FINANCIAL MANAGEMENT I

ACCT-312

Rift Valley College Center for Distance and

Continuing Education

Adama 2009
 Course content page
Chapter one: Introduction
1.1. An overview of financial Management …………………………………………….
Chapter Two: Financial Analysis and planning
2.1. Financial Analysis……………………………………………………………………
 Source of financial data………………………………………………………………
 A process to financial analysis & Interpretation……………………………………..
2.2. Financial Planning (Forecasting)……………………………………………………..
 The planning process…………………………………………………………………
 Importance of sales forecasting …………………………………………………….
 Techniques of determining future financial needs………………………………….
 Relationship between financial analysis and planning ……………………………
Chapter Three: The Time value of Money and concept of Interest
3.1. The concept of time value of money, Interest and Interest rate…………………..
3.2. The future value (Compounding)…………………………………………………..
3.3. The present value (Discounting)…………………………………………………….
Chapter four: Long-Term Investment and Financing Decisions
4.1 Bond Valuation………………………………………………………………………..
4.2 Preferred Stock Valuation…………………………………………………………….
4.3 Common Stock Valuation…………………………………………………………….
Chapter five: capital structure and leverage
5.1 The Target Capital Structure………………………………………………………….
5.2 The Concept of Leverage………………………………………………………………
5.3 Capital Structure Theory………………………………………………………………...
5.4 Factors in Capital Structure Decisions………………………………………………….
Chapter six: the cost of capital
6.1 Meaning of the Cost of Capital…………………………………………………………..
6.2 Measuring the Specific Cost of Capital…………………………………………………..
6.3 Weighted Average Cost of Capital………………………………………………………..
6.4 Marginal Cost of Capital………………………………………………………………….
 UNIT ONE
OVERVIEW OF FINANCIAL MANAGEMENT

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 The Characteristics of a Good Goal
1.9 Profit Maximization as a Decision Rule
1.9.1 Meaning of Profit Maximization
1.9.2 Limitations of Profit Maximization
1.10 Wealth Maximization as a Decision Rule
1.10.1 Meaning of Wealth Maximization
1.10.2 Limitations of Wealth Maximization

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1.11 Conflict of Goals between Management and Owners and Agency problem
1.12 Summary
1.13 Answers to Check Your Progress Questions
1.14 Model Examination Questions
1.15 Selected References
1.16 Glossary
1.0 AIMS AND OBJECTIVES

This unit aims at presenting the meaning, nature, scope and evolutions of finance. Management
of finance includes certain executives and routine functions which are discussed in detail in this
uni t .

After completing this unit, you will be able to:

 understand the meaning and importance of finance,
 explain the evolutions of financial management,
 narrate the relationship of financial management with other disciplines like
accounting, economics etc.,
 list out the functions of financial management,
 recognize the role of financial manger,
 distinguish between ownership and loan financial instruments,
 identify the constituents of financial markets,
 What is it meant by a goal; and what is the significance of having it?
 How a decision maker cans establish 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?
 Why is wealth maximization considered to be superior to profit maximization as a
goal of a firm?
 What are the threats to the wealth maximization goal of a firm?
 What is agency problem and how can it be dealt with?

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1.1 INTRODUCTION

To have a good understanding of financial management, you need to understand first what
finance is. Literally, finance means the money used in day-to-day activities of an individual or a
business for exchange of goods and services. But here our focus rather should be to consider
finance as a separate and distinct field of study like accounting, economics, mathematics, history,
geography etc..

1.1.1 What Is Finance?

C
Can you define finance?
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Finance is a distinct area of study that comprises facts, theories, concepts, principles, techniques
and practices related with raising and utilizing of funds (money) by individuals, businesses, and
governments.

Finance is a very wide and dynamic field of study. It directly affects the decisions of all
individuals and organizations that earn or raise money and spend or invest it. Therefore, finance
is also an area of study that deals with how, where, by whom, why, and through 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.

1.1.2 Major Areas of Finance

Since the concepts and areas of finance are very broad, the academic discipline of finance can be
viewed as made of specialized areas. There are several ways to summarize the major areas of
finance. One way is to review the career opportunities under it. Another way is based on the

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differences in the objectives of different organizations. For the sake of simplifying our
discussion, we summarize the major fields of finance based on career opportunities in finance.

The career opportunities again can be divided into different categories. For our convenience,
these opportunities can be categorized into two broad areas.

i) Financial Services
This is a part of finance which involves personal career opportunities as a loan officer, financial
planner, stockbroker, real estate agent, and insurance broker. It is generally concerned with the
design, development, and delivery of these financial services to individuals, business
organizations, and governments.

ii) Financial Management

Financial management is concerned with the financial decisions of a business firm. This firm can
be large or small, private or public, financial or non-financial, profit – seeking or not-for-profit.
It involves specific financial functions of the firm.

1.1.3 Meaning of Financial Management

Financial Management can be clearly defined by viewing it as a subject, a process, or a function.

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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 1.1.4 Why Study Financial Management?
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____________________.

If you are approaching financial management for the first time, you might wonder why students
like you study the field of financial management and what career opportunities exist.

Many business decisions made by firms have financial implications. Accordingly, financial
management plays a significant role in the operation of the firm. People in all functional areas of
a firm need to understand the basics of financial management. Accountants, information systems
analysts, marketing personnel and people in operations, all need to be equipped with the basic
theories, concepts, techniques, and practices of managerial finance if they have to make their
jobs more efficient and achieve their goals. That is why the course Financial Management is
offered to students in the fields of accounting, management, business administration, and
management information systems.

If you develop the necessary training and skills in financial management, you have career
opportunities in a good deal of positions as a financial analyst, capital budgeting, project finance,
cash, and credit manager, financial manager, banker, financial consultant, and even as a general
manager. The author hopes you will appreciate the importance of financial management as you
learn it more.
 Check your progress 1

1. What makes financial management distinct from other fields of finance?

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2. Why is financial management important to people even in other functional areas of a firm?
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1.2 HISTORICAL DEVELOPMENT OF FINANCIAL MANAGEMENT

Finance emerged as a field separate and distinct from economics around 1900. The first major
focus of financial management during its early years of development was the means how large
corporations of the time could raise capital. This was a period when the establishment of very
large companies like the Rockefeller oil and Morgan steel was marked.

The economic depression of the 1930s made financial management to shift to topics like
preservation of capital, maintenance of liquidity, reorganization of financially troubled
companies, and the bankruptcy process.

Until 1950s, the study of financial management had been descriptive or definitional in nature.
But in the mid 1950s, more analytical, decision – oriented approach began to evolve. These
include capital budgeting, cash and inventory management, capital structure formulation, and
allocation of income as dividends and retained earnings.

Starting the late 1960s, the primary focus of financial management has been on the relationships
between risk and return of a firm’s financial decision. That is financial management has focused
on the maximization of earnings (return) for a given level of risk; or minimization of risk for a
given level of return.

 Check your progress 2

What is the most important focus of financial management today?

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1.3 FINANCE AND RELATED FIELDS

Though finance had ceded itself from economics, it is not totally an independent field of study. It
is an integral part of the firm’s overall management. Finance heavily draws theories, concepts,
and techniques from related disciplines such as economics, accounting, marketing, operations,

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mathematics, statistics, and computer science. Among these disciplines, the field of finance is
closely related to economics and accounting.

1.3.1 Finance versus Economics

Finance and economics are closely related in many aspects. First, economics is the mother field
of finance. Second, the economic environment within which a firm operates influences the
decisions of a financial manger. A financial manger must understand the interrelationships
between the various sectors of the economy. He must also understand such economic variables
as a gross domestic product, unemployment, inflation, interests, and taxes in making financial
decisions.

Financial mangers must also be able to use the structure of decision-making provided by
economics. They must use economic theories as guidelines for their efficient financial decision
making. These theories include pricing theory through the relationships between demand and
supply, return analysis, profit maximization strategies, and marginal analysis. The last one,
particularly, is the primary economic principle used in financial management.

Basic Differences between Finance and Economics

i) Finance is less concerned with theory than is economics. Finance is basically
concerned with the application of theories and principles.
ii) Finance deals with an individual firm; but economics deals with the industry and the
overall level of the economic activity.

1.3.2 Finance versus Accounting

Accounting provides financial information through financial statements. Therefore, these two
fields are closely linked as accounting is an important input for financial decision-making.
Besides, the accounting and finance functions generally overlap; and usually it is difficult to
distinguish them. In many situations, the accounting and finance activities are within the control
of the financial manager of a firm.

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Basic Differences between Finance and Accounting
i) Treatment of income: - in accounting income measurement is on accrual basis.
Under this method revenues are recognized as earned and expenses as incurred. In
finance, however, the cash method is employed to recognize the revenue and
expenses.
ii) Decision-making: - the primary function of accounting is to gather and present
financial data. Finance, on the other hand, is primarily concerned with financial
planning, controlling and decision-making. The financial manger evaluates the
financial statements provided by the accountant by applying additional data and then
makes decisions accordingly.
iii) Accounting is highly governed by generally accepted accounting principles.

 Check your progress 3

How do you exactly describe the relationship between finance, economics, and accounting?
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1.4 THE SCOPE OF FINANCIAL MANAGEMENT

The scope of financial management refers to the range or extent of matters being dealt with in
financial management.

Traditionally, financial management was viewed as a filed of study limited to only raising of
money. Under the traditional approach, the scope and role of financial management was
considered in a very narrow sense of procurement of funds from external sources. The subject of
finance was limited to the discussion of only financial institutions, financial instruments, and the
legal and accounting relationships between a firm and its external sources of funds. Internal
financial decision makings as cash and credit management, inventory control, capital budgeting
were ignored. Simply stating, the old approach treated financial management in a narrow sense
and the financial manager as a less important person in the overall corporate management.

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However, the modern or contemporary approach views financial management in a broad sense.
Corporate finance is defined much more broadly to include any business decisions made by a
firm that affect its finance. According to the modern approach, financial management provides a
conceptual and analytical framework for the three major financial decision making functions of a
firm. Accordingly, the scope of managerial finance involves the solution to investing, financing,
and dividend policy problems of a firm. Besides, unlike the old approach, here, the financial
manager’s role includes both acquiring of funds from external sources and allocating of the funds
efficiently within the firm thereby making internal decisions.

The increased globalization of business has expanded the scope of financial management further
to include financial decisions pertaining to the international financial environment.
1.5 THE FUNCTIONS OF FINANCIAL MANAGEMENT

This refers to the special activities or purposes of financial management. The functions of
financial management are planning for acquiring and utilizing funds by a firm as well as
distributing funds to the owners in ways that achieve goal of the firm.

In general, the functions of financial management include three major decisions a firm must
make. These are:
Investment decisions
Financing decisions
Dividend decisions

1.5.1 Investment Decisions

They deal with allocation of the firm’s scarce financial resources among competing uses. These
decisions are concerned with the management of assets by allocating and utilizing funds within
the firm. Specifically, the investment decisions include:
i) Determining the asset mix or composition: - determining the total amount of the
firm’s finance to be invested in current and fixed assets.
ii) Determining the asset type: - determining which specific assets to maintain within
the categories of current and fixed assets.

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 iii) Managing the asset structure, i.e., maintaining the composition of current and fixed
assets and the type of specific assets under each category.

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).

1.5.2 Financing Decisions

The financing decisions deal with the financing of the firm’s investments, i.e., decisions whether
the firm should use equity or debt funds in order to finance its assets. They are also concerned
with determining the most appropriate composition of short – term and long – term financing. In
simple terms, the financing decisions deal with determining the best financing mix or capital
structure of the firm.

The financing decisions of a firm are generally concerned with the right side of the basic
accounting equation.

1.5.3 Dividend Decisions

The dividend decisions address the question how much of the cash a firm generates from
operations should be distributed to owners in the form of dividends and how much should be
retained by the business for further expansion. There are trade offs on the dividend policy of a
firm. On the one hand, paying out more dividends will make the firm to be perceived strong and
healthy by investors; on the other hand, it will affect the future growth of the firm. So the
dividend decision of a firm should be analyzed in relation to its financing decisions.
 Check your progress 4
What are the main activities of a firm with which financial management is involved?
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1.6 JOBS OF THE FINANCIAL STAFF

Key activities of the finance people can be related to the firm’s basic financial statements. The
primary jobs of the financial staff are:
i) Performing Financial Analysis: - financial analysis is concerned with obtaining of
the basic financial statements, applying some tools and techniques, and converting the
raw information into a standardized form. The purpose here is to give the finance
person a better opportunity to understand the firm’s financial affairs, the results of its
operations, and its cash flows.
ii) Performing Financial Forecasting: - financial forecasting is concerned with
forecasting of the firm’s sales for a given future period upon which the firm projects
its assets needs, and finally, it will evaluate whether additional finance is required.
iii) Making Investment Decisions: - include credit management, inventory control, cash
management, capital budgeting and other investment activities of a firm.
i v) Making Financing Decision: - include any activities associated with procurement or
acquisition of funds. Examples include borrowing decisions, decisions to issue shares
of common stock and preferred stock, bonds, and other securities.

 Check your progress 5

Give some examples of the specific jobs of the finance people

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1.7 AN OVERVIEW OF THE FINANCIAL ENVIRONMENT

Finance people must understand not only the internal environment, but also the financial
environment and markets within which the firm operates. They need to know where capital
required is raised, where the financial instruments are traded, and how stock prices are
determined.

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1.7.1 Financial Institutions

Financial institutions are financial intermediaries, which are specialized financial firms that
facilitate the transfer of funds from savers to demanders of 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.

1.7.2 Financial Instruments

Financial instruments are written and formal documents of transferring funds between and
among individuals, businesses, and governments. They include loans and borrowing contracts,
promissory notes, commercial papers, treasury bills, bonds, and stocks.

Under normal circumstances, two parties are involved in any financial instrument. For holders,
who have invested their money, financial instruments are financial assets. A financial asset gives
the holder the right to claim against the income and assets of its issuer. For the issuer, on the
other hand, financial instruments represent either liabilities or equity items. For instance, if you
consider a bond, it represents an investment (financial asset) for the holder, and a debt item for

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its issuer. Similarly, if you consider a 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.

1.7.3 Financial Markets

Financial markets are markets in which financial instruments are bought and sold by suppliers
and demanders of funds. They, unlike financial institutions, are places in which suppliers and
demanders of funds meet directly to transact business.

1.7.3.1 Functions of Financial Markets

Generally, financial markets play three important roles in functioning of corporate finance.
1. They assist the capital formation process. Financial markets serve as a way through
which firms can obtain the capital they need for their operations and investment.
2. Financial markets serve as resale markets for financial instruments. They create
continuous liquid markets where firms can obtain the capital they need from individuals
and other businesses easily.
3. They play a role in setting the prices of securities. The price of a financial instrument is
determined through the interaction of demand and supply of the security in the financial
markets.

1.7.3.2 Classification of Financial Markets

There are many types of financial markets and hence several ways to classify them. For our
purpose, here we shall consider the following two classifications.

1. Classification on the basis of maturity

This is based on the maturity dates of securities

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 i) Money Markets - are financial markets in which securities traded have maturities of
one-year or less. Examples of securities traded here include treasury bills, commercial
papers, short – term promissory notes and so on.
ii) Capital Markets - are financial markets in which securities of long-term funds are
traded. Major securities traded in capital markets include bonds, preferred and
common stocks.

2. Classification on the basis of the nature of securities

This is based on whether the securities are new issues or have been outstanding in the market
place.
i) Primary Markets - are financial marketers in which firms raise capital by issuing new
securities.
ii) Secondary Markets - are financial markets in which existing and already outstanding
securities are traded among investors. Here the issuing corporation does not raise new
finance.

 Check your progress 6

Identify the main factor why finance people must understand the external financial environment.
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1.8 THE CHARACTERISTICS OF A GOOD GOAL

If a firm cannot choose its right goal, it can suffer severe consequences even to the extent of
going out of business. The failure of many public enterprises in Socialist Ethiopia, for example,
can be attributed to their failure to follow clear objectives. They were considered as successful
for they created job opportunities for thousands of people. But they had failed to produce
products accepted by the general public.

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In fact, selecting the right goal is not such a simple task; but a good objective has the following
characteristics.

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.

1.9 PROFIT MAXIMIZATION AS A DECISION RULE

1.9.1 Meaning of Profit Maximization

 What do you mean profit maximization?
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________________________________.
Profit maximization is a function of maximizing revenue and /or minimizing costs. If a firm is
able to maximize its revenues for a given level of costs or minimizing costs for a given level of
revenues, it is considered to be efficient.

Profit maximization focuses on the total amount of benefits of any courses of action. This
decision rule as applied to financial management implies that the functions of managerial finance
should be oriented to making of money. Under the profit maximization decision criteria, actions
that increase profit of a firm should be undertaken; and actions that decrease profit should be
rejected. Similarly, given alternative courses of actions, decisions would be made in favor of the
one with the highest expected profits.

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Profit maximization, though widely professed, should not be used as a good goal of a firm in
financial management. This is because it fails to meet many of the characteristics of a good goal.

1.9.2 Limitations of Profit Maximization

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 short-term 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.

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 BENEFITS (PROFITS)
YEAR PROJECT X PROJECT Y
1 Br. 25,000 Br. –0-
2 5 0 ,0 0 0 5 0 ,0 0 0
3 –0- 2 5 ,0 0 0
TOTAL Br. 75,000 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

1 Br. 60,000 Br. 45,000
2 6 5 ,0 0 0 5 0 ,0 0 0
3 9 5 ,0 0 0 8 5 ,0 0 0
TOTAL Br. 220,000 Br. 180,000

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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.

Expected benefit of project A = Br. 220,000 x 50% = Br. 110,000

Expected benefit of project B = Br. 180,000 x 90% = Br. 162,000

In fact, risk can be measured in different ways, and different conclusions about the riskness of a
course of action can be reached depending on the measure used. In addition to the probability
distribution, illustrated above, risk can also be measured on the basis of the variation of cash
flows.

The more certain the expected cash flow (return), the higher the quality of benefits (i.e., low risk
to investor). Conversely, the more uncertain or fluctuating the expected benefits, the lower the
quality of benefits (i.e., high risk to investors).

 Check your progress 7

Consider a choice between the following two projects that are having equal cost but with
different variability in expected returns.
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BENEFITS
YEAR PROJECT C PROJECT D
1 Br. 2,700 Br. – 0 –
2 3 ,0 0 0 3 ,0 0 0
3 3 ,3 0 0 6 ,0 0 0
TOTAL Br. 9,000 Br. 9,000

1. Which project is preferable under profit maximization criterion?

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2. Which project is more risky?
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1.10 WEALTH MAXIMIZATION AS A DECISION RULE

1.10.1 Meaning of Wealth Maximization

 What do you mean wealth maximization?
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________________________________________.

Wealth maximization means maximization of the value of a firm. Hence wealth maximization is
also called value maximization or net present value (NPV) maximization.

To understand and appreciate the essence of wealth maximization, we need to consider the
various stakeholders in a given corporation. Stakeholders are all individuals or group of
individuals who have a direct or indirect interest in the firm. They include stockholders, debtors,
managers, employees, customers, governmental agencies and others. But among these, managers
should give priority to stockholders. In fact, the overriding premise of financial management is
that a firm should be managed to enhance the well-being or wealth of its existing common
stockholders. Stockholders’ welbeing depends on both current and expected dividend payments
and market price of the firm’s common stock.

Wealth maximization as a decision criterion is considered to be an ideal goal of a firm in

financial management. There are several reasons why wealth maximization decision criterion is
superior to other criteria. First, it has an exact measurement unlike profit maximization. It
depends on cash flows (inflows and outflows). Second, wealth maximization as a decision
criterion consider the quality as well as the time pattern of benefits. Third, it emphasizes on the
long-term and sustainable maximization of a firm’s common stock price in the financial market.
Fourth, wealth maximization gives a recognition to the interest of other stakeholders and to the
societal welfare on the long-term basis.

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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.
 Check your progress 8

Sehaba Agro Industry Company intends to open a branch either in Goba or Jijiga. Opening of
both branches cost Br. 135,000 each and the expected cash inflows from each branch over the
next ten years is Br. 25,000 per year. However, the required rates of return are 9% and 10%
respectively for Goba and Jijiga respectively.

1. Under profit maximization decision rule, where should Sehaba open a branch?
______________________________________________________________________________
______________________________________________________________________________
____________________________________________________________
2. If the goal of Sehaba is wealth maximization, which town is providing more value?
______________________________________________________________________________
______________________________________________________________________________
____________________________________________________________

1.10.2 Limitations of Wealth Maximization

The limitations of wealth maximization refer to the potential side costs of wealth maximization if
adopted as a decision criterion.

1. If wealth maximization is taken as the sole decision rule, there is a possibility that the benefits
of the society at large might be forgone. Fortunately, however, this problem is not unique to
wealth maximization. Even if an alternative goal is used, still this problem continues to persist.
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.

20
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 debt hodlers.
4. Wealth maximization is normally reflected in the firm’s stock price. But if there are
inefficiencies in financial markets, wealth maximization decision rule may lead to misallocation
of scarce resources.

 Check your progress 9

The wealth maximization goal is generally preferred to other decision criteria regardless of the
above limitations. What short and precise explanation do you have for this?
______________________________________________________________________________
__________________________________________________________________

1.11 CONFLICT OF GOALS BETWEEN MANAGEMENT AND OWNERS AND

AGENCY PROBLEM

As you understand, in a corporate form of business organization owners (stockholders) do not

run the activities of the firm. Rather, the stockholders elect the board of directors, who in turn
assign the management on behalf of the owners. So, basically, managers are agents of the owners
of the corporation and they undertake all activities of the firm on behalf of these owners.
Managers are agents in a corporation to maximize the common stockholders’ well-being.

However, there is a conflict of goals between mangers and owners of a corporation and mangers
may act to maximize their interest instead of maximizing the wealth of owners. Managers are
interested to maximize their personal wealth, job security, life style and fringe benefits.

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:

21
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.
1.12 SUMMARY

This unit has provided an introduction to financial management. The key points covered are
listed below:
- Finance is a very wide separate and distinct field of study.
- Financial management is an area of study under finance, which deals about the financial
problems of an individual firm.
- The functions of managerial finance include three interrelated decisions: (1) investment,
(2) financing, and (3) dividend.
- The jobs of the firm’s financial staff are related to the basic financial statements.
- Financial people must understand the financial institutions, financial instruments, and
financial markets.
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:

22
 - 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.
- The primary goal of firms in financial management should be to maximize the wealth of
stockholders
- Wealth maximization goal of a firm is reflected in maximizing the price of the firm’s
common stock
- Wealth maximization is a superior decision criterion because it is based on cash flows, it
considers the timing and quality of benefits
- An agency problem is the likelihood that mangers give priority to their personal interest
ahead of corporate goals.
 1.13 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS

1. Financial management deals with financial issues of a single company.

2. Because almost all actions in the entire firm are functional areas have financial implications.
2. The relationship between risk and return of any activity.
3. Finance is a subject that links economic theories with the numbers of accounting.
4. Investment, financing, and profit allocation activities.
5. Cash and credit management, inventory control, planning and budgeting, financial analysis,
borrowing etc.
6. A firm operates within a financial environment and it is directly and indirectly affected with
the components and activities of the external financial environment.
7.
1. Under profit maximization criterion the focus is on total profits. Since both projects have a
total of Br. 9,000 benefits each over the three years period, both are ranked equally.
2. The variability in project D is higher than the variability in project C. You can measure the
variability by computing the statistical standard deviation of the two projects, or you can
simply compute the gap in the cash flows for both projects. The gap for project C is Br. 300
and for project D it is Br. 3,000. Hence, project D is more risky than project C.
8.

23
1. The total benefits (cash flows) over a period of ten years is Br. 250,000 (Br. 25,000 x 10) for
each project. Therefore, it is all the same for Sehaba Agro Industry whether it opens its branch
in Goba or Jijiga under profit maximization decision rule.
2. Both projects have equal cash flows and costs; but the required rate of return for investment in
Jijiga (10%) is higher than that of investment in Goba (9%). In financial management, the more
return expected from investments of equal cost and cash flows indicates it is more risky.
Hence, under wealth maximization criterion, investment in Goba provides more value than
investment in Jijiga.
9.
Generally, the problems of wealth maximization decision criterion are also persistent even if
other criteria are used.

1.14 MODEL EXAMINATION QUESTIONS

Part I. For each of the following multiple – choice questions, select the best answer from the
given alternatives.
1. One of the following is not among the characteristics of a good goal of a firm
A) It provides a timely measure to evaluate performance.
B) It provides a clear decision criterion.
C) It gives priority to stockholders at the expense of the society.
D) It is based on long-term success.
2. The goal of a firm in financial management is:
A) To maximize profits
B) To minimize costs
C) To maximize societal welfare
D) To maximize common stock prices
3. Given alternative investment choices, an investment that should be selected under wealth
maximization goal of a firm is the one that:
A) Provides the most fluctuating cash flows for a given level of cost.
B) Has the lowest required rate of return for a given level of expected cash flows.
C) Provides the highest earnings per share.
D) Have the lowest costs.

24
4. Which of the following factors tend to help corporations to manage agency problems?
A) Agency costs
B) Mangers’ reaction to the threat of losing jobs
C) Managing corporations by stockholders themselves
D) A and B
5. Which of the following statement is true about financial management?
A) It is a general business function that deals with the management of all functional areas of
a firm.
B) As a subject of study, it had long been existing before accounting.
C) It is highly governed by generally accepted standards and principles.
D) Internal decision-makings are among the areas of focus of financial management.
6. Which one of the following statements is correct about economics and financial management?
A) Revenues are recorded as earned and expenses as incurred by the latter.
B) As a field of study, the earlier is very much younger than the latter.
C) Financial management is more focused on application of theories
D) None of the above
7. One of the following is not among the investment functions of a firm.
A) Cash management
B) Inventory control
C) Capital budgeting
D) Borrowing from a bank
8. In Ethiopia no organized stock markets are established yet. But currently there is an initiative
to establish at least one. Concurrently, the Ethiopian Government issues treasury bills to the
public. Which of the following statement is / are correct about financial markets in Ethiopia?
A) There is no money market.
B) Secondary securities markets are under way to be established.
C) Secondary securities markets have already taken their roots.
D) A and C.

25
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 firm’s 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?
3. What do you think is the reason why financial management is sometimes called corporate
finance?
4. What are some of the career opportunities available for someone studying financial
management?
5. Compare and contrast financial analysis and financial forecasting.
6. How do financial markets help setting the price of a financial assets like bond?
7. Why is it not possible for an issuing firm to raise new finance in secondary securities markets?
Work out
1. 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
1 Br. 55,000 Br. – 0 –
2 4 3 ,0 0 0 –0–
3 6 1 ,0 0 0 1 5 9 ,0 0 0
TOTAL Br. 159,000 Br. 159,000
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?

26
1.15 SELECTED REFERENCES
1. Eugene F. Brigham (1997). Fundamentals of Financial Management. 7th edition, the
Dryden press Harcourt Brace College publishers, Florida.
2. Lawrence J. Gitman (1991). Principles of Managerial Finance. 6th edition, Harper Collins
Publishers, San Diego.
3. Raymond P. Neveu (1985). Fundamentals of Managerial Finance. 2nd edition. Southwestern
publishing company.
4. Stanley B. Block and Geoffrey A. Hirt (1994). Foundations of Financial Management. 7th
edition, Irwin.
1.16 GLOSSARY
Variable – a varying thing or quantity that can often be measured. Examples include cost,
revenue, etc…
Earnings Per Share (EPS) – the total profits divided over each share of a firm’s common stock
outstanding.
Probability Distribution – A listing of all possible outcome, or events, with a chance assigned to
each outcome.
Overriding Premise – the most important idea of reasoning of all other ideas considered.
Discounted Value – the present value of future cash inflows less the present value of costs.
Fringe Benefits – additional benefits to managers and employees such as insurance coverage,
transposition facilities, post employment benefits etc.
Firm – a group of people working together for business or commercial purposes; a business
company.
Economic depression – a state of the economy when there is little economic activity and man y
people are unemployed
Liquidity – the ability of a business to generate sufficient cash from its operations to cover its
obligations
Risk – the probability that the outcome of an activity will differ from the expected activity. A
variation or deviation from the expected outcome.
Industry – group of firms in the same line of business
Capital structure – the composition fo debt and equity as well as short-term and long-term
financing.
Bankruptcy – the state when a firm is unable to pay its debts.

27
 UNIT TWO
FINANCIAL ANALYSIS AND PLANNING
Contents
Aims and Objectives
Introduction
2.1 Meaning and Objectives of Financial Analysis
 Tools and Techniques of Financial Analysis
 Stages in Financial Analysis
 Types of Financial Ratios
Liquidity Ratios
Activity Ratios
Leverage Ratios
Profitability Ratios
Marketability Ratios
 Comparing Financial Ratios
 Limitations of Ratio Analysis
2.2 Meaning and Purpose of Financial Forecasting
 Procedures in Financial Forecasting
 Methods of Forecasting Financial Requirements
The Performa Financial Statements Method
The Formula Method
 Factors that Affect Additional Financial Requirements
 Excess Capacity and Additional Financial Requirements
2.3 Summary
2.4 Answers to Check Your Progress Questions
2.5 Model Examination Questions
2.6 Selected References
2.7 Glossary

28
AIMS AND OBJECTIVES

The primary purpose of this unit is to enable students understand more and evaluate the financial
statements of a firm. At the end of the unit, students are expected to answer the following
questions.

 How do finance people generally begin performing financial analysis? What are the basic
objectives of financial analysis?
 What are some of the common methods used in financial management in order to
understand about a firm’s performance and future conditions?
 Why are financial ratios discussed under major categories? What are the major categories
and what does each category measure about a firm?
 How do you confirm whether a given financial ratio is good or bad?
What are some of the uses as well as the limitations of ratio analysis?

 What are the basic purposes of financial forecasting?

 How the three main procedures of financial forecasting are interrelated?
 What are the most common methods used in forecasting financial requirements?
 Why does the formula method of forecasting additional funds needed not produce
reliable results?
 What are the factors that affect additional financial requirements of a firm?
 How does excess capacity existing in assets affect the firm’s additional financial
requirements?
INTRODUCTION

In the previous accounting courses you have learned that financial statements report both on a
firm’s 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 firm’s assets and claims against assets at a particular point in time – time. The
income statement, on its part, reports the results of the firm’s 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.

29
However, financial statements by themselves do not give aq complete picture about a company’s
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 firm’s financial activities better. To have all this benefits, however, a finance
person should perform a financial analysis.
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 firm’s
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.

! 2.1 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.

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 firm’s position has been improving or deteriorating over
time. Financial analysis helps users obtain a better understanding of he firm’s financial

30
conditions and performance. It also helps users understand the numbers presented in the financial
statements and serve as a basis for financial decisions.

 TOOLS AND TECHNIQUES OF FINANCIAL ANALYSIS

A number of methods can be used in order to get a better understanding about a firm’s 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
firm’s 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:

i) External Analysis – an analysis performed by outsiders to the firm such as creditors, investors,
suppliers etc.
ii) Internal Analysis – an analysis performed by corporate finance and accounting departments
for his purpose of planning, evaluating, and controlling operating activities.

31
  STAGES IN FINANCIAL ANALYSIS

Financial analysis consists of the following three major stages.

i) Preparation. The preparatory steps include establishing the objectives of the analysis and
assembling the financial statements and other pertinent financial data. Financial statement
analysis focuses primarily on the balance sheet and the income statement. However, data
from statements of retained earnings and cash flows may also be used. So, preparation is
simply objective setting and data collection.
ii) Computation. This involves the application of various tools and techniques to gain a better
understanding of the firm’s financial condition and performance. Computerized financial
statement analysis programs can be applied as part of this stage of financial analysis.
iii) Evaluation and Interpretation. Involves the determination fo the meaningfulness of the
analysis and to develop conclusions, inferences, and recommendations about the firm’s
performance and financial condition. This is the most important of all the three stages of
financial analysis.

Although we have briefly seen what is meant by the three most common types of financial
analysis, our focus on this material will be on ratio analysis. So in the section that follows, we
will discuss major types of financial ratios with illustrative examples.

 TYPES OF FINANCIAL RATIOS

There are several key ratios that reveal about the financial strengths and weaknesses of a firm.
We will look at five categories of ratios, each measuring about a particular aspect of the firm’s
financial condition and performance.

Can you identify financial ratio?

______________________________________________________________________________
______________________________________________________________________________
____________________________________________________.

32
Liquidity Ratios
Liquidity ratios measure the ability of a firm to meet its immediate obligations and reflect the
short – term financial strength or solvency of a firm. In other words, liquidity ratios measure a
firm’s ability to pay its current liabilities as they mature by using current assets. There are two
commonly used liquidity ratios: the current ratio and the quick ratio.
The following financial statements pertain to Zebra Share Company. We will perform the
necessary ratio analyses using them, and then evaluate and interpret each analysis.
Zebra Share Company
Comparative Balance Sheet
December 31, 2001 and 2002
(In thousands of Birrs)
Assets 2002 2001
Current assets:
Cash 9 ,0 0 0 7 ,0 0 0
Marketable securities 3 ,0 0 0 2 ,0 0 0
Accounts receivable (net) 2 0 ,7 0 0 1 8 ,3 0 0
Inventories 2 4 ,9 0 0 2 3 ,7 0 0
Total current assets 5 7 ,6 0 0 5 1 ,0 0 0
Fixed assets:
Land and buildings 3 3 ,0 0 0 2 7 ,0 0 0
Plant and equipment 1 3 0 ,5 0 0 1 2 0 ,0 0 0
Total fixed assets 1 6 3 ,5 0 0 1 4 7 ,0 0 0
Less: accumulated depreciation 6 7 ,2 0 0 6 1 ,2 0 0
Net fixed assets 9 6 ,3 0 0 8 5 ,8 0 0
Total assets 1 5 3 ,9 0 0 1 3 6 ,8 0 0
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable 2 0 ,1 0 0 1 7 ,1 0 0
Notes payable 1 4 ,7 0 0 1 3 ,2 0 0
Taxes payable 3 ,3 0 0 3 ,0 0 0

33
 Total current liabilities 3 8 ,1 0 0 3 3 ,3 0 0
Long-term debt:
Mortgage bonds –5% 6 0 ,0 0 0 6 0 ,0 0 0
Total liabilities 9 8 ,1 0 0 9 3 ,3 0 0
Stockholders’ equity:
Preferred stock –5% (Br. 100 par) 6 ,0 0 0 -
Common stock (Br. 10 par) 3 3 ,0 0 0 3 0 ,0 0 0
Capital in excess of par value 7 ,5 0 0 4 ,5 0 0
Retained earnings 9 ,3 0 0 9 ,0 0 0
Total stockholders’ equity 5 5 ,8 0 0 4 3 ,5 0 0
Total liabilities and stockholders’ equity 1 5 3 ,9 0 0 1 3 6 ,8 0 0

Zebra Share Company

Income Statement
For the Year Ended December 31, 2002
________________________________________________________________________

Net sales Br. 196,200,000

Cost of goods sold 1 5 9 ,6 0 0 ,0 0 0
Gross profit Br. 36,600,000
Operating expenses* 2 6 ,1 0 0 ,0 0 0
Earnings before interest and taxes (EBIT) Br. 10,500,000
Interest expense 3 ,0 0 0 ,0 0 0
Earnings before taxes (EBT) Br. 7,500,000
Income taxes 3 ,6 0 0 ,0 0
Net income Br. 3,900,000

* Included in operating expenses are Br. 6,000,000 depreciation and Br. 2,700,000 lease
payment.

34
 Zebra Share Company
Statement of Retained Earnings
For the Year Ended December 31, 2002

Retained earnings at beginning of year Br. 9,000,000

Add: Net income 3 ,9 0 0 ,0 0 0
Sub-total Br. 12,900,000
Less: Cash dividends
Preferred Br. 300,000
C om m on 3 ,3 0 0 ,0 0 0
Sub-total Br. 3,600,000
Retained earnings at end of year Br. 9,300,000

i) Current ratio – measures the ability of a firm to satisfy or cover the claims of short-term
creditors by using only current assets. This ratio relates current assets to current liabilities
Current ratio = Current assets
Current liabilities
Zebra’s 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 firm’s ability to pay its current liabilities
by using its most liquid assets into cash.

35
Quick ratio = Current assets – Inventory
Current liabilities
Zebra’s 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.
Like the current ratio, the quick ratio reflects the firm’s ability to pay its short-tem obligations,
and the higher the quick ratio the more liquid the firm’s position. But the quick ratio is more
detailed and penetrating test of a firm’s liquidity position as it considers only the quick asset. The
current ratio, on the other hand, is a crude measure of the firm’s liquidity position as it takes into
account all current assets without distinction.
Check your progress 1
What is the amount of inventory for a firm whose current assets and current liabilities are Br.
400,000 and Br. 100,000 respectively and whose quick ratio is 2 times?
______________________________________________________________________________
______________________________________________________________________________
____________________________________________________________
Activity Ratios
Activity ratios measure the degree of efficiency a firm displays in using its assets. These ratios
include turnover ratios because they show how rapidly assets are being converted (turned over)
into sales or cost of goods sold. Activity ratios are also called asset management ratios, or asset
utilization ratios, or efficiency ratios. Generally, high turnover ratios are associated with good
asset management and low turnover ratios with poor asset management.
Activity ratios include:
i) Accounts Receivable turnover – measures how efficiently a firm’s accounts receivable is
being managed. It indicates how many times or how rapidly accounts receivable are converted
into cash during a year.
Accounts receivable turnover = Net sales
Accounts receivable
Zebra’s accounts receivable turnover (for 2002) = Br. 196,200 = 9.48 times
Br. 20,700

36
Interpretation: Zebra’s accounts receivable get converted into cash 9.48 times a year.
In general, a reasonably higher accounts receivable turnover ratio is preferable. A ratio
substantially lower than the industry average may suggest that a firm has more liberal credit
policy, more restrictive cash discount offers, poor credit selection or in adequate cash collection
efforts.

There are alternate ways to calculate accounts receivable value like average receivables and
ending receivables. Though many analysts prefer the first, in our case we have used the ending
balances. In computing the accounts receivable turnover ratio, if available, only credit sales
should be used in the numerator as accounts receivable arises only from credit sales.
ii) Days sales outstanding (DSO) – also called average collection period. It seeks to measure the
average number of days it takes for a firm to collect its accounts receivable. In other words, it
indicates how many days a firm’s sales are outstanding in accounts receivable.
Days sales outstanding = 365 days
Accounts receivable turnover

Zebra’s days sales outstanding = 365 days = 39 days

9 .4 8
Interpretation: Zebra’s credit customers on the average are paying their bills in almost 39 days.
If Zebra’s credit period is less than 39 days, some corrective actions should be taken to improve
the collection period.
The average collection period of a firm is directly affected by the accounts receivable turnover
ratio. Generally, a reasonably short-collection period is preferable.
iii) Inventory turnover – measures how many times per year the inventory level is sold (turned
over).
Inventory turnover = Cost of good sold
Inventory
For Zebra Company (2002) = Br. 159,600 = 6.41times
Br. 24,900

Interpretation: Zebra’s inventory is on the average sold out 6.41 times per year.

37
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

Zebra’s fixed assets turnover = Br. 196,200 = 2.04X

Br. 96,300
Interpretation: Zebra generated Br. 2.04 in net sales for every birr invested in fixed assets.

A fixed assets turnover ratio substantially lower than other similar firms indicates under
utilization of fixed assets, i.e., idle capacity, excessive investment in fixed assets, or low sales
levels. This suggests to the firm possibility of increasing outputs without additional investment in
fixed assets.

The fixed assets turnover may be deceptively low or high. This is because the book values of
fixed assets may be considerably affected by cost of assets, time elapsed since their acquisition,
or method of depreciation used.

v) Total assets turnover – indicates the amount of net sales generated from each birr of total
tangible assets. It is a measure of the firm’s management efficiency in managing its assets.
Total assets turnover = Net Sales
Total assets

38
 Zebra’s total assets turnover = Br. 196,200 = 1.27X
Br. 153, 900

Interpretation: Zebra Share Company generated Br. 1.27 in net sales for every one birr invested
in total assets.
A high total assets turnover is supposed to indicate efficient asset management, and low turnover
indicates a firm is not generating a sufficient level of sales in relation to its investment in assets.

Check your progress 2

Ogden Company has sales of Br. 5 million, out of which 75% are credit sales. The year-end
accounts receivable balance is Br. 475,000. What is the days sale outstanding?
______________________________________________________________________________
______________________________________________________________________________
____________________________________________________________

Leverage Ratios

Leverage ratios are also called debt management or utilization ratios. They measure the extent to
which a firm is financed with debt, or the firm’s ability to generate sufficient income to meet its
debt obligations. While there are many leverage ratios, we will look at only the following three.

i) Debt to total assets (Debt) Ratio – measures the percentage of total funds provided by debt.

Debt ratio = Total liabilities

Total assets

Zebra’s debt ratio = Br. 98,100 = 64%

Br. 153,900

Interpretation: At the end of 2002, 64% of Zebra’s total assets was financed by debt and 36%
(100% - 64%) was financed by equity sources.

39
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 firm’s
financial risk.

ii) Times – interest earned – measures a firm’s ability to pay its interest obligations.

Times interest earned = Earnings before interest and taxes (EBIT)

Interest expense
Zebra’s 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 firm’s 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
firm’s 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,

Zebra’s fixed charges coverage = Br. 10,500 + Br. 2,700 = 2 .3 2 X

Br. 3,000 + Br. 2,700

40
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.

Check your progress 3

Zemedkun Merchandising Company has reported operating income of Br. 120,000. T he

Company’s interest expense and total fixed charges are Br. 30,000 and Br. 80,000 respectively.
What are the times interest earned and fixed charges coverage ratios?
______________________________________________________________________________
__________________________________________________________________

Profitability Ratios

These ratios measure the earning power of a firm with respect to given level of sales, total assets,
and owner’s equity. The following ratios are among the many measures of a firm’s profitability.

i) Profit Margin – shows the percentage of each birr of net sales remaining after deducting all
expenses.

Profit margin = Net income

Net Sales

Zebra’s profit margin = Br. 3,900 = 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.

41
ii) Return on investment (assets) – measures how profitably a firm has used its investment in
total assets.

Return on investment = Net income

Total assets

Zebra’s return on investment = Br. 3,900 = 2.53 %

Br. 153,900

Interpretation: Zebra earned more than 2 cents of profits for each birr in assets.

Generally, a high return on investment is sought by firms. This can be achieved by increasing
sales levels, increasing sales relative to costs, reducing costs relative to sales, or efficiently
utilizing assets.

iii) Return on equity – indicates the rate of return earned by a firm’s stockholders on investments
made by them.
Return on equity = Net income___
Stockholders’ equity

Zebra’s return on equity = Br. 3,900 = 6.99%

Br. 55,800

Interpretation: Zebra earned almost 7 cents of profit for each birr in owner’s 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.

42
Check your progress 4

Muhammad 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

What do you mean DuPont analysis?
______________________________________________________________________________
______________________________________________________________________________
__________________________________________________.
It is an approach to assess that a firm’s return on assets and return on equity show not only the
firm’s 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
Check your progress 5
Zakir Beverage Corporation’s profit margin for year 2002 is 4% and its total assets turnover is
1.5 times. The debt ratio for the same year is 40%. What are return on investment and return on
equity ratios of Zakir for 2002?
______________________________________________________________________________
______________________________________________________________________________
____________________________________________________________
Marketability Ratios
Marketability ratios are used primarily for investment decisions and long range planning. They
include:

43
i) Earnings per share (EPS) – expresses the profits earned on each share of a firm’s common
stock outstanding. It does not reflect how much is paid as dividends.

Earnings per share = Net income – Preferred stock dividend

Number of common shares outstanding

Zebra’s Eps for 2002 = Br. 3,900 – Br. 300 = Br. 1.09
Br. 33,000  Br. 10

Interpretation: Zebra’s common stockholders earned Br. 1.09 per share in 2002.

iii) Dividends Per Share (DPS) – represents the amount of cash dividends a firm paid on
each share of its common stock outstanding.

Dividends Per Share = Total cash dividends on common shares

Number of common shares outstanding

Zebra’s DPs for 2002 = Br. 3,300 _ = Br. 1.00

Br. 33,000  Br. 10

Interpretation: Zebra distributed Br. 1 per share in dividends.

iii) Dividend pay-out (pay-out) ratio – shows the percentage of earnings paid to stockholders.

Dividends pay-out = Dividends per share

Earnings per share
= Total dividends to common stockholders
Total earnings to common stockholders
Zebra’s pay-out ratio = Br. 1.00 = Br. 3,300 = 92%
Br. 1.09 Br. 3,600
Interpretation: Zebra paid nearly 92% of its earnings in cash dividends.

44
  COMPARING FINANCIAL RATIOS

To address whether a given ratio is high or low, good or bad, a meaningful basis is needed for
comparison. Two types of ratio comparisons can be made.

i) Cross – sectional analysis – is the comparison of a firm’s 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 firm’s 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.

 LIMITATIONS OF RATIO ANALYSIS

Even though ratio analysis can provide useful information about a firm’s 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.

45
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.

2.2 MEANING AND PURPOSE OF FINANCIAL FORECASTING

Financial forecasting is one of the four major jobs of a firm’s 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:
- evaluation of a firm’s need for increased or reduced productive capacity and
- evaluation of the firm’s need for additional finance
Generally, financial forecasts are required to run a firm well. Their base, in almost all
circumstances, is forecasted financial statements. An accurate financial forecast is very important
to any firm in several aspects:
- It helps a firm to predict appropriate demand for its products.
- It helps a firm to project its sales and accordingly to predict its assets properly.
- It contributes significantly to the firm’s profitability.
- It plays a crucial role in the value maximization goal of a firm.
Financial forecasts are also means 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 firm’s management will have an opportunity to make some
decisions before hand.
So, all in all, financial forecasting is a pre requirement for the investment, financing, as well as
dividend policy decisions of a firm.
 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.

46
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 firm’s 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 lie in an accurate forecast of
sales. If this procedure is off, the firm’s 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 firm’s marketing areas,
3. The firm’s probable market share,
4. The effect of inflation on the firm’s future pricing of products,
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 firm’s 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 firm’s 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

47
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. Determine 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 firm’s 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 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 Required increase in
AFN = in assets __ normally generated funds.
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.

 METHODS OF FORECASTING FINANCIAL REQUIREMENTS

There are two methods to determine the additional financial requirements. These are:
1. The Performa financial statements method and
2. The formula method

48
1. The Pro-Forma Financial Statements Method

The pro-forma financial statements method is simply a method of forecasting financial

requirements based on forecasted financial statements. As a result, this method is also called the
projected financial statements method. Under this method, the asset requirements are first
projected for the fore coming future period. The forecast of assets helps to determine the total
financial requirements. Then, the liabilities and equity that will be generated under normal
operations are projected. Finally, the additional funds needed will be estimated.

The pro-forma financial statements method of determining additional financial requirements

involves the following steps.

1. Developing the Pro Forma Income statement

The Performa income statement provides a projection of the firm’s 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 firm’s 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.

49
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 Liabilities and Equity

Cash ----------------------------Br. 10,000 A/payable --------------------------Br. 90,000
A/receivable -----------------------70,000 Accruals --------------------------------40,000
Inventories -----------------------150,000 Current liabilities -------------Br. 130,000
Current assets -------------Br. 230,000 Long-term debt -----------------------200,000
Net fixed assets -----------------370,000 Common stock ------------------------120,000
_________ Retained earnings --------------------150,000
Total assets -------------Br. 600,000 Total laibs. and equity ------Br. 600,000

During the year just completed the firm had sales of Br. 1,800,000. In the following year, due to
increased demand to the firm’s products the financial manger estimates that sales will grow at
10%. There are no preferred stock outstanding during the year. The firm’s dividend pay-out ratio
is 60%. It is also known that the firm’s assets have been operating at full capacity. During the
same year, Blue Nile’s operating costs were Br. 1,620,000 and are estimated to increase
proportionately with sales. Assume the company’s 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
______________________________________________________________________________
______________________________

50
Sales (Br. 1,800,000 x 1.10) ------------------------------------------------------------------------------Br.
1 ,9 8 0 ,0 0 0
Operating costs (Br. 1,620,000 x 1.10) ----------------------------------------------------------------------
1 ,7 8 2 ,0 0 0
Earnings before interest and taxes (EBIT) ----------------------------------------------------------------
Br. 198,000
Interest expense ------------------------------------------------------------------------------------------------
-----40,000
Earnings before taxes (EBT) --------------------------------------------------------------------------------
Br. 158,000
Taxes (Br. 158,000 x 40%) -----------------------------------------------------------------------------------
----63,200
Net income -----------------------------------------------------------------------------------------------------
Br. 94,800
Dividends to common stock (Br. 94,800 x 60%) ---------------------------------------------------------
Br. 56,880
Addition to retained earnings (Br. 94,800 – Br. 56,880) ------------------------------------------------
Br. 37,920

Then, we construct the proforma balance sheet

Pro Forma Balance Sheet

______________________________________________________________________________
______________________________
Assets Liabilities and Equity
Cash (Br. 10,000 x 1.10) ----------------Br. 11,000 A/Payable (Br. 90,000 x 1.10) -------------
Br. 99,000
A./receivable (Br. 70,000 x 1.10) ----------77,000 Accruals (Br. 40,000 x 1.10) ----------------
----44,000
Inventories (Br. 150,000 x 1.10) ----------165,000 Current liabilities ----------------------------
Br. 143,000

51
Current assets ---------------------------Br. 253,000 Long-term debt (the increase is unknown)-
---200,000
Net fixed assets (Br. 370,000 x 1.10) ----407,000 Common stock (as long-term debt) ---------
---120,000
_______ Retained earnings (Br. 150,000 + Br.
3 7 ,9 2 0 ) 1 8 7 ,9 2 0
Total assets -----------------------Br. 660,000 Total liabilities and equity -------------
Br. 650,920

Blue Nile’s 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 Increase in normally
assets – 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
Check your progress 6
1. Briefly explain why an accurate financial forecast is crucial to the wealth maximization goal
of a firm.
______________________________________________________________________________
______________________________________________________________________________
____________________________________________________________
2. In the illustration above, the amount of interest expense is assumed to be Br. 40,000. What do
you think are the basic factors that affect the amount of interest expense?
______________________________________________________________________________
______________________________________________________________________________
____________________________________________________________

52
3. Taha Private Limited Company (PLC) had sales of Br. 5 million and total assets of Br. 4.5
million in 2002. The current liabilities during the end of the same year were Br. 1,250,000.
The PLC’s net profit margin and dividend pay-out ratios are 6% and 30% respectively. All
assets and current liabilities will vary directly with sales. Determine the additional funds
needed (AFN) for 2003 if sales are projected to grow by 5% only.
______________________________________________________________________________
______________________________________________________________________________
____________________________________________________________

2. The Formula Method

This is a much easier method of determining additional financial requirements than the pro forma
method. The formula method is a shortcut to financial forecasting. However, many companies
use the pro forma method of forecasting their financial requirements because the output of the
formula method is less meaningful. Under the shortcut method, we make the following
assumptions.

1. Each asset maintains a direct proportionate relationship with sales

2. Accounts payable and accruals increase in direct proportion to sales increase.
3. The profit margin and the dividend pay-out ratios are constant.

The formula that can be used as a shortcut to determine external capital requirements is given as:
Additional Required Spontaneous Increase in
funds = increase – increase in – retained
needed in assets liabilities earnings

AFN = (A/S) S – (L/S) S – MS1 (1 – d)

Where
AFN = Additional funds needed
A/S = Percentage relationship of variable assets to sales = Capital intensity ratio.
S = change in sales = S1 – S0 = S0 x g
S1 = Total Sales projected for the next period

53
 S0 = Total sales of the current period
L/S = Percentage relationship of variable (spontaneous) liabilities to sales
M = Net profit margin
d = Dividend payout ratio
g = The expected sales growth rate

To illustrate the formula method, consider the example given for the previous method. But
assume that Blue Nile’s net profit margin is 5%.

 Br.600,000   Br.130,000 
AFN =  
 Br.180,000*    (Br. 180,000) – 5% x
 Br.1,800,000   Br.1,800,000 
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.

Check your progress 7

1. Why do not the pro forma and the formula methods of forecasting financial requirements
result in the same AFN?
______________________________________________________________________________
______________________________________________________________________________
____________________________________________________________
2. Selam Manufacturing Company has the following ratios: A/S = 1.6; L/S = 0.4; M = 10%; and
d = 45%. Sales last year were Br. 10 million. If these ratios will remain constant next year, what

54
is the maximum sales growth rate (g) Selam can achieve without having to use additional funds
needed (AFN)? (Use the formula for AFN).
______________________________________________________________________________
______________________________________________________________________________
____________________________________________________________

 FACTORS THAT AFFECT ADDITIONAL FINANCIAL REQUIREMENTS

The external financial requirements of a firm during any given period are affected by several
factors.

1. Financial Planning. Refers to the growth rates of sales a firm has projected. Sales growth
rates and additional funds needed are positively related. At low growth rates of a sale, a firm
needs small or no external financing. The firm might even generate surplus funds at low growth
rates. As the growth rates increase, the AFN will also increase. So other factors being constant,
the higher the sales growth rates, the higher the AFN.

2. Capital Intensity. This is the amount of assets required to support each birr of sales. In the
formula, this is designated as A/S. Generally, firms with higher capital intensity ratios are with
greater capital requirements. Highly capital-intensive firms generally require more external funds
than labor intensive firms.

3. Profit Margin. Profit margin, as you might well recall from unit 3, is the net income per each
birr of net sales. It is evident from the very formula of computing AFN that external capital
requirements and net profit margin are related in opposite directions. Other factors held constant,
the higher the profit margin, the lower the external funds requirements.

4. Dividends policy. Dividend policy refers to the percentage of a firm’s net earnings paid out as
cash dividends. It is reflected in the firm’s payout ratio. The higher the dividend payout ratio, the
smaller the addition to retrained earnings, and hence the greater the requirements for external
finance.

55
Check your progress 8

What is the impact on the AFN of a firm’s decision of beginning to pay employees on a monthly
basis dropping the previous practice of paying at the end of every week?
______________________________________________________________________________
__________________________________________________________________

 EXCESS CAPACITY AND ADDITIONAL FINANCIAL REQUIREMENTS

Previously, when we were dealing with Blue Nile’s financial forecast, our assumption had been
that assets were operating at full capacity (100% capacity). Now let’s relax this assumption that
excess capacity exists in the firm’s fixed assets. In fact, theoretically excess capacity exists with
all types of assets. But as a practical matter, excess capacity normally exists primarily with
respect to fixed assets.
Assume that Blue Nile was operating at only 98% its fixed assets capacity. How does this affect
the firm’s AFN? Some procedures are involved to see the effect.
i) Determine the full capacity sales, i.e., sales that could have been produced had fixed assets
been utilized 100%.
Full Actual sales______________
capacity = Percentage of capacity at which
sales 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
= 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

56
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.

2.3 SUMMARY

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 firm’s 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.
- To compare ratios, cross – sectional or time – series analyses can be employed.
- Financial ratios though are important and useful analyses, have many problems and
limitations.

57
The key concepts covered in this unit are summarized below
- Financial forecasts are very important for both profitability and value maximization of a
firm.
- Financial forecasting is a planning process which includes forecast of sales, determining
of capacities, and deciding on how to finance capacities (assets).
- 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.
- Adjustments must be made to the additional funds needed (AFN) of a firm if excess
capacity exists in the use of its fixed assets.

2.4 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS

1. Quick ratio = Current assets – Inventory
Current liabilities
2 = Br. 400,000 – Inventory
Br. 100,000
Inventory = Br. 400,000 – Br. 200,000 = Br. 200,000
2. Credit sales = Br. 5,000,000 X 75% = Br. 3,750,000
Accounts receivable turnover = Br. 3,750,000 = 7.89X
Br. 475,000
Days sales outstanding = 365 days = 46 days
7 .8 9
3. Times interest earned = Operating income = Br. 120,000 = 4X
Interest expense Br. 30,000
Fixed charges coverage = Earnings before fixed charges
Fixed charges
= Br. 120,000 + (Br. 80,000 – Br. 30,000) = 2.13X
Br. 80,000
4. Net income = Net sales X Net profit margin = Br. 3,000,000 X 5% = Br. 150,000
Return on assets = Net income / Total assets = Br. 150,000 / Br. 1,200,000 = 12.5%

58
5. Return on investment = Net profit margin X Total assets turnover
= 4 % X 1 .5 = 6 %
Return on equity = Return on investment / 1 – Debt ratio
= 6% / 1 – 40% = 10 %
6. 1. An accurate financial forecast enables a firm to forecast sales accurately. An accurate
forecast of sales then allows appropriate forecasts of assets, costs, and expenses. This in
turn would affect the profitability as well as the wealth maximization goal.
2. The basic factors that affect the amount of interest expense are the amount or the balance of
the debt and the prevailing interest rate.
3. AFN = increase – Increase in normally
in assets generated funds
Increase in assets = Br. 4,500,000 x 5% = Br. 225,000
Increase in normally Increase in Increase in
Generated funds = spontaneous liabilities + retained earnings
= Br. 1,250,000 x 5% + (6% x Br. 5,000, 000 x 1.05) x (1 – 30%)
= Br. 62,500 + Br. 220,500
= Br. 283,000
Therefore, AFN = Br. 225,000 – Br. 283,000 = -Br. 58,000. This tells us that Taha PLC could
generate Br. 58,000 more funds than it requires for achieving its sales plan; and that is does not
require any AFN.
7. 1. Because in the pro forma method all costs and expenses are forecasted in detail, but in the
formula method assumptions which might not hold practical are made.
2. If Selam Company has to increase sales without having to use additional funds needed,
AFN will be zero. Hence,
(A/S) S – (L/S) S – MS1 (1 – d) = 0
 1.6 gs0 – 0.4gs0 – Ms0 (1 + g) (1 – d) = 0
 1.6gs0 – 0.4gs0 – 0.10s0 (1 + g) (1 – 0.45) = 0
 1.6gs0 – 0.4gs0 – (0.10s0 – 0.10gs0) = 0
 1.2gs0 – (0.055s0 – 0.055gs0) (0.55) = 0
 1.2gs0 – 0.055s0 + 0.055gs0 = 0
 1.255gs0 = 0.055s0
 1 .2 5 5 g = 0 .0 5 5
 g = 0.055/1.255 = 4.38%.

59
8. 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.
2.5 MODEL EXAMINATION QUESTIONS

Part I. multiple choice

1. Identify the factor that contributes for shorter days sales outstanding
A) Longer credit periods C) Strong cash collection policy
B) Limited cash discount offers D) Poor credit selection
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
4. 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
5. 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
6. Which one of the following factors causes the AFN of a firm to be high?

60
 A) Lower sales growth rate
B) Higher dividend payout ratio
C) Higher net profit margin
D) Lower capital intensity ratio
Part II. Exercises
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 company’s 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 firm’s annual
net sales are Br. 4,000,000; its tax rate is 40%; and its net profit margin is 5%. What is XYZ
Company’s times interest earned ratio?
Part III. Problem
1. Complete the balance sheet and sales information in the following table for Abay Transport
Ltd. Using the financial ratios that follow.
BALANCE SHEET
______________________________________________________________________________
_________________________
Cash Accounts payable
Accounts receivable Long-term debt 1 2 0 ,0 0 0
Inventories Common stock
Fixed assets ________ Retained earnings 1 9 5 ,0 0 0
Total assets Br. 1,000,000 Total liabilities and equity _______
Sales Cost of goods sold
Debt ratio: 50% Days sales outstanding: 36days
Quick ratio: 0.80X Cost of goods sold/sales: 75%
Total assets turnover: 1.5X Inventory turnover: 5X

61
2. You are given below the condensed balance sheet and income statement of Addisalem Auto
Spare Parts, PLC for 2002

Balance sheet as of December 31,2002

Cash -------------------------Br. 90,000 Accounts payable -----------------Br. 180,000
Receivables -------------------180,000 Notes payable (10% interest) ----------78,000
Inventories --------------------360,000 Accruals ----------------------------------90,000
Current assets ------------Br. 630,000 Current liabilities -----------------Br. 348,000
Net fixed assets ------------720,000 Common stock --------------------900,000
_________ Retained earnings ---------------------102,000
Total assets ---------Br. 1,350,000 Total liabilities and equity ---Br. 1,350,000

Income statement for year ended December 31, 2002

Sales -------------------------------Br. 1,800,000
Operating costs -----------------------1,625,000
EBIT ---------------------------------Br. 175,000
Interest ------------------------------------25,000
EBT--------------------------------- Br. 150,000
Taxes (40%) -----------------------------60,000
Net income --------------------------Br. 90,000

The firm’s common stock price during 2002 was Br. 24. Similarly earnings per share (EPS) and
dividends per share (DPS) were Br. 1.80 and Br. 1.08 respectively. Sales are projected to
increase by 10% in 2003. It is learned that assets are operating at full capacity.

Required:
a) Determine the AFN using the pro forma method.
b) Assume 50% of the AFN will be financed by common stock and the common stock price
remains unchanged in 2003, how many share should Addisalem issue in 2003?
c) How does the financing of AFN through common stock affects the firm’s dividend as well as
its retained earnings?

62
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)

2.6 SELECTED REFERENCES

1. Eugene F. Brigham (1997). Fundamentals of Financial Management. 7th edition, the

Dryden Press Harcourt Brace College Publishers, Florida
2. Lawrence J.Jitman (1991). Principles of Management Finance. 6th edition, Harper Collins
Publishers, San Diego.
3. Stanley B. Block and Geoffrey A. Hirt (1994). Foundations of Financial Management. 7th
edition, Irwin.
2.7 GLOSSARY
Acid – test – a detailed, rigorous, and more penetrating test.
Turnover – the rate at which assets are replaced during a period; or the rate at which sales are
generated against assets.
Leverage – the relationship between a firm’s debt balance and its earnings.
Margin – a markup over costs. The difference between the cost of something and the price for
which it is sold.
Return – the total gain or loss experienced by owners on their investment over a given period of
time.
Performa financial statements – financial statements prepared for forecasted periods.
Sales targets – a forecast of a firm’s 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 firm’s assets, particularly fixed assets,
are not currently utilized.
Fixed assets / Sales ratio – the amount of fixed assets required per birr of sales.

63
 UNIT THREE
THE TIME VALUE OF MONEY
Contents
Aims and Objectives
Introduction
3.1 The concept of time value of money
3.2 Future Value
3.2.1 Future Value of a Single Amount
3.2.2 Future Value of an Annuity
3.2.3 Future Value of Uneven Cash Flows
3.3 Present Value
3.3.1 Present Value of a Single Amount
3.3.2 Present Value of an Annuity
3.3.3 Present Value of Uneven Cash Flows
3.3.4 Present Value of a Perpetuity
3.4 Summary
3.5 Answers to Check Your Progress Questions
3.6 Model Examination Questions
3.7 Selected References
3.8 Glossary
AIMS AND OBJECTIVE
After completing this unit, students should be able to:
 appreciate the concept of the time value of money,
 understand the meaning of interest and differentiae between simple and compound
interests,
 differentiate among a single cash flow, an annuity and uneven cash flows,
 understand future and present values of various types of cash flows, and
 Understand the techniques and applications of future and present values.

64
INTRODUCTION

Many decisions in finance involve choices of receiving or paying cash at different time periods.
As you recall from the discussions of the second unit, the goal of a firm is wealth maximization.
This goal recognizes the difference in the value of equal cash flows received at different time
periods. So the concept of the time value of money is that money received now is generally
better than the same amount of money received some time later. This is because there is an
opportunity to invest the money we have now and earn a return on it. For example, if you have
Br. 1,000 today, you could save it in a bank and earn interest.

The time value of money is a very important concept in financial management. It has many
applications in financial decisions like loan settlements, investing in bonds and stocks of other
entities, acquisition of plant and equipment. Therefore, understanding the time value of money
concept is essential for a financial manager to achieve the wealth maximization goal of a firm.

The first basic point in the concept of the time value of money is to understand the meaning of
interest. Interest is the cost of using money (capital) over a specified time period. There are two
basic types of interest: simple interest and compound. Simple interest can be understood in two
different ways. One is that simple interest is an interest computed for just a period. If interest is
computed for one period only, the interest is always simple interest. Another way to understand
simple interest is that it is an interest computed for two or more periods whereby only the
principal (original) value would earn interest. In simple interest the previously earned interests
do not produce another interest.

Compound interest, on the other hand, is an interest computed for a minimum of two periods
whereby the previous interests produce another interest for subsequent or next periods. Here both
the principal and previous interests bring additional interest.

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.

65
3.1THE CONCEPT OF TIME VALUE OF MONEY

3.2 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.

3.2.1 Future Value of a Single Amount

This is the amount to which a specified single cash flow will grow over a given period of time
when compounded at a given interest rate. The formula for computing future value of a single
cash flow is given as:
FVn = PV (1 + i)n
Where:
FVn = Future value at the end of n periods
PV = Present Value, or the principal amount
i = Interest rate per period
n= Number of periods
Or
FVn = PV (FVIFi,n)
Where:
(FVIFi, n) = The future value interest factor for i and n
The future value interest factor for i and n is defined as (1 + i)n and it is the future value of 1 Birr
for n periods at a rate of i percent per period.
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?

66
To solve this problem, let’s 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
3.2.2 Future Value of an Annuity
An annuity is a series of equal periodic rents (receipts, payments, withdrawals, deposits) made at
fixed intervals for a specified number of periods. For a series of cash flows to be an annuity four
conditions should be fulfilled. First, the cash flows must be equal. Second, the interval between
any two cash flows must be fixed. Third, the interest rate applied for each period must be
constant. Last but not least, interest should be compounded during each period. If any one of
these conditions is missing, the cash flows cannot be an annuity.
Basically, there are two types of annuities namely ordinary annuity and annuity due. Broadly
speaking, however, annuities are classified into three types:
i) ordinary annuity,
ii) annuity due, and
iii) deferred annuity
i) Future value of an Ordinary Annuity – An ordinary annuity is an annuity for which
the cash flows occur at the end of each period. Therefore, the future value of an
ordinary annuity is the amount computed at the period when exactly the final (nth)
cash flow is made. Graphically, future value of an ordinary annuity can be
represented as follows:

67
 0 1 2 ------------------ n

PMT1 PMT2 ---------------PMTn

The future value is computed at point n where PMTn is made.

 (1  i )  1
n

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)
 PMT = Br. 25,000/81.670
 PMT = Br. 306.11

68
ii) Future value of an Annuity Due. An annuity due is an annuity for which the payments occur
at the beginning of each period. Therefore, the future value of an annuity due is computed
exactly one period after the final payment is made. Graphically, this can be depicted as:
0 1 2 --------------------- n

PMT1 PMT2 PMT3 ----------------------- PMTn +1

The future value of an annuity due is computed at point n where PMTn + 1 is made
FVAn (Annuity due) = PMT (FVIFAi, n) (1 + i)
Or
 (1  i ) n  1
= P MT   ( 1 + i)
 i 
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 1 2 ------------------n --------------n + x

PMT1 PMT2 PMTn

The future value of a deferred annuity is computed at point n + x
FVAn (Deferred annuity) = PMT (FVIFAi, n) (1 + i)x
 (1  i ) n  1 x
= P MT   (1 + i)
 i 
Where x = The number of periods after the final payment; and X  2.

69
Example: Henock has a savings account which he had been depositing Br. 3,000 every year on
January 1, starting in 1990. His account earns 10% interest compounded annually. The last
deposit Hencok made was on January 1, 1999. How much money will he have on December 31,
2003? (No deposits are made after 1999 January).
Jan.
1990 1991 1992 93 94 95 96 97 98 99 2000 2001 02 03 2004
3 ,0 0 0 3 ,0 0 0 3 ,0 0 0 3 ,0 0 0 3 ,0 0 0 3 ,0 0 0 3 ,0 0 0 3 ,0 0 0 3 ,0 0 0 3 ,0 0 0

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
3.2.3 Future Value of Uneven Cash Flows
Uneven cash flow stream is a series of cash flows in which the amount varies from one period to
another. The future value of an uneven cash flow stream is computed by summing up the future
value of each payment.
Example: Find the future value of Br. 1,000, Br. 3,000, Br. 4000, Br. 1200, and Br. 900
deposited at the end of every year starting year 1 through year 5. The appropriate interest rate is
8% compounded annually. Assume the future value is computed at the end of year 5.
0 1 2 3 4 5

1 ,0 0 0 3 ,0 0 0 4 ,0 0 0 1 ,2 0 0 9 0 0
FVIF8%, 4 Br. 1,000 (1,3605) = Br. 1,360.50
FVIF8%, 3 Br. 3,000 (1.2597) = 3 ,7 7 9 .1 0
FVIF8%,2 Br. 4,000 (1.1664) = 4 ,6 6 5 .6 0
FVIF8%, 1 Br. 1,200 (1.0800) = 1 ,2 9 6 .0 0
Br. 900 (1.0000) = 9 0 0 .0 0
FV = Br. 12,001.20

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Check your progress 1
1. How much must you deposit now on January 1, 1999 to have a balance of Br. 10,000 on
December 31, 2003? Interest is compounded at an 8% annual rate.
2. XYZ company plans to accumulate Br. 500,000 to retire its long-term debt on December 31,
2010. To achieve the plan, the company has just deposited Br. 100,000 today January 1,2003.
But the company knows that this deposit alone would not enable to achieve the target and
wants to make equal annual deposits starting January 1,2005 until January 1,2010. Assuming
the appropriate interest rate is 6% compounded annually, how much should XYZ deposit
every January so as to achieve its plan?

3.3 PRESENT VALUE

Present value is the exact reversal of future value. It is the value today of a single cash flow, an
annuity or uneven cash flows. In other words, a present value is the amount of money that should
be invested today at a given interest rate over a specified period so that we can have the future
value. The process of computing the present value is called discounting.
3.3.1 Present Value of a Single Amount

It is the amount that should be invested now at a given interest rate in order to equal the future
value of a single amount.
n
FVn  1 
PV =  FVn  
1  i n  1 i 
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

71
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

Check your progress 2

On January 1, 1998, Moon Corporation sold a motor vehicle to Sun Company. Sun signed a Br.
200,000 non-interest bearing promissory note due on January 1, 2001. The prevailing interest
rate for a similar note on January 1, 1998, was 9%. How much is the selling price of the motor
vehicle for Moon Corporation?
______________________________________________________________________________
______________________________________________________________________________
____________________________________________________________

3.3.2 Present Value of an Annuity

i) Present value of an Ordinary Annuity is a single amount of money that should be invested
now at a given interest rate in order to provide for an annuity for a certain number of future
periods.
 1 
1  1  i n  1  1  i  n 
PVAn = PMT    PMT   = PMT (PVIFAi, n)
 i   i 
 
 
Where:
PVAn = The present value of an ordinary annuity
(PVIFAi, n) = The present value interest factor for an annuity

1  1  i 
n

=
i

72
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 Mengesha’s 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. 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.

Check your progress 3

How large must each annual payment be for a Br. 100,000 loan to be repaid in equal installments
at the end of each of the next 5 years? The interest rate is 10%, compounded annually.
______________________________________________________________________________
__________________________________________________________________

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 1 2 3 ---------------- n

P M T1 P M T2 P M Tn

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 
PVAn = (Annuity due) = PMT   (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.

73
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.

Check your progress 4

Assume the above example except that the first payment is to be made after 1 year from the date
of purchase. How much would be the cost of the machinery now for Ruth Corporation?
______________________________________________________________________________
______________________________________________________________________________
____________________________________________________________

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
PVAn (Deferred annuity) = PMT   (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 1 2 3 4 5 6 7 8 9 10

PVAn = ? 5 ,0 0 0 5 ,0 0 0 5 ,0 0 0 5 ,0 0 0 5 ,0 0 0 5 ,0 0 0
X

74
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
3.3.3 Present Value of Uneven Cash Flows

The present value of an uneven cash flow stream is found by summing the present values of
individual cash flows of the stream.

Example: Suppose you are given the following cash flow stream where the appropriate interest
rate is 12% compounded annually. What is the present value of the cash flows?

Year 1 2 3
Cash flow Br. 400 Br. 100 Br.300
Br. 400 (0.8929) 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
3.3.4 Present Value of a Perpetuity
A perpetuity is an annuity with an indefinite cash flows. In a perpetuity payments are made
continuously forever. The present value of a perpetuity is found by using the following formula:
PV (Perpetuity) = Payment = P MT
Interest rate 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. This means that
i 7%
Receiving Br. 7,000 every year forever is equal to receiving Br. 100,000 now.

75
Check your progress 5
What do you think are some of the applications of the present value of a perpetuity?
______________________________________________________________________________
____________________________________________________________
3.4 SUMMARY
- The time value of money analysis recognizes the difference among birrs received or paid
at different points in time.
- Future value is a direct result of the compounding process
- Present value is a direct result of the discounting process
- 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
perpetuity.
- Formulas are available for computing both present values and future values of various
types of given cash flows.
- A scientific calculator or interest tables can be applied to solve time value of money
questions.
- 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.
5.5 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS
1.
1. Given: FV5 = Br. 10,000; n = 5 (January 1, 1999 to December 31, 2003); i= 8%; PV = ?
FV5 = PV (FVIF8%, 5)
 Br. 10,000 = PV (1.4693)
 PV = Br. 10,000 / 1.4693 = Br. 6,805.96
N.B. December21,2010 = January
1,2011

76
2. 2003 04 05 06 07 08 09 2010 2011

Br. 100,000 P MT P MT P MT P MT P MT P MT Br. 500,000

Br. 100,000 (FVIF6%, 8) + PMT (FVIFA6%, 6) (1.06) = Br. 500,000
 Br. 100,000 (1.5938) + PMT (6.9753) (1.06) = Br. 500,000
 Br. 159,380 + PMT (7.3938) = Br. 500,000
 PMT (7.3938) = Br. 340,620
 PMT = Br. 340,620  7.33938 = Br. 46,068.33
2.
The selling price of the motor vehicle is the present value of the promissory note.
Given: FV3 = Br. 200,000; i = 9%; n = 3 (Jan. 1,1998 to Jan. 1,2001); PV = ?
PV = FV3 (PVIF9%, 3)
= Br. 200,000 (0.7722) = Br. 154,440
3. The loan of amount of Br. 100,000 is the present value of the five equal annual payments.
Given: PVA5 = Br. 100,000; n = 5; i = 10%; PMT = ?
PVA5 = PMT (PVIFA10%, 5)
 Br. 100,000 = PMT (3.7908)
 PMT = Br. 100,000  3.7908 = Br. 26,379.66

4. Given: PMT = Br. 5,000; n = 10; i = 8%; PVAn = ?

When the payment is to start one year from the date of purchase, the cost of the machinery
would be the present value of an ordinary annuity rather than annuity due.
PVA10 = Br. 5,000 (PVIFA8%, 10)
= Br. 5,000 (6.7101) = Br. 33,550.50

5. Some of the applications of the present value of a perpetuity are when we compute the value
of an asset whose future cash flows are expected for an indefinite period like a preferred
stock and a common stock.

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3.6 MODEL EXAMINATION QUESTIONS
Problems

1. Meron started saving on January 1, 1996. Every month, she deposits Br. 150 in her bank
account, which earns 12% interest compounded monthly. On December 31, 1999, she
withdrew half of the balance in her bank account to invest somewhere else. How 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 bank’s 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 Solomon’s 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?

78
 3.7 SELECTED REFERENCES

1. Aswath Damodaran (1997). Corporate Finance: Theory and Practice. John Wiley and Sons,
Inc., New York.
2. Donald E. Kieso and Jerry J. Weygandt (1998). Intermediate Accounting. 9th edition, John
Wiley and Sons, Inc, New York.
3. Eugene F. Brigham (1997). Fundamentals of Financial Management. 7th edition, the
Dryden Press Harcourt Brace College Publishers, Florida.
4. Stanley B. Block and Geoffrey A. Hirt (1994). Foundations of Financial Management. 7th
edition, Irwin.

3.8 GLOSSARY

Cash flow – a cash inflow or a cash outflow. It is a periodic rent.

Rent – a cash receipt, deposit, withdrawal, payment, cost etc.
Interest table – a table in which the future or present values of just 1 birr are given at different
interest rates and over varying time periods.
Opportunity cost rate – the rate of return on the best available alternative investment of equal
risk.
Payment (PMT) – a series of equal cash flows at regular intervals
Uneven cash flow stream – a series of cash flows in which the amount varies from one period to
another.

79
 UNIT FOUR
LONG TERM INVESTMENT AND FINANCING DECISION

Contents
Aims and Objectives
Introduction
4.1 Bond Valuation
4.1.1 Basic Bond Valuation Model
4.1.2 Interest Rate on a Bond
4.2 Preferred Stock Valuation
4.2.1 Preferred Stock Valuation Model
4.2.2 Rate of Return on a Preferred Stock
4.3 Common Stock Valuation
4.3.1 Zero Growth Stock
4.3.2 Constant Growth Stock
4.3.3 Variable Growth Stock
4.4 Summary
4.5 Answers to Check Your Progress Questions
4.6 Model Examination Questions
4.7 Selected References
4.8 Glossary

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,

80
  To understand how to determine the expected rate of return from investments in bonds,
preferred and common stocks.

INTRODUCTION

As you have seen in the previous accounting courses, the value of an asset is determined based
on its cost (historical cost). That means all the necessary expenditures incurred from the time the
asset is acquired until it is placed in operation will be the cost of the asset. However, in financial
management, the value of an asset is quite different.

Since finance is interested more on decision making rather than recording, the value of an asset
is determined before it is purchased. The purpose is to decide whether to acquire or not to
acquire the asset. Therefore, here the historical cost cannot be used as the value of the asset.
Rather, the value of the asset is determined by valuation.

Valuation is the process of determining the worth of any asset whose value is obtained from
future cash flows. Look, the value here is not historical cost. The value of any asset in finance is
the present value of all future cash flows it is expected to provide over the relevant time period.
This value is called intrinsic value. In the remainder of this unit, we shall emphasize the intrinsic
value of an asset.

The intrinsic value of an asset is determined based on three basic inputs: cash flows (returns),
time pattern of the returns, and the discount rate. The value of an asset is, therefore, determined
by discounting the expected cash flows to their present value. To determine the present value, we
use a discount rate appropriate based on the asset’s risk.

Value can be determined for any kind of asset like buildings, machineries, factories, bonds,
stocks etc. But in this unit, we will discuss the value of three financial assets: bonds, preferred,
and common stocks.

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4.1 BOND VALUATION

Bond is a long-term debt instrument or security issued by businesses and governmental units to
raise large sums of money. Investment in a bond provides two types of cash 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.

4.1.1 Basic Bond Valuation Model

The value of a bond is the present value of the periodic interest payments plus the present value
of the par value. The value of a bond can be computed using the following equitation:
Bo = I(PVIFA kd,n) + M(PVIF kd,n)
Where:
Bo = the value of the bond
I = interest paid each period = Par Value x Coupon interest rate
Kd = the appropriate interest rate on the bond
n = The number of periods before the bond matures
M = the par value of the bond
(PVIF kd,n) = The present value interest factor for an annuity at interest rate of kd per period for
1
1
(1  k d ) n
n periods =
kd
(PVIFkd,n) = The present value interest factor at interest rate of kd per period for n periods =
1
(1  k d ) n

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Notice that we have used kd instead of i. This is because, generally, in financial management k
designates rate of return and the subscript d denotes debt security. So kd designates the rate of
return on a debt security.

Illustration: Tebaber Berta Corporation has a Br. 1,000 par value bond with an 8% coupon
interest rate outstanding. Interest is paid semiannually and the bond has 12 years remaining to its
maturity date.

Required: What is the value of the bond if the required return on the bond is 8%?

Solution:
Given: M = Br. 1,000; kd = 8% per year or 4% (8%2) per semiannual period; I = Br. 40 (Br.
1,000 x 4%); n = 24 semiannual periods (12 x 2); Bo =?
Bo = I(PVIFA kd,n) + M(PVIF kd,n)
= Br. 40(PVIFA4%, 24) + Br. 1,000(PVIF4%, 24)
= Br. 40 (15.2470) + Br. 1,000 (0.3901)
= Br. 1,000
If the appropriate discount rate (kd) remains constant at 8% (4% per semiannual period), the
value of the bond will not be changed. It will remain Br. 1,000. Suppose the appropriate discount
rate is 8% 2 years from now, what would be the value of the bond?
Solution: now n is reduced to 20[24-(2 x 2)]
Bo = Br.40 (PVIFA4%, 20) + Br. 1,000 (PVIF4%, 20)
= Br. 40 (13.5903) + Br. 1,000 (0.4564)
= Br. 1,000
Suppose the interest rate in the economy when Tebaber Berta’s bonds were issued was 6% rather
than 8%, what would be the value of the bond? Since Tebaber Berta’s bond now will be paying
more interest than do other bonds in the market, the company’s bond will be selling at a larger
price. Such bonds which are selling more than their par value are called premium bonds. Here, kd
is 6% (3% per semiannual payment), but other things are not changed. So
Bo = Br. 40 (PVIFA3%, 24) + Br. 1,000 (PVIF 3%, 24)
= Br. 40 (16.9355) + Br. 1,000 (0.4919)
= Br. 1,169.32

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So when the market interest rate (kd) is less than the coupon interest rate, the value of a bond is
always larger than the par value. An investor by deciding to invest his money on Tebaber Berta’s
bond, he will receive a 1% (4% - 3%) more interest payment than he would receive if he invested
somewhere else. This allows the investor to receive Br. 10 [Br. 1,000 x (4% - 3%)] more every
semiannual period. As a result, the investor would be willing to give more price to the bond. The
additional price is the present value of each Br. 10 he is going to receive for the next 24
semiannual periods. Therefore, the value of a premium bond can also be computed as:
Bo = Br. 1,000 + Br. 10 (PVIFA3%, 24)
= Br. 1,000 + Br. (16.9355)
= Br. 1,169.36*

* The previous value was Br. 1,169.32. The difference is due to rounding problem.
Assuming the interest rate remains constant at 6% for the next 11 years (12 periods), what would
happen to Tebaber Berta’s bond?
Bo = Br. 40 (PVIFA3%, 22) + Br. 1,000 (PVIF3%, 22)
= Br. 1,159.38

Thus, the value of the bond would fall form Br. 1,169.32 to Br. 1,159.38. If you calculate the
value of the bond at other future dates, the price would continue to fall as the maturity date
approaches.

Had the interest rate (kd) was 10% when Tebaber Berta’s bond was selling, the value of the bond
would be:
Bo = Br. 40 (PVIFA5%, 24) + Br. 1,000 (PVIF5%, 24)
= Br. 40 (13.7986) + Br. 1,000 (0.3101)
= Br. 862.04. Since Tebaber Berta’s bond now will be paying less interest than do
other bonds in the market, they are selling at a smaller price (discount bond).

If the interest rate remain constant at 10% for the next 11 years (22 periods), the value of
Tebaber Berta’s bond would be Br. 868.32. Thus, the value of the bond will have risen 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.

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Check Your Progress –1
1. When is a bond selling at premium, at par value, and at discount?
______________________________________________________________________________
______________________________________________________________________________
____________________________________________________________
2. Amha Corporation issued a new series of bonds on January 1, 1985. The bonds were sold at
their par of Br. 1,000, have 12% coupon, and mature in 20 years. Coupon payments are made
quarterly. What was the price of the bond on December 31, 1989, assuming that the level of
interest rate had fallen to 8%?
______________________________________________________________________________
______________________________________________________________________________
____________________________________________________________
4.1.2 Interest Rate on a Bond
So far we have been seeing how to determine the value of a bond if we are given the par value,
the coupon interest rate, the number of periods, and the interest rate on the bond. Next, we shall
discuss on how to find the interest rate on a bond, i.e., kd if we are given the value of the bond.
We will consider yield to maturity and yield to call.
Yield to Maturity (YTM) is the rate of return investors earn if they buy a bond at a specific
price Bo and hold it until maturity. The approximate YTM can be found using the following
approximation formula:
M  Bo
I
Approximate YTM = n
M  Bo
2
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.
Solution:
Given: M = Br. 1,000; I = Br. 100 (Br. 1,000 x 10%); n = 15; Bo = Br. 1,090; YTM = ?
Br.1,000090
Br.100 
Approximate YTM = 15  9%
Br.1,000  Br.1,090
2

85
If an investor buys Zebra’s 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
I
Approximate YTC = n
Call Pr ice  Bo
2
Example: X Company is intending to purchase Y Company’s outstanding bond which was issued
on January 1, 1997. Y bond is a Br. 1,000 par value, has a 10% annual coupon, and a 30 year
original maturity. There is a 5-year call protection, after which time the bond can be called at
108. X company is to acquire the bond on January 1, 1999 when it is selling at Br. 1,175.

Required: Determine the yield to call in 1999 for Y company bond.

Solution:
Given: I = Br. 100 (Br. 1,000 x 10%); Bo = Br. 1,175; call price = Br. 1,080 (Br. 1,000 x
108%);
n = 3 (call protection – 2 years elapsed since the bond was issued); YTC =?
Br.1,080  Br.1,175
Br.100 
Approximate YTC = 3  6.06%
Br.1,080  Br.1,175
2
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%.
Check Your Progress –2

1. The Salem Company bond currently sells for Br. 955, has a 12% coupon interest rate and Br.
1,000 par value, pays interest annually, and has 15 years to maturity. Calculate the yield to
maturity on this bond.

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______________________________________________________________________________
______________________________________________________________________________
____________________________________________________________
2. Allied Company has just issued 10,000 bonds of Br. 1,000 par value each. The bonds have
original maturity of 50 years and an annual coupon rate of 15%. There is a 10 year call provision
on the bonds. 3 years after the bonds had been issued, they were selling at Br. 1,300 each. The
call price for each bond is 109 ¾. Calculate the yield to call on Allied bonds.
______________________________________________________________________________
______________________________________________________________________________
____________________________________________________________

4.2 PREFERRED STOCK VALUATION

Preferred stock is a type of equity security that provides its owners with limited or fixed claims
on a corporation’s income and assets. Investment in a preferred stock provides a single cash
flow, i.e., constant periodic dividend payments. Preferred stock has similarities to both a bond
and a common stock. As to similarities to a bond, preferred dividends are fixed in amount and
are like interest payments. As to a common stock, the preferred dividends are paid for an
indefinite time period.

4.2.1 Preferred Stock Valuation Model

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:
Vps = Value of the preferred stock
Dps = Preferred stock dividends
Kps = The required rate of return on the preferred stock

87
Example: Abebe wishes to estimate the value of its outstanding preferred stock. The preferred
issue has a Br. 80 par value and pays an annual dividend of Br. 6.40 per share. Similar-risk
preferred stocks are currently earning a 9.3% annual rate of return. What is the value of the
outstanding preferred stock?
Solution:
Given: Dps = Br. 6.40; Kps = 9.3%; Vps =?
Br.6.40
Vps = = Br. 68.82
9.3%
So the Br. 6.40 annual dividend an investor receives for an infinite years is equal to today’s Br.
68.82 if the required rate of return is 9.3%.

4.2.2 Rate of Return on a Preferred Stock

To evaluate the worthiness of investment in a preferred stock in comparison to other investment

opportunities, we should be able to compute the rate of return on a preferred stock. If we know
the current price of a preferred stock and its dividend, we can compute the expected rate of return
on the preferred stock. This can be done using the following formula:
Dps
Kps =
Vps
Where
Kps = The expected rate of return on the preferred stock
Dps = Preferred stock dividends
Vps = Value or current price of the preferred stock
Example: A preferred stock pays an annual dividend of Br. 9 and the current market price is Br.
81. Compute the required rate of return from the preferred stock.

Solution:
Given: Dps = Br. 9; Vps = Br. 81; Kps =?
Br.9
Kps = = 1 1 .1 1 %
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%.

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4.3 COMMON STOCK VALUATION

The value of a share of common stock is the present value of the common stock’s 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.
D1 D2 D
Po =  
(1  ks) (1  ks)
1 2
(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.

The common stock valuation equation can be simplified by redefining each year’s 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.
4.3.1 Zero Growth Stock
A zero growth stock is a common stock whose future dividends are not expected to grow at all.
The expected growth rate (g) is zero. This is the simplest model to common stock valuation. It
assumes a constant, non-growing annual dividend. So here the annual dividends are all equal.
That is D1 = D2 = … = D = D.

89
A common stock with zero growth rate is a security that is expected to provide a fixed dividend
each year. Hence, a zero growth common stock is a perpetuity. Therefore, the value of a zero
growth stock is given as:
D
Po =
Ks
Example: The most recent common stock dividend of Shalom Manufacturing Corporation was
Br. 3.60 per share. Due to the firm’s maturity as well as stable sales and earnings, the dividends
are expected to remain at the current level of the foreseeable future.
Required: Determine the value of Shalom’s common stock for an investor whose required
return is 12%.
Solution:
Given: D = Br. 3.60; Ks = 12%; Po =?
Br.3.60
Po = = Br. 30
12%
The maximum price the investor would be willing to pay for a share of Shalom’s common stock
is Br. 30 for he to receive a Br. 3.60 annual dividend for an indefinite years.

4.3.2 Constant Growth Stock

Constant growth stock is a common stock whose future dividends are expected to grow at a
constant dividend growth rate (g). It is sometimes called normal growth stock. The constant
(normal) growth common stock valuation model is the most widely cited approach to common
stock valuation.

The value of a constant growth stock is the present value of the expected future dividends
growing at a constant rate of g. Here the value can be found by using the following formula:
D1
Po = ; Ks > g
Ks  g
Where:
D1 = The expected dividend at the end of year 1.
g = The expected growth rate in dividends.

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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 Corporation’s 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 Zeila’s common stock if the required return is 12%.
Solution:
Given: Do = Br. 5.40; g = 5%; Ks = 12%; Po =?
D1
Po = ; D1 = Do (1+g0) = Br. 5.40 (1.05) = Br. 5.67
Ks  g
Br.5.67
= = Br. 81
12%  5%
For an investor to receive an annual dividend of Br. 5.40 growing at 5% constantly to infinity,
the maximum price he would pay today is Br. 81.

If we are given the value of a constant growth stock, the most recent dividend, the expected
dividend growth rate, we can compute the expected rate of return as follows.
D1
Ks = 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?
Br.5.40 (1.05)
Ks = + 0 .0 5
Br.81
= 12%

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4.3.3 Variable Growth Stock

Variable growth stock is a stock whose dividends are expected to grow at variable or non-
constant rates. The model of common stock valuation that allows for a change in the dividend
growth rate is called Variable (non constant) Growth Model. It sometimes is also called
supernormal growth model.

The value of a share of variable growth stock is determined by following 4 procedures.

1. Find the value of the dividends at the end of each year during the initial growth period.
2. Find the present values of the dividends found in step 1.
3. Find the value of the stock at the end of the initial growth period
4. Add the present value of the dividends found in step 2 and the present value of the value of the
stock found in step 3 to determine the value of the stock at time zero, i.e. po.

Example: Addis Company’s 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.

Stockholders require a return of 12% on Addis’ stock

Required: Calculate the value of the stock today.
Solution:
Given: Do = Br. 1.75; g1 = 15% for 3 years; g2 = 5% from year 3 to infinity; k5 = 12%; p0 = ?
g1 = 15% g2 = 5%

Year 0 1 2 3 
D0 = Br. 1.75 D1 = Br. 2.01 D2 = Br. 2.31 D3 = Br. 2.66
PV of D1 = Br. 1.79 PVIF 12%, 1
PV of D2 = 1.84 PVIF 12%, 2
PV of D3 = 1.89 PVIF 12%, 3
P V o f P 3 = 2 8 .4 0 PVIF 12%, 3 P3 = Br. 39.90
P0 = Br. 33.92

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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
D4 D3 (1  g 2 ) Br.2.66 (1.05)
P3 =    Br.39.90
k5  g 2 k5  g 2 0.12  0.05
Therefore, the value of Addis Company’s common stock today is Br. 33.92
Check Your Progress III
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. Melat’s last dividends 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?
______________________________________________________________________________
____________________________________________________________

4.4 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.

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 - 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.
- The value of a normal growth stock is the present value of expected dividends which are
growing at a constant rate.
- The present value of a variable growth stock is computed by following 4 basic steps.
- In a constant growth stock, the required rate of return should always be greater than the
expected dividends growth rate. That is ks > g

4.5 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS

I.
1. A bond is selling at premium when the market interest rate or required rate of return (kd) is
less than the coupon interest rate, at discount when kd is greater than coupon interest rate, and at
par value when kd is equal to coupon rate.
2. Given: M = Br. 1,000; kd = 2% (8%  4); I = Br. 30 (Br. 1,000 x 12%/4); n = 60 (15 x 4) five
years have passed (Jan. 1, 1985 to Dec. 31, 1989) since the bond was issued B0 = ?
B0 = Br. 30 (PVIFA 2%, 60) + Br. 1,000 (PVFI2%, 60)
= Br. 30 (34.7609) + Br. 1,000 (0.3048)
= Br. 1,347.63

II.
1. Given M = Br. 1,000; I = Br. 120 (Br. 1,000 x 12%); n = 15; B0 = Br. 955; YTM = ?
Br.1,000  Br.955
Br.120 
Approximate YTM = 15  12.58%
Br.1,000  Br.955
2
2. Given: I = Br. 150 (Br. 1,000 x 15%); B0 = Br. 1,300; call price = Br. 1,097.50 (Br. 1,000 x
109 ¾%) n = 7 (10 – 3); YTC = ?
Br.1,097.50  Br.1,300
Br.150 
Approximate YTC = 7  10.10%
Br.1,097.50  Br.1,300
2

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III.
1. Value of common stock = PV of D1 + PV of D2 + PV of D3 + PV of P3. But P3 i.e. the selling
price at the end of 3 years = the PV at the end of year 3 of D4, D5, ----, D. Therefore, the value
of common stock = PV of D1 + PV of D2 + ---- + PV of D. Whether you hold the common
stock for 3 years of for indefinite, the value of common stock is the same.
Given: D0 = Br. 2; g = 5%, ks = 15%; P0 = ?
D1 D (1  g ) Br.2 (1.05)
P0 =  0   Br.21
Ks  g Ks  g 15%  5%
2. Given: D0 = Br. 1.15; g1 = 15%; g2 = 13%; g3 = 6%; Ks = 12%; P0 = ?
g1 = 15% g2 = 13% g3 = 6%

Year 0 1 2 3 
D0 = Br. 1.15 D1 = Br. 1.32 D2 = Br. 1.52 D3 = Br. 1.72
PV of D1 = Br. 1.18 PVIF12%, 1
PV of D2 = Br. 1.21 PVIF12%, 2
PV of D3 = 1.22 PVIF12%, 3
D4
PV of P3 = 21.63 PVIF12%, 3 P3 =  Br.30.39
Ks  g
P0 = Br. 25.24

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.

4.6 MODEL EXAMINATION QUESTIONS

Exercise
1. Selam Household Utensils Manufacturing Company is currently selling its common stock at
Br. 108. the firm’s last earnings per share was Br. 18 and its dividend payout ratio was 60%. The

95
required rate of return on the stock is 12%. Selam’s dividends are expected to grow at a constant
rate.
Required: Determine:
a) The expected dividends growth rate (g)
b) The expected stock price of Selam Company after 3 years
2. Bonds issued by Berhan Company have a par value of Br. 5,000. The bonds are currently
selling for Br. 4,250. They have 10 years remaining to maturity. The annual interest payment is
9%.
3. A firm pays Br. 2.45 dividend per share at the end of next year on a common stock that has a
selling price of Br. 35. The dividends of the firm are expected to grow at a constant rate of 6%.
Compute the required rate of return on the stock (ks).
4. Ibex Motor corporation issued bonds with a 20-year maturity, a Br. 1,000 par value, a 10%
coupon rate, and semiannual interest payments. Two years after the bonds were issued, the
market interest rate dropped to 6%.
Required: Determine the value of each bond
a) at the time the bonds were sold
b) two years after issuance
4.7 SELECTED REFERENCES

1. Aswath Damodaran (1997). Corporate Finance: Theory and Practice. John Wiley and Sons,
Inc., New York
2. Eugene F. Brigham (1997). Fundamentals of Financial Management. 7th edition, the
Dryden Press Harcourt Brace College Publishers, Florida.
3. Halpern, Weston and Brigham (1989). Canadian Managerial Finance. 3rd edition, Holt
Rinehart and Winston of Canada, Limited
4. James C. Van Horne (1989). Financial Management and Policy. 8th edition, Prentice Hall.
5. Lawrence J. Gitman (1997). Principles of Managerial Finance. 8th edition, Addison –
Wesley Longman, Inc.
6. Belayneh, Endale, Fasil and Hassen (2003). The impact of Ordinary Shares Valuation on
the Capital Structure of Ethiopian Companies: A Case Study on Four Private Financial
Institutions. Unpublished Material, Addis Ababa University.

96
4.8 GLOSSARY

Intrinsic value – the present value of expected future cash flows discounted by an appropriate

discount rate.

Discount rate – a rate based on the riskless 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.

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 UNIT SIVE
CAPITAL STRUCTURE AND LEVERAGE

Contents
Aims and Objectives
Introduction
5.1 The Target Capital Structure
5.2 The Concept of Leverage
5.2.1 Operating Leverage
5.2.2 Financial Leverage
5.3 Capital Structure Theory
5.3.1 Trade-Off Theory
5.3.2 Signaling Theory
5.4 Factors in Capital Structure Decisions
5.5 Summary
5.6 Answers to Check Your Progress Questions
5.7 Model Examination Questions
5.8 Glossary
AIMS AND OBJECTIVES

At the end of this unit you should be able to understand the following:
 the meaning and concept of capital structure
 the impact of capital structure on value of a firm
 the concept of operating and financial leverage
 the interpretation and properties of operating and financial leverage
 how to determine the optimal capital structure
 two basic theories of capital structure
 factors to be considered in setting capital structure

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INTRODUCTION

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
riskiness of the firm common stock, and this will affect Ks and Po. Therefore, the choice of a
capital structure is an important decision.

5.1THE 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 firm’s 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 riskiness of the firm’s earnings stream
 However, a higher debt ratio generally leads to a higher expected rate of return

Higher risk tends to lower a stock’s 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 firm’s
stock price.
Four primary factors influence the capital structure decision
1. Business risk, or the riskiness inherent in the firm’s operations if it used no debt. The
greater the firm’s business risk, the lower its optimal debt ratio.
2. The firm’s tax position. A major reason for using debt is that interest is deductible,
which lowers the effective cost of debt. However, if much of a firm’s 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.

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 3. Financial flexibility or the ability to raise capital on reasonable terms under adverse
conditions. Corporate treasures know that a steady supply of capital is 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. 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.

Check your progress – 1

In what sense does capital structure policy involve a trade-off between risk and return?
______________________________________________________________________________
______________________________________________________________________________
____________________________________________________________

6.2THE CONCEPT OF LEVERAGE

The leverage concept is very general. It is not unique to business or finance, and it can be used to
analyze many different types of problems. For example, other disciplines, such as economics and
engineering, use the same concept, and refer to it as elasticity. When used in a financial setting,
leverage measures the behavior of interrelated variables, such as output, revenue, earnings before
interest and taxes (EBIT), and earnings per share (EPS).

100
The material in this chapter will be easier to understand if two points are kept in mind.

1. Leverage measures the relationship between two variables, as opposed to measuring

variables independently, and the value that one variable assumes must depend on the
values assume by the second variable.
2. In order for leverage coefficients to have any useful applications, it must be possible to
identify which variable is the dependent variable. In other words, the direction of casualty
must be known. When two variables are so related, the degree of leverage describes the
responsiveness of the dependent variable to change in the independent variable.

Let Y and X represent two variables. When the values taken by Y are determined by the values
taken by X, Y is said to be dependent on X. accordingly, Y is called the dependent variable and
X is referred to as the independent variable. The algebraic statement of Y’s dependence on X is
written as:
Y = f (x)
And is read as: Y is a function of X
Suppose that the initial values of Y and X are known. The independent variable X now takes on
a new value. The change in the value of X and its percentage change are computed. The resulting
change and percentage change are also computed. Leveraged is then defined as the percentage
change in the dependent variable Y divided by the percentage change in the independent variable
X. in algebraic terms, the definition of leverage is developed as follows:
Let x = the change in the independent variable x
y = the change in the dependent variable y.
x
= the percentage change in x = % x
x
y
= the percentage change in y = % y
y
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.

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5.2.1 Operating Leverage
Operating Leverage measures the relationship between output and Riming before interest and tax
(EBIT), specifically; it measures the effect of changing levels of output on EBIT. The functional
relationship between these two variables is:
y = f (T),
Where, y = earning before interest and tax
T = number of units of output produced and sold
Earning before interest and tax = Total revenue – Total variable cost – fixed cost.
When the level of output changes from its initial value, the initial value of EBIT also changes.
Thus, operating leverage is defined as the resulting percentage change in EBIT divided by the
percentage change in output, symbolically, operating leverage is expressed as:
L ( y) y / y %  EBIT
 
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
= 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

102
 L ( y ) .667
 = 2 .6 7
L (T ) .25
The coefficient of operating leverage of 2.67 is interpreted as follows. A 1 percent change in
output from an initial value of 8000 units produces a 2.67 percent change in EBIT. Since output
increased by 25 percent from its initial value of 8000 units, EBIT increases by (2.67) (.25) = .667
or 66.7 percent.

Measurement equations equivalent to the definitional equations are used to compute and to
explain the properties of operating leverage. The measurement equation used when the income
statement relationship is describes as follows:
T (P  V )
(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)
(OL/T = 8000) =  2.67
8000 ( Br.10  Br.4)  30,000
Properties of Operating Leverage
The properties of operating leverage determine its use and a tool of financial analysis. These
properties are best explained by using operating breakeven and EBIT, operating breakeven is
defined as the value of output that makes EBIT equal to zero. At this level of output, total
revenue is just sufficient to pay operating variable and fixed costs, and no 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
T=  4000 units
Br.25  Br.10

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If operating leverage is calculated at operating breakeven, the coefficient of operating leverage
would be:
4000 ( Br.25  Br.10)

4000 ( Br.25  Br.10)  60,000
(OL/T = 4000)
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
3- A large absolute value of operating leverage (the coefficient of operating leverage
without regard to its algebraic sing) indicates that output is close to operating
breakeven and that the absolute size of EBIT is relatively small
4- A positive coefficient of operating leverage close to 1.0 indicates that output is
relatively far above operating breakeven and that the amount of EBIT is relatively
large.
5- If a high percentage of a firm’s total costs are fixed, the firm is said to have a high
degree of operating leverage.
A high degree of operating leverage, other things hold constant, means that a
relatively small change in sales will result in a large change in operating income.
Check your progress – 2
1. A firm’s production costs are as follows:
F = Br. 4,800,000
V = Br. 26

104
 What is the operating breakeven with a selling price of Br. 51 per unit?
______________________________________________________________________________
______________________________________________________________________________
____________________________________________________________
2. Coefficient operating leverage for selected values of output are contained in the first two
columns of the following table
T OL/T OL/T
before after
authomation authomation
2 2 5 ,0 0 0 6 .8 2 1 3 .0 0
2 5 0 ,0 0 0 4 .3 1 5 .9 1
2 7 5 ,0 0 0 3 .3 1 4 .0 9
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?
______________________________________________________________________________
____________________________________________________________
5.2.2 Financial Leverage
Financial leverage measures the relationship between EBIT and earning per share (EPS).
Specifically, it reflects the effect of changing levels of EBIT on EPS. The functional relationship
between these two variables is:
EPS = f (EBIT)
and the income statement relationship is: -
Profit before taxes:
EBIT – interests on debt = Y – I
Federal income taxes:
(profit before taxes) (tax rate) = (Y – I) (t)
profit after tax:
profit before taxes – federal income taxes
(Y – I) – (Y – I) (t) or
(Y – I) (1 – t)

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 Earning available to common shareholders
profit after taxes – preferred stock dividends
(Y – I) (1 – t) – E
Earning per share of common stock:
Earning available to common shareholders
number of common shares issued
EPS = (Y – I) (1 – t) – E
N
The algebraic equivalent of the complete income statement is obtained by substituting the
symbolic form of EBIT as follows:
[T ( P  V )  F  I ] (1  t )  E
EP S =
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
 
L ( EBIT ) EBIT / EBIT % EBIT
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 Assume that I = Br. 100,000, t = 0.4, E = Br. 80,000
N = 60,000, and EBIT = Br. 500,000. the EPS at this level of EBIT is
computed as:
EPS = (Br. 500,000 – Br. 100,000) (1 – 0.4) – Br. 80,000
6 0 ,0 0 0
= Br. 2.67
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
6 0 ,0 0 0
= Br. 3.67

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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
The coefficient of financial leverage of 1.87 is interpreted as follows: A 1 percent change in
EBIT from an initial value of Br. 500,000 produces a 1.87 percent change in EPS. 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) =
E
Y I 
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
(FL/Y = Br. 500,000) =  1.88
Br.80,000
Br.500,000  Br.100,000 
1  0.4
Financial leverage is sometimes called balance sheet leverage or capital structure leverage.

Check your progress – 3

A corporation produces and sells different product lines. In financing these activities, the firm
has floated two issues of the following bonds and preferred stock, and has one million shares of
common stock outstanding.
Bond issue A : Br. 10,000,000 at 8% interest rate
Bond issue B : Br. 20,000,000 at 10% interest rate
Preferred stock series A : 200,000 shares, Br. 4.50 dividends per share
Preferred stock series B : 300,000 shares, Br. 7 dividend per share

107
At the EBIT level of Br. 10,000,000, determine the values of EPS and of financial leverage.
Assume 40% tax rate.
______________________________________________________________________________
______________________________________________________________________________
____________________________________________________________

Properties of financial leverage

The properties of financial leverage can be explained by using the concept of financial
breakeven. Financial breakeven is defined as the value of EBIT that makes EPS equal to zero. At
financial breakeven the firm’s EBIT, the form produces a positive level of earnings available to
common shareholders and a positive EPS. Below this level, profit available to common
shareholders and EPS are both negative. It is thus possible for a firm to earn a positive level of
EBIT even though its EPS is negative. This will happen when the firm’s EBIT is positive but less
than its financial breakeven level. Financial breakeven is expressed as:
(Y  I ) (1  t )  E
0
N
Solving this equation for Y, or EBIT, yields:
E
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
( FL / Y  Br.4,166,667) 
Br.4,166,667Br.2,000,000  Br.1,300,000 /(1  0.4)
Br.4,166,667
  undefined
0

108
Interpretations of financial leverage
 Fundamental interpretation: the coefficient of financial leverage is the percentage change
in EPS that results from a 1 percent change in EBIT.
 Related interpretations:
1. A positive coefficient of financial leverage means that leverage is being computed for a
value of EBIT that is greater than financial breakeven.
2. A negative coefficient of financial leverage indicates that leverage is being computed for
a value of EBIT below financial breakeven
3. A large absolute value of financial leverage indicates that leverage is being computed
close to financial breakeven and that the absolute value of EPS is relatively small.
4. A positive coefficient of financial leverage close to 1.0 indicates that leverage is being
computed for a value of EBIT that is relatively far above financial breakeven and that the
corresponding value to EPS is relatively large.
5. Financial leverage refers to the use of fixed-income securities-debt and preferred stock.

5.3 CAPITAL STRUCTURE THEORY

Capital structure theory has been developed along two main lines
- tax benefit bankruptcy cost trade-off theory
- signaling theory

5.3.1 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 firm’s value rises continuously as it uses more debt, and hence its value will be
maximized by financing almost entirely with debt. MM’s 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 firm’s future investment
opportunities

109
 5. All the firm’s debt is riskless, regardless of how much debt of uses
6. EBIT is not affected by the use of debt.
Since several of these assumptions were obviously unrealistic, MM’s positions was only the
beginning of capital structure research.

Subsequent researchers, and MM themselves, extended the basic theory by relaxing the
assumptions. Other researchers attempted to test the theoretical model with empirical data to see
exactly how stock prices and capital costs are affected by capital structure. Both the theoretical
and empirical results have added to our understanding of capital structure, but none of these
studies has produced results that can be used to identify precisely a firm’s optimal capital
structure. A summary of the theoretical and empirical research are the following.
1. The fact that interest is deductible expense makes debt less expensive than common or
preferred stock. That is debt provides tax shelter benefits. As a result, using debt causes
more of the firm’s operating income (EBIT) to flow through to investors, so the more
debt a company uses, the higher its value and the higher the price of its stock.
2. The MM assumptions do not hold in the real world. First interest rate rises as the debt
ratio rises. Second, EBIT declines at extreme level of leverage. Third, expected tax rate
fall at high debt levels, and this reduces the expected value of the debt tax shelter. And,
fourth, the probability of the bankruptcy, which brings with it lawyers’ fee and other
costs, increases as the debt ratio rises.
3. Both theory and empirical evidence support the preceding discussion. However,
statistical problems prevent researchers from identifying points of threshold debt level
where bankrupt costs become material and optimal capital structure – where marginal tax
shelter benefits and marginal bankruptcy – related costs are equal.
4. Another disturbing aspect of capital structure theory is the fact that many large,
successful firms use far less debt then the theory suggests. This point led to the
development of signaling theory.

5.3.2 Signaling theory

MM assumed that investors have the same information about a firm’s 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

110
optimal capital structure. To see why, consider two situations, one in which the company’s
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 F’s 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 F’s 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, let’s 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.

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?

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6.4 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 firm’s corporate tax, the greater the advantage of debt.
7. Control: - The effect of debt versus stock on management’s control position can influence
capital structure. If management currently has voting control (over 50 percent 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 firm’s 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

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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 firm’s optimal capital structure.
11. The firm’s internal conditions: - A firm’s 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, management’s confidence in its forecasts, and the consequences on a capital
shortage.

5.5 SUMMARY

The key concepts covered are summarized below

 A firm’s optimal capital structure is that mix of debt and equity which maximizes the
price of the firm’s stock. As any point in time, the firm’s management has a specific
target capital structure in mind, presumably the optimal one, although this target may
change over time.
 Several factors influence the firm’s capital structure. These include the firm’s (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 firm’s capital structure.

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  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 MM’s 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 firm’s 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.

5.6 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 firm’s 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)
= 1 9 2 ,0 0 0 u n i t s
2. The new operating breakeven is
T = Br. 5,400,000/ (Br. 51 – Br. 25)
= 2 0 7 ,6 9 2 u n i t s
3. At the EBIT level of Br. 10,000,000, the values of EPS and Financial leverage are:
I = 0.08 (Br. 10,000,000) + 0.10 (Br. 20,000) = Br. 2,800,000
E = Br. 4.5 (200,000) + Br. 7 (300,000) = Br. 3,000,000
EPS = (Br. 10,000,000 – Br. 2,800,000) (1 – 0.4) – Br. 3,000,000 = Br. 1.32
1 ,0 0 0 ,0 0 0
(FL/Y = Br. 10,000,000) = Br. 10,000,000____________
Br. 10,000,000 – Br. 2,800,000 – Br. 3,000,000 / (1 – 04)
= 4 .5 5

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5.7 MODEL EXAMINATION QUESTIONS
Exercises
1. GIZACEW Co. manufactures ladies; watch which are sold through discount houses. Each
watch is sold for Br. 25; and fixed costs are Br. 140,000 for 30,000 watches or less; variable
costs are Br. 15 per watch
a. What is the firm’s gain or loss at sales of 8000 watches?
b. What is the company’s degree of operating leverage at sales of 8000 units? Of 1800
units?
c. What is the company’s degree of operating leverage at sales of 8000 units? Of 18000
units?
d. What happens to the breakeven point if the selling price rises to Br. 31? What is the
significance of the change to the financial manager?
e. What happens to the breakeven point of the selling rises to Br. 31 but variable costs rise
to Br. 23 unit?
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 company’s product
market is stable and the company expects no growth, all earnings are paid out as dividends.
The debt consists of perpetual bonds.
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. Olinde’s fixed costs are
Br. 200,000; 5000 components are produced and sold each year; EBIT is currently Br. 50,000;

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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
5.8 GLOSSARY
 Target capital structure. The mix of debt, preferred stock and common equity with
which the firm plans to raise capital.
 Business risk. The risk associated with projections of a firm’s future returns on assets.
 Operating leverage. The extent to which the fixed costs are used in a firm’s operations.
 Breakeven point. The volume of sales at which total costs equal total revenue, causing
operating profit (EBIT) to equal zero.
 Financial leverage. The extent to which fixed income securities (debt and preferred
stock) are used in a firm’s capital structure.
 Financial 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. The percentage change in EPS associated with a given
percentage change in EBIT.
 Symmetric information. The situation in which investors and managers have identical
information about the firm’s prospects.
 Asymmetric information. The situation in which managers have different (better)
information about their firm’s prospects than do investors.

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 UNIT SIX
THE COST OF CAPITAL
Contents
Aims and Objectives
Introduction
6.1 Meaning of the Cost of Capital
6.2 Measuring the Specific Cost of Capital
6.2.1 The Cost of Debt
6.2.2 The Cost of Preferred Stock
6.2.3 The Cost of Common Stock
6.2.4 The Cost of Retained Earnings
6.3 Weighted Average Cost of Capital
6.4 Marginal Cost of Capital
6.5 Summary
6.6 Answers to Check Your Progress Questions
6.7 Model Examination Questions
6.8 Selected References
6.9 Glossary
AIMS AND OBJECTIVES

After completing this unit, students should be able to understand:

 the meaning of cost of capita
 the implications of the cost of capital on the value of a firm,
 four major sources of capital to a firm and their cost,
 that the weighted average cost of capital is used in investment decisions,
 that the marginal cost of capital increases with raising of more and more capital during a
given period,
 the point where the costs of debt, preferred stock, common stock, or retained earnings
increases.

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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 investor’s 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.

6.1MEANING 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 firm’s 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 firm’s market value will decrease. So the
cost of capital is the rate of return that is just sufficient to leave the price of the firm’s 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
firm’s 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 firm’s 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.

6.2 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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6.2.1 The cost of debt
This is the minimum rate of return required by suppliers of debt. The relevant specific cost of
debt is the after-tax cost of new debt. Generally, debt is the cheapest source of finance to a firm
and, hence, the cost of debt is the lowest specific cost of capital. There are two basic
explanations for this. First, debt suppliers, generally, assume the lowest risk among all suppliers
of capital. They receive interest payments before preferred and common dividends are paid.
Since they assume the smallest risk, their return is the lowest. Their lowest return would be the
lowest cost of capital to the firm. Second, raising capital through debt sources entails interest
expense. The inters expense in turn reduces the firm’s income which ultimately would cause tax
payment to be reduced. So raising money in the form of debt results in the smallest tax burden,
and finally, the firm’s cost of debt would be the lowest.

Debt sources of finance may take several forms like bonds, promissory notes, bank loans. Here,
for our convenience we consider bond issue to illustrate the cost of debt.

Computing the cost of new bond issue involves three steps:

i) Determine the net proceeds from the sale of each bond
NPd = Pd – f
Where:
NPd = The net proceeds from the sale of each bond
Pd = The market price of the bond
f = Flotation costs
ii) Compute the effective before tax cost of the bond using the following approximation formula:
Pn  NPd
I
Kd = n
Pn  NPd
2
Where:
Kd = The effective before tax cost of debt
I = Annual interest payment
Pn = The par value of the bond
n = Length of the holding period of the bond in years.

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iii) Compute the after-tax cost of debt
Kdt = Kd (1 – t)
Where:
Kdt = The after-tax cost of debt
t = The marginal tax rate
Example: Currently, Abyssinia Industrial Group is planning to sell 15-year, Br. 1,000 par-value
bonds that carry a 12% annual coupon interest rate. As a result of lower current interest rates,
Abyssinia bonds can be sold for Br. 1,010 each. Flotation costs of Br. 30 per bond will be
incurred in the process of issuing the bonds. The firm’s marginal tax rate is 40%.
Required: Calculate the after tax cost of Abyssinia’s new bond issue:
Solution:
Given: Pn = Br. 1,000; I = Br. 120 (Br. 1,000 x 12%); n = 15; Pd = Br. 1,010; f = Br. 30;
t = 40%; Kdt = ?
Then apply the three steps:
i) NPd = Br. 1,010 – Br. 30 = Br. 980
Br.1,000  Br.980
Br.120 
ii) Kd = 15  12.26%
Br.1,000  Br.980
2
iii) Kdt = 12.26% (1 – 40%) = 7.36%
Therefore, the after – tax cost of Abyssinia’s new bond issue is 7.36%. That is, Abyssinia should
be able to earn a minimum of 7.36% to satisfy bondholders. Otherwise, the firm’s value will
decline.
Check your progress – 1
Ayenew Company’s financing plans for next year include the sale of long-term bonds with a
10% coupon. The company believes it can sell the bonds at a price that will provide a yield to
maturity of 12% to investors. If its marginal tax rate is 35%, what is Ayenew’s after-tax cost of
debt?
______________________________________________________________________________
______________________________________________________________________________
____________________________________________________________

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6.2.2 The cost of preferred stock
The cost of preferred stock is the minimum rate of return a firm must earn in order to satisfy the
required rate of return of the firm’s preferred stock investors. It is also the minimum rate of
return a firm’s preferred stock investors require if they are to purchase the firm’s preferred stock.

When a firm raises capital by issuing new preferred stock, it is expected to pay fixed amount of
dividends to the preferred stockholders. So it is the dividend payment that is the cost of the
preferred stock to the firm stated as an annual rate.

The cost of a new preferred stock issue can be computed by following two steps:

i) Determine the net proceeds from the sale of each preferred stock.
NPpf = Ppf – f
Where:
NPpf = Net proceeds from the sale of each preferred stock
Ppf = Market price of the preferred stock
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:

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i) NPpf = Br. 102 – Br. 2.50 = Br. 99.50
ii) Kps = Br. 12 =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 firm’s value will decrease.
Check your progress II
Sattelite Share Company plans to sale preferred stock with par value of Br. 50 per share. The
issue is expected to pay quarterly dividends of Br. 1.25 per share and to have flotation costs of
6% of the par value. The preferred stock sells at 95% of its par.
Required: Calculate the cost of preferred stock to Satellite Share Company.
______________________________________________________________________________
______________________________________________________________________________
____________________________________________________________
6.2.3 The cost of common stock
The cost of common stock is the minimum rate of return that a firm must earn for its common
stockholders in order to maintain the value of the firm. A firm does not make explicit
commitment to pay dividends to common stockholders. However, when common stockholders
invest their money in a corporation, they expect returns in the form of dividends. Therefore,
common stocks implicitly involve a return in terms of the dividends expected by investors and
hence, they carry cost.

Generally, common stock dividends are paid after interest and preferred dividends are paid. As a
result, common stock investors assume the maximum risk in corporate investment. They
compensate the maximum risk by requiring the highest return. This highest return expected by
common stockholders make common stock the most expensive source of capital.
The cost of common stock can be computed using the constant growth valuation model.
Ks = D1 + g
NPo
Where:
Ks = The cost of new common stock issue
D1 = The expected dividend payment at the end of next year

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 NPo = Net proceeds from the sale of each common stock
g = The expected annual dividends growth rate
The net proceeds from the sale of each common stock (NPo) is computed as follows:
NPo = Po – f
Where:
Po = The current market price of the common stock
f = flotation costs
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.

Check your progress III

Repentance Corporation’s share of common stock is currently selling at Br. 75. The firm’s
projected dividend per share during the next year is Br. 3.38 and the expected dividend growth
rate is 8%. Because of competitive nature of the market a Br. 3 per share under pricing is
necessary. In addition, the sale of new common stock involves underwriting fee of Br. 0.60 per
share and other flotation costs of Br. 0.90 per share.
Required: Calculate the cost of common stock for Repentance Corporation.
______________________________________________________________________________
______________________________________________________________________________
____________________________________________________________

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6.2.4 The cost of Retained Earnings

Retained earnings represent profits available for common stockholders that the corporation
chooses to reinvest in itself rather than payout as dividends. Retained earnings are not securities
like stocks and bonds and hence do not have market price that can be used to compute costs of
capital.

The cost of retained earnings is the rate of return a corporation’s 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 firm’s 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 firm’s 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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Check your progress IV
Zequala Textiles Share Company wishes to measure its cost of retained earnings. The firm’s
stock is currently selling for Br. 57.50. The firm expects to pay Br. 3.40 dividend at the end of
the year. The expected dividend growth rate is 8%.
Required: Determine th cost of retained earnings.
______________________________________________________________________________
______________________________________________________________________________
____________________________________________________________

6.3 WEIGHTED AVERAGE COST OF CAPITAL (WACC)

In the previous section we have seen how to compute the cost of capital for each individual
source of capital. The specific cost of capital is used in evaluating an investment proposal to be
financed by a particular capital source. Practically, however, investment are financed by two or
more sources of capital. In such a situation, we cannot make use of the individual cost of capital.
Rather we should use the average cost of capital employed by the firm.

The firm’s capital structure is composed of debt, preferred stock, common stock, and retained
earnings. Each capital source accounts to some portion of the total finance. But the percentage
contribution of one source is usually different from another. So we must compute the weighted
average cost of capital rather than the simple average.

The weighted average cost of capital (WACC) is the weighted average of the individual costs of
debt, preferred stock and common equity (common stock and retained earnings). It is also called
the composite cost of capital.

If the weights of the component capital sources are all given, the weighted average cost of capital
can be computed as:
WACC = WdKdt + WpsKps + WceKs
Where:
WACC = The weighted average cost of capital
Wd = The weight of debt

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 Wps = The weight of preferred stock
Wce = The weight of common equity
Kdt = The after – tax cost of debt
Kps = The cost of preferred stock
Ks = The cost of common equity
The WACC is found by weighting the cost of each specific type of capital by its proportion in
the firm’s capital structure. Weights of the individual capital sources can be calculated based on
their book value or market value.

To illustrate the computation of the WACC, look at the following example.

Muna Tools Manufacturing Company’s financial manager wants to compute the firm’s weighted
average cost of capital. The book and market values of the amounts as well as specific after-tax
costs are shown in the following table for each source of capital.
Source of capital Book value Market value Specific cost
Debt Br. 1,050,000 Br. 1,000,000 5 .3 %
Preferred stock 8 4 ,0 0 0 1 2 5 ,0 0 0 1 2 .0
Common equity 9 6 6 ,0 0 0 1 ,3 7 5 ,0 0 0 1 6 .0
Total Br. 2,100,000 Br. 2,500,000

Required: Calculate the firm’s weighted average cost of capital using:

1) book value weights
2) market value weights
Solution:
1) Total book value = Br. 2,100,000
Wd = Br. 1,050,000 = 0.5; Wps = Br. 84,000__ = 0.04; Wce = Br. 966,000 = 0.46
Br. 2,100,000 Br. 2,100,000 Br. 2,100,000
WACC = WdKdt + WpsKps + WceKs
= 0.5 (5.3%) + 0.04 (12.0%) + 0.46 (16.0%)
= 2 .6 5 % + 0 .4 8 % + 7 .3 6 %
= 1 0 .4 9 %

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The minimum rate of return on all projects should be 10.49%. Meaning, Muna should accept all
projects so long as they earn a return greater than or equal to 10.49%

2) Total Market value = Br. 2,500,000

Wd = Br. 1,000,000 = 0.4; Wps = Br. 125,000 = 0.05; Wce = Br. 1,375,000 = 0.55
Br. 2,500,000 Br. 2,500,000 Br. 2,500,000
WACC = 0.4 (5.3%) + 0.05 (12.0%) + 0.55 (16.0%)
= 2 .1 2 % + 0 . 6 0 % + 8 .8 0 %
= 1 1 .5 2 %

If the market value weights are used, Muna should accept all projects with a minimum rate of
return of 11.52%

Check your progress V

On January 1, 2002, the total assets of Zway share company were Br. 54 million. There was no
short-term debt. The firm’s optimal capital structure is given below.
Long-term debt Br. 27,000,000
Common equity 2 7 ,0 0 0 ,0 0 0
Total liabilities and equity 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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6.4 MARGINAL COST OF CAPITAL (MCC)

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 firm’s 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% cost of retained earnings (Kr) = 14%
Common equity ----------------- 50% cost of common stock (Ks) = 15%
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.

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Solutions
1) a. Breaking point (BP) common equity = Br. 900,000 = Br. 1,800,000
50%
b. Breaking point (BP) long-term debt = Br. 1,200,000 = Br. 3,000,000
40%
The breaking points computed above can be interpreted as:
Shala can meet its equity needs using retained earnings until its total finance need is Br.
1,800,000. But when total capital required is more than Br. 1,800,000, its equity needs should be
met with common stock. Similarly, until the firm’s total finance need reaches Br. 3,000,000,
shala can raise any debt at 7.3% cost. Any further finance need beyond Br. 3,000,000 will cause
the cost of debt to rise to 9.1%.

2) There are three ranges of finance that could be identified on the basis of the breaking points:
1st Range : Br. 0 to Br. 1,800,000,
2nd Range : Br. 1,800,000 to Br. 3,000,000, and
3rd Range : Br. 3,000,000 and above

3) WACC (1st range) = 0.40 (7.3%) + 0.10 (12.06%) + 0.50 (14%)

= 2 .9 2 % + 1 .2 1 % + 7 .0 0 %
= 1 1 .1 3 %
WACC (2nd range) = 0.40 (7.3%) + 0.10 (12.06%) + 0.50 (15%)
= 2 .9 2 % + 1 .2 1 % + 7 .5 0 %
= 1 1 .6 3 %
rd
WACC (3 range) = 0.40 (9.1%) + 0.10 (12.06%) + 0.50 (15%)
= 3 .6 4 % + 1 .2 1 % + 7 .5 0 %
= 1 2 .3 5 %
Check your progress VI
In the example above why have we used 14% for cost of common equity in the 1st range and
15% in the 2nd and 3rd ranges respectively?
______________________________________________________________________________
______________________________________________________________________________
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6.5 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.
- the individual cost of capital is computed on an after-tax basis and is stated as an annual
percentage.
- 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 cost of capital to be used in evaluating investment proposals is the WACC.
- 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.

6.6 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS

I. Given: yield to maturity (YTM) = 12%; t = 35%; Kdt = ?

Since no flotation cost is indicated here, the YTM of 12% to investors represents the
effective before –tax cost of debt for Ayenew company, i.e. Kd = 12%,
Therefore, Kdt = 12% (1 – 35%) = 7.80%
II. Given: Pps = Br. 50 x 95% = Br. 47.50; Dps = Br. 5 (4 x Br. 1.25); f = Br. 3 (Br. 50 x
6%); Kps
Kps = ?
Then, apply the two steps:
- NPps = Br. 47.50 – Br. 3 = Br. 44.50
- Kps = Br. 5 = 1 1 .2 4 %
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:
- Npo = Br. 75 – Br. 4.50 = Br. 70.50
- Ks = D1+ G = Br. 3.38 + 8% = 13%
Npo Br. 70.50
IV. Given: Po = Br. 57.50; D1 = Br. 3.40; g = 8%; Kr = ?

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 Then, apply the formula:
Kr = D1 + g = Br. 3.40 + 8% = 14%
Po 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 Br. 60 – Br. 6
* D1= 4%  D1 = 4%  D1 = Br. 2.40
Po Br. 60
VI. Because until the firm’s 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 2ndand 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%.

6.7 MODEL EXAMINATION QUESTIONS

Part I. Multiple choice

1. Which of the following statement is always true about a cost of capital?
A) If the cost of capital is earned by a firm on investment of its available funds, the value of
the firm will increase
B) Generally, the cost of retained earnings is cheaper than the cost of debt.
C) Wherever the cost of capital exceeds the rate of return on the firm’s invested capital, the
value of the firm is reduced.
D) The weighted average cost of capital (WACC) of a firm remains constant as long as the
firm’s target capital structure remains unchanged.
2. Normally, debt is the cheapest source of finance. This is because
A) debt suppliers expect implicit returns from a firm
B) other sources of capital have opportunity costs rather than explicit costs

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 C) firms are forced by government to use debt source of finance
D) None of the above
3. Identify the most expensive source of finance to a firm under normal circumstances
A) Common stock
B) Preferred stock
C) Retained earnings
D) Debt

Part II. Exercises

1. Zegha Technologies Company’s common stock currently sells for Br. 46 per share. The
company’s most recent dividends was Br. 4, and it expects a dividend of Br. 4.28 to be paid at
the end of the current year. The firm also expects to incur a flotation cost of Br. 5 to sell each
share of common stock issue.
Required: calculate the cost of new common stock issue and retained earnings.
2. Sidco Merchandising Company’s stock is currently selling for Br. 300 a share. The firm is
expected to earn Br. 27 per share this year and to pay a year-end dividend of Br. 18. The firm’s
investors require a 9% return on their common stock investment.
Required: What rate of growth must be expected for sidman?
3. Nile Share Company has a debt ratio of 40% and a dividend payout ratio of 50%. The firm
expects net income of Br. 5 million next year. Nile can borrow Br. 6 million at an interest rate
of 11%, another Br. 6 million at a rate of 12%, and any additional debt at a rate of 13%. The
firm’s marginal tax rate is 35%.
Required: Determine
1) The breaking point associated with the exhausting of retained earnings.
2) The points where the cost of debt will increase.
6.8 SELECTED REFERENCES
1. Engene F. Brigham (1997). Fundamentals of Financial Management. 7th edition, the Dryen
press Harcourt Brace College Publishers, Florida.
2. Lawrence J. Gitman (1997). Principles of Managerial Finance. 8th edition, Addison-Wesley
Longman Inc.

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3. Stanley B. Block and Geoffrey A. Hirt (1994). Foundations of Financial Management. 7th
edition, Irwin.

6.9 GLOSSARY

Flotation costs – any costs necessary for selling new securities

Break even – to complete a business or any other undertaking without incurring a loss.

After-tax cost – the cost of capital net of any tax impact.

Net proceeds – the cash collection from selling of securities after deducting flotation costs.

Implicit cost – a cost, which is not explicit and not clearly defined.

Breaking point – the point where the cost of individual source of capital will rise.

Weighted average – an average computed on the basis of the relative weights (proportions) of

the given data.

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 I. Choose the correct answer for the following multiple choices questions and write
you answer on the space provided.
____ 1. Which one of the following are true about management accounting
A. Produce information that is used within an organization
B. No time span for producing financial
C. Has no specific format
D. All of the above
E. None of the above
____ 2. Which one of the following bonds are issued by the corporation
A. Treasury bonds B. Corporate bonds C. Municipal bonds
D. Foreign bonds E. None of the above
____3. Which one of the following are characteristics of corporation
A. Limited liability B. the numbers of shares C. Stock ownership
D. The right of by more stock E. All of the above
____4. Which one of factors affecting interest rates
A. Inflation B. Monetary policy C. balance of payment D. Uncertainty
E. all of the above F. None of the above
____ 5. The risk that a decline in income form a bond portfolio
A. Interest rate risk B. Reinvestment rate risk C. Default risk D. All of the above
I. Work out question
I. For the following find the degree of operating leverage, degree of financial leverage
and degree of composite leverage.

Year I Year 2

Sale 900000 1200000

Fewer variables cost (40%) 360000 480000
Contribution 540000 720000
Less fixed operation expense 300000 300000
Earnings before interest and tax 240000 420000
Less interest expenses 100000 100000
Earnings before tax 140000 320000
Less taxes 56000 128000
Earnings after tax 84000 192000
Number of common share 10000 10000
Required Compute:
A. Operating leverage
B. Financial leverage and
C. Composite leverage
Using direct formulas for year land year 2
2. Tour private limited has the proposal of four years financial lcase. The firm considering the
following cash flows for the leasing option.

Lease Flows Year 1 Year 2 Year 3 Year 4

Cash 23000 20000 25000 15000

The above cash flows reflect the leasing cost with depreciation tax shield. If the firm borrows
at10% and is under 38% tax limit, find
A. Value of the leases
B. Is leasing profitable of the firm?