Smpe 202 Financial Management

NIM
NIGERIAN INSTITUTE
OF MANAGEMENT
(CHARTERED)
NIGERIAN INSTITUTE OF MANAGEMENT

(CHARTERED)
FINANCIAL MANAGEMENT
(SMPE 202)
NIM VISION: To be The Source and Symbol of Management Excellence

NIGERIAN INSTITUTE OF MANAGEMENT
(CHARTERED)
STUDY PACK
NIM / NYSC PROGRAMME
FINANCIAL MANAGEMENT
(SMPE 202)
STAGE II
For more information, please contact:

Management House
Plot 22, Idowu Taylor Street
Victoria Island Lagos
P.O. Box 2557
Lagos
Tel. 01 2701017, 2705928
Website: www.managmentnigeria.org
E-mail: mgtedu@managementnigeria.org
FINANCIAL MANAGEMENT PAGE

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FOREWORD
This study pack covers all the topics and all the basic materials necessary for adequate grasp of the
subject for the Proficiency Certificate in Management Examination of Nigerian Institute of
Management (Chartered).
While expecting candidates, to read as widely as possible on their courses, the Institute's role in
preparing this study pack, is to treat in one publication all the topics covered by the syllabus for this
particular course.
This will enhance focused study on the part of candidate. This pack is written by an expert on the
subject. The writing is reader-friendly while the issues discussed are current with the general
treatment of topics having a contemporary feel.
The topics are treated in a way not only to provide general and theoretical knowledge but to
enhance practice.
Reviewed questions are provided at the end of each pack.
We wish to express our utmost appreciation to our faculty of experts for their invaluable
development and writing of these study pack series.
We also appreciate the support provided by the Directorate of Capacity Building.
MANAGEMENT

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COURSE CONTENT
Page
PART 1 - FUNDAMENTAL CONCEPTS OF FINANCIAL
MANAGEMENT
An Overview of Financial Management and the
Financial Environment, Financial Planning,
Financial Needs Analysis, 7
PART 2 - TIME VALUE OF MONEY & RISK MANAGEMENT

Concept of Time Value of Money
Risk Management in Investment 16
PART 3 - SECURITIES AND THEIR VALUATION

Stocks, Bonds and their valuation, Financial Options,
Divisible profits, dividends policy 31
PART 4 - CAPITAL BUDGETING UNDER CERTAINTY

Capital Budgeting Under Certainty,
Evaluating Cash Flows,
Methods employed in evaluating Projects 39
PART 5 - CAPITAL BUDGETING UNDER UNCERTAINTY

Expected Value Method, Sensitivity Analysis,
Decision Tree, Portfolio Theory,
Capital Asset Pricing Model 50
PART 6 - THE COST OF CAPITAL

Cost of Ordinary Share Capital, Cost of Retained Earnings
Cost of Long-term Debt, Money vs Real Cost of Capital 62
PART 7 - FINANCIAL STATEMENT ANALYSIS

Analysis of Financial Statements
Financial Ratio Analysis - Liquidity, Leverage, Profitability, etc 69
PART 8 - CASH FLOW STATEMENT

Cash and Cash Equivalents
Classification of Cash Flows 80
PART 9 - WORKING CAPITAL MANAGEMENT

Working Capital Management, Management of Cash and
Marketable Securities, Accounts Receivables Management,
Inventory Management 87

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PART 10 SOURCES OF BUSINESS FINANCING
Short, Medium and Long-term Financing 99
PART 11 LEASING
Leasing, Types of Leasing Agreement,
Lease or Buy Decision 103
PART 12 THE NIGERIAN FINANCIAL MARKETS

Primary and Secondary Markets, Money Market
Capital Market, Securities & Exchange Commission 110
PART 13
SCELLANEOUS FINANCIAL MANAGEMENT TOPICS
Value-Based Management, Corporate Governance
Mergers and Acquisitions, Bankruptcy, Liquidation,
Business Failures and Reorganization,
International Financial Institutions,
Cases in Financial Management 117

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PART 1
FUNDAMENTAL CONCEPT OF FINANCIAL MANAGEMENT
1.1 LEARNING OBJECTIVE

At the end of this study students will be able to:
Understand the basic concept of financial management.
Be exposed to the basic area of decision making in financial management.
Be able to state the difference between financial management and other
management fields.
1.2 OVERVIEW OF FINANCIAL MANAGEMENT

Financial management can be defined as the process of making financial decisions with the ultimate
objective of maximizing the shareowners' wealth. In the world of finance, financial management is
also known by other names like corporate finance, business finance and managerial finance. It is
denoted as FM.
Financial management is the whole process of the planning utilization and controlling of financial
resources of a firm. It involves rigorous analysis of investment opportunities, identifying possible
sources of fund and cost thereon and maximization of profit and wealth of the shareholders of the
firm.
Financial management inevitably optimizes the output from a given input of funds. It attempts to
utilize the funds in the most procreative manner. Financial Management facilitates achievement of
the principal objective of a business concern which is to make enough profits, so that a fair rate of
dividend is paid and a part of the profit is retained in the business to face uncertainties in future.
Financial Management is directly related with managerial activities like raising and utilization of
available funds in the best economic way. Financial management also refers to that part of
management activity, which is concerned with the planning, and controlling of a firm's financial
resources.
Whilst financial activities should not be only limited to procurement of funds, it also explores other
prospects for organizations in areas like:
(i) determining the financial needs,
(ii) availability of funds,
(iii) cost of financing,
(iv) capital budgeting,
(v) preserving liquidity,
(vi) loaning and borrowing policies and
(vii) direction of fixed and current assets and evaluation of business firm.
It deals with discovering diverse sources for raising funds for the firm. The sources must be
appropriate and cheap for the needs of the business. The most appropriate use of such funds also
forms a part of financial management. As a separate managerial activity, it has a recent origin. It is as
useful to a small concern as to a big unit.
Financial Management may also be involved with planning, directing, monitoring,

organizing, and controlling of the monetary resources of an organization as well as financial risk
management.

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Financial Management is one of the crucial functional areas of management, because the success of
a company wholly depends on the proper use of its financial resources. The significance of financial
management cannot be overstressed. Sound financial management is necessary in all
organizations whether big, small or medium.
1.3 OBJECTIVE OF THE FIRM

The Objectives of Financial Management
The main objectives of financial management will be maximization of the enterprise's economic
value (equity) with consideration for:
profit-investment; profit-risk
Maximizing shareholder wealth as the primary goal. (Shareholder wealth is defined as the
present value of the expected future returns to the owners of the firm. It is measured by the
market value of the shareholders' common stock holdings.
Having good explanation using the Balance Sheet structure
The goal of shareholders wealth maximization specifies how financial decisions should be made. In
practice not all management decisions are consistent with this objective. Some companies have
developed an index of managerial performance that measures the success of managers in achieving
a goal of shareholders wealth maximization.
The measure called Economic Value Added is a difference between a firm's annual after/tax
operating profit and its total annual cost of capital. Some firms expect top managers and directors to
have a significant ownership stake in it.
Three major factors may be used in determining the market value of a company's shares at any
point in time. These include:
The amount of the cash flows expected to be generated for the benefit of shareholders (Only
cash can be used to acquire the assets, not depreciation)
The timing of this cash flows (=N=100 today is different from =N=100 three years from
today)
The risk of the cash flows (the greater the risk associated with an expected cash flow, the
greater is the rate of return required by investors).
The financial objectives are:

- To maximize the shareholders wealth. Shareholder wealth is defined as the present value of
the expected future returns to the owners of the firm. It is measured by the market value of
the shareholders' equity stock holdings
- To maximize the profit of the firm and ensure the firm's survival. Maximization of the
enterprise's economic value (equity): profitable-investment; profitable-risk.
- To improve productivity and ensure quality management.
- To be a market leader and increase market share of the firm.
- Maximizing shareholder wealth -.
The other non-financial objectives of Financial Management include:

- To ensure effective and human resources management system.
- To maintain adequate social responsibility of the firm.
- To provide for the welfare of management.
- To provide the highest quality of service to customers.
- Expansion of the Balance Sheet structure.

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- To increase the company's competitive power
- To create the enterprise's stability through risk minimization
1.4 APPLICATION OF FINANCIAL MANAGEMENT PRINCIPLES

The various areas of business and financial management function that should be the main
focus of companies include:
(a) Investment decisions

Using Internal/external investment decisions of undertaking projects or taking over of another
company and the withdrawal thereof or disinvestments in the event of the project becoming
unprofitable.
(b) Financing decisions

Making of capital funding planning decisions for selecting suitable funding methods to finance
long-term assets and working capital.
(c) Dividend decisions

There is direct correlation between financing decisions and dividend decisions since the retained
profits are the most important source of new funds to companies. It involves taking decisions
whether to distribute profit to enhance share value or to plough back undistributed profits for
business expansion.
(d) Liquidity Management

This involves management of funds to achieve balance between transactionary, precautionary and
speculative motives of holding money.
(e) Tax Management

This refers to the methods adopted in the preparation and putting up of claims for tax benefits that
will maximize a company's benefits.
(f) Risk Management

This is the process by which a financial manager examines all known probabilities (both subjective
and objective) for potential outcomes for all states of nature in a particular investment decision to
determine their viability.
(g) Asset Management

This relates to the process by which a financial manager takes a decision on behalf of the firm on
how to embark on an asset replacement process.
FINANCIAL DECISION GRID
Investment Decision
Financing Decision Dividend Decision
Liquidity Decision
(Working Capital Management)

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1.5 FINANCIAL PLANNING
Financial Planning might sound like something for the wealthy, but in reality it is something firms
should be doing (regardless of their current financial position), if they are to make the best out of
their operations.
In its most simple sense, Financial Planning involves working out what is most important to the
company and its goals. By adding timescales and costs, the firm can work out how to get where they
want to be in their business by planning their finances accordingly.
By aligning their finances to their goals they are presented with:
a much clearer view of where they are going
mechanism for reducing the stress involved in getting to where they want to be and
strategy to the company for control purposes
Without it, the firm is in danger of drifting through its operations and taking the risk that their most
important goals may never be realized.
What exactly is financial planning, and why is it so important?

Financial planning is the process of determining how to manage money, investment, present and
future financial goals, and the strategy that should be undertaken to obtain them.
Because our goals and desires change as we do, financial planning and investing is a task that is
never finished. How we are financially able to reach these goals, and the risk we are willing to take to
get there, necessarily means that any financial plan must be specifically tailored for an individual or
organization.
Financial planning begins by taking into account each individual's assets and liabilities at that
particular point in time. The asset categories includes investment assets and monetary investments
of all kinds, along with physical assets such as fixed assets etc.
Liabilities may range from company loans, debt owed other organizations, contingent demands
and other items meant to be paid to others in the normal course of business.
The following checklist has been put together to give some areas to consider in financial
planning:
Current financial position
Assessing your assets and liabilities
Understanding your cash flow
Building a cash reserve
Maintaining your cash reserve for unanticipated events
Consolidating your loans
Applying tax efficiency to your financial position
Functions of Financial Planning

The functions of financial planning include:
(a) planning for the acquisition, custody and expenditures of funds

(b) ensuring adequacy of financial funds
(c) assuring profitability; financial equilibrium, to remove financial risks
(d) engaging in financial forecasting
(e) general financial control of the entity

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(f) ensuring efficient allocation of financial funds according to domains of activity in the
following areas:
assets' administration
allocation of resources aimed at increasing capital
- the best mobilization of resources
sources of funds' formation (short-term, long-term ones)
the utilization of financial levers, the determination of barriers
the optimization of the capital structure
net profit
the source of own resources formation.
Tools of Financial Planning
The tools required to prepare a financial plan for your business's development, including the
following:
Basic Financial Statements - the Balance Sheet and Statement of Income
Ratio Analysis - a means by which individual business performance is compared to similar
businesses in the same category
The Projected Statement of Income - a method used to forecast future profitability
Break-Even Analysis - a method allowing the small business person to calculate the sales
level at which a business recovers all its costs or expenses
The Cash Flow Statement - also known as the Cash Budget identifies the flow of cash into
and out of the business
Pricing formulas and policies - used to calculate profitable selling prices for products and
services
1.6 FINANCIAL NEEDS ANALYSIS

While financial advice comes in many forms (and from many sources), personal financial planning
has a set strategy, involving a thorough review and analysis of all aspects of your financial affairs
and those physical factors that impact on the firm's life.
It is also the preparation of a comprehensive individualized plan to help your company achieve
financial security for long term market needs.
It has become more difficult to maximize investment returns in these uncertain economic times.
Faced with ever-changing legislation, globalization, more complex financial products/services to
choose from, higher and new taxes and a lack of time, it is becoming almost impossible to act on
your own in creating wealth, protecting assets, business interests and income, choosing the
appropriate voluntary or compulsory income instruments and in distributing your estate.
The first step for any financial plan is a Financial Needs Analysis. It is the only way to gather
information on your current situation, and to identify potential threats to the company's wellbeing.
What's required for a Financial Needs Analysis?

(a) Your personal or company's details
(b) Your current assets and liabilities
(c) Your income less expenses to determine any available income with which to work with.
(d) Your financial needs that need to be addressed and the order of their importance.
(e) Realistic assumptions as to future inflation and interest rates.
(f) Your analysis should present you with a strategy that indicates what will happen in an
emergency, or on your death or suffering a life-changing event.

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An analysis will present you with answers to all of the above concerns.
The Objective of the Financial Needs Analysis

The Objectives of the financial needs analysis include:
- The Financial Performance - the analysis' target: the identification of the strength and
weakness of the financial administration aimed at a substantiation of the firm's new
development strategy (SWOT analysis)
- The objective of the analysis - is also to determine the financial equilibrium, profitability;
risks; the appreciation of the total value of a company.
- Financial performances - the self-financing capacity and the economic risk; financial
structure optimization.
- A financial plan would ensure the availability of sufficient funds to achieve enterprise
goals.
- There should be a balancing of costs and risks so as to protect the investors.
- A financial plan should ensure flexibility so as to adjust as per the requirements.
- A financial plan should take a long-term view of the company's operations.
- The needs for funds in the near future and over a longer period should be considered
while choosing the pattern of financing.
1.7 CASH FLOW AND TAXES
Controlling the cash and other asset

Planning for and controlling the use of cash are extremely important tasks. Failure to properly
anticipate cash flows can lead to idle cash balances and lower rate of return on one hand and to cash
deficit and possible failure of the business on the other hand
In controlling cash and other business assets, funding decisions must be balanced between the three
important motives for holding money which is divided into:
(1) Transactionary this represents cash held to meet maturing and immediate obligations. The
cash is held because receipts and payments are not perfectly synchronized.
(2) Precautionary these are cash balances held in reserves to meet unforeseen fluctuations in
inflows and outflows. Sometimes, cash in this category are normally invested in marketable
securities.
(3) Speculative these represent the difference between the two above and what is available for
investment. The cash balances here are held to ensure that the firm takes advantage of bargain
purchases and fluctuations in exchange rates.
TAX PLANNING
Tax planning includes the following:
Minimizing your taxes, including:
o Income tax
o Capitals gains tax
Using tax-efficient investments
Applying independent taxation strategies

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The other aspect of a financial plan may relate to the pattern of financing the business.
There are a number of ways for raising funds. The selection of capital to be used in business
should be done carefully. The funds may be raised by issuing fresh capital or debentures.
Once a pattern of financing is selected then it becomes very difficult to modify it. A financial
plan also spells out the policies to be pursued for the floatation of various corporate securities,
particularly regarding the time of their floatation.
A financial plan should be carefully determined. It has long-term impact on the working of the
enterprise. It should ensure sufficient funds for genuine needs. Neither the plans should suffer
due to shortage of funds nor there wasteful use of them. The funds should be put to their
optimum use.

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REVISION QUESTIONS
Illustration 1.1
There are five basic function of the financial manager. List and explain these functions.
Answer to Illustration 1.1

The basic functions of the financial manager will include the following:
The various areas of business and financial management function that should be the main focus
of companies include:
(a) Investment decisions

Using Internal / external investment decisions of undertaking projects or taking over of another
company and the withdrawal thereof or disinvestments in the event of the project becoming
unprofitable.
(b) Financing decisions

Making of capital funding planning decisions of selecting suitable funding methods to finance long-
term assets and working capital.
(c) Dividend decisions

There is direct correlation between financing decisions and dividend decisions since the retained
profits are the most important source of new funds to companies. It involves taking decisions
whether to distribute profit to enhance share value or to plough back undistributed profits for
business expansion.
(d) Liquidity Management

This involves management of funds to achieve balance between transactionary, precautionary and
speculative motives of holding money.
(e) Tax Management

This refers to the methods adopted in the preparation and putting up of claims for tax benefits that
will maximize company's benefits.
(f) Risk Management

This is the process by which a financial manager examines all known probabilities (both subjective
and objective) for potential outcomes for all state of nature in a particular investment decision to
determine their viability.
(g) Asset Management

This relates to the process by which a financial manager takes a decision on behalf of the firm on how
to embark on asset replacement process.
Illustration 1.2
The financial manager acts in fiduciary capacity to the shareholders of the firm. What are the
area of conflict that can occur between the shareholders and management of the firm?
Illustration 1.3
What are the core areas of decision making in financial management?

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Illustration 1.4
The basic objective of a firm is financial. List these basic objectives.

The basic objectives of a firm include the following:
- To maximize the shareholders wealth. Shareholder wealth is defined as the present value of
the expected future returns to the owners of the firm. It is measured by the market value of
the shareholders' equity stock holdings
- To maximize the profit of the firm and ensure the firm's survival. Maximization of the
enterprise's economic value (equity): profitable-investment; profitable-risk.
- To improve productivity and ensure quality management.
- To be a market leader and increase market share of the firm.
- Maximizing shareholder wealth -.
Illustration 1.5
What is financial planning and financial needs analysis? Enumerate the various functions of
financial planning.
Illustration 1.6
List and explain the various motives for holding cash in a business environment.

In controlling cash and other business assets, funding decisions must be balanced between the
three important motives for holding money which is divided into:
(1) Transactionary this represents cash held to meet maturing and immediate obligations. The
cash is held because receipts and payments are not perfectly synchronized.
(2) Precautionary these are cash balances held in reserves to meet unforeseen fluctuations in
inflows and outflows. Sometimes, cash in this category are normally invested in marketable
securities.
(3) Speculative which represents the difference between the two above and what is available
for investment. The cash balances here are held to ensure that the firm takes advantage of bargain
purchases and fluctuations in exchange rates

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PART 2
CONCEPT OF TIME VALUE OF MONEY

At the end of this study students' will be able to:
Understand the arithmetic background underlying the concept of financial
management.
Apply these mathematical principles to the basic business and
financial concept.
Understand steps in taking decision in financial management and corporate
management.
2.2 CONCEPT OF TIME VALUE OF MONEY

Definition
The time value of money stated that the value of a naira today will not be the same in a future
period. A naira today will be less than a naira in a year's time in terms of their real value. A
naira expected sometimes in the future is not equivalent to a naira held today, because of the
time value of money. We can invest the naira today to earn interest, so that it will increase in
value to more than one naira in the future. Consequently, we would rather receive a naira
now than receive the same amount in the future, even if we are certain of receiving it later.
Simple and Compound Interest

The simple interest is the earnings on an original amount invested (principal). The
amount of principal and the interest payments remain the same from period to period.
The simple interest (S.I) is computed as:
Example: What is the Simple Interest on N100 invested for 5 years at the
rate of 5% per annum?
Solution:
Yr Principal Rate i.e. 5% of Principal
1 100 5
2 100 5
3 100 5
4 100 5
5 100 5
N25
Or
Simple Interest = P x R x T

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Compound Interest
The compound interest is the periodic interest earned on the principal plus previous earned interest.
Compound Interest = AP
Example: What is the compound interest on N100 invested 5 years if it is compound per
annum?
Solution
Period Principal Returns Cumulative (Amount)
1 100 5 105
2 105 5.2 110.25
3 110.25 5.5125 115.76
4 115.7625 5.788 121.55
5 121.55 6.0775 127.63
Or
Compound Interest (CI) AP
n
A = P(1 + r)
5
= 100(1 + 0.05)
= 100(1.05)5
= 127.63
CI = 127.63-100 = 27.63
Adjustment in Compound Interest Formula

A = P(1+r/2)2n - Semi Annual
A = P(1+r/4)4n - Quarterly Compounding
A = P(1+r/12)12n - Monthly
In general A = P(1+r/n)mn
Where, r = rate of interest
A = P(1+r/ )2n - Semi Annual
2
m=
A = P(1+ r
/4number
)4n of compounding
- Quarterlyperiods
Compounding
n =r/number
A = P(1+ 12)
12n of years
- Monthly
Future Value and Present Value of a Lump Sum

This expression is a modality for composing Principal Interest given that a
certain rate of interest is added on equal interval.
The future lump sum invested today can be computed as:
n
FV = P(1+r)

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Example: Calculate the future value of a N100 at 5% if invested per annum
for 5 years.
n
Solution: FV = P(1+r)
P = 100, r =5% = 0.05 and n = 5
5
FV = 100(1+0.05)
5
= 100(1.05) = 100 (1.2763) = N127.63
Present Value
A present value of an investment can be described as the amount of money (a lump sum) that you
would have to invest now for 'n' time periods earning interest at 'r' per time period, to build up the
value of your investment at the end of that time. It is today's value of a future sum.
1
P= Fx
(1 + r)n
ANNUITY
An annuity is a series of equal payments or receipt over some periods, with compound interest on
the payments of receipts. We can divide annuities into ordinary annuity and annuity due. It is a
simple stream of constant amount receivable over a period of time.
Ordinary Annuity
This is a series of equal payments or receipts that occur at the end of each period involved.
Ordinary Annuity Formula
Future Value Present Value
Example: Calculate the future value and present value of ordinary annuity of N6,000 deposited at
the end of the year 1 to 3 at 16% compounded annually.
Solution:
=
= N21,033.6
= N13,473.75
Alternatively, when FV is discounted, we arrive at present value i.e.

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Annuity Due
This is a series of payments or receipts that occur at the beginning of each
period involved.
Annuity due formula:
Example: Calculate the FV and PV of an annuity due of N6,000 annual

deposits at the beginning of each year, compounded at 16% interest
rate of 5 years.
Solution:
=
=
= 6,000 x 3.77
= = N22,620 = N28,110
Perpetual Annuity
This is a series of equal periodic payment or receipt expected indefinitely. The present value of a
perpetual annuity is given as:
Perpetual Annuity Formula
Example: Mr. Taiwo receives N6,000 perpetual annual payment at the rate of 16%,
what is the present value of the annuity.
Sinking Fund
This is a method of setting aside a uniform amount at every period to accumulate to a specific
amount in the future. As each periodic amount is set aside, it will be immediately invested. This is
what we call a sinking fund. It can be used in providing for replacement of fixed assets.

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Example: Ojo needs to provide N50,000 to replace his machine in 5 years time, in order to
provide this amount he decides to set aside equal amount annually out of his salary. This
amount is kept in savings account that yield 20% interest per annum. Find this amount, and the
sinking fund schedule.
Solution:
5,000 x 0.2 = A(1.4883)

10,000 = A(1.4883)
Ojo should set aside N6,718.99 yearly.
2.3 RISK MANAGEMENT IN INVESTMENT
Introduction of Risk Management in Investment

More often than not the term uncertainty is used interchangeably for risk. Although there is only a
very thin boundary separating them, it is usual to make a distinction between them in finance.
Risk can be defined as a situation in which there are known probabilities (both subjective and
objective) for potential outcomes. The decision maker is assumed to be aware of all possible future
states of nature which may occur and affect relevant decision parameters.
Furthermore it is assumed that he is able to assign a probability on the value of the occurrence of
each of these states of nature.
Uncertainty on the other hand is defined as a situation in which such probabilities are either
unknown or cannot be accurately estimated. The decision maker may or may not be aware of all the
possible states of nature, which affect his relevant decision parameters, and to assign probabilities to
them.
Identification of Different Types of Risks In Investment
The various types of risk inherent in investment management include:

business risk,
investment risk,
financial risk,
portfolio risk and
cataclysmic risk.

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Business Risks
Business risk is risk arising in investment due to variability in operating earnings, which in turn is a
function of a firm's normal operations.
It is determined by changes in the economic environment in general and by management's

decision on capital intensification within the firm.
Specifically, a firm's business risk is influenced by the ratio of its fixed costs to variable costs. That is,
it's operating leverage. An increase in fixed costs over variable costs increases a firm's operating
leverage and hence the variability in its operating earnings.
Investment or Project Risk

Investment or project risk is due to the variability in expected earnings arising from variations in
both cash outflows and inflows from an investment.
It is usually associated with errors in forecasting of consumer tastes and other demand related
influences, changes in relevant factor costs in the investment as well as in technology.
Financial Risk
Financial Risk is the variability in operating earnings arising from the commitment of the firm to
meet its fixed payment obligations due to the use of debt capital.
In other words, the use of more debt or preferred stock which increases the firm's financial leverage,
results in greater fixed obligatory payments for it and in turn increases the variability of earnings
after taxes (EAT) and earnings per share (EPS).
Portfolio Risk
Portfolio risk deals with the variability in operating earnings due to the level of efficient
diversification in firm's portfolio of assets.
A firm's portfolio risk is reduced by choosing investments with low or negative correlations with its
existing investments.
Cataclysmic Risk
Cataclysmic risk relates to the variability in earnings due to events beyond management's control
and anticipation.
Usually included in this category are expropriation by government, outright exhaustion of a natural
resource on which a firm's future operations depends, serious energy shortages, and acts of God
(earthquake, flooding etc.)
Sources of Risk for the Business Firm

The sources of risks for the business firm may be experienced mainly from the environment or the
economy and includes:
Legal
Political
Socio-cultural
Competition
Technological changes

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Management
Labour conditions
Adjusting For Risk in the Evaluation of Investments

The process of making investment decisions under uncertainty (risk) involves three steps
namely:
(i) Describing the expected return from investment.
(ii) Describing the uncertainty associated with the returns by assigning to them their
probability of occurrence
(iii) Evaluating the risk and return characteristics of the investment a number of
statistical measures are used in doing this. They include the mean variance, standard
deviation and coefficient of variation.
Conventional Techniques Used In Risk Handling

Some of the conventional techniques used in risk handling include:
(a) Payback Period
(b) Risk-Adjusted Discount Rate
(c) Certainty Equivalent
(d) Sensitivity Analysis
(a) Payback Period

Payback period is one of the oldest and commonly used methods for explicitly recognizing risk
associated with an investment project. This method, as applied in practice, is more an attempt to
allow for risk in capital budgeting decision rather than a method to measure profitability.
Because firms using this method usually prefer short payback to longer ones, and often establish
guidelines such that the firm accepts only investments with some maximum payback period, say
three or five years.
Merits
i. very simple to calculate
ii. it makes allowance for risk by:
a) focusing attention on the near term and thereby
emphasizing the liquidity of the firm through recovery of capital.
b) favoring short term projects over what may be riskier longer term
projects
Demerits
(i) it ignores the time value of cash flows
(ii) it does not make any allowance for the time pattern of the initial capital recovered.
(iii) Setting the maximum payback period as two, three or five years usually has little
logical relationship to risk preferences of individuals or companies.
It should be realized, however that the payback period, as a method used in handling risk, is
useful only in allowing for a special type of risk, the risk that a project will go exactly as
planned for a certain period of time and will then suddenly cease altogether and be worth
nothing.

22
It is essentially suited to the assessment of risks of time nature. Once a payback period has
been calculated, the decision maker would compare it with his own assessment of the
project's likely economic life, and if it the latter exceeds the former, he would accept the
project.
This is a useful procedure only if the forecasts of cash flows associated with the project are
likely to be unimpaired for a certain period.
The risk that a project will suddenly cease altogether after a certain period may arise due
to reasons such as:
civil war in the country,
closure of business due to an indefinite strike by the workers,
introduction of a new products by competitors which capture the whole market,
natural disasters such as flood or fire.
Such risks undoubtedly exist but they, by no means, constitute a large proportion of the
commonly encountered business risks. The usual risk in business is not that a project will go on
as forecast for a period and then collapse altogether, rather the normal business risk is that the
forecast of cash flows will go wrong due to lower incomes, higher cost etc.
Risk-Adjusted Discount Rate

For a long time economist theorists have assumed that, to allow for risk, the businessman
required a premium over and above an alternative which was risk-free.
Accordingly, the more uncertain the return in the future, the greater the risk and the greater
the premium required. Based on this reasoning, it is proposed that the risk be incorporated
into the capital budgeting analysis through the discount rate. That is, if the time preference
for money is to be recognized by discounting estimated future cash flows, at some risk-free
rate, to their present value, then, to allow for the riskiness of those future cash flows, a risk
premium rate may be added to the risk-free discount rate.
Such a composite discount rate will allow for both time preference and risk preference
and will be a sum of the risk-free rate and the risk-premium rate reflecting the investor's
attitude towards risk.
The risk adjusted discount rate method can be formally expressed as follows:
n NCF
NPV = -------
t
(1 + k)
t = 0
where k is a risk adjusted rate. That is
k = k +
t
kf = the risk free rate

= the risk premium

23
Sinking Fund Schedule:
a b c a+b+c
Year Balance b/f Interest@20% Sinking Fund Balance c/dc/d
1 - - 6,718.99 6,718.99
2 6,718.99 1,343.80 6,718.99 14,781.78
3 14,781.78 2,957.36 6,718.99 24,457.13
4 24,457.13 4,891.43 6,718.99 36,067.55
5 36,067.55 7,213.51 6,718.99 50,010.05
Loan Amortization
This is a method of payment of loan or term debts, which include principal amount plus interest
spread over a period of time. Installment payment is prevalent in mortgage loans and certain types
of business loans. The main feature of an installment payment is that the borrower repays the loan
in equal periodic payment that embodies both interest and principal.
Example:
Apeloko borrowed N50,000 to purchase a machine. He made arrangement to pay over 5
years period with interest rate of 20% per annum on the unpaid balance, calculate the
annual payment and the amortization
schedule.
Solution:
5,000 x 0.2 = A(1-0.4019)

10,000 = A(0.5981)
Annually payment is N16,718.99.
Amortization Schedule:
Year Principal Interest Annual Installment Principal Balance
Owing @ 20% Payment Repayment C/f
0 - - - - 50,000.00
1 50,000.00 10,000.00 16,718.99 6,718.99 4,328.01
2 43,281.01 8,656.20 16,718.99 8,062.79 35,218.22
3 35,218.22 7,043.64 16,718.99 9,675.35 25,542.01
4 25,542.87 5,108.57 16,718.99 11,610.42 13,932.45
5 13,932.45 2,756.49 16,718.99 13,932.45 -

24
Cash Flow with Growth
The cash flow can be computed with growth from year zero to perpetuity, with growth from year
one to infinity and with growth from year n to perpetuity or infinity.
1. Cash flow with growth

A(1 + g)
S n= A +
r-g
2. Cash flow with growth (g) from year n to infinity

A
S n= A +
r-g
3. Cash flow with growth (g) from year n to infinity where n > 1
-n+1
A(1 + r)
S n= r-g
Where r = Interest rate
g = Growth rate
A = Initial sum
n = Number of years
Example: Ibrahim Kuje leased a warehouse for which his lease rental is N200,000 per annum,
the lease rental is expected to be increased by 4% annually and the cost of capital is 14%.
Required:
1. What is the total lease rental to perpetuity from year zero?
2. Assume that Ibrahim Kuje would not commence the lease rental payment until year 3,
what is the lease rental to perpetuity from year 3?
3. Assume that Ibrahim Kuje would commence payment of the lease rental from year zero.
What is the total lease rental to perpetuity?
Solution:
1.
2.
= N1,349,943

25
2.4 REVISION QUESTIONS
Illustration 2.4.1
What is the compound interest on N100 invested 5 years if it is compound per annum?
Answer to Illustration 2.4.1

Period Principal Returns Cumulative (Amount)
1 100 5 105
2 105 5.2 110.25
3 110.25 5.5125 115.76
4 115.7625 5.788 121.55
5 121.55 6.0775 127.63
Or
Compound Interest (CI) AP
A = P(1 + r)n
= 100(1 + 0.05)5
= 100(1.05)5
= 127.63
CI = 127.63 100 = 27.63

A = P(1 +r/2)2n - Semi Annual
A = P(1 + r/4)4n - Quarterly Compounding
A = P(1+r/12)12n - Monthly
In general A = P(1 + r/n)mn

Where, r = rate of interest
m = number of compounding periods
n = number of years
26
Future Value and Present Value of a Lump Sum
This expression is a modality for composing Principal Interest given that a certain rate of interest is
added on equal interval.
The future lump sum invested today can be computed as:
FV = P(1 + r)n
P is otherwise known as Present Value
Example: Calculate the future value of a N100 at 5% if invested per annum

for 5 years.
Solution: FV = P
P = 100, r =5% = 0.05 and n = 5
FV = 100
= 100 = 100 (1.2763) = N127.63
Present Value
A present value of an investment can be described as the amount of money (a lump sum) that you
would have to invest now for 'n' time periods earning interest at 'r' per time period, to build up the
value of your investment at the end of that time. It is today's value of a future sum.
P=
Illustration 2.4.2
List and explain the various conventional techniques used in handling risk in an organization with
adequate examples provided for each.

Some of the conventional techniques used in risk handling include:
(a) Payback Period
(b) Risk-Adjusted Discount Rate
(c) Certainty Equivalent
(d) Sensitivity Analysis
(a) Payback Period

Payback period is one of the oldest and commonly used methods for explicitly recognizing risk
associated an investment project. This method, as applied in practice, is more an attempt to
allow for risk in capital budgeting decision rather than a method to measure profitability.
Because firms using this method usually prefer short payback to longer ones, and often establish
guidelines such that firm accepts only investments with some maximum payback period, say
three or five years.
Merits
i. very simple to calculate

27
ii. it makes allowance for risk by:
a) focusing attention on the near term future and thereby emphasizing the liquidity of
the firm through recovery of capital.
b) favoring short term project over what may be riskier longer term
projects
Demerits
(i) it ignores the time value of cash flows
(ii) it does not make any allowance for the time pattern of the initial capital recovered.
(iii) Setting the maximum payback period as two, three or five years usually has little
logical relationship to risk preferences of individuals or companies.
It should be realized, however that the payback period, as a method used in handling risk, is useful
only in allowing for a special type of risk, the risk that a project will go exactly as planned for a certain
period of time and will then suddenly cease altogether and be worth nothing.
It is essentially suited to the assessment of risks of time nature. Once a payback period has been
calculated, the decision maker would compare it with his own assessment of the project's likely
economic life, and it the latter exceeds the former, he would accept the project.
This is a useful procedure only if the forecasts of cash flows associated with the project are likely to
be unimpaired for a certain period.
The risk that a project will suddenly cease altogether after a certain period may arise due to
reasons such as:
civil war in the country,
closure of business due to an indefinite strike by the workers,
introduction of a new products by competitors which capture the whole market,
natural disasters such as flood or fire.
Such risks undoubtedly exist but they, by no means, constitute a large proportion of the commonly
encountered business risks. The usual risk in business is not that a project will go as forecast for a
period and then collapse altogether, rather the normal business risk is that the forecast of cash flows
will go wrong due to lowers incomes, higher cost etc.
Risk-Adjusted Discount Rate

For a long time the economist theorists have assumed that, to allow for risk, the businessman
required a premium over and above an alternative which was risk-free.
Accordingly, the more uncertain the return in the future, the greater the risk and the greater the
premium required. Based on this reasoning, it is proposed that the risk be incorporated into the
capital budgeting analysis through the discount rate. That is, if the time preference for money is
to be recognized by discounting estimated future cash flows, at some risk-free rate, to their
present value, then, to allow for the riskiness of those future cash flows, a risk premium rate may
be added to the risk-free discount rate.
Such a composite discount rate will allow for both time preference and risk preference and will
be a sum of the risk-free rate and the risk-premium rate reflecting the investor's attitude towards
risk.
The risk adjusted discount rate method can be formally expressed as follows:
28
n NCF
NPV = -------
t
(1 + k)
t = 0
where k is a risk adjusted rate. That is
k = k +
t
kf = the risk free rate
= the risk premium
Sinking Fund Schedule:

a b c a+b+c
Year Balance b/f Interest@20% Sinking Fund Balance c/dc/d
1 - - 6,718.99 6,718.99
2 6,718.99 1,343.80 6,718.99 14,781.78
3 14,781.78 2,957.36 6,718.99 24,457.13
4 24,457.13 4,891.43 6,718.99 36,067.55
5 36,067.55 7,213.51 6,718.99 50,010.05
Loan Amortization
This is a method of payment of loan or term debts, which include principal amount plus interest
spread over a period of time. Installment payment is prevalent in mortgage loans and certain type of
business loans. The main feature of an installment payment is that the borrower repays the loan in
equal period payment that embodies both interest and principal.
Illustration 2.4.3
Uchechukwu leased a warehouse for which his lease rental is N100,000 per annum, the lease rental
is expected to be increased by 3% annually and the cost of capital is 13%.
Illustration 2.4.4
Assume that Uchechukwu would not commence the lease rental payment until year 3.
Illustration 2.4.5
Dede Plc is a highly diversified company operating in a number of different industries. Its shares are
widely traded on the Stock Exchange and have a current market price of N3.20.
Its dividend payments over the last five years are:
Year DPS
2010 0.25
2009 0.23
2008 0.20

29
2007 0.19
2006 0.18
Diamond Plc is considering two investment opportunities: one is the Hotel and Tourism (H&T)
sector and the other is the Food and Beverages (F&B) sector. Both projects have relatively short
lives and their cash flows are as follows:
H&T F&B
Year N'm N'm
1 85 190
2 170 180
3 150 200
The investment in Hotel and Tourism would cost N300 million while that in Food and Beverages
would cost N400 million.
The Directors have discovered that industry beta for Hotel & Tourism and Food and Beverages
sectors are 1.2 and 2.2 respectively. They believe the investments being considered are typical of
projects in the relevant industries.
Diamond Plc industries beta is 1.6, treasury bill rate is 9% and the average return on companies
quoted on the stock exchange is 14%.
You are required to:
(a) (i) Compute the Net Present Values of both projects using the company's
weighted average cost of capital as a discount rate.
(ii) Compute the NPVs using a discount rate which takes account of the risk associated
with the individual projects.
(iii) Advise the Directors regarding the project to accept.
(b) Enumerate the uses and limitations of the Capital Asset Pricing Model (CAPM)
Illustration 2.4.6
A company borrows N5,000,000 at an interest rate of 10%. The duration of the loan being 5 years
and repayment is to be at a constant annual amount. Each repayment is to incorporate both the
capital sum and interest thereon.
Required:
a. Determine the annual repayment and the total service cost of the loan.
b. Prepare a repayment schedule for the loan.

30
PART 3
SECURITIES AND DIVISIBLE PROFITS

At the end of this study student will be able to;
Understand the various securities available to companies to use as capital for
business expansion.
Determine the types and effects of returns on capital employed by the business.
Know the decision guiding the declaration of dividends to shareholders.
3.2 BONDS
A bond is a long-term contract under which a borrower agrees to make payments of interest and
principal, on specific dates, to the holders of the bond. There are four main types of bonds: Treasury,
Corporate, Government, and Foreign.
Each type differs with respect to expected return and degree of risk.
Treasury bonds, sometimes referred to as government bonds, are issued by the Federal
government and are not exposed to default risk.
Corporate bonds are issued by corporations and are exposed to default risk. Different
corporate bonds have different levels of default risk, depending on the issuing company's
characteristics and on the terms of repayment.
Government Bond these are essentially bonds issued by Government

Foreign these are bonds issued outside the shores of Nigeria usually by corporate
organizations.
Bond Market
Primarily traded in the over-the-counter (OTC) market.
Most bonds are owned by and traded among large financial institutions.
Full information on bond trades in the OTC market is not published, but a representative
group of bonds is listed and traded on the bond division of the Nigerian Stock Exchange.
Key Features of Bonds

Par value face amount of the bond, which is paid at maturity (assume N1,000).
Coupon interest rate stated interest rate (generally fixed) paid by the issuer. Multiply by
par value to get dollar payment of interest.
Maturity date years until the bond must be repaid.
Issue date when the bond was issued.
Yield to maturity - rate of return earned on a bond held until maturity (also called the
promised yield).
Allows issuer to refund the bond issue if rates decline (helps the issuer, but hurts the investor).
Borrowers are willing to pay a higher interest rate, and lenders/investors require a higher
rate, for callable bonds.
Most bonds have a deferred call and a declining call premium.

31
Other Types of Bond
Convertible bond may be exchanged for ordinary shares of the firm, at the holder's option.
Warrant long-term option to buy a stated number of shares of ordinary shares at a specified
price.
Putable bond allows holder to sell the bond back to the company prior to maturity.
Income bond pays interest only when interest is earned by the firm.
Indexed bond interest rate paid is based upon the rate of inflation.
Mortgage bonds
Debentures
Subordinated debentures
Investment-grade bonds
BOND VALUATION
Bonds are one of the most important types of securities to investors, and are a major source of
financing for corporations and governments.
The value of any financial asset is the present value of the cash flows expected from that asset.
Therefore, once the cash flows have been estimated, and a discount rate determined, the value of
the financial asset can be calculated.
A bond is valued at the present value of the stream of interest payments (an annuity) plus the
present value of the par value, which is the principal amount for the bond, and is received by the
investor on the bond's maturity date. Depending on the relationship between the current interest
rate and the bond's coupon rate, a bond can sell at its par value, at a discount, or at a premium. The
total rate of return on a bond is comprised of two components: interest yield and capital gains yield.
The bond valuation concepts developed earlier in the chapter are used to illustrate interest rate and
reinvestment rate risk. In addition, default risk, various types of corporate bonds, bond ratings, and
bond markets are discussed.
Factors affecting Bond Valuation and Rating

Financial performance
Debt ratio
TIE ratio
Current ratio
Bond contract provisions

Secured vs. Unsecured debt
Senior vs. subordinated debt
Guarantee and sinking fund provisions
Debt maturity
Other Factors Affecting Valuation and Default Risks

Earnings stability
Regulatory environment
Potential antitrust or product liabilities
Pension liabilities
Potential labour problems
Accounting policies

32
3.3 STOCKS
Stock typically takes the form of shares of either ordinary shares or preferred stock. As a unit of
ownership, common stock typically carries voting rights that can be exercised in corporate
decisions.
Ordinary Shares
Ordinary shares are the most common kind of shares. An ordinary share gives the holder voting
rights in the company and entitles the person to all dividend distributions as a part-owner of the
company.
Ordinary shares include those traded privately as well as shares that trade on the various public
stock exchanges. Ordinary shares have a stated "par value", but this value is more of a technicality,
and will rarely be more than a few pennies per share. The true value of an ordinary share is based
on the price obtained through market forces, the value of the underlying business and investor
sentiment toward the company.
Ordinary shareholders are entitled to receive dividends if any are available after dividends on
preferred shares are paid. They are also entitled to their share of the residual economic value of the
company should the business unwind; however, they are last in line after bondholders and
preferred shareholders for receiving business proceeds. As such, ordinary shareholders are
considered unsecured creditors.
Features of ordinary shares

Represents ownership.
Ownership implies control.
Stockholders elect directors.
Directors elect management.
Management's goal: Maximize stock price.
Types of Stocks
Preferred stock differs from ordinary shares in that it typically does not carry voting rights but is
legally entitled to receive a certain level of dividend payments before any dividends can be issued to
other shareholders.
Convertible preferred stock is preferred stock that includes an option for the holder to convert the
preferred shares into a fixed number of common shares, usually anytime after a predetermined
date. Shares of such stock are called "convertible preferred shares" or convertible preference shares.
New equity issues may have specific legal clauses attached that differentiate them from previous
issues of the issuer. Some ordinary shares may be issued without the typical voting rights, for
instance, or some shares may have special rights unique to them and issued only to certain parties.
Often, new issues that have not been registered with a securities governing body may be restricted
from resale for certain periods of time.
Preferred stock may be hybrid by having the qualities of bonds of fixed returns and common stock
voting rights. They also have preference in the payment of dividends over common stock and also
are given preference at the time of liquidation over common stock. They have other features of
accumulation in dividend.

33
Any shares that are not preferred shares do not have any predetermined dividend amount. An
ordinary share represents equity ownership in a company and entitles the owner to a vote in matters
put before shareholders in proportion to their percentage ownership in the company.
3.4 DIVISIBLE PROFITS

The subject of corporate dividend policy has captivated economists for a long time, resulting in
intensive theoretical modeling and empirical examinations. A number of conflicting theoretical
models lacking strong empirical support define current attempts to explain the puzzling reality of
corporate dividend behavior.
Corporate dividend policy has captured the interest of economists of this century and over the last
five decades has been the subject of intensive theoretical modeling and empirical examination.
The majority of shareholders must pay taxes on dividend income. The majority of empirical works
support the hypothesis that the returns on dividend-paying stocks are increased to offset the tax
liability of dividend payments.
Further, if dividends are changed only to signal firm-specific information, aggregate dividend
changes should be small and random rather than have a systematic time series pattern and a
demonstrated positive trend (Marsh and Merton, 1987).
No single economic rationale can explain the dividend phenomenon. The preference of
shareholders for dividends (Crockett and Friend, 1988) can instead be partially explained by a
combination of factors: risk averse shareholders who have invested in capital-constrained firms, the
costs associated with systematic liquidation of holdings, agency costs and information transmission.
The incompleteness of all theoretical models is largely due to a misconception of the nature of
dividend payments.
The corporate tradition of paying dividends is the sum total of more than three hundred years of
evolution of the practice of dividend payments. Despite individual differences in policy, consistent,
identifiable patterns of dividend payment recur through companies. Managers are reluctant to
reduce dividend payments, even in periods of financial distress. Moreover, dividends are increased
only if a corporation's management is confident that the higher levels can be maintained. Executives
believe that shareholders expect significant dividends to be paid, and shareholders believe that they
deserve these dividends. In practice, shareholders prefer dividend payments despite the tax liability.
Dividend Relevancy
It is said that there are many reasons for paying dividends and many other reasons for not paying
any dividends. The import of this sentence is that dividends are controversial.
Dividend is mainly cash, or other benefits, distribution for earnings. Dividends have following
types:
Regular dividends: those paid by company quarterly, semi-annually or annually.

Extra dividends: paid once and not to be repeated
Special dividends: unlikely to be repeated
Stock dividends: paid in shares of stocks.
For a long time the debate is on hold as to how the dividend policy affects company value. Some
researchers believe that dividends increase investors wealth (Gordon 1959), others suggests that
dividends are irrelevant (Miller and Modigliani, 1961).

34
Payment of Dividend
Dividends are a distribution of profits to the owners of a company and are thus the most direct way of
rewarding them for their investment. However, in most companies there is a certain amount of
'expectations for tomorrow' in that much of the profits are retained in the company and only a
proportion is paid as a dividend.
When dividend is low, the only way the owners can cash in on the success of their investment is to sell
their shares or borrow money against the strengthening price of their shares.
Other sources of rewarding the owners of business could be from:

(a) Capital growth (share price appreciation)
(b) Productivity bonus for directors in executive capacity
(c) Bonus or script issue
(d) Rights issue
Factors Determining Dividend Payment and Policy
The factors that will affect Directors' decision to come up with a dividend policy and recommend
dividend payment to shareholders include:
1. The Legal Factor
2. Government Regulations
3. Availability of funds to pay dividend
4. Share valuation
5. Internal reinvestment opportunities
6. Loan redemption
7. The Risk Factor
8. Taxation
9. Level of inflation
10. Control to be exercised
11. Dividend policy of companies in the same industry
12. Liquidity preferences of the dormant shareholders
Factors governing share prices

The price of listed shares on the Nigerian Stock Exchange NSE fluctuates every now and then. The
price for shares goes up and down owing to a number of factors occurring in individual business units
(i.e. listed companies) through to a complex environment of the entire economic system.
No economic activity operates in a vacuum. In our boundless, inter-connected world, the smallest
tremor can detonate an earthquake; the spark can ignite a wild fire, so also is information traded to
affect share prices.
(i) Markets react promptly and uncharacteristically to rumours of war,
(ii) Change in regulatory environment (business), political climate seen as negative by
the business (investing) community, and interest rate variation to general performance of
the economy. The share prices on the NSE which is a secondary market are affected either
positively or negatively by a number of factors occurring within and outside the economic
system.
(iii) The influence from within the country is generally categorised as domestic factors.
Those that are impacting on the business and investment from outside the country are
defined as global factors. Thus, before buying or selling shares one should first ascertain
both global and domestic factors which may be influencing the market, and establish a
good timing of buying or selling one's shares. Traditionally, share prices are higher when a

35
country's economy is doing stronger and lower when the country experiences poor
economic performance.
(iv) Interest rates play a major role in determining stock market trends. Bull markets
(those in an upward market) are usually associated with low interest rates, and bear
markets (those in a downward trend) with high interest rates. Interest rates are
determined by the demand for capital it pushes them up and this normally indicates
that the economy is thriving and shares are probably expensive. Low interest indicate
low demand for capital, thus liquidity builds up on the economy, driving share prices
down.
(v) Company profits are very much an issue in share investment. Companies doing well
in their business activities are likely to attract more investors, thereby resulting in high
demand of their shares. Entities which are not doing well may result in investors selling
their shares on the market. Selling en masse will result in more shares flooding the
market and consequently bringing the price down an abundance of a commodity
leads to price decline.
(vi) A political development inside or outside the country - may have bearing on
share price. Usually this factor cuts across all the shares on the market, in other words it
is a factor that impacts on all the shares irrespective of the sector classification. The
political factor is visible through regulatory processes and its influence (not specific) in
share price becomes the eventuality.
(vii) Perception factors have their own fair share of contribution to share price fluctuation.
The fact that Nigeria is classified as a developing economy means that general
perceptions towards developing economies will impact on local share prices as well.
(viii) The random forces the Great Unknowns combine with the everyday laws of
supply and demand. Whichever way the wind blows, prices can rise quickly as they
fall, confounding the best plans of some industries while rescuing others from the brink
of disaster.
(ix) The cyclical nature of business itself shapes the peaks and valleys of a dynamically
shifting market. An investor may not be able to predict these forces, but analyzing and
understanding them, one will be better equipped to weather the lows as you wait for
the tide of fortune to turn.
(x) Demand and Supply This fundamental rule of economics holds good for the
equity market as well. The price is directly affected by the trend of stock market trading.
When more people are buying a certain stock, the price of that stock increases and
when more people are selling the stock, the price of that particular stock falls. Now it is
difficult to predict the trend of the market but your stock broker can give you a fair idea
of the ongoing trend of the market, but follow the advice blindly.
(xi) News News is undoubtedly a huge factor when it comes to stock price. Positive news
about a company can increase buying interest in the market while a negative press
release can ruin the prospect of a stock. Having said that, you must always remember
that often times, despite amazingly good news, a stock can show least movement. It is
the overall performance of the company that matters more than news. It is always wise
to take a wait and watch policy in a volatile market or when there is mixed reaction
about a particular stock.
It has to borne in mind that the factors above are, by no means, the only factors that can influence
share price movement on the exchange.

36
Like any other commodity, in the stock market, share prices are also dependent on so many factors.
So, it is hard to point out just one or two factors that affect the price of the stocks. There are still some
factors that directly influence share prices.
3.5 FINANCIAL OPTIONS

A contract in which the writer (seller) promises that the contract buyer has the right, but not the
obligation, to buy or sell a certain security at a certain price (the strike price) on or before a certain
expiration date, or exercise date. The asset in the contract is referred to as the underlying asset, or
simply the underlying. An option giving the buyer the right to buy at a certain price is called a call,
while one that gives him/her the right to sell is called a put.
Options contracts are used both in speculative investments, in which the option holder believes
he/she can secure a price much higher (or lower) than the fair market value of the underlying on the
expiration date. For example, one may purchase a call option to buy corn at a low price, expecting
the price of corn to rise significantly by the time the option is exercised. The investors may then buy
the corn at the agreed-upon low price and instantly resell it for a tidy profit. Cases in which the
option holder is correct are called in the money options, while cases in which the market moves in
the opposite direction of the speculation are called out of the money. Like all speculative investing,
this is a risky venture.
Other investors use option contracts for a completely different purpose: to hedge against market
movements that would cause their other investments to lose money. For example, the same corn
investor may buy the commodity at fair market value with the hope of the price rising. He/she may
then buy a put contract at a high price in case the price of corn declines. This will limit his/her risk: if
the price of corn falls, the investor has the option to sell at a high price and, if the price of corn rises
(especially higher than the strike price of the option), then he/she will choose not to exercise the
option.
Illustration 3.6.1
Differentiate between Ordinary shares and bonds.
Illustration 3.6.2
What are financial options? Under what circumstances are financial options used?
Illustration 3.6.3
List and explain different factors that may affect the decisions to declare dividends by
companies.
(i) Markets react promptly and uncharacteristically to rumours of war,
(ii) Change in regulatory environment (business), political climate seen as negative by the
business (investing) community, and interest rate variation to general performance of the
economy. The share prices on the NSE which is a secondary market are affected either
positively or negatively by a number of factors occurring within and outside the
economic system.

37
(iii) The influence from within the country is generally categorised as domestic factors. Those
that are impacting on the business and investment from outside the country are defined
as global factors. Thus, before buying or selling shares one should first ascertain both
global and domestic factors which may be influencing the market, and establish a good
timing of buying or selling ones shares. Traditionally, share prices are higher when
country's economy is doing stronger and lower when the country experiences poor
economic performance.
(iv) Interest rates play a major role in determining stock market trends. Bull markets (those in
an upward market) are usually associated with low interest rates, and bear markets
(those in a downward trend) with high interest rates. Interest rates are determined by the
demand for capital pushes them up and normally indicates that the economy is thriving
and that shares probably expensive. Low interest indicate low demand for capital, thus
liquidity builds up on the economy, driving share price down.
(v) Company profits are very much an issue in share investment. Companies doing well in
their business activities are likely to attract more investors, thereby resulting in high
demand of their shares. Entities which are not doing well business wise may result in
investors selling their shares on the market. Selling en masse will result in more shares
flooding the market and consequently bringing the price down an abundance of a
commodity leads to price decline.
(vi) A political development inside or outside the country - may have bearing on share
price. Usually this factor cut across all the shares on the market, in other words it is factor
that impacts on all the shares irrespective of the sector classification. The political factor is
visible through regulatory processes and its influence (not specific) in share price
becomes the eventuality.
(vii) Perception factors have their own fair share of contribution to share price fluctuation.
The fact that Nigeria is classified as a developing economy, it means that general
perceptions towards developing economies will impact on local share prices as well.
(viii) The random forces the Great Unknowns combine with the everyday laws of supply
and demand. Whichever way the wind blows, prices can rise quickly as they fall,
confounding the best plans of some industries while rescuing others from the brink of
disaster.
(ix) The cyclical nature of business itself, to shape the peaks and valleys of a dynamically
shifting market. An investor may not be able to predict these forces, but analyzing and
understanding them, one will be better equipped to weather the lows as you wait for the
tide of fortune to turn.
(x) Demand and Supply This fundamental rule of economics holds good for the equity
market as well. The price is directly affected by the trend of stock market trading. When
more people are buying a certain stock, the price of that stock increases and when more
people are selling he stock, the price of that particular stock falls. Now it is difficult to
predict the trend of the market but your stock broker can give you fair idea of the ongoing
trend of the market but be careful before you blindly follow the advice.
(xi) News News is undoubtedly a huge factor when it comes to stock price. Positive news
about a company can increase buying interest in the market while a negative press
release can ruin the prospect of a stock. Having said that, you must always remember
that often times, despite amazingly good news, a stock can show least movement. It is the
overall performance of the company that matters more than news. It is always wise to
take a wait and watch policy in a volatile market or when there is mixed reaction about a
particular stock.

38
PART 4
PROJECTS EVALUATION
CAPITAL BUDGETING UNDER CERTAINTY

At the end of this study students will be able to;
Understand the various techniques of investment appraisal.
Determine the effect of environmental condition using various technique
appraisals on management decision.
Know the impact of various macroeconomic factors on financial decisions.
4.2 CAPITAL BUDGETING TECHNOLOGIES UNDER CERTAINTY
INTRODUCTION
Capital budgeting can be explained to be a firm's decision to invest its current funds most
effectively in long term activities in anticipation of an expected flow of future benefits over a
series of years. However, the investment decision could be in the form of addition,
disposition, replacement and modification of activities or asset base that would ensure good
returns on the utilization of the firm's assets. Therefore, the manager has to give
consideration to the following factors when capital budgeting decision is being made viz:
a. The existence of huge expenditures or large cash exposure.
b. The involvement of long gestation period between initial expenditures and returns.
c. The expectation of higher returns because of factors (a) and (b) above.
Going by the factors above, the manager must not fail to make appropriate investment or
selection of good projects because, the volume of fixed assets far exceed current assets and
the owners of the company (shareholders) are long term investors, with high expectation of
returns which can only be met with the higher returns from long term assets. These
assertions, call for the need to examine the different methods of selecting investments in long
term assets, hence the discussion of the following methods or techniques:
a. Payback Period (PBP)

b. Accounting Rate of Return (ARR)
c. Net Present Value (NPV)
d. Internal Rate of Return (IRR)
Payback Period Method (PBP)

This technique measures projects on the basis of the period within which the investment pays
back itself or the period of recovery of the initial investment. This means that we would
measure the full recovery of the project cash outflow through the project cash inflow. CIMA
defines payback as the period usually expressed in years, in which the cash outflows will
equate the cash inflows from a project. It is evident that this method pays attention to the
shortness of the project i.e. the shorter the period of recovery of initial outlay, the more
beneficial and acceptable the project becomes and this constitutes the decision rule.

39
Example
Bright Koroko runs a manufacturing business. The project involves an immediate cash outlay
of N200,000. He estimates that the net cash inflows from the project will be as follows:
Year N
1 20,000
2 40,000
3 220,000
4 80,000
Calculate Bright Koroko payback period for the project.
Solution
Year Cash flows Cumulative
Cash flows
N N
0 (200,000) 0
1 20,000 20,000
2 40,000 60,000
3 220,000 300,000
4 80,000
Payback period 2 yrs + 140 12 = 7.6 months

220
Payback period = 2 years, 7.6 months
Decision Rules
a. Using the PBP, accept all projects whose payback period is shorter than the
company's required PBP.
b. If mutually exclusive projects are involved, whereby only one of the projects can
be undertaken, the rule is to accept the project with the shorter PBP.
Advantages
a. It is simple to calculate and understand.
b. Of all the methods of capital budgeting, it least exposes the firm to problems of
uncertainty, since it focuses on shortness of project to pay the initial outlay.
c. It is a fast screening technique, especially for the firms that have liquidity problems.
Disadvantages
a. It does not incorporate time value of money i.e. it does not recognize the fact that the
value of N1 today, will be far more than the value of N1 in two or three years time.
This constitutes the alternative forgone of money due to passage of time and not
inflation.
b. It ignores cash flows after the payback period.
c. Like all the other techniques, it does not take into account the risk associated with
each project and the attitude of the company to risk.

40
4.3 ACCOUNTING RATE OF RETURN METHOD (ARR)
This method is a function of the concept of return on capital employed or invested (ROCE of
(ROI), in that it measures the ratio of accounting profits to the accounting investments and
evaluates project based on these ratio or return. The following two ways of determining the
ratio are allowed or acceptable for examination purposes.
Example
Ojutonsoro recently convinced his friends and relations to grant him a loan of
N100,000, which he intends to invest in a farming project. He estimates that
project will yield the following returns annually for next five consecutive years.
Year N
1 30,000.00
2 30,000.00
3 40,000.00
4 30,000.00
5 20,000.00
There were no expectations of scrap values at the end of the fifth year and he intends
to evaluate the project on the basis of accounting rate of return.
You are required to provide this accounting rate of return on the assumption that the
annual returns are profits after deprecation but before taxation.
Solution
If option (a) under the ARR method is used, then the ARR will be:
Decision Rules
a. The rule is to invest in all projects whose accounting rate of return are h i g h e r t h a n t h e
company's predetermined minimum acceptable ARR.
b. Where mutually exclusive projects are concerned, the rule is to accept the project
with the highest ARR as long as that highest ARR is also higher than the company's
minimum acceptable ARR (Note: where the question does not give the minimum
ARR, the above decision should be made and given to the examiner).
Advantages
a. It is easy to calculate.
b. Unlike the payback period, it makes use of all the profits for the years
of the project.

41
c. Divisionalised companies would find the technique easier to understand because it
is similar to their normal annual performance evaluation technique.
Disadvantages
a. It does not recognize the time value of money.
b. It is an average and as such will hide the sizes and timing of the individual cash flows.
c. It is not good on accounting profit which may differ as a result of differences in
accounting methods used in calculating depreciation instead of the more relevant
capital allowances.
d. It does not take into consideration the risk associated with each
project as well as the attitude of the management of the company to risk.
Discounted Payback Period Method

The principals and decision rules are the same as in the normal payback period method, the only
differences, is that the cash flows to be used are discounted at the given or appropriate cost of
capital. Therefore, this version of payback technique, will not suffer from the disadvantage of
discountenance of time value concerned.
Example
Using the Ojutonsoro example, calculate the discounted payback of the project, if the
cost of capital is 10% per annum.
Solution
Year Cash flows DF @ 10& PV Cumulative Discounted
Cash flows
N N N N
0 (100,000) 1.00 - -
1 30,000 0.9091 27,273 27,273
2 30,000 0.8264 24,792 52,065
3 40,000 0.7513 30,052 82,117
4 30,000 0.6830 20,490 102,607
5 20,000 0.6209 12,418 115,025
PBP = 3 years + 17883 x 12

20490
= 3 years 10.5 months
Note: 17883 = 1,000,000 829,117
4.4 NET PRESENT VALUE METHOD (NPV)

The net present value is a summation of all discounted cash flow (PV) associated with a
project i.e. (the difference between the PV of cash outlay or outflow and the positive PV of
the cash inflows).
Decision Rule
a. Accept all projects that produce positive Net Present Value (NPV).
b. If mutually exclusive projects are involved, the rule is to accept the project that
produces the highest positive Net Present Value.

42
Example
At a cost of capital of 10% per annum. Calculate the NPV of Ojutonsoro's
project.
Year Cash flows DF @ 10& PV
N N N
0 (100,000) 1.00 (100,000)
1 30,000 0.9091 27,273
2 30,000 0.8264 24,792
3 40,000 0.7513 30,052
4 30,000 0.6830 20,490
5 20,000 0.6209 12,418
+NPV 15,025
Advantages
a. It recognizes the time value of money.
b. It measures in absolute terms (value) the increase in the wealth of the shareholders
through the acceptance of a project.
c. It is additive, in that decisions can be reached on a combination of projects, through
the addition of their respective NPV.
d. Unlike the payback period, it measures projects by the utilization of
all cash flows of the project.
e. It is useful than the ARR in decisions under capital rationing i.e. shortage of
investments funds.
Disadvantages
a. It is more difficult to calculate than PBP and ARR.
b. It relies heavily on the correct estimation of the cost of capital i.e.
where errors occur in the cost of capital used for discounting the decision using the
NPV would be misleading.
c. Unlike the ARR, non-accounting managers may not be conversant
with the decision rule of NPV, especially in large decentralized organizations.
d. Like all the other methods, it does not take risk into account.
Internal Rate of Return Method (IRR)

The IRR is that cost of capital, or return that will produce an NPV of zero if applied to a
project. It is a breakeven point cost of capital. It is also the cost of capital or discount rate that
will equate the cash inflows of a project with the cash outflows of that project.
In order to generate the cost of capital that will produce exactly zero NPV, the following
procedures may be followed:
a. Generate two (2) opposite values of NPV (+ and values) using two different
discount rates earlier calculated.

43
b. Interpolate between the two discount rates generated in (a) above in order to
estimate the cost of capital that will produce a NPV. Moreover, it is implied that the
higher the cost of capital, the lower the NPV and vice versa.
c. The interpolation formula can be defined as:

If the NPV at H% (the higher rate used) is NNH and if the NPV at L% (the
lower rate used) is NNL, then
E.g
NPVL = N200 NPVH = N-80
= 4% + 4.33%
= 8.33%
Example
Using the same Ojutonsoro example, calculate the IRR for the project.
Year Cash flows DF @ 10& PV DF @ 10& PV
N N N N N
0 (100,000) 1.00 (100,000) 1.00 (100,000)
1 30,000 0.9091 27,273 0.8333 24,999
2 30,000 0.8264 24,792 0.6944 20,832
3 40,000 0.7513 30,052 0.5787 23,148
4 30,000 0.6830 20,490 0.4822 14,466
5 20,000 0.6209 12,418 0.4109 8,038
+NPV 15,025 -NPV (8,517)
= 10%+6.38%
=16.38%

44
Decision Rule
a. Using the IRR techniques, the rule is to accept all projects whose IRR are greater than the
company's cost of capital.
b. If mutually exclusive projects are being considered, the rule is to accept the project that
produces the highest IRR.
Advantages
a. It recognizes the time value of money.
b. It is more attractive to divisional managers in large organizations since they are used to a
return approach in evaluations.
c. It provides a margin of safety in the calculation of a company's cost capital i.e. it measures
all allowable margins of error.
Disadvantages
a. It is more difficult to calculate than the other methods.
b. Where the cash flows of a project are unconventional in which case, cash flows occur in
between cash outflows and vice versa, the IRR techniques will produce more than one IRR
for a project. It can lead to a situation of sub-optional decision.
c. Where mutually exclusive projects are being considered, the IRR may produce a decision
that will conflict with the NPV decision in that the IRR, being a rate of return does not
recognize the size or scale of a project.
d. It does not recognize the risks associated with the project as well as the attitude of the
management of a company to the risk involved.
Modification of IRR
The IRR can be modified for any of the following reasons viz:
a. Where the cash flows are unconventional.
b. Where projects are mutually exclusive.
The situation above can be taken care of by the following two methods:
a. Extended yield method.
b. Incremental yield approach.
a. Extended Yield Method

By this method, we modify the IRR technique in order to produce a unique IRR rather than
multiple IRR. The following step may be adopted:
i. Convert the unconventional cash flow into conventional cash flows by discounting
all future cash flow backward at the given cost of capital until they are fully absorbed
by the positive cash flow (cash inflow) so they become a zero cash flow.
b. Incremental Yield Method

Where projects are mutually exclusive, it means that we cannot undertake all the projects.
We must undertake only one which means that acceptance of only one project is equivalent
to rejection of all other mutually exclusive projects.
IRR will produce conflicting results with NPV where mutually exclusive projects are involved
because IRR does not recognize the scale or size of investments. For this reason we must modify the
cash flow of mutually exclusive projects, if we are forced to evaluate them using IRR. Hence the
method for this modification is called INCREMENTAL YIELD APPROACH. Under this method,

45
revise the cash flow to generate differential or incremental cash flow. Thereafter, we calculate IRR of
this incremental cash flow and base our decision for project selection on the project that generated
this incremental cash flow (i.e. the project that was kept constant).
Steps for Calculating Incremental IRR

The following steps are to be followed in calculating the incremental IRR:
a. Calculate the incremental cash flow by keeping one project constant (i.e. subtracting the
cash flow of the projects from the cash flow of the project that was kept constant e.g. Project
Y-Z if incremental cash flows are generated from Y-Z then Y must be kept constant.
b. Calculate the IRR of these incremental cash flows in the normal way.
c. If the IRR of these incremental cash flows is greater than the company's cost of capital then
the project that was kept constant must be better than the other project and must be
accepted. On the hand, if the IRR of the incremental cash flow is lower than the cost of
capital, than the project that was kept constant must be rejected.
Example
Dike Ltd's two accountants are in disagreement as to which of two mutually exclusive
projects to undertake. One based his conclusion on an IRR computation, the other by
funding the projects' NPVs at Dike's required rate of return of 10%. The first
project requires an investment of N1,410,400 and will generate net cash saving of
N300,000 per annum for 10 years. The second project only requires N867,800 to be
invested to generate N200,000 for 10 years.
Required
a. Produce the calculation of the two accountants.
b. Produce an unambiguous result by considering the internal investment.
c. If the alternative investment rate was 14%, which of the two projects would be
accepted.
d. Compare your conclusion in (c) with calculation of the NPV of both projects at
the alternative rate of 14%.
Solution
a. Project 1 Project 2
Year Cash flow DF @ 10% PV Year Cash flow DF @ 10% PV
N N N N
0 (1,410,400) 1.00 (1,410,400) 0 (867,800) 1.00 (867,800)
1-0 300,000 6.1446 1,843,380 1-10 200,000 6.1446 1,228,920
+NPV 432,980 +NPV 361,120

N N N N
0 (1,410,400) 1.00 (1,410,400) 0 (867,800) 1.00 (867,800)
1-0 300,000 41925 1,257,750 1-10 200,000 4.1925 838,500
+NPV 154,100 +NPV 29,300

46
= 10% + 7.39 = 10% + 9.25
= 17.39% = 19.25%
Using NPV, Project 1 should be accepted
Using IRR, Project 2 should be accepted
b. Project 1 (P1) Project 2 (P2)
Year Cash flow Year Cash flow Incremental
Cash flows
(P1-P2)
N N N
0 (1,410,400) 0 (867,800) (542,600)
1-10 300,000 1-10 200,000 100,000
Incremental Cash Flows

Year Cash flow @10% PV @20% PV
N N N
0 (542,600) 1.00 (542,600) 1.00 (542,600)
1-10 100,000 6.1446 614,460 4.1925 419,250
+NPV 71,860 NPV (123,350)
= 10% + 3.68 = 13.68%
a. Since the IRR of the incremental cash flows is greater than the company's cost of capital,
it means project 1, which was held constant should be accepted. This tallies with the
result of the NPV.
If the investment rate is now 14%, it means the decision to accept project 1 will no more
hold as the incremental IRR is lesser than the cost of capital of 14%. Therefore, project 2,
now looks more attractive and should be accepted.
a. Project 1 Project 2
N N N N
0 (1,410,400) 1.00 (1,410,400) 0 (867,800) 1.00 (867,800)
1-10 300,000 5.21611,564,830 1-10 200,000 5.2161 10,431,220
+NPV 154,430 +NPV 175,420
From the calculations of the NPV based on 14% cost of capital, project 2 show higher NPV,
and therefore should be accepted. This confirms the decision (c) above.

47
The Net Terminal Value (Net Future Value)
It is the compounded sum of the Net Present Value over the life of an asset. It is the compound
value of the net return of an asset.
Formula:
Example
Senam and Co invested in a project which has a life span of 4 years with initial
capital outlay of N240,000. The capital inflows are as shown:
Year 1 80,000
Year 2 130,000
Year 3 80,000
Year 4 70,000
The cost of capital for the project is 10%. What is the net terminal value of the
project?
Solution
Step 1: Compute the Net Present Value
Year Cash flow DF(10%) PV
0 (240,000) 1 (240,000)
1 80,000 0.909 72,720
2 130,000 0.826 107,380
3 80,000 0.751 60,080
4 70,000 0.683 47,810
47,990
Illustration 4.5.1
Arewa Plc has found that after using equipment for two years a better model of the
equipment is now in the market. The new equipment will not only produce the current
volume of the company's product more efficiently but it will allow an increased output of the
product. The existing equipment has cost N32,000 and was being depreciated straight-line
over a 10 years period, at the end of which it would be scrapped. The market value of this
equipment is currently N15,000 and there is a prospective purchaser.
The new equipment is now available at a cost of N123,500. Because of its more complex
mechanism, the new equipment is expected to have a useful life of only eight years. A scrap
value of N20,500 is considered reasonable.

48
A comparison of the existing and new equipment now available shows the following:
Existing Equipment New Equipment
Annual capacity 200,000 units 230,000 units
Selling price per unit N0.95 N0.95
Production cost per unit
Labour N0.12 N0.08
Materials N0.48 N0.46
Fixed overheads N0.24 N0.16
The marketing manager is of the opinion that the additional output can be sold at 95k per
unit.
If the new equipment were to be run at the old production level of 200,000 units per annum,
the operators would be freed for a proportional period of time for re-assignment to the other
operations of the company.
The marketing manager has suggested that the advanced model should be purchased by
the company to replace the existing equipment. The cost of capital is 15 percent.
You are required to calculate:
a. Pay back period.
b. Average annual rate of return on investment.
c. The net present value.
d. The internal rate of return.
Illustration 4.5.2
Find the IRR of the project given below and state whether the project should be accepted if
the investment required a minimum return of 20%.
Year Cash Flow
0 (4,000)
1 1,200
2 1,410
3 1,875
4 1,150
Illustration 4.5.3
Project X involves an initial outlay of N32,400. Its working life is expected to be three years.
The cash streams generated by it are expected to be as follows:
Year Cash Flow
1 N16,000
2 N14,000
3 N12,000
What is the IRR?

49
PART 5
CAPITAL BUDGETING UNDER UNCERTAINTY

Understand the effect of risk and uncertainty in the environment on investment
appraisal
Appreciate the value of various investment appraisal techniques used under risky
situations.
Determine the criterion for decision making within risky environment.
5.2 CAPITAL BUDGETING UNDER UNCERTAINTY

There is capital budgeting or investment appraisal under certainty, under risk and under
uncertainty. Certainty occur when the financial manager has absolute knowledge of events,
risk occur when the financial manager has partial knowledge of events and uncertainty is
when the financial manager has no knowledge at all of events and circumstances in the
economy.
Method of Investment Appraisal under Risk and Uncertainty

1. Expected Value Method.
2. Sensitivity Analysis Method.
3. Decision Tree Method.
1. Expected Value Method

The expected value methods recognize the probability of occurrence of each return
over the life of the asset. The return is called expected value such that probability
of occurrence is considered.
Example
Adewunmi Plc has just secured a project with initial capital of N30,000,
generating returns of N40,000 in year 1, N40,000 in year 2, N60,000 in year
3 with a probability of 30% in year 1, 30% in year 2 and 40% in year 3. The
cost of capital is 10% per annum. Should the project be undertaken?
Solution
Year Cash flow Prob. Expected DF (10%) PV
N Cash flow
0 (30,000) 1 1 1 (30,000)
1 40,000 0.3 12,000 0.909 10,908
2 40,000 0.3 12,000 0.826 9,912
3 60,000 0.4 24,000 0.751 18,024
NPV 8,844

50
Decision Rule
Undertake the project since it has a positive NPV.
1. Sensitivity Analysis Method

The sensitivity analysis measures the margin of safety, it measures the least price for
which a product can be sold that will not result into loss. It identifies the variables of a
project that will be critical to investment decision. It is a deterministic simulation. It
indentifies unfavourable changes or errors of estimates in the variables such as:
1. Contribution margin.
2. Selling price.
3. Variable cost.
4. Fixed cost.
5. Outlay.
6. Project life.
Example
Tobechukwu Ltd plans to invest in a project the sum of N750,000 which has a life span
of 5 years, generating 20,000 units annually of a product called Dandi. The selling price
of Dandi is N40 per unit and variable cost is N20 per unit of the product. Annual fixed
cost amounts to N150,000, the cost of capital is 15%.
Required:
i. Should Tobechukwu & Co invest in the project?
ii. Compute sensitivity analysis of the project.
Solution
Step 1: Compute the NPV of the project

Selling price 40
Variable cost (20)
Contribution 20
Total contribution 20 x 20,000 = 400,000
Less Fixed cost 150,000
Annual Return (AR) 250,000
PV of profit for 5 years
3.35 x 250,000 = 837,500
Less outlay 750,000
NPV 87,500
Step 2: Compute the sensitivity margin for each of the variables
1.

51
2.
3.
4.
5.
SMPL
n = 4.222 years
1. Decision Tree Method

In decision tree analysis, there are series of possibilities and various decision situations based
on the environmental factors surrounding the firm at this time. It is used to solve problems
where the probability of occurrence and non-occurrence are known resulting to more than a
single possible outcome.
Example
Realworth Ltd. is a Soft drink manufacturing and distribution company. The firm's
products have seasonal sales with different probability of occurrence. The firm operates
under three seasons with different seasonal sales of which probability of sales is 40%
during raining season, 30% in wet season and 30% during dry season. Sales can be
high and low for each season. The table below shows the various possible sales.

52
Sales Level Rain Wet Dry
High 40,000 60,000 100,000
Low 30,000 40,000 45,000
The initial outlay of the project is N200,000 and cost of capital is 15%. The project will have a
life span of 5 years.
Required: Should the project be undertaken?
Solution
Step 1: Draw the decision tree
R 0.4 40,000
W
0.3 60,000
0.3 100,000
H
L 30,000
R 0.4
W
0.3 40,000
D
45,000
0.3
SEASON
High
Cash flow Prob. ECF
40,000 0.4 16,000
60,000 0.3 18,000
100,000 0.3 30,000
64,000

53
Low
Cash flow Prob. ECF
30,000 0.4 12,000
40,000 0.3 12,000
45,000 0.3 13,500
37,500
Since the project will have a life span of 5 years

APV = 3.35
High = 64,000 x 3.35 = 214,400
Low = 37,500 x 3.35 = 125,625
Total PV = 340,025
Less initial outlay 200,000
NPV 145,025
Decision: The project should be undertaken.
5.3 PORTFOLIO THEORY

The portfolio of an asset is a combination of investment assets of different risk nature. They help to
minimize total risk and increase return. The proportion of each asset in the portfolio is measured by
mean rate of return.
INTRODUCTION
The historical rate of return: This is the weighted average rate of return (for the individual
investment assets in the portfolio). The proportion of total fund invested in each asset is the weight
which is also known as the money weighted mean rate of return.
Expected Return
Expected Return ' n(probability of return) (possible return)
E(R1) = (P1)(R1) + (P2) (R2) + (P3) (R3) . + (Pn Rn)
E(R1) = E(P1)(R1)
Risk Measurement
Since investment is risky and return might take a range of values, it is important therefore to
measure the dispersion and hence be able ascertain the level of risk of the investment. The variance
and standard deviation are being used for this purpose.
The higher the variance of an expected return, the higher the risk.
For a project or investment or portfolio of investment to be accepted the return must be
equal to or greater than zero.
Variance = (probability){possible return - expected return}2
t = 1
The Standard Deviation
The standard deviation is the square root of the variance. Standard
Devi ation: n { P1 (R1 - R1}2

t= 1

54
Relative Risk Measurement
Where the expected returns differ in major ways, it is expedient to use relative risk
measurement method called coefficient of variance (CV) Coefficient of variance (CV) =
Standard Deviation of returns
Expected Rate of Return

(R1)
Required Rate of Return
It is the minimum rate of return acceptable as compensation for deferring present consumption (in
investments) for future consumption. It is the net present value of expected return that is equal to
zero.
If:
Required rate of return > 0. (Accept investment)
Required rate of return < 0. (Reject investment)
Required rate of return is calculated using the internal rate of return method; (IRR). Since the IRR
measures the percentage of return where the expected return is minimum.
The Real Risk Free Rate (RRFR)

It is the interest rate where there is no inflation and uncertainty about future cash flows. It reflects the
time - value of money. The real rate of return is influenced by the preference for present
consumption over future consumption (investment) and the available investment opportunities.
The economic growth of the nation positively determines investment rate, investment opportunities
is bound to increase in a growing economy.
The Nominal Risk-Free Rate (NRFR)

It is the interest rate that incorporates inflation and the monetary environmental factors. The relative
ease or tightness in the capital market is another factor influencing the nominal risk - free rate.
Risk Premium
The risk premium is the increase in required rate of return over and above the nominal rate of return.
The required rate of return is the internal rate of return (IRR) of the asset, while the nominal rate of
return is that return offered by the market.
Due to uncertainty in investment, an investor would require an amount over and above the nominal
rate of return; these uncertainties include business risk, financial risk and liquidity risk, exchange
rate risk, and country risk.
The Liquidity Risk

Is the uncertainty provoked by the secondary market for an investment.
The Exchange Rate Risk
The risk brought about by purchasing an investment quoted or denominated in foreign currency.
The tendency for the exchange rate risk to increase as international business increases is very high.
Country Risk
Occurs as a result of major political or economic change in a nation. Investors with investment asset
in a politically unstable nation must incorporate this into their basket of risks.

55
The Standard Deviation of Independent Cash Inflow
Where investment asset possesses an independent cash inflow (or returns) and the possible net
present value has not been enumerated, the standard deviation of expected net present value
(ENPV) is calculated thus:
S.O = V1 + V2 + V3 . + Vn
(1 + r) 2 (1 + r) 4 (1 + r) 5 (1 + r) 2n
The Systematic Risk

The systematic risk of a portfolio is the undiversifiable market risk of the portfolio. It is provoked by
factors outside the control of the individual investor. It is brought about by heterogeneous factors
such as change in political environment, change in economic environment, natural disaster etc. It is
totally outside the control of the individual investor. It measures the portion of an individual asset's
total variance attributable to the variability of the total market portfolio.
The systematic risk is measured by the co-variance of individual assets of the market portfolio. It
is the undiversifiable risk of the portfolio.
The Unsystematic Risk

This is the risk unique to an individual asset; it is the diversifiable risk of the portfolio. The
unsystematic risk can be eliminated by diversification. A Well diversified portfolio would have
eliminated the unsystematic risks. The market does not compensate an investor for holding
unsystematic risks.
The Beta: (B)
The beta factor measures the systematic risk of an asset. The Beta factor measures the rate of
risk in a portfolio to the rate of return. It is measured by the scope of the security market line
(SML). The higher the systematic risk the higher the beta factor. (B)
The Security Market Line: (SML)
The security market line measures the relationship between risk and return on all available risky
assets. The risk preference of the individual investor is reflected in the nature of investment they
select, as measured by the security market line.
The risk and return is measured by the security market line (SML) Where an individual investor
perceives there will be movement on the security market line. A change in the financial risk will
provoke movement in the security market line. An increase in financial risk will increase the return -
risk position of the asset; this will provoke an upward movement.
Return = Changes in return
Risk Changes in risk

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Rate of Return The Slopes Measure risk to Return
Return
Risk
Risk free case of return (Rf)
Risk
5.4 CAPITAL ASSET PRICING MODEL (CAPM)

The capital asset pricing model states that the required return of any asset is a function of the
level of risk.
The capital asset pricing model is a measure of the relationship of individual asset in a portfolio
to the asset risk return in the portfolio.
It is also used to measure risk return on a portfolio to the market return. The capital asset pricing
model is a well diversifiable risk eliminating all unsystematic risk as assumed by Modigliani and
Miller. The CAPM measures return to risk as below.
R1 = Rf + BI(Rm - Rf)
Where: RI = Return in individual asset
Rf = Risk free rate of return
BI = Beta factor
Rm = Market rate of return
Market Premium
The market premium is measured by the CAPM as the difference in the market risk to the risk free
rate of return.
Market premium = Rm Rf
The purpose of the capital asset pricing model is to maximize the shareholder's wealth.
Limitation of Capital Asset Pricing Model Appraisal
1. It is a single period model whereas majority of capital budgeting decisions are multi-period
in nature.
2. Computation of the input to the CAPM is difficult e.g the calculation of beta factor market
risk (Rm), risk free rate of return (Rf) etc
3. It assumes that all assets are well diversified. This may not be easy to ascertain as such
casting doubt on the effectiveness of the CAPM.
4. The return on investment is considered but distribution of such return to shareholders is
neglected in CAPM.
5. It narrows down the objective of a firm to shareholders' wealth maximization rather than the
maximization of the stakeholders' wealth.

57
The Portfolio Risk
The portfolio risk measures the totality of risk associated with a portfolio. This is measured as
follows:
Op = Px x + (I P ) y + 2p(I P) x y xy
xy = Correlation coefficient
xy = Co.vx,y = Co.variance of x, y
x y (S.Dx) (S.Dy)
P(x 1) (y y)
p(x x1)2 (y y)2
Where x = means of x
P = probability
Y = Means of y
Example
Gorimapa Ltd is a highly diversified company operating a number of different industries. Its shares
are widely traded on the stock exchange and have a current market price of N3.20 ex-div. Its
dividend payment over the last five years have been as follows:
1987:25k per share (paid recently)
1986:23k
1985:20k
1984:19k
1983:18k
The board of directors of Gorimapa have recently become interested in the CAPM as the basis for
determining discount rates for investment decision. They have been advised that Gorimapa's
historical beta value is 1.6. The average return on the companies quoted on the stock exchange (as
recently published by Business Times) is 14% and return on government stock is 9% Gorimapa is
now considering two investment opportunities, one is the hotels division, another is the brewing
division. Both projects have relatively short lives and the cash flow (N'000) are as follows:Year 0 cost
Year 0 cost Hotels Brewing

0 (300) (400)
1 85 190
2 170 180
:3 150 200
The directors have discovered that the industries' beta for hotels and brewing are 1.2 and 2.2
respectively.
They believed that the investments they are considering are typical projects in the relevant
industries.

58
(a) Compute the NPVs of both projects using the company WACC as a discount rate.
(b) Compute the NPVs using discount rate which takes into account the risk
associated with the individual projects.
(c) Advise the directors as to which, of the opportunities to accept Ignore taxation
(ICAN Nov. 1988 Q. 4)
Answer
1a. Computation of the net present value using WACC.
Cost of equity = D0(I + g) + g
Pv
= 0.25(1.086) + 0.086
3.20 = 0.1708
Note 1:
Growth Rate (g) =
8.6% = dn 1 = 5 1 25 -1 = 4 24
du 18 18
= 0.086
Note 2:
Year Pv Dfc @ 17.08% Hotel Cash Flow Brewing Cash Flow
0 1 (300) (300) (400) (400)
1 0.85 85 72 190 162
2 0.72 170 122 180 130
3 0.61 150 92 200 122
NPV (14) 14
B(i) Risk adjusted discount rate for Hotels division.

Discount Rate = R1 + B(Rm Rf)
= 9 + 12(14 9)
= 15%
(ii) Risk adjusted discount rate for Brewing division
Discount Rate Rb = Rf + B1 + (Rm Rf)
= 9 + 2.2(14 9) = 20%
Computation of Net Present Value
Year DCF @ 15% Cash Flow PV Year DCF @ 20% Cash Flow PV
0 1 (300) (300) 0 1 400 (400)

1 0.87 85 74 1 0.833 190 158
2 0.756 170 129 2 0.694 180 125
3 0.658 150 99 3 0.579 200 116
NPV 2 NPV (1)

59
(3) The hotels project should be rejected if the weighted average cost of capital is used to
appraise the project because it gives negative net present value while the brewing
project should be accepted as it gives a net present value of N14,000. If element
of risks are however incorporated in the brewing division's data, the decision might
be reversed using a discount rate to which risk associated with the projects in
consideration (i.e CAPM) would cause a reversal of the above decision.
The decision on CAPM would be preferred as this decision considered risk attached to the
specific project and as such, the hotels division project should be accepted. The NPV is
however rather small. That is, a small change in the variables would affect the viability of the
project. Sensitivity should therefore be incorporated into the analysis for other variables
aside from the cost of capital. The brewing complements the hotel division and the project
might be accepted if other qualitative factors are considered notwithstanding its negative net
present value and if capital is not a constant.

Illustration 5.5.1
You are considering investment in one or both of two securities and you are given the
following information.
Security Possible rates of return Probability of occurrence

X 30 0.3
25 0.4
20 0.3
Y 50 0.2
30 0.6
10 0.2
Required:
1(a) Calculate the expected return for each security separately and for
a portfolio comprising 60%x and 40%y assuming positive correlation between the
possible rates of return from the shares comprising the portfolio.
(b) Calculate the expected risk of each security separately and of the portfolio as defined
above. [For this purpose the measure of risk may be taken as the standard deviation
of probable variance from the expected rate of return].
2) List and explain two methods that can be used in evaluating capital projects under
portfolio analysis.
Illustration 5.5.2
Omo-Odua Ltd. is considering investing in either of two projects X and Y.
Each project costs N40,000. Cost of capital to the company is 15%. The
projected earnings (cash inflows) from the two projects and the P.V. factors
are:
Year X Y P.V. Factor

N N 15%
1 22,000 20,000 0.870
2 22,0000 20,000 0.756
3 24,000 22,000 0.658

60
4 24,000 22,000 0.572
5 30,000 34,000 0.497
6 30,000 34,000 0.432
7 28,000 28,000 0.376
Rate of company taxation is taken as 50%.

You are required to evaluate the projects using the Net Present Value method and
profitability index to decide which one to choose.
Illustration 5.5.3
Using the Discounted Cash Flow Yield (Internal Rate of Return) for evaluating investment
opportunities has the basic weakness that it does not give attention to the amount of the
capital investment, in that a return of 20% on an investment of N1,000 may be given a
higher ranking than a return of 15% on an investment of N10,000.
Comment in general on the above statement and refer in particular to the problem of giving
priorities to (ranking) investment proposals.
Your answers should make use of the following information:

Year Project X Project Y
Cash Flow Cash Flow
N N
0 (Capital Investments) 1,000 10,000
1 Cash Flows 240 2,300
Cost of Capital 10% 10%
Illustration 5.5.4
Amaco Limited is planning to embark on a project estimated to cost N500,000.
The cash flows from this project are estimated below for its three year life and its probability.
Year 1 Year 2 Year 3
Probability Cash Flow Probability Cash Flow Probability Cash Flow
100,000 0.15 190,000 0.25 150,000 0.20
150,000 0.10 230,000 0.30 225,000 0.15
210,000 0.30 285,000 0.20 250,000 0.25
270,000 0.25 325,000 0.25 300,000 0.30
300,000 0.20 330,000 0.10
The company has already established the certainty equivalent factors of 0.95, 0.85, and 0.80
respectively for years 1, 2, and 3. The company's cost of capital is 12 percent and the risk free rate in
the economy in 8 percent.
Evaluate this project, using
a. The risk adjusted discount rate.
b. The certainty equivalent analysis.

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PART 6
THE COST OF CAPITAL

At the end of this chapter students will be able to:
Know how to determine the return on various sources of finance and the rate.
Understand the various techniques of determining cost of capitals and the effect on
firms' return.
Understand how to apply cost of capital as a benchmark for financial decision
making.
6.2 THE COST OF CAPITAL

An important element in decision-making about the use of any resource is the cost. The cost
of finance is generally termed as the cost of capital. Individual components of capital may
have quite different costs, being obtained from different markets. It is necessary to consider
these individual components and also the way in which they combine to give an appropriate
overall cost of capital, which is normally expressed in percentage per annum. Cost of capital
is clearly important for the calculation of the profitability or otherwise of an investment
project.
The average cost of capital is the cost of the capital currently employed; being the weighted
average of the costs for the individual component. The marginal cost of capital is the cost of
the next increment of capital to be employed. Average COC is important to the measures of
performance and to current valuation of the business while the marginal cost is to be used to
determine whether or not proposed developments are likely to be profitable. At some point,
marginal cost is likely to become equal to average cost and then rise above it. In essence, the
marginal cost of capital is the total change in the cost of finance incurred through a new
project, which is apportioned to the marginal finance. This rate may be appropriate when a
project requires the raising of specific finance. Thus the project must achieve the return
necessary to make it pay.
The use of WACC assumes that the new financing will not radically alter the organization's
risk profile and that the optimal capital structure is in operation. When a project is likely to
have an impact on the overall structure the marginal cost should be considered. WACC
further assumes that the marginal cost will be associated with lower cost debt fianc and MC
< WACC, may not be the case.
The Cost of Ordinary Share Capital

The dividend paid on ordinary share depends on the availability of profit and is paid only at
the option of the board of directors. Some people therefore argue that ordinary shares
capital has no cost. This is, however, not possible in the long run. The cost of equity capital is
taken to be the rate which has to be paid in order to maintain the present market value of the
equity either in cash or an accretion to the reserves leading to capital appreciation.

62
Example
General Duty Plc. has an OSC of nominal value of N1m in shares of N1.00. It earns an annual
profit of 100,000 and pays the whole of this as dividend. The current market value of General
Duty's shares is N1.50. The cost of equity capital to General Duty is the same as the yield on the
equity to the investor i.e.
= 6.67%
Where E = cost of equity capital

d = dividend per share
m = market value of share
Where as in practice, there are retained earnings; there will also be growth in
the capital value of the investment.
Example
Gen Duty Plc distributes only 5k per share. The other 5k is ploughed back
to the business for future growth in earnings and dividend. In this case,
= 8.33%
Where g = expected growth based on retained profit.

The marginal cost of equity capital is determined by the conditions surrounding a new issue and
these would need to be predicted before computation. Note that the amount received by the
company is less than the amount paid to the investors, due to issue costs such as advertising, cost of
stationeries, underwriting premiums, financial and legal advice, etc.
Example
General Duty Plc intends to raise additional capital of 200,000 ordinary shares. It
expects that profit will increase in proportion to increase in capital, allowing the
maintenance of the present rate of dividend and growth and judges that the issuing
price of the new share will have to be set at N1.40 to ensure success. The cost of issue
will be 2k per share.
= 8.62% per annum

Cost of Retained Earnings
For a company to retain some of its profit instead of distributing them is equivalent to the fresh
equity to existing shareholders (bonus or script issues). The cost of retained earnings is the same as
the cost of existing equity. The only gain to the company is the avoidance of issuing costs.

63
Cost of Preferred Capital
The determination of the cost of preference capital is exactly like that of equity capital. The present
cost is the yield currently received by shareholder and the marginal cost is the yield which has to be
offered in order to attract fresh preference funds. The formula used is the same as that of equity but
the consideration for growth is totally excluded.
Example
General Duty Plc has in issue some 8% N1.00 preference shares. The dividend has always been
paid and since it is well covered, is always expected to be paid. The shares stand in the market at
1/2
90k each. It is proposed to make a further issue of these shares at 87 , each. Issue cost will
1/2
amount to 1 k per share. Determine both present and marginal cost of the preference capital.
a. Present Cost
= 8.89% per annum
b. Marginal Cost
= 871/2-11/2
= 9.30% per annum
Where p = the cost of preference capital.
Cost of Long Term Debt

The cost of long term debt is the yield received by its holder at current market price. The marginal
cost is the yield, which must be given to attract new investment after allowing for issue cost.
Example
General Duty Plc has in issue some 10% debenture stock which stands in the
market at 85. A new issue to be made will have to offer 121/2% and issue cost would
be 1% of nominal value. Compute the present and the marginal cost of the debt.
a. Present Cost
= 11.76 per annum
b. Marginal Cost
Where D = cost of debt

= 12.63% per annum
i = rate of interest
C = issuing cost

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Cost of Redeemable and Irredeemable Debenture
Debenture generally is a long term loan. It can be a redeemable debenture or irredeemable
debenture. A redeemable debenture is one that can be terminated within a specified period of time.
The irredeemable debenture is one that continues till the life span of the debenture expires.
Cost of Irredeemable Debenture
Example:
Tunde Alabi purchased a 30% irredeemable debenture for N200 ex-int.
Compute the cost of debt.
Cost of Redeemable Debenture

The cost of a redeemable debenture can only be calculated using the Internal Rate of Return
Method (IRR).
Example
Dominion Impact Ltd is financed by N20m 10% redeemable debenture currently quoted at
N200 each. The debenture would be redeemed in 10 years time at par. Corporate tax is at
30%.
Required: Compute the cost of the redeemable debenture.
Solution
Using the IRR Method
Year CF Df @ 10% PV DF @ 8% PV
0 (100) 1 (100) 1 100
Interest 1-10 7 7.7217 54.05 6.710 46.97
Scrap Value 10 100 0.6139 61.39 00.4651 46.31
15.44 6.719

65
6.3 MONEY Vs. REAL COST OF CAPITAL
Money Cost of Capital
Where the cash flows are to be inflated, or have been inflated, or have been given in future
values, the rule is to discount this inflated cash flows using the money cost of capital. The
money cost of capital is the nominal cost of capital, which has been adjusted for inflation and
is usually calculated by reference to the money market rate of interest.
The Real Cost of Capital

As an alternative, we can leave the cash flows but adjust the cost of capital. Where the cash
flows are given in current terms at year zero, we must discount them with the real cost of
capital.
The real cost of capital is that CoC that has been adjusted for inflation. The adjustment
formula is:
Where R = the real cost

M = money cost
I = inflation rate
Note:
The use of either the money cost of capital or the real cost of capital will produce exactly the same
NPV for a given project.
Weighted Average Cost of Capital

A firm WACC is fa composite of individual cost of financing weighted by the % of financing
provided by each source. Therefore a firm's WACC is a function of:
a. The individual cost of capital; and
b. The makeup of capital structure is % of fund provided by debt, preference stock and
common stock.
1. Calculate the cost of capital for each individual source of financing used by the firm, which
generally include debt, preferred stock and common stock.
2. Determine the % of debt, preferred stock and common stock to be used in financing future
investment.
3. Using the individual cost and capital structure in the first 2 steps and the overall weighted
cost of capital for the various amount of financing that might be needed.
Note that it will be adjusted since the current market value has changed.

66
Example
Baba Fashion Plc has N1m debenture stock in issue, quoted at N50 per N100 of nominal stock,
N625,000 preference shares of N1 each quoted at 50k and in ordinary N1 share standing at
25k. The costs of capital of these securities are 90%, 12% and 18% respectively. This capital
structure is to be monitored. Calculate the WACC.
Securities Market Value Proportion Cost of Capital

N'000
Debenture 500 0.250 0.09
Preference share 250 0.125 0.12
Ordinary shares 1,250 0.625 0.18
2,000 1.00
The above can equally be calculated thus:
= 0.0225 + 0.1125 + 0.015

= 0.15 or 15%
The WACC is therefore 15%. This figure represents an approximate cut off rate of return on real
investments.

Illustration 6.1
Explorer Limited is to be formed to explore for Gold in Nigeria. It is estimated that N10
million will be required and that this will generate earnings before interest and taxation in the
range of 2 to 2.2 million naira per annum.
Two proposals are being considered. The first is to finance the company through an issue of
10,000,000 ordinary shares at par. The second is to issue 5,000,000 ordinary N1 shares also
at par along with 5,000,000 of 10% loan stock at N1 each. If the first proposal is used it is
estimated that the ordinary shareholders will expect to see the company earn a return after
company tax of 10%. However, because of the additional risk which will arise if loan is used,
the shareholders will expect the return to be 15%.

I Calculate the market value of the ordinary shares immediately after their issue for

67
both proposals. Consider earnings of N2,000,000 and N2,200,000.
ii. Calculate the weighted average cost of capital in each of the above four
situations.
iii. Discuss the merits of the alternate methods of financing both in theory and in
practice, from the point of view of the company and the shareholders.
Illustration 5.2
Sunspring Plc, issued N4,000,000 15% debenture stock redeemable at par in six (6) years
time and have a current market value of N108 cum int. The company's equity capital has
N7,000,000 ordinary share of N1 each and retained earning of N1,500,000. The current
market value of the ordinary share is N4.25 cum dividend.
The company has N2,000,000 of 9% preference share, currently priced at 70 kobo per
share. Equity dividend for the current period is N1,750,000 the project dividend growth rate
is 7% per annum. Corporate tax rate is 35%. Dividend on ordinary share is about to be paid,
debenture interest are due but unpaid. The preference share dividend have been paid.
Sunspring Plc, needs your advice on the appropriate cost of capital to use in appraising the
investment projects.

68
PART 7
FINANCIAL STATEMENT ANALYSIS

Appreciate the various financial and business ratios and the formulas.
Measure the value of financial ratios on performance analysis of a firm.
Understand the value of financial ratio analysis on the management decision making
system.
7.2 FINANCIAL STATEMENT ANALYSIS

INTRODUCTION
Financial statement analysis is a technique through which financial managers obtain useful
information that aid decision making towards the achievement of organizational objectives.
Such information includes financial ratios and working capital movement.
Financial Ratio is the relationship between two pieces of financial data. Working Capital is
the difference between Current Assets and Current Liabilities. They are both useful tools for
comparison and decision making.
The financial data is useful in the preparation of these tools and are obtained from the firm's
financial statements, which include Balance Sheet and Profit and Loss Account.
Users of Financial Statements

The users of the financial statements of a business are the parties who have interest in the
operation of the business. These parties comprise of both internal and external users of
financial statements.
Internal Users:
i. Management: They are interested in financial statements because they are useful in
the management and control process of the business. Financial statements provide
them the tools for decision making for future running of the business.
ii. Employees: The employees' use financial data to determine the strength of the
organization, the ability to pay good returns for their services and stability and
security of employment.
External Users:
i. Shareholders: These are the owners of the business and they are interested in the
profitability and potential growth of the business.
ii. Creditors (Bank and other financial institutions): They are interested in the ability of
the business to pay interest and repay principal sum on a due date.
iii. Government: Government requires financial statements for economic planning
and tax assessment purposes. Statistical data relating to businesses and employees
are easily obtained from the final account of business firms.
iv. Financial Analysts and Advisers: These set of users of financial statements need
them as inputs in the process of discharging their duties as analysts and investment
advisers. This is common among the stockbrokers, consultants, etc.
v. Competitors: They use financial statements for comparison purposes.

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7.3 CONCEPT OF FINANCIAL RATIO
As discussed earlier, financial ratios are useful tools in the decision making process. They
are useful in comparing business performance at both industry and within the company
over time.
There are three major facets of comparison:

1. Trend Analysis: This involves comparing the present ratio with the past and expected
future ratio for the same company. For example, if the current ratio of a firm in 2000 is
1.2:1, and this changes to 1.8:1 in 2001, this implies that there is an improvement in the
liquidity position of such firm during the period.
2. Cross Sectional Analysis: This involves comparing the company's ratio with the ratios
of similar firms at the same point in time. Example, comparing current ratio of ABC Bank
Ltd, with DEF Bank current ratio.
3. Industrial Analysis: Comparing the company's ratio with industry average at the same
point in time.
7.4 OVERVIEW OF FINANCIAL STATEMENTS

The two most important financial statements commonly prepared by organizations are:
i. Balance sheet and
ii. Profit and loss account
The third one is cash flow statement.
The balance sheet shows the financial position of a firm at a particular date; the profit and
loss account shows the results of operation over a particular accounting period. The cash
flow statement shows the movement of cash during the accounting period. In other words it
gives information about cash inflows and outflows during an accounting period.
The balance sheet and the profit and loss account are the main final account of any
business.
Balance sheet
The balance sheet may be presented in two forms:
i. Horizontal format; and
ii. Vertical format.
The balance sheet items are categorized into two viz Assets and Liabilities
Assets are resources of a business which are expected to provide future benefits to the
owners. These assets may be in physical form e.g. land, building, equipment etc or non
physical form such as goodwill, debtors, etc.
The total assets of a business can be divided into Fixed and Current Assets. Fixed assets are
those that have life greater than one year. Examples of such are land, building, vehicle,
goodwill, long term investment, etc.
Current assets are those that often change form in the course of doing business and can
generally be converted to cash within one accounting period. Examples are stock,
prepayment, short-term investment, etc.

70
Liabilities are those debts owned by a business to third parties called creditors. This can
also be divided into Long-term Liabilities and Current Liabilities.
Long Term Liabilities are the amount owed by the business payable in the future, but not
within one accounting period. Examples are debentures, long term loans etc.
Current Liabilities are the amount owed by a business on short term basis and therefore
must be paid within a period of one year. Examples are trade creditors, accrued wages,
overdraft, taxes, etc.
Owner Interest This is the excess of Assets over Liabilities. This includes capital invested in
the business, share capital, reserve or retained earnings etc.
This is another final account produced in a business firm. This can be horizontal or vertically
presented. This account shows the summary of business operation for a period of one year.
It shows how profit or looses are arrived at during the period.
Useful Summary
i. Total Assets = Fixed Assets + Current Assets
ii. Total Liabilities = Long Term Liabilities + Current Liabilities +
Shareholders Fund
iii. Shareholder's Equity = Total Assets Total Liabilities
iv. Capital Employed = Total Assets Current Liabilities
v. Working Capital = Current Assets Current Liabilities
TEE PLC COMPARATIVE BALANCE SHEET AS AT 31ST DEC 2000 AND 2001
2001 2000
N'000 N'000 N'000 N'000
Fixed Assets:
Land and Building 18,000 18,000
Machinery and Equipment at cost 45,000 41,500
Less Accumulated Deprecation (11,000) 34,000 (8,000) 33,500
Current Assets:
Cash 5,000 3,500
Trade Debtors 22,000 18,500
Stock 30,000 32,000
Prepaid Expense 3,000 1,000
60,000 55,000
Less Current Liabilities:

Trade Creditors 20,000 19,000
Accrued Creditors 2,000 800
Short Term Loan 5,200 4,000
27,200 32,800 23,800 31,200
Total Assets Less Current Liabilities 84,800 82,700

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FINANCED BY:
Ordinary Share Capital of N1 each 23,000 21,000
Capital Reserves 4,800 4,500
Retained Profits 22,000 20,700
10% preference share of N1 each 10,000 10,000
5% debentures 25,000 26,500
84,500 82,700
Example
Tobechukwu Ltd plans to invest in a project the sum of N750,000 which has a life span of 5
years generating 20,000 units annually of a product called Dandi. The selling price of Dandi
is N40 per unit and variable cost is N20 per unit of the product. Annual fixed cost amounts to
N150,000, the cost of capital is 15%.
Required:
I Should Tobechukwu & Co invest in the project?
ii. Compute sensitive analysis of the project.
Solution
Step 1: Compute the NPV of the project
Selling price 40
Variable cost (20)
Contribution 20
Total contribution 20x20,000 = 400,000
Less fixed cost 150,000
Annual Return (AR) 250,000
PV of profit for 5 years
3.35 x 250,000 = 837,500
Less outlay 750,000
NPV 87,500
ST
TEE PLC PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31 DEC
2001 2000
N'000 N'000
Sales 180,000 165,000
Less: Cost of Good Sold (105,000) (100,500)
Gross Profit 75,000 64,500
Operating Expenses:
Selling Expenses (25,000) (21,000)
General and Admin. Expenses (18,500) (16,000)
Op-rating Profit (PBIT) 31,500 27,500
Interest Expenses (1,250) (1,325)
Profit before Tax (PBIT) 30,250 26,125
Corporate Tax (18,150) (15,705)
Profit after Tax (PAT) 12,100 10,470

72
Preference Dividend Paid 1,000 1,000
Ordinary Dividend Paid 9,800 8,000
Retained Profits 1,300 1,450
Note:
i. Goods worth N110 million was purchased in 2000 and purchases of N121
million was included in 2001.
st
ii. The market price per share as at 31 December 2000 is N2.50k, whereas the
market price as at 31st December 2001 was N2.10k.
st
iii. Stock as at 31 December 1999 was N53 million.
iv. Prepared tax is N2,445.
7.6 TYPES OF FINANCIAL RATIOS

Financial ratios are many. One or more may be useful to a particular user. For example,
creditors and bankers will be interested in the current or quick ratio of their customers; the
shareholder will be interested in the profitability and price earnings ratio. Therefore, it
may be difficult to classify these ratios according to their needs. However, the following
classifications have been developed for analytical purpose:
a. Liquidity ratios.
b. Long term solvency and stability ratios.
c. Profitability and efficiency ratios.
d. Investor or stock market ratios.
a. LIQUIDITY RATIOS
This is concerned with the rate of conversion of current assets and current liabilities to
cash. This ratio includes current ratio, acid test or quick ratio, debtors' turnover,
average collection period, creditors' payment period and stock turnover.
i Current Ratio: This is the ratio of current assets to current liabilities.
It shows the ability of a firm's current asset to meet its current obligations that are due
within a year. The normal industrial average is 2:1.
ii Acid Test Ratio or Quick Ratio

This is measured as;
This is a more stringent measure of liquidity. It is similar to current ratio except that the stock
(inventory) is taken off the current assets. This is because stock is considered the most liquid
of all current assets. The normal industrial average is 1:1.
For Tee Plc in section 4(2001)

3
iii. Debtors Turnover: This is the ratio of annual credit sales to debtors
N.B: If a sale is not available, total sales figure can be used.

For Tee Plc in section 4 (2001)
iv. Average Collection Period (ACP)

This shows the average length of time in which debts remain uncollected. This is
calculated as:
This is usually expressed in days.

If it is expressed in months, it will be 14 days. This implies that debtors will make payment after 45
days of purchases on credit.
v. Creditors Payment Period (CPP)

This shows the average length of time in which company's creditors remain unpaid. This is
calculated as:
This may also be expressed in days or months.

In the case of Tee Plc in section 4 (2001)
This is equivalent to average 2 months 6 days that the creditors remain unpaid.
vi. Stock Turnover (Inventory Turnover)
This ratio measures the number of times the firm turns over its inventory. A high inventory
turnover sometimes may be regarded as a sign of efficiency while in some cases it may not
be.
This is measured as:

73
The average inventory is the sum of closing stock of the immediate past financial year and the
closing stock of the current year in consideration.
The company stock turnover is almost 4 times during the period.
a. LONG TERM SOLVENCY AND STABILITY RATIOS

These ratios are concerned with the ability of a company to meet its long term obligations.
They include fixed interest cover; fixed dividend cover, total debt to shareholders funds,
gearing ratio and debt ratio.
i. Fixed Interest Cover

This shows the number of times the net operating income (Profit before Interest and Tax
(PBI) will pay the fixed interest. This is obtained as follows:
i. Fixed Dividend Cover

This ratio shows the number of times the profit after tax can cover the fixed dividend payable
by the company. This is measured as:
The company's PAT can pay fixed dividend (preference share dividends) 12.1 times.
i. Total Debt to Shareholders Fund (TDS)

This is the ratio of total debt to the shareholders funds. It shows the vulnerability of
shareholders' funds to external liabilities. This is measured as:
Total Debt = total current liabilities plus long-term liabilities e.g. debentures and long
term loans.
Shareholders Funds = share capital (ordinary+ preference + reserves +retain profit +
share premiums)

74
The total debt (external liabilities) is about 88% of shareholder funds.
i. Gearing Ratio (Leverage Ratio)

This measures the degree of vulnerability of shareholders fund to fixed interest
capital such as debentures, term debt and preference share capital.
This is measured as:
For Tee Plc, in the section 4 (2001)
A gearing greater than 0.61 is said to be relatively high.
i. Debt Ratio (DR)

This shows relationship between total debts to total assets. It is expressed in percentage.
For Tee Plc, in the section 4 (2001)
c. PROFITABILITY AND EFFICIENCY RATIOS

These ratios are concerned with relative efficiency in the utilization of company's
resources. These ratios are return on capital employed; return on total assets, gross
profit margin, net profit margin, capital employed turnover, total assets turnover, and
return on shareholders' equity.
i. Return on Capital Employed (ROCE)

This measures the overall profitability of the business. It falls into the category of
primary ratios. The ratio is calculated as follows:
PBIT = Profit Before Interest and Tax

Capital employed = total assets current liabilities
In the case of Tee Plc, in section 4 (2001)
PBIT is 37.1% of the total capital employed.

75
i. Return on Total Assets (ROTA)
This is another measure of the overall profitability of the business. This is a primary
ratio and it is measured as:
In the case of Tee Plc, in section 4 (2001)
PBIT is 278% of total assets.
i. Return on Shareholder Equity (ROE)

This represents the earning power of shareholders' fund in the business. It is
measured as:
For Tee Plc, in section 4 (2001)
i. Gross Profit Margin (GPM)

This ratio shows the relative efficiency of the business after taking into consideration,
the cost of production. This is measured as:
Gross profit is about 42% of total sales.
i. Net Profit Margin (NPM)

This ratio shows the relative efficiency of the business after taking into consideration
the other expenses and incomes. It is obtained as:
Net profit before interest and tax is about 17.5% of the total sales.

76
i. Capital Employed Turnover (CET)
This shows the efficiency in the utilization of capital employed for the business. This
is measured as:
i. Total Assets Turnover (TAT)

This also measures the extent in which the business utilizes the investment in
generating sales.
d. INVESTORS' OR STOCK MARKET RATIOS

These ratios are concerned with the value of a firm. And they are used by financial analysts
and shareholders. They contain Earning per Share, Dividend per Share, Price Earnings
Ratio, Earnings Yield and Dividend Yield.
i. Earnings Per Share (EPS)

This is the return attributable to each equity. It is measured as:
ii. Dividend Per Share (DPS)

This shows the actual amount declared per share or equity. It is measured as:
Total Ordinary Dividend=Earnings available for ordinary shareholders less retained profit.
For Tee Plc, in section 4 (2001).
i. Price Earnings Ratio (PE)

This ratio measures the real value or worth of the company's share in the market. It is
calculated as: PE ratio is equal to the number of year earning (rate given in the last
published financial statement) needed to cover the current market price per share.
The value of the PE ratio reflects the market appraisal of the shares future prospect.

77
ii. Risk adjusted discoutrate for Brewing division
Discount Rate Rb = R1 + B1 (Rm R1)
= 9 + 2.2 (14 9) = 20%
Computation of Net Present Value
(3) The hotels project should be rejected if the weighted average cost of capital is used to appraise
the project because it gives negative net present value while the brewing project should be accepted
as it gives a net present value of N14,000. If element of risk are however incorporated in the brewing
divisions data, the decision might be reversed using a discount rate to which risk is associated
within the projects in consideration (i.e CAPM) would cause a reversal of the above decision.
The decision on CAPM would be preferred as this decision considered risk attached to the specific
project and such, the hotels division project should be accepted. The NPV is however rather small.
That is, a small change in the variables would affect the viability of the project. Sensitivity should
therefore be incorporated into the analysis of the other variables aside from the cost of capital. The
brewing complements the hotel division and the project might be accepted if qualitative factors are
considered notwithstanding its negative net present value and if capital is not a constant.

Illustration 7.7.1
You are given the following Financial Statement in respect of;
WAZOBIA NIGERIA LIMITED
Trading and Profit Loss Account for the Year ended 31 December 2009
2009 2008
N'000 N'000 N'000 N'000
Sales 1,840 1,444
Less Cost of Sales:
Opening Stock 116 90
Purchases 1,388 1,061
Other Expenses 64 48
1,568 1,199
Closing Stock 157 116
1,411 1,083
Gross Profit 429 361
Less Expenses:
Salaries & Selling Exp. 78 72
Salaries & Wages 56 50
Rent and Rates 25 24
Bad and Doubtful Debts 6 8
Depreciation 44 32
Interest on Mortgage 8 10
Power and Lighting 17 15
General Expenses 72 24
Audit Fees 34 24
7 347 7 303
Net Profit 82 58

78
Appropriations: 2009 2008
N'000 N'000 N'000 N'000
Provision for Taxation 18 12
Transfer to General Reserves 10 8
Dividend Payable 30 20
58 40
Retained in the Profit and Loss Account 24 18
WAZOBIA NIGERIA LIMITED

Balance Sheet as at 31 December, 2009
2009 2008
N N
Fixed Assets (less depreciation)
Land and Buildings 83 60
Plant and Machinery 240 160
Motor Vehicle 40 40
Total Net Fixed Asset 363 260
Current Asset
Work in Progress 67 46
Stock (Finished Goods) 90 70
Debtors (Less doubtful debts) 110 80
Bank Cash 20 30
287 226
Less: Current Liability
Creditors 45 60
Bank Overdraft 52 26
Dividend Payable 30 20
Taxation 18 12
145 118
Net Working Capital 142 108
Net Asset 505 308
Financed by: Equity Funds
Issued Paid up Capital of N0.50 300 200
Capital Reserves 23 -
General Reserves 60 50
Profit and Loss 42 425 18 268
10% Mortgage Loan 80 100
505
368
Market Price per Share N1.50 N1.25
Illustration 7.7.2
There are five categories of financial ratios list and explain them.

79
PART 8
CASH FLOW STATEMENT

Understand the value of cash flow statement.
Apply the cash flow analysis to every day operational cash flow decision making
process.
Prepare a simple cash flow statement for management.
8.2 CASH FLOW STATEMENT

A statement of cash flow provides information about the cash receipt and cash payments of
an enterprise over a given period. It indicates the pattern of cash generation and utilization.
The information provided if used with related disclosure and other information of the
financial statement will assist users to:
1. Assess the impact of its current transactions-operating, investing and financing
activities on its performance and financial position.
2. Assess the ability of the enterprise to meet its debt obligations, pay dividend and
other claims.
3. Assess the ability of the enterprises to finance ongoing operations and growth from
internal sources and determine the amount of external financing required.
4. Reconcile profit and Loss Account with cash flow.
5. Assess the ability of an enterprise to generate positive net flows.
Cash: This comprises of cash on hand and demand deposit denominated in Naira and
foreign currencies.
Cash Equivalent: This is short term highly liquid investment that are readily convertible to
known amount of cash and which are subject to an insignificant risk of changes in values.
Generally they are within 3 months of maturity.
Classification of Cash Flows

A statement of cash flow, present cash flows according to the activities, which give rise to
them.
The classification is as stated below:
i. Operating Activities: These include normal trading activities of an enterprise e.g.
production and delivery of goods and services and other supporting activities
included in determining operating profit.
ii. Investing Activities: These relate to acquisition and disposal of fixed assets, statement
properties and other productive assets held for use in producing the usual goods and
services other than stock held for processing or resale.
iii. Financing Activities: These include resources obtained from lenders and awareness
of enterprises and reporting the amount obtained either as they become due or when
there is surplus for the needs of the enterprise. They also include the payment of
returns to providers of such financing in form of interest and dividends as well as
expenses directly related to obtaining the finance.

80
Format
XYZ LTD
st
Cash Flow Statement for the Year Ended 31 Dec. 2005
N N
Operating Activities
Operating profit
Adjustment for items not involving
Movement of cash:
Depreciation x
Amortization x
Profit/loss on sale of fixed assets x
Profit/Loss on sale of investment x
Deferred income recognized x
Cash inflow before working capital changes x
Increase/Decrease in stock x
Increase/Decrease in Debtors x
Increase/Decrease in Credit x
Increase Accruals x x
Tax paid (x)
Cash inflow from operating activities
Investing Activities
Purchase of fixed assets x
Purchase of investment x
Sale of fixed asset x
Sale of fixed asset investment x
Dividend received x
Interest received x
Net cash inflow from investing activities

Financing Activities
Issue of shares x
Redemption of shares (x)
Issue of debentures x
Redemption of debentures (x)
Dividend paid (x)
Interest paid (x) x
Net cash inflow from investing activities
Increase/decrease in cash and cash enquiries x
Cash and cash equivalent of the beginning x
Cash and cash equivalent of the end x
IllustrationFrom the following information in the books of Kate Ltd, prepare a

cash flow statement for the year ended 31st December 1996.
Balance Sheet as at 31st December
1996 1997
N'000 N'000 N'000 N'000
Fixed Asset at cost 8,300 5,600
Less Deprecation 3,150 2,300
5,150 3,300

81
Current Assets:
Stock 5,516 7,204
Debtors 3,994 3,120
Less provision 180 3,814 210 2,910
90 60
Cash 9,420 10,174
Current Liabilities due within one year:

Creditors 1,416 1,520
Taxation 735 580
Proposed Dividend 1,200 800
Bank Overdraft 629 3,980 105 3,005
5,440 7,169
Working Capital 10,590 10,489
Less: Creditors Failing
Due after one year 500 3,000
Loan Capital 10,090 7,469
Financed By:
Capital and Reserves: N'000 N'000
Share Capital 5,000 4,000
Share Premium 1,000 -
Profit and Loss Account 4,090 3,469
10,090 7,469
Profit for the year
Less Taxation for the accounting year 2,556
735 1,821
Undistributed profit b/f 3,469 5,290
Less: Proposed dividend 1,200 4,090
Notes:
1. An item of fixed asset which has cost of N1,120,000 and having been
depreciated at N 740,000 was sold during the year for N 465,000. The
profit thereof had been included in the net profit for the year.
2. 1,000,000 shares of N 1.00 had been issued at a par of 1 per share.
Solution
KATE LTD
Cash Flow Statement for the year ended 31st December 1996
N'000 N'000
Cash Flow from Operating Activities
Profit before Taxation 2,556
Adjustment for items not involving cash:
Depreciation of Fixed Assets 1,590
Profit on sale of Fixed Asset (85) 1,505
Working Capital Charges:
Decrease in Stock 1,688
Increase in Debtors (904)
Decrease in Creditors and Accruals (104) 680 4,741
Tax Paid (580)
Cash Inflow from Operating Activities 4,161
Cash Inflow Investing Activities:
Perchance of Fixed Asset (3,820)

82
Proceeds from sale of Fixed Asset 465
Net Cash Inflow from Investing Activities (3,355)
Cash Flow from Financing Activities:
Net Proceed of Capital Floatation 2,000
Debenture Redemption (2,500)
Dividend Paid (800)
Net Cash Inflow from Financing Activities (1,300)
Net Decrease in Cash and Cash Equivalent (494)
st
Cash and Cash Equivalent at 1 Jan (45)
Cash and Cash equivalent at 31/12/96 (539)
Illustration 8.3.1
st
The following are the balance sheets of IWALOLA Ltd as at 31 December
2000 and 2001.
st
The balance sheet of the company as at 31 March 2000 was as follows:
N'000 N'000 N'000
Land and Building at cost 1,800
Plant and Machinery at cost 5,800
Depreciation (3,850) 1,950
Stocks and Work in Progress 3,150
Debtors 1,900
Cash and Bank Balance 500 5,550
Bank Overdraft 1,500
Creditors 1,550
Taxation 1,150 (4,200) 1,350
5,100
Financed By:
Ordinary Share Capital @ N1 1,000
Share Premium 600
Retained Profit 3,500 5,100
IWALOLA LTD
BALANCE SHEET AS AT 32ST MARCH 2001
N'000 N'000 N'000
Land and Building (Cost) 3,500
Plant and Machinery (Cost) 6,100
Depreciation (3,900) 2,200
Stocks and Work in Progress 3,435
Debtors 2,200
Cash and Bank Balance 160
5,795

83
Bank Overdraft 1,750
Creditors 1,450
Taxation 820 (4,020) 1,775
7,475
8% N1 Convertible Debentures (2,000)
5,475
Financed By:
Ord. Share Capital 1,200
Retained Profit 3,725
Shared Premium 550
5,475
Notes:
st
1. The profit for the year ended 31 March 2001 after changing all expenses
including loss on the sale of the plant but before depreciation and taxation was
N1,715,000. The companies' income tax provided for in the profit and loss
st
account for the year ended 31 March, 2001 amounted to N670,000 while
dividend paid during the year and charged against the profit and loss after tax
was N180,000.
2. During the year, plant and machinery which had cost N1,200,000 in
respect of which depreciation of N590,000 had been provided was sold.
There had been a right issue of ordinary shares at the rate of one for 10 at a price
st
of N1.50 per share payable in full on 1 April 2000. Subsequently, a script
(bonus) issue of one for 11 had been made utilizing share premium account.
Eight per cent N1 convertible debenture was issued at par in April 2000 for
st
2,000,000 payable in full. The conversion terms exercisable on 31 March 2004
are 1 ordinary share for every two N1 debenture.
You are required to prepare for IWALOLA Ltd. a Cash Flow Statement for
the year ended 31st March, 2001.
Illustration 8.3.2
From the following information in the books of Kate Ltd, prepare a cash flow statement
for the year ended 31st December 1996.
Balance Sheet as at 31st December

1996 1997
N'000 N'000 N'000 N'000
Fixed Asset at cost 8,300 5,600
Less Deprecation 3,150 2,300
5,150 3,300
Current Assets:
Stock 5,516 7,204
Debtors 3,994 3,120
Less provision 180 3,814 210 2,910
90 60
Cash 9,420 10,174

84
Current Liabilities due within one year:
Creditors 1,416 1,520
Taxation 735 580
Proposed Dividend 1,200 800
Bank Overdraft 629 3,980 105 3,005
5,440 7,169
Working Capital 10,590 10,489
Less: Creditors Failing
Due after one year 500 3,000
Loan Capital 10,090 7,469
Financed By:
Capital and Reserves: N'000 N'000
Share Capital 5,000 4,000
Share Premium 1,000 -
Profit and Loss Account 4,090 3,469
10,090 7,469
Profit for the year
Less Taxation for the accounting year 2,556
735 1,821
Undistributed profit b/f 3,469 5,290
Less: Proposed dividend 1,200 4,090
Notes:
1. An item of fixed asset which has cost of 1,120,000 and having been
depreciated at 740,000 was sold during the year for 465,000. The
Profit thereof had been included in the net profit for the year.
2. 1,000,000 shares of 1.00 had been issued at a par of 1 per share.
KATE LTD
st
Cash Flow Statement for the year ended 31 December 1996
N'000 N'000
Cash Flow from Operating Activities
Profit before Taxation 2,556
Adjustment for items not involving cash:
Depreciation of Fixed Assets 1,590
Profit on sale of Fixed Asset (85) 1,505
Working Capital Charges:
Decrease in Stock 1,688
Increase in Debtors (904)
Decrease in Creditors and Accruals (104) 680
4,741
Tax Paid
(580)

85
Cash Inflow from Operating Activities 4,161
Cash Inflow Investing Activities:

Perchance of Fixed Asset (3,820)
Proceed from sale of Fixed Asset 465
Net Cash Inflow from Investing Activities (3,355)
Cash Flow from Financing Activities:
Net Proceed of Capital Floatation 2,000
Debenture Redemption (2,500)
Dividend Paid (800)
Net Cash Inflow from Financing Activities (1,300)
Net Decrease in Cash and Cash Equivalent (494)
st
Cash and Cash Equivalent at 1 Jan (45)
Cash and Cash equivalent at 31/12/96 (539)
Illustration 8.3.3
The Balance Sheet and Profit & Loss Accounts of OLOWOLAGBA BANK PLC as
st
at 31 December, 1999 are as follows:
1999 1998
Assets N'000 N'000
Cash and short term fund 5,963,210 2,675,086
Bills discounted 1,530,036 942,000
Investments 120,698 160,140
Loans and advances 4,497,088 2,690,006
Other assets 915,986 566,852
Equipment on lease 199,874 368,792
Fixed assets 1,170,220 970,088
14,387,112 8,372,964
Liabilities
Deposit and current accounts 9,149,866 5,112,332
Taxation 66,226 43,132
Dividend payable 136,216 126,734
Other liabilities 3,405,098 1,541,840
12,757,406 6,824,038
Long Term Liabilities
22% Floating rate redeemable
Debenture stock 52,292 59,762
12,809,698 6,824,038
1999 1998
Capital & Reserves N'000 N'000
Called up share capital 1,130,452 1,126,852
Share premium 31,850 29,030
Statutory reserve 321,976 263,514
Debenture redemption reserve 52,292 36,484
General reserve 40,844 33,284
Shareholders fund 1,577,414 1,489,164
14,387,112 8,372,964
Acceptances, guarantees & engagements on behalf

of customers' & customers' liabilities thereof 4,472,128 5,921,714

86
PART 9
WORKING CAPITAL MANAGEMENT

Understand the meaning of working capital and its management in
business.
Apply the mechanics of working capital to business management.
Determine the various components of working capital and demonstrate the
knowledge of how to apply them appropriately.
9.2 Management of Working Capital

Working capital management involves the relationship between a firm's short-term assets and its
short-term liabilities. The goal of working capital management is to ensure that a firm is able to
continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and
upcoming operational expenses. The management of working capital involves managing
inventories, accounts receivable and payable, and cash.
Working Capital Management is about management of liquidity. This can be managed by

reviewing each component of the liquid assets and liabilities within the balance sheet.
We are able to assist in the review of each of these and provide alternative strategic techniques to
each component including other financial options. This may include a combination of asset
finance, invoice discounting and releasing capital from existing assets.
The working capital ratio is calculated as:

Working Capital = Current assets Current liabilities
If a company's current assets do not exceed its current liabilities, then it may run into trouble paying
back creditors in the short term. The worst-case scenario is bankruptcy. A declining working capital
ratio over a longer time period could also be a red flag that warrants further analysis. For example, it
could be that the company's sales volumes are decreasing and, as a result, its accounts receivables
number continues to get smaller and smaller.
Working capital also gives investors an idea of the company's underlying operational efficiency.
Money that is tied up in inventory or money that customers still owe to the company cannot be used
to pay off any of the company's obligations. So, if a company is not operating in the most efficient
manner (slow collection), it will reflect by way of increase in requirements for working capital. This
can be seen by comparing the working capital from one period to another; slow collection may
signal an underlying problem in the company's operations.
Positive working capital means that the company is able to pay off its short-term liabilities. Negative
working capital means that a company currently is unable to meet its short-term liabilities with its
current assets (cash, accounts receivable and inventory). It is also known as "net working capital".
9.3 Importance of Working Capital in Business

The working capital is the life-blood and nerve centre of a business firm. The sufficiency of working
capital assists in raising credit standing of a business because of better terms on goods bought,

87
lesser cost of manufacturing due to the acceptance of cash discounts, favorable rates of interest etc.
No business can run effectively without a sufficient quantity of working capital. It is crucial to retain
right level of working capital. Finance management is required to decide the amount of accurate
working capital.
A business enterprise with ample working capital is always in a position to avail itself of any
favorable opportunity either to buy raw materials or to implement a special order or to wait for
enhanced market status.
Cash is needed to carry out day-to-day workings and buy inventories etc. The shortage of cash may
badly affect the position of a business concern. The receivables management is related to the
volume of production and sales. For escalating sales there may be a need to offer additional credit
facilities. While sales may ascend, the danger of bad debts and cost involved in it may have to be
considered against the benefits.
Inventory control is also a significant constituent in working capital management. The deficiency of
inventory may cause work stoppage. On the other hand, surplus inventory may result in blocking of
money in stocks.
The overall success of the company depends upon its working capital position. So, it should be
handled properly because it shows the efficiency and financial strength of the company.
The finance profession recognizes the three primary reasons offered by economist John Maynard
Keynes to explain why firms hold cash. The three reasons are for the purpose of speculation, for the
purpose of precaution, and for the purpose of making transactions. All three of these reasons stem
from the need for companies to possess liquidity.
Speculation
Economist Keynes described this reason for holding cash as creating the ability for a firm to take
advantage of special opportunities that if acted upon quickly will favor the firm. An example of this
would be purchasing extra inventory at a discount that is greater than the carrying costs of holding
the inventory.
Precaution
Holding cash as a precaution serves as an emergency fund for a firm. If expected cash inflows are
not received as expected cash held on a precautionary basis could be used to satisfy short-term
obligations that the cash inflow may have been bench marked for.
Transaction
Firms are in existence to create products or provide services. The provision of services and creation
of products results in the need for cash inflows and outflows. Firms hold cash in order to satisfy the
cash inflow and cash outflow needs that they have.
Float is defined as the difference between the book balance and the bank balance of an account.
For example, assume that you go to the bank and open a checking account with N500. You receive
no interest on the N500 and pay no fee to have the account.
Now assume that you receive your water bill in the mail and that it is for N100. You write a check for
N100 and mail it to the water company. At the time you write the N100 check you also record the

88
payment in your bank register. Your bank register reflects the book value of the checking account.
The check will literally be "in the mail" for a few days before it is received by the water company and
may go several more days before the water company cashes it.
In the time between the moments you write the check and when the bank cashes the check there
will be a difference in your book balance and the balance the bank lists for your checking account.
That difference is float. This float can be managed. If you know that the bank will not learn about
your check for five days, you could take the N100 and invest it in a savings account at the bank for
the five days and then place it back into your checking account "just in time" to cover the N100
check.
Float is calculated by subtracting the book balance from the bank balance.
Float at Time 0: N500 - N500 = N0
9.4 Ways to Manage Cash

Firms can manage cash in virtually all areas of operations that involve the use of cash. The
goal is to receive cash as soon as possible while at the same time waiting to pay out cash as
long as possible. Below are several examples of how firms are able to do this.
Sales
The goal for cash management here is to shorten the amount of time before the cash is received.
Firms that make sales on credit are able to decrease the amount of time that their customers wait
until they pay the firm by offering discounts.
For example, credit sales are often made with terms such as 3/10 net 60. The first part of the sales
term "3/10" means that if the customer pays for the sale within 10 days they will receive a 3%
discount on the sale. The remainder of the sales term, "net 60," means that the bill is due within 60
days. By offering an inducement, the 3% discount in this case, firms are able to cause their
customers to pay off their bills early. This results in the firm receiving the cash earlier.
Inventory
The goal here is to put off the payment of cash for as long as possible and to manage the cash being
held. By using a JIT inventory system, a firm is able to avoid paying for the inventory until it is
needed while also avoiding carrying costs on the inventory. JIT is a system where raw materials are
purchased and received just in time, as they are needed in the production lines of a firm.
1. Working Capital Cycle
Cash flows in a cycle into, around and out of a business. It is the business's life blood and every
manager's primary task is to help keep it flowing and to use the cashflow to generate profits. If a
business is operating profitably, then it should, in theory, generate cash surpluses. If it doesn't
generate surpluses, the business will eventually run out of cash and expire.
The faster a business expands, the more cash it will need for working capital and investment. The
cheapest and best sources of cash exist as working capital right within business. Good management
of working capital will generate cash which will help improve profits and reduce risks. Bear in mind
that the cost of providing credit to customers and holding stocks can represent a substantial
proportion of a firm's total profits.

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There are two elements in the business cycle that absorb cash - Inventory (stocks and work-in-
progress) and Receivables (debtors owing you money). The main sources of cash are Payables
(your creditors) and Equity and Loans.
Each component of working capital (namely inventory, receivables and payables) has two
dimensions ........TIME ......... and MONEY. When it comes to managing working capital - TIME IS
MONEY. If you can get money to move faster around the cycle (e.g. collect monies due from
debtors more quickly) or reduce the amount of money tied up (e.g. reduce inventory levels relative
to sales), the business will generate more cash or it will need to borrow less money to fund working
capital. Similarly, if you can negotiate improved terms with suppliers e.g. get longer credit or an
increased credit limit; you effectively create free finance to help fund future sales.
2. Sources of Additional Working Capital

Sources of additional working capital include the following:
Reserves
Existing cash
Profits (when you secure it as cash!)
Payables (credit from suppliers)
New equity or loans from shareholders
Bank overdrafts or lines of credit
Long-term loans
If you have insufficient working capital and try to increase sales, you can easily over-stretch the
financial resources of the business. This is called overtrading. Early warning signs include:
Pressure on existing cash
Exceptional cash generating activities e.g. offering high discounts for
early cash payment
Bank overdraft exceeds authorized limit
Seeking greater overdrafts or lines of credit

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Part-paying suppliers or other creditors
Paying bills in cash to secure additional supplies
Management pre-occupation with surviving rather than managing
Frequent short-term emergency requests to the bank (to help pay wages, pending receipt of a
cheque
3. Handling Receivables (Debtors)
Cashflow can be significantly enhanced if the amounts owing to a business are collected faster.
Every business needs to know.... who owes them money.... how much is owed.... how long it is
owing.... for what it is owed.
Late payments erode profits and can lead to bad debts.
Slow payment has a crippling effect on business; in particular on small businesses who can least
afford it. If you don't manage debtors, they will begin to manage your business as you will gradually
lose control due to reduced cashflow and, of course, you could experience an increased incidence
of bad debts.
The following measures will help manage your debtors:

1. Have the right mental attitude to the control of credit and make sure that it gets the
priority it deserves.
2. Establish clear credit practices as a matter of company policy.
3. Make sure that these practices are clearly understood by staff, suppliers and
customers.
4. Be professional when accepting new accounts, and especially larger ones.
5. Check out each customer thoroughly before you offer credit. Use credit agencies,
bank references, industry sources etc.
6. Establish credit limits for each customer... and stick to them.
7. Continuously review these limits when you suspect tough times are coming or if
operating in a volatile sector.
8. Keep very close to your larger customers.
9. Invoice promptly and clearly.
10. Consider charging penalties on overdue accounts.
11. Consider accepting credit /debit cards as a payment option.
12. Monitor your debtor balances and ageing schedules, and don't let any debts get too
large or too old.
Recognize that the longer someone owes you, the greater the chance you will never get paid. If the
average age of your debtors is getting longer, or is already very long, you may need to look for the
following possible defects:
weak credit judgement

poor collection procedures
lax enforcement of credit terms
slow issue of invoices or statements
errors in invoices or statements
customers dissatisfaction.

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Debtors due over 90 days (unless within agreed credit terms) should generally demand immediate
attention. Look for the warning signs of a future bad debt. For example:
longer credit terms taken with approval, particularly for smaller orders
use of post -dated checks by debtors who normally settle within agreed
terms
evidence of customers switching to additional suppliers for the same goods
new customers who are reluctant to give credit references
receiving part payments from debtors.
Profits only come from paid sales.

The act of collecting money is one which most people dislike for many reasons and therefore put on
the long finger because they convince themselves there is something more urgent or important that
demands their attention now. There is nothing more important than getting paid for your
product or service. A customer who does not pay is not a customer. Here are a few ideas
that may help you in collecting money from debtors:
Develop appropriate procedures for handling late payments.

Track and pursue late payers.
Get external help if your own efforts fail.
Don't feel guilty asking for money.... its yours and you are entitled to it.
Make that call now. And keep asking until you get some satisfaction.
In difficult circumstances, take what you can now and agree terms for the
remainder. It lessens the problem.
When asking for your money, be hard on the issue - but soft on the person .
Don't give the debtor any excuses for not paying.
Make it your objective to get the money - not to score points or get even.
4. Managing Payables (Creditors)
Creditors are a vital part of effective cash management and should be managed carefully to
enhance the cash position.
Purchasing initiates cash outflows and an over-zealous purchasing function can create liquidity
problems. Consider the following:
Who authorizes purchasing in y our company - is it tightly managed or

spread among a number of (junior) people?
Are purchase quantities geared to demand forecasts?

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Do you use order quantities which take account of stock-holding and
purchasing costs?
Do you know the cost to the company of carrying stock?
Do you have alternative sources of supply? If not, get quotes from major
suppliers and shop around for the best discounts, credit terms, and reduce
dependence on a single supplier.
How many of your suppliers have a returns policy?
Are you in a position to pass on cost increases quickly through price
increases to your customers?
If a supplier of goods or services lets you down can you charge back the cost
of the delay?
Can you arrange (with confidence!) to have delivery of supplies staggered or
on a just-in-time basis?
There is an old adage in business that if you can buy well then you can sell well. Management of your
creditors and suppliers is just as important as the management of your debtors. It is important to
look after your creditors - slow payment by you may create ill-feeling and can signal that your
company is inefficient (or in trouble!).
Remember, a good supplier is someone who will work with you to enhance the future viability and
profitability of your company.
5. Inventory (Stocks) Management

Managing inventory is a juggling act. Excessive stocks can place a heavy burden on the cash
resources of a business. Insufficient stocks can result in lost sales, delays for customers etc.
The key is to know how quickly your overall stock is moving or, put another way, how long each item
of stock sits on shelves before being sold. Obviously, average stock-holding periods will be
influenced by the nature of the business. For example, a fresh vegetable shop might turn over its
entire stock every few days while automobile factory would be much slower as it may carry a wide
range of rarely-used spare parts in case somebody needs them.
Nowadays, many large manufacturers operate on a just-in-time (JIT) basis whereby all the
components to be assembled on a particular day, arrive at the factory early that morning, no earlier -
no later. This helps to minimize manufacturing costs as JIT stocks take up little space, minimize
stock-holding and virtually eliminate the risks of obsolete or damaged stock. Because JIT
manufacturers hold stock for a very short time, they are able to conserve substantial cash. JIT is a
good model to strive for as it embraces all the principles of prudent stock management.
The key issue for a business is to identify the fast and slow stock movers with the objectives of
establishing optimum stock levels for each category and, thereby, minimize the cash tied up in
stocks. Factors to be considered when determining optimum stock levels include:

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What are the projected sales of each product?
How widely available are raw materials, components etc.?
How long does it take for delivery by suppliers?
Can you remove slow movers from your product range without
compromising best sellers?
Remember that stock sitting on shelves for long periods of time ties up money which is not working
for you. For better stock control, try the following:
Review the effectiveness of existing purchasing and inventory systems.

Know the stock turn for all major items of inventory.
Apply tight controls to the significant few items and simplify controls for the
trivial many.
Sell off outdated or slow moving merchandise - it gets more difficult to sell
the longer you keep it.
Consider having part of your product outsourced to another manufacturer
rather than make it yourself.
Review your security procedures to ensure that no stock "is going out the
back door!"
Higher than necessary stock levels tie up cash and cost more in insurance, accommodation costs
and interest charges.
9.5. Key Working Capital Ratios

The following, easily calculated, ratios are important measures of working capital utilization.
Ratio Formulae Result Interpretation
On average, you turn over the value of y our

entire stock every x days. You may need to
Average Stock break this down into product groups for
Stock
* 365/ =x effective stock management.
Turnover
Cost of Goods days Obsolete stock, slow moving lines will
(in days)
Sold extend overall stock turnover days. Faster
production, fewer product lines, just in
time ordering will reduce average days.

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It take you on average x days to collect
monies due to you. If your official credit
Receivables Debtors * terms are 45 day and it takes you 65
=x
Ratio 365/ days... why?
days
(in days) Sales One or more large or slow debts can dra g
out the average days. Effective debtor
management will minimize the days.
On average, you pay your suppliers every x

days. If you negotiate better credit terms
this will in crease. If you pay earlier, say, to
Creditors *
Payables get a discount this will decline. If you
365/ =x
Ratio simply defer paying your suppliers (without
Cost of Sales days
(in days) agreement) this will also increase - but
(or Purchases)
your reputation, the quality of service and
any flexibility provided by your suppliers
may suffer.
Total Current Current Assets are assets that you can

Current Assets/ =x readily turn in to cash or will do so within
Ratio Total Current times 12 months in the course of business.
Liabilities Current Liabilities are amount you are due
to pay within the coming 12 months. For example,
1.5 times means that you should be able to
lay your hands on $1.50 for every $1.00 you
owe. Less than 1 times e.g. 0.75 means that
you could have liquidity problems and be
under pressure to generate sufficient cash to
meet oncoming demands.

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(Total Current Similar to the Current Ratio but takes
Assets - account of the fact that it may take time to
Quick =x
Inventory)/
Ratio times convert inventory into cash.
Total Current
Liabilities
(Inventory +
Working A high percentage means that working
Receivables - As % capital needs are high relative to your sales.
Capital
Payables)/ Sales
Ratio
Sales
Other working capital measures include the following:

Bad debts expressed as a percentage of sales.
Cost of bank loans, lines of credit, invoice discounting etc.
Debtor concentration - degree of dependency on a limited number of customers.
Once ratios have been established for your business, it is important to track them over time and to
compare them with ratios for other comparable businesses or industry sectors.
When planning the development of a business, it is critical that the impact of working capital be fully
assessed when making cashflow forecasts. Financial planning software packages - Exl-Plan and
Cashflow Plan - can facilitate this task as they provide for the setting of targets for receivables,
payables and inventory.
Watching the financial ratios

Ratios are the most powerful tools of financial analysis. Financial ratios are designed to show
relationship among items in the financial statements.
The absolute figures reported in the financial statements will not provide meaningful understanding
of the financial performance of an entity unless they are related to one another.
Ratios help to put absolute figures into the right perspectives and help analysts to make qualitative
statements.
The analyst who in this case might be a director is conversant with the accounting language used in
interpretation of financial results.
REVISION QUESTIONS
Illustration 9.6.1
Regular stream of cash flow into a business is an important event that must take place in a business
to assist such entity manages its working capital effectively.
(a) What are the steps required to be put in place by a company to manage the cash flow
expected from the receivables generated in the business?.
(b) What are the possible effects of a weak receivables management policy?
(c) What would you consider as warning signs of future bad debts?

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Illustration 9.6.2
Haruna Plc intends to apply for working capital finance from its bankers and has been requested to
prepare an estimate of its needs, which should include 25% of your estimated figure to account for
contingencies. The following is the company's projected income statement for the coming year.
N'000
Sales 22,470
Cost of goods sold (16,371)
Gross profit 6,099
Admin & selling expenses (2,889)
Profit before tax 3,210
Income tax (1,070)
Profit after tax 2,140
The following schedule relates to cost of goods sold

N'000
Raw materials consumed 8,988
Wages and other manufacturing expenses 6,687
Depreciation 2,515
18,190
Less:
Stock of finished goods (10% of production) 1,819
Cost of goods sold 16,371
Work in Progress
Goods equivalent to 15% of the year's production are in progress, and are usually valued at full
materials cost plus 40% of other expenses
Raw materials
It is the Company's policy to keep two months consumption of materials in stock.
Others
Wages and other manufacturing expenses are paid monthly in arrears. Suppliers give month's
trades credit while sales are 20% in cash and the balance on two months credit.
Required:
Determine the working capital requirement of the company and estimate the financing needs
on the basis of the information given. (Assume 12 month calendar year)

N'000
Investment in inventories
Raw materials consumed x 2

12
= 8,988 x 2
12 1,498

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Work in progress: 15% of cost of production
= 15% of ( (8,988 + (40% x 6,687) )
= 15% 0f N11,663 1,749
Finished Goods
10% of (8,988 + 6,687)
= 10% 0f N15,675 1,568
4,815
Investment in Debtors
80% of Sales x 2/12
= 80% of N22,470 x2
12
= N(17,976 x 1)
6 2,996
Investment in Current Assets 7,811
Current Liabilities:
Manufacturing Expenses:
1/12 x Wages and other manufacturing expenses
= N(1 x 6687)
12 557
Creditors: 1 month:
= Material purchase = 8,988
12 12 749
1,306
Net working capital (Actual) = N(7,811 1,306) 6,505

Add 25% for contingencies (25% 0f N6,505) 1,625
Estimated financing needs 8,131
The company will require a working capital of N8,131,000 from its bankers.

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PART 10
SOURCES OF BUSINESS FINANCING

State the various source of financing available to business organizations.
Determine which source of finance a firm should apply and at what
time.
Report to management suitable source of finance per time.
10.2 SOURCES OF BUSINESS FINANCING

We can classify sources of business financing 'into three main groups: Short-term, Medium-
term and Long-term sources. Short-term sources are financing sources of up to 1 year
duration. Medium-term sources are financing sources of 1 year to 7 years duration, while
long-term sources are financing sources of 7 years or more duration.
Short-term Financing
Short-term finance sources are a flexible source of financing usually used in financing short-
term working capital needs. The sources of short-term financing include the following:
1. Borrowing from friends and relatives

This sources of finance is unreliable and is risky for the provider of finance. For
instance, you might find it difficult to enforce repayment against a defaulting relative.
2. Borrowing from cooperatives

This source of finance is restricted to only members of the cooperative. The amount
might be interest free or carry a little interest rate.
3. Trade Credits
Trade credits are created when the firm purchases raw materials, supplies or goods
for a resale on credit terms without signing any formal agreement for the liability.
They are thus called purchases on open account and they represent the largest
source of short-term financing for most firms. Trade credits represent an unsecured
form of financing since no specific assets are pledged as collateral for the
liability.
4. Accruals
Accruals are amounts owing on services rendered to the firm for which payment has
not been made. Accruals include wages payable, taxes payable, etc. The amount
owed is a source of financing.
5. Bank borrowing
Bank borrowing usually takes these forms: bank overdraft and bank loans.
Bank Overdrafts
Banks provide bank overdrafts. Under an overdraft arrangement, banks allow a firm to
overdraw its account with it even though the firm has insufficient funds deposited in the
account to meet the withdrawal. The firm will be required to maintain a current account with

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the bank before it can obtain this financing. A limit will be placed on this facility and the firm
is free to obtain as much or as little cash within the overdraft limit.
The bank charges interest on the account overdrawn outstanding at any time.
Bank Loans
Bank loans are a formal agreement between a bank and the borrower that the bank will lend
a specific amount of money for a specific period. Interest is payable on the whole of this sum
for the duration of the loan. Interest charge and requirements for security are similar to an
overdraft. However, unlike an overdraft that is payable on demand, bank loans cannot be
withdrawn before the expiry of the loan period.
In granting any form of bank borrowing, the bank usually takes into consideration the
following factors:
i. The purpose for which the advance is required.
ii. The amount of the advance
iii. The term of the advance
iv. How will the advance be paid?
v. The security for the advance.
vi. Does the character or record of the customer justify the advance?
Three main services viz:

i. Taking over the management of clients' sales ledgers.
ii. Insuring their clients; against the risk of bad debt. This can be done
with recourse or without recourse.
iii. For providing finance by means of advances against the security of trade
debtors, a factor will usually charge a fee of about 1.5 % - 2.5 % of sales for the first
two services. A factor in providing the third service, a source of short-term financing,
will charge a fee above bank rates. The factor will normally advance about 75% -
90% of the book value of debts, the remaining amount (less the fee) being paid when
the debtor are collected.
1. Acceptance Credits
This is a form of short-term financing used in trade financing. A bill of exchange is one
method of settlement in a trade between a seller and buyer. A bill of exchange is a
document drawn by the seller on the buyer requiring him to pay a certain sum of
money at some future date. A bill of exchange takes two forms: trade bills and bank
bills.
A trade bill is a bill of exchange in which the buyer acknowledges it by writing
accepted across it and signing it. The seller may then hold the bill until the end of the
agreed period (30, 60, 90 or 180 days) on which the buyer is to pay.
Medium Term Financing

The following are the major sources of medium-term financing:
1. Term Loans
This is a negotiated loan between a bank and a company for between 4-10 years
usually at a fixed rate of interest. The interest rate might also be variable, adjusted at a
period rollover date (say every 3,6 or 12 months) in line with recent movements in
the bank prime rate or any other base rate. Bank lending is usually at a base rate plus

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a margin depending on the credit worthiness of the borrower. Bank lending can be
secured or unsecured.
2. Hire purchase Agreement

A hire purchase agreement is a credit sale agreement by which the owner of the asset
or supplier grants the purchaser the right to take possession of the asset but
ownership will not pass until all the purchase payments or installments have been
made. The purchaser will pay the hire purchase payment over an agreed period.
3. Lease
A lease is a contract between the owner of an asset (lessor) and the user of the asset
(lessee) granting the user or lessee the exclusive right to use the asset, for an agreed
period in return for the payment of rent. A lease transaction is different from a hire
purchase contract. In hire purchase, the intention of both parties is that the
equipment passes to the purchaser on the fulfillment of certain conditions stated in
the agreement. The lease agreement merely creates the right to use an asset for a
definite period and at a specified rent, the lessor may not necessarily transfer title of
the asset. The main advantage of leasing to the lessee is the acquisition of an asset
without having to buy. This conserves organizations funds. Leasing is usually
regular when the cost of equipment is high and there is liquidity in the economy.
There are two types of lease called finance lease and operating lease.
Different types of assets could be a subject matter of a lease. Some typical items that
would be leased include computers and related items, plants and equipment,
aircrafts, ships, motorcars, tractors, trucks, forklifts, generators, boat etc.
4. Sale and Lease-back

Sale and leaseback arrangement is an arrangement by which a firm sells its asset to a
financial institution (usually insurance companies) or leasing company for cash and
the financial institution or leasing company immediately leases it back to the firm so
that the firm (lessee) can raise a large amount of cash through it.
1. Loan Term Financing

Loan stock is a long-term debt finance raised by a company for which interest is paid
usually at a fixed rate. The company must pay the interest whether it makes profit or
not. Loan stock also has a nominal value. Debentures are a form of loan stock that is
legally defined as the written acknowledgement of a debt incurred by a company,
usually given under the company seal and containing provisions as to the payment
of interest and eventual repayment of principal. When a company issues debenture,
there will be a trust deed that would empower a trustee (usually a bank or insurance
company) to intervene for debenture holders if the company does not fulfill the
conditions under which the debentures were issued.
Loan stock and debenture are often secured. The security can take the form of fixed
charge (usually on a specific property) or floating charge (charge on certain assets of
the company, e.g. stock and debts). Floating charge can crystallize to a specific
change if the company defaults in meeting its obligations under the terms of the loan
stock/debentures.

101
2. Preference Shares
The holders of preference shares are entitled to a fixed percentage dividend before
ordinary shareholders can be paid any dividend. A preference dividend can only be
paid if there are sufficient distributable profits available. However, with cumulative
preference shares, a company can carry forward an unpaid dividend to later years,
which it must pay before an ordinary dividend. Preference shares have the
advantages of not restricting a company's borrowing capacity since preference share
capital is not secured against assets of the company.
3. Ordinary Shares
Ordinary shareholders are the owners of the firm. They exercise control over the firm
through their voting rights. Ordinary shareholders bear the greatest risk in the firm.
They also benefit from the success of the firm. Ordinary shares have nominal or par
value. A firm contemplating on raising funds through ordinary shares will incur
floatation cost. Control might be diluted if a company issues the shares to outsiders.
The holders of ordinary shares earn their rewards from the firm in the form of
ordinary dividends. The amount of an ordinary dividend a company declares varies
on the fortunes of the company. However, a company must pay all fixed obligations
before it can pay ordinary dividends.
4. Retained Earnings
Retained earnings is part of a company's profits kept after payment of dividend. It
thus, is a source of financing. It is a cheap source of raising finance as compared to
share issue, as no issue cost is involved. Raising funds through retained earnings also
avoids dilution of control since there is no share issue to outsiders. Retained earnings
are an important source of financing for companies that do not have access to the
capital market.
Illustration 10.3.1
Sources of fund are divided into three main groups, list and explain four sources
from each group.
Illustration 10.3.2
NIM Plc is considering expanding its business empire costing N5,000,000. Explain
three ways available to raise the required funds
Illustration 10.3.3
List four fundamental problems encountered when a firm wants to raise fund from the
money market.
Illustration 10.3.4
List the sources of finance according to whether they are short term or long term source
of finance

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PART 11
LEASING
11.1 LEARNING OBJECTIVES

Understand leasing as a method of business finance.
State the various types of leasing and the sources available to get them.
Determine which type of leasing a firm should apply and at what time.
Report to management suitable sources of leasing.
11.2 LEASING
Leasing is a contractual agreement between two people, where the right to use the asset is
transferred by the owner (the Lessor) to the (Lessee) for an agreed period of time and for a
consideration called "Lease rental".
The lease rental usually is paid at an agreed time either monthly, quarterly, half-yearly or
annually. The cash flow and profit generation of the leasing must be considered when fixing
the periodic lease rental payment. There is the primary lease agreement and the secondary
lease agreement.
The primary lease agreement entails payment of both the asset cost and the profit
thereon for a period of 4 years to 5 years.
The secondary lease is a perpetual lease agreement with a nominal lease rental being
paid.
Lease rental could be paid up-front in which case more rental is paid at the initial life of the
asset and less rental paid at the later life of the asset. Where the lessee pay less rental at the
initial life of the asset and higher rental toward the end of the asset's life it is known as BACK-
ENDED lease.
11.3 TYPES OF LEASING AGREEMENT

Finance Leasing and Operating Leasing are the two major types of leasing agreements.
Finance Lease
Finance lease is mostly undertaken by banks and non bank financial institutions. Finance
lease is equally known as "Capital on full payout lease" It relies on the proceeds from the
lease rentals in the primary lease period to recover both the industrial and trade margins.
The aggregation of the primary lease rental covers either the initial capital outlay or cost of
the asset and some amount of rents or returns on the investments. The secondary lease
rental accounts majorly for returnon the leased asset.
The risk on the asset and cost of maintenance remains the function of the lessee. He claims
the capital allowance on the asset. Infact, the right of ownership after the payment of the
primary lease rental is transferred to the lessee.
All insurance cover on the asset is done by the lessee. The secondary lease period rental

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payment non-time account for only the recovery of the assets salvage value on the asset
leased.
Operating Lease
In operating lease the asset cost is not wholly amortized during the primary lease period; the
lessor while giving the lessee the use of the asset retains practically all risk, obligations, and
ownership in regard like early obsolescence, appreciation in value) of the asset.
This occurs where the owner of the asset sells the asset to a leasing company,
transferring ownership right to the leasing company but however retains the usage of the
asset for a payment of lease rental to the new owner (the lessor).
11.4 ADVANTAGES OF LEASING

1. PURCHASE PRICE
The initial capital outlay which is natural in purchase of asset is avoided in leasing. Such
huge amount can be invested in some other profitable investment. Leasing thus provides
liquidity for the business organization.
2. OFF-BALANCE SHEET FINANCING

Leasing, being an off-balance sheet financing (operating leasing) present a strong but cheap
means of financing to the business organization. The business can make use of the asset
without necessarily buying it.
3. Where an asset is needed for a short period it will make no sense buying such an
asset where leasing can be done. Leasing thus provides opportunity to use an asset for a
short period without having to incur huge purchase cost. This accounts for why
conglomerates lease vehicles rather than outrightly purchasing them.
4. ILLIQUIDITY
Most times an investor may not be liquid enough to take a bank loan, for asset purchase but
by leasing such asset could easily be acquired.
5. RISK TRANSFER
The risk of obsolescence involved in dynamic assets is easily transferred to the lessor in the
leasing agreement under an operating lease agreement. This enables the lessee to cancel his
agreement in case the asset becomes obsolete.
11.5 DISADVANTAGES
1. Loss of Claim on Depreciation
The capital allowance is normally claimed by the lessor in operating lease rather than such
benefit accruing to the user of the asset.
2. Ownership Right
The ownership right in operating lease belongs to the lessor as such the user will not have full
authority on the asset.
11.6 PROCESS IN LEASE FINANCE CALCULATIONS

Three cases are available under leasing decision. For the financial manager, they are to assist
him decide on whether to:
1. Obtain a loan to finance the purchase of the asset.
2. Purchase the asset from company's purse.
3. Lease the asset.

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11.7 DECISION CRITERION (Where the company is in a taxable position.
Step 1: Compute tax benefit on interest on loan and tax benefit on capital allowance.
Tax benefit on Interest = Tax rate X Interest on loan
Step 2: Compute the cash repayment using amortization method.

Cash repayment = Loan or r(Loan)
n -n
1 ( 1 + r) 1(1 + r)
r
Step 3: Multiply the annual repayment by number of years total cash repayment.
Step 4: Deduct tax benefit on interest and capital allowance and annual cash
repayment to get real annual cash paid.
Step 5: Compute the present value of net cash repayment.
CASE 2: Leasing
Follow the first 5 steps above.
11.8 LEASING OR BUYING DECISION

Step 6: Compare the present value of net cash repayment and loan with present value
of net cash repayment and leasing.
Step 7: Accept the method that yields the least cost.
ILLUSTRATION 1
James and Mary Plc. have just secured a profitable investment opportunity using an asset
with initial capital outlay of N2 million with a zero residual value after 6 years.
The financial manager of the company is considering the method of finance to adopt. Two
opportunities are available.
1) The usage of loan with a 20% interest, with a constant annual repayment.
2) Finance by leasing from a leasing company at an annual rental
N600,000.00
Capital allowance on the asset is 20% straight line over 6 years. The company income tax is
35%. The company cost of capital is 13%.
Required:
Advice the company on which of the two options to select where the, company is in a taxable
position.
Answer
1. Prepare an amortization schedule for the loan in order to identify the annual repayment and
tax savings on the interest.
-n -6
Step 1: 1 (1 + r) = 1 (1.20)
r 0.20 = 3.3255

105
Year payment
Annual Cash
Year Capital B/F Interest 20% Capital Repaid Balance
Paid
1. 2,000,000 601413 400,000 201,413 1,798,587
2. 1,798,587 601,413 359,717 241,695.6 1,556,891
3. 1,556,891.4 601,413 311,378 290,035 1,266,857
4. 1,266,857 601,413 253,371 348,042 918,815
5. 918,815 601,413 183,763 501,170 501,165
6. 501,165 601,413 100,233 501,180 NIL
Repayment Schedule
Time Saving on Saving on Capital Total Benefit

Interest Allowance
Yr1. 140,000 116,667 256,667
Yr2. 125,900 116,667 242,567
Yr3. 108,982 116,667 225,650
Yr4. 88,680 116,667 205,347
Yr5. 64,317 116,667 180,984
Yr6. 35,082 116,667 151,749
NB: Saving on interest = 20% of capital balance multiplied by 35% capital balance saving on
capital allowance = capital allowance multiplied by 5%.
OPTION 2
Year NCF DCF PV
Item lease rental 0-5 600,000 4.5172 2,710,200
Tax saving in rental 1-6 210,000 3.998 (839,580)
Tax saving on capital allowance 2-7 116,667 3.5376 (412,721)
1,457,899
Advice: It will be advisable for the company to lease the asset than for loan to purchase
the asset.
1LLUSTRATION 2
Assuming from the above that the company is in a non-taxable position.

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ANSWER
Note: Where the company is in a non-taxable position then there shall be no tax benefit on
both capital and interest on loan or lease.
Loan will be: 601,413 @ 3.998 = 2,404,450
Lease Rental amount 600,000 @ 4.5172 = 2,710,320
In the above case it will be better for the company to take loan for the purchase of the
asset.

ILLUSTRATION 11.9.1
James and Mary Plc. have just secured a profitable investment opportunity using an asset
with initial capital outlay of N2 million with a zero residual value after 6 years.
The Financial Manager of the Company is considering the method of finance to adopt. Two
2) Finance by leasing from a leasing company at an annual rental
N600,000.00
Required:
Advice the company on which of the two options to select where the, company is in a
taxable position.
ANSWER TO ILLUSTRATION 11.9.1

tax savings on the interest.
-n -6
Step 1: 1 (1 + r) = 1 (1.20)
r 0.20 = 3.3255
Year payment
1. 601,413
2. 601,413
3. 601,413
4. 601,413
5. 601,413
6. 601,413

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Repayment Schedule
Annual Cash
Year Capital B/F Interest 20% Capital Repaid Balance
Paid
1. 2,000,000 601413 400,000 201,413 1,798,587
2. 1,798,587 601,413 359,717 241,695.6 1,556,891
3. 1,556,891.4 601,413 311,378 290,035 1,266,857
4. 1,266,857 601,413 253,371 348,042 918,815
5. 918,815 601,413 183,763 501,170 501,165
6. 501,165 601,413 100,233 501,180 NIL
Time Saving on Saving on Capital Total Benefit

Interest Allowance
Yr1. 140,000 116,667 256,667
Yr2. 125,900 116,667 242,567
Yr3. 108,982 116,667 225,650
Yr4. 88,680 116,667 205,347
Yr5. 64,317 116,667 180,984
Yr6. 35,082 116,667 151,749
NB: Saving on interest = 20% of capital balance multiplied by 35% capital balance saving on
capital allowance = capital allowance multiplied by 5%.
OPTION 2
Year NCF DCF PV
Item lease rental 0-5 600,000 4.5172 2,710,200
Tax saving in rental 1-6 210,000 3.998 (839,580)
Tax saving on capital allowance 2-7 116,667 3.5376 (412,721)
1,457,899
Advice: It will be advisable for the company to lease the asset than for loan to purchase the asset.
ILLUSTRATION 11.9.2
ANSWER ILLUSTRATION 11.9.2

Note: Where the company is in a non-taxable position then there shall be no tax benefit on both
capital and interest on loan or lease.

108
Loan will be: 601,413 @ 3.998 = 2,404,450
Lease Rental amount 600,000 @ 4.5172 = 2,710,320
In the above case it will be better for the company to take loan for the purchase of the asset.
ILLUSTRATION 11.9.1
James and Mary Plc. have just secured a profitable investment opportunity using an asset with
initial capital outlay of N2 million with a zero residual value after 6 years.
The Financial Manager of the Company is considering the method of finance to adopt. Two
2) Finance by leasing from a leasing company at a annual rental N600,000.00
Required:
Advice the company on which of the two options to select where the, company is in a taxable
position.
ANSWER TO ILLUSTRATE 11.9.1

tax
Savings on the interest.
-n 6
Step 1:1 (1 + r) = 1(1.20)
R 0.20
= 3.3255
Year payment
1. 601,413
2. 601,413
3. 601,413
4. 601,413
5. 601,413
6. 601,413
Advise: It will be advisable for the company to lease the asset than for loan to purchase the asset.
ILLUSTRATION 11.9.2
ANSWER TO ILLUSTRATION 11.9.2

Note: Where the company is in non-taxable position then there shall be no tax benefit on both
capital and interest on loan or lease. Loan will be: 601,413 @ 3.998 = 2,404,450
Lease Rental amount 600,000 @ 4.5172=2,710,320
In the above case it will be better for the company to take loan for the purchase of the asset.

109
ILLUSTRATION 11.9.3
Okonkwo Ltd. is considering leasing a building for its use at a cost 30,000 per annum payable yearly
in advance. The Financial Manager of the company is of the view that it might be better to negotiate
the purchase of the building outright and the owners agreed to sell it for N2, 000,000 Estate Valuers
put the value of the building after 21 years at N1, 500,000. The company's cost of capital is 10%. A
general inflation e of 2.7% per annum is expected over the life of the lease.
Advise Okonkwo Ltd., on the two options.

Company Tax is assumed at 50%. Ignore Capital Allowances.
2) What is the advantage of leasing over outright purchase of assets?
3) List four problems associated with finance leasing
4) State the similarities and differences between operating leasing, finance lease and hire purchase
PART 12
THE NIGERIAN FINANCIAL MARKETS

Understand the historical and legal formulation of the Nigerian Financial System.
Appreciate the operation of the Nigerian Financial System.
Estimate the value of the Nigerian Financial System in the economic growth of the
nation.
12.2 THE NIGERIAN FINANCIAL MARKETS

The financial market in any country is one of the major pillars of economic growth and
development, the market serves the function of enabling the efficient allocation of financial
resources among the economic agents. It serves as the channel through which the surplus
funds are transmitted between surplus units and the deficit units. In addition, the market
serves a broad range of clientele, including different levels of government, corporate bodies,
and individuals within and outside the country. It also provides both short and long term
finance needs to those clientele listed above.
The market can be broadly divided into two segments:

The money and
Capital market.
The money market is an arrangement whereby short term financial services are
provided. Mostly, money market instruments have at most one year maturity.
The capital market on the other hand, provides medium to long term financial
services. The issue of securities (i.e. financial instruments) in these two markets are of
two types:
Primary and Secondary Markets

The primary market is the market for new issues. It is a market in which new securities are
bought and sold for the first time.
The secondary market is the one in which the existing securities are bought and sold.
Money Market
The money market is where the short term securities are bought and sold. It is the vehicle
through which surplus funds flow from the surplus units to the deficits units. The security
traded in this market has maturity time of not more than one year.
The major participants in the money market include individuals, companies, banks,
discount houses and government. New issues and existing issues are both traded in the
money market segment; therefore, the market has both primary and secondary segments.
There are several instruments available through which funds can be traded in the money
market. These include treasury bills, treasury certificates, certificates of deposit, banker's
acceptances, commercial paper, eligible development stocks and banker's unit funds.

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Evolution of the Nigerian Money Market
The Nigerian money market started with the operation of the Treasury Bills Ordinance of
1959 and 1960. Before the passing of the Treasury Bill Ordinance in 1959 there was no
organized domestic money market in Nigeria. The financial system was linked to the
London market. Nigerian businessmen and Government had no effective machinery for
mobilizing funds for their businesses and development respectively. Aside the problem of
effective mobilization of funds, all the benefits of a money market eluded the country. The
motivation for the establishment of Nigeria money market was then pertinent.
Motive for the Establishment of the Nigerian Money Market

The following prompted the establishment of the money market in Nigeria:
i. Localizing the credit base: This was meant to provide local investors the avenue for
retention of funds in Nigeria and for the investment of funds repatriated from
abroad.
ii. To provide the needed machinery for the provision of short term financing to the
government.
iii. To establish monetary autonomy which is a prerequisite of the working of a
sovereign state
iv. The need for the country to enjoy the functions of a money market especially in the
operating and executing of government monetary policy effectively.
The first ever monetary instrument issued in Nigeria was Treasury Bill issued by the Central
Bank the of Nigeria in 1960. This was followed by the Call Money Fund also initiated in the
same year. The major Call Money Fund was issued by Central Bank of Nigeria in 1962. The
issue of other money market instruments followed subsequently.
Commercial Paper (CP) and Treasury Certificates (TC) 1968.
Certificate of Deposits (CD), Bankers' Unit Fund (BUF), Eligible.
Development Stock (EDS) 1975 etc.
At its earlier stage, a phenomenal increase in money market instruments characterized the
market. This was made possible as more commercial merchant banks were established in
anticipation of meeting the need for domesticalising the Nigerian Financial System, which
was hitherto directly linked to the London financial market.
Another feature of the money market is the overwhelming preponderance of government

instruments (Treasury Bills, Treasury Certificates and Eligible Development Stocks) in the
market.
The corollary from the above shows that government remained the most active participant
in the market at its early stage. The Federal Government's development projects were
mainly financed through the issuing of money market instruments. Example of this is the
financing of the second development plan of 1962-1968. Also between 1967-70, another
federal government active participation in the money market was recorded mainly to
prosecute the civil war. The Federal Government's use of money market funding began to
fall with the emergence of the rise in oil revenue. During the same period, Treasury Bills
issued stagnated with new issues made mainly to replace maturing bills.
Money Market Instruments

Money market instruments are fixed income assets of high liquidity, very low risk, and short

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maturity. The maturity is mostly less than 12 months, although, some instruments have
maturity of more than 12 months e.g. Treasury Certificates and Eligible Development
Stocks.
These instruments include:
Treasury Bills (TB)
Treasury Certificates (TC)
Commercial Paper (CP)
Eligible Development Stocks (EDS)
Bankers Unit Funds (BUF)
Certificate of Deposits (CD)
Bankers Acceptances (BA)
Treasury Bills (TB)

These are the most popular marketable government securities. They are issued at discount
and have 91 days maturity. Once they are issued, Treasury Bills can be bought and sold in
the secondary market through a government securities dealer.
The return of the bill is the difference between the face value and the purchase value of the
instruments. The first issue of treasury bills was made in Nigeria in 1960.
The advantages of treasury issues include short maturity, a virtually default-free status, and
ready marketability. Their primary disadvantage lie in the fact that yields are normally the
lowest of any marketable security.
Treasury Certificate (TC)

The Federal Government Treasury Certificates have longer maturities and consequently
higher returns. They are also issued at discount. The first TC was issued in 1968 to bridge the
maturity gap between the short tenured treasury bills (TB) and the long tenured
Development Stocks (DS).
Commercial Paper (CP)

Commercial Paper consists of short term unsecured promissory notes that are issued by
large, well-known corporations and finance companies. The investors in the CP, are
normally high net worth and credit worthy individuals and institutional investors.
The CPs are also issued at discount and have maturities ranging between 2 or 3 days to 270
days. The secondary market for commercial papers in Nigeria is yet to be recorded.
Therefore their marketability is weak and there is high tendency for default risk, although
they attract higher return than TBs and TCs.
Eligible Development Stocks (EDS)

The eligible development stock is another government used instrument for securing
medium term financing for medium term government finance needs. It was first issued in
Nigeria by the Federal Government in 1975.
A secondary market exits for EDS and its marketability is higher than that of commercial
papers. The maturity period for the EDS is 3 years or less.
Bankers Unit Fund (BUF)

BUF was introduced by the CBN in 1975 as a means to mop up excess liquidity in the

112
banking system. It was also designed to provide avenue for merchants, commercial banks
and other financial institutions to invest part of their liquid funds in a money market asset
linked to Federal Government Stocks. Participants in the scheme invest in multiples of
N10,000 and the fund is in turn invested in available government stocks of various
maturities. Thus, the operation of the scheme is subject to the availability of government
stock.
Certificated of Deposit (CDs)

A Certificate of Deposit is a receipt from a bank for deposit of funds with a stated maturity
and specified interest rate. They are used to transfer surplus funds from one bank to another.
There are two type of certificate of deposits; Negotiable and Non Negotiable Certificates of
Deposits.
The Negotiable Certificate of Deposit (NCD) can be disposed of or sold to someone

else before its maturity. The NCD has a maturity range of 3 to 36 months. The first certificate
of deposit was introduced in Nigeria in 1975.
The Non Negotiable Certificate of Deposit (NNCD) has a feature of time deposit receipt,
which cannot be negotiated before its maturity.
Bankers' Acceptances (BAs)

A bankers' acceptance is a short-term instrument issued by a firm as part of commercial
transaction. Payment is guaranteed by a commercial bank (drawee bank) who accepts and
acknowledges its obligation to honour a draft on the due date. The draft face must have
been signed across by an appropriate authority, which makes it acceptable by the drawee
bank.
Bankers' acceptances are commonly used in financing instruments in international trade, as

well as in certain lines of domestic trade. The maturity period of the instrument ranges
between 30 to 180 days. The BAs are relatively safe investments, since both the bank and
the borrower are liable for the amount due at maturity. The BAs attract lower rate of
discount than CPs.
The Capital Market

The capital market is an arrangement where long term financial instruments can be bought
and sold. Unlike the money market, the capital market has both primary and secondary
markets.
The major participants in the capital market include stock exchange, central bank,
commercial banks, merchant banks, government, corporate organizations, insurance
companies and individuals.
There are three major instruments used in the capital market. They include: debt
instruments, preferred stock and common stock. Details about these instruments would be
discussed later in this chapter.
The most common nature of the capital market is that it is a market for long term securities
and provides services that are essential to a modern economy. It provides access to a variety
of financial instruments that enable economic agents to pool, price and exchange risk.

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Evolution of Nigerian Capital Market
At independence in 1960, Nigeria had no capital market. The predominance of the foreign
owned commercial and merchant banks did not encourage the provision of a capital market
in Nigeria. It meant that those who had funds surplus to their immediate requirements had
no market for them in the country. The only option opened to them was to repatriate those
funds for investment overseas. This resulted in a negative net capital flow at a time when the
country needed all the funds it could lay hands on for developmental purposes. Both
Nigerian businessmen and the government had no effective means of financing their capital
investment during the period. The effect of this brought about the establishment of a capital
market in Nigeria.
The operations of the Nigerian capital market began on the establishment of Lagos Stock
Exchange (LSE) in 1960. It commenced business on 15th September 1961. The Nigerian
Stock Exchange Act transformed the Lagos Stock Exchange to the Nigeria Stock Exchange
(NSE) in 1977.
The Nigeria Securities and Exchange Commission (NSEC) was established in 1977. Unlike
the CBN, NSEC is not an operator in the market of buying and selling securities. Its primary
function is to oversee the securities market and ensure orderly operations.
12.3 MAJOR FUNCTIONS OF NSEC

Established in 1977 as the apex institution in the capital market in Nigeria, NSEC has the
following functions:
1. Registering all securities proposeD to be offered for subscription by the public or
to be offered privately with the intention that they would be held ultimately other
than by those to whom the offerS were made;
2. Registering all stockbrokers, registrars, securities dealers and other agents
3. Determining the price, timing and volume of issues coming into the market with a
view to preventing the market from being over-flooded with issues;
4. Monitoring the securities market to ensure orderly, fair and equitable dealing and to
forestall or take steps to forestall illegal or unethical dealings, such as inside trading, at
the expense of the public; and
5. Determining the basis for allotment of securities offered to the market to ensure
spread and equity.
The Capital Market Instrument

There are three major types of instruments in the capital market. They include debt
instrument, preferred stock and common or ordinary stock.
Debt Instruments
Debt instruments in the capital market are those for securing long-term or loan borrowing.
That is, they are bought and sold in the market for funding huge and long term investment.
These debt instruments may be classified as follows:
i. Those secured by specific assets e.g. mortgage bonds.
ii. Those not secured by specific physical assets e.g. debentures or occasionally, bonds
Debt instruments are long-term issues raised by organizations or government parastatals.

They attract fixed rates of interest, which are paid at a stated coupon rate on their nominal
value. Suppose the nominal value of the bond is N200,000 and the coupon rate is 10% the
bond will receive N20,000 interest.
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One peculiarity of Debt instruments is that their obligations are met before payment, due to
long term capital market instruments
Preferred Stock
The preferred stock occupies an intermediate position between long-term debt and common
stock. Like long-term debt, e.g. bonds, preferred stock is considered a fixed income security,
like common stock, it is part of the stockholder equity.
The preferred stock holder receives dividend while the debt holder receive fixed interest
payment. On the part of the investors, the debt securities attract low risk than the preferred
stocks. Although the expected returns from preferred stock has a nominal value and dividend
is paid at a fixed percentage of the nominal amount.
Common Stock
A company's common stock holder (Ordinary Shareholder) is its true owner. The common
stock holders of a company have residual claim in the company. Their claims are paid after
the debt holders and preferred stock holders have been paid in full. Common stock is
considered a permanent form of long term financing, since, unlike the debt and preferred
stock, common stock has no maturity date.
A common stock holder's income is not certain; hence, common stock is a variable income
security. The expected return on the common stock investment is high as well as risky.
The Nigerian Stock Exchange (NSE)

The NSE was established following the report of the Barback committee set up in May 1958.
It was granted certificate of registration of business name in March 1959 and incorporated on
15th June 1961. It was initially called Lagos Stock Exchange (LSE). The LSE was
transformed into NSE by the Federal Government on 2nd December 1977 with additional
branches in Kaduna and Port Harcourt.
Functions of Nigerian Stock Exchange (NSE)

The following are some of the basic functions of the Nigerian Stock Exchange:
1. To provide the machinery for mobilizing private and public savings and
making these available for productive investment through stocks and shares. That
is, to assist in the mobilization and allocation of the nation's capital resources among
numerous competing alternative uses.
2. To encourage the investment of savings as soon as it is clear that stocks and shares are
readily available.
3. To provide opportunities for raising new capital.
4. To provide a central meeting place for members to buy and sell existing securities and
for granting quotation to new issues.
5. To promote increasing participation by the public in the private sector of the
economy.
6. To reduce the risk of liquidity by facilitating the purchase and sale of new and old
securities.
7. To provide opportunities for continued operation and attraction of foreign capital for
the nation's development.
8. To act as a channel for implementing the indigenization and privatization policy by
providing facilities to foreign business to offer their shares to the Nigerian public for
subscription.

115
9. To enhance opportunities for raising new capital and help the development of
enterprises in all sectors of the economy.
10. To see to the efficient allocation of available capital funds.
11. It provides information on the price and value of securities to buyers including sellers
and other operators in the market.

Illustration 12.4.1
The Nigerian Financial Market consists of both the Money and the Capital Market. What are
the instruments used in the two markets.
Illustration 12.4.2
What are the major functions of the Nigerian Stock Exchange (NSE)?
Answer To Illustration 12.4.2

The following are some of the basic functions of the Nigerian Stock Exchange:
1. To provide the machinery for mobilizing private and public savings and making these
available for productive investment through stocks and shares. That is, to assist in the
mobilization and allocation of the nation's capital resources among numerous
competing alternative uses.
2. To encourage the investment of savings as soon as it is clear that stocks and share are
readily available.
3. To provide opportunities for raising new capital.
4. To provide a central meeting place for member to buy and sell existing securities and for
granting quotation to new issues.
5. To promote increasing participation by the public in the private sector of the economy.
6. To reduce the risk of liquidity by facilitating the purchase and sale of new and old securities.
7. To provide opportunities for continued operation and attraction of foreign capital for the
nations development.
8. To act as a channel for implementing the indigenization and privatization policy by
providing facilities to foreign business to offer their share to the Nigerian public for
subscription.
9. To enhance opportunities for raising new capital and help the development of enterprises in
all sectors of the economy.
10. To see the efficient allocation of available capital funds to the diverse use on the economy.
11. It provides information on the price and value of securities to the buyers including sellers
and other operators in the market.
Illustration 12.4.3
What are the basic functions of the Nigerian Capital Market?
Illustration 12.4.4
Briefly explain the basic functions of the Nigerian stock market
Illustration 12.4.5
What are the functions of the Nigerian Securities and Exchange Commission?

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PART 13
MISCELLANEOUS FINANCIAL MANAGEMENT TOPICS

Appreciate the various other topics like Value Based Management, bankruptcy,
business failures and reorganization as well as International Financial Institutions like
World Bank, IMF and IFC
Determine knowledge of the functions of various institutions.
13.2 Value Based Management

Value Based Management is the management approach that ensures corporations are run
consistently on value (normally: maximizing shareholder value).
Value-Based Management (VBM) is a customer-focused system built upon shared principles and
core values, which is designed to instill an ownership culture within an organization. VBM is
catalyzed by "authentic leaders" who actively seek to empower others; it is developed and sustained
from the ground-up.
Value-Based Management offers workers an opportunity to participate as first-class shareholders in
the company's equity growth, and in monthly and annual profits on a profit centre basis.
Experience has shown that where reinforced by a VBM culture, people become empowered to
make better decisions, discipline their own behavior, and work together more effectively as a team.
Because each person contributes, risks and shares as an owner, as well as a worker, VBM helps
unite everyone's self interest around the company's bottom-line and corporate values.
Value-Based Management calls for a new philosophy of leadership. It holds that a genuine leader
sees himself or herself as the ultimate servant and a teacher, one who empowers others to realize
their hidden potential, not one who rules by fear or refuses to be accountable to others.
A well-designed Value-Based Management system sharpens and crystallizes the leader's

philosophy around a set of universal moral principles. Through a participatory, company-wide
process, the foundation is laid for an ongoing ownership sharing culture within the company. Such
a culture typically incorporates an employee stock ownership plan (ESOP), individual and team
performance feedback (i.e. formula-based cash profit sharing), ownership education and sharing
of financial information, and structured participatory management and governance. VBM builds
checks-and-balances in the governance and accountability system to allow executives flexibility to
make traditional executive decisions, while avoiding unworkable "management by committee."
Value Based Management aims to provide consistency of:

- the corporate mission (business philosophy),
- the corporate strategy (courses of action to achieve corporate mission and purpose),
- corporate governance (who determines the corporate mission and
- regulates the activities of the corporation),
- the corporate culture,
- corporate communication,
- organization of the corporation,
- decision processes and systems,
- performance management processes and systems, and

117
- reward processes and systems, with the corporate purpose and values a corporation wants
to achieve (normally: maximizing shareholder value).
Value Based Management is dependent on corporate purpose and corporate values.
13.3 CORPORATE GOVERNANCE

Corporate governance is "the system by which companies are directed and controlled" (Cadbury
Committee, 1992). It involves a set of relationships between a company's management, its board,
its shareholders and other stakeholders; it deals with prevention or mitigation of the conflict of
interests of stakeholders. Ways of mitigating or preventing these conflicts of interests include the
processes, customs, policies, laws, and institutions which have impact on the way a company is
controlled. An important theme of corporate governance is the nature and extent of accountability
of people in the business, and mechanisms that try to decrease the principalagent problem.
Corporate governance also includes the relationships among the many stakeholders involved and
the goals for which the corporation is governed. In contemporary business corporations, the main
external stakeholder groups are shareholders, debt holders, trade creditors, suppliers, customers
and communities affected by the corporation's activities. Internal stakeholders are the board of
directors, executives, and other employees. It guarantees that an enterprise is directed and
controlled in a responsible, professional, and transparent manner with the purpose of safeguarding
its long-term success. It is intended to increase the confidence of shareholders and capital-market
investors.
A related but separate thread of discussion focuses on the impact of a corporate governance system
on economic efficiency, with a strong emphasis on shareholders' welfare; this aspect is particularly
present in contemporary public debates and developments in regulatory policy (see regulation and
policy regulation).
There has been renewed interest in the corporate governance practices of modern corporations
since 2001, particularly due to the high-profile collapses of a number of large corporations, most of
which involved accounting fraud.
Corporate scandals of various forms have maintained public and political interest in the regulation
of corporate governance. In the U.S., these include Enron Corporation and MCI Inc. (formerly
WorldCom). Their demise is associated with the U.S. Federal government passing the Sarbanes-
Oxley Act in 2002, intending to restore public confidence in corporate governance.
Comparable failures in Australia (HIH, One.Tel) are associated with the eventual passage of the
CLERP 9 reforms. Similar corporate failures in other countries stimulated increased regulatory
interest (e.g., Parmalat in Italy).
13.4 MERGERS AND ACQUISITION
Mergers and acquisition are the two major forms of business combination. Merger means a
combination of two or more companies where only one company survives and others go out
existence. Consolidation means combination of two companies where by an entirely new company
is formed. Amalgamation means the combination of more than two companies into one new legal
entity. Acquisition is a form of business combination in which the acquiring company purchases a
controlling interest of the other. It is otherwise called Take Over. In such arrangement, there is the
Holding Company (Parent) and subsidiary (the acquired). The acquired company then becomes
an affiliate.

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Tender Offer: This is a merger or acquisition strategy whereby the interested company bids to take
over another without the prior interest of management or board of directors of the merger
candidate. This act is known as unfriendly takeover attempt. In the process, the acquiring company
makes a tender offer i.e. announcing her desires to pay a certain price above the then existing
market price of the merger candidate.
White Knight: This is a counter strategy to tender offer. It is a means by which the merger
candidate's management tries to find another, more friendly acquiring company that would be
willing to enter into a bidding war with the first acquiring company.
Types of Merger
Mergers generally are classified according to whether they are horizontal, vertical or conglomerate.
Horizontal Merge: Exists when two or more companies that compete directly with
one another merge.
Vertical Merge: Exists when two or more companies that have a buyer- seller
relationship with one another merge.
Conglomerate Merge: Is a combination of two or more companies in which either
competes directly with the other and no buyer-seller relationship.
Reasons for Mergers

1. Availability of lower cost of assets.
2. Greater economies of scale (synergism).
3. Larger market advantage.
4. Greater diversification and reduction of risk.
5. External financing opportunities.
Valuation of Merger Candidates

1. Comparative price earnings ratio method.
2. Adjusted book value method.
3. Discounted cash flow method.
13.5 BANKRUPTCY
Bankruptcy is a legal status of an insolvent person or an organization, that is, one that cannot repay
the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often
initiated by the debtor.
Bankruptcy is not the only legal status that an insolvent person or organization may have, and the
term bankruptcy is therefore not the same as insolvency. In some countries, including the United
Kingdom, bankruptcy is limited to individuals, and other forms of insolvency proceedings, for
example liquidation and administration, are applied to companies. In the United States the term
bankruptcy is applied more broadly to formal insolvency proceedings.
Bankruptcy laws in most countries will help people who can no longer pay their creditors get a fresh
start by liquidating assets to pay their debts or by creating a repayment plan. Bankruptcy laws also
protect troubled businesses and provide for orderly distributions to business creditors through
reorganization or liquidation.

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13.6 LIQUIDATION
Liquidation is the process by which a company (or part of a company) is brought to an end, and the
assets and property of the company redistributed. Liquidation is also sometimes referred to as
winding-up or dissolution, although dissolution technically refers to the last stage of liquidation.
Liquidation may either be compulsory (sometimes referred to as a creditors' liquidation) or
voluntary (sometimes referred to as a shareholders' liquidation, although some voluntary
liquidations are controlled by the creditors, see below).
Compulsory liquidation
The parties who are entitled by law to petition for the compulsory liquidation of a company vary
from jurisdiction to jurisdiction, but generally, a petition may be lodged with the court for the
compulsory liquidation of a company by:
- the company itself
- any creditor who establishes a prima facie case
- shareholders
- the Federal Minister (or equivalent)
- the Official Receiver
Grounds
The grounds upon which one can apply for a compulsory liquidation also vary between
jurisdictions, but the normal grounds to enable an application to the court for an order to
compulsorily wind-up the company are:
- the company has so resolved the company was incorporated as a public company,
and has not been issued with a trading certificate (or equivalent) within 12 months
of registration
- it is an "old public company" (i.e., one that has not re-registered as a public
company or become a private company under more recent companies legislation
requiring this) it has not commenced business within the statutorily prescribed time
(normally one year) of its incorporation, or has not carried on business for a
statutorily prescribed amount of time
- the number of members has fallen below the minimum prescribed by statute
- the company is unable to pay its debts as they fall due, it is just and equitable to wind
up the company.
- In practice, the vast majority of compulsory winding-up applications are made
under one of the last two grounds.
An order will not generally be made if the purpose of the application is to enforce payment of a debt
which is bona fide disputed. A "just and equitable" winding-up enables the ground to subject the
strict legal rights of the shareholders to equitable considerations. It can take account of personal
relationships of mutual trust and confidence in small parties, particularly, for example, where there
is a breach of an understanding that all of the members may participate in the business, or of an
implied obligation to participate in management. An order might be made where the majority
shareholders deprive the minority of their right to appoint and remove their own director.
The order
Once liquidation commences (which depends upon applicable law, but will generally be when the
petition was originally presented, and not when the court makes the order), dispositions of the
company's property are generally void, and litigation involving the company is generally

120
restrained. Upon hearing the application, the court may either dismiss the petition, or make the
order for winding-up.
Voluntary liquidation
Voluntary liquidation occurs when the members of the company resolve to voluntarily wind-up the
affairs of the company and dissolve. Voluntary liquidation begins when the company passes the
resolution, and the company will generally cease to carry on business at that time (if it has not done
so already). If the company is solvent, and the members have made a statutory declaration of
solvency, the liquidation will proceed as a members' voluntary winding-up. In such case, the
general meeting will appoint the liquidator(s). If not, the liquidation will proceed as a creditor's
voluntary winding-up, and a meeting of creditors will be called, to which the directors must report
on the company's affairs. Where a voluntary liquidation proceeds by way of creditor's voluntary
liquidation, a liquidation committee may be appointed.
Where a voluntary winding-up of a company has begun, a compulsory liquidation order is still
possible, but the petitioning contributory would need to satisfy the court that a voluntary
liquidation would prejudice the contributories.
In addition, the term liquidation is sometimes used when a company wishes to divest itself of some
of its assets. This is used, for instance, when a retail establishment wishes to close stores. They will
sell to a company that specializes in store liquidation instead of attempting to run a store closure sale
themselves.
Priority of claims
The main purpose of a liquidation where the company is insolvent is to collect in the company's
assets, determine the outstanding claims against the company, and satisfy those claims in the
manner and order prescribed by law.
The liquidator must determine the company's title to property in its possession. Property which is in
the possession of the company, but which was supplied under a valid retention of title clause will
generally have to be returned to the supplier. Property which is held by the company on trust for
third parties will not form part of the company's assets available to pay creditors.
Before the claims are met, secured creditors are entitled to enforce their claims against the assets of
the company to the extent that they are subject to a valid security interest. In most legal systems,
only fixed security takes precedence over all claims; security by way of floating charge may be
postponed to the preferential creditors.
Dissolution
Having wound-up the company's affairs, the liquidator must call a final meeting of the members (if
it is a members' voluntary winding-up), creditors (if it is a compulsory winding-up) or both (if it is a
creditors' voluntary winding-up). The liquidator is then usually required to send final accounts to
the Registrar and to notify the court. The company is then dissolved.
Fresh Start Options for Limited Companies

In the advanced economies, many companies in debt decide it's more beneficial to start again by
creating a new company, often referred to as a 'phoenix' company. In business terms this will mean
liquidating a company as the only option and then resuming under a different name with the same
customers, clients and suppliers, but in Nigeria, it is rare to find such happening.

121
In some circumstances it can be ideal for the company. It can be a way to start trading profitably
having left unfavourable lease agreements and historic debt behind.
13.7 BUSINESS FAILURES

Business failure refers to a company ceasing operations following its inability to make a profit or to
bring in enough revenue to cover its expenses. A profitable business can fail if it does not generate
adequate cash flow to meet expenses.
In a broad perspective, business failures can be classified into two categories; catastrophic failure
and general lack of success. Catastrophic failures are the primary result of economic factors.
According to Dun and Bradstreet, over 75% of those businesses that cite economic factors as a
reason for failure, indicate that a lack of profits is the primary reason. Catastrophic failures also
result from the death of a partner, fire, fraud, burglary and acts of God.
Businesses can also fail as a result of wars, recessions, high taxation, high interest rates, excessive
regulations, management decisions, insufficient marketing, inability to compete with other similar
businesses, or a lack of interest from the public in the business's offerings. Some businesses may
choose to shut down prior to an expected failure. Others may continue to operate until they are
forced out by a court order.
Why Small Businesses Fail

When you're starting a new business, the last thing you want to focus on is failure. But if you address
the common reasons for failure up front, you'll be much less likely to fall victim to them yourself.
Here are the top 7 reasons why businesses fail and tips for avoiding them.
According to statistics published by the Small Business Administration (SBA), seven out of ten new
employer establishments survive at least two years and 51 percent survive at least five years. This is
a far cry from the previous long-held belief that 50 percent of businesses fail in the first year and 95
percent fail within five years.
The following list summarize the 12 leading management mistakes that lead to business failures.
1) Going into business for the wrong reasons
2) Poor management and advice from family and friends
3) Insufficient capital
4) Wrong Location
5) Lack of planning
6) Family pressure on time and money commitments
7) Over-expansion and pride
8) Lack of market awareness
9) Lack of financial responsibility, awareness and financial mismanagement
10) Lack of a clear focus
11) Too much money
1. You start your business for the wrong reasons.

Would the sole reason you would be starting your own business be that you would want to
make a lot of money? Do you think that if you had your own business that you'd have more
time with your family? Or maybe that you wouldn't have to answer to anyone else? If so,
you'd better think again.

122
On the other hand, if you start your business for these reasons, you'll have a better chance at
entrepreneurial success:
You have a passion and love for what you'll be doing, and strongly believe -- based on educated
study and investigation -- that your product or service would fulfill a real need in the
marketplace.
You are physically fit and possess the needed mental stamina to withstand potential challenges.
Often overlooked, less-than-robust health has been responsible for more than a few
bankruptcies.
You have drive, determination, patience and a positive attitude. When others throw in the towel,
you are more determined than ever.
Failures don't defeat you. You learn from your mistakes, and use these lessons to succeed the
next time around. Studies of successful business owners showed they attributed much of their
success to "building on earlier failures;" on using failures as a "learning process."
You thrive on independence, and are skilled at taking charge when a creative or intelligent
solution is needed. This is especially important when under strict time constraints.
You like -- if not love -- your fellow man, and show this in your honesty, integrity, and
interactions with others. You get along with and can deal with all different types of individuals.
2. Poor Management
Many report on business failures cites poor management as the number one reason for failure.
New business owners frequently lack relevant business and management expertise in areas such as
finance, purchasing, selling, production, and hiring and managing employees. Unless they
recognize what they don't do well, and seek help, business owners may soon face disaster. They
must also be educated and alert to fraud, and put into place measures to avoid it.
Neglect of a business can also be its downfall. Care must be taken to regularly study, organize, plan
and control all activities of its operations. This includes the continuing study of market research and
customer data, an area which may be more prone to disregard once a business has been
established.
A successful manager is also a good leader who creates a work climate that encourages
productivity.
He or she has a skill at hiring competent people, training them and is able to delegate. A good
leader is also skilled at strategic thinking, able to make a vision a reality, and able to confront
change, make transitions, and envision new possibilities for the future.
3. Insufficient Capital
A common fatal mistake for many failed businesses is having insufficient operating funds.
Business owners underestimate how much money is needed and they are forced to close before
they even have had a fair chance to succeed. They also may have an unrealistic expectation of
incoming revenues from sales.
It is imperative to ascertain how much money your business will require; not only the costs of
starting, but the costs of staying in business. It is important to take into consideration that many
businesses take a year or two to get going. This means you will need enough funds to cover all costs
until sales can eventually pay for these costs. This business startup calculator will help you predict
how much money you'll need to launch your business.

123
4. Location, Location, Location
Location is critical to the success of your business. Whereas a good business location may
enable a struggling business to ultimately survive and thrive, a bad location could spell disaster
to even the best-managed enterprise.
Some factors to consider:
Where your customers are
Traffic, accessibility, parking and lighting
Location of competitors
Condition and safety of building
Local incentive programmes for business start-ups in specific targeted areas
The history, community flavor and receptiveness to a new business at a prospective site
5. Lack of Planning
Anyone who has ever been in charge of a successful major event knows that were it not for
their careful, methodical, strategic planning -- and hard work -- success would not have
followed. The same could be said of most business successes.
It is critical for all businesses to have a business plan. Many small businesses fail because of
fundamental shortcomings in their business planning. It must be realistic and based on
accurate, current information and educated projections for the future.
Components may include:

Description of the business, vision, goals, and keys to success
Work force needs
Potential problems and solutions
Financial: capital equipment and supply list, balance sheet, income statement and cash
flow analysis, sales and expense forecast
Analysis of competition
Marketing, advertising and promotional activities
Budgeting and managing company growth
In addition, most bankers request a business plan if you are seeking to secure additional capital
for your company.
6. Over-expansion
A leading cause of business failure, overexpansion often happens when business owners
confuse success with how fast they can expand their business. A focus on slow and steady
growth is optimum. Many a bankruptcy has been caused by rapidly expanding companies.
At the same time, you do not want to repress growth. Once you have an established solid customer
base and a good cash flow, let your success help you set the right measured pace. Some indications
that an expansion may be warranted include the inability to fill customer needs in a timely basis,
and employees having difficulty keeping up with production demands.
If expansion is warranted after careful review, research and analysis, identify what and who you
need to add in order for your business to grow. Then with the right systems and people in place,
you can focus on the growth of your business, not on doing everything in it yourself.

124
13.8 INTERNATIONAL FINANCIAL INSTITUTIONS
The African Development Bank (ADB)
The ADB is a multilateral development bank whose shareholders include 53 African countries
(regional member countriesRMCs) and 24 non-African countries from the Americas, Asia, and
Europe (non-regional member countriesnon-RMCs).
It was established in 1964, with its headquarters in Abidjan, Cte d'Ivoire, and officially began
operations in 1967. However, due to political instability in Cte d'Ivoire, the Governors'
Consultative Committee (GCC), at a meeting in February 2003 in Accra, Ghana, decided to move
the Bank to its current temporary location in Tunis, Tunisia. The Bank has been operating from this
Temporary Relocation Agency since February 2003.
AFREXIM
The African Export Import Bank (the Bank) was established in Abuja, Nigeria in October, 1993
by African Governments, African private and institutional investors as well as non-African financial
institutions and private investors for the purpose of financing and promoting intra- and extra-
African trade. The Bank was established under the twin constitutive instruments of an Agreement
signed by member states and multilateral organizations, and which confers on the Bank the status
of an international organization; as well as a Charter, governing its corporate structure and
operations, signed by all Shareholders. The authorized share capital of the Bank is Seven Hundred
and Fifty Million United States Dollars (US$750 million)
The Bank headquartered in Cairo, the capital of the Egypt, commenced operations on September
30, 1994, following the signature of a Headquarters Agreement with the host Government in
August, 1994. The Bank has branch offices in Harare, Zimbabwe; Abuja Nigeria and Tunis,
Tunisia.
Objectives of the Bank

To extend direct credit to eligible African exporters by providing pre- and post-shipment
finance.
To extend short-term credit and medium-term loans to African exporters and importers.
To finance imports needed for export development such as imports of equipment, spare
parts and raw materials.
To promote and provide insurance and guarantee services covering commercial and non-
commercial risks associated with African exports.
To promote development within Africa of a market for bankers' acceptances and other trade
documents.
To promote and finance South-South trade between African and other countries.
To assist African clearing houses and payment arrangements to promote intra-African trade.
To undertake market research and provide ancillary services, such as advisory and support
services and organization of trade fairs, aimed at expanding intra- and extra-African trade.
International Monetary Fund - IMF

The International Monetary Fund (IMF) is an international organization that provides financial
assistance and advice to member countries.
The IMF was born at the end of World War II, out of the Bretton Woods Conference in 1945. The
Fund was created out of a need to prevent economic crises like the Great Depression.
With its sister organization, the World Bank, the IMF is the largest public lender of funds in the

125
world. It is a specialized agency of the United Nations and is run by its 184 member states.
Membership is open to any country that conducts foreign policy and accepts the statutes of the
Fund.
The fund is created for the purpose of:
1. Promoting global monetary and exchange stability.
2. Facilitating the expansion and balanced growth of international trade.
3. Assisting in the establishment of a multilateral system of payments for current transactions.
The IMF plays three major roles in the global monetary system. The Fund surveys and monitors
economic and financial developments, lends funds to countries with balance-of-payment
difficulties, and provides technical assistance and training for countries requesting it.
What Does It Do?
The IMF is responsible for the creation and maintenance of the international monetary system, the
system by which international payments among countries take place. It thus strives to provide a
systematic mechanism for foreign exchange transactions in order to foster investment and
promote balanced global economic trade.
Sources of Funding
The IMF gets its money from quota subscriptions paid by member states. The size of each quota is
determined by how much each government can pay according to the size of its economy. The
quota in turn determines the weight each country has within the IMF - and hence its voting rights -
as well as how much financing it can receive from the IMF.
The larger the country, the larger its contribution; thus the U.S. contributes about 18% of total
quotas while the Seychelles Islands contribute a modest 0.004%. If called upon by the IMF, a
country can pay the rest of its quota in its local currency. The IMF may also borrow funds, if
necessary, under two separate agreements with member countries.
IMF Benefits
The IMF offers its assistance in the form of surveillance, which it conducts on a yearly basis for
individual countries, regions and the global economy as a whole. However, a country may ask for
financial assistance if it finds itself in an economic crisis, whether caused by a sudden shock to its
economy or poor macroeconomic planning. A financial crisis will result in severe devaluation of the
country's currency or a major depletion of the nation's foreign reserves. In return for the IMF's help,
a country is usually required to embark on an IMF-monitored economic reform program, otherwise
known as Structural Adjustment Policies (SAPs).
WORLD BANK
The World Bank is a vital source of financial and technical assistance to developing countries
around the world.
The bank is made up of two unique development institutions owned by 185 member
countriesthe International Bank for Reconstruction and Development (IBRD) and the
International Development Association (IDA).
Each institution plays a different but supportive role in the bank's mission of global poverty
reduction and the improvement of living standards. The IBRD focuses on middle income and
creditworthy poor countries, while IDA focuses on the poorest countries in the world. Together they
provide low-interest loans, interest-free credit and grants to developing countries for education,
health, infrastructure, communications and many other purposes.

126
The World Bank is like a cooperative, where its 185 member countries are shareholders. The
shareholders are represented by a Board of Governors, who are the ultimate policy makers at the
World Bank. Generally, the governors are member countries' ministers of finance or ministers of
development. They meet once a year at the Annual Meetings of the Boards of Governors of the
World Bank Group and the International Monetary Fund.
Fund Generation
IBRD lending to developing countries is primarily financed by selling AAA-rated bonds in
the world's financial markets. While IBRD earns a small margin on this lending, the greater
proportion of its income comes from lending out its own capital.
This capital consists of reserves built up over the years and money paid in from the Bank's
185 member country shareholders. IBRD's income also pays for World Bank operating
expenses and has contributed to IDA and debt relief.
IDA, the world's largest source of interest-free loans and grant assistance to the poorest
countries, is replenished every three years by 40 donor countries. Additional funds are
regenerated through repayments of loan principal on 35-to-40-year, no-interest loans,
which are then available for re-lending. IDA accounts for nearly 40% of the World Bank's
lending.
Loans
Through the IBRD and IDA, the bank offers two basic types of loans and credits: investment
loans and development policy loans.
Investment loans are made to countries for goods, works and services in support of
economic and social development projects in a broad range of economic and social
sectors.
Development policy loans (formerly known as adjustment loans) provide quick-disbursing
financing to support countries' policy and institutional reforms.
Grants
Grants are designed to facilitate development projects by encouraging innovation, co-
operation between organizations and local stakeholders' participation in projects. In recent
years, IDA grantswhich are either funded directly or managed through
partnershipshave been used to:
o Relieve the debt burden of heavily indebted poor countries
o Improve sanitation and water supplies
o Support vaccination and immunization programmes to reduce the incidence of
communicable diseases like malaria
o Combat the HIV/AIDS pandemic
o Support civil society organizations
o Create initiatives to cut the emission of greenhouse gasses
International Finance Corporation (IFC)
IFC, a member of the world bank group has 174 member countries which collectively
determine its activities and policies.
Established in 1956, IFC fosters economic growth in developing countries by
o financing private sector investments through:
long term loans
equity and quasi-equity
guarantees
risk management
o mobilizing capital in the international finance markets
o providing advice and technical assistance

127
IFC's mandate is to promote sustainable economic development through the private sector. IFC
pursues this goal through innovative solutions to the challenges of development, as it invests in
companies and financial institutions in emerging markets.
IFC considers positive developmental impact an integral part of good business, and focuses much
of its effort on the countries with the greatest need for investment. It recognizes that economic
growth is sustainable only if it is environmentally and socially sound and helps improve the quality
of life for those living in developing countries.
IFC provides investments and advisory services to build the private sector in developing countries
IFC fosters sustainable economic growth in developing countries by financing private sector
investment, mobilizing capital in the international financial markets, and providing advisory
services to businesses and governments.
IFC helps companies and financial institutions in emerging markets create jobs, generate tax
revenues, improve corporate governance and environmental performance, and contribute to their
local communities. The goal is to improve lives, especially for the people who most need the
benefits of growth.
Where IFC works

IFC invests in enterprises majority-owned by the private sector throughout most developing
countries in the world. Developing regions include:
Sub-Saharan Africa
East Asia & the Pacific
South Asia
Europe & Central Asia
Latin America & the Caribbean
Middle East & North Africa
IFC Strategic Priorities

IFC emphasizes five strategic priorities for maximizing its sustainable development impact:
Strengthening its focus on frontier markets, particularly the SME sector;
Building long-term partnerships with emerging global players in developing countries;
Differentiating IFC from its competitors through sustainability;
Addressing constraints to private sector investment in infrastructure, health, and education;
and
Developing domestic financial markets through institution building and the use of
innovative financial products

128
13. 9 REVISION QUESTIONS
Illustration 13.9.1
A limited liability company is considering acquiring either B or C Ltd. A Limited has a high
expected growth rate and sells at a higher P/E ratio than A.B Ltd. On the other hand, A
Limited has a low exchange ratio for B's share while that of C's share is 2:1.
Given the following information:
A B C
Sales 1,200mill. 130mill. 100mill.
Net Income 120mill. 12mill. 16mill.
Common share outstanding 40 4 4
EPS N32 N3 N4
PS N1.65 N1.5 N52
Market price of shares N30 N21 N52
P/E Ratio 10.0 7.0 13.0
Expected growth rate 7% 5% 12%
Required:
Show the former financial statement for A after merging with B & C.
Solution:
Before After Merger After Merger
With B With C
Sales 1,200mill. 1,330mill. 1,300mill.
Net Income 120mill. 133mill. 136mill.
Common Shares Outstanding 40mill. 43.2mill. 48mill.
EPS N3.00 N3.06 N2.83
Stock of shares after merger = Sm + Exchange Ratio (SC)

Sm = Outstanding common share before merger
Sc = Outstanding common share of merger candidate
The exchange ratio for merger candidate;

Common Share Ratio Value of Share after merger
A 40
B 4 1/1.2 0.8x4 =3.2
C 4 2/1 2.0x4 =8.0
It is worthy of note that the acquisition of a company with a lower P/E ratio causes the
earnings per share EPS figure of the acquiring company to decrease.
Accounting Method of Merger

1. Purchase method (involves goodwill).
2. Pooling of interest method.
In the purchase method, the total value paid or exchanged for the acquired firm assets is
recorded in the acquiring company's books. Any difference between the total value paid
and the fair market value of the acquired assets is termed goodwill.

129
In the pooling of interest method, the acquired company's assets are recorded on the
acquiring company's books at their cost (net deprecation) when acquired.
Example: Suppose that Company B acquires Company A's outstanding common stock for
N10 million. The book value of the acquired shares is N7 million. The book of Company A
and B before acquisition is as follows:
A B
Total assets (book value) N12 N50
Liabilities (book value) 5 15
Shareholder equity (book value) 7 35
Show the purchase and the pooling of the interest method of accounting for the mergers.
Solution:
Purchase Method (B's Account)
Before After
Total assets 50 65
Liability 15 20
Shareholder's equity 35 45
Pooling of interest method (B's account)

Before After
Total assets 50 62
Liability 15 20
Shareholder's equity 35 42
Illustration 13.9.2
Explain the terms merger and consolidation
Illustration 13.9.3
(a) Explain the term Corporate Governance in business management (5 marks)
(b) List and explain FOUR important business goals which good Corporate
Governance seeks to promote (10 marks)
(c) Mention FIVE steps a business organization should take to entrench good
Corporate Governance structure and practices in their business (10 marks)
Illustration 13.9.4
Write short notes on the roles of the following financial institutions in financing
international trade and private and public entities in Nigeria:
(a) International Monetary Fund (IMF)
(b) International Finance Corporation

130

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NIM

NIGERIAN INSTITUTE OF MANAGEMENT

NIM VISION: To be The Source and Symbol of Management Excellence

NIM / NYSC PROGRAMME

For more information, please contact:

FINANCIAL MANAGEMENT PAGE

Reviewed questions are provided at the end of each pack.

We also appreciate the support provided by the Directorate of Capacity Building.

FINANCIAL MANAGEMENT PAGE

PART 2 - TIME VALUE OF MONEY & RISK MANAGEMENT

PART 3 - SECURITIES AND THEIR VALUATION

PART 4 - CAPITAL BUDGETING UNDER CERTAINTY

PART 5 - CAPITAL BUDGETING UNDER UNCERTAINTY

PART 6 - THE COST OF CAPITAL

PART 7 - FINANCIAL STATEMENT ANALYSIS

PART 8 - CASH FLOW STATEMENT

PART 9 - WORKING CAPITAL MANAGEMENT

FINANCIAL MANAGEMENT PAGE

PART 12 THE NIGERIAN FINANCIAL MARKETS

FINANCIAL MANAGEMENT PAGE

1.1 LEARNING OBJECTIVE

1.2 OVERVIEW OF FINANCIAL MANAGEMENT

Financial Management may also be involved with planning, directing, monitoring,

FINANCIAL MANAGEMENT PAGE

1.3 OBJECTIVE OF THE FIRM

The financial objectives are:

The other non-financial objectives of Financial Management include:

FINANCIAL MANAGEMENT PAGE

1.4 APPLICATION OF FINANCIAL MANAGEMENT PRINCIPLES

(a) Investment decisions

(b) Financing decisions

(c) Dividend decisions

(d) Liquidity Management

(e) Tax Management

(f) Risk Management

(g) Asset Management

FINANCIAL DECISION GRID

Financing Decision Dividend Decision

(Working Capital Management)

FINANCIAL MANAGEMENT PAGE

What exactly is financial planning, and why is it so important?

Functions of Financial Planning

(a) planning for the acquisition, custody and expenditures of funds

FINANCIAL MANAGEMENT PAGE

1.6 FINANCIAL NEEDS ANALYSIS

What's required for a Financial Needs Analysis?

FINANCIAL MANAGEMENT PAGE

The Objective of the Financial Needs Analysis

1.7 CASH FLOW AND TAXES

Controlling the cash and other asset

FINANCIAL MANAGEMENT PAGE

FINANCIAL MANAGEMENT PAGE

Answer to Illustration 1.1

(a) Investment decisions

(b) Financing decisions

(c) Dividend decisions

(d) Liquidity Management

(e) Tax Management

(f) Risk Management

(g) Asset Management

FINANCIAL MANAGEMENT PAGE

Answer to Illustration 1.4

Answer to Illustration 1.6

FINANCIAL MANAGEMENT PAGE