CHAPTER 1 – FRAMEWORK OF FINANCIAL

MANAGEMENT

1.1 INTRODUCTION:
Finance can be defined as the art and science of managing money. Virtually all
individuals and organizations earn or raise money and spend or invest money.
Finance is concerned with the process, institutions, markets and instruments involved
in the transfer of money among and between individuals, businesses and
governments.
Finance consists of three interrelated areas:
i) Money and capital markets, which deals with securities markets and
financial institutions.
ii) Investments, which focuses on the decisions of both individuals and
institutional services as they choose securities for their investment
portfolios.
iii) Financial management or managerial finance, which is concerned with
the duties of the financial manager in the business firm. Financial
managers actively mange the financial affairs of many types of
business- financial and non-financial, private and public, large and
small, profit-seeking and not-for-profit.

Relationship to Economics:
The field of finance is closely related to economics. Financial managers must
understand the economic framework and be alert to the consequences of varying
levels of economic activity and changes in economic policy. They must also be able
to use economic theories as guidelines for efficient business operations. Examples
include supply and demand analysis, profit maximizing strategies and price theory. A
basic knowledge of economics is therefore necessary to understand both the
environment and the decision techniques of managerial finance.

Relationship to accounting:
The firm’s finance and accounting activities are closely related and generally overlap.
Indeed managerial finance and accounting are not often easily distinguishable. In
small firms the accountant often carries out the finance function, and in large firms
many accountants are closely involved in various finance functions. However, there
are two basic differences between finance and accounting:
i) Emphasis on cash flows. The accountant’s function is to develop and
provide data for measuring the performance of the firm, assessing its
financial position, and paying taxes. Using certain standardized and
generally accepted principles, the accountant prepares financial
statements that recognize revenue at the point of sale and expenses
when occurred is accrual basis of accounting.

The financial manager, on the other hand, places primary emphasis on

cash flows. He or she maintains the firm’s solvency by planning the
cash flows necessary to satisfy its obligations and to acquire assets
needed to achieve the firm’s goals. The financial manager uses this
cash basis to recognize the revenues and expenses only with respect

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 to actual inflows and outflows of cash. Regardless of its profit or loss, a
firm must have sufficient cash flows
ii) Decision-making: whereas accountants devote most of their
attention to the collection and presentation of financial data, financial
managers evaluate the accounting statements, develop additional
data, and make decisions based on their assessment of the associated
returns and risks. Accountants provide consistently developed and
easily interpreted data about the firm’s past, present and future
operations. Financial managers use these data, either in raw form or
after adjustments and analysis, as inputs to the decision making
process.

1.2 THE FINANCIAL MANAGER’S RESPNSIBILITIES:

The manager’s task is to acquire and use funds so as to maximize the value of the
firm. The financial manager’s primary responsibilities include:
i. Financial analysis and planning: this is concerned with monitoring
the firm’s financial condition, evaluating the need for increased (or
reduced) productive capacity, and determining what financial is
required.
ii. Investment decisions: the financial manager must determine the
mix of current and fixed assets and attempts to maintain optimal levels
for reach type of current asset. The financial manager also decided
which fixed assets to acquire and when existing fixed assets need to
be modified, replaced or liquidated.
iii. Financing decisions: financing decisions involve two major areas.
First, the most a[appropriate mix of short term and long term financing
must be established. A second and equally important concern is which
individual short term or long term sources of financing are the best at
a given point in time. Many of these decisions are dictated by necessity
but some require in depth analysis of the financing alternatives, their
costs, and their long run implications.
iv. Dealing with the financial markets: the financial manager must
deal with the money and capital markets where funds are raised, the
firm’s securities are traded and its investors either make or lose
money.
v. Risk management. All businesses face risks, including natural
disasters, uncertainties in commodity and security prices, volatile
interest rates and fluctuating exchange rates. The financial manager is
usually responsible for the firm’s overall risk management, including
identifying the risks that should be hedged and them in the most
efficient manner.
In summary, financial managers make decisions regarding which assets their firms
should acquire, how those assets should be financed, and how the firm should
manage its existing resources.

GOALS OF FINACIAL MANAGEMENT

Shareholder wealth maximization:

The goal of the firm, and therefore of all managers and employees, is to maximize
the wealth of the owners for whom it is being operated. The wealth of corporate
owners is measured by the share price of the stock, which in turn is based on the
timing of returns (cash flows), their magnitude and their risk. When considering each
financial decision alternative or possible action in terms of its impact on the share
price of the firm’s stock, financial managers should accept only those actions that are

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expected to increase share price. Because share price represents the owners’ wealth
in the firm, share price maximization is consistent with owner-wealth maximization.

What about stakeholders?

Although shareholder wealth maximization is the primary goal, in recent years many
firms have broadened their focus to include the interests of stakeholders as well as
shareholders. Stakeholders are groups such as employees, customers, suppliers,
creditors, owners and others who have a direct economic link to the firm. Employees
are paid for their labour, customers purchase the firm’s products or services,
suppliers are paid for the materials and services they provide, creditors provide debt
financing that is to be repaid subject to specified terms, and owners provide equity
financing for which they expect to be compensated. A firm with a stakeholder focus
consciously avoids actions that would prove detrimental to stakeholders. The goal is
not to maximize stakeholders well being but to preserve it.

The stakeholder view does not alter the shareholder wealth maximization goal. Such
a view is often considered part of the firm’s social responsibility and is expected to
provide maximum long-run benefit to shareholders by maintaining positive
stakeholder relationships. Such relationships should minimize stakeholder turnover,
conflicts and litigation. Clearly, the firm can better achieve its goal of shareholder
wealth maximization with cooperation of-rather than conflict with-its stakeholders.

Profit maximization.
To achieve the goal of profit maximization, the financial manager takes only those
actions that are expected to contribute to the firm’s overall profits. For each
alternative being considered, the financial manager would select the one that is
expected to result in the highest monetary return. Corporations normally measure
profits in terms of EPS, which is calculated by dividing the period’s total earnings
available for the firm’s common stockholders by the number of shares of common
stock outstanding.

But, is profit maximization a reasonable goal? No; it fails for a number of reasons. It
ignores the following

i. Timing: because the firm can earn a return on funds it receives, the
receipt of funds sooner rather than later is preferred.
ii. Cash flows: profits do not necessarily result in cash flows available to
stockholders. Owners receive cash flow either in the form of cash
dividends or proceeds from selling their shares for a higher price than
initially paid. A greater EPS does not necessarily mean that a firm’s
board of directors will vote to increase dividend payments. Also, a
higher EPS does not necessarily translate into a higher stock price.
Firms sometimes experience earnings increases without any
correspondingly favorable change in stock price.
iii. Risk; profit maximization also disregards risk-the chance that actual
outcomes may differ from those expected. A basic premise in
managerial finance is that a trade-off exists between return (cash flow)
and risk. Cash flow and risk affect share prices differently: Higher cash
flows are generally associated with higher share prices. Higher risk
tends to result in a lower share price because the stockholder must be
compensated for the greater risk. In general, stockholders are risk
averse- i.e. they avoid risk. When risk is involved, stockholders expect
to earn higher rates of return on investments of higher risk and lower
rates on lower-risk investments. Thus, differences in risk can
significantly affect the value of an investment.

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Social responsibility:
Another issue that deserves consideration is social responsibility: should businesses
operate strictly in their stockholder’s best interests, or are firms also partly
responsible for the welfare of their employees, customers and communities in which
they operate? Certainly, firms have ethical responsibility to provide a safe working
environment for their employees, to ensure that their production processes are not
endangering the environment, to engage in fair hiring practices, and produce
products that are safe to consumers. However, socially responsible actions such as
these have costs to businesses, and are questionable whether businesses would
incur these costs voluntarily. It is clear, however, that if some forms act in a socially
responsible manner while other firms do not, then the socially responsible firms will
be at a disadvantage in attracting investors because of the extra costs involved.

Does this mean that firms should not exercise socially responsibility? Not at all, but it
does mean that most significant cost-increasing actions will have to be put on a
mandatory rather a voluntary basis to ensure that the burden falls uniformly on all
businesses. In spite of the fact that many socially responsible actions must be
mandated by the government, in recent years numerous forms have been voluntarily
taking actions, especially in the area of environmental protection, because these
actions help sales. For some firms, socially responsible actions may not even be very
costly, because the companies often heavily advertise such actions, and many
consumers prefers to by from socially responsible companies rather than from
companies that shun social responsibility.

The role of Ethics.

Ethics are standards of conduct or moral behavior. Business ethics can be thought of
as a company’s attitude and conduct towards its employees, customers, community
and stakeholders. Today, the business community in general and the financial
community in particular are developing and enforcing ethical standards. The goal of
these ethical standards is to motivate businesses and market participants to adhere
to both the letter and the spirit of laws and regulations concerned with business and
professional practice. A firm’s commitment to business ethics can be measured by
the tendency of the firm and its employees to adhere to laws and regulations relating
to such factors as product safety and quality, fair employment practices, fair
marketing and selling practices, the use of confidential information for personal gain,
community involvement, bribery, and illegal payments to foreign governments to
obtain businesses.

The implementation of a proactive ethics program is believed to enhance corporate

value. An ethics program can produce a number of positive benefits: reduce potential
litigation and judgment costs; maintain a positive corporate image; build shareholder
confidence; and gain the loyalty, commitment and respect of all of the firm’s
shareholders. Such actions, by maintaining and enhancing cash flows and reducing
perceived risk (as a result of greater investor confidence) are expected to positively
affect the firm’s share price. Ethical behavior is there viewed as necessary for
achievement of the firm’s goal of shareholder wealth maximization.

1.3 AGENCY RELATIONSHIPS

An agency relationship can be defined as a contract under which one or more people
(the principals) hire another person (the agent) to perform some service on their
behalf, and delegate some decision-making authority to that agent. Within the
financial management framework, agency relationships exist between shareholders
and managers and between shareholders and creditors.

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Shareholders versus managers.

We have seen that the goal of the financial manager should be to maximize the
wealth of the owners of the firm. Thus management can be viewed as agents of the
owners who have hired and given them decision-making authority to manage the
firm for the owners benefit. Technically, any manager who owns less than 100% of
the firm is to some degree of the owners.

In theory, most financial managers would agree with the goal of shareholder wealth
maximization. In practice, however, managers are also concerned with their personal
wealth, job security, lifestyle, and fringe benefits, such as posh offices, country club
memberships, and limousines, all provided at company expense. Such concerns may
make managers reluctant or unwilling to take mote than moderate risk if they
perceive that too much risk may result of such a ‘satisfying’ approach (a compromise
between satisfaction and maximization) is a less than a maximum return and a
potential loss of wealth to the shareholders. For example, the manager may decide to
lead a more relaxed lifestyle and not work as hard to maximize shareholder wealth,
because less of this wealth will accrue to him/her. Also, the manager may decide to
consume more perquisites, because the costs will be borne by the shareholders. The
potential conflict of interest is referred to as the agency problem- the lokihood that
managers may place personal goals ahead of corporate goals.

RESOLVING THE AGENCY PROBLEM

Market forces
In recent years, institutions such as mutual funds, insurance companies and pension
funds that hold large blocks of a firm’s stock have become more active in
management. To ensure management competence and minimize agency problems,
these institutions shareholders have actively used their votes to oust under-
performing managers and replace them with more competent managers. In addition
to their legal voting rights, large shareholders are able to communicate with an exert
pressure on management to perform **

Another market force that has in recent years threatened management to perform in
the best interest of shareholders is the possibility of a hostile takeover. A hostile
takeover is the acquisition of the firm (the target) by another firm or a group of firms
(the acquirer) that is not supported by management. Hostile takeovers typically
occur when the acquirer feels that the target firm is being poorly managed and, as a
result, is undervalued in the market place. The constant threat of a takeover
motivates management to act in the best interests of the shareholders.

Agency costs:
Agency costs include all costs borne by shareholders to encourage managers to
maximize the firm’s stock price rather than act in their own self-interests. Agency
costs are of several types:
(i) Monitoring expenditures to prevent ‘satisficing’ (rather than share price
maximizing) behaviors by management. These outlays pay for auditors
and control procedures that are used to assess and limit managerial
behavior to those actions that tend to be in the best interests of the
shareholders.

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 (ii) Expenditures to structure the organization in a way that will limit
undesirable managerial behavior, such as appointing outside investors to
the board of directors.
(iii) Opportunity costs resulting from the difficulties that large organizations
typically have in responding to new opportunities. The firm’s necessary
organizational structure, decision hierarchy, and control mechanism may
cause profitable opportunities to be forgone because of management’s
inability to seize upon them quickly.

Managerial incentives.
These are the most powerful, popular and expensive agency costs incurred by firms.
They result from structuring managerial compensation to correspond with share price
maximization. The objective is to give managers incentives to act in the best
interests of the shareholders and to compensate them for such actions. In addition,
the resulting compensation packages allow firms to compete for and hire the best
managers available. Compensation plans can be divided into two groups- incentive
plans and performance plans.

Incentive plans tend to tic management compensation to share price. The most
popular incentive plan is the granting of executive stock options to management.
These options allow managers to purchase stock at stock at some time in the future
at a given price; the options would be valuable if the market price of the stock rises
above the option purchase price. The firms using these plans believe that allowing
managers to purchase stock at a fixed price would provide an incentive for them to
take actions which would maximize the stock’s price. Although in theory these
options should motivate, they are sometimes criticized because positive
management performance can be masked in a poor stock market in which share
prices in general have declined due to economic and behavioral ‘market forces’
outside of management’s control.

The use of performance plans has grown in popularity in recent years due to their
relative independence from market forces. These plans compensate managers on the
basis of their proven performance measured by earnings per share (EPS), growth in
EPS, return on assets, return on equity, and so on. Performance shares often uses in
these plans. Another form of performance based compensation is cash bonuses,
cash payments tied to the achievement of certain performance goals. Under
performance plans, management understands in advance the formula used to
determine the amount of performance shares of cash bonus it can earn during the
period.

The current view:

Although experts agree that an effective way to motivate management is to tie

compensation to performance, the execution of many compensation plans has been
closely scrutinized in recent years. Stockholders- both individuals and institutions
have publicly questioned the appropriateness of the heavy compensation packages
(including salary, bonus, and long-term compensation) that many corporate
executives receive. Although these sizeable compensation packages may be justified
by significant increases in shareholder wealth, recent studies have failed to find a
strong relationship between CEO compensation packages (without corresponding
share price performance) is expected to drive down executive compensation in the
future.

Shareholders and creditors

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A second agency problem arises because of potential conflicts between stockholders
and creditors. Creditors lend funds to the firm at rates that are based on:

(i) The riskiness of the firm’s existing assets.

(ii) Expectations concerning the riskiness of future assets additions

(iii) The firm’s existing capital structures (i.e. the amount of debt financing it
uses)

(iv) Expectations concerning future capital structure changes

These are the factors that determine the riskiness of the firm’s cash flows and
hence the safety pf its debt issues, so creditors base their required rates of return
on expectations regarding these factors.

Now, suppose the stockholders, acting through management, cause the firm to
take on new projects that have grater risks than were anticipated by the
creditors. This increases risk will cause the required rate of return on the firm’s
debt to increase, which in turn will cause the value of the outstanding debt to fall.
If the riskier capital investments turn out to be successful, all of the benefits will
go out to the stockholders, because the creditors get only a fixed return, but if
things go sour, the bondholders will have to share the losses. Similarly, if the firm
increases its level of debt effort to boost profits, the value of the old debt will
decrease, because the old debt’s bankruptcy protection will be lessened by the
issuance of the new debt. In both of these situations, stockholders will be gaining
at the expense of the firm’s creditors.

Can and should stockholders, through their managers, agents, try to exprotriate
wealth from the firm’s creditors? In general, the answer is no. first, as such
attempts are made, creditors will protect themselves against such stockholders
actions though restrictions in credit agreements. Second, if creditors perceive
that managers are trying to take advantage of them in unethical ways, they will
either refuse to deal further with them or else will require a much higher than
normal rate of interest to compensate for the risks of such possible exploitation.
Thus, firms, which try to deal unfairly with creditors, either loose access to the
debt markets or are saddled with higher interest rates, both of which can lead to
a decrease in the long run value of the stock.

In view of these constraints, it follows that the goal of maximizing shareholder

wealth requires fair play with creditors: stockholders wealth depends on fair play
abiding by both the letter and spirit of credit agreements. Therefore, the
managers, as agents of both the creditors and the shareholders, must act in a
manner which is fairly balanced between the interests of these two classes of
security holders. Similarly, because of other constraints and sanctions,
management actions would expropriate wealth form the firm’s employees,
customers, suppliers, or community will ultimately be to the detriment of
shareholders. Thus, the goal of shareholder wealth maximization requires the fair
treatment of all parties, or stakeholders, whose economic position is affected by
managerial actions.

OVERVIEW OF FINANCIAL MARKETS AND INSTITUTIONS:

THE FINACIAL MARKETS:

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 Financial markets provide a forum in which suppliers of funds and demanders of
funds can transact business. People and organizations needing money are
brought together with those having surplus funds in the financial markets. The
following are some of the major types of markets:

(i) Physical (real) asset markets are those for tangible assets e.g.
commodities, real estate, machinery etc. financial asset markets deal
with securities eg stocks, bonds, mortgages and other claims on real
assets. As well as derivative securities e.g. options, futures and others
whose values are derived from changes in the prices of other financial
assets.

(ii) Spot markets and future markets are terms that refer to whether the
assets are being bought or sold for on the ‘spot delivery’ (within a few
days) or for delivery at some future date.

(iii) Money markets are the markets for short term highly liquid debt
securities. Capital markets are the markets for long-term debt and
corporate stocks.

(iv) Mortgage markets deal with loans on residential, commercial, and

industrial real estate, and on farmland, while consumer credit markets
involve loans on appliances, education, vacation etc.

(v) Primary markets are the markets in which corporations raise new
capital ie where companies sell new issues of common stock to raise
capital. Secondary markets are markets in which existing, already
outstanding securities are traded among investors.

FINANCIAL INSTITUTIONS

Transfer of capital between savers and those who need capital take place in three
different ways:

i. Direct transfers of money and securities, which occur when a business sells its
securities directly to savers, without going through any type of financial
institution. The business delivers its securities to savers, who in turn give the
firm the money it needs.

ii. Transfers may also go through an investment bank, which serves as a

‘middleman, and facilitates the issuance of securities. The company sells its
stocks or bonds to the investment bank, which in turn sells these same
securities to savers.

iii. Transfers can also be made through a financial intermediary such as a bank or
mutual fund. The intermediary obtains funds from savers, issuing its own
securities in exchange, and then uses the money to purchase and then hold a
business’s securities. Since the intermediaries are generally large, they gain
economies of scale in analyzing the creditworthiness of potential borrowers, in
processing and collecting loans, and in pooling risks and thus helping
individual savers diversify. Examples of intermediaries include:

a) Commercial banks

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b) Investment banks

c) Insurance companies

d) SACCOS

e) Pension funds which are retirement plans by corporations or

government agencies for their workers.

f) Mutual funds. These are companies which accept money from savers
and then use these funds to buy securities issued by businesses or
governmental units. They pool funds and thus reduce risks through
diversification. They also achieve economies of scale, which lower the
costs of analyzing securities, managing portfolios, and buying and
selling securities.

SECURITIES EXCCHANGES:

Securities exchange provide the market place in which firms can raise
funds through the sale of new securities and purchasers of securities can
maintain liquidity by being able to resell them when necessary. Securities
exchanges are commonly called stock markets, although bonds, common
stock, preferred stock, and a variety of other investment vehicles are all
traded on these exchanges. The two key types of securities exchanges are
the organized exchange and over-the-counter exchange.

Organized securities exchanges are tangible organizations that act as

secondary markets where outstanding securities are resold. Each of the
larger ones occupies its own building, has specifically designated
members, and has elected governing body-its board of governors.

The over-the-counter (OTC) exchange is an intangible market for the

purchase and sale of securities not listed by the organized exchanges. The
OTC traders, known as dealers, are linked with purchasers and sellers of
securities through telecommunications networks that provide current bid
and ask prices of the actively mark-up or profit. The OTC market thus
included the relatively few dealers who hold inventories of OTC securities
and are said to ‘make a market’ in these securities, the several brokers
who act as agents in bringing these dealers together with investors, and
the computers, terminals and electronic network that provide a
communications link between dealers and brokers.

Securities exchanges, thus, create continuous liquid markets in which

firms can obtain needed financing. They also create efficient markets that
allocate funds to their most productive uses. This is especially true for
securities that are actively traded on major exchanges, where the
competition among wealth-maximizing investors determines and
publicizes prices that are believed to be close to their true value. The
competitive market created by the major securities exchanges provided a
forum in which share price is continuously adjusted to changing demand
and supply conditions.

EFFICIENT MARKETS

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An efficient capital market is one in which security prices adjust rapidly to the
arrival of new information and therefore, the current prices of securities reflect all
information about the security.

The efficient market is defined as “A market having a large number of rational profit
maximisers, actively competing with each trying to predict future market values of
individual securities, and where important current information is almost freely
available to all participants”.
The Efficient Market Hypothesis states that at any given time, security prices fully
reflect all available information. The implications of the efficient market hypothesis
are truly profound. Most individuals that buy and sell securities (stocks in particular),
do so under the assumption that the securities they are buying are worth more than
the price that they are paying, while securities that they are selling are worth less
than the selling price. But if markets are efficient and current prices fully reflect all
information, then buying and selling securities in an attempt to outperform the
market will effectively be a game of chance rather than skill

Securities markets are flooded with thousands of intelligent, well-paid, and

well-educated investors seeking under and over-valued securities to buy and
sell. The more participants and the faster the dissemination of information,
the more efficient a market should be.

The debate about efficient markets has resulted in hundreds and

thousands of empirical studies attempting to determine whether specific
markets are in fact "efficient" and if so to what degree. Many novice investors
are surprised to learn that a tremendous amount of evidence supports the
efficient market hypothesis. Early tests of the EMH focused on technical
analysis and it is chartists whose very existence seems most challenged by
the EMH. And in fact, the vast majority of studies of technical theories have
found the strategies to be completely useless in predicting securities prices.
However, researchers have documented some technical anomalies that
may offer some hope for technicians, although transactions costs may reduce
or eliminate any advantage.

Researchers have also uncovered numerous other stock market

anomalies that seem to contradict the efficient market hypothesis. The
search for anomalies is effectively the search for systems or patterns that can
be used to outperform passive and/or buy-and-hold strategies. Theoretically
though, once an anomaly is discovered, investors attempting to profit by
exploiting the inefficiency should result its disappearance. In fact, numerous
anomalies that have been documented via back-testing have subsequently
disappeared or proven to be impossible to exploit because of transactions
costs.

The paradox of efficient markets is that if every investor believed a market

was efficient, then the market would not be efficient because no one would
analyze securities. In effect, efficient markets depend on market participants
who believe the market is inefficient and trade securities in an attempt to
outperform the market.

In reality, markets are neither perfectly efficient nor completely inefficient. All
markets are efficient to a certain extent, some more so than others. Rather than

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being an issue of black or white, market efficiency is more a matter of shades of
gray. In markets with substantial impairments of efficiency, more knowledgeable
investors can strive to outperform less knowledgeable ones. Government bond
markets for instance, are considered to be extremely efficient. Most researchers
consider large capitalization stocks to also be very efficient, while small capitalization
stocks and international stocks are considered by some to be less efficient. Real
estate and venture capital, which don't have fluid and continuous markets, are
considered to be less efficient because different participants may have varying
amounts and quality of information.

Market efficiency is a description of how prices in competitive markets respond to

new information.. Very soon the meat is gone, leaving only the worthless bone
behind, and the water returns to normal. Similarly, when new information reaches a
competitive market there is much turmoil as investors buy and sell securities in
response to the news, causing prices to change. Once prices adjust, all that is left of
the information is the worthless bone. No amount of gnawing on the bone will yield
any more meat, and no further study of old information will yield any more valuable
intelligence."

There are three forms of the efficient market hypothesis

1. The "Weak" form asserts that all past market prices and data are fully
reflected in securities prices. In other words, technical analysis is of no use.

2. The "Semistrong" form asserts that all publicly available information is fully
reflected in securities prices. In other words, fundamental analysis is of no
use.

3. The "Strong" form asserts that all information is fully reflected in securities
prices. In other words, even insider information is of no use.
"
The Value of an Efficient Market
It is important that stock/share markets are efficient for at least three reasons:
To encourage share buying – accurate pricing is required if individuals are going to
be encouraged to invest in private enterprise. If shares are incorrectly priced many
savers will refuse to invest because of a fear that when they come to sell the price
may be perverse and may not represent the fundamental attractions of the firm. This
will seriously reduce the availability of funds to companies and inhibit growth.
Investors need to know they are paying a fair price and that they will be able to sell
at a fair price – that the market is a “fair game”.
To give correct signals to company managers – Since the maximization of
shareholder wealth can be represented by the share price in an efficient market,
sound financial decision-making relies on the correct pricing of the company’s
shares. In implementing a shareholder wealth-enhancing decision the manager will
need to be assured that the implication of the decision is accurately signalled to
shareholders and to management through a rise in the share price. It is important
that managers receive feedback on their decisions from the share market so that
they are encouraged to pursue shareholder wealth strategies.
To help allocate resources – allocation efficiency requires both operating efficiency
and pricing efficiency. If a poorly run company in a declining industry has highly
valued shares because the stock market is not pricing correctly then this firm will be
able to issue new shares, and thus attract more of society’s savings for use within its
business. This would be wrong for society as the funds would be better used
elsewhere.

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 CHAPTER 2- RISK AND RETURN
2.1 INTRODUCTION
To maximize share price, the financial manager must learn to assess two key
determinants: risk and return. Each financial decision presents certain risk and return
characteristics, and the unique combination of these characteristics has an impact on
share price.

In the most basic sense, risk is the chance of financial loss. Assets having greater
chances of loss are viewed as more risky than those with lesser chances of loss. More
formally, the term risk is used interchangeably with uncertainty to refer to the
variability of returns associated with a given asset.

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The return is the total gain or loss experienced on an investment over a given period
of time. It is commonly measured as the change in value plus any cash distributions
during the period, expressed as a percentage of the rate of return earned on any
asset over period t, is commonly defined as:

Kt = Pt – Pt-1 + Ct
Pt-1
Where K is the actual or expected rate of return during period t
Pt Is the price (value) of an asset at time t
Pt-1 Is the price of an asset at time t-1
Ct Is the cash flow received from the asset investment in the time period t-
1 to t.

RISK PREFERENCE
Feelings about risk differ among managers and firms. The three basic risk preference
behaviours are:
• For the risk – indifferent manager, the return does not change as risk
increases. In essence, no change in return would be required for the increase
in risk clearly, this attitude is nonsensical in almost any business context.
• For the risk – averse manager, the required return increase in risk because
they shy away from risk, these managers require higher expected returns to
compensate them for taking greater risk.
• For the risk – seeking manager, required return decreases for an increase
in risk. Theoretically, because they enjoy risk, these managers are willing to
give up some return to take more risk. However, such behaviour would not be
likely to benefit them.

2.2 PROBABILITY DISTRIBUTIONS:

In general, risk refers to the profitability that some unfavourable event will occur.
A probability distribution Is defined as a set of possible outcomes, with a
probability of occurrence attached to each outcome. If we multiply each possible
outcome by its probability of occurrence and then sum these products, we have a
weighted average of outcomes. The weights are the probabilities, and the
weighted average is defined as the expected value. Since the outcomes are rates
of return, the expected values are expected rates of return.

RETURN ESTIMATES ON THREE ALTERNATIVE INVESTMENTS

State of the probability of
economy Occurrence project 1 project 2 project 3

Deep recession 0.05 12.0% -3.0% -2.0%

Mild recession 0.20 10.0 6.0 9.0
Average economy 0.50 9.0 11.0 12.0
Mild boom 0.20 8.5 14.0 15.0
Strong boom 0.05 8.0 19.0 26.0

Expected Rate of Return 9.2% 10.3% 12.0%

Variance 0.71% 19.31 23.20
Standard deviation 0.84% 4.39% 4.82%
Coefficient of variation 0.09 0.43 0.40

13
As an example, project 3’s required rate of return is computed as follows:
E(R) =
= R1(P1)+R2(P2)+R3(P3)+R4(P4)
= -2.0%(0.05)+9.0%(0.20)+12.0(0.50)+155(0.20)+26%(0.05)
= 12.0%

The expected rates of return on the other two investment alternatives can be similarly
calculated and are shown in the table above.

ASSET HELD IN ISOLATION

VARIANCE AND STANDARD DEVIATION

Variance is an a measure of the dispersion of a distribution around its expected
value. The larger the variance, the greater the dispersion. Variance is computed
by the formula
Variance =π 2 (Ri-E(R)]2
In words, the variance is the sum of the squared deviations weighted by each
deviations probability of occurrence.

As an example, the variance for project 3 is computed as follows:

π2 = Pi (Ri-E(R)]2
=0.05(-2.0-12)2 +0.50(12-12)2 +0.20(15-12)2 + 0.05(26-12)2 = 23.2

The variance for the other two investments can be similarly calculated and are
shown in the above table

Since it is difficult to attach meaning to a squared percentage, the square root of

the variance, standard deviation, is computed as an alternative measure of risk.
n
Standard deviation = √Variance= √π2 = π= √ΣPi (Ri-E(r)
i=1

The standard deviation for the other projects can be similarly computed and are
shown in the table above.
π=√232 = 4.82%

COEFFICIENT OF VARIATION

The coefficient of variation, CV, is a measure of relative risk that is useful in

comparing the risk of assets with different expected returns.

CV=Standard deviation = π
Expected return E(R)
The CV shows the risk per unit of return, and provides a more meaningful basis
for comparison when the expected returns on two alternatives are not the same.

The CV of project 3 is calculated as:

CV= 4.82% = 0.40
12.0%

The CV for the other two investments can be similarly computed and are shown in
the table above.

14
 THE MEAN –VARIANCE CRITERION:
The mean –variance criterion is one possible decision rule that can be used to
choose among possible investment alternatives. This criteria is based on two
assumptions:
1. The decision maker is risk averse.
2. The distributions being evaluated are approximately normal distribution.
The first assumption is certainly true for the average investor: the second
condition generally holds well for securities such as stocks and bonds, but
it does not always hold for physical asset investments.

The mean – variance criterion is based on a comparison of expected

returns and standard deviations and can be stated symbolically as
follows:

Alternative X is preferred to alternative Y if and only if either

E(R)X > E(R)Y AND SD(X)< SD(Y) E(R)= Expected Return
OR
E(R)>E(R)Y AND SD(X)SD(Y) <SD = Standard Deviation
Applying this criterion to the three investments above, we find that no one
alternative is necessarily preferred to any other alternative, because the alternatives
with the higher variances also have higher expected rates of return.

However, application of the mean – variance criterion to non – normal distributions

may result in an anomaly called the mean variance paradox, a situation in which the
mean variance criterion leads to incorrect decisions. For example, we have concluded
that neither project 2 nor 3 is preferred under the mean variance criterion. But,
project 3 is clearly preferred to 2 because it has a higher outcome for each possible
state of economy. Thus, regardless of which state of economy occurs we would
always get a higher rate of return from project 3 than from 2 i.e. project 3
dominates 2 as an investment.

What about a choice between projects 1 and 3?

Theoretically, the choice should be made on the basis of risk aversion of the owners
of the firm. However, financial managers generally cannot measure stockholders’ risk
aversion, so managers often substitute their own preferences, along with other more
tangible factors. For example, project 3 has a probability, albeit low, of rate of return
of – 20% i.e. a loss. Perhaps, the financial manager is unwilling to accept any chance
of a loss, and hence would reject that alternative. Also, the financial manager must
consider his or her confidence in the estimated rates of return. Is he/ she equally
confident of the accuracy of the probability distributions of all three alternatives or is
there reason to be more confident in one alternative or another? If the decision
maker “doesn’t trust the numbers”, then he/she may well reject what seems on
paper to be the best alternative.

A portfolio is a combination or collection of assets or securities.

EXPECTED RETURN FOR A PORTFOLIO

The expected rate for a portfolio is simply the weighted average of the expected
rates of Return for the individual investments in the portfolio. The weights are the
proportions of the total value of the investment.
E(Rp) = Σ Wi Ri
i=1

15
Where W1 = is the percent of the portfolio invested in asset I
Ri – is the expected rate of return for asset i

2.3 RISK OF A PORTFOLIO

Two basic concepts in statistics, co-variance and correlation, must be understood in
order to understand portfolio risk.

CO- VARIANCE of Returns:

Co-Variance is a measure of the degree to which two variables “move together” over
time. In portfolio analysis, we are usually concerned with co-Variance of rates of
Return.
A positive Co-variance means that the rates of return for two investments tend to
move in the same directions during the same time period.

A negative Co-variance indicates that the Rates of Return for two investments tend to
move in different directions during specified time intervals over time.

A zero Co- variance indicates that there is no relationship between the variables, i.e.
the variables are independent.

CORRELATION CO-EFFICIENT:

Standardizing the Co-variance by the individual Standard deviations yields the

correlation co-efficient (√AB) which varies in the ranger -1 to +1.

A value of +1 indicates a perfect positive correlation, meaning the returns for the two
stocks move together in a completely linear manner.

A value of -1 means that there is a perfect negative correlation between the two
return series such that when one stocks rate of return is above the mean , the other
stock’s rate of return will be below its mean by the comparable amount.
Cov (AB)= Σ Pi(RAi - RA) (RBi-RB)
I=1
√AB = Cov (A,B), Thus Cov (A,B)= √ABπAπB
πAπB
The Terry Corporation is considering three possible capital projects for next year.
Each project has a 1 – year life, and project returns depend on next year’s state of
the economy. The estimated rates of return are shown in the following table

State of the Probability of Rates of return if state occurs

Economy occurring A B C
Recession 0.25 10% 9% 14%
Average 0.50 14 13 12
Boom 0.25 16 18 10

REQUIRED
a) Compute each project’s Expected rate of return, variance, Standard deviation
and co-efficient of variation.
b) Apply the Mean – Variance criterion to the alternative projects. Do any of the
projects dominate any of the others according to this criterion?

16
QUESTIONS AND ANSWERS
ST-1 Stocks A and B has the following historical returns:

Year Stock A’s Returns, kA Stock B’s Returns, kB

1884 -12.24% -5.00%

1985 23.67 19.55
1986 35.45 44.09
1987 5.82 1.20
1988 28.30 21.16

Calculate the average rate of return for each stock during the period
1984 through 1988. Assume that someone held a portfolio consisting
of 50 percent of Stock A and 50 percent of Stock B. What would have
been the realized rate of return on the portfolio in each year from 1984
through 1988? What would have been the average return on the
portfolio during this period?
Now calculate the standard deviation of returns for each stock and for
the portfolio.
On the basis of the extent to which the portfolio has a lower risk than
the stocks held individually, would you guess that the correlation
coefficient between returns on the two stocks is closer to 0.9 or to
-0.9?
If you added more stocks at random to the portfolio, what is the most
accurate statement of what would happen to σp?
σp would remain constant.
σp would decline to somewhere in the vicinity of 15 percent.
σp would decline to zero if enough stocks were included

SOLUTION
ST- 1
a. The average rate of return for each stock is calculated by simply
averaging the returns over the five-year period. The average return
for each stock is 16.20 percent, calculated for Stock A as follows:
kA vg = (-12.24% + 23.67% + 35.45% + 5.82% + 28.30%)/5
= 16.20%
The realized rate of return on a portfolio made up of Stock A and
Stock B would be calculated by finding the average return in each
year as kA (% of Stock A) + kB (% of Stock B) and then averaging
these yearly returns.

Year Portfolio AB’s Return, kAB

1984 -8.62%

17
 1985 21.61
1986 39.77
1987 3.51
1988 24.73
kA vg = 16.20%
b. The standard deviation of returns is estimated, using Equation 4-3a,
as follows :

Estimated σ = S = √Σ(kt – kAvg)2

N–1 (4-3a)

For Stock A, the estimated σ is 19.3 percent:

σA = √(-12.24 – 16.2)2 + (23.67 – 16.2)2 + … + (28.30 – 16.2)2

5–1
= √1,489.35
4 = 19.3%
The standard deviation of returns for Stock B and for the portfolio
are similarly determined, and they are as follows:

Stock A Stock B Portfolio AB

Standard deviation 19.3 19.3 18.9
c. Since the risk reduction from diversification is small (σAB falls only
from 19.3 to 18.9 percent), the most likely value of the correlation
coefficient is 0.9. If the correlation coefficient were -0.9, the risk
reduction would be much larger. In fact, the correlation coefficient
between Stocks A and B is 0.93.
d. If more randomly selected stocks were added to the portfolio, σp
would decline to somewhere in the vicinity of 15 percent; see Figure
4.7. σp would remain constant only if the correlation coefficient were
+1.0, which is most unlikely. σp would decline to zero only if the
correlation coefficient, r, were equal to zero and a large number of
stocks were added to the portfolio, or if the proper proportions were
held in a two-stock portfolio with r = -1.0.

ST 2 The staff of Scampini Manufacturing has estimated the following

net cash flows and probabilities for a new manufacturing process:

Net Cash Flow_______________

Year P = 0.2 P = 0.6 P = 0.2___
0 ($100,000) ($100,000) ($100,000)
1 20,000 30,000 40,000
2 20,000 30,000 40,000

18
 3 20,000 30,000 40,000
4 20,000 30,000 40,000
5 20,000 30,000 40,000
5* 0 20,000 30,000

Line 0 gives the cost of the process, Lines 1 through 5 give operating cash flows, and
Line 5* contains the estimated salvage values. Scampini’s cost of capital for an
average risk project is 10 percent.

a. Assume that the project has average risk. Find the project’s expected NPV. (Hint:
Use expected values for the net cash flow in each year.)
b. Find the best case and worst case NPVs. What is the probability of occurrence of
the worst case if the cash flows are perfectly dependent (perfectly positively
correlated) over time? If they are independent over time?
c. Assume that all the cash flows are perfectly positively correlated, that is, there
are only three possible cash flow streams over time: (1) the worst case, (2) the
most likely, or base, case, and (3) the best case, with probabilities of 0.2, 0.6, and
0.2, respectively. These cases are represented by each of the columns in the
table. Find the expected NPV, its standard deviation, and its coefficient of
variation.
d. The coefficient of variation of Scampini’s average project is in the range 0.8 to
1.0. If the coefficient of variation of a project being evaluated is greater than 1.0,
2 percentage points are added to the firm’s cost of capital. Similarly, if the
coefficient of variation is less than 0.8, 1 percentage point is deducted from the
cost of capital. What is the project’s cost of capital? Should Scampini accept or
reject the project?

ST-2
a. First, find the expected cash flows:
Year Expected Cash Flow
0 0.2(-$100,000) + 0.6(-$100,000) + 0.2(-$100,000) =
($100,000)
1 0.2($20,000) + 0.6($30,000) + 0.2($40,000) =
$30,000
2 $30,000
3 $30,000
4 $30,000
5 $30,000
5* 0.2($0) + 0.6($20,000) + 0.2($30,000) =
$18,000

Next, determine the NPV based on the expected cash flows:

NPV = -$100,000 + $30,000 + $30,000 + $30,000
(1.10)1 (1.10)2 (1.10)3
+ $30,000 + $30,000 + $18,000
(1.10)4 (1.10)5 = $24,900
b. For the worst case, the cash flow values from the cash flow column
farthest on the left are used to calculate NPV:
NPV = $100,000 + $20,000 + $20,000 + $20,000
(1.10)1 (1.10)2 (1.10)3

19
 + $20,000 + $20,000 + $0
(1.10)4 (1.10)5 = $24,184

similarly, for the best case, use the values from the column farthest
on the right. Here the NPV is $70,259.
If the cash flows are perfectly dependent, then the low cash flow in
the first year will mean a low cash flow in every year. Thus, the
probability of the worst case occurring is the probability of getting
the $20,000 net cash flow in Year 1, or 20 percent. If the cash flows
are independent, the cash flow in each year can be low, high, or
average, and the probability of getting all low cash flows will be:
0.2(0.2)(0.2)(0.2)(0.2) = 0.25 = 0.00032 = 0.032%
c. The base case NPV is found using the most likely cash flows and is
equal to $26.142. This value differs from the expected NPV of
$24,900 because the Year 5 cash flows are not symmetric. Under
these conditions, the NPV is as follows:
P NPV
0.2 ($24,184)
0.6 26,142
0.2 70,259

Thus, the expected NPV is 0.2(-$24,184) + 0.6($26,142) +

0.2(70,259) = $24,900. As is generally the case, the expected NPV
is the same as the NPV of the expected cash flows found in part a.
The standard deviation is $29,904:
σ2 NPV = 0.2(-$4.184 - $24.900)2 + 0.6($26.142 - $24,900)2
+ 0.2($70,259 - $24,900)2
= $894,261,126
σ2 NPV = √$894,261,126 = $29,904.
The coefficient of variation, CV, is $29,904/$24,900 = 1.20.
d. Since the project’s coefficient of variation is 1.20, the project is
riskier than average, and hence the project’s risk-adjusted cost of
capital is 10% + 2% = 12%. The project now should be evaluated
by finding the NPV of the expected cash flows, as in Part a, but
using a 12 percent discount rate. The risk-adjusted NPV is $18,357,
and therefore the project should be accepted.

20
 CHAPTER 3 - INVESTMENT DECISIONS - CAPITAL
BUDGETING

3.1 INTRODUCTION
Capital budgeting is vital in marketing decisions. Decisions on investment, which take
time to mature, have to be based on the returns which that investment will make.
Unless the project is for social reasons only, if the investment is unprofitable in the
long run, it is unwise to invest in it now.
Often, it would be good to know what the present value of the future investment is, or
how long it will take to mature (give returns). It could be much more profitable putting
the planned investment money in the bank and earning interest, or investing in an
alternative project.

The time value of money

Recall that the interaction of lenders with borrowers sets an equilibrium rate of
interest. Borrowing is only worthwhile if the return on the loan exceeds the cost of the
borrowed funds. Lending is only worthwhile if the return is at least equal to that which
can be obtained from alternative opportunities in the same risk class.
The interest rate received by the lender is made up of:
i) The time value of money: the receipt of money is preferred sooner rather than later.
Money can be used to earn more money. The earlier the money is received, the
greater the potential for increasing wealth. Thus, to forego the use of money, you must
get some compensation.
ii) The risk of the capital sum not being repaid. This uncertainty requires a premium as
a hedge against the risk, hence the return must be commensurate with the risk being
undertaken.
iii) Inflation: money may lose its purchasing power over time. The lender must be
compensated for the declining spending/purchasing power of money. If the lender
receives no compensation, he/she will be worse off when the loan is repaid than at the
time of lending the money.
a) Future values/compound interest
Future value (FV) is the value in dollars at some point in the future of one or more
investments.
FV consists of:
i) the original sum of money invested, and
ii) the return in the form of interest.
The general formula for computing Future Value is as follows:
FVn = Vo (l + r)n
where
Vo is the initial sum invested
r is the interest rate
n is the number of periods for which the investment is to receive interest.
Thus we can compute the future value of what Vo will accumulate to in n years when it
is compounded annually at the same rate of r by using the above formula.
Exercise 6.1 Future values/compound interest
i) What is the future value of $10 invested at 10% at the end of 1 year?
ii) What is the future value of $10 invested at 10% at the end of 5 years?
We can derive the Present Value (PV) by using the formula:
FVn = Vo (I + r)n
By denoting Vo by PV we obtain:
FVn = PV (I + r)n
by dividing both sides of the formula by (I + r)n we derive:

21
Rationale for the formula:
As you will see from the following exercise, given the alternative of earning 10% on his
money, an individual (or firm) should never offer (invest) more than $10.00 to obtain
$11.00 with certainty at the end of the year.

Exercise 6.2 Present value

i) What is the present value of $11.00 at the end of one year?
ii) What is the PV of $16.10 at the end of 5 years?
b) Net present value (NPV)
The NPV method is used for evaluating the desirability of investments or projects.

where:
Ct = the net cash receipt at the end of year t
Io = the initial investment outlay
r = the discount rate/the required minimum rate of return on investment
n = the project/investment's duration in years.
The discount factor r can be calculated using:

Examples:

N.B. At this point the tutor should introduce the net present value tables from any
recognised published source. Do that now.
Decision rule:
If NPV is positive (+): accept the project
If NPV is negative(-): reject the project
NExercise 6.3 Net present value

A firm intends to invest $1,000 in a project that generated net receipts

of $800, $900 and $600 in the first, second and third years
respectively. Should the firm go ahead with the project?

Attempt the calculation without reference to net present value tables

first.

c) Annuities

N.B. Introduce students to annuity tables from any

recognised published source.

22
 A set of cash flows that are equal in each and every period is called
an annuity.

Example:

Year Cash Flow ($)

0 -800

1 400

2 400

3 400

PV = $400(0.9091) + $400(0.8264) + $400(0.7513)

= $363.64 + $330.56 + $300.52

= $994.72

NPV = $994.72 - $800.00

= $194.72

Alternatively,

PV of an annuity = $400 (PVFAt.i) (3,0,10)

= $400 (0.9091 + 0.8264 + 0.7513)

= $400 x 2.4868

= $994.72

NPV = $994.72 - $800.00

= $194.72

d) Perpetuities

A perpetuity is an annuity with an infinite life. It is an equal sum of money to be paid in each period
forever.

where:

C is the sum to be received per period

r is the discount rate or interest rate

23
Example:

You are promised a perpetuity of $700 per year at a rate of interest of 15% per annum. What price
(PV) should you be willing to pay for this income?

= $4,666.67

A perpetuity with growth:

Suppose that the $700 annual income most recently received is expected to grow by a rate G of
5% per year (compounded) forever. How much would this income be worth when discounted at
15%?

Solution:

Subtract the growth rate from the discount rate and treat the first period's cash flow as a perpetuity.

= $735/0.10

= $7,350

e) The internal rate of return (IRR)

Refer students to the tables in any recognised published source.

• The IRR is the discount rate at which the NPV for a project equals zero. This rate means that the
present value of the cash inflows for the project would equal the present value of its outflows.

• The IRR is the break-even discount rate.

• The IRR is found by trial and error.

where r = IRR

IRR of an annuity:

where:

24
Q (n,r) is the discount factor
Io is the initial outlay
C is the uniform annual receipt (C1 = C2 =....= Cn).

Example:

What is the IRR of an equal annual income of $20 per annum which accrues for 7 years and costs
$120?

=6

From the tables = 4%

Economic rationale for IRR:

If IRR exceeds cost of capital, project is worthwhile, i.e. it is profitable to undertake. Now attempt
exercise 6.4

Exercise 6.4 Internal rate of return

Find the IRR of this project for a firm with a 20% cost of capital:

YEAR CASH FLOW

0 -10,000

1 8,000

2 6,000

a) Try 20%
b) Try 27%
c) Try 29%

Net present value vs internal rate of return

Independent vs dependent projects

NPV and IRR methods are closely related because:

i) both are time-adjusted measures of profitability,

and
ii) their mathematical formulas are almost identical.

So, which method leads to an optimal decision: IRR or NPV?

a) NPV vs IRR: Independent projects

Independent project: Selecting one project does not preclude the

choosing of the other.

25
With conventional cash flows (-|+|+) no conflict in decision arises; in
this case both NPV and IRR lead to the same accept/reject decisions.

Figure 6.1 NPV vs IRR Independent projects

If cash flows are discounted at k1, NPV is positive and IRR > k1:
accept project.

If cash flows are discounted at k2, NPV is negative and IRR < k2:
reject the project.

Mathematical proof: for a project to be acceptable, the NPV must be

positive, i.e.

Similarly for the same project to be acceptable:

where R is the IRR.

Since the numerators Ct are identical and positive in both instances:

• implicitly/intuitively R must be greater than k (R > k);

• If NPV = 0 then R = k: the company is indifferent to
such a project;
• Hence, IRR and NPV lead to the same decision in
this case.

b) NPV vs IRR: Dependent projects

26
NPV clashes with IRR where mutually exclusive projects exist.

Example:

Agritex is considering building either a one-storey (Project A)

or five-storey (Project B) block of offices on a prime site. The
following information is available:

Initial Investment Outlay Net Inflow at the Year End

Project A -9,500 11,500

Project B -15,000 18,000

Assume k = 10%, which project should Agritex undertake?

= $954.55

= $1,363.64

Both projects are of one-year duration:

IRRA:

$11,500 = $9,500 (1 +RA)

= 1.21-1

therefore IRRA = 21%

IRRB:

$18,000 = $15,000(1 + RB)

= 1.2-1

27
 therefore IRRB = 20%

Decision:

Assuming that k = 10%, both projects are acceptable because:

NPVA and NPVB are both positive

IRRA > k AND IRRB > k

Which project is a "better option" for Agritex?

If we use the NPV method:

NPVB ($1,363.64) > NPVA ($954.55): Agritex should

choose Project B.

If we use the IRR method:

IRRA (21%) > IRRB (20%): Agritex should choose

Project A. See figure 6.2.

Figure 6.2 NPV vs IRR: Dependent projects

Up to a discount rate of ko: project B is superior to project A, therefore

project B is preferred to project A.

Beyond the point ko: project A is superior to project B, therefore

project A is preferred to project B

The two methods do not rank the projects the same.

Differences in the scale of investment

NPV and IRR may give conflicting decisions where projects differ in
their scale of investment. Example:

28
 Years 0 1 2 3

Project A -2,500 1,500 1,500 1,500

Project B -14,000 7,000 7,000 7,000

Assume k= 10%.

NPVA = $1,500 x PVFA at 10% for 3 years

= $1,500 x 2.487
= $3,730.50 - $2,500.00
= $1,230.50.

NPVB == $7,000 x PVFA at 10% for 3 years

= $7,000 x 2.487
= $17,409 - $14,000
= $3,409.00.

IRRA =

= 1.67.

Therefore IRRA = 36% (from the tables)

IRRB =

= 2.0

Therefore IRRB = 21%

Decision:

Conflicting, as:

 NPV prefers B to A
 IRR prefers A to B

NPV IRR

Project A $ 3,730.50 36%

Project B $17,400.00 21%

See figure 6.3.

29
 Figure 6.3 Scale of investments

To show why:

i) the NPV prefers B, the larger project, for a discount rate below 20%

ii) the NPV is superior to the IRR

a) Use the incremental cash flow approach, "B

minus A" approach
b) Choosing project B is tantamount to choosing
a hypothetical project "B minus A".

0 1 2 3

Project B - 14,000 7,000 7,000 7,000

Project A - 2,500 1,500 1,500 1,500

"B minus A" - 11,500 5,500 5,500 5,500

IRR"B Minus A"

= 2.09

= 20%

c) Choosing B is equivalent to: A + (B - A) = B

d) Choosing the bigger project B means choosing the

smaller project A plus an additional outlay of $11,500

30
 of which $5,500 will be realised each year for the
next 3 years.

e) The IRR"B minus A" on the incremental cash flow is

20%.

f) Given k of 10%, this is a profitable opportunity,

therefore must be accepted.

g) But, if k were greater than the IRR (20%) on the

incremental CF, then reject project.

h) At the point of intersection,

NPVA = NPVB or NPVA - NPVB = 0,

i.e. indifferent to projects A and B.

i) If k = 20% (IRR of "B - A") the company should

accept project A.

• This justifies the use of NPV

criterion.

Advantage of NPV:

• It ensures that the firm reaches an optimal scale of

investment.

Disadvantage of IRR:

• It expresses the return in a percentage form rather

than in terms of absolute dollar returns, e.g. the IRR
will prefer 500% of $1 to 20% return on $100.
However, most companies set their goals in absolute
terms and not in % terms, e.g. target sales figure of
$2.5 million.

3.2 THE TIMING OF THE CASH FLOW

The IRR may give conflicting decisions where the timing of cash flows
varies between the 2 projects.

Note that initial outlay Io is the same.

0 1 2

Project A - 100 20 125.00

Project B - 100 100 31.25

"A minus B" 0 - 80 88.15

Assume k = 10%

NPV IRR

31
Project A 17.3 20.0%

Project B 16.7 25.0%

"A minus B" 0.6 10.9%

IRR prefers B to A even though both projects have identical initial

outlays. So, the decision is to accept A, that is B + (A - B) = A. See
figure 6.4.

Figure 3.4 Timing of the cash flow

The horizon problem

NPV and IRR rankings are contradictory. Project A earns $120

at the end of the first year while project B earns $174 at the end
of the fourth year.

0 1 2 3 4

Project A -100 120 - - -

Project B -100 - - - 174

Assume k = 10%

NPV IRR

32
Project A 9 20%

Project B 19 15%

Decision:

NPV prefers B to A
IRR prefers A to B.

The profitability index - PI

This is a variant of the NPV method.

Decision rule:

PI > 1; accept the project

PI < 1; reject the project

If NPV = 0, we have:

NPV = PV - Io = 0
PV = Io

Dividing both sides by Io we get:

PI of 1.2 means that the project's profitability is 20%. Example:

PV of CF Io PI

Project A 100 50 2.0

Project B 1,500 1,000 1.5

Decision:

Choose option B because it maximises the firm's profitability by

$1,500.

Disadvantage of PI:

Like IRR it is a percentage and therefore ignores the scale of

investment.

The payback period (PP)

The CIMA defines payback as 'the time it takes the cash inflows from
a capital investment project to equal the cash outflows, usually
expressed in years'. When deciding between two or more competing

33
projects, the usual decision is to accept the one with the shortest
payback.

Payback is often used as a "first screening method". By this, we mean

that when a capital investment project is being considered, the first
question to ask is: 'How long will it take to pay back its cost?' The
company might have a target payback, and so it would reject a capital
project unless its payback period were less than a certain number of
years.

Example 1:

Years 0 1 2 3 4 5

Project A 1,000,000 250,000 250,000 250,000 250,000 250,000

For a project with equal annual receipts:

= 4 years

Example 2:

Years 0 1 2 3 4

Project B - 10,000 5,000 2,500 4,000 1,000

Payback period lies between year 2 and year 3. Sum of money

recovered by the end of the second year

= $7,500, i.e. ($5,000 + $2,500)

Sum of money to be recovered by end of 3rd year

= $10,000 - $7,500

= $2,500

= 2.625 years

Disadvantages of the payback method:

• It ignores the timing of cash flows within the

payback period, the cash flows after the end of
payback period and therefore the total project return.

34
 • It ignores the time value of money. This means that
it does not take into account the fact that $1 today is
worth more than $1 in one year's time. An investor
who has $1 today can either consume it immediately
or alternatively can invest it at the prevailing interest
rate, say 30%, to get a return of $1.30 in a year's
time.

• It is unable to distinguish between projects with the

same payback period.

• It may lead to excessive investment in short-term

projects.

Advantages of the payback method:

• Payback can be important: long payback means

capital tied up and high investment risk. The method
also has the advantage that it involves a quick,
simple calculation and an easily understood concept.

The accounting rate of return - (ARR)

The ARR method (also called the return on capital employed (ROCE)
or the return on investment (ROI) method) of appraising a capital
project is to estimate the accounting rate of return that the project
should yield. If it exceeds a target rate of return, the project will be
undertaken.

Note that net annual profit excludes depreciation.

Example:

A project has an initial outlay of $1 million and generates net receipts

of $250,000 for 10 years.

Assuming straight-line depreciation of $100,000 per year:

= 15%

35
 = 30%

Disadvantages:

• It does not take account of the timing of the profits

from an investment.

• It implicitly assumes stable cash receipts over time.

• It is based on accounting profits and not cash flows.

Accounting profits are subject to a number of different
accounting treatments.

• It is a relative measure rather than an absolute

measure and hence takes no account of the size of
the investment.

• It takes no account of the length of the project.

• it ignores the time value of money.

The payback and ARR methods in practice

Despite the limitations of the payback method, it is the method most

widely used in practice. There are a number of reasons for this:

• It is a particularly useful approach for ranking

projects where a firm faces liquidity constraints and
requires fast repayment of investments.

• It is appropriate in situations where risky

investments are made in uncertain markets that are
subject to fast design and product changes or where
future cash flows are particularly difficult to predict.

• The method is often used in conjunction with NPV

or IRR method and acts as a first screening device to
identify projects which are worthy of further
investigation.

• it is easily understood by all levels of management.

• It provides an important summary method: how

quickly will the initial investment be recouped?
QUESTIONS AND ANSWERS – INVESTMENT DECESIONS
ST-1 You have been asked by the president of Ellis Construction Company,
headquartered in Toledo, to evaluate the proposed acquisition of new
earthmover. The mover’s basic price is $ 50, 000, and it will cost another
$10,000 to modify it for special use by Ellis Construction. Assume that the
mover falls into the ACRS 3-year class. It will be sold after 3 years for $ 20,000,
and it will require an increase in net working capital (spare parts inventory) of

36
 $2,000. The earthmover purchase will have no effect on revenues, but it is
expected to save Ellis $ 20,000 per year in before tax operating costs, mainly
labor. Elli’s marginal federal–plus–state tax rate is 40 percent.
a) What is the company’s net investment if it acquires the earthmover?
(That is, what are the Year 0 cash flow?)
b) What are the operating cash flows in Years 1, 2, 3?
c) What are the additional (none operating) cash flows in Year 3?
d) If the project’s cost of capital is 10 percent, should the earthmover be
purchased?

ST-2 The Dauten Toy Corporation currently uses an injection moulding machine
that was purchased 2 years ago. This machine is being depreciated on a
straight line basis toward a $ 500 salvage value, and it ha 6 years of
remaining life. Its current book value is $ 2,600, and it can be sold for $ 3,000
at this time. Thus, the annual depreciation expense is ($ 2,600 - $ 500)/6 = $
350 per year.

Dauten is offered a replacement machine has a cost of $ 8,000, an estimated

useful life of 6 years, and an estimated salvage value of $ 800. This machine
falls into the ACRS 5- Year class, and under current law it does not qualify for
investment tax credit. The replacement machine would permit an output
expansion, so sales would raise by $ 1,000 per year, even so, the new
machine’s much greater efficiciency would still cause operating expenses to
decline by $ 1,500 per year. The new machine would require that inventories
be increased by $ 2,000, but accounts payable would simultaneously increase
by $ 500.

Dauten’s marginal federal-plus-state tax rate is 40 percent, and its cost of

capital is 15 percent. Should it replace the old machine?
SOLUTIONS – INVESTMENT DECESIONS
St-1a. estimated investment requirements:
Price (50,000)
Modification (10,000)
Cnange in net working capital (2,000)
Total investment ($62,000)
b. Operating Cash flows:

Year 1 Year 2
Year 3
1. After-tax cost savings a $ 12,000 $ 12,000 $
12,000
2. depreciation b 19,800 27,000
9,000
3. depreciation tax savings c 7,920 10,800
3,600

Net cash flow (1+3) $ 39,920 $ 22,800 $ 15,600

c. End–of- Project Cash Flows:

37
 Salvage value $ 20,000
Tax on salvage value a (6,320)
Net working capital recovery 2,000
$ 15,680
Sale price $ 20,000
Less book value $ 4,200
Taxable income $ 15,800
Tax at 40% $ 6,320

Book value = Deprectable basis – Accumulate depreciation

= $ 60,000 - $ 55,800 = $ 4,200

d. Project NPV:

NPV = - $ 62,000 + $ 19,920 + $ 22,800 + $31,280

(1.10)1 (1.10)2 (1.10)3

= - $ 1.547

Because the earthmover has a negative NPV, it should not be

purchased.

ST-2 First determines the net cash flow at = 0:

Purchase price ($ 8,000)

Sale of old machine 3,000
Tax on sale of old machine ( 160) a
Change in net working capital ( 1,500) b
Total investment ($ 6,660)

The market value is $ 3,000 - $ 2,600 = $ 400 above the book value.
Thus, there is a $ 400 recapture of depreciation and Dauten would
have to pay 0.40 ($ 400) = $ 160 in taxes.
b
The change in net working capital is a $ 2,000 increase liabilities,
which totals to $ 1,500.

Now, examine the operating cash inflows:

Sales increase $ 1,000

Cost decrease 1,500
Increase in pre-tax operating revenues $ 2,500

38
Depreciation:

Year 1 2 3 4 5 6
Newa $ 1,600 $ 2,560 $ 1,520 $ 960 $ 880 $ 480
Old 350 350 350 350 350
Change $ 1,250 $ 2,210 $1,170 $ 610 $ 530 $ 130
Depreciation
Tax savingsb $ 500 $ 884 $ 468 $ 244 $ 212 $
52
a
Depreciable basis = $ 8.000 Depreciation expense in each year equals depreciable basis times the ACRS
percentage allowances of $ 1,005, and it would also receive $ 800 from the sale of the replacement
machine. However, since the machine would be fully depreciated, the firm must pay 0.40 ($ 800) = $ 320
in taxes on the sale. Also, by undertaking the replacement now, the firm forgoes the right to sell the old
machine for $ 500 in year. No tax would be due, because the $ 500 salvage value would equal the old
machine’s year 6 book value.
Finally: place all the cash flows on time line

0 1 2 3 4 5

Net investment ($6,660)

After-tax revenue increase $1,500 $1,500 $1,500 $1,500 $1,500
$1,500
Depreciation tax savings 500 884 468 244 212
52
Working capital recovery
1,500
Salvage value on new machine 800
Tax on salvage value machine (320)
(500)
Net cash flow ($6,660) $2,000 $2,384 $1,968 $1,744 $1,712
$3,032

The Net present value of this incremental value of this incremental

cash flow stream, when discounted at 15 percent, $ 1,335. Thus, the
replacement should be made.
QQUESTIONS - CAPITAL BUDGETING
ST-1 You are a financial analyst for Porter Electronics Company. The
Director
of capital budgeting has asked you to analyze two proposed
capital investments, projects S and L. each project has a cost of
$10,000, and the cost of capital for each for each project is 12
percent. The projects’ expected net cash flows are as follows:
Expected Net Cash Flow
Year project S Project L
0 ($10,000) ($10,000)
1 6,500 3,500

39
 2 3,000 3,500
3 3,000 3,500
4 1,000 3,500

a. Calculate each project’s payback period. Net present value

(NPV), internal rate of return (IRR), and modified internal
rate of return (IRR*).
b. Which project or projects should be accepted if they are
independent?
c. Which project should be accepted if they are mutually
exclusive?
d. How might a change in the cost of capital produce a
conflict between the NPV and IRR rankings of these two
projects? Would this conflict exist if K were 5%? (Hint: Plot
the NPV profiles.)
e. Why does the conflict exist?

SOLUTIONS
ST-1 a. Payback:
To determine the payback, construct the cumulative cash flows for
each project:
Cumulative Cash Flow
Year Project S Project L
0 ($10,000) ($10,000)
1 ( 3,500) ( 6,500)
2 ( 500) ( 3,000)
3 2,500 500
4 3,500 4,000

PaybackS = 2+ $500 = 2.17 Years

$ 3.000

PaybackL = 2+ $3,000 = 2.86 years

$3,500

Net Present Value (NPV):

NPVS = -$10,000 + $6,500 + $3,000 + $3,000 + $1,000

(1.12)1 (1.12)2 (1.12)3 (1.12)4

NPVL = $10,000 + $3,500 $3,500 $3,500 $3,500

(1.12)1 (1.12) 2
(1.12) 3
(1.12)4
= $630.72

Internal Rate of Return (IRR):

40
To solve for each project’s IRR, find the discount rates which equate
each NPV to zero:
IRR*S = 18.0%
IRR*L = 15.0%

Modified internal Rate of Return (IRR*):

To obtain each project’s IRR*, begin by finding each project’s terminal
value (TV) of cash inflows.

TVS = $6,500(1.12)3 +$3,000(1.12)2 + $3,000(1.12)1

+ $1,000 = $17,255.23

TVL = $3,500(1.12)3 + $3,500(1.12)2 + $3,500(1.12)1 + $3,500 =

$16,727.65

Now, each project’s IRR is that discount rate which equates the PV of
the TV to each project’s cost, $ 10,000;
IRR*S = 14.61%
IRR*L = 13.73%

The following table summarizes the project rankings by each method:

Project Which
Ranks Higher

Payback S
NPV S
IRR S
IRR* S

Note that all methods rank Project S over Project L, in addition, both
projects are acceptable under the NPV, IRR and IRR*criteria. Thus, both
projects should be accepted if they are independent.

a. In this case, we would choose the project with the higher

NPV at K = 12%, or project S.
Part II Strategic Long-Term Investments Decisions
b. To determine the effects of changing the cost of capital,
plot the NPV profiles of each project. The cross over rate
occurs at about 6 to percent.
NPV profiles for S and L

NPV $

41
4,000* NPVL

3,000 *
NPVS Crossover Rate = 6.2%
2,000

1,000

0 5 10 15 20 Cost of Capital (%)

IRRL
1,000

Cost of capital NPV NPV

0% $ 3,500 $ 4,000
4 2,544 2,705
8 1,707 1,592
12 966 631
16 307 (206)
18 5 (585)

If the firm’s cost of capital is less than 6 percent, a conflict exists

because NPVL>NPVS, but IRRS> IRRL. Therefore, if k were 5 percent, a
conflict would exist. Note, however, that when K = 5.0%, IRR*L =
10.83%: hence the modified IRR ranks the projects correctly, even if K
is to the left of the crossover point.

c) The basic cause of the conflict is differing reinvestment rate

assumptions between NPV and IRR. NPV assumes that cash flow can
reinvested at the cost of capital, while IRR assumes reinvestment at
the (generally) higher IRR. The high reinvestment rate assumption
under IRR makes early cash flows especially valuable and hence
short – term projects look better under IRR.

42
 CHAPTER FOUR- TIME VALUE OF MONEY
4.1 INTRODUCTION

When a company (or government) borrows money from the public or banks (bondholders)
Bond
and agrees to pay it back later
Par Value The amount of money that the company borrows. Usually it is $1,000.
Coupon This is like interest. The company makes regular payments to the bondholders, like every
Payments 6 months or every year.
The legal stuff. A written agreement between the company and the bond holder. They talk
Indenture about how much the coupon payments will be, and when the money (par value) will be
paid back to the bondholder.
Maturity Date Date when the company pays the par value back to the bondholder.
Market Interest
This changes everyday.
Rate

The Present Value of the Coupon The Present Value of the Par Value
The Present =
Payments (an annuity)
+
Value of a Bond (time value of money)

Example

• Par Value = $ 1,000

• Maturity Date is in 5 years

• Annual Coupon Payments of $100, which is 10%

• Market Interest rate of 8%

The Present Value of the Coupon Payments (an annuity) = $399.27

The Present Value of the Par Value (time value of money) =$680.58

The Present Value of a Bond = $ 399.27 + $ 680.58 = $1,079.86

What is the value of Preferred Stock?

This is easy. Preferred stock is basically a perpetuity.

4.2 What is the value of Common Stock?

This is not easy. This is a mess. Think about it. What is the value of a share of stock in a specific company?
In one sense it is the price the stock trades at. Both the buyer and seller agree to exchange the stock at that
price. We assume that they are both rational people and both know something about the company and its
future plans and profit potential. So, yes, that is one method: check the price of the stock in the paper or on
the internet. But that's pretty darn easy. It's not really finance. It's more like reading. And I don't know if
you realize this or not, but they don't give Nobel Prizes for reading. So there are other ways of doing stock
valuation too.

The Gordon Growth Formula, also known as The Constant Growth Formula assumes that a company
grows at a constant rate forever. This, by the way, is impossible. I mean, it can't grow forever. You know, if
a company doubles in size every 5 years, pretty soon every single person in the world is their customer and
then they can't grow at that rate anymore. (because the world population isn't doubling ever 5 years).

43
BUT, if we go ahead and assume that a company has a constant growth rate, we can use the following
formula to get its value.

Constant Growth Formula Po = D 1 / ( Ks - G )

• Po = Price
• D1 = The next dividend. D1 = D0 (1 + G)
• Ks = Rate of Return
• G = Growth Rate
What is all this D1 and D0 stuff ?
• D1 is the next dividend
• D0 is the last dividend
Well we are assuming that the company has constant growth, right. So we take the last
divided, multiply it by the growth rate and we can get the next dividend.
Example
• Last years dividend = $ 1.00
• Growth Rate = 5%
• Rate of Return = 10%
First figure out D1.
• D1 = D0 (1 + G)
• D1 = $1.00 ( 1 + .05)
• D1 = $1.00 (1.05)
• D1 = $1.05
Next us the formula.
• Po = D 1 / ( Ks - G )
• Po = $1.05 / (10% - 5%)
• Po = $1.05 / 5%
• Po = $21.00

Bond Yield-to-Maturity
Imagine you are interested in buying a bond, at a market price that's different from
the bond's par value. There are three numbers commonly used to measure the
annual rate of return you are getting on your investment:

44
 Coupon Annual payout as a percentage of the
Rate: bond's par value
Current Annual payout as a percentage of the
Yield: current market price you'll actually pay
Yield-to- Composite rate of return off all payouts,
Maturity: coupon and capital gain (or loss)
(The capital gain or loss is the difference between par value and the price you
actually pay.)

The yield-to-maturity is the best measure of the return rate, since it includes all
aspects of your investment. To calculate it, we need to satisfy the same condition as
with all composite payouts:

Whatever r is, if you use it to calculate the present values of all

payouts and then add up these present values, the sum will equal your
initial investment.

In an equation,
1. c(1 + r)-1 + c(1 + r)-2 + . . . + c(1 + r)-n + B(1 + r)-n = P

where
c = annual coupon payment (in dollars, not a percent)
n = number of years to maturity
B = par value
P = purchase price
You should try to form a mental picture of what this equation is saying. The left side
represents n+1 different compound interest curves, all starting out now, and each
one ending at the moment that the payout it corresponds to takes place. Most of
these curves will lie pretty low to the axis, because they only grow to a value of c, the
coupon payment. The very last curve will be a lot taller, and end up at the par value
B. And if you add up the present values of all these curves (that's the left side of the
equation), the sum will exactly equal the purchase price of the bond (that's the right
side).

As with most composite payout problems, equation 1 can't be solved exactly, in

general. The nice part is that all yield-to-maturity problems have basically the same
form, so people have been able to create programmable calculators and computer
programs (and even tables back in the old days) to help you find r.

Example: Suppose your bond is selling for $950, and has a coupon rate of 7%; it
matures in 4 years, and the par value is $1000. What is the YTM?

The coupon payment is $70 (that's 7% of $1000), so the equation to satisfy is

2. 70(1 + r)-1 + 70(1 + r)-2 + 70(1 + r)-3 + 70(1 + r)-4 + 1000(1 + r)-4 = 950
Of course you aren't really going to solve this, so you just use the popup calculator
instead, and find that r is 8.53%. If you want, you can plug this number back into
equation 2, just to make sure it checks out.

One thing to notice is that the YTM is greater than the current yield, which in turn is
greater than the coupon rate. (Current yield is $70/$950 = 7.37%). This will always
be true for a bond selling at a discount. In fact, you will always have this:
Bond Selling Satisfies This Condition

45
 At . . .
Coupon Rate < Current Yield <
Discount
YTM
Coupon Rate > Current Yield >
Premium
YTM
Coupon Rate = Current Yield =
Par Value
YTM

Bond Yields and Prices

Once a bond has been issued and it's trading in the bond market, all of its future
payouts are determined, and the only thing that varies is its asking price. If you buy
such a bond the yield to maturity you'll get on your investment naturally increases if
you can buy it at a lower price: as they say, bond prices and yields "move" in
opposite directions. That can be confusing since people aren't always consistent in
the way they talk about bond performance. If somebody says "10 year treasuries
were down today", they probably mean that the asking price was down (so it was a
bad day for bond holders); but they sometimes mean that the yield to maturity was
down because the asking price was up (a good day for bond holders).

QUESTIONS AND ANSWERS

ST-2 Assume that is now January 1, 1989. On January 1, 1990, you will deposit
$1,000 into savings account paying an 8 percent interest rate.
a). If the bank compounds interest annually, how much will you have in your account
on January 1, 1993?
b). what would your January 1, 1993, balance be if the bank used quarterly
compounding rather than annual compounding?
c). suppose you deposited the $1,000 in 4 payments of $250 each on January 1 of
1990, 1991, 1992, and 1993. How much would you have in your account on
January 1, 1993, based on 8 percent annual compounding?
d). Suppose you deposited 4 equal payments in your account on January 1 of 1990,
1991, 1992, and 1993. Assuming an 8 percent interest rate, how large would your
payments have to be for you to obtain the same ending balance you calculated in
part a?

ST-3 Assume that it is now January 1, 1989 and you will need $1,000 on January 1,
1993. Your Bank compounds interest at an 8 percent rate annually.
a). How much must you deposit on January 1, 1990, to have a balance of $1,000 on
January 1. 1993?
b). If you want to make equal payments on each January 1 from 1990 through 1993
to accumulate the $1,000, how large must each of the 4 payments be?
c). If your father were to offer either to make the payments calculated in part b
($221.92) or give you a lump sum of $750 on January 1, 1990, which would you
choose?
d). If you have only $750 on July 1, 1990, what interest rate, compounded annually,
would you have to earn to have necessary $1,000 on January 1, 1993?
e). suppose you can deposit only $186.29 each January 1 from 1990 through 1993,
but you still need $1,000 on January 1, 1993. What interest rate, with annual
compounding, must you seek out to achieve your goal?
f). to help you reach your $1,000 goal, your father offers to give you $400 on January
1, 1990. You will get a part-time job and make 6 additional payments of equal
amounts each 6 months thereafter. If all of this money is deposited in a bank which
pays 8 percent, compounded semiannually, how large must your payments be?

46
g). What is the effective annual rate being paid by the bank in part f?
Reinvestment rate risk was defined in chapter 3 as being the risk that maturing
securities (and coupon payments on bonds) will have to be reinvested at a lower rate
of interest that they were previously earning. Is there a reinvestments rate risk
implied in the preceding analysis? If so, how might this risk be eliminated?

ST-4 Bank A pays 8 percent interest, compounded quarterly, on its money market
account. The managers of Bank B want its money market account to equal Bank A’s
effective annual rate, but interest is to be compounded on a monthly basis. What
nominal, or stated, rate must Bank B set?

SOLUTIONS TO SELF-TEST PROBLEMS

ST-a.1/1/89 1/1/90 1/1/91 1/1/92

1/1/93
$1,000

$1,000 is being compounded for 3 years, so your balance on

January 1993, is $1,259.71:
FV = PV (1+k) n = $1,000(1+0.08)³
=$1,259.71.
The effective annual rate for 8 percent, compounded quarterly, is
effective
Annual = (1 +0.08)4 – 1.0
4

= (1.02)4 – 1.0=0.0824=8.24%

Therefore, FV = $1,000(1.0824)3= $1,000(1.2681) = $1,268.10.

Alternatively, use FVIF for 2%, 3 X 4 =12 Periods

FV =$1,000(FVIF 2% 12 periods) = $1,000(1.2682) = $1,268.20.

(Calculator solution = $1,268.24.)

Note that since the interest factors are carried to only four decimal
places, rounding errors occur. Rounding errors also occur between
calculator and tabular solutions.

c. 1/1/89 1/1/90 1/1/91 1/1/92

1/1/93
$250 $250 $250 $250

As you work this problem, keep in mind that tables assume that
payments are made at the end of each period. Therefore, you may
solve this problem by finding the future value of an annuity of
$250 for 4 years at 8 percent:

47
 PMT (FVIFA k.n) = $250(45061) = $1,126.53.

FV = $1,259.71:k = 8%: n= 4

PMT (FVIFA 8%, 4 years) = FV

PMT (4.5061) = $1.259.71
PMT = $1,259.71/4.5061 =
$279.56.

Therefore, you would have to make 4 payments of $279.56 each to

have a balance of $1,259.71 on January 1, 1993.
ST-3 a. Set up a time like those in the preceding problem, and that
your deposit will grow for 3 years at 8 percent. the fact that it is now
January 1, 1989, is irrelevant. the deposit on January 1, 1990, is the PV,
and the
$1,000 = FV, Here is the solution:
FV = $1,000: n= 3; k =8%.
FV (PVIF8%, 3 years) = PV

PV = $1,000(0.7938) = $793.80 = Initial deposit to

accumulate
$1,000
(Calculator solution = $793.83)

Here we are dealing with a 4-year annuinity whose first payment

occurs one year from today, on 1/1/90, and whose future value must
equal $1,000. You should set up a time to help visualize the situation.
Here is the solution:
FV = $1,000; n = 4: k = 8%.

PMT (FVIFA 8%4 years ) = FV

PMT = FV
(FVIFA 8%4 years)

= $1,000
4.5061
= $221.92 = payment necessary to accumulate$1,000.

This problem can be approached in several ways. Perhaps

The simplest is to ask this question. ‘’If I received $750 on
1/1/90 and deposited it to earn 8 percent, what would I have required
$1,000 on 1/1/93?’’ The answer is no:

$750(1.08) (1.08) (1.08) = $944.78.

48
This indicates that you should let your father make the payments
rather than accept the lump sum of $750. You could also compare the
$750 with the PV of payments:
PMT = $221.92: k = 8% n = 4.

PMT (PVIFA 8%4 years) = PV

$221.92(3.3121) = $735.02 = present value
of the required
payments.

This is less than the $750 lump sum offer, so your initial reaction might be to
accept the lump sum of $750. However, this would be a mistake. As we saw
before, if you were to deposit the $750 on January 1, 1990, at an 8 percent
interest rate, to be withdrawn in January 1, 1993, interest would be compounded
for only 3 years, from January 1, 1990, to December 31, 1992, and the future
value would be only

The problem is that when you found the $735.02 PV of the annuity you were
finding the value of the annuity today, on January 1, 1989. You were comparing
$725.02 today with the lump sum of $750 one year from now. This is, of course,
invalid. What you should have done was take the $735.02, recognize that this is
the PV of an annuity as of January 1, 1989, multiply $735.02 by 1.08 to get
$793.82, and compare $793.82 with the lump sum of $750. You would then take
your father’s offer to make the payments rather than take the lump sum on
January 1, 1990.

PV = $750; FV = $1,000; n = 3: k =?
PV (FVIFk3 years) = FV
FVIF k3 years) = FV
PV
= $1,000 =1.3333.
$750
Use the future value of $1 table (Table A-3 at the end of the book) for 3 periods to
find the interest rate corresponding to an FVIF of 1.3333. Look across the period 3
row of the table until you come to 1.3333. The closest value is 1.3310, in the 10
percent column. Therefore, you would require an interest rate of approximately
10 percent to achieve your $1,000 goal. The exact rate required, found with a
financial calculator, is 10.0642 percent.

FV = $1,000; PMT = $186.29; n = 4; k =?

PMT (FVIFA k, 4 years ) = FV

$186.29(FVIFA ) = $1,000
k, 4 years

FVIFA k, 4 years = $1,000 = 5.3686.

49
 *
Using Table A-4 at the end of the book, we find that 5, 3680
corresponds to a 20 percent interest rate. You might be able to find a
borrower willing to offer you a 20 percent interest rate, but there would
be some risk involved – he or she might not actually pay you your
$1,000!
(Calculator solution = 19.9997%)

f. 1/1/89 1/1/90 1/1/91 1/1/92 1/1/93

$400 ? ? ? ? ? ?

Find the future value of the original $400 deposit:

FV = PV (FVIF4%, 6) = $400(1.2653) = $506.12.

This means that on January 1, 1993, you need an additional sum of

$493.88:

$1,000.00 - $506.12 = $493.88.

This will be accumulated by making 6 equal payments which earn 8

percent compounded semi annually, or 4 percent each 6 months;

FV = $493.88; n = 6; k = 4%
PMTV (FVIFA4%, 6) = FV

PMT = FV
(FVIFA4% 6)

= $493.88 = $74.46
6.6330

50
 CHAPTER FIVE - COST OF CAPITAL
Cost of capital is minimum rate of return required by investors. It’s
minimum rate of return which maintain market value per share
at its current.

Significance of cost of capital

1. Firms cost of capital is the discount rate used in evaluating the

desirability of investment projects. It’s minimum rate of return
required on investment on investment. It cut off or target or
hundle rate.

2. Cost of capital is significant in designing the firms capital structure –

A firms target capital structure should aim at minimizing cost of
capital and maximizing the market value of the firms.

3. Knowledge of cost of capital is useful to management when deciding

on method of financing at a given time. Cheaper sources of funds
would be employed by the company to finance it’s operation.

4. Cost of capital can be used to evaluate financing performance of top

management. Such evaluation will involve comparison of actual
profitability of project undertaken with projected overall cost of
capital and an appraisal of actual cost incurred in raising
required funds.

5. Cost of capital is useful in designing a firm’s dividend policy;

dividend policy is mainly concerned with how to give to shareholders.

CLASSIFICATION OF COST OF CAPITAL

1. FUTURE AND HISTORICAL COSTS. Historical costs refer to costs

incurred on funds raised to finance firm’s current project. Future
cost on the otherhand refers to the cost that the firms would
incur when raising funds to finance its future projects.in decision
making the relevant cost are future costs not historical costs.

QUESTION ONE

Lancaster Engineering, Inc, (LEI) has the following capital structure.

Which it considers to be optimal:

Debt 25%

51
Preferred stock 15

Common 60

100

LEI’s expected net income this year is $ 34,285.72: its established

dividend payout ratio is 30 percent: its federal –plus –state tax rate is
40 percent and investors expect earnings and dividends to grow at a
constant rate of 9 percent in the future. LEI paid a dividend of $ 3.60
per share last year, and as its stock currently sells at a price of $ 60
per share.

LEI can obtain new capital in the following ways.

• Common: New common stock has a floatation cost of 10 percent

for up to $12,000 of new stock and new stock and 20 percent for
all common over $12,000.

• Preferred: new preferred stock with a dividend of $ 11 can be

sold to the public at a price of $ 100 per share. However,
floatation costs of $ 5 per share will be incurred for up to $ 7,500
of preferred, rising to $ 10 per share, or 10 percent, on all
preferred over $ 7,500.

• Debt: up to $ 5,000 of debt can be sold at an interest rate of 12

percent: debt in the range of $ 5,001 to $ 10,000 must carry an
interest rate of 14 percent: and all debt over $ 10,000 will have
an interest rate of 16 percent. LEI has the following investment
opportunities:

Cost Annual Net project

Project at: = 0 Cash Flow life IRR

A $ 10,000 $ 2,191.20 7 years 12.0%

B 10,000 3,154.42 5 17.4

C 10,000 2,170.18 8 14.2

D 20,000 3,789.48 10 13.7

E 20,000 5,427.84 6 16

(a) Find the break points in the MCC schedule.

(b) Determine the cost of each capital structure component.

52
 (c) Calculate the weighted average cost of capital in the interval
between each break in the MCC schedule.

(d)Calculate the IRR for project E.

(e) Construct a graph showing the MCC and schedules.

(f) Which projects should LEI accept?

SOLUTIONS

a. A break point will occur each time a low-cost type of capital is used
up. We establish the break points as follows, after first noting
that LEI has $ 24,000 of retained earnings:

Retained earnings = (Total earnings) (1.0-payout)

= $ 34,285.72 (0.7)

= $ 24,000

Break point = Total amount of low-cost capital of a given type

Fraction of this type of capital in the capital

structure

Break

Capital used up Break Point Calculation

Number

Retained earnings BPRE = $ 24,000 = $ 40,000

2

0.60

10% floatation commonBP10%E= $ 24,000+ $ 12,000 = $ 60,000

4

0.60

5% floatation preferred BP5%P = $7,500 = $ 50,000 3

0.15

12% debt BP12%D = $5,000 = $ 20,000 1

0.25

53
14% debt BP14%D = $5,000 +$5,000 = $ 40,000
2

0.2

Summary of Break Points

1. There are three common equity costs and hence two changes,
and, therefore, two equity–induced breaks in the MCC. There are
two preferred costs and hence one preferred break. There are
three debt costs and hence two debt breaks.

2. The numbers in the third column of the table designate the

sequential order of the breaks, determined after all the break
points were calculated. Note that the second debt and the break
for retained earnings

3. The first break point occurs at $ 20,000, when the 12 percent

debt is used up. The second break point, $ 40,000, results from
using up both retained earnings and the 14 percent debt. The
MCC curve also rises at $ 50,000 and $ 60,000, as preferred
stock with a 5 percent floatation cost and common stock with a
10 percent floatation cost, respectively, are used up.

b. Component costs within indicated total capital interval are as

follows: Retained earnings (used in interval $0 to $ 40,000):

Ks = D1 +g = D0 (1+g) +g

Po Po

3.60(1.09) + 0.09

60

= 0.0654 + 0.09 = 15.54

Common with F = 10% ($40, 0001 to $ 60,000):

Ke = D1 + g = $ 3.924 + 9% = 16.27%

P0 (1.0-F) $60(0.9)

54
Preferred with F = 20% (over $60,000):

Ke = $ 3.924 + 9% = 17.18%

$60(0.8)

Preferred with F = 5% ($ 0 to $ 50,000):

Kp = preferred dividend = $ 11 = 11.58%

Pn $100(0.95)

Preferred with F = 10% ( Over $50,000):

K p = $11 = 12.22%

$100(0.9)

Debt at K1 = 12% ($0 to 20,000):

K d (1-T) = 12% (0.6) = 7.20%

Debt at K d = 14% ($20,001 to $40,000):

Kd (1-T) = 14 %( 0.6) = 8.40%

Debt at Kd = 16% (OVER $40,000):

K d (1-T) = 16 %( 0.6) = 9.60%

c. WACC calculations within indicated total capital intervals:

1. $0 to $20,000 (debt = 7.2%, preferred = 11.58%, and retained

earnings (RE) = 15.54%):

WACC1 = WdKd (1-T) + WpKp +WsKs

= 0.25(7.2%)+0.15(11.58%)+0.60(15.54%) = 12.86%

2. $20,001 to $40,000(debt=8.4%, preferred = 11.58%, and RE =

15.54%):

WACC2 = 0.25(8.4%) + 0.15(11.58%) + 0.60(15.54%) = 13.16%

3. $40,001 to $50,000(debt=9.6%, preferred =11.58%, and equity

= 16.27%):

WACC3=0.25(9.6%) + 0.15(11.58%) + 0.6(16.27%) = 13.90%.

55
 4. $50,001 to $60,000 (debt = 9.6%, preferred = 12.22% and equity
=16.27%):

WACC4 = 0.25(9.6%) + 0.15(12.22) + 0.60(16.27%) = 14.00%

MICC and IOS Schedules for Lancaster Engineering, Inc.

Percent

17.5 B = 17.4%

17.0

16.5 E=16.0%

16.0

15.5 C = 14.2%

15.0 WACC3 = 13.9%

14.5

14.0 WACC12.86%

13.5 WACC = 12.86%

13.0

12.5

12.0 A= 12.0%

0 20 40 60 80 New Capital (Thousands of Dollars)

WACC4 = 0.25(9.6%)+0.15(12.22%)+0.60(16.27%)=14.00%

5. Over $60,000 (debt = 9.6%, preferred = 12.22% and equity =

17.18%):

WACC5 = 0.25(9.6%) +0.15(12.22%) +0.60(17.18%)= 14.54%

b) IRR calculation for project E:

PVIFAK.6 = $20,000 = 3.6847

$5.427.84

56
 This is the factor for 16 percent, so IRRE = 16%

c) See the graph of the MCC and IOS schedules for LEI at the top
of the page.
LEI should accept Projects B, E, AND C. It should reject A and D, because
their IRRs do not exceed the marginal costs of funds needed to finance
them. The firm’s capital budget would total $ 40,000.

QUESTION TWO

Sasini Company has the following capital structure, which it considers

to be optimal

Debt 25%

Preferred stock 15

Common stock 60

Total capital 100%

Sasini’s net income expected this year is $ 17,142.86, its established

dividend payout ratio is 30%: its tax rate is 30%: and investors expect
earnings and dividends to grow at a constant rate of 9% in the future.
Sasini paid a dividend of $ 3.60 per share, last year and its stock
currently sells at a price of $ 60 per share. Treasury bonds yield 11%
an average stock has a 14% expected rate of return: and Sasini’s beta
is 1.51. These terms will apply to new security offerings.

Common: New common stock would have a flotation cost of 10%

Preferred: New preferred stock could be sold in the public at a price of

$ 100 per share, with a dividend of $11. Floatation costs of $5 per
share would be incurred.

Debt: debt could be sold at an interest rate of 12%.

REQUIRED:

(i) Calculate the component costs of debt, preferred stock, retained

earnings, and new common stock.

(ii) How much new capital can be raised before Sasini must sell new
equity?

(iii) What is the WAC when Sasini meets its equity requirement with
retained earnings? With new common stock?

57
(iv) Construct a graph showing Sasini’s MCC schedule

SOLUTION TO QUESTION TWO

SASINI

1. a) Effective cost of debt /after tax of debt

kd = 12% (1-tax) = 12% (1-0.3)= 8.4%

a) Cost of preferred stock (kp)

Kp = annual dividends = 11 = 0.1158

(Po - F) (100-5)

(Always translate to %) = 11.6%

b) Retained earnings

Ks = DO (1+g) +g

Po

Ks = 3.6(1+0.09) +0.09 = 0.1554 x 100

60

Ks = 15.54%

D) New common stock

ke = Do(1+g) +g

(Po-F) or Po (1-f)

=3.6(1+0.09) + 0.09

60(1- 0.1)

= 16.27%

(ii) Break point of fund

58
BPE = available equity

Weight of 11

Available equity

Profit after tax 17,142.86

Less

Dividends (30% x 17,142.86) 5,142.86

Available retained earnings 12,000.00

Weight of equity = common stock

BPE = 12,000

0.6

= $ 20,000

NB: Break point same as jumps

iii) WACC with Sasini’s retained earnings

ii) Specific cost of capital
Ke = 15.54
Kd = 3.4
Kp = 11.6%
iii) Weights
W e = 0.6
W d = 0.25
W p = 0.15
WACC = 15.54 (0.6) + 8.4 (0.25) + 11.6 (0.15)
=13.164
WACC = kewe + kdwd + kpwp

Ke = 16.3% (3) weight

Kd=8.4% we = 0.6
Kp = 11.6% wd = 0.25
Wp = 0.15

WACC = 16.3 (0.6) + 8.4 (0.25) + 11.6(0.15) = 13.60

SASINI’S MCC SCHEDULE

59
Range of Sources of Specific cost Weights of WACC
financing capital of capital capital
E
A-B up to D 13.16%
20,000 P
C-D E
D 13.16%
P
Above 20,00

SASINI’S GRAPH

13.8

13.7

13.6 13.6%

13.5
jump/break

13.4

13.3

13.2

13.1

20,000 40,000
Range of financing

60
CHAPTER 6 - SOURCES OF FINANCE
6.1 SOURCES OF FUNDS

A company might raise new funds from the following sources:

 The capital markets:

i) new share issues, for example, by companies acquiring a stock market listing for the first time

ii) rights issues

Loan stock
Retained earnings
Bank borrowing
Government sources
Business expansion scheme funds
Venture capital
Franchising.

Ordinary (equity) shares

Ordinary shares are issued to the owners of a company. They have a nominal or 'face' value,
typically of $1 or 50 cents. The market value of a quoted company's shares bears no relationship
to their nominal value, except that when ordinary shares are issued for cash, the issue price
must be equal to or be more than the nominal value of the shares.

Deferred ordinary shares

are a form of ordinary shares, which are entitled to a dividend only after a certain date or if
profits rise above a certain amount. Voting rights might also differ from those attached to other
ordinary shares.

Ordinary shareholders put funds into their company:

a) by paying for a new issue of shares

b) through retained profits.

Simply retaining profits, instead of paying them out in the form of dividends, offers an
important, simple low-cost source of finance, although this method may not provide enough
funds, for example, if the firm is seeking to grow.

A new issue of shares might be made in a variety of different circumstances:

a) The company might want to raise more cash. If it issues ordinary shares for cash, should the
shares be issued pro rata to existing shareholders, so that control or ownership of the company
is not affected? If, for example, a company with 200,000 ordinary shares in issue decides to
issue 50,000 new shares to raise cash, should it offer the new shares to existing shareholders, or
should it sell them to new shareholders instead?

i) If a company sells the new shares to existing shareholders in proportion to their existing
shareholding in the company, we have a rights issue. In the example above, the 50,000 shares
would be issued as a one-in-four rights issue, by offering shareholders one new share for every
four shares they currently hold.

ii) If the number of new shares being issued is small compared to the number of shares already
in issue, it might be decided instead to sell them to new shareholders, since ownership of the
company would only be minimally affected.

b) The company might want to issue shares partly to raise cash, but more importantly to float'
its shares on a stick exchange.

61
c) The company might issue new shares to the shareholders of another company, in order to
take it over.

New shares issues

A company seeking to obtain additional equity funds may be:

a) an unquoted company wishing to obtain a Stock Exchange quotation

b) an unquoted company wishing to issue new shares, but without obtaining a Stock Exchange
quotation

c) a company which is already listed on the Stock Exchange wishing to issue additional new
shares.

The methods by which an unquoted company can obtain a quotation on the stock market are:

a) an offer for sale

b) a prospectus issue
c) a placing
d) an introduction.

Offers for sale:

An offer for sale is a means of selling the shares of a company to the public.

a) An unquoted company may issue shares, and then sell them on the Stock Exchange, to raise
cash for the company. All the shares in the company, not just the new ones, would then become
marketable.

b) Shareholders in an unquoted company may sell some of their existing shares to the general
public. When this occurs, the company is not raising any new funds, but just providing a wider
market for its existing shares (all of which would become marketable), and giving existing
shareholders the chance to cash in some or all of their investment in their company.

When companies 'go public' for the first time, a 'large' issue will probably take the form of an
offer for sale. A smaller issue is more likely to be a placing, since the amount to be raised can be
obtained more cheaply if the issuing house or other sponsoring firm approaches selected
institutional investors privately.

Rights issues

A rights issue provides a way of raising new share capital by means of an offer to existing
shareholders, inviting them to subscribe cash for new shares in proportion to their existing
holdings.

For example, a rights issue on a one-for-four basis at 280c per share would mean that a
company is inviting its existing shareholders to subscribe for one new share for every four
shares they hold, at a price of 280c per new share.

A company making a rights issue must set a price which is low enough to secure the acceptance
of shareholders, who are being asked to provide extra funds, but not too low, so as to avoid
excessive dilution of the earnings per share.

6.2 PREFERENCE SHARES

Preference shares have a fixed percentage dividend before any dividend is paid to the ordinary
shareholders. As with ordinary shares a preference dividend can only be paid if sufficient
distributable profits are available, although with 'cumulative' preference shares the right to an
unpaid dividend is carried forward to later years. The arrears of dividend on cumulative
preference shares must be paid before any dividend is paid to the ordinary shareholders.

62
From the company's point of view, preference shares are advantageous in that:

Dividends do not have to be paid in a year in which profits are poor, while this is not the case
with interest payments on long term debt (loans or debentures).

Since they do not carry voting rights, preference shares avoid diluting the control of existing
shareholders while an issue of equity shares would not.

Unless they are redeemable, issuing preference shares will lower the company's gearing.
Redeemable preference shares are normally treated as debt when gearing is calculated.

The issue of preference shares does not restrict the company's borrowing power, at least in the
sense that preference share capital is not secured against assets in the business.

The non-payment of dividend does not give the preference shareholders the right to appoint a
receiver, a right which is normally given to debenture holders.

However, dividend payments on preference shares are not tax deductible in the way that
interest payments on debt are. Furthermore, for preference shares to be attractive to investors,
the level of payment needs to be higher than for interest on debt to compensate for the
additional risks.

For the investor, preference shares are less attractive than loan stock because:

they cannot be secured on the company's assets

the dividend yield traditionally offered on preference dividends has been much too low to
provide an attractive investment compared with the interest yields on loan stock in view of the
additional risk involved.

Loan stock

Loan stock is long-term debt capital raised by a company for which interest is paid, usually half
yearly and at a fixed rate. Holders of loan stock are therefore long-term creditors of the
company.

Loan stock has a nominal value, which is the debt owed by the company, and interest is paid at
a stated "coupon yield" on this amount. For example, if a company issues 10% loan stocky the
coupon yield will be 10% of the nominal value of the stock, so that $100 of stock will receive $10
interest each year. The rate quoted is the gross rate, before tax.

Debentures are a form of loan stock, legally defined as the written acknowledgement of a debt
incurred by a company, normally containing provisions about the payment of interest and the
eventual repayment of capital.

Debentures with a floating rate of interest

These are debentures for which the coupon rate of interest can be changed by the issuer, in
accordance with changes in market rates of interest. They may be attractive to both lenders and
borrowers when interest rates are volatile.

Security

Loan stock and debentures will often be secured. Security may take the form of either a fixed
charge or a floating charge.

a) Fixed charge; Security would be related to a specific asset or group of assets, typically land
and buildings. The company would be unable to dispose of the asset without providing a
substitute asset for security, or without the lender's consent.

b) Floating charge; With a floating charge on certain assets of the company (for example,
stocks and debtors), the lender's security in the event of a default payment is whatever assets
of the appropriate class the company then owns (provided that another lender does not have a

63
prior charge on the assets). The company would be able, however, to dispose of its assets as it
chose until a default took place. In the event of a default, the lender would probably appoint a
receiver to run the company rather than lay claim to a particular asset.

The redemption of loan stock

Loan stock and debentures are usually redeemable. They are issued for a term of ten years or
more, and perhaps 25 to 30 years. At the end of this period, they will "mature" and become
redeemable (at par or possibly at a value above par).

Most redeemable stocks have an earliest and latest redemption date. For example, 18%
Debenture Stock 2007/09 is redeemable, at any time between the earliest specified date (in
2007) and the latest date (in 2009). The issuing company can choose the date. The decision by
a company when to redeem a debt will depend on:

a) how much cash is available to the company to repay the debt

b) the nominal rate of interest on the debt. If the debentures pay 18% nominal interest and the
current rate of interest is lower, say 10%, the company may try to raise a new loan at 10% to
redeem the debt which costs 18%. On the other hand, if current interest rates are 20%, the
company is unlikely to redeem the debt until the latest date possible, because the debentures
would be a cheap source of funds.

There is no guarantee that a company will be able to raise a new loan to pay off a maturing
debt, and one item to look for in a company's balance sheet is the redemption date of current
loans, to establish how much new finance is likely to be needed by the company, and when.

Mortgages are a specific type of secured loan. Companies place the title deeds of freehold or
long leasehold property as security with an insurance company or mortgage broker and receive
cash on loan, usually repayable over a specified period. Most organisations owning property
which is unencumbered by any charge should be able to obtain a mortgage up to two thirds of
the value of the property.

As far as companies are concerned, debt capital is a potentially attractive source of finance
because interest charges reduce the profits chargeable to corporation tax.

Retained earnings

For any company, the amount of earnings retained within the business has a direct impact on
the amount of dividends. Profit re-invested as retained earnings is profit that could have been
paid as a dividend. The major reasons for using retained earnings to finance new investments,
rather than to pay higher dividends and then raise new equity for the new investments, are as
follows:

a) The management of many companies believes that retained earnings are funds which do not
cost anything, although this is not true. However, it is true that the use of retained earnings as a
source of funds does not lead to a payment of cash.

b) The dividend policy of the company is in practice determined by the directors. From their
standpoint, retained earnings are an attractive source of finance because investment projects
can be undertaken without involving either the shareholders or any outsiders.

c) The use of retained earnings as opposed to new shares or debentures avoids issue costs.

d) The use of retained earnings avoids the possibility of a change in control resulting from an
issue of new shares.

Another factor that may be of importance is the financial and taxation position of the company's
shareholders. If, for example, because of taxation considerations, they would rather make a
capital profit (which will only be taxed when shares are sold) than receive current income, then
finance through retained earnings would be preferred to other methods.

64
A company must restrict its self-financing through retained profits because shareholders should
be paid a reasonable dividend, in line with realistic expectations, even if the directors would
rather keep the funds for re-investing. At the same time, a company that is looking for extra
funds will not be expected by investors (such as banks) to pay generous dividends, nor over-
generous salaries to owner-directors.

Bank lending

Borrowings from banks are an important source of finance to companies. Bank lending is still
mainly short term, although medium-term lending is quite common these days.

Short term lending may be in the form of:

a) an overdraft, which a company should keep within a limit set by the bank. Interest is charged
(at a variable rate) on the amount by which the company is overdrawn from day to day;

b) a short-term loan, for up to three years.

Medium-term loans are loans for a period of from three to ten years. The rate of interest charged
on medium-term bank lending to large companies will be a set margin, with the size of the
margin depending on the credit standing and riskiness of the borrower. A loan may have a fixed
rate of interest or a variable interest rate, so that the rate of interest charged will be adjusted
every three, six, nine or twelve months in line with recent movements in the Base Lending Rate.

Lending to smaller companies will be at a margin above the bank's base rate and at either a
variable or fixed rate of interest. Lending on overdraft is always at a variable rate. A loan at a
variable rate of interest is sometimes referred to as a floating rate loan. Longer-term bank loans
will sometimes be available, usually for the purchase of property, where the loan takes the form
of a mortgage. When a banker is asked by a business customer for a loan or overdraft facility,
he will consider several factors, known commonly by the mnemonic PARTS.

- Purpose
- Amount
- Repayment
- Term
- Security

PThe purpose of the loan A loan request will be refused if the purpose of the loan is not
acceptable to the bank.

AThe amount of the loan. The customer must state exactly how much he wants to borrow.
The banker must verify, as far as he is able to do so, that the amount required to make
the proposed investment has been estimated correctly.

RHow will the loan be repaid? Will the customer be able to obtain sufficient income to make
the necessary repayments?

TWhat would be the duration of the loan? Traditionally, banks have offered short-term
loans and overdrafts, although medium-term loans are now quite common.

SDoes the loan require security? If so, is the proposed security adequate?

Leasing

A lease is an agreement between two parties, the "lessor" and the "lessee". The lessor owns a
capital asset, but allows the lessee to use it. The lessee makes payments under the terms of the
lease to the lessor, for a specified period of time.

65
Leasing is, therefore, a form of rental. Leased assets have usually been plant and machinery,
cars and commercial vehicles, but might also be computers and office equipment. There are two
basic forms of lease: "operating leases" and "finance leases".

Operating leases

Operating leases are rental agreements between the lessor and the lessee whereby:

a) the lessor supplies the equipment to the lessee

b) the lessor is responsible for servicing and maintaining the leased equipment

c) the period of the lease is fairly short, less than the economic life of the asset, so that at the
end of the lease agreement, the lessor can either

i) lease the equipment to someone else, and obtain a good rent for it, or
ii) sell the equipment secondhand.

Finance leases

Finance leases are lease agreements between the user of the leased asset (the lessee) and a
provider of finance (the lessor) for most, or all, of the asset's expected useful life.

Suppose that a company decides to obtain a company car and finance the acquisition by means
of a finance lease. A car dealer will supply the car. A finance house will agree to act as lessor in
a finance leasing arrangement, and so will purchase the car from the dealer and lease it to the
company. The company will take possession of the car from the car dealer, and make regular
payments (monthly, quarterly, six monthly or annually) to the finance house under the terms of
the lease.

Other important characteristics of a finance lease:

a) The lessee is responsible for the upkeep, servicing and maintenance of the asset. The lessor
is not involved in this at all.

b) The lease has a primary period, which covers all or most of the economic life of the asset. At
the end of the lease, the lessor would not be able to lease the asset to someone else, as the
asset would be worn out. The lessor must, therefore, ensure that the lease payments during the
primary period pay for the full cost of the asset as well as providing the lessor with a suitable
return on his investment.

c) It is usual at the end of the primary lease period to allow the lessee to continue to lease the
asset for an indefinite secondary period, in return for a very low nominal rent. Alternatively, the
lessee might be allowed to sell the asset on the lessor's behalf (since the lessor is the owner)
and to keep most of the sale proceeds, paying only a small percentage (perhaps 10%) to the
lessor.

Why might leasing be popular

The attractions of leases to the supplier of the equipment, the lessee and the lessor are as
follows:

The supplier of the equipment is paid in full at the beginning. The equipment is sold to the
lessor, and apart from obligations under guarantees or warranties, the supplier has no further
financial concern about the asset.

The lessor invests finance by purchasing assets from suppliers and makes a return out of the
lease payments from the lessee. Provided that a lessor can find lessees willing to pay the
amounts he wants to make his return, the lessor can make good profits. He will also get capital
allowances on his purchase of the equipment.

Leasing might be attractive to the lessee:

66
i) if the lessee does not have enough cash to pay for the asset, and would have difficulty
obtaining a bank loan to buy it, and so has to rent it in one way or another if he is to have the
use of it at all; or

ii) if finance leasing is cheaper than a bank loan. The cost of payments under a loan might
exceed the cost of a lease.

Operating leases have further advantages:

The leased equipment does not need to be shown in the lessee's published balance sheet, and
so the lessee's balance sheet shows no increase in its gearing ratio.

The equipment is leased for a shorter period than its expected useful life. In the case of high-
technology equipment, if the equipment becomes out-of-date before the end of its expected life,
the lessee does not have to keep on using it, and it is the lessor who must bear the risk of
having to sell obsolete equipment secondhand.

The lessee will be able to deduct the lease payments in computing his taxable profits.

Hire purchase

Hire purchase is a form of instalment credit. Hire purchase is similar to leasing, with the
exception that ownership of the goods passes to the hire purchase customer on payment of the
final credit instalment, whereas a lessee never becomes the owner of the goods.

Hire purchase agreements usually involve a finance house.

i) The supplier sells the goods to the finance house.

ii) The supplier delivers the goods to the customer who will eventually purchase them.
iii) The hire purchase arrangement exists between the finance house and the customer.

The finance house will always insist that the hirer should pay a deposit towards the purchase
price. The size of the deposit will depend on the finance company's policy and its assessment of
the hirer. This is in contrast to a finance lease, where the lessee might not be required to make
any large initial payment.

An industrial or commercial business can use hire purchase as a source of finance. With
industrial hire purchase, a business customer obtains hire purchase finance from a finance
house in order to purchase the fixed asset. Goods bought by businesses on hire purchase
include company vehicles, plant and machinery, office equipment and farming machinery.

Government assistance

The government provides finance to companies in cash grants and other forms of direct
assistance, as part of its policy of helping to develop the national economy, especially in high
technology industries and in areas of high unemployment. For example, the Indigenous Business
Development Corporation of Zimbabwe (IBDC) was set up by the government to assist small
indigenous businesses in that country.

Venture capital

Venture capital is money put into an enterprise which may all be lost if the enterprise fails. A
businessman starting up a new business will invest venture capital of his own, but he will
probably need extra funding from a source other than his own pocket. However, the term
'venture capital' is more specifically associated with putting money, usually in return for an
equity stake, into a new business, a management buy-out or a major expansion scheme.

The institution that puts in the money recognises the gamble inherent in the funding. There is a
serious risk of losing the entire investment, and it might take a long time before any profits and
returns materialise. But there is also the prospect of very high profits and a substantial return on
the investment. A venture capitalist will require a high expected rate of return on investments,
to compensate for the high risk.

67
A venture capital organisation will not want to retain its investment in a business indefinitely,
and when it considers putting money into a business venture, it will also consider its "exit", that
is, how it will be able to pull out of the business eventually (after five to seven years, say) and
realise its profits. Examples of venture capital organisations are: Merchant Bank of Central Africa
Ltd and Anglo American Corporation Services Ltd.

When a company's directors look for help from a venture capital institution, they must recognise that:

the institution will want an equity stake in the company

it will need convincing that the company can be successful
it may want to have a representative appointed to the company's board, to look after its interests.

The directors of the company must then contact venture capital organisations, to try and find
one or more which would be willing to offer finance. A venture capital organisation will only give
funds to a company that it believes can succeed, and before it will make any definite offer, it will
want from the company management:

a) a business plan

b) details of how much finance is needed and how it will be used

c) the most recent trading figures of the company, a balance sheet, a cash flow forecast and a
profit forecast

d) details of the management team, with evidence of a wide range of management skills

e) details of major shareholders

f) details of the company's current banking arrangements and any other sources of finance

g) any sales literature or publicity material that the company has issued.

A high percentage of requests for venture capital are rejected on an initial screening, and only a
small percentage of all requests survive both this screening and further investigation and result
in actual investments.

Franchising

Franchising is a method of expanding business on less capital than would otherwise be needed.
For suitable businesses, it is an alternative to raising extra capital for growth. Franchisors
include Budget Rent-a-Car, Wimpy, Nando's Chicken and Chicken Inn.

Under a franchising arrangement, a franchisee pays a franchisor for the right to operate a local
business, under the franchisor's trade name. The franchisor must bear certain costs (possibly for
architect's work, establishment costs, legal costs, marketing costs and the cost of other support
services) and will charge the franchisee an initial franchise fee to cover set-up costs, relying on
the subsequent regular payments by the franchisee for an operating profit. These regular
payments will usually be a percentage of the franchisee's turnover.

Although the franchisor will probably pay a large part of the initial investment cost of a
franchisee's outlet, the franchisee will be expected to contribute a share of the investment
himself. The franchisor may well help the franchisee to obtain loan capital to provide his-share
of the investment cost.

The advantages of franchises to the franchisor are as follows:

 The capital outlay needed to expand the business is reduced substantially.

 The image of the business is improved because the franchisees will be motivated to achieve
good results and will have the authority to take whatever action they think fit to improve the
results.

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The advantage of a franchise to a franchisee is that he obtains ownership of a business for an
agreed number of years (including stock and premises, although premises might be leased from
the franchisor) together with the backing of a large organisation's marketing effort and
experience. The franchisee is able to avoid some of the mistakes of many small businesses,
because the franchisor has already learned from its own past mistakes and developed a scheme
that works.

69
 CLASS ASSIGNMENT

DFI 501: FINANCIAL MANAGEMENT

ASSIGNMENT ONE:

QUESTION ONE:

a) A company is planning to invest $50,00 (before tax) in a personnel training

program. The $50,000 outlay will be charged off as an expense by the firm this
year (year 0). The returns from the program, in the form of greater productivity
and a reduction in employee turnover are estimated as follows (on an after-tax
basis):
Years 1 – 10 $5,000 per year
Years 11 – 20 $15,000 per year.
The company has estimated its cost of capital to be 15%. Assume that the entire
$50,000 is paid at time 0. The marginal tax rate for the firm is 30%.

REQUIRED:
Should the firm undertake the training program?
b) Majestic Mining Company (MMC) is negotiating for the purchase of a new piece of
equipment for their current operations. MMC wants to know the maximum price
that it should be willing to pay for the equipment i.e. how high the price must be
for the equipment to have a zero NPV. You are given the following facts
i) The new equipment would replace existing equipment that has a
current market value of $20,000.
ii) The new equipment would not affect revenues, but before-tax
operating costs would be reduced by $10,000 per year for eight years.
These savings in costs would occur at year-end.
iii) The old equipment is now 5 years old. It is expected to last for another
eight years, and it is expected to have no resale value at the end of
those eight years. It was purchased for $40,000 and is being
depreciated to zero on a straight-line basis over 10 years.
iv) The new equipment will be depreciated to zero using straight-line
depreciation over five years. MMC expects to be able to sell the
equipment for $5,000 at the end of 8 years. The proceeds from this
sale would be subject to taxes at a rate of 30%.
v) MMC has profitable ongoing operations.
vi) The appropriate discount rate is 12%.
c) Sony International has an investment opportunity to produce a new stereo Colour
TV. The required investment on January 1 2005 is $32 million. The firm will
depreciate the investment to zero using the straight-line method. The firm is in
the 30% tax bracket. The price of the product on January 1 will be $400 per unit.
That price will stay constant in real terms. Labour costs will be $15 per hour on
January 1, they will increase at 2% per year in real terms. The inflation rate is 5%.
Revenues are received and costs paid at year-end.

Year 1 Year 2 Year 3 Year

4
Physical production, in units 100,000 200,000 200,000
150,000

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 Labour input, in hours 2,000,000 2,000,000 2,000,000
2,000,000
Energy input, physical units 200,000 200,000 200,000
200,000

The risk less nominal discount rate is 4%. The real discount rate for costs and
revenues is 8%.

REQUIRED:
Calculate the NPV of this project.
d) An acre planted with trees is estimated to be worth $4,000 in 25 years. If you
want to realize a 12% return on your investment, how much can you afford to
invest per acre?

DFI 501: FINANCIAL MANAGEMENT

ASSIGNMENT TWO:

a) The Bozo basketball company (BBC) earned $10 a share last year and paid a
dividend of $6 a share. Next year you expect BBC to earn $11 and continue its
pay-out ration. Assume that you expect to be to be able to sell the stock for $132
a year from now. If you required 14% on this stock, how much would you be
willing to pay for it?
b) Gentry Company’s latest annual dividend of $1.25 a share was paid yesterday
and maintained its historic 7% annual rate of growth. You plan to purchase the
stock today because you feel that the dividend growth rate will increase to 8% for
the next three years and the selling price of the stock will be $40 per share at the
end of that time.

REQUIRED:
i) How much should you be willing to pay for the Gentry company stock if
you require a 14% return?
ii) What is the maximum price you should be willing to pay for the Gentry
company stock if you feel that the 8% growth rate can be maintained
indefinitely and you require a 14% return?
c) A bond with the following characteristics is available:
Principal: $1,000
Term to Maturity: 20 years
Coupon Rate: 8%
Semi-annual payments

Calculate the price of the bond if the market interest rate is:
i) 8%
ii) 10%
iii) 6%
d) Locust software is one of a myriad of companies selling word processor programs.
Their newest program will cost $5 million to develop first year profits will be $1.2
million. As a result of competition, profits will fall by 4% each year. All inflows of
cash occur at year-end. If the market discount rate is 16%, what is the value of
the company?
e) You are offered the opportunity to buy a note for $12,800. The note is certain to
pay $2,000 at the end of each of the next 10 years. If you buy the note, what rate
of interest will you receive?

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f) You need $25,000 five years from now. You budget to make equal payments at
the end of every year into an account that pays a stated annual interest rate of
7%. What are your annual payments?
g) You have won a lottery and the officials offer you the choice of the following
alternative payouts:

Alternative 1: $10,000 one year from now

Alternative 2: $20,000 five years from now

Which one should you choose if the discount rate is (i) 10% or (ii) 20%? What rate
makes the options equally attractive to you?

ASSIGNMENT THREE:

Discuss the various short-term and long-term sources of funds available to

companies and businesses, highlighting their advantages and disadvantages.
SOLUTION
ASSIGNEMENT ONE

Question One:

a) Cost of the training program $ 50,000

Les tax savings (30% of 50,000) $ (15,000)
Initial cash outlay $ 35,000
Present value of the cash inflows will be as follows:
5,000 (PVIFA) + 15,000 (PVIFA) - (PVIFA)
= 5,000 (5.0188) + 15,000 (6,2593 – 5,0188) 15,10
= 25,094 + 18,607.50 = $ 43,701.5

To get the Net Present Value of cash inflows – Initial Investment

Therefore NPV = 43, 701.5 – 35,000 = $ 8,701.50
NPV = $ 8,701.50

Decision: undertake the training program since the NPV is greater than
zero (positive) or $ 8,701.50.

b) Initial Cash Outlay:

$ $
New equipment x
Market value of old equipment 20,000
Book value of new equipment (20,000)
Gain/loss 0
Tax consequences -
Net cash outlay x

Incremental Depreciation:
Year 1-5 6-8
New machine 0.2 x -
Old machine 2,500 2,500
0.2 x – 2500 (2,500)

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Cash flows $ $
Year 1-5 6-8
Savings 10,000 10,000
Less: Incremental depreciation 0.2x – 2,500 2,500
Savings before tax 12,500 – 0.2x 12,500
Tax @ 30% 0.3 (12,500 – 0.2x) 3,750
Savings after tax 0.7 (12,500-0.2x) 8,750
Add.Increamental depreciation (0.2x – 2,500) (2,500)
Annual cash flows 6,250 + 0.06x 6,250

Terminal cash flows:

Market value of new machine $
Less; Tax consequences @ 30% 5,000
Terminal cash flows (1,500)
$ 3,500
Discounting the cash flows:-
(6,250 + 0.06x) PVIFA 12%, 5YRS + 6,250 (PVIFA12%, 8YRS – PVIFA12%, 5YRS) +
3500 (PVIFA12%, 8YRS) =X

= (6,250 + 0.0 6x) 3.6048 + 6,250 (4.9676 – 3.6048) + 3,500 (0.4039)

=x

= 32,461.15 + 0.2163x = x
The price of new machine shall be $ 41,419.74

C SONY INTERNATIONAL

Year 1 2 3 4
$ $ $ $
Sales 40,000,000 80,000,000 80,000,000 60,000,000
Labour 30,000,000 30,600,000 31,212,000 31,836,240
Energy 1,000,000 1,030,000 1,060,900 1,092,727
Depreciation 8,000,000 8,000,000 8,000,000 8,000,000
39,000,000 39,630,000 40,272,900 40,928,967

Profit tax 1,000,000 40,370,000 39,727,100 19,071,033

Tax 30% 300,000 12,111,000 11,918,130 5, 721,309.90
After tax profit 700,000 28,259,000 27,808,970 13, 349,723
Add depreciation 8,000,000 8,000,000 8,000,000 8,000,000
Cash inflows 8,700,000 36,259,000 35,808,970 21,349,723.10
Inflation 9,135,000 38,071,950 37,599,418.50 22,417,209.26
Adjustments

Inflation adjustments are given by 1+R = (1+r) (1+i)

Where R = nominal rate
r = real rate
I = inflation rate

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R = [1+0.08) (1+0.05)] – 1
R = 13.4%

Year cash flows PVIF 13.4% PV

1 9,135,000 0.8818 8,055,243
2 38,071,950 0.7776 29,604,748.32
3 37,599,418.50 0.6857 25,781,921.27
4 22,417,209.26 0.6047 13,555,686.44
76,997,599.03
Initial cost 32,000,000

NPV = $ 44,997,599.03

D. 4, 000 PVIF = 4,000 X 0.0588 = $ 235.2

The price per acre will be $ 235.2

ASSIGNMENT II

A. Previous year earnings per share (EP0) = $ 10

Previous year dividends per share d0 = $ 6
Earnings per share next year EPS1 = $ 11
Dividends per share next year d1 = ?
Cost of capital (Ks) = 14%
Pay out ratio = 6 = 60% and g = 6.6 = 6.0 (1+g) = 0.1 or 10%
10

Therefore Dividends next year D1 = EPS1 x payout ratio = 11x6% = $ 6.6

Price of share p1 = d1/ Ks-g = 6.6 = $ 165
0.14 – 0.1
Shall be willing to pay $ 165 per share

B. i) price = present value of all supernormal growth + present value of price

After supernormal period

Thus
Period Dividends PVif14% PV
1 1.25 (1+0.08) = 1.350.8772 1.1842
2 1.25 (1+0.08)2= 1.458 0.7695 1.1219
3 1.25 (1+0.08)3 = 1.574 0.6750 1.0625
3.36

Present value after super normal growth

= 40 (pvif14%, 3years) = 40(0.6750) = 27

Price per share = 27 + 3.36 = $ 30.368

Price = $ 30.37

ii) P = d1 = 1.25 (1+0.08) = $ 22.5

Ks-g 0.14-0.08

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Thus if the cost of capital is 14% and growth is 8%, then the price of the share will be
$ 22.5

c) Calculation of the price of a bond if the market rate is

(i) 8%
Value of the bond (V) = I (PVifAin) + M (PVIfi, n)
Bonds per value = $ 1000, coupon rate = 8%, years to maturity = 20 years
with semi annual interest payments.

Therefore periodic interest payments = 4% x 1000 = $40

V= 40 (PVIFA) + 1000 (PVIF)
= 40 (19.7928) + 1000 (Doesn’t change since the market rate is equal to the
coupon rate)

ii) If the market rate is 10%

Then value of the bond (V) = I (PVIFAi, n) + M (PVIFi, n)
= 40 (PVIFA5, 40) + 1000(PVIF5, 40years)
= 40 (17.1591) + 1000(0.1420) = 828.36
Value of the bond (V) = $ 828.36

iii) If the market rate is 6%

Then V = I (PVIFAi, n) + 1000 (PVIFi, n)
V = I (PVIFA3, 40) + 1000 (PVIF3, 40)
= 40 (23.1148) + 1000(0.3066)
V = $ 1,231.19
Thus at 6% the value of the bond = $1,331.19

D) Value of firm (V) = x1

Ks-g
= 1,200,000(1-0.04)
0.16+0.04

E) 12,800 = 2000 PVIFA r, 10

= PVIFAr, 10 = 12,800 = 6.4
2000
PVIFAr, 10 = 6.4
From the tables r = 9%

F) Amount required in 5 years = $ 25,000

Instalments to be paid to an account charging 7% interest payment
2,500 = x PVIFA7%, 5Years
25,000 = 5.7507 x
X = 25,000 = $ 4,347.27
5.7507
The amount of yearly instalments to be paid = $ 4,347.27

G i) Alternative 1: To receive $ 10,000 a year from now

Alternative 2: To receive $ 2,000 five years from now
Evaluation of the alternatives at discount rate of 10%.
Present value of 10,000 at 10% received after a year
= 10,000 (PVIF10, 1) = 10,000 x 0.9091 = $ 9091
Present value of 2,000 received after five yeas at 10% discount rate
= 20,000 (PVIF10, 5) = 20,000 x 0.6209 = $ 12418

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Choice: choose 20,000 to be received in five years because the present value of
20,000 is higher ($ 12,418) compared to $ 10,000 received after one year whose
present value is $ 9019.

ii) At discount rate 20%

Present value of $ 10,000 received after one year
= 10,000 (PVIF20, 1) = 1,000 x 0.8333 = $ 8,333
Present value of $ 20,000 received after five years
20,000(PVIF20, 5) = 20,000 x 0.419 = $ 8038

Choice: take 10,000 be received after one year because the present value of 20% is
higher ($ 8,333) compared to that of $ 20,000 received after five years ($ 8,333).

The discount rate that makes the two options attractive:-

10,000 = 20,000
(1+r) (1+r) 5

10,000 (1+r) 5 = 20,000 (1+r)

20,000 = (1+r) 4
10,000

2 = (1+r) 4
r = 4√2- 1 (1.1892-1) = 0.1892
r = 18.9%
At 18.9% the two options shall be both attractive (the same)

INTRODUCTION

Firms make decisions on investment both in the short term as well as in the long term. These
decisions are require firms to commit resources in terms of people, materials, money and time.
A firm therefore seeks several sources of finance to meet their investment objectives. These
sources of funds can be classified both in the short term and long term.
This paper examines these sources of funds within the framework of their nature, advantages
and disadvantages.

LONG TERM SOURCES OF FINANCE

A. Equity Financing

Shares or common stock provide ownership rights to investors. Holders of common shares are
called shareholders or stockholders and are the legal of the company. Ordinary share are a
source of permanent capital since they do nod have a maturity date for the capital by
shareholders by purchasing shares they are entitled for dividends.

Merits of Equity
Since ordinary shares are not redeemable the company has no liability for cash associated with
its redemption. It is permanent capital and is available for use as long as the company trades.
• Equity capital increases the company’s financial base and thus its borrowing limit. Lenders
generally lend in proportion to the company’s equity capital. By issuing ordinary shares,
the company increases its financial capability.
• A company is not legally to pay dividends it times of financial difficulties. It can reduce
or suspend payment of dividends. Thus it can avoid cash flow associated with ordinary
shares.
• A company is not legally obliged to pay dividends it times of financial difficulties. thus
it can avoid cash out flow associated with ordinary shares

Demerits of Equity

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 • Shares have a higher cost for two reasons: dividends are not tax deductible as are
interest payments and floatation costs on ordinary shares are higher than those
on debts.
• Ordinary shares are riskier from the investor’s point of view as their uncertainty
regarding dividends and capital gains. Therefore, they require high rate of return.
• The issuance of new ordinary shares dilutes the existing shareholder’s earnings
per share if the profits do not increase immediately in proportion to the increase
in the number of ordinary shares. While shareholders have a pre-emptive right to
retain their proportionate ownership, they may not have funds to invest in
additional shares. The issuance of ordinary shares can change ownership.

B. Debentures:

A debenture is a long-term instrument or promissory note for raising loan capital. The
firm promises to pay interest and principal as stipulated. The purchasers of
debentures are called debenture holders.

MERITS
1. It involves less cost to the firm than equity financing because;
 Investors consider debentures as a relatively less risky investment
alternative and therefore require a lower rate of return.
 Interest payments are deductible.
2. It increases holders do not have voting rights therefore debenture issue does not
cause dilution of ownership.
3. Debenture holders do not participate in extraordinary earnings of the company. Thus
payments are limited to interest paid.
4. During high periods of inflation, debenture issue benefits the company. The
obligation of paying interest and principal, though fixed decline in real terms.
Demerits
1. Debentures may result in legal obligation of p [paying interest and principal, which, if
not paid, can force a company into liquidation.
2. It increases the firm’s financial leverage of paying interest, which may be particularly
disadvantageous to those firms with fluctuating sales and earnings.
3. Debentures must be paid on maturity and therefore at some point it involves
substantial cash flows.
4. Debentures indenture may contain restrictive covenants, which may limit the
company’s operating flexibility in future.

C. Preference Shares
Preference shares can be considered a hybrid security since they have features of both the
ordinary shares and the debentures.
They are similar to common shares in that:-
• The non payment of dividends does not force the company into insolvency.
• Dividends are not deductible for tax purposes.
• Has no fixed maturity date.
• Dividend rate is fixed whether the business makes profit or not.
• Preference shareholders have claims on income prior to ordinary shares.
• They usually do not have voting rights.
• It is a perpetual security therefore it does not have a maturity date.

They are similar to debentures in that:-

• Preference shares do not participate in residual income.
• The preference shareholders have claims on income and assets prior to that of
common shareholders.
• Preference shares do not voting except when the dividends have been accumulated
for several years.
Advantages
1. Preference shares provide a financial leverage, which is advantageous since
preference dividend is a fixed obligation. The non payment of these dividends does not
force the company into insolvency.

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 2. Preference shares provides sane financial flexibility to the company since it
can post pone payment of dividend.
3. Preference shares do not participate in excess profits, a do ordinary shares.
Therefore the preference dividend is restricted to a stated amount.
4. They do not have voting rights except in the case of dividends in arrears.

Disadvantages
1. Preference dividend is not tax deductible.
2. they have a cumulative attribute thus an obligation upon the company to pay

D. Leasing
Leasing is available through the granting of an asset to a company, which obtains full use of an
asset for a specific period of time in return for payment of regular charge. At the end of the
lease period (usually 99 years in Kenya) the owner may repossess the asset or the lessee may
get the option to purchase the asset or review the lease contract.

MERITS
1. Lease charges are tax deductible expenses thus will reduce the company’s tax
liability
2. the lessee enjoys the benefits of wear and tear which also reduces tax liability
3. There is no immediate cash outlay, the firm therefore reaps profits from an
investment it has not incurred i.e. no capital expenditure on its part.
4. in situation of economic recession e.g. with inflationary effects the firms leasing
the asset stands to gain in that the rental charges will be lower then due to effects of
inflation which reduce the real value of money.

DEMERITS
1. The periodic rental charges may outweigh the cost of the same as.
2. Lease finance entails implicit costs like maintenance and insurance.
3. Financing through leasehold is only limited to financing fixed assets and does not
have any provision for working capital.

E. MORTAGE FINANCE
This is a source of finance that is available to companies with freehold properties such as land
and buildings. It is an arrangement where the mortage agrees to give a specific sum of money
on the mortgagor on the strength of land or building acting as the security for this finance.
MERITS
1. Interest paid on mortgage is tax deductible/allowable expense thus it reduces a
companies tax liability.
2. The firm continues to use the asset mortgaged in its financing endeavours and at
the same time having received a lump sum of funds to finance its operations.
3. Later payments of mortgage loan due to the impact of inflation.

DEMERITS
1. Interest and principal repayments are legally binding to pay failure to which may
lead the borrower to receivership in the extreme.
2. It is expensive because it carries both explicit and implicit costs i.e. the interest
expense and insurance of the security respectively.
3. Mortage finance increases the company’s gearing level thus increasing financial
risks same time agrees to lease the same asset back at an agreed rental charge.
MERITS
1. It is easier to set up and does not involve tedious formalities thus very flexible.
2. Does not call for securities.
3. Does not affect the company’ gearing level and financial risk.

DEMERITS
1. It entails implicit costs such as repairs and maintenance of the leased asset.

G. INSTITUTIONAL INVESTORS
These are corporate companies, which avail finance for long –term use. They include trustee
companies, pension organizations, insurance companies. These avail finance in large

78
 quantities and usually do this to earn a return on the same finance or to acquire ownership
in those companies to safeguard their interest.

MERITS
1. They are cheaper to access this sort of finance because it will be available in large sums and
from a few companies e.g. floatation costs will be low.
2. Investors can rescue the firm if it is facing financial problems beyond the control of itself.
3. these institutions using their financial experience offer advisory services to the companies in
investment issue so as to utilise such finance more profitably

DEMERITS
1. They influence the firm’s dividend policy and as such this may be to the detriment of
smaller shareholders.
2. Investors with a majority shareholding use their voting rights in an advantageous
way which may lead to takeovers and acquisitions as they might support proponents
of takeover bids in particular if these are competitors.
3. They may disrupt the company’s running through the various they would want the
company to implement which may not be interest of the interest of the shareholders.

Source of SHORT-TERM FUNDS

Short-term sources of finance are arranged in advance from bank and other suppliers
recording it as debt.
Trade credit refers to credit that a customer receives from suppliers of goods in the normal
course of business. In practice the buying firm does not have to pay cash immediately for
purchases made. Trade credit is mostly an informal arrangement made or granted on an open
account basis. It may also take the form of bills payable. A bill is a formal acknowledgement of
an obligation to repay a specific sum of stated standing amount.

MERITS
1. It is relatively easy to obtain except in cases of financially unsound firms.
2. It is automatic and does not require negotiations.
3. Its easy availability is particularly important to small firms which generally face
difficulties accessing other sources of finance from the capital markets.
4. Trade credit is very flexible especially since it grows with growth of the firm’s
revenue figures.
5. It is an informal spontaneous source of funds.
6. The firm does not need to give security to acquire trade credit thus an advantage for
smaller firms which do not have assets to pledge.
7. It does not affect the gearing level of the company.
8. For most lending economies bank lending rates are higher than rates of discount
offered on trade credit.
9. Trade credit is partly cost free i.e. the supplier does not charge any interest if the
firm pays within the credit window. However there is an opportunity cost which is the
discount foregone.

DEMERITS
1. This source of finance is not reliable because in the event of default on buyer’s
side the seller might cut future credit by limiting the buyer from obtaining credit.
2. Availability of financing depends on the reputation of the debtor which might in
some cases be pegged to the size of the firm, smaller firms may be restricted
from obtaining credit.
3. It is normally restricted to working capital items and as such may not be
available to finance other activities like acquisition of fixed assets which affect
long-term profitability.

B. COMMERCIAL PAPER
Commercial paper consists of promissory notes of large companies, which are sold to other
businesses, insurance companies, pension funds or even individuals. The maturity of the paper
is usually several months. These securities can be easily sold in the money market. The
company that offers commercial paper must have a high reputation on credit worthiness. They
are normally restricted to large commercial firms, or treasury bills written by the government.

79
MERITS
1. The growing popularity of commercial paper can be attributed to the rapid growth of
the money market, mutual funds, insurances and the need to find securities for short
term investment.
2. The compensating balance requirements are associated with issuance of the CP
trough the firm is generally required to maintain a commercial bank relationship of
approved credit equal to the amount of the CP outstanding.
3. Firms enjoy the prestige associated with being able to float a CP at a lower rate than
that charged against short-term loans by commercial banks. Commercial paper is
normally sold at a discount rate.

DEMERITS
1. Though funds offered through issuance of CP are cheaper, they are very
unpredictable.
2. A firm may pay a higher rate of bank loan; it is also buying some degree of loyalty
and commitment that is unavailable in the CP market.
3. CPs limited to only large firms that are proven to be credit worthy.

C. SHORT TERM LOANS FROM COMMERCIAL BANKS

Commercial banks may offer or supply short-term funds in the form of overdrafts and Notes
payable.
1. Overdrafts: an overdraft is an arrangement made available to allow a company to
overdraw funds from its bank account in excess of the minimum balance. Some
interest is charged on the overdrawn amount.
2. Cash credit: this is interest on the credit granted.
3. Line of credit: this is a formal/informal that will be made available by the bank
within a specified period of time.
4. Notes payable: this involves discounting of commercial papers, bills of exchange
and promissory notes held by the company.

MERITS
1. They are highly negotiable instruments which can be easily liquidated at any time.
2. They are cheaper to obtain and finance. The discount rates are normally lower
than bank rates on loans.
3. No security is normally required in lines of credit.

DEMERITS
1. Banks require that a regular borrower maintain an average account balance equal to
a certain percentage of the outstanding loan.
2. There is a possibility of the negotiable instrument to be dishonoured by the drawer
and thus the drawer may have to offset or settle any liability incurred thereon.
3. Negotiability and thus liquidity as investment will depend upon the good will depend
upon the goodwill of the drawer which might lack in some cases.
4. They involve costs i.e. discounts which may be substantially high depending on
conditions prevailing e.g. stamp duty.

D. TRADE DEBTORS, ACCRUDE EXPENSES AND DEFERRED INCOME.

A firm can obtain discount debtors with a bank and obtain immediate finance. Debtors can also
be used a security for loans in particular overdraft facilities. Accrued expenses represent short-
term liability that a firm acquires for services already utilised. They therefore constitute
interest free sources of funds. They are accrues salaries & wages, accrued income taxes,
interest payable e.t.c

Deferred income represents funds received for goods and services that a firm has agreed to
deliver at some future date. These receipts increase the firm’s liquidity and therefore
constitute a source of finance e.g. insurance premium.

MERITS
1. They are interest free.

80
 2. Do not require any form of collateral.

DEMERITS
They are short-term sources hence they might not contribute to the company’s profitability, as
they cannot be used to acquire fixed assets.

81
 EXAMINATION QUESTIONS AND ANSWERS

UNIVERSITY OF NAIROBI

DEPARTMENT OF ACCOUNTING

DFI 501: FINANCIAL MANAGEMENT

TEST II 07/11/04 TIME: 2.00 – 3.30 PM

INSTRUCTIONS:

a. Attempt ALL questions.

b. Show all the necessary workings and computations.

c. Marks are allocated as shown at the end of each question.

QUESTION ONE: (31 Marks)

a. Discuss the Trade-off theory of capital structure

b. Kay and Gay Companies are identical in every respect, except that Kay
Company has Shs 10 million of 5% bonds outstanding, while Gay
Company does not use debt financing. Both firms have book assets of
shs. 20 milion,and they both expect to earn a 10% return on those
assets before interest and taxes. The cost of equity to Gay Company is
estimated to be 10%.

Assume that there are no corporate or personal income taxes and that
all of the MM assumptions apply.

REQUIRED:

(i) Compute the value of each firm (3 marks)

(ii) Compute the cost of equity for each firm (3 marks)

(iii) What is the market value of equity for each firm? (2 marks)

(iv) Calculate the WACC for each firm (3 marks)

a) Assume that all the facts hold as in (b) above, except that both firms are
subject to a 30% tax rate. (3 marks)

REQUIRED:

i) Compute the value of each firm (4 marks)

ii) Compute the cost of equity for each firm (3 marks)

iii) What is the market value of equity for each firm? (2 marks)

82
 iv) Calculate the WACC for each firm (4 marks)

b) Explain how MM used the arbitrage process to prove the validity of

proposition 1 when the company does not pay taxes. (5 marks)

QUESTION TWO: (26 marks)

a. Baggy Company is analyzing two proposed investment projects. A and

B. Each project has a cost of Sh 1,500,000 and the firm’s cost of capital is
12%. The projects’ expected net cash flows are as follows:

YEAR EXPECTED NET CASH FLOWS

PROJECT A PROJECT B

1 Sh 975,000 Sh 525,000

2 450,000 525,000

3 450,000 525,000

4 150,000 525,000

REQUIRED:

(i) Calculate each project’s Regular payback period, discounted payback period, Net
present value (NPV), internal Rate (IRR) and Modified Internal rate of Return
(MIRR). (16 marks)

(ii) Which project (s) should be accepted if they are independent? Mutually exclusive?
(2 marks)

b) Kentucky Company currently uses an injection moulding machine that was

purchased two years ago. This machine is being depreciated on a straight – line
basis towards a Sh 75,000 salvage value, and it has 6 years of remaining useful
life, its current book value is Sh 390,000, and it can be sold for Sh 450,000 at
time.

The Company is offered a replacement machine which has a cost of Sh 1,200,000, an

estimated useful life of 6 years and a zero salvage value. The company uses straight
– line method of depreciation on the new machine. The replacement machine would
permit an output expansion, so sales would rise by Sh 150,000 per yea; even so, the
new machine’s much greater efficiency would still cause operating expenses to
decline by Sh 22,500 per year. The Company tax rate is 30% and its cost of capital is
15%.

REQUIRED:

Should the old machine be replaced? (8 marks)

83
SOLUTIONS FOR TEST II 07/11/04

a) Trade-off theory of capital structure is when a firm considers

the benefits of using debt and companies to the costs/risks
associated with debt financing of bankruptly and agency costs
as well as financing distress.

K=levered

G = un – levered firm

K-Debt of 10 million, I = 5%

Book assets = 20m

EBIT = 10 x 20m = 2 m

100

Cost of equity to Gay K ev = 10%

K ev = 10%

i) Value of each firm

Let value of Gay be Vn = value of intervered

VG = E = EBIT

VG = 2,000,000 = 20 M

0.1

Value of Gay = VG = 20 M

Vk = value of k = Debt + Ek

Ek = EBIT

K eL

K et = K eu + (K en - i) (1-T) D/E

In this case both value of VL = VU.

= VL = VK = 20 M

i) Value of book firms’ = 20 M

84
ii) Cost of equity K eg =K eL

K eu= K eg = 0.1 = 10%

K eg = 10%

Also K eL =K eu + (K e u -i) D/E

K Ev = 10% + (10-5)10 M/10M

= 15%

K Ev = 15%

iii) Market value of equity

a) E Gay
=
EBIT/ E Keg
=
20 M Financing on equity only.

E kay = EBIT – iD = 2,000,000 – 0.5 x 10,000,000

K Ev 1.5

Vk = Debt +Ek

VK = 20 M = 10 M + EK

Value of equity, Ek = 10m

v) WACC = EBIT

WACCk and WACCG = 2,000,000 = 0.1

20,000,000

Both WACC = 10%

c) i) with taxes 30% rate

ii) Value of each firm

a) value of Gay VG = EBIT (1-T)

Keu

V unlevers = VGay = 2 m (1-0.3)

0.1

85
VG = 14 M

b) Value of levered Vk = VG = + TD

= 14m + 0.3 x 10 m

= 17 m

ii) Cost of equity

K eg = 10%

= cost of equity Gay = 10%

K ek =K eg + (K eg - i) (1-T) D/E

= 10% + (10-5) (0.7) x 10/7

= 15%

iii) Equity Values:

Equity Gay = 14 m

Equity Kay = 7 m

iv) WACC = EBIT (1-T)

WACC of Gay = 10%

WACC Kay = 2m (1-0.3) = 0.0323

17 m

= 8.23%

c) Arbitrage process is the process whereby investors will continue

to sell the shares of the higher valued firm as they buy the shares
of the less valued firm until an equilibrium is reached at when the
two firms will be equally valued. Under preposition 1, MM explains
that through arbitrage process the value to the value of the
unlevered firms.

ii) Regular pay back:

Initial investments = 1,500,000

86
 Project A Project B

975,000 525,000

450,000 525,000

450,000 525,000

150,000 525,000

Pay Back A = 2 years + 95,000 x 12 months

450,000

= 2.16 years

B = 2 years + 450,000

525,000

= 2. 857 years

ii) Discounted payback

PVIF A PV Project B PV

0.8929 975,000 870,577.5 525,000 468,772.5

0.7972 450,000 358,740 525,000 418,530

0.7118 450,000 320,310 525,000 373,685

0.6355 150,000 95,325 525,000 333,637.5

Discount payable 144,952 94,634

Project A = 2years + 270,683 = 2.845 years

B = 3 years + 239, 04.5 = 3.71 years

333,637

= 3.71 years

NPV for A = 144,952

NPV for B = 94,634

87
 IRR :B 525,000 PVIA r,L = 1,500,000

PVIFAR,L = 2.857

IRR = 15%

IRR for B = 15%

MIRR
n
Σ C of = nΣ CIF (1+K)Nn-t
t
= (1+k) (1+e)n

For A 975,000(1+0.12)3 + 450,000 (1.12)2 + 450,000(1.12)1 +

150,000 (1.12)0

1,000,000 = 1,369,804.8 + 564,480 + 504,000 + 150,000

(1+ MIRR)4

1,500,000 = 2588284

(1+ MIRR) 4

(1+MIRR)4 = 1.72552

MIRR = 4√1.725 – 1

= 0.1461

= 14.61%

Project B 525,000(1.12)3 +525,000(1.12) + 525,000 (1)

MIRR = 0.137 = 13.7%

Project B MIRR = 13.7%

ii) Accept project

If independent accept Both A and B

ii) If mutually exclusive: accept project A

It has a higher NPV and higher MIRR than the other project.

d) Salvage = 75,000

88
Bv = 390,000

MP = 450,000

New M/C cost = 1,200,000 6 years life zero salvage

Depreciate old M/C = 390,000 – 75,000

= 52,500

Dep of new M/C = 1.2 M – 0 = 200,000

Sales incremental Sh 150,000

Benefit reduced costs Sh 225,000

375,000

Benefits 375,000

Cost outlay=

Initial on of new 1,200,000

Disposal of old M/C 450,000

Add, Tax in gain 30% 18,000 (432,000)

Investment = Sh. 768,000

Benefits = 375,000

EBIT 375,000

Less

Earned after tax 262,000

Add dep. = 0.3 x 44,250

306,750

= 306,750 PVIFA15% 6 + 0

= 3.7845 X 306,750 = 1.160,895

89
 NPV = 1,160,898 – 768,000
NPV = 392,895 Hence Replace old machine as NPV >

UNIVERSITY OF NAIROBI
MODULE II DEGREE PROGRAMME 2003/2004

EXAMINATIONS FOR THE DEGREE OF MASTER OF BUSINESS

ADMINISTRATION

DFI 501: FINANCIAL MANAGEMENT

DATE: 3RD DECEMBER, 2004 TIME: 6.00 PM –

8.00 PM

INSTRUCTIONS:
a) Attempt ALL questions.
b) Show all the necessary workings and computations.
c) Marks are allocated as shown at the end of each question.

QUESTION ONE:
a Explain how the goal of stock price maximization is beneficial to
society
(6 marks)
b Distinguish between:
(i) Business and financial risks. (3 marks)
(ii) Systematic and unsystematic risks.(3 marks)
(iii) Capital gains yield and Dividend yield (3 marks)
c Explain the two propositions advanced by Modigliani and Miller (MM)
to explain the relationship between capital structure and the value
of a firm as well as cost of capital when there are corporate taxes.
(6 marks)
d Discuss the relationship between corporate ethics and shareholder
wealth maximization. (4
marks)

90
QUESTION TWO:
a Stocks A and B have the following historical dividend and price data:

STOCK A STOCK B
YEAR DIVIDEND YEAR-END PRICE DIVIDEND YEAR-END
PRICE
1998 - Sh 12.25 - Sh22.00
1999 Sh 1.00 9.75 Sh2.40 18.50
2000 1.05 11.00 2.60 19.50
2001 1.15 13.75 2.85 25.25
2002 1.30 13.25 3.05 22.50
2003 1.50 15.50 3.25 24.00

Assume that an investor holds a portfolio consisting of 40% A and 60% B.

REQUIRED:
i) Calculate the actual (realized) rate of return for each stock and for the
portfolio in each year from 1999 through 2003. (8 marks)
ii) Compute the Mean (average) return for each stock and the portfolio.
(3 marks)

b Raymond enterprises has the following capital structure, which it considers to be

optimal under present and forecasted conditions.

Debt 30%
Preferred stock 20
Equity 50

For the coming year, management expects after-tax earnings of Sh2.5 million.
Raymond’s pas dividend policy of paying out 60% of earnings will continue.
Present commitments from its banker will allow Raymond to borrow according to
the following schedule:

LOAN AMOUNT INTEREST RATE

Sh0 to Sh500,000 10%

Sh500,001 to Sh900,000 12%
Sh900,001 and above 14%
New preferred stock with a dividend of Sh11 can be sold to the public at a price of
Sh100 per share. Floatation costs of 5% will be incurred.

The current market price of its stock is Sh30 per share; its last dividend was Sh3
per share; and the expected growth rate is 5%. External equity can be sold at a
floatation cost of 15%. The company’s tax rate is 30%.

REQUIRED:
i) Determine the breaks in the MCC schedule. (4 marks)
ii) Compute the WACC in each of the intervals between the breaks (10 marks)

QUESTION THREE:

91
 a) Explain why capital budgeting decisions are important to the success
of a firm. (5 marks)
b) The BigBee bottling Company is contemplating the replacement of one
of its bottling machines with a newer and more efficient one. The old
machine has a book value of Sh1,200,000 and a remaining useful life
of 5 years. The firm does not expect to realize any return for scrapping
the old machine in 5 years but it can sell it now to another firm in the
industry for Sh530,000. The old machine is being depreciated towards
a zero salvage value.
b) Jane has been employed as the new credit manager for KINGORI Company and is
alarmed to find that the company sells on credit terms of net 90 days while industry
wide credit terms have recently been lowered to net 30 days. On annual credit sales
of Sh2.5 million, the company currently averages 95 days’ sales in accounts
receivable. Jane estimates that tightening the credit terms to 30 days of sales, and
the savings on investment in them should more than overcome any loss in profit. The
Company’s variable cost ration is 85% and the interest rate on funds invested in
receivables is 18%.

REQUIRED:
Should the Company change its credit terms? (7 marks)

c) Micro-tech Company is expanding rapidly, and it currently needs to retain all of its
earnings, hence it does not pay any dividends. However, investors expect Micro-tech
to begin paying dividends, with the first dividend of Sh3 coming three years from
today. The dividend should grow rapidly at a rate of 40% per year during years 4,5,6
and 7 after which the dividends should grow at a constant rate of 8% per year. The
required return on the stock is 15%.

REQUIRED:
Compute the value of the stock. (8 marks)

The new machine has a purchase price of Sh2, 350,000 an estimated useful life of 5
years, and an estimated salvage value of Sh290, 000. It’s expected to economize on
electric power usage, labour and repair costs, as well as to reduce the number of
defective bottles. In total, an annual savings of Sh510,000 will be realized if the new
machine is installed. The company’s marginal tax rate is 30%, and it has a 20% cost
of capital. The company uses straight-line depreciation.

REQUIRED:
Should the firm purchase the new machine? (8 marks)

c) KAJEMBE Company is considering two mutually exclusive investments. The

projects’ expected net cash flows are as follows:

YEAR EXPECTED NET CASH FLOWS

PROJECT A PROJECT B

0 Sh (468,000) Sh (636,000)
1 216,000 204,000
2 432,000 204,000
3 432,000 204,000
4 432,000 204,000
5 (288,000) (204,000)

REQUIRED:

92
Compute each project’s NPV, IRR and MIRR, assuming a required rate of return of
14%. (12 marks)

QUESTION FOUR:

a) KONGONI Company is considering changing its credit terms from 2/15, net 30, to
3/10 net 30, in order to speed collections. At present, 60% of KONGONI’S customers
take the 2% discount. Under the new terms, discount customers are expected to rise
to 70%. Regardless of the credit terms, half of the customers who do not take the
discount are expected to pay on time, while the remainder will pay 10 days late. The
change does not involve a relaxation of credit standards; therefore bad debt losses
are not expected to rise above their present 2% level. However, the more generous
cash discount terms are expected to increase sales from Sh1 million to Sh1.2 million
per year. The variable cost ration is 70%, the interest rate of funds invested in
accounts receivable is 12%.

REQUIRED:
Should the Company change its credit terms? (10 marks)

UNIVERSITY OF NAIROBI

DEPARTMENT OF ACCOUNTING

DFI 504: FINANCE MANAGEMENT

TEST THREE: 13/7/03

INSTRUCTIONS:

Attempt ALL questions

Show all the necessary workings and complaints.

Question One: (35 marks)

Jane a recent MBA graduate is planning to go into the wholesale building supply
business with her sister Winnie, who majored in building construction. The
firm would sell primarily to general contractors, and it would start operating
next January. Sales would be slow during the cold months, rise during the
spring, and then fall of again in the summer, when construction in the area
slows. The terms of sale are ‘’net 30’’, but because of special incentives, the
sisters expect 30% of the customers to pay on the 10th day following the sale,
50% to pay on the 40th day, and the remaining 20% to pay on the 70th day. No
bad debt losses are expected, because Winnie, the building construction
expert, knows which contractors are having financial problems.

Required:

Assume that on coverage, the sisters expect annual sales of 18,000 items at an
average price of sh 100 per item and a variable cost ratio of 75%. (Assume a 360 day
year)

What is the expected average accounts receivable level? (5 marks)

If the bank loans cost is 12%, what is the annual cost of carrying the receivables? (3
marks)

93
 Assume that now it is several years later. The sisters are concerned about the
firm’s current credit terms, which are now ‘’net 30’’. Gross sales are now running at
sh 1,000,000 a year and 80% of the firm’s paying customers generally pay full
amount on day 30, while the other 20% pay, on average, on day 40. 2% of the
firm’s gross sales end up as bad debt losses.

The sisters are now considering a change in the firm’s credit policy. The change
would entail changing the credit terms to ‘’2/10, net 20’’, employing stricter credit
standards before granting credit, and enforcing collections with greater vigour than
in the past.

The net expected result is for sales to increase to 1,100,000; for 60% of the paying
customers to take the discount and pay on the 10th day; for 30% to pay full amount
on day 20; for 10% to pay late on day 30; and for bad debt losses to fall from 2% to
1% of gross sales. The firm’s variable cost ratio will remain unchanged at 75% and
the cost of carrying receivables will remain unchanged at 12%.

Required:
Describe the four variables that make up a firm’s credit policy and explain how
each of them affects sales and collections. (8 marks)
Under the current credit policy, what is the firm’s Days sales outstanding (DSO)?
What would the expected DSO be if the credit policy change were made?
What would be the firm’s expected cost granting discounts under the new policy?
What is the firm increased change in the level of investment on receivables?
What is the incremental before tax profit associated with the change in credit
terms? Should the company make the change? (8 marks)

QUESTION TWO: (15 marks)

The ABC Company purchased a machine 5 years ago at a cost of sh. 1,000,000. It
had an expected life of 10 years at the time of purchase salvage value of sh. 100,000
at the end of 10 years. It is being depreciated by the straight –line method towards a
salvage value of sh. 100,000.

A new machine can be purchased for sh. 1,500,000 including installations costs. Over
its 5 year life it will reduce cash operating expenses by sh 500,000 per year. Sales
are not expected to change. At the end of its useful life, the machine is estimated to
be worthless. Assume straight-line depression for the new machine as well. The old
machine can be sold to day for sh. 650,000. The firm’s tax is 30%. The appropriate
discount rate is 15%.

REQUIRED:

Should the firm replace the old machine? (15 marks)

QUESTION THREE: (10 marks)

What are the primary implications of portfolio theory? (5 marks)

Explain, briefly the trade-off theory of capital structure. (5 marks)

SOLUTIONS FOR TEST THREE: 13/7/03

D SOo = 80% (30) + 20% (40) = 32 days

94
 DSO N = 60% (10) + 30% (20) + 10% (30) = 15 days
exp. Cost granting discounts under new policy.
= (PNSN- PODOSO)
= (60% x 99% x 1,100,000x 2%-0)
= 13068

Di = (DSON- DSO O SOO/360 + V(DSON) SN-SO

360
= (15-32) 1,000,000+ 0.75 (15) (100,000)
360 360
= 44,097

No discount
DP = (SN-SO) (1-VC)-BNSN –BOSO) – (PNSNDN- POSODO)-kd(Di)
= (1,100,000 – 1,000,000) (1 – 0.75) – (1%x1, 100, 000-0)
– 12% (- 44,097:2)

= 26,233.64 incremental profit

COST OF CAPITAL
Total Oil is planning a large expansion program during the coming
year, which is estimated to require $180 million of financing and to
yield a 16% return. No other projects are under consideration. Total Oil
wants to raise the funds in accordance with its target capital structure
shown hereunder:

Market values Debt 30%

Preferred 20

Common 50 amount of retained

Total Oil expects net earnings available to common shareholders this

year of 280 million, and the dividend payout ratio is expected to be
30%. The company has a marginal tax of 30%

External sources of funds:

Debt: up to $150 million can be raised at an 11% interest rate without

issue costs. Above that amount, the interest rate will be 14%

Preferred: Up TO $150 million can be sold at par value of $60 to yield

the investor 12%. Floatation costs are 4% on the first $150 million,
then floatation costs increase to 6%

95
Common: Current market price is $18 per share. The last dividend
was $1.50 and the expected growth rate is 12%. The floatation costs
are 8%.

Required:

What is the break point in the MCC schedule due to retained earnings
being used up?

What is the component cost of retained earnings? (7

marks)

What is the component cost for less than $150 million of preferred
stock? What is the component cost of preferred stock above this
amount? What is the break point due to low-cost preferred stock
being used up? (6 marks)

What is the component cost of up to $120 million of debt? What is

the cost above this point? What is the break point due to low-cost
debt being used up? (6 marks)

What is the component cost of new equity? (7 marks)

What is the marginal cost of $180 million of capital? Should the

expansion program be undertaken? (8 marks)

(Total: 34 marks)

SOLUTIONS FOR TOTAL OIL

Break point in the Mcc = Available capital

Weight of the capital

Hence

Break point of retained earnings = available RE

Weight of RE

To get retained earnings

After tax profit xx

Less preferred dividends (xx)

Profits available to

Ordinary shareholder xx 80

96
 Less ordn dividends

(dividend) payment ratio (xx) (30% of 30) 24

RE available xx 56

(a) Net earnings

P Br = 80 (1-30 0.3) or 56 = 112m

0.5 0.5

= 112m kg = DO (1+g) + g
P-*
(ii) kr = DO (1+g) +g P(1+F)
PO = 1.5 (1+0.2) +*
= 1.5 ((1+ 0.12) + 0.12 18(1-0.06)
18 = 0.2193
= 21.3%

= 22.03%
(b) (i) kp = annual dividends
Po - F
or
Po (1-F)
Annual dividends – par x dividend
Value rate
= 12% x 60=
Hence

Kp = 7.2 = 7.2
60 (1-04) 57.6
= 12.5%

(ii) Above & 150

kp = annual dividends
po (1-F)

= 0.12 x 60 = 7.2 = 12.77%

60 9(1-0.06) 56.4

Break point

Bpp = Available preferred stock

Weight of preferred stock
= 150 = 750m

97
 0.2
(c) (i) up to 120m effective cost of debt/after tax
Kd = kd (1 – tax)
= 11 (1-03)
= 7.7%

above 120m after tax cost debt or effective cost debt:

kd = 14 (1- 0.3)
= 9.8%

(iii) Bpd = available debt

Weight of debt

= 120 = 400m
0.3

competent cost of new equity

kg = DO (1+g) +g
po (1 –F)
= 1.5 (1 +0.12) + 0.12
18 (1-0.08)

= 2.62 + 0.12
10.56
= 22.1%

If the RRR is 16% is greater than the cost of capital then accept the
perfect as *

98
 UNIVERSITY OF NAIROBI
DEPARTMENT OF ACCOUNTING
DFI 501: FINANCIAL MANAGEMENT

MAKE – UP TEST DATE 23/03/03 TIME 2.00 – 3.30 P.M

INSTRUCTIONS:
c) Attempt ALL questions.
d) Show all the necessary workings and computations.
e) Marks are allocated as shown at the end of each question.

QUESTION ONE: (30 Marks)

Mumias industries currently sells on terms of 2/10, net 40”, with bad
debt losses running at 2% of gross sale. Of the 98% of the customers
who pay, 60% take the discount and pay on day 10, while 40% pay on
day 40. The firm’s gross sales are currently $ 1,000,000 per year, with
variable costs amounting to 60% of sales. The firm finances
receivables with a 10% line of credit and there are sufficient fixed
assets to support a doubling in sales.

The firm‘s credit manager has proposed that credit terms be changed
to ‘2/20, net 60’ and she estimates that this charge would increase
sales to $ 100,000. However, bad debt losses at the new sales level
would be 30%. It is expected that 75% of the paying customers would
take the discount under the new terms, paying on day 20, while 25%
would now pay on day 60.

REQUIRED:
a) What are the old and new Days sales outstanding? (4 marks)
b) Should the change in credit terms be made? (11 marks)
c) Assume that the firm’s competitors immediately react to
the change in credit terms by easing their terms. This causes
Mumias to gain no new customers; however, of the existing buyers
who pay (2% continue as bad debt losses), 75% now take the
discount and pay on day 20, while 25 % pay on day 60. What is
the effect on the firm’s pre-tax profits?
(7 marks)

d) Refer back to the original terms, collection experience and level

of sales. Suppose that the firm’s credit manager decides to
shorten the collection period by tightening the credit terms to
‘2/10, net 30’. Bad debt losses would remain at 2% of gross
sales and collection percentages are expected to remain at 60%
and 40%. However, this tightening of credit terms is expected to

99
 reduce gross sales to $ 900,000. Would this decision be
desirable? (8 marks)

MUMIAS INDUSTRIES
c) Days sales outstanding
∆0 = 60% (10) + 40% (40)
= 22 days

∆sn = 75(20) +25% (60)

= 30 days

d) Look at impact of profits

∆ Profit = (SN-SO)(1-rc) – (BN SN-B0 S0)= (PN SN ∆N – P0 S0 0∆) – kd (∆ I)

∆I = (∆ S ON -∆ S0 O) ( SN -360) + V(S00) (∆SN -S0)/ 360)

If sales are to decrease)

∆1 = (∆ S ON -∆ S0 O) ( SN -360) + V (∆S00) (SN -S0)/ 360)

∆1 = (30-22) 1,000,000 + 0.6 (30) (100,000-1,000, )

360 360

= 27,222.22 incremental debtors

∆P = (1,100,000-1,000,000)(1-0.6)-(3% X 1,100,000 -2%X1,000,000) –

(75% X 97% X 1,100,000 X 2% - 60% X 98% X 1,000,000 X 2%) – 10%
(27,222.22) = 20,032.778

Should change credit terms, because it will result in incremental profit

of 20,032.778

∆S0N = 75 (20)-25% (60) = 30 DAYS

∆I = (30-22) (1,000,000) + 0.6(30) (1M-1M)
360 360

= 22,222.22 New Debtors

∆P = (1m-1m) (1-0.6) – 2% x 1m – 2% x 1m)

(2% x 1m x 60% x 98%) – 10% (22,222.02)
= -5,162.22
Change should not be made because pre-tax profit goes down by
5,162.22
d) use decreased sales
∆I = (∆ S ON -∆ S O0 SN / 360 + V (-∆ S00 ) S N -S0 / 360

= (18-22) 900,000 + 0.6 (22) (900,000-1,000,000)

100
 4 360 360
- 10,000 – 3,666.06 = -13,667

Change in profit
∆P = (900,000-1,000,000) (1-0.6)- (2% X 900,000-2% X 1,000,000)-
(98% X60% X2% X 900,000 – 98% X 75% X 2% X 1,000,000) -10%
(27222.22) = 20032.775
Should change credit terms. Because it will result in incremental profit
of Ksh 20,032.778

∆S0N = 75 (20)-25 %(60)=30 Days

∆I = (30-22) (1,000,000)+0.6(30)(1M-1M)

360 360

= 22,222.22 New debtors

∆P =(1M-1M) (1-0.6)-2% X 1M -2%X1M) – (2% X 98%X1Millionx75%-

2%x1Mx60%x98%)-10%(22,222.02) = -5,162.22

Change should not be made because pre-tax profit goes down by

5,162.22

Use decreased sales

∆i= (∆SoN - ∆Soo) SN/360 +V(∆Soo) SN-SO

360

= (18-22) 900,000 + 0.6(22) (900,000-1,000,000)

4 360 360

- 10,000 -366,666 = -13,667

Change in profit

∆P = (900,000-1,000,000)(1-0.6)-(2%X900,000-2%X1,000,000)-
(98%X60%X2%X900,000-98%X76%X2%X1,000,000)-10%

101
DFI 501: FINANCIAL MANAGEMENT

ASSIGNMENT THREE

QUESTION ONE
ABC Limited has just developed a new product to be called X-2 and is
now considering whether to put it into production. The following
information is available:
Production of X-2 will require the purchase of new machinery at a cost
of $24 million payable immediately. The machinery is specific to the
production of x-2 and will be obsolete and valueless when that
production ceases. The machinery has a production life of 4 years and
a production capacity of 30,000 units per year.
Production costs of X-2 (at year 1 prices) are estimated as follows:
Variable materials $80 per unit
Variable labour 120 per unit
Variable overheads 120 per unit
Fixed cost (including depreciation) $8 million per year.
The selling price of X-2 will be $800 per unit (at year 1 prices). Demand
is
Expected to be 25,000 units per annum for the next four years.
The retail price index is expected to increase at 5% per annum for the
next four years and the selling price of X-2 is expected to increase at
the same rate. Annual inflation rates for production costs are expected
to be as follows:
Variable 4%
Variable labour 10
Variable overheads 4
Fixed costs 5
The company’s weighted average cost of capital in nominal terms is
expected to be 15%. The company’s tax rate is 30%.

REQUIRED:
Advice the directors of ABC Ltd whether it should produce X-2

QUESTION TWO
The owner of Makanga Ltd wishes to replace an old garage equipment
with a more efficient modern one. The book value of the old equipment
is $30 million it has a remaining economic life of 5 years. Its current
market value is $18 million and it has a zero salvage value after 5
years. The new equipment costs $66 million, will have an estimated
economic life of 5 years and an estimated salvage value of $12 million.
Annual cost savings amount to $30 million before tax and depreciation.
The company’s marginal tax rate is 30% and its cost of capital is 20%.
Assume straight-line depreciation.

102
REQUIRED:

Using the NPV criterion, should the old equipment be replaced?

QUESTION THREE:
Discuss the various long-term and short-term sources of funds,
indicating their advantages and disadvantages.

QUESTION TWO
Book value & 30 million
Remaining life = 5 years – salvage DEP old = 6m
Market value = 18m

New equipment Depr New = 66 – 12 = 10.8

Life = 5 years 5
Salvage = 12M
Annual salvage before tax and depr = 30m
Tax rate= 30%
cos of capital = 20%

Cash outflows
Year 108
0 (66m) 6
4.8
* proceed 18
48m 48m
Loss of 1.2m
Tax shield 30%x12 3.6 m
44.4m

Cash inflow
Year Savings change savings before tax Tax Saving after
Depr. Tax
1 30 4.8 25.2 7.56 17.64
2 30 4.8 25.2 7.56 17.64
3 30 4.8 25.2 7.56 17.64
4 30 4.8 25.2 7.56 17.64
5 30 4.8 25.2 7.56 17.64
Xxx
Savings after tax Add ds Cash flow 20% PV
1 17.64 4.8 22.44 0.8330 18.6
2 17.64 4.8 22.44 0.69440 15.5
3. 17.64 4.8 22.44 0.5787 12
4. 17.64 4.8 22.44 0.4823 10.8

103
5. 17.64 4.8 22.44 0.1019 9.02
*
67.10
12m (0 4019) 4.82
71 925

NPV =∑ P.V cash inflow – cash out flaw

71.925

27.525
Decision criteria
The equipment should be replaced because it has a position not go
present value
Therefore accept.

QUESTION ONE S.P – selling price

Depreciation 24 = 6m V.m – variable *
4 V.L – Variable *
V.O – Variable ove
*
Year S.P V.M V.L V.O TVC
0 0 0 0 0 0
1 * 89 120 20 320
2 840 832 * 12.48 360
3 832 80.53 145.2 129.72 36*52
4 920 89.99 159.98 134.98 38*

Revenue = spx quotation (25 000) DT = 6m x 0.3

Variable cost = v.c quantity (25,000) = 1800*
VC = VM +V.L +0.6

Advice
The directors should put the new product into production.
a) MOGOTHO Company’s annual cash requirements average about
Sh 1,000,000 per year. It costs about sh 5 per transaction to transfer
funds between the cash account and the marketable securities
account, and the current interest rate on marketable securities is
about 5%
REQUIRED:
Use the Baumol model to calculate the optimal transfer amount
between cash and marketable securities (3 marks)
What is the company’s average cash balance? (2 marks)
How many transfers would be required in a year? (2 marks)
What is the total cost associated with the average cash balance? (3
marks)

104
 What is the total cost associated with the average cash balance? (3
marks)
Are economies of scale in cash management implicit in the Baumol
model?
(2 marks)
What assumptions underlie the Baumol model? (2 marks)

SOLUTIONS
Annual cost requirements = sh 1000 000
Transfer costs sh 5/ transactions
Interest is 5%

optimal size and transfer = √2 x 1000 000 x 5

5%
= sh 14,142

ii) AV. Cash balance = sh 1000000

360 14,142 = 4,071
= sh 2,778 sh 2778 2

iii) Transfer = Sh 1000 000 =71

14142

Costs
= (71x5) + (5% x14142) = sh 708

UNIVERSITY OF NAIROBI
MODULE II DEGREE PROGRAMME 2004/2005

EXAMINATIONS FOR THE DEGREE OF MASTER OF BUSINESS

ADMINISTRATION

DFI 501: FINANCIAL MANAGEMENT

DATE: 3RD APRIL, 2000 TIME: 6.00 PM – 8.00 PM

INSTRUCTIONS

(a) Attempt All questions.

(b) Show all the necessary workings and computations.
(c) Marks are allocated as shown at the end of each question.

QUESTION ONE:

(a) What is the difference between stock price maximization and profit
maximization?

105
 Under what condition might profit maximization and Not lead to
stock price?

(b) Describe THREE ways by which funds cam be transferred between savers
and borrows.

© Discuss the trade-off theory of capital structure.

(d) Explain the FOUR credit policy variables.

QUESTION TWO:

(a) Makala Company, a product of generators is in the situation described below.

EBIT Ksh8,000,000
Debit outstanding Ksh4,000,000
Share of common stock outstanding Ksh1,000,000
Book value per share Ksh10
Interest rate on debt Ksh10%
Cost of equity Ksh15%
(Tax rate) Ksh30%

Since Makala Company’s product market is stable and the company expects no
growth, all earnings are paid out as dividends. The debt consists of perpetual
bonds.

REQUIRED:

IComputer the RPS and price per share for Makala Company. (5 Marks)
ii. Computer Makala’s WACC. (5 Marks)

iii Makala Company can increase its debt by Ksh8,000,000 to Sh12,000,000

using the new debt to buy back and retire some of its shares at the current price.
Its interest rate on debt will be 15% (it will have to call and retire old). Its cost of
equity will rise to 18%. EBIT will remain constant. Should the Company change
its capital structure?

(b) Dowell Industries sell on terms of 3/10, Net 30. Total sales for the year are
sh912,500. 40% of the customers pay on the 10th day and take discounts, while the
other 60% of the customers pay on the 10th day and take the discounts, while the
other 60% pay, on average, 40 days after their purchases.

REQUIRED:

i. Computer the Day’s Sale Outstanding. (2 Marks)

ii. What is the average amount of receivables? (3Marks)

106
 iii. What would happen to average receivables if Dowell toughened up on its
collection policy with the result that all non-discount customers paid on
the 30th day? (3Marks

QUSTION THREE

The condensed Balance Sheet for Kitui Company is given below:

2004
Ksh
Current assets 25,000,000
Net fixed assets 35,000,000
Total assets 60,000,000
========

Current Liabilities 10,000,000

Long-term debit 14,000,000
Preferred Stock 4,500,000
Common stock 16,000,000
Retained earnings 15,500,000
Total liabilities and equity 60,000,000
========

The company’s EPS last year we Sh3.20; the stock sells for Sh55; and last year’s
dividend was Sh2.10. A floatation cost of 15% would be required to issue new common
stock. The preferred stock pays a dividend of Sh3.30 per share and new preferred stock
could be sold at a price to net the company Sh 30 per share. Security analysts are
projecting that the common dividend will grow at a rate of 9% per year.

The firm can issue additional long-term debt at an interest rate of 12% and it is marginal
tax is 30%. The market risk premium is %5; the risk-free rate is 6% and the company’s
beta1.12.

REQUIRED

Computer the firm’s WACC. (13 Marks)

(b) Komoro Company paid a dividend of Sh3 last year. The earnings and dividends
are expected to grow at a rate of 8% indefinitely. The company ha a beta co-
efficient of 1.5, the yield on Treasury bonds is 8% and the average rate of return
on the market is 12%.

REQUIRED

107
 i. Compute the firm’s stock price. (4 Marks)
ii. Compute the expected dividend yield the capital yield and the total return during
the first year. (2 Marks)
iii. Assume that Komoro Company is expected to experience super-normal growth of
30% for the four years, then to return to its long-run constant growth rate 8%.
What is the next stocks value under these conditions?
(6 Marks)

QUESTION FOUR

The staff Heymann manufacturing has estimated the following net cash flow and
probabilities for a new manufacturing process.

YEAR NET CASH FLOWS

P=0.2 P=0.6 p=0.2

Sh Sh Sh
0 (100,000) (100,000) (100,000)
1 20,000 30,000 40,000
2 20,000 30,000 40,000
3 20,000 30,000 40,000
4 20,000 30,000 40,000
5* 0 20,000 30,000

* Line 5 contains the estimated salvage values.

Heymann’s cost of capital is 10%.

REQUIRED

Compute the project’s expected NVP (8Marks)

QUSTION FOUR:

NPV =30,000 Pulf a y 18,000 Pulf – 100,000

10% 5 years 10 5 years
=30,000 x 3.7908 + 18000 x 0.6209 – 100,00
=24,900.2

(b) Kentucky mining Company is deciding whether or not to open a strip mine, the
net cost of which is Sh2 million. Net cash inflows are expected to be Sh123
Million, all coming at the end of year 1. the land must be returned to its natural
state at a cost of Sh 12 Million, payable at the end of year 2.

108
REQUIRED:

i. Should the project be accepted if k = 10%? If K = 20% (5Marks)

ii. What is the project’s MIRR at K=10% At K=20%? Does the MIRR lead to the
same accept/reject decision as the NPV method? (8Marks)

© Task Company’s bonds will mature in 10 years. The bonds have a face value of
Sh10,000 and an 8% coupon rate paid semi-annually. The price of the bond is
sh11,000. What is the yield to maturity (YTM)?

i. (2) + 13 pulf – 12m pulf

10% 1 yrs 10 2 yrs

-2 + 13 (0.9091)-12 (0.8264) =-0.0985m

(98,500)
(2) + 13 pulf – 12m pulf
20% 1yr 20% 2yrs

-2 + 13 (0.8333)-12 (0.6944) =0.5001m

500,100
======
(ii) 0 (2m)
1 13 Profcot = T.V
2 +1
3 (12m)

Profcost = 2m + 12(0.8264) =11.9168m

T.V =13(1.1) =14.3 1+1m1nR =1.0943]

Profcosts = T.V
(1 +m1rr0 m1rr =9.54%
======
11,916,800=14,300,000
(1+m1RR)

(1+m1Rn)=1.199986

109
SOLUTIONS FOR 3RD APRIL, 2000

Q1(c)

(C) Trade Off Theory Of Capital Structure

The optimal capital structure is found by balancing the tax shield benefits of leverage
against the financial distress and agency costs of leverage. This is a trade off between
marginal costs and benefits of debt financing and the result is an optimal capital structure
that falls between 0 and 100% debt.

1 (d.) Credit Policy Variable

• Credit period is the length of time that buyers are given to pay for their purchases.
• Credit standards refer to the minimum financial strength of acceptable credit
customers and the amount of credit available to different customers.
• Collection policy is measured by the toughness or laxity in following up slow paying
accounts.
• Any discounts given for early payment, including the discount amount and the period.

Q1

- To achieve profit maximization, the financial manger takes only those actions that are
expected to contribute to the firms overall profits. For each alternative being
considered, the financial manager would select the one that is expected to result in the
highest monetary return. Profit is therefore measured in terms of earnings per share
(EPS) , measured by dividing the total earnings by the number of common shares
outstanding.
- Stock price maximization aims at maximizing the wealth of stocks holders, which is
Measured by the price of the stock prices are based on the timing of cash flows or
returns, their magnitude and their risk financial managers in maximizing stock
process accept only those actions that increase share prices because share price
represents the owners wealth in the firm.

- Under what conditions may profit maximization not lead to share price
maximization?

- Cash flows –maximum profits do not necessarily result in cashflows available to

stockholders and firms may experience high earnings that do not translate into high
stock prices.
- Risk- profit maximization disregard risk and a trade off exists between return and
risk. Higher cashflows are associated with higher share price-while higher risk results
in lower share prices, where risk is involved stockholders expect higher rates of return
on investments.

110
1 (b) ways in which funds are transferred between savers and borrowers:-
• Direct transfers of money and securities where a business sells its securities directly
to saves. Firms deliver securities to saver who in turn give the firm the money it
needs
• Investments bank – serves as a middleman facilitating issuance of securities. Firm
sells stocks and bonds to investments bank which in trun sell these securities to
savers.
• Through financial intermediaries. Banks and mutual funds are intermediaries that
obtain funds from savers, issue them with their own securities and then use the money
to purchase other securities. Because of their large size, they can pool risks and help
savers diversify. Intermediaries include commercial banks investment banks,
insurance companies and saccos.

QUESTION FOUR:

a). Npv =38,000 Pvif A + 18,000 Pvif - 100,000

10%5yr 10%5yr

= 30,000 x 3.7908 + 18,000 x 0.6209 - 100,000

= 24,900.2

b) (2) + 13Pvif – 12m P v i f

10%1yr 10%2yr

-2+13(0.9091) – 12 (0.8264)= -0.0985m

(98,500)

(2) + 13 pvif – 12m Pvif

20%1yr 20%2yrs

-2+13(0.8333) –12 (0.66944) = 0.5001m

=500,100.

ii) 0 - (2m)
1.13 Pv of cost = t.v
2-(12) 1-MIRR

Pv of cost = 2m +12 (0.8264) = 11.9168m

T.v =13 (1- 1)1 = 14.3

111
Pv of cost = T.V
(1+MIRR)N

11,916,800 = 14,300,000
(1+MIRR)N

Q4

1+mirr = 1.09543
MIRR = 9.54%

For 20% - Pv of costs = 2m +12 (0.6944)=10.3328

TV = 13(1.2)1 = 15.6

10,332,880 = 15,600,000
(1+1MIRR) 2
2
(1+MIRR) = 1.5097

1+ MIRR = 1.2287
MRR = 22.87%

C).Y T M = Interest + Per value-market

No of yr’s

Per value + market

2

= 400 + 10,000 – 11,000

20

10,000 + 11,000
2
350 = 0.033
10,500

=6.7%

112
QUESTION TWO

E.) EXIT 8,000,000

INTEREST 400,000

E. BT 7,600,000

TAX 30% 2,280,000

5,320,00
EPS = 5,320,000
1,000,000 = SH. 5.32 per share

E = (EBIT – ID) (1-T) = ( 8m - 0.1 X 4M) (1-0.3)

Ke 0.15

= 35,466,667
Price per share =35.46 per share

ii.) Kd = 10% (1 – 0.3) = 7%

ke = 15%
V = D+E
=35,666,667

WACC = EBIT (1-T) = 8M (1 – 0.3)

V 39,466,667

WACC = 14.189%

iii.) E= (EBIT – IB) (1-T) = (8m – 0.15 x 12m) (1-0.3)

Ke 0.18

= 24,111,111.

Q2

V = 24,111,111 +12,000,000

=36,111,111

113
Do not charge the capital, structure value of the firm has decreased.

b (i) Do = 3%
So= 912,500
Dso = 40%x10%+60%x40% 28days

(ii ) D1 =(DSon – DS00) 30 + VD SON (SN – S00)

300 300

(28 – 0) 0 + 0 (28)
300

=0

iii) DSON = 40% X 10 + 60% x 30 = 22

D=3 g=8 beta 1.5 field =8% market =12%

Cost or required rate of return
r= 8 + (12 –8) 1.5 = 14%

r = D (1+g) + g
P

0.14 = 3 (1.03 ) + 0.08

p

0.06 = 3.24 p = 3.24 = 54

p 0.06

Price = sh 54
(ii) Dividend field

D 1 = 3 x 1.08 = 3.24

Price = 3.24 (1.08) = 58.32.

0.14 – 0.08
capital gain = 4.32.

total return =(3.24 + 4.32) PVIF 14% = 6.63

Total return = 6.63 = 12.28%

54

Dividend PV

114
D1 3 X 1.3 = 3.9 0.8772 3.421

D2 3 X (1.3) 2 = 5.07 0.7695 3.901

D3 3 X (1X3) 3 = 6.591 20.6750 4.449

D4 3(1.3) 4 = 8.5683 0.5921 5.126

16.896

Price after yr F. = 8.583 (1.08) = 154.2294

0.14 – 0.08

per of price =91.319

add PV of dividend =16.896

stock value = 108.215

QUESTION 3

Eps =3.2 Price = 55 D 2.1 F= 0.15 x 55 = 8.25 g = 9%

Kd = 12% Tax 30% mrk (1) = 5% R f = 6 % k Beta 1.12

Cost of retained earnings = D ( 1+gd) + g.

P
= 2.1 (1.09) = 13.16%

55
cost of common stock
ks = D (1+g) +g

p-f

= 2.1 (1-09) + 0.09 = 13.90%

55 –8.25

cost of preference stock D = 3.30 =11%

P 30

115
Cost of debt after tax =

Kd = rf+b (Mr-Rf)
=6% + 1.12 (11.0 –6) = 12.6%

WACC proportion

Debt 14,000 ,000 28%

Preferred 4,500,000 9%
Common 16,000,000 32%
Retained 15,400,000 31%

50,000 ,000

WACC = (0.28 X 11.6 ) + (0.09 X 11 ) +(.032 X 13.9 )+(0.31 X 13.16 )

WACC = 12.7656% = 12.77%

116