dividend is not deductible

Claims on income and assets Senior to Equity

4.3 VALUATION OF LONG TERM SECURITIES (BONDS AND SHARES)

Valuation is the process that links return and risk to determine the worth of an asset. The

key inputs to the valuation process include cash flows, their timing and the risk (required return) associated with the cash flows.
Cash flows. The value of an asset depends on the cash flows it is expected to provide

over the ownership period. The cash flow could be regular, intermittent or single. The ash flows from stocks are dividends and capital gains and from bonds are interest and the redemption value.
Timing. We must incorporate the timing of the cash flows in valuation calculations. For

computational convenience and custom the cash flows are assumed to occur at the end of the period, unless otherwise stated.
Risk (required return). In general the greater the risk (the less certain) of a cash flow,

the lower its value of the cash flow. In the valuation process the required return is used to incorporate risk in the analysis. The higher the risk the greater the required return: the lower the risk the less the required return. The required return could range from the risk free rate upwards depending on level of risk.

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4.3.1

Valuation Concepts

The term value could mean different things to different people. A brief description and contrasts of some of the major concepts of value follows.
Liquidation vs. going concern value Liquidation value is the amount of money that could be realized if an asset (or group of

assets) is sold separately from its operating organization. Going concern value of a firm is the amount the firm could be sold for as a continuing operating business. The valuation models we discuss assume that we are dealing with going concerns.
Book value vs. market value Book value is the accounting value of an asset as given by the asset cost less

accumulated depreciation. Market value is the market price at which an asset trades in an open market price.
Intrinsic value Intrinsic value is the price a security ought to have based on all factors bearing on its

valuation. This is the economic value of a security.

4.3.2

Basic Valuation Model

The value of any asset is the present value of all future cash flows it is expected to provide over the relevant period.

CF + CF (1+ k ) (1+ k )
1 2 1

+ ... +

CF (1+ k )
n

(4.1)

Where V0

=
t

The current value of asset (at time 0) Cash flow expected at end of time period t

CF
k n

= =

required return relevant time period

Using PVIF notation the basic valuation equation can be stated as;

83

CF1 x (PVIFk,1) + CF2 x (PVIFk,2) ++ CFn x (PVIFk,n)

Firms long term securities include bonds, preferred stock and ordinary shares. Our discussion in the remainder of the lecture will focus on the mechanics of valuing each of these financial assets. We start first with bonds, followed by preference shares and end with the ordinary shares, which poses the most challenging valuation difficulties.

4.3.3

Bond Valuation

Bonds are long-term debt instruments used by business and government to raise money. Most pay interest semi annually at a slated coupon interest rate, have an initial maturity of 10-30 years and have a par or face value of Sh.1000 that must be repaid at maturity. The simplest and common type of bond is one that pays the bondholder two forms of cash flows if held to maturity i.e. periodic interest and the bonds face value at maturity. The interest is an annuity and the face value is a single payment received at a specified future date. The basic equation for the value of such a bond with n years to maturity and which pays interest ,I , annually is;

B
B0 I n M

I
1

(1+ k d ) (1+ k d )
= = = =

I
2

+ ... +

I
n

(1+ k d ) (1+ k d )

M
n

(4.2)

Where current value of the bond (at time zero). annual interest paid in shillings (coupon interest x face value) number of years to maturity par value (face value) in shillings required return on a bond

The interest payments can be discounted using PVIFA tables while the payment at maturity will be discounted using PVIF tables. The discounting notation is;
= I * ( PVIFA ) + M * ( PVIF ) k d ,n k d ,n

84

Example

Mills Co has issued a 10% coupon interest rate, 10 year bond with a Sh. 1000 par value, which pays interest annually. The required rate of return of similar bonds is 10%. What is the value of the bond? The values of the variables are; I = per value x coupon rate = 1000*10% = Sh 100 M kd n B0 = = = = = 1000 10% 10 years 100 x (PVIFA10%,10yrs) + 1000x (PVIF10%,10yrs) 1000 x 6.145 + 1000 x .386 =Sh.1000.50.

Substituting the values in the valuation formula for bonds leads to,

The answer is the same as the par value of Sh.1000 except for rounding differences In practice, however, the value of a bond in the market place is rarely equal to its par value. Some may be quoted above their par value, and some below: It all depends on the bonds required return and the time to maturity. We will discuss the effect of these two on the value of bonds.
Required Returns and Bond Values

Whenever the required return on bond differs from its coupon interest rate the bonds value will differ from its par value. (The required return may differ for two reasons: 1. Economic conditions may have changed since the bond was issued, causing a shift in cost of long term funds 2. The firms risk class may change. When the required return is greater the coupon interest rate, the bond value, B0, will be less than its par value M, and the bond sells at a discount M-B0. When the required return falls below the coupon interest rate, the bond value, B0, will be greater than par, M, and the bond sells at a premium equal to B0-M.

85

Example

In the preceding example of Mills Company, the required return equalled the coupon interest rate and the bonds value equalled its Sh.1000 par value. If required return were greater than the coupon rate of 10% i.e. 12%, the value of the bond would be as follows; B0 = = 100 x (PVIFA12%,10yrs) + 1000x (PVIF12%,10yrs) 100 x 5.650 + 1000 x .322 = Sh.887.00.

The bond will sell at a discount of Sh.113 (1000-887) and is said to be a discount bond. Conversely, if the bonds required return fell to say, 8%, the bonds value would be: B0 = = 100 x (PVIFA8%,10yrs) + 1000x (PVIF8%,10yrs) 100 x 6.710 + 1000 x .463 = Sh.1134.00

The bond will sell at a premium of Sh.134 (1134 1000). The bond is called a premium bond
Figure 4.1 The relationship between value of a bond and the required rate of return.

The graph is downward sloping, implying that bas interest rates rise bonds lose value. Market value of bonds (Sh.) 1200 1100 1000 900 8002 4 6 8 10 12 14

Required return, kd%

Time to Maturity and Bond Values

The value of bond will approach par value as the message of time moves the bonds value closer to maturity (when required return equals the coupon rate the bonds value remains at par until it matures).

86

Market value of
bonds

1200 1100 1000 900 800

premium bond required return = par value discount bond

10

1 0
Time to maturity

Figure 4.2 Relationship between maturity and value of a bond

Interest Rate Risk

The chance that interest rate will change and thereby change the required return and bond value is called interest rate risk. How much interest rate risk a bond has depends on how sensitive its price is to changes in interest rates This sensitivity directly depends on two things: the time to maturity and the coupon rate. Investors in bonds should keep in mind the following; 1. All other things equal, the longer the time to maturity, the greater the interest rate risk. 2. All other things equal, the lower the coupon rate, the greater the interest rate risk. Bondholders are more concerned with rising rates which decrease bond values. The shorter the amount of time until maturity the less responsive is the bonds market value to a given change in the required. Also, if two bonds with different coupon rates have the same maturity, then the value of the one with lower coupon is more dependent on the face amount to be received at maturity. As a result its value will fluctuate more as interest rates change. In other words,

87

the bond with the higher coupon has a larger cash flow early in its life, so its value is less sensitive to changes in the discount rate. If time will return when interest rates are volatile financiers prefer lining shorter to hedge against interest rate risk.
Perpetual Bonds

This is a bond that never matures- a perpetuity. A consol is an example. The present value of a perpetual bond is equal to the capitalized value of an infinite stream of interest payments. If a bond promises, fixed annual interest payment, I, forever its value at investors required rate of return, kd, is,

I
1

(1+ k d ) (1+ k d )

I
2

+ ...

(1+ k d )

This should reduce to

B
Example

(4.3)
d

You intend to buy a bond that pays Sh. 500 per year forever. If your required rate of return is 12%, what is the maximum you should pay for the bond? The PV of the security would be B0 = 500/0.12 =
Sh.4166.7

This is the amount you will be willing to pay for this bond.
Zero Coupon Rate Bonds

Zero coupon rate bonds make no periodic interest payment but instead the bond is sold at a deep discount from its face value. The bond is then redeemed at face value on its maturity. The valuation formula for a zero coupon bonds is truncated version of that used for normal interest paying bond. The present value of interest payment is loped off leaving only the payment at maturity.

88

Therefore,

B
=
Example

(1+ k d )

(4.4)

M ( PVIF

k d ,n

ABC Ltd., issues a zero coupon bond having a 10 year maturity and a face value of Sh. 1000. Investors require a return of 12%. How much should an investor pay for the bond? B0 = = = = 1000/(1.12)10 1000 (PVIF12%,10yrs) 1000 x 0.322
Sh 322

The bond is worth Sh.322.

Semi Annual Compounding Interest

Most bonds pay interest twice a year. As a consequence the valuation equation changes
2n

B0 =
t =1

I /2
t

(1+ k d / 2) (1+ k d / 2)

M
2n

(4.5)

= B0 =

1 I * PVIFA1 , 2 n + M * PVIF 1 , 2 n 2 2k d 2k d

Notice that the assumption of semi- annual accounting once taken applies even to the maturity value.
Example

10% coupon bonds of ABC Ltd., have 12 years to maturity and annual required rate of return is 14%. What is the value of a Sh.1000 par value bond that pays interest semiannually?

89

I *( ) + M * ( PVIF 7%, 24) 2 PVIFA7%, 24 = 50 (11.469) + 1000 (.197) = Sh.770.4

Yield to Maturity (YTM)

When investors evaluate and trade bonds, they consider yield to maturity (YTM), which is the rate of return investors earn if they buy a bond at a specific price and hold it until maturity. The YTM is analogous to the Internal rate of return from an investment in the bond. The yield to maturity on a bond with current price equal to its par value (i.e. B0 =M) will always equal the coupon rate. When the bond value differs from par, the yield to maturity will differ from the coupon rate.

The yield to maturity on a bond can found by sowing equation for kd in the equation below.

B0 =
t =1

I
t

(1+ k d ) (1+ k d )

M
n

(4.6)

The required return is the bonds yield to maturity. The YTM can be found by trial and error procedures.
Example

Mills Company bond which currently sells for Sh.1080, has a 10% coupon rate and Sh.1000 par value, pays interest annually and has 10 years to maturity. Find YTM of the bond.
1080 =
t =1

10

100
t

(1+ k d ) (1+ k d )

1000
10

or,

1080 = 100 * PVIFA ,10 + 1000 * PVIF ,10 kd kd

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Trial and error

We know that when Kd = 10% (equal coupon rate), then B0 = 1000. Thus the discount rate to result in 1080 must be less than 10%. (Try a lower rate if the PV of cash flows at a given rate is lower than the market price of the bond). Try 9% Next try 8% = = 100 x 6.418 + 1000 x .422 = 1063.80 (The 9% rate is not low 100 x 6.710 + 1000 x .463 = 1134 enough to get Sh.1080).

Because 1080 lies between 1063.80 and 1134 the YTM must be between 8% and 9%. Because 1080 is closer to 1063.80, the YTM to the nearest whole per cent is 9%. By using interpolation, we find the more precise YTM value to be 8.77% as follows;
Interpolation

1134 1063.80 1080 1063.80 YTM = 9% - 16.20 70.20

= = = =

70.20 16.20 9% - 0.2307692

8.77%)

Using a financial calculator, we get 8.766%.

4.4

Preference Shares Valuation

A type of stock that promises a fixed dividend but at the discretion of the Board of directors. It has preference over ordinary shares in the payment of dividends and claims on the assets it has no maturity date (unless redeemable) and give the fixed nature of the dividend is similar to a perpetuity.

Thus the PV of a preferred stock, V p , is

D k

(4.7)

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Where Dp is the stated annual dividend, per share and kp is the appropriate discount rate.
Example

A company had issued a 9% Sh.100 par value preference shares and an investors require a rate of return of 14% on this investment. Find the value of a preference share to investors. Dp = 9%*100 = Sh.9 kp Vp
Example

= =

0.14 9/0.14 = Sh.64.29

The value of the preference share is,

A preferred stock paying a dividend of Sh. 5 and having a required return of 13% will have a value of Sh.38.46 (50.13)

4.5

Valuation of Ordinary Shares

Common shareholders expect to be rewarded through periodic cash dividends and an increasing share value. It is the expectation of future to dividends and a future selling price (which itself is based on future dividends) that gives value to a share. Cash dividends are broadly defined to mean all cash distributions and are the foundation for valuation of shares.
Dividend discount models are designed to compute the intrinsic value of a share under

specific assumptions as to the expected growth patterns of future dividends and the appropriate discount rate to apply.
Basic stock valuation equation

The value of a share is equal to the PV of all future dividends it is expected to provide over an infinite time horizon (from a valuation viewpoint only dividends are relevant).

D + D ... D (1+ k s) (1+ k s) (1+ k s

1 2 1 2

(4.8)

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Where

P0 ks Dt

= = =

current value of ordinary share required return on ordinary shares per share dividend at end of year t.

We illustrate the use of this formula to estimate the value of ordinary stock under three dividend growth assumptions i.e. zero growth in dividends, constant growth in dividends, and variable growth phases.
Zero growth assumes a constant, non-growing dividend stream i.e. D1 = D2 = = D =

D. The dividend stream is a perpetuity and can be valued as such i.e.

P
Example

(4.9)

The dividend of Den Company is expected to remain constant at Sh. 3 indefinitely. If required return on its stock is 15% the value of its ordinary share would be Sh.20 ( i.e. 3 = 20 ) 0.15
Constant Growth

The constant growth model, assumes that dividends will grow at a constant rate, g. If we let D0 equal the most recent dividend, then

D (1+ g ) + D (1+ g ) P= (1+ k s) (1+ k s)

1 0 0 0 1 2

D 0(1+ g ) ++ (1+ k s)

or,
(4.10)

D + D (1+ k s) (1+ k s)
1 2 1

++

D (1+ k s)

The equation can be simplified and rewritten as

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ks g

(4.11)

(D1 is the coming years dividend , ks is the required return on the stock and g is the constant growth rate in dividends). Gordons model is a common name for the constant growth model.
Example

Lama Company has paid the following dividends over the past years Year 1999 2000 2001 2002 2003 2004 div per share 1.00 1.05 1.12 1.20 1.29 1.40

The average growth of dividends for the past five years is expected to persist in the foreseeable future. You are required to determine the value of the companys shares after payment of the dividend of 2004. First find the average rate of growth in dividend over last five years. Let the average growth rate be g. Then the dividend of year 2004 denoted by D2004 is found by growing the dividend of year 1999 as follows: D2004 (1+g) 5 = =
g %, 5

D1999 x (1+g)5 D2004/D1999 = 1.40

FVIF

1.40 1.00

By looking across the table for FVIFs (in the 5-year row) the factor closest to 1.40 for 5 years is 7%. Therefore, g is 0.07.

D k
s

1.50 =Sh.18.75 0.15 0.07

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The value of the stock is Sh.18.75

Variable Growth Model

The dividend valuation approach can be manipulated to allow for changes in the dividend growth rates. For instance the model could be based on the assumptions that dividends initially grow at a supernormal rate for a number of years followed by normal growth rate into the foreseeable future. In such a situation our dividend model can be modified as follows. Let gs equal the initial growth rate (supernormal growth for n years),and gn equal the subsequent growth rate (normal growth to infinity) and Dt be the dividend paid at end of time period t The formula for the value of the share, P0, is

D (1+ g s) = P (1+ k s)
n 0 0 t =1 t

D * 1 (k g ) (1+ ) ks
n +1 s n

(4.12)

The first term on the left hand side, represents the present value of dividends during the initial phase of supernormal growth; the second term, Dn+1/( ks-gs)*1/(1+ks),represent the present value of the price of the stock at the end of the initial growth period. STEPS 1. Find the value of dividends at the end of each year Dt, during the initial growth years 1 to n by Dt = D0 x (1 + gs)t
t

2. Find present value of the dividends expected during the initial growth phase i.e.

D (1+ g s) (1+ k s)
n 0 t =1 t

D ( PVIF k
t =1 t

,t

3. Find value of stock at the end of the initial growth phase i.e.

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D k g
n +1 s

(Same as Gordons constant growth model)

n

Next we discount

to the present i.e.

P * PVIF k
n

,n

4. Add the PVs in 2 and 3 to find the value of stock.

Example

Waka Industries has just paid the 2004 annual dividend of Sh. 1.50 per share. The firms financial manager expects that these dividends will increase at 10% annual rate over the next 3 years. At the end of the3 years, (end of 2007) the growth rate will decline to 5% for the foreseeable future. The firms required rate of return is15%. Estimate the current value of Waka share i.e. the value at end of 2004 (P0 = P2004).
Solution

Find value of cash dividends in each of the next 3 years and their PVs at end of year 2004 as below: Remember D0 =D2004 =Sh.1.50
Year(t) End of year Dividend =D0 (1.1)t Present value

PVIF
0.870 0.756 0.658

15%,t

1 2 3

2005 2006 2007

1.65 1.82 2.00

1.44 1.38 1.32

Sh.4.14

Present value of dividends during initial growth phase

Next the price of the stock at the end of the initial growth phase (at the end of 2007) can be found first by calculating the dividend to be paid at end of the year 2008 ( Dn +1 = D2008 ) = D2007 x (1 + 0.05) = 2.00 x 1.05= Sh.2.10.

2008

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Using Gordons constant growth model, the price of the stock at end of 2007 is calculated as follows;

2007

D k g
s

20081
n

2.10 = Sh.21 0.15 0.05

The value of Sh.21 at end of year 2007 must be converted into PV (end of 2004). Using 15% as the required return, (PVIF 15%,3yrs) x 21 = 0.658 x 21 = Sh.13.82. Finally, we add the present values to get the value of the stock i.e. P2004 = 4.14 + 13.82 = Sh.17.96

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REVIEW QUESTIONS

1. 2. 3. 4.

Define valuations. Briefly describe three key inputs to the valuation process. Briefly explain the meaning of the efficient markets hypothesis (EMH). What is meant by a bonds yield to maturity (YTM)? What relationship between the required return and coupon rate will caused bond to sell (a) at a discount? (B) At a premium? And (c) it per value ? Explain.

5.

Describe compare and contrast the following common stock valuation models: a) zero-growth, b) constraint growth and c) variable-growth.

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LECTURE 5: LONG-TERM INVESTMENT DECISION PROCESS AND RELEVANT CASH FLOWS 5.0 INTRODUCTION
Long-term investment decisions are important and take up a considerable amount of a financial managers attention because of two reasons: (1) They consume quite a sizable amount of a firms funds (2) The decisions determine the future viability and competitiveness of the firm.
Objectives

At the end of this lecture you should be able to: 1. Explain the motives for capital expenditure and the steps followed in the capital budgeting process. 2. Define and explain the basic terminologies used to describe projects, funds availability, decision approaches and cash flow patterns. 3. Discuss and compute the major components of relevant cash flows. 4. Calculate, interpret and evaluate the pay back period, the net present value, the profitability index and the internal rate of return of investment proposals. 5. discuss difficulties and conflicts in using discounted cash flow methods . In this lecture we shall discuss the motives, terminologies and procedures in the capital budgeting process. We will also explain the major components of the cash flows employed in making the long-term investment decision. The next lecture will complete

99

the discussion by examining the specific techniques employed in making the long-term investment decision.

5.1 THE BASICS OF CAPITAL BUDGETING PROCESS

Capital budgeting is the process of evaluating and selecting long term investments

consistent with the firms goal of owner wealth maximization. For a manufacturing firm, capital investment are mainly to acquire fixed assets-property, plant and equipment. Note that typically, we separate the investment decision from the financing decision: first make the investment decision then the finance manager chooses the best financing method.

5.1.1

Capital Expenditure Motives

A capital expenditure is an outlay of funds by the firm that is expected to provide benefits over a period of time greater than one year (In contrast, operating expenditures benefits are received within one year). The basic motives for capital expenditures are to expand replace, or renew fixed assets, or obtain some other less tangible benefit over a long period of time. These key motives for making capital expenditures are briefly outlined below. 1. Expansion: The most common motive for capital expenditure is to expand the cause of operations usually through acquisition of fixed assets. Growing firms need to acquire new fixed assets rapidly. 2. Replacements As a firms growth slows down and it reaches maturity, most capital expenditure will be made to replace obsolete or worn out assets. Outlays of repairing an old machine should be compared with net benefit of replacement. 3. Renewal An alternative to replacement may involve rebuilding, overhauling or refitting an existing fixed asset.. A physical facility could be renewed by rewiring and adding air conditioning.

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4. Other purposes Some expenditure may involve long-term commitments of funds in expectations of future return i.e. advertising, R&D, management consulting and development of view products. Other expenditures include installation of pollution control and safety devises mandated by the government.

5.1.2

Steps in Capital Budgeting Process

The capital budgeting process consists of five distinct but interrelated steps. It begins with proposal generation, followed by review and analysis, decision making, implementation and follow-up. These six steps are briefly outlined below. 1. Proposal generation: Proposals for capital expenditure are made at all levels within a business organization. Many items in the capital budget originate as proposals from the plant and division management. Project recommendations may also come from top management, especially if a corporate strategic move is involved ( for example , a major expansion or entry into a new market). A capital budgeting system where proposals originate with top management is referred to a
top-down system, and one where proposals originate at the plant or division level

is referred to as bottom-up system. In practice many firms use a mixture of the two systems, though in modern times has seen a shift to decentralization and a greater use of the bottoms-up approach. Many firm offer cash rewards for proposal that are ultimately adopted. 2. Review and analysis: Capital expenditure proposals are formally reviewed for two reasons. First, to assess their appropriateness in light of firms overall objectives, strategies and plans and secondly, to evaluate their economic viability. Review of a proposed project may involve lengthy discussions between senior management and those members of staff at the division and plant level who will be involved in the project if it is adopted. Benefits and costs are estimated and converted into a series of cash flows and various capital budgeting techniques applied to assess economic viability. The risks associated with the projects are also evaluated. 3. Decision making: Generally the board of directors reserves the right to make final decisions on the capital expenditures requiring outlays beyond a certain amount. 101

Plant manager may be given the power to make decisions necessary to keep the production line moving (when the firm is constrained with time it cannot wait for decision of the board. 4. Implementation: One approval has been received and funding availed implementation commences. For minor outlays the expenditure is made and payment is rendered: For major expenditures, payment may be phased, with each phase requiring approval of senior company officer. 5. Follow-up: involves monitoring results during the operation phase of the asset. Variances between actual performance and expectation are analyzed to help in future investment decision. Information on the performance of the firms past investments is helpful in several respects. It pinpoints sectors of the firms activities that may warrant further financial commitment; or it may call for retreat if a particular project becomes unprofitable. The outcome of an investment also reflects on the performance of those members of the management involved with it. Finally, past errors and successes provide clues on the strengths and weaknesses of the capital budgeting process itself.

5.1.3

Basic Terminology

Before we develop the concept, lecturing and practices of capital budget some basic terminology need to be explained.
Independent versus Mutually Exclusive Projects Independent projects are those whose cash flows are unrelated or independent of one

another; the acceptance of one does not eliminate the others from further considerations (if a firm has unlimited funds to invest, all independent project that meet it minimum acceptance criteria will be implemented i.e. installing a new computer system, purchasing a new computer system, and acquiring a new limousine for the CEO.
Mutually exclusive projects are projects that compete with one another, no that the

acceptance of one eliminates the acceptance of one eliminates the others from further consideration. For example, a firm in need of increased production capacity could either,

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(1) Expand it plant (2) Acquire another company, or (3) contract with another company for production of required items.

Unlimited Funds versus Capital Rationing Unlimited funds This is the financial situation in which a firm is able to accept all

independent projects that provide an acceptable return (Capital budgeting decisions are simply a decision of whether or not the project clears the hurdle rate).
Capital rationing This is the financial situation in which the firm has only a fixed

number of shillings to allocate among competing capital expenditures. A further decision as to which of the projects that meet the minimum requirements is to be invested in has to be taken.
Conventional versus Non-Conventional Cash flows Conventional cash flow pattern consists of an initial outflow followed by only a series of

inflows. ( For example a firm spends Sh.10 million and expects to receive equal annual cash inflows of Sh.2 million in each year for the next 8 years) Cash inflows 2m 0 Cash 10m Outflow End of year 1 2 2m 3 2m 4 2m 5 2m 6 2m 7 2m 8

The cash inflows could be unequal

Non-conventional cash flows This is a cash flow pattern in which an initial outflow is

not followed only by a series of inflows, but with at least one cash outflow. For example the purchase of a machine may require Sh.20 million and may generate cash flows of Sh.5 million for 4 years after which in the 5th year an overhaul costing Sh.8million may be required. The machine would then generate Sh.5 million for the following 5 years.

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Inflows 5m Outflows 10m

5m

5m

5m

5m

5m

5m

5m

5m

5m

5m

8m

Evaluating projects with unconventional patterns poses challenges that require an analysts special attention
Relevant versus Incremental Cash flows

To evaluate capital expenditure alternatives, the firm must determine the relevant cash
flows which are the incremental after-tax initial cash flow and the resulting subsequent

inflows associated with a proposed capital expenditure. Incremental cash flows represent the additional cash flows (inflowing and outflows) expected to result from a proposed capital expenditure.
Sunk Costs versus Opportunity Cost Sunk costs are cash outlays that have already been made (past outlays) and therefore

have no effect on the cash flows relevant to a current decision. Therefore sunk costs should not be included in a projects incremented cash flows.
Opportunity costs are cash flows that could be realized from the best alternative use of

an owned asset. They represent cash flows that can therefore not be realized, by employing that asset in the proposed project. Therefore, any opportunity cost should be included as a cash outflow when determining a projects incremental cash outflows.

5.2 CASH FLOW COMPONENTS

The cash flows of any project can include three basic components: (1) An initial investment (2) Operating cash flows (3) Terminal cash flows. All projects will have the first two; some however, lack the final components. We will discuss these components in following sections. 104

5.2.1

Initial Investment

The initial investment is the relevant cash outflow for a proposed project at time zero. It is found by subtracting all cash inflows occurring at time zero from all cash outflows occurring at time zero. Atypical format used to determine initial cash flow is shown below. Cost on new asset Installation cost Installed cost of new asset Proceeds from sale of old assets + Tax on sale of old assets After-tax proceeds from sale of old asset + Change in Net working capital
Initial Investment

XX XX XX XX (XX) XX XX
XX

We will elaborate some of the items appearing in the above determination.

The installed cost of new asset = cost of new asset (acquisition cost) + installation cost

(additional cost necessary to put asset into operation) +After-tax proceeds from sale of old asset. The last variable in the equation is explained as follows.
After tax proceeds from sale of old asset =
The difference between old assets sale proceeds and any applicable taxes or tax refunds resulting from the sale of existing assets

Proceeds from sale of old assets +

Cash inflows net of any removal or cleanup cost resulting from the sale of an existing asset(** by the co)

Tax on sale of old asset

Tax that depends upon the relationship between old assets sale proceeds and its written down value(Capital Gains Tax)

105

Change in networking capital (NWC) Net working capital is the difference between

current assets (CA) and current liabilities (CL) i.e. NWC = CA CL. Changes in NWC often accompany capital expenditure decisions. If a company acquires a new machinery to expand its levels of operation, levels of cash, accounts receivables, inventories, accounts payable, accruals will increase. Increases in current assets are uses of cash while increases in current liabilities are sources of cash. As long as the expanded operations continue, the increased investment in current assets (cash, accounts receivables and inventory) and increased current liabilities (accounts payables and accruals) would be expected to continue. Generally, current assets increase by more than the increase in current liabilities, resulting in an increase in NWC which would be treated as an initial outflow (This is an internal build up of accounts with no tax implications, and a tax adjustment is therefore unnecessary).

5.2.2
-

Operating Cash Flows

These are incremental after tax cash during its lifetime. Three points should be noted:Benefits should be measured on after tax basis because the firm will not have the use of any benefits until it has satisfied the governments tax claims. All benefits must be measured on a cash flow basis by adding back any non-cash charges (depreciation) Concern is only with the incremental (relevant) cash flows. Focus should be only on the change in operating cash flows as a result of proposed project. The following income statement format is useful in the determination of the operating cash flows.

106

Shs Revenue Expenses Profits before depreciation Depreciation Profit before tax Taxes Profit after taxes Add back depreciation
Operating Cash flows

XX (XX) XX (XX) XX (XX) XX XX

XX

5.2.3

Terminal Cash Flows

The cash flows resulting from the termination and liquidation of a project at end of its economic life are its terminal cash flow. Terminal cash flow is determined as incremental after tax proceeds from sale or termination of a new asset or project. The format below can be used to determine terminal cash flows. Proceeds from sale of new assets Project XX XX XX Proceeds from sale of old asset XX XX XX XX
XX

Tax on sale of new asset

Tax on sale of old asset Change in NWC

Terminal Cash Flow

Note that for a replacement decision both the sale proceeds of the old asset and the new

asset are considered. In the case of other decision (other than replacement), the proceeds of an old asset would be zero. Note also that with the termination of the project the need for the increased working capital is assumed to end. This will be shown as a cash inflow due to the release of the working capital to be used business needs. The amount recovered 107

at termination will be equal to the amount shown in the calculation of the initial investment.

5.3 CAPITAL INVESTMENT TECHNIQUES

The preferred technique should time value procedures, risk and return considerations and valuation concepts to select capital expenditures that are consistent with the firms goals of maximizing owners wealth. The three most popular techniques are the payback period, net present value, and internal rate of return. We will use one basic problem to illustrate all the techniques.
Example

The problem concerns MALI Limited, a medium sized metal fabricator that is currently contemplating two projects: project A requires an initial investment of Sh.42million and project B requires an initial investment of Sh.45million. The projected relevant cash flows for the two projects are shown below.
PROJECT A Initial Investment (yr 0) Operating cash flows PROJECT B

Sh.42 million Sh.14 million Sh.14 million Sh.14 million Sh.14 million Sh.14 million Sh.14 million

Sh.45 million Sh.28 million Sh.12 million Sh.10 million Sh.10 million Sh.10 million Sh.14 million

Year 1 Year 2 Year3 Year 4 Year 5 Average

5.3.1

Payback Period

The payback period is the exact amount of time required for the firm to recover its initial investment in a project as calculated from cash inflows. In case off an annuity the pay back period can be found by dividing initial investment by annual cash inflow. For a mixed stream of inflows the yearly cash inflow must be accumulated until the initial investment is recovered.

108

Decision Criteria

When pay back period is used to make accept/reject decision, the decision criteria are as follows:

If the Pay back period is less than the maximum acceptable Pay back period set by management accepts the project. If the pay back period is greater than the maximum acceptable pay back period, reject the project

The length of the maximum acceptable pay back period is subjectively determined by management based on factors such as the type of project (i.e. replacement or expansion), the risk of the project, and the perceived relationships between pay back period and share values, past experiences and future prospects. It will be the length of time management feels results in good value-creating investment decisions.
Calculating Pay Back Period for MALI Limited

For project a (annuity Stream) Pay back period =

42 = 3.0 years 14

For project B (a mixed stream), the initial investment of Sh.45million will be recovered between the 2nd and 3rd year-ends. Year 1 2 3 4 5 Cash flow (Sh) 28million 12million 10million 10million 10million 5 = 2.5 years 10 Cumulative cash flow (Sh.) 28million
40million 50million

60million 70million

Pay back period

2+

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Only 50% of year 3 cash inflows of Sh.10million are needed to complete the pay back period of the initial investment ofSh.45million. Therefore pay back period of project B is 2.5 years. If MALI Ltd.s maximum acceptable Pay back period was 2.75 years, Project A would be rejected and project B would be accepted. If projects were being ranked, Project B would be preferred.
5.3.1.1 Strengths and Weaknesses of the Pay Back Period Method

The Pay back period is widely used by (1) large firms to evaluate small projects; (2) small firms to evaluate most projects.
Advantages of the pay back period. The pay back period boasts the following strengths: -

Is simple and has intuitive appeal It considers cash flows rather than accounting projects Can be viewed as a measure of risk exposure can be used as a supplement to other sophisticated techniques

Weaknesses of the pay back period. The method suffers from the following

shortcomings: 1. The benchmark Pay back period used is merely a subjectively set number y management (the maximum number of years management decides cash flows must breakeven no link to wealth maximization). 2. Fails to take fully into account time factor in the value of money. This weakness can be demonstrated using the following example.

Example

A company is considering two projects, Project Gold and Project Silver, whose relevant cash flows are given below. Project GOLD Project SILVER Initial Investment Sh. 50million Sh.50 million

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________________________________________________________________________ Year 1 2 3 4 5 Pay back period Cash flows (Sh.) 5 million 5 million 40 million 10 million 10 million 3 years 80 million 2 million 8 million 10 million 10 million 3 years

Both projects have 3-year Pay back periods but more of the Sh.50million of the initial investment in project Silver is received sooner than is recovered for project Gold within the 3-year Pay back periods. 3. Failure to recognize cash flows after the pay back period.
Example

Take the following data for two projects, X and Y. X

Initial Investment Year Sh.10million Cash flow

Y
Sh. 10million

1 2 3 4 5 Pay back period

Sh.5million 5 million 1 million 0.1 million 0.1 million 2 years

Sh.3 million 4million 3million 4million 3 million 3 years

Strict adherence to pay back period suggests that project X be preferred. But we looked beyond Pay back period we see that Project X returns a paltry Sh.1.2million while project Y would bring in Sh.7million.

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5.3.2

Net Present Value (NPV)

A sophisticated capital budgeting technique; found by subtracting a projects initial investment from present value of its cash inflows discounted at a rate equal to the firms cost of capital. NPV = PV of cash inflows Initial Investment (II)

NPV =
n

CF (1+ k )
n t t =1

II ( InitialInvestment )

(6.1)

= CF t * PVIF k ,t II
t =1

Decision Criteria

When NPV is used to make accept reject decisions, the decision criteria are as follows:

If the NPV is greater than 0, accept the project If the NPV is less than 0, reject the project.

If NPV > 0, the firm will earn a return greater than its cost of capital, thereby enhancing the market value of the firm and shareholders wealth. Calculating NPV for MALI Limited.
Project A

Annual Cash inflow (annuity) PVIFA 10%, 5 years (table A-4) PV Less initial Investment
Net Present Value

Sh.14million * 3.791 53.074million 42.million

11.074million

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Project B

Year 1 2 3 4 5

Cash Inflows 28million 12m 10m 10m 10m Present Value

PVIF .909 .826 .751 .683 .621

PV 25.452m 9.912m 7.510m 6.830m 6.210m 55.914m 45.000m

10.912m

Less initial investment

NPV

5.3.3

The Internal Rate of Return (IRR)

Probably the most sophisticated capital budgeting technique, the internal rate of return (IRR) is the discount rate that equates the PV of cash inflows with the initial investment associated with the project (thereby causing NPV = 0). In other words, it is the compound annual rate of return , which would cause the investor to be indifferent between investing in the project and not investing in it.the firm will earn if it invests in the project and received the given cash flows. Mathematically, the IRR is found by solving the following equation for k

CF (1+ k )
n t t =1

= II ( Initial Investment )

Decision Criteria The IRR is used to make accept-reject decision as follows:

If the IRR is greater than the cost of capital, accept the project. If the IRR is less than the cost of capital, reject the project.

113

The decision rule guarantees that the firm earns at least its required return (cost of capital) which should enhance its market value and the wealth of its owners.
Calculating the IRR

It is not usually a simple matter to determine the internal rate of return of an investment without a financial calculator, a computer, or solving high order equations. In practice, a method of approximation (Trial and error) which gives answers accurate to two decimal places in the percentage figure is employed.
Trial and Error Approach

For an annuity calculating the IRR is considerably easier than calculating it for a mixed stream of operating cash inflows. The steps of the trial and error process are as follows: (1) Calculate Pay back period for the project (2) Find, from PVIFA, tables for the life of the project, the PVIFA closest to the Pay back period calculated in (1) above. (3) The discount rate associated with the factor is the projects IRR For Mali Company Project A has an annuity stream Payback period = 42,000,000/14,000,000 = 3.000. According to table of PVIFAs (Table A4), the PVIFA closest to 3.000 for 5years, is 3.058 (for 19%) and 2.991(for 20%). The value closest to 3.000 is 2.991; therefore, the IRR of the project A, to the nearest 1%, is 20%. Interpolating = 20 of 19.86%. Since the cost of capital for Mali Ltd is 11% the project is acceptable.
For Mixed cash flow Stream Steps.

3.000 2.991 *1%(20% 19%) , will give a more accurate IRR 3.058 2.99

Project B has a mixed operating cash flow stream. Having already worked out the projects NPV at the discount rate of 11% to be Sh.10.922 million, the discount rate that should result to zero NPV would have to be considerably higher than 11%.The trial and error steps proceed as follows, and are summarized in Table 5.4 below.

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We try first a discount rate of 20%, which gives an NPV of Sh.1,282,000. We have to try a higher rate, say, 21%. The NPV is Sh.+494,000. A higher discount rate of 22% makes the NPV to turn negative to Sh. -256,000. The IRR lies between 21% and 22%: to the nearest 1% it is 22% We can interpolate to get a more accurate rate. 22 + 0 256 = 21.66% 494 256

Table 5.4: determining IRR through trial and error process

Try 20% Year 0 1 2 3 4 5 CFs -45m +28m 12m +10m +10m +10m PVIF 1.000 .833 .694 .579 .482 .402 PV -45m +8.328m +5.79m +4.82m +4.02m
+1.282

Try 21% PVIF 1.000 .683 .564 .467 .386 PV -45m +8.196m +5.640m +4.670 +3.860
+.494

Try 22% PVIF 1.000 .672 .551 .451 .370 PV -45m +22.96m +8.064m +5.510 +4.410m +3.700
-.256

+23.324m ..826

+23.128m .820

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5.3.4 NPV Profile

In general the NPV and the IRR methods lead to the same accept reject decision. The graph

NP V

IRR

Discount rate

Shows the relationship between NPV and discount k.. When discount rate is zero NPV is simply total cash inflows less total cash outflows. (The highest NPV will occur with 0% discount rate). As the discount rate increases, the NPV falls and the graph slopes downwards to the right. When the curve intersects the horizontal axis NPV is zero and the discount rate at this point, by definitions, represents the IRR.. For discount rates higher than the IRR, the NPV is negative. It is clear from the profile that the NPV rule will be consistent with the IRR decision rule: If the cost of capital (required rate of return) is less than the IRR, the project will be accepted because NPV is positive. For required rates greater than the IRR we would reject project because the NPV would be negative.

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5.3.5

Profitability Index

The profitability index (PI) or benefit cost ratio of a project is the ratio of the PV of future net cash flows to the initial cash outlay. It can be expressed as PI =
t =1 n

CF / II , where II is the initial outlay. (1+ k )

t t

Acceptance Criterion. As long as the PJ is 1.00 or greater the investment proposal is

acceptable. For most projects, the NPV method and the PI method give the same accept/reject signals. Using Mali Ltd examples the PIs of the two projects are: Project A, PI = Project B, PI = PV (CFs) 53,074,000 = = 1.26 . InitialInvestment 42,000,000 PV (CFs) 55,914,000 = = 1.24 . InitialInvestment 45,000,000

Both projects are acceptable as their Profitability indexes are greater than 1.0. However, Project A is marginally better than Project B.

5.4

POTENTIAL DIFFICULTIES IN USING DISCOUNTED CASH FLOW METHODS

For a single conventional, independent projects, the IRR, NPV and PI methods lead us to make similar accept/reject decision. Various types of circumstances and projects differences can cause ranking difficulties. Four situations that could cause inconsistencies arise: (1) when funds are limited necessitating capital rationing and, (2) when ranking two or more project proposals with varied lives, (3) when ranking two or more projects with different Investment scales, and (4) when projects have opposite cash flow patterns.

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5.4.1

Capital Rationing

Occurs any time there is a budget constraint or ceiling on the amount of money that can be invested during a specific period of time (For example, the company has to depend on internally-generated funds because of borrowing difficulties, or a division can make capital expenditures only up to a certain ceiling). With capital rationing, the firm attempts to select the combination of investments that will provide the greatest increase in the firm of the value subject to the constraining limit.
Example

Assume your firm faces the following investment opportunities:

Project Initial Cash Flows IRR NPV PI

Shs.000 A B C D E F G H 50,000 35,000 30,000 25,000 15,000 10,000 10,000 1,000 15% 19 28 26 20 37 25 18

Sh.000 12,000 15,000 42,000 1,000 10,000 11,000 13,000 100 1.24 1.43 2.40 1.04 1.67 2.10 2.30 1.10

If the budget ceiling for initial cash flows during the present period is Shs.65,000,000 and the proposals are independent of each other, your aim should be to select the combination projects that provide the highest in firm value the Shs.65 m can deliver. Selecting projects in descending order of profitability according to various discounted cash flows methods, which exhausts Sh.65 million reveals the following:
Using the IRR Using the NPV

Project A B C

IRR 37% 28 26

NPV Initial outlay Sh 000 Shs.000 11,000 10,000 30,000 30,000 25,000 25,000 54,000 65,000

Project NPV Sh 000 C B 42,000 15.000 57,000

Initial flow Sh.000 30,000 35,000 65,000

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Using the PI

Project PI C G F E 2.40 2.30 2.10 1.67

NPV Sh000 42,000 13,000 11,000 10,000 76,000

Initial outlay Sh000 30,000 10,000 10,000 15,000 65,000

With capital rationing you would accept projects C, E, F and G which deliver an NPV of Sh.76million. The universal rule to follow is When operating under a constraint, select the projects that deliver the highest return per shilling of the constraint (the initial investment outlay). Put another way, select that mix of projects that gives you the biggest bang for the buck. We achieve this buy employing the profitability index which ranks projects on the basis of the return per shilling of initial investment outlay. Under conditions of capital rationing it is evident that the investment policy is less than optimal Optimal policy requires that no positive NPV projects be rejected.

5.4.2

Scale Differences

Example Suppose a firm has two mutually exclusive projects that are expected to generate

following Cash flows

End of Year Project A Cash flows (Sh) Project B Cash flows (Sh)

0 1 2

-1000,000 0 400,000 IRR NPV Sh000

-100,000,000 0 156,250,000 PI

If the required rate of return is 10% the NPV, IRR and PI of the projects are as below:

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Project A Project B

100% 25%

231 29,132

3.31 1.29

Ranking of projects based on our results RANKING 1st 2nd IRR A B NP B A PI A B

Using the IRR and PI shows preference for project A, while NPV indicates preference for Project B. Because IRR and PI are expressed as a proportion the scale of the project is ignored. In contrast results of NPV are expressed in absolute shilling increases in value of the firm. With regard to absolute increase in value of the firm, NPV is preferable.

5.4.3 IRR)
patterns.
End of year

Differences in Cash Flow Patterns (Multiple

Example Assume a firm is facing two mutually exclusive projects with following cash flow Project C Cash flows Sh000 Project D Cash flows Sh000

0 1 2 3

-1,200 1,000 500 100

-1,200 100 600 1,080

Note that project Cs cash flows decrease while those of project D increase over time.

The IRR for projects are as follows Project C - 33% Project D - 17%

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For every discount rate> 10% project Cs NPV and PI will be> than project Ds. For every discount rate < 10% project Ds NPV and PI will > project Cs. K<10% K>10% NPV PI C D C D

RANKING 1st 2
nd

IRR C D

NPV PI D C D C

When we examine the NPV profiles of the two projects, 10% represents the discount rate at which the two projects have identical NPVs. This discount rate is referred to as
Fishers rate of intersection. On one side of the Fishers rate it will happen that the

NPV and PI on one hand, and the IRR on the other give conflicting rankings. We observed conflict is due to the different implicit assumption with respect to the reinvestment rate on intermediate cash flows released from the project. The IRR implicitly assumes that funds can be reinvested at the IRR over the remaining life of the project. With the IRR the implicit reinvestment rate will differ from project to project unless their IRRs are identical. For the NPV and PI methods assume reinvestment at a rate equal to the required rate of return as the discounts factor. The rate will be the same for all projects. Since the reinvestment rate represents the minimum return on opportunities available to the firm, the NPV ranking should be used. In this way, we identify the project that contributes most to shareholder wealth.

5.4.4

Differences in Project Lives

When projects have different lives, a key question is what happens at the end of the shortlived project? Two alternatives assumptions can be considered. (1) Replace with (a) identical project or (b) a different project. (2) Do not replace. The Do not replace alternative is considered first. 121

Example

Suppose you are faced with choosing between 2 mutually exclusive investments X and Y that have the following Cash flows.
End of year Project X Cash flows Sh. 000 Project Y Cash flows Sh. 000

0 1 2 3 follows:

- 1000 0 0 3,375

- 1000 2000 0 0

If the required rate of return is 10% we can summarize our investment appraisal results as
IRR NPV PI

Sh000 X Y
RANKING

50% 100% IRR Y X

1536 818 NPV X Y

2.54 1.82 PI X Y

Rank 1st 2nd

Once again a conflict in ranking arises. Both the NPV and the PI prefer project X to Y, while The IRR criterion choose Y over X. Again, in this case of no replacement, the NPV method should be used because it will choose projects that add the greatest absolute increment in value to the firm.
Replacement Chain When faced with a chose between mutually exclusive investments

having unequal life that will require replacement, we can view the decision as one involving a series of replications or a replacement chain of respective alternatives over some common investment horizon.

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Repeating each project until the earliest rate that we can terminate each project in the same year results in a multiple like-for-like replacement chains covering the shortest common life. We solve the NPV for each replacement chain as follows: NPV chain = Where n = single replication project life in years NPV= singe replication NPV for a project with n- year R = umber of replications needed K= discount rate The value of each replacement chain therefore is simply the PV of the sequenced of NPV , generated by the replacement chain.
Example

Assume the following regarding mutually exclusive investments alternatives A and B, both of which requires future replacement
Project A project B

Single replication life (n) Single replication PV calculated at project specific required rate of return (NPVn) Number of replication to provide shortest common life Project specific discount rate

5 years Sh. 5,328 2 10%

10 years Sh. 8000 1 10%

At first glance project B looks better than project A (8000 Vs 5328). However the need to make future replacements dictates that we consider values provided over same common life i.e. 10 years. The NPV can then be re-worked as follows

NPV for first 5 years NPV for replicated project=5328* NPV of chain

= 5328

PVIF

10%, 5 yrs

= 3303
8638

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The NPV of project B is already known i.e. Sh. 8000. Comparing with Sh. 8638 present value of the replacement chain, project A is preferred.

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REVIEW QUESTIONS

1.

Define, and differentiate between each of the following sets of capital budgeting terms; (a) independent vs. mutually exclusive projects (b) unlimited funds vs. capital rationing (c ) accept/reject vs. ranking approaches (d) conventional vs. non conventional cash flow patterns. (e) annuity vs. mixed stream cash flows (f) Bank vs. opportunity cost (g) incremental cash flows vs. irrelevant cash flows.

2.

Describe each of the following input to the initial investment, and show how the initial investment is calculated by using them. (a) cost of new assets (b) installation cost (c) proceeds from sale of old asset (d) tax on sale of old asset; and (e) change in net working capital.

3. 4. 5. 6. 7.

What is the terminal cash flow? Explain its determination in a replacement decisions. What is the internal rate of return (IRR) on an investment? How is it determined? Do the net present value (NPV) and internal rate of return (IRR) always agree with respect to talking decisions? Explain. What is capital budgeting? What are the key motives for making capital expenditure?

8. Why does capital budgeting rely for analysis purposes on cash flows rather than net income.
PROBLEMS 5.1 The Mbuni Glass Company uses a process of capital rationing in its decision making .The firms cost of capital is 13% . The company will only invest Sh. 60 million this year. It has determined the internal rates of return for the following projects. Project Project Size(Shs millions) Internal rate of return A 10 15% B 30 14% C 25 16.5% D 10 17% E 10 23% F 20 11% G 15 16% Required Pick the projects that the firm should accept. (a)

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If projects D and E were mutually exclusive, how would that affect your overall answer in (a) above. 5.2 Maringo Ltd.'s chief financial officer (CFO) expects the firms profits after taxes for the next 5 five years to be as follows.
(b) Year Net profits after taxes (Shs millions) 2008 100 2009 150 2010 200 2011 250 2012 320 The CFO is beginning to develop the relevant cash flows needed to analyze whether to renew or replace the companys only depreciable asset, a machine that originally cost Sh.30 million, has a current book value of zero, and can now be sold for Sh.20 million. He estimates that at the end of 5 years the existing machine can be sold to net Sh.2 million before taxes. The CFO plans to use the following information to develop the relevant cash flows for each of the alternatives. Alternative I: Renew the existing machine at a total depreciable cost of Sh.90 million. The renewed machine will have a 5 year useful life and be depreciated on straight line basis with a salvage value of Sh.10 million. The renewal decision could result in the following projected revenues and expenses (excluding taxes).

Year Revenue (millions) Expenses (excldg. Depn) (millions 2008 1,000 801 2009 1,175 884 2010 1,300 918 2011 1,425 943 2012 1,550 968 The renewed machine would result in an increased investment of Sh.15 million in net working capital. Alternative II: Replace the existing machine with a new machine costing Sh.100 million and requiring installation cost of Sh.10 million. The new machine would have a usable life of 5 years and a salvage value after 5 years of Sh.20 million before taxes. The firms projected revenues and expenses (excluding depreciation) if it acquires the machine, would be as follows: Year Revenue ( Shs millions) Expenses (Shs millions) 2008 1,000 764 2009 1,175 839 2010 1,300 914 2011 1,425 989 2012 1,550 998 The new machine would result in an n increased investment of Sh.22 millions in net working capital. The firm is subject to 40% tax on both ordinary income and capital gains>

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Required a. b. c. d.

Calculate the initial investment associated with each alternative Calculate the incremental operating cash flows associated with each alternative Calculate the terminal cash flows at the end of year 5 associated with each alternative. Based solely on the cash flows (without discounting) which alternative appears to be better? Why?

5.3 Pima Watch Company Ltd. is considering an investment of Sh.1,500,000, which produces the following inflows.

Year Cash flow 1 Sh.800,000 2 700,000 3 400,000 You are going to use the net present value profile to approximate the value for the internal rate of return. Follow the following steps. (a) Determine the net present value of the project based on a zero discount rate. (b) Determine the net present value of the project based on a 10% discount rate. (c) Determine the net present value of the project based on a 20% discount rate. (d) Draw the NPV profile of the project and observe the discount rate at which the NPV is zero. This is an approximation of the IRR of the project. (e) Actually compute the IRR by interpolation and compare your answer to the answer to part (d). 5.4 Waziri Industries is currently analyzing the purchase of a new machine costing Sh.16,000,000 and requiring Sh. 2,000,000 in installation costs. The use of this machine is expected to result in an increase in net working capital of Sh.3,000,000 to support the expanded level of operations. The firm will write down the installed cost of the machine at a rate of 20% per annum for tax purposes and expects to sell the machine to net Sh.1,000,000 before taxes at the end of its usable life. The firm is subject to 30% tax rate on both ordinary income and capital gains. Required (a) Calculate the terminal cash flow for a usable life of (1) 3 years (2) 5 years, and (3) 7years. (b) Discuss the effect of usable life on terminal cash flows using your findings in (b). (c) Assuming a 5 year usable life, calculate the terminal cash flows if the machine were sold to net (1) Sh.900,000 (2) Sh.17,000,000 before taxes at the end of 5 years. (d) Discuss the effect of sale price on terminal cash flows using your findings in (c). 5.5 A machine currently in use was purchased two years ago for Sh.4 million. The machine is being depreciated on a straight line basis to write off the cost over a 5 year usable life. The current machine can be sold today to net Sh.3.6 million. After

127

removal and cleanup costs. A new machine with a three year usable life can be purchased today at a price of Sh.14 million. It requires Sh.1 million to install and has a usable life of 3 years. If the new machine were acquired the investment in accounts receivable will increase by Sh.1 million and inventory investment will rise by Sh 2.5 million., and accounts payable would increase by Sh.1.5 million. Profits before depreciation and taxes are expected to be Sh.7 million for each of the next 3 years with the old machine and Sh.12 million in the first year and Sh.13 million for each of the next 2 years with the new machine. At the end of the next 3 years the market value of the old machine will equal to zero, but the new machine will be sold to net Sh.3.5 million before taxes. Both ordinary corporate income and capital gains are taxed at the rate of 30%. Required (a) Determine the initial investment associated with the proposed replacement. (b) Calculate the incremental cash flows associated with the replacement decision for the next 3 years. (c) Calculate the terminal cash flows associated with the replacement decision. (d) Depict on a time line the relevant cash flows found in (a), (b) and (c) associated with the proposed replacement decision. 5.6 Molo Limited is developing the relevant cash flows associated with the proposed replacement of an existing machine tool with a technologically advanced one. Given the following costs associated with the replacement decision explain whether each could be treated as a sunk or opportunity cost. (a) Molo would be able to use the same tooling it had used on the old machine (which has a book value of Sh.4 million) for the new machine. (b) Molo would be able to use its existing computer system to develop programs for operating the new machine tool. The old machine tool did not require these programs. Although the firms computer system has excess capacity the capacity could be leased to another firm for an annual fee of Sh.1.7 million. (c) Molo would have to acquire additional space to accommodate the new larger machine tool. The space that would be used is currently being leased to another company for Sh.1 million. (d) Molo would use a small storage facility to store the increased output of the new machine tool. The storage facility was built by Molo at a cost of Sh.12 million 3 years ago. Because of its unique configuration and location, it is currently of no use to either Molo or any other company. (e) Molo would retain an existing overhead crane which it had planned to sell for its Sh. 18 million market value. Although the crane was not needed with the old machine it will be used to position raw materials on the new machine tool. 5.7 Bidii Limited is in the process of choosing the better of two equal risk, mutually exclusive, capital expenditure projects. The relevant cash flows for each project are shown below. The firms cost of capital is 14%. Year Project M Project N 0 (Initial investment) -Sh.28,500,000 -Sh.27,000,000 1 (Operating cash flows) +Sh.10,000,000 +Sh.11,000,000

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2 3 4
Required (a) (b) (c) (d) (e)

+Sh.10,000,000 +Sh.10,000,000 +Sh.10,000,000

+Sh.10,000,000 +Sh.9,000,000 +Sh.8,000,000

Each projects pay back period The NPV for each project The IRR for each project Summarize the decision criterion for each measure calculated above. Draw the NPV profiles for each project on the same axes and explain circumstances under which conflicts in ranking may arise. 5.8 Magarini Limited is considering two mutually exclusive projects. The firm which has a cost of capital of 12% t\has estimated the following cash flows. Year Project A Project B 0 (Initial investment) -130 million -85 million 1 (Operating cash flows) 25 million +40 million 2 35 million +35 million 3 45 million +30 million 4 50 million +10 million 5 55 million +5 million Required (a) NPV of each project (b) IRR of each project (c) Draw NPV profile of each project on same axes. (d) Evaluate and discuss the ranking of the projects based on your findings above. (e) Explain your findings in (d) in light of the pattern of cash flows associated with each project. 5.9 Mzima Limited is considering the purchase of a new printing press. The total installed cost of the printing press is Sh 22 million. This outlay could be partially offset by the sale of an existing press, which has a book value of nil, was purchased at Sh.10 million10 years ago and could be sold to fetch Sh. 12 million currently before taxes. As a result of the new press sales for each of the next 5 years are expected to increase by Sh. 16 million, but product costs (excluding depreciation) will represent 50% of the sales. The new press will not affect the firms working capital requirements. The new press will be write-down on declining balance for a period of 5 Years. Assume a tax rate of 40%. Required (a) Determine the initial investment (b) Operating cash flows attributable to the new press (c) The pay back period. The NPV and the IRR related to the proposed new press. (d) Make a recommendation to accept or reject the new press and justify your answer. 5.10 Mugoya Limited, a large machine shop, is considering replacing one of its lathes with either of two new lathes, Bingwa or Hodari. Bingwa is highly automated , computer controlled lathe; Hodari is a less expensive lathe that uses standard technology. A

129

financial analyst has prepared estimates of the initial investment and incremental cash flows associated with the two lathes as shown below. Year Bingwa (Shs, millions) Hodari (Shs. millions) 0 (Initial investment) -660 -360 1 (Operating Cash flows) +128 +88 2 +182 +120 3 +166 +96 4 +168 +86 5 +450 +207 Fifth year cash flows include the salvage value of the lathes. Mogayas cost of capital is 13% and is in the 40% tax bracket and requires all project to have a maximum payback period of 4 years. Required a. Determine the pay back period for each lathe b. Assess the acceptability and ranking using (1) NPV and (2) IRR c. Summarize project rankings according to the 3 techniques above. Is there any conflicts d. Which lathe should ultimately be accepted? Why?

130

LECTURE SIX INTEREST RATE FUNDAMENTALS AND COST OF CAPITAL

6.0 INTRODUCTION

For economic growth, controlled inflation and full employment in our economy, funds (money) must flow from savers (suppliers) to investors (demanders). This occurs through the medium of financial institutions and markets. The interest rate (cost of money) prevailing in the economy acts as regulating mechanism that control the flow of these funds from the surplus units (savers) to the deficit units (borrowers). Generally, the lower the interest rate the greater the flow of funds and the greater the economic growth. When funds are obtained by selling an ownership interest (equity) the cost to the issuer (demander) is commonly called the required rate of return.
Objectives At the end of the lecture students should be conversant with: 1. Interest rate fundamentals and term structure of interest rate 2.Sources and costs of long term capital 3. Weighted average cost of capital (WACC) and weighted marginal cost of capital (WMCC) 4. Financing and investment decisions using IOS and WMCC schedules1.

6.1 Interest Rate Fundamentals

Interest rate is the compensation paid by the borrower of funds to the lender, from the borrowers perspective it is the cost of funds. The nominal rate is the actual rate of interest charged by the supplier of funds and paid by the demander. The nominal rate encompasses:i) The real rate 131

ii) iii)

The inflation premium and, The risk premium.

This can be expressed as Ki = K* + IP + RPi ------ (I) Where Ki is the nominal rate of interest K* is the real rate of interest IP is the risk premium RPi is the risk premium
Real Rate

This is the rate that creates equilibrium between the supply of savings and the demand for investible funds in a perfect world, without inflation; where fund suppliers and demanders have no liquidity preference, and where all outcomes are certain. The real rate of interest is the most basic cost of money. Figure 1 below shows that the real rate of interest is an equilibrium for funds (So = D) and occurs at rate of interest of Ko.

132

Real rate of interest K2 K0 K1 S0 S1

S0 S1

Funds supplied (demanded)

Changing economic conditions, lasts and preference can cause the real interest level to rise or fall. For example, a trade surplus could shift the supply function of money downwards and cause the real rate of interest to fall to a new level of K1. (On the other hand an increase in taxation my shift the supply curves upwards occasioning a rise in real rate of interest to K2.
Inflationary Premium

The premium for inflationary premium represents the average rate of expected inflation over the life of a loan or investment. A rise in the inflation rate depreciates the value of money: suppliers of money will demand a higher compensation in nominal terms resulting in higher premium for inflation. Factors that cause inflationary pressure such as government fiscal policies, consumer tastes, costs of raw materials and political events impact the inflationary premium.
Risk Premium

The risk premium consist of a number of issuer and issue related characteristics including default risk, maturity risk, liquidity premium, contractual provisions and tax risk. The highest premium for risk comes with high risk of default, long term maturity, unfavorable contractual provisions and strongest tax conditionalities defined as the required return on 133

a risk free asset (91 day treasury bills). RF = K* + IP ..2

It embodies the real rate of interest plus

inflationary expectation. It can be represented as:-

Recall equation (1) giving as the nominal rate of interest. Introducing RF, the equation can be rewritten as:Ki = RF + RPi Thus the nominal rate of interest has two basic components; the risk free rate and the risk premium. For a risky assets, therefore the real rate of interest could be estimated by:K* = RF IP
6.1.1 TERM STRUCTURE OF INTEREST RATES

Definition: For bonds of similar risk the term structure of interest rate relates the interest rate or required rate of return to the time to maturity of the securities.
Yield to Maturity (YTM)

The annual rate of interest on a security purchased on a govendary and Yield to Maturity (YTM). The yield to maturity, Ki is computed exactly in the same way you would solve for the internal rate of return (IRR) on a security. A bond that promises to pay 15% coupon at end of each year for 3 year, then pay a face-value of Kshs1,000. If the current market price is obscured to be Sh.977.54 then the YTM can be found by solving for k d , in the following expression. 977.54 =
3

t =1

150
t

(1+ k d ) (1+ k d )

1000
3

can through trial and error determined to be 16%. This is the securitys yield to

maturity.

134

Yield Curves

It is a graph of the term structure of interest rates that depict the relationship between the yield to maturity of a security of (y axis) and the time to maturity (x axis): It shows the pattern of interest rates on securities of equal quality but different maturities. We have 3 zero coupon bonds that pay a force value of Kshs1,000 upon maturity. The three bonds have maturities of one, two and three years and are observed to have a current market price of Kshs826.45, 718.18 and 640.66 respectively. The implied yields to maturity can be found by solving for relationship, in the following

(1+ k d )

For the three bonds are the YTMs are:One year bond Two year bond Three year bond 21% 18% 16%

135

We can plot a yield curve relating yields to maturity with time to maturity as below:-

Yield curve

3 Time of maturity

The yield curve could take several forms; 1. 2. 3. Invested yield curve - is a downward sloping yield curve that indicates generally cheaper long term borrowing costs than short term borrowing costs. Normal yield curve an upward sloping yield curve that indicates generally cheaper short term borrowing costs than long term borrowing costs. Flat yield curve a yield curve that reflects relatively similar borrowing costs for both short and long term loans.

136

YTM Normal

YTM Inverted

YTM Flat

Time to maturity

Time to maturity

Time to maturity

The shape of the yield curve provides useful insights into future interest rate expectations which could affect a firms financial decisions. When a firm is faced with a downward sloping curve a financial manager is likely to rely on long term financing. When the yield is upward sloping the manager will use cheaper short term financing.
6.2 THEORIES OF TERM STRUCTURE

The theories of term structure attempt to explain why yield curves take on different shapes. Three theories are the expectation hypothesis, liquidity preference theory, and market segmentation theory.
Expectation hypothesis

This hypothesis suggests that the yield curve reflects investors expectations about future interest rates. For example, differing inflation expectations associated with different maturities will cause nominal interest rates to vary. An increasing inflation expectations results in an upward sloping yield curve; a decreasing inflation expectation results in downward sloping yield curve and a stable inflation expectation results in a flat yield

137

curve. The observed strong relationship between inflation and interest rates supports this widely accepted theory.
Liquidity preference theory -

It suggest that for any issuer, long term interest rates tend to be higher than short term rates due to the lower liquidity and higher responsiveness to general interest rate movement of longer term securities. This happens because:i) ii) Investors perceive less risk in short term securities than in longer term securities because short term securities are more liquid. Borrowers are generally willing to pay higher rate for long term funds because they are saved the need to arrange roll over of short term debt may be at a higher interest rate. In general therefore, longer maturities tend to call for higher interest rates than shorter maturities.
Market Segmentation Theory.

The theory suggests that the market for loans is segmented on the basis of maturity and that the supply of, and demand for loans within each segment determine the prevailing interest rate. The scope of the yield curve will be determined by the general relationship between the rates prevailing in each segment. Modigliani and Sutch (1966) argue that there is relatively little substitution between assets of different maturities because investors have preferred habitats. The equilibrium between suppliers and demanders of short term funds (seasonal business loans) would determine prevailing short term rates and the equilibrium suppliers and demanders of long term funds (real estate loans) would determine prevailing long term rates. Therefore low rates in the short term segment and high rates in the long term segment should cause the yield curve to be upward sloping, vice versa.

138

6.3 COST OF CAPITAL

Cost of capital acts as a major link between the firms investment decision and the wealth of the owners of a firm. It is the magic number that is used to decide whether a proposed corporate stock price. Our concern is with long-term sources, which supply the permanent financing.
Definition

Cost of capital can be defined as the rate of return that a firm must earn on its project investments to maintain the market value of its shares. Or, As the minimum rate of return required by suppliers of capital firm to attract their funds to the firm. If risk is held constant, projects with rate of return above the cost of capital will increase the value of the firm, vice versa.
Cost of capital and risk

The following equation explains the general relationship between risk and financing costs.

k = r + bp + fp K1
i f i i

Where:

k r bp
i f

= =

specific cost of the type of long term financing risk free cost of the given type of financing business risk premium of firm i financial risk premium faced by firm i

= =

fp

The equation indicates that the cost of each type of capital depends on the risk free cost of that type of funds, the business risk of the firm and the financial risk of the firm. 139

Business risk is the risk to the firm of being unable to cover operating costs. Financial

risk is the risk of the firm of being unable to cover required

6.3.1 SPECIFIC SOURCES OF CAPITAL

The right hand side of the balance sheet comprises current liabilities, long-term debt, preferences shares capital, and ordinary share capital. Our concern is only with the longterm sources of funds because they supply the permanent financing.
COST OF DEBT Before tax cost of debt

The before tax cost of debt can be derived by solving for the discount rate

, that

equates the market price of the bond with present value of cash flows from the bond over its life (interest plus principal payments). This is the same as funding the internal rate of return (IRR) on the bonds cash flows. This cost, k d , also know as the yield to maturity can be calculated by using the formula

Bo =
t =1

I +P (1+ k d )
t t

Where B0 , is the current market price of bold (net proceeds (minus any flotation costs). Pt and

are the payment of principal and interest in period t .

If principal payment occurs only at maturity and if the interest payments are constant the relationship would simplify to: -

Bo =
t =1

I
t

(1+ k d ) (1+ k d )

M
n

140

Where M is the payment at maturity and I is the periodic interest payment. By solving for k d , the discount rate the equates the present value of cash payments to suppliers of debt to current market price of debt, we find the rate of return required by the lenders.
Example

A company intends to sale a bond to raise capital. The features of the bond are: Par value Kshs. 1,000 Coupon rate 9% Discount on issue Kshs. 20 Flotation cost 2% of par value
Find the cost of debt financing Soution

Net proceeds of from sale of bond = 1000 20 2% x 1000 = 960 The cash flows associates with ABC Companys bond issue are as follows End of year 0 1 20 20 CF +960 -90 -1000

We work out the cost of debt k d , through trial and error. The discount rate must be higher than the 9% (because 960 < 1000, the par value. The present value at a 9% is Sh. 1000, same as par value. Lets try 10%. The present value of cash flows is given by 90* PVIFA10%, 20 yrs + 1000 * PVIF 10%, 20 yrs =Sh. 915.26.

of

141

Because 960 is between 1000 and 915.26 the however 9% to the nearest whole %,

must be between 9% and 10%. It is

By using interpolation the bonds before tax cost is 40 = 9.47% 85 = 9.47

9% +

After tax cost of debt

The specific cost of financing must be selected on an after tax basis. Because interest on debt is tax deductible it reduces taxes by an amount equal to the product of the interest payment and firms tax rate. The after-tax cost of debt will be substantially lower than the before tax cost and will be given by k i = k d (1 T )

Where

is the before tax cost of debt and is T is the firms tax rate.

If the ABC Co is in the 40% tax bracket, the after tax cost of debt will be 9.47 x (1-0.4) = 9.47 x 0.6

= 5.68% Typically the explicit of debt is less than the cost of alternative forms of long term financing primarily because of the tax deductibility of interest. The higher the rate of corporation tax is, the greater the tax benefits in having debt finance when compared with equity finance. In the example above, if the rate of tax had been 50%, the cost of debt would have been 9.47(1-.5) =4.74%

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Example:

Owen Allot plc has in issue 10% debentures of a nominal value of Sh.1000. the market price is Sh.900 ex interest. Calculate the cost of this capital if the debenture is: a. b.
Solution

Irredeemable; Redeemable at par after 10 years.

Ignore taxation.
100 = 11.1% 900

The cost of irredeemable debt capital is I

=
0

The cost of redeemable debt capital. The best trial and error figure to try first is, 12%. Year Cash flow Discount PV Factor 12% 1.000 (900.00) 5.650 565.00 0.322 322.00 (13.00) Discount PV factor 11% 1.000 (90.00) 5.889 58.89 0.352 35.20 40.90 13.00 = 11.76% 40.90 + 13.00

0 Market value (900) 1-10 Interest 100 10 Capital repayment 1000

The approximate cost of debt capital is, therefore 12

The cost of debt capital estimated above represents the cost of continuing to use the finance rather than redeem the securities at their current market price. It would also represent the cost of raising additional fixed interest capital if we assume that the cost of the additional capital would be equal to the cost of that already issued. If a company has not already issued-any fixed interest capital, it may estimate the cost of doing so by

Approximating before tax cost of debt

Therefore tax cost of debt using following equation:

, for a bond with Kshs.1000 par value center approximate

143

I+

1000 N d

n + 1000 Nd 2

Where I = annual interest payments

= net proceeds from sale of debt

n = number of years to bonds maturity Substituting in previous example:

1000 960 20 960 + 1000 2

90 +

= 9.4%.

COST OF PREFERRED STOCK The cost of irredeemable preferred stock,

is the ratio of the preferred stock

dividend to the firms net proceeds from sale of the preferred stock ( Market price minus any flotation costs and discounts).

D Np
p

Where k p cost of preferred stock,

annual dividend, and

the net proceeds from

sale of preference shares, excluding any flotation costs. Because preferred stock dividend are paid out of the firms after tax cash flows, a tax adjustment is not required as was in the case of debt.
Example

144

ABC Co is contemplating issuance of a 10% preferred stock expected to sell for its Kshs.87 per share par value. The cost of selling the stock is expected to be Shs.5 per share. Find the cost of preferred stock = 10% x 87 = Kshs.8.70

D
N

87 5

Kshs. 82

8.70 = 10.6% 82

COST OF ORDINARY SHARE CAPITAL

The cost of equity is the return required on by investors in the market place. The cost,

, is the rate at which investors discount the expected dividends of the firm to

determine its share value. There are 2 forms of equity financing 1. Retained earnings 2. New issues of equity.

In the context of the dividend discount model approach the cost of equity

can be

thought of as the discount rate that equates the present value of cash flows with the current market price of the share. Recall from valuation.

P0 =
t =1

D (1+ k s)
t

Where P0 = current market price per share, end of period t and

is dividend expected to be paid at the

is discount rate, the cost of equity.

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In estimating future dividend, assumptions necessary. The most frequently used assumptions are zero growth in dividends, constant growth in dividends, and variable growth rates.
Constant Growth Rate

If future dividends are expected to grow at a constant rate, the expression to use in estimating cost of equity is

P0 =

D (1 + g ) = D k g k g
0 1

Therefore, cost of equity is

Example

D (1 + g ) + g = D P P
0 0

+g

ABC dividends are expected to grow at a constant rate of 5% into the foresable future. The company has just paid dividend of Shs.3.80 and is share is selling at a market price of Shs.50 calculate of cost of equity.

ks =

3.80 (1 + 0.05) + 0.05 = 3.99 + 0.05 = 12.98%

50 50

Growth Phases

If growth in dividends is expected to vary in future a modification in the dividend model will be in order. Usually above normal growth is followed by normal growth. For instance, if dividend were expected to growth 15% compound rate for 5 years, at 10% for next 5 years, and the gowth at 5% rate into the firescible future the equation would be: -

146

D (1+ 0.15 + D (1+ 0.10) + D * 1 P = k 0.05 (1+ k s) (1+ k s) (1+ k s)

5 t 0 10 t 5 11 0 t =1 t t =6 t s

10

If current dividend paid is 2/= and current market price is Sh.70, the 10.42%.
Cost of Retained Earnings

would be

The cost of retained earning, Kr, to the firm is the same as the cost of equity. =

It is not necessary to adjust the cost of retained earnings for flotation costs because retention is an internal financing received without incurring these costs. The cost of retained earnings for ABC Co as calculate above for Ks. Cost or retained earnings is always lower than cost of a new issue due to absence of flotation costs when financing projects with retained earnings.
Cost of new issues

The cost of new issue of equity

is determined by calculating the cost of equity net of

any discounts and associated flotation costs. Because of flotation costs and discounts the proceeds from an issue will be less than current market price of the stock and hence its cost will be more expensive. The cost of new issues can be calculated by modifying equations as follows. If net proceeds =

i.e.

( Price - Flotation cots). The cost of equity,

under the two assumptions of no growth. and constant growth will be

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No Growth

With constant growth = k n =

D N

1 n

+g

Example:

The Co estimates that to sell a new issue the shares will have also to be priced at Sh.47, and in addition flotation costs of Sh..2.50 per share will be incurred. What is cost of new issue if the company has and will experience a constant growth in dividend of 5%, and is currently selling at a price of Sh.50. Dividend next year is expected to be Sh. 4.00 per share.

4.00 + 0.05 = 14% 47 2.50

This is the value to be used in subsequent calculations of a firms cost of capital.

6.3.2 WEIGHTED AVERAGE COST OF CAPITAL

WACC reflects the expected average future cost of funds over the long run; found by weighing the cost of each specific source of capital by its proportion in the firms capital structure.

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The calculation of the WACC is performed by multiplying the specific cost of each form of financing by its proportion in the firms capital structure and summing the weighted values

k (WACC ) = wi * k i + w p * k p + ws * k s
Where

w w w w

= = = +

proportion of long term debt in capital structure proportion of preference stock in capital structure proportion of equity in capital structure
p

= 1

the firms equity weight ws is multiplied by either the cost if retained earnings of new equity

or cost

, which cost is used depend on whether the firms equity will come

from retained earnings on new issues.

Example:

ABC Co costs of various types of capitals are

Cost of debt

5.6%

Cost of preference

k
k

10% 13% = 14%

Cost of retained earnings Cost of new equity

n

The Co target capital structure proportions are: -

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Weight Debt Preferred stock Equity 40% 10% 50% 100% The company has a sizable amount of retained earnings that it intends to use for future investments. Find companys WACC Weight Debt Preferred stock Equity 0.4 0.1 0.5 Cost 5.6% 10.6 13.0 Weighted Cos 2.2% 1.1 6.5 9.8 WACC =
9.8%

Arguments for using WACC

The weighted average cost of capital is recommended for use in investment appraisal on the assumptions that: a. Net investments must be financed by new sources of funds; retained earnings, new share issues, new loans and so on; b. The cost of capital to be applied to project evaluation must reflect the marginal cost of new capital; and c. The weighted average cost of capital reflects the companys long-term future capital structure, and capital costs. If this were not so, the current weighted average cost would become irrelevant because eventually it would not relate to any actual cost of capital.

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It has been argued that the current weighted average cost of capital should be used to evaluate project, because a companys capital structure changes only very slowly over time; therefore the marginal cost of new capital should be roughly equal to the weighted average cost of current capital. If this view is correct, then by undertaking investments, which offer a return in excess of the WACC, a company will increase the market value of its ordinary shares in the long run. This is because the excess returns would provide surplus profits and dividends for the shareholders.
Arguments against using the WACC

The arguments against using the WACC as the cost of capital for investment appraisal are based on criticism of the assumptions that are used to justify use of the WACC. The main arguments against the WACC are as follows. a. New investments undertaken by a company might have different business risk characteristics from the companys existing operations. As a consequence, the return required by investors might go up (or down) if the investments are undertaken, because their business risk is perceived to be higher (or lower). b. The finance that is raised to fund a new investment might substantially change the capital structure and the perceived financial risk of investing in the company. Depending on whether the project is financed by equity or by debt capital, the perceived financial risk of the entire company might change. This must be taken into account when appraising investments. c. Many companies raise floating rate debt capital as well as fixed interest debt capital. With floating rate debt capital, the interest rate is variable, and is altered every three or six months or so in line with changes in

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current market interest rates.

The cost of debt capital will therefore Floating rate debt is difficult to

fluctuate as market conditions vary.

incorporate into a WACC computation, and the best that can be done is to substitute an equivalent fixed interest debt capital cost in place of the floating rate debt cost.
WEIGHTING SCHEME

Weights can be calculated based on book value or market value and using historic or target proportions.
Book value vs. Market value

Book value weights use historical accounting values to measure the proportion of each type of capital in the firms financial structure. Market value weights measure the proportion of each type of capital at its current market value. Market value weights are appealing, because the market value of securities closely approximate the actual shilling amounts to be received from their sale. In addition the long term cash flows from investments to which cost of capital is applied are estimated in terms of current as wells future Market values.
Historic versus Target

Historic weights are either book or market value weights based on the proportions of each type of capital in the existing capital structure while target capital structure is the desired optimal capital structure proportions. From a purely theoretical point of view the preferred weighting is target market value proportion.

WEIGHTED MARGINAL COST OF CAPITAL

As volume of financing increase the cost of various types of financing will increase, raising the firms WACC. Therefore, it is useful to calculate WMCC, which is the firms

152

WACC associated with its next shilling of total new financing. The marginal cost is the WACC relevant to current decisions. As larger amounts of financing are raised the greater the risk to the funds providers. Therefore the WMCC is an increasing function of the level of total new financing. Another factor that causes WACC to increase is that as retained earnings are exhausted equity will have to be sourced through more expensive new issues.
Finding Breaking points

To calculate WMCC, we must calculate the breaking points, which reflect the level of total new financing at which cost of one of the financing components rises. following general equation can be used to find breaking points. BPj = Afj Wj Where: BPj AFj Wj = = = breaking point for financing source j amount of funds circulable from source j at a given cost (before BP) capital structure weight for financing source j. The

Example

ABC Co has Kshs.300,000 of retained earnings available whose cost is 13%. If it exhausts the returned earnings it must use more expensive new issue of equity whose cost is 14%. The firm expects that it can borrow only Kshs.400,000 of debt at the 5.6% cost, additional debt will have an after tax cost of 8.4%. Unlimited amounts of funds can be raised by issuing preferred stock at cost of 10.6% The company target capital structure proportions are:

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Weight Debt Preferred stock Equity

Required:

40% 10% 50% 100%

Determine the breaking points Calculate the WMCC after each breaking point Draw WMCC schedule.

Solution (a) Breaking points:

Two breaking points exist (1) When the Kshs.300,000 of retained earnings is exhausted and (2) When the Kshs.400,000 of debt costing 5.6% is exhausted. BP equity = AF Ws BP debt = AFj Wj = = 300,000 0.5 400,000 0.4 = Sh.1,000,000 = Sh.600,000

No breaking is caused by increase use of preference shares.

(b) Calculating WMCC

Next we calculate the WACC between breaking points. First find WACC between total financing of Sh.0 Sh.600,000, then WACC from Sh.600,000 Sh.1,000,000 then above Sh.1,000,000. WACC for ranges of total financing:

154

Sh.0 600,000 Sh .600,000 1,000,000 Sh.1,000,000 and above (c) WMCC graph (c) 12

0.4 (5.6) + 0.1 (10.6) + 0.5 (13) 0.4 (5.6) + 0.1 (10.6) + 0.5 (14.0) 0.4 (5.6) + 0.1 (10.6) + 0.5 (14.0)

= = =

9.8% 10.3% 11.5%

11.5% 10.3% 10 9.8%

600,000

1,000,000 Total new finances

INVESTMENT OPPORTUNITY SCHEDULE (IOS) AND THE WMCC SCHEDULE

The investments made by firm depend on two things. The returns on investment opportunities The cost of financing the opportunities.

The firms IOS is a ranking of investment possibilities from best to worst (lowest return). As the cumulative amount of money invested in a firms capital project increase, its IRR on the projects will decrease. The first project selected will have the highest return, followed by the second highest and so on until the funds available are exhausted. We can use the concept of the investment opportunity schedule and the WMCC schedule to simultaneously illustrate the interdependence of the investment and the financing decisions.

155

Lets go back to the preceding example of ABC company. Suppose ABC has the following investment opportunities available during a given year. Investment opportunity A B C D E F G Opportunitys Initial IRR 15% 10.0 12.0 11.0 14.0 13.0 14.5 Investment Sh. 000 100 100 300 200 400 100 200

The following IOS can be prepared ranking the projects according to their IRRs from the most to the least preferable. company has prepared the following investment opportunity schedule:

Investment opportunity A G E F C

Opportunitys Initial IRR 15% 14.5 14.0 13.0 11.0 Sh. 000 100 200 400 100 300

Cum. Sh. 000 100 300 700 800 1100

Investment investment

156

D B

11.0 10.0

200 100

1300 1400

We can plot the project returns against the cumulative investment on the same axes as the WMCC schedule the firm should accept projects up to the point at which the marginal return on its investment equals its weighted marginal cost of capital.

157

15 14 13 12.5 12 F 11.5
WMCC

11 C 10.5 10
9.5

IOS

* 200 400 600 800 1000 1200 1400

By using the WMCC and IOS schedules the firms optimal capital budget is determined as (1,100,000). 158

By raising Sh. 1100,000 of new financing and investing in projects AGEF and C the firm should maximize shareholder width.
Review Questions

1. 2.

A cost of capital can be said to consist of three elements. What are they? What is the dividend valuation model formula for the cost of equity: (a) with no dividend growth? (b) with dividend growth? How is the after-tax cost of debt of debt capital calculated? Why should a weighted average cost of capital be used as the discount rate, instead of the cost of the funds that are specifically used to finance each new investment? On what assumption is it appropriate to use the weighted average cost of capital as the discount rate for investment evaluation? Should weightings be based on the market values or the book values of the sources of capital?

3. 4. 5. 6.

Problems

6.1 Explain and distinguish between: a) Weighted average cost of capital, and b) Marginal weighted average cost of capital. Nyuki Ltd is a company operating in eh telecommunications industry. The companys balance sheet as at 31 March 2007 is as below:

Liability and Owners Equity Sh 000 Sh 000 159

Current liabilities 18% debentures (sh. 000) 10% preference shares Ordinary shares (sh.10 par) Retained earnings

12,500 16,000 6,250 12,500 28,125 75,375

Current assets Net fixed asset

32,500 42,875

75,375

Additional Information

1. 2.

The debentures are selling at Sh. 950 in the market and will be redeemed 10 years from now. By the end of last financial period the company had declared and paid sh.500 as dividend per share. The dividends are expected to grow at an annual rate of 10% in the forecast future. Currently the companys shares are trading at sh.38 per share at the local stock exchange.

3. 4. 5.
Required:

The preference shares were floated in 2002 and their prices have remained constant. Most Banks are lending out money at an interest rate of 22% per annum. The corporation tax rate is 40%.

i) ii)

The market weights average cost of capital for the firm. Why are markets value weights preferable to book value weight when determining the weighted average cost of capital for a firm.

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LECTURE EIGHT ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENT 8.1 Introduction

Financial statements are essentially historical and static documents. They tell us what has happened during a particular period or series of periods of time. The most valuable information to most users of financial statements or reports, however, concerns what probably will happen in the future. In this lecture we will discuss how financial statement analysis can assist statement users in predicting the future by means of comparing and evaluating financial trends and cross-sectional positions of firms.
Objectives At the end of this lecture you should be able to:

1. 2. 3.

Discuss the needs of the users of financial statements. Discuss the types of comparison used in financial statement analysis Compute financial ratios and use them to evaluate financial strengths and weaknesses

4. 5. 6.

Use the Dupont system to carry out a complete ratio analysis of the firm Explain common size and index analysis Discuss the limitations of financial statement analysis

161

8.2 DEFINITION AND OBJECTIVES OF FINANCIAL ANALYSIS

Financial analysis is the process or critically examining in detail, accounting information

given in financial statements and reports. It is a process of evaluating relationship between component parts of financial statements to obtain a better understanding of a firms performance. Financial statement analysis involves three basic procedures:
Selection This involves the selection from the total information available about an

enterprise, the information that is relevant to the decision under consideration.

Relation This involves arranging the information in a manner that will bring out a

significant relationship(s).
Evaluation This involves the study of the relationship and interpretation of the result

thereof.
The specific objectives of financial statement analysis are to:

(a). assess the past, present and future earnings of an enterprise, (b). assess the operational efficiency of the firms a whole and its various divisions or departments (c). asses the short term and tong term solvency of the firm, (d). assess the performance of one firm against another or the industry as whole and the performance of one division against another. (e) Assist in the developing of forecasts and preparing of budgets, (f) Assess the financial stability of the business under review, and (g) Assist in the understanding of the real meaning and significance of financial Information. Financial statements are essentially a record of the past. Business decisions naturally affect the future. Analysts therefore study financial statements as evidence of past performance that may be used in the prediction of future performance. 162

8.3 SOURCES OF INFORMATION

The first procedure in financial statement analysis is to obtain useful information. The main sources of financial information include, but are not limited to, the following;
Published reports

Quoted companies normally issue both interim and annual reports, which contain comparative financial statements and notes thereto. Supplementary financial information and management discussion as well as analysis of the comparative years' operations and prospects for the future will also be available. These reports are normally made available to the public as well as the shareholders of the company.
Registrar of Companies

Public companies are required by law to file annual reports with the registrar of companies. These reports are available for perusal upon payment of a minimum fee.
Credit and Investment Advisory Agencies

Some firms specialize in compiling financial information for investors in annual supplements. Many trade associations also collect and publish financial information for enterprises in various industries. Major stock brokerage firms and investment advisory services compile financial information about public enterprises and make it available to their customers. Some brokerage firms maintain a staff or research analysis department that study business conditions, review published financial statements, meet with chief executives of enterprises to obtain information on new products, industry trends, negative changes and interpret the information for their clients.
Audit Reports

When an independent auditor performs an audit the audit report-is usually addressed to the shareholders of the audited enterprise. The audit firms frequently also prepare a management report, which deals with a wide variety of Issues encountered in the course of the audit Such a management report is not a public document, however, it is a useful source of financial information.

163

Government Statistics and Market Research Organizations

8.4 COMPARISONS IN FINANCIAL ANALYSIS

The figures in the financial statements are rarely significant or important in themselves. It is their relationships to other quantities, amounts and the direction of change from one point in time to another point in time that is of importance. It is only through comparison of data that one can gain insight and make intelligent judgments. Analysis thus involves establishing significant relationships that points to changes as well as trends. The two comparisons widely used for analytical purpose involve trend and crosssectional analyses.

Trend Analysis
This is also known as time series analysis, horizontal analysis or temporally analysis. It involves the comparison of the present performance with the result of previous periods for the same enterprise. Trend analysis is therefore usually employed when financial data is available for three or more periods. Developing trends can be seen by using multiyear comparisons and knowledge of these trends can assist in controlling current operations and planning for the future. It can be carried out by computing percentages for the element of the financial statement that is under observation. Trend percentage analysis states several years' financial data in terms of a base year, which is set to be equal to 100%. In conducting trend analysis the following need to be taken into account: (i) Accounting principles and policies employed in the preparation of financial statement must be followed consistently for the periods for which an analysis is being made to allow comparability. (ii) (iii) The base year selected must be normal and a representative year. Trend percentages should be calculated only for these items, which have logical relationship.

164

(iv) (v)
Example

Trend percentages should be carefully studied after considering the absolute figures, otherwise they may lead to misleading conclusions. To make meaningful comparisons, trend percentage should be adjusted in light of price changes to the base year.

Assume that the following data is extracted from the books of ABC Ltd.

2004 Sh. Million sales 725 Net income 99

2003 Sh. Million 700 97.5

2002 Sh. Million 650 93.75

2001 Sh. Million 575 86.25

2000 Sh. Million 500 75

From the above absolute figures, there appears to be a general increase in safes and income over the years. When expressing the above date in terms of percentages with 2000 being the base year, the following trend percentage is observed.

.
Sales Net Income Net income/Sales

2004

2003

2002

2001

2000

145% 132 % 13.7%

140% 130 % 13.9%

130% 125 % 14.4%

115% 115 % 15%

100% 100 % 15%

From the above table it can be observed that: i) ii) Sales and net income have grown over the years but at a 'increasing rate, Net income has not kept pace with growth in sates. When net income is expressed as a percentage of rates,

165

iii)

It is further observed that net income as a percentage of sates is decreasing over the years and this needs to be investigated.

Financial statement analysis is not an end by itself; rather the analyses enable the right questions, for which management has to look for answers.

Graph

percentage 150 140 130 120 110

2000 2001 2002 2003 2004 years

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From the line graph, one can observe that the growth rate for sales has decreased. The same applies is net income as shown by the slope of the curves. One may also conclude from the curves that between 2001 and 2000 sales and income have grown at the same rate. Subsequently, growth in net income failed to keep pace with the growth in sates.
Problems of Trend analysis

(a).

To ensure comparability of figures, the results of each year will have to be adjusted using consistent accounting policies. The task of adjusting statements to bring them to a common basis could be taunting.

(b). Comparison becomes difficult when the unit of measurement changes in value due to general inflation. Comparisons become quite difficult over time. (c). If the enterprise's environment changes over time with the result that performance that was considered satisfactory in the past may no longer be considered so. More specific measures rather than general trends may be preferred in such instances.

Cross Sectional Analysis

This involves the comparison of the financial performance of a company against other companies within its industry or industry averages at the same point in time. It may simply involve comparison of the present performance or a trend of the past performance. The idea under this approach is to use bench-marking, whereby areas in which the company excels benchmark companies are identified, and more importantly areas that need improvement highlighted. The typical bench-marks used in cross-sectional analysis may be a comparable company, a leader in the industry, an average firm or industry norms (averages).
Problems Of Cross Sectional Analysis

(a).

It is difficult to find a comparable firm within the same industry. This is because firms may have businesses which are diversified to a greater or lesser extent. Further, industry averages are not particularly useful when analyzing firms with

167

multi-product lines. The choice of the appropriate benchmark industry for such firms is a difficult task. (b). Businesses operating in the same Industry may be substantially different in that, they may manufacture tile same product but one may be using rented equipment while the another uses its own making comparison difficult . (c). Two firms may use accounting policies, which are quite different resulting in difference m financial statements It is usually very difficult for an external user to identify differences in accounting policies yet one must bear them in mind when interpreting two sets of accounts. (d). The analyst must recognize that ratios with large deviations from the norm are only the symptoms of a problem. Once the reason for the problem is known management must develop prescriptive actions for eliminating it. The point to keep in mind is that ratio analysis merely directs attention to potential areas of concern; it does not provide conclusive evidence as to the existence of a problem.

8.4 RATIOS
The most common tools of financial analysis are ratios. A ratio is simply a mathematical expression of an amount or amounts in terms of another or others. A ratio may be expressed as a percentage, as a fraction, or a stated comparison between two amounts. The computation of a ratio does not add any information not already existing in the amount or amounts under study. A useful ratio may be computed only when a significant

relationship exists between two amounts. A ratio of two unrelated amounts is

meaningless. It should be re-emphasized that a ratio by itself is useless, unless compared with the same ratio over a period of time and/or a similar ratio for a different company and the industry. Ratios focus attention on relationships which are significant but the full interpretation of a ratio usually requires, further investigation of the underlying data. Thus ratios are an aid to analysis and interpretation and not a substitute for sound thinking.

8.4.1

Classification of Ratios
168

Financial ratios may grouped into four basic categories: liquidity ratios, debt ratios, activity ratios and profitability and investment ratios.
Liquidity Ratios.

Liquidity refers to an enterprise's ability to meet its short-term obligations as and when they fall due. Liquidity ratios are used to assess the adequacy of a firms working capital. Shortfalls in working capital may lead to inability to pay bills and disruptions in operations, which may be the forerunner to bankruptcy. The tree basic measures of liquidity are (1) net working capital, (2) the current ratio, and (3) the quick (acid-test) ratio. As will become clear, for all the three measures, the higher their values the more liquid the firm is. It should however be emphasized that excessive liquidity sacrifices profitability even as inadequate liquidity may lead to insolvency a trade-off exists between profitability and liquidity (risk).

Net Working Capital Net working capital ,although not a ratio is a common measure of

a firms overall liquidity it is calculated as follows:

Net working capital = current assets current liabilities Net working capital represents current assets that are financed from long term capital

resources that do not require repayment in the short-run, implying that the portion is still available for repayment of short-term debts.
Example

2004 Sh.000 Current assets 26,400 Current liabilities (13,160)

Net working capital 13,240

2003 Sh.000 15,600 (6,400)

9,200.

In the year 2003 Sh.9.2 million of working capital is available to repay Sh.6.4 million of current liabilities and in 2004 Sh.13.24 million is available of working capital to pay sh.l3.16 million of current liabilities. This reflects a strong liquidity position in the years.

169

The figure of net working capital, being an absolute figure requires standardization before its use for comparing performance of different firms. For example net working

capital as a percent of sales can be calculated and used for such comparison. A timeseries comparison of the firms net working capital is often helpful in evaluating its operations.

Current ratio The current ratio is one of the most commonly cited financial ratios and

tests, in short-term, the debt-paying ability of an enterprise. A high current ratio is assumed to indicate a strong liquidity position while a low current ratio is assumed to indicate a relatively weak liquidity position. The RULE of the thumb is that current-assets should be twice current liabilities. The current ratio is expressed as follows:

Current ratio = Current assets / Current liabilities Example

Using the data from the previous example the current ratios for the two years is arrived as follows. 2004 26400 /13,160
= 2: 1

2003 15600/6400
= 2.4: 1

Observation

The enterprise appears to nave a strong liquidity position. There has been, however, a slight drop from year 2003 to year 2004. For every shilling that is owed in 2004, the firm has Sh.2 to pay the debt and for every shilling0wed in 2003 , the firm has Sh.2.40 available to meet the liability. If the firms current ratio is divided into 1.0 and the resulting value is subtracted from 1.0, the difference when multiplied by 100 represents the percent by which the firms current assets can shrink without making it impossible for the firm to cover its current liabilities.

170

A current ratio of 2 means that the firm can still cover its current liabilities even if its current assets shrink by 50 percent ([1.0 (1.0/2.0)]* 100).
Quick ratio or Acid test ratio.

The current ratio has further been refined to Quick ratio or Acid Test Ratio. This ratio tests the short-term debt paying ability of an enterprise without having to rely on inventory and prepayments Inventories are generally the least liquid current asset and prepayments are generally not convertible to cash. Therefore for a company whose inventories include work-in-progress, and slow-moving items the quick ratio is a better indicator of liquidity than the current ratio. The rule of the thumb is for every shilling of current liability owed, the enterprise should have a shilling of current quick assets available to meet it i.e. a quick ratio of 1.0. It is given by;
(Current assets-inventories-prepayments)/(Current liabilities) Activity Ratios

Activity ratios measure the speed with which accounts are converted into sales or cash. Activity ratios can be categorized into two groups: The first group measures the activity of the most i9mportant current accounts, which include inventory, accounts receivable, and accounts payable1. The second group measures the efficiency of utilization of total assets and fixed assets.
Inventory Ratios Average sales period ( Age of inventory) This ratio measures the average number of

days taken to sell the average inventory carried by a firm. It is given by:
(Average inventory x 365 days )/(Cost of sales)

Where, average inventory =(Beginning inventory+ Ending inventory)/2

In order to calculate activity ratios using current accounts the averages of these amounts during the year are preferred.. These averages can be approximated by summing the beginning-of-year and the-end-of year account balances and dividing by 2. When data needed to find the averages are unavailable, year-end values may be used to calculate activity ratios for current accounts.

171

Inventory turnover ratio. Inventory turnover ratio measure the number of times a

company's inventory has been sold during the year.

Inventory turnover = Cost of sales/Average Inventory

Accounts Receivable Ratios Average Collection Period (Age of accounts receivable or days sales outstanding)

The ratio measures the average number of days taken by an enterprise to collect its trade receivables. The ratio is computed as follows
(Average trade receivables X 365 days)/ (Credit sales) Or, 365 days/(Accounts receivable turnover ratio)

Where, average trade receivables = (Beginning + Ending trade receivables)/2 The average collection period should only be judged in relation to a firms credit terms. Only then can one draw definitive conclusions about the effectiveness of a firms credit and collection policies.
Accounts receivable turnover ratio The accounts receivable turnover ratio measures the

number of times an enterprise has turned accounts receivable into cash during the year. The higher the times the more efficient a company will be assumed to be in collecting its debts. The ratio is computed as follows:
Accounts receivable turnover = Annual Credit sates/Average trade receivables Trade Creditors Ratios (vi) Average payment period (Age of trade payable) ratio. This ratio measures the

average number of days taken to pay an accounts payable. It is computed as follows:(Average trade payables X 365 days)/Credit purchases Or

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365 days/(Accounts payable turnover ratio)

Where average accounts payable=(Beginning + Ending accounts payable)/2

Accounts payable turnover ratio. The accounts payable turnover ratio measures the

efficiency with which firms pay their trade creditors. The higher the number of times, the more efficient the enterprise is assumed to be in paying its creditors. It is calculated as follows;
Accounts payable turnover ratio = Annual Credit purchases/Average trade payables Leverage ratios

A firm is said to be financially leveraged whenever it finances a portion of its assets by debts. Debts commit a firm to payment of interest and repayment of capital. Borrowing increases the risk of default and it is only advantageous to shareholders if the return earned on the funds borrowed is greater than the cost of the funds. There two classifications of measures of debt: (1) Measures of the degree of indebtedness measure the amount of debt relative to other significant balance sheet amounts. Common measure of the degree of indebtedness include the debt ratio, the debt/equity ratio, and the debt to-total capitalization, (2) Measures of the ability to service debt assesses a firms ability to make the contractual payments required on a scheduled basis over the life of the debt. Commonly referred to as coverage ratios, they include times-interest earned, and the fixed charge coverage ratios.
Debt to equity ratio This ratio measures the proportion of assets provided by

providers of long-term debt funds for each shilling of assets provided by the shareholders. It is computed as follows:

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Total long term debt/Total stockholders funds Debt to total assets ratio (Debt ratio) This ratio measures the proportion of assets

financed by outsiders. It is calculated as follows;

Total liabilities / Total assets Debt/total capitalization ratio Indicates the proportion of capital provided by outsiders.

The formula for Debt/Total capitalization ratio is;

Long-term debt/(Long-term debt + Shareholders funds) The times interest earned ratio This is also known as the interest cover ratio. This ratio

measures the ability of a firm to meet its interest payment out of the current earnings. It reflects the likelihood that creditors will continue to receive their interest payments. It is It is computed as follows:Earning before interest and tax/Interest expense
Fixed charge coverage ratio The fixed payment coverage ratio measures the firms

ability to meet all fixed payment obligations. Loan interest, principal payments, on debt, scheduled lease payments, and preferred stock dividends are commonly included in this ratio. The formula for the fixed charge coverage ratio is as follows:
(Earnings before interest and tax + lease payments)/(interest + lease payments +{(principal payments + preferred stock dividends)*[1/(1-T)]}

Where T is the corporate tax rate applicable to the firms income. The term [1/(1-T)] is included to adjust the after tax principal and preferred stock dividend payments back to a before-tax equivalent that is consistent with the before-tax values of all other terms. The fixed payment coverage ratio measures the risk the firm will be unable to meet scheduled fixed payments and thus be driven into bankruptcy. The lower the ratio the greater the risk to both lender and owners.

174

Profitability Ratios Profitability ratios evaluate the firms earnings with respect to a given level of sales, a

certain level of assets, the owners investment, or share value. Evaluating the future profitability potential of the firm is crucial since in the long run, the firm has to operate profitably in order to survive. The ratios are of importance to long term creditors, shareholders, suppliers, employees and their representative groups. All these parties are interested in the financial soundness of an enterprise. The ratios commonly used to measure profitability include:
Gross Profit Margin

This ratio measures the percentage of each shilling of sales remaining after the firm has paid for its goods. The higher the gross profit margin the better, and the lower the relative cost of merchandise sold. The formula for calculating the gross profit margin is as follows:
Gross profit margin = (Sales cost of goods sold)/ Net Sales = Gross profits/ Net Sales Operating Profit Margin

This ratio measures the percentage of each shilling of sales that remains after paying of for the goods sold and the operating expenses. This is a measure of pure profits because they measure only the profits earned on operations ignoring any financial charges and government taxes. The operating profit margin is calculated as follows:
Operating profit margin = Operating profits/Net Sales = Earnings before interest and taxes/Net Sales

175

Net Profit Margin

The net profit margin measures the percentage of each shilling of sales remaining to the owners of the firm after paying off all expenses, including financing charges and taxes. The higher the firms net profit margin the better for the owners. The ratio is calculated as follows:
Net profit margin = Profit after taxes/Net Sales Return on Total Assets (ROA)

This ratio is also called the return on investment (ROI) and measures how well management has employed available assets in generating profits from its assets. The return on total assets is calculated as follows:
Return on total assets = Profit after taxes/ Total assets Return on Equity (ROE)

The return on equity measures the return earned on the owners investment in the firm. This ratio measures the ability of an enterprise to generate income for its owners. Return on equity is calculated as follows: Return on equity = (Profits after taxes preference dividend)/Ordinary Shareholders funds Where, ordinary shareholders equity =Total shareholders funds less preference share capital.
Investment Ratios Investment ratios help equity shareholders and other investors to assess the value of an

investment in the ordinary shares of a company, The value of an investment in the ordinary shares in a listed company is its market value, and so investment ratios must have regard not only to information in the company published accounts, but also to the current price. The following are the common investment ratios.
Earnings per Shape (EPS)

This ratio represents or reflects the amount of shillings or cents earned per ordinary share. It is considered so critical that the accounting profession requires its disclosure on the face of the income statement for quoted companies(IAS 33).

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It is given by
EPS = (Profit after taxes -Preference dividends)/The number of ordinary Shares outstanding Dividend pay-out ratio.

This ratio reflects a company's dividend policy. It indicates the proportion of earnings per share paid out to ordinary shareholders as divided. It is computed as follows:
Dividend pay-out ratio = Dividends per ordinary share / Earnings per share

Where ordinary dividends per share = Ordinary dividends/ Number of ordinary shares

Dividend Yield Ratio

This shows the dividend return being provided by the share. It is given by
Dividend yield = Dividends per share / Market price per share Price Earnings Ratio (The P/E Ratio)

This ratio is used in comparing stock investment opportunity. It is an index of determining whether shares are relatively cheap or relatively expensive. It measures the amount investors are willing to pay for each shilling of the firms earnings. It is given by
PER=Market price per ordinary share/Earnings per share

This price earnings ratio reflects the consideration that investors are willing to pay for a stream of a shillings of earnings in the future. The price-earnings ratio is widely used by investors as a general guideline in gauging stock values. Investors increase or decrease the price-earnings ratio that they are willing to accept for a share of stock according to how they view its future prospects. Companies with ample opportunity for growth

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generally have high price-earnings ratio, with the opposite being for companies with limited growth.

LIMITATIONS OF RATIOS

1. Ratios are insufficient in themselves as a basis of judgment about the future. They are simply indicators or what to investigate. Therefore, they should not be viewed as an end but as a starting point. 2. They are useless when used in isolation. They have to be compared over time for the same firm or across firms with the industry's average. 3. Ratios are based on financial statements. Any weaknesses of the financial statements are also captured within the ratios. 4. Comparing ratios across firms may be difficult because the firms may not be comparable. Data among companies may not provide meaningful comparisons because of factors such as use of different accounting policies and the size of the company.

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LECTURE TEN WORKING CAPITAL MANAGEMENT 10.0 INTRODUCTION

Investment decisions apply to both current assets and plant and equipment assets. However, the investment decision techniques for current assets may differ because current assets have some unique characteristics: (1) (2) The amount of investment in each asset may vary from day to day Decisions regarding investment in one type of current asset may impact on the investment in other current assets. For example, a relaxation in credit terms that leads to an increase in debtors may call for an increased investment in stocks. This lesson has two goals: First we will discuss the concepts underlying the management of working capital as a whole. Secondly, we will specifically focus on the management of current liabilities. The next lesson will complete the topic by discussing the management of current assets.
Objectives

At the end of this lecture you should be able to: 1. 2. Provide a definition and explanation of working capital concepts Discuss the two polar working capital strategies: aggressive and conservative strategies. 3. Describe the basic types and characteristics of current liabilities (short term financing)

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10.1

DEFINITIONS AND GENERAL CONCEPTS OF WORKING

CAPITAL Definitions of Working Capital

Working capital can be defined from two perspectives. (1) Net working capital is defined as the difference between the firms current asset and the firms current liabilities. (2) Net working capital is the firms current assets financed with long-term funds.

Working Capital Management Decisions

In principle, current asset investment decisions, as in the case of investment in fixed assets, calls for a cost-benefit evaluation of a large number of alternatives, and the selection of that alternative that produces the greatest net benefit. The typical process will feature the following activities: (1) The financial manager estimates the costs and benefits of each alternative. (2) The net present value (NPV) must be calculated for each alternative given the discount rate approximate to the degree of risk involved (3) The alternative with the highest NPV is chosen and implemented. In practice, however, the NPV approach is rarely used for evaluating working capital investment decisions. The alternative approach, commonly used, is to maximize average net profit, with the amount invested treated as its equivalent annual cost. The management of working capital boils down to balancing the risks and benefits of holding excessive, to those of holding too little, working capital. In this lesson and the next, we focus our attention on the management of each of the individual current asset and current liability times. This is a preferred approach given the fact that each item has its own unique characteristics. Generally, it is to be expected that current liabilities be the preferred source of financing current assets (because current liability is a cheap source of finance and the maturity of current liabilities parallels the

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liquidity of current assets). Management, however, must weigh the desire of a higher return against the risk of insolvency (if, for example, the bank suspends its overdraft facilities or creditors demand earlier payment).

Overcapitalization and Overtrading

The finance manager must be wary of two polar extremes in working capital management. These extremes are, (i) over-capitalization and, (2) over-trading.
Over Capitalization (Conservative Financing Strategy)

If a company manages its working capital, so that there are excessive stocks, debtors and cash and very few creditors, there will be an over-investment by the company in current assets. Working capital will be excessive and the company is said to be overcapitalized ( i.e. the company will have too much capital invested in unnecessarily high levels of current assets). The result of this would be that the return on investment will be lower than it should, with long-term funds unnecessarily tied up when they could be more profitably invested elsewhere.
Indicators of over-capitalization

Accounting ratios can assist in judging whether over capitalization is present. (1)
Sales/Working capital ratio:- the volumes of sales as a multiple of

working capital should indicate whether the total volume of working capital is too high (compared to the past and industry norms). (2) (3)
Liquidity ratio. A current ratio and a quick ratio in excess of the industry

norm or past ratios will indicate over-investment in current assets

Turn-over periods. Excessive stock and debtors turnover periods or too

short creditor payment period might indicate that the volume of debtors and stocks is unnecessarily high, or creditors volume too low.
Over-trading (Aggressive Financing Strategy)

Overtrading occurs when a business tries to do too much too quickly with too little longterm capital: The capital resources at hand are not sufficient for the volume of trade.

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Though initially an over-trading business may operate at a profit, liquidity problems could soon set in, disrupting operations and posing insolvency problems.
Symptoms of over-trading

Accounting indicators of overtrading include: (1) Rapid increases in turn-over ratios (over-heating) (2) Stock turnover and debtors turnover might slow down with consequence that there is a rapid increase in current assets. (3) The payment period to trade creditors lengthens (4) Bank over-drafts often reach or exceed the limit of facilities offered by the bank. (5) The debt ratios rise (6) The current ratio and quick ratio fall and the net working capital (NWC) could be negative.

Operating and Cash Conversion Cycles

We can understand better the management of working capital by appreciating the interlinkages of flows in the current section of the balance sheet. Opportunities to improve efficiency in collecting, holding and disbursing funds center on flows through this section of the balance sheet, depicted in the bottom part of Figure 12.1. We diagram these flows in more detail in Figure 12.2, which shows the steps along the way as funds flow through the firms accounts. Let us assume that KQ Ltd. orders raw materials at point A and receives them 14 days later at B. Terms of 2/10, net 30 are offered, so the firm pays the invoice 10 days later at C. However, it takes 2 days for the check to clear, and KQs bank account is not charged until point D. KQ turns its inventory six times per year, so 60 days after the materials are received, the product is sold and the customer is billed. The collection period is 30 days, 28 for the customer to pay and 2 for the check to arrive by mail (G), KQ processes the payment and deposits it 2 days later at H. Another 2 days elapses while KQs bank collects the funds from the customers bank. The firms total financing requirement is affected by the total time lag from point B to point J. The firm itself can control some factors that determine the various lags, but some

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it cannot. Some of the lags affect the cash balance, while others affect other components of working capital such as accounts receivable and inventory. When we address ourselves to cash management, we are concerned with time period BCD and FGHJ. Time period AB is beyond the firms control and does not directly affect its financial statements although it may affect production schedules. Time period DE is determined by the firms production process and inventory policy and affects the total investment in inventory. Time period EF is determined by the firms credit terms and the payment policies of its customers, and affects the total investments receivable.
Operating (trading) cycle (OC)

Operating cycle is the amount of time that elapses from the point when the firm inputs materials and labour into the production process to the point when cash is collected from the sale of the resulting finished product. The cycle is made up of two components; the average age of inventory and the average collection period.
OC = average age of inventory (AAI) + average collection period (ACP). The Cash Conversion Cycle (CCC) (12.1)

This is the amount of time the firms cash is tied up between payment for production inputs and receipts of payment from the sale of the resulting finished product. For a manufacturing firm, the cash conversion cycle indicates the length of time it takes for an investment in raw materials to be ultimately realised as a cash receipt after sale of the manufactured product. This cycle could be broken into several sub-periods: The period of time it takes: (a) (b) (c) (d) (e) Between ordering and receipt of raw materials; For trade creditors to be paid For raw materials held in stock to be introduced into the production process For the finished goods held in stock to be sold For cash to be realised from debtors.

It is to be noted that purchase of input on credit allows the firm to partially offset the length of time resources are tied up in the operating cycle.

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Assuming no time lag between the raising of sales and purchase orders and their execution, the cash conversion cycle can be determined by:
CCC = Operating Cycle (OC) Average payment period (APP) (12.2)

Or
CCC = AAI + ACP APP (12.3)

For a manufacturing company, CCC = Average age of raw materials + average age of work in progress + average age of finished goods + average collection period average payment period The cash cycle is thus the period between payment of cash to creditors (cash out) and the receipt of cash from debtors (cash-in). The length of period has direct effect on the liquidity of a company. The amount tied up in working capital (WC) will be equal to the value of raw materials (RM), Workin-progress (WIP), finished goods (FG) and debtors less creditors. The more the amount of WC tied up, the less liquid the company is. If the turn-over periods for stocks and debtors lengthen, or the payment period to creditors shortens: (1) The cash cycle will lengthen (2) The investment in working capital is increased.

Example

ABC Ltd sells merchandise on credit terms, requiring payment within 60 days of sale. On average it takes 85 days to manufacture, warehouse and sale a finished product. Raw material suppliers require payment within 45 days and employees are paid every 15 days. The firm calculates its weighted average payment period for raw materials and labour to be 35 days. Determine (1) the operating cycle (2) the cash conversion cycle.
Solution

(1)

Average age of inventories (AAI) = 85 days

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Average collection period (ACP) = 70 days Operating cycle(OC) = AAI + ACP = 85 + 70 = 155 days (2) Cash conversion cycle (CCC) = OC APP = 155 35 = 120 days

10.2

MANAGEMENT OF CURRENT LIABLITIES

Current liabilities are sources of short term financing which assist firms finance current assets and meet other short term financing needs. The three broad categories of short term financing are: 1. Spontaneous sources 2. unsecured sources 3. secured sources We will briefly discuss the characteristics of each of these sources .

Spontaneous Sources
Spontaneous financing arises automatically from the day-to-day operations of the firm. The most common forms of spontaneous financing come from trade credit from suppliers, and accrued expenses. This financing is interest free and requires no collateral.
Accounts payable

The purchaser obtains goods and services, agreeing to pay later in accordance with the credit terms stated on suppliers invoice. Trade credit is credit extended in connection with goods purchased for resale. It is this qualification that distinguishes trade credit from other forms of credit. Suppliers often give cash discounts on open accounts for payment within a specified period. The credit terms specify the credit period, the size of the cash discount, the cash discount period, and the date the credit period begins , which is usually at the end of each month (EOM). For example, terms of 2/10, net 30 EOM, mean a discount of 2% may be taken if the invoice is paid within 10 days of the invoice date; otherwise the full payment is due within 30 days from the end of the month of purchase. If the EOM is not part of the terms then counting begins from the date of the invoice. Prompt-payment cash

discounts are to be distinguished from quantity (bulk) discounts given for purchase of
large quantities, and also from trade discounts given at different points in the distribution

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chain (wholesale versus retail, etc.). Proper management of credit offered by suppliers requires that: 1. The firm takes the cash discounts by paying on the last day of the discount period. The annual percentage cost of giving up cash discounts is quite high. This cost can be estimated using the following equation.
Cost of giving up discount = CD/(100%-CD)*365/N (12.4)

Where CD = stated cash discount as a percentage N = number of days payment can be delayed by giving up the cash discount
Example

ABC Ltd. purchased Sh.100,000 worth of merchandise on 27 February from a supplier extending credit terms of 2/10, net 30 EOM. Calculate the cost of giving up the cash discount. Solution The annualized effective cost of giving the discount = CD/(100%- CD)*(365/N) = 2%/(100%-2%)*(365/20) = 37.24% This is a very high cost indeed and is equivalent borrowing at 37.24%. (NB If we were to take the discount the firm would pay on 10 March. By giving up the discount it costs the firm Sh.2,000 (100,000-98,000)). 2. Stretch accounts payable The firm should pay its bills as late as possible without damaging its credit rating. The full extent of the credit period should be utilized in the case where cash discounts are not offered. Caution is to be exercised in stretching payments as this may harm the firms reputation and at worst can cot the firm its sources of supply.
Accruals

Accruals are the other major source of spontaneous financing. Accrued expenses arise when a firm consumes services (other than trade services) without having to make immediate payment for them .Typical expenses that generate accrued financing include wages and salaries, utilities, rent, etc.

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Unsecured sources of short term financing

Unsecured source of financing is one against which no specific assets are pledged as collateral. Businesses obtain unsecured short term credit from three sources i.e. trade credit, banks and commercial paper. Trade credit Most trade credit is extended via the open account that results in accounts payable discussed in the preceding section. There are however two other less common sources of trade credit; The promissory note (trade) and the trade acceptances. 1. Promissory note Is usually called a note payable (trade) on the balance sheet. Such notes bear interest and have specified maturity date. They are used in situations in which a purchaser of goods on credit has failed to meet the terms of an open credit agreement and the supplier wishes a formal acknowledgement of the debt and a specific agreement on a future payment date. 2. Trade acceptances Under this arrangement the purchaser acknowledges the debt formally by accepting a draft drawn by then seller calling for payment on a specified date at a designated bank. After acceptance, the draft is returned to the seller and the goods are shipped. Bank loans Commercial banks are by far the largest suppliers of unsecured loans to businesses. Businesses need to establish a cordial relationship with their bank that can facilitate lending transactions. For a successful relationship to blossom banks will generally look for honesty and integrity ,managerial competence and frank communication in their clients. In addition detailed and specific information regarding the nature of the financing requirement, the amounts and timing of the need, the uses to which the funds will be put, and when and how the bank will be repaid may be needed. Banks lend unsecured short term loans in three forms: a line of credit, a revolving credit agreement, and a single payment note.
1. Single payment note This is a short term , one-time-loan, payable as a single amount at its maturity. It generally has a maturity of 30-daysto 9 months and may have either a fixed or floating rate. 2. Lines of credit A line of credit is an agreement between a business and a bank showing the maximum amount the business could borrow and owe the bank at any point in time. Lines of credit are not contractual and legally binding upon the bank, but they are nearly always honored. The major benefit, to a business, of a line of credit is its convenience and administrative simplicity. From the banks point of view the major attraction of a line of credit is that it eliminates the need to examine the creditworthiness of a customer each time the customer wants to borrow. The terms of a credit line may require a floating interest rate, operating change restrictions, compensating balances, and annual cleanup provisions ( a period usually of 1or 2 months during which the loan is completely paid off). A line of credit is often used to finance seasonal working capital needs or other temporary requirements. 3. Revolving credit agreement Involve a contractual and binding commitment by the bank to provide funds during a specified period of time. Because the bank legally guarantees the availability of funds, the borrower pays a commitment fee of or percent per year on the average unused portion of the commitment. Revolving credit agreement, like a line of credit, permit the firm to borrow up to a

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certain maximum amount; but unlike a line of credit, are not subject to clean-up provisions. Commercial Paper A commercial paper is a form of financing that consists of short term promissory notes issued by firms with high credit standing. Commercial paper is typically sold at a discount from its par value. Consequently, the interest charged is determined by the size of the discount and the time to maturity. Commercial paper distributed through the stock exchange is known as a money market instrument. The use of commercial paper to raise funds is advantageous because the cost is lower relative to bank loans and the borrower avoids the cost of maintaining compensating balances required on bank loans. Additionally , borrowers who need to raise huge amounts of money can satisfy their needs more conveniently by issuing commercial paper. Example A company has issued a Sh.100,000,000 par value worth of commercial paper with a 90day maturity, for Sh.98,000,000. Find the effective annual rate of interest on the paper. Solution The effective annual rate = (1+D/N) -1 (12.1) Where D = discount N = net proceeds from issue n = 365/time to maturity The effective 90-day rate is = D/Np = 2,000,000/98,000,000 = 0,0204 Therefore ,effective annual rate = (1+0.0204) - 1 = 0.0841 = 8.41% (n =365/90 = 4)

Secured Sources of Short Term Financing

A loan is one obtained by a borrower pledging specific asset(s) as security. In the case of shot term loans, lenders insist on collateral that is reasonably liquid. Inventory, accounts receivable, and marketable securities are the assets commonly used as security. Usually the interest on secured loans is higher than interest on unsecured loans because of the perceived risk and the costs of negotiation and administration. The primary sources of secured loans are the commercial banks and non-bank financial institutions. In considering the use of a companys asset as security we should keep in mind the adverse effect of such action on unsecured creditors who may take them into account in any future transactions.

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LECTURE ELEVEN MANAGEMENT OF CURRENT ASSETS 11.0 INTRODUCTION

In this lecture we discuss the effective management and control of specific current asset items so as to achieve efficient operations consistent with the minimization of holding , investment and transaction costs associated with the current assets.
Learning Objectives Objectives At the end of this lecture you should

be able to: 1. Discuss motives for holding cash and marketable securities and discuss the strategies for efficient management of cash. Describe the basic characteristics of marketable securities. 2. Explain the credit policy variables and assess the impact of changes in credit and collection policy on financial variables including profits. 3. State the inventory management fundamentals and apply the basic inventory management models.

.
11.1 MANAGEMENT OF CASH AND MARKETABLE SECURITIES

Cash management involves five interrelated goals: (1) How to accelerate the collection of cash (2) How to control cash disbursements (3) How the appropriate working balance is determined

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(4) How to invest any temporary idle funds in interest bearing marketable securities. (5) How to forecast and manage cash shortages.

Let us consider these goals in some detail

11.1.1 ACCELERATING COLLECTION OF CASH

Quick movement of remittances from dispersed locations to central management prevents the build up of idle or lazy cash balances. Good cash management practice would aim at reducing the time by between (1) When payment is initiated by a debtor sending a cheque in payment and (2) The time when funds become available for use in the recipients bank account. Three contributors to a lengthy time lag, which need attention are: 1 2 3 4 Transmission delay, when payment is sent through post. Lodgment delay, by the payee in presenting, after receipt. Clearance delay, by the bank after receipt of cash or cheque.

Measures to reduce the time lag will target these contributory factors and include payee setting up efficient cheque handling procedures to eliminate lodgment delays.
Automation; Facilities such as Bankers Automated Clearing Services (BACS)

enable speedy computerized transfer of funds between banks. For regular payments, standing orders or direct debits may be arranged.
Concentration Banking. Firms with regional sales outlets often designate certain

of these offices as regional collection centers. Customers within each region are instructed to remit payment to these offices, which deposit these receipts in local banks. The funds are transferred later from these bank branches to a concentration or disbursing bank from which bill payments are dispatched. The purpose is to limit mail time. Concentration banking also permits the firm to reduce the idle balances by storing its cash more efficiently in one (few)

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concentration account(s) rather than in many dispersed accounts. This reduces the requirement for large working balances.
5 Lock Box System The purpose is to eliminate the time between the receipt of

remittances by the company and their deposit in the bank. In this system the customer sends the payments to a post office box, which is emptied at least daily by the firms bank. The bank opens the payment envelopes, deposits the checks in the firms account and sends deposit slip to the firm. The lock boxes are normally geographically dispersed and funds are ultimately transferred to a disbursing bank.
6 7 Personal collection of checks by messengers. A messenger shuttles around

collecting checks from customers whose accounts are due. Establishing good bank relations to expedite cheque clearance.

11.1.2 CONTROLLING DISBURSEMENTS

The firms objective with respect to payments should be not only to pay slowly but also slow down the availability of funds to suppliers once the payment has been dispatched. Some of the methods for lengthening the collection period of a firms checks are. 1 Lengthening Mail Delivery Time Payments are placed in the mail at locations from which it is known that a great deal of time will likely elapse before the payment is received by the supplier. regional office. 2.
Playing the Float. This refers to the amount of money tied up in checks that have

Payments also may be mailed to the

suppliers corporate headquarters address rather than the local post office or

been written but have yet to be collected or paid on. Playing the float means to write checks against money not currently in the firms checking account. Firms are able to play the float because they know that a delay will likely exist between the receipt and deposit of check by their supplier and the actual withdrawal of funds from their account. Using float firms create what is effectively and interest free loan.

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3.

Use Drafts. This is a slow and awkward payment procedure.

Used to pay

salaries: an employee can only cash the draft at this bank after the bank gets consent from his employer. 4.
Accruals. Another tool for stretching a firms payment is accruals. Accruals or

C.L. that represent a service or good that has been received by the firm but not yet paid for wages, rent, tax.
DETERMINING THE OPTIMAL CASH BALANCE

Cash is the ready currency to which all liquid assets can be reduced. Marketable securities are short term, interest-earning money market instruments. The level of cash and money and marketable securities held by firms is determined by the motives of holding them.
Transaction Motive - Holding cash and marketable securities for the purpose of making

planned payments for items such as purchase of stock and payment of wages.
Safety Motive - Balances held mainly in highly liquid marketable securities to cater for

unexpected demand for cash or emergencies.

Speculative Motive A firm may want ready funds at hand to quickly take advantage of

any opportunities that may arise. Safety and speculative motives are together referred to as precautionary motives. The working balance of cost is maintained for transaction purposes. If the firm has too small a working balance, it runs out of cash. It then liquidates marketable securities or borrows both involving transaction costs. If on the other hand the firm maintains too high a working balance it foregoes the opportunity to earn interest on marketable securities an opportunity cost. The optimal working balance occurs total costs Finding the optimum (transaction costs plus opportunity cost) are at a minimum.

involves a trade-off between falling transaction costs against rising opportunity costs.
Baumol Model

This inventory management model was applied to cash balance problem by Baumol. Inputs to the Baumol model include:

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1. 2. 3. Let

Total cash outflow (demand) over the period Transactions costs of replenishing cash balance by borrowing or selling securities The interest rate that can be earned on securities. Q d c i = = = = amount converted into cash by selling securities or borrowing Total cash outflow (demand) per period (year) Transaction costs of each sale of securities or borrowing The interest rate that can be earned per period (year) i.e. the cost of holding cash rather than investing it

Then Q* (Optimal size of cash transfer)

2dc i

(13.1)

Example:

The Triad Company anticipates Sh.15 million in cash outlays during the next year. The outlays are expected to occur equally throughout the year. Triads treasurer reports that the firm can invest in marketable securities yielding 8% and the cost of shifting funds from marketable securities portfolio to cash is Sh.7, 500 per transaction. Assume the company will meet its cash demands by selling marketable securities. Using the Baumol model: (a) (b) (c) (d) (e) Determine optimal size of Triads transfer of funds from marketable securities to cash. What will be Triads average cash balance? How many transfers from marketable securities to cash will be required during the year? What will be the total cost associated with Triads cash requirements? How would your answers to (a) and (b) change if transaction cost could be reduced to Sh.5, 000 per transaction? or if Triad could invest in marketable securities to yield 10%?

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SOLUTION (a)

Q* (Optimal size of cash transfer) We can determine that; d =

(2dc/i)
i = 0.08; c = 7500.

150 million;

Therefore, Q* =
= (b) (c)

(2 x 150,000,000 x 7500)/0.08
Sh.5,303,301

Triads average cash balance = Q*/2 = Number of transfers =

5,303,301/2 = Sh.2,651,650 =
28.3

150,000,000/5,303,301

(d)

Total costs = holding cost + transaction cost = 2,651,650 x 0.08 + 28.3 x 7,500 = 212,132 + 212,250 = Sh.424,381.

Miller-Orr Model

This a model that provides for cost-efficient cash balances between determining an upper limit and the return point for cash balances: This model, unlike the Baumol model that assumes certainty, is based on the assumption that receipts and disbursements are completely random. The Miller-Orr model requires the determination of: (a) (b) (c) An upper limit, which is the maximum amount of cash to be held Lower limit, which is the minimum amount of cash to be held (assumed to be zero) Return point, which is the target cash balance considered optimal. This control limit model gives an answer in terms of the maximum and the minimum balances and provides a decision rule, rather than a fixed schedule of transfers. The important implication of the model is that the greater the variability of a firms cash flow the higher should be the minimum balance.
Setting the Return and Upper Point The value the firm sets for the return point

depends on (1) conversion costs, (2) the daily opportunity cost of funds, and (3) the

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variance of daily net cash flows. The variance is estimated by using daily net flows ( i.e. inflows minus outflows). The return point is estimated by:
Return Point = 3 [ (3 x conversion cost x variance of daily net cash (13.2) flows)/(4* daily opportunity cost)]

The upper limit for cash balance in this model is always set at three times the return point. Therefore
Upper limit = 3x return point. Figure 13.1: Miller-Orr Model: Cash balance control limits (13.3)

In Figure 13.1 when cash balance reaches the upper limit, at t1, an amount equal to the upper limit minus the return point are transferred out of the cash account and into marketable securities.
Cash converted to marketable = upper limit return point securities (13.4)

The cash balance continues to fluctuate and falls to zero (the lower limit) at t2 when market securities equal to the return point minus the lower limit are sold and proceeds transferred to cash working balance.
Marketable securities converted to cash = return balance lower limit (zero) (13.5) Example

It costs XYZ Company Sh. 3,000 to convert marketable securities to cash and vice versa; the firms marketable securities portfolio earns an 8% annual return. The variance of XYZ Companys daily net cash flows is estimated to be Sh. 2,7000,000. Determine the return point and the upper limit.
Solution

(i) Return point = (ii) the upper limit line =

3[(3 x 3000 x 2,700,0000/(4*0.00022)] 3 x return point = 3 x 13,990

= Sh.13,990 = Sh.41,970

NB: Daily opportunity cost = 8%/360 = 0.00022

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11.1.3 INVESTING IDLE CASH MARKETABLE SECURITIES

It may happen the firm finds itself holding cash balances in excess of its requirements. Two causes of this build-up could be :1. Build up of transactions balances due to the seasonal nature of business, and 2. Build up of precautionary balances needed to take care of emergencies or unexpected profitable opportunities. Cash in excess of requirements should be invested in interest bearing assets that can be converted readily into cash.
Investment Criteria

Because the cash must be available at short notice it will be invested in short-term debt instruments (rather than shares) after examining three principal characteristics: 1. Default risk the possibility tat interest or principal might not be paid on time and in the amount promised. 2. Maturity the time period over which interest and principal are to be made. 3. Marketability ease with which an asset can be converted to cash.
Investment Alternatives

The principal types of interest bearing assets that meet the criteria of low default risk, short maturity and ready marketability are often referred to as money market securities and include: 1. Government Treasury Bills. These bills are issued weekly by the government (Treasury), are readily marketable and have maturities ranging from 91 to 360 days. 2. Bank Certificate of Deposit (CDs). Are fixed maturity time deposits placed with leading commercial banks. CDs of largest banks are marketable, have low default risk (although not zero) and have maturities ranging from 91 to 360 days. 3. Commercial Paper. These are short term unsecured promissory notes of large corporations. Commercial papers are usually issued by major finance companies, banks and some non-financial firms.

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4. Bankers Acceptances. These are drafts drawn against deposits in commercial banks. They are usually used in foreign trade. The draft has a specific payment date and has a guaranteed payment at maturity by the bank that accepts it.
DEALING WITH CASH SHORTAGES

Cash flow shortages can arise in several ways. 1. Making losses perpetual loss making eventually results in cash flow scarcity. 2. Inflation in periods of inflation, a firm needs ever-increasing amounts of cash just to replace used up or worn out assets. 3. Growth growing companies need additional fixed assets and increased levels of stocks and debtors. 4. Seasonal business cyclical sales or demand may make cash balances to fluctuate sharply during the year. 5. One-off expenditures, such as repayment of a loan at maturity, purchase of expensive asset and natural disasters could lead to a severe strain on cash reserves.
Easing Cash Shortages.

Shortages may be alleviated by: 1. Postponing capital expenditures that are not crucial and urgent. 2. Disposal of fixed assets which are not core or critical for survival. 3. Renegotiating contracts to defer or even reduce payment obligations. Instances include: Rescheduling loan repayment Deferral of corporation tax payment by negotiating with Kenya Revenue Authority Retrenchment of staff 4. Freezing of payment of dividends.

11.2 Accounts Receivable Management

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Account Receivables are amounts of money owed to a firm by customers who have

bought goods and services on credit. Management of receivables aims at determining the optimal level of investment in receivables, which maximizes the benefits and minimizes the costs of holding receivables. Economic conditions, competition, product pricing, product quality and the firms accounts receivables management policies are the chief influences on the level of a firms accounts receivable. Of all these factors, the last one is under the control of the finance manager. Our concern is to focus on this last factor. As with other current assets, the manager can vary the level of accounts receivable in keeping with the trade-off between profitability and risk. The firms financial manager controls accounts receivable through the establishments and management of: (1) credit policy, which is determination of credit selection, credit
standards and credit terms, and (2) collection policy.

Let us consider these management variables.

11.2.1 CREDIT SELECTION

This is the decision whether to extend credit to a customer and how much credit to extend. A credit investigation is first carried out on the prospective customer in whom the five Cs of credit are employed. The five Cs of credit are key dimensions
character, capacity, capital collateral and conditions used by the credit analysts to

focus their analysis on an applicants credit worthiness. A brief discussion of these characteristics follows.
Character This refers to the creditors willingness to honour obligations. The applicants

record of meeting past obligations financial, contractual, and moral - is closely scrutinized. Any past litigation against the applicant would also be relevant.
Capacity This considers the applicants ability to generate cash to repay the requested

credit. Financial statement analysis, especially liquidity and debt rations are useful in assessing capacity.

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Capital Considers the financial strength of the applicant as reflected by his net worth

position. The applicants debts relative to equity and the profitability ratios will be used in this assessment.
Collateral Looks at the amount of assets the applicant can pledge to secure the credit to

be advanced. The asset structure as revealed in the balance sheet and record of any legal claims against the applicant will be helpful in this assessment.
Conditions The prevailing economic and business climate as well as unique

circumstance affecting the applicant will be considered. Character and Capacity receive primary attention; capital, collateral and conditions play a supplementary role.
Sources of Information on the Debtor

The evaluation of an applicant begins when he fills a form providing basic financial and credit data and references. Additional information will be obtained from other sources depending on time and expense and size of credit involved. The credit analyst may obtain information from the following sources.
Financial Statements The seller may request the audited financial statements of the

applicant for a number of years. The trends shown by the statements would help gauge financial strengths.
Credit Rating And Reports Credit rating agencies provide subscribers with credit

rating and estimates of overall financial strength for many companies (Dun & Bradstreet is the largest mercantile credit reporting agency in the world. In Kenya, the industry is in its infancy with Metropol Rating Agency one among the very few firms active).
Bank Checking The applicants bank could be a good source of information for the

credit analyst. The credit analyst can obtain information such as average cash balance carried, loan granted and recovery of loan experience. Despite existence of banking secrecy laws, the credit applicant will allow his bank to provide the information in order to facilitate his being granted credit.

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Trade checking Credit information is frequently exchanged among companies

selling to the same customer. Companies can ask other supplies about their experience with an account.
Credit Analysis

Having collected information, the credit analyst must conduct a credit analysis of the applicant. The analyst must decide on the applicants credit worthiness and the maximum amount of credit the applicant can support the line of credit (maximum amount a credit customer can owe the selling firm at any one time). Two approaches to credit analysis are discussed below.
(a) Investigations Procedures

The following ad hoc procedures are usually employed by small firms and by big firms on small accounts (1) Applicants financial statements and accounts payable ledger can be used to calculate the average payment period (2) Consult past experience to see whether the firm has sold previously to the account (applicant) and whether that experience has been satisfactory. (3) A through ratio analysis of the accounts liquidity activity, debt and profitability. (4) A credit rating agencys recommendation could be obtained and used to estimate the maximum line of credit to extend. (5) Time series comparison should be performed to uncover any trends.
(6) The credit analyst's own subjective judgment of a firms credit worthiness could

be decisive.
(a) Credit scoring systems

These systems employ quantitative approaches to decide whether or not to grant credit, by assigning numerical scores to various characteristics related to the applicants credit worthiness. The credit score is a weighted average of scores obtained on key financial and credit characteristics. In consumer credit, plastic credit cards are often given out on the basis of a credit-scoring system that rates such things as occupation, duration of employment, home ownership, years of residence and annual income. Numerical rating systems are also used by some companies extending trade credit (credit granted from one business to another). 200

Credit Decision And Line Of Credit

Once the analyst has marshaled the necessary evidence and analyzed it, two decisions must be made: (1) Whether to extend the credit (2) Whether to establish a line of credit. A line of credit is used where repeat sales are expected. It is the maximum limit on the amount the firm will permit to be owed at any one time by the applicant. In essence it is the maximum risk exposure that the firm will allow itself to undergo for an account.
11.2.2 CREDIT STANDARDS

Credit standards define the minimum criteria for the extension of credit to a customer. Extension of credit has its costs (risks) even as it has benefits. In determining the optimal credit standards, marginal costs of credit should be related to the marginal profits from the increased sales.
Key variables that should be considered in evaluating relaxation or tightening of

credit standards are: (a) Clerical and collection expenses If credit standards are relaxed/tightened, more/less credit is offered and a bigger/smaller credit department is needed to service accounts. (b) Investment in Receivable The higher the firms average accounts receivables are, the more expensive they are to carry, and vice versa. Thus a relaxation of credit standards can be expected to result in higher carrying costs and a tightening of credit standards results in a lover carrying costs. (c) Default and Bad date Expenses: the probability of (risk) of acquiring a bad debt increases as credit standards are relaxed and decreases as the standards become more restrictive. (d) Sales Volume and contribution margin: it is expected that as credit standards are relaxed, sales (contribution margin) will be expected to increase; a tightening of credit standards is expected to reduce sales (contribution margin).

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The table below summarizes the basic change and effects on profit expected to result from relaxation of credit standards.
Table 13.1 Effect of a relaxation of credit standards Item Direction of Change Effect on Profits

Sales volume(contribution) Average Collection period Bad debt expense

+ + +

+ -

The opposite effects result when standards are tightened.

Example

XY Co. is currently making annual sales of 120,000 units at Sh.10 per unit. The variable cost per unit is Sh.6 and average cost per unit, given the current sales volume is Sh.8. The firm is contemplating a relaxation of credit standards that is expected to result in 15% increase in unit sales, an increase in average collection period from 30 days to 45 days, and an increase in bad debt loss rate from 2% to 3% of total sales. Additional working capital (apart from accounts receivable) needed will remain at 25% of sales even if the credit standards are relaxed. The firm has excess capacity and can increase sales without a corresponding increment in Fixed Assets. The firms cost of capital is 12%. Determine whether it is advisable for the firm to relax its credit standards. Assume 360-day year.
Solution

Additional Profit Contributions from Sales

Current plan

Sales revenue (120,000 x 10) Less costs Variable (120,000 x 6) Fixed (8-6) x 120,000) Total costs Net profit

1,200,000 720,000 240,000 960,000

240,000

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Proposed plan

Sales revenue (120,000 x 115% x 10) Less: Costs Variables (138,00 x 6) Fixed (no change) Total costs Net profit

1,380,000 828,000 240,000 1,068,000

312,000

Addition profit contribution with new plan = 312,000 240,000 = Sh.72,000 Other costs of new plan
Cost of the investment in Accounts receivables (A/R)

Under the current plan: Average A/R = 1,200,000 x 30 = Sh.100,000 360 Average Investment in A/R = variable cost ratio(VC ratio) x Average A/R =( 6/10) x 100, 000 = 60,000 Cost of Investment in A/R = 60,000 x 15% = Sh.9,000 Under proposed Plan: 1,380,000 x( 45/360)*VC ratio = 172,500 x 0.60 = 103,500 Cost of investment in A/R = 103,500 x 15% = Sh.15,525 Incremental cost of investment in A/R = 15525-9,000 = Sh. 6,525
Cost of additional working capital (WC) under proposed plan

Current plans WC needs = 25% x 1,200,000 = 300,000 Cost working capital = 15% x 300,000 = Sh.45,000 Proposed plans WC needs = 25% x 1,380,000 = 345,000 Cost of WC
Bad debt losses

= 15% x 345,000 = Sh.51,750 =51,750-45.000 = Sh.6,750 24,000 41,000

Marginal increment in cost of WC Current plan = 2% x 1,200,000 Proposed Plan = 3% x 1,380,000

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Marginal increment in bad debts

17,400

Overall benefits of relaxation in credit standards = 72,000 6,525 6,750 17,400 =

Sh.41.325. Therefore a relaxation in credit standards is advisable. 11.2.3 CREDIT TERMS (TERMS OF SALE)

Credit terms specify the repayment terms required of all credit customers ( i.e. 2/10,net 30. Credit terms make specification on three issues: (1) (2) (3) the cash discount the cash discount period the credit period (2)% (10 days) (30 days)

Changes in any aspect of the firms credit terms may have an effect on its overall profitability of the company.
Cash Discounts

An increase in a cash discount will lead to the following changes and effect, as shown in Table 11.2
Table 11.2 Shows the effects of a n increase in cash discounts granted on the financial variable . A decrease will have the opposite effects. Item Direction of change Effect on profits

Sales volume Average Collection period Bad debt expenses Profit per unit

+ -

+ + + -

The sales volume increases since the cash discount effectively reduces the price for those firms ready to pay within the discount period. (assuming demand is elastic). The Average collection period decreases because the discount acts as an inducement for early payment. The bad debt expense falls because as people pay earlier, the risk of a bad debt decreases. The increase in sales, and the decrease in average collection period and bad

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debt expense have a positive effect on net profits. Increased cash discount has however the negative effect of a decreased profit margin per unit as more people take the discount and pay the reduced price.
Example

XYZ Co. is contemplating initiating a cash discount of 2% for payment within 10 days of purchase. The firms current average collection period is 30 days.. Credit sales of 120,000 units at a price of Sh.10 are made annually. Variable cost per unit is Sh.6, and average cost per unit is Sh.8. If the discount is initiated 70% of sales will be on discount and sales will increase by 10%. The average collection period will drop to 15 days. Bad debt expenses currently at 2% of sales will fall to 1%. Total working capital needed will not be affected by the cash discount. The firms required return on investment is 12%. Assume no additional capital investment will be necessary. Evaluate the proposal to initiate a discount.
Solution

An additional (10% x 120,000) 12,000 units will be sold whose contributions to profit is 12,000 x 4 = Sh.48,000 Average Investment in A/R (receivables). Current plan 120,000/12 = 100,000 Proposed plan = 1,320,000/24 = 55,000 Reduction in Average A/R = Savings = 45,000 x 12% = Sh.5,400 Bad debts Expenses Current plan = 2% x 1,200,000 = 24,000 Proposed plan = 1% x 1,320,000 = 13,200 Saving in bad debt losses Cash discount costs Cash discount 2% x 1,320,000 x 70% = Sh.18,480
10,800

45,000

Net benefit of cash discount =48,00 + 5,400 + 10,800 18,480 = Sh.45,720

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The Cash Discount Period

Increased cash discount period leads to the following changes in profits.

Table 11.3 Shows the impact of an increased cash discount period on the financial variables of a firm granting credit Change Item (increase + ) (Decrease -) Effects on profits (profits +) (negative )

Sales volume Average Collection period non discount taker now paying earlier Profit per unit Bad debt expense Average collection period due to discount takers still taking the cash discount but now paying later

+ due to

+ +

When cash discount period is increased, there is a positive effect on profits because people who formerly were not taking the discount will now take it thereby reducing the average collection period. On the negative side people who already were taking the cash discount will be able to still take it and pay later thus slowing down collection of receivables.
Credit Period

The following effect on profits can be expected form an increase in the credit period. Item Change Effect on Profits

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Sales volume Average Collection period Bad debt expense and the bad debts expense.
Example

+ + +

+ -

Increasing the credit period should increase sales, the average collection period,

A company is considering increasing its credit period from 30 to 60 days. The average collection period currently 45 days is expected to increase to 75 days. Bad debt expenses currently 1% of sales, are expected to increase to 3%. Sales (credit) are expected to increase by 15% to 69,000 units. The selling price and variable cost per unit are Sh.16 and Sh.12 respectively. The firms cost of capital is 15%. Assess the planned increase in discount period.
Solution

Additional profit contribution from sales 9000 x 4 Cost marginal investment in A/R Proposed credit period [(16 x 69,000)/4.8]*0.15 Present credit period [(16 x 60,000)/8.0]*0.15 Cost of marginal investment Cost of marginal bad debts Bad debts with current plan 0.03 x 1,104,000 Bad debts with current plan 0.01 x 960,000 Cost of marginal bad debts Net loss from implementation of proposed plan This suggests that the change should not be made. 9,600 (23,520)
(3,945)

36,000

34,500

18,075 (16,425)

33,120

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11.2.4 COLLECTION POLICIES

Are the procedures followed to collect account receivables when they are due. The level of bad debts is a reflection, partially on the effectiveness of a firms collection policies and partially on the credit policies on which extension of credit is based. If we assume the level of bad debts attributable to credit policies is constant, increasing collection expenditures affect the overall level of bad debts as shown below.

Beyond point A additional collection expenditures will not reduce the firms bad debt losses enough to justify the outlay in funds.
Trade-Offs

The trade-offs expected from tightening of collection efforts are as follows

Table13.5 Shows the trade-offs of tightening collection policies. Item Change Effect on Profits

Bad debt expense A.C.P Sales volume Collection expenditures

+ +

+ -

Increased collection expenditures should reduce the bad debt expense and the average collection period/thereby increasing profits. The negative effects of this policy include lost sales and increased collection expenditures. The various strategies for

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tightening or relaxing the collection effort may be assessed by calculating the marginal cost of increased efforts and the decreased profit contribution from sales and comparing this to savings from both reduced bad debt expenses and decreased investment in accounts receivable.
Types Of Collections Techniques

As an account becomes more and more overdue, the collection techniques used become more personal and strict. The collection techniques used may include.
Letters: When an account becomes long overdue a firm normally sends a polite

letter reminding the customer of his obligation. A second and third more demanding letter may be sent if the customer does not respond.
Telephone Calls: The credit manager or the companys lawyer may call the

customer and personally request for pay if letters prove unavailing.

Personal Visits: A local sales person may be sent to confront the customer. Collection Agencies: A firm engages the services of a debt collector. This technique

should be used sparingly because the fees are normally high.

Legal Action: This step is taken as a last resort. If may force the customer into

bankruptcy.
Cost Consideration

Generally the effort expended in collecting depends upon the size of the account and the possibility of ultimate collection. Affirm should usually not spend more on collection fees than the value of the account to be collected (more than what it expects to collect). Banks may be prepared to spend more so that they are not perceived as always writing off poor debts.
CLASS ILLUSTRATIONS Example one R Ltd is considering a change of credit policy, which will result in an

increase in the average collection period from one to two months. The relaxation in

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credit is expected to produce an increase in sales each year amounting to 25% of the current sales volume. Selling price per unit Variable cost per unit Current annual sales Sh.1000 850 240 million

The required rate of return on investment is 20%. Assume that the 25% increase in sales would result in additional stocks of Sh.10 million and additional creditors of Sh.2 million. Advise the Company whether or not to extend the credit period if: (a) (b) all customers take the longer period of two months. Existing customers do not change their payment habits; only the new customers take a full two months credit.
Solution:

The change in credit policy is justifiable if the rate of return on the additional investment in working capital would exceed 20%. Contribution/sales ratio Increase in sales revenue Increase in contribution profits 15% x 600 (a) If all the debtors take 2 months credit Average debtors after sales increase (2/12 x 300 m Less current average debtors (1/x x 240 m) Increase in debts Increase in stocks Less increase in creditors Net increase in WC investment Cost of investment in WC (38m x 0.2)
Net increase in benefit (9m 7.6m)

15% 60 million 9 million 50,000,000 20,000,00 30,000,000 10,000,000 40,000,000 2,000,000 38,000,000
7,600,000 1.400,000

(b)

If only new debts take 2 months credit

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Increase in stock Increase in stocks Increase in creditors Net increase in WC investment Cost on investment (18m x 0.2)
Net benefit ( 9m 3.6m) =

10,000,000 10,000,000 (2,000,000) 18,000,000 3,600,000

5,400,000

It is worthwhile taking on the new credit policy in both cases.

Example 2: Credit Term

LP Ltd has annual credit sales of Sh. 120 million, and three months are allowed for payment. The Co decides to offer 2% discount for payment made within ten days of the invoice being sent, and to reduce the maximum time allowed for payment to two months. It is estimated that 58% of the customers will take the discount. If the company requires a 20% return on investments, what will be the effect of the discount if the cost per unit is Sh. 90 and the selling price is Sh. 100? Assume volume of sales will be unaffected by discount.
Solution:

Current volume of debtors

3/12 x 120m =

30,000,000 11,666,667 18,333,333 3,666,667 (1,200,000)

2,466,667

Volume of debtors with changed policy (10/360 x 50% x 120 m) + (2/360 x 50% x 120m) = Reduction in debtor with change Saving in cost of investment in debtors (20% x 18,333,333) Less discount allowance each year (22 x 50% x 120m)
Net benefit of new discount policy each year

Example Three: Bad Debt risk KK Ltd. achieves current annual sales of Sh.18,million. The cost of sales is 80% of this

amount but bad debts average 1% of total sales, and annual profit is as follows: Sales 18,000,000

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Less costs of sales Less bad debts Profit

(1 4,400,000) 3,600,000 (180,000)

3,420,000

The company is considering the following effects of changes in its current credit policy.
Present policy proposed policy

Additional sales (%) Av. Collection period Bad debt (% of sales) 1%

1 month

25% 2 months 3%

The company requires a 20% return on its investment. If cost of sales is 75% variable and 25% fixed and on the assumption that: (a) (b) There would be no increase in fixed costs from the extra turnover. There would be no increase in average stocks or creditors

What is the preferable policy.

Solution:

(1)

The increase in profit before cost of additional finance for proposals is: Increase contribution margin from additional sales is: 25% x 18m x 40%* Less increase in bad debts: (3% x 22.5m) 180,000 Increase in annual profit * The CM/S ratio is 100% - 75% x 80% = 40% (495,000)
1,305,000

1,800,000

(2)

Proposed investment in debtors 22.5m x 2/12 Less current investment in debtors (18m x 1/12) Additional investment Cost of additional finance at 20% 3,750,000 1,500,000 2,250,000
450,000

Net benefit of proposed policy (1 305,000 450,000) = Sh.855,000

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Example Four: collection policy CP Ltd requires advice on its debt policy. Should the Current policy be discarded in

favour of Options 1 or 2?
Current policy Option 1 Option 2

Annual expenditure on debt collection Bad debt losses (% of Sales) Average collection period investments.
Solution:

240,000 3% 2 months

300,000 2% 1 months

400,000 1% 1 month

Current credit sales are Sh. 4,800,000 and the company requires 15% return on its

Current policy 800,000 (144,000)

Option 1 600,000
30,000

Option 2 400,000
60,000

Average Debtors (a) Savings in cost of investment in debtors (15% x red) Bad debt loses (sales value)
(b)

(96,000)
48,000

(48,000)
96,000

Reduction in bad debt losses

Benefits of each option (a) + (b) Extra cost of debt collection Net benefit/(loss) from option
Option 1 is preferable.

78,000 60,000
18,000

156,000 160,000
(4,000)

11.3 Inventory Management

Inventories ensure the smooth functioning of the production-sale or purchase-sale process of firms. A stock of raw materials and work-in-progress facilitates the production function while finished goods stocks provide a buffer that enables the firm to satisfy sales demands as they arise.
Types of Inventory

The basic types of inventory are:

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(a)

Raw materials are necessary for production of the final product. The actual

level of raw materials stocked depends on: (b)

lead time it takes to receive an order. The longer the lag between
placement and receipt of an order the higher the stock levels.

The frequency of use. The stocks of frequently used items will be higher. The investment required: greater amounts of outlay are necessary for
expensive items. The physical characteristics of the inventory itself. Bulky and perishable items would not be ordered in large quantities.

Work-in-progress (W.I.P) These are partially finished goods that are at

some intermediate stage of production. They occur because production processes are not instantaneous. The longer the firms production cycle the higher the level of W.I.P inventory expected. The W.I.P is the least liquid of a firms inventory (it hard to sell partially finished goods or over use them as security for loans) and has the characteristics that it builds up in value as it an item is transformed from raw materials to finished state.
( c) Finished goods These consist of items already produced but not yet sold.

The level of finished goods inventory is determined by: Projected demand. Safety stocks may be maintained as security against unexpected demand or production stoppages. The production process. Scheduling and proper planning of production process may reduce inventory levels. Investment made in finished goods inventory. Inventories of specialized high-cost items will normally be kept at a minimum. Inventory as an Investment The relationship between inventory an account receivable inventory and account receivable are closely related. A decision to extend credit to a customer may result in increased sales that can only be supported by higher levels of stocks and A/R. The credit terms extended will also influence the investment in inventories

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and receivables since longer credit may allow a firm to move items from inventory to receivables. Since cost of carrying an item as inventory is higher than as A/R such a strategy is advantageous.
Optimal Investment in Inventories

The inventory is an investment in the sense that it requires the firm to tie up its money. Average inventory = cost of goods sold Inventory turnover The management of stocks involves the balancing of the cost of stock shortages against the costs of holding stocks. Three aspects of stock management are: (1) (2) (3) The economic order quantity (EOQ) can be used to decide the optimum order size (which minimizes ordering plus stockholding costs) Deciding on whether to take advantage of discounts for bulk purchases. Decision on how to deal with uncertainty in demand and/or the supply leadtime. The question to be addressed is: How much buffer stock is necessary to eliminate the risk of stock-outs?
Stock Costs

Stock costs can be classified into four groups. (a) Holding Costs: the cost of capital tied up, warehousing and handling costs, deterioration, obsolescence, insurance and pilferage. (b) Procuring costs (ordering costs): for goods purchased externally these comprise, clerical costs, telephone charges and delivery costs. (c) Shortage Costs may include: (i) (ii) (iii) the loss of a sale and the contribution from the lost sale. The extra cost of having to buy an emergency supply of stocks at a high cost. The cost of lost production and sales, where the stock-out bring an entire process to a halt.

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(d) Cost of the stock itself the suppliers price will need to be considered when bulk discounts are given. Minimizing inventory costs: cost (Sh) total operating stock costs

carrying cost

ordering and stock out costs

inventory levels The objective is to minimize total costs (holding and ordering costs) T = (Qh)/2 + (cd)/Q stock levels average total hold Q 2 Time The order quantity (EOQ) which will minimize these total costs (no bulk purchase discounts) is
EOQ = Example:
2cd h

(13.6)

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The demand for a commodity is 40,000 units a year, at a steady rate. It costs Sh. 2000 to place an order, and 40/- to hold a unit for a year. Find the order size to minimize stock costs, the number of orders placed each year, and the length of the stock cycle.
Solution

EOQ =

2cd h

2 * 2,000 * 40,000 40

= 2000 units Number of orders in a year = 40,000/2,000 = 20 orders The stock cycle = 52 20 = 2.6 weeks. Total inventory cost will be: Ordering cost = 20 x 2000 = Sh.40,000 Carrying cost = 2000/2)*40 = Sh.40,000 Total costs
Sh. 80,000 a year.

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Problems
11.1 Joan Mbaka, a financial analyst for Kuona Mbee Distillers has been asked to investigate a proposed change in the firm's credit terms. The companys founder and chief executive believes that by increasing the credit period from 30 to 65 days, two important benefits will result: (1) sales will increase as a result of attracting new customers, and (2) some existing customers will purchase merchandise sooner to ensure its availability, given the unpredictable timing of the selling seasons. Annual sales are estimated to increase from the current level of Sh.400 million to Sh.480 million. Eighty percent of this increase is attributable to new customers, and the other 20% is expected to result from existing customers. Because some existing customers will be making their purchases earlier than in the past, their actions will merely result in a shifting of inventory to accounts receivable. Joan estimated that the decline in inventory investment attributable to the actions of existing customers would just equal the additional accounts receivable investment associated with their actions. Joans investigation indicates that with the extended credit period, the firms average collection period would increase 45 to 90 days. In addition, bad debts would increase from 1 to 2.5 % of sales. The firms variable costs are expected to continue to amount to 80% of each Sh.1 of sales. Kuona Mbee Processors currently requires a 16% rate of return on equal-risk accounts receivable investments, and its cost of carrying Sh.1 inventory for 1 year is 26 cents. Required

a. Find the additional annual profit contribution expected from the increased credit period. b. Determine the increase in Kuona Mbees average investment in accounts receivable and the resulting annual cost attributable to the proposed increase in the credit period. c. Calculate the annual savings resulting from the decrease in inventory investment attributable to the existing customers earlier purchases. d. Calculate the annual cost expected to result from the increase in bad debt expenses attributable to the proposed lengthening of the credit period. e. Use your findings in a through d to advise Joan on whether or not the proposed increase in the credit period can be financially justified. Explain your recommendations. f. What impact, if any, would ignoring the effect of the proposed increase in the credit period on the level of inventory investment found in c have on your recommendation in e? Explain.

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DFI 501: FINANCIAL MANAGEMENT

CLASS DISCUSSION QUESTIONS QUESTION ONE a). Explain the meaning of the term leverage as applied in finance (6 marks)

b. Nameless Drapers Ltd. makes a patented headscarf that wholesales for Sh.600. Each scarf has variable operating cost of Sh.350. Fixed operating costs are Sh.5,000,000 per year. The firm pays Sh.1,300,000 interest and preferred dividends of Sh.700,000 per year. At this point the firm is selling 30,000 scarves a year and is in the 40% tax bracket. Required i. ii. iii. iv. v. vi. Calculate Nameless Drapers operating breakeven point in units and shillings. (4 marks) Based on the firms current sales of 30,000 units, calculate its EBIT and net profits. (2marks) Calculate the firms degree of operating leverage (DOL) (3marks). Calculate the firms degree of financial leverage (DFL) (3marks) Calculate the firms degree of total leverage (DTL). (3 marks) Nameless Drapers Ltd. has entered into a contract to produce and sell an additional 15,000 scarves in the coming year. Use the DOL and the DFL to predict the changes in the EBIT and the net profit (3 marks) (Total: 25 marks) QUESTION TWO (a) The most recent balance sheet of Nguvu Limited is presented below: Nguvu Limited Balance Sheet-30 June 2007 Sh. 000 Sh. 000 Current Assets 88,000 Trade creditors 22,000 Fixed Assets (net) 132,000 Accrued expenses 22,000 Current Liabilities 44,000 Long term debt 88,000 Ordinary shares 22,000 Retained earnings 66,000 220,000 220,000 The company is about to embark on an advertising campaign which is expected to raise sales from their present level of Sh.275 million to Sh.385 million by the end of next financial year. The firm is currently operating at full capacity and will have to increase its investment in both current and fixed assets to support the projected level of sales. It is estimated that both categories of assets will rise in direct proportion to the projected increase in sales. For the year just ended, the firms net profits were 6% of the years sales but are expected to rise to 7% of the projected sales. To help support its anticipated growth in assets needs next year the firm has suspended plans to pay cash dividends to its shareholders. In years past a dividend of Sh. 6.60 had been paid annually. Nguvu Ltd.s trade creditors and accrued expenses are expected to vary directly with sales. Notes payable will be used to supply the extra external funds needed to finance next years operations that are not forthcoming from other sources. Required Prepare a pro-forma balance sheet of Nguvu Ltd as at 30 June 2008. (13 marks)

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(b) Biashara Traders are concerned about managing their cash in an efficient manner. On average trade debtors are collected in 45 days. Stocks turns over 4.8 times in a year and trade creditor are paid approximately 30 days after they arise. Assume a 360-day year. Required Calculate the following for the firm: (i) The cash cycle (6marks) (ii) The operating cycle (6marks) (Total: 25marks) QUESTION THREE (a) Identify the five Cs of credit and briefly outline their role in credit selection. (10 marks) (b) Fashion Furniture is evaluating the extension of credit to a new group of customers. Although these customers will provide Sh.18million in additional sales, 12 percent are likely to be uncollectible. The company will also incur Sh 1.4 million in additional collection expenses. Production and marketing costs represent 80 percent of sales. The firm is in the 40 percent tax bracket and has a receivable turnover of 5 times. No other asset buildup will be required to service the new customers. Required (i) If Fashion Furniture has a 10% required return determine the financial viability of extending credit. (6 marks) above?

(ii) If 15 percent of the new sales prove uncollectible, does this affect your decision in (4 marks) (iii) Should the credit be extended if receivables turnover drop to 1.5, and 12 percent of accounts are uncollectible? (5 marks) (Total: 25 marks)

QUESTION FOUR The following financial statements as at the end of 2004, and historical ratios relate to Biashara limited. Corresponding average ratios for the industry in which Biashara operates are also provided. Biashara Limited Income Statement For year ended 31 December 2004 Net sales Cash Credit Total Less: cost of goods sold Gross profit Less: Operating expenses Selling General and admin. Sh. 300,000 9,700,000 10,000,000 7,500,000 2,500,000 300,000 700,000

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Depreciation Operating profit Less: interest expense Profit before tax Less Taxes (40%) Profits after tax Less preference dividend Earnings available to ordinary shareholders Less ordinary dividend To retained earnings

200,000

1,200,000 1,300,000 200,000 1,100,000 440,000 660,000 50,000 610,000 200,000 410,000

Biashara Limited Balance sheet As at 31 December 2004 ASSETS Current assets Cash Marketable securities Accounts receivables Inventories Total current assets Gross fixed assets Less: Accumulated depn Net fixed assets Other assets Total assets LIABILITIES AND EQUITY Current liabilities Accrued liabilities Notes payable Accounts payable Total current liabilities Long term debts Shareholders equity Preference shares Ordinary shares (Sh. 75 par) Share premium Retained earnings Total shareholders equity Total liabilities and equity Note: (a) (b) (c) Sh 200,000 50,000 800,000 950,000 2,000,000 12,000,000 3,000,000 9,000,000 1,000,000 12,000,000 100,000 200,000 100,000 1,200,000 3,000,000 1,000,000 3,000,000 2,800,000 1,000,000 7,800,000 12,000,000

Annual credit purchases of Sh.6,200,000 were made. The annual principal payment on the long term loan debt is Sh.100,000. The firm has 25,000 shares of Sh.2 preference shares outstanding. HISTORICAL DATA FOR BIASHARA LIMITED AND INDUSTRY AVERAGES

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DATA Current ratio Net working capital Acid test ratio Average age of accounts receivable Inventory turnover Average age of accounts payable Debt ratio Debt-equity ratio Debt-to-total capitalization ratio Gross profit margin Operating profit margin Net profit margin Total assets turnover Return on investment Return on equity Earnings per share Dividends per share Book value per share Times interest earned Total debt coverage Required (a) (b) 2002 1.40 Sh.760,000 1.00 45.0 days 9.52 58.53 days .20 .25 .22 .30 .12 .067 .74 .049 .078 Sh.8.65 Sh.2.60 Sh.140 8.2 4.8 2003 1.55 Sh.720,000 .92 36.4 days 9.21 60.75 days .20 .27 .22 .27 .12 .067 .80 .054 .085 Sh.11.05 Sh.3.65 Sh.150 7.3 4.5

INDUSTRY AVERAGE 2004 1.85 Sh.1,200,000 1.05 35.0 days 8.60 45.75 days .30 .39 .27 .25 .10 .058 .74 .043 .084 Sh.7.45 Sh.2.45 Sh.175 8.0 4.5

Compute the corresponding ratios for Biashara Limited for 2004. Select appropriate ratios and analyze the liquidity, leverage, activity and profitability of the company both cross-sectionally and trend wise.

QUESTION FIVE The following projections of sales have been made in respect of Mugumo Company for the seven months of 2006.The company closes its year and prepares its accounts on 31st December. January February March April May June July Sh.900,000 Sh.2,200,000 Sh.1,350,000 Sh.2,400,000 Sh.3,000,000 Sh.2,700,000 Sh.2,250,000

Additional Information 1. 10% of the sale are sold for cash and the rest collected as follows: 60% collected in the month following the month of sale 30% collected in the second month following the month of sale 2. November and December 2005 sales were Sh.2,200,000 and Sh 1,750,000 respectively 3. Mugumo purchases and pays for the merchandise one month in advance . Cost of goods sold average 60% of sales price. 4. Salaries and wages average Sh.600,000 per month, 20% of which is always accrued and paid at the year end.

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Monthly rent payments amount to Sh.250,000. In addition the company pays Sh.200,000 in miscellaneous expenses. 6. Depreciation expense per month is Sh. 90,000. 7. Tax payments amounting to Sh.230,000 are to be paid each quarter beginning March. 8. The companys cash balance at December 31st 2005 was Sh228,000;a minimum balance of Sh.150,000 must be mantained at all times. 9. All borrowings are to be made at the beginning of the month in even thousands and at an interest rate of 12% per annum. Monthly interest payments are to be made beginning the month following the month of borrowing 10. Any excess cash is to be used to repay any loans outstanding. This repayment of the principal is to be done in even thousands. Required (a) Prepare a cash budget for Mugumo Limited covering the first six months of 2006. (b) Explain the uses of a cash budget.

5.

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DFI 501: FINANCIAL MANAGEMENT CONTINUOUS ASSESSMENT TEST 1 KISUMU CAMPUS JULY 2009 Instructions 1. Answer all the four questions. Marks allocated are shown at the end of each question. 2. Be neat and show necessary workings. 3. When appropriate qualitative answers to be brief and in point form. 4. Time allowed: 2 hours. QUESTION ONE Urembo Fabrics Ltd. (UFL), an apparel manufacturer, is in the process of expanding its productive capacity to introduce a new line of products. Current plans call for a possible expenditure of Sh.1 billion on four projects of equal size (i.e. Sh.250 million), but with different returns. Project A will increase the firms processed yarn capacity and has an expected return of 15%. Project B will increase capacity for woven fabrics and carries a return of 13.5%. Project C is a venture into synthetic fibres and is expected to earn 11.2%. Project D is an investment into dye and textile chemicals and is expected to show a 10.5% return. The firms capital structure consists of 40 percent debt and 60 percent common equity, and this will continue in the future. UFL has Sh.150 million in retained earnings available for investment. The companys ordinary share is now selling at Sh.30 and underwriting expenses are estimated at Sh.3 per share if new shares are issued (after exhausting the retained profits). Ordinary dividends for the next year will be Sh.1.50 per share, and earnings and dividends, which have grown consistently at 9%, are expected to maintain this growth rate in future. The yield on comparative bonds has been hovering at 11%. The companys investment banker feels that the firstSh.200 million of bonds could be sold to yield 11% while additional debt might require a 2% premium.

Assume a corporate tax rate of 45%.

Required (a) (b) (c) (d)

Determine the break points in the firms capital structure. (4 marks) Calculate the marginal average cost of capital before and after each break point determined in (a) above. (6 marks) Based on the information on the potential returns on the four projects and the marginal average cost of capital of the firm, determine the firms optimal capital investment budget. (4 marks) Depict your answer in (c) above by graphing the investment opportunity, and the weighted marginal cost of capital schedules on the same axes. (6 marks)

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(e)

A key concept in the capital asset pricing model (CAPM) is the beta. Write brief explanatory notes on the beta (5 marks) (Total: 25 marks) QUESTION TWO

Mark Sang is considering giving up his paid employment and venturing into business on his own account. He is considering purchasing a quarry pit with a life of 35 years. To purchase the quarry, Mark will have to pay Sh.2,375,000 now. Mark wishes to work the quarry for the next 20 years, which coincides with the remaining active life in paid employment. Mark earns Sh.250,000 per annum from his current job. Mark predicts that the net operating cash receipts from the business (before any compensation to himself) will be Sh.625,000 per annum for the first 15 years and Sh.500.000 per annum for the last 5 years. He thinks that the business could be sold at the end of 20 years for Sh.750,000. Further, Mark thinks that certain capital replacements and improvements would be necessary and this would amount to Sh,50,000 per annum for the first 5 years, Sh.75,000 per annum for the next 5 years, Sh.100,000 per annum for the next 7 years and nothing for the last 3 years. These expenditures are to be incurred at the beginning of each year. To finance the purchase of the quarry pit , Mark would have to realize his savings which are invested to yield a rate of return of 10% before tax , and have a comparable risk factor to the Quarry business. Required
(a) Compute the net present value of the business and advice Mark on whether or not (14 marks) to buy the business (Ignore income tax). (b) State and explain three circumstances in which the IRR and the NPV techniques could lead to conflicting rankings of investment projects. (6 marks) (Total: 20 marks)

QUESTION THREE (a) The Great Rift Valley Company has just finished making an annual dividend payment of Sh.2 per share of its ordinary stock. Earnings and dividends are expected to grow at a 9% annual rate indefinitely. Investors currently require a rate of return of 13%. The company is considering several business strategies and wishes to determine the effect of these strategies on the wealth of its shareholders. Strategy I Continuing the present strategy, which results in the expected growth rate and required rate of return stated above.

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Strategy II Expanding timber holdings, which will increase the expected dividend growth rate to 11% in the foreseeable future, but will increase the risk of the company. As a result the rate of required return will increase to 16%. Strategy III Integrate into retail stores, which will increase the dividend growth rate to 10%, and increase the required rate of return to 14% in the foreseeable future. Strategy IV Acquiring a competitor, which will result in the growth of dividends at an annual rate of 16% for the next five years to be followed by a growth of dividend of 7% thereafter indefinitely. The required rate return would be maintained at 13%. Required

From the standpoint of market price per share, determine the best strategy. (16 marks)
(b) Chakaza Betting Ltd. has outstanding a Sh.1000 face value bond with a 14% coupon rate and 3 years until maturity. Interest payments are made semi-annually. Required (i) (ii) (iii)

The value of the bond if the annual required return is (1) 12%, and (2) 14%. (3 marks) The yield to maturity on the bond assuming it is currently selling at Sh. (3 marks) 953.61. The value of a bond similar to the one of Chakaza except that the bond is a zero-coupon, pure discount bond, and that the annual required rate of return is 16%. (3 marks) (Assume semi-annual discounting) (Total: 25 marks)

QUESTION FOUR

(a)

Squirrel Photocopiers Limited uses 165,000 reams of A-4 paper a year. Its current paper supplier charges Sh.250 per ream. Annual inventory carrying costs are 1.5 percent of inventory value. The costs of placing and receiving an order of paper are Sh.325. Assume that inventory replenishment occurs virtually instantaneously. Required Determine the following for the company: The Economic Order Quantity (3marks) (i) The total annual inventory cost (3marks) (ii) (2marks) (iii) The optimal ordering frequency Mtongwe Limited has an average selling price of Sh.100 for a component it manufactures for sale in the local market. Variable costs are sh.70 per unit and fixed costs amount to Sh.1,700,000. The company has financed its assets by have issued 40,000 ordinary shares.

(b)

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(c)

Another company in the same industry, Bombululu Limited, has the same operating information but has financed its assets with 20,000 ordinary shares and a loan which has an interest payment of Sh.160,000 per year. Both companies are in the 40% tax bracket and have sales of Sh.7,000,000 in the current financial year. Required For each company , determine: The degree of operating leverage (3marks) (i) The degree of financial leverage (3marks) (ii) (3marks) (iii) The degree of combined leverage The break-even point (3marks) (iv) (5marks) List and briefly discuss the 5Cs of credit (Total: 25marks)

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