Financial Management Teaching Material1

Chapter One
An over view of Financial Management

1.1 The nature and scope of financial management
Definition: Financial management is an art and science of managing money.
 As an art it requires some skills which can be used by professionals.
 As a science it involves some study and research used to come up with standards and principles.
 Financial management includes the process and transfer of money among and between individuals,
business and government.
 It is also used as mediator between who want to save their money & who want to invest money of
others.
Scope of finance
A firm secures whatever capital it needs and employs it (finance activity) in activities which generate
returns on invested capital (production and marketing activities).
Financial Management Vs Economics & Accounting

Economics
 Financial managers need to have a good understanding of the economic environment.
 Some economic concepts are used by financial management such as:
o Demand & Supply concept
o Profit maximization principle (i.e. MR = MC)
o Pricing concept
Accounting
 Focuses on providing financial information to the user group.
 Accounting relies on past events, whereas the financial management focuses on the future.
 Accounting deals on preparing financial statement, this must be changed to other in understandable
form by the financial manager.
Accounting Financial management
Incomes statement Analysis of F/S
Capital statement Eg. -Ratio analysis
Balance sheet Common size statements
Statement of cash flows
1.2 The goals of financial management

The goals of managerial finance are:
1. Profit maximization
2. Stockholder wealth maximization
3. Managerial reward maximization: when the firms make a profit management give a bonus for
their employees.
4. Behavioral goal: change employees mind to think for the advancement of the organization.
5. Social responsibility: keep the environment in well manner. Avoid environmental pollutions.
1. Profit maximization.
Objective: - to get large amount of profits in short period of time.
- It is short term goal
GEBRIE WORKU, AAUCC 1

- A firm may maximize its short-term profits at the expense of its long term profitability and still
realize this goal. In contrast, stockholder wealth maximization is a long term goal, since
stockholders are interested in future as well as present profits.
- You can attain maximum profit through selling a portion of your assets but you are
endangering the existence of the business.
Advantages
- easy to calculate profits
- easy to determine the link between financial decisions and profits.
Disadvantages
- emphasis only on short-term
- ignores risk and uncertainty
2. Stockholder wealth maximization

Objective: is attained when highest market value of common stock is maintained.
Advantages
Wealth maximization is generally preferred because:
- emphasis on long-term
- recognizes risks and uncertainty
Disadvantages
- offers no clear link between financial decisions and stock price
- Leads to anxiety of management and frustrations.
The roles of financial managers

The financial manager performs the following functions:
1. Financial analysis, forecasting and planning
- Monitoring the firms financial position
- Determines the proper amount of funds to employ in the firm
2. Investment decisions
- Make efficient allocations of funds to specific assets
- Make long-term capital budget & expenditure dictions
3. Financing and capital structure decisions
- Determines both the mix of short-term and long-term financing and equity/debt financing.
- Raises funds on the most favorable terms possible.
4. Management of financial resources
- Manages working capital
- Maintains optimal level of investment in each of the current assets.
5. Risk management
-As future is uncertain, the financial manager should consider/expectation of risk and protect the
resources.
1.3 Financial management decisions

Finance functions or decisions include:
- investment or long-term asset mix decision

- financing or capital mix decision
- dividend or profit allocation decision
- liquidity or short-term asset mix decision
A firm performs finance functions simultaneously and continuously in the normal operation. Finance
functions used to skilful planning, control and execution of a firm’s activities.
Investment decisions
 Investment decisions or capital budgeting involves the decision of allocation of capital or commitment
of funds to long term assets that would yield benefits in the future.
 Investment process should be evaluated in terms of both expected return and risk
Financing decisions
 Financing decisions is the second important function to be performed by the finance manager
 Deals with when, where, and how to acquire funds to meet the firm’s investment needs
 The mix of debt and equity is known as the firm’s capital structure. The financial manager
must strive to obtain the best financing mix or the optimum capital structure for his or her firm.
 The firm’s capital structure is considered to be optimum when the market value of shares is
maximized.
 The use of debt affects the return and risk of shareholders, it may increase the return on equity
funds but it always increases risk. A proper balance will have to be struck between return and
risk.
Dividend decisions
 The financial manager must decide whether the firm should distribute all profits or
retain them or distribute a portion and retain the balance
 Like the capital structure policy, the dividend policy should be determined in terms of
its impact on the shares holders’ value. The optimum dividend policy is one that
maximizes the market value of the firm’s shares.
Liquidity decisions
 Current assets must be managed efficiently for safeguarding the firm against the dangers of illiquidity
and insolvency.
 An investment in current assets affects the firm’s profitability, liquidity and risk. A conflict exists
between liquidity and profitability while managing current assets. Example, if the firm does not invest
sufficient funds in current assets, it may become illiquid. But it would lose profitability as idle current
assets would not earn any thing. Therefore, a proper tradeoff must be achieved between profitability
and liquidity.
 In order to ensure that neither insufficient nor unnecessary funds are invested in current assets, the
financial manager should develop sound techniques of managing current assets.
 Financial manager should estimate firm’s needs for current assets and make sure that funds would be
made available when needed.
1.4 Financial Markets and Institutions

Financial Institutions:
Financial institutions are financial intermediaries which include insurance companies, pension funds and
investment banks.

Financial Market:
Financial markets include primary markets, where new securities are sold, and secondary markets, where
existing securities are traded.
Primary Markets Vs Secondary Markets

A primary markets is one in which a borrower issues new securities in exchange for cash from an investor
(buyer). New sales of treasury bills, stock or bonds all take place in the primary markets. The issuers of these
securities receive cash from the buyers of these securities, who in turn receive financial claims that previously
did not exist.
Secondary markets: markets where existing securities are traded among investors. Once new securites have
been sold in the primary market, an efficient mechanism must exist for their resale if investors are to view
securites as attractive opportunities. Secondary markets give investors the means to trade existing securities.
Financial assets
Major types of financial assets are:
1. Non marketable
2. Money markets
3. Capital market
4. Derivative market
1. Non marketable financial assets: assets that represent personal transactions between the owner and the
issuer. That is, you as the owner of a savings account at a bank must open the account personally, you must
deal with the bank in maintaining the account or in closing it. In contrast, marketable securities trade in
impersonal markets-the buyer (seller) does not know who the seller (buyer) is, and does not care.
It includes:
 Saving accounts: saving account are held at commercial banks or institutions such as saving and loan
association and credit unions. Saving accounts in insured institutions offer a high degree of safety on
both the principal and the return on that principal. Liquidity (which can be defined as the ease with
which an asset can be converted to cash) is taken for granted.
 Nonnegotiable certificate: commercial banks and other institutions offer a variety of savings
certificate known as certificate of deposits (CDs). These certificates are available for various
maturities, with higher rates offered as maturity increases.
 Money markets deposit accounts: financial institutions offer money market deposit accounts with no
interest rate ceilings. Money markets accounts, with a required minimum deposit to open, pay
competitive money market rates and insured up with some amount.
2. Money markets: include short term, highly liquid, relatively low risk debt instrument sold by governments,
financial institutions, and corporations to investors with temporary excess funds to invest. Some of these
instruments are negotiable and actively traded, and some are not. It includes:
 Treasury bills: the premier money market instrument, a fully guaranteed, very liquid IOU from
the government. They are sold on auction basis.
 Negotiable certificate of deposit ( CDs): issued in exchange for a deposit of funds by most
banks, the CD is a marketable deposit liability of the issuer, who usually stands ready to sell
new CDs on demand. The deposit is maintained in the bank until maturity, at which the time
holder receives the deposit plus interest. However, these CDs are negotiable, meaning that they
can be sold in the open market before maturity.

 Commercial paper: a short term, unsecured promissory note issued by large, well known, and
financially strong corporations (including finance companies). Commercial paper usually sold
at a discount either by the issuer or indirectly through a dealer, with rates comparable to CDs.
 Eurodollars: dollar denominated and developed in Europe. Major international banks transact
among themselves with other participants including multinational corporations and
government. Maturities mostly short term, often less than six months.
 Repurchase agreement (RPs): an agreement between a borrower and a lender (typically
institutions) to sell and repurchase government securities. The borrower initiates a RP by
contracting to sell securities to a lender and agreeing to repurchase these securities at a
prespecified price on a stated date. The effective interest rate is given by the difference
between the purchase price and the sale price. The maturity of RPs is generally very short,
from three days to 14 days, and some times overnight.
 Banker's acceptance: a time draft drawn on a bank by a customer, whereby the bank agrees to
pay a particular amount at a specified future date. Banker's acceptances are negotiable
instruments because the holder can sell them for less than face value.
3. Capital Markets: encompass fixed income and equity securities with maturities greater than one year. Risk
is generally much higher than in the money market because of the time to maturity and the very nature of the
securities sold in the capital markets. Marketability is poor in some cases. The capital markets include both
debt and equity securities, with equity security having no maturity date. It includes:
 Fixed income securities
 Treasuries bonds
 agencies
 Municipal bonds
 corporate bonds
 Equities
 Preferred stock
 common stock
5. Derivative Markets: securities that derive their value in whole or in part by having a claim on some
underlying security. It includes
 Forward options
 futures
 swaps
 caps
 floor
Derivative markets are important to investors because they provide a way for investors to manage portfolio
risk.

Chapter Two
Evaluation of Financial Performance

Financial statement analysis
2.1 An over view of financial analysis
Definition: financial analysis is an evaluation of a firm's past performance and prospects for the future.
 The focus of financial analysis is on key figures in the financial statements and the significant relation
ships that exist between them.
 The analysis of financial statements is a process of evaluating relationship b/n component parts of f/s to
obtain a better understanding of the firm's financial condition and performance.
 Financial analysis helps users understand the numbers presented in financial statements and serve as a
basis for financial decision making.
Financial analysis consists of three major stages. These are:
1. Preparation and selection: - the preparatory steps include establishing the objective of the analysis and
assembling the financial statements and other financial data.
 Objectives depend on the prospective of the financial statement user and the questions to be answered by
the analyst. For instance, management analysis financial statements to help in planning and decision
making. The analysis providing answers to such questions as:
• How has the firm performed in the past?
• What are the firm's strengths and weaknesses?
• What changes are needed to improve future performance?
2. Computation and relation: - arrange it in a way that will bring about significant relationship.
It involves the application of various tools and techniques to gain a basic understanding of the firm's
financial condition and performance. The most frequently used techniques in analyzing f/s are:
a. Ratio analysis: converts birr amounts in to ratios.
b. Common- size statements: express individual statement accounts as percentage of a base amount.
3. Evaluation and interpretation: involves the determination of the meaningfulness of the analysis and to
develop conclusions, inferences, and recommendations about the firm's performance and financial condition.
Financial statement analysis focuses primarily on the balance sheet and the income statement. How
ever, data from the following two statements may also be used:
- the statement of retained earnings, and
- the statement of changes in cash flow
2.2 ways of financial analysis:

There are three ways of financial analysis:
1. Horizontal analysis /trend analysis /: - as the name indicates in horizontal analysis, we compare financial
statement of a firm for different accounting periods.
 it gives an indication of the direction of change and refects whether the firm's financial performance
has improved, deteriorated or remained constsnt over time.
 Making use of comparative financial statement. e.g. I/S or balance sheet of period 2 with period 1
Note

 It is important to show both the dollar amount of change and the percentage of change because either one
alone might be misleading.
 In case where analysis of financial statements of large number of years is to be made, the horizontal
analysis becomes cumbersome. As result, it is recommendable to use trends relative to a certain base year.
(the base year is 100% )
2. Vertical analysis /common size statement/
Analysis of financial statements where a significant item on a financial statement is used as a base value
and other all items ate compared to it.
Example in the case of balance sheet, total asset as abases value. Each asset account expressed in
terms of total asset
- In the case of income statement, net sales as abase value. All expenses and net income are
expressed in terms of net sales.
 the primary objective of vertical analysis is to highlight relationship b/n components of
financial statements ,not to assess trends in individuals components over time
 it helps us to disclose the internal structure of an enterprise
 it indicates the existing relationship between each income statement account and
revenue
 shows the mix of assets that produce income and the mix of the source of capital
 it also helps us to further assess financial status of a firm in the industry
Example
Firm A Firm B
Asset:
Current asset 40% 60%
Fixed asset 60% 40%
Total 100% 100%
Note: firm B is more liquid than firm A
3. Ratio analysis
"A single figure by itself has no meaning but when expressed in terms of a related figure, it yields
significant inferences".
 Ratio analysis standardizes financial data by converting birr figure in the financial
statements into ratios. A financial ratio is a mathematical relationship among several
numbers usually stated in the form of percentage or times
 Ratio analysis helps us to draw meaningful conclusions and make interpretations about
a firm's:
-Financial conditions, and
- Performance
2.3 Basis of comparisons:
-Ratio, as yardsticks or financial flags of a firm’s overall performance, is meaningful only when compared
with other information.
Comparisons can be made in the following ways:
1. Industry standards /comparisons: are standards used to compare a firm’s financial conditions to that of the
industry average as a whole and reflects its performance in relation to its competitors.
E.g. Comparison of Ethiopian air lines performance with air lines industry average

2. Historical standards/trend analysis/: are standards used to compare current performance to past trends with
in the same firm and indicate the direction of change in performance. It helps us to determine whether the
firm’s financial conditions is improving or deteriorating.
3.Management goals for key ratios: are standards or plans set in advance for specific ratios or financial
statement accounts and serve as to assess the status of financial position and as a basis for evaluating actual
performance.
Examples, Management may se a net profit margin of 20 percent at the beginning and evaluate the actual
performance.
2.4 Types of financial ratios
Financial ratio classified into five categories. These are:
1. Liquidity ratios
2. Activity ratios
3. Leverage ratios
4. Profitability ratios
5. Market value ratio
Example,
ABC Company
Balance sheet
As of December, 31
(In thousands)
yr2001 yr2000
Assets:
Current assets:
Cash 675 450
A/R 1,050 700
Marketable securities 975 650
Inventory 1,900 950
Total current asset 4,600 2,750
Plant assets (net) 3,125 1,250
Total assets 7,725 4,000
Liabilities
Current liability 900 450
Ling term liability 1,800 800
Total liabilities 2,700 1250
Stockholders’ equity
Common stock (100par) 2,000 2,000
Retained earning 3,025 750
Total liabilities &SHE 7,725 4,000

ABC Company
Income statement
For the year ended, December 31
(in thousands)
yr2001 yr2000
Sales 2250 1800
Sales returns 375 300
Net sales 1875 1500
CGS 1000 850
GP 875 650
Operating expense:
Selling expense 300 200
General expense 105 60
Total expense 405 260
Income from operation 470 390
Other income 130 80
Earning before interest and tax (EBIT) 600 470
Interest expense 100 55
Earning before tax (EBT) 500 415
Income tax(40%) 200 166
Net income 300 249
1.liquidity ratios
“are a firm’s current assets sufficient to pay its current liability “
Liquidity ratios measure the ability of a firm to meet its short term obligations and reflect the short term
financial strength/solvency of a firm.
Two commonly used ratios are:
A. Current ratio:- measures a firm’s ability to satisfy or cover the claims of short term creditors by using
only current assets. That is, it measures a firm’s short term solvency or liquidity.
Current ratio =Current assets

Current liabilities
Current ratio for ABC (for yr2000)= 2750
450
=6.1 times
Interpretation: ABC has birr 6.1 in current assets available for every one birr in current liabilities.
 Low ratio-suggests that a firm may face difficulty in paying its short term obligations.

 High ratio- indicates that too much capital is tied up in current assets and a firm may be
sacrificing some return.
Note: the ratio highly exceeds the industry average (i.e. 2 times) so that ABC is able to pay its debts when
they are due.
 A reasonable higher (moderate)the ratio,

- the larger the amount of birr availability in current assets per birr of current liability
- the more the firm’s liquidity position
- the greater the safety of funds of short term creditors (i.e. less risk to creditors)
 A very lower current ratio results opposite from current ratio out lined as above. A low current ratio
could be improved by:
-long term borrowing to increase current assets
-liquidating current liabilities using long term financing
 A very high current ratio may indicate,
-excessive cash due to poor cash management
-excessive A/R due to poor credit management
-excessive inventories due to poor inventory management
- A firm is not making full use of its current borrowing capacity
There fore, a firm should have a reasonable current ratio.
B. Acid –test or quick – ratio: - measures the short term liquidity by removing the least liquid assets
such as:
- Inventories: are excluded because they are not easily and readily convertible in to cash.
More over, losses are most likely to occur in the event of selling inventories
- Prepaid expenses: are excluded because they are not available to pay off current debts.
Prepaid expenses include prepaid rent, prepaid insurance, prepaid advertising, supplies
Quick assets are:
 cash
 marketable securities
 receivables
Quick Ratio = Quick Asset
Current liabilities
or
= Current Assets- (Inventory+ prepaid expenses)
Current liabilities
Quick Ratio for ABC (for yr.2000) = 450+700+65 = 4 times
450
Or
2750.950 = 4 times
450
Interpretation: ABC has birr 4 in quick assets for every birr in current liabilities.
 The current ratio is a crude measure of a firm’s liquidity position as it takes into account all current assets
with out any distinction in their composition.
2) Activity ratios

These ratios are also called.
♦ Efficiency ratios or
♦ Asset- utilization ratios
Activity ratios are employed to evaluate the efficiency with which the firm manages and utilizes its
assets. These ratios are also called turnover ratios because they indicate the speed with which assets are
being converted or turned over into sales.
i.e Merchandise A/R

Cash
 Overall liquidity ratios generally do not give an adequate picture of company’s real liquidity due to
differences in the kinds of current assets & liabilities the company holds. Thus, it is necessary to evaluate
the activity ratio.
Example:-
ABC Café XYZ Café
(Birr) (Birr)
Cash 0 7000
Marketable security 0 17,000
AIR 0 5,000
Inventories 35,000 6,000
Total current asset 35,000 35,000
Current Liabilities
A/P 0 6,000
N/P 14,000 6,000
Accruals 0 2,000
Total current liability 14,000 14,000
The two cafeterias have the same liquidity (current ratio) but their composition is different.
CR = CA CR = CA
CL CL
=35000 =35000
14,000 14,000
= 2.5 times = 2.5 times
Activity (Asset utilization) Ratios include

1) A/R turnover ratio
2) A/P “ “
3) Inventory “ “
4) FA “ “
5) Total Asset “ “
1) A/R turnover ratio: - measures the liquidity if a firm’s accounts receivable. That is, it indicates how
many times or how rapidly A/R is converted into cash during a year. Financial analysts apply two tools
to judge he quality or liquidity of A/R.
⇒ A/R turnover
⇒ Collection period
A/R turnover = Net credit sales (Total sales)

Average A/R
A/R turnover for ABC (yr 2000) = 1500
700
= 2.14 times
AIR turnover for (yr 2001)= 1875

875*
= 2.14 times
*To compute average A/R sum up the last year A/R ( i.e beginning of this year) and the A/R of the current
year and divide by two .
Interpretation :- ABC’s A/R are converted into cash 2.14 times in year. A reasonably high A/R turnover
is preferable.
A ratio substantially lower than the industry average may suggest that a firm has:
♦ More liberal credit policy (i.e longer time credit period), poor credit selection, and
inadequate collection effort or policy which could lead.
 A/R to be too high
 Bad debts or uncorrectable Receivables
♦ More restrictive cash discount (i.e no or little cash discount) that could make sales to be too low.
A/R turnover = Net sales
A/R
Note: - As result of the above factors,

♦ The firm could have poor profitability position.
♦ The firm’s funds would be tied-up in receivable as payments by customers are delayed.
A ratio substantially higher than the industry average may suggest that a firm has:
♦ More restrictive credit policy (i.e. short term credit period)
♦ More liberal cash discount offers (i.e. larger discount and sale increase)
♦ More restrictive credit selection.
♦ More rigorous collection effort or policy
Note: the outcomes of a higher A/R turnover could be
♦ avoidance of the risk of bad debts
♦ Increase the firm’s profitability position.
♦ Small funds tied-up in A/R
♦ Customers pay quickly
A reasonable High ratio is required for a firm to be efficient in converting its A/R into cash.
If available, only credit sales should be used in the numerator as A/R arises only from credit sales.
Average collocation period (ACP)

Represents the average length of time a firm must wait to receive cash after making a sale. That is, it
indicates how many days a firm takes to convert receivable into cash or number of days sales are tied
up in A/R
ACP= 360 day ACP= Receivables
A/R turnover Average sales per day

= 360 days
Net sales
Average A/R
=360 x Average A/R

Net sales
= 360 x average A/R
Net sales
= 1 X Average A/R
net sales
360
1 X Average A/R
Average sales per day
= Average A/R
Average sales per day
ACP= 360 days Receivable

A/R turnover or Average sales per day
= 360 days = 700 = 700
2.14 1500 4.16
=168 days 360 =168 days
Assume, the credit term of ABC is 2/10 ,n/75.

Interpretation: - Customer of ABC, on the average, is not paying their bills on time as the ACP greater than
the credit term (75 days). In general, a reasonably short collection period is preferable.
ABC takes about 168 days to collect its A/R and this lengthy collection period suggests that the firm might
have potential problems in that:
♦ It isn’t effective in collecting its A/R
♦ It may give credit to marginal customers
♦ Thus, the firm’s profitability is adversely affected.
2) A/P turnover ratio :- measures how rapidly creditors are paid. That is, how rapidly or how many times
A/P are paid during a year.
Example, Assume for XYZ café net purchase (on credit) =150,000
A/P- Dec 31, 2000 30,000
A/P turnover = net purchase
A/P
= 150,000
30,000
=5 times
Interpretation :- Assume that industry average of A/P turnover is 6 times.

XYZ cafe pays its creditors lower times a year (i.e 5 times). Thus, it may be rated a risky borrower.
♦ Average payment period (APP):- measures the average length of time creditors must wait to receive their
cash or simply the average time needed by a firm to pay its A/P to creditiors or suppliers from which
purchase made.
APP= 360 days A/P

A/P turnover over Average purchase per
day
APP for XYZ cafe = 360 days

5 times = 72 days
Assume, suppliers on the average extend, say 60 days credit terms.

Interpretation: - XYZ café would be given a low credit rating (low credit worthiness). That is XYZ is a risky
borrower.
3. Inventory turn over: the frequency at which inventory is converted into sales/ A/R. That is how fast
inventory is sold or turned over?
Inventory turn over= CGS
Average inventory
Inventory turnover for ABC ( 2001) = 1000

950 + 1900
2
= 0.7 times
Note:- The average inventory is the average of beginning and ending balances of inventory.
Interpretation:- ABC’s inventory is sold out or turned over 0.7 times per year. It general, a high inventory
turnover ratio is better than a low ratio.
 An Inventory turnover significantly higher than the industry average indicates:
• Superior selling practices
• Improved profitability as less money is tied-up in inventory.
Possible problems of high inventory turnover
• Very low level of inventory (i.e under investment in inventory)
• Lost sales due to insufficient inventory (i.e risk of out of stock)
• Stoppage of production process for manufacturing firms.
A very low inventory turn over suggests:
• Excessive inventory or over investment in anticipation of strike or price decreases.
• Inferior quality goods, stock of un salable / obsolete goods.
Possible problems of a very low inventory turnover
- Cost of funds locked-up or tied up in inventory (opportunely cost)
- Deterioration
- Rental of space
- Insurance cost, properly tax, and other inventory carrying costs.
Average age of inventory (AAI):- The number of days inventory is kept before it is sold to customers.

AAI = 360 days
Inventory turnover
360 days
0.7
= 514 days
Interpretation: - ABC carries its inventory for 514 days.
The lengthening of the holding period shows a potently greater risk of obsolescence.
Operating Cycle: - is the number of days it takes to convert inventory and receivables to cash.
Inventory A/R Cash
AAI ACP
Operating cycle = AAI + ACP where, AAI, Average Age of Inventory
ACP, Average Collection Period
Operating cycle for ABC= 514 days +168 days
= 682 days
Interpretation :- ABC takes 682 days to convert inventory and receivables to cash.
A short operating cycle is desirable.
4) Fixed Asset turnover: - measures the efficiency of a business firm with which the firm has been using its
fixed assets to generate revenue
Fixed Assert turnover = Net sales
Net fixed asset.
Fixed Asset turnover = 1500
ABC (for 2000) 1250
=1.2 times
Interoperation:-ABC generated birr 1.20 in net sales for every birr invested in fixed assets.
Other things being equal, a ratio substantially below the industry average:
-Shows underutilization of available fixed assets. (i.e presence of idle capacity) relative to the industry.
-Indicates possibility to expand activity level without requiring additional capital investment.
 Shows over investment in fixed assets, low sales, or both.
-helps the financial manager to reject funds requested by production managers for new capital investments.
Suggests that sales should be increased, some fixed asses
Should be disposed of , or both.
♦ Other things being equal, a ratio higher than the industry average:
- Requires the firm to make additional capital investments to operate a higher level
of activity.
- Shows more efficiency in managing and utilizing fixed assets.
A firms fixed asset turnover is affected by:
- The cost of the assets.
- The time elapsed since their acquisition.
- The depreciation methods used
5. Total Asset turnover:- measures a firms efficiency in managing its total assets to generate sales.
=Net sales
Net total assets
(For year 2000) =1500
4000
= 0.375 times

Net total assets = Net fixed assets + Current Asset.
Depreciation is excluded.
Interoperation: - ABC generates birr 0.375 in net sales for every birr invested in total assets.
 A high ratio suggests greater efficiency in using assets to produce sale
 A low ratio suggests that ABC is not generating a sufficient volume of sales for the size of its
investment in assets. Therefore, ABC should take steps to :-
-increase sales
-Dispose of some of its investment in assets or both.
Caution has to be taken in making comparison b/n Asset turnover ratio of different organization because the
initial cost of fixed asset differs from one organization to another. Moreover, the method of depreciation
has its own impact on total asset turnover. Inflation has an impact. Comparing an old firm which had
acquired many of its fixed assets at low prices with a new company which had acquired at high price may
lead misleading.
Firm A (Meta Brewery) Firm B (Dashen Brewery)

 Old and well established company - New company
 Old fixed assets recorded at lower historical cost -New fixed assets purchased at higher
prices
 Tend to have higher fixed asset turnover -Tend to have lower fixed asset turnover
These differences could result from:
-Differences in net cost of fixed assets but not from differences operational
efficiencies. Thus, the analyst should consider these facts while comparing
Firm A and Firm B
3. Leverage, solvency and long term debt ratio
Solvency is a firm’s ability to pay long term debt as they come due.
Leverage shows the degree of indebtness of a firm.
There are two debt measurement tools. These are
A. Financial leverage ratio: measures degree of indebtness
B. Coverage ratio: measures ability to pay debt
A) Financial leverage. These ratios examine balance sheet ratios and determine the extent to which
borrowed funds have been used to finance the firm. It is the relationship of borrowed funds and owner’s
capital. This can be:
a) Debt ratio
b) Debt equity ratio
a) Debt ratio: the percentage of assets financed through debt
Debt ratio = Total Liability for ABC (yr 2000) 1250/4000=31.25%
Total Assets
Interpretation: creditors have financed ABC about 31 cents of every birr assets. It is obviously implies
that owners have financed 68.75 percent of total assets.
Higher ratio shows- more of a firm’s asset are provided by creditors relative to owners
-The firm may face some difficulty in raising additional debt.
-Further creditors may require a higher rate of return( interest rate) for taking higher
risk
Creditors prefer moderate or low debt ratio, because low debt ratio provides creditors more protection in case
a firm experiences financial problems.

b) Debt –equity ratio: expresses the relationship between the amounts of a firm’s total assets financed by
creditors (debt) and owners (equity). Thus, this ratio reflects the relative claims of creditors and
shareholders’ against the asset of the firm/
Debt-equity ratio= Total Liability
Stockholders equity
For ABC ( yr 2000)=1250/2750=45.45%

Interpretation: Lenders’ contribution is 0.45 times of stock holders’ contributions. That is.
0.3125/0.6875=0.4545
=Debt ratio
Equity ratio
=Total liability = Total liability X Total assets = Total Liability
Total assets Total assets Stockholders equity Stockholders equity
Stock holders equity
Total assets
B) Coverage ratio: these ratio measures the risk of debt by income statement ratios designed to determine
the number of times fixed charges are covered by operating profits. Hence, they are computed from
information available in the income statement.. It measures the relationship between what is normally
available from operations of the firm’s and the claims of outsiders. The claims of a firm are normally met
from the earnings or operating profits of the firm. These claims include loan principal and interest, lease
payment and preferred stock dividends.
The coverage ratios include:
A. Times Interest Earned Ratio: measures the ability of an a firm to pay interest on a timely basis.
= EBIT
Interest expense
For ABC ( yr 2001)=600/100= 6 times
Interpretation: ABC earning can cover 6 times its interest expense.
A low ratio suggests:
- Creditors are at more risk in receiving interest due.
-failure to meet interest payment can bring legal action by creditors possibly resulting in bankruptcy.
- The firm may face difficulty in raising additional financing through debt as it is more than similar firms.
A high ratio suggests the firm has sufficient margin of safety to cover its interest charges.
B. Fixed Charge coverage ratio: measures the firm’s ability to meet all fixed payment obligation, such as
loan principal, interest, lease payment and preferred stock dividends. It helps to assess the business
organization ability to meet all fixed payments.
Fixed charge coverage ratio= EBIT + Lease payments
Interest+ Lease Payment+( principal pmt+ P/stock dividend)
1-T
Where, T is tax rate.
Note: a firm’s fixed charges are examined on a before tax basis. Interest payments and lease payments are
made on a before tax basis, so no need of adjustment. Principal payments and preferred stock dividend are
not tax deductible and are paid from after tax earnings, a tax adjustment is necessary. That is, the payment
grossed up by dividing (1-T) to find the before tax income.
Example, assume, Interest expense: 100000
Lease payment: 50,000
Principal payment: 10,000

Preferred stock dividend: 20,000
Tax rate: 40 percent
Fixed charge coverage ratio= 600+50
100+50+(10+20/1-0.4)
3.25 times
Interpretation: ABC is able to cover its fixed charges 3.25 times.
If the ratio is lower:
-The firm may be unable to meet its fixed charges if earnings decline and may be
forced into bankruptcy.
-Creditors and preferred stockholders see the firm as more risky.
A high ratio suggests a good protection in the event of worsening financial position
4. Profitability ratio
These ratios are used to measure the management effectiveness. Besides management of the company,
creditors and owners are also interested in the profitability of the company. Creditors want to get interest
and repayment of principal regularly. Owners want to get a required rate of return on their investment. The
ratio includes:
A. Gross profit margin
B. Operating profit margin
C. Net profit margin
D. Return on investment
E. Return on equity
F. Earning per share
A. Gross profit margin
This ratio indicates management effectiveness in pricing policy, generating sales and controlling
production costs.
Gross profit margin= Gross profit

Net sales
For ABC( yr 2000) = 650/1500=43.3%

Interpretation: The company profit is 0.43 cents for each birr of sales.
A high gross profit margin ratio is a sign of good management. A gross margin ratio may increase by the
following factors:
 Higher sales price, CGS remaining constant
 Lower CGS, sales prices remaining constant
A low gross profit margin may reflect higher CGS due to the firm’s:
 Inability to purchase raw materials at favorable terms
 Inefficient utilization of plant and machinery
 Over investment in plant and machinery, resulting higher cost of production
The ratio also low due to a fall in prices in the market or marked reduction in selling by the firm in an
attempt to obtain large sales volume.
B. Operating profit margin: measures the percentage of operating profit to sales.
Operating profit margin= EBIT

Net sales

For ABC( yr 2000)=470/1500=31.3%
Interpretation: ABC generates 31 cents operating profits for each of birr sales.
C. Net profit Margin: measures the percentage of net income to sales.
Net profit margin= Net income

Net sales
For ABC (yr 2000) =249/1500=16.6%

Interpretation: ABC generates nearly 17 cents in net income for each of birr net sales.
D. Return on investment (ROI): measures the overall effectiveness of management in utilizing assets in
the process of generating revenue. It reflects how effectively and efficiently the firm’s assets are used.
This ratio is also called Return on Asset (ROA).
Or using Dupont formula: ROA= net profit margin X Total asset turnover
= Net income X Net sales
Net sales Total assets
ROA= Net income

Total assets = 249/4000=6.225% or
=0.06225x0.375=6.225%
Interpretation: ABC generates little more than 6 cents for every birr invested in assets.
E. Return on equity( ROE): measures the rate of return realized by stockholders on their investment.
ROE= Net income Or ROE= ROA X Equity multiplier

Stockholders equity Where, Equity multiplier= Total assets
Stockholder equity
Leverage ratio measures how the firm finances its assets. Basically, firms can finance with either debt or
equity. ROA= ROE, with only equity financing that asset is equal to stockholders equity and leverage
multiplier is 1.
For ABC (yr 20000=249/2750=9.05%
Interpretation: ABC generates about 9 cents for every birr in shareholders equity.
F. Earning per share (EPS) represents the amount of birr earned on behalf of each outstanding shares of
common stock.
EPS= Net income

No. of C/stock shares outstanding For ABC (2000) 249/20=12.45
Interpretation: ABC earns birr 12.45 for each shares outstanding.
5. Market Value ratio: these ratio are primarily used for investment decisions and long range planning
and include:

A, Price/ Earning ratio(P/E ratio): shows the amount investors are willing to pay for each birr of the firm’s
earnings.
P/E ratio= Current Market price per share

Earning per share
Or
P/E ratio= D1/E1
k-g
Where, D1/E1, is the expected dividend payout ratio
K, is the required rate of return for the stock
g, is expected growth rate in dividends.
Assume, that ABC year end Dec 31, 2000 market price of common stock is birr 115 per share.
P/E ratio=115/12.45=9.24 times.
Interpretation: the market is willing to pay 9.24 birr for every birr in earnings.
A high P/E multiplier often reflects the market’s perception of the firm’s growth prospects. Thus, if investors
believe that a firm’s future earnings potential is good and they may be willing to pay a higher price for the
stock.
B. Book value per share: is the value of each share of common stock based on the firm’s accounting records.
Book value per share= Total stockholders equity- Preferred stock

No. of common shares outstanding
For ABC (yr 2000) =2750-0/20=137.50 birr/share

C. Dividend Ratios. These can be: i) Dividend payout ratio
ii) Dividend yield
i) Dividend Payout ratio: shows the percentage of earnings distributed at the end of the accounting period. It
is the birr amount of dividend paid on a share of common stock outstanding during the reporting period.
Dividend payout ratio= Dividend Per share

Earning per share
Assume that ABC dividend per share is birr 2.49 Dividend payout ratio = 2.49/12.45=20%
Interpretation: ABC paid 20 percent of its earning as dividend. The higher the ratio may reflect the firms
lower growth opportunities.
ii) Dividend yield: shows the rate earned by shareholders from dividends relative to the current price of the
stock. Dividend yield is part of a stock’s total return.
Dividend yield= Dividend per share

Market price per share
For ABC Dividend yield = 2.49/115=2.17%
Limitation of Ratio analysis

The ratio analysis is a widely used technique to evaluate the financial position and performance of a business.
But there are certain problems in using ratios. The analysts should be aware of these problems. The following
are some of the limitations of the ratio analysis.
1. Many large firms operate different divisions in different industries, and for such enterprises it is
difficult to develop a meaningful set industry average.
2. Most firms want to be better than industry average approximations. So merely attains average
performance is not sufficient.
3. Non recognition of inflation in financial statement makes a ratio analysis difficult
4. Firms can employ a “ window dressing” technique to make their financial statement more stronger
5. Different accounting methods are employed by different enterprises.
Chapter Three
FUNDAMENTAL FINANCIAL CONCEPTS

3.1 Time value of Money
The recognition of the time value of money and risk is extremely vital in financial decision -making.
The welfare of owner's would be maximized when net worth or net present value is created form making a
financial decision. What is net present value? It is a time value concept.
If an individual behaves rationally, he would not value the opportunity to receive a specific amount of
money now equally with the opportunity to have the same amount at some future date. Most individuals value
the opportunity to receive money now higher than waiting for one or more years to receive the same amount.
Three reasons for this are
• Risk
• Preference for consumption
• Investment opportunities
Risk:- we live under risk or uncertainty. As an individual is not certain about future cash receipts, he prefers
receiving cash now.
Preference for consumption: most people have subjective preference for present consumption over future
consumption of goods and services either because of the urgency of their present wants or because of the risk
of not being in a position to enjoy future consumption that may be caused by illness or death, or because of
inflation.
Investment Opportunities: - Most individuals prefer cash to day to future cash because of the available
investment opportunities to which they can put present cash to earn additional cash.
Future Values
Interest: When A borrows money from B, then A has to pay certain amount to B for the use of the money.
The amount paid by A is called Interest.
Principal:- The amount borrowed by A from B is called principal.
Amount :( Total Amount):- the sum of the interest and principal is usually called the amount.
A). Simple Interest and the future Value:-

When interest is payable on the principal only, it is called simple interest.
E.g. Simple interest on birr 100 at 5% per annum will be birr 5 each year. i.e. at the end of one year, total
amount will be birr 105, at the end of second year, it will be birr 110 and so on.
 When money is put out at simple interest, the interest is payable for each year, but is not added to the
principal.
Let P be the principal and n, the number of years for which the principal is lent, r, the rate of interest
per annum.
Fn= P+ Pnr P (1 +nr)
Example 1. Find the future value if birr 20, 000 is borrowed at 6 percent simple interest for 3 months.
Here, 3 months is 3/12 = 1/4 of a year, so n = 1/4
Hence, Fv = p+pnr
=20,000 + 20,000 (3/12x 6%)
= 20,000+300 = birr 20,300
Example 2 Mamush has placed birr 500 in an employees’ savings account that pays 8% simple interest. How
long will it be, in months, until the investment amount to birr 530?
Fv= P (1+nr)
530 =500(1+nx8%)
530= 500(1+0.08n)
n=0.75 Years
N= 0.75x12 months
= 9 month
Example 3 At what annual rate of simple interest will an investment of birr 1000 for 2 years grow to the
amount of birr 1100?
F= p (1+nr)
1100= 1000 (1+2r)
r=5%
Simple Discount: present value
P= F
(1+ nr)
Example 1 How much will Mimi have to invest now in the 8% simple interest savings account in order to
have birr 600 a year from now ?
P= F
(1+nr)
= 600
(1+ 1x8%) = birr 555.56
Example 2 Find the present value of birr 1000 at 9% simple interest due 8 months from now.
P= F
(1+nr)
= 1000
(1+ 8/12 x 9%) = birr 943.40
B). Compound Interest and the future value

If the money is lent at compound interest, the interest is added each year to the principal and for the following
year the interest is calculated on their sum.
Let p be the principle and n, the number of years for which the principal is lent at i, percent per annum
compound interest.
Fn =P (1+i) n
Example 1 If you deposited birr 10,000 in NIB bank which was paying a 6% rate of interest compounded
annually on a ten year time deposit, how much would the deposit grow at the end of ten years?
Fv = P (1+) n
= 10000(1.06)10
= 10000(1.7908)
=Birr 17,908.48
Example 2
If Sara deposited birr 10,000 in Awash Bank which was paying a 6 percent rate of interest
compounded semiannually, on a ten year time deposit, How much would the deposit grow at the end of ten
years?
I=6%/2= 3%, since it is compounded semiannually,
n= 10x2 =20
Fv= p (1ti) n
= 10,000 (1.03)20
= 10,000(1.8061)
=birr 18,061.11
Exercise
If Fekadu deposited birr 8,000 in Dashen Bank which was paying a 4% rate of interest compounded quarterly
on an 8 year time deposit ,how much the deposit grow at the end of 8 years?
Fn =10,999.53
Example 3
A sum of money may double itself in n years, compounded at 12 percent interest annually. Find n ?
Fv= p(l+i)n
2P= P(l+i)n
2=(l+0.12)n
2=(1.12)n
log 2 = log 1.12n
log2= n log 1.12

n= log2
log 1.12
n= 0.301029
0.049218
= 6 years
Exercise
At 8% compounded annually, how many years will it take far birr 2,000 to grow to birr 3,000
F= p(l+i)n
3000=2000(1.08) n
3000 =1.08 n
2000
1.5 =1.08n

log 1.5 = log 1.08n
log 1.5=n log 1.08
n= log1.5
log1.08
n=0.17609  n=5.27
0.03342
Example 4, IF Ato Gebru Tsehayneh deposited birr 11,000 in commercial Bank of Ethiopia at i, rate of
interest compounded annually, on a 5 years time deposit, the deposit would be birr 14,720.48. Find the
interest rate?
Fv = p (l+i) n
14720.48= 11,000(l+i)5
14720.48 = (l+i) 5
11,000
1.338225 =(l+i)5
(1.338225)1/5= (l+i)
=1.05999= l+i
i=1.05999-1
i=6%
Exercise
Find the rate of interest that, compounded annually, will result in tripling a sum of money in 10 years.
Solution i=11.61%
Compound Discount: present Value
F= P (l+i) n
Dividing both sides of the future value formula by (l+i) n leads to
F = P
(l+i) n
By The definition of negative exponent,
P=F (l+i)-n
Example 1 Suppose that an investor wants to find out the present value of birr 20,000 to be received after 5
years. Her interest rate is 12% compounded annually. Find the present value?
P= F (l+i) -n
= 20,000(1.12)-5
20,000(0.5674)
Birr 11,348.54
Example 2 How much must be deposited now in an account paying 8% compounded monthly in order to
have just enough in the account 5 years from now to make a birr 10,000 down payment on a home?
P= F (l+i)-n i=8/12= 0.00666

=10,000(1+8/12%)-60 n= 5x12= 60
=10,000(0.671210)
= 6,712.10
Exercise 6

What sum of money deposited now at 8% compounded quarterly will provide just enough money to pay a
birr 1,000 debit due 7 years from now?
Solution =birr 574.37
Effective Rate
Because of lack of comparability, it is hard to judge whether interest quoted at 8 percent compounded
semiannually results in more or less interest than would be the case if the rate was 7.9 percent compounded
monthly. To make the comparison possible, we change both to their equivalent annual rates, there equivalents
are called effective rate.
Example: Birr 1 at 8 % compounded quarterly for one year would amount to

F= P(l+i) n
=1(1+8/4%) 4
= 1(1.02)4
=1.08243
Which is the same as, the amount of birr 1 at a rate of 0.08243, or 8.243% for one year.
F= 1(1.08243)1
= 1.08243
Similarly, Birr at 7.9% compounded monthly for one year would amount to
F= P(l+i)n
=1(1+7.9%) 12
12
=1.08192
Which is equivalent to the amount of birr 1 at a rate of 8.192 percent for one year.
Effective rate of i compounded m times a year

re= (l+i)m – l, where i = J
m
Where, J= nominal (annual rate)
m= compounded times a year
re= effective rate
Example 1 find the effective rate of 24% compounded monthly.
i = 24% = 2%
12
m= 12 months in a year.
re= (1+ 0.02)12-1
= 1.26824-1
= 0.26824
= 26.824%
Example 2 Find the effective rate of 15 percent compounded annually, semiannually, quarterly and weekly.
Annually: 15%, re =15%
Semiannually: re =15.563%
Quarterly: re = 15.865%
Weekly: re = 16.158%
Annuity Payments

An Annuity is a series of fixed payment (or receipt) in which each payment is made at the end / beginning of
the period. Annuity can be:
i) Ordinary Annuity
ii) Annuity Due
i) Ordinary Annuities: Future Value

An ordinary Annuity is a series of equal periodic payments in which each payment is made at the end of the
period.    Periods
0 1 2 3 n
Fv=R [(1+i) n-1] Where n=Number of periods

i i=Interest rate per period
p=Payment per period
Fv= future value of the annuity
Example. Supposes Martha deposits birr 1000 at the end of each year for 3 years at 6 % rate of interest. How
much would this annuity accumulate at the end of the third year?
Fu= R[(1+i)n-1]
i
=1000[(1.06)3-1]
0.06
=1000(3.1836)
Fv =birr 3183.60
Example 2: If birr 100 is Deposited in an account at the end of every quarter for the next 5 years, how much
will be in the account at the time of the final deposit if interest is 8 % compounded quarterly?
i=8%=2%
4
n=5x4=20
Fv=100[(1.02)20-1
0.02
=100[24.2974
= 2429.74
Exercise: When Derartu was born, her parents decided to deposit birr 500 every 6 months at the end for 15
years in an account earning 6% compounded semiannually. How much will be in account after the last
deposit is made?
F=R[1+i)n-1] i=6%/2=3%
i n=15X2=30
=500[(1.03)30-1]
0.03
=birr 23787.71
Ordinary Annuities: Sinking fund

A sinking fund is fund in to which periodic payments are made in order to accumulate a specified amount at
point in the future.
F= R [l+i) n-1]
i
R= F
[(1+i)n-1]
i
R=F[ i ]
n
(1+i) -1
Example: How much should be deposited in a sinking fund at the end of each quarter for 5 years to
accumulate birr 10,000 if the fund earns 8 % compounded quarterly?
N=5x4=20
i= 8%/2=2%
R=F[ i ]
(1+i)n-1
R=10,000 [ 0.02 ]
(1.02)20-1
=10,000(0.0411567) = birr 411.57
Ordinary Annuities: Present Value

Present value annuity calculations arise when we wish to determine what lump sum must be deposited in an
account now if this sum and the intersect it earns are to provide equal payments for a stated number of
periods, with the last payment making the account balance zero.
P=R[1-(1+i)-n]
i
Example 1
What sum deposited now in an account earning 8% interest compounded quarterly will provide quarterly
payments of birr 1000 for 10 years, the first payments to be made 3 months from now?
n=10x4=40
i=8%=2%
4
p=R[1-(1+i)-n]
i
=1000[1-(1.02)-40]
0.02
=1000(27.35548)
=birr 27355.48
Example 2.a) The directors of a company have voted to establish a fund that will pay a retiring accountant,
birr 1000 per month for the next 10 years , the first payment to be made a month from now. How much
should be placed in the fund if it earns interest at 12% compounded monthly?
b) How much interest will the fund earn during its existence?
a) p=R[1-(1+i)-n] n=10x12=120
i i=12%/12=0.01

=1000[1-(1+0.01)-120
0.01
=69,700.52
b) We have 120 payment X birr 1000=birr 120,000
Interest earned= 120,000-69700.52
=50299.48
Example. Ato Ayalkebet borrowed birr 5,000 to buy a television. He will amortize the 1000 by monthly
payments of birr R each over a period of 3 years. The payment is made at the end of each month.
a) Find the monthly payment if interest is 12% compounded monthly.
b) Find the total amount Ato Ayalkebet will pay.
a) P=R[1-(1+i)-n] I=12%=1%
i 12
5,000=R[1-01)-36 n=3x12=36
0.01
5,000=R[30.107505]
R=5,000
30.107505
R= 166.07
b) Ato Ayailkebet pays birr 166.07 a month for 36 months. The total paid will be
= 36x166.07 =5978.52 of which interest is 5978.52-5000=978.52
Exercise: A birr 70,000 car is to be purchased by paying birr 10,000 in cash and mortgage for 30 years at 12%
compounded monthly. The payment is made at the end of each month.
a) Find the monthly payment on the mortgage
b) What will be the total amount of interest paid?
a) P=R[ 1-(1+i)-n] i=12%/12=1%
i n=30x12=360
360
60,000=R[1-1.01)- ]
0.01
R=617.17
b) The total amount paid in 360 months will he
360x617.17=222,181.20
Interest paid will be 222,181.20-60,000
=162,181.20
ii. Annuity due: future value
Annuity due is a series of equal periodic payments in which each payment is made at the beginning of the
period.
_____________ Periods Fv=R[(1+i)n-1] (1+i)

0 1 2……..n i
Example, suppose Daniel deposits birr 1000 at the beginning of each year for 3 years at 6% rate of interest
How much would this annuity accumulate after the third year payment is made?
Fv=R[1+i)n-1](1+i)
i

=1000[(1.06)3-1](1.06)
0.06
=birr 3374.62
Example 2. If birr 100 is deposited in an account at the beginning of every quarter for the next 5 years, how
much will be in the account at the time of the final deposit if interest is 8% compounded quarterly?
Solution
Fv=R[(1+i)n-1] (1+i) n=5x4=20
i i=8%/4=2%
20-
=100[(1.02) 1(1.02)
0.02
=birr 2478.33
Annuity Due: present value
P=R[1-(1+i)-n](1+i)
i
Example. What sum deposited now in an account earing 8% interest compounded quarterly will provide
quarterly payments of birr 1000 for 10 years, the first payment to be made now?
n=10x4=40
i=8%/4=2%
P=R[1-(1+i)-n](1+i)
i
=1000[1-(1.02)-40](1.02)
0.02
=27,902.59
Example 2:
On September 1,2002 Zerfie borrowed birr 5,000 to buy a house. She will amortize the loan by monthly
payment of birr R starting from September 1,2001each over a period of 3 years. Find the monthly payment if
interest is 12% compounded monthly?
i=12%=1% n=3X12=36
12
-n
P=R[1-(1+i) ](1+i)
i
5000=R[1-(1.06)-36](1.01)
0.01
5000=R[30.40858]
R=164.43
Present value of a mixed stream
ABC company has been offered an opportunity to receive the following mixed stream of cash flows over the
next five years.
Year Cash flows
1 Birr 400
2 800
3 500
4 400
5 300
If the firm earn 9 Percent on its investment,

A) what is the future value for this opportunity
B) what is the present value for this opportunity
A) Future value
Year Cash flows
1. Birr 400x(1.09)1=
2 800x(1.09)2=
3. 500x(1.09)3=
4 400x(1.09)4=
5 300x(1.09)5=
Future value =
B) Present value
Year Cash flows
1. Birr 400x(1.09)1=366.80
2 800x(1.09)2=673.60
3. 500x(1.09)3=386.00
4 400x(1.09)4=283.20
5 300x(1.09)5=195.00
Present value =1904.60
Example 2, Assume that you can choose between receiving birr 3000 either as an ordinary three years, birr
1000 annuity or receiving birr 1500, birr 1000 and birr 500 at the end of years 1,2 and 3, respectively.
Which alternative would you prefer assume the annual interest rate was 10 percent?
Solution: To compare, you should compute the present value of each alternative and select the alternative
which result in higher amount of present value?
Alternative 1(Present value of ordinary annuity)
PV=R[ 1-(1+i)-n]
i
=1000[1-(1.1)-3 =2487
0.1
Alternative 2( Mixed stream)
Year Cash flow PV
1 1500 1500(1.1)-1=1363.5
2 1000 1000(1.1)-2=826
3 500 500(1.1)-3=375.50
Present value =2565, therefore, the second alternative is better.
A mixed stream with embedded annuity
Example1 A cash flows in the following years and interest of 12 percent per annum.
Year Cash flow Present value
1 10000
2 10000 10000[1-(1.12)-4 ] =30373
3 10000 0.12
4 10000
5 15000 15000(1.12)-5 =8511
6 16000 16000(1.12)-6 =8106
7 17000 17000(1.12)-7 =7690
Present value =54680

Example2,
Year Cash flow Present value
1 5000 5000(1.12)-1=4464.29
2 6000 6000(1.12)-2=4783.16
3 8000
4 8000 8000[1-(1.12)-3] (1.12)-2=15317.80
5 8000 0.12
6 9000 9000(1.12)-6=4559.68
Present value 29125
Perpetuities: Perpetuity can be defined as an annuity that has an indefinitely long life. Any perpetuity can be
discounted by dividing the value of one payment by the required rate of return. An important special case of
an annuity arises when the level stream of cash flow continues forever. Perpetuities are also called Consol.
Perpetuity present value X Rate = Cash flow
Pv x r = C
Therefore, given a cash flow and a rate of return, we can compute the present value very easily.
Pv for a perpetuity = C
r
Example, An investment offers a perpetual cash flow of birr 500 every year. The return you require on such
an investment is 8 percent, what is the value of this investment? The value of this perpetuity is:
Pv = C/r = 500/0.08=6250
Loan Amortization
Loan amortization refers to the determination of equal periodic loan payments necessary to provide a lender
with a specified interest return and repay the loan principal over a specified period.
Loan amortization schedule is a schedule of equal payments to repay loan . It shows the allocation of each
loan payment to interest and principal.
Example,
An individual borrow birr 6,000 at 10 percent and agree to make equal annual end of year payments over four
years.
Required: Prepare loan amortization schedule?]
Present value formula should apply to find the periodic loan payment.
Pv=R[1-(1+i)-n]
i

6000=R[1-(1.1)-4]
0.1
R= 6000
3.170
R= 1892.74
Loan Amortization schedule

1.End of year 2. Loan Payments End of Year
payment 3. Interest Principal 4=2-3 Principal 5=5-4
0 - - - 6,000
1 1,892.74 6,000x10% =600 1292.74 4,707.26
2 1,892.74 4,707.26 x10%=470.73 1422.01 3,285.25
3 1,892.74 3,285.25x 10%=328.53 1,564.21 1,721.04
4 1,892.74 1,721.04x10%=172.10 1720.64 0
Chapter Four
Risk, Return and Financial Asset Portfolios
Return: if you buy an asset of any sort, your gain (or loss) from that investment is called the return on your
investment. This return will usually have two components: income component and capital gain or capital loss
on the investment.
The rate of return can be calculated with the following formula:
Kt= Pt – Pt-1 + D
Pt-1
Where, kt, required rate of return
Pt, Price of asset at time t
Pt-1, Price of asset at time t-1
D, dividend paid
Example,
End of year Price of asset Dividend
1 birr 21 0
2 19 1
3 18 1
4 21 1.05
5 24 1.05
6 26 1.10
Required: calculate rate of return?
Year Pt Pt-1 D Kt
1 21 - 0 -
2 19 21 1 19-21+1/21= -0.0476

3 18 19 1 18-19+1/19= 0
4 21 18 1.05 21-18+1.05/18= 0.225
5 24 21 1.05 24-21+1.05/21= 0.1929
6 26 24 1.10 26-24+1.10/24 = 0.1292
Mean:
The mean of rate of return is calculated as follows:
Mean=∑r
n
Example,
The mean for the above example is 0.0476+0+0.225+0.1929+0.1292
5
=0.0999
=10%
Probabilities: Probabilities can be used to more precisely assess an asset’s risk. The probability of a
given outcome is its chance of occurring.
The expected value of a return: is the most likely return on a given asset
- n
K=∑ ki X Pri
i=1
Where, Ki= return for the ith outcome
Pri= probability of occurrence of the ith out come
n= number of out comes considered
K= the expected value of a return
Standard Deviation: The most common statistical indicator of an asset’s risk is the standard deviation.
It measures the dispersion around the expected value. The expression for the standard deviation of
returns, ‫ح‬k, is given as:
n
‫ح‬k= ∑(Ki-K)2 X Pri
Expected values of returns for assets A and B

Example
Asset A
Possible outcomes Probability (1) Return (%) (2) Weighted value (3) =(1)X(2)
Pessimistic 0.25 13 3.25

Most likely 0.50 15 7.50
Optimistic 0.25 17 4.25
Expected return = 15
Asset B
Possible outcomes Probability (1) Return (%) (2) Weighted value (3) =(1)X(2)
Pessimistic 0.25 7 1.75
Most likely 0.50 15 7.50
Optimistic 0.25 23 5.75
Expected return 15
Standard deviation of the returns for Assets A and B

Example,
Asset A
i ki k ki-k (ki-k)2 Pri (Ki-k)2 X Pri
1 13 15 -2 4 0.25 1
2 15 15 0 0 0.50 0
3 17 15 2 4 0.25 1
∑ (ki –k)2 X Pri = 2
Therefore, ‫ح‬kA= 2 =1.41%
Asset B
i ki k ki-k (ki-k)2 Pri (Ki-k)2 X Pri
1 7 15 -8 64 0.25 16
2 15 15 0 0 0.50 0
3 23 15 8 64 0.25 16
∑ (ki –k)2 X Pri = 32
Therefore, ‫ح‬kA= 32 =5.66%
In general, the higher the standard deviation, the greater the risk. The higher risk of asset B is clearly reflected
in its higher standard deviations.

Variance: shows how far the actual return deviates from the average in a typical year. It is the average
squared difference between the actual return and the average return.
Coefficient of variation
It is a measure of relative dispersion used in comparing the risk of assets with differing expected returns.
Cv= ‫ح‬k
K
Where, ‫ح‬k is standard deviation
K is expected value of return.
Example, Coefficient of variation for asset A is 1.41/15=0.094

Coefficient of variation for asset B is 5.66/15=0.377
Asset B has the higher coefficient of variation and is therefore more risky than asset A. The higher the
coefficient of variation is, the greater the risk.
Note: since both assets have the same expected return, the coefficient of variation has not provided any more
information than the standard deviations. The real utility of the coefficient of variation is in comparing assets
that have different expected returns.
Example,
Asset X Asset Y
Expected return 12% 20%
Standard deviation 9% 10%
Coefficient of variation 9/12=0.75 10/20=0.5
If the firm were to compare the assets only with standard deviations, it would prefer asset X, since asset X has
a lower standard deviation than asset Y. However, using coefficient of variations, risk is lower in asset Y than
asset X. Therefore, the use of the coefficient of variation to compare asset risk is effective because it also
considers the relative size, or expected return of the assets.
Covariance: statistical representation of the degree to which the returns on two assets move together over
time; calculated as the sum of the product of each asset’s deviation from its expected value over time divided
by the number of time periods. The covariance of asset A and B can be computed as follows:
‫ح‬AB= ∑ (rA-rA) (rB-rB)

n

Correlations
Correlation is a statistical measure of the relationship, if any, between series of numbers representing data of
any kind. If two series move in the same direction, they are positively correlated. If the series move in
opposite directions, they are negatively correlated. Correlation is a statistical representation of the degree to
which returns on two securities vary together over time, with a maximum value of +1 (perfect positive
correlation) and a minimum value of -1 (perfect negative correlation)
Correlation coefficient: a measure of the degree of correlation between two series.
 Perfectly positively correlated: describes two positively correlated series that have a correlation
coefficient of +1
 Perfectly negatively correlated: describes two negatively correlated series that have a correlation
coefficient of -1
 Uncorrelated: describes two series that lack only relationship or interaction and therefore have a
correlation coefficient close to zero.
Example, For positively correlated
- cyclical business, i.e having high sales when the economy is expanding and low
sales during rescission
For negatively correlated
- Counter cyclical business: having low sales during economic expansion and high sales
during recession
Coefficient correlation= Covariance

(Sd) (Sd)
Risk Preference
The three basic preference behaviors are
 Risk averse: the attitude toward risk in which an increased return would be required for an increase
in risk.
 Risk indifferent: the attitude toward risk in which no change in return would be required for an
increase in risk.
 Risk seeking: the attitude toward risk in which a decreased return would be accepted for an
increase in risk
Risk and time

The variability of the returns and the risk increases with the passage of time.
Risk of a portfolio
The risk of any single proposed asset investment should not be views independent of other assets. New
investments must be considered in light of their impact on the risk and return of the portfolio of assets. The
financial manager’s goal for the firm is to create efficient portfolio. Efficient portfolio is a portfolio that
maximizes return for a given level of risk or minimizes risk for a given level of return. The statistical concept
of correlation is useful in the process of diversification that is used to develop an efficient portfolio.
A Portfolio is a collection of securities held by a single investor, whether an individual or institution. The
main incentive for forming portfolios is diversification, which is the allocation of investable funds to a variety
of sources.
A perfect market is a market without any impediments to trading, such as transaction costs or costly
information. The assumptions are:
1. Securities markets operate with no transaction costs
2. All investors have free access to the complete body of information about everything relevant to the pricing
of securities.
3. All investors appraise this information in a similar way; that is, they have homogeneous expectations
4. Investors are interested only in the risk and expected return characteristics of securities. They seek
securities with higher expected returns and try to avoid risk.
5. All investors in the marketplace have the same one period time horizon.
The concept of dominance
When an investor has investment opportunities in which this risk/return trade off is not confronted, one
investment opportunity “dominates” the other. In establishing a definition of dominance, one security
dominates another if it meets at least one of the following three conditions:
A. One security offers greater expected return, but the same risk, than another security
B. One security offers the same expected return, but lower risk, than another security
C. One security offers greater expected return, but lower risk, than another security
Portfolio return and standard deviation
The return on a portfolio is calculated as a weighted average of the returns on the individual assets.
Kp= (w1 X k1) + (w2 X k2) + ……+ (wn X kn)
Where, Kp is portfolio return

Example, Wn= the proportion of the portfolio total value
Kn = the return on asset

A portfolio is to be constructed by investing birr 100,000 in three financial assets. The birr amounts
committed to each asset, the return value are as follows:
Asset Birr investment Return
A 20,000 9%
B 30,000 11%
C 50,000 14%
Total 100,000
Required: Calculate the expected return for portfolio?
The proportion (W) of each asset can be obtained as follows: Asset A (w1)= 20000/100000=0.2 and similarly
you can calculate for asset B and C. The proportion for asset B and C is 0.3 and 0.5, respectively.
Kp= (w1 X k1) + (w2 X k2) + ……+ (wn X kn)
= 0.2(9%)+0.3(11%)+0.5(14%)
=12.1%
Exercise:
If security A has an expected return of 10% and security B has an expected return of 15%, how should you
weight your holdings to get an expected return of 12%?
Solution
The sum of investment in security A and B must be 100%, therefore , we can write as
A +B =1……………..Equation 1
With the formula of expected return on portfolio 0.1A +0.15B =0.12…………..Equation 2
Solve the two equations simultaneously; the proportion security A and B is 60% and 40 %
Example,
Return
Year Asset A Asset B
1 14% 7%
2 9% 12%
3 12% 6%
4 4% 10%
5 11% 5%
Required: Compute
1. Variance and standard of asset A
2. Variance of asset B
3. Covariance of asset A and B
4. Coefficient of correlation between asset A and B
Solution:

Year rA rB ( rA-rA) (rB-rB) (rA-rA) (rB-rB) (rA-rA)2 (rB-rB)2
1 0.14 0.07 (0.14-0.1)=0.04 (0.07-0.08)=-0.01 -0.0004 0.0016 0.0001
2 0.09 0.12 (0.09-0.1)=-0.01 (0.12-0.08)=0.04 -0.0004 0.0001 0.0016
3 0.12 0.06 (0.12-0.1)=0.02 (0.06-0.08)=-0.02 -0.0004 0.0004 0.0004
4 0.04 0.10 (0.04-0.1)=-0.06 (0.10-0.08)=0.02 -0.0012 0.0036 0.0004
5 0.11 0.05 (0.11-0.1)=0.01 (0.05-0.08)=-0.03 -0.0003 0.0001 0.0009
∑ =-0.0027 0.0058 0.0034
1) The variance of asset A is 2) The variance of asset B is
‫ح‬A2=(rA-rA)2 ‫ح‬B2 = (rB-rB)2

n n
=0.0058 =0.0012 0.0034 =0.0007

5 5
3) The covariance of asset A and B is ‫ح‬AB= ∑ (rA-rA) (rB-rB)
n
=-0.0027/5= -0.0005
A positive covariance indicates that the values of two variables tend to increase and decrease together. A
negative covariance indicates that the two variables tend to move in opposite directions.
4) The coefficient correlation of asset A and B are computed as follows:
Coefficient correlation= Covariance
(Sd) (Sd)
CAB= ‫ح‬AB
( ‫ح‬A)( ‫ح‬B)
= -0.0005
(0.0346)(0.0265)
= -0.54
Exercise
ABC corporation owns a portfolio which consists of two common stocks: stock M and stock E. The amount
invested in each stock is birr 120,000 and birr 280,000, respectively. The rates of returns on each stock in
three economic conditions are given below.

Economic condition Probability Return on stock M Return on stock E
Recession 0.2 7% 6%
Stagnant 0.5 9% 10%
Expanding 0.3 12% 15%
Required:1) calculate expected rate of return on stock M and E?
2) The portfolio returns of stocks M and E?
Solution:
1) The expected return for stock M= 0.2(7%)+0.5(9%)+0.3(12%)
=9.5%
The expected return for stock E= 0.2(6%)+0.5(10%)+0.3(15%)
=10.7%
2) The portfolio returns of stock M and E
Stock Amount invested Proportion Return
M 120,000 0.3 9.5
E 280,000 0.7 10.7
Therefore, the portfolio return is 0.3(9.5%)+0.7(10.7%)
=10.34%
The formula for the variance of a two asset portfolio using the correlation coefficient is:
2
‫ح‬P=
Where wl and w2 are the proportion of the components of asst 1 and asset 2
1 ‫ ح‬and 2 ‫ ح‬are standard deviations of the components of asset 1 and 2
r1,2 is the correlation coefficient between the returns of component assets 1 and 2
Example, you are trading in a market that has only two securities available. Security A has an expected return
of 8 % and a standard deviation of 40 %. Security B has an expected return of 20% and a standard deviation
of 120%.
1. If you place 40 % of your money in A and the remaining 60% in B, what is your expected return?
2. If the correlation between the returns of securities A and B is 0.8, what is the variance and the standard
deviation of the portfolio?

Solution
1. The expected return on any portfolio depends on the percentage invested in each stock and the expected
return of the stock:
Expected return= 0.4(8%)+0.6(20%) =15.2%
2. The problem provides almost all of the information necessary to solve the formula for the variance of a
portfolio of imperfectly correlated assets:
You must remember that the variance of a security’s return is the square of the standard deviation so:
2
‫ح‬A=(0.4)2=0.16 and 2 ‫ح‬B=(1.2)2=1.44
and the proportion wl =40% and w2=60%
Therefore, Variance of portfolio= (0.4)2(0.16)+(0.6)2(1.44)+2(0.4)(0.6)(0.4)(1.2)(0.8)
=0.0256+0.5184+0.1843=0.7283
Standard deviation= square root of variance
= (0.7283)1/2=0.853=85.3%
Diversification and risk reduction
Increasing the number of financial assets in a portfolio is referred to as diversification. The portion of a
portfolio’s risk that can be reduced or eliminated by diversification is called diversifiable risk.( unsystematic
risk). It is unique to a particular firm and/or the industry in which it operates. The goods and services provided
by the industry, action of competitors, the quality of the firm management, operating leverage, capital
structure, financial leverage, and marketing strategies are some of the factors that combine to produce
unsystematic risk.
The portion of a portfolio’s risk that can not be eliminated by diversification is called non- diversifiable risk
(Systematic risk). It represents portion of total portion risk caused by factors that affect the prices of all
securities. Example, national economic and political development, business cycle, inflation, unemployment,
fiscal and monetary policy.
A portfolio that contains a large number of securities exhibits only systematic risk. An investor’s expected
rate of return holding a portfolio of risky financial assets is thus based on the expected rate of return and the
systematic risk contained in the portfolio and not on the risk-return characteristics of individual assets.
The beta coefficient
It is the slope of the security characteristic line, which shows the volatility of a security’s returns relative to
that of the market portfolio. It is index of systematic risk. This index measures the amount of systematic risk

contained in individual securities and portfolio relative to financial markets. This index also is used to
determine the rate of return that an investor expects from individual securities and portfolios. Systematic risk
is often referred to as market risk. Beta coefficient can be obtained for actively traded stocks form published
sources such as value line investment survey. The beta coefficient for the market is considered to be equal to
1.0, all other betas are viewed in relation to this value. Asset betas make take on values that are either positive
or negative, but positive beta is the norm. One important point for beta is beta tend to change in particular
ways over time.
Beta and their interpretation
Asset’s Beta Interpretation
Positive Move in same direction as market
Zero Unaffected by market movement
Negative Beta= Covariance of security
Move withdirection
in opposite market to market
Market variance
BA= ‫ح‬AM
2
‫ح‬m
Example, the following presents estimates of market returns and hypothetical security A.
Year Market risk (rm) Return of asset A (rA)
1 0.0830 0.115
2 0.2216 0.24
3 0.0089 0.0975
4 0.0306 -0.0652
5 0.1275 0.1123
6 0.2057 0.1879
7 0.13 0.1443
8 -0.007 0.1234
Required: compute
A. Variance of the market and asset A
B. Covariance of asset A and market
C. Beta coefficient
Solution:
Year (rm) (rA) (rA-rA) (rm-rm) (rm-rm)2 (rA-rA) (rm-rm)
1 0.0830 0.115 -0.0044 -0.0170 0.0003 0.0001

2 0.2216 0.24 0.1206 0.1216 0.0148 0.0147
3 0.0089 0.0975 -0.0219 -0.0911 0.0083 0.0020
4 0.0306 -0.0652 -0.1846 -0.0694 0.0048 0.0128
5 0.1275 0.1123 -0.0071 0.0275 0.0008 -0.0002
6 0.2057 0.1879 0.0685 0.1057 0.0112 0.0072
7 0.13 0.1443 0.0249 0.0300 0.0009 0.0007
8 -0.007 0.1234 0.0040 -0.1070 0.0114 -0.0004
∑ 0.8003 0.9552 0.0525 0.0369
Mean (rA )= ∑rA = 0.9552 =0.1194
n 8
Mean (rm) = ∑rm = 0.8003 =0.10
n 8
Variance of market ( 2 ‫ح‬m)= ∑(rm-rm)2 = 0.0525 = 0.0066
n 8
Covariance (‫ح‬Am)= 0.0369 = 0.0046
8
Beta (BA) = ‫ح‬AM =0.0046
2
‫ح‬m 0.0066
=0.6970
Note: a beta of 1.0 means that a security contains the same degree of systematic risk as found in the market. In
actual practice, all corporate beta coefficients have a value that is greater than zero and less than 3.0
Portfolio Betas
The beta of a portfolio can be easily estimated by using the beta of the individual assets it includes. Let wi, the
proportion of the portfolio’s total birr value represented by assets and bi, the beta of asset i, the portfolio beta,
Bp using Bi and wi as defined as:
Bp= ∑wi X Bi
i
Where, wi is the proportion of security
Bi is the beta value of each security
It states that the weighted average of the financial asset beta contained in portfolio.
Example, four financial assets are purchased with birr 50,000. The percentage composition of the portfolio
and its corresponding betas are:

Financial assets Birr investment Xi Bi
A 20,000 40% 1.3
B 15,000 30% 1.1
C 10,000 20% 1.0
D 5,000 10% 0.8
Required: 1) compute the portfolio beta (Bp)?
2) Suppose that asset A is sold for birr 30,000 and the proceeds are invested as asset E with a beta
of 1.4, compute the new portfolio beta?
1. Portifolio beta(Bp)= = ∑wiBi = wa X b1+wb X b2+wc X b3
i = 0.4(1.3)+ 0.3(1.1) + 0.2(1.0) + 0.1(0.8)
= 1.13
2. Financial assets Birr investment Xi Bi

B 15,000 25% 1.1
C 10,000 17% 1.0
D 5,000 8% 0.8
E 30,000 50% 1.4
Total 60,000 100%
Bp= 0.25(1.1)+0.17(1.0)+0.08(0.8)+0.5(1.4)
=1.21
Risk and Return: The Capital Asset Pricing Model (CAPM)

The most important aspect of risk is the overall risk of the firm as viewed by investors in the market place.
Overall risk significantly affects investment opportunities and the owner’s wealth. The basic theory that links
together risk and return for all assets is called the William Sharp’s Capital Asset Pricing Model (CAPM)
Types of risk
1. Diversifiable risk (unsystematic risk): is the portion of an asset’s risk that is attributable to firm specific,
random causes, can be minimized through diversification. It is unique risk or asset specific risk.
Example, A firm specific event such as strikes, lawsuits, regulatory action and loss of a key account.
3. Non diversifiable risk (systematic risk): is the relevant portion of an asset’s risk attributable to market
factors that affect all firms, can not be eliminated through diversification. It is also said to be market risk.

Example, war, inflation, international incidents and political events.
4. Total risk: is the combination of a security’s non diversifiable and diversifiable risk.
Total security risk= Non diversifiable + Diversifiable risk
Diversifiable risk
Risk
Non diversifiable risk Total risk
No of securities (Assets) in portfolio.

Any investor can create a portfolio of assets that will eliminate all diversifiable risk, the only relevant risk is
non diversifiable risk. Therefore, any investor must concern only with non diversifiable risk.
William Sharp CAPM Model

Ki = Rf + [bi (km- Rf)]
Where, Ki is required return of asset i
Rf is risk free rate of return
Bi is beta coefficient
Km is market return; the return on the market portfolio of assets.
The required return on an asset, Ki, is an increasing function of beta, bi, which measures non diversifiable
risk. In other words, the higher the risk, the higher the required return, and the lower the risk, the lower the
required return. The model can divide in to two parts:
1) the risk fee rate, RF and
2) the risk premium, bi(km-Rf)
The (km-Rf) portion of the risk premium is called the market risk premium, since it represents the premium
the investor must receive for taking the average amount of risk associated with holding the market portfolio of
assets.
Example, ABC corporation wishes to determine the required return of an asset Z that has a beta bZ if 1.5. The
risk free rate of return is 7 %, the return on the market portfolio of assets is 11%.
Required: Determine
1. Required return of asset Z
2. The market risk premium
3. The risk premium
Solution
Kz = Rf + [bi (km- Rf)]
7+[1.5 (11- 7)]
7+6
13

Market risk premium= km-Rf
= 11- 7
=4%
Risk premium= bi (km- Rf)
=1.5(11-7)
=6%
The security Market line (SML)

When the capital asset pricing model (CAPM) is depicted graphically, it is called the security market line
(SML). The SML reflects for each level of non diversifiable risk (beta) the required return in the market place.
SML
13 ………………………….
11 …………………
Return
7 ……Market risk…………Risk Premium……
premium
0 1 1.5 2
Beta(risk)

Chapter Five
Valuation of Financial Assets
Valuation concept is the process that links risk and return to determine the worth of an asset.
Bond Valuation
When a corporation or government wishes to borrow money from the public on a long term basis, it usually
does so by issuing or selling debt securities that is generally called bonds. A bond is normally an interest only
loan, meaning that the borrower will pay the interest every period, but none of the principal will be repaid
until the end of the loan.
Terminologies
Coupon: is the stated interest payments made on a bond
Face value: is the principal amount of a bond that is repaid at the end of the term. It is also called par value.
Coupon rate: is the annual coupon divided by the face value of a bond.
Maturity: is specified date at which the principal amount of a bond is paid
Example,
ABC corporation borrow birr 1000 for 10 years at interest of 8 percent. The corporation will pay 0.08x1000
=80 birr interest for 10 years. The birr 80 regular interest payments that the corporation promises to make are
called the bond’s Coupon. The par value is the amount repaid at the end and in this example it is birr1000.
The annual coupon divided by the face value is the coupon rate and it is 80/1000=8%.
Example,
Suppose that an investor purchases a four year debt instrument with the following payments promised by the
borrower.
Year Interest payment Principal payment Cash flow
1 birr 120 0 120
2 120 0 120
3 140 0 140

4 150 1000 1,150
Assume that the one year rates for the next four years are: r1=7%, r2=8%, r3=9%, r4=10%,
Required: Determine the current value or price of this debt instrument today?
Solution:
Po= a1 + a2 + a3 +…. An .
(1+r1) (1+r1)(1+r2) (1+r1)(1+r2) (1+r3) (1+r1)(1+r2) (1+r3)…..(1+rn)
Po= 100 + 120 + 140 + 1,150 .

(1.07) (1.07)(1.08) (1.07)(1.08) (1.09) (1.07)(1.08) (1.09) (1.10)
=1,138.43
Exercise
A birr 1000 face, 8% annual payment coupon bond with three years to maturity has a yield of 12%.
Required:
1) What is its price?
2) If the yield on the bond changes to 10% , which way do you expect its price to move? Why?
Solution:
1. The price is the present value of the three years worth of coupon payments plus the present value of the
face amount in three years discounted at 12%.
Po= a1 + a2 + a3 +…. An .
(1+r1)1 (1+r1)2 (1+r3)3 (1+rn)n
Po= a1 + a2 + a3 +…. An .
(1+r1)1 (1+r1)2 (1+r3)3 (1+rn)n
po= 80 + 80 + 80 + 1000
(1.12)1 (1.12)2 (1.12)3 (1.12)3
=903.92
Or
Price of a Bond can be computed using annuity

formula as
Po= R [1-(1+i)-n] +F(1+i)-n
i
Where, R is coupon paid each period
i is rate per period
n is number of periods
F is bond’s face value
P= 80 [1-(1.12)-3] +1000(1.12)-3
0.12
=903.92
2. Price with a 10% yield
Po= 80 + 80 + 80 + 1000
(1.1)1 (1.1)2 (1.1)3 (1.1)3
=72.73+66.12+60.11+751.31
=950.27

The prices of coupon bonds with fixed payments are inversely related to their yields. As one discounts
(divides) the fixed payments by a smaller yield, a larger price results. Notice that the present value of each
coupon payment has risen as the discount factor has fallen. A coupon bond’s nominal yield could fall
because the real rate of interest has fallen or, more likely, because the market’s opinion of expected
inflation has fallen. Changes in bond prices are directly related to time to maturity and inversely related
to bond yield.
Exercise
A birr 1000 face value, 10% coupon bond with semi annual payments and two years to maturity has a
yield to maturity of 8%.
Required:
a) Compute its price.
Solution,
The price is the present value of the actual payments. With semi annual payments, the investor will receive an
annual payment of 0.1(1000)=100 as two payments of 100/2=50 birr every six months. The annual yield of
8% must also be converted to a semi annual basis for a semi annual yield of (0.08/2)=0.04
Po= 50 + 50 + 50 + 1050
1 2 3
(1.04) (1.04) (1.04) (1.04)4
=48.04+46.23+44.45+897.54
=1,036.26
Exercise,
You are trying to decide between purchasing birr 1000 face value bonds with 10% annual coupons and one
year or two years to maturity. The expected real rate of interest is 3% and the expected inflation rate is 6%.
Required:
1. Compute the nominal yield for the one year bond
2. What is its price?
3. Compute the nominal yield for the two year bond
4. What is its price?
Solution,
1. The nominal interest rate is determined by the expected real rate and the expected inflation rate:
(1+R)= (1+r)(1+h)
(1+R)=(1.03)(1.06)
R=9.18%
2. The price of the one year bond is just the present value of the terminal payments, 0.1(1000)=100 in interest,
plus the face value:
P= 1100 =1,007.51
(1.0918)1
3. The two year nominal rate is determined by compounding the annual relationships:
(1+R)2= (1+r)2(1+h)2
(1+R)2=(1.03)2(1.06)2
(1+R)= (1.192)1/2=9.18%
Notice that this is identical to the nominal one year yield since the same interest rates are expected to hold ove
the two year interval.
4. The price of the two year bond is the present value of the two payments discounted at 9.18%

P= 100 + 1100
(1.0918) (1.0918)2
1
=91.59+922.80=1014.39
Common stock Valuation

A share of common stock is more difficult to value in practice than a bond for the following reasons:
 The promised cash flow are not known in advance
 The life of the investment is essentially forever since common stock has no maturity.
 There is no way to easily observe the rate of return that the market requires.
However, there are cases under which we can come up with the present value of the future cash flows for
a share of stock and thus determine its value.
A corporation doesn’t make a definite or explicit commitment to pay dividends to common stock holder.
However, when common stockholders invest their funds in a corporation, they also expect returns in the form
of dividends.
Common stockholders assume the highest degree of financial risk because they have residual rights on
dividends and up on liquidations. Because of these, common stockholders expect a higher return and that is
why cost of common stock is the most expensive.
On common stock, dividends:
- are never granted
- are not legally required, and
- are not fixed as in the case of preferred stock
Therefore, common stock dividends can increase, decrease, or remain constant.
Common stock cash flows
Common stockholders expect to be awarded through the receipt of periodic cash dividends and an increasing
or at least non declining share value. Like current owners, prospective owners and security analysts frequently
estimate the firm’s value. They choose to purchase the stock when they believe that it is undervalued ( i.e
that its true value is greater than its market price) and to sell it when they feel that it is overvalued ( i.e that
its market price is greater than its true value)
Common stock valuation model

Like bonds, the value of a share of common stock is equal to the present value of all future benefits it is
expected to provide. Simply, the value of a share of common stock is equal to the present value of all future
dividends it is expected to provide over an infinite time horizon. Although by selling stock at a price above
that originally paid, a stockholder can earn capital gain in addition to dividends, what is really sold is the right
to all future dividends. Therefore, from a valuation viewpoint, only dividends are relevant. The basic
valuation model is given as follows:
Po = D1 + D2 + . . . .+ Doo
(1+ks)1 (1+ks)2 (1+ks)oo
where, po= value of common stock
Dt= per share dividend expected at the end of year t
Ks= required return on common stock

The equation can be simplified somewhat by redefining each yea’s dividend, Dt, in terms of anticipated
growth. The growth can be seen into three cases:
1. Zero growth
The simplest approach to dividend valuation, the zero growth model, assumes a constant, non growing
dividend stream.
D1=D2=D3=…=Doo
Po= D1
Ks
The equation shows that with zero growth the value of a share of stock would equal the present value of
perpetuity of D1 birrs discounted at a rate Ks
Example,
The dividend of ABC company is expected to remain constant at birr 3 per share indefinitely. If the required
return on its stock is 15 percent.
Required: Determine the value of the stock?
Po= D1/ks= 3/0.15=birr 20
Since preferred stock typically provides its holders with a fixed annual dividend over its assumed infinite life.
This equation can be used to find the value of preferred stock.
2. Constant growth
The most widely cited dividend valuation approach, the constant growth model,assumes that dividends will
grow at a constant rate, g, that is less than the required return, ks (g<ks). Letting Do represent the current
dividend the equation can be rewritten as follows:
Po= Do(1+g)1 + Do(1+g)2 + …+ Do(1+g)oo
(1+ks)1 (1+ks)2 (1+ks)oo
If we simplify the equation it can be rewritten as follows:
Po = D1
Ks-g
The constant growth model is commonly called the Gordon Model.

Example,
A firm’s earnings for the next period are expected to be birr 2.50 per share. The firm follows a constant
payout policy, retaining 60% of all earnings for future investment. This reinvestment should generate a 6%
rate of growth in earnings. If the cost of capital for this firm is 11%, what share price should prevail?
Solution
First we must find the dividend for the next period. With a constant payout policy of paying 40% of earnings
and projected earnings of birr 2.50, the dividend for the next period is:
D1=0.4(2.50)=1.0
Using constant growth model,
Po = D1
Ks-g
= 1 =20 birr
(0.11-0.06)
The cost of common stock is calculated as follows:

Example,
ABC company issued common stock to investors for birr 20 per share and incurs a selling expense of birr 1
per share. The current dividend is birr 1.50 per share and is expected to grow at a 6% annual rate
Required: Compute the specific cost of this common stock?
Solution:
Po= birr 20 per share Ks= D1 + g
F= birr 1 per share Nps
Do= birr 1.50 per share Where, Nps is net proceeds of the new common stock ( Nps=Po-f)
g = 6% Po is current market price of the common stock
Nps= Po-f=20-1=19 F is flotation cost
D1=1.5(1.06)=1.59
Ks= D1 +g = 1.59 +0.06
Nps 19
=0.0837+0.06=14.37%
Example,
Dividend per share on a firm’s common stock is expected to be birr 1 in next year and is expected to grow at
6% per year perpetually. Assuming the market price per share is birr 25 and no flotation costs, compute the
cost of common stock to the firm.
Solution:
D1=1
G= 0.06 Nps=Po=25, because no flotation costs.
Ks= D1 + g
Nps
=1 +0.06 =0.04+0.06 =10%
2
Exercise
Refer the above example and compute the expected market value per share assuming the current dividend per
share is birr 1 (D0=1)
A. at the end of year 1
B. at the end of year 3
C. at the end of year 7
Solution,
Po= Dt
Ks-g
A) Po at the end of year 1

Po= Dl = Do(1+g)1 = 1(1.06)1 =26.50 birr
Ks-g ks-g 0.10-0.06
B) Po at the end of year 3
Po= D3 = Do(1+g)3 = 1(1.06)3 =29.79 birr
Ks-g ks-g 0.10-0.06
C) Po at the end of year 7

Po= D7 = Do(1+g)7 = 1(1.06)7 =37.40 birr
Ks-g ks-g 0.10-0.06

3. Variable growth (Multiple growth case)
Many firms grow at a rapid rate for a number of years and then now down to an “average” growth rate. Other
companies pay no dividends for a period of years, often during their early growth period. The constant growth
model is unable to deal with these situations therefore; the multiple growth model is needed.
Multiple growth is defined as a situation in which the expected future growth in dividends must be described
using two or more growth rates. Although any number of growth rates is possible, most stocks can be
described using two or possibly three.
A well known multiple growth rates model is the two stage growth rate model. This model assumes near term
growth at a rapid rate for some period (typically, 2 to 10 years) followed by a steady long term growth rate
that is sustainable ( i.e a constant growth rate). This can be described in equation form as
Po = n Do(1+g1)t + Dn(1+gc) 1
∑ (1+k)t k-g (1+k)n
t=1
Where, Po= the estimated value of the stock today
Do= the current dividend
g1= the supernormal ( or subnormal) growth rate for dividends
gc= the constant growth rate for dividends
k= required rate of return
n= the number of periods of supernormal (or subnormal) growth
Dn= the dividend at the end of the abnormal growth period
Conceptually, the valuation process is summing up the present values.

Po= Discounted value of all dividends through the unusual growth period n + the discounted value of the
constant growth model which covers the period n+1 to oo
Example,
ABC Corporation has been undergoing rapid growth for the last few years. The current dividend of birr 2 per
share is expected to continue to grow at the rapid rate of 20 percent a year for the next three years. After that
time ABC is expected to slow down, with the dividend growing at a more normal rate of 7 percent a year for
the indefinite future. Because of the risk involved in such rapid growth, the required rate of return on this
stock is 22 percent.
Required: calculate the implied price for ABC company stocks?
Solution:
To solve for the value of this stock, it is necessary to identify the entire stream of future dividends from year 1
to infinity, and discount the entire stream back to time period zero. After the third year a constant growth
model can be used which accounts for all dividends from the beginning of year 4 to infinity.
We first calculate the dividends for each individual year of the abnormal growth period. And we discount
each of these dividends at the required rate of return.
Present value
1
D1=2(1.2) =2.40 x(1.22)-1=1.97
2
D2=2(1.2) =2.88 x(1.22)-2=1.94
D3=2(1.2)3=3.46 x(1.22)-3=1.91
Present value of the first three years of dividends=5.82
P3=3.46(1.07) =24.68 x(1.22)-3=13.60
0.22-0.07
Present value of the stock at time period zero 19.42

Preferred stock valuation
The cost of preferred stock is the minimum rate of return required by preferred stockholders to purchase a
firm’s preferred stock. When a corporation sells preferred stock, it expects to pay dividend to investors in
return for their money capital. Dividend payments on preferred stock are made after interest payment on debt
and before dividend payment on common stock. Thus, both the risky ness of preferred stock to investor and
the resulting cost of issuing preferred stock fall some where between debt and common stock. It is hybrid
security, sharing features of both bonds and common stock.
Chapter six
Long term Investment Decisions (Capital budgeting decisions)

The capital budgeting decision process
The capital budgeting process involves generating long term investment proposals; reviewing, analyzing, and
selecting them; and implementing and following up on those selected. Why do financial managers give these
long term investment decision so much attention? Because long term investment represent sizable outlays of
funds that commit a firm to some course of action, procedures are needed to analyze and select applying
appropriate decision techniques. Attention must be given to measuring relevant cash flows and applying
appropriate decision techniques.
Capital budgeting: is the process of evaluating and selecting long term investments that are consistent with
the firm’s goal of owner wealth maximization. Capital budgeting and financing decisions are treated
separately. Once a proposed investment has been determined to be acceptable, the financial manager then
chooses the best financing method.
Capital expenditure motives
A capital expenditure is a plan for an outlay of funds by an enterprise that is expected to provide benefit over
a period more than one year, such as purchase of fixed assets. A current expenditure is an outlay resulting
in benefits received within one year. Fixed asset outlays are capital expenditures, but not all capital
expenditures are classified as fixed assets. Example. A 100,000 birr outlay for advertising that produces
benefit over a long period is a capital expenditure. How ever, it is not a fixed asset.
The basic motives for capital expenditure are to expand, replace, or renew fixed assets or to obtain some other
less tangible benefit over a long period.
- These expenditures have long- term effects and, once made, are not easily reversed.
- Sound capital investment decisions can lead to higher earnings and stock prices, which help the firm to
achieve its goal of maximizing share holder wealth. Capital budgeting is a dynamic process because
the firm’s changing environment may affect the desirability of current or proposed investments.
The capital budgeting process involves five major steps:
1. Generating project proposals
Proposals for capital expenditures are made by people at all levels with in the organization.
Investment proposals may be classified in to four distinct types

a) Expansion projects:- to increase existing capacity or to make new products or enter new
markets.
b) Replacement projects:- replacing worn out or obsolete facilities or equipments with new ones.
c) Renewal:- to upgrade or improve existing fixed assets such as rebuilding an existing machine.
d) Safety or environmental projects:- It is mandatory or non-revenue producing projects to
maintain good working condition required by government, labor unions, or insurance
companies such as expenditure on pollution control devices and ventilator.
2). Review and Analysis
The proposals are reviewed:
 To assess their appropriateness in light of the firm’s overall objectives and plans and, more important,
 To evaluate their economic validity. The proposed costs and benefits are estimated and then converted
into a series of relevant cash flows to which various capital budgeting techniques are applied to
measure the investment merit of the potential outlay. Evaluating project proposals using
a) Unsophisticated or traditional techniques eg. PBP, ARR
b) Sophisticated or time adjusted or discounted cash flow techniques eg. NPV, IRR
Estimating cash flows

Net cash flow = cash inflows – cash out flows. Non-cash expenses are added to net income.
Selecting projects which depends on:
 Project types:-Independent projects
-Mutually exclusive projects
 Availability of funds
 Decision Criteria: - ranking projects according to a prescribed rate or minimum acceptable rate of
return.
3) Decision making.
The actual birr outlay and the importance of a capital expenditure determine the organizational level at which
the expenditure decisions is made.
4). Implementation
Once a proposal has been approved and funding has been made available, the implementation phase begins.
Implementing and reviewing projects
 Implementation stage- involves developing formal procedures for authorizing the
expenditure of funds for capital projects
5). Follow up
Involves monitoring the results during the operating phase of a project. The comparisons of actual outcomes
in terms of costs and benefits with those expected and those of previous projects are vital. When actual
outcomes deviate from projected out comes, action may be required to cut costs, improve benefits, or possibly
terminate the project.
Basic terminologies
Some of the basic terminologies are
Independent versus mutually exclusive projects
The two most common project type are:
1) Independent projects and
2) Mutually exclusive projects.

Independent projects are projects whose cash flows are unrelated or independent of one another, the
acceptance of one does not eliminate the others from further consideration. If a firm has unlimited funds to
invest, all the independent projects that meet its minimum investment criteria can be implemented.
Mutually exclusive projects are projects that have the same function and therefore compete with one another.
The acceptance of one of a group of mutually exclusive projects eliminates all other projects in the group
from further consideration.
Capital rationing means that there is only limited birr available for capital expenditure and that numerous
projects will compete for these limited birrs. The firm must therefore ration its funds by allocating them to
projects that will maximize share value.
Conventional versus non conventional cash flow
Conventional cash flow patterns consist of an initial outflow followed by a series of inflows. For example,
a firm may spend 100,000 birr today and expect to receive cash inflow of birr 3000 each year for the next 40
years.
A non conventional cash flow is any pattern in which an initial outflow is not followed by a series of inflow.
For example, the purchase of a machine may require an initial cash outflow of birr 20, 000 and may generate
cash inflows of birr 4000 each year for 5 years and in the sixth year an outflow of 6000 may be required to
overhaul the machine , after which it generates inflow of 4000 each year for five years.
Cash flow principles

Estimating cash flaws is the most difficult task. The difficulty in estimating cash flows arises because of
uncertainty and accounting ambiguities. Mostly accounting data form the basis for estimating cash flows. If
care is not taken in adjusting the accounting data errors could be made in estimating cash flows.
Cash flow is a simple and objectively defined concept. It is simply the difference between birr received and
birr paid out. Cash flow should not be confused with profits. Changes in profits do not necessarily mean
changes in cash flaws. It is not uncommon in practice that firms experience cash shortages in spite of
increasing profits. Cash flow is not the same thing as profit, for two reasons: first, profit, as measured by an
accountant, is based on accrual concept- revenue is recognized when it is earned, rather than when cash is
received, and expense is recognized when it is incurred rather than when cash is paid. In other words, profit
includes cash revenues as well as receivables and excludes cash expenses as well as payables. Second, for
computing profit, only revenue expenditures are entirely charged to profits while capital expenditures are
capitalized as assets and depreciated over their economic life. Only annual depreciation is charged to profit.
Depreciation is an accounting entry and does not involve any cash flow. Thus, the measurement of profit
excludes some cash flaws such as capital expenditures and includes some non-cash items such as
depreciation. Cash flow ignores depreciation since it is a non cash item
Types of Cash Flows

The relevant cash flows used to make capital budgeting decisions include the initial investment, operating
cash inflows, and a terminal cash flow.
A typical investment will have three components of cash flows
1) Initial investment
2) Incremental cash flow (operating cash inflows)
3) Terminal cash flow.
All projects whether for expansion, replacement, renewal or some other purpose have the first two
components. Some, however, lack the terminal cash flow.
1) Initial investment

Initial investment is the net cash outlay in the period in which an asset is purchased. It refers to the relevant
cash out flows at time zero to be considered when evaluating a prospective capital expenditure.
It includes:-
• Installed cost of the new assets which comprises purchasing price (including accessories & spare
parts) insurance, transportation & installation costs.
• After tax proceeds from sale of old assets .(In case of replacement decisions )
• Change in net working capital. (when an asset is purchased for expanding revenues)
Initial investment= Installed cost – after tax proceeds ± Change in Net working capital
Installed cost= cost of new asset+ installation costs

After tax proceeds = proceeds from the sale of old asset ± Tax on sale of old asset.
Change in working capital= Current asset- current liability
Example
ABC Company is considering the purchase of a new grading machine to replace the existing one. The
existing machine was purchased three years ago at installed cost of birr 50,000; it was being depreciated
by the straight line method using an economic life of 5 years and scrap value of birr 3,000. The new
machine costs Birr 60,000 and requires birr 5,000 in installation costs is expected to have a useful life of
6 years and scrap value of birr 2,000. And with this new machine the firms current asset and current
liabilities will rise by birr 6500 and birr 4000, respectively. The old machinery could be sold at birr
25,000. The firm is under 40% tax bracket. Determine initial investment?
Solution
Initial investment = Installed cost- after tax proceeds + Net working capital.
Old machine
Cost =50,000
Scrap value = 3,000
ELF= 5 years
Depreciation = 50,000-3000
5
= 9400
Accumulated depreciation = 9400x 3
28,200
Book value= 50,000 -28,200
=21,800
Sale 25,000
Book value 21,800
Gain 3200
Tax (40%) 1280
After tax gain 1920

After tax proceeds = Book valve + after tax gain
= 21800 + 1920
= 23,720
or
Net working capital = current Asset- current liability.

= 6500- 4000
=2500
 Initial investment =60,000+5000 – 23,720+2500
= 43,780 birr
After tax proceeds form sale of existing plant Assets.

Case i) Selling price greater than original cost
Capital gain=proceeds- original cost
Assume selling price 100,000
Original cost 80,000
Capital gain 20,000
Note: tax rate for capital gain and ordinary gain may be different.
Case ii) Selling price is less than original cost but greater than book value
Gain = proceeds- Book value
After tax proceeds from sales of P/A = BV+ After tax gain
Case iii) selling price equal to Book value
After tax proceeds= Book value (or proceeds), since no gain or no loss.
Case iv) selling price less than Book value
After tax proceeds= proceeds + tax shield
Assume, Book value= 40,000
Selling price = 30,000
Tax = 40%
Loss= 30,000-40,000
(10,000)
Tax shield = 40 % x 10,000
=4,000
After tax proceeds= 30,000 +4,000
=34,000
Note: if the net proceeds from the sale are expected to exceed the book value, a tax payment shown as an
outflow (deduction from sale proceeds) would occur. When the net proceeds from the sale are below book
value, a tax rebate shown as a cash inflow (addition to sale proceeds) would result.
2. Incremental Cash flow
The incremental cash flows represent the additional cash flows-outflows or inflows that are expected to result
from a proposed capital expenditure. Given estimates of the revenue, expenses, and depreciation associated
with both the old and new asset, it is possible to estimate the operating cash flows for a replacement decision.
Accounting Income Vs cash flow
Depreciation expense is considered when we determine the net income but it is not out lay of cash on the
business organization.

Sunk cost:- out lay of a firm that have already been committed and hence, is not affected by the accept /
reject decisions under consideration. Sunk costs are not incremental costs & should not be included in the
analysis.
 Method 1 To compute incremental (relevant) cash flow :

1) Compute after tax cash flows of each proposal by adding back non- cash charges.
=NI after tax + Depreciation exp.
2) Deduct the cash inflows after tax result from the old asset from the cash inflow generated by the
new asset.
Or
Method 2
Incremental cash flow = (Increase in Revenue – Increase in cash charge) (1-Tax)
+ (increase in depreciation expense) (Tax rate)
Example 1
A new plant Asset:
Original cost = 80,000 with a useful life of 10 years
Annual revenue = 60,000
Annual operating cost = 25,000
An old plant Asset:-
Annual Depreciation expense = 7,000
Annual revenue = 50,000
Annual operating cost & expense = 30,000
Tax= 40%
Required: Determine incremental cash flow?
Method 1
New P/A Old P/A
Revenue 60,000 Revenue 50,000
Cost 25,000 Cost 30,000
Depreciation exp 8,000 33,00 Depreciation 7,000 37,000
EBT 27,000 EBT 13,000
Income tax (40%) 10,800 Tax (40%) 5,200
Net Income 16,200 Net income 7,800
Add: Depreciation exp 8,000 Add: Depreciation exp 7,000
Cash inflow from new Asset=24,200 Cash inflow from old Asset 14,800
Incremental cash flow =24,200-14,800

= 9,400
Method 2
Incremental = (Increase in Revenue – increase in cash charge) (1-Tax) + (increase in deprecation exp) (Tax)
Cash flow = [(60,000- 50,000) - (25,000-30,000)] (1-40%) + (8000-7000) (40%)
= [(10,000) - (-5000)] (60%) + (1,000) (40%)

= (15,000) (60%) + (1000) (40%)
= 9,000 +400
= 9,400
3) Terminal cash Flows
It is the after tax nonoperating cash flow occurring in the final year of the cash flow resulting from
termination and liquidation of a project at the end of its economic life.
Cash flows associated with a project’s termination generally include the disposal value of the project plus or
minus any taxable gains or losses associated with its sale. In most case, the disposal value at the end of the
projects useful life results in a taxable gain since its book value is usually zero. The terminal cash flow must
include the recapture of working capital investments required in the initial out lay.
Terminal cash flow= after tax proceeds from sale of new asset
– After tax proceeds from sale of old asset
± Change in net working capital
After tax proceeds from sale of new asset= proceeds from sale of new asset ± tax on sale of new asset
After tax proceeds from sale of old asset= proceeds from sale of old asset ± tax on sale of old asset
Example 1
A company expects to be able to liquidate a new office equipment at the end of its useful life at birr 60,000.
The office equipment will have a book value of birr 25,000.The old machine can be liquidated at the end of
the year to net zero because it will completely obsolete. The firm expects to recover its birr 15,000 net
working capital investment up on termination of the project. Assume a tax rate is 40%.
Required: Determine terminal cash flow?
Solution
After tax proceeds from sale of new Equipment Birr 60,000
Less: Book value 25,000
Taxable income (gain) 35,000
Tax (40%) 14000
After tax proceeds from new equipment 46,000
Less: After tax proceeds from sale of old Equipment 0
Add: Recovery net working capital 15,000
Terminal cash flow 61,000
Capital budgeting techniques

Capital budgeting techniques are used by firms to select projects that will enhance owner wealth.
It can be:
A) Traditional methods 1) Pay back periods
(Non-discounted methods) 2) Accounting rate of return
B) Discounted methods 3) net present value
4) Internal rote of return.
A) Traditional method( non-discounted method)
1) Pay back period (PBP)
i) Even cash in flow (annuity)

-is to measure the expected number of years to recover the original investment. If the project generates
constant annual cash in flows, the PBP is computed by dividing the initial investment by the cash inflow
through increased revenue or cost saving.
PBP= Initial Investment
Annual cash inflow
:
Example 1: Assume that initial investment of a project is 120,000 birr and yields after tax cash inflow of
25,000 for 10 years and the maximum pay back period set by firm’s managements is 5 years. The pay back
period of the project is
PBP= 120,000
25,000
=4.8 Years
Accept Reject Rule
Accept the project if the actual or computed pay back period is less than the maximum payback period
set by the firm otherwise the project is rejected. In ranking two projects having the same maximum allowable
payback, the project with shorter pay back period should be chosen because it pays for itself more quickly.
Therefore, accept the project because the payback period (4.8 years) is less than the Maximum allowable
payback period (5 years).
ii) Uneven cash in flow (mixed stream)

In case of unequal cash inflows, the payback period can be found out by adding up the cash inflows until the
total is equal to the initial investment.
Example 2
Compute the pay back period for the following cash flows, assuming a net investment of birr 25,000 and
target payback period of 3 years?
Year Net investment Cash in flows
0 25000 0
1 10000
2 7000
3 6000
4 2000
5 2000
Solutions
Year Net cash inflows Commutative net cash inflows
1 10,000 10,000
2 7,000 17,000
3 6,000 23,000
4 2,000 25,000
5 2,000 27,000
Payback period= 4 years
Reject the project as the computed payback period of 4 years is greater than the target payback period of 3
years.
Example 3

Melat pvt ltd.co is evaluating two projects with the following cash inflows.
Year Cash inflows
Project A Project B
0 (56,000) (56,000)
1 14,000 22,000
2 16,000 20,000
3 18,000 20,000
4 20,000 14,000
5 25,000 17,000
Requited: - Compute the PBP for each project and, show which one is more desirable?
Solution
Cumulative net cash inflows
Year Project A Project B
1 14,000 22,000
2 30,000 42,000
3 48,000 62,000
4 68,000 76,000
5 93,000 93,000
PBP for project A=3 years +56,000-48,000
68,000-48,000
= 3Years +8,000
20,000
= 3Years +0.4
= 3.4 Years
PBP for project B= 2 Years + 56,000-42,000
62000-42000
= 2 Years +14,000
20,000
= 2 Years + 0.7 Years
= 2.7 Years
Melat should prefer project B over project X because it has a shorter payback period of 2.7 Years
Advantage of payback period
1) It is easy to understand and easy to calculate.
2) It costs less than most of the sophisticated techniques which requires a lot of the analyses time & the
use of computers.
3) It provides a crude measure of risk because it considers projects with shorter payback period as less
risky.
4) It measures the time required for a project to recover the initial investment & there fore, it provides a
measure of liquidity.
Disadvantage
1) It doesn’t measure the profitability of investment because it ignores cash inflows earned after the
payback period.
For example, consider the following project X&Y
Project x Project y
Initial Investment 15,000 15,000
Cash Inflows

Year 1 5,000 4,000
2 6,000 5,000
3 4,000 6,000
4 0 8,000 Ignored
5 0 9,000 “
6 0 3,000 “
PBP: project X=3 years
Project Y=3 years
As per the payback rule both the projects are equally desirable since both return the initial investment in 3
years. However, from profitability point of View, project Y is more attractive than project X.
2. It ignores the time value of money for it fails to consider the magnitude and timing of cash inflows.
Project x Project y
Project cost 15,000 15,000
Cash inflow year
1 10,000 1,000
2 4,000 4,000
3 1,000 10,000
Total cash inflows 15,000 15,000
Both projects have the same PBP, but project X would be more acceptable because of the time value of
money. Cash today is better than cash tomorrow.
3. It biases capital budgeting decisions in favor of short- term projects and against long term projects.
2. Accounting Rate of Return (ARR):- measure profitability of the capital investment from conventional
accounting stand point by relating or associating accounting NI with initial investment.
- Tells us the percentage of net income that has already generated a result of commitment of certain
money.
- It is based on accounting information rather than on cash flows.
- Depreciation is a non-cash flow expense, so, it should be added with net income to come up with the
cash flow(NI=CF- Depreciation )
ARR = NI .
Average investment
.
Example 1,
Anwar Company is considering an investment in x- project based on the following information:
Initial Investment= 15,000
Annual net income = 3,000
Useful life= 5 years
Target ARR= 30 %
ARR= NI
Average investment
= 3,000
15,000 Average
2
ARR= 40%

Accept Reject Rule: Accept the project if the computed ARR is Greater than the minimum target ARR set by
the firm otherwise the project is rejected.
Anwar company should accept the investment in x- project because the actual ARR (40%) is greater than the
target ARR of 30 %
Example 2
Asteway co is considering an investment in project X based on the following information.
Initial investment= 15,000
Annual cash inflow= 4,500
Useful life= 5 years (straight line method of depreciation is used)
Target ARR= 30 %
Required: Determine ARR?
Solution
Deprecation exp =15,000
5 years
= 3,000
NI=CF- Depreciation EXP
=4,500-3,000
=1,500
NI .
ARR= Average Investment
=1500
15,000 Average
2
=15,000
7,500
ARR= 20%
Asteway co should reject the investment in project X because the actual ARR (20%) is less than the target
ARR of 30%
Exercise
A project will cost 60,000 birr. Its stream of earnings before deprecation and taxes during first year through
five years is expected to be birr 20,000, 22,000, 25,000, 27,000& 29,000, respectively. Assume estimated life
and salvage value is 5 years & 500 birr, respectively. Again assume income tax rate is 55% .Target ARR is
15%. Depreciation is to be computed on straight line method.
Required: Determine ARR?
Solution
Year Profit before deprn & tax Deprn.exp Profit after deprn Tax (55%) NI
1 20,000 11,000 9,000 4950 4050
2 22,000 11,000 11,000 6050 4950
3 25,000 11,000 14,000 7,700 6,300
4 27,000 11,000 16,000 8,800 7,200
5 29,000 11,000 18,000 9,900 8,100
Total Net income 30,600
Average Annual net income=30600
5
= 6120

Deprn Exp= 60,000-5000
5 Average net investment= (cost of machine-Salvage) +Salvage
2
=11,000 = (60,000-5,000) +5000
2
=32,500
ARR= NI .
Average investment
= 6120 =18.83%
32,500
There fore, the project is accepted because the computed ARR is greater than the target ARR.
Advantages of ARR
1. It is easy to calculate.
2. It is understandable
3. It considers the entire stream of income in calculating the project’s profitability.
Disadvantages of ARR
It uses accounting income rather than cash flows.
It ignores the time value of money
B) Discounted methods
3) Net present Value (NPV)
It is one of the discounted cash flow (DCF) techniques explicitly recognizing the time value of money.
NPV should be found out by subtracting initial investment from present Value of cash inflows.
Steps in the calculation of NPV
1. Net cash flows of the investment project should be forecasted based on realistic assumptions.
2. Appropriate discount rate should be identified to discount the forecasted cash flows. The
appropriate discount rate is the firms opportunity cost of capital which is equal to the required rate
of return expected by investors on investments of equivalent risk.
3. Compute the present value of net cash flows & summing up to come up the present value of the
net cash flows generated by the project
4. Compute the excess of sum of present value over the initial investment.
NPV=∑ of PV- Initial Investment.
Accept Reject Rule

. Accept if NPV>0(i.e. NPV is positive)
. Reject if NPV<0(i.e. NPV is negative)
. Project may be accepted if NPV=0
Example 1
A company is considering the following investment projects.
Net cash in flows:
1 12,000 5,400
2 10,000 8,000
3 8,000 10,000
4 5,400 12,000

Total 35,400 35,400
Assume initial investment is 25,000 and discount rate is 12% .Determine NPV of project A& project B?
Project A
Year NCF Pvat 12% Pv of cash inflows
1 12,000 (1.12)-1 = 10714.3
-2
2 10,000 (1.12) =7971.93
3 8,000 (1.12)-3 = 5694.24
4 5,400 (1.12)-4 = 3431.79
Present Value= 27812.26
Less: Initial Investment= 25,000
NPV= 2812.26
Project B
Year NCF PVAT 12% Pv of cash inflows
1 5400 (1.12)-1= 4,821.43
2 8,000 (1.12)-2= 6,377.55
-3
3 10,000 (1.12) = 7117.80
4 12,000 (1.12)-4= 7626.22
Present Value= 25943
Less: Initial invest=25,000
NPV= 943
Therefore, both project A & B are acceptable since their NPV Positive.
Mutually exclusive Decisions

Two or more investment are said to be mutually exclusive when accepting one of them excludes all others
from being accepted. Mutually exclusive decisions occur whenever a corporation receives competitive bids
for a given project. The bids are mutually exclusive because the winning bid exclude all other bids from being
accepted.
4) The Internal Rate of Return

The internal rate of return (IRR) of an investment proposal is defined as the discount rate that produces a zero
NPV. Thus, the actual rate of return that a project earns profits and the time value of money are taken into
account.
i) When cash flows are in Annuity form
When the cash flows of an investment are in annuity form, its IRR can be computed very easily.
Example,
A project that required a net investment of birr 100,000 produces annual cash flows for 16 years each of birr
14,000 and a required rate of 10%. The IRR for this project is found by dividing the value of one cash flow
into the net investment and locating the resulting quotient in the present value annuity table
100,000/14,000=7.143
Table value IRR
7.379 11%
6.974 12%

Thus, the IRR for this project is between 11% and 12 % and computed as follows:
1. Identify the closest rates of return
2. compute the NPV for each of these two closest rates
NPV at 11% = 14,000/(7.379)-100,000=3,306
NPV at 12%=14,000/(6.974)-100000= -2,364
3. Compute the sum of the absolute values of the NPVs obtained in step2
4. Divide the sum obtained in step3 into the NPV of the smaller discount rate identified in
step 1. Then add the resulting quotient to the smaller discount rate
3,306/5670=0.58
IRR=11%+0.58=11.58%
Accept if IRR is greater than the cost of capital. Therefore accept the project.
When cash flows are not in Annuity form
When the cash flows of an investment are not in annuity form, the computation of its IRR can become
tedious. In order to minimize the difficulty, it is necessary to make a good first guess at the project’s IRR and
apply interpolation methods.
Example,
A project with a net investment of birr 60,000, a required rate of return of 13 %, and the following cash flows:
Year CF
1 20,000
2 20000
3 20000
4 15000
5 15000
6 15000
Required: Calculate the IRR?
Guess at 20 % and compute the Npv, the Npv=405
At 21% the Npv= -940
Then the IRR with interpolation computed as follows:
Interest NPV
20% 405
IRR 0
21% -940
There fore, IRR=20%+(0-405) (21-20)%
-940-405
20%+405 (1)%
1345
20%+0.3%
IRR= 20.3%
Conflicting ranking
Conflicting ranking using NPV and IRR result from differences in the magnitude and timing of cash flows.
Which approach is better NPV or IRR? On a purely theoretical basis, Npv is the better approach to capital
budgeting but evidence suggests that in spite of theoretical superiority of Npv, financial manager prefer to use
IRR. The preference for IRR is attributable to the general disposition of business people toward rates of
return rather than actual birr amounts.
Capital Rationing Decisions

Capital rationing happens when a situation in which a corporation is unable to finance its entire capital
budget.
Example,
Assume that a corporation is considering three independent capital budgeting projects. The corporation
advertises for competitive bids on each project. One bid is received on project A, three bids are received on
project B, and two bids are received on project C. the corporation’s financial managers then calculate the
following net investments and NPV coefficients on all the bids for each project:
Net investment NPV
Project A
Bid A-1 3,000,000 250,000
Project B
Bid B-1 3,000,000 200,000
Bid B-2 3,500,000 250,000
Bid B-3 4,000,000 225,000
Project C
Bid C-1 5,000,000 300,000
Bid C-2 6,000,000 325,000
Since only one bid is available for project A, it is evaluated on accept /reject basis. The bid is acceptable
because its NPv is positive.
The three bids on project B are mutually exclusive B-2 is chosen because it shows the largest positive Npv.
The two bids on project C are also mutually exclusive. C-2 is chosen.
In the absence of capital rationing, the capital budget would consist of alternatives A-1,B-2 and C-2. The total
investment required in order to adopt this budget is 3 million+3.5 million+6 million=12.5 million. If 12.5
million is available, the capital budget can be adopted. However, if only 12 million is available, capital
rationing exists because the funds needed for the capital budget exceed the amount of funds available.
The decision rule for capital rationing problems selects a capital budget from sets of feasible investment
alternatives. A group of investments alternatives is called a feasible set when it meets the following
conditions:
1. The set contains no mutually exclusive alternatives.
2. The total net investment required for the set does not exceed the net investment
constraint, or capital constraint.
3. When all the feasible sets have been identified, choose the set of feasible investment
alternatives that contains the largest total
Feasible sets for projects A,B,C for a capital rationing
Examples,
Feasible set Net investment NPV
A-1,B-1,C-1 11 million 750,000
A-1,B-1,C-2 12 million 775,000
A-1,B-2,C-1 11.5 million 800,000
A-1,B-3,C-1 12 million 775,000
The feasible project with capital rationing is A-1,B-2, and C-1.
Methods for incorporating risk in to capital budgeting

Expected cash flows and expected net present value
Under conditions of risk, a separate probability distribution is used to summarize the possible net investments
or cash flows for each year. The first step in evaluating the desirability of a risky project is to compute the

expected value of each probability distribution. This is obtained by multiplying each possible cash value by its
probability of occurrence and adding the resulting products.
Et=∑(fi) (pi)
I
Where, fi is possible cash value i for year t
Pi is probability of occurrence of fi
Et is expected value
Example, Expected values of cash flow and probability distributions are as follows:
Cash flow Probability
Year1 2000 0.3
4000 0.4
6000 0.3
Year 2 1000 0.1
3000 0.5
7000 0.4
El= 0.3x2000+0.4x4000+0.3x6000
=4000
E2=0.1x1000+0.5x3000+0.4x7000=4400
Expected Net present value
The expected net present value of a capital budgeting alternatives, ENpv, is computed as follows. Let k*
represent the risk free rate of return, then:
ENPV=∑ . Et
t=0 (1+k*)t
Example,
Possible Net Investment Probability
(4,000) 0.3
(5,000) 0.4
(6,000) 0.3
The bracket (negative) values indicate that a net investment is a cash outflow. This probability distribution
has an expected value of (5,000)
Et
Year 0 (5,000)
Year 1 4,000
Year 2 4,400
If the risk free-rate of return is 8 percent, the NPV statistics for this project are calculated as follows. The
expected NPV is computed
ENPV = -5,000 + 4,000 + 4,4000

(1+0.08)0 (1 +0.08)1 (1 +0 .08)2
=-5000+3703.70+3772.09
= 2,076

Sensitivity and scenario analysis
Two approaches for dealing with project risk to capture the variability of cash inflows ans NPVs are
sensitivity analysis and scenario analyses.
Sensitivity analysis is a behavioral approach that uses a number of possible values for a given variable, such
as cash inflows, to asses its impact on the firm’s return, measured by NPV. In capital budgeting, one of the
most common sensitivity approaches is to estimate the NPVs associated with pessimistic, most likely, and
optimistic cash inflow estimates. By subtracting the pessimistic outcome NPV from the optimistic outcome
NPV, the range can be determined.
Example, Assume ABC Company’s financial manager made pessimistic, most likely and optimistic estimates
of the cash inflows for each project. The cash inflow estimates and resulting NPVs in each case are
summarized as follows.
Sensitivity analysis of ABC’s projects X and Y
Project X Project Y
Initial investment Birr 10,000 Birr 10,000
Annual cash inflows
Outcome
Pessimistic Birr 1,500 Birr 0
Most likely 2,000 2,000
Optimistic 2,500 4,000
Range 1,000 4,000
Net present values*
Outcome
Pessimistic Birr 1,409 Birr -10,000
Most likely 5,212 5,212
Optimistic 9,015 20,424
Range 7,606 30,424
* The values were calculated by using the corresponding annual cash inflows. A 10 percent cost of capital and
a 15 year life for the annual cash inflows were used.

Comparing the ranges of cash inflows (birr 1000 for project X and 4000 for project Y) and, more important,
the ranges of NPVs (birr 7,606 for project X and birr 30,424 for Y) makes it clear that project X is less risky
than project Y. Given that both projects have the same most likely NPV of birr 5,212, the assumed risk averse
decision maker will take project X because it has less risk and no possibility of loss.
Scenario analysis, which is a behavioral approach similar to sensitivity analysis but broader in scope, is used
to evaluate the impact of various circumstances on the firm’s return. Rather than isolating the effect of a
change in a single variable, scenario analysis is used to evaluate the impact on return of simultaneous change
in a number of variables, such as cash inflows, and the cost of capital, resulting from differing assumptions
relative to economic and competitive conditions. For example, the firm could evaluate the impact of both high
inflation (scenario 1) and low inflation (scenario 2) on a project’s NPV. Each scenario will affect the firm’s
cash inflows, cash outflows, and cost of capital, thereby resulting in different levels of NPV. The decision
maker can use these NPV estimates to roughly assess the risk involved with respect to the level of inflation.
Certainty Equivalent
One of the most direct and theoretically preferred approaches for risk adjustment is the use of certainty
equivalents, which represents the percent of estimated cash inflow that investors would be satisfied to receive
for certain rather than the cash inflow that investors would be satisfied to receive for certain rather than the
cash inflows that are possible for each year. The basic expression for NPV when certainty equivalents are
used for risk adjustment is as follows:
NPV=∑et X CFt - I
(1+Rf)t
Where, et is certainity equivalent factor in year t (0≤ et≤1)
CFt is relevant cash inflow in year t
Rf is risk free rate of return
The equation is shows that the project is adjusted for risk by first converting the expected cash inflows to
certain amounts, etXCFt, and discounting the cash inflows at the risk free rate, Rf.
Example, ABC Company wishes to consider risk in the analysis of two projects, A and B. The cost of capital
is 10 percent when considering risk. The project cash flows are as follows
Project A Project B
Initial investment Birr 42,000 Birr 45,000
Year Cash flows
1 14,000 28,000
2 14,000 12,000
3 14,000 10,000
4 14,000 10,000
5 14,000 10,000
By ignoring risk differences and using net present value at 10 percent cost of capital, project A is preferred
over project B, since its NPV of birr 11074 is greater than N’s NPV of birr 10,914. Assume however, that on
further analysis the firm found that project A is actually more risky than project B. to consider the deferring
risks; the firm estimated the certainty equivalent factors for each project’s cash inflows for each year.
Certainty equivalent for project A and B are as follows:
1 0.90 1.00
2 0.90 0.90
3 0.80 0.90
4 0.70 0.80

5 0.60 0.70
Upon investigation, ABC’s management estimated the prevailing risk free rate of return, Rf, to be 6 percent.
Required: calculate the NPV.
Project A
year Cash Certainty equivalent Certainty cash Present value
flows factor inflows
1 14,000 0.90 12,600 X(1.06)-1=11,882
2 14,000 0.90 12,600 X(1.06)-2=11,214
3 14,000 0.80 11,200 X(1.06)-3=9,408
4 14,000 0.70 9,800 X(1.06)-4=7,762
5 14,000 0.60 8,400 X(1.06)-5=6,275
Present value of cash inflows=46,541
Less: initial investment =42,000
NPV =4,541
Project B
year Cash flows Certainty equivalent Certainty cash Present value
factor inflows
1 28,000 1.00 28,000 X(1.06)-1=26,404
2 12,000 0.90 10,800 X(1.06)-2=9612
3 10,000 0.90 9,000 X(1.06)-3=7560
4 10,000 0.80 8,000 X(1.06)-4=6336
5 10,000 0.70 7,000 X(1.06)-5=5229
Present value of cash inflows=55141
Less: initial investment =45,000
NPV =10,141
Note that as a result of the risk adjustment, project B is now preferred. The usefulness of the certainty
equivalent approach for risk adjustment should be quite clear, the only difficulty lies in the need to make
subjective estimates of the certainty equivalent factors.

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Chapter One

An over view of Financial Management

Financial Management Vs Economics & Accounting

1.2 The goals of financial management

GEBRIE WORKU, AAUCC 1

2. Stockholder wealth maximization

The roles of financial managers

1.3 Financial management decisions

GEBRIE WORKU, AAUCC 2

1.4 Financial Markets and Institutions

GEBRIE WORKU, AAUCC 3

Primary Markets Vs Secondary Markets

GEBRIE WORKU, AAUCC 4

GEBRIE WORKU, AAUCC 5

Evaluation of Financial Performance

2.2 ways of financial analysis:

GEBRIE WORKU, AAUCC 6

GEBRIE WORKU, AAUCC 7

GEBRIE WORKU, AAUCC 8

Current ratio =Current assets

GEBRIE WORKU, AAUCC 9

 A reasonable higher (moderate)the ratio,

GEBRIE WORKU, AAUCC 10

i.e Merchandise A/R

Activity (Asset utilization) Ratios include

GEBRIE WORKU, AAUCC 11

AIR turnover for (yr 2001)= 1875

Note: - As result of the above factors,

Average collocation period (ACP)

GEBRIE WORKU, AAUCC 12

=360 x Average A/R

ACP= 360 days Receivable

Assume, the credit term of ABC is 2/10 ,n/75.

GEBRIE WORKU, AAUCC 13

APP= 360 days A/P

APP for XYZ cafe = 360 days

Assume, suppliers on the average extend, say 60 days credit terms.

Inventory turnover for ABC ( 2001) = 1000

GEBRIE WORKU, AAUCC 14

GEBRIE WORKU, AAUCC 15

Firm A (Meta Brewery) Firm B (Dashen Brewery)

GEBRIE WORKU, AAUCC 16

For ABC ( yr 2000)=1250/2750=45.45%

GEBRIE WORKU, AAUCC 17

Gross profit margin= Gross profit

For ABC( yr 2000) = 650/1500=43.3%

Operating profit margin= EBIT

GEBRIE WORKU, AAUCC 18

C. Net profit Margin: measures the percentage of net income to sales.

Net profit margin= Net income

For ABC (yr 2000) =249/1500=16.6%

ROA= Net income

ROE= Net income Or ROE= ROA X Equity multiplier

EPS= Net income

GEBRIE WORKU, AAUCC 19

P/E ratio= Current Market price per share

Book value per share= Total stockholders equity- Preferred stock

For ABC (yr 2000) =2750-0/20=137.50 birr/share

Dividend payout ratio= Dividend Per share

Dividend yield= Dividend per share

GEBRIE WORKU, AAUCC 20

FUNDAMENTAL FINANCIAL CONCEPTS

GEBRIE WORKU, AAUCC 21

_____ Periods Fv=R[(1+i)n-1] (1+i)