Professional Documents
Culture Documents
Contents
1.0 Aims and Objectives
1.1 Introduction
1.1.1 What is Finance?
1.1.2 Major Areas of Finance
1.1.3 Meaning of Financial Management
1.1.4 Why Study Financial Management?
1.2 Historical Development of Financial Management
1.3 Finance and Related Fields
1.3.1 Finance Versus Economics
1.3.2 Finance Versus Accounting
1.4 The Scope of Financial Management
1.5 The Functions of Financial Management
1.5.1 Investment Decisions
1.5.2 Financing Decisions
1.5.3 Dividend Decisions
1.6 Jobs of the Financial Staff
1.7 An Overview of the Financial Environment
1.7.1 Financial Institutions
1.7.2 Financial Instruments
1.7.3 Financial Markets
1.8 Summary
1.9 Answers to Check Your Progress Questions
1.10 Model Examination Questions
1.11 Selected References
1.12 Glossary
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what money is transferred among and between individuals, businesses, and governments.
It is concerned with the processes, institutions, markets, and instruments involved in the
transfer of funds.
In addition to principles and techniques, finance requires individual judgment of the
person making the financial decision. Hence, finance can also be defined as the art and
science of managing money.
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Financial management is one major area of study under finance. It deals with decisions
made by a business firm that affect its finances. Financial management is sometimes
called corporate finance, business finance, and managerial finance. These terms are used
interchangeably in this material.
Financial management can also be defined as a decision making process concerned with
planning for raising, and utilizing funds in a manner that achieves the goal of a firm.
There are many specified business functions performed by a business unit. These include
marketing, production, human resource management, and financial management.
Financial management is one of the important functions of a firm. It is a specified
business function that deals with the management of capital sources and uses of a firm.
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ii)
Finance deals with an individual firm; but economics deals with the industry
and the overall level of the economic activity.
ii)
iii)
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ii)
iii)
The investment decisions of a firm also involve working capital management and capital
budgeting decisions. The former refers to those decisions of a firm affecting its current
assets and short term liabilities. The later, on the other hand, involves long term
investment decisions like acquisition, modification, and replacement of fixed assets.
Generally, the investment decisions of a firm deal with the left side of the basic
accounting equation: A = L + OE (Assets = Liabilities + Owners Equity).
Financial Management - I, BY Abdi .D
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i)
ii)
iii)
iv)
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Financial institutions are financial intermediaries, which are specialized financial firms
that facilitate the transfer of funds from savers to demanders of capital.
capital. They accept
savings form customers and lend this money to other customers or they invest it. In many
instances, they pay savers interest on deposited funds. In some cases, they impose service
charges on customers for the services they render. For example, many financial
institutions impose service charges on current accounts.
The key participants in financial transactions of financial institutions are individuals,
businesses, and government. By accepting the savings from these parties, financial
institutions transfer again to individuals, business firms, and governments. Since financial
institutions are generally large, they gain economies of scale in the transfer of money
between savers and demanders. By pooling risks, they help individual savers to diversify
their risk.
The major classes of financial institutions include commercial banks, savings and loan
associations, mutual savings banks, credit unions, pension funds and life insurance
companies. Among these, commercial banks are by far the most common financial
institutions in many countries worldwide. In Ethiopia too, commercial banks are the
major institutions that handle the savings and borrowing transactions of individuals,
businesses, and governments.
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common stock, it represents an investment and equity item for the holder and issuer
respectively.
The issuer gives the financial asset to the purchaser (holder) in exchange for some
valuable consideration, usually in the form of cash or another financial asset.
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i)
ii)
ii)
Financial management is an area of study under finance, which deals about the
financial problems of an individual firm.
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The jobs of the firms financial staff are related to the basic financial statements.
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How can a decision maker establishes a goal that best suites to the interest of his
firm?
What are the two most common decision criteria that are highly emphasized in
financial management?
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1. It is clear and unambiguous a clear goal will lead to decision criteria that do not vary
from case to case and from person to person.
2. It provides a clear and timely measure to evaluate the success or failure of decisions.
There should be some means to measure the objective.
3. It does not affect the specific benefits of a firm.
4. It does not affect the welfare of the society.
5. It is based on long-term success of the firm.
Even though there are many alternative decision rules in the sections that follow, we
describe and evaluate the decision criteria for financial management, which are widely
discussed in many finance literature.
2.3 PROFIT MAXIMIZATION AS A DECISION RULE
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1. Ambiguity. The term profit or income is vague and ambiguous concept. It is very
illusive and has no precise quonotation. Different people understand profit in different
several ways. There are many different economic and accounting definitions of profit,
each open to its own set of interpretations. Even in accounting profit might refer to shortterm or long-term profit, total profit or profit on a per share basis (earnings per share),
and before or after text profit. Then, the question or the problem would be which profit is
to be maximized? Maximizing one may lead to minimizing the other.
Furthermore, problems related to inflation and international currency transactions
complicate the issue of profit maximization.
2. Cash flows. The profit a firm has reported does not represent the cash flows to the
business. Firms reporting a very high total profit or earnings per share might face
difficulty of paying cash dividends to stockholders. Sometimes, companies might even
declare bankruptcy though reporting a positive income
3. Timing of Benefits. The profit maximization criterion ignores the differences in the
time pattern of benefits received from investment proposals. This criterion does not
consider the distinction between returns (benefits) received in different time periods and
treats all benefits as equally valuable irrespective of the time pattern differences in
benefits. In other words, the profit maximization ignores the time value of money, i.e.,
money today is better than money tomorrow. Also it does not consider the sooner, the
better principle.
To understand this limitation better let us consider the following example.
Example Akaki Manufacturing Share Company wants to choose between two projects:
project X and project Y. both projects cost the same, are equally risky and are expected to
provide the following benefits over three years period.
BENEFITS (PROFITS)
YEAR
PROJECT X
PROJECT Y
Br. 25,000
Br.
50,000
0-
50,000
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0-
TOTAL
Br. 75,000
25,000
Br. 75,000
The profit maximization criterion ranks both projects as being equal. However, project X
provides higher benefits in earlier years and project Y provides larger benefits in latter
years. The higher benefits of project X in earlier years could be reinvested to earn even
higher profits for later years. Profit seeking organizations must consider the timing of
cash flows and profits because money received today has a higher value than money
received tomorrow. Cash flows in early years are valued more highly than equivalent
cash flows in later years.
4. Quality of Benefits (Risk of Benefits). Profit maximization assumes that risk or
uncertainty of future benefits is of on concern to stockholders. Risk is defined as the
probability that actual benefit will differ from the expected benefit. Financial decision
making involves a risk-return trade-off. This means that in exchange for taking
greater risk, the firm expects a higher return. The higher the risk, the higher the
expected return.
Example Nyala Merchandising Private Limited Company must choose between two
projects. Both projects cost the same. Project A has a 50% chance that its cash flows
would be actual over the next three years. Project B, on the other hand, has a 90%
probability that its cash flows for the next three years would be realized.
BENEFITS
YEAR
PROJECT A
PROJECT B
Br. 60,000
Br. 45,000
65,000
50,000
95,000
85,000
Br. 220,000
Br. 180,000
TOTAL
Under profit maximization, project A is more attractive because it adds more to Nyala
than project B. However, if we consider the risk of the two projects, the situation would
be reversed.
Financial Management - I, BY Abdi .D
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PROJECT C
PROJECT D
Br. 2,700
Br. 0
3,000
3,000
3,300
6,000
Br. 9,000
Br. 9,000
TOTAL
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________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
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recognition to the interest of other stakeholders and to the societal welfare on the longterm basis.
Technically, wealth maximization as a decision rule involves a comparison of value to
cost. Thus, an action that has a discounted value that exceeds its cost can be said to create
value and such action should be undertaken. Whereas an action with less discounted
value than cost reduces wealth and, therefore, should be rejected. The discounted value is
a value which takes risk and timing of benefits into account.
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2. When managers of a corporation are separate from owners, there is a potential for a
conflict of interest between them. This conflict of interest can lead to the maximization of
manages interest instead of the welfare of stockholders.
3. When the goal of a firm is stated in terms of stockholders wealth, actions that increase
the wealth of stockholders could be taken as the expense of other stakeholders like
debthodlers.
4. Wealth maximization is normally reflected in the firms stock price. But if there are
inefficiencies in financial markets, wealth maximization decision rule may lead to
misallocation of scarce resources.
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The natural conflict of interest between stockholders and managerial interest create
agency problems. Agency problems are the likelihood that mangers may place their
personal goals a head of corporate goals. Theoretically, agency problems are always there
as long as mangers are agents of owners.
Corporations (owners) are aware of these agency problems and they incur some costs as a
result of agency. These costs are called agency cost and include:
1. Monitoring expenditures are expenditures incurred by corporations to monitor or
control the activities of managers. A very good example of a monitoring expenditure
is fees paid by corporations to external auditors.
2. Bonding expenditures are cost incurred to protect dishonesty of mangers and other
employees of a firm. Example: fidelity guarantee insurance premium.
3. Structuring expenditures expenditures made to make managers fell sense of
ownership to the corporation. These include stock options, performance shares, cash
bonus etc.
4. Opportunity costs unlike the previous three, these costs are not explicit expenditures.
Opportunity costs are assumed by corporations due to hindrances of decisions by them as
a result of their organizational structure and hierarchy.
On top of the above costs assumed by corporations, there are also other ways to motivate
managers to act in the best interest of owners. These ways include to make know
managers that they would be fired if they do not act to maximize shareholders wealth and
that the corporation could be overtaken by others if its value is very much lower than
other firms.
2.6 SUMMARY
The primary purpose of this unit were (1) to indicate the basic characteristics of a good
objective, (2) to discuss profit maximization and wealth maximization as decision rules,
and (3) to give an overview of agency problem. The key concepts covered are listed
below:
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A good objective of a firm is not vague and ambiguous, provides timely measure,
does not affect specific benefits of a firm nor does it affect societal welfare, and is
based on long-term achievement.
An agency problem is the likelihood that mangers give priority to their personal
interest ahead of corporate goals.
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D) A and B
Part II. Give short answers for the following questions
1. What is the difference between profit maximization and wealth maximization? Under
what conditions might profit maximization lead to wealth maximization?
2. Which action is better under wealth maximization decision criterion? An action that
increases a firms stock price from a current level of Br. 40 to Br. 50 in 5 years, or an
action that keeps the stock at Br. 40 for 5 years after which time it increases to Br. 80?
Exercise: ABC Company intends to invest in either project A or project B. both projects
cost Br. 105,000 and the expected cash inflows are given below:
EXPECTED CASH INFLOWS
YEAR
PROJECT A
PROJECT B
Br. 55,000
Br. 0
43,000
61,000
159,000
Br. 159,000
Br. 159,000
TOTAL
The required rate of return is 9% for each project. Assume only one of the two projects is
to be chosen. In which project should ABC Company invest if it uses
1. Profit maximization as a decision rule?
2. Wealth maximization as a decision rule?
2.9 SELECTED REFERENCES
1. Aswath Damondaran (1997). Corporate Finance: Theory and Practice John Wiley
and Sons, Inc. New York.
Financial Management - I, BY Abdi .D
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Why are financial ratios discussed under major categories? What are the
major categories and what does each category measure about a firm?
What are some of the uses as well as the limitations of ratio analysis?
3.1 INTRODUCTION
In the previous accounting courses you have learned that financial statements report both
on a firms financial position and financial performance. The four basic financial
statements present about different aspects of financial conditions, operating results, and
cash flows. The balance sheet shows a firms assets and claims against assets at a
particular point in time time. The income statement, on its part, reports the results of the
firms operations over a period of time. Similarly, the statements of retained earnings and
cash flows show the change in retained earnings and cash between two balance sheet
dates.
However, financial statements by themselves do not give aq complete picture about a
companys financial condition, operating results, and cash flows. Neither can a real value
of financial statements could be derived in themselves alone. Therefore, to predict the
future and to help anticipate future conditions, financial statements should be analyzed
further. This analysis helps to identify current strengths and weakness of the firm. It
facilitates planning the future, and helps to control the firms financial activities better. To
have all this benefits, however, a finance person should perform a financial analysis.
3.2 MEANING AND OBJECTIVES OF FINANCIAL ANALYSIS
Financial analysis refers to analysis of financial statements and it is a process of
evaluating the relationships among component parts of financial statements.
The focus of financial analysis is on key figure in the financial statements and the
significant relationships that exist between them. Financial analysis is used by several
groups of users like managers, credit analysts, and investors.
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The analysis of financial statements is designed to reveal the relative strengths and
weakness of a firm. This could be achieved by comparing the analysis with other
companies in the same industry, and by showing whether the firms position has been
improving or deteriorating over time. Financial analysis helps users obtain a better
understanding of he firms financial conditions and performance. It also helps users
understand the numbers presented in the financial statements and serve as a basis for
financial decisions.
3.3 TOOLS AND TECHNIQUES OF FINANCIAL ANALYSIS
A number of methods can be used in order to get a better understanding about a firms
financial status and operating results. The most frequently used techniques in analyzing
financial statements are:
i) Ratio Analysis is a mathematical relationship among money amounts in the financial
statements. They standardize financial data by converting money figures in the financial
statements. Ratios are usually stated in terms of times or percentages. Like any other
financial analysis, a ratio analysis helps us draw meaningful conclusions and
interpretations about a firms financial condition and performance.
ii) Common size Analysis expresses individual financial statement accounts as a
percentage of a base amount. A common size status expresses each item in the
balance sheet as a percentage of total assets and each item of the income statement as
a percentage of total sales. When items in financial statements are expressed as
percentages of total assets and total sales, these statements are called common size
statements.
iii) Index Analysis expresses items in the financial statements as an index relative to the
base year. All items in the base year are assumed to be 100%. Usually, this analysis is
most appropriate for income statement items.
According to users of financial information, there are two techniques of financial
analysis. These are:
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Assets
Current assets:
Cash
Marketable securities
Accounts receivable (net)
Inventories
Total current assets
Fixed assets:
Land and buildings
Plant and equipment
Total fixed assets
Less: accumulated depreciation
Net fixed assets
Total assets
Liabilities and stockholders equity
Current liabilities:
Accounts payable
Notes payable
Taxes payable
Total current liabilities
Long-term debt:
Mortgage bonds 5%
Total liabilities
Stockholders equity:
Preferred stock 5% (Br. 100 par)
Financial Management - I, BY Abdi .D
2001
9,000
3,000
20,700
24,900
57,600
7,000
2,000
18,300
23,700
51,000
33,000
130,500
163,500
67,200
96,300
153,900
27,000
120,000
147,000
61,200
85,800
136,800
20,100
14,700
3,300
38,100
17,100
13,200
3,000
33,300
60,000
98,100
60,000
93,300
6,000
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30,000
4,500
9,000
43,500
136,800
Income Statement
For the Year Ended December 31, 2002
________________________________________________________________________
Net sales
Br. 196,200,000
159,600,000
Gross profit
Br. 36,600,000
Operating expenses*
26,100,000
Br. 10,500,000
Interest expense
3,000,000
Br. 7,500,000
Income taxes
3,600,00
Net income
Br. 3,900,000
* Included in operating expenses are Br. 6,000,000 depreciation and Br. 2,700,000 lease
payment.
Zebra Share Company
Statement of Retained Earnings
For the Year Ended December 31, 2002
Retained earnings at beginning of year
Add: Net income
Sub-total
Br. 9,000,000
3,900,000
Br. 12,900,000
Br. 300,000
Common
3,300,000
Sub-total
Br. 3,600,000
Br. 9,300,000
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i) Current ratio measures the ability of a firm to satisfy or cover the claims of shortterm creditors by using only current assets. This ratio relates current assets to current
liabilities
Current ratio = Current assets
Current liabilities
Zebras current ratio (for 2002) = Br. 57,600 = 1.51 times
Br. 38,100
Interpretation: Zebra has Br. 1.51 in current assets available for every 1 Br. in current
liabilities.
Relatively high current ratio is interpreted as an indication that the firm is liquid and in
good position to meet its current obligations. Conversely, relatively low current ratio is
interpreted as an indication that the firm may not be able to easily meet its current
obligations. A reasonably higher current ratio as compared to other firms in the same
industry indicates higher liquidity position. A very high current ratio, however, may
indicate excessive inventories and accounts receivable, or a firm is not making full use of
its current borrowing capacity.
ii) Quick ratio (Acid test ratio)- measures the short-term liquidity by removing the least
liquid current assets such as inventories. Inventories are removed because they are not
readily or easily convertible into cash. Thus, the quick ratio measures a firms ability to
pay its current liabilities by using its most liquid assets into cash.
Quick ratio = Current assets Inventory
Current liabilities
Zebras quick ratio (for 2002) = Br. 57,600 Br. 24,900 = 0.86 times
Br. 38,100
Interpretation: Zebra has Br. 0.86 in quick assets available for every one birr in current
liabilities.
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Like the current ratio, the quick ratio reflects the firms ability to pay its short-tem
obligations, and the higher the quick ratio the more liquid the firms position. But the
quick ratio is more detailed and penetrating test of a firms liquidity position as it
considers only the quick asset. The current ratio, on the other hand, is a crude measure of
the firms liquidity position as it takes into account all current assets without distinction.
Net sales
Accounts receivable
Zebras accounts receivable turnover (for 2002) = Br. 196,200 = 9.48 times
Br. 20,700
Interpretation: Zebras accounts receivable get converted into cash 9.48 times a year.
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365 days
Accounts receivable turnover
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Br. 24,900
Interpretation: Zebras inventory is on the average sold out 6.41 times per year.
In computing the inventory turnover, it is preferable to use cost of goods sold in the
numerator rather than sales. But when cost of goods sold data is not available, we can
apply sales. In general, a high inventory turnover is better than a low turnover. But
abnormally high inventory turnover might result from very low level of inventory. This
indicates that stock outs will occur and sales have been very low. A very low turnover, on
the other hand, results from excessive inventory levels, presence of inferior quality,
damaged or obsolete inventory, or unexpectedly low volume of sales.
iv) Fixed assets turnover measures how efficiently a firm uses it fixed assets. It shows
how many birrs of sales are generated from one birr of fixed assets
Fixed assets turnover =
Net sales___
Net fixed assets
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Net Sales
Total assets
Total liabilities
Total assets
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Interpretation: At the end of 2002, 64% of Zebras total assets was financed by debt and
36% (100% - 64%) was financed by equity sources.
A high debt ratio implies that a firm has liberally used debt sources to finance its assets.
Conversely, a low ratio implies the firm has funded its assets mainly with equity sources.
Debt ratio reflects the capital structure of a firm. The higher the debt ratio, the more the
firms financial risk.
ii) Times interest earned measures a firms ability to pay its interest obligations.
Times interest earned = Earnings before interest and taxes (EBIT)
Interest expense
Zebras times interest earned = Br. 10,500 = 3.50X
Br. 3,000
Interpretation: Zebra has operating income 3.5 times larger than the interest expense.
The times interest earned ratio implicitly assumes a firms operating income (EBIT) is
available to meet its interest obligations. However, earnings before interest and taxes is
an income concept and not a direct measure of cash. Hence, this ratio provides only an
indirect measure of the firms ability to meet its interest payments.
iii) Fixed charges coverage measures the ability of a firms to meet all fixed obligations
rather than interest payments alone. Fixed payment obligations include loan interest and
principal, lease payments, and preferred stock dividends.
Fixed charges coverage = Income before fixed charges and taxes
Fixed charges
For Zebra Company, the other fixed charge payment in addition to interest is lease
payment. Therefore,
Zebras fixed charges coverage = Br. 10,500 + Br. 2,700
= 2.32X
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Interpretation: the fixed charges (interest and lease payments) of Zebra Share Company
are safely covered 2.32 times.
Like times interest earned, generally, a reasonably high fixed charges coverage ratio is
desirable. The fixed charges coverage ratio is required because failure of the firm to meet
any financial obligation will endanger the position of a firm.
= 2%
Br. 196,200
Interpretation: Zebra generated 2 cents in profits for every one birr in net sales.
The net profit margin ratio is affected generally by factor as sales volume, pricing
strategy as well as the amount of all costs and expenses of a firm.
ii) Return on investment (assets) measures how profitably a firm has used its
investment in total assets.
Financial Management - I, BY Abdi .D
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Return on investment =
Net income
Total assets
Net income___
Stockholders equity
Zebras return on equity = Br. 3,900 = 6.99%
Br. 55,800
Interpretation: Zebra earned almost 7 cents of profit for each birr in owners equity
We can also use the following alternative way to calculate return on equity.
Return on equity = Return on investment
1 Debt ratio
A high return on equity may indicate that a firm is more risky due to higher debt balance.
On the contrary, a low ratio may indicate greater owners capital contribution as compared
to debt contribution. Generally, the higher the return on equity, the better off the owners.
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Muhammed Fertilizers Company has assets amounting to Br. 1,200,000. The firm has
generated Br. 3,000,000 in annual net sales, with a 5% net profit margin. What is the net
income and return on assets for Zemedkun?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
Dupont System of Analysis
It is an approach to assess that a firms return on assets and return on equity show not
only the firms earning power but also efficiency and leverage. This analysis breaks down
these two ratios as follows:
Return on assets = Profit margin X Total assets turnover
Return on equity =Profit margin X Total assets turnover X Total assets/equity
= Profit Margin X Total assets turnover X Equity Multiplier
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= Br. 1.09
Br. 3,300 _
= Br. 1.00
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i) Cross sectional analysis is the comparison of a firms ratios to those other firms in
the same industry at the same point in time. Here, the firm is interested in how well it has
performed in relation to other firms. Generally, cross sectional analysis is preformed
based on industry averages of different financial ratios.
ii) Time series analysis is an evaluation of a firms financial ratios over time. Here,
the current period ratios are compared with those of the past years. The purpose is to
determine whether the firm is progressing or deteriorating.
To obtain the highest possible information about a firm, usually, a combination of both
cross sectional and time-series analyses are applied.
3.7 LIMITATIONS OF RATIO ANALYSIS
Even though ratio analysis can provide useful information about a firms financial
conditions and operations, it has the following problems and limitations.
1. Generally, any single financial ratio does not provide sufficient information by itself.
2. Sometimes a comparison of ratios between different firms is difficult. One reason
could be a single firm may have different divisions operating in different industries.
Another reason could be the financial statements may not be dated at the same point in
time.
3. The financial statements of firms are not always reliable, particularly, when they are
not audited.
4. Different accounting principles and methods employed by different companies can
distort comparisons.
5. Inflation badly distorts comparison of ratios of a firm over time.
6. Seasonal factors inherent in a business can also lead us to deceptive conclusion. For
example, the inventory turnover ratio for a stationery materials selling company will be
different at different time periods of a year.
3.8 SUMMARY
Financial Management - I, BY Abdi .D
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The primary purpose of this unit was to learn how to analyze financial statements.
The basic points discussed are:
-
There are several techniques of financial analysis; but ratio analysis is common.
Financial ratios are classified into different categories, measuring about a firms
liquidity, activity, leverage, earning powers, and other related aspects.
Current and quick ratios are the two commonly used liquidity ratios.
Activity ratios include turnover ratios like accounts receivable turnover, inventory
turnover, fixed assets turnover, and total assets turnover.
Leverage ratios reveal two information associated with debt of a firm. These
ratios include debt ratio, times interest earned, and fixed charges coverage.
Profitability ratios indicate the earning power of a firm. Ratios under this category
include profit margin, return on assets, and return on investment.
Marketability ratios, unlike the other categories, do not measure specific aspect of
a firm. Earnings per share, dividends per share, and pay-out ratio are among the
most common types.
Financial ratios, though are important and useful analyses, have many problems
and limitations.
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= Br. 120,000 = 4X
Interest expense
Br. 30,000
2. If new shares of common stock are issued in exchange for the existing debt of a firm,
then
A) Return on investment increases.
B) Times interest earned ratio will decrease.
C) Return on stockholders equity will decrease.
D) Current and quick ratios will increase.
3. A relatively lower return on assets is always an indicator of poor asset management.
A) True
B) False
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1. A company has current liabilities of Br. 75,000, mortgages notes payable of Br.
200,000, and long-term bond of Br. 225,000. If the total stockholders equity of the
company amounts to Br. 750,000, what is the debt ratio?
2. A firm has a current ratio of 1.5 and a quick ratio of 1.0. If the current assets other than
cash amount to Br. 2,500,000, what is the mathematical relationship between
inventories and current liabilities for this firm?
3. ABC companys return on investment was 25% last year, and the net profit margin was
10%. What are the total net sales for the year if total assets are Br. 20 million?
4. XYZ corporation has Br. 1,000,000 of debt outstanding of 10% interest rate. The firms
annual net sales are Br. 4,000,000; its tax rate is 40%; and its net profit margin is 5%.
What is XYZ Companys times interest earned ratio?
Cash
Accounts payable
Accounts receivable
Long-term debt
Inventories
Common stock
Fixed assets
________
Total assets
Br. 1,000,000
Sales
120,000
Retained earnings
195,000
_______
Inventory turnover: 5X
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4.1 INTRODUCTION
In the first unit, we discussed that financial management involves planning for raising
and utilizing funds. Financial mangers should be able to plan before hand in making
investment and financing decisions. So, financial forecasting helps financial mangers to
predict events before they occur. This, particularly, is true when they plan to raise funds
externally. Because a firms profit is often insufficient to finance assets in the normal
course of business, additional sources of finance should be considered.
Financial forecasting also forces financial mangers to develop financial statements before
hand. These financial statements are called Pro forma financial statements. They include
forecasted sales and forecasted expenses, forecasted assets, forecasted liabilities, and
forecasted stockholders equity. Based on these forecasted items, the financial manger is
able to determine the amount of finance to be obtained from external sources.
4.2 MEANING AND PURPOSE OF FINANCIAL FORECASTING
Financial forecasting is one of the four major jobs of a firms financial staff, namely
performing financial forecasting and analysis, making investment decisions, and making
financing decisions. It is generally a planning process which involves forecasting of sales,
assets, and financial requirements. In other words, financial forecasting is a process
which involves:
-
Generally, financial forecasts are required to run a firm well. Their base, in almost all
circumstances, are forecasted financial statements. An accurate financial forecast is very
important to any firm in several aspects:
-
It helps a firm to project its sales and accordingly to predict its assets properly.
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Financial forecasts are also meanses for forecasted financial statements. By their virtue, a
firm can forecast its income statement, balance sheet and other related statements.
Besides, key ratios can be projected. Once financial statements and ratios have been
forecasted, the financial forecast will be analyzed. Finally, the firms management will
have an opportunity to make some decisions before hand.
So, all in all, financial forecasting is a prerequirment for the investment, financing, as
well as dividend policy decisions of a firm.
4.3 PROCEDURES IN FINANCIAL FORECASTING
The financial forecasting process generally involves the following procedures:
i) Forecasting of sales for the future period
ii) Determining the assets required to meet the sales targets, and
iii) Deciding on how to finance the required assets.
The above three procedures are very important in projecting the financial statements and
key financial ratios. However, among the three procedures, the first one, i.e, sales forecast
is the most crucial.
Sales forecast is a forecast of a firms unit and birr sales for some future period. It is
generally based on recent sales trends and forecast of the economic prospects of the
nation, region, industry and other factors. This procedure starts usually by reviewing the
sales of the recent pasts. The whole crucial points of a financial forecasting process lies in
an accurate forecast of sales. If this procedure is off, the firms profitably as well as its
value will be negatively affected. So in forecasting sales, several factors should be
considered:
1. the historical sales growth pattern of the firm at both divisional and corporate levels,
2. the level of economic activity in each of the firms marketing areas,
3. the firms probable market share,
4. the effect of inflation on the firms future pricing of products,
Financial Management - I, BY Abdi .D
Page 55
5. the effect of advertising campaigns, cash and trade discounts, credit terms, and other
similar factors alike on future sales,
6. Individual products sales forecasts at each divisional level.
Forecast of sales is a base for forecasting of the firms income statement which in turn
helps to project retained earnings. In forecasting the income statement assumptions about
the costs, tax rates, interest charges and dividends are required.
Sales forecasts are also grounds for determination of the firms assets requirement.
If sales are to increase, then assets must also grow. The amount each asset account must
increase depends whether the firm was operating at full capacity or not. If higher sales are
projected, more cash will be needed for transactions, higher sales will create higher
receivables. Similarly, higher sales require higher inventory and higher plant and
equipment.
Finally, the firm will face the question of financing its required assets. Some of the
required finance can be covered by the increased retained earnings. The retained earnings
increment will result from increased sales and profit. Still some other portion of the
finance can be covered by some liabilities which will grow by the same proportion with
that of sales. The remaining finance must be obtained from available external sources.
The third procedure of the financial forecasting process, i.e. forecast of financial
requirements involves again three sub procedures. These are:
1. Determining how much money (finance) the firm will need during the forecasted
period. This will be done based on sales and assets forecast.
2. Determing how much of the total required finance, the firm will be able to generate
internally during the same period. There are two types of finance that will be
generated under normal operations. The first is portion of the net income retained in
the firm (retained earnings). The second one is the increase in the firms liabilities as
a direct and automatic result of its decision to increase sales. This finance is called
spontaneous finance. For example, if sales are to increase, inventory must increase.
The increase in inventory requires more purchases which in turn causes the accounts
Financial Management - I, BY Abdi .D
Page 56
payable to be increased. The accounts payable will increase spontaneously with the
increase in sales. Other examples include accruals like salaries and wages payable
and income tax payable.
3. Determining the additional external financial requirements. Any balance of the total
finance that cannot be met with normally generated funds must be obtained from
external sources. This finance is called the additional funds needed (AFN).
Required increase
AFN =
in assets
Required increase in
__
Additional funds needed (AFN) are funds that a firm must raise externally through
borrowing (bank loans, promissory notes, bonds, etc.) or by issuing new shares of
common stock or preferred stock.
4.4 METHODS OF FORECASTING FINANCIAL REQUIREMENTS
There are two methods to determine the additional financial requirements. These are:
1. The proforma financial statements method and
2. The formula method
Page 57
The proforma income statement provides a projection of the firms net income for the
forecasted period. This enables the firm to estimate the amount of retained earnings it will
generate during the period. In developing the projected income statement, first, a forecast
of sales should be established. Second, cost of goods sold should be determined. Third,
other expenses (operating and non-operating) should be computed. Next, the net income
should be determined. Finally, based on the amount of dividends, the amount of addition
to retained earnings should be determined.
2. Constructing the Pro Forma Balance Sheet
Higher sales must be supported by higher asset amounts. Some of the assets increase can
be financed by retained earnings, and spontaneous finance. The remaining blanc must be
financed from external sources. In the forecast of the firms balance sheet, first, those
balance sheet items that are expected to increase directly with sales are forecasted. Next,
the spontaneously increasing liabilities are forecasted. Then, the liability and equity items
that are not directly affected by sales are set. Next, the value of retained earnings for the
forecasted period is obtained. Finally, the AFN will be raised.
Example
Blue Nile Share Company is a medium sized firm engaged in manufacturing of various
household utensils. The financial manger is preparing the financial forecast of the
following year. At the end of the year just completed, the condensed balance sheet of the
company has contained the following items.
Assets
A/receivable -----------------------70,000
Accruals --------------------------------40,000
--------------------------------40,000
Inventories -----------------------150,000
-----------------------150,000
_________
Page 58
During the year just completed the firm had sales of Br. 1,800,000. In the following year,
due to increased demand to the firms products the financial manger estimates that sales
will grow at 10%. There are no preferred stock outstanding during the year. The firms
dividend pay-out ratio is 60%. It is also known that the firms assets have been operating
at full capacity. During the same year, Blue Niles operating costs were Br. 1,620,000 and
are estimated to increase proportionately with sales. Assume the companys interest
expense will be Br. 40,000 during the next year and its tax rate is 40%.
Required: Determine the additional funds needed (AFN) of Blue Nile Share Company
for the next year using the proforma financial statements method.
Solution
First, we develop the proforma income statement
Pro Forma Income Statement
____________________________________________________________________________________________________________
Assets
_______
Page 59
Blue Niles forecasted total assets as shown above are Br. 660,000. However, the
forecasted total liabilities and equity amount to only Br. 650,920. Since the balance sheet
must balance, i.e. A = L + OE, the difference must be covered by additional funds.
Therefore, AFN = Br. 660,000 Br. 650,920 = Br. 9,080.
Or AFN = increase in
assets
Increase in normally
generated funds
= [Br. 660,000 Br. 600,000] [(Br. 99,000 Br. 90,000) + (Br. 44,000 Br.
40,000) + Br. 37,920]
= Br. 60,000 Br. 50,920
= Br. 9,080
Page 60
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
Required
=
increase
Spontaneous
in assets
increase in
liabilities
Increase in
retained
earnings
Page 61
Br.600,000
AFN =
Br .1,800,000
Br.180,000
*
Br.130,000
Br
.1,800,000
(Br. 180,000) 5% x
Br 1,980,000** (1 60%)
= Br. 60,000 Br. 13,000 Br. 39,600
= Br. 7,400
To increase sales by 10% (Br. 180,000), the formula suggests that Blue Nile must
increase its assets by 60,000. In other words, the firm will require a Br. 60,000 more fund
for the forecasted year. Out of this, Br. 13,000 will come from spontaneous increase in
liabilities. Another Br. 39,600 will be obtained from retained earnings. The remaining Br.
7,400 must be raised from external sources like by issuing new shares of stocks or by
borrowing.
* S = S1 S0 = S0 x sales growth rate (g) = Br. 1,800,000 x 10% = Br. 180,000
** S1 = S0 + S0g = S0 (1 +g) = Br. 1,800,000 (1 + 0.10) = Br. 1,980,000.
Page 62
constant next year, what is the maximum sales growth rate (g) Selam can achieve without
having to use additional funds needed (AFN)? (Use the formula for AFN).
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
Page 63
dividend payout ratio, the smaller the addition to retrained earnings, and hence the greater
the requirements for external finance.
Actual sales______________
= Percentage of capacity at which
fixed assets were operated
= Br. 1,800,00
= Br. 1,836,735
98%
ii) Determine the target fixed assets/sales ratio
Target fixed assets/sales ratio = Actual fixed assets
Full capacity sales
Financial Management - I, BY Abdi .D
Page 64
= Br. 370,000
= 20%
Br. 1,836,735
iii) Determine the new required level of fixed assets.
Required level of = (Target fixed assets/sales ratio) X (Projected sales)
fixed assets
= 20% X Br. 1,980,000 = Br. 396,000
Previously Blue Nile forecasted it would need to increase fixed assets at the same rate as
sales or by 10%. That means, the firm forecasted an increase from Br. 370,000 to Br.
407,000. Now we see that the actual required increase is only from Br. 370,000 to Br.
396,000. Thus, the capacity adjust forecast is Br. 11,000 (Br. 407,00 Br. 396,000) less
than the earlier forecast. Therefore, the projected AFN would decline from an estimated
Br. 9,080 to Br. -1,920 (Br. 9,080 Br. 11,000). The negative AFN indicates the firm
would even produce excess funds of Br. 1,920 than it requires.
4.7 SUMMARY
The key concepts covered in this unit are summarized below
-
Financial forecasts are very important for both profitability and value
maximization of a firm.
The two most common methods of forecasting the financial requirement of a firm
are: (1) the projected financial statement method and (2) The formula method.
The external capital requirement of a firm is affected by its sales growth rate,
capital intensity ratio, net profit margin, and dividend payout ratio.
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generated funds
Increase in
= spontaneous liabilities
Increase in
+ retained earnings
Page 66
g = 0.055/1.255 = 4.38%.
III. When the firm starts paying at the end of each month, its balance of salaries payable
would be more than when it was paying weekly. The increase in salaries payable is an
increase in accruals which is a spontaneous finance. Finally, the increase in
spontaneous finance would cause the AFN to be smaller.
4.9
4.9 MODEL EXAMINATION QUESTIONS
Part I. Multiple choice
1. In determining the additional financial requirements (AFN) of a firm for a given period
under consideration,
A) The fixed assets are always forecasted to incase proportionally with sales.
B) The addition to retained earnings is forecasted as a specified percentage of sales.
C) AFN is simply computed by deducting spontaneous liabilities from the required
increase in the current level of assets
D) None of the above
2. Which of the following statement(s) is (are) true for a firm having sales expansion
plan, if its fixed assets operate below full capacity?
A) Fixed assets increase at a rate faster than sales growth rate.
B) Fixed assets increase at a rate slower than the growth of sales
C) Fixed assets are not affected by sales expansion plan
D) Fixed assets increase until full capacity sales are achieved
3. Which one of the following factors causes the AFN of a firm to be high?
A) Lower sales growth rate
B) Higher dividend payout ratio
C) Higher net profit margin
D) Lower capital intensity ratio
Part II. Problem
You are given below the condensed balance sheet and income statement of Addisalem
Auto Spare Parts, PLC for 2002
Financial Management - I, BY Abdi .D
Page 67
Receivables -------------------180,000
Inventories --------------------360,000
--------------------360,000
Accruals ----------------------------------90,000
----------------------------------90,000
_________
Page 68
c) How does the financing of AFN through common stock affects the firms dividend as
well as its retained earnings?
d) Assume also that the remaining 50% is to be financed by notes payable, how does this
affect interest expense?
e) Determine the AFN using the formula method
f) If fixed assets were operating at only 96% of capacity during 2002, how does this
affect AFN? (Use the formula method)
4.10 SELECTED REFERENCES
1. Eugene F. Brigham (1997). Fundamental of Financial Management.
Management. 7th edition, the
Dryden press Harcourt Brace College Publishers, Florida.
2. Halpern, Weston, and Brigham (1989). Canadian Managerial Finance.
Finance. 3rd edition,
Holt, Rinehart and Winston of Canada, Limited.
3. Stanley B. Block and Geoffrey A. Hirt (1994). Foundations of Financial
Management.
Management. 7th edition, Irwin.
4.11 GLOSSARY
Proforma financial statements financial statements prepared for forecasted periods.
Sales targets a forecast of a firms sales in terms of both units and amounts.
Full capacity a situation where by all the assets of a firm are being utilized 100%.
Spontaneous finance a finance available to a firm as a direct or indirect result of a
sales increment decision of the firm.
Labor intensive highly utilizing labor force
Excess capacity a situation whereby some portion of a firms assets, particularly fixed
assets, are not currently utilized.
Fixed assets / Sales ratio the amount of fixed assets required per birr of sales.
Page 69
Page 70
Though we have discussed both simple and compound interest, in financial management
we are largely interested on compound interest. So in the sections that follow we shall
discuss the concepts and techniques of the time value of money in the context of
compound interest.
5.2 FUTURE VALUE
To understand future value, we need to understand compounding first. Compounding is a
mathematical process of determining the value of a cash flow or cash flows at the final
period. The cash flow(s) could be a single cash flow, an annuity or uneven cash flows.
Future value (FV) is the amount to which a cash flow or cash flows will grow over a
given period of time when compounded at a given interest rate. Future value is always a
direct result of the compounding process.
Page 71
Example: Hana deposited Br. 1,800 in her savings account in Meskerem 1990. Her
account earns 6 percent compounded annually. How much will she have in Meskerem
1997?
To solve this problem, lets identify the given items: PV = Br, 1,800; i = 6%; n = 7
(Meskerem 1990 Meskerem 1997).
FVn = PV (1 + i)n
= Br. 1,800 (1.06)7
= Br. 2,706.53
The (FVIFi,n) can be found by using a scientific calculator or using interest tables given
at the end of this material. From the first table by looking down the first column to period
7, and then looking across that row to the 6% column, we see that FVIF6%,7 = 1.5036.
Then, the value of Br. 1,800 after 7 years is found as follows:
FVn = PV (FVIFi,n)
FV7 = Br. 1,800 (FVIF6%, 7)
= Br. 1,800 (1.5036) = Br. 2,706.48
ordinary annuity,
ii)
iii)
deferred annuity
Page 72
2 ------------------
FVAn = PMT
i
Where:
FVAn = Future value of an ordinary annuity
PMT = Periodic payments
i = Interest rate per period
n = Number of periods
Or
FVAn = PMT (FVIFAi,n)
Where:
(FVIFAi, n) = the future value interest factor for an annuity
=
(1 i ) n 1
i
Example: You need to accumulate Br. 25,000 to acquire a car. To do so, you plan to
make equal monthly deposits for 5 years. The first payment is made a month from today,
in a bank account which pays 12 percent interest, compounded monthly. How much
should you deposit every month to reach your goal?
Given: FVAn = Br. 25,000; i = 12% 12 = 1%; n = 5 x 12 = 60 months; PMT = ?
FVAn = PMT (FVIFAi, n)
Br. 25,000 = PMT (FVIFA, %, 60)
Br. 25,000 = PMT (81.670)
Financial Management - I, BY Abdi .D
Page 73
2 --------------------- n
= PMT
Example: Assume that pervious example except that the first payment is made today
instead of a month from today. How much should your monthly deposit be to accumulate
Br. 25,000 after 60 months?
FVAn (Annuity due) = PMT (FVIFAi, n) (1 + i)
Br. 25,000 = PMT (FVIFAi, n) (1 + i)
Br. 25,000 = PMT (81.670) (1.01)
PMT = Br. 25,000/82.487
PMT = Br. 303.08
iii) Future value of Deferred Annuity is an annuity for which the amount is computed
two or more period after the final payment is made.
0
2 ------------------n --------------n + x
PMT1 PMT2
PMTn
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= PMT
3,000
93
94
3,000 3,000
95
3,000
96
97
3,000 3,000
98
3,000 3,000
The future value is computed on December 31, 2003 (or January 1, 2004).
Given: PMT = Br. 3,000; i = 10%; n = 10; x = 5
FVAn (Deferred annuity) = PMT (FVIFAi, n) (1 + i)x
= Br. 3,000 (FVIFA 10%, 10) (1.10)5
= Br. 3,000 (15.937) (1.6105)
= Br. 76, 999.62
Page 75
FVIF8%, 3
3,779.10
4,665.60
1,296.00
FVIF8%,2
FVIF8%, 1
900.00
FV = Br. 12,001.20
Page 76
FVn
1 i n
FVn
Where:
PV = Present Value
FVn = Future value at the end of n periods
i = Interest rate per period
n = Number of periods
Or
PV = FVn (PVIFi, n)
Where:
(PVIFi, n) = The present value interest factor for i and n = 1/ (1 + i)n
Example: Zelalem PLC owes Br. 50,000 to ALWAYS Co. at the end of 5 years.
ALWAYS Co. could earn 12% on its money. How much should ALWAYS Co. accept
from Zelalem PLC as of today?
Given: FV5 = Br. 50,000; n = 5 years; i = 12%; PV = ?
PV = FV5 (PVIF12%, 5)
= Br. 50,000 (0.5674) = Br. 28,370
Page 77
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
PVAn = PMT
1
1 1 i n
1 1 i n
PMT
= PMT (PVIFAi, n)
Where:
PVAn = The present value of an ordinary annuity
(PVIFAi, n) = The present value interest factor for an annuity
=
1 1 i
i
Example: Ato Mengesha retired as general manager of Tirusew Foods Company. But he
is currently involved in a consulting contract for Br. 35,000 per year for the next 10 years.
What is the present value of Mengeshas consulting contract if his opportunity costs is
10%?
Given: PMT = Br. 35,000; n = 10 years; i = 10%; PVAn = ?
PVA10 = Br. 35,000 (PVIFA10%, 10)
= Br. 35,000 (6.1446) = Br. 215,061.
215,061. This means if the required rate of
return is 10%, receiving Br. 35,000 per year for the next 10 years is equal to receiving Br.
215,061 today.
Page 78
________________________________________________________________________
________________________________________________________________________
ii) Present value of an Annuity Due is the present value computed where exactly the
first payment is to be made. Graphically, this is shown below:
0
3 ---------------- n
PMT1 PMT2
PMTn
The present value of an annuity due is computed at point 1 while the present value of an
ordinary annuity is computed at point 0.
1 (1 i ) n
(1 + i) = PMT (PVIFAi, n) (1 + i)
i
Example: Ruth Corporation bought a new machine and agreed to pay for it in equal
installments of Br. 5,000 for 10years. The first payment is made on the date of purchase,
and the prevailing interest rate that applies for the transaction is 8%. Compute the
purchase price of the machinery.
Given: PMT = Br. 5,000; n = 10 years; i = 8%; PVAn (Annuity due) = ?
PVA (Annuity due) = Br. 5,000 (PVIFA 8%, 10) (1.08)
= Br. 5,000 (6.7101) (1.08) = Br. 36,234.54. So the cost of the
machinery for Ruth is Br. 36,234.54. We have identified the case as an annuity due rather
than ordinary annuity because the first payment is made today, not after one period.
Page 79
iii) Present value of a Deferred Annuity is computed two or more periods before the first
payment is made.
1 (1 i ) n
-x
-x
(1 + i) = PMT (PVIFAi, n) (1 + i)
i
Where x is the number of periods between the date when he first payment is made and
the date the present value is computed.
Example: Sefa Chartered Accountants has developed and copyrighted an accounting
software program. Sefa agreed to sell the copyright to Steel company for 6 annual
payments of Br. 5,000 each. The payments are to begin 5 years from today. If the annual
interest rate is 8%, what is the present value of the six payments?
0
10
PVAn = ?
X
Given: n = 6; PMT = Br. 5,000; X = 4; PVA6 (Deferred annuity) = ?
i = 8% PVA6 (Deferred annuity) = Br. 5,000 (PVIFA8%, 6) (1.08)-4
= Br. 5,000 (4.6229) (0.7350) = Br. 16,989.16
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Year
Cash flow
Br. 400 (0.8929)
Br. 400
Br. 100
Br.300
PVIF12%, 1
= Br. 357.16
Br. 100 (0.7972)
PVIF12%, 2
= Br. 79.72
Br. 300 (0.7118) PVIF12%, 3
= Br. 213.54
Br. 650.42
PMT
i
Example: What is the present value of a perpetuity of Br. 7,000 per year if the
appropriate discount rate is 7%?
Given: PMT = Br. 7,000; i = 7%;, PV (Perpetuity) = ?
PV (Perpetuity) = PMT = Br. 7,000 = Br. 100,000.
100,000. This means that
i
7%
receiving Br. 7,000 every year forever is equal to receiving Br. 100,000 now.
Page 81
5.4 SUMMARY
-
The time value of money analysis recognizes the difference among birrs received
or paid at different points in time.
Future value can be computed for a single cash flow, an annuity, and an uneven
cash flow stream.
Present value can be computed for a single cash flow, an annuity, uneven cash
flows, and a perpetuity.
Formulas are available for computing both present values and future values of
various types of given cash flows.
The longer the time period and the higher the interest rate, the larger the future
value. But the opposite is true for present values.
The concepts and techniques of the time value of money have many applications
in financial management.
04
05
06
PMT
PMT
07
08
09
2010 2011
Br. 500,000
Page 82
Page 83
much will Meron have in her bank account on December 31, 2004? (Meron has not
interrupted her monthly deposits).
2. Solomon decided to start a savings account on January 1, 1995. After making a yearly
deposit of Br. 15,000 for 3 years (Jan. 1, 1995 through Jan. 1, 1997); he left for abroad.
He returned home late 1998 and resumed his savings plan with quarterly deposits of Br.
3,000 each beginning January 1, 1999. The banks interest rate was 9% compounded
annually from January 1, 1995, through January 1, 1998, and 12% compounded
monthly there after. What is the balance in Solomons savings account on January 1,
2002?
3. You have just taken a 30-year mortgage loan for Br. 200,000. The annual interest rate
on the loan is 6% compounded monthly. How large is your monthly payment if the first
payment is to be made three months after you have taken the loan?
4. Nahom invests in a Br. 180,000 annuity insurance policy at 6% compounded monthly
on January 1, 1999. The first of 48 receipts from the annuity is payable to Nahom 12
months after the annuity is purchased. What will be the amount of each of the 48 equal
monthly receipts?
5. Mr. Atila acquired Demmy Textile Factory agreeing to pay Br. 1.5 million per year for
17 years starting the date of acquisition. Local newspapers reported Atila acquired
textile factory for Br. 25.5 million (1.5 million x 17). The appropriate interest rate is 9%
compounded annually. Do you agree with the newspapers? Why or why not?
6. You are trying to assess the value of a small merchandising company that is for sale.
The firm is expected to generate an annual cash flow of Br. 25,000 for an indefinite
time period. The rate of return required from the company is 10%. How much is your
assessment of the value of the company?
5.7 SELECTED REFERENCES
1. Aswath Damodaran (1997). Corporate Finance: Theory and Practice.
Practice. John Wiley
and Sons, Inc., New York.
2. Donald E. Kieso and Jerry J. Weygandt (1998). Intermediate Accounting.
Accounting. 9th edition,
John Wiley and Sons, Inc, New York.
Financial Management - I, BY Abdi .D
Page 84
Page 85
UNIT 6: VALUATION
Contents
6.0 Aims and Objectives
6.1 Introduction
6.2 Bond Valuation
6.2.1 Basic Bond Valuation Model
6.2.2 Interest Rate on a Bond
6.3 Preferred Stock Valuation
6.3.1 Preferred Stock Valuation Model
6.3.2 Rate of Return on a Preferred Stock
6.4 Common Stock Valuation
6.4.1 Zero Growth Stock
6.4.2 Constant Growth Stock
6.4.3 Variable Growth Stock
6.5 Summary
6.6 Answers to Check Your Progress Questions
6.7 Model Examination Questions
6.8 Selected References
6.9 Glossary
6.0 AIMS AND OBJECTIVES
The main purpose of studying this unit is to achieve the following objectives:
to appreciate one of the main applications of the concept of the time value of
money,
to differentiate among a bond, a preferred stock, and a common stock,
to identify the basic inputs in valuation of an asset,
to understand the techniques of computing the value of a bond, a preferred stock,
and a common stock,
to be able to interpret the values of financial assets,
Financial Management - I, BY Abdi .D
Page 86
Page 87
flows. One is the periodic interest payment by the issuing party. Another is the price paid
to the investor upon maturity. The first, i.e., the interest payment is based on the par value
of the bond and the coupon interest rate. The par value is the face value of the bond
which will be paid to the investor upon maturity. Par value is also called maturity value.
For instance if the par value of a bond is Br. 1,000, the issuer should pay the investor Br.
1,000 when the maturity date of the bond arrives. The coupon interest rate is the rate
which the issuer pays to the investor on the par value of the bond. If A Company invests
in a Br. 1,000 par value, 10-year, 8% coupon bonds of B Company, A shall receive Br. 80
(Br. 1,000 x 8%) per year for 10 years.
1
(1 k d ) n
kd
(PVIFkd,n) = The present value interest factor at interest rate of kd per period for n
periods =
1
(1 k d ) n
Page 88
Page 89
Page 90
from Br. 862.04 to Br. 868.32. If you further calculate the value of the bond at other
future dates, the price would continue to rise as the maturity date approaches.
Approximate YTM =
Example: Zebra Company has a Br. 1,000 par value, 10% coupon interest rate, and 15
years to maturity. The bond is currently selling at Br. 1,090. Compute the YTM.
Financial Management - I, BY Abdi .D
Page 91
Solution:
Given: M = Br. 1,000; I = Br. 100 (Br. 1,000 x 10%); n = 15; Bo = Br. 1,090; YTM = ?
Br.1,000090
15
9%
Br.1,000 Br.1,090
2
Br .100
Approximate YTM =
If an investor buys Zebras bond at Br. 1,090 and holds it for 15 years, the approximate
yield or rate of return per year is 9%.
Yield to call (YTC) is the rate of return earned by an investor if he buys a bond at a
specified price, Bo, and the bond is called before its maturity date. YTC, therefore, is
computed only for callable bonds. A callable bond is a bond which is called and retired
prior to its maturity date at the option of the issuer. A bond is called by an issuer when the
market interest rate falls below the coupon interest rate. The YTC can be found by
solving the following equation.
Call Pr ice Bo
n
Call Pr ice Bo
2
Approximate YTC =
Page 92
Br.1,080 Br.1,175
3
6.06%
Br.1,080 Br.1,175
2
Br.100
Approximate YTC =
If X Company buys Y Company bond and holds the bond until the bonds are called by Y
Company, the approximate annual rate of return would be 6.06%.
Page 93
The value of a preferred stock is the present value of all future preferred dividends it is
expected to provide over an infinite time horizon. Most preferred stocks entitle their
owners to regular and fixed dividend payments. If the payments last forever, the issue is a
perpetuity. Therefore, the value of a preferred stock is found by the following formula:
Dps
VPS = Kps
Where:
Br.6.40
= Br. 68.82
9.3%
So the Br. 6.40 annual dividend an investor receives for an infinite years is equal to
todays Br. 68.82 if the required rate of return is 9.3%.
Kps = Vps
Where
Page 94
Br.9
= 11.11%
Br.81
For an investor to invest Br. 81 in this preferred stock and to receive an annual dividend
of Br. 9, his minimum required rate of return is 11.11%.
6.4 COMMON STOCK VALUATION
The value of a share of common stock is the present value of the common stocks
dividend expected over an infinite time horizon. The value of a share of common stock is
also equal to the sum of the present value of the expected dividends and the present value
of the expected selling price of the stock. The selling price in turn will depend on the
dividends to be received by the purchasing party.
To understand the value of a common stock we should keep in mind two points. First, the
dividends are expected for an infinite time period. Second, the dividends are not constant.
Therefore, the value of a common stock is found by summing the present values of
annual dividends.
Po =
D1
D2
D
1
2
(1 ks)
(1 ks)
(1 ks )
Where:
Po = Value of the common stock at time zero (as of today)
D1, D2, , D = Pre share dividend expected at the end of each year
Ks = the required rate of return on the common stock.
Financial Management - I, BY Abdi .D
Page 95
The common stock valuation equation can be simplified by redefining each years
dividend. The dividends are defined in terms of anticipated dividends growth. Generally,
there are three cases accordingly. These are:
1. Zero growth common stock,
2. Constant growth common stock, and
3. Variable growth common stock.
Hence, common stock valuation approaches are developed under each of the above
dividend growth models. Next sections will discus each model one by one.
D
Ks
Br.3.60
= Br. 30
12%
Page 96
The maximum price the investor would be willing to pay for a share of Shaloms
common stock is Br. 30 for he to receive a Br. 3.60 annual dividend for an indefinite
years.
D1
; Ks > g
Ks g
Where:
D1 = The expected dividend at the end of year 1.
g = The expected growth rate in dividends.
D1 = Do(1+g), where Do is the most recent dividend. Similarly D2 = D1 (1+g) and so on.
To find the value of a common stock (constant growth) at one year, first, find the
expected dividend at the end of next year.
Example: Zeila Motor Corporations common stock currently pays an annual dividend of
Br. 5.40 per share. The dividends are expected to grow at a constant annual rate of 5% to
infinity. Estimate the value of Zeilas common stock if the required return is 12%.
Solution:
Given: Do = Br. 5.40; g = 5%; Ks = 12%; Po =?
Po =
D1
; D1 = Do (1+g0) = Br. 5.40 (1.05) = Br. 5.67
Ks g
Page 97
Br.5.67
= Br. 81
12% 5%
D1
g
P0
Where:
Ks = The expected rate of return on a constant growth stock
D1/P0 = Expected dividend yield.
g = Expected dividend growth rate = capital gains yield.
Example: Assume the above example except that you are given the value of common
stock of Br. 81 instead of the required return. Compute the expected rate of return?
Ks =
Br.5.40 (1.05)
+ 0.05
Br.81
= 12%
Page 98
Example: Addis Companys most recent annual dividend, which was paid yesterday, was
Br. 1.75 per share. The dividends are expected to experience a 15% annual growth rate
for the next 3 years. By the end of 3 years growth rate will slow to 5% per year to
infinity.
1
D1 = Br. 2.01
g2 = 5%
2
PVIF 12%, 2
PV of D3 = 1.89
PVIF 12%, 3
PV of P3 = 28.40
PVIF 12%, 3
P3 = Br. 39.90
P0 = Br. 33.92
D1 = D0 (1 + g1) = Br. 1.75 (1.15) = Br. 2.01
D2 = D1 (1 + g1) = Br. 2.01 (1.15) = Br. 2.31
D3 = D2 (1 + g1) = Br. 2.31 (1.15) = Br. 2.66
P3 =
D3 (1 g 2 )
Br.2.66 (1.05)
D4
Br.39.90
k5 g 2
k5 g 2
0.12 0.05
Therefore, the value of Addis Companys common stock today is Br. 33.92
Page 99
1. You are considering the purchase of Zemen company common stock that paid dividend
of Br. 2 yesterday. You expect the dividend to grow at the rate of 5% per year for the
next 3 years, and, if you buy the stock, you plan to hold it for 3 years and then sell it.
Calculate the value of the common stock if your required rate of return is 15%
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
2. Melat computers Incorporated is experiencing a period of rapid growth. Earnings and
dividends are expected to grow at 15% rate during the next 2 years, at 13% in the third
year, and at a constant rate of 6% thereafter. Melats last dividend was Br. 1.15, and the
required rate of return on the stock is 12%. Calculate the value of the stock today.
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
3. Can we compute the value of a common stock whose future dividends are expected to
decline at a constant rate?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
6.5 SUMMARY
The main points covered in unit 6 are the following:
-
Valuation determines the value of an asset based on its future cash flows, their
timing and associated risk.
The value of an asset is the present value of expected future cash flows discounted
by an appropriate required rate of return.
The value of a bond is the present value of interest payments and maturity value
The value of preferred stock is the present value of expected preferred dividends.
The value of a zero growth stock is the present value of expected fixed dividends.
Page 100
The value of a normal growth stock is the present value of expected dividends
which are growing at a constant rate.
In a constant growth stock, the required rate of return should always be greater
than the expected dividends growth rate. That is ks > g
Br.120
Approximate YTM =
2. Given: I = Br. 150 (Br. 1,000 x 15%); B 0 = Br. 1,300; call price = Br. 1,097.50 (Br.
1,000 x 109 %) n = 7 (10 3); YTC = ?
Br.1,097.50 Br.1,300
7
10.10%
Br.1,097.50 Br.1,300
2
Br.150
Approximate YTC =
III.
Page 101
D1
D (1 g )
Br.2 (1.05)
0
Br.21
Ks g
Ks g
15% 5%
g2 = 13%
2
g3 = 6%
3
PVIF12%, 3
PV of P3 = 21.63 PVIF12%, 3
P3 =
D4 P0 = Br. 25.24
Br.30.39
Ks g
D1 = Br. 1.15 (1.15) = Br. 1.32; D2 = Br. 1.32 (1.15) = Br. 1.52; D3 = Br.
1.52(1.13) = Br. 1.72
P3 = Br. 1.72 (1.06) = Br. 30.30
12% - 6%
3. Yes we can compute using the constant growth stock model. The only thing new here is
that the expected growth rate (g) will be negative.
6.7 MODEL EXAMINATION QUESTIONS
Exercise
Financial Management - I, BY Abdi .D
Page 102
Page 103
6.9 GLOSSARY
Intrinsic value the present value of expected future cash flows discounted by an
appropriate discount rate.
Discount rate a rate based on the riskness of an asset used to determine the present
value.
Maturity date a specified date on which the par value of a bond must be repaid.
Coupon rate a rate of interest payment specified on a bond.
Market interest rate the interest rate on bonds available in the market whose risk is
similar to the bond under consideration. It is a discount rate on a bond issue.
Premium bond a bond selling at a price above its par value.
Discount bond a bond selling at a price below its par value.
Yield the rate of return on any investment
Supernormal growth a growth which is more than the average of normal companies in
the industry.
Page 104
Page 105
In unit 8 when we will calculate the weighted average cost of capital for use in capital
budgeting, we will take the capital structure weights, or the mix of securities the firm
uses to finance its assets, as a given. However, if the weights are changed, the calculated
cost of capital and thus the set of acceptable projects, also will change. Further changing
the capital structure will affect the riskness of the firm common stock, and this will affect
Ks and Po. Therefore, the choice of a capital structure is an important decision.
7.2 THE TARGET CAPITAL STRUCTURE
A firm analyzes a number of factors, and then it establishes a target capital structure. This
targest may change over time as conditions vary, but at any given moment the firms
management has a specific capital structure in mind. If the actual debt ratio is become the
target level, expansion capital will probably be raised by issuing debt, whereas if the debt
ratio is above the target, equity will probably be used.
Capital structure policy involves a trade-off between risk and return:
Using more debt raises the riskness of the firms earnings stream
However, a higher debt ratio generally leads to a higher expected rate of return
Higher risk tends to lower a stocks price, but higher expected rate of return raises it.
Therefore, the optimal capital structure strikes a balance between risk and return so as to
maximize a firms stock price.
Four primary factors influence the capital structure decision
1. Business risk,
risk, or the riskness inherent in the firms operations if it used no debt.
The greater the firms business risk, the lower its optimal debt ratio.
2. The firms tax position.
position. A major reason for using debt is that interest is
deductible, which lowers the effective cost of debt. However, if much of a firms
income is already sheltered from taxes by depreciation tax shields or tax loss
carry-forwards, its tax ratio will be low, so debt will not be as advantageous as it
would be to a firm with a higher effective tax rate.
3. Financial flexibility,
flexibility, or the ability to raise capital on reasonable terms under
adverse conditions.
conditions. Corporate treasures know that a steady supply of capital is
Financial Management - I, BY Abdi .D
Page 106
necessary for stable operations, which is vital for long-run success. They also
know that when money is tight in the economy, or when a firm is experiencing
operating difficulties, suppliers of capital prefer to provide funds to companies
with strong balance sheet. Therefore, both the potential further need for funds and
the consequences of a funds shortage have a major influence on the target capital
structure the greater the probable future need for capital, and the worse the
consequences of a capital budget, the stronger the balance sheet should be.
4. Managerial conservatism or aggressiveness.
aggressiveness. Some managers are more
aggressive than others, hence some firms are more inclined to use debt in an effort
to boost profits. This factor does not affect, the optimal, or value- maximizing,
capital structure, but it does influence the target capital structure.
These four points larger determine the target capital structure, but operating conditions
can cause the actual capital structure to vary from the target.
Page 107
Then,
L ( y)
y / y
L ( x)
x / x
The left hand side of the above equation is read as: the leverage of y with respect to x.
Financial Management - I, BY Abdi .D
Page 108
L (T )
T / T
% output
Example: Assume that the price per unit of output (p) is Br. 10, and variable cost per unit
of output (y) is Br. 4, and fixed cost (F) is Br. 30,000, and the level of output (T) is 8000
units. By using the formula EBIT is computed as follows:
y = Total revenue Total variable cost fixed cost
y = TP TV F
or y = T (P V) F
y = 8000 (Br. 10 Br. 4) Br. 30,000
= Br. 18,000
Now assume that the level of output increases from 8000 to 10,000 units. The resulting
EBIT is computed as:
y = 10,000 (Br. 10 Br. 4) Br. 30,000
Financial Management - I, BY Abdi .D
Page 109
= Br. 30,000
The coefficient of operating leverage is computed as follows:
Percentage change in output = 2000/8000 = 25%
Percentage change in EBIT = Br. 12000/Br. 18000 = 66.7%
L( y )
y / y
L (T )
T / T
L ( y)
.667
= 2.67
L (T )
.25
(OL/T) = T ( P V ) F
The left hand side of the equation is read as: operating leverage, given the value of
output.
B1 putting the date of the previous example the above equation can be illustrated as
follows:
8000 ( Br.10 Br.4)
Page 110
earnings are available to cover financial costs, when output exceeds operating breakeven,
the total revenue that is generated provides a positive level of EBIT; below operating
breakeven, the firm incurs an operating loss. The operating breakeven is expressed as
follows:
T (P V) F = 0
and solving for T yields
F
T = P V
Example Assume that P = Br. 25, V = Br. 10, and F = Br. 60,000. Operating breakeven
is calculated as follows:
Br.60,000
undefined
0
Note that the coefficient of operating leverage at operating breakeven has undefined
value, not a value of zero.
Interpretations of operating leverage
Fundamental interpretation: - The percentage change in EBIT that results from a
given percentage change in output it equal to the value of operating leverage at
the initial value of output multiplied by the percentage change in output.
Related interpretations: 1- A positive coefficient of operating leverage indicates that the leverage is
being computed at a level of output greater than operating breakeven.
2- A negative coefficient of operating leverage indicates that leverage is being
computed at a level of output below operating breakeven
Page 111
OL/T
before
authomation
OL/T
after
authomation
225,000
6.82
13.00
250,000
4.31
5.91
275,000
3.31
4.09
Page 112
A firm decides to automate a portion of its production process. As a result, fixed costs
increases to Br. 5,400,000, but the unit variable cost decreases to Br. 25. What is the new
operating breakeven?
________________________________________________________________________
________________________________________________________________________
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Page 113
EPS =
[T ( P V ) F I ] (1 t ) E
N
When the level of EBIT changes from its initial value, the initial value of EPS also
changes. Financial leverage is thus defined as the resulting percentage change in EPS
divided by the percentage change in EBIT. Symbolically, financial leverage is expressed
as:
L ( EPS )
% EPS
EPS / EPS
Note that EBIT is the independent variable when measuring financial leverage, but the
dependent variable when measuring operating leverage. As a result, EBIT, is sometimes
called the linking pin variable with respect to leverage application in finance.
Example
If EBIT increases from Br. 500,000 to Br. 600,000, the resulting EPS is:
EPS = (Br. 60,000 Br. 100,000) (1 0.4) Br. 80,000
60,000
= Br. 3.67
The financial leverage is computed as:
Percentage change in EBIT = Br. 100,000/Br. 500,000 = 20%
Percentage change in EPS = Br. 1/Br. 2.67 = 37.45%
L ( EPS )
0.3745
1.87
L ( EBIT )
0.2
Page 114
Since EBIT increased by 20 percent from its initial value, EPS increased by 1.87 (0.20) =
0.374 or 37.4 percent.
The measurement equation used to compute the coefficient of financial leverage when the
income statement relationship is:
Y
(FL/Y) = Y I E
1 t
The left hand side of the above equation is read as: financial leverage, given the value of
EBIT.
By putting the data of the pervious example, equation is illustrated as:
500,000
1.88
1 0.4
Page 115
Y = I + 1 t
Example Assume I = Br. 2,000,000 and E = Br. 1,300,000. Financial breakeven is
calculated as: Assuming 40% tax rate.
Y = Br. 2,000,000 + Br. 1,300,000 / (1 0.4) = Br. 4,166,667
If financial leverage is calculated at financial breakeven, the resulting coefficient of
financial leverage has an undefined value, computing by using the above equation:
Br.4,166,667
Br.4,166,667Br .2,000,000 Br.1,300,000 /(1 0.4)
Br.4,166,667
undefined
0
( FL / Y Br.4,166,667)
Page 116
tax benefit
signaling theory
Trade-off theory
Modern capital structure theory begins in 1958, when professors Franco Modigliani and
Merton Milles (hereafter MM) published what has been called the most influential article
ever written. MM proved, under a very restrictive set of assumptions, that because of the
tax deductibility of interest on debt, a firms value rises continuously as it uses more debt,
and hence its value will be maximized by financing almost entirely with debt. MMs
assumptions included the following:
1. There is no brokerage costs
2. There is no personal taxes
3. Investors can borrow as the same rate as corporations
4. Investors have the same information as management about the firms future
investment opportunities
5. All the firms debt is riskless, regardless of how much debt of uses
Financial Management - I, BY Abdi .D
Page 117
Page 118
Signaling theory
MM assumed that investors have the same information about a firms prospects as its
managers this is called symmetric information. However, managers often have better
information than outside investors. This is called asymmetric information, and it has an
important effect on the optimal capital structure. To see why, consider two situations, one
in which the companys managers know that its prospects are extremely favorable (Firms
F), and one in which the mangers know that the future looks unfavorable (Firm U).
Suppose, for example, that Firm Fs have just discovered a nonpatentable cure for the
common cold. They want to keep the new product a secret as long as possible to delay
competitors entry into the market. New plant must be built to make the new product, so
capital must be raised. How should Firm Fs management raise the needed capital? If the
firm sells stock, then, when profits from the new product start flowing in, the price of
stock will rise sharply, and the purchasers of the new stock will have made a bonanza.
The current stockholders (including the managers) will also do well, but not as well as
they would have done of the company had not sold sock before the price increased,
because then they would not have had to share the benefits of the new product with the
new stockholders. Therefore, one would expect a firm with very favorable prospects to
try to avoid selling stock and rather, to raise any required new capital by other means,
including using debt beyond the normal targest capital structure.
Now, lets consider Firm U. suppose its managers have information that new orders are
off sharply because a competitor has installed new technology which has improved its
products quality. Firm U must upgrade its own facilities, at a high cost, just to maintain
in recent sales level. As a result, in return on investment will fall (but not as much as if it
took no action, which would lead to a 100 percent loss through bankruptcy). How should
Firm U raise the needed capital? Here the situation is just the reverse of that facing Firm
F, which did not want to sell stock so as to avoid having to share the benefits of future
development. A firm with unfavorable prospects would want to sell stock, which would
mean bringing in new investors to share the losses.
Page 119
The conclusion from all this is that firms with extremely bright prospect prefer not to
finance through new stock offerings, whereas firms with poor prospects do like to finance
with outside equity. How should you, as an investor, react to this conclusion?
7.5 FACTORS IN CAPITAL STRUCTURE DECISIONS
Firms generally should consider the following factors which influence capital structure
decisions.
1. Sales stability: - A firm whose sales are relatively stable can safely take on more debt
and incur higher fixed charges than a company with unstable sales.
2. Asset structure: - Firms whose assets are suitable as security for loans tend to use
rather heavily. General purpose assets which can be used by many businesses make good
collateral, whereas special-purpose assets do not. Thus, real state companies are usually
highly leveraged, whereas companies involved in technological research employ less
debt.
3. Operating leverage: - Other things the same, a firm with less operating leverage is
better able to employ financial leverage because, as we saw, the interaction of operating
and financial leverage determines the overall effect of a decline in sales on operating
income and net cash flow.
4. Growth rate: - Other things the same, faster-growing firms must rely more heavily on
external capital.
5. Profitability: - One often observes, that firms with very high rates of return on
investment use relatively little debt. Although there is no theoretical justification for this
fact, one practical explanation is that very profitable firms simply do not need to do much
debt financing. Their higher rates of return enable them to do most of their financing with
retained earnings.
6. Taxes: - Interest is a deductible expense, and deductions are most valuable to firms
with high tax rates. Hence, the higher a firms corporate tax, the greater the advantage of
debt.
7. Control: - The effect of debt versus stock on managements control position can
influence capital structure. If management currently has voting control (over 50 percent
Financial Management - I, BY Abdi .D
Page 120
of the stock), but is not in a position to buy any more stock, it may choose debt for new
financing. One the other hand, management may decide to use equity if the firms
financial situation is so weak that he use of debt might subject it to serious risk of default
because, if the firms gores into default, the mangers will almost surely lose their jobs.
8. Management attitudes: - Since no one can provide that one capital structure will lead
to higher stock prices than another, management can exercise its own judgment about the
proper capital structure. Some management tend to be more conservative than others, and
thus use less debt than the average firm in their industry, whereas aggressive management
use more debt in the quest for higher profits.
9. Lender and rating agency attitude: - Regardless of mangers own analyses of this
proper leverage factors for their firms, lenders and rating agencies attitudes frequently
influence financial structure decisions. In the majority of the cases, the corporations
discusses its capital structure with lenders and rating agencies and gives much weight to
their advice.
10. Market conditions: - Conditions in the stock and bond market undergo both long-and
short-run changes that can have an important bearing on a firms optimal capital
structure.
11. The firms internal conditions: - A firms own internal condition can also have a
bearing on its target capital structure.
12. Financial flexibility: - maintaining financial flexibility, which from an operational
view point, means maintaining adequate reserve borrowing capacity. Determining an
adequate reserve borrowing capacity is judgmental, but it clearly depends on the
factors mentioned previously in the unit, including the firm forecasted need for funds,
predicted capital market conditions, managements confidence in its forecasts, and the
consequences on a capital shortage.
7.6 SUMMARY
The key concepts covered are summarized below
A firms optimal capital structure is that mix of debt and equity which maximizes
the price of the firms stock. As any point in time, the firms management has a
Financial Management - I, BY Abdi .D
Page 121
specific target capital structure in mind, presumably the optimal one, although this
target may change over time.
Several factors influence the firms capital structure. These include the firms (1)
business risk (2) tax position (3) need for financial flexibility, and (4) managerial
conservatism and aggressiveness.
The degree of operating leverage shows how changes in sales affect operating
income, whereas the degree of financial leverage shows how changes in operating
income affect earnings per share.
Financial leverage is the extent to which fixed-income securities (debt and
preferred stock) are used in a firms capital structure.
Modeigliani and Miller developed a trade-off theory of capital structure. They
showed that debt is useful because interest is that deductible, but also that debt
brings with its costs associated with actual or potential bankruptcy. Under MMs
theory, the optimal capital structure strikes a balance between the tax benefit of
debt and the costs associated with bankruptcy
An alternative (or, really, complementary) theory of capital structure relates to the
signals given to investors by a firms decision to use debt or stock to raise new
capital. The use of stock is a negative signal, while, using debt is a positive, or at
least a neutral, signal. As a result, companies try to maintain a reserve borrowing
capacity, and this means using less debt in normal times the MM trade-off
theory would suggest.
7.7 ANSWERS TO CHECK YOUR PROGRESS
1. Capital structure policy involves a trade-off between risk and return since using more
debt raises the riskness of the firms earning stream. However, a higher debt ratio
generally leads to a higher expected rate of return
2. 1 with a selling price of Br. 51 per unit, the operating breakeven is:
T = Br. 4,800,000/ (Br. 51 Br. 26)
= 192,000 units
Financial Management - I, BY Abdi .D
Page 122
Br. 10,000,000____________
Br. 10,000,000 Br. 2,800,000 Br. 3,000,000 / (1 04)
= 4.55
Page 123
2. TSEHAY Co., producer of turbine generators; is in this situation: EBIT = Br. 4 million;
tax = T = 35%; debt outstanding = D = Br. 2 million; kd = 10%; ks = 15%; shares of
stock outstanding = No = 600,000; and book value per share = Br. 10. Since the
companys product market is stable and the company expects no growth, all earnings
are paid out as dividends. The debt consists of perpetual bonds.
a. What are the earnings per share (EPS) and its price per share (Po)?
b. What is the weighted average cost of capital (WACC)?
c. The company can increase debt by Br. 8 million, to a total of Br. 10 million using
the new debt to buy back and retire some of its shares at the current price. Its
interest rate on debt will be 12 percent (it will have to call and refund the old
debt), and its cost of equity will rise from 15 percent to 17 percent. EBIT will
remain constant, should the company change its capital structure.
d. If the company did not have to refund the Br. 2 million of old debt, how would
this affect thing? Assume that the new and the still outstanding debt are equally
risky, with kd = 12%, but that the coupon rates on the old debt is 10 percent.
3. ALEMU Co. produces Building materials which sell for p = Br. 100. Olindes fixed
costs are Br. 200,000; 5000 components are produced and sold each year; EBIT is
currently Br. 50,000; and the assets (all equity financed) are Br. 500,000. The company
estimates that it can change its production process, adding Br. 400,000 to investment and
Br. 50,000 to fixed operating costs. This change will
(1) Reduce variable cost per unit by Br. 10 and (2) increase output by 2000 units, but (3)
the sales price on all units will have to be lowered to Br. 95 to permit sales of the
additional output. The company uses no debt and its average cost of capital is 10 percent
a) Should the company make the change
b) Would the company degree of operating leverage increase or decrease if it
made the change? What about its breakeven point?
c) Suppose the company were unable to raise additional, equity financing
and had to borrow the Br. 400,000 to make the investment at an interest
rate of 10 percent, use the DU pont equation to find the expected ROA of
the investment. Should the company make the change if debt financing
must be used
Financial Management - I, BY Abdi .D
Page 124
7.9 GLOSSARY
Target capital structure.
structure. The mix of debt, preferred stock and common equity
with which the firm plans to raise capital.
Business risk.
risk. The risk associated with projections of a firms future returns on
assets.
Operating leverage.
leverage. The extent to which the fixed costs are used in a firms
operations.
Breakeven point.
point. The volume of sales at which total costs equal total revenue,
causing operating profit (EBIT) to equal zero.
Financial leverage.
leverage. The extent to which fixed income securities (debt and
preferred stock) are used in a firms capital structure.
Financial risk.
risk. An increase in stockholders risk, over and above basic business
risk, resulting from the use of financial leverage.
Degree of operating leverage. The percentage change in EBIT resulting from a
given percentage change in sales.
Degree of financial leverage.
leverage. The percentage change in EPS associated with a
given percentage change in EBIT.
Symmetric information.
information. The situation in which investors and managers have
identical information about the firms prospects.
Asymmetric information.
information. The situation in which managers have different (better)
information about their firms prospects than do investors.
Page 125
Page 126
8.1 INTRODUCTION
As you well understand, two parties are involved in a financial asset under normal
circumstances. One is the party issuing the financial asset. Another is the one that buys or
invests on the financial asset. In unit 6, when we were discussing about valuation, we
emphasized on the investor. That is, how much is the maximum price the investor would
pay for the financial asset? To decide on this, the investor would discount the expected
future cash flows. The discounting is done based on the investors required rate of return.
The rate of return required by the investor should definitely be provide by some other
party. The party which should provide the investor its required rate of return is the issuing
party. For example, if the required rate of return by an investor on a given bond is 10%,
the issuing company should provide this 10% to the investor. This required rate of return
that should be met by the issuing company becomes its cost. This is a cost on the capital
the issuing company wants to raise.
Therefore, the required rate of return on investments in financial assets by the investor is
the cost of capital for the company issued the financial assets. But, generally, the cost of
capital for the issuing company is higher than the required rate of return by the investor.
This is because when the issuing company issues a financial asset, it must incur some
costs. These costs incurred by the issuer in relation to issuance of financial assets are
called flotation costs. Examples include advertising costs, commissions paid to those
selling the financial assets, cost of printing documents, costs of registration with
government agencies, discounts to encourage the sale of securities, and so on.
8.2 MEANING OF THE COST OF CAPITAL
The cost of capital is the minimum rate of return that a firm must earn in order to satisfy
the overall rate of return required by its investors. It is also the minimum rate of return a
firm must earn on its invested capital to maintain the value of the firm unchanged. The
second definition considers the cost of capital as a break even rate.
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If a firms actual rate of return exceeds its cost of capital, the value of the firm would
increase. If on the other hand, the cost of capital is not earned, the firms market value
will decrease. So the cost of capital is the rate of return that is just sufficient to leave the
price of the firms common stock unchanged.
The cost of capital serves as a discount rate when a firm evaluates an investment
proposal. Suppose a firm is considering investment on a plant. The finance required for
this investment is to be raised by selling a common stock issue. Now, after raising capital,
the firm is expected to provide required rate of return to those who invest on the common
stock. This in effect is the firms cost of capital. So to decide to invest on the plant, the
minimum rate of return from the investment at least should be equal to the required rate
of return by the common stockholders. If the required rate of return by the firms
common stockholders is 13%, then the firm should earn a minimum of 13% on its
investment on the plant. The 13% minimum rate of return that should be earned by the
firm is, therefore, its cost of capital.
8.3 MEASURING THE SPECIFIC COST OF CAPITAL
The cost of capital for any particular capital source or security issue is called the specific
cost of capital. It is also called individual cost of capital or component cost of capital.
Each type of capital contained the capital structure of a firm include:
1. Debt
2. Preferred stock
3. Common stock
4. Retained earnings
Two important points you should bear in mind about the specific cost of capital. One is
that it is computed on an after-tax basis. Meaning, if there would be any tax implication
on the individual source of capital, it should be considered. In almost all circumstances,
the tax implication is only on debt sources of finance. The second point is that the
specific cost of capital is expressed as an annual percentage or rate like 6%, 9%, or 10%.
The cost of capital is not stated in terms of birrs.
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Pn NPd
n
Pn NPd
2
Kd =
Where:
Br.120
ii) Kd =
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Therefore, the after tax cost of Abyssinias new bond issue is 7.36%. That is, Abyssinia
should be able to earn a minimum of 7.36% to satisfy bondholders. Otherwise, the firms
value will decline.
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f = Flotation costs
ii) Compute the cost of preferred stock issue
Kps = Dps__
NPpf
Where:
Kps = The cost of preferred stock
DPs = The pre share annual dividend on the preferred stock
Example: Sefa Computer Systems Company has just issued preferred stock. The stock
has 12% annual dividend and Br. 100 par value and was sold at 102% of the par value. In
addition, flotation costs of Br. 2.50 per share must be paid. Calculate the cost of the
preferred stock.
Solution:
Given: Pps = Br. 102 (Br. 100 x 102%); Dps = Br. 12 (Br 100 x 12%); f = Br. 2.50;
Kps =?
Then apply the two steps:
i) NPpf = Br. 102 Br. 2.50 = Br. 99.50
ii) Kps = Br. 12
=12.06%
=12.06%
Br. 99.50
Therefore, Sefa Company should be able to earn a minimum of 12.06% on any
investment financed by the new preferred stock issue. Otherwise, the firms value will
decrease.
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Example: An issue of common stock is sold to investors for Br. 20 per share. The issuing
corporation incurs a selling expense of Br. 1 per share. The current dividend is Br. 1.50
per share and it is expected to grow at 6% annual rate. Compute the specific cost of this
common stock issue.
Solution
Given: Po = Br. 20; Do = Br. 1.50; g = 6%; f = Br. 1; Ks = ?
Then apply the two steps:
i) NPo = Br. 20 Br. 1 = Br. 19
ii) Ks = D1 + g = Br. 1.50 (1.06) = 14.37%
Npo
Br. 19
Therefore, the firm should be able to earn a minimum return of 14.37% on investments
that are financed by the new common stock issue.
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The cost of retained earnings is the rate of return a corporations common stockholders
expect the corporation to earn on their reinvested earnings, at least equal to the rate
earned on the outstanding common stock. Therefore, the specific cost of capital of
retained earnings is equated with the specific cost of common stock. However, flotation
costs are not involved in the case of retained earnings.
Computing the cost of retained earnings involves just a single procedure of applying the
following formula:
Kr = D1 + g
Po
Where:
Kr = The cost of retained earnings
D1 = The expected dividends payment at the end of next year
Po = The current market price of the firms common stock
g = The expected annual dividend growth rate.
Example: Zeila Auto Spare Parts Manufacturing company expects to pay a common
stock dividend of Br. 2.50 per share during the next 12 months. The firms current
common stock price is Br. 50 per share and the expected dividend growth rate is 7%. A
flotation cost of Br. 3 is involved to sale a share of common stock.
Required: Compute the cost of retained earnings
Solution
Given: Po = Br. 50; D1 = Br. 2.50; g = 7%; Kr = ?
Then apply the formula:
Kr = D1+ g = Br. 2.50 + 7% = 12%
Po
Br. 50
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Source of capital
Debt
Book value
Market value
Specific cost
Br. 1,050,000
Br. 1,000,000
5.3%
Preferred stock
84,000
125,000
12.0
Common equity
966,000
1,375,000
16.0
Br. 2,100,000
Br. 2,500,000
Total
Br. 2,100,000
Br. 2,100,000
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Br. 2,500,000
Br. 2,500,000
Br. 27,000,000
Common equity
27,000,000
Br. 54,000,000
New bonds will have a 10% coupon rate and will be sold at Par. Common stock currently
has a market price of Br. 60 and can be sold with a flotation cost of Br. 6 per share.
Dividend yield is estimated to be 4% and the expected dividend growth rate is 8%
Required: Calculate:
1) the cost of debt assuming s 40% marginal corporate tax rate
2) the cost of common equity (50% common stock and 50% retained earnings)
3) the weighted average cost of capital
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8.5 MARGINAL COST OF CAPITAL (MCC)
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As a firm tries to have more new capital, the cost of each birr will rise at some point.
Thus, the marginal cost of capital (MCC) is the cost of obtaining additional new capital.
Technically speaking, the MCC is the weighted average cost of the last birr of new capital
obtained. So the concept of marginal cost of capital is discussed in the context of the
weighted average cost of capital.
As a firm raises larger and larger amounts of capital, the weighted average cost of capital
also rises. But the question would be at what point the firms costs of debt, preferred stck,
and common equity as well as WACC increase?
The first point, therefore, in computing the MCC is to determine the breaking points
where the cost of capital will increase.
The technical aspects of the MCC can be better understood using an example.
Example: The target capital structure of Shala Corporation and other pertinent data are
given below.
Long-term debt ------------------ 40%; cost of preferred stock (Kps) = 12.06%
Preferred stock -------------------10%
Shala Corporation has Br. 900,000 available retained earnings. But when the firm fully
utilizes its retained earnings, it must use the more expensive new common stock
financing to meet its equity needs. In addition, the firm expects that it can borrow up to
Br. 1,200,000 of debt at 7.3% after-tax cost. Additional debt will have an after-tax cost of
9.1%.
Required
1) What is the breaking point associated with the
a. exhausting of retained earnings?
b. Increment of debt between Br. 0 to Br. 1,200,000?
2) Determine the ranges of total new financing where the WACC will rise
3) Calculate the WACC for each range of finance.
Solutions
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8.6 SUMMARY
This unit showed the concept of the cost of capital. The key points covered are:
-
the cost of capital is the minimum rate of return a firm should earn on its invested
capital.
generally, the cost of dept is the cheapest and the cost of common stock is the
most expensive among all other component costs of capital.
the WACC of a firm increases as the firm raises more and more new capital.
a break point will occur each time one of the specific costs of capital increases.
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6%); Kps
Kps = ?
Then, apply the two steps:
-
Kps = Br. 5
= 11.24%
Br. 44.50
III. Given: Po = Br. 75; D1 = Br. 3.38; g = 8%; f = Br. 4.50 (Br. 3 + Br. 0.60 + Br. 0.90);
Ks = ?
Then, apply the two steps:
-
Br. 70.50
Br. 57.50
V. 1. Since no flotation cost is involved here and the bonds are sold at par value, the
effective before tax cost of debt (Kd) = coupon rate = 10%.
Kdt = 10% ( 1 40%) = 6%
2. Given: Po = Br. 60; f = Br. 6; dividend yield (D1/po) = 4%; g = 8%
Cost of retained earnings (Kr) = D1 + g = 4% + 8% = 12%
Po
Cost of common stock (Ks) = D1 + g = Br. 2.40* + 8% = 12.44%
Npo
* D1= 4% D1
Po
Br. 60 Br. 6
= 4% D1 = Br. 2.40
Br. 60
VI. Because until the firms total new financing amounts to Br. 1,800,000, it can meet its
equity needs using retained earnings whose cost is 14%. But in the 2 ndand 3rd ranges the
total financing is more than Br. 1,800,000 and the firm should use new common stock
issue in place of retained earnings; and the cost of common stock is 15%.
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