FM-AU New

ADAMA SCIENCE AND TECHNOLOGY UNIVERSITY
SCHOOL OF BUSINESS AND ECONOMICS

INTERNATIONAL TRADE AND INVESTMENT MANAGEMENT
DEPARTMENT
Financial Management (Acct 311)
UNIT 1: THE NATURE AND SCOPE OF FINANCIAL MANAGEMENT
1.1 An overview of Financial Management
To have a good understanding of financial management, you need to understand first To have a good understanding of financial management, you need to understand first
what finance is. Literally, finance means the money used in day-to-day activities of an what finance is. Literally, finance means the money used in day-to-day activities of an
individual or a business for exchange of goods and services. But here our focus rather individual or a business for exchange of goods and services. But here our focus rather
should be to consider finance as a separate and distinct field of study like accounting, should be to consider finance as a separate and distinct field of study like accounting,
economics, mathematics, history, geography etc. economics, mathematics, history, geography etc.
1.1.1 1.1.1 What Is Finance? What Is Finance?
Finance is a distinct area of study that comprises facts, theories, concepts, principles, Finance is a distinct area of study that comprises facts, theories, concepts, principles,
techniques and practices related with raising and utilizing of funds (money) by techniques and practices related with raising and utilizing of funds (money) by
individuals, businesses, and governments. individuals, businesses, and governments.
Finance is a very wide and dynamic field of study. Therefore, finance is also an area of Finance is a very wide and dynamic field of study. Therefore, finance is also an area of
study that deals with how, where, by whom, why, and through what money is transferred study that deals with how, where, by whom, why, and through what money is transferred
among and between individuals, businesses, and governments. It is concerned with the among and between individuals, businesses, and governments. It is concerned with the
processes, institutions, markets, and instruments involved in the transfer of funds. processes, institutions, markets, and instruments involved in the transfer of funds.
In addition to principles and techniques, finance requires individual judgment of the In addition to principles and techniques, finance requires individual judgment of the
person making the financial decision. Hence, finance can also be defined as person making the financial decision. Hence, finance can also be defined as the art and the art and
science of managing money. science of managing money.
1.1.2 1.1.2 Meaning of Financial Management Meaning of Financial Management
Financial management can be defined as a decision making process concerned with Financial management can be defined as a decision making process concerned with
planning for raising, and utilizing funds in a manner that achieves the goal of a firm. planning for raising, and utilizing funds in a manner that achieves the goal of a firm.
Financial management is sometimes called corporate finance, business finance, and Financial management is sometimes called corporate finance, business finance, and
managerial finance. These terms are used interchangeably in this material. managerial finance. These terms are used interchangeably in this material.
Financial Management - I, BY Abdi .D Page 1
There are many specified business functions performed by a business unit. These include There are many specified business functions performed by a business unit. These include
marketing, production, human resource management, and financial management. marketing, production, human resource management, and financial management.
Financial management is one of the important functions of a firm. It is a specified Financial management is one of the important functions of a firm. It is a specified
business function that deals with the management of capital sources and uses of a firm. business function that deals with the management of capital sources and uses of a firm.
1.1.3 1.1.3 FINANCE AND RELATED FIELDS FINANCE AND RELATED FIELDS
Though finance had ceded itself from economics, it is not totally an independent field of Though finance had ceded itself from economics, it is not totally an independent field of
study. It is an integral part of the firms overall management. Finance heavily draws study. It is an integral part of the firms overall management. Finance heavily draws
theories, concepts, and techniques from related disciplines such as economics, theories, concepts, and techniques from related disciplines such as economics,
accounting, marketing, operations, mathematics, statistics, and computer science. Among accounting, marketing, operations, mathematics, statistics, and computer science. Among
these disciplines, the field of finance is closely related to economics and accounting. these disciplines, the field of finance is closely related to economics and accounting.
1.1.3.1 1.1.3.1 Finance versus Economics Finance versus Economics
Finance and economics are closely related in many aspects. First, economics is the Finance and economics are closely related in many aspects. First, economics is the
mother field of finance. Second, the economic environment within which a firm operates mother field of finance. Second, the economic environment within which a firm operates
influences the decisions of a financial manger. A financial manger must understand the influences the decisions of a financial manger. A financial manger must understand the
interrelationships between the various sectors of the economy. He must also understand interrelationships between the various sectors of the economy. He must also understand
such economic variables as a gross domestic product, unemployment, inflation, interests, such economic variables as a gross domestic product, unemployment, inflation, interests,
and taxes in making financial decisions. and taxes in making financial decisions.
Financial mangers must also be able to use the structure of decision-making provided by Financial mangers must also be able to use the structure of decision-making provided by
economics. They must use economic theories as guidelines for their efficient financial economics. They must use economic theories as guidelines for their efficient financial
decision making. These theories include pricing theory through the relationships between decision making. These theories include pricing theory through the relationships between
demand and supply, return analysis, profit maximization strategies, and marginal demand and supply, return analysis, profit maximization strategies, and marginal
analysis. The last one, particularly, is the primary economic principle used in financial analysis. The last one, particularly, is the primary economic principle used in financial
management. management.
Basic Differences between Finance and Economics Basic Differences between Finance and Economics
i) i) Finance is less concerned with theory than is economics. Finance is basically Finance is less concerned with theory than is economics. Finance is basically
concerned with the application of theories and principles. concerned with the application of theories and principles.
ii) ii) Finance deals with an individual firm; but economics deals with the industry Finance deals with an individual firm; but economics deals with the industry
and the overall level of the economic activity. and the overall level of the economic activity.
1.1.3.2 1.1.3.2 Finance versus Accounting Finance versus Accounting
Accounting provides financial information through financial statements. Therefore, these Accounting provides financial information through financial statements. Therefore, these
two fields are closely linked as accounting is an important input for financial decision- two fields are closely linked as accounting is an important input for financial decision-
making. Besides, the accounting and finance functions generally overlap; and usually it is making. Besides, the accounting and finance functions generally overlap; and usually it is
difficult to distinguish them. In many situations, the accounting and finance activities are difficult to distinguish them. In many situations, the accounting and finance activities are
within the control of the financial manager of a firm. within the control of the financial manager of a firm.
Basic Differences between Finance and Accounting Basic Differences between Finance and Accounting
i) i) Treatment of income: - Treatment of income: - in accounting income measurement is on accrual in accounting income measurement is on accrual
basis. Under this method revenues are recognized as earned and expenses as basis. Under this method revenues are recognized as earned and expenses as
incurred. In finance, however, the cash method is employed to recognize the incurred. In finance, however, the cash method is employed to recognize the
revenue and expenses. revenue and expenses.
ii) ii) Decision-making: - Decision-making: - the primary function of accounting is to gather and the primary function of accounting is to gather and
present financial data. Finance, on the other hand, is primarily concerned with present financial data. Finance, on the other hand, is primarily concerned with
financial planning, controlling and decision-making. The financial manger financial planning, controlling and decision-making. The financial manger
evaluates the financial statements provided by the accountant by applying evaluates the financial statements provided by the accountant by applying
additional data and then makes decisions accordingly. additional data and then makes decisions accordingly.
iii) iii) Accounting is highly governed by generally accepted accounting principles. Accounting is highly governed by generally accepted accounting principles.
1.2 GOAL OF THE FIRM AND AGENCY PROBLEM
1.2.1. THE NEED FOR A GOAL 1.2.1. THE NEED FOR A GOAL
Recall that financial management is concerned with decision making to achieve the goal Recall that financial management is concerned with decision making to achieve the goal
of a firm. But the question is what is this goal of a firm? Before trying to address the of a firm. But the question is what is this goal of a firm? Before trying to address the
question, let us first describe the meaning of a goal. question, let us first describe the meaning of a goal.
A goal or an objective provides a framework for the decision maker. In most cases, the A goal or an objective provides a framework for the decision maker. In most cases, the
goal is stated in terms of maximizing or minimizing some variable. A goal, therefore, is goal is stated in terms of maximizing or minimizing some variable. A goal, therefore, is
an explicit operational guide or decision rule for the decision maker. an explicit operational guide or decision rule for the decision maker.
A firm might have a number of alternative goals at a point in time when evaluating a A firm might have a number of alternative goals at a point in time when evaluating a
given course of action. These goals include maximization of profits, size, value, social given course of action. These goals include maximization of profits, size, value, social
welfare or minimization of costs, risk etc. welfare or minimization of costs, risk etc.
1.2.2 PROFIT MAXIMIZATION AS A DECISION RULE 1.2.2 PROFIT MAXIMIZATION AS A DECISION RULE
1.2.2.1 Meaning of Profit Maximization 1.2.2.1 Meaning of Profit Maximization
Profit maximization is a function of maximizing revenue and /or minimizing costs. If a Profit maximization is a function of maximizing revenue and /or minimizing costs. If a
firm is able to maximize its revenues for a given level of costs or minimizing costs for a firm is able to maximize its revenues for a given level of costs or minimizing costs for a
given level of revenues, it is considered to be efficient. given level of revenues, it is considered to be efficient.
Profit maximization focuses on the total amount of benefits of any courses of action. This Profit maximization focuses on the total amount of benefits of any courses of action. This
decision rule as applied to financial management implies that the functions of managerial decision rule as applied to financial management implies that the functions of managerial
finance should be oriented to making of money. Under the profit maximization decision finance should be oriented to making of money. Under the profit maximization decision
criteria, actions that increase profit of a firm should be undertaken; and actions that criteria, actions that increase profit of a firm should be undertaken; and actions that
decrease profit should be rejected. Similarly, given alternative courses of actions, decrease profit should be rejected. Similarly, given alternative courses of actions,
decisions would be made in favor of the one with the highest expected profits. decisions would be made in favor of the one with the highest expected profits.
Profit maximization, though widely professed, should not be used as a good goal of a Profit maximization, though widely professed, should not be used as a good goal of a
firm in financial management. This is because it fails to meet many of the characteristics firm in financial management. This is because it fails to meet many of the characteristics
of a good goal. of a good goal.
1.2.2.2 Limitations of Profit Maximization 1.2.2.2 Limitations of Profit Maximization
1. Ambiguity. 1. Ambiguity. The term profit or income is vague and ambiguous concept. It is very The term profit or income is vague and ambiguous concept. It is very
illusive and has no precise connotation. Different people understand profit in different illusive and has no precise connotation. Different people understand profit in different
several ways. There are many different economic and accounting definitions of profit, several ways. There are many different economic and accounting definitions of profit,
each open to its own set of interpretations. Even in accounting profit might refer to short- each open to its own set of interpretations. Even in accounting profit might refer to short-
term or long-term profit, total profit or profit on a per share basis (earnings per share), term or long-term profit, total profit or profit on a per share basis (earnings per share),
and before or after text profit. Then, the question or the problem would be which profit is and before or after text profit. Then, the question or the problem would be which profit is
to be maximized? Maximizing one may lead to minimizing the other. to be maximized? Maximizing one may lead to minimizing the other.
Furthermore, problems related to inflation and international currency transactions Furthermore, problems related to inflation and international currency transactions
complicate the issue of profit maximization. complicate the issue of profit maximization.
2. Cash flows. 2. Cash flows. The profit a firm has reported does not represent the cash flows to the The profit a firm has reported does not represent the cash flows to the
business. Firms reporting a very high total profit or earnings per share might face business. Firms reporting a very high total profit or earnings per share might face
difficulty of paying cash dividends to stockholders. Sometimes, companies might even difficulty of paying cash dividends to stockholders. Sometimes, companies might even
declare bankruptcy though reporting a positive income declare bankruptcy though reporting a positive income
3. Timing of Benefits. 3. Timing of Benefits. The profit maximization criterion ignores the differences in the The profit maximization criterion ignores the differences in the
time pattern of benefits received from investment proposals. This criterion does not time pattern of benefits received from investment proposals. This criterion does not
consider the distinction between returns (benefits) received in different time periods and consider the distinction between returns (benefits) received in different time periods and
treats all benefits as equally valuable irrespective of the time pattern differences in treats all benefits as equally valuable irrespective of the time pattern differences in
benefits. In other words, the profit maximization ignores the time value of money, i.e., benefits. In other words, the profit maximization ignores the time value of money, i.e.,
money today is better than money tomorrow. Also it does not consider the sooner, the money today is better than money tomorrow. Also it does not consider the sooner, the
better principle. better principle.
To understand this limitation better let us consider the following example. To understand this limitation better let us consider the following example.
Example Example Akaki Manufacturing Share Company wants to choose between two projects: Akaki Manufacturing Share Company wants to choose between two projects:
project X and project Y. both projects cost the same, are equally risky and are expected to project X and project Y. both projects cost the same, are equally risky and are expected to
provide the following benefits over three years period. provide the following benefits over three years period.
BENEFITS (PROFITS) BENEFITS (PROFITS)
YEAR YEAR PROJECT X PROJECT X PROJECT Y PROJECT Y
1 1 Br. 25,000 Br. 25,000 Br. 0- Br. 0-
2 2 50,000 50,000 50,000 50,000
3 3 0- 0- 25,000 25,000
TOTAL TOTAL Br. 75,000 Br. 75,000 Br. 75,000 Br. 75,000
The profit maximization criterion ranks both projects as being equal. However, project X The profit maximization criterion ranks both projects as being equal. However, project X
provides higher benefits in earlier years and project Y provides larger benefits in later provides higher benefits in earlier years and project Y provides larger benefits in later
years. The higher benefits of project X in earlier years could be reinvested to earn even years. The higher benefits of project X in earlier years could be reinvested to earn even
higher profits for later years. Profit seeking organizations must consider the timing of higher profits for later years. Profit seeking organizations must consider the timing of
cash flows and profits because money received today has a higher value than money cash flows and profits because money received today has a higher value than money
received tomorrow. Cash flows in early years are valued more highly than equivalent received tomorrow. Cash flows in early years are valued more highly than equivalent
cash flows in later years. cash flows in later years.
4. Quality of Benefits (Risk of Benefits). 4. Quality of Benefits (Risk of Benefits). Profit maximization assumes that risk or Profit maximization assumes that risk or
uncertainty of future benefits is of no concern to stockholders. Risk is defined as the uncertainty of future benefits is of no concern to stockholders. Risk is defined as the
probability that actual benefit will differ from the expected benefit. Financial decision probability that actual benefit will differ from the expected benefit. Financial decision
making involves a risk-return trade-off. This means that in exchange for taking making involves a risk-return trade-off. This means that in exchange for taking
greater risk, the firm expects a higher return. The higher the risk, the higher the greater risk, the firm expects a higher return. The higher the risk, the higher the
expected return. expected return.
Example Example Nyala Merchandising Private Limited Company must choose between two Nyala Merchandising Private Limited Company must choose between two
projects. Both projects cost the same. Project A has a 50% chance that its cash flows projects. Both projects cost the same. Project A has a 50% chance that its cash flows
would be actual over the next three years. Project B, on the other hand, has a 90% would be actual over the next three years. Project B, on the other hand, has a 90%
probability that its cash flows for the next three years would be realized. probability that its cash flows for the next three years would be realized.
BENEFITS BENEFITS

YEAR YEAR PROJECT A PROJECT A PROJECT B PROJECT B
1 1 Br. 60,000 Br. 60,000 Br. 45,000 Br. 45,000
2 2 65,000 65,000 50,000 50,000
3 3 95,000 95,000 85,000 85,000
TOTAL TOTAL Br. 220,000 Br. 220,000 Br. 180,000 Br. 180,000
Under profit maximization, project A is more attractive because it adds more to Nyala Under profit maximization, project A is more attractive because it adds more to Nyala
than project B. However, if we consider the risk of the two projects, the situation would than project B. However, if we consider the risk of the two projects, the situation would
be reversed. be reversed.
Expected benefit of project A = Br. 220,000 x 50% = Br. 110,000 Expected benefit of project A = Br. 220,000 x 50% = Br. 110,000
Expected benefit of project B = Br. 180,000 x 90% = Br. 162,000 Expected benefit of project B = Br. 180,000 x 90% = Br. 162,000
In fact, risk can be measured in different ways, and different conclusions about the In fact, risk can be measured in different ways, and different conclusions about the
riskiness of a course of action can be reached depending on the measure used. In addition riskiness of a course of action can be reached depending on the measure used. In addition
to the probability distribution, illustrated above, risk can also be measured on the basis of to the probability distribution, illustrated above, risk can also be measured on the basis of
the variation of cash flows. the variation of cash flows.
The more certain the expected cash flow (return), the higher the quality of benefits (i.e., The more certain the expected cash flow (return), the higher the quality of benefits (i.e.,
low risk to investor). Conversely, the more uncertain or fluctuating the expected benefits, low risk to investor). Conversely, the more uncertain or fluctuating the expected benefits,
the lower the quality of benefits (i.e., high risk to investors). the lower the quality of benefits (i.e., high risk to investors).
1.2.3 WEALTH MAXIMIZATION AS A DECISION RULE 1.2.3 WEALTH MAXIMIZATION AS A DECISION RULE
1.2.3.1 1.2.3.1 Meaning of Wealth Maximization Meaning of Wealth Maximization
Wealth maximization means maximization of the value of a firm. Hence wealth Wealth maximization means maximization of the value of a firm. Hence wealth
maximization is also called value maximization or net present value (NPV) maximization is also called value maximization or net present value (NPV)
maximization. maximization.
Wealth maximization as a decision criterion is considered to be an ideal goal of a firm in Wealth maximization as a decision criterion is considered to be an ideal goal of a firm in
financial management. There are several reasons why wealth maximization decision financial management. There are several reasons why wealth maximization decision
criterion is superior to other criteria. First, it has an exact measurement unlike profit criterion is superior to other criteria. First, it has an exact measurement unlike profit
maximization. It depends on cash flows (inflows and outflows). Second, wealth maximization. It depends on cash flows (inflows and outflows). Second, wealth
maximization as a decision criterion considers the quality as well as the time pattern of maximization as a decision criterion considers the quality as well as the time pattern of
benefits. Third, it emphasizes on the long-term and sustainable maximization of a firms benefits. Third, it emphasizes on the long-term and sustainable maximization of a firms
common stock price in the financial market. Fourth, wealth maximization gives common stock price in the financial market. Fourth, wealth maximization gives
recognition to the interest of other stakeholders and to the societal welfare on the long- recognition to the interest of other stakeholders and to the societal welfare on the long-
term basis. term basis.
Technically, wealth maximization as a decision rule involves a comparison of value to Technically, wealth maximization as a decision rule involves a comparison of value to
cost. Thus, an action that has a discounted value that exceeds its cost can be said to create cost. Thus, an action that has a discounted value that exceeds its cost can be said to create
value and such action should be undertaken. Whereas an action with less discounted value and such action should be undertaken. Whereas an action with less discounted
value than cost reduces wealth and, therefore, should be rejected. The discounted value is value than cost reduces wealth and, therefore, should be rejected. The discounted value is
a value which takes risk and timing of benefits into account. a value which takes risk and timing of benefits into account.
1.2.3 1.2.3 CONFLICT OF GOALS BETWEEN MANAGEMENT AND OWNERS AND
AGENCY PROBLEM
As you understand, in a corporate form of business organization owners (stockholders) As you understand, in a corporate form of business organization owners (stockholders)
do not run the activities of the firm. Rather, the stockholders elect the board of directors, do not run the activities of the firm. Rather, the stockholders elect the board of directors,
who in turn assign the management on behalf of the owners. So, basically, managers are who in turn assign the management on behalf of the owners. So, basically, managers are
agents of the owners of the corporation and they undertake all activities of the firm on agents of the owners of the corporation and they undertake all activities of the firm on
behalf of these owners. Managers are agents in a corporation to maximize the common behalf of these owners. Managers are agents in a corporation to maximize the common
stockholders well-being. stockholders well-being.
However, there is a conflict of goals between managers and owners of a corporation and However, there is a conflict of goals between managers and owners of a corporation and
mangers may act to maximize their interest instead of maximizing the wealth of owners. mangers may act to maximize their interest instead of maximizing the wealth of owners.
Managers are interested to maximize their personal wealth, job security, life style and Managers are interested to maximize their personal wealth, job security, life style and
fringe benefits. fringe benefits.
The natural conflict of interest between stockholders and managerial interest create The natural conflict of interest between stockholders and managerial interest create
agency problems. Agency problems are the likelihood that mangers may place their agency problems. Agency problems are the likelihood that mangers may place their
personal goals a head of corporate goals. Theoretically, agency problems are always there personal goals a head of corporate goals. Theoretically, agency problems are always there
as long as mangers are agents of owners. as long as mangers are agents of owners.
Corporations (owners) are aware of these agency problems and they incur some costs as a Corporations (owners) are aware of these agency problems and they incur some costs as a
result of agency. These costs are called agency cost and include: result of agency. These costs are called agency cost and include:
1. 1. Monitoring expenditures Monitoring expenditures are expenditures incurred by corporations to monitor or are expenditures incurred by corporations to monitor or
control the activities of managers. A very good example of a monitoring expenditure control the activities of managers. A very good example of a monitoring expenditure
is fees paid by corporations to external auditors. is fees paid by corporations to external auditors.
2. 2. Bonding expenditures Bonding expenditures are cost incurred to protect dishonesty of mangers and other are cost incurred to protect dishonesty of mangers and other
employees of a firm. Example: fidelity guarantee insurance premium. employees of a firm. Example: fidelity guarantee insurance premium.
3. 3. Structuring expenditures Structuring expenditures expenditures made to make managers fell sense of expenditures made to make managers fell sense of
ownership to the corporation. These include stock options, performance shares, cash ownership to the corporation. These include stock options, performance shares, cash
bonus etc. bonus etc.
1.3 THE FUNCTIONS OF FINANCIAL MANAGEMENT
This refers to the special activities or purposes of financial management. The functions of This refers to the special activities or purposes of financial management. The functions of
financial management are planning for acquiring and utilizing funds by a firm as well as financial management are planning for acquiring and utilizing funds by a firm as well as
distributing funds to the owners in ways that achieve goal of the firm. distributing funds to the owners in ways that achieve goal of the firm.
In general, the functions of financial management include three major decisions a firm In general, the functions of financial management include three major decisions a firm
must make. These are: must make. These are:
Financing decisions Financing decisions
Investment decisions Investment decisions
Dividend decisions Dividend decisions
1.3.1 Financing Decisions 1.3.1 Financing Decisions
The financing decisions The financing decisions deal with the financing deal with the financing of the firms investments, i.e., decisions of the firms investments, i.e., decisions
whether the firm should whether the firm should use equity or debt use equity or debt funds in order to finance its assets. They are funds in order to finance its assets. They are
also concerned with determining the most appropriate composition of short term and also concerned with determining the most appropriate composition of short term and
long term financing. In simple terms, the financing decisions deal with determining the long term financing. In simple terms, the financing decisions deal with determining the
best financing mix or capital structure of the firm. best financing mix or capital structure of the firm.
The financing decisions of a firm are generally concerned with the right side of the basic The financing decisions of a firm are generally concerned with the right side of the basic
accounting equation. accounting equation.
1.3.2 Investment Decisions 1.3.2 Investment Decisions
They deal with allocation of the firms scarce financial resources among competing uses. They deal with allocation of the firms scarce financial resources among competing uses.
These decisions are concerned with the management of assets by allocating and utilizing These decisions are concerned with the management of assets by allocating and utilizing
funds within the firm. Specifically, the investment decisions include: funds within the firm. Specifically, the investment decisions include:
i) i) Determining the asset mix or composition: - Determining the asset mix or composition: - determining the total amount of determining the total amount of
the firms finance to be invested in current and fixed assets. the firms finance to be invested in current and fixed assets.
ii) ii) Determining the asset type: - Determining the asset type: - determining which specific assets to maintain determining which specific assets to maintain
within the categories of current and fixed assets. within the categories of current and fixed assets.
iii) iii) Managing the asset structure Managing the asset structure, i.e., maintaining the composition of current , i.e., maintaining the composition of current
and fixed assets and the type of specific assets under each category. and fixed assets and the type of specific assets under each category.
The investment decisions of a firm also involve working capital management and capital The investment decisions of a firm also involve working capital management and capital
budgeting decisions. The former refers to those decisions of a firm affecting its current budgeting decisions. The former refers to those decisions of a firm affecting its current
assets and short term liabilities. The later, on the other hand, involves long term assets and short term liabilities. The later, on the other hand, involves long term
investment decisions like acquisition, modification, and replacement of fixed assets. investment decisions like acquisition, modification, and replacement of fixed assets.
Generally, the investment decisions of a firm deal with the left side of the basic Generally, the investment decisions of a firm deal with the left side of the basic
accounting equation: A = L + OE (Assets = Liabilities + Owners Equity). accounting equation: A = L + OE (Assets = Liabilities + Owners Equity).
1.3.3 Dividend Decisions 1.3.3 Dividend Decisions
The dividend decisions address the question how much of the cash a firm generates from The dividend decisions address the question how much of the cash a firm generates from
operations should be distributed to owners in the form of dividends and how much should operations should be distributed to owners in the form of dividends and how much should
be retained by the business for further expansion. There are trade offs on the dividend be retained by the business for further expansion. There are trade offs on the dividend
policy of a firm. On the one hand, paying out more dividends will make the firm to be policy of a firm. On the one hand, paying out more dividends will make the firm to be
perceived strong and healthy by investors; on the other hand, it will affect the future perceived strong and healthy by investors; on the other hand, it will affect the future
growth of the firm. So the dividend decision of a firm should be analyzed in relation to its growth of the firm. So the dividend decision of a firm should be analyzed in relation to its
financing decisions. financing decisions.
1.4 AN OVERVIEW OF THE FINANCIAL ENVIRONMENT 1.4 AN OVERVIEW OF THE FINANCIAL ENVIRONMENT
Finance people must understand not only the internal environment, but also the financial Finance people must understand not only the internal environment, but also the financial
environment and markets within which the firm operates. They need to know where environment and markets within which the firm operates. They need to know where
capital required is raised, where the financial instruments are traded, and how stock capital required is raised, where the financial instruments are traded, and how stock
prices are determined. prices are determined.
1.4.1 Financial Institutions 1.4.1 Financial Institutions
Financial institutions are financial intermediaries, which are specialized financial firms Financial institutions are financial intermediaries, which are specialized financial firms
that facilitate the transfer of funds from savers to demanders of capital. They accept that facilitate the transfer of funds from savers to demanders of capital. They accept
savings form customers and lend this money to other customers or they invest it. In many savings form customers and lend this money to other customers or they invest it. In many
instances, they pay savers interest on deposited funds. In some cases, they impose service instances, they pay savers interest on deposited funds. In some cases, they impose service
charges on customers for the services they render. For example, many financial charges on customers for the services they render. For example, many financial
institutions impose service charges on current accounts. institutions impose service charges on current accounts.
The key participants in financial transactions of financial institutions are individuals, The key participants in financial transactions of financial institutions are individuals,
businesses, and government. By accepting the savings from these parties, financial businesses, and government. By accepting the savings from these parties, financial
institutions transfer again to individuals, business firms, and governments. Since financial institutions transfer again to individuals, business firms, and governments. Since financial
institutions are generally large, they gain economies of scale in the transfer of money institutions are generally large, they gain economies of scale in the transfer of money
between savers and demanders. By pooling risks, they help individual savers to diversify between savers and demanders. By pooling risks, they help individual savers to diversify
their risk. their risk.
The major classes of financial institutions include commercial banks, savings and loan The major classes of financial institutions include commercial banks, savings and loan
associations, mutual savings banks, credit unions, pension funds and life insurance associations, mutual savings banks, credit unions, pension funds and life insurance
companies. Among these, commercial banks are by far the most common financial companies. Among these, commercial banks are by far the most common financial
institutions in many countries worldwide. In Ethiopia too, commercial banks are the institutions in many countries worldwide. In Ethiopia too, commercial banks are the
major institutions that handle the savings and borrowing transactions of individuals, major institutions that handle the savings and borrowing transactions of individuals,
businesses, and governments. businesses, and governments.
1.4.2 Financial Instruments 1.4.2 Financial Instruments
Financial instruments are written and formal documents of transferring funds between Financial instruments are written and formal documents of transferring funds between
and among individuals, businesses, and governments. They include loans and borrowing and among individuals, businesses, and governments. They include loans and borrowing
contracts, promissory notes, commercial papers, treasury bills, bonds, and stocks. contracts, promissory notes, commercial papers, treasury bills, bonds, and stocks.
Under normal circumstances, two parties are involved in any financial instrument. For Under normal circumstances, two parties are involved in any financial instrument. For
holders, who have invested their money, financial instruments are financial assets. A holders, who have invested their money, financial instruments are financial assets. A
financial asset gives the holder the right to claim against the income and assets of its financial asset gives the holder the right to claim against the income and assets of its
issuer. For the issuer, on the other hand, financial instruments represent either liabilities issuer. For the issuer, on the other hand, financial instruments represent either liabilities
or equity items. For instance, if you consider a bond, it represents an investment or equity items. For instance, if you consider a bond, it represents an investment
(financial asset) for the holder and a debt item for its issuer. Similarly, if you consider a (financial asset) for the holder and a debt item for its issuer. Similarly, if you consider a
common stock, it represents an investment and equity item for the holder and issuer common stock, it represents an investment and equity item for the holder and issuer
respectively. respectively.
The issuer gives the financial asset to the purchaser (holder) in exchange for some The issuer gives the financial asset to the purchaser (holder) in exchange for some
valuable consideration, usually in the form of cash or another financial asset. valuable consideration, usually in the form of cash or another financial asset.
1.4.3 Financial Markets 1.4.3 Financial Markets
Financial markets are markets in which financial instruments are bought and sold by Financial markets are markets in which financial instruments are bought and sold by
suppliers and demanders of funds. They, unlike financial institutions, are places in which suppliers and demanders of funds. They, unlike financial institutions, are places in which
suppliers and demanders of funds meet directly to transact business. suppliers and demanders of funds meet directly to transact business.
1.4.3.1 Functions of Financial Markets 1.4.3.1 Functions of Financial Markets
Generally, financial markets play Generally, financial markets play three important roles three important roles in functioning of corporate in functioning of corporate
finance. finance.
1. 1. They assist the capital formation process. Financial markets serve as a way They assist the capital formation process. Financial markets serve as a way
through which firms can obtain the capital they need for their operations and through which firms can obtain the capital they need for their operations and
investment. investment.
2. 2. Financial markets serve as resale markets for financial instruments. They create Financial markets serve as resale markets for financial instruments. They create
continuous liquid markets where firms can obtain the capital they need from continuous liquid markets where firms can obtain the capital they need from
individuals and other businesses easily (serve as a secondary market). individuals and other businesses easily (serve as a secondary market).
3. 3. They play a role in setting the prices of securities. The price of a financial They play a role in setting the prices of securities. The price of a financial
instrument is determined through the interaction of demand and supply of the instrument is determined through the interaction of demand and supply of the
security in the financial markets. security in the financial markets.
1.4.3.2 Classification of Financial Markets 1.4.3.2 Classification of Financial Markets
There are many types of financial markets and hence several ways to classify them. For There are many types of financial markets and hence several ways to classify them. For
our purpose, here we shall consider the following two classifications. our purpose, here we shall consider the following two classifications.
1. Classification on the basis of maturity 1. Classification on the basis of maturity
This is based on the maturity dates of securities This is based on the maturity dates of securities
i) i) Money Markets Money Markets - are financial markets in which securities traded have - are financial markets in which securities traded have
maturities of one-year or less. Examples of securities traded here include maturities of one-year or less. Examples of securities traded here include
treasury bills, commercial papers, short term promissory notes and so on. treasury bills, commercial papers, short term promissory notes and so on.
ii) ii) Capital Markets - Capital Markets - are financial markets in which securities of long-term funds are financial markets in which securities of long-term funds
are traded. Major securities traded in capital markets include bonds, preferred are traded. Major securities traded in capital markets include bonds, preferred
and common stocks. and common stocks.
2. Classification on the basis of the nature of securities 2. Classification on the basis of the nature of securities
This is based on whether the securities are new issues or have been outstanding in the This is based on whether the securities are new issues or have been outstanding in the
market place. market place.
i) i) Primary Markets Primary Markets - are financial marketers in which firms raise capital by - are financial marketers in which firms raise capital by
issuing new securities. issuing new securities.
ii) ii) Secondary Markets Secondary Markets - are financial markets in which existing and already - are financial markets in which existing and already
outstanding securities are traded among investors. Here the issuing outstanding securities are traded among investors. Here the issuing
corporation corporation does not raise new finance does not raise new finance. .
UNIT 3: FINANCIAL ANALYSIS UNIT 3: FINANCIAL ANALYSIS
Contents Contents
1.0 1.0 Aims and Objectives Aims and Objectives
3.1 Introduction 3.1 Introduction
3.2 Meaning and Objectives of Financial Analysis 3.2 Meaning and Objectives of Financial Analysis
3.3 Tools and Techniques of Financial Analysis 3.3 Tools and Techniques of Financial Analysis
3.4 Stages in Financial Analysis 3.4 Stages in Financial Analysis
3.5 Types of Financial Ratios 3.5 Types of Financial Ratios
3.5.1 Liquidity Ratios 3.5.1 Liquidity Ratios
3.5.2 Activity Ratios 3.5.2 Activity Ratios
3.5.3 Leverage Ratios 3.5.3 Leverage Ratios
3.5.4 Profitability Ratios 3.5.4 Profitability Ratios
3.5.5 Marketability Ratios 3.5.5 Marketability Ratios
3.6 Comparing Financial Ratios 3.6 Comparing Financial Ratios
3.7 Limitations of Ratio Analysis 3.7 Limitations of Ratio Analysis
3.8 Summary 3.8 Summary
3.9 Answers to Check Your Progress Questions 3.9 Answers to Check Your Progress Questions
3.10 Model Examination Questions 3.10 Model Examination Questions
3.11 Selected References 3.11 Selected References
3.12 Glossary 3.12 Glossary
3.0 AIMS AND OBJECTIVES 3.0 AIMS AND OBJECTIVES
The primary purpose of this unit is to enable students understand more and evaluate the The primary purpose of this unit is to enable students understand more and evaluate the
financial statements of a firm. At the end of the unit, students are expected to answer the financial statements of a firm. At the end of the unit, students are expected to answer the
following questions. following questions.
How do finance people generally begin performing financial analysis? What How do finance people generally begin performing financial analysis? What
are the basic objectives of financial analysis? are the basic objectives of financial analysis?
What are some of the common methods used in financial management in What are some of the common methods used in financial management in
order to understand about a firms performance and future conditions? order to understand about a firms performance and future conditions?
Why are financial ratios discussed under major categories? What are the Why are financial ratios discussed under major categories? What are the
major categories and what does each category measure about a firm? major categories and what does each category measure about a firm?
How do you confirm whether a given financial ratio is good or bad? How do you confirm whether a given financial ratio is good or bad?
What are some of the uses as well as the limitations of ratio analysis? What are some of the uses as well as the limitations of ratio analysis?
3.1 INTRODUCTION 3.1 INTRODUCTION
In the previous accounting courses you have learned that financial statements report both In the previous accounting courses you have learned that financial statements report both
on a firms financial position and financial performance. The four basic financial on a firms financial position and financial performance. The four basic financial
statements present about different aspects of financial conditions, operating results, and statements present about different aspects of financial conditions, operating results, and
cash flows. The balance sheet shows a firms assets and claims against assets at a cash flows. The balance sheet shows a firms assets and claims against assets at a
particular point in time time. The income statement, on its part, reports the results of the particular point in time time. The income statement, on its part, reports the results of the
firms operations over a period of time. Similarly, the statements of retained earnings and firms operations over a period of time. Similarly, the statements of retained earnings and
cash flows show the change in retained earnings and cash between two balance sheet cash flows show the change in retained earnings and cash between two balance sheet
dates. dates.
However, financial statements by themselves do not give aq complete picture about a However, financial statements by themselves do not give aq complete picture about a
companys financial condition, operating results, and cash flows. Neither can a real value companys financial condition, operating results, and cash flows. Neither can a real value
of financial statements could be derived in themselves alone. Therefore, to predict the of financial statements could be derived in themselves alone. Therefore, to predict the
future and to help anticipate future conditions, financial statements should be analyzed future and to help anticipate future conditions, financial statements should be analyzed
further. This analysis helps to identify current strengths and weakness of the firm. It further. This analysis helps to identify current strengths and weakness of the firm. It
facilitates planning the future, and helps to control the firms financial activities better. facilitates planning the future, and helps to control the firms financial activities better.
To have all this benefits, however, a finance person should perform a financial analysis. To have all this benefits, however, a finance person should perform a financial analysis.
3.2 MEANING AND OBJECTIVES OF FINANCIAL ANALYSIS 3.2 MEANING AND OBJECTIVES OF FINANCIAL ANALYSIS
Financial analysis refers to analysis of financial statements and it is a process of Financial analysis refers to analysis of financial statements and it is a process of
evaluating the relationships among component parts of financial statements. evaluating the relationships among component parts of financial statements.
The focus of financial analysis is on key figure in the financial statements and the The focus of financial analysis is on key figure in the financial statements and the
significant relationships that exist between them. Financial analysis is used by several significant relationships that exist between them. Financial analysis is used by several
groups of users like managers, credit analysts, and investors. groups of users like managers, credit analysts, and investors.
The analysis of financial statements is designed to reveal the relative strengths and The analysis of financial statements is designed to reveal the relative strengths and
weakness of a firm. This could be achieved by comparing the analysis with other weakness of a firm. This could be achieved by comparing the analysis with other
companies in the same industry, and by showing whether the firms position has been companies in the same industry, and by showing whether the firms position has been
improving or deteriorating over time. Financial analysis helps users obtain a better improving or deteriorating over time. Financial analysis helps users obtain a better
understanding of he firms financial conditions and performance. It also helps users understanding of he firms financial conditions and performance. It also helps users
understand the numbers presented in the financial statements and serve as a basis for understand the numbers presented in the financial statements and serve as a basis for
financial decisions. financial decisions.
3.3 TOOLS AND TECHNIQUES OF FINANCIAL ANALYSIS 3.3 TOOLS AND TECHNIQUES OF FINANCIAL ANALYSIS
A number of methods can be used in order to get a better understanding about a firms A number of methods can be used in order to get a better understanding about a firms
financial status and operating results. The most frequently used techniques in analyzing financial status and operating results. The most frequently used techniques in analyzing
financial statements are: financial statements are:
i) Ratio Analysis i) Ratio Analysis is a mathematical relationship among money amounts in the financial is a mathematical relationship among money amounts in the financial
statements. They standardize financial data by converting money figures in the statements. They standardize financial data by converting money figures in the
financial statements. Ratios are usually stated in terms of times or percentages. Like financial statements. Ratios are usually stated in terms of times or percentages. Like
any other financial analysis, a ratio analysis helps us draw meaningful conclusions and any other financial analysis, a ratio analysis helps us draw meaningful conclusions and
interpretations about a firms financial condition and performance. interpretations about a firms financial condition and performance.
ii) Common size Analysis ii) Common size Analysis expresses individual financial statement accounts as a expresses individual financial statement accounts as a
percentage of a base amount. A common size status expresses each item in the percentage of a base amount. A common size status expresses each item in the
balance sheet as a percentage of total assets and each item of the income statement as balance sheet as a percentage of total assets and each item of the income statement as
a percentage of total sales. When items in financial statements are expressed as a percentage of total sales. When items in financial statements are expressed as
percentages of total assets and total sales, these statements are called common size percentages of total assets and total sales, these statements are called common size
statements. statements.
iii) Index Analysis iii) Index Analysis expresses items in the financial statements as an index relative to expresses items in the financial statements as an index relative to
the base year. All items in the base year are assumed to be 100%. Usually, this the base year. All items in the base year are assumed to be 100%. Usually, this
analysis is most appropriate for income statement items. analysis is most appropriate for income statement items.
According to users of financial information, there are two techniques of financial According to users of financial information, there are two techniques of financial
analysis. These are: analysis. These are:
i) External Analysis i) External Analysis an analysis performed by outsiders to the firm such as creditors, an analysis performed by outsiders to the firm such as creditors,
investors, suppliers etc. investors, suppliers etc.
ii) Internal Analysis ii) Internal Analysis an analysis performed by corporate finance and accounting an analysis performed by corporate finance and accounting
departments for he purpose of planning, evaluating, and controlling operating departments for he purpose of planning, evaluating, and controlling operating
activities. activities.
3.4 STAGES IN FINANCIAL ANALYSIS 3.4 STAGES IN FINANCIAL ANALYSIS
Financial analysis consists of the following three major stages. Financial analysis consists of the following three major stages.
i) Preparation. i) Preparation. The preparatory steps include establishing the objectives of the analysis The preparatory steps include establishing the objectives of the analysis
and assembling the financial statements and other pertinent financial data. Financial and assembling the financial statements and other pertinent financial data. Financial
statement analysis focuses primarily on the balance sheet and the income statement. statement analysis focuses primarily on the balance sheet and the income statement.
However, data from statements of retained earnings and cash flows may also be used. However, data from statements of retained earnings and cash flows may also be used.
So, preparation is simply objective setting and data collection. So, preparation is simply objective setting and data collection.
ii) Computation. ii) Computation. This involves the application of various tools and techniques to gain a This involves the application of various tools and techniques to gain a
better understanding of the firms financial condition and performance. Computerized better understanding of the firms financial condition and performance. Computerized
financial statement analysis programs can be applied as part of this stage of financial financial statement analysis programs can be applied as part of this stage of financial
analysis. analysis.
iii) Evaluation and Interpretation iii) Evaluation and Interpretation. Involves the determination fo the meaningfulness of . Involves the determination fo the meaningfulness of
the analysis and to develop conclusions, inferences, and recommendations about the the analysis and to develop conclusions, inferences, and recommendations about the
firms performance and financial condition. This is the most important of all the three firms performance and financial condition. This is the most important of all the three
stages of financial analysis. stages of financial analysis.
Although we have briefly seen what is meant by the three most common types of Although we have briefly seen what is meant by the three most common types of
financial analysis, our focus on this material will be on ratio analysis. So in the section financial analysis, our focus on this material will be on ratio analysis. So in the section
that follows, we will discuss major types of financial ratios with illustrative examples. that follows, we will discuss major types of financial ratios with illustrative examples.
3.5 TYPES OF FINANCIAL RATIOS 3.5 TYPES OF FINANCIAL RATIOS
There are several key ratios that reveal about the financial strengths and weaknesses of a There are several key ratios that reveal about the financial strengths and weaknesses of a
firm. We will look at five categories of ratios, each measuring about a particular aspect of firm. We will look at five categories of ratios, each measuring about a particular aspect of
the firms financial condition and performance. the firms financial condition and performance.
3.5.1 Liquidity Ratios 3.5.1 Liquidity Ratios
Liquidity ratios measure the ability of a firm to meet its immediate obligations and reflect Liquidity ratios measure the ability of a firm to meet its immediate obligations and reflect
the short term financial strength or solvency of a firm. In other words, liquidity ratios the short term financial strength or solvency of a firm. In other words, liquidity ratios
measure a firms ability to pay its current liabilities as they mature by using current measure a firms ability to pay its current liabilities as they mature by using current
assets. There are two commonly used liquidity ratios: the current ratio and the quick ratio. assets. There are two commonly used liquidity ratios: the current ratio and the quick ratio.
The following financial statements pertain to Zebra Share Company. We will perform the The following financial statements pertain to Zebra Share Company. We will perform the
necessary ratio analyses using them, and then evaluate and interpret each analysis. necessary ratio analyses using them, and then evaluate and interpret each analysis.
Zebra Share Company Zebra Share Company
Comparative Balance Sheet Comparative Balance Sheet
December 31, 2001 and 2002 December 31, 2001 and 2002
(In thousands of Birrs) (In thousands of Birrs)
Assets Assets 2002 2002 2001 2001
Current assets: Current assets:
Cash Cash 9,000 9,000 7,000 7,000
Marketable securities Marketable securities 3,000 3,000 2,000 2,000
Accounts receivable (net) Accounts receivable (net) 20,700 20,700 18,300 18,300
Inventories Inventories 24,900 24,900 23,700 23,700
Total current assets Total current assets 57,600 57,600 51,000 51,000
Fixed assets: Fixed assets:
Land and buildings Land and buildings 33,000 33,000 27,000 27,000
Plant and equipment Plant and equipment 130,500 130,500 120,000 120,000
Total fixed assets Total fixed assets 163,500 163,500 147,000 147,000
Less: accumulated depreciation Less: accumulated depreciation 67,200 67,200 61,200 61,200
Net fixed assets Net fixed assets 96,300 96,300 85,800 85,800
Total assets Total assets 153,900 153,900 136,800 136,800
Liabilities and stockholders equity Liabilities and stockholders equity
Current liabilities: Current liabilities:
Accounts payable Accounts payable 20,100 20,100 17,100 17,100
Notes payable Notes payable 14,700 14,700 13,200 13,200
Taxes payable Taxes payable 3,300 3,300 3,000 3,000
Total current liabilities Total current liabilities 38,100 38,100 33,300 33,300
Long-term debt: Long-term debt:
Mortgage bonds 5% Mortgage bonds 5% 60,000 60,000 60,000 60,000
Total liabilities Total liabilities 98,100 98,100 93,300 93,300
Stockholders equity: Stockholders equity:
Preferred stock 5% (Br. 100 par) Preferred stock 5% (Br. 100 par) 6,000 6,000 - -
Common stock (Br. 10 par) Common stock (Br. 10 par) 33,000 33,000 30,000 30,000
Capital in excess of par value Capital in excess of par value 7,500 7,500 4,500 4,500
Retained earnings Retained earnings 9,300 9,300 9,000 9,000
Total stockholders equity Total stockholders equity 55,800 55,800 43,500 43,500
Total liabilities and stockholders equity Total liabilities and stockholders equity 153,900 153,900 136,800 136,800
Income Statement Income Statement
For the Year Ended December 31, 2002 For the Year Ended December 31, 2002
_______________________________________________________________________
_
Net sales Net sales Br. 196,200,000 Br. 196,200,000
Cost of goods sold Cost of goods sold 159,600,000 159,600,000
Gross profit Gross profit Br. 36,600,000 Br. 36,600,000
Operating expenses* Operating expenses* 26,100,000 26,100,000
Earnings before interest and taxes (EBIT) Earnings before interest and taxes (EBIT) Br. 10,500,000 Br. 10,500,000
Interest expense Interest expense 3,000,000 3,000,000
Earnings before taxes (EBT) Earnings before taxes (EBT) Br. 7,500,000 Br. 7,500,000
Income taxes Income taxes 3,600,00 3,600,00
Net income Net income Br. 3,900,000 Br. 3,900,000
* Included in operating expenses are Br. 6,000,000 depreciation and Br. 2,700,000 lease * Included in operating expenses are Br. 6,000,000 depreciation and Br. 2,700,000 lease
payment. payment.
Statement of Retained Earnings Statement of Retained Earnings
For the Year Ended December 31, 2002 For the Year Ended December 31, 2002
Retained earnings at beginning of year Retained earnings at beginning of year Br. 9,000,000 Br. 9,000,000
Add: Net income Add: Net income 3,900,000 3,900,000
Sub-total Sub-total Br. 12,900,000 Br. 12,900,000
Less: Cash dividends Less: Cash dividends
Preferred Preferred Br. 300,000 Br. 300,000
Common Common 3,300,000 3,300,000
Sub-total Sub-total Br. 3,600,000 Br. 3,600,000
Retained earnings at end of year Retained earnings at end of year Br. 9,300,000 Br. 9,300,000
i) Current ratio i) Current ratio measures the ability of a firm to satisfy or cover the claims of short- measures the ability of a firm to satisfy or cover the claims of short-
term creditors by using only current assets. This ratio relates current assets to current term creditors by using only current assets. This ratio relates current assets to current
liabilities liabilities
Current ratio = Current ratio = Current assets Current assets
Current liabilities Current liabilities
Zebras current ratio (for 2002) = Zebras current ratio (for 2002) = Br. 57,600 Br. 57,600 = 1.51 times = 1.51 times
Br. 38,100 Br. 38,100
Interpretation: Interpretation: Zebra has Br. 1.51 in current assets available for every 1 Br. in current Zebra has Br. 1.51 in current assets available for every 1 Br. in current
liabilities. liabilities.
Relatively high current ratio is interpreted as an indication that the firm is liquid and in Relatively high current ratio is interpreted as an indication that the firm is liquid and in
good position to meet its current obligations. Conversely, relatively low current ratio is good position to meet its current obligations. Conversely, relatively low current ratio is
interpreted as an indication that the firm may not be able to easily meet its current interpreted as an indication that the firm may not be able to easily meet its current
obligations. A reasonably higher current ratio as compared to other firms in the same obligations. A reasonably higher current ratio as compared to other firms in the same
industry indicates higher liquidity position. A very high current ratio, however, may industry indicates higher liquidity position. A very high current ratio, however, may
indicate excessive inventories and accounts receivable, or a firm is not making full use of indicate excessive inventories and accounts receivable, or a firm is not making full use of
its current borrowing capacity. its current borrowing capacity.
ii) Quick ratio (Acid test ratio)- ii) Quick ratio (Acid test ratio)- measures the short-term liquidity by removing the least measures the short-term liquidity by removing the least
liquid current assets such as inventories. Inventories are removed because they are not liquid current assets such as inventories. Inventories are removed because they are not
readily or easily convertible into cash. Thus, the quick ratio measures a firms ability to readily or easily convertible into cash. Thus, the quick ratio measures a firms ability to
pay its current liabilities by using its most liquid assets into cash. pay its current liabilities by using its most liquid assets into cash.
Quick ratio = Quick ratio = Current assets Inventory Current assets Inventory
Zebras quick ratio (for 2002) = Zebras quick ratio (for 2002) = Br. 57,600 Br. 24,900 Br. 57,600 Br. 24,900 = 0.86 times = 0.86 times
Br. 38,100 Br. 38,100
Interpretation: Interpretation: Zebra has Br. 0.86 in quick assets available for every one birr in current Zebra has Br. 0.86 in quick assets available for every one birr in current
liabilities. liabilities.
Like the current ratio, the quick ratio reflects the firms ability to pay its short-tem Like the current ratio, the quick ratio reflects the firms ability to pay its short-tem
obligations, and the higher the quick ratio the more liquid the firms position. But the obligations, and the higher the quick ratio the more liquid the firms position. But the
quick ratio is more detailed and penetrating test of a firms liquidity position as it quick ratio is more detailed and penetrating test of a firms liquidity position as it
considers only the quick asset. The current ratio, on the other hand, is a crude measure of considers only the quick asset. The current ratio, on the other hand, is a crude measure of
the firms liquidity position as it takes into account all current assets without distinction. the firms liquidity position as it takes into account all current assets without distinction.
Check your progress I Check your progress I
What is the amount of inventory for a firm whose current assets and current liabilities are What is the amount of inventory for a firm whose current assets and current liabilities are
Br. 400,000 and Br. 100,000 respectively and whose quick ratio is 2 times? Br. 400,000 and Br. 100,000 respectively and whose quick ratio is 2 times?
_______________________________________________________________________ _______________________________________________________________________
_______________________________________________________________________ _______________________________________________________________________
_______________________________________________________________________ _______________________________________________________________________
___ ___
3.5.2 Activity Ratios 3.5.2 Activity Ratios
Activity ratios measure the degree of efficiency a firm displays in using its assets. These Activity ratios measure the degree of efficiency a firm displays in using its assets. These
ratios include turnover ratios because they show how rapidly assets are being converted ratios include turnover ratios because they show how rapidly assets are being converted
(turned over) into sales or cost of goods sold. Activity ratios are also called asset (turned over) into sales or cost of goods sold. Activity ratios are also called asset
management ratios, or asset utilization ratios, or efficiency ratios. Generally, high management ratios, or asset utilization ratios, or efficiency ratios. Generally, high
turnover ratios are associated with good asset management and low turnover ratios with turnover ratios are associated with good asset management and low turnover ratios with
poor asset management. poor asset management.
Activity ratios include: Activity ratios include:
i) Accounts Receivable turnover i) Accounts Receivable turnover measures how efficiently a firms accounts receivable measures how efficiently a firms accounts receivable
is being managed. It indicates how many times or how rapidly accounts receivable are is being managed. It indicates how many times or how rapidly accounts receivable are
converted into cash during a year. converted into cash during a year.
Accounts receivable turnover = Net sales Accounts receivable turnover = Net sales
Accounts receivable Accounts receivable
Zebras accounts receivable turnover (for 2002) = Zebras accounts receivable turnover (for 2002) = Br. 196,200 Br. 196,200 = 9.48 times = 9.48 times
Br. 20,700 Br. 20,700
Interpretation: Interpretation: Zebras accounts receivable get converted into cash 9.48 times a year. Zebras accounts receivable get converted into cash 9.48 times a year.
In general, a reasonably higher accounts receivable turnover ratio is preferable. A ratio In general, a reasonably higher accounts receivable turnover ratio is preferable. A ratio
substantially lower than the industry average may suggest that a firm has more liberal substantially lower than the industry average may suggest that a firm has more liberal
credit policy, more restrictive cash discount offers, poor credit selection or in adequate credit policy, more restrictive cash discount offers, poor credit selection or in adequate
cash collection efforts. cash collection efforts.
There are alternate ways to calculate accounts receivable value like average receivables There are alternate ways to calculate accounts receivable value like average receivables
and ending receivables. Though many analysts prefer the first, in our case we have used and ending receivables. Though many analysts prefer the first, in our case we have used
the ending balances. In computing the accounts receivable turnover ratio, if available, the ending balances. In computing the accounts receivable turnover ratio, if available,
only credit sales should be used in the numerator as accounts receivable arises only from only credit sales should be used in the numerator as accounts receivable arises only from
credit sales. credit sales.
ii) Days sales outstanding (DSO) ii) Days sales outstanding (DSO) also called average collection period. It seeks to also called average collection period. It seeks to
measure the average number of days it takes for a firm to collect its accounts measure the average number of days it takes for a firm to collect its accounts
receivable. In other words, it indicates how many days a firms sales are outstanding receivable. In other words, it indicates how many days a firms sales are outstanding
in accounts receivable. in accounts receivable.
Days sales outstanding = 365 days Days sales outstanding = 365 days
Accounts receivable turnover Accounts receivable turnover
Zebras days sales outstanding = Zebras days sales outstanding = 365 days 365 days = 39 days = 39 days
9.48 9.48
Interpretation: Interpretation: Zebras credit customers on the average are paying their bills in almost Zebras credit customers on the average are paying their bills in almost
39 days. If Zebras credit period is less than 39 days, some corrective actions should be 39 days. If Zebras credit period is less than 39 days, some corrective actions should be
taken to improve the collection period. taken to improve the collection period.
The average collection period of a firm is directly affected by the accounts receivable The average collection period of a firm is directly affected by the accounts receivable
turnover ratio. Generally, a reasonably short-collection period is preferable. turnover ratio. Generally, a reasonably short-collection period is preferable.
iii) Inventory turnover iii) Inventory turnover measures how many times per year the inventory level is sold measures how many times per year the inventory level is sold
(turned over). (turned over).
Inventory turnover = Inventory turnover = Cost of good sold Cost of good sold
Inventory Inventory
For Zebra Company (2002) = For Zebra Company (2002) = Br. 159,600 Br. 159,600 = 6.41times = 6.41times
Br. 24,900 Br. 24,900
Interpretation: Interpretation: Zebras inventory is on the average sold out 6.41 times per year. Zebras inventory is on the average sold out 6.41 times per year.
In computing the inventory turnover, it is preferable to use cost of goods sold in the In computing the inventory turnover, it is preferable to use cost of goods sold in the
numerator rather than sales. But when cost of goods sold data is not available, we can numerator rather than sales. But when cost of goods sold data is not available, we can
apply sales. In general, a high inventory turnover is better than a low turnover. But apply sales. In general, a high inventory turnover is better than a low turnover. But
abnormally high inventory turnover might result from very low level of inventory. This abnormally high inventory turnover might result from very low level of inventory. This
indicates that stock outs will occur and sales have been very low. A very low turnover, on indicates that stock outs will occur and sales have been very low. A very low turnover, on
the other hand, results from excessive inventory levels, presence of inferior quality, the other hand, results from excessive inventory levels, presence of inferior quality,
damaged or obsolete inventory, or unexpectedly low volume of sales. damaged or obsolete inventory, or unexpectedly low volume of sales.
iv) Fixed assets turnover iv) Fixed assets turnover measures how efficiently a firm uses it fixed assets. It shows measures how efficiently a firm uses it fixed assets. It shows
how many birrs of sales are generated from one birr of fixed assets how many birrs of sales are generated from one birr of fixed assets
Fixed assets turnover = Fixed assets turnover = Net sales___ Net sales___
Net fixed assets Net fixed assets
Zebras fixed assets turnover = Zebras fixed assets turnover = Br. 196,200 Br. 196,200 = 2.04X = 2.04X
Br. 96,300 Br. 96,300
Interpretation: Interpretation: Zebra generated Br. 2.04 in net sales for every birr invested in fixed Zebra generated Br. 2.04 in net sales for every birr invested in fixed
assets. assets.
A fixed assets turnover ratio substantially lower than other similar firms indicates under A fixed assets turnover ratio substantially lower than other similar firms indicates under
utilization of fixed assets, i.e., idle capacity, excessive investment in fixed assets, or low utilization of fixed assets, i.e., idle capacity, excessive investment in fixed assets, or low
sales levels. This suggests to the firm possibility of increasing outputs without additional sales levels. This suggests to the firm possibility of increasing outputs without additional
investment in fixed assets. investment in fixed assets.
The fixed assets turnover may be deceptively low or high. This is because the book The fixed assets turnover may be deceptively low or high. This is because the book
values of fixed assets may be considerably affected by cost of assets, time elapsed since values of fixed assets may be considerably affected by cost of assets, time elapsed since
their acquisition, or method of depreciation used. their acquisition, or method of depreciation used.
v) Total assets turnover v) Total assets turnover indicates the amount of net sales generated from each birr of indicates the amount of net sales generated from each birr of
total tangible assets. It is a measure of the firms management efficiency in managing total tangible assets. It is a measure of the firms management efficiency in managing
its assets. its assets.
Total assets turnover = Total assets turnover = Net Sales Net Sales
Total assets Total assets
Zebras total assets turnover = Zebras total assets turnover = Br. 196,200 Br. 196,200 = 1.27X = 1.27X
Br. 153, 900 Br. 153, 900
Interpretation: Interpretation: Zebra Share Company generated Br. 1.27 in net sales for every one birr Zebra Share Company generated Br. 1.27 in net sales for every one birr
invested in total assets. invested in total assets.
A high total assets turnover is supposed to indicate efficient asset management, and low A high total assets turnover is supposed to indicate efficient asset management, and low
turnover indicates a firm is not generating a sufficient level of sales in relation to its turnover indicates a firm is not generating a sufficient level of sales in relation to its
investment in assets. investment in assets.
Check your progress II Check your progress II
Ogaden Company has sales of Br. 5 million, out of which 75% are credit sales. The year- Ogaden Company has sales of Br. 5 million, out of which 75% are credit sales. The year-
end accounts receivable balance is Br. 475,000. What is the days sale outstanding? end accounts receivable balance is Br. 475,000. What is the days sale outstanding?
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3.5.3 Leverage Ratios 3.5.3 Leverage Ratios
Leverage ratios are also called debt management or utilization ratios. They measure the Leverage ratios are also called debt management or utilization ratios. They measure the
extent to which a firm is financed with debt, or the firms ability to generate sufficient extent to which a firm is financed with debt, or the firms ability to generate sufficient
income to meet its debt obligations. While there are many leverage ratios, we will look at income to meet its debt obligations. While there are many leverage ratios, we will look at
only the following three. only the following three.
i) Debt to total assets (Debt) Ratio i) Debt to total assets (Debt) Ratio measures the percentage of total funds provided by measures the percentage of total funds provided by
debt. debt.
Debt ratio = Debt ratio = Total liabilities Total liabilities
Zebras debt ratio = Zebras debt ratio = Br. 98,100 Br. 98,100 = 64% = 64%
Br. 153,900 Br. 153,900
Interpretation: Interpretation: At the end of 2002, 64% of Zebras total assets was financed by debt and At the end of 2002, 64% of Zebras total assets was financed by debt and
36% (100% - 64%) was financed by equity sources. 36% (100% - 64%) was financed by equity sources.
A high debt ratio implies that a firm has liberally used debt sources to finance its assets. A high debt ratio implies that a firm has liberally used debt sources to finance its assets.
Conversely, a low ratio implies the firm has funded its assets mainly with equity sources. Conversely, a low ratio implies the firm has funded its assets mainly with equity sources.
Debt ratio reflects the capital structure of a firm. The higher the debt ratio, the more the Debt ratio reflects the capital structure of a firm. The higher the debt ratio, the more the
firms financial risk. firms financial risk.
ii) Times interest earned ii) Times interest earned measures a firms ability to pay its interest obligations. measures a firms ability to pay its interest obligations.
Times interest earned = Times interest earned = Earnings before interest and taxes (EBIT) Earnings before interest and taxes (EBIT)
Interest expense Interest expense
Zebras times interest earned = Zebras times interest earned = Br. 10,500 Br. 10,500 = 3.50X = 3.50X
Br. 3,000 Br. 3,000
Interpretation: Interpretation: Zebra has operating income 3.5 times larger than the interest expense. Zebra has operating income 3.5 times larger than the interest expense.
The times interest earned ratio implicitly assumes a firms operating income (EBIT) is The times interest earned ratio implicitly assumes a firms operating income (EBIT) is
available to meet its interest obligations. However, earnings before interest and taxes is available to meet its interest obligations. However, earnings before interest and taxes is
an income concept and not a direct measure of cash. Hence, this ratio provides only an an income concept and not a direct measure of cash. Hence, this ratio provides only an
indirect measure of the firms ability to meet its interest payments. indirect measure of the firms ability to meet its interest payments.
iii) Fixed charges coverage iii) Fixed charges coverage measures the ability of a firms to meet all fixed obligations measures the ability of a firms to meet all fixed obligations
rather than interest payments alone. Fixed payment obligations include loan interest and rather than interest payments alone. Fixed payment obligations include loan interest and
principal, lease payments, and preferred stock dividends. principal, lease payments, and preferred stock dividends.
Fixed charges coverage = Fixed charges coverage = Income before fixed charges and taxes Income before fixed charges and taxes
Fixed charges Fixed charges
For Zebra Company, the other fixed charge payment in addition to interest is lease For Zebra Company, the other fixed charge payment in addition to interest is lease
payment. Therefore, payment. Therefore,
Zebras fixed charges coverage = Zebras fixed charges coverage = Br. 10,500 + Br. 2,700 Br. 10,500 + Br. 2,700 = 2.32X = 2.32X
Br. 3,000 + Br. 2,700 Br. 3,000 + Br. 2,700
Interpretation: Interpretation: the fixed charges (interest and lease payments) of Zebra Share Company the fixed charges (interest and lease payments) of Zebra Share Company
are safely covered 2.32 times. are safely covered 2.32 times.
Like times interest earned, generally, a reasonably high fixed charges coverage ratio is Like times interest earned, generally, a reasonably high fixed charges coverage ratio is
desirable. The fixed charges coverage ratio is required because failure of the firm to meet desirable. The fixed charges coverage ratio is required because failure of the firm to meet
any financial obligation will endanger the position of a firm. any financial obligation will endanger the position of a firm.
Check your progress III Check your progress III
Zemedkun Merchandising Company has reported operating income of Br. 120,000. T he Zemedkun Merchandising Company has reported operating income of Br. 120,000. T he
Companys interest expense and total fixed charges are Br. 30,000 and Br. 80,000 Companys interest expense and total fixed charges are Br. 30,000 and Br. 80,000
respectively. What are the times interest earned and fixed charges coverage ratios? respectively. What are the times interest earned and fixed charges coverage ratios?
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3.5.4 Profitability Ratios 3.5.4 Profitability Ratios
These ratios measure the earning power of a firm with respect to given level of sales, These ratios measure the earning power of a firm with respect to given level of sales,
total assets, and owners equity. The following ratios are among the many measures of a total assets, and owners equity. The following ratios are among the many measures of a
firms profitability. firms profitability.
i) Profit Margin i) Profit Margin shows the percentage of each birr of net sales remaining after shows the percentage of each birr of net sales remaining after
deducting all expenses. deducting all expenses.
Profit margin = Profit margin = Net income Net income
Net Sales Net Sales
Zebras profit margin = Zebras profit margin = Br. 3,900 Br. 3,900 = 2% = 2%
Br. 196,200 Br. 196,200
Interpretation: Interpretation: Zebra generated 2 cents in profits for every one birr in net sales. Zebra generated 2 cents in profits for every one birr in net sales.
The net profit margin ratio is affected generally by factor as sales volume, pricing The net profit margin ratio is affected generally by factor as sales volume, pricing
strategy as well as the amount of all costs and expenses of a firm. strategy as well as the amount of all costs and expenses of a firm.
ii) Return on investment (assets) ii) Return on investment (assets) measures how profitably a firm has used its measures how profitably a firm has used its
investment in total assets. investment in total assets.
Return on investment = Return on investment = Net income Net income
Zebras return on investment = Zebras return on investment = Br. 3,900 Br. 3,900 = 2.53 % = 2.53 %
Br. 153,900 Br. 153,900
Interpretation: Interpretation: Zebra earned more than 2 cents of profits for each birr in assets. Zebra earned more than 2 cents of profits for each birr in assets.
Generally, a high return on investment is sought by firms. This can be achieved by Generally, a high return on investment is sought by firms. This can be achieved by
increasing sales levels, increasing sales relative to costs, reducing costs relative to sales, increasing sales levels, increasing sales relative to costs, reducing costs relative to sales,
or efficiently utilizing assets. or efficiently utilizing assets.
iii) Return on equity iii) Return on equity indicates the rate of return earned by a firms stockholders on indicates the rate of return earned by a firms stockholders on
investments made by themselves. investments made by themselves.
Return on equity = Return on equity = Net income___ Net income___
Stockholders equity Stockholders equity
Zebras return on equity = Zebras return on equity = Br. 3,900 Br. 3,900 = 6.99% = 6.99%
Br. 55,800 Br. 55,800
Interpretation: Interpretation: Zebra earned almost 7 cents of profit for each birr in owners equity Zebra earned almost 7 cents of profit for each birr in owners equity
We can also use the following alternative way to calculate return on equity. We can also use the following alternative way to calculate return on equity.
Return on equity = Return on equity = Return on investment Return on investment
1 Debt ratio 1 Debt ratio
A high return on equity may indicate that a firm is more risky due to higher debt balance. A high return on equity may indicate that a firm is more risky due to higher debt balance.
On the contrary, a low ratio may indicate greater owners capital contribution as compared On the contrary, a low ratio may indicate greater owners capital contribution as compared
to debt contribution. Generally, the higher the return on equity, the better off the owners. to debt contribution. Generally, the higher the return on equity, the better off the owners.
Check your progress IV Check your progress IV
Muhammed Fertilizers Company has assets amounting to Br. 1,200,000. The firm has Muhammed Fertilizers Company has assets amounting to Br. 1,200,000. The firm has
generated Br. 3,000,000 in annual net sales, with a 5% net profit margin. What is the net generated Br. 3,000,000 in annual net sales, with a 5% net profit margin. What is the net
income and return on assets for Zemedkun? income and return on assets for Zemedkun?
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Dupont System of Analysis Dupont System of Analysis
It is an approach to assess that a firms return on assets and return on equity show not It is an approach to assess that a firms return on assets and return on equity show not
only the firms earning power but also efficiency and leverage. This analysis breaks down only the firms earning power but also efficiency and leverage. This analysis breaks down
these two ratios as follows: these two ratios as follows:
Return on assets = Profit margin X Total assets turnover Return on assets = Profit margin X Total assets turnover
Return on equity =Profit margin X Total assets turnover X Total assets/equity Return on equity =Profit margin X Total assets turnover X Total assets/equity
= Profit Margin X Total assets turnover X Equity Multiplier = Profit Margin X Total assets turnover X Equity Multiplier
Check your progress V Check your progress V
Zakir Beverage Corporations profit margin for year 2002 is 4% and its total assets Zakir Beverage Corporations profit margin for year 2002 is 4% and its total assets
turnover is 1.5 times. The debt ratio for the same year is 40%. What are return on turnover is 1.5 times. The debt ratio for the same year is 40%. What are return on
investment and return on equity ratios of Zakir for 2002? investment and return on equity ratios of Zakir for 2002?
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3.5.5 Marketability Ratios 3.5.5 Marketability Ratios
Marketability ratios are used primarily for investment decisions and long range planning. Marketability ratios are used primarily for investment decisions and long range planning.
They include: They include:
i) Earnings per share (EPS) i) Earnings per share (EPS) expresses the profits earned on each share of a firms expresses the profits earned on each share of a firms
common stock outstanding. It does not reflect how much is paid as dividends. common stock outstanding. It does not reflect how much is paid as dividends.
Earnings per share = Earnings per share = Net income Preferred stock dividend Net income Preferred stock dividend
Number of common shares outstanding Number of common shares outstanding
Zebras Eps for 2002 = Zebras Eps for 2002 = Br. 3,900 Br. 300 Br. 3,900 Br. 300 = Br. 1.09 = Br. 1.09
Br. 33,000 Br. 33,000 Br. 10 Br. 10
Interpretation: Interpretation: Zebras common stockholders earned Br. 1.09 per share in 2002. Zebras common stockholders earned Br. 1.09 per share in 2002.
ii) Dividends Per Share (DPS) ii) Dividends Per Share (DPS) represents the amount of cash dividends a firm paid on represents the amount of cash dividends a firm paid on
each share of its common stock outstanding. each share of its common stock outstanding.
Dividends Per Share = Dividends Per Share = Total cash dividends on common shares Total cash dividends on common shares
Number of common shares outstanding Number of common shares outstanding
Zebras DPs for 2002 = Zebras DPs for 2002 = Br. 3,300 _ Br. 3,300 _ = Br. 1.00 = Br. 1.00
Br. 33,000 Br. 33,000 Br. 10 Br. 10
Interpretation: Interpretation: Zebra distributed Br. 1 per share in dividends. Zebra distributed Br. 1 per share in dividends.
iii) Dividend pay-out (pay-out) ratio iii) Dividend pay-out (pay-out) ratio shows the percentage of earnings paid to shows the percentage of earnings paid to
stockholders. stockholders.
Dividends pay-out = Dividends pay-out = Dividends per share Dividends per share
Earnings per share Earnings per share
= = Total dividends to common stockholders Total dividends to common stockholders
Total earnings to common stockholders Total earnings to common stockholders
Zebras pay-out ratio = Zebras pay-out ratio = Br. 1.00 Br. 1.00 = = Br. 3,300 Br. 3,300 = 92% = 92%
Br. 1.09 Br. 1.09 Br. 3,600 Br. 3,600
Interpretation: Interpretation: Zebra paid nearly 92% of its earnings in cash dividends. Zebra paid nearly 92% of its earnings in cash dividends.
3.6 COMPARING FINANCIAL RATIOS 3.6 COMPARING FINANCIAL RATIOS
To address whether a given ratio is high or low, good or bad, a meaningful basis is To address whether a given ratio is high or low, good or bad, a meaningful basis is
needed for comparison. Two types of ratio comparisons can be made. needed for comparison. Two types of ratio comparisons can be made.
i) Cross sectional analysis i) Cross sectional analysis is the comparison of a firms ratios to those other firms in is the comparison of a firms ratios to those other firms in
the same industry at the same point in time. Here, the firm is interested in how well it has the same industry at the same point in time. Here, the firm is interested in how well it has
performed in relation to other firms. Generally, cross sectional analysis is preformed performed in relation to other firms. Generally, cross sectional analysis is preformed
based on industry averages of different financial ratios. based on industry averages of different financial ratios.
ii) Time series analysis ii) Time series analysis is an evaluation of a firms financial ratios over time. Here, is an evaluation of a firms financial ratios over time. Here,
the current period ratios are compared with those of the past years. The purpose is to the current period ratios are compared with those of the past years. The purpose is to
determine whether the firm is progressing or deteriorating. determine whether the firm is progressing or deteriorating.
To obtain the highest possible information about a firm, usually, a combination of both To obtain the highest possible information about a firm, usually, a combination of both
cross sectional and time-series analyses are applied. cross sectional and time-series analyses are applied.
3.7 LIMITATIONS OF RATIO ANALYSIS 3.7 LIMITATIONS OF RATIO ANALYSIS
Even though ratio analysis can provide useful information about a firms financial Even though ratio analysis can provide useful information about a firms financial
conditions and operations, it has the following problems and limitations. conditions and operations, it has the following problems and limitations.
1. Generally, any single financial ratio does not provide sufficient information by itself. 1. Generally, any single financial ratio does not provide sufficient information by itself.
2. Sometimes a comparison of ratios between different firms is difficult. One reason 2. Sometimes a comparison of ratios between different firms is difficult. One reason
could be a single firm may have different divisions operating in different industries. could be a single firm may have different divisions operating in different industries.
Another reason could be the financial statements may not be dated at the same point in Another reason could be the financial statements may not be dated at the same point in
time. time.
3. The financial statements of firms are not always reliable, particularly, when they are 3. The financial statements of firms are not always reliable, particularly, when they are
not audited. not audited.
4. Different accounting principles and methods employed by different companies can 4. Different accounting principles and methods employed by different companies can
distort comparisons. distort comparisons.
5. Inflation badly distorts comparison of ratios of a firm over time. 5. Inflation badly distorts comparison of ratios of a firm over time.
6. Seasonal factors inherent in a business can also lead us to deceptive conclusion. For 6. Seasonal factors inherent in a business can also lead us to deceptive conclusion. For
example, the inventory turnover ratio for a stationery materials selling company will be example, the inventory turnover ratio for a stationery materials selling company will be
different at different time periods of a year. different at different time periods of a year.
3.8 SUMMARY 3.8 SUMMARY
The primary purpose of this unit was to learn how to analyze financial statements. The primary purpose of this unit was to learn how to analyze financial statements.
The basic points discussed are: The basic points discussed are:
- - There are several techniques of financial analysis; but ratio analysis is common. There are several techniques of financial analysis; but ratio analysis is common.
- - Financial ratios are classified into different categories, measuring about a firms Financial ratios are classified into different categories, measuring about a firms
liquidity, activity, leverage, earning powers, and other related aspects. liquidity, activity, leverage, earning powers, and other related aspects.
- - Current and quick ratios are the two commonly used liquidity ratios. Current and quick ratios are the two commonly used liquidity ratios.
- - Activity ratios include turnover ratios like accounts receivable turnover, inventory Activity ratios include turnover ratios like accounts receivable turnover, inventory
turnover, fixed assets turnover, and total assets turnover. turnover, fixed assets turnover, and total assets turnover.
- - Leverage ratios reveal two information associated with debt of a firm. These Leverage ratios reveal two information associated with debt of a firm. These
ratios include debt ratio, times interest earned, and fixed charges coverage. ratios include debt ratio, times interest earned, and fixed charges coverage.
- - Profitability ratios indicate the earning power of a firm. Ratios under this category Profitability ratios indicate the earning power of a firm. Ratios under this category
include profit margin, return on assets, and return on investment. include profit margin, return on assets, and return on investment.
- - Marketability ratios, unlike the other categories, do not measure specific aspect of Marketability ratios, unlike the other categories, do not measure specific aspect of
a firm. Earnings per share, dividends per share, and pay-out ratio are among the a firm. Earnings per share, dividends per share, and pay-out ratio are among the
most common types. most common types.
- - To compare ratios, cross sectional or time series analyses can be employed. To compare ratios, cross sectional or time series analyses can be employed.
- - Financial ratios, though are important and useful analyses, have many problems Financial ratios, though are important and useful analyses, have many problems
and limitations. and limitations.
3.9 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS 3.9 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS
I. I. Quick ratio = Quick ratio = Current assets Inventory Current assets Inventory
2 = 2 = Br. 400,000 Inventory Br. 400,000 Inventory
Br. 100,000 Br. 100,000
Inventory = Br. 400,000 Br. 200,000 = Br. 200,000 Inventory = Br. 400,000 Br. 200,000 = Br. 200,000
II. II. Credit sales = Br. 5,000,000 X 75% = Br. 3,750,000 Credit sales = Br. 5,000,000 X 75% = Br. 3,750,000
Accounts receivable turnover = Accounts receivable turnover = Br. 3,750,000 Br. 3,750,000 = 7.89X = 7.89X
Br. 475,000 Br. 475,000
Days sales outstanding = Days sales outstanding = 365 days 365 days = 46 days = 46 days
7.89 7.89
III. III. Times interest earned = Times interest earned = Operating income Operating income = = Br. 120,000 Br. 120,000 = 4X = 4X
Interest expense Br. 30,000 Interest expense Br. 30,000
Fixed charges coverage = Fixed charges coverage = Earnings before fixed charges Earnings before fixed charges
Fixed charges Fixed charges
= = Br. 120,000 + (Br. 80,000 Br. 30,000) Br. 120,000 + (Br. 80,000 Br. 30,000) = 2.13X = 2.13X
Br. 80,000 Br. 80,000
IV. IV. Net income = Net sales X Net profit margin = Br. 3,000,000 X 5% = Br. 150,000 Net income = Net sales X Net profit margin = Br. 3,000,000 X 5% = Br. 150,000
Return on assets = Net income / Total assets = Br. 150,000 / Br. 1,200,000 = 12.5% Return on assets = Net income / Total assets = Br. 150,000 / Br. 1,200,000 = 12.5%
V. V. Return on investment = Net profit margin X Total assets turnover Return on investment = Net profit margin X Total assets turnover
= 4% X 1.5 = 6% = 4% X 1.5 = 6%
Return on equity = Return on investment / 1 Debt ratio Return on equity = Return on investment / 1 Debt ratio
= 6% / 1 40% = 10% = 6% / 1 40% = 10%
3.10 MODEL EXAMINATION QUESTIONS 3.10 MODEL EXAMINATION QUESTIONS
Part I. Multiple choice Part I. Multiple choice
1. Identify the factor that contributes for shorter days sales outstanding 1. Identify the factor that contributes for shorter days sales outstanding
A) A) Longer credit periods Longer credit periods C) Strong cash collection policy C) Strong cash collection policy
B) B) Limited cash discount offers Limited cash discount offers D) Poor credit selection D) Poor credit selection
2. If new shares of common stock are issued in exchange for the existing debt of a firm, 2. If new shares of common stock are issued in exchange for the existing debt of a firm,
then then
A) A) Return on investment increases. Return on investment increases.
B) B) Times interest earned ratio will decrease. Times interest earned ratio will decrease.
C) C) Return on stockholders equity will decrease. Return on stockholders equity will decrease.
D) D) Current and quick ratios will increase. Current and quick ratios will increase.
3. A relatively lower return on assets is always an indicator of poor asset management. 3. A relatively lower return on assets is always an indicator of poor asset management.
A) A) True True B) False B) False
Part II. Exercises Part II. Exercises
1. A company has current liabilities of Br. 75,000, mortgages notes payable of Br. 1. A company has current liabilities of Br. 75,000, mortgages notes payable of Br.
200,000, and long-term bond of Br. 225,000. If the total stockholders equity of the 200,000, and long-term bond of Br. 225,000. If the total stockholders equity of the
company amounts to Br. 750,000, what is the debt ratio? company amounts to Br. 750,000, what is the debt ratio?
2. A firm has a current ratio of 1.5 and a quick ratio of 1.0. If the current assets other than 2. A firm has a current ratio of 1.5 and a quick ratio of 1.0. If the current assets other than
cash amount to Br. 2,500,000, what is the mathematical relationship between cash amount to Br. 2,500,000, what is the mathematical relationship between
inventories and current liabilities for this firm? inventories and current liabilities for this firm?
3. ABC companys return on investment was 25% last year, and the net profit margin was 3. ABC companys return on investment was 25% last year, and the net profit margin was
10%. What are the total net sales for the year if total assets are Br. 20 million? 10%. What are the total net sales for the year if total assets are Br. 20 million?
4. XYZ corporation has Br. 1,000,000 of debt outstanding of 10% interest rate. The 4. XYZ corporation has Br. 1,000,000 of debt outstanding of 10% interest rate. The
firms annual net sales are Br. 4,000,000; its tax rate is 40%; and its net profit margin is firms annual net sales are Br. 4,000,000; its tax rate is 40%; and its net profit margin is
5%. What is XYZ Companys times interest earned ratio? 5%. What is XYZ Companys times interest earned ratio?
Part III. Problem Part III. Problem
Complete the balance sheet and sales information in the following table for Abay Complete the balance sheet and sales information in the following table for Abay
Transport Ltd. Using the financial ratios that follow. Transport Ltd. Using the financial ratios that follow.
BALANCE SHEET BALANCE SHEET
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Cash Cash Accounts payable Accounts payable
Accounts receivable Accounts receivable Long-term debt Long-term debt 120,000 120,000
Inventories Inventories Common stock Common stock
Fixed assets Fixed assets ________ ________ Retained earnings Retained earnings 195,000 195,000
Total assets Total assets Br. 1,000,000 Br. 1,000,000 Total liabilities and equity Total liabilities and equity _______ _______
Sales Sales Cost of goods sold Cost of goods sold
Debt ratio: 50% Debt ratio: 50% Days sales outstanding: 36days Days sales outstanding: 36days
Quick ratio: 0.80X Quick ratio: 0.80X Cost of goods sold/sales: 75% Cost of goods sold/sales: 75%
Total assets turnover: 1.5X Total assets turnover: 1.5X Inventory turnover: 5X Inventory turnover: 5X
3.11 SELECTED REFERENCES 3.11 SELECTED REFERENCES
1. Eugene F. Brigham (1997). 1. Eugene F. Brigham (1997). Fundamentals of Financial Management Fundamentals of Financial Management. 7 . 7
th th
edition, the edition, the
Dryden Press Harcourt Brace College Publishers, Florida Dryden Press Harcourt Brace College Publishers, Florida
2. Lawrence J.Jitman (1991). 2. Lawrence J.Jitman (1991). Principles of Management Finance Principles of Management Finance. 6 . 6
th th
edition, Harper edition, Harper
Collins Publishers, San Diego. Collins Publishers, San Diego.
3. Stanley B. Block and Geoffrey A. Hirt (1994). 3. Stanley B. Block and Geoffrey A. Hirt (1994). Foundations of Financial Foundations of Financial
Management Management. 7 . 7
th th
edition, Irwin. edition, Irwin.
3.12 GLOSSARY 3.12 GLOSSARY
Acid test Acid test a detailed, rigorous, and more penetrating test. a detailed, rigorous, and more penetrating test.
Turnover Turnover the rate at which assets are replaced during a period; or the rate at which the rate at which assets are replaced during a period; or the rate at which
sales are generated against assets. sales are generated against assets.
Leverage Leverage the relationship between a firms debt balance and its earnings. the relationship between a firms debt balance and its earnings.
Margin Margin a markup over costs. The difference between the cost of something and the a markup over costs. The difference between the cost of something and the
price for which it is sold. price for which it is sold.
Return Return the total gain or loss experienced by owners on their investment over a given the total gain or loss experienced by owners on their investment over a given
period of time. period of time.
UNIT 4: FINANCIAL FORECASTING UNIT 4: FINANCIAL FORECASTING
Contents Contents
2.0 2.0 Aims and Objectives Aims and Objectives
4.2 Meaning and Purpose of Financial Forecasting 4.2 Meaning and Purpose of Financial Forecasting
4.3 Procedures in Financial Forecasting 4.3 Procedures in Financial Forecasting
4.4 Methods of Forecasting Financial Requirements 4.4 Methods of Forecasting Financial Requirements
4.4.1 The Performa Financial Statements Method 4.4.1 The Performa Financial Statements Method
4.4.2 The Formula Method 4.4.2 The Formula Method
4.5 Factors that Affect Additional Financial Requirements 4.5 Factors that Affect Additional Financial Requirements
4.6 Excess Capacity and Additional Financial Requirements 4.6 Excess Capacity and Additional Financial Requirements
At the end of this unit you should be able to answer the following questions: At the end of this unit you should be able to answer the following questions:
What are the basic purposes of financial forecasting? What are the basic purposes of financial forecasting?
How are the three main procedures of financial forecasting interrelated? How are the three main procedures of financial forecasting interrelated?
What are the most common methods used in forecasting financial What are the most common methods used in forecasting financial
requirements? requirements?
Why does the formula method of forecasting additional funds needed not Why does the formula method of forecasting additional funds needed not
produce reliable results? produce reliable results?
What are the factors that affect additional financial requirements of a firm? What are the factors that affect additional financial requirements of a firm?
How does excess capacity existing in assets affect the firms additional How does excess capacity existing in assets affect the firms additional
financial requirements? financial requirements?
In the first unit, we discussed that financial management involves planning for raising In the first unit, we discussed that financial management involves planning for raising
and utilizing funds. Financial mangers should be able to plan before hand in making and utilizing funds. Financial mangers should be able to plan before hand in making
investment and financing decisions. So, financial forecasting helps financial mangers to investment and financing decisions. So, financial forecasting helps financial mangers to
predict events before they occur. This, particularly, is true when they plan to raise funds predict events before they occur. This, particularly, is true when they plan to raise funds
externally. Because a firms profit is often insufficient to finance assets in the normal externally. Because a firms profit is often insufficient to finance assets in the normal
course of business, additional sources of finance should be considered. course of business, additional sources of finance should be considered.
Financial forecasting also forces financial mangers to develop financial statements before Financial forecasting also forces financial mangers to develop financial statements before
hand. These financial statements are called Pro forma financial statements. They include hand. These financial statements are called Pro forma financial statements. They include
forecasted sales and forecasted expenses, forecasted assets, forecasted liabilities, and forecasted sales and forecasted expenses, forecasted assets, forecasted liabilities, and
forecasted stockholders equity. Based on these forecasted items, the financial manger is forecasted stockholders equity. Based on these forecasted items, the financial manger is
able to determine the amount of finance to be obtained from external sources. able to determine the amount of finance to be obtained from external sources.
4.2 MEANING AND PURPOSE OF FINANCIAL FORECASTING 4.2 MEANING AND PURPOSE OF FINANCIAL FORECASTING
Financial forecasting is one of the four major jobs of a firms financial staff, namely Financial forecasting is one of the four major jobs of a firms financial staff, namely
performing financial forecasting and analysis, making investment decisions, and making performing financial forecasting and analysis, making investment decisions, and making
financing decisions. It is generally a planning process which involves forecasting of sales, financing decisions. It is generally a planning process which involves forecasting of sales,
assets, and financial requirements. In other words, financial forecasting is a process assets, and financial requirements. In other words, financial forecasting is a process
which involves: which involves:
- - evaluation of a firms need for increased or reduced productive capacity and evaluation of a firms need for increased or reduced productive capacity and
- - evaluation of the firms need for additional finance evaluation of the firms need for additional finance
Generally, financial forecasts are required to run a firm well. Their base, in almost all Generally, financial forecasts are required to run a firm well. Their base, in almost all
circumstances, are forecasted financial statements. An accurate financial forecast is very circumstances, are forecasted financial statements. An accurate financial forecast is very
important to any firm in several aspects: important to any firm in several aspects:
- - It helps a firm to predict appropriate demand for its products. It helps a firm to predict appropriate demand for its products.
- - It helps a firm to project its sales and accordingly to predict its assets properly. It helps a firm to project its sales and accordingly to predict its assets properly.
- - It contributes significantly to the firms profitability. It contributes significantly to the firms profitability.
- - It plays a crucial role in the value maximization goal of a firm. It plays a crucial role in the value maximization goal of a firm.
Financial forecasts are also meanses for forecasted financial statements. By their virtue, a Financial forecasts are also meanses for forecasted financial statements. By their virtue, a
firm can forecast its income statement, balance sheet and other related statements. firm can forecast its income statement, balance sheet and other related statements.
Besides, key ratios can be projected. Once financial statements and ratios have been Besides, key ratios can be projected. Once financial statements and ratios have been
forecasted, the financial forecast will be analyzed. Finally, the firms management will forecasted, the financial forecast will be analyzed. Finally, the firms management will
have an opportunity to make some decisions before hand. have an opportunity to make some decisions before hand.
So, all in all, financial forecasting is a prerequirment for the investment, financing, as So, all in all, financial forecasting is a prerequirment for the investment, financing, as
well as dividend policy decisions of a firm. well as dividend policy decisions of a firm.
4.3 PROCEDURES IN FINANCIAL FORECASTING 4.3 PROCEDURES IN FINANCIAL FORECASTING
The financial forecasting process generally involves the following procedures: The financial forecasting process generally involves the following procedures:
i) Forecasting of sales for the future period i) Forecasting of sales for the future period
ii) Determining the assets required to meet the sales targets, and ii) Determining the assets required to meet the sales targets, and
iii) Deciding on how to finance the required assets. iii) Deciding on how to finance the required assets.
The above three procedures are very important in projecting the financial statements and The above three procedures are very important in projecting the financial statements and
key financial ratios. However, among the three procedures, the first one, i.e, sales key financial ratios. However, among the three procedures, the first one, i.e, sales
forecast is the most crucial. forecast is the most crucial.
Sales forecast is a forecast of a firms unit and birr sales for some future period. It is Sales forecast is a forecast of a firms unit and birr sales for some future period. It is
generally based on recent sales trends and forecast of the economic prospects of the generally based on recent sales trends and forecast of the economic prospects of the
nation, region, industry and other factors. This procedure starts usually by reviewing the nation, region, industry and other factors. This procedure starts usually by reviewing the
sales of the recent pasts. The whole crucial points of a financial forecasting process lies in sales of the recent pasts. The whole crucial points of a financial forecasting process lies in
an accurate forecast of sales. If this procedure is off, the firms profitably as well as its an accurate forecast of sales. If this procedure is off, the firms profitably as well as its
value will be negatively affected. So in forecasting sales, several factors should be value will be negatively affected. So in forecasting sales, several factors should be
considered: considered:
1. the historical sales growth pattern of the firm at both divisional and corporate levels, 1. the historical sales growth pattern of the firm at both divisional and corporate levels,
2. the level of economic activity in each of the firms marketing areas, 2. the level of economic activity in each of the firms marketing areas,
3. the firms probable market share, 3. the firms probable market share,
4. the effect of inflation on the firms future pricing of products, 4. the effect of inflation on the firms future pricing of products,
5. the effect of advertising campaigns, cash and trade discounts, credit terms, and other 5. the effect of advertising campaigns, cash and trade discounts, credit terms, and other
similar factors alike on future sales, similar factors alike on future sales,
6. Individual products sales forecasts at each divisional level. 6. Individual products sales forecasts at each divisional level.
Forecast of sales is a base for forecasting of the firms income statement which in turn Forecast of sales is a base for forecasting of the firms income statement which in turn
helps to project retained earnings. In forecasting the income statement assumptions about helps to project retained earnings. In forecasting the income statement assumptions about
the costs, tax rates, interest charges and dividends are required. the costs, tax rates, interest charges and dividends are required.
Sales forecasts are also grounds for determination of the firms assets requirement. Sales forecasts are also grounds for determination of the firms assets requirement.
If sales are to increase, then assets must also grow. The amount each asset account must If sales are to increase, then assets must also grow. The amount each asset account must
increase depends whether the firm was operating at full capacity or not. If higher sales are increase depends whether the firm was operating at full capacity or not. If higher sales are
projected, more cash will be needed for transactions, higher sales will create higher projected, more cash will be needed for transactions, higher sales will create higher
receivables. Similarly, higher sales require higher inventory and higher plant and receivables. Similarly, higher sales require higher inventory and higher plant and
equipment. equipment.
Finally, the firm will face the question of financing its required assets. Some of the Finally, the firm will face the question of financing its required assets. Some of the
required finance can be covered by the increased retained earnings. The retained earnings required finance can be covered by the increased retained earnings. The retained earnings
increment will result from increased sales and profit. Still some other portion of the increment will result from increased sales and profit. Still some other portion of the
finance can be covered by some liabilities which will grow by the same proportion with finance can be covered by some liabilities which will grow by the same proportion with
that of sales. The remaining finance must be obtained from available external sources. that of sales. The remaining finance must be obtained from available external sources.
The third procedure of the financial forecasting process, i.e. forecast of financial The third procedure of the financial forecasting process, i.e. forecast of financial
requirements involves again three sub procedures. These are: requirements involves again three sub procedures. These are:
1. Determining how much money (finance) the firm will need during the forecasted 1. Determining how much money (finance) the firm will need during the forecasted
period. This will be done based on sales and assets forecast. period. This will be done based on sales and assets forecast.
2. Determing how much of the total required finance, the firm will be able to generate 2. Determing how much of the total required finance, the firm will be able to generate
internally during the same period. There are two types of finance that will be internally during the same period. There are two types of finance that will be
generated under normal operations. The first is portion of the net income retained in generated under normal operations. The first is portion of the net income retained in
the firm (retained earnings). The second one is the increase in the firms liabilities as the firm (retained earnings). The second one is the increase in the firms liabilities as
a direct and automatic result of its decision to increase sales. This finance is called a direct and automatic result of its decision to increase sales. This finance is called
spontaneous finance. For example, if sales are to increase, inventory must increase. spontaneous finance. For example, if sales are to increase, inventory must increase.
The increase in inventory requires more purchases which in turn causes the accounts The increase in inventory requires more purchases which in turn causes the accounts
payable to be increased. The accounts payable will increase spontaneously with the payable to be increased. The accounts payable will increase spontaneously with the
increase in sales. Other examples include accruals like salaries and wages payable increase in sales. Other examples include accruals like salaries and wages payable
and income tax payable. and income tax payable.
3. Determining the additional external financial requirements. Any balance of the total 3. Determining the additional external financial requirements. Any balance of the total
finance that cannot be met with normally generated funds must be obtained from finance that cannot be met with normally generated funds must be obtained from
external sources. This finance is called the additional funds needed (AFN). external sources. This finance is called the additional funds needed (AFN).
Required increase Required increase Required increase in Required increase in
AFN = AFN = in assets __ normally generated funds. in assets __ normally generated funds.
Additional funds needed (AFN) Additional funds needed (AFN) are funds that a firm must raise externally through are funds that a firm must raise externally through
borrowing (bank loans, promissory notes, bonds, etc.) or by issuing new shares of borrowing (bank loans, promissory notes, bonds, etc.) or by issuing new shares of
common stock or preferred stock. common stock or preferred stock.
4.4 METHODS OF FORECASTING FINANCIAL REQUIREMENTS 4.4 METHODS OF FORECASTING FINANCIAL REQUIREMENTS
There are two methods to determine the additional financial requirements. These are: There are two methods to determine the additional financial requirements. These are:
1. The proforma financial statements method and 1. The proforma financial statements method and
2. The formula method 2. The formula method
4.4.1 The Pro-Forma Financial Statements Method 4.4.1 The Pro-Forma Financial Statements Method
The pro-forma financial statements method is simply a method of forecasting financial The pro-forma financial statements method is simply a method of forecasting financial
requirements based on forecasted financial statements. As a result, this method is also requirements based on forecasted financial statements. As a result, this method is also
called the projected financial statements method. Under this method, the asset called the projected financial statements method. Under this method, the asset
requirements are first projected for the fore coming future period. The forecast of assets requirements are first projected for the fore coming future period. The forecast of assets
helps to determine the total financial requirements. Then, the liabilities and equity that helps to determine the total financial requirements. Then, the liabilities and equity that
will be generated under normal operations are projected. Finally, the additional funds will be generated under normal operations are projected. Finally, the additional funds
needed will be estimated. needed will be estimated.
The pro-forma financial statements method of determining additional financial The pro-forma financial statements method of determining additional financial
requirements involve the following steps. requirements involve the following steps.
1. Developing the Pro Forma Income statement 1. Developing the Pro Forma Income statement
The proforma income statement provides a projection of the firms net income for the The proforma income statement provides a projection of the firms net income for the
forecasted period. This enables the firm to estimate the amount of retained earnings it forecasted period. This enables the firm to estimate the amount of retained earnings it
will generate during the period. In developing the projected income statement, first, a will generate during the period. In developing the projected income statement, first, a
forecast of sales should be established. Second, cost of goods sold should be determined. forecast of sales should be established. Second, cost of goods sold should be determined.
Third, other expenses (operating and non-operating) should be computed. Next, the net Third, other expenses (operating and non-operating) should be computed. Next, the net
income should be determined. Finally, based on the amount of dividends, the amount of income should be determined. Finally, based on the amount of dividends, the amount of
addition to retained earnings should be determined. addition to retained earnings should be determined.
2. Constructing the Pro Forma Balance Sheet 2. Constructing the Pro Forma Balance Sheet
Higher sales must be supported by higher asset amounts. Some of the assets increase can Higher sales must be supported by higher asset amounts. Some of the assets increase can
be financed by retained earnings, and spontaneous finance. The remaining blanc must be be financed by retained earnings, and spontaneous finance. The remaining blanc must be
financed from external sources. In the forecast of the firms balance sheet, first, those financed from external sources. In the forecast of the firms balance sheet, first, those
balance sheet items that are expected to increase directly with sales are forecasted. Next, balance sheet items that are expected to increase directly with sales are forecasted. Next,
the spontaneously increasing liabilities are forecasted. Then, the liability and equity items the spontaneously increasing liabilities are forecasted. Then, the liability and equity items
that are not directly affected by sales are set. Next, the value of retained earnings for the that are not directly affected by sales are set. Next, the value of retained earnings for the
forecasted period is obtained. Finally, the AFN will be raised. forecasted period is obtained. Finally, the AFN will be raised.
Example Example
Blue Nile Share Company is a medium sized firm engaged in manufacturing of various Blue Nile Share Company is a medium sized firm engaged in manufacturing of various
household utensils. The financial manger is preparing the financial forecast of the household utensils. The financial manger is preparing the financial forecast of the
following year. At the end of the year just completed, the condensed balance sheet of the following year. At the end of the year just completed, the condensed balance sheet of the
company has contained the following items. company has contained the following items.
Assets Assets Liabilities and Equity Liabilities and Equity
Cash ----------------------------Br. 10,000 Cash ----------------------------Br. 10,000 A/payable --------------------------Br. 90,000 A/payable --------------------------Br. 90,000
A/receivable -----------------------70,000 A/receivable -----------------------70,000 Accruals -------------------------------- Accruals --------------------------------40,000 40,000
Inventories ----------------------- Inventories -----------------------150,000 150,000 Current liabilities -------------Br. 130,000 Current liabilities -------------Br. 130,000
Current assets -------------Br. 230,000 Current assets -------------Br. 230,000 Long-term debt -----------------------200,000 Long-term debt -----------------------200,000
Net fixed assets -----------------370,000 Net fixed assets -----------------370,000 Common stock ------------------------120,000 Common stock ------------------------120,000
_________ _________ Retained earnings -------------------- Retained earnings --------------------150,000 150,000
Total assets ------------- Total assets -------------Br. 600,000 Br. 600,000 Total laibs. and equity ------ Total laibs. and equity ------Br. 600,000 Br. 600,000
During the year just completed the firm had sales of Br. 1,800,000. In the following year, During the year just completed the firm had sales of Br. 1,800,000. In the following year,
due to increased demand to the firms products the financial manger estimates that sales due to increased demand to the firms products the financial manger estimates that sales
will grow at 10%. There are no preferred stock outstanding during the year. The firms will grow at 10%. There are no preferred stock outstanding during the year. The firms
dividend pay-out ratio is 60%. It is also known that the firms assets have been operating dividend pay-out ratio is 60%. It is also known that the firms assets have been operating
at full capacity. During the same year, Blue Niles operating costs were Br. 1,620,000 at full capacity. During the same year, Blue Niles operating costs were Br. 1,620,000
and are estimated to increase proportionately with sales. Assume the companys interest and are estimated to increase proportionately with sales. Assume the companys interest
expense will be Br. 40,000 during the next year and its tax rate is 40%. expense will be Br. 40,000 during the next year and its tax rate is 40%.
Required: Required: Determine the additional funds needed (AFN) of Blue Nile Share Company Determine the additional funds needed (AFN) of Blue Nile Share Company
for the next year using the proforma financial statements method. for the next year using the proforma financial statements method.
Solution Solution
First, we develop the proforma income statement First, we develop the proforma income statement
Pro Forma Income Statement Pro Forma Income Statement
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_ _
Sales (Br. 1,800,000 x 1.10) ------------------------------------------------------------------------------Br. 1,980,000 Sales (Br. 1,800,000 x 1.10) ------------------------------------------------------------------------------Br. 1,980,000
Operating costs (Br. 1,620,000 x 1.10) ---------------------------------------------------------------------- Operating costs (Br. 1,620,000 x 1.10) ----------------------------------------------------------------------1,782,000 1,782,000
Earnings before interest and taxes (EBIT) ----------------------------------------------------------------Br. 198,000 Earnings before interest and taxes (EBIT) ----------------------------------------------------------------Br. 198,000
Interest expense ----------------------------------------------------------------------------------------------------- Interest expense -----------------------------------------------------------------------------------------------------40,000 40,000
Earnings before taxes (EBT) --------------------------------------------------------------------------------Br. 158,000 Earnings before taxes (EBT) --------------------------------------------------------------------------------Br. 158,000
Taxes (Br. 158,000 x 40%) --------------------------------------------------------------------------------------- Taxes (Br. 158,000 x 40%) ---------------------------------------------------------------------------------------63,200 63,200
Net income ----------------------------------------------------------------------------------------------------- Net income -----------------------------------------------------------------------------------------------------Br. 94,800 Br. 94,800
Dividends to common stock (Br. 94,800 x 60%) --------------------------------------------------------- Dividends to common stock (Br. 94,800 x 60%) ---------------------------------------------------------Br. 56,880 Br. 56,880
Addition to retained earnings (Br. 94,800 Br. 56,880) ------------------------------------------------ Addition to retained earnings (Br. 94,800 Br. 56,880) ------------------------------------------------Br. 37,920 Br. 37,920
Then, we construct the proforma balance sheet Then, we construct the proforma balance sheet
Pro Forma Balance Sheet Pro Forma Balance Sheet
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_ _
Assets Assets Liabilities and Equity Liabilities and Equity
Cash (Br. 10,000 x 1.10) ----------------Br. 11,000 A/Payable (Br. 90,000 x 1.10) -------------Br. 99,000 Cash (Br. 10,000 x 1.10) ----------------Br. 11,000 A/Payable (Br. 90,000 x 1.10) -------------Br. 99,000
A./receivable (Br. 70,000 x 1.10) ----------77,000 Accruals (Br. 40,000 x 1.10) -------------------- A./receivable (Br. 70,000 x 1.10) ----------77,000 Accruals (Br. 40,000 x 1.10) --------------------44,000 44,000
Inventories (Br. 150,000 x 1.10) ---------- Inventories (Br. 150,000 x 1.10) ----------165,000 165,000 Current liabilities ----------------------------Br. 143,000 Current liabilities ----------------------------Br. 143,000
Current assets ---------------------------Br. 253,000 Long-term debt (the increase is unknown)----200,000 Current assets ---------------------------Br. 253,000 Long-term debt (the increase is unknown)----200,000
Net fixed assets (Br. 370,000 x 1.10) ----407,000 Common stock (as long-term debt) ------------120,000 Net fixed assets (Br. 370,000 x 1.10) ----407,000 Common stock (as long-term debt) ------------120,000
_______ Retained earnings (Br. 150,000 + Br. 37,920) _______ Retained earnings (Br. 150,000 + Br. 37,920) 187,920 187,920
Total assets ----------------------- Total assets -----------------------Br. 660,000 Br. 660,000 Total liabilities and equity ------------- Total liabilities and equity -------------Br. 650,920 Br. 650,920
Blue Niles forecasted total assets as shown above are Br. 660,000. However, the Blue Niles forecasted total assets as shown above are Br. 660,000. However, the
forecasted total liabilities and equity amount to only Br. 650,920. Since the balance sheet forecasted total liabilities and equity amount to only Br. 650,920. Since the balance sheet
must balance, i.e. A = L + OE, the difference must be covered by additional funds. must balance, i.e. A = L + OE, the difference must be covered by additional funds.
Therefore, AFN = Br. 660,000 Br. 650,920 = Br. 9,080. Therefore, AFN = Br. 660,000 Br. 650,920 = Br. 9,080.
Or AFN = increase in Increase in normally Or AFN = increase in Increase in normally
assets generated funds assets generated funds
= [Br. 660,000 Br. 600,000] [(Br. 99,000 Br. 90,000) + (Br. 44,000 Br. = [Br. 660,000 Br. 600,000] [(Br. 99,000 Br. 90,000) + (Br. 44,000 Br.
40,000) + Br. 37,920] 40,000) + Br. 37,920]
= Br. 60,000 Br. 50,920 = Br. 60,000 Br. 50,920
= = Br. 9,080 Br. 9,080
1. Briefly explain why an accurate financial forecast is crucial to the wealth maximization 1. Briefly explain why an accurate financial forecast is crucial to the wealth maximization
goal of a firm. goal of a firm.
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2. In the illustration above, the amount of interest expense is assumed to be Br. 40,000. 2. In the illustration above, the amount of interest expense is assumed to be Br. 40,000.
What do you think are the basic factors that affect the amount of interest expense? What do you think are the basic factors that affect the amount of interest expense?
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3. Taha Private Limited Company (PLC) had sales of Br. 5 million and total assets of Br. 3. Taha Private Limited Company (PLC) had sales of Br. 5 million and total assets of Br.
4.5 million in 2002. The current liabilities during the end of the same year were Br. 4.5 million in 2002. The current liabilities during the end of the same year were Br.
1,250,000. The PLCs net profit margin and dividend pay-out ratios are 6% and 30% 1,250,000. The PLCs net profit margin and dividend pay-out ratios are 6% and 30%
respectively. All assets and current liabilities will vary directly with sales. Determine respectively. All assets and current liabilities will vary directly with sales. Determine
the additional funds needed (AFN) for 2003 if sales are projected to grow by 5% the additional funds needed (AFN) for 2003 if sales are projected to grow by 5%
only. only.
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4.4.2 The Formula Method 4.4.2 The Formula Method
This is a much easier method of determining additional financial requirements than the This is a much easier method of determining additional financial requirements than the
pro forma method. The formula method is a shortcut to financial forecasting. However, pro forma method. The formula method is a shortcut to financial forecasting. However,
many companies use the pro forma method of forecasting their financial requirements many companies use the pro forma method of forecasting their financial requirements
because the output of the formula method is less meaningful. Under the shortcut method, because the output of the formula method is less meaningful. Under the shortcut method,
we make the following assumptions. we make the following assumptions.
1. Each asset maintains a direct proportionate relationship with sales 1. Each asset maintains a direct proportionate relationship with sales
2. Accounts payable and accruals increase in direct proportion to sales increase. 2. Accounts payable and accruals increase in direct proportion to sales increase.
3. The profit margin and the dividend pay-out ratios are constant. 3. The profit margin and the dividend pay-out ratios are constant.
The formula that can be used as a shortcut to determine external capital requirements is The formula that can be used as a shortcut to determine external capital requirements is
given as: given as:
Additional Additional Required Required Spontaneous Spontaneous Increase in Increase in
funds funds = = increase increase increase in increase in retained retained
needed needed in assets in assets liabilities liabilities earnings earnings
AFN = (A/S) AFN = (A/S) S (L/S) S (L/S) S MS S MS
1 1 (1 d) (1 d)
Where Where
AFN = Additional funds needed AFN = Additional funds needed
A/S = Percentage relationship of variable assets to sales = Capital intensity ratio. A/S = Percentage relationship of variable assets to sales = Capital intensity ratio.
S = change in sales = S S = change in sales = S
1 1 S S
0 0 = S = S
0 0 x g x g
S S
1 1 = Total Sales projected for the next period = Total Sales projected for the next period
S S
0 0 = Total sales of the current period = Total sales of the current period
L/S = Percentage relationship of variable (spontaneous) liabilities to sales L/S = Percentage relationship of variable (spontaneous) liabilities to sales
M = Net profit margin M = Net profit margin
d = Dividend payout ratio d = Dividend payout ratio
g = The expected sales growth rate g = The expected sales growth rate
To illustrate the formula method, consider the example given for the previous method. To illustrate the formula method, consider the example given for the previous method.
But assume that Blue Niles net profit margin is 5%. But assume that Blue Niles net profit margin is 5%.
AFN = AFN =
( )
,
_

,
_
000 , 800 , 1 .
000 , 130 .
000 , 180 .
000 , 800 , 1 .
000 , 600 .
*
Br
Br
Br
Br
Br
(Br. 180,000) 5% x (Br. 180,000) 5% x
Br 1,980,000** (1 60%) Br 1,980,000** (1 60%)
= Br. 60,000 Br. 13,000 Br. 39,600 = Br. 60,000 Br. 13,000 Br. 39,600
= = Br. 7,400 Br. 7,400
To increase sales by 10% (Br. 180,000), the formula suggests that Blue Nile must To increase sales by 10% (Br. 180,000), the formula suggests that Blue Nile must
increase its assets by 60,000. In other words, the firm will require a Br. 60,000 more fund increase its assets by 60,000. In other words, the firm will require a Br. 60,000 more fund
for the forecasted year. Out of this, Br. 13,000 will come from spontaneous increase in for the forecasted year. Out of this, Br. 13,000 will come from spontaneous increase in
liabilities. Another Br. 39,600 will be obtained from retained earnings. The remaining Br. liabilities. Another Br. 39,600 will be obtained from retained earnings. The remaining Br.
7,400 must be raised from external sources like by issuing new shares of stocks or by 7,400 must be raised from external sources like by issuing new shares of stocks or by
borrowing. borrowing.
* * S = S S = S
1 1 S S
0 0 = S = S
0 0 x sales growth rate (g) = Br. 1,800,000 x 10% = Br. 180,000 x sales growth rate (g) = Br. 1,800,000 x 10% = Br. 180,000
** S ** S
1 1 = S = S
0 0 + S + S
0 0g = S g = S
0 0 (1 +g) = Br. 1,800,000 (1 + 0.10) = Br. 1,980,000. (1 +g) = Br. 1,800,000 (1 + 0.10) = Br. 1,980,000.
1. Why do not the pro forma and the formula methods of forecasting financial 1. Why do not the pro forma and the formula methods of forecasting financial
requirements result in the same AFN? requirements result in the same AFN?
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2. Selam Manufacturing Company has the following ratios: A/S = 1.6; L/S = 0.4; M = 2. Selam Manufacturing Company has the following ratios: A/S = 1.6; L/S = 0.4; M =
10%; and d = 45%. Sales last year were Br. 10 million. If these ratios will remain 10%; and d = 45%. Sales last year were Br. 10 million. If these ratios will remain
constant next year, what is the maximum sales growth rate (g) Selam can achieve without constant next year, what is the maximum sales growth rate (g) Selam can achieve without
having to use additional funds needed (AFN)? (Use the formula for AFN). having to use additional funds needed (AFN)? (Use the formula for AFN).
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4.5 FACTORS THAT AFFECT ADDITIONAL FINANCIAL REQUIREMENTS 4.5 FACTORS THAT AFFECT ADDITIONAL FINANCIAL REQUIREMENTS
The external financial requirements of a firm during any given period are affected by The external financial requirements of a firm during any given period are affected by
several factors. several factors.
1. Financial Planning. 1. Financial Planning. Refers to the growth rates of sales a firm has projected. Sales Refers to the growth rates of sales a firm has projected. Sales
growth rates and additional funds needed are positively related. At low growth rates of a growth rates and additional funds needed are positively related. At low growth rates of a
sale, a firm needs small or no external financing. The firm might even generate surplus sale, a firm needs small or no external financing. The firm might even generate surplus
funds at low growth rates. As the growth rates increase, the AFN will also increase. So funds at low growth rates. As the growth rates increase, the AFN will also increase. So
other factors being constant, the higher the sales growth rates, the higher the AFN. other factors being constant, the higher the sales growth rates, the higher the AFN.
2. Capital Intensity. 2. Capital Intensity. This is the amount of assets required to support each birr of sales. This is the amount of assets required to support each birr of sales.
In the formula, this is designated as A/S. Generally, firms with higher capital intensity In the formula, this is designated as A/S. Generally, firms with higher capital intensity
ratios are with greater capital requirements. Highly capital-intensive firms generally ratios are with greater capital requirements. Highly capital-intensive firms generally
require more external funds than labor intensive firms. require more external funds than labor intensive firms.
3. Profit Margin 3. Profit Margin. Profit margin, as you might well recall from unit 3, is the net income . Profit margin, as you might well recall from unit 3, is the net income
per each birr of net sales. It is evident from the very formula of computing AFN that per each birr of net sales. It is evident from the very formula of computing AFN that
external capital requirements and net profit margin are related in opposite directions. external capital requirements and net profit margin are related in opposite directions.
Other factors held constant, the higher the profit margin, the lower the external funds Other factors held constant, the higher the profit margin, the lower the external funds
requirements. requirements.
4. Dividends policy. 4. Dividends policy. Dividend policy refers to the percentage of a firms net earnings Dividend policy refers to the percentage of a firms net earnings
paid out as cash dividends. It is reflected in the firms payout ratio. The higher the paid out as cash dividends. It is reflected in the firms payout ratio. The higher the
dividend payout ratio, the smaller the addition to retrained earnings, and hence the greater dividend payout ratio, the smaller the addition to retrained earnings, and hence the greater
the requirements for external finance. the requirements for external finance.
What is the impact on the AFN of a firms decision of beginning to pay employees on a What is the impact on the AFN of a firms decision of beginning to pay employees on a
monthly basis dropping the previous practice of paying at the end of every week? monthly basis dropping the previous practice of paying at the end of every week?
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4.6 EXCESS CAPACITY AND ADDITIONAL FINANCIAL REQUIREMENTS 4.6 EXCESS CAPACITY AND ADDITIONAL FINANCIAL REQUIREMENTS
Previously, when we were dealing with Blue Niles financial forecast, our assumption Previously, when we were dealing with Blue Niles financial forecast, our assumption
had been that assets were operating at full capacity (100% capacity). Now lets relax this had been that assets were operating at full capacity (100% capacity). Now lets relax this
assumption that excess capacity exists in the firms fixed assets. In fact, theoretically assumption that excess capacity exists in the firms fixed assets. In fact, theoretically
excess capacity exists with all types of assets. But as a practical matter, excess capacity excess capacity exists with all types of assets. But as a practical matter, excess capacity
normally exists primarily with respect to fixed assets. normally exists primarily with respect to fixed assets.
Assume that Blue Nile was operating at only 98% its fixed assets capacity. How does this Assume that Blue Nile was operating at only 98% its fixed assets capacity. How does this
affect the firms AFN? Some procedures are involved to see the effect. affect the firms AFN? Some procedures are involved to see the effect.
i) Determine the full capacity sales, i.e., sales that could have been produced had fixed i) Determine the full capacity sales, i.e., sales that could have been produced had fixed
assets been utilized 100%. assets been utilized 100%.
Full Full Actual sales______________ Actual sales______________
capacity = Percentage of capacity at which capacity = Percentage of capacity at which
sales sales fixed assets were operated fixed assets were operated

= = Br. 1,800,00 Br. 1,800,00 = Br. 1,836,735 = Br. 1,836,735
98% 98%
ii) Determine the target fixed assets/sales ratio ii) Determine the target fixed assets/sales ratio
Target fixed assets/sales ratio = Target fixed assets/sales ratio = Actual fixed assets Actual fixed assets
Full capacity sales Full capacity sales
= = Br. 370,000 Br. 370,000 = 20% = 20%
Br. 1,836,735 Br. 1,836,735
iii) Determine the new required level of fixed assets. iii) Determine the new required level of fixed assets.
Required level of = (Target fixed assets/sales ratio) X (Projected sales) Required level of = (Target fixed assets/sales ratio) X (Projected sales)
fixed assets fixed assets
= 20% X Br. 1,980,000 = Br. 396,000 = 20% X Br. 1,980,000 = Br. 396,000
Previously Blue Nile forecasted it would need to increase fixed assets at the same rate as Previously Blue Nile forecasted it would need to increase fixed assets at the same rate as
sales or by 10%. That means, the firm forecasted an increase from Br. 370,000 to Br. sales or by 10%. That means, the firm forecasted an increase from Br. 370,000 to Br.
407,000. Now we see that the actual required increase is only from Br. 370,000 to Br. 407,000. Now we see that the actual required increase is only from Br. 370,000 to Br.
396,000. Thus, the capacity adjust forecast is Br. 11,000 (Br. 407,00 Br. 396,000) less 396,000. Thus, the capacity adjust forecast is Br. 11,000 (Br. 407,00 Br. 396,000) less
than the earlier forecast. Therefore, the projected AFN would decline from an estimated than the earlier forecast. Therefore, the projected AFN would decline from an estimated
Br. 9,080 to Br. -1,920 (Br. 9,080 Br. 11,000). The negative AFN indicates the firm Br. 9,080 to Br. -1,920 (Br. 9,080 Br. 11,000). The negative AFN indicates the firm
would even produce excess funds of Br. 1,920 than it requires. would even produce excess funds of Br. 1,920 than it requires.
The key concepts covered in this unit are summarized below The key concepts covered in this unit are summarized below
- - Financial forecasts are very important for both profitability and value Financial forecasts are very important for both profitability and value
maximization of a firm. maximization of a firm.
- - Financial forecasting is a planning process which includes forecast of sales, Financial forecasting is a planning process which includes forecast of sales,
determining of capacities, and deciding on how to finance capacities (assets). determining of capacities, and deciding on how to finance capacities (assets).
- - The two most common methods of forecasting the financial requirement of a firm The two most common methods of forecasting the financial requirement of a firm
are: (1) the projected financial statement method and (2) The formula method. are: (1) the projected financial statement method and (2) The formula method.
- - The external capital requirement of a firm is affected by its sales growth rate, The external capital requirement of a firm is affected by its sales growth rate,
capital intensity ratio, net profit margin, and dividend payout ratio. capital intensity ratio, net profit margin, and dividend payout ratio.
- - Adjustments must be made to the additional funds needed (AFN) of a firm if Adjustments must be made to the additional funds needed (AFN) of a firm if
excess capacity exists in the use of its fixed assets. excess capacity exists in the use of its fixed assets.
I. I. 1. An accurate financial forecast enables a firm to forecast sales accurately. An 1. An accurate financial forecast enables a firm to forecast sales accurately. An
accurate forecast of sales then allows appropriate forecasts of assets, costs, and accurate forecast of sales then allows appropriate forecasts of assets, costs, and
expenses. This in turn would affect the profitability as well as the wealth expenses. This in turn would affect the profitability as well as the wealth
maximization goal. maximization goal.
2. The basic factors that affect the amount of interest expense are the amount or the 2. The basic factors that affect the amount of interest expense are the amount or the
balance of the debt and the prevailing interest rate. balance of the debt and the prevailing interest rate.
3. AFN = increase Increase in normally 3. AFN = increase Increase in normally
in assets generated funds in assets generated funds
Increase in assets = Br. 4,500,000 x 5% = Br. 225,000 Increase in assets = Br. 4,500,000 x 5% = Br. 225,000
Increase in normally Increase in Increase in Increase in normally Increase in Increase in
generated funds = spontaneous liabilities + retained earnings generated funds = spontaneous liabilities + retained earnings
= Br. 1,250,000 x 5% + (6% x Br. 5,000, 000 x 1.05) x (1 30%) = Br. 1,250,000 x 5% + (6% x Br. 5,000, 000 x 1.05) x (1 30%)
= Br. 62,500 + Br. 220,500 = Br. 62,500 + Br. 220,500
= Br. 283,000 = Br. 283,000
Therefore, AFN = Br. 225,000 Br. 283,000 = -Br. 58,000. This tells us that Taha PLC Therefore, AFN = Br. 225,000 Br. 283,000 = -Br. 58,000. This tells us that Taha PLC
could generate Br. 58,000 more funds than it requires for achieving its sales plan; and could generate Br. 58,000 more funds than it requires for achieving its sales plan; and
that is does not require any AFN. that is does not require any AFN.
II. II. 1. Because in the pro forma method all costs and expenses are forecasted in detail, but 1. Because in the pro forma method all costs and expenses are forecasted in detail, but
in the formula method assumptions which might not hold practical are made. in the formula method assumptions which might not hold practical are made.
2. If Selam Company has to increase sales without having to use additional funds 2. If Selam Company has to increase sales without having to use additional funds
needed, AFN will be zero. Hence, needed, AFN will be zero. Hence,
(A/S) (A/S) S (L/S) S (L/S) S MS S MS
1 1 (1 d) = 0 (1 d) = 0
1.6 gs 1.6 gs
0 0 0.4gs 0.4gs
0 0 Ms Ms
0 0 (1 + g) (1 d) = 0 (1 + g) (1 d) = 0
1.6gs 1.6gs
0 0 0.4gs 0.4gs
0 0 0.10s 0.10s
0 0 (1 + g) (1 0.45) = 0 (1 + g) (1 0.45) = 0
1.6gs 1.6gs
0 0 0.4gs 0.4gs
0 0 (0.10s (0.10s
0 0 0.10gs 0.10gs
0 0) = 0 ) = 0
1.2gs 1.2gs
0 0 (0.055s (0.055s
0 0 0.055gs 0.055gs
0 0) (0.55) = 0 ) (0.55) = 0
1.2gs 1.2gs
0 0 0.055s 0.055s
0 0 + 0.055gs + 0.055gs
0 0 = 0 = 0
1.255gs 1.255gs
0 0 = 0.055s = 0.055s
0 0
1.255g = 0.055 1.255g = 0.055
g = 0.055/1.255 = g = 0.055/1.255 = 4.38%. 4.38%.
III. III. When the firm starts paying at the end of each month, its balance of salaries payable When the firm starts paying at the end of each month, its balance of salaries payable
would be more than when it was paying weekly. The increase in salaries payable is an would be more than when it was paying weekly. The increase in salaries payable is an
increase in accruals which is a spontaneous finance. Finally, the increase in increase in accruals which is a spontaneous finance. Finally, the increase in
spontaneous finance would cause the AFN to be smaller. spontaneous finance would cause the AFN to be smaller.
4. 4.9 MODEL EXAMINATION QUESTIONS 9 MODEL EXAMINATION QUESTIONS
1. 1. In determining the additional financial requirements (AFN) of a firm for a given period In determining the additional financial requirements (AFN) of a firm for a given period
under consideration, under consideration,
A) A) The fixed assets are always forecasted to incase proportionally with sales. The fixed assets are always forecasted to incase proportionally with sales.
B) B) The addition to retained earnings is forecasted as a specified percentage of sales. The addition to retained earnings is forecasted as a specified percentage of sales.
C) C) AFN is simply computed by deducting spontaneous liabilities from the required AFN is simply computed by deducting spontaneous liabilities from the required
increase in the current level of assets increase in the current level of assets
D) D) None of the above None of the above
2. Which of the following statement(s) is (are) true for a firm having sales expansion 2. Which of the following statement(s) is (are) true for a firm having sales expansion
plan, if its fixed assets operate below full capacity? plan, if its fixed assets operate below full capacity?
A) A) Fixed assets increase at a rate faster than sales growth rate. Fixed assets increase at a rate faster than sales growth rate.
B) B) Fixed assets increase at a rate slower than the growth of sales Fixed assets increase at a rate slower than the growth of sales
C) C) Fixed assets are not affected by sales expansion plan Fixed assets are not affected by sales expansion plan
D) D) Fixed assets increase until full capacity sales are achieved Fixed assets increase until full capacity sales are achieved
3. Which one of the following factors causes the AFN of a firm to be high? 3. Which one of the following factors causes the AFN of a firm to be high?
A) A) Lower sales growth rate Lower sales growth rate
B) B) Higher dividend payout ratio Higher dividend payout ratio
C) C) Higher net profit margin Higher net profit margin
D) D) Lower capital intensity ratio Lower capital intensity ratio
Part II. Problem Part II. Problem
You are given below the condensed balance sheet and income statement of Addisalem You are given below the condensed balance sheet and income statement of Addisalem
Auto Spare Parts, PLC for 2002 Auto Spare Parts, PLC for 2002
Balance sheet as of December 31,2002 Balance sheet as of December 31,2002
Cash -------------------------Br. 90,000 Cash -------------------------Br. 90,000 Accounts payable -----------------Br. 180,000 Accounts payable -----------------Br. 180,000
Receivables -------------------180,000 Receivables -------------------180,000 Notes payable (10% interest) ----------78,000 Notes payable (10% interest) ----------78,000
Inventories -------------------- Inventories --------------------360,000 360,000 Accruals ---------------------------------- Accruals ----------------------------------90,000 90,000
Current assets ------------Br. 630,000 Current assets ------------Br. 630,000 Current liabilities -----------------Br. 348,000 Current liabilities -----------------Br. 348,000
Net fixed assets ------------720,000 Net fixed assets ------------720,000 Common stock --------------------900,000 Common stock --------------------900,000
_________ _________ Retained earnings --------------------- Retained earnings ---------------------102,000 102,000
Total assets --------- Total assets ---------Br. 1,350,000 Br. 1,350,000 Total liabilities and equity --- Total liabilities and equity ---Br. 1,350,000 Br. 1,350,000
Income statement for year ended December 31, 2002 Income statement for year ended December 31, 2002
Sales -------------------------------Br. 1,800,000 Sales -------------------------------Br. 1,800,000
Operating costs ----------------------- Operating costs -----------------------1,625,000 1,625,000
EBIT ---------------------------------Br. 175,000 EBIT ---------------------------------Br. 175,000
Interest ------------------------------------ Interest ------------------------------------25,000 25,000
EBT--------------------------------- Br. 150,000 EBT--------------------------------- Br. 150,000
Taxes (40%) ----------------------------- Taxes (40%) -----------------------------60,000 60,000
Net income -------------------------- Net income --------------------------Br. 90,000 Br. 90,000
The firms common stock price during 2002 was Br. 24. Similarly earnings per share The firms common stock price during 2002 was Br. 24. Similarly earnings per share
(EPS) and dividends per share (DPS) were Br. 1.80 and Br. 1.08 respectively. Sales are (EPS) and dividends per share (DPS) were Br. 1.80 and Br. 1.08 respectively. Sales are
projected to increase by 10% in 2003. It is learned that assets are operating at full projected to increase by 10% in 2003. It is learned that assets are operating at full
capacity. capacity.
Required: Required:
a) Determine the AFN using the pro forma method. a) Determine the AFN using the pro forma method.
b) Assume 50% of the AFN will be financed by common stock and the common stock b) Assume 50% of the AFN will be financed by common stock and the common stock
price remains unchanged in 2003, how many share should Addisalem issue in 2003? price remains unchanged in 2003, how many share should Addisalem issue in 2003?
c) How does the financing of AFN through common stock affects the firms dividend as c) How does the financing of AFN through common stock affects the firms dividend as
well as its retained earnings? well as its retained earnings?
d) Assume also that the remaining 50% is to be financed by notes payable, how does this d) Assume also that the remaining 50% is to be financed by notes payable, how does this
affect interest expense? affect interest expense?
e) Determine the AFN using the formula method e) Determine the AFN using the formula method
f) If fixed assets were operating at only 96% of capacity during 2002, how does this f) If fixed assets were operating at only 96% of capacity during 2002, how does this
affect AFN? (Use the formula method) affect AFN? (Use the formula method)
1. Eugene F. Brigham (1997). 1. Eugene F. Brigham (1997). Fundamental of Financial Management Fundamental of Financial Management. 7 . 7
th th
Dryden press Harcourt Brace College Publishers, Florida. Dryden press Harcourt Brace College Publishers, Florida.
2. Halpern, Weston, and Brigham (1989). 2. Halpern, Weston, and Brigham (1989). Canadian Managerial Finance Canadian Managerial Finance. 3 . 3
rd rd
edition, edition,
Holt, Rinehart and Winston of Canada, Limited. Holt, Rinehart and Winston of Canada, Limited.
th th
Proforma financial statements Proforma financial statements financial statements prepared for forecasted periods. financial statements prepared for forecasted periods.
Sales targets Sales targets a forecast of a firms sales in terms of both units and amounts. a forecast of a firms sales in terms of both units and amounts.
Full capacity Full capacity a situation where by all the assets of a firm are being utilized 100%. a situation where by all the assets of a firm are being utilized 100%.
Spontaneous finance Spontaneous finance a finance available to a firm as a direct or indirect result of a a finance available to a firm as a direct or indirect result of a
sales increment decision of the firm. sales increment decision of the firm.
Labor intensive Labor intensive highly utilizing labor force highly utilizing labor force
Excess capacity Excess capacity a situation whereby some portion of a firms assets, particularly fixed a situation whereby some portion of a firms assets, particularly fixed
assets, are not currently utilized. assets, are not currently utilized.
Fixed assets / Sales ratio Fixed assets / Sales ratio the amount of fixed assets required per birr of sales. the amount of fixed assets required per birr of sales.
UNIT 4: THE TIME VALUE OF MONEY UNIT 4: THE TIME VALUE OF MONEY
Many decisions in finance involve choices of receiving or paying cash at different time Many decisions in finance involve choices of receiving or paying cash at different time
periods. As you recall from the discussions of the second unit, the goal of a firm is wealth periods. As you recall from the discussions of the second unit, the goal of a firm is wealth
maximization. This goal recognizes the difference in the value of equal cash flows maximization. This goal recognizes the difference in the value of equal cash flows
received at different time periods. So the concept of the time value of money is that received at different time periods. So the concept of the time value of money is that
money received now is generally better than the same amount of money received some money received now is generally better than the same amount of money received some
time later. This is because there is an opportunity to invest the money we have now and time later. This is because there is an opportunity to invest the money we have now and
earn a return on it. For example, if you have Br. 1,000 today, you could save it in a bank earn a return on it. For example, if you have Br. 1,000 today, you could save it in a bank
and earn interest. and earn interest.
The time value of money is a very important concept in financial management. It has The time value of money is a very important concept in financial management. It has
many applications in financial decisions like loan settlements, investing in bonds and many applications in financial decisions like loan settlements, investing in bonds and
stocks of other entities, acquisition of plant and equipment. Therefore, understanding the stocks of other entities, acquisition of plant and equipment. Therefore, understanding the
time value of money concept is essential for a financial manager to achieve the wealth time value of money concept is essential for a financial manager to achieve the wealth
maximization goal of a firm. maximization goal of a firm.
The first basic point in the concept of the time value of money is to understand the The first basic point in the concept of the time value of money is to understand the
meaning of interest. Interest is the cost of using money (capital) over a specified time meaning of interest. Interest is the cost of using money (capital) over a specified time
period. There are two basic types of interest: simple interest and compound. Simple period. There are two basic types of interest: simple interest and compound. Simple
interest can be understood in two different ways. One is that simple interest is an interest interest can be understood in two different ways. One is that simple interest is an interest
computed for just a period. If interest is computed for one period only, the interest is computed for just a period. If interest is computed for one period only, the interest is
always simple interest. Another way to understand simple interest is that it is an interest always simple interest. Another way to understand simple interest is that it is an interest
computed for two or more periods whereby only the principal (original) value would earn computed for two or more periods whereby only the principal (original) value would earn
interest. In simple interest the previously earned interests do not produce another interest. interest. In simple interest the previously earned interests do not produce another interest.
Compound interest, on the other hand, is an interest computed for a minimum of two Compound interest, on the other hand, is an interest computed for a minimum of two
periods whereby the previous interests produce another interest for subsequent or next periods whereby the previous interests produce another interest for subsequent or next
periods. Here both the principal and previous interests bring additional interest. periods. Here both the principal and previous interests bring additional interest.
Though we have discussed both simple and compound interest, in financial management Though we have discussed both simple and compound interest, in financial management
we are largely interested on compound interest. So in the sections that follow we shall we are largely interested on compound interest. So in the sections that follow we shall
discuss the concepts and techniques of the time value of money in the context of discuss the concepts and techniques of the time value of money in the context of
compound interest. compound interest.
5.2 FUTURE VALUE 5.2 FUTURE VALUE
To understand future value, we need to understand compounding first. Compounding is a To understand future value, we need to understand compounding first. Compounding is a
mathematical process of determining the value of a cash flow or cash flows at the final mathematical process of determining the value of a cash flow or cash flows at the final
period. The cash flow(s) could be a single cash flow, an annuity or uneven cash flows. period. The cash flow(s) could be a single cash flow, an annuity or uneven cash flows.
Future value (FV) is the amount to which a cash flow or cash flows will grow over a Future value (FV) is the amount to which a cash flow or cash flows will grow over a
given period of time when compounded at a given interest rate. Future value is always a given period of time when compounded at a given interest rate. Future value is always a
direct result of the compounding process. direct result of the compounding process.
5.2.1 Future Value of a Single Amount 5.2.1 Future Value of a Single Amount
This is the amount to which a specified single cash flow will grow over a given period of This is the amount to which a specified single cash flow will grow over a given period of
time when compounded at a given interest rate. The formula for computing future value time when compounded at a given interest rate. The formula for computing future value
of a single cash flow is given as: of a single cash flow is given as:
FVn = PV (1 + i) FVn = PV (1 + i)
n n
Where: Where:
FVn = Future value at the end of FVn = Future value at the end of n n periods periods
PV = Present Value, or the principal amount PV = Present Value, or the principal amount
i = Interest rate per period i = Interest rate per period
n= Number of periods n= Number of periods
Or Or
FVn = PV (FVIFi,n) FVn = PV (FVIFi,n)
Where: Where:
(FVIFi, n) = The future value interest factor for (FVIFi, n) = The future value interest factor for i i and and n n
The future value interest factor for The future value interest factor for i i and and n n is defined as (1 + i) is defined as (1 + i)
n n
and it is the future value and it is the future value
of 1 Birr for of 1 Birr for n n periods at a rate of periods at a rate of i i percent per period. percent per period.
Example: Example: Hana deposited Br. 1,800 in her savings account in Meskerem 1990. Her Hana deposited Br. 1,800 in her savings account in Meskerem 1990. Her
account earns 6 percent compounded annually. How much will she have in Meskerem account earns 6 percent compounded annually. How much will she have in Meskerem
1997? 1997?
To solve this problem, lets identify the given items: PV = Br, 1,800; i = 6%; n = 7 To solve this problem, lets identify the given items: PV = Br, 1,800; i = 6%; n = 7
(Meskerem 1990 Meskerem 1997). (Meskerem 1990 Meskerem 1997).
FVn = PV (1 + i) FVn = PV (1 + i)
n n
= Br. 1,800 (1.06) = Br. 1,800 (1.06)
7 7
= = Br. 2,706.53 Br. 2,706.53
The (FVIFi,n) can be found by using a scientific calculator or using interest tables given The (FVIFi,n) can be found by using a scientific calculator or using interest tables given
at the end of this material. From the first table by looking down the first column to period at the end of this material. From the first table by looking down the first column to period
7, and then looking across that row to the 6% column, we see that FVIF6%,7 = 1.5036. 7, and then looking across that row to the 6% column, we see that FVIF6%,7 = 1.5036.
Then, the value of Br. 1,800 after 7 years is found as follows: Then, the value of Br. 1,800 after 7 years is found as follows:
FVn = PV (FVIFi,n) FVn = PV (FVIFi,n)
FV7 = Br. 1,800 (FVIF6%, 7) FV7 = Br. 1,800 (FVIF6%, 7)
= Br. 1,800 (1.5036) = = Br. 1,800 (1.5036) = Br. 2,706.48 Br. 2,706.48
5.2.2 Future Value of an Annuity 5.2.2 Future Value of an Annuity
An annuity is a series of equal periodic rents (receipts, payments, withdrawals, deposits) An annuity is a series of equal periodic rents (receipts, payments, withdrawals, deposits)
made at fixed intervals for a specified number of periods. For a series of cash flows to be made at fixed intervals for a specified number of periods. For a series of cash flows to be
an annuity four conditions should be fulfilled. an annuity four conditions should be fulfilled. First First, the cash flows must be equal. , the cash flows must be equal.
Second Second, the interval between any two cash flows must be fixed. , the interval between any two cash flows must be fixed. Third Third, the interest rate , the interest rate
applied for each period must be constant. applied for each period must be constant. Last Last but not least, interest should be but not least, interest should be
compounded during each period. If any one of these conditions is missing, the cash flows compounded during each period. If any one of these conditions is missing, the cash flows
cannot be an annuity. cannot be an annuity.
Basically, there are two types of annuities namely ordinary annuity and annuity due. Basically, there are two types of annuities namely ordinary annuity and annuity due.
Broadly speaking, however, annuities are classified into three types: Broadly speaking, however, annuities are classified into three types:
i) i) ordinary annuity, ordinary annuity,
ii) ii) annuity due, and annuity due, and
iii) iii) deferred annuity deferred annuity
i) Future value of an Ordinary Annuity i) Future value of an Ordinary Annuity An ordinary annuity is an annuity for which An ordinary annuity is an annuity for which
the cash flows occur at the end of each period. Therefore, the future value of an the cash flows occur at the end of each period. Therefore, the future value of an
ordinary annuity is the amount computed at the period when exactly the final (n ordinary annuity is the amount computed at the period when exactly the final (n
th th
) cash ) cash
flow is made. Graphically, future value of an ordinary annuity can be represented as flow is made. Graphically, future value of an ordinary annuity can be represented as
follows: follows:
0 0 1 1 2 ------------------ 2 ------------------ n n
PMT PMT
1 1 PMT PMT
2 2 ---------------PMTn ---------------PMTn
The future value is computed at point The future value is computed at point n n where PMTn is made. where PMTn is made.
FVAn = PMT FVAn = PMT
1
1
]
1
+
i
i
n
1 ) 1 (
Where: Where:
FVAn = Future value of an ordinary annuity FVAn = Future value of an ordinary annuity
PMT = Periodic payments PMT = Periodic payments
n = Number of periods n = Number of periods
Or Or
FVAn = PMT (FVIFAi,n) FVAn = PMT (FVIFAi,n)
Where: Where:
(FVIFAi, n) = the future value interest factor for an annuity (FVIFAi, n) = the future value interest factor for an annuity
= =
i
i
n
1 ) 1 ( +
Example: Example: You need to accumulate Br. 25,000 to acquire a car. To do so, you plan to You need to accumulate Br. 25,000 to acquire a car. To do so, you plan to
make equal monthly deposits for 5 years. The first payment is made a month from today, make equal monthly deposits for 5 years. The first payment is made a month from today,
in a bank account which pays 12 percent interest, compounded monthly. How much in a bank account which pays 12 percent interest, compounded monthly. How much
should you deposit every month to reach your goal? should you deposit every month to reach your goal?
Given: FVAn = Br. 25,000; i = 12% Given: FVAn = Br. 25,000; i = 12% 12 = 1%; n = 5 x 12 = 60 months; PMT = ? 12 = 1%; n = 5 x 12 = 60 months; PMT = ?
FVAn = PMT (FVIFAi, n) FVAn = PMT (FVIFAi, n)
Br. 25,000 = PMT (FVIFA, %, 60) Br. 25,000 = PMT (FVIFA, %, 60)
Br. 25,000 = PMT (81.670) Br. 25,000 = PMT (81.670)
PMT = Br. 25,000/81.670 PMT = Br. 25,000/81.670
PMT = PMT = Br. 306.11 Br. 306.11
ii) Future value of an Annuity Due ii) Future value of an Annuity Due. An annuity due is an annuity for which the . An annuity due is an annuity for which the
payments occur at the beginning of each period. Therefore, the future value of an payments occur at the beginning of each period. Therefore, the future value of an
annuity due is computed exactly one period after the final payment is made. annuity due is computed exactly one period after the final payment is made.
Graphically, this can be depicted as: Graphically, this can be depicted as:
0 0 1 1 2 --------------------- n 2 --------------------- n
PMT PMT
1 1 PMT PMT
2 2 PMT PMT
3 ----------------------- 3 ----------------------- PMTn + 1 PMTn + 1
The future value of an annuity due is computed at point n where PMT The future value of an annuity due is computed at point n where PMT
n + 1 n + 1 is made is made
FVAn (Annuity due) = PMT (FVIFAi, n) (1 + i) FVAn (Annuity due) = PMT (FVIFAi, n) (1 + i)
Or Or
= PMT = PMT
1
]
1
+
i
i
n
1 ) 1 (
( 1 + i) ( 1 + i)
Example: Example: Assume that pervious example except that the first payment is made today Assume that pervious example except that the first payment is made today
instead of a month from today. How much should your monthly deposit be to accumulate instead of a month from today. How much should your monthly deposit be to accumulate
Br. 25,000 after 60 months? Br. 25,000 after 60 months?
FVAn (Annuity due) = PMT (FVIFAi, n) (1 + i) FVAn (Annuity due) = PMT (FVIFAi, n) (1 + i)
Br. 25,000 = PMT (FVIFAi, n) (1 + i) Br. 25,000 = PMT (FVIFAi, n) (1 + i)
Br. 25,000 = PMT (81.670) (1.01) Br. 25,000 = PMT (81.670) (1.01)
PMT = Br. 25,000/82.487 PMT = Br. 25,000/82.487
PMT = Br. 303.08 PMT = Br. 303.08
iii) Future value of Deferred Annuity iii) Future value of Deferred Annuity is an annuity for which the amount is computed is an annuity for which the amount is computed
two or more period after the final payment is made. two or more period after the final payment is made.
0 0 1 1 2 ------------------n --------------n + x 2 ------------------n --------------n + x

PMT PMT
1 1 PMT PMT
2 2 PMTn PMTn
The future value of a deferred annuity is computed at point n + x The future value of a deferred annuity is computed at point n + x
FVAn (Deferred annuity) = PMT (FVIFAi, n) (1 + i) FVAn (Deferred annuity) = PMT (FVIFAi, n) (1 + i)
x x
= PMT = PMT
1
]
1
+
i
i
n
1 ) 1 (
(1 + i) (1 + i)
x x
Where x = The number of periods after the final payment; and X Where x = The number of periods after the final payment; and X 2. 2.
Example: Example: Henock has a savings account, which he had been depositing Br. 3,000 every Henock has a savings account, which he had been depositing Br. 3,000 every
year on January 1, starting in 1990. His account earns 10% interest compounded year on January 1, starting in 1990. His account earns 10% interest compounded
annually. The last deposit Hencok made was on January 1, 1999. How much money will annually. The last deposit Hencok made was on January 1, 1999. How much money will
he have on December 31, 2003? (No deposits are made after 1999 January). he have on December 31, 2003? (No deposits are made after 1999 January).
Jan. Jan.
1990 1990 1991 1991 1992 1992 93 94 95 96 97 98 99 2000 2001 02 03 93 94 95 96 97 98 99 2000 2001 02 03
2004 2004
3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000
The future value is computed on December 31, 2003 (or January 1, 2004). The future value is computed on December 31, 2003 (or January 1, 2004).
Given: PMT = Br. 3,000; i = 10%; n = 10; x = 5 Given: PMT = Br. 3,000; i = 10%; n = 10; x = 5
FVAn (Deferred annuity) = PMT (FVIFAi, n) (1 + i) FVAn (Deferred annuity) = PMT (FVIFAi, n) (1 + i)
x x
= Br. 3,000 (FVIFA 10%, 10) (1.10) = Br. 3,000 (FVIFA 10%, 10) (1.10)
5 5
= Br. 3,000 (15.937) (1.6105) = Br. 3,000 (15.937) (1.6105)
= = Br. 76, 999.62 Br. 76, 999.62
5.2.3 Future Value of Uneven Cash Flows 5.2.3 Future Value of Uneven Cash Flows
Uneven cash flow stream is a series of cash flows in which the amount varies from one Uneven cash flow stream is a series of cash flows in which the amount varies from one
period to another. The future value of an uneven cash flow stream is computed by period to another. The future value of an uneven cash flow stream is computed by
summing up the future value of each payment. summing up the future value of each payment.
Example: Example: Find the future value of Br. 1,000, Br. 3,000, Br. 4000, Br. 1200, and Br. 900 Find the future value of Br. 1,000, Br. 3,000, Br. 4000, Br. 1200, and Br. 900
deposited at the end of every year starting year 1 through year 5. The appropriate interest deposited at the end of every year starting year 1 through year 5. The appropriate interest
rate is 8% compounded annually. Assume the future value is computed at the end of year rate is 8% compounded annually. Assume the future value is computed at the end of year
5. 5.
0 0 1 1 2 2 3 3 4 4 5 5
1,000 3,000 4,000 1,200 900 1,000 3,000 4,000 1,200 900
FVIF8%, 4 FVIF8%, 4 Br. 1,000 (1,3605) = Br. 1,360.50 Br. 1,000 (1,3605) = Br. 1,360.50
FVIF8%, 3 FVIF8%, 3 Br. 3,000 (1.2597) = 3,779.10 Br. 3,000 (1.2597) = 3,779.10
FVIF8%,2 FVIF8%,2 Br. 4,000 (1.1664) = 4,665.60 Br. 4,000 (1.1664) = 4,665.60
FVIF8%, 1 FVIF8%, 1 Br. 1,200 (1.0800) = 1,296.00 Br. 1,200 (1.0800) = 1,296.00
Br. 900 (1.0000) = Br. 900 (1.0000) = 900.00 900.00
FV = FV = Br. 12,001.20 Br. 12,001.20
1. How much must you deposit now on January 1,1999 to have a balance of Br. 10,000 1. How much must you deposit now on January 1,1999 to have a balance of Br. 10,000
on December 31, 2003? Interest is compounded at an 8% annual rate. on December 31, 2003? Interest is compounded at an 8% annual rate.
2. XYZ company plans to accumulate Br. 500,000 to retire its long-term debt on 2. XYZ company plans to accumulate Br. 500,000 to retire its long-term debt on
December 31, 2010. To achieve the plan, the company has just deposited Br. 100,000 December 31, 2010. To achieve the plan, the company has just deposited Br. 100,000
today January 1,2003. But the company knows that this deposit alone would not today January 1,2003. But the company knows that this deposit alone would not
enable to achieve the target and wants to make equal annual deposits starting January enable to achieve the target and wants to make equal annual deposits starting January
1,2005 until January 1,2010. Assuming the appropriate interest rate is 6% 1,2005 until January 1,2010. Assuming the appropriate interest rate is 6%
compounded annually, how much should XYZ deposit every January so as to achieve compounded annually, how much should XYZ deposit every January so as to achieve
its plan? its plan?
5.3 PRESENT VALUE 5.3 PRESENT VALUE
Present value is the exact reversal of future value. It is the value today of a single cash Present value is the exact reversal of future value. It is the value today of a single cash
flow, an annuity or uneven cash flows. In other words, a present value is the amount of flow, an annuity or uneven cash flows. In other words, a present value is the amount of
money that should be invested today at a given interest rate over a specified period so that money that should be invested today at a given interest rate over a specified period so that
we can have the future value. The process of computing the present value is called we can have the future value. The process of computing the present value is called
discounting. discounting.
5.3.1 Present Value of a Single Amount 5.3.1 Present Value of a Single Amount
It is the amount that should be invested now at a given interest rate in order to equal the It is the amount that should be invested now at a given interest rate in order to equal the
future value of a single amount. future value of a single amount.
PV = PV =
( )
n
n
i
FVn
i
FVn
,
_
+ 1
1
1
Where: Where:
PV = Present Value PV = Present Value
FVn = Future value at the end of n periods FVn = Future value at the end of n periods
n = Number of periods n = Number of periods
Or Or
PV = FVn (PVIFi, n) PV = FVn (PVIFi, n)
Where: Where:
(PVIFi, n) = The present value interest factor for (PVIFi, n) = The present value interest factor for i i and and n n = 1/ (1 + i) = 1/ (1 + i)
n n
Example: Example: Zelalem PLC owes Br. 50,000 to ALWAYS Co. at the end of 5 years. Zelalem PLC owes Br. 50,000 to ALWAYS Co. at the end of 5 years.
ALWAYS Co. could earn 12% on its money. How much should ALWAYS Co. accept ALWAYS Co. could earn 12% on its money. How much should ALWAYS Co. accept
from Zelalem PLC as of today? from Zelalem PLC as of today?
Given: FV Given: FV
5 5 = Br. 50,000; n = 5 years; i = 12%; PV = ? = Br. 50,000; n = 5 years; i = 12%; PV = ?
PV = FV5 (PVIF12%, 5) PV = FV5 (PVIF12%, 5)
= Br. 50,000 (0.5674) = = Br. 50,000 (0.5674) = Br. 28,370 Br. 28,370
On January 1,1998, Moon Corporation sold a motor vehicle to Sun Company. Sun signed On January 1,1998, Moon Corporation sold a motor vehicle to Sun Company. Sun signed
a Br. 200,000 non-interest bearing promissory note due on January 1, 2001. The a Br. 200,000 non-interest bearing promissory note due on January 1, 2001. The
prevailing interest rate for a similar note on January 1, 1998, was 9%. How much is the prevailing interest rate for a similar note on January 1, 1998, was 9%. How much is the
selling price of the motor vehicle for Moon Corporation? selling price of the motor vehicle for Moon Corporation?
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___ ___
5.3.2 Present Value of an Annuity 5.3.2 Present Value of an Annuity
i) Present value of an Ordinary Annuity i) Present value of an Ordinary Annuity is a single amount of money that should be is a single amount of money that should be
invested now at a given interest rate in order to provide for an annuity for a certain invested now at a given interest rate in order to provide for an annuity for a certain
number of future periods. number of future periods.
PVAn = PMT PVAn = PMT
( ) ( )
1
]
1
1
1
1
1
]
1

i
i
PMT
i
i
n n
1 1 1
1
1
= PMT (PVIFAi, n) = PMT (PVIFAi, n)
Where: Where:
PVAn = The present value of an ordinary annuity PVAn = The present value of an ordinary annuity
(PVIFAi, n) = The present value interest factor for an annuity (PVIFAi, n) = The present value interest factor for an annuity
= =
( )
i
i
n
+ 1 1
Example: Example: Ato Mengesha retired as general manager of Tirusew Foods Company. But he Ato Mengesha retired as general manager of Tirusew Foods Company. But he
is currently involved in a consulting contract for Br. 35,000 per year for the next 10 is currently involved in a consulting contract for Br. 35,000 per year for the next 10
years. What is the present value of Mengeshas consulting contract if his opportunity years. What is the present value of Mengeshas consulting contract if his opportunity
costs is 10%? costs is 10%?
Given: PMT = Br. 35,000; n = 10 years; i = 10%; PVAn = ? Given: PMT = Br. 35,000; n = 10 years; i = 10%; PVAn = ?
PVA10 = Br. 35,000 (PVIFA10%, 10) PVA10 = Br. 35,000 (PVIFA10%, 10)
= Br. 35,000 (6.1446) = = Br. 35,000 (6.1446) = Br. 215,061 Br. 215,061. This means if the required rate of . This means if the required rate of
return is 10%, receiving Br. 35,000 per year for the next 10 years is equal to receiving Br. return is 10%, receiving Br. 35,000 per year for the next 10 years is equal to receiving Br.
215,061 today. 215,061 today.
How large must each annual payment be for a Br. 100,000 loan to be repaid in equal How large must each annual payment be for a Br. 100,000 loan to be repaid in equal
installments at the end of each of the next 5 years? The interest rate is 10%, compounded installments at the end of each of the next 5 years? The interest rate is 10%, compounded
annually. annually.
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__ __
ii) Present value of an Annuity Due ii) Present value of an Annuity Due is the present value computed where exactly the is the present value computed where exactly the
first payment is to be made. Graphically, this is shown below: first payment is to be made. Graphically, this is shown below:
0 0 1 1 2 2 3 ---------------- n 3 ---------------- n
PMT PMT
1 1 PMT PMT
2 2 PMTn PMTn
The present value of an annuity due is computed at point 1 while the present value of an The present value of an annuity due is computed at point 1 while the present value of an
ordinary annuity is computed at point 0. ordinary annuity is computed at point 0.
PVAn = (Annuity due) = PMT PVAn = (Annuity due) = PMT
1
]
1
+

i
i
n
) 1 ( 1
(1 + i) = PMT (PVIFAi, n) (1 + i) (1 + i) = PMT (PVIFAi, n) (1 + i)
Example: Example: Ruth Corporation bought a new machine and agreed to pay for it in equal Ruth Corporation bought a new machine and agreed to pay for it in equal
installments of Br. 5,000 for 10years. The first payment is made on the date of purchase, installments of Br. 5,000 for 10years. The first payment is made on the date of purchase,
and the prevailing interest rate that applies for the transaction is 8%. Compute the and the prevailing interest rate that applies for the transaction is 8%. Compute the
purchase price of the machinery. purchase price of the machinery.
Given: PMT = Br. 5,000; n = 10 years; i = 8%; PVAn (Annuity due) = ? Given: PMT = Br. 5,000; n = 10 years; i = 8%; PVAn (Annuity due) = ?
PVA (Annuity due) = Br. 5,000 (PVIFA 8%, 10) (1.08) PVA (Annuity due) = Br. 5,000 (PVIFA 8%, 10) (1.08)
= Br. 5,000 (6.7101) (1.08) = = Br. 5,000 (6.7101) (1.08) = Br. 36,234.54. Br. 36,234.54. So the cost of the So the cost of the
machinery for Ruth is Br. 36,234.54. We have identified the case as an annuity due rather machinery for Ruth is Br. 36,234.54. We have identified the case as an annuity due rather
than ordinary annuity because the first payment is made today, not after one period. than ordinary annuity because the first payment is made today, not after one period.
Assume the above example except that the first payment is to be made after 1 year from Assume the above example except that the first payment is to be made after 1 year from
the date of purchase. How much would be the cost of the machinery now for Ruth the date of purchase. How much would be the cost of the machinery now for Ruth
Corporation? Corporation?
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___ ___
iii) Present value of a Deferred Annuity iii) Present value of a Deferred Annuity is computed two or more periods before the first is computed two or more periods before the first
payment is made. payment is made.
PVAn (Deferred annuity) = PMT PVAn (Deferred annuity) = PMT
1
]
1
+

i
i
n
) 1 ( 1
(1 + i) (1 + i)
-x -x
= PMT (PVIFAi, n) (1 + i) = PMT (PVIFAi, n) (1 + i)
-x -x
Where Where x x is the number of periods between the date when he first payment is made and is the number of periods between the date when he first payment is made and
the date the present value is computed. the date the present value is computed.
Example: Example: Sefa Chartered Accountants has developed and copyrighted an accounting Sefa Chartered Accountants has developed and copyrighted an accounting
software program. Sefa agreed to sell the copyright to Steel company for 6 annual software program. Sefa agreed to sell the copyright to Steel company for 6 annual
payments of Br. 5,000 each. The payments are to begin 5 years from today. If the annual payments of Br. 5,000 each. The payments are to begin 5 years from today. If the annual
interest rate is 8%, what is the present value of the six payments? interest rate is 8%, what is the present value of the six payments?
0 0 1 1 2 2 3 3 4 4 5 5 6 6 7 7 8 8 9 9 10 10

PVAn = ? PVAn = ? 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000
X X
Given: n = 6; PMT = Br. 5,000; X = 4; PVA Given: n = 6; PMT = Br. 5,000; X = 4; PVA
6 6 (Deferred annuity) = ? (Deferred annuity) = ?
i = 8% PVA i = 8% PVA
6 6 (Deferred annuity) = Br. 5,000 (PVIFA (Deferred annuity) = Br. 5,000 (PVIFA
8%, 8%, 6) (1.08) 6) (1.08)
-4 -4
= Br. 5,000 (4.6229) (0.7350) = = Br. 5,000 (4.6229) (0.7350) = Br. 16,989.16 Br. 16,989.16
5.3.3 Present Value of Uneven Cash Flows 5.3.3 Present Value of Uneven Cash Flows
The present value of an uneven cash flow stream is found by summing the present values The present value of an uneven cash flow stream is found by summing the present values
of individual cash flows of the stream. of individual cash flows of the stream.
Example: Example: Suppose you are given the following cash flow stream where the appropriate Suppose you are given the following cash flow stream where the appropriate
interest rate is 12% compounded annually. What is the present value of the cash flows? interest rate is 12% compounded annually. What is the present value of the cash flows?
Year Year 1 1 2 2 3 3
Cash flow Cash flow Br. 400 Br. 400 Br. 100 Br. 100 Br.300 Br.300
Br. 400 (0.8929) PVIF12%, 1 Br. 400 (0.8929) PVIF12%, 1
= = Br. 357.16 Br. 357.16
Br. 100 (0.7972) PVIF12%, 2 Br. 100 (0.7972) PVIF12%, 2
= = Br. 79.72 Br. 79.72
Br. 300 (0.7118) PVIF12%, 3 Br. 300 (0.7118) PVIF12%, 3
= = Br. 213.54 Br. 213.54
Br. 650.42 Br. 650.42
5.3.4 Present Value of a Perpetuity 5.3.4 Present Value of a Perpetuity
A perpetuity is an annuity with an indefinite cash flows. In a perpetuity payments are A perpetuity is an annuity with an indefinite cash flows. In a perpetuity payments are
made continuously forever. The present value of a perpetuity is found by using the made continuously forever. The present value of a perpetuity is found by using the
following formula: following formula:
PV (Perpetuity) = PV (Perpetuity) = Payment Payment = = PMT PMT
Interest rate i Interest rate i
Example: Example: What is the present value of a perpetuity of Br. 7,000 per year if the What is the present value of a perpetuity of Br. 7,000 per year if the
appropriate discount rate is 7%? appropriate discount rate is 7%?
Given: PMT = Br. 7,000; i = 7%;, PV (Perpetuity) = ? Given: PMT = Br. 7,000; i = 7%;, PV (Perpetuity) = ?
PV (Perpetuity) = PV (Perpetuity) = PMT PMT = = Br. 7,000 Br. 7,000 = = Br. 100,000 Br. 100,000. This means that . This means that
i 7% i 7%
receiving Br. 7,000 every year forever is equal to receiving Br. 100,000 now. receiving Br. 7,000 every year forever is equal to receiving Br. 100,000 now.
What do you think are some of the applications of the present value of a perpetuity? What do you think are some of the applications of the present value of a perpetuity?
_______________________________________________________________________ _______________________________________________________________________
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___ ___
- - The time value of money analysis recognizes the difference among birrs received The time value of money analysis recognizes the difference among birrs received
or paid at different points in time. or paid at different points in time.
- - Future value is a direct result of the compounding process Future value is a direct result of the compounding process
- - Present value is a direct result of the discounting process Present value is a direct result of the discounting process
- - Future value can be computed for a single cash flow, an annuity, and an uneven Future value can be computed for a single cash flow, an annuity, and an uneven
cash flow stream. cash flow stream.
- - Present value can be computed for a single cash flow, an annuity, uneven cash Present value can be computed for a single cash flow, an annuity, uneven cash
flows, and a perpetuity. flows, and a perpetuity.
- - Formulas are available for computing both present values and future values of Formulas are available for computing both present values and future values of
various types of given cash flows. various types of given cash flows.
- - A scientific calculator or interest tables can be applied to solve time value of A scientific calculator or interest tables can be applied to solve time value of
money questions. money questions.
- - The longer the time period and the higher the interest rate, the larger the future The longer the time period and the higher the interest rate, the larger the future
value. But the opposite is true for present values. value. But the opposite is true for present values.
- - The concepts and techniques of the time value of money have many applications The concepts and techniques of the time value of money have many applications
in financial management. in financial management.
I. I.
1. Given: FV 1. Given: FV
5 5 = Br. 10,000; n = 5 (January 1, 1999 to December 31, 2003); i= 8%; PV = Br. 10,000; n = 5 (January 1, 1999 to December 31, 2003); i= 8%; PV
= ? = ?
FV FV
5 5 = PV (FVIF8%, 5) = PV (FVIF8%, 5)
Br. 10,000 = PV (1.4693) Br. 10,000 = PV (1.4693)
PV = Br. 10,000 / 1.4693 = PV = Br. 10,000 / 1.4693 = Br. 6,805.96 Br. 6,805.96
2. 2003 2. 2003 04 04 05 05 06 06 07 07 08 08 09 09 2010 2010 2011 2011

Br. 100,000 PMT PMT PMT PMT PMT PMT Br. 500,000 Br. 100,000 PMT PMT PMT PMT PMT PMT Br. 500,000
Br. 100,000 (FVIF Br. 100,000 (FVIF
6% 6%, 8) + PMT (FVIFA , 8) + PMT (FVIFA
6% 6%, 6) (1.06) = Br. 500,000 , 6) (1.06) = Br. 500,000
Br. 100,000 (1.5938) + PMT (6.9753) (1.06) = Br. 500,000 Br. 100,000 (1.5938) + PMT (6.9753) (1.06) = Br. 500,000
Br. 159,380 + PMT (7.3938) = Br. 500,000 Br. 159,380 + PMT (7.3938) = Br. 500,000
PMT (7.3938) = Br. 340,620 PMT (7.3938) = Br. 340,620
PMT = Br. 340,620 PMT = Br. 340,620 7.33938 = 7.33938 = Br. 46,068.33 Br. 46,068.33
II. II.
The selling price of the motor vehicle is the present value of the promissory note. The selling price of the motor vehicle is the present value of the promissory note.
Given: FV Given: FV
3 3 = Br. 200,000; i = 9%; n = 3 (Jan. 1,1998 to Jan. 1,2001); PV = ? = Br. 200,000; i = 9%; n = 3 (Jan. 1,1998 to Jan. 1,2001); PV = ?
PV = FV PV = FV
3 3 (PVIF (PVIF
9% 9%, 3) , 3)
= Br. 200,000 (0.7722) = = Br. 200,000 (0.7722) = Br. 154,440 Br. 154,440
III. III. The loan of amount of Br. 100,000 is the present value of the five equal annual The loan of amount of Br. 100,000 is the present value of the five equal annual
payments. payments.
Given: PVA Given: PVA
5 5 = Br. 100,000; n = 5; i = 10%; PMT = ? = Br. 100,000; n = 5; i = 10%; PMT = ?
PVA PVA
5 5 = PMT (PVIFA = PMT (PVIFA
10% 10%, 5) , 5)
Br. 100,000 = PMT (3.7908) Br. 100,000 = PMT (3.7908)
PMT = Br. 100,000 PMT = Br. 100,000 3.7908 = 3.7908 = Br. 26,379.66 Br. 26,379.66
IV. IV. Given: PMT = Br. 5,000; n = 10; i = 8%; PVAn = ? Given: PMT = Br. 5,000; n = 10; i = 8%; PVAn = ?
When the payment is to start one year from the date of purchase, the cost of the When the payment is to start one year from the date of purchase, the cost of the
machinery would be the present value of an ordinary annuity rather than annuity due. machinery would be the present value of an ordinary annuity rather than annuity due.
PVA PVA
10 10 = Br. 5,000 (PVIFA = Br. 5,000 (PVIFA
8% 8%, 10) , 10)
= Br. 5,000 (6.7101) = = Br. 5,000 (6.7101) = Br. 33,550.50 Br. 33,550.50
V. V. Some of the applications of the present value of a perpetuity are when we compute the Some of the applications of the present value of a perpetuity are when we compute the
value of an asset whose future cash flows are expected for an indefinite period like a value of an asset whose future cash flows are expected for an indefinite period like a
preferred stock and a common stock. preferred stock and a common stock.
N.B. December21,2010 = January
1,2011
Problems Problems
1. Meron started saving on January 1, 1996. Every month, she deposits Br. 150 in her 1. Meron started saving on January 1, 1996. Every month, she deposits Br. 150 in her
bank account, which earns 12% interest compounded monthly. On December 31, 1999, bank account, which earns 12% interest compounded monthly. On December 31, 1999,
she withdrew half of the balance in her bank account to invest somewhere else. How she withdrew half of the balance in her bank account to invest somewhere else. How
much will Meron have in her bank account on December 31, 2004? (Meron has not much will Meron have in her bank account on December 31, 2004? (Meron has not
interrupted her monthly deposits). interrupted her monthly deposits).
2. Solomon decided to start a savings account on January 1, 1995. After making a yearly 2. Solomon decided to start a savings account on January 1, 1995. After making a yearly
deposit of Br. 15,000 for 3 years (Jan. 1, 1995 through Jan. 1, 1997); he left for abroad. deposit of Br. 15,000 for 3 years (Jan. 1, 1995 through Jan. 1, 1997); he left for abroad.
He returned home late 1998 and resumed his savings plan with quarterly deposits of Br. He returned home late 1998 and resumed his savings plan with quarterly deposits of Br.
3,000 each beginning January 1, 1999. The banks interest rate was 9% compounded 3,000 each beginning January 1, 1999. The banks interest rate was 9% compounded
annually from January 1, 1995, through January 1, 1998, and 12% compounded annually from January 1, 1995, through January 1, 1998, and 12% compounded
monthly there after. What is the balance in Solomons savings account on January 1, monthly there after. What is the balance in Solomons savings account on January 1,
2002? 2002?
3. You have just taken a 30-year mortgage loan for Br. 200,000. The annual interest rate 3. You have just taken a 30-year mortgage loan for Br. 200,000. The annual interest rate
on the loan is 6% compounded monthly. How large is your monthly payment if the first on the loan is 6% compounded monthly. How large is your monthly payment if the first
payment is to be made three months after you have taken the loan? payment is to be made three months after you have taken the loan?
4. Nahom invests in a Br. 180,000 annuity insurance policy at 6% compounded monthly 4. Nahom invests in a Br. 180,000 annuity insurance policy at 6% compounded monthly
on January 1, 1999. The first of 48 receipts from the annuity is payable to Nahom 12 on January 1, 1999. The first of 48 receipts from the annuity is payable to Nahom 12
months after the annuity is purchased. What will be the amount of each of the 48 equal months after the annuity is purchased. What will be the amount of each of the 48 equal
monthly receipts? monthly receipts?
5. Mr. Atila acquired Demmy Textile Factory agreeing to pay Br. 1.5 million per year for 5. Mr. Atila acquired Demmy Textile Factory agreeing to pay Br. 1.5 million per year for
17 years starting the date of acquisition. Local newspapers reported Atila acquired 17 years starting the date of acquisition. Local newspapers reported Atila acquired
textile factory for Br. 25.5 million (1.5 million x 17). The appropriate interest rate is 9% textile factory for Br. 25.5 million (1.5 million x 17). The appropriate interest rate is 9%
compounded annually. Do you agree with the newspapers? Why or why not? compounded annually. Do you agree with the newspapers? Why or why not?
6. You are trying to assess the value of a small merchandising company that is for sale. 6. You are trying to assess the value of a small merchandising company that is for sale.
The firm is expected to generate an annual cash flow of Br. 25,000 for an indefinite The firm is expected to generate an annual cash flow of Br. 25,000 for an indefinite
time period. The rate of return required from the company is 10%. How much is your time period. The rate of return required from the company is 10%. How much is your
assessment of the value of the company? assessment of the value of the company?
1. Aswath Damodaran (1997). 1. Aswath Damodaran (1997). Corporate Finance: Theory and Practice Corporate Finance: Theory and Practice. John Wiley . John Wiley
and Sons, Inc., New York. and Sons, Inc., New York.
2. Donald E. Kieso and Jerry J. Weygandt (1998). 2. Donald E. Kieso and Jerry J. Weygandt (1998). Intermediate Accounting Intermediate Accounting. 9 . 9
th th
edition, edition,
John Wiley and Sons, Inc, New York. John Wiley and Sons, Inc, New York.
3. Eugene F. Brigham (1997 3. Eugene F. Brigham (1997). Fundamentals of Financial Management ). Fundamentals of Financial Management. 7 . 7
th th
Dryden Press Harcourt Brace College Publishers, Florida. Dryden Press Harcourt Brace College Publishers, Florida.
Management. Management. 7 7
th th
Cash flow Cash flow a cash inflow or a cash outflow. It is a periodic rent. a cash inflow or a cash outflow. It is a periodic rent.
Rent Rent a cash receipt, deposit, withdrawal, payment, cost etc. a cash receipt, deposit, withdrawal, payment, cost etc.
Interest table Interest table a table in which the future or present values of just 1 birr are given at a table in which the future or present values of just 1 birr are given at
different interest rates and over varying time periods. different interest rates and over varying time periods.
Opportunity cost rate Opportunity cost rate the rate of return on the best available alternative investment of the rate of return on the best available alternative investment of
equal risk. equal risk.
Payment (PMT) Payment (PMT) a series of equal cash flows at regular intervals a series of equal cash flows at regular intervals
Uneven cash flow stream Uneven cash flow stream a series of cash flows in which the amount varies from one a series of cash flows in which the amount varies from one
period to another. period to another.
UNIT 6: VALUATION UNIT 6: VALUATION
Contents Contents
6.0 Aims and Objectives 6.0 Aims and Objectives
6.2 Bond Valuation 6.2 Bond Valuation
6.2.1 Basic Bond Valuation Model 6.2.1 Basic Bond Valuation Model
6.2.2 Interest Rate on a Bond 6.2.2 Interest Rate on a Bond
6.3 Preferred Stock Valuation 6.3 Preferred Stock Valuation
6.3.1 Preferred Stock Valuation Model 6.3.1 Preferred Stock Valuation Model
6.3.2 Rate of Return on a Preferred Stock 6.3.2 Rate of Return on a Preferred Stock
6.4 Common Stock Valuation 6.4 Common Stock Valuation
6.4.1 Zero Growth Stock 6.4.1 Zero Growth Stock
6.4.2 Constant Growth Stock 6.4.2 Constant Growth Stock
6.4.3 Variable Growth Stock 6.4.3 Variable Growth Stock
The main purpose of studying this unit is to achieve the following objectives: The main purpose of studying this unit is to achieve the following objectives:
to appreciate one of the main applications of the concept of the time value of to appreciate one of the main applications of the concept of the time value of
money, money,
to differentiate among a bond, a preferred stock, and a common stock, to differentiate among a bond, a preferred stock, and a common stock,
to identify the basic inputs in valuation of an asset, to identify the basic inputs in valuation of an asset,
to understand the techniques of computing the value of a bond, a preferred stock, to understand the techniques of computing the value of a bond, a preferred stock,
and a common stock, and a common stock,
to be able to interpret the values of financial assets, to be able to interpret the values of financial assets,
to understand how to determine the expected rate of return from investments in to understand how to determine the expected rate of return from investments in
bonds, preferred and common stocks. bonds, preferred and common stocks.
As you have seen in the previous accounting courses, the value of an asset is determined As you have seen in the previous accounting courses, the value of an asset is determined
based on its cost (historical cost). That means all the necessary expenditures incurred based on its cost (historical cost). That means all the necessary expenditures incurred
from the time the asset is acquired until it is placed in operation will be the cost of the from the time the asset is acquired until it is placed in operation will be the cost of the
asset. However, in financial management, the value of an asset is quite different. asset. However, in financial management, the value of an asset is quite different.
Since finance is interested more on decision making rather than recording, the value of an Since finance is interested more on decision making rather than recording, the value of an
asset is determined before it is purchased. The purpose is to decide whether to acquire or asset is determined before it is purchased. The purpose is to decide whether to acquire or
not to acquire the asset. Therefore, here the historical cost cannot be used as the value of not to acquire the asset. Therefore, here the historical cost cannot be used as the value of
the asset. Rather, the value of the asset is determined by valuation. the asset. Rather, the value of the asset is determined by valuation.
Valuation is the process of determining the worth of any asset whose value is obtained Valuation is the process of determining the worth of any asset whose value is obtained
from future cash flows. Look, the value here is not historical cost. The value of any asset from future cash flows. Look, the value here is not historical cost. The value of any asset
in finance is the present value of all future cash flows it is expected to provide over the in finance is the present value of all future cash flows it is expected to provide over the
relevant time period. This value is called intrinsic value. In the remainder of this unit, we relevant time period. This value is called intrinsic value. In the remainder of this unit, we
shall emphasize the intrinsic value of an asset. shall emphasize the intrinsic value of an asset.
The intrinsic value of an asset is determined based on three basic inputs: cash flows The intrinsic value of an asset is determined based on three basic inputs: cash flows
(returns), time pattern of the returns, and the discount rate. The value of an asset is, (returns), time pattern of the returns, and the discount rate. The value of an asset is,
therefore, determined by discounting the expected cash flows to their present value. To therefore, determined by discounting the expected cash flows to their present value. To
determine the present value, we use a discount rate appropriate based on the assets risk. determine the present value, we use a discount rate appropriate based on the assets risk.
Value can be determined for any kind of asset like buildings, machineries, factories, Value can be determined for any kind of asset like buildings, machineries, factories,
bonds, stocks etc. But in this unit, we will discuss the value of three financial assets: bonds, stocks etc. But in this unit, we will discuss the value of three financial assets:
bonds, preferred, and common stocks. bonds, preferred, and common stocks.
6.2 BOND VALUATION 6.2 BOND VALUATION
Bond is a long-term debt instrument or security issued by businesses and governmental Bond is a long-term debt instrument or security issued by businesses and governmental
units to raise large sums of money. Investment in a bond provides two types of cash units to raise large sums of money. Investment in a bond provides two types of cash
flows. One is the periodic interest payment by the issuing party. Another is the price paid flows. One is the periodic interest payment by the issuing party. Another is the price paid
to the investor upon maturity. The first, i.e., the interest payment is based on the par value to the investor upon maturity. The first, i.e., the interest payment is based on the par value
of the bond and the coupon interest rate. The par value is the face value of the bond of the bond and the coupon interest rate. The par value is the face value of the bond
which will be paid to the investor upon maturity. Par value is also called maturity value. which will be paid to the investor upon maturity. Par value is also called maturity value.
For instance if the par value of a bond is Br. 1,000, the issuer should pay the investor Br. For instance if the par value of a bond is Br. 1,000, the issuer should pay the investor Br.
1,000 when the maturity date of the bond arrives. The coupon interest rate is the rate 1,000 when the maturity date of the bond arrives. The coupon interest rate is the rate
which the issuer pays to the investor on the par value of the bond. If A Company invests which the issuer pays to the investor on the par value of the bond. If A Company invests
in a Br. 1,000 par value, 10-year, 8% coupon bonds of B Company, A shall receive Br. in a Br. 1,000 par value, 10-year, 8% coupon bonds of B Company, A shall receive Br.
80 (Br. 1,000 x 8%) per year for 10 years. 80 (Br. 1,000 x 8%) per year for 10 years.
6.2.1 Basic Bond Valuation Model 6.2.1 Basic Bond Valuation Model
The value of a bond is the present value of the periodic interest payments plus the present The value of a bond is the present value of the periodic interest payments plus the present
value of the par value. The value of a bond can be computed using the following value of the par value. The value of a bond can be computed using the following
equitation: equitation:
B B
o o = I(PVIFA k = I(PVIFA k
d d,n) + M(PVIF k ,n) + M(PVIF k
d d,n) ,n)
where: where:
B B
o o = the value of the bond = the value of the bond
I = interest paid each period = Par Value x Coupon interest rate I = interest paid each period = Par Value x Coupon interest rate
K K
d d = the appropriate interest rate on the bond = the appropriate interest rate on the bond
n = The number of periods before the bond matures n = The number of periods before the bond matures
M = the par value of the bond M = the par value of the bond
(PVIF k (PVIF k
d d,n) = The present value interest factor for an annuity at interest rate of kd per ,n) = The present value interest factor for an annuity at interest rate of kd per
period for n periods = period for n periods =
d
n
d
k
k ) 1 (
1
1
+
(PVIF (PVIF
kd kd,n) = The present value interest factor at interest rate of kd per period for n ,n) = The present value interest factor at interest rate of kd per period for n
periods = periods =
n
d
k ) 1 (
1
+
Notice that we have used k Notice that we have used k
d d instead of i. This is because, generally, in financial instead of i. This is because, generally, in financial
management management k k designates rate of return and the subscript designates rate of return and the subscript d d denotes debt security. So k denotes debt security. So k
d d
designates the rate of return on a debt security. designates the rate of return on a debt security.
Illustration: Illustration: Tebaber Berta Corporation has a Br. 1,000 par value bond with an 8% Tebaber Berta Corporation has a Br. 1,000 par value bond with an 8%
coupon interest rate outstanding. Interest is paid semiannually and the bond has 12 years coupon interest rate outstanding. Interest is paid semiannually and the bond has 12 years
remaining to its maturity date. remaining to its maturity date.
Required: Required: What is the value of the bond if the required return on the bond is 8%? What is the value of the bond if the required return on the bond is 8%?
Solution: Solution:
Given: Given: M = Br. 1,000; k M = Br. 1,000; k
d d = 8% per year or 4% (8% = 8% per year or 4% (8% 2) per semiannual period; I = Br. 40 2) per semiannual period; I = Br. 40
(Br. 1,000 x 4%); n = 24 semiannual periods (12 x 2); Bo =? (Br. 1,000 x 4%); n = 24 semiannual periods (12 x 2); Bo =?
Bo = I(PVIFA k Bo = I(PVIFA k
d d,n) + M(PVIF k ,n) + M(PVIF k
d d,n) ,n)
= Br. 40(PVIFA = Br. 40(PVIFA
4 4%, 24) + Br. 1,000(PVIF %, 24) + Br. 1,000(PVIF
4 4%, 24) %, 24)
= Br. 40 (15.2470) + Br. 1,000 (0.3901) = Br. 40 (15.2470) + Br. 1,000 (0.3901)
= = Br. 1,000 Br. 1,000
If the appropriate discount rate (k If the appropriate discount rate (k
d d) remains constant at 8% (4% per semiannual period), ) remains constant at 8% (4% per semiannual period),
the value of the bond will not be changed. It will remain Br. 1,000. Suppose the the value of the bond will not be changed. It will remain Br. 1,000. Suppose the
appropriate discount rate is 8% 2 years from now, what would be the value of the bond? appropriate discount rate is 8% 2 years from now, what would be the value of the bond?
Solution: Solution: now n is reduced to 20[24-(2 x 2)] now n is reduced to 20[24-(2 x 2)]
Bo = Br.40 (PVIFA4%, 20) + Br. 1,000 (PVIF4%, 20) Bo = Br.40 (PVIFA4%, 20) + Br. 1,000 (PVIF4%, 20)
= Br. 40 (13.5903) + Br. 1,000 (0.4564) = Br. 40 (13.5903) + Br. 1,000 (0.4564)
= = Br. 1,000 Br. 1,000
Suppose the interest rate in the economy when Tebaber Bertas bonds were issued was Suppose the interest rate in the economy when Tebaber Bertas bonds were issued was
6% rather than 8%, what would be the value of the bond? Since Tebaber Bertas bond 6% rather than 8%, what would be the value of the bond? Since Tebaber Bertas bond
now will be paying more interest than do other bonds in the market, the companys bond now will be paying more interest than do other bonds in the market, the companys bond
will be selling at a larger price. Such bonds which are selling more than their par value will be selling at a larger price. Such bonds which are selling more than their par value
are called premium bonds. Here, k are called premium bonds. Here, k
d d is 6% (3% per semiannual payment), but other things is 6% (3% per semiannual payment), but other things
are not changed. So are not changed. So
Bo = Br. 40 (PVIFA3%, 24) + Br. 1,000 (PVIF 3%, 24) Bo = Br. 40 (PVIFA3%, 24) + Br. 1,000 (PVIF 3%, 24)
= Br. 40 (16.9355) + Br. 1,000 (0.4919) = Br. 40 (16.9355) + Br. 1,000 (0.4919)
= = Br. 1,169.32 Br. 1,169.32
So when the market interest rate (k So when the market interest rate (k
d d) is less than the coupon interest rate, the value of a ) is less than the coupon interest rate, the value of a
bond is always larger than the par value. An investor by deciding to invest his money on bond is always larger than the par value. An investor by deciding to invest his money on
Tebaber Bertas bond, he will receive a 1% (4% - 3%) more interest payment than he Tebaber Bertas bond, he will receive a 1% (4% - 3%) more interest payment than he
would receive if he invested somewhere else. This allows the investor to receive Br. 10 would receive if he invested somewhere else. This allows the investor to receive Br. 10
[Br. 1,000 x (4% - 3%)] more every semiannual period. As a result, the investor would be [Br. 1,000 x (4% - 3%)] more every semiannual period. As a result, the investor would be
willing to give more price to the bond. The additional price is the present value of each willing to give more price to the bond. The additional price is the present value of each
Br. 10 he is going to receive for the next 24 semiannual periods. Therefore, the value of a Br. 10 he is going to receive for the next 24 semiannual periods. Therefore, the value of a
premium bond can also be computed as: premium bond can also be computed as:
Bo = Br. 1,000 + Br. 10 (PVIFA3%, 24) Bo = Br. 1,000 + Br. 10 (PVIFA3%, 24)
= Br. 1,000 + Br. (16.9355) = Br. 1,000 + Br. (16.9355)
= = Br. 1,169.36 Br. 1,169.36* *
* The previous value was Br. 1,169.32. The difference is due to rounding problem. * The previous value was Br. 1,169.32. The difference is due to rounding problem.
Assuming the interest rate remains constant at 6% for the next 11 years (12 periods), Assuming the interest rate remains constant at 6% for the next 11 years (12 periods),
what would happen to Tebaber Bertas bond? what would happen to Tebaber Bertas bond?
Bo = Br. 40 (PVIFA3%, 22) + Br. 1,000 (PVIF3%, 22) Bo = Br. 40 (PVIFA3%, 22) + Br. 1,000 (PVIF3%, 22)
= = Br. 1,159.38 Br. 1,159.38
Thus, the value of the bond would fall form Br. 1,169.32 to Br. 1,159.38. If you calculate Thus, the value of the bond would fall form Br. 1,169.32 to Br. 1,159.38. If you calculate
the value of the bond at other future dates, the price would continue to fall as the maturity the value of the bond at other future dates, the price would continue to fall as the maturity
date approaches. date approaches.
Had the interest rate (k Had the interest rate (k
d d) was 10% when Tebaber Bertas bond was selling, the value of ) was 10% when Tebaber Bertas bond was selling, the value of
the bond would be: the bond would be:
Bo = Br. 40 (PVIFA5%, 24) + Br. 1,000 (PVIF5%, 24) Bo = Br. 40 (PVIFA5%, 24) + Br. 1,000 (PVIF5%, 24)
= Br. 40 (13.7986) + Br. 1,000 (0.3101) = Br. 40 (13.7986) + Br. 1,000 (0.3101)
= = Br. 862.04 Br. 862.04. Since Tebaber Bertas bond now will be paying less interest than . Since Tebaber Bertas bond now will be paying less interest than
do other bonds in the market, they are selling at a smaller price (discount bond). do other bonds in the market, they are selling at a smaller price (discount bond).
If the interest rate remain constant at 10% for the next 11 years (22 periods), the value of If the interest rate remain constant at 10% for the next 11 years (22 periods), the value of
Tebaber Bertas bond would be Br. 868.32. Thus, the value of the bond will have risen Tebaber Bertas bond would be Br. 868.32. Thus, the value of the bond will have risen
from Br. 862.04 to Br. 868.32. If you further calculate the value of the bond at other from Br. 862.04 to Br. 868.32. If you further calculate the value of the bond at other
future dates, the price would continue to rise as the maturity date approaches. future dates, the price would continue to rise as the maturity date approaches.
Check Your Progress 1 Check Your Progress 1
1. When is a bond selling at premium, at par value, and at discount? 1. When is a bond selling at premium, at par value, and at discount?
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2. Amha Corporation issued a new series of bonds on January 1, 1985. The bonds were 2. Amha Corporation issued a new series of bonds on January 1, 1985. The bonds were
sold at their par of Br. 1,000, have 12% coupon, and mature in 20 years. Coupon sold at their par of Br. 1,000, have 12% coupon, and mature in 20 years. Coupon
payments are made quarterly. What was the price of the bond on December 31, 1989, payments are made quarterly. What was the price of the bond on December 31, 1989,
assuming that the level of interest rate had fallen to 8%? assuming that the level of interest rate had fallen to 8%?
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6.2.2 Interest Rate on a Bond 6.2.2 Interest Rate on a Bond
So far we have been seeing how to determine the value of a bond if we are given the par So far we have been seeing how to determine the value of a bond if we are given the par
value, the coupon interest rate, the number of periods, and the interest rate on the bond. value, the coupon interest rate, the number of periods, and the interest rate on the bond.
Next, we shall discuss on how to find the interest rate on a bond, i.e., k Next, we shall discuss on how to find the interest rate on a bond, i.e., k
d d if we are given if we are given
the value of the bond. We will consider yield to maturity and yield to call. the value of the bond. We will consider yield to maturity and yield to call.
Yield to Maturity (YTM) Yield to Maturity (YTM) is the rate of return investors earn if they buy a bond at a is the rate of return investors earn if they buy a bond at a
specific price Bo and hold it until maturity. The approximate YTM can be found using specific price Bo and hold it until maturity. The approximate YTM can be found using
the following approximation formula: the following approximation formula:
Approximate YTM = Approximate YTM =
2
Bo M
n
Bo M
I
+
+
Example: Zebra Company has a Br. 1,000 par value, 10% coupon interest rate, and 15 Example: Zebra Company has a Br. 1,000 par value, 10% coupon interest rate, and 15
years to maturity. The bond is currently selling at Br. 1,090. Compute the YTM. years to maturity. The bond is currently selling at Br. 1,090. Compute the YTM.
Solution: Solution:
Given: Given: M = Br. 1,000; I = Br. 100 (Br. 1,000 x 10%); n = 15; Bo = Br. 1,090; YTM = ? M = Br. 1,000; I = Br. 100 (Br. 1,000 x 10%); n = 15; Bo = Br. 1,090; YTM = ?
Approximate YTM = Approximate YTM = % 9
2
090 , 1 . 000 , 1 .
15
000090 , 1 .
100 .
+
+
Br Br
Br
Br
If an investor buys Zebras bond at Br. 1,090 and holds it for 15 years, the approximate If an investor buys Zebras bond at Br. 1,090 and holds it for 15 years, the approximate
yield or rate of return per year is 9%. yield or rate of return per year is 9%.
Yield to call (YTC) Yield to call (YTC) is the rate of return earned by an investor if he buys a bond at a is the rate of return earned by an investor if he buys a bond at a
specified price, Bo, and the bond is called before its maturity date. YTC, therefore, is specified price, Bo, and the bond is called before its maturity date. YTC, therefore, is
computed only for callable bonds. A callable bond is a bond which is called and retired computed only for callable bonds. A callable bond is a bond which is called and retired
prior to its maturity date at the option of the issuer. A bond is called by an issuer when prior to its maturity date at the option of the issuer. A bond is called by an issuer when
the market interest rate falls below the coupon interest rate. The YTC can be found by the market interest rate falls below the coupon interest rate. The YTC can be found by
solving the following equation. solving the following equation.
Approximate YTC = Approximate YTC =
2
Pr
Pr
Bo ice Call
n
Bo ice Call
I
+
+
Example: X Company is intending to purchase Y Companys outstanding bond which Example: X Company is intending to purchase Y Companys outstanding bond which
was issued on January 1, 1997. Y bond is a Br. 1,000 par value, has a 10% annual was issued on January 1, 1997. Y bond is a Br. 1,000 par value, has a 10% annual
coupon, and a 30 year original maturity. There is a 5-year call protection, after which coupon, and a 30 year original maturity. There is a 5-year call protection, after which
time the bond can be called at 108. X company is to acquire the bond on January 1, 1999 time the bond can be called at 108. X company is to acquire the bond on January 1, 1999
when it is selling at Br. 1,175. when it is selling at Br. 1,175.
Required: Required: Determine the yield to call in 1999 for Y company bond. Determine the yield to call in 1999 for Y company bond.
Solution: Solution:
Given: Given: I = Br. 100 (Br. 1,000 x 10%); Bo = Br. 1,175; call price = Br. 1,080 (Br. I = Br. 100 (Br. 1,000 x 10%); Bo = Br. 1,175; call price = Br. 1,080 (Br.
1,000 x 108%); 1,000 x 108%);
n = 3 (call protection 2 years elapsed since the bond was issued); YTC n = 3 (call protection 2 years elapsed since the bond was issued); YTC
=? =?
Approximate YTC = Approximate YTC = % 06 . 6
2
175 , 1 . 080 , 1 .
3
175 , 1 . 080 , 1 .
100 .
+
Br Br
Br Br
Br
If X Company buys Y Company bond and holds the bond until the bonds are called by Y If X Company buys Y Company bond and holds the bond until the bonds are called by Y
Company, the approximate annual rate of return would be 6.06%. Company, the approximate annual rate of return would be 6.06%.
Check Your Progress 2 Check Your Progress 2
1. The Salem Company bond currently sells for Br. 955, has a 12% coupon interest rate 1. The Salem Company bond currently sells for Br. 955, has a 12% coupon interest rate
and Br. 1,000 par value, pays interest annually, and has 15 years to maturity. Calculate and Br. 1,000 par value, pays interest annually, and has 15 years to maturity. Calculate
the yield to maturity on this bond. the yield to maturity on this bond.
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2. Allied Company has just issued 10,000 bonds of Br. 1,000 par value each. The bonds 2. Allied Company has just issued 10,000 bonds of Br. 1,000 par value each. The bonds
have original maturity of 50 years and an annual coupon rate of 15%. There is a 10 year have original maturity of 50 years and an annual coupon rate of 15%. There is a 10 year
call provision on the bonds. 3 years after the bonds had been issued, they were selling at call provision on the bonds. 3 years after the bonds had been issued, they were selling at
Br. 1,300 each. The call price for each bond is 109 . Calculate the yield to call on Allied Br. 1,300 each. The call price for each bond is 109 . Calculate the yield to call on Allied
bonds. bonds.
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6.3 PREFERRED STOCK VALUATION 6.3 PREFERRED STOCK VALUATION
Preferred stock is a type of equity security that provides its owners with limited or fixed Preferred stock is a type of equity security that provides its owners with limited or fixed
claims on a corporations income and assets. Investment in a preferred stock provides a claims on a corporations income and assets. Investment in a preferred stock provides a
single cash flow, i.e., constant periodic dividend payments. Preferred stock has single cash flow, i.e., constant periodic dividend payments. Preferred stock has
similarities to both a bond and a commn stock. As to similarities to a bond, preferred similarities to both a bond and a commn stock. As to similarities to a bond, preferred
dividends are fixed in amount and are like interest payments. As to a common stock, the dividends are fixed in amount and are like interest payments. As to a common stock, the
preferred dividends are paid for an indefinite time period. preferred dividends are paid for an indefinite time period.
6.3.1 Preferred Stock Valuation Model 6.3.1 Preferred Stock Valuation Model
The value of a preferred stock is the present value of all future preferred dividends it is The value of a preferred stock is the present value of all future preferred dividends it is
expected to provide over an infinite time horizon. Most preferred stocks entitle their expected to provide over an infinite time horizon. Most preferred stocks entitle their
owners to regular and fixed dividend payments. If the payments last forever, the issue is a owners to regular and fixed dividend payments. If the payments last forever, the issue is a
perpetuity. Therefore, the value of a preferred stock is found by the following formula: perpetuity. Therefore, the value of a preferred stock is found by the following formula:
VPS = VPS =
Kps
Dps
Where: Where:
Vps = Value of the preferred stock Vps = Value of the preferred stock
Dps = Preferred stock dividends Dps = Preferred stock dividends
Kps = The required rate of return on the preferred stock Kps = The required rate of return on the preferred stock
Example: Example: Abebe wishes to estimate the value of its outstanding preferred stock. The Abebe wishes to estimate the value of its outstanding preferred stock. The
preferred issue has a Br. 80 par value and pays an annual dividend of Br. 6.40 per share. preferred issue has a Br. 80 par value and pays an annual dividend of Br. 6.40 per share.
Similar-risk preferred stocks are currently earning a 9.3% annual rate of return. What is Similar-risk preferred stocks are currently earning a 9.3% annual rate of return. What is
the value of the outstanding preferred stock? the value of the outstanding preferred stock?
Solution: Solution:
Given: Given: Dps = Br. 6.40; Kps = 9.3%; Vps =? Dps = Br. 6.40; Kps = 9.3%; Vps =?
Vps = Vps =
% 3 . 9
40 . 6 . Br
= Br. 68.82 = Br. 68.82
So the Br. 6.40 annual dividend an investor receives for an infinite years is equal to So the Br. 6.40 annual dividend an investor receives for an infinite years is equal to
todays Br. 68.82 if the required rate of return is 9.3%. todays Br. 68.82 if the required rate of return is 9.3%.
6.3.2 Rate of Return on a Preferred Stock 6.3.2 Rate of Return on a Preferred Stock
To evaluate the worthiness of investment in a preferred stock in comparison to other To evaluate the worthiness of investment in a preferred stock in comparison to other
investment opportunities, we should be able to compute the rate of return on a preferred investment opportunities, we should be able to compute the rate of return on a preferred
stock. If we know the current price of a preferred stock and its dividend, we can compute stock. If we know the current price of a preferred stock and its dividend, we can compute
the expected rate of return on the preferred stock. This can be done using the following the expected rate of return on the preferred stock. This can be done using the following
formula: formula:
Kps = Kps =
Vps
Dps
Where Where
Kps = The expected rate of return on the preferred stock Kps = The expected rate of return on the preferred stock
Dps = Preferred stock dividends Dps = Preferred stock dividends
Vps = Value or current price of the preferred stock Vps = Value or current price of the preferred stock
Example: Example: A preferred stock pays an annual dividend of Br. 9 and the current market A preferred stock pays an annual dividend of Br. 9 and the current market
price is Br. 81. Compute the required rate of return from the preferred stock. price is Br. 81. Compute the required rate of return from the preferred stock.
Solution: Solution:
Given: Given: Dps = Br. 9; Vps = Br. 81; Kps =? Dps = Br. 9; Vps = Br. 81; Kps =?
Kps = Kps =
81 .
9 .
Br
Br
= 11.11% = 11.11%
For an investor to invest Br. 81 in this preferred stock and to receive an annual dividend For an investor to invest Br. 81 in this preferred stock and to receive an annual dividend
of Br. 9, his minimum required rate of return is 11.11%. of Br. 9, his minimum required rate of return is 11.11%.
6.4 COMMON STOCK VALUATION 6.4 COMMON STOCK VALUATION
The value of a share of common stock is the present value of the common stocks The value of a share of common stock is the present value of the common stocks
dividend expected over an infinite time horizon. The value of a share of common stock is dividend expected over an infinite time horizon. The value of a share of common stock is
also equal to the sum of the present value of the expected dividends and the present value also equal to the sum of the present value of the expected dividends and the present value
of the expected selling price of the stock. The selling price in turn will depend on the of the expected selling price of the stock. The selling price in turn will depend on the
dividends to be received by the purchasing party. dividends to be received by the purchasing party.
To understand the value of a common stock we should keep in mind two points. First, the To understand the value of a common stock we should keep in mind two points. First, the
dividends are expected for an infinite time period. Second, the dividends are not constant. dividends are expected for an infinite time period. Second, the dividends are not constant.
Therefore, the value of a common stock is found by summing the present values of Therefore, the value of a common stock is found by summing the present values of
annual dividends. annual dividends.
Po = Po =
+
+ +
+
+
+ ) 1 ( ) 1 ( ) 1 (
2
2
1
1
ks
D
ks
D
ks
D
Where: Where:
Po = Value of the common stock at time zero (as of today) Po = Value of the common stock at time zero (as of today)
D D
1 1, D , D
2 2, , D , , D
= Pre share dividend expected at the end of each year = Pre share dividend expected at the end of each year
Ks = the required rate of return on the common stock. Ks = the required rate of return on the common stock.
The common stock valuation equation can be simplified by redefining each years The common stock valuation equation can be simplified by redefining each years
dividend. The dividends are defined in terms of anticipated dividends growth. Generally, dividend. The dividends are defined in terms of anticipated dividends growth. Generally,
there are three cases accordingly. These are: there are three cases accordingly. These are:
1. 1. Zero growth common stock, Zero growth common stock,
2. 2. Constant growth common stock, and Constant growth common stock, and
3. 3. Variable growth common stock. Variable growth common stock.
Hence, common stock valuation approaches are developed under each of the above Hence, common stock valuation approaches are developed under each of the above
dividend growth models. Next sections will discus each model one by one. dividend growth models. Next sections will discus each model one by one.
6.4.1 Zero Growth Stock 6.4.1 Zero Growth Stock
A zero growth stock is a common stock whose future dividends are not expected to grow A zero growth stock is a common stock whose future dividends are not expected to grow
at all. The expected growth rate (g) is zero. This is the simplest model to common stock at all. The expected growth rate (g) is zero. This is the simplest model to common stock
valuation. It assumes a constant, non-growing annual dividend. So here the annual valuation. It assumes a constant, non-growing annual dividend. So here the annual
dividends are all equal. That is D dividends are all equal. That is D
1 1 = D = D
2 2 = = D = = D
= D. = D.
A common stock with zero growth rate is a security that is expected to provide a fixed A common stock with zero growth rate is a security that is expected to provide a fixed
dividend each year. Hence, a zero growth common stock is a perpetuity. Therefore, the dividend each year. Hence, a zero growth common stock is a perpetuity. Therefore, the
value of a zero growth stock is given as: value of a zero growth stock is given as:
Po = Po =
Ks
D
Example: Example: The most recent common stock dividend of Shalom Manufacturing The most recent common stock dividend of Shalom Manufacturing
Corporation was Br. 3.60 per share. Due to the firms maturity as well as stable sales and Corporation was Br. 3.60 per share. Due to the firms maturity as well as stable sales and
earnings, the dividends are expected to remain at the current level of the foreseeable earnings, the dividends are expected to remain at the current level of the foreseeable
future. future.
Required: Required: Determine the value of Shaloms common stock for an investor whose Determine the value of Shaloms common stock for an investor whose
required return is 12%. required return is 12%.
Solution: Solution:
Given: Given: D = Br. 3.60; Ks = 12%; Po =? D = Br. 3.60; Ks = 12%; Po =?
Po = Po =
% 12
60 . 3 . Br
= Br. 30 = Br. 30
The maximum price the investor would be willing to pay for a share of Shaloms The maximum price the investor would be willing to pay for a share of Shaloms
common stock is Br. 30 for he to receive a Br. 3.60 annual dividend for an indefinite common stock is Br. 30 for he to receive a Br. 3.60 annual dividend for an indefinite
years. years.
6.4.2 Constant Growth Stock 6.4.2 Constant Growth Stock
Constant growth stock is a common stock whose future dividends are expected to grow at Constant growth stock is a common stock whose future dividends are expected to grow at
a constant dividend growth rate (g). It is sometimes called normal growth stock. The a constant dividend growth rate (g). It is sometimes called normal growth stock. The
constant (normal) growth common stock valuation model is the most widely cited constant (normal) growth common stock valuation model is the most widely cited
approach to common stock valuation. approach to common stock valuation.
The value of a constant growth stock is the present value of the expected future dividends The value of a constant growth stock is the present value of the expected future dividends
growing at a constant rate of g. Here the value can be found by using the following growing at a constant rate of g. Here the value can be found by using the following
formula: formula:
Po = Po =
g Ks
D
1
; Ks > g ; Ks > g
Where: Where:
D D
1 1 = The expected dividend at the end of year 1. = The expected dividend at the end of year 1.
g = The expected growth rate in dividends. g = The expected growth rate in dividends.
D D
1 1 = Do(1+g), where Do is the most recent dividend. Similarly D2 = D1 (1+g) and so on. = Do(1+g), where Do is the most recent dividend. Similarly D2 = D1 (1+g) and so on.
To find the value of a common stock (constant growth) at one year, first, find the To find the value of a common stock (constant growth) at one year, first, find the
expected dividend at the end of next year. expected dividend at the end of next year.
Example: Example: Zeila Motor Corporations common stock currently pays an annual dividend of Zeila Motor Corporations common stock currently pays an annual dividend of
Br. 5.40 per share. The dividends are expected to grow at a constant annual rate of 5% to Br. 5.40 per share. The dividends are expected to grow at a constant annual rate of 5% to
infinity. Estimate the value of Zeilas common stock if the required return is 12%. infinity. Estimate the value of Zeilas common stock if the required return is 12%.
Solution: Solution:
Given: Given: Do = Br. 5.40; g = 5%; Ks = 12%; Po =? Do = Br. 5.40; g = 5%; Ks = 12%; Po =?
Po = Po =
g Ks
D
1
; D ; D
1 1 = Do (1+g = Do (1+g
0 0) = Br. 5.40 (1.05) = Br. 5.67 ) = Br. 5.40 (1.05) = Br. 5.67
= =
% 5 % 12
67 . 5 .
Br
= Br. 81 = Br. 81
For an investor to receive an annual dividend of Br. 5.40 growing at 5% constantly to For an investor to receive an annual dividend of Br. 5.40 growing at 5% constantly to
infinity, the maximum price he would pay today is Br. 81. infinity, the maximum price he would pay today is Br. 81.
If we are given the value of a constant growth stock, the most recent dividend, the If we are given the value of a constant growth stock, the most recent dividend, the
expected dividend growth rate, we can compute the expected rate of return as follows. expected dividend growth rate, we can compute the expected rate of return as follows.
Ks = Ks =
g
P
D
+
0
1
Where: Where:
Ks = The expected rate of return on a constant growth stock Ks = The expected rate of return on a constant growth stock
D D
1 1/P /P
0 0 = Expected dividend yield. = Expected dividend yield.
g = Expected dividend growth rate = capital gains yield. g = Expected dividend growth rate = capital gains yield.
Example: Example: Assume the above example except that you are given the value of common Assume the above example except that you are given the value of common
stock of Br. 81 instead of the required return. Compute the expected rate of return? stock of Br. 81 instead of the required return. Compute the expected rate of return?
Ks = Ks =
81 .
) 05 . 1 ( 40 . 5 .
Br
Br
+ 0.05 + 0.05
= 12% = 12%
6.4.3 Variable Growth Stock 6.4.3 Variable Growth Stock
Variable growth stock is a stock whose dividends are expected to grow at variable or Variable growth stock is a stock whose dividends are expected to grow at variable or
non-constant rates. The model of common stock valuation that allows for a change in the non-constant rates. The model of common stock valuation that allows for a change in the
dividend growth rate is called Variable (non constant) Growth Model. It sometimes is dividend growth rate is called Variable (non constant) Growth Model. It sometimes is
also called supernormal growth model. also called supernormal growth model.
The value of a share of variable growth stock is determined by following 4 procedures. The value of a share of variable growth stock is determined by following 4 procedures.
1. Find the value of the dividends at the end of each year during the initial growth period. 1. Find the value of the dividends at the end of each year during the initial growth period.
2. Find the present values of the dividends found in step 1. 2. Find the present values of the dividends found in step 1.
3. Find the value of the stock at the end of the initial growth period 3. Find the value of the stock at the end of the initial growth period
4. Add the present value of the dividends found in step 2 and the present value of the 4. Add the present value of the dividends found in step 2 and the present value of the
value of the stock found in step 3 to determine the value of the stock at time zero, i.e. value of the stock found in step 3 to determine the value of the stock at time zero, i.e.
po. po.
Example: Example: Addis Companys most recent annual dividend, which was paid yesterday, Addis Companys most recent annual dividend, which was paid yesterday,
was Br. 1.75 per share. The dividends are expected to experience a 15% annual growth was Br. 1.75 per share. The dividends are expected to experience a 15% annual growth
rate for the next 3 years. By the end of 3 years growth rate will slow to 5% per year to rate for the next 3 years. By the end of 3 years growth rate will slow to 5% per year to
infinity. infinity.
Stockholders require a return of 12% on Addis stock Stockholders require a return of 12% on Addis stock
Required: Required: Calculate the value of the stock today. Calculate the value of the stock today.
Solution: Solution:
Given: Do = Br. 1.75; g Given: Do = Br. 1.75; g
1 1 = 15% for 3 years; g = 15% for 3 years; g
2 2 = 5% from year 3 to infinity; k = 5% from year 3 to infinity; k
5 5 = 12%; p = 12%; p
0 0
= ? = ?
g g
1 1 = 15% = 15% g g
2 2 = 5% = 5%
Year 0 1 2 3 Year 0 1 2 3
D D
0 0 = Br. 1.75 D = Br. 1.75 D
1 1 = Br. 2.01 D = Br. 2.01 D
2 2 = Br. 2.31 D = Br. 2.31 D
3 3 = Br. 2.66 = Br. 2.66
PV of D PV of D
1 1 = Br. 1.79 PVIF 12%, 1 = Br. 1.79 PVIF 12%, 1
PV of D PV of D
2 2 = 1.84 PVIF 12%, 2 = 1.84 PVIF 12%, 2
PV of D PV of D
3 3 = 1.89 PVIF 12%, 3 = 1.89 PVIF 12%, 3
PV of P PV of P
3 3 = = 28.40 28.40 PVIF 12%, 3 P PVIF 12%, 3 P
3 3 = Br. 39.90 = Br. 39.90
P P
0 0 = = Br. 33.92 Br. 33.92
D D
1 1 = D = D
0 0 (1 + g (1 + g
1 1) = Br. 1.75 (1.15) = Br. 2.01 ) = Br. 1.75 (1.15) = Br. 2.01
D D
2 2 = D = D
1 1 (1 + g (1 + g
1 1) = Br. 2.01 (1.15) = Br. 2.31 ) = Br. 2.01 (1.15) = Br. 2.31
D D
3 3 = D = D
2 2 (1 + g (1 + g
1 1) = Br. 2.31 (1.15) = Br. 2.66 ) = Br. 2.31 (1.15) = Br. 2.66
P P
3 3 = =
90 . 39 .
05 . 0 12 . 0
) 05 . 1 ( 66 . 2 . ) 1 ( 3 4
2 5
2
2 5
Br
Br
g k
g D
g k
D
Therefore, the value of Addis Companys common stock today is Br. 33.92 Therefore, the value of Addis Companys common stock today is Br. 33.92
Check Your Progress III Check Your Progress III
1. You are considering the purchase of Zemen company common stock that paid dividend 1. You are considering the purchase of Zemen company common stock that paid dividend
of Br. 2 yesterday. You expect the dividend to grow at the rate of 5% per year for the of Br. 2 yesterday. You expect the dividend to grow at the rate of 5% per year for the
next 3 years, and, if you buy the stock, you plan to hold it for 3 years and then sell it. next 3 years, and, if you buy the stock, you plan to hold it for 3 years and then sell it.
Calculate the value of the common stock if your required rate of return is 15% Calculate the value of the common stock if your required rate of return is 15%
_______________________________________________________________________ _______________________________________________________________________
_______________________________________________________________________ _______________________________________________________________________
_______________________________________________________________________ _______________________________________________________________________
___ ___
2. Melat computers Incorporated is experiencing a period of rapid growth. Earnings and 2. Melat computers Incorporated is experiencing a period of rapid growth. Earnings and
dividends are expected to grow at 15% rate during the next 2 years, at 13% in the third dividends are expected to grow at 15% rate during the next 2 years, at 13% in the third
year, and at a constant rate of 6% thereafter. Melats last dividend was Br. 1.15, and the year, and at a constant rate of 6% thereafter. Melats last dividend was Br. 1.15, and the
required rate of return on the stock is 12%. Calculate the value of the stock today. required rate of return on the stock is 12%. Calculate the value of the stock today.
_______________________________________________________________________ _______________________________________________________________________
_______________________________________________________________________ _______________________________________________________________________
_______________________________________________________________________ _______________________________________________________________________
___ ___
3. Can we compute the value of a common stock whose future dividends are expected to 3. Can we compute the value of a common stock whose future dividends are expected to
decline at a constant rate? decline at a constant rate?
_______________________________________________________________________ _______________________________________________________________________
_______________________________________________________________________ _______________________________________________________________________
_______________________________________________________________________ _______________________________________________________________________
___ ___
The main points covered in unit 6 are the following: The main points covered in unit 6 are the following:
- - Valuation determines the value of an asset based on its future cash flows, their Valuation determines the value of an asset based on its future cash flows, their
timing and associated risk. timing and associated risk.
- - The value of an asset is the present value of expected future cash flows discounted The value of an asset is the present value of expected future cash flows discounted
by an appropriate required rate of return. by an appropriate required rate of return.
- - The value of a bond is the present value of interest payments and maturity value The value of a bond is the present value of interest payments and maturity value
- - The value of preferred stock is the present value of expected preferred dividends. The value of preferred stock is the present value of expected preferred dividends.
- - The value of a zero growth stock is the present value of expected fixed dividends. The value of a zero growth stock is the present value of expected fixed dividends.
- - The value of a normal growth stock is the present value of expected dividends The value of a normal growth stock is the present value of expected dividends
which are growing at a constant rate. which are growing at a constant rate.
- - The present value of a variable growth stock is computed by following 4 basic The present value of a variable growth stock is computed by following 4 basic
steps. steps.
- - In a constant growth stock, the required rate of return should always be greater In a constant growth stock, the required rate of return should always be greater
than the expected dividends growth rate. That is ks > g than the expected dividends growth rate. That is ks > g
I. I.
1. A bond is selling at premium when the market interest rate or required rate of return 1. A bond is selling at premium when the market interest rate or required rate of return
(k (k
d d) is less than the coupon interest rate, at discount when kd is greater than coupon ) is less than the coupon interest rate, at discount when kd is greater than coupon
interest rate, and at par value when kd is equal to coupon rate. interest rate, and at par value when kd is equal to coupon rate.
2. Given: M = Br. 1,000; kd = 2% (8% 2. Given: M = Br. 1,000; kd = 2% (8% 4); I = Br. 30 (Br. 1,000 x 12%/4); n = 60 (15 x 4); I = Br. 30 (Br. 1,000 x 12%/4); n = 60 (15 x
4) five years have passed (Jan. 1, 1985 to Dec. 31, 1989) since the bond was issued B 4) five years have passed (Jan. 1, 1985 to Dec. 31, 1989) since the bond was issued B
0 0 = ? = ?
B B
0 0 = Br. 30 (PVIFA 2%, 60) + Br. 1,000 (PVFI2%, 60) = Br. 30 (PVIFA 2%, 60) + Br. 1,000 (PVFI2%, 60)
= Br. 30 (34.7609) + Br. 1,000 (0.3048) = Br. 30 (34.7609) + Br. 1,000 (0.3048)
= = Br. 1,347.63 Br. 1,347.63
II. II.
1. Given M = Br. 1,000; I = Br. 120 (Br. 1,000 x 12%); n = 15; B 1. Given M = Br. 1,000; I = Br. 120 (Br. 1,000 x 12%); n = 15; B
0 0 = Br. 955; YTM = ? = Br. 955; YTM = ?
Approximate YTM = Approximate YTM = % 58 . 12
2
955 . 000 , 1 .
15
955 . 000 , 1 .
120 .
+
Br Br
Br Br
Br
2. Given: I = Br. 150 (Br. 1,000 x 15%); B 2. Given: I = Br. 150 (Br. 1,000 x 15%); B
0 0 = Br. 1,300; call price = Br. 1,097.50 (Br. = Br. 1,300; call price = Br. 1,097.50 (Br.
1,000 x 109 %) 1,000 x 109 %)
n n
= 7 (10 3); YTC = ? = 7 (10 3); YTC = ?
Approximate YTC = Approximate YTC = % 10 . 10
2
300 , 1 . 50 . 097 , 1 .
7
300 , 1 . 50 . 097 , 1 .
150 .
+
Br Br
Br Br
Br
III. III.
1. Value of common stock = PV of D 1. Value of common stock = PV of D
1 1 + PV of D + PV of D
3 3 + PV of P + PV of P
3 3. But P3 i.e. the . But P3 i.e. the
selling price at the end of 3 years = the PV at the end of year 3 of D selling price at the end of 3 years = the PV at the end of year 3 of D
4 4, D5, ----, D , D5, ----, D . .
Therefore, the value of common stock = PV of D Therefore, the value of common stock = PV of D
2 2 + ---- + PV of D + ---- + PV of D . .
Whether you hold the common stock for 3 years of for indefinite, the value of common Whether you hold the common stock for 3 years of for indefinite, the value of common
stock is the same. stock is the same.
Given: Given: D D
0 0 = Br. 2; g = 5%, ks = 15%; P = Br. 2; g = 5%, ks = 15%; P
0 0 = ? = ?
P P
0 0 = =
21 .
% 5 % 15
) 05 . 1 ( 2 . ) 1 (
0 1
Br
Br
g K
g D
g K
D
s s

2. Given: D 2. Given: D
0 0 = Br. 1.15; g = Br. 1.15; g
1 1 = 15%; g = 15%; g
2 2 = 13%; g = 13%; g
3 3 = 6%; Ks = 12%; P0 = ? = 6%; Ks = 12%; P0 = ?
g g
1 1 = 15% g = 15% g
2 2 = 13% g = 13% g
3 3 = 6% = 6%

Year 0 1 2 3 Year 0 1 2 3
D D
0 0 = Br. 1.15 D = Br. 1.15 D
1 1 = Br. 1.32 D = Br. 1.32 D
2 2 = Br. 1.52 D = Br. 1.52 D
3 3 = Br. 1.72 = Br. 1.72
PV of D PV of D
1 1 = Br. 1.18 PVIF12%, 1 = Br. 1.18 PVIF12%, 1
PV of D PV of D
2 2 = Br. 1.21 PVIF12%, 2 = Br. 1.21 PVIF12%, 2
PV of D PV of D
3 3 = 1.22 PVIF12%, 3 = 1.22 PVIF12%, 3
PV of P PV of P
3 3 = = 21.63 21.63 PVIF12%, 3 P PVIF12%, 3 P
3 3 = =
39 . 30 .
4
Br
g K
D
s

D D
1 1 = Br. 1.15 (1.15) = Br. 1.32; D = Br. 1.15 (1.15) = Br. 1.32; D
2 2 = Br. 1.32 (1.15) = Br. 1.52; D = Br. 1.32 (1.15) = Br. 1.52; D
3 3 = Br. = Br.
1.52(1.13) = Br. 1.72 1.52(1.13) = Br. 1.72
P P
3 3 = = Br. 1.72 (1.06) Br. 1.72 (1.06) = Br. 30.30 = Br. 30.30
P
0
= Br. 25.24
12% - 6% 12% - 6%
3. Yes we can compute using the constant growth stock model. The only thing new here 3. Yes we can compute using the constant growth stock model. The only thing new here
is that the expected growth rate (g) will be negative. is that the expected growth rate (g) will be negative.
Exercise Exercise
1. Selam Household Utensils Manufacturing Company is currently selling its common 1. Selam Household Utensils Manufacturing Company is currently selling its common
stock at Br. 108. the firms last earnings per share was Br. 18 and its dividend payout stock at Br. 108. the firms last earnings per share was Br. 18 and its dividend payout
ratio was 60%. The required rate of return on the stock is 12%. Selams dividends are ratio was 60%. The required rate of return on the stock is 12%. Selams dividends are
expected to grow at a constant rate. expected to grow at a constant rate.
Required: Required: Determine: Determine:
a) The expected dividends growth rate (g) a) The expected dividends growth rate (g)
b) The expected stock price of Selam Company after 3 years b) The expected stock price of Selam Company after 3 years
2. Bonds issued by Berhan Company have a par value of Br. 5,000. The bonds are 2. Bonds issued by Berhan Company have a par value of Br. 5,000. The bonds are
currently selling for Br. 4,250. They have 10 years remaining to maturity. The annual currently selling for Br. 4,250. They have 10 years remaining to maturity. The annual
interest payment is 9%. interest payment is 9%.
3. A firm pays Br. 2.45 dividend per share at the end of next year on a common stock that 3. A firm pays Br. 2.45 dividend per share at the end of next year on a common stock that
has a selling price of Br. 35. The dividends of the firm are expected to grow at a has a selling price of Br. 35. The dividends of the firm are expected to grow at a
constant rate of 6%. Compute the required rate of return on the stock (ks). constant rate of 6%. Compute the required rate of return on the stock (ks).
4. Ibex Motor corporation issued bonds with a 20-year maturity, a Br. 1,000 par value, a 4. Ibex Motor corporation issued bonds with a 20-year maturity, a Br. 1,000 par value, a
10% coupon rate, and semiannual interest payments. Two years after the bonds were 10% coupon rate, and semiannual interest payments. Two years after the bonds were
issued, the market interest rate dropped to 6%. issued, the market interest rate dropped to 6%.
Required: Required: Determine the value of each bond Determine the value of each bond
a) at the time the bonds were sold a) at the time the bonds were sold
b) two years after issuance b) two years after issuance
1. Aswath Damodaran (1997). 1. Aswath Damodaran (1997). Corporate Finance: Theory and Practice Corporate Finance: Theory and Practice. John Wiley . John Wiley
and Sons, Inc., New York and Sons, Inc., New York
2. Eugene F. Brigham (1997). 2. Eugene F. Brigham (1997). Fundamentals of Financial Management Fundamentals of Financial Management. 7 . 7
th th
Dryden Press Harcourt Brace College Publishers, Florida. Dryden Press Harcourt Brace College Publishers, Florida.
3. Halpern, Weston and Brigham (1989). 3. Halpern, Weston and Brigham (1989). Canadian Managerial Finance. Canadian Managerial Finance. 3 3
rd rd
edition, edition,
Holt Rinehart and Winston of Canada, Limited Holt Rinehart and Winston of Canada, Limited
4. James C. Van Horne (1989). 4. James C. Van Horne (1989). Financial Management and Policy Financial Management and Policy. 8 . 8
th th
edition, Prentice edition, Prentice
Hall. Hall.
5. Lawrence J. Gitman (1997). 5. Lawrence J. Gitman (1997). Principles of Managerial Finance Principles of Managerial Finance. 8 . 8
th th
edition, Addison edition, Addison
Wesley Longman, Inc. Wesley Longman, Inc.
6. Belayneh, Endale, Fasil and Hassen (2003). 6. Belayneh, Endale, Fasil and Hassen (2003). The impact of Ordinary Shares The impact of Ordinary Shares
Valuation on the Capital Structure of Ethiopian Companies: A Case Study on Valuation on the Capital Structure of Ethiopian Companies: A Case Study on
Four Private Financial Four Private Financial Institutions Institutions. . Unpublished Material, Addis Ababa Unpublished Material, Addis Ababa
University. University.
Intrinsic value Intrinsic value the present value of expected future cash flows discounted by an the present value of expected future cash flows discounted by an
appropriate discount rate. appropriate discount rate.
Discount rate Discount rate a rate based on the riskness of an asset used to determine the present a rate based on the riskness of an asset used to determine the present
value. value.
Maturity date Maturity date a specified date on which the par value of a bond must be repaid. a specified date on which the par value of a bond must be repaid.
Coupon rate Coupon rate a rate of interest payment specified on a bond. a rate of interest payment specified on a bond.
Market interest rate Market interest rate the interest rate on bonds available in the market whose risk is the interest rate on bonds available in the market whose risk is
similar to the bond under consideration. It is a discount rate on a bond issue. similar to the bond under consideration. It is a discount rate on a bond issue.
Premium bond Premium bond a bond selling at a price above its par value. a bond selling at a price above its par value.
Discount bond Discount bond a bond selling at a price below its par value. a bond selling at a price below its par value.
Yield Yield the rate of return on any investment the rate of return on any investment
Supernormal growth Supernormal growth a growth which is more than the average of normal companies in a growth which is more than the average of normal companies in
the industry. the industry.
UNIT 7: CAPITAL STRUCTURE AND LEVERAGE UNIT 7: CAPITAL STRUCTURE AND LEVERAGE
Contents Contents
7.0 Aims and Objectiv0es 7.0 Aims and Objectiv0es
7.2 The Target Capital Structure 7.2 The Target Capital Structure
7.3 The Concept of Leverage 7.3 The Concept of Leverage
7.3.1 Operating Leverage 7.3.1 Operating Leverage
7.3.2 Financial Leverage 7.3.2 Financial Leverage
7.4 Capital Structure Theory 7.4 Capital Structure Theory
7.4.1 Trade-Off Theory 7.4.1 Trade-Off Theory
7.4.2 Signaling Theory 7.4.2 Signaling Theory
7.5 Factors in Capital Structure Decisions 7.5 Factors in Capital Structure Decisions
At the end of this unit you should be able to understand the following: At the end of this unit you should be able to understand the following:
the meaning and concept of capital structure the meaning and concept of capital structure
the impact of capital structure on value of a firm the impact of capital structure on value of a firm
the concept of operating and financial leverage the concept of operating and financial leverage
the interpretation and properties of operating and financial leverage the interpretation and properties of operating and financial leverage
how to determine the optimal capital structure how to determine the optimal capital structure
two basic theories of capital structure two basic theories of capital structure
factors to be considered in setting capital structure factors to be considered in setting capital structure
In unit 8 when we will calculate the weighted average cost of capital for use in capital In unit 8 when we will calculate the weighted average cost of capital for use in capital
budgeting, we will take the capital structure weights, or the mix of securities the firm budgeting, we will take the capital structure weights, or the mix of securities the firm
uses to finance its assets, as a given. However, if the weights are changed, the calculated uses to finance its assets, as a given. However, if the weights are changed, the calculated
cost of capital and thus the set of acceptable projects, also will change. Further changing cost of capital and thus the set of acceptable projects, also will change. Further changing
the capital structure will affect the riskness of the firm common stock, and this will affect the capital structure will affect the riskness of the firm common stock, and this will affect
K K
s s and P and P
o o. Therefore, the choice of a capital structure is an important decision. . Therefore, the choice of a capital structure is an important decision.
7.2 THE TARGET CAPITAL STRUCTURE 7.2 THE TARGET CAPITAL STRUCTURE
A firm analyzes a number of factors, and then it establishes a target capital structure. This A firm analyzes a number of factors, and then it establishes a target capital structure. This
targest may change over time as conditions vary, but at any given moment the firms targest may change over time as conditions vary, but at any given moment the firms
management has a specific capital structure in mind. If the actual debt ratio is become the management has a specific capital structure in mind. If the actual debt ratio is become the
target level, expansion capital will probably be raised by issuing debt, whereas if the debt target level, expansion capital will probably be raised by issuing debt, whereas if the debt
ratio is above the target, equity will probably be used. ratio is above the target, equity will probably be used.
Capital structure policy involves a trade-off between risk and return: Capital structure policy involves a trade-off between risk and return:
Using more debt raises the riskness of the firms earnings stream Using more debt raises the riskness of the firms earnings stream
However, a higher debt ratio generally leads to a higher expected rate of return However, a higher debt ratio generally leads to a higher expected rate of return
Higher risk tends to lower a stocks price, but higher expected rate of return raises it. Higher risk tends to lower a stocks price, but higher expected rate of return raises it.
Therefore, the optimal capital structure strikes a balance between risk and return so as to Therefore, the optimal capital structure strikes a balance between risk and return so as to
maximize a firms stock price. maximize a firms stock price.
Four primary factors influence the capital structure decision Four primary factors influence the capital structure decision
1. 1. Business risk Business risk, or the riskness inherent in the firms operations if it used no debt. , or the riskness inherent in the firms operations if it used no debt.
The greater the firms business risk, the lower its optimal debt ratio. The greater the firms business risk, the lower its optimal debt ratio.
2. 2. The firms tax position The firms tax position. A major reason for using debt is that interest is . A major reason for using debt is that interest is
deductible, which lowers the effective cost of debt. However, if much of a firms deductible, which lowers the effective cost of debt. However, if much of a firms
income is already sheltered from taxes by depreciation tax shields or tax loss income is already sheltered from taxes by depreciation tax shields or tax loss
carry-forwards, its tax ratio will be low, so debt will not be as advantageous as it carry-forwards, its tax ratio will be low, so debt will not be as advantageous as it
would be to a firm with a higher effective tax rate. would be to a firm with a higher effective tax rate.
3. 3. Financial flexibility Financial flexibility, , or the ability to raise capital on reasonable terms under or the ability to raise capital on reasonable terms under
adverse conditions adverse conditions. Corporate treasures know that a steady supply of capital is . Corporate treasures know that a steady supply of capital is
necessary for stable operations, which is vital for long-run success. They also necessary for stable operations, which is vital for long-run success. They also
know that when money is tight in the economy, or when a firm is experiencing know that when money is tight in the economy, or when a firm is experiencing
operating difficulties, suppliers of capital prefer to provide funds to companies operating difficulties, suppliers of capital prefer to provide funds to companies
with strong balance sheet. Therefore, both the potential further need for funds and with strong balance sheet. Therefore, both the potential further need for funds and
the consequences of a funds shortage have a major influence on the target capital the consequences of a funds shortage have a major influence on the target capital
structure the greater the probable future need for capital, and the worse the structure the greater the probable future need for capital, and the worse the
consequences of a capital budget, the stronger the balance sheet should be. consequences of a capital budget, the stronger the balance sheet should be.
4. 4. Managerial conservatism or aggressiveness Managerial conservatism or aggressiveness. Some managers are more . Some managers are more
aggressive than others, hence some firms are more inclined to use debt in an effort aggressive than others, hence some firms are more inclined to use debt in an effort
to boost profits. This factor does not affect, the optimal, or value- maximizing, to boost profits. This factor does not affect, the optimal, or value- maximizing,
capital structure, but it does influence the target capital structure. capital structure, but it does influence the target capital structure.
These four points larger determine the target capital structure, but operating conditions These four points larger determine the target capital structure, but operating conditions
can cause the actual capital structure to vary from the target. can cause the actual capital structure to vary from the target.
Check your progress 1 Check your progress 1
In what sense does capital structure policy involve a trade-off between risk and return? In what sense does capital structure policy involve a trade-off between risk and return?
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7.3 THE CONCEPT OF LEVERAGE 7.3 THE CONCEPT OF LEVERAGE
The leverage concept is very general. It is not unique to business or finance, and it can be The leverage concept is very general. It is not unique to business or finance, and it can be
used to analyze many different types of problems. For example, other disciplines, such as used to analyze many different types of problems. For example, other disciplines, such as
economics and engineering, use the same concept, and refer to it as elasticity. When used economics and engineering, use the same concept, and refer to it as elasticity. When used
in a financial setting, leverage measures the behavior of interrelated variables, such as in a financial setting, leverage measures the behavior of interrelated variables, such as
output, revenue, earnings before interest and taxes (EBIT), and earnings per share (EPS). output, revenue, earnings before interest and taxes (EBIT), and earnings per share (EPS).
The material in this chapter will be easier to understand if two points are kept in mind. The material in this chapter will be easier to understand if two points are kept in mind.
1. 1. Leverage measures the relationship between two variables, as opposed to Leverage measures the relationship between two variables, as opposed to
measuring variables independently, and the value that one variable assumes must measuring variables independently, and the value that one variable assumes must
depend on the values assume by the second variable. depend on the values assume by the second variable.
2. 2. In order for leverage coefficients to have any useful applications, it must be In order for leverage coefficients to have any useful applications, it must be
possible to identify which variable is the dependent variable. In other words, the possible to identify which variable is the dependent variable. In other words, the
direction of casualty must be known. When two variables are so related, the direction of casualty must be known. When two variables are so related, the
degree of leverage describes the responsiveness of the dependent variable to degree of leverage describes the responsiveness of the dependent variable to
change in the independent variable. change in the independent variable.
Let Y and X represent two variables. When the values taken by Y are determined by the Let Y and X represent two variables. When the values taken by Y are determined by the
values taken by X, Y is said to be dependent on X. accordingly, Y is called the dependent values taken by X, Y is said to be dependent on X. accordingly, Y is called the dependent
variable and X is referred to as the independent variable. The algebraic statement of Ys variable and X is referred to as the independent variable. The algebraic statement of Ys
dependence on X is written as: dependence on X is written as:
Y = f (x) Y = f (x)
And is read as: Y is a function of X And is read as: Y is a function of X
Suppose that the initial values of Y and X are known. The independent variable X now Suppose that the initial values of Y and X are known. The independent variable X now
takes on a new value. The change in the value of X and its percentage change are takes on a new value. The change in the value of X and its percentage change are
computed. The resulting change and percentage change are also computed. Leveraged is computed. The resulting change and percentage change are also computed. Leveraged is
then defined as the percentage change in the dependent variable Y divided by the then defined as the percentage change in the dependent variable Y divided by the
percentage change in the independent variable X. in algebraic terms, the definition of percentage change in the independent variable X. in algebraic terms, the definition of
leverage is developed as follows: leverage is developed as follows:
Let Let x = the change in the independent variable x x = the change in the independent variable x
y = the change in the dependent variable y. y = the change in the dependent variable y.

x
x
= the percentage change in x = % = the percentage change in x = % x x

y
y
= the percentage change in y = % = the percentage change in y = % y y
Then, Then,

x x
y y
x L
y L
/
/
) (
) (
The left hand side of the above equation is read as: the leverage of y with respect to x. The left hand side of the above equation is read as: the leverage of y with respect to x.
7.3.1 Operating Leverage 7.3.1 Operating Leverage
Operating Leverage measures the relationship between output and Riming before interest Operating Leverage measures the relationship between output and Riming before interest
and tax (EBIT), specifically; it measures the effect of changing levels of output on EBIT. and tax (EBIT), specifically; it measures the effect of changing levels of output on EBIT.
The functional relationship between these two variables is: The functional relationship between these two variables is:
y = f (T), y = f (T),
Where, y = earning before interest and tax Where, y = earning before interest and tax
T = number of units of output produced and sold T = number of units of output produced and sold
Earning before interest and tax = Total revenue Total variable cost fixed cost. Earning before interest and tax = Total revenue Total variable cost fixed cost.
When the level of output changes from its initial value, the initial value of EBIT also When the level of output changes from its initial value, the initial value of EBIT also
changes. Thus, operating leverage is defined as the resulting percentage change in EBIT changes. Thus, operating leverage is defined as the resulting percentage change in EBIT
divided by the percentage change in output, symbolically, operating leverage is expressed divided by the percentage change in output, symbolically, operating leverage is expressed
as: as:

output
EBIT
T T
y y
T L
y L
%
%
/
/
) (
) (
Example: Example: Assume that the price per unit of output (p) is Br. 10, and variable cost per unit Assume that the price per unit of output (p) is Br. 10, and variable cost per unit
of output (y) is Br. 4, and fixed cost (F) is Br. 30,000, and the level of output (T) is 8000 of output (y) is Br. 4, and fixed cost (F) is Br. 30,000, and the level of output (T) is 8000
units. By using the formula EBIT is computed as follows: units. By using the formula EBIT is computed as follows:
y = Total revenue Total variable cost fixed cost y = Total revenue Total variable cost fixed cost
y = TP TV F y = TP TV F
or y = T (P V) F or y = T (P V) F
y = 8000 (Br. 10 Br. 4) Br. 30,000 y = 8000 (Br. 10 Br. 4) Br. 30,000
= Br. 18,000 = Br. 18,000
Now assume that the level of output increases from 8000 to 10,000 units. The resulting Now assume that the level of output increases from 8000 to 10,000 units. The resulting
EBIT is computed as: EBIT is computed as:
y = 10,000 (Br. 10 Br. 4) Br. 30,000 y = 10,000 (Br. 10 Br. 4) Br. 30,000
= Br. 30,000 = Br. 30,000
The coefficient of operating leverage is computed as follows: The coefficient of operating leverage is computed as follows:
Percentage change in output = 2000/8000 = 25% Percentage change in output = 2000/8000 = 25%
Percentage change in EBIT = Br. 12000/Br. 18000 = 66.7% Percentage change in EBIT = Br. 12000/Br. 18000 = 66.7%

T T
y y
T L
y L
/
/
) (
) (

25 .
667 .
) (
) (
T L
y L
= = 2.67 2.67
The coefficient of operating leverage of 2.67 is interpreted as follows. A 1 percent change The coefficient of operating leverage of 2.67 is interpreted as follows. A 1 percent change
in output from an initial value of 8000 units produces a 2.67 percent change in EBIT. in output from an initial value of 8000 units produces a 2.67 percent change in EBIT.
Since output increased by 25 percent from its initial value of 8000 units, EBIT increases Since output increased by 25 percent from its initial value of 8000 units, EBIT increases
by (2.67) (.25) = .667 or 66.7 percent. by (2.67) (.25) = .667 or 66.7 percent.
Measurement equations equivalent to the definitional equations are used to compute and Measurement equations equivalent to the definitional equations are used to compute and
to explain the properties of operating leverage. The measurement equation used when the to explain the properties of operating leverage. The measurement equation used when the
income statement relationship is describes as follows: income statement relationship is describes as follows:
(OL/T) = (OL/T) =
F V P T
V P T

) (
) (
The left hand side of the equation is read as: operating leverage, given the value of The left hand side of the equation is read as: operating leverage, given the value of
output. output.
B1 putting the date of the previous example the above equation can be illustrated as B1 putting the date of the previous example the above equation can be illustrated as
follows: follows:
(OL/T = 8000) = (OL/T = 8000) =
67 . 2
000 , 30 ) 4 . 10 . ( 8000
) 4 . 10 . ( 8000
Br Br
Br Br
Properties of Operating Leverage Properties of Operating Leverage
The properties of operating leverage determine its use and a tool of financial analysis. The properties of operating leverage determine its use and a tool of financial analysis.
These properties are best explained by using operating breakeven and EBIT, operating These properties are best explained by using operating breakeven and EBIT, operating
breakeven is defined as the value of output that makes EBIT equal to zero. At this level breakeven is defined as the value of output that makes EBIT equal to zero. At this level
of output, total revenue is just sufficient to pay operating variable and fixed costs, and no of output, total revenue is just sufficient to pay operating variable and fixed costs, and no
earnings are available to cover financial costs, when output exceeds operating breakeven, earnings are available to cover financial costs, when output exceeds operating breakeven,
the total revenue that is generated provides a positive level of EBIT; below operating the total revenue that is generated provides a positive level of EBIT; below operating
breakeven, the firm incurs an operating loss. The operating breakeven is expressed as breakeven, the firm incurs an operating loss. The operating breakeven is expressed as
follows: follows:
T (P V) F = 0 T (P V) F = 0
and solving for T yields and solving for T yields
T = T =
V P
F
Example Assume that P = Br. 25, V = Br. 10, and F = Br. 60,000. Operating breakeven Example Assume that P = Br. 25, V = Br. 10, and F = Br. 60,000. Operating breakeven
is calculated as follows: is calculated as follows:
T = T =
units
Br Br
Br
4000
10 . 25 .
000 , 60 .
If operating leverage is calculated at operating breakeven, the coefficient of operating If operating leverage is calculated at operating breakeven, the coefficient of operating
leverage would be: leverage would be:
(OL/T = 4000) (OL/T = 4000)
undefined
Br
Br Br
Br Br

0
000 , 60 .
000 , 60 ) 10 . 25 . ( 4000
) 10 . 25 . ( 4000
Note that the coefficient of operating leverage at operating breakeven has undefined Note that the coefficient of operating leverage at operating breakeven has undefined
value, not a value of zero. value, not a value of zero.
Interpretations of operating leverage Interpretations of operating leverage
Fundamental interpretation: - The percentage change in EBIT that results from a Fundamental interpretation: - The percentage change in EBIT that results from a
given percentage change in output it equal to the value of operating leverage at given percentage change in output it equal to the value of operating leverage at
the initial value of output multiplied by the percentage change in output. the initial value of output multiplied by the percentage change in output.
Related interpretations: - Related interpretations: -
1- A positive coefficient of operating leverage indicates that the leverage is 1- A positive coefficient of operating leverage indicates that the leverage is
being computed at a level of output greater than operating breakeven. being computed at a level of output greater than operating breakeven.
2- A negative coefficient of operating leverage indicates that leverage is being 2- A negative coefficient of operating leverage indicates that leverage is being
computed at a level of output below operating breakeven computed at a level of output below operating breakeven
3- A large absolute value of operating leverage (the coefficient of operating 3- A large absolute value of operating leverage (the coefficient of operating
leverage without regard to its algebraic sing) indicates that output is close to leverage without regard to its algebraic sing) indicates that output is close to
operating breakeven and that the absolute size of EBIT is relatively small operating breakeven and that the absolute size of EBIT is relatively small
4- A positive coefficient of operating leverage close to 1.0 indicates that 4- A positive coefficient of operating leverage close to 1.0 indicates that
output is relatively far above operating breakeven and that the amount of output is relatively far above operating breakeven and that the amount of
EBIT is relatively large. EBIT is relatively large.
5- If a high percentage of a firms total costs are fixed, the firm is said to have 5- If a high percentage of a firms total costs are fixed, the firm is said to have
a high degree of operating leverage. a high degree of operating leverage.
A high degree of operating leverage, other things hold constant, means that a A high degree of operating leverage, other things hold constant, means that a
relatively small change in sales will result in a large change in operating relatively small change in sales will result in a large change in operating
income. income.
1. A firms production costs are as follows: 1. A firms production costs are as follows:
F = Br. 4,800,000 F = Br. 4,800,000
V = Br. 26 V = Br. 26
What is the operating breakeven with a selling price of Br. 51 per unit? What is the operating breakeven with a selling price of Br. 51 per unit?
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2. Coefficient operating leverage for selected values of output are contained in the first 2. Coefficient operating leverage for selected values of output are contained in the first
two columns of the following table two columns of the following table
T T OL/T OL/T OL/T OL/T
before after before after
authomation authomation authomation authomation
225,000 6.82 13.00 225,000 6.82 13.00
250,000 4.31 5.91 250,000 4.31 5.91
275,000 3.31 4.09 275,000 3.31 4.09
A firm decides to automate a portion of its production process. As a result, fixed costs A firm decides to automate a portion of its production process. As a result, fixed costs
increases to Br. 5,400,000, but the unit variable cost decreases to Br. 25. What is the new increases to Br. 5,400,000, but the unit variable cost decreases to Br. 25. What is the new
operating breakeven? operating breakeven?
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7.3.2 Financial Leverage 7.3.2 Financial Leverage
Financial leverage measures the relationship between EBIT and earning per share (EPS). Financial leverage measures the relationship between EBIT and earning per share (EPS).
Specifically, it reflects the effect of changing levels of EBIT on EPS. The functional Specifically, it reflects the effect of changing levels of EBIT on EPS. The functional
relationship between these two variables is: relationship between these two variables is:
EPS = f (EBIT) EPS = f (EBIT)
and the income statement relationship is: - and the income statement relationship is: -
Profit before taxes: Profit before taxes:
EBIT interests on debt = Y I EBIT interests on debt = Y I
Federal income taxes: Federal income taxes:
(profit before taxes) (tax rate) = (Y I) (t) (profit before taxes) (tax rate) = (Y I) (t)
profit after tax: profit after tax:
profit before taxes federal income taxes profit before taxes federal income taxes
(Y I) (Y I) (t) or (Y I) (Y I) (t) or
(Y I) (1 t) (Y I) (1 t)
Earning available to common shareholders Earning available to common shareholders
profit after taxes preferred stock dividends profit after taxes preferred stock dividends
(Y I) (1 t) E (Y I) (1 t) E
Earning per share of common stock: Earning per share of common stock:
Earning available to common shareholders Earning available to common shareholders
number of common shares issued number of common shares issued
EPS = EPS = (Y I) (1 t) E (Y I) (1 t) E
N N
The algebraic equivalent of the complete income statement is obtained by substituting the The algebraic equivalent of the complete income statement is obtained by substituting the
symbolic form of EBIT as follows: symbolic form of EBIT as follows:
EPS = EPS =
N
E t I F V P T ) 1 ( ] ) ( [
When the level of EBIT changes from its initial value, the initial value of EPS also When the level of EBIT changes from its initial value, the initial value of EPS also
changes. Financial leverage is thus defined as the resulting percentage change in EPS changes. Financial leverage is thus defined as the resulting percentage change in EPS
divided by the percentage change in EBIT. Symbolically, financial leverage is expressed divided by the percentage change in EBIT. Symbolically, financial leverage is expressed
as: as:

EBIT
EPS
EBIT EBIT
EPS EPS
EBIT L
EPS L
%
%
/
/
) (
) (
Note that EBIT is the independent variable when measuring financial leverage, but the Note that EBIT is the independent variable when measuring financial leverage, but the
dependent variable when measuring operating leverage. As a result, EBIT, is sometimes dependent variable when measuring operating leverage. As a result, EBIT, is sometimes
called the linking pin variable with respect to leverage application in finance. called the linking pin variable with respect to leverage application in finance.
Example Example Assume that I = Br. 100,000, t = 0.4, E = Br. 80,000 Assume that I = Br. 100,000, t = 0.4, E = Br. 80,000
N = 60,000, and EBIT = Br. 500,000. the EPS at this level of EBIT is N = 60,000, and EBIT = Br. 500,000. the EPS at this level of EBIT is
computed as: computed as:
EPS = EPS = (Br. 500,000 Br. 100,000) (1 0.4) Br. 80,000 (Br. 500,000 Br. 100,000) (1 0.4) Br. 80,000
60,000 60,000
= Br. 2.67 = Br. 2.67
If EBIT increases from Br. 500,000 to Br. 600,000, the resulting EPS is: If EBIT increases from Br. 500,000 to Br. 600,000, the resulting EPS is:
EPS = EPS = (Br. 60,000 Br. 100,000) (1 0.4) Br. 80,000 (Br. 60,000 Br. 100,000) (1 0.4) Br. 80,000
60,000 60,000
= Br. 3.67 = Br. 3.67
The financial leverage is computed as: The financial leverage is computed as:
Percentage change in EBIT = Br. 100,000/Br. 500,000 = 20% Percentage change in EBIT = Br. 100,000/Br. 500,000 = 20%
Percentage change in EPS = Br. 1/Br. 2.67 = 37.45% Percentage change in EPS = Br. 1/Br. 2.67 = 37.45%

87 . 1
2 . 0
3745 . 0
) (
) (

EBIT L
EPS L
The coefficient of financial leverage of 1.87 is interpreted as follows: A 1 percent change The coefficient of financial leverage of 1.87 is interpreted as follows: A 1 percent change
in EBIT from an initial value of Br. 500,000 produces a 1.87 percent change in EPS. in EBIT from an initial value of Br. 500,000 produces a 1.87 percent change in EPS.
Since EBIT increased by 20 percent from its initial value, EPS increased by 1.87 (0.20) = Since EBIT increased by 20 percent from its initial value, EPS increased by 1.87 (0.20) =
0.374 or 37.4 percent. 0.374 or 37.4 percent.
The measurement equation used to compute the coefficient of financial leverage when the The measurement equation used to compute the coefficient of financial leverage when the
income statement relationship is: income statement relationship is:
(FL/Y) = (FL/Y) =
t
E
I Y
Y

1
The left hand side of the above equation is read as: financial leverage, given the value of The left hand side of the above equation is read as: financial leverage, given the value of
EBIT. EBIT.
By putting the data of the pervious example, equation is illustrated as: By putting the data of the pervious example, equation is illustrated as:
(FL/Y = Br. 500,000) = (FL/Y = Br. 500,000) =
88 . 1
4 . 0 1
000 , 80 .
000 , 100 . 000 , 500 .
000 , 500

Br
Br Br
Financial leverage is sometimes called balance sheet leverage or capital structure Financial leverage is sometimes called balance sheet leverage or capital structure
leverage. leverage.
A corporation produces and sells different product lines. In financing these activities, the A corporation produces and sells different product lines. In financing these activities, the
firm has floated two issues of the following bonds and preferred stock, and has one firm has floated two issues of the following bonds and preferred stock, and has one
million shares of common stock outstanding. million shares of common stock outstanding.
Bond issue A : Br. 10,000,000 at 8% interest rate Bond issue A : Br. 10,000,000 at 8% interest rate
Bond issue B : Br. 20,000,000 at 10% interest rate Bond issue B : Br. 20,000,000 at 10% interest rate
Preferred stock series A : 200,000 shares, Br. 4.50 dividends per share Preferred stock series A : 200,000 shares, Br. 4.50 dividends per share
Preferred stock series B : 300,000 shares, Br. 7 dividend per share Preferred stock series B : 300,000 shares, Br. 7 dividend per share
At the EBIT level of Br. 10,000,000, determine the values of EPS and of financial At the EBIT level of Br. 10,000,000, determine the values of EPS and of financial
leverage. Assume 40% tax rate. leverage. Assume 40% tax rate.
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Properties of financial leverage Properties of financial leverage
The properties of financial leverage can be explained by using the concept of financial The properties of financial leverage can be explained by using the concept of financial
breakeven. Financial breakeven is defined as the value of EBIT that makes EPS equal to breakeven. Financial breakeven is defined as the value of EBIT that makes EPS equal to
zero. At financial breakeven the firms EBIT, the form produces a positive level of zero. At financial breakeven the firms EBIT, the form produces a positive level of
earnings available to common shareholders and a positive EPS. Below this level, profit earnings available to common shareholders and a positive EPS. Below this level, profit
available to common shareholders and EPS are both negative. It is thus possible for a available to common shareholders and EPS are both negative. It is thus possible for a
firm to earn a positive level of EBIT even though its EPS is negative. This will happen firm to earn a positive level of EBIT even though its EPS is negative. This will happen
when the firms EBIT is positive but less than its financial breakeven level. Financial when the firms EBIT is positive but less than its financial breakeven level. Financial
breakeven is expressed as: breakeven is expressed as:
0
) 1 ( ) (

N
E t I Y
Solving this equation for Y, or EBIT, yields: Solving this equation for Y, or EBIT, yields:
Y = I + Y = I +
t
E
1
Example Example Assume I = Br. 2,000,000 and E = Br. 1,300,000. Financial breakeven is Assume I = Br. 2,000,000 and E = Br. 1,300,000. Financial breakeven is
calculated as: Assuming 40% tax rate. calculated as: Assuming 40% tax rate.
Y = Br. 2,000,000 + Br. 1,300,000 / (1 0.4) = Br. 4,166,667 Y = Br. 2,000,000 + Br. 1,300,000 / (1 0.4) = Br. 4,166,667
If financial leverage is calculated at financial breakeven, the resulting coefficient of If financial leverage is calculated at financial breakeven, the resulting coefficient of
financial leverage has an undefined value, computing by using the above equation: financial leverage has an undefined value, computing by using the above equation:

undefined
Br
Br Br Br
Br
Br Y FL

0
667 , 166 , 4 .
) 4 . 0 1 /( 000 , 300 , 1 . 000 , 000 , 2 . 667 , 166 , 4 .
667 , 166 , 4 .
) 667 , 166 , 4 . / (
Interpretations of financial leverage Interpretations of financial leverage
Fundamental interpretation: the coefficient of financial leverage is the percentage Fundamental interpretation: the coefficient of financial leverage is the percentage
change in EPS that results from a 1 percent change in EBIT. change in EPS that results from a 1 percent change in EBIT.
Related interpretations: Related interpretations:
1. 1. A positive coefficient of financial leverage means that leverage is being computed A positive coefficient of financial leverage means that leverage is being computed
for a value of EBIT that is greater than financial breakeven. for a value of EBIT that is greater than financial breakeven.
2. 2. A negative coefficient of financial leverage indicates that leverage is being A negative coefficient of financial leverage indicates that leverage is being
computed for a value of EBIT below financial breakeven computed for a value of EBIT below financial breakeven
3. 3. A large absolute value of financial leverage indicates that leverage is being A large absolute value of financial leverage indicates that leverage is being
computed close to financial breakeven and that the absolute value of EPS is computed close to financial breakeven and that the absolute value of EPS is
relatively small. relatively small.
4. 4. A positive coefficient of financial leverage close to 1.0 indicates that leverage is A positive coefficient of financial leverage close to 1.0 indicates that leverage is
being computed for a value of EBIT that is relatively far above financial being computed for a value of EBIT that is relatively far above financial
breakeven and that the corresponding value to EPS is relatively large. breakeven and that the corresponding value to EPS is relatively large.
5. 5. Financial leverage refers to the use of fixed-income securities-debt and preferred Financial leverage refers to the use of fixed-income securities-debt and preferred
stock. stock.
7.4 CAPITAL STRUCTURE THEORY 7.4 CAPITAL STRUCTURE THEORY
Capital structure theory has been developed along two main lines Capital structure theory has been developed along two main lines
- - tax benefit bankruptcy cost trade-off theory tax benefit bankruptcy cost trade-off theory
- - signaling theory signaling theory
Trade-off theory Trade-off theory
Modern capital structure theory begins in 1958, when professors Franco Modigliani and Modern capital structure theory begins in 1958, when professors Franco Modigliani and
Merton Milles (hereafter MM) published what has been called the most influential article Merton Milles (hereafter MM) published what has been called the most influential article
ever written. MM proved, under a very restrictive set of assumptions, that because of the ever written. MM proved, under a very restrictive set of assumptions, that because of the
tax deductibility of interest on debt, a firms value rises continuously as it uses more debt, tax deductibility of interest on debt, a firms value rises continuously as it uses more debt,
and hence its value will be maximized by financing almost entirely with debt. MMs and hence its value will be maximized by financing almost entirely with debt. MMs
assumptions included the following: assumptions included the following:
1. 1. There is no brokerage costs There is no brokerage costs
2. 2. There is no personal taxes There is no personal taxes
3. 3. Investors can borrow as the same rate as corporations Investors can borrow as the same rate as corporations
4. 4. Investors have the same information as management about the firms future Investors have the same information as management about the firms future
investment opportunities investment opportunities
5. 5. All the firms debt is riskless, regardless of how much debt of uses All the firms debt is riskless, regardless of how much debt of uses
6. 6. EBIT is not affected by the use of debt. EBIT is not affected by the use of debt.
Since several of these assumptions were obviously unrealistic, MMs positions was only Since several of these assumptions were obviously unrealistic, MMs positions was only
the beginning of capital structure research. the beginning of capital structure research.
Subsequent researchers, and MM themselves, extended the basic theory by relaxing the Subsequent researchers, and MM themselves, extended the basic theory by relaxing the
assumptions. Other researchers attempted to test the theoretical model with empirical data assumptions. Other researchers attempted to test the theoretical model with empirical data
to see exactly how stock prices and capital costs are affected by capital structure. Both to see exactly how stock prices and capital costs are affected by capital structure. Both
the theoretical and empirical results have added to our understanding of capital structure, the theoretical and empirical results have added to our understanding of capital structure,
but none of these studies has produced results that can be used to identify precisely a but none of these studies has produced results that can be used to identify precisely a
firms optimal capital structure. A summary of the theoretical and empirical research are firms optimal capital structure. A summary of the theoretical and empirical research are
the following. the following.
1. 1. The fact that interest is deductible expense makes debt less expensive than The fact that interest is deductible expense makes debt less expensive than
common or preferred stock. That is debt provides tax shelter benefits. As a result, common or preferred stock. That is debt provides tax shelter benefits. As a result,
using debt causes more of the firms operating income (EBIT) to flow through to using debt causes more of the firms operating income (EBIT) to flow through to
investors, so the more debt a company uses, the higher its value and the higher the investors, so the more debt a company uses, the higher its value and the higher the
price of its stock. price of its stock.
2. 2. The MM assumptions do not hold in the real world. First interest rate rises as the The MM assumptions do not hold in the real world. First interest rate rises as the
debt ratio rises. Second, EBIT declines at extreme level of leverage. Third, debt ratio rises. Second, EBIT declines at extreme level of leverage. Third,
expected tax rate fall at high debt levels, and this reduces the expected value of expected tax rate fall at high debt levels, and this reduces the expected value of
the debt tax shelter. And, fourth, the probability of the bankruptcy, which brings the debt tax shelter. And, fourth, the probability of the bankruptcy, which brings
with it lawyers fee and other costs, increases as the debt ratio rises. with it lawyers fee and other costs, increases as the debt ratio rises.
3. 3. Both theory and empirical evidence support the preceding discussion. However, Both theory and empirical evidence support the preceding discussion. However,
statistical problems prevent researchers from identifying points of threshold debt statistical problems prevent researchers from identifying points of threshold debt
level where bankrupt costs become material and optimal capital structure where level where bankrupt costs become material and optimal capital structure where
marginal tax shelter benefits and marginal bankruptcy related costs are equal. marginal tax shelter benefits and marginal bankruptcy related costs are equal.
4. 4. Another disturbing aspect of capital structure theory is the fact that many large, Another disturbing aspect of capital structure theory is the fact that many large,
successful firms use far less debt then the theory suggests. This point led to the successful firms use far less debt then the theory suggests. This point led to the
development of signaling theory. development of signaling theory.
Signaling theory Signaling theory
MM assumed that investors have the same information about a firms prospects as its MM assumed that investors have the same information about a firms prospects as its
managers this is called symmetric information. However, managers often have better managers this is called symmetric information. However, managers often have better
information than outside investors. This is called asymmetric information, and it has an information than outside investors. This is called asymmetric information, and it has an
important effect on the optimal capital structure. To see why, consider two situations, one important effect on the optimal capital structure. To see why, consider two situations, one
in which the companys managers know that its prospects are extremely favorable (Firms in which the companys managers know that its prospects are extremely favorable (Firms
F), and one in which the mangers know that the future looks unfavorable (Firm U). F), and one in which the mangers know that the future looks unfavorable (Firm U).
Suppose, for example, that Firm Fs have just discovered a nonpatentable cure for the Suppose, for example, that Firm Fs have just discovered a nonpatentable cure for the
common cold. They want to keep the new product a secret as long as possible to delay common cold. They want to keep the new product a secret as long as possible to delay
competitors entry into the market. New plant must be built to make the new product, so competitors entry into the market. New plant must be built to make the new product, so
capital must be raised. How should Firm Fs management raise the needed capital? If the capital must be raised. How should Firm Fs management raise the needed capital? If the
firm sells stock, then, when profits from the new product start flowing in, the price of firm sells stock, then, when profits from the new product start flowing in, the price of
stock will rise sharply, and the purchasers of the new stock will have made a bonanza. stock will rise sharply, and the purchasers of the new stock will have made a bonanza.
The current stockholders (including the managers) will also do well, but not as well as The current stockholders (including the managers) will also do well, but not as well as
they would have done of the company had not sold sock before the price increased, they would have done of the company had not sold sock before the price increased,
because then they would not have had to share the benefits of the new product with the because then they would not have had to share the benefits of the new product with the
new stockholders. Therefore, one would expect a firm with very favorable prospects to new stockholders. Therefore, one would expect a firm with very favorable prospects to
try to avoid selling stock and rather, to raise any required new capital by other means, try to avoid selling stock and rather, to raise any required new capital by other means,
including using debt beyond the normal targest capital structure. including using debt beyond the normal targest capital structure.
Now, lets consider Firm U. suppose its managers have information that new orders are Now, lets consider Firm U. suppose its managers have information that new orders are
off sharply because a competitor has installed new technology which has improved its off sharply because a competitor has installed new technology which has improved its
products quality. Firm U must upgrade its own facilities, at a high cost, just to maintain products quality. Firm U must upgrade its own facilities, at a high cost, just to maintain
in recent sales level. As a result, in return on investment will fall (but not as much as if it in recent sales level. As a result, in return on investment will fall (but not as much as if it
took no action, which would lead to a 100 percent loss through bankruptcy). How should took no action, which would lead to a 100 percent loss through bankruptcy). How should
Firm U raise the needed capital? Here the situation is just the reverse of that facing Firm Firm U raise the needed capital? Here the situation is just the reverse of that facing Firm
F, which did not want to sell stock so as to avoid having to share the benefits of future F, which did not want to sell stock so as to avoid having to share the benefits of future
development. A firm with unfavorable prospects would want to sell stock, which would development. A firm with unfavorable prospects would want to sell stock, which would
mean bringing in new investors to share the losses. mean bringing in new investors to share the losses.
The conclusion from all this is that firms with extremely bright prospect prefer not to The conclusion from all this is that firms with extremely bright prospect prefer not to
finance through new stock offerings, whereas firms with poor prospects do like to finance finance through new stock offerings, whereas firms with poor prospects do like to finance
with outside equity. How should you, as an investor, react to this conclusion? with outside equity. How should you, as an investor, react to this conclusion?
7.5 FACTORS IN CAPITAL STRUCTURE DECISIONS 7.5 FACTORS IN CAPITAL STRUCTURE DECISIONS
Firms generally should consider the following factors which influence capital structure Firms generally should consider the following factors which influence capital structure
decisions. decisions.
1. Sales stability: - 1. Sales stability: - A firm whose sales are relatively stable can safely take on more debt A firm whose sales are relatively stable can safely take on more debt
and incur higher fixed charges than a company with unstable sales. and incur higher fixed charges than a company with unstable sales.
2. Asset structure: - 2. Asset structure: - Firms whose assets are suitable as security for loans tend to use Firms whose assets are suitable as security for loans tend to use
rather heavily. General purpose assets which can be used by many businesses make good rather heavily. General purpose assets which can be used by many businesses make good
collateral, whereas special-purpose assets do not. Thus, real state companies are usually collateral, whereas special-purpose assets do not. Thus, real state companies are usually
highly leveraged, whereas companies involved in technological research employ less highly leveraged, whereas companies involved in technological research employ less
debt. debt.
3. Operating leverage: - 3. Operating leverage: - Other things the same, a firm with less operating leverage is Other things the same, a firm with less operating leverage is
better able to employ financial leverage because, as we saw, the interaction of operating better able to employ financial leverage because, as we saw, the interaction of operating
and financial leverage determines the overall effect of a decline in sales on operating and financial leverage determines the overall effect of a decline in sales on operating
income and net cash flow. income and net cash flow.
4. Growth rate: - 4. Growth rate: - Other things the same, faster-growing firms must rely more heavily on Other things the same, faster-growing firms must rely more heavily on
external capital. external capital.
5. Profitability: - 5. Profitability: - One often observes, that firms with very high rates of return on One often observes, that firms with very high rates of return on
investment use relatively little debt. Although there is no theoretical justification for this investment use relatively little debt. Although there is no theoretical justification for this
fact, one practical explanation is that very profitable firms simply do not need to do much fact, one practical explanation is that very profitable firms simply do not need to do much
debt financing. Their higher rates of return enable them to do most of their financing with debt financing. Their higher rates of return enable them to do most of their financing with
retained earnings. retained earnings.
6. Taxes: - 6. Taxes: - Interest is a deductible expense, and deductions are most valuable to firms Interest is a deductible expense, and deductions are most valuable to firms
with high tax rates. Hence, the higher a firms corporate tax, the greater the advantage of with high tax rates. Hence, the higher a firms corporate tax, the greater the advantage of
debt. debt.
7. Control: - 7. Control: - The effect of debt versus stock on managements control position can The effect of debt versus stock on managements control position can
influence capital structure. If management currently has voting control (over 50 percent influence capital structure. If management currently has voting control (over 50 percent
of the stock), but is not in a position to buy any more stock, it may choose debt for new of the stock), but is not in a position to buy any more stock, it may choose debt for new
financing. One the other hand, management may decide to use equity if the firms financing. One the other hand, management may decide to use equity if the firms
financial situation is so weak that he use of debt might subject it to serious risk of default financial situation is so weak that he use of debt might subject it to serious risk of default
because, if the firms gores into default, the mangers will almost surely lose their jobs. because, if the firms gores into default, the mangers will almost surely lose their jobs.
8. Management attitudes: - 8. Management attitudes: - Since no one can provide that one capital structure will lead Since no one can provide that one capital structure will lead
to higher stock prices than another, management can exercise its own judgment about the to higher stock prices than another, management can exercise its own judgment about the
proper capital structure. Some management tend to be more conservative than others, and proper capital structure. Some management tend to be more conservative than others, and
thus use less debt than the average firm in their industry, whereas aggressive management thus use less debt than the average firm in their industry, whereas aggressive management
use more debt in the quest for higher profits. use more debt in the quest for higher profits.
9. Lender and rating agency attitude: - 9. Lender and rating agency attitude: - Regardless of mangers own analyses of this Regardless of mangers own analyses of this
proper leverage factors for their firms, lenders and rating agencies attitudes frequently proper leverage factors for their firms, lenders and rating agencies attitudes frequently
influence financial structure decisions. In the majority of the cases, the corporations influence financial structure decisions. In the majority of the cases, the corporations
discusses its capital structure with lenders and rating agencies and gives much weight to discusses its capital structure with lenders and rating agencies and gives much weight to
their advice. their advice.
10. Market conditions: - 10. Market conditions: - Conditions in the stock and bond market undergo both long-and Conditions in the stock and bond market undergo both long-and
short-run changes that can have an important bearing on a firms optimal capital short-run changes that can have an important bearing on a firms optimal capital
structure. structure.
11. The firms internal conditions: - 11. The firms internal conditions: - A firms own internal condition can also have a A firms own internal condition can also have a
bearing on its target capital structure. bearing on its target capital structure.
12. Financial flexibility: - 12. Financial flexibility: - maintaining financial flexibility, which from an operational maintaining financial flexibility, which from an operational
view point, means maintaining adequate reserve borrowing capacity. Determining an view point, means maintaining adequate reserve borrowing capacity. Determining an
adequate reserve borrowing capacity is judgmental, but it clearly depends on the adequate reserve borrowing capacity is judgmental, but it clearly depends on the
factors mentioned previously in the unit, including the firm forecasted need for funds, factors mentioned previously in the unit, including the firm forecasted need for funds,
predicted capital market conditions, managements confidence in its forecasts, and the predicted capital market conditions, managements confidence in its forecasts, and the
consequences on a capital shortage. consequences on a capital shortage.
The key concepts covered are summarized below The key concepts covered are summarized below
A firms optimal capital structure is that mix of debt and equity which maximizes A firms optimal capital structure is that mix of debt and equity which maximizes
the price of the firms stock. As any point in time, the firms management has a the price of the firms stock. As any point in time, the firms management has a
specific target capital structure in mind, presumably the optimal one, although this specific target capital structure in mind, presumably the optimal one, although this
target may change over time. target may change over time.
Several factors influence the firms capital structure. These include the firms (1) Several factors influence the firms capital structure. These include the firms (1)
business risk (2) tax position (3) need for financial flexibility, and (4) managerial business risk (2) tax position (3) need for financial flexibility, and (4) managerial
conservatism and aggressiveness. conservatism and aggressiveness.
The degree of operating leverage shows how changes in sales affect operating The degree of operating leverage shows how changes in sales affect operating
income, whereas the degree of financial leverage shows how changes in operating income, whereas the degree of financial leverage shows how changes in operating
income affect earnings per share. income affect earnings per share.
Financial leverage is the extent to which fixed-income securities (debt and Financial leverage is the extent to which fixed-income securities (debt and
preferred stock) are used in a firms capital structure. preferred stock) are used in a firms capital structure.
Modeigliani and Miller developed a trade-off theory of capital structure. They Modeigliani and Miller developed a trade-off theory of capital structure. They
showed that debt is useful because interest is that deductible, but also that debt showed that debt is useful because interest is that deductible, but also that debt
brings with its costs associated with actual or potential bankruptcy. Under MMs brings with its costs associated with actual or potential bankruptcy. Under MMs
theory, the optimal capital structure strikes a balance between the tax benefit of theory, the optimal capital structure strikes a balance between the tax benefit of
debt and the costs associated with bankruptcy debt and the costs associated with bankruptcy
An alternative (or, really, complementary) theory of capital structure relates to the An alternative (or, really, complementary) theory of capital structure relates to the
signals given to investors by a firms decision to use debt or stock to raise new signals given to investors by a firms decision to use debt or stock to raise new
capital. The use of stock is a negative signal, while, using debt is a positive, or at capital. The use of stock is a negative signal, while, using debt is a positive, or at
least a neutral, signal. As a result, companies try to maintain a reserve borrowing least a neutral, signal. As a result, companies try to maintain a reserve borrowing
capacity, and this means using less debt in normal times the MM trade-off capacity, and this means using less debt in normal times the MM trade-off
theory would suggest. theory would suggest.
7.7 ANSWERS TO CHECK YOUR PROGRESS 7.7 ANSWERS TO CHECK YOUR PROGRESS
1. Capital structure policy involves a trade-off between risk and return since using more 1. Capital structure policy involves a trade-off between risk and return since using more
debt raises the riskness of the firms earning stream. However, a higher debt ratio debt raises the riskness of the firms earning stream. However, a higher debt ratio
generally leads to a higher expected rate of return generally leads to a higher expected rate of return
2. 1 with a selling price of Br. 51 per unit, the operating breakeven is: 2. 1 with a selling price of Br. 51 per unit, the operating breakeven is:
T = Br. 4,800,000/ (Br. 51 Br. 26) T = Br. 4,800,000/ (Br. 51 Br. 26)
= 192,000 units = 192,000 units
2. The new operating breakeven is 2. The new operating breakeven is
T = Br. 5,400,000/ (Br. 51 Br. 25) T = Br. 5,400,000/ (Br. 51 Br. 25)
= 207,692 units = 207,692 units
3. At the EBIT level of Br. 10,000,000, the values of EPS and Financial leverage are: 3. At the EBIT level of Br. 10,000,000, the values of EPS and Financial leverage are:
I = 0.08 (Br. 10,000,000) + 0.10 (Br. 20,000) = Br. 2,800,000 I = 0.08 (Br. 10,000,000) + 0.10 (Br. 20,000) = Br. 2,800,000
E = Br. 4.5 (200,000) + Br. 7 (300,000) = Br. 3,000,000 E = Br. 4.5 (200,000) + Br. 7 (300,000) = Br. 3,000,000
EPS = EPS = (Br. 10,000,000 Br. 2,800,000) (1 0.4) Br. 3,000,000 (Br. 10,000,000 Br. 2,800,000) (1 0.4) Br. 3,000,000 = Br. 1.32 = Br. 1.32
1,000,000 1,000,000
(FL/Y = Br. 10,000,000) = (FL/Y = Br. 10,000,000) = Br. 10,000,000____________ Br. 10,000,000____________
Br. 10,000,000 Br. 2,800,000 Br. 3,000,000 / (1 04) Br. 10,000,000 Br. 2,800,000 Br. 3,000,000 / (1 04)
= 4.55 = 4.55
Exercises Exercises
1. GIZACEW Co. manufactures ladies; watch which are sold through discount houses. 1. GIZACEW Co. manufactures ladies; watch which are sold through discount houses.
Each watch is sold for Br. 25; and fixed costs are Br. 140,000 for 30,000 watches or Each watch is sold for Br. 25; and fixed costs are Br. 140,000 for 30,000 watches or
less; variable costs are Br. 15 per watch less; variable costs are Br. 15 per watch
a. a. What is the firms gain or loss at sales of 8000 watches? What is the firms gain or loss at sales of 8000 watches?
b. b. What is the companys degree of operating leverage at sales of 8000 units? Of What is the companys degree of operating leverage at sales of 8000 units? Of
1800 units? 1800 units?
c. c. What is the companys degree of operating leverage at sales of 8000 units? Of What is the companys degree of operating leverage at sales of 8000 units? Of
18000 units? 18000 units?
d. d. What happens to the breakeven point if the selling price rises to Br. 31? What is What happens to the breakeven point if the selling price rises to Br. 31? What is
the significance of the change to the financial manager? the significance of the change to the financial manager?
e. e. What happens to the breakeven point of the selling rises to Br. 31 but variable What happens to the breakeven point of the selling rises to Br. 31 but variable
costs rise to Br. 23 unit? costs rise to Br. 23 unit?
2. TSEHAY Co., producer of turbine generators; is in this situation: EBIT = Br. 4 2. TSEHAY Co., producer of turbine generators; is in this situation: EBIT = Br. 4
million; tax = T = 35%; debt outstanding = D = Br. 2 million; k million; tax = T = 35%; debt outstanding = D = Br. 2 million; k
d d = 10%; k = 10%; k
s s = 15%; = 15%;
shares of stock outstanding = N shares of stock outstanding = N
o o = 600,000; and book value per share = Br. 10. Since = 600,000; and book value per share = Br. 10. Since
the companys product market is stable and the company expects no growth, all the companys product market is stable and the company expects no growth, all
earnings are paid out as dividends. The debt consists of perpetual bonds. earnings are paid out as dividends. The debt consists of perpetual bonds.
a. a. What are the earnings per share (EPS) and its price per share (Po)? What are the earnings per share (EPS) and its price per share (Po)?
b. b. What is the weighted average cost of capital (WACC)? What is the weighted average cost of capital (WACC)?
c. c. The company can increase debt by Br. 8 million, to a total of Br. 10 million using The company can increase debt by Br. 8 million, to a total of Br. 10 million using
the new debt to buy back and retire some of its shares at the current price. Its the new debt to buy back and retire some of its shares at the current price. Its
interest rate on debt will be 12 percent (it will have to call and refund the old interest rate on debt will be 12 percent (it will have to call and refund the old
debt), and its cost of equity will rise from 15 percent to 17 percent. EBIT will debt), and its cost of equity will rise from 15 percent to 17 percent. EBIT will
remain constant, should the company change its capital structure. remain constant, should the company change its capital structure.
d. d. If the company did not have to refund the Br. 2 million of old debt, how would If the company did not have to refund the Br. 2 million of old debt, how would
this affect thing? Assume that the new and the still outstanding debt are equally this affect thing? Assume that the new and the still outstanding debt are equally
risky, with k risky, with k
d d = 12%, but that the coupon rates on the old debt is 10 percent. = 12%, but that the coupon rates on the old debt is 10 percent.
3. ALEMU Co. produces Building materials which sell for p = Br. 100. Olindes fixed 3. ALEMU Co. produces Building materials which sell for p = Br. 100. Olindes fixed
costs are Br. 200,000; 5000 components are produced and sold each year; EBIT is costs are Br. 200,000; 5000 components are produced and sold each year; EBIT is
currently Br. 50,000; and the assets (all equity financed) are Br. 500,000. The company currently Br. 50,000; and the assets (all equity financed) are Br. 500,000. The company
estimates that it can change its production process, adding Br. 400,000 to investment and estimates that it can change its production process, adding Br. 400,000 to investment and
Br. 50,000 to fixed operating costs. This change will Br. 50,000 to fixed operating costs. This change will
(1) Reduce variable cost per unit by Br. 10 and (2) increase output by 2000 units, but (3) (1) Reduce variable cost per unit by Br. 10 and (2) increase output by 2000 units, but (3)
the sales price on all units will have to be lowered to Br. 95 to permit sales of the the sales price on all units will have to be lowered to Br. 95 to permit sales of the
additional output. The company uses no debt and its average cost of capital is 10 percent additional output. The company uses no debt and its average cost of capital is 10 percent
a) a) Should the company make the change Should the company make the change
b) b) Would the company degree of operating leverage increase or decrease if it Would the company degree of operating leverage increase or decrease if it
made the change? What about its breakeven point? made the change? What about its breakeven point?
c) c) Suppose the company were unable to raise additional, equity financing Suppose the company were unable to raise additional, equity financing
and had to borrow the Br. 400,000 to make the investment at an interest and had to borrow the Br. 400,000 to make the investment at an interest
rate of 10 percent, use the DU pont equation to find the expected ROA of rate of 10 percent, use the DU pont equation to find the expected ROA of
the investment. Should the company make the change if debt financing the investment. Should the company make the change if debt financing
must be used must be used
Target capital structure Target capital structure. The mix of debt, preferred stock and common equity . The mix of debt, preferred stock and common equity
with which the firm plans to raise capital. with which the firm plans to raise capital.
Business risk Business risk. The risk associated with projections of a firms future returns on . The risk associated with projections of a firms future returns on
assets. assets.
Operating leverage Operating leverage. The extent to which the fixed costs are used in a firms . The extent to which the fixed costs are used in a firms
operations. operations.
Breakeven point Breakeven point. The volume of sales at which total costs equal total revenue, . The volume of sales at which total costs equal total revenue,
causing operating profit (EBIT) to equal zero. causing operating profit (EBIT) to equal zero.
Financial leverage Financial leverage. The extent to which fixed income securities (debt and . The extent to which fixed income securities (debt and
preferred stock) are used in a firms capital structure. preferred stock) are used in a firms capital structure.
Financial risk Financial risk. An increase in stockholders risk, over and above basic business . An increase in stockholders risk, over and above basic business
risk, resulting from the use of financial leverage. risk, resulting from the use of financial leverage.
Degree of operating leverage. Degree of operating leverage. The percentage change in EBIT resulting from a The percentage change in EBIT resulting from a
given percentage change in sales. given percentage change in sales.
Degree of financial leverage Degree of financial leverage. The percentage change in EPS associated with a . The percentage change in EPS associated with a
given percentage change in EBIT. given percentage change in EBIT.
Symmetric information Symmetric information. The situation in which investors and managers have . The situation in which investors and managers have
identical information about the firms prospects. identical information about the firms prospects.
Asymmetric information Asymmetric information. The situation in which managers have different (better) . The situation in which managers have different (better)
information about their firms prospects than do investors. information about their firms prospects than do investors.

UNIT 8: THE COST OF CAPITAL UNIT 8: THE COST OF CAPITAL
Contents Contents
8.0 Aims and Objectives 8.0 Aims and Objectives
8.2 Meaning of the Cost of Capital 8.2 Meaning of the Cost of Capital
8.3 Measuring the Specific Cost of Capital 8.3 Measuring the Specific Cost of Capital
8.3.1 The Cost of Debt 8.3.1 The Cost of Debt
8.3.2 The Cost of Preferred Stock 8.3.2 The Cost of Preferred Stock
8.3.3 The Cost of Common Stock 8.3.3 The Cost of Common Stock
8.3.4 The Cost of Retained Earnings 8.3.4 The Cost of Retained Earnings
8.4 Weighted Average Cost of Capital 8.4 Weighted Average Cost of Capital
8.5 Marginal Cost of Capital 8.5 Marginal Cost of Capital
After completing this unit, students should be able to understand: After completing this unit, students should be able to understand:
the meaning of cost of capita the meaning of cost of capita
the implications of the cost of capital on the value of a firm, the implications of the cost of capital on the value of a firm,
four major sources of capital to a firm and their cost, four major sources of capital to a firm and their cost,
that the weighted average cost of capital is used in investment decisions, that the weighted average cost of capital is used in investment decisions,
that the marginal cost of capital increases with raising of more and more capital that the marginal cost of capital increases with raising of more and more capital
during a given period, during a given period,
the point where the costs of debt, preferred stock, common stock, or retained the point where the costs of debt, preferred stock, common stock, or retained
earnings increases. earnings increases.
As you well understand, two parties are involved in a financial asset under normal As you well understand, two parties are involved in a financial asset under normal
circumstances. One is the party issuing the financial asset. Another is the one that buys or circumstances. One is the party issuing the financial asset. Another is the one that buys or
invests on the financial asset. In unit 6, when we were discussing about valuation, we invests on the financial asset. In unit 6, when we were discussing about valuation, we
emphasized on the investor. That is, how much is the maximum price the investor would emphasized on the investor. That is, how much is the maximum price the investor would
pay for the financial asset? To decide on this, the investor would discount the expected pay for the financial asset? To decide on this, the investor would discount the expected
future cash flows. The discounting is done based on the investors required rate of return. future cash flows. The discounting is done based on the investors required rate of return.
The rate of return required by the investor should definitely be provide by some other The rate of return required by the investor should definitely be provide by some other
party. The party which should provide the investor its required rate of return is the issuing party. The party which should provide the investor its required rate of return is the issuing
party. For example, if the required rate of return by an investor on a given bond is 10%, party. For example, if the required rate of return by an investor on a given bond is 10%,
the issuing company should provide this 10% to the investor. This required rate of return the issuing company should provide this 10% to the investor. This required rate of return
that should be met by the issuing company becomes its cost. This is a cost on the capital that should be met by the issuing company becomes its cost. This is a cost on the capital
the issuing company wants to raise. the issuing company wants to raise.
Therefore, the required rate of return on investments in financial assets by the investor is Therefore, the required rate of return on investments in financial assets by the investor is
the cost of capital for the company issued the financial assets. But, generally, the cost of the cost of capital for the company issued the financial assets. But, generally, the cost of
capital for the issuing company is higher than the required rate of return by the investor. capital for the issuing company is higher than the required rate of return by the investor.
This is because when the issuing company issues a financial asset, it must incur some This is because when the issuing company issues a financial asset, it must incur some
costs. These costs incurred by the issuer in relation to issuance of financial assets are costs. These costs incurred by the issuer in relation to issuance of financial assets are
called flotation costs. Examples include advertising costs, commissions paid to those called flotation costs. Examples include advertising costs, commissions paid to those
selling the financial assets, cost of printing documents, costs of registration with selling the financial assets, cost of printing documents, costs of registration with
government agencies, discounts to encourage the sale of securities, and so on. government agencies, discounts to encourage the sale of securities, and so on.
8.2 MEANING OF THE COST OF CAPITAL 8.2 MEANING OF THE COST OF CAPITAL
The cost of capital is the minimum rate of return that a firm must earn in order to satisfy The cost of capital is the minimum rate of return that a firm must earn in order to satisfy
the overall rate of return required by its investors. It is also the minimum rate of return a the overall rate of return required by its investors. It is also the minimum rate of return a
firm must earn on its invested capital to maintain the value of the firm unchanged. The firm must earn on its invested capital to maintain the value of the firm unchanged. The
second definition considers the cost of capital as a break even rate. second definition considers the cost of capital as a break even rate.
If a firms actual rate of return exceeds its cost of capital, the value of the firm would If a firms actual rate of return exceeds its cost of capital, the value of the firm would
increase. If on the other hand, the cost of capital is not earned, the firms market value increase. If on the other hand, the cost of capital is not earned, the firms market value
will decrease. So the cost of capital is the rate of return that is just sufficient to leave the will decrease. So the cost of capital is the rate of return that is just sufficient to leave the
price of the firms common stock unchanged. price of the firms common stock unchanged.
The cost of capital serves as a discount rate when a firm evaluates an investment The cost of capital serves as a discount rate when a firm evaluates an investment
proposal. Suppose a firm is considering investment on a plant. The finance required for proposal. Suppose a firm is considering investment on a plant. The finance required for
this investment is to be raised by selling a common stock issue. Now, after raising capital, this investment is to be raised by selling a common stock issue. Now, after raising capital,
the firm is expected to provide required rate of return to those who invest on the common the firm is expected to provide required rate of return to those who invest on the common
stock. This in effect is the firms cost of capital. So to decide to invest on the plant, the stock. This in effect is the firms cost of capital. So to decide to invest on the plant, the
minimum rate of return from the investment at least should be equal to the required rate minimum rate of return from the investment at least should be equal to the required rate
of return by the common stockholders. If the required rate of return by the firms of return by the common stockholders. If the required rate of return by the firms
common stockholders is 13%, then the firm should earn a minimum of 13% on its common stockholders is 13%, then the firm should earn a minimum of 13% on its
investment on the plant. The 13% minimum rate of return that should be earned by the investment on the plant. The 13% minimum rate of return that should be earned by the
firm is, therefore, its cost of capital. firm is, therefore, its cost of capital.
8.3 MEASURING THE SPECIFIC COST OF CAPITAL 8.3 MEASURING THE SPECIFIC COST OF CAPITAL
The cost of capital for any particular capital source or security issue is called the specific The cost of capital for any particular capital source or security issue is called the specific
cost of capital. It is also called individual cost of capital or component cost of capital. cost of capital. It is also called individual cost of capital or component cost of capital.
Each type of capital contained the capital structure of a firm include: Each type of capital contained the capital structure of a firm include:
1. 1. Debt Debt
2. 2. Preferred stock Preferred stock
3. 3. Common stock Common stock
4. 4. Retained earnings Retained earnings
Two important points you should bear in mind about the specific cost of capital. One is Two important points you should bear in mind about the specific cost of capital. One is
that it is computed on an after-tax basis. Meaning, if there would be any tax implication that it is computed on an after-tax basis. Meaning, if there would be any tax implication
on the individual source of capital, it should be considered. In almost all circumstances, on the individual source of capital, it should be considered. In almost all circumstances,
the tax implication is only on debt sources of finance. The second point is that the the tax implication is only on debt sources of finance. The second point is that the
specific cost of capital is expressed as an annual percentage or rate like 6%, 9%, or 10%. specific cost of capital is expressed as an annual percentage or rate like 6%, 9%, or 10%.
The cost of capital is not stated in terms of birrs. The cost of capital is not stated in terms of birrs.
8.3.1 The cost of debt 8.3.1 The cost of debt
This is the minimum rate of return required by suppliers of debt. The relevant specific This is the minimum rate of return required by suppliers of debt. The relevant specific
cost of debt is the after-tax cost of new debt. Generally, debt is the cheapest source of cost of debt is the after-tax cost of new debt. Generally, debt is the cheapest source of
finance to a firm and, hence, the cost of debt is the lowest specific cost of capital. There finance to a firm and, hence, the cost of debt is the lowest specific cost of capital. There
are two basic explanations for this. First, debt suppliers, generally, assume the lowest risk are two basic explanations for this. First, debt suppliers, generally, assume the lowest risk
among all suppliers of capital. They receive interest payments before preferred and among all suppliers of capital. They receive interest payments before preferred and
common dividends are paid. Since they assume the smallest risk, their return is the common dividends are paid. Since they assume the smallest risk, their return is the
lowest. Their lowest return would be the lowest cost of capital to the firm. Second, lowest. Their lowest return would be the lowest cost of capital to the firm. Second,
raising capital through debt sources entails interest expense. The inters expense in turn raising capital through debt sources entails interest expense. The inters expense in turn
reduces the firms income which ultimately would cause tax payment to be reduced. So reduces the firms income which ultimately would cause tax payment to be reduced. So
raising money in the form of debt results in the smallest tax burden, and finally, the raising money in the form of debt results in the smallest tax burden, and finally, the
firms cost of debt would be the lowest. firms cost of debt would be the lowest.
Debt sources of finance may take several forms like bonds, promissory notes, bank loans. Debt sources of finance may take several forms like bonds, promissory notes, bank loans.
Here, for our convenience we consider bond issue to illustrate the cost of debt. Here, for our convenience we consider bond issue to illustrate the cost of debt.
Computing the cost of new bond issue involves three steps: Computing the cost of new bond issue involves three steps:
i) Determine the net proceeds from the sale of each bond i) Determine the net proceeds from the sale of each bond
NPd = Pd f NPd = Pd f
Where: Where:
NPd = The net proceeds from the sale of each bond NPd = The net proceeds from the sale of each bond
Pd = The market price of the bond Pd = The market price of the bond
f = Flotation costs f = Flotation costs
ii) Compute the effective before tax cost of the bond using the following approximation ii) Compute the effective before tax cost of the bond using the following approximation
formula: formula:
Kd = Kd =
2
NPd Pn
n
NPd Pn
I
+
+
Where: Where:
Kd = The effective before tax cost of debt Kd = The effective before tax cost of debt
I = Annual interest payment I = Annual interest payment
Pn = The par value of the bond Pn = The par value of the bond
n = Length of the holding period of the bond in years. n = Length of the holding period of the bond in years.
iii) Compute the after-tax cost of debt iii) Compute the after-tax cost of debt
Kdt = Kd (1 t) Kdt = Kd (1 t)
Where: Where:
Kdt = The after-tax cost of debt Kdt = The after-tax cost of debt
t = The marginal tax rate t = The marginal tax rate
Example: Example: Currently, Abyssinia Industrial Group is planning to sell 15-year, Br. 1,000 Currently, Abyssinia Industrial Group is planning to sell 15-year, Br. 1,000
par-value bonds that carry a 12% annual coupon interest rate. As a result of lower current par-value bonds that carry a 12% annual coupon interest rate. As a result of lower current
interest rates, Abyssinia bonds can be sold for Br. 1,010 each. Flotation costs of Br. 30 interest rates, Abyssinia bonds can be sold for Br. 1,010 each. Flotation costs of Br. 30
per bond will be incurred in the process of issuing the bonds. The firms marginal tax rate per bond will be incurred in the process of issuing the bonds. The firms marginal tax rate
is 40%. is 40%.
Required: Required: Calculate the after tax cost of Abyssinias new bond issue: Calculate the after tax cost of Abyssinias new bond issue:
Solution: Solution:
Given: Given: Pn = Br. 1,000; I = Br. 120 (Br. 1,000 x 12%); n = 15; Pd = Br. 1,010; f = Br. 30; Pn = Br. 1,000; I = Br. 120 (Br. 1,000 x 12%); n = 15; Pd = Br. 1,010; f = Br. 30;
t = 40%; Kdt = ? t = 40%; Kdt = ?
Then apply the three steps: Then apply the three steps:
i) NPd = Br. 1,010 Br. 30 = Br. 980 i) NPd = Br. 1,010 Br. 30 = Br. 980
ii) Kd = ii) Kd = % 26 . 12
2
980 . 000 , 1 .
15
980 . 000 , 1 .
120 .
+
Br Br
Br Br
Br
iii) Kdt = 12.26% (1 40%) = iii) Kdt = 12.26% (1 40%) = 7.36% 7.36%
Therefore, the after tax cost of Abyssinias new bond issue is 7.36%. That is, Abyssinia Therefore, the after tax cost of Abyssinias new bond issue is 7.36%. That is, Abyssinia
should be able to earn a minimum of 7.36% to satisfy bondholders. Otherwise, the firms should be able to earn a minimum of 7.36% to satisfy bondholders. Otherwise, the firms
value will decline. value will decline.
Ayenew Companys financing plans for next year include the sale of long-term bonds Ayenew Companys financing plans for next year include the sale of long-term bonds
with a 10% coupon. The company believes it can sell the bonds at a price that will with a 10% coupon. The company believes it can sell the bonds at a price that will
provide a yield to maturity of 12% to investors. If its marginal tax rate is 35%, what is provide a yield to maturity of 12% to investors. If its marginal tax rate is 35%, what is
Ayenews after-tax cost of debt? Ayenews after-tax cost of debt?
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8.3.2 The cost of preferred stock 8.3.2 The cost of preferred stock
The cost of preferred stock is the minimum rate of return a firm must earn in order to The cost of preferred stock is the minimum rate of return a firm must earn in order to
satisfy the required rate of return of the firms preferred stock investors. It is also the satisfy the required rate of return of the firms preferred stock investors. It is also the
minimum rate of return a firms preferred stock investors require if they are to purchase minimum rate of return a firms preferred stock investors require if they are to purchase
the firms preferred stock. the firms preferred stock.
When a firm raises capital by issuing new preferred stock, it is expected to pay fixed When a firm raises capital by issuing new preferred stock, it is expected to pay fixed
amount of dividends to the preferred stockholders. So it is the dividend payment that is amount of dividends to the preferred stockholders. So it is the dividend payment that is
the cost of the preferred stock to the firm stated as an annual rate. the cost of the preferred stock to the firm stated as an annual rate.
The cost of a new preferred stock issue can be computed by following two steps: The cost of a new preferred stock issue can be computed by following two steps:
i) Determine the net proceeds from the sale of each preferred stock. i) Determine the net proceeds from the sale of each preferred stock.
NPpf = Ppf f NPpf = Ppf f
Where: Where:
NPpf = Net proceeds from the sale of each preferred stock NPpf = Net proceeds from the sale of each preferred stock
Ppf = Market price of the preferred stock Ppf = Market price of the preferred stock
f = Flotation costs f = Flotation costs
ii) Compute the cost of preferred stock issue ii) Compute the cost of preferred stock issue
Kps = Kps = Dps__ Dps__
NPpf NPpf
Where: Where:
Kps = The cost of preferred stock Kps = The cost of preferred stock
DPs = The pre share annual dividend on the preferred stock DPs = The pre share annual dividend on the preferred stock
Example: Example: Sefa Computer Systems Company has just issued preferred stock. The stock Sefa Computer Systems Company has just issued preferred stock. The stock
has 12% annual dividend and Br. 100 par value and was sold at 102% of the par value. In has 12% annual dividend and Br. 100 par value and was sold at 102% of the par value. In
addition, flotation costs of Br. 2.50 per share must be paid. Calculate the cost of the addition, flotation costs of Br. 2.50 per share must be paid. Calculate the cost of the
preferred stock. preferred stock.
Solution: Solution:
Given: Pps = Br. 102 (Br. 100 x 102%); Dps = Br. 12 (Br 100 x 12%); f = Br. 2.50; Given: Pps = Br. 102 (Br. 100 x 102%); Dps = Br. 12 (Br 100 x 12%); f = Br. 2.50;
Kps =? Kps =?
Then apply the two steps: Then apply the two steps:
i) NPpf = Br. 102 Br. 2.50 = Br. 99.50 i) NPpf = Br. 102 Br. 2.50 = Br. 99.50
ii) Kps = ii) Kps = Br. 12 Br. 12 = =12.06% 12.06%
Br. 99.50 Br. 99.50
Therefore, Sefa Company should be able to earn a minimum of 12.06% on any Therefore, Sefa Company should be able to earn a minimum of 12.06% on any
investment financed by the new preferred stock issue. Otherwise, the firms value will investment financed by the new preferred stock issue. Otherwise, the firms value will
decrease. decrease.
Sattelite Share Company plans to sale preferred stock with par value of Br. 50 per share. Sattelite Share Company plans to sale preferred stock with par value of Br. 50 per share.
The issue is expected to pay quarterly dividends of Br. 1.25 per share and to have The issue is expected to pay quarterly dividends of Br. 1.25 per share and to have
flotation costs of 6% of the par value. The preferred stock sells at 95% of its par. flotation costs of 6% of the par value. The preferred stock sells at 95% of its par.
Required: Required: Calculate the cost of preferred stock to Satellite Share Company. Calculate the cost of preferred stock to Satellite Share Company.
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8.3.3 The cost of common stock 8.3.3 The cost of common stock
The cost of common stock is the minimum rate of return that a firm must earn for its The cost of common stock is the minimum rate of return that a firm must earn for its
common stockholders in order to maintain the value of the firm. A firm does not make common stockholders in order to maintain the value of the firm. A firm does not make
explicit commitment to pay dividends to common stockholders. However, when common explicit commitment to pay dividends to common stockholders. However, when common
stockholders invest their money in a corporation, they expect returns in the form of stockholders invest their money in a corporation, they expect returns in the form of
dividends. Therefore, common stocks implicitly involve a return in terms of the dividends dividends. Therefore, common stocks implicitly involve a return in terms of the dividends
expected by investors and hence, they carry cost. expected by investors and hence, they carry cost.
Generally, common stock dividends are paid after interest and preferred dividends are Generally, common stock dividends are paid after interest and preferred dividends are
paid. As a result, common stock investors assume the maximum risk in corporate paid. As a result, common stock investors assume the maximum risk in corporate
investment. They compensate the maximum risk by requiring the highest return. This investment. They compensate the maximum risk by requiring the highest return. This
highest return expected by common stockholders make common stock the most highest return expected by common stockholders make common stock the most
expensive source of capital. expensive source of capital.
The cost of common stock can be computed using the constant growth valuation model. The cost of common stock can be computed using the constant growth valuation model.
Ks = Ks = D D
1 1 + g + g
NPo NPo
Where: Where:
Ks = The cost of new common stock issue Ks = The cost of new common stock issue
D D
1 1 = The expected dividend payment at the end of next year = The expected dividend payment at the end of next year
NPo = Net proceeds from the sale of each common stock NPo = Net proceeds from the sale of each common stock
g = The expected annual dividends growth rate g = The expected annual dividends growth rate
The net proceeds from the sale of each common stock (NPo) is computed as follows: The net proceeds from the sale of each common stock (NPo) is computed as follows:
NPo = Po f NPo = Po f
Where: Where:
Po = The current market price of the common stock Po = The current market price of the common stock
f = flotation costs f = flotation costs
Example: Example: An issue of common stock is sold to investors for Br. 20 per share. The issuing An issue of common stock is sold to investors for Br. 20 per share. The issuing
corporation incurs a selling expense of Br. 1 per share. The current dividend is Br. 1.50 corporation incurs a selling expense of Br. 1 per share. The current dividend is Br. 1.50
per share and it is expected to grow at 6% annual rate. Compute the specific cost of this per share and it is expected to grow at 6% annual rate. Compute the specific cost of this
common stock issue. common stock issue.
Solution Solution
Given: Given: Po = Br. 20; Do = Br. 1.50; g = 6%; f = Br. 1; Ks = ? Po = Br. 20; Do = Br. 1.50; g = 6%; f = Br. 1; Ks = ?
Then apply the two steps: Then apply the two steps:
i) NPo = Br. 20 Br. 1 = Br. 19 i) NPo = Br. 20 Br. 1 = Br. 19
ii) Ks = ii) Ks = D D
1 1
+ g = + g = Br. 1.50 (1.06) Br. 1.50 (1.06) = = 14.37% 14.37%
Npo Br. 19 Npo Br. 19
Therefore, the firm should be able to earn a minimum return of 14.37% on investments Therefore, the firm should be able to earn a minimum return of 14.37% on investments
that are financed by the new common stock issue. that are financed by the new common stock issue.
Repentance Corporations share of common stock is currently selling at Br. 75. The Repentance Corporations share of common stock is currently selling at Br. 75. The
firms projected dividend per share during the next year is Br. 3.38 and the expected firms projected dividend per share during the next year is Br. 3.38 and the expected
dividend growth rate is 8%. Because of competitive nature of the market a Br. 3 per share dividend growth rate is 8%. Because of competitive nature of the market a Br. 3 per share
under pricing is necessary. In addition, the sale of new common stock involves under pricing is necessary. In addition, the sale of new common stock involves
underwriting fee of Br. 0.60 per share and other flotation costs of Br. 0.90 per share. underwriting fee of Br. 0.60 per share and other flotation costs of Br. 0.90 per share.
Required: Required: Calculate the cost of common stock for Repentance Corporation. Calculate the cost of common stock for Repentance Corporation.
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8.3.4 The cost of Retained Earnings 8.3.4 The cost of Retained Earnings
Retained earnings represent profits available for common stockholders that the Retained earnings represent profits available for common stockholders that the
corporation chooses to reinvest in itself rather than payout as dividends. Retained corporation chooses to reinvest in itself rather than payout as dividends. Retained
earnings are not securities like stocks and bonds and hence do not have market price that earnings are not securities like stocks and bonds and hence do not have market price that
can be used to compute costs of capital. can be used to compute costs of capital.
The cost of retained earnings is the rate of return a corporations common stockholders The cost of retained earnings is the rate of return a corporations common stockholders
expect the corporation to earn on their reinvested earnings, at least equal to the rate expect the corporation to earn on their reinvested earnings, at least equal to the rate
earned on the outstanding common stock. Therefore, the specific cost of capital of earned on the outstanding common stock. Therefore, the specific cost of capital of
retained earnings is equated with the specific cost of common stock. However, flotation retained earnings is equated with the specific cost of common stock. However, flotation
costs are not involved in the case of retained earnings. costs are not involved in the case of retained earnings.
Computing the cost of retained earnings involves just a single procedure of applying the Computing the cost of retained earnings involves just a single procedure of applying the
following formula: following formula:
Kr = Kr = D D
1 1
+ g + g
Po Po
Where: Where:
Kr = The cost of retained earnings Kr = The cost of retained earnings
D D
1 1 = The expected dividends payment at the end of next year = The expected dividends payment at the end of next year
Po = The current market price of the firms common stock Po = The current market price of the firms common stock
g = The expected annual dividend growth rate. g = The expected annual dividend growth rate.
Example: Example: Zeila Auto Spare Parts Manufacturing company expects to pay a common Zeila Auto Spare Parts Manufacturing company expects to pay a common
stock dividend of Br. 2.50 per share during the next 12 months. The firms current stock dividend of Br. 2.50 per share during the next 12 months. The firms current
common stock price is Br. 50 per share and the expected dividend growth rate is 7%. A common stock price is Br. 50 per share and the expected dividend growth rate is 7%. A
flotation cost of Br. 3 is involved to sale a share of common stock. flotation cost of Br. 3 is involved to sale a share of common stock.
Required: Required: Compute the cost of retained earnings Compute the cost of retained earnings
Solution Solution
Given: Given: Po = Br. 50; D Po = Br. 50; D
1 1 = Br. 2.50; g = 7%; Kr = ? = Br. 2.50; g = 7%; Kr = ?
Then apply the formula: Then apply the formula:
Kr = Kr = D D
1 1
+ g = + g = Br. 2.50 Br. 2.50 + 7% = 12% + 7% = 12%
Po Br. 50 Po Br. 50
Zequala Textiles Share Company wishes to measure its cost of retained earnings. The Zequala Textiles Share Company wishes to measure its cost of retained earnings. The
firms stock is currently selling for Br. 57.50. The firm expects to pay Br. 3.40 dividend firms stock is currently selling for Br. 57.50. The firm expects to pay Br. 3.40 dividend
at the end of the year. The expected dividend growth rate is 8%. at the end of the year. The expected dividend growth rate is 8%.
Required: Required: Determine th cost of retained earnings. Determine th cost of retained earnings.
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8.4 WEIGHTED AVERAGE COST OF CAPITAL (WACC) 8.4 WEIGHTED AVERAGE COST OF CAPITAL (WACC)
In the previous section we have seen how to compute the cost of capital for each In the previous section we have seen how to compute the cost of capital for each
individual source of capital. The specific cost of capital is used in evaluating an individual source of capital. The specific cost of capital is used in evaluating an
investment proposal to be financed by a particular capital source. Practically, however, investment proposal to be financed by a particular capital source. Practically, however,
investment are financed by two or more sources of capital. In such a situation, we cannot investment are financed by two or more sources of capital. In such a situation, we cannot
make use of the individual cost of capital. Rather we should use the average cost of make use of the individual cost of capital. Rather we should use the average cost of
capital employed by the firm. capital employed by the firm.
The firms capital structure is composed of debt, preferred stock, common stock, and The firms capital structure is composed of debt, preferred stock, common stock, and
retained earnings. Each capital source accounts to some portion of the total finance. But retained earnings. Each capital source accounts to some portion of the total finance. But
the percentage contribution of one source is usually different from another. So we must the percentage contribution of one source is usually different from another. So we must
compute the weighted average cost of capital rather than the simple average. compute the weighted average cost of capital rather than the simple average.
The weighted average cost of capital (WACC) is the weighted average of the individual The weighted average cost of capital (WACC) is the weighted average of the individual
costs of debt, preferred stock and common equity (common stock and retained earnings). costs of debt, preferred stock and common equity (common stock and retained earnings).
It is also called the composite cost of capital. It is also called the composite cost of capital.
If the weights of the component capital sources are all given, the weighted average cost If the weights of the component capital sources are all given, the weighted average cost
of capital can be computed as: of capital can be computed as:
WACC = WdKdt + WpsKps + WceKs WACC = WdKdt + WpsKps + WceKs
Where: Where:
WACC = The weighted average cost of capital WACC = The weighted average cost of capital
Wd = The weight of debt Wd = The weight of debt
Wps = The weight of preferred stock Wps = The weight of preferred stock
Wce = The weight of common equity Wce = The weight of common equity
Kdt = The after tax cost of debt Kdt = The after tax cost of debt
Kps = The cost of preferred stock Kps = The cost of preferred stock
Ks = The cost of common equity Ks = The cost of common equity
The WACC is found by weighting the cost of each specific type of capital by its The WACC is found by weighting the cost of each specific type of capital by its
proportion in the firms capital structure. Weights of the individual capital sources can be proportion in the firms capital structure. Weights of the individual capital sources can be
calculated based on their book value or market value. calculated based on their book value or market value.
To illustrate the computation of the WACC, look at the following example. To illustrate the computation of the WACC, look at the following example.
Muna Tools Manufacturing Companys financial manager wants to compute the firms Muna Tools Manufacturing Companys financial manager wants to compute the firms
weighted average cost of capital. The book and market values of the amounts as well as weighted average cost of capital. The book and market values of the amounts as well as
specific after-tax costs are shown in the following table for each source of capital. specific after-tax costs are shown in the following table for each source of capital.
Source of capital Source of capital Book value Book value Market value Market value Specific cost Specific cost
Debt Debt
Preferred stock Preferred stock
Common equity Common equity
Total Total
Br. 1,050,000 Br. 1,050,000
84,000 84,000
966,000 966,000
Br. 2,100,000 Br. 2,100,000
Br. 1,000,000 Br. 1,000,000
125,000 125,000
1,375,000 1,375,000
Br. 2,500,000 Br. 2,500,000
5.3% 5.3%
12.0 12.0
16.0 16.0
Required: Required: Calculate the firms weighted average cost of capital using: Calculate the firms weighted average cost of capital using:
1) 1) book value weights book value weights
2) 2) market value weights market value weights
Solution: Solution:
1) Total book value = Br. 2,100,000 1) Total book value = Br. 2,100,000
Wd = Wd = Br. 1,050,000 Br. 1,050,000 = 0.5; Wps = = 0.5; Wps = Br. 84,000__ Br. 84,000__ = 0.04; Wce = = 0.04; Wce = Br. 966,000 Br. 966,000 = 0.46 = 0.46
Br. 2,100,000 Br. 2,100,000 Br. 2,100,000 Br. 2,100,000 Br. 2,100,000 Br. 2,100,000
WACC = WdKdt + WpsKps + WceKs WACC = WdKdt + WpsKps + WceKs
= 0.5 (5.3%) + 0.04 (12.0%) + 0.46 (16.0%) = 0.5 (5.3%) + 0.04 (12.0%) + 0.46 (16.0%)
= 2.65% + 0.48% + 7.36% = 2.65% + 0.48% + 7.36%
= = 10.49% 10.49%
The minimum rate of return on all projects should be 10.49%. Meaning, Muna should The minimum rate of return on all projects should be 10.49%. Meaning, Muna should
accept all projects so long as they earn a return greater than or equal to 10.49% accept all projects so long as they earn a return greater than or equal to 10.49%
2) Total Market value = Br. 2,500,000 2) Total Market value = Br. 2,500,000
Wd = Wd = Br. 1,000,000 Br. 1,000,000 = 0.4; Wps = = 0.4; Wps = Br. 125,000 Br. 125,000 = 0.05; Wce = = 0.05; Wce = Br. 1,375,000 Br. 1,375,000 = 0.55 = 0.55
Br. 2,500,000 Br. 2,500,000 Br. 2,500,000 Br. 2,500,000 Br. 2,500,000 Br. 2,500,000
WACC = 0.4 (5.3%) + 0.05 (12.0%) + 0.55 (16.0%) WACC = 0.4 (5.3%) + 0.05 (12.0%) + 0.55 (16.0%)
= 2.12% + 0.60% + 8.80% = 2.12% + 0.60% + 8.80%
= = 11.52% 11.52%
If the market value weights are used, Muna should accept all projects with a minimum If the market value weights are used, Muna should accept all projects with a minimum
rate of return of 11.52% rate of return of 11.52%
On January 1, 2002, the total assets of Zway share company were Br. 54 million. There On January 1, 2002, the total assets of Zway share company were Br. 54 million. There
was no short-term debt. The firms optimal capital structure is given below. was no short-term debt. The firms optimal capital structure is given below.
Long-term debt Br. 27,000,000 Long-term debt Br. 27,000,000
Common equity Common equity 27,000,000 27,000,000
Total liabilities and equity Total liabilities and equity Br. 54,000,000 Br. 54,000,000
New bonds will have a 10% coupon rate and will be sold at Par. Common stock currently New bonds will have a 10% coupon rate and will be sold at Par. Common stock currently
has a market price of Br. 60 and can be sold with a flotation cost of Br. 6 per share. has a market price of Br. 60 and can be sold with a flotation cost of Br. 6 per share.
Dividend yield is estimated to be 4% and the expected dividend growth rate is 8% Dividend yield is estimated to be 4% and the expected dividend growth rate is 8%
Required: Required: Calculate: Calculate:
1) 1) the cost of debt assuming s 40% marginal corporate tax rate the cost of debt assuming s 40% marginal corporate tax rate
2) 2) the cost of common equity (50% common stock and 50% retained earnings) the cost of common equity (50% common stock and 50% retained earnings)
3) 3) the weighted average cost of capital the weighted average cost of capital
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8.5 MARGINAL COST OF CAPITAL (MCC) 8.5 MARGINAL COST OF CAPITAL (MCC)
As a firm tries to have more new capital, the cost of each birr will rise at some point. As a firm tries to have more new capital, the cost of each birr will rise at some point.
Thus, the marginal cost of capital (MCC) is the cost of obtaining additional new capital. Thus, the marginal cost of capital (MCC) is the cost of obtaining additional new capital.
Technically speaking, the MCC is the weighted average cost of the last birr of new Technically speaking, the MCC is the weighted average cost of the last birr of new
capital obtained. So the concept of marginal cost of capital is discussed in the context of capital obtained. So the concept of marginal cost of capital is discussed in the context of
the weighted average cost of capital. the weighted average cost of capital.
As a firm raises larger and larger amounts of capital, the weighted average cost of capital As a firm raises larger and larger amounts of capital, the weighted average cost of capital
also rises. But the question would be at what point the firms costs of debt, preferred stck, also rises. But the question would be at what point the firms costs of debt, preferred stck,
and common equity as well as WACC increase? and common equity as well as WACC increase?
The first point, therefore, in computing the MCC is to determine the breaking points The first point, therefore, in computing the MCC is to determine the breaking points
where the cost of capital will increase. where the cost of capital will increase.
The technical aspects of the MCC can be better understood using an example. The technical aspects of the MCC can be better understood using an example.
Example: Example: The target capital structure of Shala Corporation and other pertinent data are The target capital structure of Shala Corporation and other pertinent data are
given below. given below.
Long-term debt ------------------ 40%; cost of preferred stock (Kps) = 12.06% Long-term debt ------------------ 40%; cost of preferred stock (Kps) = 12.06%
Preferred stock -------------------10% cost of retained earnings (Kr) = 14% Preferred stock -------------------10% cost of retained earnings (Kr) = 14%
Common equity ----------------- 50% cost of common stock (Ks) = 15% Common equity ----------------- 50% cost of common stock (Ks) = 15%
Shala Corporation has Br. 900,000 available retained earnings. But when the firm fully Shala Corporation has Br. 900,000 available retained earnings. But when the firm fully
utilizes its retained earnings, it must use the more expensive new common stock utilizes its retained earnings, it must use the more expensive new common stock
financing to meet its equity needs. In addition, the firm expects that it can borrow up to financing to meet its equity needs. In addition, the firm expects that it can borrow up to
Br. 1,200,000 of debt at 7.3% after-tax cost. Additional debt will have an after-tax cost of Br. 1,200,000 of debt at 7.3% after-tax cost. Additional debt will have an after-tax cost of
9.1%. 9.1%.
Required Required
1) 1) What is the breaking point associated with the What is the breaking point associated with the
a. a. exhausting of retained earnings? exhausting of retained earnings?
b. b. Increment of debt between Br. 0 to Br. 1,200,000? Increment of debt between Br. 0 to Br. 1,200,000?
2) 2) Determine the ranges of total new financing where the WACC will rise Determine the ranges of total new financing where the WACC will rise
3) 3) Calculate the WACC for each range of finance. Calculate the WACC for each range of finance.
Solutions Solutions
1) a. Breaking point (BP) common equity = 1) a. Breaking point (BP) common equity = Br. 900,000 Br. 900,000 = Br. 1,800,000 = Br. 1,800,000
50% 50%
b. Breaking point (BP) long-term debt = b. Breaking point (BP) long-term debt = Br. 1,200,000 Br. 1,200,000 = Br. 3,000,000 = Br. 3,000,000
40% 40%
The breaking points computed above can be interpreted as: The breaking points computed above can be interpreted as:
Shala can meet its equity needs using retained earnings until its total finance need is Br. Shala can meet its equity needs using retained earnings until its total finance need is Br.
1,800,000. But when total capital required is more than Br. 1,800,000, its equity needs 1,800,000. But when total capital required is more than Br. 1,800,000, its equity needs
should be met with common stock. Similarly, until the firms total finance need reaches should be met with common stock. Similarly, until the firms total finance need reaches
Br. 3,000,000, shala can raise any debt at 7.3% cost. Any further finance need beyond Br. Br. 3,000,000, shala can raise any debt at 7.3% cost. Any further finance need beyond Br.
3,000,000 will cause the cost of debt to rise to 9.1%. 3,000,000 will cause the cost of debt to rise to 9.1%.
2) There are three ranges of finance that could be identified on the basis of the breaking 2) There are three ranges of finance that could be identified on the basis of the breaking
points: points:
1 1
st st
Range : Br. 0 to Br. 1,800,000, Range : Br. 0 to Br. 1,800,000,
2 2
nd nd
Range : Br. 1,800,000 to Br. 3,000,000, and Range : Br. 1,800,000 to Br. 3,000,000, and
3 3
rd rd
Range : Br. 3,000,000 and above Range : Br. 3,000,000 and above
3) WACC (1 3) WACC (1
st st
range) = 0.40 (7.3%) + 0.10 (12.06%) + 0.50 (14%) range) = 0.40 (7.3%) + 0.10 (12.06%) + 0.50 (14%)
= 2.92% + 1.21% + 7.00% = 2.92% + 1.21% + 7.00%
= = 11.13% 11.13%
WACC (2 WACC (2
nd nd
range) = 0.40 (7.3%) + 0.10 (12.06%) + 0.50 (15%) range) = 0.40 (7.3%) + 0.10 (12.06%) + 0.50 (15%)
= 2.92% + 1.21% + 7.50% = 2.92% + 1.21% + 7.50%
= = 11.63% 11.63%
WACC (3 WACC (3
rd rd
range) = 0.40 (9.1%) + 0.10 (12.06%) + 0.50 (15%) range) = 0.40 (9.1%) + 0.10 (12.06%) + 0.50 (15%)
= 3.64% + 1.21% + 7.50% = 3.64% + 1.21% + 7.50%
= = 12.35% 12.35%
Check your progress VI Check your progress VI
In the example above why have we used 14% for cost of common equity in the 1 In the example above why have we used 14% for cost of common equity in the 1
st st
range range
and 15% in the 2 and 15% in the 2
nd nd
and 3 and 3
rd rd
ranges respectively? ranges respectively?
_______________________________________________________________________ _______________________________________________________________________
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_______________________________________________________________________ _______________________________________________________________________
___ ___
This unit showed the concept of the cost of capital. The key points covered are: This unit showed the concept of the cost of capital. The key points covered are:
- - the cost of capital is the minimum rate of return a firm should earn on its invested the cost of capital is the minimum rate of return a firm should earn on its invested
capital. capital.
- - the individual cost of capital is computed on an after-tax basis and is stated as an the individual cost of capital is computed on an after-tax basis and is stated as an
annual percentage. annual percentage.
- - generally, the cost of dept is the cheapest and the cost of common stock is the generally, the cost of dept is the cheapest and the cost of common stock is the
most expensive among all other component costs of capital. most expensive among all other component costs of capital.
- - the cost of capital to be used in evaluating investment proposals is the WACC. the cost of capital to be used in evaluating investment proposals is the WACC.
- - the WACC of a firm increases as the firm raises more and more new capital. the WACC of a firm increases as the firm raises more and more new capital.
- - a break point will occur each time one of the specific costs of capital increases. a break point will occur each time one of the specific costs of capital increases.
I. Given: I. Given: yield to maturity (YTM) = 12%; t = 35%; Kdt = ? yield to maturity (YTM) = 12%; t = 35%; Kdt = ?
Since no flotation cost is indicated here, the YTM of 12% to investors represents the Since no flotation cost is indicated here, the YTM of 12% to investors represents the
effective before tax cost of debt for Ayenew company, i.e. Kd = 12%, effective before tax cost of debt for Ayenew company, i.e. Kd = 12%,
Therefore, Kdt = 12% (1 35%) = 7.80% Therefore, Kdt = 12% (1 35%) = 7.80%
II. Given: II. Given: Pps = Br. 50 x 95% = Br. 47.50; Dps = Br. 5 (4 x Br. 1.25); f = Br. 3 (Br. 50 x Pps = Br. 50 x 95% = Br. 47.50; Dps = Br. 5 (4 x Br. 1.25); f = Br. 3 (Br. 50 x
6%); Kps 6%); Kps
Kps = ? Kps = ?
Then, apply the two steps: Then, apply the two steps:
- - NPps = Br. 47.50 Br. 3 = Br. 44.50 NPps = Br. 47.50 Br. 3 = Br. 44.50
- - Kps = Kps = Br. 5 Br. 5 = 11.24% = 11.24%
Br. 44.50 Br. 44.50
III. Given: III. Given: Po = Br. 75; D1 = Br. 3.38; g = 8%; f = Br. 4.50 (Br. 3 + Br. 0.60 + Br. 0.90); Po = Br. 75; D1 = Br. 3.38; g = 8%; f = Br. 4.50 (Br. 3 + Br. 0.60 + Br. 0.90);
Ks = ? Ks = ?
Then, apply the two steps: Then, apply the two steps:
- - Npo = Br. 75 Br. 4.50 = Br. 70.50 Npo = Br. 75 Br. 4.50 = Br. 70.50
- - Ks = Ks = D D
1 1
+ G = + G = Br. 3.38 Br. 3.38 + 8% = 13% + 8% = 13%
Npo Br. 70.50 Npo Br. 70.50
IV. Given: IV. Given: Po = Br. 57.50; D Po = Br. 57.50; D
1 1 = Br. 3.40; g = 8%; Kr = ? = Br. 3.40; g = 8%; Kr = ?
Then, apply the formula: Then, apply the formula:
Kr = Kr = D D
1 1
+ g = + g = Br. 3.40 Br. 3.40 + 8% = 14% + 8% = 14%
Po Br. 57.50 Po Br. 57.50
V. 1. V. 1. Since no flotation cost is involved here and the bonds are sold at par value, the Since no flotation cost is involved here and the bonds are sold at par value, the
effective before tax cost of debt (Kd) = coupon rate = 10%. effective before tax cost of debt (Kd) = coupon rate = 10%.
Kdt = 10% ( 1 40%) = 6% Kdt = 10% ( 1 40%) = 6%
2. Given: 2. Given: Po = Br. 60; f = Br. 6; dividend yield (D Po = Br. 60; f = Br. 6; dividend yield (D
1 1/po) = 4%; g = 8% /po) = 4%; g = 8%
Cost of retained earnings (Kr) = Cost of retained earnings (Kr) = D D
1 1

+ g = 4% + 8% = 12% + g = 4% + 8% = 12%
Po Po
Cost of common stock (Ks) = Cost of common stock (Ks) = D D
1 1 + g = + g = Br. 2.40* + Br. 2.40* + 8% = 12.44% 8% = 12.44%
Npo Br. 60 Br. 6 Npo Br. 60 Br. 6
* * D D
1 1= 4% = 4% D D
1 1 = 4% = 4% D D
1 1 = Br. 2.40 = Br. 2.40
Po Br. 60 Po Br. 60
VI. VI. Because until the firms total new financing amounts to Br. 1,800,000, it can meet its Because until the firms total new financing amounts to Br. 1,800,000, it can meet its
equity needs using retained earnings whose cost is 14%. But in the 2 equity needs using retained earnings whose cost is 14%. But in the 2
nd nd
and 3 and 3
rd rd
ranges the ranges the
total financing is more than Br. 1,800,000 and the firm should use new common stock total financing is more than Br. 1,800,000 and the firm should use new common stock
issue in place of retained earnings; and the cost of common stock is 15%. issue in place of retained earnings; and the cost of common stock is 15%.
1. Which of the following statement is always true about a cost of capital? 1. Which of the following statement is always true about a cost of capital?
A) A) If the cost of capital is earned by a firm on investment of its available funds, the If the cost of capital is earned by a firm on investment of its available funds, the
value of the firm will increase value of the firm will increase
B) B) Generally, the cost of retained earnings is cheaper than the cost of debt. Generally, the cost of retained earnings is cheaper than the cost of debt.
C) C) Wherever the cost of capital exceeds the rate of return on the firms invested Wherever the cost of capital exceeds the rate of return on the firms invested
capital, the value of the firm is reduced. capital, the value of the firm is reduced.
D) D) The weighted average cost of capital (WACC) of a firm remains constant as long The weighted average cost of capital (WACC) of a firm remains constant as long
as the firms target capital structure remains unchanged. as the firms target capital structure remains unchanged.
2. Normally, debt is the cheapest source of finance. This is because 2. Normally, debt is the cheapest source of finance. This is because
A) A) debt suppliers expect implicit returns from a firm debt suppliers expect implicit returns from a firm
B) B) other sources of capital have opportunity costs rather than explicit costs other sources of capital have opportunity costs rather than explicit costs
C) C) firms are forced by government to use debt source of finance firms are forced by government to use debt source of finance
D) D) None of the above None of the above
3. Identify the most expensive source of finance to a firm under normal circumstances 3. Identify the most expensive source of finance to a firm under normal circumstances
A) A) Common stock Common stock
B) B) Preferred stock Preferred stock
C) C) Retained earnings Retained earnings
D) D) Debt Debt
Part II. Exercises Part II. Exercises
1. Zegha Technologies Companys common stock currently sells for Br. 46 per share. 1. Zegha Technologies Companys common stock currently sells for Br. 46 per share.
The companys most recent dividends was Br. 4, and it expects a dividend of Br. 4.28 The companys most recent dividends was Br. 4, and it expects a dividend of Br. 4.28
to be paid at the end of the current year. The firm also expects to incur a flotation cost to be paid at the end of the current year. The firm also expects to incur a flotation cost
of Br. 5 to sell each share of common stock issue. of Br. 5 to sell each share of common stock issue.
Required: Required: calculate the cost of new common stock issue and retained earnings. calculate the cost of new common stock issue and retained earnings.
2. Sidco Merchandising Companys stock is currently selling for Br. 300 a share. The 2. Sidco Merchandising Companys stock is currently selling for Br. 300 a share. The
firm is expected to earn Br. 27 per share this year and to pay a year-end dividend of Br. firm is expected to earn Br. 27 per share this year and to pay a year-end dividend of Br.
18. The firms investors require a 9% return on their common stock investment. 18. The firms investors require a 9% return on their common stock investment.
Required: Required: What rate of growth must be expected for sidman? What rate of growth must be expected for sidman?
3. Nile Share Company has a debt ratio of 40% and a dividend payout ratio of 50%. The 3. Nile Share Company has a debt ratio of 40% and a dividend payout ratio of 50%. The
firm expects net income of Br. 5 million next year. Nile can borrow Br. 6 million at an firm expects net income of Br. 5 million next year. Nile can borrow Br. 6 million at an
interest rate of 11%, another Br. 6 million at a rate of 12%, and any additional debt at a interest rate of 11%, another Br. 6 million at a rate of 12%, and any additional debt at a
rate of 13%. The firms marginal tax rate is 35%. rate of 13%. The firms marginal tax rate is 35%.
Required: Required: Determine Determine
1) 1) The breaking point associated with the exhausting of retained earnings. The breaking point associated with the exhausting of retained earnings.
2) 2) The points where the cost of debt will increase. The points where the cost of debt will increase.
1. Engene F. Brigham (1997). 1. Engene F. Brigham (1997). Fundamentals of Financial Management Fundamentals of Financial Management. 7 . 7
th th
Dryen press Harcourt Brace College Publishers, Florida. Dryen press Harcourt Brace College Publishers, Florida.
2. Lawrence J. Gitman (1997). 2. Lawrence J. Gitman (1997). Principles of Managerial Finance Principles of Managerial Finance. 8 . 8
th th
edition, Addison- edition, Addison-
Wesley Longman Inc. Wesley Longman Inc.
th th
Flotation costs Flotation costs any costs necessary for selling new securities any costs necessary for selling new securities
Break even Break even to complete a business or any other undertaking without incurring a loss. to complete a business or any other undertaking without incurring a loss.
After-tax cost After-tax cost the cost of capital net of any tax impact. the cost of capital net of any tax impact.
Net proceeds Net proceeds the cash collection from selling of securities after deducting flotation the cash collection from selling of securities after deducting flotation
costs. costs.
Implicit cost Implicit cost a cost, which is not explicit and not clearly defined. a cost, which is not explicit and not clearly defined.
Breaking point Breaking point the point where the cost of individual source of capital will rise. the point where the cost of individual source of capital will rise.
Weighted average Weighted average an average computed on the basis of the relative weights an average computed on the basis of the relative weights
(proportions) of the given data. (proportions) of the given data.


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