CHAPTER ONE

INTRODUCTION

Financial management is that managerial activity which is concerned with the process of procuring and judicious use of financial resources with a view to maximising the value of the firm thereby the value of the owners.

The Traditional view of Financial Management

Traditional functions of Financial Manager of a firm include the following* Sourcing for short term and long term funds from financial institutions.* Mobilisation of funds through financial instruments like Equity Shares, Preference

Shares, Debentures and Bonds.* Orientation of Finance function with the Accounting function and compliance of legal

provisions relating to funds procurement and utilisation.

However, with increase in complexity of modern business situation, the role of a Finance Manager is not just confined to procurement of funds, but the functioning is extended to judicious and efficient use of funds available to the firm, keeping in view the objectives of the firm and expectations of the owners of the business. Hence we have:

Modern Approach to Financial Management

This involves the Financial Manager’s ability to analyse the firm and to determine the following:* The total funds requirement of the firm* The assets to be acquired, and* The pattern of financing the assets.

Three major functions of Financial Manager:

(a) Investment decisions(b) Finance decisions(c) Dividend decisions

Investment Decisions: Investment decisions relate to the careful selection of viable and profitable investment proposals, allocation of funds to the investment proposals with a view to obtain net present value of the future earnings of the company and to maximize its value. It is the function of a Finance Manager to carefully analyse the different alternatives of investment, determination of investment levels in different assets i.e., fixed assets and current assets. The investment decisions of a Finance Manager cover the following areas:

* Ascertainment of total volume of funds, a firm can commit.* Appraisal and selection of capital investment proposals.* Measurement of risk and uncertainty in the investment proposals.* Prioritisation of investment decisions.

1

* Funds allocation and its rationing.* Determination of fixed assets to be acquired.* Determination of levels of investments in current assets viz, inventory, cash, marketable

securities, receivables etc., and its management.* Buy or lease decisions.* Asset replacement decisions.* Restructuring, reorganisation, mergers and acquisitions.* Securities analysis and portfolio management etc.

Finance Decisions: It is one of the important functions of a Finance Manager is procurement of funds for the firm’s investment proposals and its working capital requirements. In fund raising decisions, he should keep in view the cost of funds from various sources, determination of debt-equity mix, and the in maximisation of earnings per share to the equity holders, consideration of control and financial strain on the firm in determining level of gearing, impact of interest and inflation rates on the firm etc. The Finance Manager involve in following finance decisions:

a) Determination of degree or level of gearingb) Determination of financing pattern or long term funds requirementc) Determination of financing pattern of medium and short term funds requirement.d) Raising of funds through issue of financial instruments viz, Equity shares, Preference

shares, Debentures, Bonds etc.e) Arrangement of funds from Banks and Financial Institutions for long term, medium term

and short term needs.f) Arrangement of finance for working capital requirement.g) Consideration of interest burden on the firm.h) Consideration of debt level changes and its impact on firm’s bankruptcyi) Taking advantage of interest and depreciation in reducing the tax liability of the firm.j) Consideration of various modes of improving the earnings per share (EPS) and the

market value of the share.k) Consideration of cost of capital of individual components and weighted average cost of

capital to the firm.l) Analysis of impact of different levels of gearing on the firm and individual shareholder.m) Optimisation of financing mix to improve return to the equity shareholders and

maximisation of wealth of the firm and value of the shareholders’ wealth.n) Portfolio managemento) Consideration of impact of over capitalisation and under capitalisation on the firm’s

profitability.p) Consideration of foreign exchange risk exposure of the firm and decisions to hedge the risk.q) Study of impact of stock market and economic conditions of the country on modes of

financing.r) Maintenance of balance between owners’ capital to outside capital.s) Maintenance of balance between long term funds and short term funds.t) Evaluation of alternative use of funds.u) Setting of budgets and review of performance for control action.v) Preparation of cashflow and funds flow statements and analysis of performance through

ratios to identify the problem areas and its correction, etc.

2

Dividend Decisions: The dividend decisions of a Finance Manager is mainly concerned with the decisions relating to the distribution of earnings of the firm among its equity holder and the amounts to be retained by the Firm. The Finance Manager will involve in taking the following dividend decisions:

a) Determination of dividend and retention policies of the firm.b) Consideration of impact of levels of dividend and retention of earnings on the market

value of the share and the future earnings of the Company.c) Consideration of possible requirements of funds by the firm for expansion and

diversification proposals for financing existing business requirements.d) Reconsideration of distribution and retentions policies in born and recession periods.e) Consideration of impact of legal and cashflow constraints on dividend decisions.

The investment, finance and dividend decisions are interrelated to each other and, therefore, the Finance Manager while taking any decision, should consider the impact from all the three angles simultaneously.

Important Functions of Financial Manager

The important functions of a Finance Manager in a modern business firm consist of the following.Provision of capital: To establish and execute programmes for the provision of capital required by the business.

* Investor relations: To establish and maintain an adequate market for the company’s securities and to maintain adequate liaison with investment bankers, financial analysis and shareholders.

* Short term financing: To maintain adequate sources for company’s current borrowing from commercial banks and other lending institutions.

* Banking and custody: To maintain banking arrangement, to receive, have custody of and disburse the company’s monies and securities.

* Credit and collections: To direct the granting of credit and the collection of accounts due to the company, including the supervision of required special arrangements for financing sales, such as time payment and leasing plans.

* Reporting and interpreting: To compare performance with operating plans and standards, and to report and interpret the results of operations to all levels of management and to the owners of the business.

* Evaluating and consulting: To consult with all segment of management responsible for policy or action concerning any phase of the operation of the business as it relates to the attainment of objectives and the effectiveness of polices, organization structure and procedures.

3

* Tax administration: To establish and administer tax polices and procedures.

* Government reporting: To supervise or co-ordinate the preparation of reports to Government agencies.

* Protection of assets: To ensure protection of assets for the business through internal control, internal auditing and proper insurance coverage.

* Economic appraisal: To appraise continuously economic and social forces and *Government influences, and to interpret their effect upon the business.

Financial Management vs. Accounting Function

Just as production and sales are major functions in an enterprise, finance too is an independent specialised function and it is well knit with other functions. Financial Management is a separate management area. In many organisations accounting and finance functions are clubbed and the finance function is often considered as part of the functions of the Accountant.

But the Financial Management is something more than an art of accounting and book keeping in the sense that, accounting function discharges the function of systematic recording of transactions relating to the firm’s transactions in books of account and summarising the same for presenting in financial statements viz, Profit and Loss Account and Balance Sheet, Funds flow and Cash flow statements.

The Finance Manager will make use of the accounting information in analysis and review of the firm’s business position in decision making. In addition to the analysis of financial information available from the books of account and records of the firm, a Finance Manager uses the other methods and techniques like Capital budgeting techniques, Statistical and Mathematical models and Computer applications in decision making to maximise the value of the firm’s wealth and value of the owners’ wealth. In view of the above, Finance function is a distinct and separate function rather than simply an extension of accounting function.

Financial Management is the key function, many a firm prefers to centralise the function to keep constant control on the finances of the firm. Any inefficiency in Financial Management will be concluded with a disastrous situation. But, as far as, the routine matters are concerned, the finance function could be decentralised with adoption of responsibility accounting concept. It is advantageous to decentralise accounting function to speed-up the process of information. But since the accounting information is used in taking financial decisions, proper controls should be exercised on accounting function in processing of accurate and reliable information to the needs of the firm. The centralisation or decentralisation of accounting and finance functions mainly depend on the attitude of the top level management.

4

Goal of the “Financial Management” and “Firm”The goal of Financial Management is to maximise the present wealth of the owners. The firm as an organization is not a unified structure but a coalition of individuals, some organised into groups, each with varying interests and objective. The following five objectives are glaring for a firm.

* Production Goal: This would ensure that output neither fluctuated widely nor fell below some previously determined minimum acceptable level.

* Inventory Goal: Sufficient stocks of raw materials, components and finished goods should be held to ensure that production is uninterrupted by shortages and that there is enough stock to satisfy customer needs.

* Sales Goals: The management of the firm, and particularly those responsible for marketing, are both judged and judge themselves by the ability to maintain and expand sales levels.

* Market Share Goal: Market share should not fall below an acceptable level. As a performance indicator market share is easily measured, and often used by shareholders.

* Profit Goal: Sufficient profit must be made to be able to finance investment and to distribute as dividends to shareholders.

Stakeholders Groups:There is a variety of different groups or individuals whose interest are directly affected by the activities of a firm. These groups or individuals are referred to as stakeholders in the firms. Some of the stakeholders in a firm includes:

Ordinary (equity) stakeholdersPreference stakeholdersLong-Term creditorsTrade creditorsEmployeesFinancial consumersGovernmentManagement.

Objectives of stakeholders groups: The various groups of stakeholders in a firm will have different goals, which will depend in part on the particular situation of the enterprise. Some of the more important aspects of these different goals are as follows:

Ordinary (equity) stakeholders: are the providers of the risk capital of a company and usually their goal will be to maximize the wealth which they have as a result of the ownership of the shares in the company.

5

Trade creditors: have supplied goods or services to the firm. Trade creditors will generally, be, profit maximizing firms themselves and have the objective of being paid the full amount due by the date agreed. On the other hand, the usually wish to ensure that they continue their trading relationship with the firm and may sometimes be prepared to accept later payment to avoid jeopardizing that relationship.

Long-term creditors: which will often be banks, have the objective of receiving payments of interest and capital on the loan by the due date for the repayments. Where the loan is secured on assets of the company, the creditor will be able to appoint a receiver to dispose of the company’s assets if the company defaults on the repayments. To avoid the possibility that, this may result in a loss to the lender if the assets are not sufficient to cover the loan, the lender will wish to minimize the risk of default and will not wish to lend more than the prudent value of the available assets.

Employees: will usually want to maximize their rewards paid to them in salaries and benefits, according to the particular skills and the rewards available is alternative employment. Most employees will also want continuity of employment.

Government: These are the objectives, which can be formulated in political terms. Government agencies impinge on the firms activities in different ways, these include taxation of the firms’ profits, the provision of grants, health and safety legislation, training initiatives and so on. Government policies will often be related to macroeconomic objectives such as sustained economic growth and high levels of employment.

Management: like other employees (and managers who are not directors) will normally be interested. They are:

Financial Objectives

Financial management is the management of the finances of a business, that is, financial planning and financial control in order to achieve the financial objectives of the business. The theory of company finance is based on the assumption that the objective of management is to maximize the market value of the company. Specifically, the main objective of a company should be to maximize the wealth of its ordinary shareholders.

Ordinary shareholders, preference shareholders, loan stockholders and other long-term and owners of the company, its ordinary shareholders. Any retained profits are undistributed wealth of these equity shareholders.

What is Wealth?

Shareholders wealth comes from two sources:1. Cash flows from streams of future dividends 2. Capital gains arising on disposal of the share.

6

These cash flows are discounted (converted to present value) using an appropriate interest are of time preference). The present value of all these cash flows put together is referred to as shareholders wealth.

Other financial targets:

In addition to the main objectives of wealth maximization a company might set some other financial target such as:A restriction on the company’s management’s level of gearing or debt: For example, a company’s management might decide that: the ratio of long-term debt capital to equity capital should never exceed, say 1:1;- the cost of interest payments should never be higher than, say 25% of the total profits before interest and tax.

A target for profit retention: For example, management might set a target that dividend cover (the ratio of distributable profits to dividends actually distributed) should not be less than say, 2.5 times.

A target for operating profitability: For example, management might set a target for the profits/sales ratio (say, a minimum of 10%) or for a return on capital employed (say, a minimum ROCE of 20%).

These financial targets are not primary financial objectives, but they can act as subsidiary targets which should help a company to achieve its main financial objective without incurring excessive risks.

However, these targets are usually measured over a year rather than over the long-term, and it is the maximization of shareholder wealth in the long-term that ought to be the corporate objective.

Short-term measures of the return can encourage a company to pursue short-term objectives at the expense of long-term ones: for example by deferring new capital investments, or spending only small amounts on research and development and on training.

Non-Financial Objectives

A company may have important non-financial objectives, which could limit the achievement of financial objectives.

Examples of non-financial objectives are as follows:

The Welfare of Employees: A company might try to provide good wages and salaries, comfortable and safe working conditions, good training and career development, and good

7

pensions. If redundancies are necessary, many companies will provide generous redundancy payments, or spend money trying to find alternative employment for redundant staff.

The welfare of management: Managers will often take decisions to improve their own circumstances, even though their decisions will incur expenditure and so reduce profits. High salaries, company cars and other parks are all examples of managers promoting their own interests. The welfare of society as a whole: The management of some companies are aware of the role that their company has to play in providing for the well being of society. For example oil companies are aware of their role as providers of energy for society, faced with the problems of protecting the environment and preserving the Earths dwindling energy resources.

The provision of a service: The major objectives of some companies will include provision of a service to the public. The fulfillment of responsibilities toward customers and supplier responsibilities towards customers expects, and dealing honestly and fairly with customers. Responsibilities towards suppliers are expressed mainly in terms of trading relationships. A company’s size could give it considerable power as a buyer. The company should not use its power unscrupulously. Suppliers might rely on getting prompt payment, in accordance with the agreed terms of trade.

Is Wealth Maximisation in Public Interest?

It is generally believed that wealth maximization is in public interest. More than 200 years ago. Adam Smith post dated in his invisible hand argument that if individuals and firms pursue the goal of wealth maximization, then they will automatically maximize the overall economic welfare of the nations.

The argument is still valid today. First, share price maximisation requires efficient, low-cost operations that produce the required quality maximisation demands the development of new products that consumers want and need, so the profit motive leads to new technology, new products, and new jobs. Finally, share price maximisation necessitates efficient and courteous service, adequate stocks of merchandise, and well located business establishment, because these factors are all necessary to make good sales, and sales are necessary for profits. Therefore, the types of actions that help a firm increase the price of its shares are also directly enterprise economies have been so much successful than socialistic and other types of economic systems.

The arguments against the wealth maximisation objective are numerous:

Wealth maximisation is a consequence of perfect competition (which rests on many assumptions e.g. free entry and exit from the market, free flows of information, etc), and in the face of imperfect modern markets today it cannot be a legitimate objective of the firm.

It is also argued that profit maximisation, as a business objective was developed in the early 19th century when the characteristic feature of the business structure were self-financing, private property and single entrepreneurship. The only aim of the single owner then was to enhance his individual wealth and personal power, which could easily be satisfied by the profit maximisation

8

objective. However, in the contemporary placing of things, ownership and management are separated. In this changed business structure, to the owner/manager who has to reconcile the conflicting objective of the environment, profit maximisation is regarded as unrealistic, difficult, inappropriate and immoral.

Profit Maximisation Versus Wealth Maximisation

Profit maximization as an objective suggests that organizations must develop and operate an accounting system that ensures objective reporting of financial results as well as establish financial control system, which monitor and control costs so as to ensure that goals are attained by operating managers.

Wealth maximization suggests that management must always seek to determine whether investments to be undertaken on behalf of share holders serve to maximize the wealth (economic value) of the shareholders and to inform owners of the financial implications of specific decisions. It therefore emphasizes financial analysis as an important function of management.

In the long run, there is no inconsistency between profit maximization and wealth maximization. Profit maximization emphasizes short-run analysis while wealth maximization encourages long-run analysis through careful assessment of all future benefits that are expected to arise from an investment and provides a means of giving appropriate weights to future benefits depending on when they are expected to mature.

WHY MANAGERS SHOULD WORK IN THE INTEREST OF SHAREHOLDERS

There are practical reasons why managers should work in shareholders’ best interest. Some of these are discussed below:

(i) Unwanted Take Over: Hostile takeover (where management does not want the firm to be take over) are most likely to occur when a firms share is undervalued relative to its potential indicating poor managerial decisions. If this happens, the managers either lose their jobs or the autonomy that they had prior to the acquisition. Thus to avoid takeover, managers have an incentive to take actions which maximise share price.

(ii) Managerial Labour Market: It has been argued that the managerial Labour Market exerts a great deal of influence on managerial behaviour, perhaps even enough to make the agency problem unimportant and not worth worrying about. It is argued that the managers wealth is the present value of current and future income. The better the managerial performance, as measured by share price, the greater will the salary that the manager will command, both in his or her present employment and in future employment. Thus, if the capital markets (share prices) provide efficient signals concerning managerial performances, and if the managerial labour market correctly values managerial performance, then it is the manager’s own interest to act in the shareholders best interest.

9

(iii) The Threat of Firing: In companies where share ownership is concentrated in the hands of large institutions rather than individuals, the institutional money managers have the clout, if they choose, to exercise considerable influence over firms operations. Whereas, fragmented individual investors may be uniformed, lazy or simply ‘vote with their feet’ by selling share in firms where performance is below par, the institutional investors are more likely to work actively to oust an inefficient management.

(iv) Future Financing: Other factors remaining the same, a high share price is a good sign of ‘vote of confidence’ on management by the stock market. This vote of confidence is an important variable required by managers when going back to the stock market for additional finance both equity and debt.

Why should Managers bother to know who their shareholders are?

A company’s senior management should remain aware of who its major shareholders are, and it will help to retain shareholder support if the company’s chairman or managing director meets occasionally with the major shareholder to exchange view and opinions.

The advantages of knowing who the company’s shareholders are, can be listed as follows:

1. The company’s management might gain some insights into likely shareholder preference for either high dividends or retained earnings for profit growth and capital gain. For public companies, changes in shareholders might give some insight into reasons for recent share price movements.

2. The company’s management should be able to obtain some insight into shareholders attitudes to both risk and gearing. If a company planned a new investment, its management might have to consider the relative merits of seeking equity finance or debt finance, and shareholder attitudes would be worth knowing about before the decision is taken.

3. Management might need to know the composition of its shareholders in case of an unwelcome takeover bid from another company in order to identify key shareholders whose support against the takeover bid might be crucial to the outcome.

Advantages of having a wide range of shareholders include:

1. There is likely to be greater activity in the market in the firms shares:2. There is less likelihood of one shareholder having a controlling interest. Since

shareholdings are smaller on average, there is likely to be less effect on the share price if one shareholder sells his holding.

3. There is a greater likelihood of a take-over bid being frustrated.

10

Disadvantages include:

1. The administration costs involved in a large body of shareholders will be higher e.g. sending out copies of the annual report and accounts, counting proxy votes, registering new shareholders, paying dividends etc.

2. A large number of shareholders will have varying tax rates and objectives in holding the firm’s shares, which makes dividend/retention policy more difficult to decide for the management.

COMPARISON OF FINANCIAL OBJECTIVES IN PRIVATE AND PUBLIC BUSINESS

Financial Management in government is substantially different from financial management in industrial or commercial companies for some fairly obvious reasons:

i. Government departments do not necessarily operate to make profit and the objectives of a department cannot be expressed in terms of maximising return on capital employed.

ii. Government services are provided without the commercial pressures or competition of the market. There are no competitive reasons for controlling costs or being efficient when services are rendered.

iii. Government departments have full-time professional civil servants as their managers, but planning and control decisions are taken by politicians.

iv. The financial markets regard the government as a totally secure borrower, and so the government can usually borrow whatever it takes provided it is prepared to pay a suitable rate of interest.

v. Federal Government borrowing is coordinated ‘centrally’ by Treasury and CBN. Individual departments of government do not have to borrow funds themselves.

vi. State governments raise some taxes locally and can do some borrowing in the financial markets, but they also rely on some of their funds from central government.

vii. Companies rely heavily on retained profits as a source of fund. Government departments can not rely on any such source because they do not make profits. Some government services must be paid for by ‘customer’ e.g. medical prescriptions, although the price that is charged might not cover the costs in full.

We can now summarise the difference in the objectives of a company and those of a state-owned enterprise, as follows: A Company’s main objective will be a financial one. The aim of maximising the wealth of shareholders is too simplistic a view of what this objective is, but shareholders must be provided with satisfactory returns. The main objective of a state-owned enterprise is unlikely to be financial one.

11

A company’s financial objective can be expressed in terms of maximising the wealth of shareholders (dividends and share value). A state-owned enterprise cannot express financial objectives in this way, but may express financial objectives in the form of return on capital employed, or profit/sales ratio etc.

A company’s financial targets will include targets for dividend and borrowing/gearing levels. These matters, which are important for companies, are irrelevant to state-owned enterprises.

A company’s will have some non-financial objectives, just as a state-owned enterprises will have some financial ones (e.g. to cover their operating costs, or to make a profit which will be used to provide funds to central government).

The objectives of a company will be formulated into planning targets by the company’s management (board of directors). In a state-owned enterprise, management will have less freedom of decision-making, and many have to accept targets that are imposed on them by government departments and government ministries.

The success or failure of a public company’s financial management will be reflected in the share price. The same gauge of success or failure is not available for a state-owned enterprise.

Although the emphasis in the course of studying FM will normally be on companies the application of many of the subjects to public corporations should not be ignored.

The Agency Problem

Agency relationship is a contract under which one or more persons (the principals) hire another person (the agent) to perform some service on their behalf and delegate some decision making authority to the agent. Within the financial management framework, agency relationships exit:

Between ordinary shareholders and managers and between creditors and shareholders. These relationships are discussed below:

Shareholders and Managers

An agency problem arises whenever a manager owns less than 100 percent of the company’s ordinary shares.

If a company is solely owned and managed by a single individuals we can assume that the owner-manager will take every possible action to increase his or her own welfare. If the owner-manager releases a portion of his or her ownership by selling some shares, conflict of interest might arise.

12

Examples of possible conflict includes:

1. Managers might not work industriously to maximise shareholder’s wealth if they will not fairly share in the benefits of their labour.

2. There might be little incentive for managers to undertake significant creative activities including looking for profitable new ventures or developing new technology.

3. Managers might rewards themselves with high salaries or perks (i.e. non monetary rewards such as holiday entitlements, working conditions, company cars etc.).

4. To minimise the above problems and to ensure that managers act in the best interest of shareholders. These shareholders will have to incur agency costs, which may take several forms;

a. expenditures to monitor managerial actions e.g. setting up a management audit,

b. be expenditures to bond the managers,

c. opportunity costs associated with lost profit opportunities because the organisational structure does not permit managers to take action on as timely a basis as would be possible if the managers were also the owners.

Apart from the above points, the conflicts of interest can also be minimised through proper structuring of managerial incentives. More and more, companies are tying manager’s compensation to the company’s performance, and research suggests that this motivate managers to operate in a manner consistent with share price maximisation. The main ways of implementing this policy include:

i. making payment a function of profits:ii. Issuing to management equity or share options, warrants or deferred equity.

A lot of advantages and disadvantages are involved in each of these:

Profits: The main advantage is that it is simple to design and operate. The main problems relate to the potential lack of correlation between reported profits and shareholders wealth and the case with which profits can be altered-policies can be pursued which increase short-term profit but which are not in the long-term best interest of the firm) e.g. adequate attention might not be paid to research and development and advertising, etc.) Furthermore, profits can easily be altered by changes in the accounting conventions applied.

Equity: The issue of equity to management has the advantage of making the reward to management directly connected with the reward to shareholders. However, this only applies if managers continue to hold the equity issued. Therefore to apply this policy there should be some restriction placed on the sale of equity share issued to management.

13

Share options warrants, deferred equity: These delay the return by making the exercise, date and therefore potential reward, a future event. The date for earliest exercise needs to be chosen with care, too early a date may mean that management will concentrate on only short term performance of equity price, too distant a date will reduce the intended incentive. It must be emphasised here that this approach does not actually make the reward to managers identical to, or a direct function of, the reward to equity holders but makes the reward to managers a function of share price at some future time. Managers will therefore prefer to pursue a policy o earnings retention to maximise future share price even if shareholders would prefer greater immediate distributions.

Shareholders Versus Creditors

Another agency problem arises because of potential conflicts between shareholders and creditors. Creditors lend funds to the firm at rates which are based on:

1. The riskiness of the firms existing assets.2. Expectation concerning the riskiness of future additions to assets.3. Expectations concerning future capital structure changes.

These factors determine the riskiness of the company’s cash flows (i.e. the degree of variability), hence the safety of its debts, so the creditors set their required rate of return, hence the cost of debt to the company, on these expectations.

The suppliers of debt finance are concerned, that they are not fooled or misled by a company’s management.

There are a number of ways in which managers (appointed by shareholders) can act in the interest of the shareholders rather than debt holders:

i. Dividend: Large cash dividend will secure part of the company’s value for the shareholders at the expense of the creditors

ii. Playing for time: In general, if a company is going to fall it is better that this happens sooner rather than later from the creditor’s point of view. However, manager may try to hide the extent of the problem by cutting back on R & D, maintenance, etc, and this make the year’s result better at the expense of the next year’s.

iii. Changing risk: The company may change the risk of the business without informing the lenders.

For example, management may negotiate a loan for a relatively safe investment project offering good security and therefore carrying only modest interest charges and then use the funds to finance a far riskier investment. Alternatively, management may arrange further loans, which increases the risk of the initial creditors by undercutting their assets banking. These actions will again be to the advantage of the shareholder and to the cost of creditors.

14

In each of the above situations, the shareholders would be expropriating wealth from debt holders. It is because of the risk that managers might act in this way that most loan agreement contain restrictive covenants for protection of the lender, the costs of these covenants to the firms in terms of constraints upon managers freedom of action often being referred to as agency costs.

Some of these restrictive covenants include:

1. Allow the appointment of a receiver and manager to realise the security should there be default in interest and capital payments.

2. Maximise the security taken. In practice debentures are likely to be secured by fixed and floating charges on the company’s assets.

3. Limit further borrowings by the company. By putting a ceiling on total gearing the debenture holders limit the risk to themselves and force equity shareholders to contribute at least a proportion of any further finance required, which may reduce the desire of directors to accept ‘last ditch’ risky projects.

4. Limit dividends payable. This will contract evasion of the equity base by shareholders removing their fund when the company appears to be heading for difficulties.

5. Require the company to provide regular financial information. This is particularly useful where the debenture holder is a bank lending an overdraft secured by debenture and notification financial problems at an early stage can enable the bank to limit the amount at risk by curtailing the facility.

6. Required personal guarantees of directors. The possibility is likely only to apply where the directors are also major shareholders, and is likely to focus their minds on policies which will be the interests of the debenture holders as much as the equity shareholders.

7. Demand higher than market rates or interest on fresh lending as compensation for the extra risk undertaken in lending to a highly geared company.In view of these constraints, it follows that the goal of maximising shareholder’s wealth is consistent with fair play with creditors. Shareholder’s wealth depends on continued access to capital markets, and access depends on fair play and abiding by the letter and the spirit of contracts and agreements. Therefore, the managers, as agents of both the creditors and the shareholder, must act in a manner that is reasonably consistent with the best interest of both classes of security holders.

Furthermore, because of other constraints and sanctions, management actions that would expropriate wealth from the firms employees, customers, suppliers, or the community will ultimately be to the detriment of shareholders. It is concluded, then in the contemporary placing of things, the goal of shareholders wealth maximisation also implies the fair treatment of all

15

other groups whose economic positions is affected by the performance and hence value, of the firm.

CHAPTER TWO

MATHEMATICS OF FINANCE

Definition of Terms

Simple Interest: Interest that is paid only on principal invested.

Compound Interest: Interest that is paid on the principal as well as on any interests earned but not withdrawn during earlier periods.

Annuity: a fixed payment or receipt each year for a specified number of years.

Sinking Fund: A fund which is created out of, fixed payments each year to accumulate to a future sum after a specified period.

Present Value: The present value of a future cash in flow or outflow is the amount of current cash that is of equivalent desirability, to the decision maker, to a specified amount of cash to be received or paid at a future date.

Perpetuity: When an annuity is expected to occur indefinitely, it is called perpetuity.

Compounding: The process of determine the future value of cash flows at a given interest rate at the end of a given period.

Discounting: The process of determining the present value of cash flows at a given interest rate at the beginning of a given period.

Principal: The capital sum invested.

Review of Formulae

1) Simple Interest: S =

Where: S = Simple InterestP = PrincipalR = Interest rate per annumT = Number of interest bearing periods usually

in years.2) Compound Interest:

The principles of compound interest form the basis of discounting and annuity calculation so must be understood.

16

The basic compounding formula is: S = P (1+r)n

Where: S = a sum arising in the futurer = rate of interest usually expressed as an interest rate

per annum e.g. 10%.It appears in the formula as a decimal, i.e. 10% 0.10n = number of interest bearing periods, usually expressed in yearsP = Principal

Illustration 1:

How much will N5000 amount to at 10% compounded over 6 years?S = N5000 (1+0.10) 6 = N5000 X 1,772 = N8860

Note: The compound interest factor (1+0.10)6, can be found using a calculator or logarithms but tables are more normally used. Look in an annuity table under 10% for 6 years and the factor is 1.772.

Illustration 2:

How long will it take for a given sum to treble itself at 17% p.a. compound?i.e. to find ‘n’ such that: 3 = 1(1+0.17)n

A annuity table can be used as a shortcut solution method. Look under 17% to find the factor closest to 3. This will be found to be 3.001 opposite 7 years. i.e. a given sum will treble itself in almost exactly 7 years at 17% p.a. compound.

Discounting:

Compounding looks forward from a known present sum that, with the addition of re-invested interest, equals some future value. On occasions the future sum is known (or estimate) and it is required to calculate the present value. This process is known as discounting and is effectively the obverse of compounding.

The compounding formula given above can be restated in terms of discounting to a present value thus:

P =

17

Illustration 3:

What is the present value of N15000 received in 10 years time with a discount rate of 14%?

P = = N4050

Note: Again, calculators or logarithms could be used to evaluate the expression but discount tables are normally used.

i.e. where P = 15000 x 0.270 = N4050

Discounting a series:

The most important application of discounting is in connection with investment appraisal and the normal requirement is to discount a series of cash flows and not just a single figure. In such circumstances the formula given above becomes:

NPV =

Where C = the net cash flow in the period,i = the period numberr = discount rate.

Illustration 4:

What is the present value of the following cash flows, which are deemed to arise at the end of each year, when the discount rate is 15%?

Period Now after 1 year after 2 years after after 3 yearsCash flow (2000) 800 1000 1300

NPV = (2000)+ 800+ 1000+ 1300(1+0.15)0 (1+0.15)1 (1+0.15)2 (1+0.15)3

The expression has been given in full for illustrative purposes only and is not normally necessary as the discount factors from a discount table can be used thus:NPV = -2000+(800 x 0.870) + (1000 x 0.756) + (1300 x 0.658) = +N307.4

18

Where the cash flows vary from year to year, as in illustration 4, a separate calculation has to be made for each year but where the cash flows are constant for all years, i.e. an annuity, the discounting process is simplified considerably.

Annuities:

Where a constant cash flow is received each year the series is known as an annuity. The present value could be found by separately discounting each year but the series can be brought together into one expression, as follows:

P =

Where: A is the regular cash receipt, i.e., the annuity.

Illustration 5:

What is the present value of an annuity of N1000 p.a. received for 10 years when the discount rate is 12%?

P =

Because annuities are commonly encountered, tables are available for the annuity factor which ordinarily is given by:

The annuity factor under 12% for 10 years is 5.650. it will be noted that the Annuity factors are simply the summation of the discount factors from Table A.

Present value is N 1000 x 5.650 = N5,650

Illustration 6:

Evaluate:5000 x A5/0.10

2000 x A8/0.02

Solution:5000 x A5/0.10 = 5000 x 3.791 = 189552000 x A8/0.02 = 2000 x 3.837 = 7674

19

Illustration 7:

A firm agrees to pay an employee the following amounts at the end of each year.Year 1 2 3 4Amount (N) 6,000 7,500 9,000 10,000However, the employee prefers to receive the same amount in each of the years. What is the preferred amount given that the discount rate is 10%?

Solution:

It is necessary first to find the Present Value (PV) of the payments. PV = (6000 x 0.909) + (7500 x 0.826) + (9000 x 0.751) + (10000 x 0.683) = N25,238

From Table B the annuity factor for 4 years at 10% is 3.170.

Equal payment in each of the 4 years =

NOTE: The process is known as annualizing and is a useful procedure for dealing with replacement problems where there are various possible life cycles. If the annualised equivalent to each of the cycles is found a direct comparison is possible.

Perpetuities:

Where a stream of cash flows goes on forever the expression in the outer brackets in the annuity formula given above reduces to 1 and the formula simplifies considerably to:

P =

Illustration 8:

What is the present value of a perpetual annuity of N1000 at 20% P = A/r = N1000 / 0.2 = N5000

Compounding/discounting at intervals other than annual:Conventionally, particular in examinations, it is assumed that all compounding and discounting is at yearly intervals. This need not be so and discounting or compounding can take place at my interval, e.g. monthly, quarterly, half-yearly or continuously. Continuous discounting or compounding requires special tables but the normal tables can be used for discrete periods other than yearly as shown in the following example.

Illustration 9:What is the present value of N30,000 received in 3 years time discounted at half yearly intervals at 20% p.a.?

20

Solution:Discount rate per period = Discount rate p.a. / No. Of periods p.a. = 20% / 2 = 10%From discount tables for 6 periods at 10% (i.e. treat the years column as periods). The discount factor is 0.564.

PV N30,000 x 0.564 = N16920

Similar principles apply to compounding problems. The more frequently a value is discounted / compounded, the smaller / larger will be the result. True annual rate of interest =

Note: The rule given, above only provides an approximate answer. If an exact answer is required the following: formula can be used.

Where: n = number of times compounded in a yearr = normal yearly rate

Illustration 10:

What is the true annual rate of interest if the normal rate is 10% p.a. but interest is paid half yearly at 5%?True rate = {(1+0. ½) 2.1} x 100% = 10.25%

Practice Questions

Question 1:

A Company takes a loan of N500,000 at 18% p.a. for a period of five years. The loan is to be repaid by five uniform amounts, with each amount covering capital and interest.

Required:

1. Calculate the annual repayment and prepare an amortisation schedule for the loan.

2. Assume that there is a grace period of two years during which neither interest nor capital will be paid but the interest will be calculated and added to the loan. Repayment will be by three uniform amounts over the last three years. Calculate the annual repayment.

3. Assume that repayment is by a balloon payment at the end of year five.

21

Calculate the balloon payment.

Question 2:

Ade Plc is considering the acquisition of Yemi Ltd. The most recent financial statements of Yemi indicate a profit after tax (PAT) of N20,000,000. Assuming cost of capital of 15% p.a., determine the maximum amount Ade should be willing to pay for the entire share capital of Yemi Ltd. Under the following independent scenarios.

a. PAT will remain constant to infinity.

b. PAT will remain constant for the next ten years and then grow at 5% p.a. to infinity.

c. PAT will grow by 20% p.a. for the next four years and then remain constant to infinity.

d. PAT will grow by 20% p.a. for next four years and then grow by 5% p.a. to infinity

e. Repeat (d) above but instead of a growth of 5%, assume a decline of p.a. to infinity.

22

CHAPTER THREE

SOURCES OF FINANCE

There are categories of sources of finance a firm can explore: They are: Long-term, Medium-term and short-term.

Long Term Sources of Finance

These include:Shares DebenturesReservesSales and leaseback etc.

Common shares, Preference shares and debentures are three important securities used by the firms to raise funds to finance their activities.

Common shares provide ownership rights to common shareholders. They are the legal owners of the company. As a result, they have residual claims on income and assets of the company. They have the rights to elect the board of directors and maintain their proportionate ownership in the company, called the preemptive right. The preemptive right of the common shareholders is maintained by raising new equity funds through rights issues.

A Debenture is a written acknowledgement of indebtedness given under a company seal. A Debenture or bond is a long-term promissory note. The debenture trust deed or indebenture defines the legal relationship between the issuing company and the debenture trustee who represent the debenture holders have prior claim on the company’s income and assets. They will be paid before shareholders are paid anything. Debenture could be secured and unsecured and convertible and non-convertible. Debentures are issued with a maturity date. They are generally retired after 7 to 10 years by installments.

Preference shares are a hybrid security as it includes some features of both a common share and a debenture. In regard to claims on income and assets, it stands before a common share but after a debenture. Come preference shares have a cumulative feature, requiring that all prior year outstanding preference shares could be redeemable viz., with a maturity date or irredeemable viz., perpetual, without maturity date. Like debentures, a firm can issue convertible or non-convertible preference shares.

Term loans are of more than a year’s maturity. Generally, they are available for a period of 6 to 10 years. In some cases, maturity could be as long as 25 years. Interest on term loans is tax deductible. Mostly, term loan are secure through an equitable mortgage on immovable assets to protect their interest, lending institutions impose a number of restriction on the borrowing firm.

23

A sale and leaseback is an arrangement under which a business intending to raise some additional capital sell some of his assets (usually land and buildings) to a finance house under an arrangement that enables it to continue to have the use of the same assets under a lease agreement.

Leases: A lease is an agreement for the use of the asset for a specified rental fee. The owner of the asset called the lessor and the user the lessee. Two important categories of leases are operating leases and financial leases.

(i) Operating leases: are short-term, cancelable leases where the risk of obsolescence is borne by the lessor.

(ii) Financial leases: are long-term non-cancelable leases where any risk in the use of the asset is borne by the lessee and he enjoys the returns too.

The most compelling reason for leasing equipment rather than buying it is the tax advantages of depreciation, which can mutually benefits both the lessee and the lessor. Other advantages include convenience and flexibility as well as specialized services to the lessee. Lease proves handy to those firms, which cannot obtain loan capital form normal sources.

Financial lease involves fixed obligations in the form of the lease rentals. Thus it is like a debt and can be evaluated that way. Given the lease rental and tax shields, one can find the amount of debt, which these cash flows can service. This is the equivalent loan. If the equivalent loan is more than the cost of the asset, it is not worth leasing the equipment. You can also approach lease evaluation by calculating the Net Advantage of Lease (NAL). After-tax lease rental and tax shields may be discounted at the after-tax borrowing rate while operating costs and salvage value at the firm’s cost of capital to find out NAL.

Medium-Term Sources of Finance

These include:Hire PurchaseBank Loans

Under the Hire Purchase system, assets (goods equipment, etc) are delivered to a person or business in return for his undertaking to pay agreed amounts at specified intervals for a certain period, and on the understanding that at the end of that period, when the payments are completed, the goods become his absolute property. The goods remain the property of vendor until the payments are completed and in the event of a default on the part of the hire-purchaser, the vendor can take steps to recover them.

24

Banks loans: These are provided by the banks to their reliable and trusted customers.

Short-Term Sources of Finance

Most important short-term sources of financing current assets are:

Trade creditDeferred income and accrued expensesBank financesFactoring/Invoice discountingCommercial paper (CP)

The first two sources are available in the normal course of business, and therefore, they are called ‘spontaneous source of working capital finance’. They do not involve any explicit costs. They are called ‘non-spontaneous/negotiated sources of working capital finance’.

Trade credit refers to the credit that a buyer obtains from the suppliers of goods and services. The payment is required to be made within a specified period. Suppliers sometimes offer cash discount. Buyers should calculate the cost of fore-going cash discount to decide whether cash discount should be accepted. The following formula could be used.

The buyer should also consider the implicit costs of trade credit and particularly, that of stretching accounts payable. These implicit costs may be built into the prices of goods and services. The buyer can negotiate for lower prices for making payment in cash. Accrued expenses and differed income also provide some funds for financing working capital. However, it is a limited sources, as payment of accrued expenses cannot be postponed for a long period. Similarly, advance income will be received only when there is a demand-supply gap or the firm is a monopoly.

Bank finance is the most common negotiated source of the working capital finance. It can be availed in the forms of overdraft, cash credit, discount of bills and short-term loans. Bank finance is regulated by the CBN. Each company’s working capital need is determined as per the prescribed norms. However, even now banks are the largest providers of working capital finance to firms.

25

Factoring has proved to be an important source of working capital finance in the developed countries. It involves a business obtaining short-term funds from a finance house on the security of its unpaid invoices (debtors). The same process is described as invoice discounting when the facility is attached to a particular invoice and factoring when it relates to the business’s debtors generally. Clearly the reputations of the business seeking the facility and the debtors are key issues in granting these facilities.

Commercial paper is a money market instrument for raising short-term finance. Investors would generally invest in commercial paper of a financially sound and credit worthy firm. Commercial papers are usually of 91 to 180 days’ maturity. The interest rate will be determined in the market. While the CBN is yet to develop guidelines for both factoring and commercial paper, they are important money market instrument economies.

26

CHAPTER FOUR

COST OF CAPITAL

A company’s activities are financed from different sources i.e. equity, preference shares, obtained earnings, loans etc.

A company does not acquire and use these different funds without cost. A cost of using the funds is called cost of capital.

The cost of capital has two aspects to it:

a. It is the cost of funds that a company raises and uses, and the return that investors expect to be paid for putting funds into the company.

b. It is the minimum return that a company must make on its own investment, to earn the cash flows out of which investors can be paid their return.

The cost of capital can therefore be measured by studying the returns required by investors, and then used to derive a discount rate for DCF analysis and investment appraisal.

Cost of Capital as an Opportunity Cost of Finance

The cost of capital, however it is measured, is an opportunity cost of finance because it is the minimum return that investors require. If they do not get this return, they will transfer some or all of their investment somewhere else.

More technically, the cost of any capital is the discount rate that equates the current market value of that capital to the present value of the future cash flows associated with it. It is the minimum rate of return required by the provider of capital.

A. Cost of Equity: Cost of equity is the discount rate that makes the current market value of equity ex-div to equal the present value of associated future cash flows. The associated future cash flows are streams of future dividends. It is also called ‘Dividend Yields’.

If the future dividend per share (DPS) is expected to be constant in amount than the ex-dividend share price (MV) is calculated by these formulae.

so r = d/MV

Cost of equity (Ke) = d/MVWhere: r= is the shareholders cost of capital

d = is the annual dividend per shareMV = current market value ex-dividend

27

Cost of equity (Ke) = d/MVWhere: r = is the shareholders cost of capital

d = is the annual dividend per shareMV = current market value ex-dividend.

Application of the Formulae: ke = d/MV. This is applicable where there is no growth in the dividend.ke =do (1+g) + g. This is applicable where divided is growing at g% per annum MV

Derivation of Growth Rate: There are two methods of deriving the growth rate (g).1. The extrapolation of past earnings,2. Gordon model

Extrapolation of Past Earnings:

GORDON MODEL:g = (r x b)r = ROCEb = rate of retention

Note: Where the examiner is silent as to what method to be used you then assume extrapolation of past earning.

B. Cost of Preference Shares: Cost of preference share is the minimum rate of return required by the providers of preference share capital on their investment. It is the discount rate that makes the current market value ex-div to equal the present value of future cash flows associated with that security. Preference share could be redeemable or irredeemable.

(i) Redeemable Preference Share: Cost of redeemable preference share is the minimum rate of return required by the providers of redeemable preference share capital on their investment. It is equivalent to the discount rate that equates the current market value ex-div to the present values of future cash flows.

The present values of future cash flows.

a. Dividend due from year 1 to the year of redemption.b. The redemption value.

28

The discount rate must be calculated by trial and error in a way similar to the calculation of internal rate of return (IRR).

Illustration 1:

Crown Nig. Ltd. Has 100,000, N100, 10% preference shares currently valued at N120 per share.

A premium of 15% is payable on redemption of the shares in 5 years time when market value is expected to be N150 per share. What is the current cost of capital?

Solution:

Cost of capital = IRR of the following cash flows.Market value (year 0) = N120,000Dividend per year (year 1-5) = N10,000Redemption value (year 5) = N115,000

Year CF(N) DF(10%) PV(N)0

1.53

(120000)10000

115,000

1003.790.62NPV

(120000)3790071300

(10,800)(10,800)

Year CF(N) DF(6%) PV(N)0

1.53

(120000)10000

115,000

1004.210.74NPV

(120000)42100851007200

We then obtain the IRR by interpolation.

IRR = 6% +

Cost of capital = 7.6%.

Note: The market value of the share on redemption has been ignored because the security is being redeemed at a premium of 15%.

(ii) Irredeemable Preference share: Cost of irredeemable preference share is the minimum rate of return required by the providers of discount rate that equates the current market value (ex-div) to the present value (PV) of future dividends.

29

PV (to infinity)

C. Cost of Redeemable Debt: This is the minimum rate of return required by the providers of redeemable debt. The discount rate makes the current market value ex-interest to equal the present value of future cash flows.The future cashflow are:

X Interest from year 1 to the year of redemption.X Redemption value receivable in the year of redemption.

The discount rate must be calculated by Trial and error similar in all respects to that of redeemable preference share.

Illustration 2:

a. A certain Pharmaceutical company has in issue N100,000 redeemable 10% debenture. The present capitalization is N85, 500 ex-interest and the debentures are redeemable in 18 years time at their nominal value. What would their cost be?

b. Repeat example 2 (a) above and assume a tax rate of 40%.

Solution:

a. Without Tax

Cost of debt = K0 = interest / market value= 10,000 /85,500= 11.7%.

b. With tax at a rate of 40%.

D. Weighted Average Cost of Capital (WACC): This is the return on investment required to meet the cost of servicing all of the various kinds of share and loan capital employed by a business. The cost of servicing each type of capital is determined and the average is found after weighing each cost by the proportion of the total, which the respective types constitute. It is usual to base the proportion on market capitalization.

For instance, if a company employed only equity and debt:

WACC =

Practical Problems and Limitations in the Use of WACC:

30

1) Business Risk:

The calculation of and use of WACC are based on the assumption that the new project belongs to the same risk class as existing projects. In practice, it is likely that the new project may not belong to the same business risk class.

The use of WACC in such circumstances would be misleading.

2) Financial Risk:

The use of WACC is also based on the assumption that gearing ratio will remain constant. In financing the project, if the existing debt-equity ratio were altered, that would lead to alteration in financial risk thereby invalidating the use of WACC.

Problems Associated with Different Sources of Finance:

In practice many companies use alternative sources of finance that makes the computation of WACC difficult.

Floating rate debt:

With floating rate debt, the rate is variable and is altered regularly in line with changes in current market interest rate. The cost of debt capital will fluctuate over time as market condition varies.

The use of bank overdraft:

Many companies make use of band overdraft as a ‘permanent’ capital.This creates two problems:The interest rate is variable.

Unlisted Securities i.e. unquoted debt, preference shares, ordinary shares:

Convertible Loan Stock:

The estimation of true cost of convertible loan stock is notoriously difficult, as the calculation requires an assumption about whether the holder would convert and if he will convert at what point in time.

Foreign Company Loan:

Where a company has a substantial foreign currency loan, fluctuation in the exchange rate adds a new dimension to calculation of cost of capital. Off-Balance-Sheet Financing:

31

Substantial off-balance-sheet financing in the form of lease agreement, acceptance credit, commercial papers etc creates further difficulties.

Validity of the Model’s objectives:

The dividend valuation model used in calculating cost of equity (the most important component of WACC) assumes that the objective of the company is to maximize the wealth of the ordinary shareholders. In practice, the company is a coalition of many shareholders and it is therefore considered immoral, unrealistic and difficult to single out the ordinary shareholders for the maximization of their own wealth.

Constant Dividend Growth:

The model assumes that the rate if growth in divided will remain constant to infinity. In practice many complex factors (legal, taxation, liquidity, prudence etc) will influence the amount of dividend to be distributed.

Constant Company tax rate:

In calculating the cost of debt it is assumed that the rate of tax will remain constant. In practice, the tax rate will depend on current government fiscal policy.

Not withstanding the above limitations, the WACC is a reasonable starting point in determining the appropriate discount rate. In practice a check on the calculation can be made by comparing the result with the WACC of similar companies and the risk of return (i.e. return on government securities).

Problems of Estimation:

Bank Overdraft

The rate of interest payable on a bank overdraft will fluctuate with general changes in interest rates. For example, it is likely to be granted at a given percentage rate above the bank’s base rate. Thus, unlike fixed interest loan stock, if interest rate fluctuate while the funds are being used, the interest rate changes in computing the overdraft rate to be included in the WACC.

Overdrafts are normally regarded as short-term sources of funds because technically they are repayable on demand. However, the reality for many smaller firms is that the overdraft is a major long-term source of funds. Such a firms should attempt to identify its core overdraft (i.e. the amount which is expected to be outstanding for many years) separately from the variable portion which results from fluctuations in working capital. Only the core overdraft should be included in the WACC calculation.

Convertible Loan Stock

The holder of convertible loan stock receives fixed interest for a number of years and then he

32

may convert his holding to ordinary shares at a predetermined conversion price over a range of possible dates. Alternatively, he may prefer redemption of the loan stock at a price on the due date.

The cost will be the discount rate, which equates the current market value of the stock with the following stream of cash flows:

- Annual net of tax interest to redemption/conversion.

- Redemption proceeds for those not converting

- Market value of shares received by those converting.

Further uncertainty are posted by the fact that the company may encourage have the right to redeem the loan stock over a range of dates (a stick to encourage conversion) or may offer different conversion prices at different dates (a carrot).

Hurdle rate or cut-off rate: is the minimum DCF yield (i.e. IRR) required by a firm on it, investments. Project IRR is calculated and it is compared with the hurdle rate.

The project is acceptable if its IRR is at least equal to the cut-off rate.

Important Points:

Management should ensure that the hurdle rate is set above. ‘The Company’s cost of capital’ if it wishes to increase the wealth of present shareholders.

The presence of inflation: Projects will normally show a higher IRR where the money cash inflows are increasing year by year. The hurdle rate should be correspondingly increased.

Taxation: If a company is financed by a mixture of equity and debt, then the presence of debt will usually bring about a lower combined cost of capital. The interes ton loan capital is an allowable expense in computing a firm’s tax liability. In this situation a lower hurdle rate may be acceptable.

Risk will be an important factor in determining the hurdle rate for an individual project. Where the cash flows from a new project are negatively correlated with those of the company’s existing investments, then acceptance of the project should reduce the overall risk inherent in the company’s earnings stream. When this happens, the board may consider reducing the hurdle rate for the project, any fall in the rate of return being compensated by the lowering of the overall risk.

Reasons Why Managers need to Know the Cost of Equity Capital

33

Knowledge of the cost of equity capital is fundamental to the official financial management of an organisation. For a typical private sector organization the major functions of finance can be considered under the following headings:

- financing decision- the investment decision- the dividend decision.

All of these decisions should in theory by made with the objectives of maximizing shareholder wealth and most of the decision models in financial management are formulated to this end.

To make decisions on the financing of the organisation the manager needs to know the cost of the various sources of finance at his disposal in order that he may select the most efficient funding package. A major decision area concerns the relative proportions of debt and equity capital. To be able to make judgements on what level of gearing to adopt, the manager must know how the cost of equity varies with respect to the amount of debt taken on. If this is not clearly understood a fall in equity value could result if a sub-optional gearing ratio is adopted.

To formulate the company’s investment policy the manager needs to be able to compare the costs of funds used with the benefits to be obtained from projects. Thus the cost of equity becomes an essential part of the calculation of the WACC for use in capital budgeting.

Care must be taken that the behaviour of the cost of equity with respect to systematic business risk is also understood. If projects are undertaken that yield returns less than those required by investors the company’s share price will fall.

If this is the case then the company will find it difficult to raise finance in the future or possibly it will be subject to an unwanted takeover bid.

Note that investment decisions include not only capital budgeting but also working capital management and acquisition policy.

Finally, it can be argued that knowledge of the cost of equity is important in the divided decision. If a company adopts a residual approach to divided it will pay out as dividends funds that cannot be invested profitably. In making this decision as knowledge of the cost of equity is clearly essential.

In conclusion, in practice, companies may not be operated in order to maximize shareholders wealth, but at the very least a satisfactory level of return has to be provided for shareholders. Knowledge of the cost of equity is essential to gauge this satisfactory level of return.

Marginal Cost of Capital: This is the cost of servicing new capital, which has to be provided. The cost should take into account, issue costs and the underwriting of new issues. It should also provide for possible effect on any existing capital. It is applicable when evaluating a new project for which new capital is specifically being raised.

34

MCC =

Illustration 3:

In capital expenditure decisions one of the most important concepts is the cost of capital.

Discuss the various criteria used and problems encountered in determining the cost of capital, illustrating your answer by using the information given below:Present position per balance sheet:

N N NAssets: 1,000,000Fixed 300,00Net current 1,300,000Equity:Ordinary shares 250,000 750,000Reserves 500,000

Loan capital: 6% (redeemable in 1 year) 100,000 7% (redeemable 3 years) 150,000 9% (redeemable 25 years) 300,000

100,000150,000300,000

550,0001,300,000

Ordinary dividends = 14%Earnings (before interest charges and taxation) = N250,000Market value of equity = N900,000The long-range plan of this company shows a projected capital structure of N1,600,000 being N600,000 loan capital and N1, 000,000 equity.

It may be assumed that the market rate for loans is at present 10%. Assume that income tax is at 40%.Solution:Broadly speaking there are five main sources of 92Capital:

Equity Profit retentionPreference share;Debt share; and Short-term debt.

35

Only (a) and (b) are relevant to the company in the illustration but each one may have different cost.

Cost of equity = KeCost of retention = KrCost of debt = Kd

The cost of equity is the return required by the equity investors. The problem is how to measure it. One approach is to use the dividend valuations.

Model of the firm with a growth in dividends.

Ke = (where g = growth rate)

=

= 3.89% + g

The problem is then, what estimate can be used for the growth rate?Measurement of growth:

Several criteria can be applied e.g. Consider an average annual growth in dividends over a past period (no information given.

Attempt a projection of the actual growth rate based on detailed analysis of capital investment, sales, growth and other economic variables.

On the assumption that future investment is financed by retention, use the accounting return (ROCE) as a measure of growth (Gordon’s model).

Solution:

ROCE =

Earning N NEarningsLoan interest:6% x 100,0007% x 150,0009% x 300,000

Taxation (40%)32,600

6,00010,50027,000

125,000

(43,500)81,500(32,600)48,900

36

ROCE: 48,900 = 6.5%750,000

However, reserves should be taken at the beginning of the period:

Earnings as aboveLess: Dividends (14%)

Reserves at end of yearReserves at beginning of year

N48,900(35,000) 13,900500,000486,100

N

More realistic ROCE =

Ke = 3.89% + 6.64% = Approx. 11%

However, the retention rate should also affect growth and if

B = proportion of cash flow retained for reinvestment then:

Ke =

So a better measure of g would be (0.0664) x (0.29) = 0.0193. This gives a low measure of Ke = 5.82% so presumably anticipated growth is higher.

Other methods for measuring Ke:

Ke might be measured as the actual rate of return required by shareholders over some past period by equating Ke = i and solving for

Po =

Where Po = Price paid for shareDn = Dividend received in year n; and Po = Selling price in n years.

Another method is to assume that all dividends are re-invested in shares immediately, and to calculate the return as the difference between buying prices and proceeds at the end of a period.

37

Problems Associated With Calculating the Cost of Capital:

Many other problems can be encountered in calculating the cost of capital. These include:- The cost of equity issues. This encourages the use of ***.- Fluctuations in share price.- Changes in Ke due to changes in business risk.- Problems of optimal capital structures and the effect on financial risk- (related to gearing)- the impact of inflation on Ke- Changes in legislation, e.g. Tax changes, dividend restraint, etc.

38

CHAPTER FIVECAPITAL STRUCTURE AND THE CONCEPT OF LEVERAGE

Introduction: Most of the traditional theory in financial management is based on the assumption that the objective as the company is to maximize the market value of its ordinary shares. It further assumes that the value of a share is the discounted present value of the future dividends.

i.e. VE =

Where:VE = value of equity shareDo = current dividend per shareKE = cost of equityg = Growth rate of dividend

The manager can theoretically increase the value of a company by two ways(1) Increase the size of the dividend payment. (2) Make cost of equity share smaller.(i) above can only be done by making more profitable investment decisions.

The second method of reducing cost of equity is the object of this write-up. The issue at state is whether it might be possible to take business decisions whose principal function is to reduce cost of equity (Ke) and by extension the WACC.

Capital structure decision deals with the question of whether it is possible to trade off the costs (financial risk) and benefits (lower cost of capital) of debt and, by a judicious combination of debt and equity finance, achieve a lower WACC and hence a higher total value for a given level of operating earning.

THEORIES OF CAPITAL STRUCTURE

There are two main theories about the effect of change in gearing on the WACC and value of equity.

These are:

a. The traditional theory

b. The Modigliani and Miller (MM) theory.

These theories are based on the following fundamental assumptions:- that the company employs only two types of capital (i.e. debt and equity)- that all earning are paid out as divided by the company - that the gearing of a company can be changed immediately by issuing debt to- replace shares, or by issuing shares to retire debt.

39

- No transaction costs- The operating earnings of the company are not expected to grow. The business risk is

assumed constant and independent of capital structure.

Taxation, for the time being, is ignored.

Traditional Theory: The theory believes that gearing will affect the WACC of a company and therefore its market values. As an organization introduces debt into its capital structure, so the WACC falls because of the theoretically lower cost of debt finance compared with equity finance.

As the level of debt increases, however, the return required by the ordinary shareholders will begin to rise because of the following factors:

The equity providers will start to get worried about the adequacy of operating profits to meet the huge debenture interest and still pay dividends.

The equity providers are also worried over the possibility that the debenture holders can interfere with the management of the company.

The possibility of forced liquidation in case of failure to meet loan interest.

The above factors put together will be referred to as financial risk. Thus the equity providers are taking additional risk (over and above the normal business risk) and will therefore ask higher returns to compensate for higher risk.

As the return required by equity holder increases, the WACC will continue to fall because the proportion of debt, and hence its weight, is becoming ever larger. Eventually, a point will be reached where providers of debentures themselves will demand higher returns because:

A higher level of operating income will be required to meet the ever-increasing debenture interest.

There may be no adequate physical asset to secure additional debentures. Thus the comparatively risk-free advantage of debt begins to decline as the financing charge on pre-tax profits becomes ever greater. The increasing cost of equity coupled with the now increasing cost of debt will force the WACC to increase.

The theory therefore concludes that for each company there is an optimal gearing ratio where the mix of equity and debt gives rise to:

The lowest WACC andThe highest market value of the company.The traditional theory can be represented graphically.

40

The theory suggests that each company should determine and maintain this optimal gearing level because it is at this point that the market value of the company is maximized. For new projects, financing at the optimal mix of debt and equity will ensure the maximization of the market value of the company.

Modigliani-Miller (MM) Theory: These two professors challenged the traditional view and came up with their own theory known as Modigliani and Miller (MM) theory.

Specific Assumptions of MM:

Securities are traded in the perfect capital market situation.

- This specifically means that investors:

- are free to buy or sell securities,

- They can lend unlimited amount of money and borrow within their capability to pay.

- They behave rationally.

- Transaction costs do not exist.

- All relevant information is freely available.

- Companies can be grouped into homogenous business risk class.

- No limited liability

- No distinction between corporate and personal taxation.

Given the above stated assumptions, MM argue that for companies in the same risk class, the total market value and the WACC are independent on future expected earnings discounted at the rate appropriate to the business risk class:

* With a rise in the level of gearing the cost of equity increases in a manner such as to exactly offset the greater proportion of cheaper capital, so that the WACC remains unchanged.

* Therefore, the discount rate to apply in evaluating investment projects is totally independent of the company’s method of financing the investment.

The Arbitrage Process: The term ‘arbitrage’ is used in many areas of finance, not just in the MM theory of capital structure. It refers to the process of buying and selling that takes place within an unstable capital market. This affects prices by the interaction of demand and supply and returns the market to equilibrium. The process of buying and selling yields a profit to those undertaking it.

41

MM suggest that if two companies have the same level of business risk, they must, all things being equal, have the same WACC, and if they also have the same level of earnings, the companies will have the same total market value. If this situation does not hold, as is proposed by the traditional theory, MM argue that shareholders will undertake arbitrage transactions, which will result, in share prices returning to their equilibrium position.The transactions involved in the arbitrage process are that shareholders in a company with the lower WACC sell their shares and purchase shares in the company with the higher WACC, borrowing or lending to maintain the same level of financial risk before and after.

Illustration 1:1. Two companies A & B both have the same level of business risk but different capital

structures. A summary of market value and earnings is given below:A B

Market values:EquityDebt

EBITInterestDividends

N90,000-90,000

20,000- 20,000

50,00050,000100,000

20,0005,00015,000

Required:

Determine whether the 2 companies are in equilibrium. (You should be specific in your answer).

- An investor holding 5% of the equity of the company B has approached you with the following questions:

- Whether he can increase his earnings from the same investment through arbitrage. Whether he can hold his earning constant and reduce his investment.

Solution:

The two companies are not in equilibrium because they have different market value despite the fact that they have the same business risk and the same operating earnings. This can also be confirmed by looking at the WACC.

Company A:Ke = Ko = Div / MV = 20,000 / 90,000 = 22%

NOTE: For Company A, the capital is also geared hence the cost of capital is also WACC.

42

Company B:

Ke = 15,000 / 50,000 = 30%Kd = 5,000/50,000 = 10%Capital Value Cost IncomeEquity 50,000 -30 15,000Debit 50,000 -10 5,000 100,000 20,000

WACC = N20,000 / 100,000 = 20%.

Since the WACC of the companies are not the same, the two companies are not in equilibrium even through they have the same business risk and the same operation earnings. Since the two WACC are not the same, we must conclude that the two companies are not in equilibrium.

Case 1: Additional income from the same investment

An investor in company B sells his 5% holding. 5% x N50,000 = N2, 500 He borrows 5% of debit of 50,000 = N2,500

(The amount the investor should borrow is determined by the Debit / Equity ratio of Company B).The total amount available (i.e. N5, 000) is invested in the equity of Company A.

Income:Before arbitrage: Dividend = 5% of N15,000 = N750After arbitrage: Dividend = 5000 / 90,000 x N20, 000 = N1,111Less interest on amount borrowed: 10% x N2, 500 = (250)

861

The investor has through arbitrage increased his earnings from N750 to N861.

The additional income is therefore N (861-750) = N111Case II: Same income from smaller investment.He will sell part of holding N2,500Amount to be borrowed N2,500

N5,000

The investor will now invest sufficient amount in the equity of Company A such that he holds 5% i.e. 5% x X 90,000 = N4,500 in (i) above.

New Income:N

Dividend from company A: 5% of 20,000 1000Less interest on borrowed amount: 10% x 2,500 (250)

(750)

43

The income of the investor is held constant.

Conclusion:

Following the profitable investment of investment from Company B to Company A by the above hypothetical investor, other investors in Company B will also commence the movement of their investment to Company A. This will increase the supply of the Company’s B share in the capital market and following the law of demand and supply the value per share of company B must fall.

On the other hand, as more share holders demand the shares of company A and following the law of supply and demand the value per share in company A must rise. This process will continue until a point where there is no further profit for the arbitrage to exercise. This is the equilibrium point where the total market value of Company A equals that of B and the WACC of A equals the WACC of B. It therefore follows that the mode of financing a company has no impact on the value of the company nor the weighted average lost of capital (WACC).

44

CHAPTER SIXINVESTMENT POLICY (CAPITAL BUDGETING)

Capital budgeting involves the commitment of current funds in long-term projects or activities. Here, management decisions about investment are based on estimates about the future, which definitely is not certain. According to Drunker, ‘what is certain about the future is that it is uncertain’.

Capital budgeting/investment has the following salient features:

- They involves a large commitment of resources

- They are risky, since we are projecting into the future, which is unknown to us.

- They are irreversible by nature. Once a decision is taken, it cannot be reversed without a substantial capital loss.

Importance of Capital Budgeting: The major importance of capital budgeting lies in the fact that it assists management in making investment decisions that will satisfy the ‘twin’ objective mentioned below:

- Provide an adequate return for investor

- Achieve the company’s financial objective of maximizing the wealth of its shareholders.

Capital Budgeting Under Certainty

As earlier mentioned, investment decisions involve future estimates which are subject to uncertainties. For the purpose of academic exercise however, we are going to assume a future that is certain in our discussion under this topic. In other words, our estimates will turn out to be exact in future.

Definitions:

Independent Projects: Two (or more) projects are said to be independent if the decision to undertake (or not to undertake) one does not affect the decision to undertake (or not to undertake) the other (or another) project. In other words, decisions on individuals projects are made based on their merit without taking cognizance of the outcome of the others.

Mutually Exclusive Projects: Two projects, say A and B are said to be mutually exclusive if the decision to undertake project a automatically precludes undertaking project b and vice versa.

Mutually Dependent Projects: Two projects, say A and B are said to be mutually dependent if acceptance of project. A automatically means the acceptance of B. Here, the two projects are either taken together or rejected together.

45

Principal Methods of Evaluating Capital Projects

The principal methods of evaluating capital projects are:

1. Traditional or Non-discounting Techniques:

a. Return on investment (ROI) or Accounting Rate of Return (ARR): This approach make the assumption that the main factor in determining the worth of an investment is the level of profitability that is expected to be achieved.

Unfortunately, there are several different definitions of ARR. The two most popular definitions are:

a) ARR =

b) ARR =

Where: Average investment = Initial investment + NBV 2

For examination purposes, definition ‘(a)’ is recommended, except where there is any instruction to the contrary.

Illustration: A company has a target ARR of 20% and is now considering the following project:Capital cost of Asset N80,000Estimated life 4 years.Estimate profit before depreciation

NYear 1 20,000Year 2 25,000Year 3 35,000Year 4 25,000

The capital asset would be depreciated by 25% of its cost each year, and would have no residual value. Should the project be undertaken?

Solution: Working Notes-Estimation of Average Annual Profit:Total profit over 4 years = N (20,000 + 25,000 + 35,000 + 25,000) = N105,000Average Annual Profit = N105,000 / 4 = N26,250Estimation of depreciation per annual cost of asset = N80,000Life span of Asset = 4Residual value = NilDepreciation/Annum = N (80,000.0) / 4 = N20,000 p.a.Average Annual profit = N (26,250.20,000) = N6, 250.

ARR =

46

NOTE: Average Investment = N (80,000 + 0) /2 = N40,000

Decision: The project should not be undertaken as it failed to yield a target return of 20%.

Tutorial Note: Where definition ‘b’ is employed in solving this problem, the final percentage figure could be different (as in the above case where, if ‘(b)’ is employed, we have 7.86% but the decision will always be the same.

Advantages of ARR: The advantages include:

- It is very simple to calculate and understand. The fact remains that not all management personnel are skilled in financial management techniques, most especially, those that involve complicated calculations. In addition, profit estimates made in form of ‘percentages’ will easily convince the shareholders

- It considers the profit of the project throughout its working life.

- It facilitates expenditure follow-up due to more readily available data from the Accounting records.

- Divisional performance can easily be compared in an organisation.

Disadvantages of ARR:

- The method does not take account of the timing of the profits from an investment. i.e. it fails to account for the ‘time value of money’

- It ignores the fact that profit from different projects may accrue at an uneven rate.

- How do we define profit? Since profit is capable of varying definitions (i.e. subjective), the decision as to the acceptability or otherwise of a project will definitely be affected.

- Does not use cash flows

- The method does not consider the working capital that will be needed in managing the investment.

- There is no objective way of determining the minimum acceptable rate of returns.

- Gives more weight to future receipts.

b. Payback Period (PBP):

47

This method of investment appraisal considers how long a project would take to pay back the initial investment made in it. It is a cash measure and as such, it measures the number of years it takes to recoup the initial investment in cash terms. The shorter the PBP, the more worthwhile the project.

When an independent project (or single project) is being considered, the PBP of such a project would be compared with a standard PBP already set by the management of the organization. If the PBP of the project is shorter or at worst equal to the standard set, the project will be undertaken but it otherwise, it must be rejected.

PROJECT A PROJECT BYear Cashflow (N) Cashflow (N)0 (100,000) (100,000)1 20,000 80,0002 30,000 60,0003 40,000 20,0004 50,000 10,0005 60,000 10,000

SOLUTION: PROJECT A PROJECT B

Year Cashflow (N) Cashflow (N) Cashflow (N) Cum. Cashflow (N)0 (100,000) (100,000) (100,000) (100,000)1 20,000 (80,000) 80,000 (20,000)2 30,000 (50,000) 60,000 -3 40,000 (10,000) 20,000 -4 50,000 - 10,000 -5 60,000 - 10,000 -

PBPA = 3 years (10,000 / 50,000 x 12) months = 3 years 2 months.

PBPB = 1 year (20,000 / 60,000 x 12) months = 1 year 4 months.

Decision: The management is advised to undertake project B which has the shorter PBP of 1 year and 4 months as compared to project A with a PBP of 3 Years and 2 months.

Advantages of PBP:

- It is easy to calculate.- Where risk increase with the life of the project, it may be used as a safeguard against risk.- Emphasizes liquidity in that it ensures selection of projects that provide immediate cash.- Payback is often used as a simple initial screening method for project appraisal.- Considers cash flows as against profits.

Disadvantages of PBP:

48

- How do we determine a target PBP for independent project? This might pose a big problem as there is no objective way of determining the standard PBP.

- The method does not consider the time value of money

- The method also ignores cash flows outside the PBP

- It is not a measure of profitability.

- It has no relation with the wealth maximization principle.

NOTE: Both the IRR and PBP methods are jointly referred to as the ‘TRADITIONAL OR NON-DISCOUNTING METHODS’ of project appraisal.

Where the given cashflow over the years is constant then:

PBP =

2. DISCOUNTED CASH FLOW METHODS (DCF): Discounted cash flow method is made up of two major techniques viz:

- The Net present value technique (NPV)- The International Rate of Return technique (TRR).

Treatment of some Common Items of Cost Under the DCF Method

- Depreciation: This item of cost should not be considered at all when determining our net cashflow. It is a mere provision and does not involve movement of cash.

- Sunk Cost: This refers to costs, which have been incurred in the past and as such, they are irrelevant to our appraisal. Our interest lies only in the future costs.

- Opportunity Cost: Where as a result of undertaking a certain project, some amount of income is lost, perhaps due to the conversion of material from the old investment to the new project or due to the shortage of labour created by the new project; the contribution so lost should be added to the cost of production in the new venture. That is what is meant by opportunity cost in investment appraisal. For example, if a business is making use of a building that otherwise could have been rented out, say at a rate of N25,000 per annum, such or amount becomes a cost to the business.

- Overheads: Where additional overhead is incurred, because a particular project is undertaken, such an amount becomes relevant. Generally, however, we should always ignore any given overhead absorption rate.

49

- Interest Rate: Interest generally should be ignored. This becomes necessary to avoid double counting since the DCF calculation is based on a particular ‘cost of capitals’.

- Working Capital: Any amount of working capital introduced into an investment must always be recorded. Where no time is given, the end of the project life will be an appropriate time to assume.

a. Net Present Value (NPV) Method:

This method considers the summation of the discounted cash flows from the project over the entire life of the project. When the total discounted cashflow and the NPV is positive or at worst, equal to zero, the project is considered worthwhile (if an independent project). For a mutually exclusive project, the one with the highest NPV will be undertaken. In absolute terms, the NPV of a project represents an increase in the shareholders wealth resulting from the project.

Illustration: Texas Ltd. is considering the manufacture of a new product which would involve the use of both a new machine (costing N150,000) and an existing machine which cost N80,000 two years ago and has a current net book value of N60,000.There is sufficient capacity on this machine, which has so far been under utilized. Annual sales of the produce would be 5,000 units at a selling price of N32 per unit.Unit costs would be:

NDirect labour (4 hours x 12) 8.00Direct materials 7.00Fixed cost including depreciation 9 .00

24.00

The project would have a 5 year life, after which the new machine would have net residual value of N10, 000. because direct labour is continually in short supply, labour resources would have to be diverted from other work which currently earns a contribution of N150 per direct labour hour. The fixed overhead absorption rate would be N2.25 per direct labour hour (N9 per unit) but actual expenditure on fixed overhead would not alter.Working capital requirement would be N10, 000 in the first year rising to N15,000 in the second year and remaining at this level until the end of the project when it will all be recovered.Given that the company’s cost of capital is 20%; you are required to advise the management of Texas Ltd. on the suitability of the project. Ignore Taxation.

SOLUTION: working NotesInitial outlay = N150,000Scrap value of the machine = N10,000Estimation of contribution per Unit of the product:

50

N N

Selling price / Unit 32Direct labour (4 hr x N2) 8Direct materials 7Opportunity cost (N1.5 x 4hrs)** 6 (21)Contribution per Unit 11

Total Contribution / annum = N 11 x 5,000 Units = N55,000

Year (a) Initial

Outlay

N

(150,000)

(b)

Cash flow

(c)

Working capital

N

(10,000)

(a+b+c)

Net cash flow

N

(160,000)

DF

20% value

N

Present

Value

N

(160,000)

1

2

3

4

5

-

-

-

-

10,000

55,000

55,000

55,000

55,000

55,000

(5,000)

-

-

-

15,000

50,000

55,000

55,000

55,000

80,000

0.833

0.694

0.579

0.487

0.402

41,650

38,170

31,170

26,510

32,160

10,335

Decision: The management is advised to undertake the project as it has a positive NPV of N10, 335. It is worthwhile.

Note:** This shows the contribution lost per unit of output from other work as a result of transferring labour hour from the work, as a cost to the new project. (i.e. labour hours required per unit multiplied by the contribution per labour hour).

Advantages of NPV:

1) The method takes cognizance of all the cash flows over the entire life of the project.

2) It recognizes the time value of money since the cash flows are discounted using the company’s cost of capital and according to the year of receipt.

3) The method is consistent with the objective of maximizing the wealth of shareholders.

51

Disadvantages of NPV:

1) The method did not consider risks associated with projects

2) Where alternative projects of different life spans, which are repeatable, are being considered it may lead to wrong decisions being made.

3) The method assumes the knowledge of the company’s cost of capital, which in reality is a difficult concept to measure accurately.

4) Requires estimates of cash flows.

5) Sensitive to discount rates.

b. International Rate of Return (IRR) Method:

This method involves the calculation of two NPVs, using rates for the cost of capital, which are likely to give NPVs close to zero. It is the interest rate that will equate the present value of cah inflows with the present value of cash out flows of an investment, i.e. it is the discount rate at which NPV = 0.

It is sometimes referred to as:

- Discounted cashflow yield. Technique

- Break even rate

- Marginal efficiency of capital rate.IRR is computed using a technique referred to as ‘Linear Interpolation’ which involves using two discount rates within which the IRR is expected to Ife, i.e. one gives a positive NPV and the other gives a negative NPV.

Where D1 = Discount rate which gives a positive NPD2 = Discount rate which gives a negative NPVP1 = Positive NPVP2 = Absolute value of negative NPV.

With respect to independent projects, the project should be undertaken if the IRR of the project is either equal to, or higher than the standard IRR of the company. If otherwise, the project should be rejected.

52

For mutually exclusive projects, the one with the highest IRR should be undertaken.

Illustration:

A company is trying to decide whether to buy a machine for N160,000 that will save costs of N40,000 a year for five years and which will have a resale value of N20,000 at the end of that period. Determine the IRR of the project.

Solution:

We first assume a discount rate of 10%

Year Cash flow (N) DF@10% PV(N) 0 (160,000) 1,000 (160,000) 1-5 40,000 3.791 151,640 5 20,000 0.621 12,420

4, 060

Next, we assume a higher Discount rate, say 15%

Year Cash flow (N) DF@10% PV(N) 0 (160,000) 1,000 (160,000) 1-5 40,000 3.3521 134,080 5 20,000 0.497 9,940

15,980

IRR = D1 +

=

Advantages of IRR:

- It considers the cash flow over the entire life of the project.- The method is consistent with the objective of maximizing the shareholders wealth.- The method does not assume a known cost of capital- It considers the time value of money.

Disadvantages of IRR:

- It involves complicated calculations- It is difficult to understand and use in practice- The method sometimes gives more than one result- The IRR method ignores the relative size of investment- Furthermore, IRR should not be used to select between mutually exclusive projects.

53

NPV VS IRR

When decisions are to be taken with respect to independent projects having conventional cash flows, both the NPV and IRP method will definitely yield the same result provided the organization is not constrained for funds. However, IRR when applied to non-conventional cash flows may yield multiple rates. In addition, when it comes to mutually exclusive projects (projects may be mutually exclusive for technical or financial reasons), the two methods sometimes lead to different ranking.

However, in case of such disagreement, it is recommended that NPV method should be relied on as it indicates the immediate gain in market capitalization to equity investors.

REASONS FOR THE CONTROVERSY BETWEEN THE TWO METHODS

- Projects may have different expected lives- Projects may have different initial cash outlays.- Variation in the timing/ pattern of cash flows.

Capital Rationing & the Profitability Index (PI)

In considering Capital Budgeting up till this point, it has been assumed that funds will always be available to finance all profitable projects. If funds are insufficient, then the firm will have to reject/some profitable investment proposals. This situation is described as ‘Capital Rationing’.

Capital Rationing may arise due to:

- External factors - Internal constraints imposed by management.

External Capital Rationing: mainly occurs due to the imperfections of the market system. The firm is unable to obtain necessary capital to finance all its profitable investment opportunities because of these imperfections.

Internal Capital Rationing: is caused by self-imposed restrictions by management. Management may fix an arbitrary limit to the amount of funds to be invested by the divisional managers or may decide not to obtain additional capital by incurring debt.

It is obvious that under a situation of capital rationing, a firm would not be able to accept all profitable investments. To select some and to reject others, a comparison among the profitable projects should be made.

54

The selection process under capital rationing will thus involve two steps:

- Ranking project according to some measure of profitability.- Selecting projects according to some measure of profitability until the funds are

exhausted.

The ‘Profitability Index (PI)’ also known as the ‘Benefits-Cost ratio; Rt is the ratio of the present value of future cash benefits, at the required rate of return to the initial cash outlay of the investment. It may be gross or net, net being simply gross minus one.PI = Present value of Cash Inflows

Initial Cash outlay

The ‘Accept – or-Reject rule using PI is to accept the project if its PI is greater than one. Such a project will have positive NPV.

Although projects can be ranked using the NPV, IRR or PI, it is argued that the PI determines the relative profitability of investment projects being a ratio of future wealth per Naira of present investment.

Advantages of PI:

- Considers all cash flows- Recognizes the time value of money- Relative measure of profitability- Generally consistent with the wealth maximization principle.

Disadvantages of PI:- Requires estimates of cash flows, which is a tedious task- Sometimes fails to indicate correct choice between mutually exclusive projects.

Illustration 1:

The initial Cash outlay of a project is N100,000 and it generates cash inflows of N40,000, N30,000, N50,000 and N20,000 in four years.

Required: Calculate the NPV and PI of the project. Assume a 10% rate of discount.

Solution:Year Cash inflow(N) Discount factor PV(N)1 40,000 0.909 36,3602 30,000 0.826 24,7803 50,000 0.751 37,5504 20,000 0.683 13,666

112,350Less outlay (100,000)

55

NPV 12,350PI (Gross) = 112,350 = 1.1235

100,000PI (Net) = 1.1235.-1.0 = 0.1235.

Illustration 2:

DJAN Ltd. Has N10 million allocated for capital expenditure purposes. The following six projects are under consideration.

Project Required Investment(N million)

Annual Cashflow(N)

Project (Years)

ABCDEF

5.01.53.54.52.04.7

169,20928,6846\74,33682,65934,94357,931

5810131518

If the firm’s minimum required rate of return is 12%, which projects can be accepted with the budget ceiling of N10 million?

SOLUTION:

The first step is to rank the projects according to profitability index (PI).

Project PI RankingABCDEF

1.220.951.221.201.181.19

162435

The second step is to accept the projects in descending order. The following two projects would be accepted.

Project Investment PI NPVAC

5.0 Million3.5 Million

1.221.20

1.1 Million0.7 Million

8.5 Million 1.8 Million

56

Thus the firm is able to utilize N8.5 million out of N10 million. The next best project needs an investment of N2.0 million while the firm has only N1.5 million.

Under capital rationing, the approach of the firm should be to select projects in a manner that the maximum NPV is obtained subject to the appropriate to accept many lower order (in terms of ranking) smaller projects than a single large project because of the possibility of idle funds such as the N1.5 million in illustration 2.This situation will persist for as long as projects are regarded as indivisible, i.e. project an entity to be accepted or rejected in its entirely.

In illustration 2, the selection of a large project. Project A excludes the chances of accepting small projects. Projects E and D, which together with Project C will exhaust the entire budget and will generate more NPV.

Project Investment PI NPVCDE

3.5 million2.0 million4.5 million

1.201.191.18

700,000380,000810,000

8.5 Million 1,890,000

The problem of indivisibility can prove to be serious and make the selection process quite unworthy. Because of their different re-investment assumptions, the three DCF techniques NPV, IRR and PI give conflicting ranking to projects. This has been called the ‘ranking error problem’. The problem of ranking error can be resolved if a commerce-investment rate is assumed.

NPV VS PI

The NPV method and the PI have the same accept-or-reject rules, because PI can be greater than one only when the project’s NPV is positive. In the case of marginal projects, NPV will be zero and PI will be equal to one. However, a conflict may arise between the two methods if a choice between mutually exclusive projects has to be made.

Under such circumstances, the NPV method should be preferred except under capital rationing because the NPV represents the net increase in the firm’s wealth.

Where two mutually exclusive return the same NPV, say N100,000 and one project costs twice as much as the other, the NPV method will indicate that both are equally desirable in absolute terms.

However, the PI being a relative measure will evaluate both projects relatively and will give the correct answer. Between two mutually exclusive projects with the same NPV, the one with lower initial cost (or higher PI) be selected.

57

CHAPTER SEVENDIVIDEND POLICY

Those earnings, which are distributed to shareholder, are called Dividends. The percentage of earnings paid as dividend is referred to as a ‘pay-out ratio’ or ‘retention ratio’. A high payout ratio or a low retention ratio means more dividends and less funds for expansion and growth. A low payout or high retention ratio on the other hand means into more growth.

Does Dividend Policy Affect the Market Value of the Firm|?

One view is that whether dividend will increase value or not depends on the profitable investment opportunities available to the firm and the firms cost of capital. If the firm has profitable opportunities, its value will be maximized when 100% of earnings are retained.

Another view is that because of the uncertainty of capital gains, investors like more dividends. This implies that the market price of shares of high-payout companies will command premium.

MM do not agree with the view that dividends affect the market value of shares. According to them, if the investment policy of the firm is given, then dividend policy is a trade off between cash dividends and issued of common shares. The share price will adjust by the amount of dividend distributed. Thus the existing shareholder is neither better off not worse off. His wealth remains unchanged. For their view, MM assumes perfect capital markets, no transaction costs and no taxes.

The practical world is not that simple. There exists transaction costs as well as taxes. Except for tax-exempt investors, there does not seen to be a strong reason for investors to prefer high-payment shares. Infact, in a world with differential taxes where capital firms are taxed at a lower rate than incomes, investors in high-tax brackets would prefer low-payout shares.

Dividend can be paid in cash or in shares. The cash account and the resumes account of a company will be reduced when the cash dividend is paid. Thus, both the total assets and the net worth of the company are reduced when the cash dividend is distributed. The market price of the share drops in most cases by the amount of cash divided.

An issue of bonus shares (also known as script dividend) represents a capitalization of reserves in the form of a distribution of shares in addition to the cash dividend paid to the existing shareholders. This has the effect of increasing the number of issued shares of the company. The shares are distributed proportionately so that a shareholder retains proportionate ownership of the company. For example, if a shareholder owns 100 shares of the company at the time when a 10% (1:10) bonus issue is made, he will receive 10 additional shares.

The declaration of bonus shares will increase the paid-up share capital and reduce the reserves and retained earnings of the company. The total net worth is not affected by the bonus issue. Infect, a bonus issue represents a re-capitalization of the owners equity portion.

58

Illustration:

The following is the capital structure of Jay-Jay and co.;N’million

Paid-up share capital (100,000 shares of N10 each) 1.00Share Premium 1.50Reserves 0.80

3.33A (1:10) bonus issue is declared at a time when the market price per share is N30. What will be the effect of the bonus issue on the capital structure?

Solution:

A 1:10 bonus issue implies an issue of 10,000 new shares to the existing shareholders. Thus a shareholder holding 10 shares will get an additional share. At a market price of N30 / share the total value of new shares issued will be N300.000. This amount would be transferred from reserve account into the equity share-capital account and the share premium account.

MPS – Par value = Premium on shareN(30-10) = N20

The new capitalization will be as follows: N’millionEquity share capital (110,000 shares of N10 each) 11Share Premium 17Reserves 0.5

3.3NOTE: The issue of bonus shares does not change the total net worth of the company. Only the account balances are readjusted.

Bonus shares have psychological appeal. Companies generally prefer to pay cash dividend practice while financing expansion and growth by issuing new shares or borrowing.

Companies like to follow a stable dividend policy, since investors generally prefer such a policy the reason of certainty. A stable dividend policy does not mean constant dividend per share. It means reasonably predictable dividend policy.

The firm’s ability to pay dividend depends on its funds requirements for growth, shareholders desire and liquidity. Any extreme changes in dividend policy are read as signals of management expectation about the companies future performance. Thus, dividends have information contents. This is why earnings patterns of companies generally fluctuate more than their dividend policy patterns.

In practice, a number of factors will have to be considered by management before deciding on the appropriate dividend policy of the firm.

59

Factors Affecting Dividend Policy

These include:

- Liquidity: availability of funds

- Restrictions in loan covenants

- Investment and financing opportunities

- Rate of business expansion

- Dividend policy of similar companies / Industry averages

- Tax implications: Withholding tax on dividends versus Capital Gains tax.

- Statutory regulations / Government restrictions

- Information content of dividends

- Profitability, future earnings prospects and stability of profits

- Dilution of control accompanying new share issues

- Level of inflation

- Repayment of mature debts

60

CHAPTER EIGHTWORKING CAPITAL MANAGEMENT

There are two concepts of working capital – the gross concept and the net concept.

- Gross Working capital refers to an organization’s investment Assets and Current Liabilities.

Current Assets: are the assets which can be converted into cash within accounting year (or operating cycle) and include cash., short-time investments, debtors bill receivable and stocks.

Current Liabilities: are outsiders claims on the assets of a business which are expected to mature for payment within an accounting year and include creditors, bill payable and outstanding expenses.

Net Working capital can be positive or negative.- Positive net working capital arises when current assets exceed current liabilities.

- Negative net working capital occurs when current liabilities exceed current assets.The two concepts of working capital-gross & net-are not exclusive, rather they have equal significance from management viewpoint.The gross concept is a quantitative concept. It focuses on:

- Optimum investment in current assets and

- Financing of current assets with a view to avoiding excessive or inadequate investment in current assets and highlighting the need of arranging funds to finance current assets and also investment opportunities for excessive funds.

The net concept, since it considers the difference between current assets and current liabilities is a qualitative concept. It focuses on:

- The liquidity position of the organisation,

- Suggests the extent to which working capital needs may be financed by permanent sources of funds and

- The question of judicious mix of long-term funds for financing current assets.

For every organization, there is a minimum amount of working capital that is permanent. Therefore, a portion of the working capital should be financed with the permanent or long-term sources of funds.

61

DETERMINANTS OF WORKING CAPITAL

There are no set rules or formulae to determine the working capital requirement of a company. A large number of factors influence the working capital needs of companies. All factors are of different importance and the importance of individual factors change with time and he operating environment of the company.

These factors include:

- Nature and size of business: Trading companies have less investment in fixed assets but large working capital while public utilities like NEPA have little need for working capital and invest abundantly in fixed assets. Also bigger companies require more working capital than small companies.

- Operating Cycle: The longer the operating cycle, the larger the working capital requirement.

- Business (Seasonal & Cyclical) fluctuations

- Production Policy

- The firm’s credit policy

- Availability of credit

- Growth and expansion activities

- Operating efficiency

- Price level changes / Inflation

- Profit margins: A high net profit margin contributes towards the working capital pool.

Illustration 1:N.000 N.000

Current Assets:Raw materials 200Work-in-progress 300Finished goods 100Debtors 400Cash 100Gross Working Capital 1,100Current Liabilities 400Creditors 100Taxation 200 (700)Net working capital 400

62

The objective of financial management is to ensure that the business has adequate working capital. Excessive working capital is expensive and inadequate working capital is also dangerous.

Permanent and Fluctuating Working Capital

Permanent Working Capital

This is the element of working capital that can be regard as fixed over time. For example, a company may always carry certain base stock levels, cash balance may not fall below a particular level and a given amount of debtors will always be carried. It is normally recommended that permanent working capital should be financed with permanent (capital or long-term debt).

Fluctuating Working Capital:

This is the extra working capital needed to support the changing level of production and sales activities. The component is best financed using short-term finance.

THE WORKING CAPITAL CYCLE

The working capital or cash operating cycle is the total length of time required to complete the following sequence of events:

- Conversion of cash into raw materials;

- Conversion of raw materials into work in progress;

- Conversion of work in progress into finished goods;

- Conversion of finished goods into debtors through sales; and conversion of debtors into cash.

Thus, working capital cycle is the total length of time between investing cash in paying for raw materials at the start of the production process and its recovery at the end with the collection of cash from debtors.

The working Capital Cycle can be shortened by:

- Increasing *** turnover by a sales campaign;

- Dispose of slow moving and obsolete stock;

- Reduce raw materials and finished goods stocks

63

- Change the credit terms for its customers, offering discounts for early payment;

- Credit control procedures could be tightened up, with credit limits and slow payers being monitored closely by the credit controller;

- Negotiate extended credit terms with suppliers.

ESTIMATING WORKING CAPITAL REQUIREMENT

The amount tied up in working capital is equal to the value of raw materials, work-in-progress, in finished stocks and debtors less creditors. The size of this net figure has a direct effect on the liquidity of an organisation. The computation of the net investment in working capital is similar to that of working capital cycle except that we are now interested in the naira value rather than number of days.

Illustration 2:

A Company is to manufacture a new product and has prepared the following budget for its first year of operation.

N NSales 2,400,000Direct material 800,000Direct labour 600,000Overhead 400,000 (1,800,000)Profit 600,000

You are given the following additional information:- Debtors *****40% will pay within 30 days of sales, the next 40% will pay within 45

days and the balance within 60 days.- Raw materials *** will be in store for 36 days on average- Work-in-progress: the production cycle will be 72 days.- Finished Goods *** will be in store for 45 days on average- Creditors: suppliers of raw materials will give credit of 27 days.

Further more, 60% of the overhead will be supplied on credit of 15 days.- For ease of calculation assume 360 days in a year.

Required:

a. Calculate the amount of *** capital required by the company.

b. List the various methods of financing working capital.

64

Solution:a. Estimate of Working Capital N N

Debtors: 1st 40% = 80,000

2 nd 40% = 120,000

Balance= 80,000 280,000

Raw materials: 80,000

***: Raw Materials: 72 / 360 x 80,000 160,000Conversion cost: 1 / 2 / 72 x 360 x 1,000,000 100,000 260,000

Finished Goods: 45 / 360 x 800,000

Creditors: Raw Materials:Overheads: Total Current LiabilitiesNet working Capital

Working Capital can be financed using

- Bank overdraft

- Factoring

- Acceptance credit

- Commercial papers

- Retained earnings

- New equity or long-term loan may be used to finance the permanent component of working capital.

Overtrading and Over-Capitalisation

Overtrading

Overtrading (or under-capitalization) occurs when a business tries to do too much too quickly with too little working capital and liquid resource.

SYMPTOMS AND CONSEQUENCES OF OVERTRADING

65

- A rapid increase in sales turnover;

- A rapid increase in the volume of current assets and possibly also fixed assets;

- A decline in stock turnover and debtors turnover period meaning that the rate of increase in stocks and debtors would be greater than the rate of increase in sales;

- Most of the increase in assets is financed by credit especially

* Trade creditors. The payment period to creditors is likely to become much slower.* Bank overdraft, which often reaches or even exceeds the limit of the facilities

agreed by the bank;* Some debt ratios and liquidity ratio will alter dramatically;* The proportion of total assets financed by proprietors capital will decline, and the

proportion financed by credit will slower;* Eventually a business might have a liquid deficit *** which is an excess of

current liabilities over current assets.

Causes of Overtrading

Internal Factors:

- Increase in fixed assets without a corresponding increase in equity or borrowing, that is, fixed assets are being financed from current assets.

- Excessive stock holding

- Excessive credit period being granted to customers

- By expansion of turnover, without a corresponding increase in the working capital.

- Higher sales will result in higher debtors and this must be financed.

- By trading at a loss. A deficiency in net cash flow will result in a fall in net current assets.

- By repaying long term loans without replacing them meaning that they are paid out of liquid resources.

- By lending money (that is, excessive car loan, housing loan e.t.c to staff and other forms of lending).

External Factors:

66

- By inflation: in a period of price inflation, a business needs ever

- increasing amounts of cash just to replace used-up and worn out assets. A drain in liquidity will result and could lead to over trading unless funds are available through fresh capital or retained earnings.

- By too much reliance on bank overdraft facilities which may be withdrawn as a result of a change of policy either by the bank or government.

- By too much reliance on bank overdraft facilities which may be withdrawn as a result of a change of policy either by the bank or government.

- By government intervention to hold down prices or profit margins in inflationary times, so that net cash flow is less than it otherwise could be.

- By changes in the taxation system which increase the amount of tax payable.

- By a change in the date of payment of tax. If the date is brought forward working capital will fall in the period between the new and old dates of payment, this could impose liquidity problems during that period such that the company be over-trading.

Over-Capitalisation

Over-capitalization (or under-trading) arises when the amount of capital employed in the business is too great for the volume of trading being undertaken. It is also used to describe the situation where assets that cannot be remuneratively employed (intangible assets) represent a company’s capital.

Causes of Over-Capitalisation

- Raising of funds without regards to the scale of production

- Large retention of profits

- Purchase of business paid for using own shares and where excessive valuations have been placed on goodwill and/or the tangible assets (particularly fixed assets). This situation is often referred to as watering of capital.

SYMPTOMS AND CONSEQUENCES OF OVER-CAPITALISATION

- Insufficient revenue to adequately remunerated capital employed.- Downward trend in share value.- Reduction of capital or enforced liquidation may follow.CASH MANAGEMENT

67

Cash is the most important current asset for the operations of business. It is the basic input needed to keep the business running on a continuous basis; it is also the ultimate output expected from the activities of the business.

A Company should keep sufficient cash, neither more, for less Cash shortage will disrupt the fir ms operations while excessive cash will simply remain idle, without contributing *** towards the company’s profitability.

Cash Management is concerned with the managing of Cash flows into and out of the business Cash flows within the business Cash balances by the business at any point in time by financing deficits and investing surpluses.

Reason/motives for holding cash:

Transactions motive:

To meet expenses as they arise in the ordinary course of business. This is necessary because cash receipts and payments are not perfectly synchronised.

Precautionary Motive:To invest in profitable opportunities as and when they arise. Cash budgeting and credit policy are key issues in cash management.

Credit Policy:

For effective management of credit, a business should lay down clear-out guidelines and procedures for granting credit to customer. A business should not follow the policy of treating all customers equal for the purpose of extending credit. Each case should be fully examined before credit is granted. Similarly, collection procedure will differ from customer to customer.

Credit evaluation procedures should involve the following step.

- Credit information: Collecting credit information should therefore be less than the potential profitability.

Sources of such information include:

a) Financial statementsb) Bank referencec) Trade references *** existing customers of the prospective debtor d) Credit Bureau reports- Credit Investigation and analysis: This involves analyzing the collected information- Credit Limits: The amount of credit granted and the terms of credit.- Collection Procedures.Cash Discounts

68

A cash discount is a reduction in payment offered to customers to induce them to repay credit obligations within a specified period of time, which will be less than the normal credit period. It is usually expressed as a percentage of sales. Cash discount terms indicate the rate of discount and the period for which it is available. If the customer does not avail the offer, he must have payment within the normal credit.

In practice, credit terms would include:the rate of cash discount,the cash discount period,the net credit period.

For example, credit terms may be expressed as 112/10, n/3011. This means that a 2% discount will be granted if the customer pays within 10 days and if otherwise, he must pay by day 30 without discount.

A firm uses cash discount as a tool to increase sales and accelerate collections from customers. Thus the level of debtors and associated costs may be reduced. The cost involved is the discounts taken by customers.

Calculating Effective Cost of Cash DiscountConsider the following cash discount terms:115/20, 11/6011 (from a supplier)

The customer has two options.Option 1 *** Take Discount

This means that from an invoice of *** 1,000 the customer must pay N950 (95% of N 1, 000) on day 20 to pay earlier than day 20 is not necessary).

Option 2 *** Do not take Discount

In this case, the customer must pay the entire N1,000 on day 60. For option 2 to be selected, the customer must prepared to invest N950 (the money he fails to pay to day 20) for a period of 40 days (60*** 20) to generate minimum interest of N50 (N1,000 **** 950). The rate of interest that makes N950 to amount to N1,000 after 40 days is called the effective cost or implies cost or annualised cost of taking the discount. The rate can be calculated using either simple interest or compound interest.

Using simple interest:Interest = (P x T x R) / 100N50 = 950 x 40 x R

365R = 48%

Using compound interest:

69

A = P(1+R)n1,000 = 950 (1+R)40/385(1,000/950) 365/40 = 1+R

= 60%

Notes:* The compound interest approach gives the precise solution, but is much more difficult to

calculate.* The simple interest approach is an acceptable working approximation in practice.

Decision with Effective Rate:

The effective cost is compared with costs of alternative sources of funding working capital. In the above example, if short-term finance is available at 25% (lending and borrowing rate) should the discount be accepted?

In this case, the discount should be accepted because the effective cost is more than cost of short-term finance.We can confirm our conclusion with the following calculations.

ACCEPT REJECTDISCOUNT DISCOUNT N N

Amount paid 950 1,000Less Interest on money invested: 0.25 x 40/360 - (26)Net payment 950 974

The point here is that the short-term lending rate of 25% is too small to give the required minimum interest of N50.

- A cash discount should be accepted by a debtor if the effective cost is more than short term cost of fund and should be rejected if otherwise;

- A supplier can give cash discount if the effective cost is less than short term cost of fund but should not give if otherwise

Cash budgets:

Liquidity and cashflow management are key factors in the successful operation of any organisation and it is with good reason that the cash budget should receive close attention from both accountant and mangers.

The cash budget shows the effect of budgeted activities*** selling, buying, paying wages, investing in capital equipment and so on *** on the cash flow of the organisation. Cash

70

budgeting is a continuous activity with budgets being rolled forward as time progresses. The budgets are usually subdivided into reasonably short period *** months or weeks.

A cash budget synchronizes anticipated cash receipts with anticipated cash payments. It considers both the magnitude and timing of cashflow over a period. It is prepared in order to ensure that there will be just sufficient cash in hand to cope adequately with planned activities. The cash budget may show that there is likely to be a deficiency of cash in some future period *** in which case overdraft or loans will have o be arranged or activities curtailed or alternatively the budget may be show that there is likely to be a cash surplus, in which case appropriate investment or use for the surplus can be planned rather than merely leaving the cash idle in a current account.

Cash budgets are good examples of rolling budget, i.e. where the process of continuous budgeting takes place whereby regularly each period (week, month, quarter as appropriate) a new future period is added to the budget whilst the earliest period is deleted. In this way the rolling budget is continually revised so as to reflect the most up to date position. The process of continuous budgeting could, of course, be carried out for any type of budget, not just cash budgets.

Illustration:

The opening cash balance on 1 January was expected to be N30,000. the sales budgeted were as follows:

NNovember 80,000December 90,000January 75,000February 75,000March 80,000

Analysis of records shows that debtors settle according to the following pattern:60% within the month of sale25% the month following15% the month following

Extracts from the Purchases budget were as follows: N

December 60,000January 55,000February 45,000March 55,000

* All purchases are on credit and experience shows that 90% are settled in the month of purchase and that the balance is settled the month after.

71

* Wages are N15,000 per month and overheads of N20,000 per month (including N5,000 depreciation) are settled monthly.

* Taxation of N8,000 has to be settled in February and the company will receive settlement of an insurance claim of N25,000 in March.Prepare a cash budget for January, February and March.

SolutionWorkings Notes:Receipts from sales NJanuary cash: November (15%) X 80,000) 12,000

December (25% X 90,000) 22,500January (60% X 75,000) *****

*****

February cash: December ******December (25% X 75,000) 22,500January (60% X 75,000) *****

March cash: January (15% X 75,000) ******** February (25% X 75,000) ******** March (60% X 75,000) ********

Payments for Purchases N

January cash: December (10% X 60,000) 6,000January (90% X 55,000 49,500

55,500

February cash: January (10% X 55,000) 5,500February (90% X 45,000) 40,500

54,000

March cash: February (10% X 45,000) 4,500 March (90% X 55,000) 49,500

54,000

72

CHAPTER NINE

STOCK CONTROL

Inventory or stock control is a qualitative control technique with strong financial implications. For many organisations inventory control in perhaps the single most important control technique having direct relationships with production, marketing, purchasing and financial policies.

The main objective of stock control is to minimise the total costs associated with holding and ordering stock. These costs include storage, insurance, the cost of capital tied up in stock, and administrative costs of placing an order.

Only relevant costs, that is, costs, affected by stock ordering and stockholding decisions, need be considered. Thus unless discounts are available for large orders, the cost of the stock itself is irrelevant because total purchases per year will be the same, whether a few large orders or small orders are made.

Types of Inventory

A convenient classification of the types of inventory is as follows: Raw materials: The materials, components, fuels etc. Used in manufacture of products.Work-in-progress (WIP): Partly finished goods and materials, sub-assemblies etc. held between manufacturing stages.Finished goods: completed products ready for sale or distribution.

The particular items included in each classification depends on the particular firm. What would be classified as a finished product for one company might be classified as raw materials for another.

For example, steel bars would be classified as a finished product for steel mill and raw material for a nut and bolt manufacturer.

Reasons for Holding Stocks:

The main reasons for holding stocks can be summarised as follows:* to ensure sufficient goods are available to meet anticipated demand;* to absorb variations in demand and production;* to provide a buffer between production processes. This is applicable to work-in-progress

stocks which effectively decouple operations;* to take advantage of bulk purchasing discounts;* to meet possible shortage in usage or demand;* to enable production processes to flow smoothly and efficiently;* as a necessary part of the production process, e.g. The ***** maturing of whiskey;* as deliberate investment policy particularly in times of inflation or possible shortage.

73

Alternative Reasons for Stocks

The reasons given above are the logical ones based on deliberate decisions. However, stocks accumulate for other, less praises worthy reasons, typical of which are the following:

a) Obsolete items are retained in stock

b) Poor or non-existent inventory control resulting in over-large orders, replenishment orders being out of pahse with production, etc.

c) Inadequate or non-existent stock records.

d) Poor liaison between the Production Control, Purchasing and Marketing departments.

e) Sub-optimal decision making, e.g. the Production Department might increase W-I-P stocks unduly so as to ensure long production runs.

Stocks Costs

Whether because of deliberate policy or not, stock represents an investment by the organisation. As with any other investment, the cost of holding stock must be related to the benefits to be gains. To do this effectively, the costs must be identified and this can be done in three categories: costs of holding stock, costs of obtaining stock, and stockout costs.

Costs of Holding Stock

These costs, also known as CARRYING costs, include the following:a) Interest on capital invested in the stock.

b) Storage charges (rent, lighting, heating, refrigeration, air conditioning, etc).

c) Stores staffing, equipment maintenance and running cost’s

d) Handing costs

e) Audit, stocktaking or inventory costs

f) Insurance and security

g) Deterioration and obsolescence

h) Pilferage, vermin damage, etc.

74

Costs of Obtaining Stock:

These costs, sometimes known as ORDERING costs, include the following:

a) The clerical and administrative costs associated with the Purchasing, Accounting, and Goods Received departments.

b) Transport costs. Where goods are manufactured internally, the set up and tooling costs associated with each production run.

Note: Some students consider ordering costs to include only those costs associated with ordering external to the firm. However, internal ordering (i.e. own manufacture) may involve high cost for production planning, set-up, **** tooling.

Stockout Costs:

These are the costs associated with running out of stock. The avoidance of these costs is the basic reason why stocks are held in the first instance. These costs include the following:Lost contribution through the lost sales caused by the stockout.

* Loss of future sales because customers go elsewhere.* Loss of customer goodwill* Cost of production stoppages caused by stockouts of W–I–P or raw materials.* Labour frustration over stoppages.* Extra costs associated with urgent, often small quantity replenishment purchases.

Clearly, many of these costs are difficult to quantity, but they are often significant.

Consequences of Unduly High Stock Levels:

a) Loss of interest on capital (opportunity cost) tied down in stocksb) Higher insurance costsc) Risk of theft or pilferaged) Risk of damage or firee) Obsolescence. Objective of / Need For Inventory Control

The overall objective of inventory control is to maintain stock levels so that the combing costs detailed above, are at a minimum. This is done bye establishing two factors, when to order and how many to order.

75

Basic Terminology

* Lead or Procurement time: The period of time, expressed in days, weeks, months, etc, between ordering (either externally or internally) and replenishment, i.e., when the goods are available for use.

* Demand: The amount required by sales, production, etc. Usually expressed as a rate of demand per week, month or year. Estimates of the rate of demand the lead-time are critical factors in inventory control systems.

* Economic Ordering Quantity (EOQ) or Economic batch Quantity (EBQ): This is a calculated ordering quantity, which minimizes the balance of cost between inventory holding costs and reorder costs.

* Physical Stock: The number of items physically in stock at a given *********

76

CHAPTER TENBUSINESS VALUATION

Introduction

Values and Forecast

There are several basis of valuation, all of which depend on forecasts. A purchaser buys a business or an individual asset for the income which he expects it to produce in the future.

To the extent that valuations are based on predictions of the future, it is therefore uncertain figures which reflect the optimism or pessimism of the person making the valuation.

In any negotiation or litigation concerning business or share valuation, many experts will arrive at different amounts reflecting different expectations of future events, indeed many valuer will give ranges of value within which they believe the correct figure lies.

A single share has no determined value in isolation, its value depends on:

(a) Who own the shares and how many?

(b) How the shareholders are distributed?

(c) What he intends to do with the shares?

Circumstance of Valuation

1. Capital transfer tax

2. Merger or takeover

3. Acquisition of minority interest

4. When a private company wants to go public

5. When shares are pledged as collateral for a loan

6. When shares are sold

Theoretical Value of a Business

In theory, the purchaser of a business is buying a stream of future income (cashflows), to arrive at a suitable purchase price, the purchaser will:

77

i. estimate likely cashflows;

ii. discount cashflows to their present value

iii. add together the separate amounts to give the present value of the income stream.

Where future cashflows are constant to perpetuity:

where A= constant cashflows r = cost of capital

Illustration

People Limited intends to acquire Ayilara Limited, the acquisition will lead to an income of N10,000 per annum for 10 years, assuming a discount rate of 20%, what is the maximum price to pay for the asset?

PV = 10,000 x (CDF at 20% for 10 years) = 10,000 x 4.2 = N42,000

From above calculation, prospective purchaser would be willing to pay up to N42,000 for the business. Any change in the estimates of income, or the appropriate discount rate would affect the valuation.

Note: Income stream (cashflows) is not reported profit figure which appears on the business profit and loss account but the cashflows resulting from the acquisition of the item being valued.

The income stream may be adjusted if prospective purchaser believes that the use of the business assets in a different combination and by different users will produce a higher income stream.

Basis of Valuation

A valuation may therefore be based on

a. Earnings

b. Assets

An earnings based valuation values the business according to the total stream of expected income.

78

An Assets based valuation arrives at the value of a business by adding together the values of the individual assets and subtracting liabilities.

There are several ways of arriving at a valuation based on earnings, these are:

1. Earnings Yield ValuationThis is simply earnings expressed as a percentage of the market value of a business.

where EY = Earnings yield E = EarningsMV= Market value

It therefore follows that, given the expected level of earnings, we can obtain the market value as follows:

Illustration: Estimated maintainable earnings is N240,000 p.a and the earnings yield is 25%. Calculate the value of the business.

N960,000

2. Price Earning Ratio Valuation

Price Earning ratio is the measure of how many years earnings will purchase the market value of the business.

P/E ratio may be based oni. Historic P/E - Last audited accountii. Current P/E - Current resultiii. Future P/E - Earnings of future year

P/E ratio is expressed as

It will be seen that the value of a business can be calculated from the estimated earnings and the required P/E ratio,

i.e. MV =P/E x E or Price Earning X Earning

Illustration

Estimated maintainable earnings is N240,000 per annum.The P/E ratio is 4. Calculate the value of the business.

79

MV = 240,000 x 4 = 960,000

3. Super Profit Valuation (Dual Capitalisation Method)

This basis regards earnings as consisting of two elements:

a. Normal profits - which might be earned by any company in the trade

b. Super Profits - the additional profits being earned by the business under consideration because of a variety of factors operating its favour.

The procedure is as follows:

i. Estimate the maintainable earnings

ii. Estimate the going concern value of net tangible assets (excluding goodwill).

iii. Apply the “normal” rate of return to the value in (ii) above, to determine the normal level of earnings.

iv. Deduct the “normal” earnings from the estimated maintainable earnings to obtain the super profits.

v. Capitalized the super profit by a higher required yield (or lower P/E).

The total value of the business is then found by adding together the capital value of the “normal” profits and the capital value of the “super” profits.

Illustration

Estimated maintainable earnings of Abiola Limited is N240,000. The going concern value of net tangible assets is N800,000. A 25% return is required on “normal” profits and a 40% return on “super” profits. Calculate the value of the business.

N25% return on N800,000 is 200,000Estimated maintainable earnings 240,000“Super” profits 40,000

Capitalized value of “Super” profits is

80

N

Total capital values of earnings are:“Normal” earnings 800,000“Super” profits 100,000

900,000Super profits and goodwill are usually closely related, from above calculation, the value of the goodwill could be said to be N100,000.

4. Dividend Yield

This is the gross dividend expressed as an annual rate of return on the share price i.e.

Dividend yield =

Thus market value =

5. Asset BasisThe purchaser of a business is buying a collection of assets. If the management of the business has not been very efficient, the total historic earnings produced by the collection of assets may not provide a realistic basis of valuation. The following bases are in general use:

a. Current Market Value

This represents to current market value of the company assets i.e. cost of setting up equivalent venture.

b. Break-up Value

This represent the value of the company’s assets if sold in piecemeal.

Berliner Method

This attempts to take into consideration both the asset value of a company and its earnings potential. Two values of the company are obtained:

i. Value based on capitalizing expected future profits at an acceptable rate of return.ii. Value based on going-concern value of the company’s net tangible assets.

The value placed on the company is then calculated as

81

This method is a compromise without any particular theoretical backing but it may produce an acceptable purchase figure.

Meaning of a Value

The value of a share or business is the amount a fully informed purchaser will pay a fully informed seller in an arms length transaction.

The implications are:

a. Value depend on the Company’s ability to generate earnings

b. Value may vary according to the position of the buyer and the company being acquired i.e. is the shares being acquired for the purpose of interfering in the management of the company or not. Furthermore, it is the size relative to any existing shareholding i.e. to a 49% shareholder, a further 2% is critical.

82

CHAPTER ELEVEN

MERGERS AND ACQUISITION

Organisation grow in size and complexity for a number of reasons.

1. Increase in demand for their product

2. Ambitions of those in command e.g. to increase power and to increase financial benefit/position.

3. Fear of being take-over

Business combination can take the following forms:

1. Vertical integration: i.e. combination of two firms which are in the same industry but at different stages in the process of producing and selling a product, if a company were to take over a supplier of raw material this is known as backward vertical integration.

2. Horizontal integration: i.e. where a firm takes over or merges with a company in the same industry and at the same level with that industry e.g. A merger with a Direct Competitor.

3. Conglomerate Merger/Take Over: i.e. where two firms which are unrelated or only, indirect related combined.

Reasons for Acquisition

a. Purchase To achieve economies of size in buyingTo secure scarce raw materials

b. Production To achieve economies of scaleTo standardized productTo acquire expertise

c. Marketing To diversify into other products/market conglomerateTo eliminate competition To rationalize distribution

83

d. Research and Development To buy ideas and projectsTo gain access into the capital marketTo obtain a stock exchange quotation

To obtain economies in capital expenditure To obtain tax benefit To improve earnings per shareTo achieve greater asset backing as security for further loans

f. General To buy management skillTo fend off a potential bidder-you want to be so large to fend off a potential bidder

Factors to Consider in All Possible Acquisitions

1. Ownership - What is the share structure, do share carry votes, who are the main shareholders, how important are the institutional investors.

2. Management - How good is the existing management.

3. Finance - How much is to be placed on the vendor company.

- How is the purchase consideration going to be settled.

4. Competition - The market situation which the company will find itself if the acquisition is successful.

5. Rival Bidders - The existence of and competitive strength of rival bidders must be considered

6. Taxation - The possibility of any tax advantage must be considered.

De-Merger

This is the splitting up of a corporate body into two or more separate and independent bodies.

84

Method of Effecting a De-Merger

The method will depend upon the existing organization i.e. whether their activities are merely division or whether they are separately formed subsidiaries.

The possible methods are:

1. To sell the share capital of unwanted subsidiary either to another company i.e. labour buy out or to the existing management i.e. management buy out. The major problem is how the value is determine.

2. To liquidate the Net Assets by piece-meal realization. This may involve redundancy payment that may give rise to possible loss of goodwill with employees, customers and suppliers.

3. A reconstruction scheme involving the setting up of separate company’s with the distribution of shares of the unwanted company.

Benefit of a De-Merger

1. To sell off an unprofitable subsidiary.

2. To make a profit on the sale of subsidiary

3. Sell of a subsidiary with a higher risk in its operating CF so as to reduce the business risk of a company as a whole.

4. To sell of a subsidiary that is not part of a core business of the group.

5. To give greater autonomy to Local Management in order to encourage personal motivation and improved result.

6. To effect the sale of one activity to raise finance essential for the survival of the remaining activity of the company.

Disadvantages

1. Loss of Economies of scale

2. Lower turnover and status for the company

3. A lesser ability to raise extra finance especially debt finance to support new investment and expansion.

85