1

Advanced Finance
for Non-Finance
Managers
Mar 25 Mar 29 / 2006
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Objective
This workshop is designed for non-finance
managers and employees in all types of
functions and industries in both public and
private sectors.
Will familiarize you with the main accounting
and finance principles. Specifically, this
workshop will:
Make you understand the terminology of finance and
accounting
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Objective Contd
Introduce you to financial statements
Explain the components of the balance sheet and income
statements
Use ratio analysis to analyze financial statements
Develop a better understanding of the finance function and the
basic principles underlying financial accounting
Develop a more productive working relationship with
accounting and finance staff to enhance your value to the
organization
Understand the various pricing methods and time value of
money
Applying the acquired knowledge to make various financially
sound decisions about project appraisal, feasibility studies,
and acquisition valuations.
Apply budgetary controls efficiently
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FINANCIAL DIRECTOR
TREASURER
(1)
MANAGEMENT
ACCOUNTANT
(2)
INTERNAL
AUDIT
(3)
IT
(4)
SECRETARIAL/
LEGAL
(5)
FINANCIAL RECORDING
PREPARATION OF
FINANCIAL ACCOUNTS
TAX PLANNING
SECURITY OF ASSETS
CASH MANAGEMENT
CREDIT CONTROL
BUDGETTING
MANAGEMENT
CONTROL REPORTS
COSTING
PROJECT EVALUATION
INTERNAL CHECK
LIASON WITH
EXTERNAL AUDITORS
LIASON WITH IT
BUSINESS SYSTEMS
REVIEW
FINANCIAL
MANAGEMENT
INFORMATION
DEVELOPMENT AND
CONTROL OF IT
ACTIVITIES
TRAINING PROCEDURE
MANUALS
SHAREHOLDER
MATTERS
MINUTES OF BOARD
MEETINGS
INSURANCE
LIASON WITH LEGAL
ADVISORS
LEGAL REPORTING
Functions 3+4+5 in some organisations may report to different heads
- Internal Audit C.E.O.
- Secretary to the Board to the Chairmans Office
- IT may have a separate board position
FINANCIAL DIRECTOR
TREASURER
(1)
MANAGEMENT
ACCOUNTANT
(2)
INTERNAL
AUDIT
(3)
IT
(4)
SECRETARIAL/
LEGAL
(5)
FINANCIAL DIRECTOR
TREASURER
(1)
MANAGEMENT
ACCOUNTANT
(2)
INTERNAL
AUDIT
(3)
IT
(4)
SECRETARIAL/
LEGAL
(5)
FINANCIAL RECORDING
PREPARATION OF
FINANCIAL ACCOUNTS
TAX PLANNING
SECURITY OF ASSETS
CASH MANAGEMENT
CREDIT CONTROL
BUDGETTING
MANAGEMENT
CONTROL REPORTS
COSTING
PROJECT EVALUATION
INTERNAL CHECK
LIASON WITH
EXTERNAL AUDITORS
LIASON WITH IT
BUSINESS SYSTEMS
REVIEW
FINANCIAL
MANAGEMENT
INFORMATION
DEVELOPMENT AND
CONTROL OF IT
ACTIVITIES
TRAINING PROCEDURE
MANUALS
SHAREHOLDER
MATTERS
MINUTES OF BOARD
MEETINGS
INSURANCE
LIASON WITH LEGAL
ADVISORS
LEGAL REPORTING
Functions 3+4+5 in some organisations may report to different heads
- Internal Audit C.E.O.
- Secretary to the Board to the Chairmans Office
- IT may have a separate board position
5
PAST NOW FUTURE
FINANCIAL
ACCOUNTS

MANAGEMENT
ACCOUNTS

FINANCIAL
DECISION
MAKING

Recording of a) Costing systems a) Capital investment
financial b) Budgetary Control appraisal
transactions c) Standard costs b) Cash flow analysis
d) Contribution c) Cost benefit
accounting techniques
e) Strategy management d) Financial evaluation
accounting of corporate strategic
alternatives
e) Evaluation of funding
options
ACCOUNTANCY

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MODULE 1

The Construction of Financial
Statements & Their Interpretation
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The Accounting Entity
Accounting of entities must be kept separate
from those outside the entities, and even
separate from its owners.
Otherwise, the accounting records will be
biased and do not reflect the true financial
position of the entity.
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Accounting Statements -
The Language Of Business
The financial accounting statements convert to
monetary terms the activities of a business.
Accounts are prepared to make available to
interested parties information as to transactions
that have taken place over a period and
information as to the financial position of a
business at a given date, including net cash flow
generated.
These accounts are respectfully called: the
Profit and Loss Account, the Balance Sheet, the
funds flow or cash flow statement, and Retained
Earnings.
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Accounting Statements -
Contd
The form of accounts will vary in accordance
with the information a company wishes to
disclose.
Published accounts to be made available to the
shareholders of a company often contain only the
minimum information which is legally required to be
disclosed.
Whereas accounts prepared for management will
disclose all relevant information required by management
to support the planning and control of each business
activity.
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Financial Statements
Balance sheet provides a snapshot of a firms
financial position at one point in time.
Income statement summarizes a firms revenues
and expenses over a given period of time.
Statement of retained earnings shows how
much of the firms earnings were retained, rather
than paid out as dividends.
Statement of cash flows reports the impact of a
firms activities on cash flows over a given period of
time.

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Uses of Accounting Statements
1. Shareholders / investors
2. Suppliers of Goods & Services
3. Banks and Bond holders
4. Taxation
5. Management
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Double Entry
We need to understand the DOUBLE ENTRY
concept because all accounting is based on it.
Double entry means that each transaction must
have debit and credit entries. Also, the sum of
debits must equal the sum of credits in EACH
transaction.
The double entry principle is based on each
accounting transaction affecting:
at least two items and some affect three or more
After a transaction is recorded, the total of the assets side
on the balance sheet always equals the total of the
equities and liabilities side.

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Chart of Accounts
The chart of accounts is a numbered hierarchical
list of all accounts and their sub-accounts used in
transactions that are related to all financial
statements such as the balance sheet and income
statement.
The chart of accounts provided several levels of
details depending on the needed detail per
category.
All of the transactions debits and credits must be
numbered according to the chart of accounts so
that accounting and financial information is readily
obtained, summarized, and analyzed correctly.
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Journals And Ledgers
In a manual accounting system, the debits and
credits for each transaction are first entered in a
book called a journal.
Later on, the journal entries are copied, or posted
to another book called the ledger.
The journal lists the transactions in the order in
which they occur, while the ledger contains a page
for each account.
Each account in the system has an identifying
number.

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Distinction Between Assets and
Expenses
Asset: an item that benefits the entitys
future periods. Examples include land,
buildings, furniture, equipment, cars, etc.
Expense: an item that is used up in the
current period. Examples include salaries,
utility bills, etc.

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Distinction Between Assets and
Expenses Contd
These rules are not followed exactly. Some
items that theoretically should be assets are
recorded as expenses. For example:
Pencils are expensed because the amount of record
keeping it as an asset is not worthwhile. Such items
can include small tools, supplies, and similar items.
Some companies even expense insurance policies
even though it covers a whole year.
In making these choices, we are applying the
materiality principle which is an accepted
accounting principle.
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Distinction Between Assets and
Expenses Contd
Materiality Principle: an entity can depart
from the accrual principle if the effect on
accounting information is NOT material and
does NOT mislead users of such information.
This leads to reduced record keeping.
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COST ALLOCATIONS
Some costs that the entity incurs during a period
may be debited to more than one expense or asset
account. For example, if an entity is separated into
departments or cost centers, then fractions of the
cost should be allocated to the different
departments. This process is called cost
allocation.
The basis for cost allocation is that each purpose
should bear its fair share of the total cost.
Charge each department/project only with the
expenses that can be traced directly to it.
Record all other expenses as general expenses.
These other expenses are called overhead.

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Balance Sheet
Some regard the balance sheet as the most
important individual financial statement. It shows,
as of a certain date and in summarised form,
the capital employed in the business and the various sources
from which the capital is derived
as well as the manner in which that capital is employed (or
invested in fixed or current assets).
Expressing it another way, the balance sheet lists:
what the business owns: fixed and current
and the sources of money which have made possible the
acquisition of those assets.
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Balance Sheet Contd
The money to acquire assets is normally
available from a number of sources:
(a) Capital subscribed by the shareholders or
stockholders (equity)
(b) Long term loans and other long term payables,
deferred taxation (debt or liabilities)
(c) Short term loans such as bank overdrafts, trade
and other payables (debt)
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Balance Sheet Equation
The balance sheet is the fundamental accounting
equation and has two sides:
Assets = Liabilities + Equities
The left-hand side is called the assets side. Amounts on this
side show the resources owned by the entity.
The right-hand side shows the amount of funds supplied to the
entity from various sources such as owners and creditors.
In the balance sheet, the total of the assets side is
always equal to the equities plus liabilities side.
This is why we call it a balance sheet.

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Items of Balance Sheet
Assets: Current Assets, Fixed Assets, and
Accumulated Depreciation
Current Assets: comprise inventory, receivables,
Short Time investments, prepaid expenses, and
cash in banks which have been acquired for the
purpose of conversion into cash together with
whatever balance of cash is held to finance day-to-
day operations.
Fixed Assets: are those held by a business for the
purpose of earning revenue directly or indirectly, and
NOT for the purpose of resale in the ordinary course
of business. Examples include land and buildings,
processing plant, computers etc.
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Items of Balance Sheet Contd
Depreciation: The purpose of depreciation is to spread
the original cost of a fixed asset over its expected useful
life.
Thus, if a piece of equipment costs, say $100, and is
expected to last for ten years, then depreciation at the rate
of $10 per year is charged to the profit and loss account as
a cost-depreciation.
Instead of crediting the asset account directly when
debiting the depreciation expense account, the credit is
entered into a contra account called Accumulated
Depreciation.
With this procedure, the balance sheet reports both the
original cost of the asset and the accumulated
depreciation to date.
The difference between Accumulated Depreciation and the original
cost is called Net Book Value.
When Accumulated Depreciation builds up so that it equals the
original cost of the asset, we stop recording depreciation expense.
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Items of Balance Sheet Contd
Current Liability: Accounts Payable,
Short term debts, and Accruals
Accounts Payable: trade payables and accrued
expenses - amounts due for goods and services
supplied on credit
Short term Debts: bank overdrafts, and other short
term loans -loans to company to finance current
trading activities
Accrued provisions: for wages, taxes, and dividends
that are payable within one year.
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Items of Balance Sheet Contd
Long Term Liabilities: bonds, debentures and permanent
loans (debt)
Equity: Equity or Net Worth, is the capital invested by the
shareholders and consists of share capital, reserves and
cumulative retained profits:
Share Capital: issued and paid up capital (or shares)
Capital reserves: increases in the value of assets, premiums on
issue of shares - revaluation gains - non operational gains
Retained Earnings: revenue reserves or retained profits or earnings -
undistributed profits which have been set aside for permanent use in
the business - operational gains
The final net profit or income expressed as a % of the equity
provides the best measurement of how well the
shareholders capital is managed. This measurement is
called ROE or Return On Equity profit available to
shareholders as a percentage of equity.
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Structure of a Balance Sheet
TOTAL ASSETS
Current Assets
Cash
Accounts Receivable
Prepaid Expenses
Inventory
Net Fixed Assets
Fixed Assets
Less Accumulated
Depreciation



Capital: Liabilities & Equity
Liabilities
Current Liability
Accounts Payable (A/P)
Short term Debts
Provisions
Long Term Liability: Loans and
Bonds
Equity
Shares
Capital Reserves
Retained Profit (Retained
Earnings)



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How Transactions Affect The
Balance Sheet
Each event recorded in the accounting
records is called a transaction. The following
example illustrates the main types of
transactions that affect a balance sheet.
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Balance Sheet: First Transaction
Increases assets and Equity by the same amount.
The first transaction is the formation of the company
Computer Solutions. Assume that the owners of the
company invest $10,000.
Record $10,000 in cash on the asset side
Also record $10,000 on the equities side since the
owners have legal claim to this amount.
Assets Equities + Liabilities
512 cash $10,000 101 Paid-in Capital $10,000
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Balance Sheet: Second Transaction
Increases one asset and decreases another asset
by the same amount, leaving the total assets
unchanged.
Computer Solutions uses $2,000 of its cash to buy
equipment.
Record the $2,000 decrease by making the Cash
item $8,000 on the assets side.
Also record $2,000 equipment on the asset side.
Assets Equities + Liabilities (E&Q)
512 cash $8,000 101 Paid-in Capital $10,000
224 Equipment $2,000
______ _______
Total Assets $10,000 Total E&L $10,000
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Balance Sheet: Third Transaction
Increases one asset, decreases another asset, and
increases a liability.
Computer solutions buys office furniture for $5,000. The
company paid $1,000 in cash and agreed to pay $4,000
in two payments to the vendor.
Record the $1,000 decrease by making the cash item $7,000 on
the assets side.
Record the $5,000 furniture on the asset side.
Record the $4,000 in the Accounts Payable (A/P) on the liabilities
side. In essence, the vendor has a claim against the company for
$4,000.
Assets Equities + Liabilities (E&Q)
512 Cash $7,000 101 Paid-in Capital $10,000
224 Equipment $2,000 401 Accounts Payable $4,000
226 Furniture $5,000 ______
Total Assets $14,000 Total E&L $14,000
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Balance Sheet: Fourth Transaction
Decreases both an asset and a liability by the
same amount, so the total of the two sides of
the balance remain equal.
Computer Solutions pays $3,000 to the vendor.
Record the $3,000 decrease in cash by reducing cash
from $7,000 to $4,000.
Record the $3,000 paid to the vendor by reducing A/P
from $4,000 to $1,000.
Assets Equities + Liabilities (E&Q)
512 Cash $4,000 101 Paid-in Capital $10,000
224 Equipment $2,000 401 Accounts Payable $1,000
226 Furniture $5,000 _______
Total Assets $11,000 Total E&L $11,000
36
DEBIT AND CREDIT
Debit and Credit provide a convenient way
for applying the double entry principle.
For each item in the balance sheet there is
an account to keep track of.
Increases in accounts are additions and
decreases are subtractions.

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Rules For Debit and Credit
The basic accounting equation: Assets = Liabilities
+ Equity
Another accounting equation: Debits = Credits. This
applies to every transaction.
For this equation to work, the rules for Liabilities
and Equity must be the opposite of the rules for
Assets. Since liabilities and equity are on the
right-hand-side of the balance sheet, increases in
liabilities and equity are credits.

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Rules For Debit and Credit Contd
The rules for debit and credit are as follows:
To increase an asset account, then Debit it; to
decrease an asset account, then Credit it
On the contrary, to increase a liability or equity
account, then Credit it; to decrease a liability or
equity account, then Debit it.
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Examples: Journal entries for
Previous transactions
The following examples use the customary format
in accounting. The debit portion appears first, and
the credit portion is given next and indented.
Debit Credit
1. The entity received $10,000 in cash from its
owners:
512 Cash $10,000
101 Paid-in-Capital $10,000
$10,000 $10,000
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Examples: Previous transactions Contd
2. Computer Solutions uses $2,000 of its cash to buy
equipment. Increased equipment and decreased cash:
Debit Credit
224 Equipment $2,000
512 Cash $2,000
$2,000 $2,000
3. Computer solutions buys office furniture for $5,000. The company
paid $1,000 in cash and agreed to pay $4,000 in two payments
to the vendor:
226 Furniture $5,000
512 Cash $1,000
401 Accounts Payable $4,000
$,5,000 $5,000
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Examples: Previous transactions Contd
4. Computer Solutions pays $3,000 to the vendor.
Paid cash to decrease A/P:

Debit Credit

401Accounts Payable $3,000
512Cash $3,000
$3,000 $3,000
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Transfer from Journals to T Account
An account is compared to the letter T and posts
(Transfers) increases and decreases from various
journal transactions to the relevant account.
Debits refer to the left-hand side of the T-account
Credits refer to the right-hand side of the T-account
Taking the Cash account as an example, where
cash is an asset. Since assets are on the left-hand
side of the Balance Sheet, increases in assets are
debits. In general, we record:
Increases in Asset (Cash) are Debits (left hand side of T-
account)
Decreases in Asset (Cash) are credit (right hand side of T-
account)
The balance of the account is the difference between
increases and decreases.

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Db Cr
10,000 2,000
1,000
3,000
4,000
Cash
Transfer from Journals to cash T Account
Db Cr
2,000
2,000
Eqp Db Cr
5,000
5,000
Furn
Db Cr
10,000
10,000
Capital Db Cr
3,000 4,000
1,000
A/P
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Balance Sheet: Computer Solutions
Because of space limitations, the balance sheet format is often printed as follows:
Assets
Cash 4,000
Equipment 2,000
Furniture 5,000
Total Assets 11,000 $
Liabilities
Accounts Payable 1,000
Total Liabilities 1,000
Equity
Paid-in-Capital 10,000
Total Equity 10,000
Total Liabilities & Equity 11,000 $
Computer Solutions
Balance Sheet as of January 31, xxxx
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Journal Transactions
(Chronologically & Debits = Credits per transaction)


Transfer to T Accounts
(Map journals to relevant accounts. Either Debits or
Credits. Each Account has a Balance )



Transfer T Accounts to Financial
Statements
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The Income Statement
Revenues and expenses of an accounting period
are reported in a financial statement called the
Income Statement. This statement is also called
the Profit & Loss Statement or operating
statement. The difference between revenues and
expenses is income.
Since revenues and expenses are increases and
decreases in equity, the income statement explains
changes in ONE item on the balance sheet which is
the Retained Earnings account.
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The Income Statement Contd
The income statement summarizes the changes in
equity that occurred during an accounting period
due to the operating activities during that period.
The income statement tells whether an accounting
period was or was not profitable.
If a business operates profitably, its equity
increases by the amount of profit.
If the nonprofit organization breaks even, its equity
remains unchanged.
The income statement reports for a period of time,
such as a month or a year, while the balance sheet
reports the entitys financial condition as of one
moment.
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Rules for Revenues and Expenses

We saw that increases in equity are credit
entries while decreases are debit entries.
Since revenues increase equity, revenues
are always credits.
Since expenses decrease equity, expenses
are always debits.
The accounting system contains an account
for each type of revenue for example, sales
revenue and for each type of expense for
example, salary expense.
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Relations of Balance Sheet and
Income Statement
The amounts recorded in revenue and
expense accounts are used in preparing the
income statement for the period. Then these
accounts are transferred to equity because
they are temporary accounts showing
increases and decreases in equity.
Retained Earnings is the account used
for the accumulated amounts of income for
All periods to date.
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Income statement

Sales
COGS
Other Expenses
EBITDA
Depr. & Amort.
EBIT
Interest Exp.
EBT
Taxes (40%)
Net income
2002
6,034,000
5,528,000
519,988
(13,988)
116,960
(130,948)
136,012
(266,960)
(106,784)
(160,176)
2001
3,432,000
2,864,000
358,672
209,328
18,900
190,428
43,828
146,600
58,640
87,960
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Statement of Retained Earnings
(2002)
Balance of retained
earnings, 12/31/01 $203,768
Add: Net income, 2002 (160,176)
Less: Dividends paid (11,000)
Balance of retained
earnings, 12/31/02 $32,592
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Balance Sheet: Assets
2002 2001
Cash 7,282 57,600
A/R 632,160 351,200
Inventories 1,287,360 715,200
Total CA 1,926,802 1,124,000
Gross FA 1,202,950 491,000
Less: Acc/Dep. 263,160 146,200
Net FA 939,790 344,800
Total Assets 2,866,592 1,468,800
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Balance sheet: Liabilities and Equity
Accts payable
Notes payable
Accruals
Total CL
Long-term debt
Common stock
Retained earnings
Total Equity
Total L & E
2002
524,160
636,808
489,600
1,650,568
723,432
460,000
32,592
492,592
2,866,592
2001
145,600
200,000
136,000
481,600
323,432
460,000
203,768
663,768
1,468,800
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Other data
2002 2001
No. of shares 100,000 100,000
EPS -$1.602 $0.88
DPS $0.11 $0.22
Stock price $2.25 $8.50
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When is Profit Profit?
Are the following really recording profit?
Extended Credit Periods: some give extending credit to high
risk in order to record revenues. They end up in doubtful
receivables and uncollectible receivables
Investment Loss: buying shares at the high end as investment
then having to mark them down as losses when the market
value goes down.
Inventory charges: some companies stock for months ahead
only to write them down later when demand drops for them
(especially high tech equipment)
Goodwill impairment: goodwill is the premium paid over net
asset acquired. What if it turned out not as good?
Taking shares instead of cash: making sales to customers,
recording a profit, and taking customer shares instead of cash.
Once shares go down, a loss must be reported.

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Problem 1
In the coming transactions, you will be
examining the transactions for Mr. Nassars
advertising agency. You are required to do
the following: 1) write the Journal Vouchers,
2) create the T-accounts, 3) after finishing all
of the T-accounts, deduce the Balance Sheet
and the Income Statement.
Transactions That took place in January are
as follows:
57
January 1: Mr. Nassar obtains license for his advertising agency and invests
$10,000 in exchange for 10,000 shares of $1 par value.
January 2: he rents an office and pays $800 in advance for two months (Prepaid
rent).
January 4: purchases art equipment (fixed assets) for $4,200 with cash.
January 5: purchases office equipment (fixed assets) for $3,000 from BHV. Pays
$1,500 in cash and agrees to pay the rest next month (A/P).
January 6: Purchases art supplies (Inventory) for $1,800 and office supplies
(Inventory) for $800 from Star stationary on account (A/P).
January 8: pays $480 for a one-year life insurance (Prepaid).
January 9: pays Star stationary $1,000 of the amount owed.
January 10: performs a service (revenue) for an automobile dealer by placing
advertisements in the newspaper and collects a fee of $1,400.
January 15: pays his secretary wages (expense) of $600.
January 19: performs a service (revenue) by placing several major advertisements
for Zara stores. The fee is $2,800 and will be collected next month (A/R).
January 29: receives and pays the utility bill (expense) of $100.
January 30: receives (but does not pay- A/P) the telephone bill (expense) of $70.
January 31: declared and paid a dividend of $1,400.

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Analysis of Financial Statements
STABILITY is a measure of a firm's capacity to stay in
business. The capacity to survive, therefore, depends on the
supply of cash available to an organization relative to the
demands for cash likely to be made upon it.
PROFITABILITY measures the degree to which it can make
an adequate return to those who have supplied it with funds.
profits do not guarantee survival. In fact most companies
which go bankrupt make profits right up to the last moment.
Cash can flow out of the system due to:
The operating cash flow time lag.
The existence of non-operating cash flows.


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Cash Flow Analysis
While it is true that revenue and cost will
result in a flow of cash in and out of the
system, it is not necessary that they should
take place at the same time.
Operating Cash Flow results from current
assets and current liabilities of the balance
sheets.

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Operating Cash Flow System
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Non-Operating Cash Flow
Superimposed on the net operating cash flow there may be
other cash movements which do not arise solely as a result
of the day to day trading operations of a business, e.g. loan
repayments, investment grants received etc.
The relevant balance sheet items are: Equity, Long term
liabilities, and fixed assets.
In general, both loan and repayments and tax are items
which must be paid when due, i.e. they are not payments
which can made or withheld at the direction of management,
whereas dividends and capital expenditure can. These latter
items can to a certain degree be reduced if their payment
would place the company in financial difficulties, so they are
not so potentially dangerous.



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Total Cash Flow System
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The combined Cash/Overdraft box can be
considered as the cash receptacle or liquidity
tank of a business.
It is critical to the health of the firm that
this tank does not run dry.
Liquidity ratios help assess the company
stability: Current ratio / acid test ratio /
working capital over sales.

64

RATIO ANALYSIS
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Why Are Ratios Useful?
Ratios standardize numbers and facilitate
comparisons.
Ratios are used to highlight weaknesses and
strengths.
They can be calculated quickly and are very
often more meaningful to non-financial
managers than a full sheet of financial
figures.

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Why Are Ratios Useful? Contd
Ratios must be monitored frequently with
respect to industry averages and also with
respect to prior performance.
This will identify strengths and weaknesses
and problem areas. In addition, it will reflect
the success of the companys policies and
the achievement of the stated goals and
objectives.
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What Are The Five Major Categories Of Ratios,
And What Questions Do They Answer?
Liquidity: Can we make required payments? helps determine
how solvent an entity is and how well it can meet its current
obligations such as wages, operational expenses, etc.
Asset management: right amount of assets vs. sales? Helps
determine how effectively current and long term assets are
used by the company.
Debt management: Right mix of debt and equity? determines
the companys leverage. The higher the debts to assets are the
higher the leverage and the higher the risk. Highly leveraged
companies are subject to high fluctuations in profits and
losses.
Profitability: Do sales prices exceed unit costs, and are sales
high enough as reflected in PM, ROE, and ROA? Determines
the profitability from the companys operations and are used
heavily in stock and company pricing.
Market value: Do investors like what they see as reflected in
P/E and M/B ratios?

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Liquidity Ratios
Measure the companys STABILITY. Ratios include:
Current Ratio (Current Assets / Current Liabilities). In
general this ratio is equal to 2. However, Many companies
successfully operate under 2. the importance is in the
TREND.
Deficiency in this ratio is that the numerator has three heterogeneous
values: Inventory (Stock); Debtors (A/R) and Cash.
From a simple example we can see that two firms with the same current
ratio, can have vastly different cash flow profiles: i.e.
Firm A Firm B
Stock. (Inventory) 15,000 5,000
Drs. (A/R) 4,000 14,000
Cash. 1,000 1,000
20,000 20,000
Current Liabilities. 10,000 10,000
Current Ratio. 2 2
Firm A will have an inflow of cash from debtors over a given period of
4,000 whereas the corresponding figure from B over a similar period is
14,000. Firm B is therefore far more liquid than Firm A but this fact is
not recognized by the current ratio.

69
Liquidity Ratios Contd
Quick Ratio = (Current Assets Inventory) / Current
Liabilities. This ratio tends to range from .75 to 1.0. From the
previous example:
Firm A Firm B
Current Assets - Stock 5,000 15,000
Current Liabilities 10,000 10,000

Quick Ratio .5 1.5
By this Firm B is rightly shown to be much more liquid than Firm A,
whereas they both come out equal on the current ratio test.
A third measure used is one which relates Working Capital
(Current Assets - Current Liabilities) / total Sales x100%.
The range of values possible is very wide, but a figure of 25% to
33% is fairly common for manufacturing industries.



70
Debt Management Ratios
Debt to Assets ratio = Total Debts / Total Assets
This ratio shows the extent to which assets are financed from
debt rather than equity (owners). From the lenders point of
view, the lower the percentage of debt financing, the better
since the ownership funds provide a cushion to absorb
possible losses from operations or losses in asset value in the
future.
Debt to Equity ratio = Debts (Interest bearing) /
Equity
This ratio also indicates the debt capacity of a business. A
high gearing (leveraged), say 65%, indicates assets financed
mainly by debt and a low future borrowing capacity available.
A low gearing indicates the opposite, say 30%.
71
Leverage
Debt is useful in increasing ROE provided it
is not overused.
A company with 20,000 in equity and 0 debt
will have 10% ROE with 2000 in NIBD. The
same company will have 18% ROE if 10,000
is in debt and 1800 in NIBD 200 in interest-
(1800 / 10000).
72
Asset Management ratios
Asset Turnover = Sales/Assets
This ratio is a measure of activity and is often used
to judge the efficiency with which the company is
using its assets to produce sales.
We can calculate the Number of Days
Sales in the Inventory as follows:


365
Sales
Inventory

365
Sales
Inventory

73
Profitability Ratios
ROE = Net Income before div / Equity. This
ratio measures the return to the owners of
the business.
ROA = PBIT / Total Assets. Measures
operational efficiency.
ROI = PBIT / (Equity + Long Term Debt)
Profit Margin = PBIT / Sales. This ratio
should be linked to Sales/Assets ratio to
arrive to ROA
74
ROA Du Pont Pyramid
This ratio measures the OPERATING
EFFICIENCY of a firm. Therefore we can look
on it as the prime measure of management's
performance and the single most important
determinant of a company's overall
performance.
If we introduce the turnover figure we find that
the ratio can be exploded and expressed as the
product of two subsidiary ratios:


75
Du Pont Pyramid Contd
As a further illustration we can consider two
companies:
A - supermarket
B - chemical manufacturer
with the following characteristics:
Firm A Firm B
Sales 10,000 10,000
P.B.I .T. 600 1,000
T. Assets 2,500 6,600

76
Du Pont Pyramid Contd
77
While Firm A has a margin on sales of only 6%,
compared to 10% for Firm B (Ratio No. 2), the
former firm has a much better overall performance
(Ratio No. 1), because of its high sales - T.A. ratio
(Ratio No. 3).
However, in itself the ratio does not indicate what
action should be taken to improve performance. For
the purpose of decision making and control the
ratio must be analyzed into its constituent
elements.

Du Pont Pyramid Contd
78
Du Pont Pyramid Contd
79
1. Net Sales 3,000.0
Costs excluding Depreciation 2,616.2
Depreciation 100.0
2. Total Operating Costs 2,716.2
Earnings Before Interest & Tax (1-2) [EBIT] 283.8
Less Interest 88.0
Earnings Before Tax [EBT] 195.8
Tax (EBT x 40%) 78.3
Net Income Before Dividends 117.5
Dividends 61.5
Addition to Retained Earnings 56.0
Income Statement for the year ending Dec 31st
Allied Food Products (millions of $)
80
Assets Liabilities
Cash & Marketable securities 10 Accounts Payable 60
Accounts Receivable 375 Notes Payable 110
Inventories 615 Accruals 140
Total Current Assets 1,000 Total Current Liabilities 310
Fixed Assets 1,500 long Term Bonds 754
Accumulated depreciation (500) Total Liabilities 1,064
Net Fixed Assets 1,000
Equity
Preferred Stock 40
Common Stock 130
Retained Earnings 766
Total Equity 936
Total Assets 2,000 Total Liabilities & Equity 2,000
Allied Food Products (millions of $)
Balance Sheet as of December 31, 2005
81
Opening Balance: Retained Earnings 710.0
Income for the year 117.5
Subtotal 827.5
Subtract dividends 61.5
Retained Earnings 766.0
Allied Food Products (millions of $)
Retained Earnings
Note 1: the change in Retained Earnings is due to the Net income
(+117.5) minus dividends (-61.5).
Note 2: the Retained Earnings balance is shown on the Balance
Sheet.
Note 3: Retained Earnings does not necessarily mean an increase in
Cash.
82
Ratio Formula Calculation Ratio Industry Comment
Liquidity
Current Ratio Current assets/Current Liabilities 4.2
Acid Test (Quick Ratio) Current assets (w/o inventory) /
Current Liabilities
2.1
Asset Management
Inventory Turnover Sales/Inventories 9
Total Assets Turnover Sales/Total Assets 1.8
Debt Management
Debt ratio Total Debts / TotalAssets 40%
Profotability
Profit Margin net Income Before Div./sales 5.00%
Return on Total Assets (ROA) Net Income Before Div./Tot Assets 9%
Return on Equity net Income Before Div./ Equity 8.00%
Market Value
Earnings Per Share Net Income Before Div./# of
Shares Outstanding
8.0
Dividend Per ordinary Share Div. to Common Shareholders / #
of Shares Outstanding
0.7
Price to Earning Ratio (P/E) Market Price per share / Earnings
per Share
5.0
83
Ratio Formula Calculation Ratio Industry Comment
Liquidity
Current Ratio Current assets/Current Liabilities 1000/310 3.2 4.2 Poor
Acid Test (Quick Ratio) Current assets (w/o inventory) /
Current Liabilities
385/310 1.2 2.1 Poor
Asset Management
Inventory Turnover Sales/Inventories 3000/615 4.9 9 Poor
Total Assets Turnover Sales/Total Assets 3000/2000 1.5 1.8 Insufficient
Debt Management
Debt ratio Total Debts / TotalAssets 1064/2000 53.20% 40% high (Risky)
Profotability
Profit Margin net Income Before Div./sales 117.5/3000 3.90% 5.00% Poor
Return on Total Assets (ROA) Net Income Before Div./Tot Assets 117.5/2000 5.80% 9% Poor
Return on Equity net Income Before Div./ Equity 117.5/936 12.6% 8.00% Good
Market Value
Earnings Per Share Net Income Before Div./# of
Shares Outstanding
117.5 / 130 0.9 8.0 Poor
Dividend Per ordinary Share Div. to Common Shareholders / #
of Shares Outstanding
61.5/130 0.5 0.7 Poor
Price to Earning Ratio (P/E) Market Price per share / Earnings
per Share
2/0.9 2.2 5.0 Poor
84
Liquidity Ratios
In our example, the industry average for
similar companies is higher than Allied Food.
Therefore, liquidity should be increased by
cutting current costs or increasing current
assets.
85
Asset Management Ratios
In our example:
The inventory turnover ratio for the industry is much
higher than Allied Foods. There may be problems in
stocking too much inventory, or carrying obsolete or
slow-moving items. The new trend is for companies
to carry as little inventory as possible in order to free
capital and save on storage and obsolescence.
The total asset ratio is not sufficiently high which
means the company is not using its resources
efficiently enough. This ratio can be improved by
improving sales or decreasing total assets.
86
Debt Management Ratios:
Highly leveraged and risky. Makes the company
volatile to market fluctuations.
Profitability Ratios: In our example,
The profit margin is lower than the industry average.
It can be improved by cutting costs or increasing
sales.
The return on total assets (ROA) is poor compared
to the industry average. Income has to be increased
or total assets must be used more efficiently.

87
MODULE 2

COSTING & CONTRIBUTION ACCOUNTING
88
Costing
There are many purposes for which costs are
used:
To communicate actual performance say against
plan
To aid motivation - urge cost reduction
As a basis of project appraisal - introduce cost
saving equipment, enter new market
89
Costing Contd
Costs are classified into two categories
Direct: those which can be identified with a product. Example:
Purchase of headlamp units in assembly of an automobile.
Indirect: have no apparent or immediate relationship with the
product. Example: Salary of senior legal executive in the
automobile manufacturer.
Indirect costs have to be assigned to the product on
some suitable basis. A cost driver is identified per
type of overhead and distribution is done
accordingly.
90
Costing Contd
Name the possible cost driver for the
following: Electricity / Security Guards / Multi
tasked employee
Electricity:
Square Meter
Security guards:
Per employee
Multi tasked employees
Number of worked hours
91


Product X units
1,000
Direct material used 5,000
Direct labour charged 2,000
Direct production expense 3,000
Total direct costs 10,000
Indirect cost or overhead allocation
Production overhead 50% of labour 1,000
Marketing overhead 2 per unit 2,000
Administrative overhead 2 per unit 2,000
Full costs 15,000
Selling price per unit : 20 x 1,000 units = 20,000
Profit 5,000
92
COSTING SYSTEMS

Two major costing MIS Systems have tended
to be used over the years, dictated by the
unique needs of the user industry:
Job Costing Systems
Process Costing Systems

93
Job Costing
Within a Job Costing System, each
Customer order is treated as one of Cost
Assignment. Each order or job is assigned a
unique job number and all costs incurred are
assigned to that number. The results are
monitored against estimates or quotations to
the Customer for the work in hand.
94
Job Costing Contd
Job Costing is utilised in industries and
service corporations where each product or
service is unique. Example:
Civil Engineering
Custom built IT manufactures
Transport Maintenance
Software Development
95
Job No. J 1437
DESCRIPTION
PRICE TO
CUSTOMER
750,000
Surfacing 10 kilometers of route 14.6
COSTING '000
ESTIMATE
'000
ACTUAL
MaterIal

Stone
Asphalt
Binder


10
150
5


10
140
5
TOTAL 165 155
Labour

Grade 1
Grade 2


100
150


90
140
TOTAL 250 230
Equipment

Grader
Roller
Transport


50
70
50


60
50
50
TOTAL 170 160
TOTAL (A) (Summary) 585 545
Overheads 50% of Labour 125 115
TOTAL COSTS (B) 710 660
96
Process Costing
It is the most common method of collecting
costs under an MIS System.
Here, each process in the development of
the product, from input of basic ingredients to
packaged product, is identified and costs are
collected for each stage of this process to
allow actual outlay to be compared with the
predetermined standard (referred to above in
the paragraph on Standard Costing).
97
Cost per Unit processed
Process1
Assembly of
20 $
Process 2
Mix &
Fermenting
10 $
Process 3
Flavouring
5 $
4 $
3 $
Assembly of
20 $
Assembly of
Raw Materials
Assembly of
20 $
Mix &
10 $
Mix &
10 $
5 $
Flavouring Flavouring
5 $
Finishing
4 $
Finishing
Process 4
Finishing
4 $
3 $
Process 5
Packaging
3 $
TOTAL STANDARD PROCESS
COST PER UNIT 42$.
98
BREAK EVEN ANALYSIS
It is a technique associated with the direct
costing approach. Break even analysis is
concerned with establishing at what volume
or value of output our Corporate Unit will
break even, cover its fixed costs, neither
make a profit or loss but break even.
99
BREAK EVEN ANALYSIS Contd
This approach requires a company to
segregate its costs in its period operating
statement into:
Fixed Costs, i.e. rent of distribution store. Those
costs are uninfluenced by volume of output and of
sales.
Variable Costs. Those costs are directly variable with
sales i.e. cost of paper wrapper for confectionery
bar.
100
BREAK EVEN ANALYSIS Contd
Each bar requires a paper wrapper. The more you
produce and sell, the more printed paper wrappers
you must purchase, while inside a defined period
the rent of your distribution store - a fixed amount -
is not effected by the volume of confectionery bars
you produce and sell in that period.
The formula for calculating break even is:
Fixed Cost / Contribution per Unit
or, if break even is required in units,
Fixed Cost / Contribution Margin Percentage

101
Example of Break Even
Choc Bar Selling Price (A) 100
Variable Cost of Manufacturing and Distribution 60
1) Contribution per Unit (B) 40
Contribution % (P.V. Ratio)
2) Contribution Margin: Percentage of Sales 40 %

3) Fixed Cost of Choc Bar Company
Rent 10,000
Salaries 20,000
Others 10,000
Total 40,000
Break Even Point in units =40000/40= 1000 units
Break Even Point in value =40000/40%= 100,000
102
A GRAPHICAL PRESENTATION OF A
BREAK EVEN ANALYSIS
TOTAL REVENUE (SALES)
NET PROFIT AREA
TOTAL COSTS
Net loss area
BREAK EVEN POINT
MONETARY VALUE
B.E.P. VALUE
FIXED COSTS
VARIABLE COSTS
B.E.P.
(VOLUME)

VOLUME UNITS
OR VALUE If volume not available
V
A
L
U
E




103
Break Even Problem

104
MODULE 3


BUDGETING & CASH PLANNING
105
Two Methods Of Cash
Forecasting
Receipts and Payments Basis (suitable for
short term cash flow, i.e. usually one year)
on a month by month basis.
Funds Flow Basis (suitable for longer term,
say three years) often done on a year by
year basis.
106
Cash Receipts And Payment Forecast Basis
If detailed operating and capital expenditure
(projects) budgets are available, then the
preparation of the Cash Forecast is rendered
easier. The following budgets are used for the
preparation of the Cash Forecast:
Sales : Credit Policy
Purchases : Suppliers Credit Available
Personnel : Payroll Contracts
Overheads Expenditure : Cash Commitments
Capital expenditure : Cash Commitments on Additional
Investment in Fixed Assets/projects in this period
Dividend policy on dividends to be paid in this period
Tax policy and payment budgets
107
CASE STUDY : THE GREEN CORPORATION
The following budget data is supplied by the Green Corporation (in 000)
1. Receipts
1. The sales REVENUE of this company is budgeted at 1,000 per month with two months
credit given to customers by GREEN CORPORATION.
2. The share capital to be received from the shareholders in month 5 is 1,000.
2. Payments
1. The payroll of the company is 300 per month.
2. Product Purchases amount to 500 per month. One months credit is given by suppliers to
GREEN CORPORATION.
3. Delivery expenses (freight) are for cash amount to 100 per month.
4. There is a company formation tax payment of 200 due in month 3.
5. A new truck fleet will be acquired at a cost of 300, in month 4.
6. Stockholding or inventory is to be provided as follows:
300 in month 1
and
500 in month 2- for cash
7. The depreciation charge for the year was computed at 200.
3. General
The opening bank overdraft (short term loan) of this company is 600, which has
been spent last year on acquiring warehouses and equipment.
4. Problem
1. To calculate the cash position of the company in its first twelve months of operation.
2. To establish if bank facilities or a credit line of 1300 are adequate to cope with the
budgeted cash position as established in 1. above and if not, to indicate what further action
should be taken by GREEN CORPORATION.
108
Month 1 2 3 4 5 6 7 8 9 10 11 12 Tot.
RECEIPTS (Inflow)
Sales
Share Capital / Loans
TOTAL (A)
PAYMENTS (Outflow)
Wages (Payroll)
Purchases
Delivery Expenses
Stocks (Inventory)
Taxation
Capital Expense Truck fleet
TOTAL (B)
MONTHLY SURPLUS / DEFICIENCY
(A-B)
OPENING BANK BALANCE (O/D)
CLOSING BANK BALANCE (O/D)
109
Month 1 2 3 4 5 6 7 8 9 10 11 12 Tot.
RECEIPTS (Inflow)
Sales
1,00
0
1,00
0
1,00
0
1,00
0
1,00
0
1,00
0
1,00
0
1,00
0
1,00
0
1,00
0
10,000
Share Capital / Loans
1,00
0
1,000
TOTAL (A)
1,00
0
1,00
0
2,00
0
1,00
0
1,00
0
1,00
0
1,00
0
1,00
0
1,00
0
1,00
0
11,000
PAYMENTS (Outflow)
Wages (Payroll) 300 300 300 300 300 300 300 300 300 300 300 300 3,600
Purchases 500 500 500 500 500 500 500 500 500 500 500 5,500
Delivery Expenses 100 100 100 100 100 100 100 100 100 100 100 100 1,200
Stocks (Inventory) 300 500 800
Taxation 200 200
Capital Expense Truck fleet 300 300
TOTAL (B) 700
1,4
00
1,10
0
1,20
0
900 900 900 900 900 900 900 900 11,600
MONTHLY SURPLUS /
DEFICIENCY (A-B)
(700)
(1,4
00)
(100) (200)
1,10
0
100 100 100 100 100 100 100 (600)
OPENING BANK BALANCE (O/D) -600
-
1,3
00
-
2,70
0
-
2,80
0
-
3,00
0
-
1,90
0
-
1,80
0
-
1,70
0
-
1,60
0
-
1,50
0
-
1,40
0
-
1,30
0
-600
CLOSING BANK BALANCE (O/D) -1,300
-
2,7
00
-
2,80
0
-
3,00
0
-
1,90
0
-
1,80
0
-
1,70
0
-
1,60
0
-
1,50
0
-
1,40
0
-
1,30
0
-
1,20
0
-1,200
110
Funds Flow Statements
Where substantial future expenditure on
fixed assets or acquisition programmes are
planned, it will be necessary to view the
financing position for several years ahead.
Where such funds flow statements are
prepared for a number of future years, they
are not concerned with the same amount of
detail as the yearly receipts and payments
cash forecast.
111
SOURCES OF FUNDS USES OF FUNDS
Profit 100 Working Capital increase 80
Depreciation 80 Taxation 30
Shares issued 100 Dividend 50
Bonds issued 50 Fixed Asset Formation
(Project Expenditure)
70
TOTAL (A) 330 TOTAL (B) 230
Sources (A) 330
Uses (B) (230)
Surplus for Period 100
Operating Bank 0 / D (250)
Closing Bank 0 / D (150)
112
MODULE 4


PROJECT EVALUATION
113
What is capital budgeting?
Analysis of potential additions to fixed
assets.
Long-term decisions; involve large
expenditures.
Very important to firms future.

114
Steps to capital budgeting
1. Estimate Cash Flows (inflows & outflows).
2. Assess riskiness of CFs.
3. Determine the appropriate cost of capital.
4. Find Net Present Value (NPV) and/or
Internal Rate of return (IRR).
5. Accept if NPV > 0 and/or IRR > WACC.

115
What is the difference between normal and
non-normal cash flow streams?
Normal cash flow stream Cost (negative CF)
followed by a series of positive cash inflows. One
change of signs.
Nonnormal cash flow stream Two or more
changes of signs. Most common: Cost (negative
CF), then string of positive CFs, then cost to close
project. Nuclear power plant, strip mine, etc.

116
What is the payback period?
The number of years required to recover a
projects cost, or How long does it take to
get our money back?
Calculated by adding projects cash inflows
to its cost until the cumulative cash flow for
the project turns positive.


117
Strengths and weaknesses of
payback
Strengths
Provides an indication of a projects risk and liquidity.
Easy to calculate and understand.
Weaknesses
Ignores the time value of money.
Ignores CFs occurring after the payback period.

118
Calculating payback
Payback
L
= 2 + / = 2.375 years

CF
t
-100 10 60 100

Cumulative -100 -90 0 50
0 1 2
3
=
2.4
30 80
80
-30
Project L
Payback
S
= 1 + / = 1.6 years

CF
t
-100 70 100 20

Cumulative -100 0 20 40
0 1 2
3
=
1.6
30 50
50
-30
Project S
119
Cost of Capital
120
Capital Structure
Items on the right hand side of a firms balance
sheet (Debt / preferred stock / equity) are called
capital components.
Any increase in total assets must be financed by
one or a combination of capital components.
The company defines an optimal mix of financing
distributed between:
Debt
Preferred Stock
Retained Earnings
New Stock issuing
121
Cost of Capital - Cost of Debt
It is the interest rate paid on debt MINUS the
tax savings that result since interest is tax
deductible.
Cost of Debt after tax savings = Interest rate Tax savings
Cost of Debt = Kd (1-T). Example:
Cost of a 10% loan with 40% tax bracket = 10 (1-0.4)= 6%
122
Cost of Capital - Cost of
Preferred Stock
Cost of preferred stock (Kp) = Preferred
Dividend / Price of preferred stock
Kp = Dp / Pp
If Allied has a preferred stock that pays $10
dividend per share and sells for $97.5 per
share in the open market Kp =
10/97.5=10.3%
No tax adjustment is made because
preferred dividends are not tax deductible.
123
Cost of Capital - Cost of
Retained Earnings
Use of Retained Earnings in capital projects
is NOT FREE.
The cost involves the Opportunity cost
principle. The companys after tax earnings
belong to stockholders. They could have
received these RE as dividends and invested
in other stock.
What rate of return can stockholders expect
to earn on this or other comparable stock?
124
Cost of Retained Earnings Contd
Risk: specific versus Systematic Risk
Specific risk: rises from events specific to a particular
company with nothing to do with general market and
economic conditions. This risk is diversifiable.
Systematic risk: arise from general business risk
factors (inflation, monetary policy, oil prices,
unemployment). This Risk is non-diversifiable.
125
Cost of Retained Earnings Contd
To estimate cost of RE, we use the Capital
Asset Pricing Model (CAPM). This model
estimates the required rate of return (Ks) as
follows:
Ks = Risk Free Rate + Company Beta x Market Risk premium
Ks = Krf + (Km Krf)
Example: Assume that Krf = 8%; Km = 13%; = 0.7
Ks = 8% + (13% - 8%) 0.7 = 11.5%
126
127
Cost of Retained Earnings Contd
Another way to estimate cost of RE is to
obtain the Expected rate of return. This
model estimates the required rate of return
(Ks) as follows:
Ks = Dividend / Price of stock + expected growth
Ks = D1 / Po + g = D1 / P0 + (retention rate) (ROE)
Example:
Ks = $1.24 / $23 + (0.6) (13.4%) = 5.4% + 8% = 13.4%
128
Cost of Capital - Cost of New
Stock
This cost will be higher than RE because of
the cost involved in issuing and selling of the
new stock (Flotation costs - F).
Ke = D1 / Po(1-F) + g = $1.24 / $23 (1-0.1) + 8% = 14%
129
Weighted Average Cost of Capital
(WACC)
Reflects the average cost of the various
sources of funds.
A company defines the optimal mix of the
various fund raising options so as to keep the
stability and proportions of debt to asset
balanced.
130
Calculation of WACC
Suppose a companys structure is as follows:
45% debt (Assume Kd = 6%)
55% common equity RE (Assume Kd = 13%)
WACC = 0.45 (6%) + 0.55 (13%) = 2.7% +
7.15% = 9.85%
Companies should take projects that have
estimated returns above WACC.
IRR>WACC
131
TIME VALUE OF MONEY



132
Time lines

0 1 2 3
CF
0
CF
1
CF
3
CF
2
i%
Show the timing of cash flows.

Tick marks occur at the end of periods, so Time 0
is today; Time 1 is the end of the first period (year,
month, etc.) or the beginning of the second period.
133
Drawing time lines:
$100 lump sum due in 2 years;
3-year $100 ordinary annuity


100
0 1 2
i%
$100 lump sum due in 2 years
100 100 100
0 1 2 3
i%
3 year $100 ordinary annuity
134
Drawing time lines:
Uneven cash flow stream; CF
0
= -$50,
CF
1
= $100, CF
2
= $75, and CF
3
= $50
100 50 75
0 1 2 3
i%
-50
Uneven cash flow stream
135
What is the future value (FV) of an initial
$100 after 3 years, if I/YR = 10%?
Finding the FV of a cash flow or series of cash
flows when compound interest is applied is called
compounding.
FV can be solved by using the arithmetic, financial
calculator, and spreadsheet methods.


FV = ?
0 1 2 3
10%
100
136
Solving for FV:
The arithmetic method
After 1 year:
FV
1
= PV ( 1 + i ) = $100 (1.10)
= $110.00
After 2 years:
FV
2
= PV ( 1 + i )
2
= $100 (1.10)
2
=$121.00
After 3 years:
FV
3
= PV ( 1 + i )
3
= $100 (1.10)
3
=$133.10
After n years (general case):
FV
n
= PV ( 1 + i )
n


137
What is the present value (PV) of $100
due in 3 years, if I/YR = 10%?
Finding the PV of a cash flow or series of cash
flows when compound interest is applied is called
discounting (the reverse of compounding).
The PV shows the value of cash flows in terms of
todays purchasing power.

PV = ? 100
0 1 2 3
10%
138
Solving for PV:
The arithmetic method
Solve the general FV equation for PV:
PV = FV
n
/ ( 1 + i )
n

PV = FV
3
/ ( 1 + i )
3

= $100 / ( 1.10 )
3

= $75.13

139
What is the difference between an
ordinary annuity and an annuity
due?
Ordinary Annuity
PMT PMT PMT
0 1 2 3
i%
PMT PMT
0 1 2 3
i%
PMT
Annuity Due
140
What is the PV of this uneven
cash flow stream?

0
100
1
300
2
300
3
10%
-50
4
90.91
247.93
225.39
-34.15
530.08 = PV
141
Net Present Value (NPV)
Sum of the PVs of all cash inflows and
outflows of a project:

n
0 t
t
t
) k 1 (
CF
NPV
142
Rationale for the NPV method
NPV = PV of inflows Cost
= Net gain in wealth
If projects are independent, accept if the
project NPV > 0.
If projects are mutually exclusive, accept
projects with the highest positive NPV,
those that add the most value.
143
Internal Rate of Return (IRR)
IRR is the discount rate that forces PV of
inflows equal to cost, and the NPV = 0:


144
How is a projects IRR similar to a
bonds YTM?
They are the same thing.
Think of a bond as a project. The YTM on
the bond would be the IRR of the bond
project.
EXAMPLE: Suppose a 10-year bond with a
9% annual coupon sells for $1,134.20.
Solve for IRR = YTM = 7.08%, the annual return for
this project/bond.

145
Rationale for the IRR method
If IRR > WACC, the projects rate of return is
greater than its costs. There is some return
left over to boost stockholders returns.

146
Reinvestment rate
assumptions
NPV method assumes CFs are reinvested at k, the
opportunity cost of capital.
IRR method assumes CFs are reinvested at IRR.
Assuming CFs are reinvested at the opportunity
cost of capital is more realistic, so NPV method is
the best. NPV method should be used to choose
between mutually exclusive projects.
Perhaps a hybrid of the IRR that assumes cost of
capital reinvestment is needed.

147
Since managers prefer the IRR to the NPV
method, is there a better IRR measure?
Yes, MIRR is the discount rate that causes
the PV of a projects terminal value (TV) to
equal the PV of costs. TV is found by
compounding inflows at WACC.
MIRR assumes cash flows are reinvested at
the WACC.


148
MUTUALLY EXCLUSIVE PROPOSALS
The significant factor about mutually exclusive
proposals is, as the name implies, that the decision
required is a choice between competing
alternatives, both of which may be viable, but
implementation of one precludes implementation of
the other.
In comparing mutually exclusive projects, there is a
need to determine the alternative investments
involved.
If the alternative with the lower investment has the greater
DCF return, it is economically preferable.
If the alternative with the higher investment has the lower DCF
return, it will only be economically preferable if the DCF return
on the incremental investment (i.e. B-A above) is greater than
the company Hurdle Rate of Return for such projects.
149
Two projects A and B are mutually exclusive and have
the following Net Cash Flows:
Project A Project B
B A
(Increment)
Expenditure at start of
year 1
- 1,000 - 1,300 - 300
Income during year 1 + 500 + 625 + 125
Income during year 2 + 500 + 625 + 125
lncome during year 3 + 500 + 625 + 125
DCF return (IRR) 29.2% 26.1% 15.3%
150
In this example, straight comparison of the DCF
returns shows Project A to be preferable. However
the B - A Column shows the DCF return on the
investment of an extra or incremental 300 in
Project B to be 15.3%.
Given that the projects are mutually exclusive, if the
business Hurdle Rate of Return is 12%, the
investment of the extra 300 is economically viable
and Project A will be chosen in the absence of
other investment opportunities in the company.
151
VALUATION
Placing Value on a Company for
Possible Acquisition
152
Valuation
A guide and constraint on negotiated price
Negotiated price tends to fall between
future based (uncertain) valuation of performance,
AND
Historically (certain) based results valuations
The final price is a matter of dealing.
Valuation fixes:
The floor price at which you enter, and
The ceiling price at which you exit



153
Corporate Acquisition
There are three traditional methods of
valuation of a company for acquisition :
A Net Current Valued Assets or Adjusted Equity
Valuation with a Market to Book adjustment
Capitalization of Future Maintainable Profit or
Earnings, a Price Earnings Basis (P/E Ratio)
Discounted Value of Future Maintainable Net Cash
Flows. Discounted Cash Flow model of Valuation
(DCF Approach)

154
Corporate Acquisition Other
Methods
Liquidation Value.
For Quoted Company, Current Stock Market
Valuation. Number of stock units by Average
Market Value per unit. Bid tends to push up price of
shares. Offeree has to bear this factor in mind in
setting Offer Price
Acquisition Price Earning trend as paid to owners of
other companies acquired in recent years in that
industry or sector
If a Company is a private company. Stock Market
Valuation of related Quoted Company in that
industry sector

155
Method 1 Adjusted Equity
In looking at the Asset Valuation approach, a
Premium to Book Value may be used.
Amount depends on sector in which the
company operates in.
If Market to Book is two times (MB Ratio of
2). Assume a company has 20,000 and
$30,000 in Equity 2x30,000 = $60,000
Share price = $3.
156
Method 2 capitalization of
Maintainable Future (P/E Ratio)
Many industries have developed a rule of thumb
approach to Valuation.
We buy at 5 years Price Earnings Ratio
We sell at a Price Earnings Ratio of 7 years
The problem with these simple rules nowadays is
lack of continuity in markets such as technology
etc.
CLIMATE HAS A BIG INFLUENCE
If Acquisition of companies in that sector is the vogue, then
P.E. Ratios demanded will be high
IF Acquisition market is quiet, P.E. Ratios tend to drop back.

157
Method 2 (P/E Ratio) Contd
Example: Maintainable Future Profits are
calculated at $160,000 with P/E of 5
company value = $800,000
The next slide illustrates the calculation of
Maintainable Future Profits
158
159
Method 3 The Discounted Cash
Flow Model (DCF)
First get WACC
Terminal Value can be calculated as a
perpetuity (Last evaluated year / WACC)
Discount Net Cash Flows using WACC
160