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NATIONAL INSTITUTE OF PUBLIC ADMINISTRATION

BACHELORS DEGREE IN BUSINESS ADMINISTRATION

CORPORATE FINANCE AND FINANCIAL MODELLING MODULE

BACHELORS DEGREE IN ACCOUNTANCY AND FINANCE

PREPARED BY
SHUKO MARY ZYAMBO
MSc Finance and Accounting

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Contents
Role and Purpose of Financial Management .................................................................................................. 4
The First Principles of Corporate Finance ................................................................................................... 4
The objectives in decision making .............................................................................................................. 4
The role of Financial Managers .................................................................................................................. 4
The Financial System ..................................................................................................................................... 5
The Role of The financial System ................................................................................................................ 5
The Five Components of the Financial System ............................................................................................ 6
Financial institutions .................................................................................................................................. 7
Financial instruments ................................................................................................................................. 7
Financial markets ....................................................................................................................................... 7
Financial ratio analysis ................................................................................................................................... 9
Liquidity or short term solvency ratios ....................................................................................................... 9
Activity ratios........................................................................................................................................... 10
Profitability ratios .................................................................................................................................... 10
Financial Leverage Ratios ......................................................................................................................... 11
Benefits and limitations of ratio analysis techniques ................................................................................ 11
Limitations of ratio analysis...................................................................................................................... 12
Forecasting and techniques of financial planning and control ................................................................. 13
Financial Control ...................................................................................................................................... 13
Working Capital Management ..................................................................................................................... 14
The elements of working capital .............................................................................................................. 14
Managing Liquidity .................................................................................................................................. 15
Overtrading ............................................................................................................................................. 16
Cash Management ................................................................................................................................... 16
Investment in short term funds ................................................................................................................ 17
Trade Receivable management ................................................................................................................ 17
Management of Trade Payables ............................................................................................................... 18
Inventory Management ........................................................................................................................... 19
Investment Appraisal Techniques ................................................................................................................ 20
Capital Budgeting ..................................................................................................................................... 20
The Time Value of Money ........................................................................................................................ 21

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Investment appraisal Methods ................................................................................................................. 24
Inflation in investment appraisal .............................................................................................................. 33
Risk and Uncertainty in investment appraisal ........................................................................................... 33
Sources of Finance ....................................................................................................................................... 35
Debt Financing ......................................................................................................................................... 38
Equity Finance ......................................................................................................................................... 38
The dividend policy .................................................................................................................................. 40
The weighted Average Cost of Capital WACC ............................................................................................... 41
Cost of Equity .......................................................................................................................................... 42
Capital asset pricing Model (CAMP) ......................................................................................................... 43
Cost of debt ............................................................................................................................................. 43
The Portfolio Theory ................................................................................................................................ 45
Capital structure ...................................................................................................................................... 46
Modigliani Miller Theory .......................................................................................................................... 46
Managing foreign Exchange Risk .................................................................................................................. 48
What is Foreign Exchange Risk? ............................................................................................................... 49
Managing Foreign Exchange Risk ............................................................................................................. 49
Business Valuation Methods ........................................................................................................................ 52
Asset-based valuation .............................................................................................................................. 53
Income based approach ........................................................................................................................... 54
Cash flow based Valuation Method .......................................................................................................... 56
Bibliography ................................................................................................................................................ 59

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Role and Purpose of Financial Management

The First Principles of Corporate Finance


 Always invest in those projects that will yield a greater return than the
minimum acceptable hurdle. The hurdle rate can be your cost of capital and for
those projects that are more risky this hurdle rate should also be elevated and
it should always reflect the financing used, how much debt and how are equity.
 Returns on investments need to be measured using cash flows generated and
the timing and both negative and positive aspects of these should be taken
into consideration.

 Always select a financing mix that will reduce your cost of capital(Hurdle rate)
and corresponds to the assets that are being financed
 If financial managers are unable to find investments that will beat the hurdle
rate ,the funds available should be given back to the shareholders in terms of
dividends
The objectives in decision making
 The main priority that financial managers have when it comes to corporate
finance decision is to maximise the value of the firm.
 The second most important decision is to maximise the shareholders wealth.
 When markets are seen to be efficient when the stock is traded, the objective
is to maximise the stock prize.
 All other objective just fall in place to help maximise the value of the firm

The role of Financial Managers


 Financial managers have a big role to the stockholders that hire them, financial
managers have to make sure they are maximise stockholders wealth by
choosing on investments that will yield a high return for money invested
 The financial managers also have a big role to bondholders; they should
protect bondholder’s interest and make sure that interest is paid first before
dividends are distributed in case the company makes profit.
 They also have a role to society and have to make sure that social costs such as
pollution to the environment can be associated to the firm and the obligations
such as taxes are paid on time.

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 Finally they have a role to the financial markets, the have to provide accurate
financial information in a timely manner.

What is likely to go wrong?


A situation can happen where

 The shareholders can have minimal control over the financial managers and
the financial managers can decide to put their own interest first.
 The bondholders can also loose respect for an organisation if their own
interests ate not taken care of and may decide not to lend finances again.
 If financial managers do not take care of all these aspects the organisation may
be in trouble. Financial managers can also provide inaccurate financial
information and delay delivering this information and this can cause investors
to be misled.
Other objectives

 The other objectives that the organisation can choose to focus are
 A firm can choose to increase the stock prize
 To increase earnings and reduce costs
 To increase sales and look for better marketing strategies
 To maximise the market share and all these objectives are aligned to the main
objective which is maximizing firm value.

The Financial System


 A financial system is a system that brings investors and borrowers together. It
is a marketplace entities and people trade and exchange financial commodities
and securities such as precious metals, agricultural goods and securities such
as stocks and bonds
 There are general markets and specialised markets in the financial system. The
general markets trade many commodities while the specialised markets trade
only one commodity. The financial system works by bring together those who
have excess funds to those that have need for funds including households,
entities and the government.
The Role of The financial System
The financial markets are an important part of the economy as they accelerate
economic growth and in brief the financial markets achieve the following important
goal

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 Savings Mobilization: The financial system helps funds to move from those
that have excess funds (savers) such as the government, business firms, and
the public sector to those that are in need of the funds the borrowers. For
example the lenders (e.g. bond buyers) and the borrowers (e.g. bond issuers)
are connected in the financial markets
 Investments: This is an important role in that it allows both entities and
individuals to invest in listed companies in financial market to help them get a
return on their excess funds
 National Growth: The financial system helps funds to move from firm to firm
or industry to industry based on demand in that it helps the flow of these
funds from surplus entities to deficit entities
 Entrepreneurship Growth: The financial system allows entrepreneurs to access
funds and invests in other projects
The Five Components of the Financial System
The financial system has five main components and these are
Money
 Money can be defined as a mode of payment of goods and services
Therefore money theories look at the changes in money supply in accordance
to changes in the economic activities and price level of a country
Money and Recession
 The periodic but irregular upwards and downwards movement of aggregate
output produced in the economy is referred to as the business cycle
 Sustained (persistent) downwards movement in the business cycle are referred
to as recessions
 Sustained (persistent) upward movement in the business cycle are referred to
as expansions
Money and Inflation
 The aggregate price level is the average price of good and services in an
economy
 Inflation refers to the continual rise in the price levels in an economy which will
in turn affect all economic players
 There is a direct link between inflation and the growth of money in an
economy over long periods of time .A sharp increase in the inflation rate
usually has to do with a sharp rise in the growth of money supply
 Countries that have high rates of inflation have rapidly growing money supplies

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Financial institutions
These allow funds to move from those that have excess funds with no productive use
for them to those with shortages of funds

 Financial institutions also allow people to earn a decent return on their money
and high prevent risk by saving in an bank, financial companies and insurance
companies
 Banks reduce the need to move around with money for example cheque, debit
cards and credit cards can be used to make large payments
 Banks also reduce the inconvenience of spending time in queues by
innovations such as debit cards, deposit card taking ATM and services such as
mobile banking that allows customers to pay for bills and transfer money
without leaving the comfort of their homes.
 Financial innovations simply refer both technological and service advances.
Technological advances help facilitate payments and access to information and
the emergence of recent financial instruments and services, new forms of
organisation and more developed and complete financial markets
 Banks help in the study of money and the economy because they have been a
source of rapid financial innovations
Financial instruments
 Financial instruments in financial markets refer to the commodities and
products that are traded in the financial markets. The other name for financial
instruments is securities
 A security is a formal obligation that allows one party to receive payments or
share assets from the other for example loans, bonds and stocks.
 For example a simple bank loan is also a financial instrument
Financial markets
 Financial markets is a place that brings individuals, companies and
governments together to allow them to buy and to sell financial securities for
example bonds and stock and also trade in commodities such as Agricultural
goods and precious metals at a low transaction cost .
 Markets such as bond markets and stock markets help to promote economic
efficiency by transferring financial resources from those who do not have
productive use of funds(savers ) to those who do(investors)
The stock Market
 Stocks are a share of ownership on a firm’searnings or assets for those
individuals that have put in resources in the business.

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 A stock increase wealth and therefore affects the willingness of people to
spend. The higher the stock market index due to higher share prices the more
likely people will spend because their returns will also be higher.
 The changes in the stock will also affect the firm’s ability to raise funds. When
the stock prize is higher investors are willing as they know that they will have a
greater return on their investments
 When the stock price decrease people are less likely to spend as they will not
make much wealth
 The changes in stock price also affect a firm’s decision to sell stock to finance
investment spending. A recession causes the stock price to fall when ever
thing else held constant and therefore consumer spending also decreases.
The Bond markets and interest rates

 A bond is a debt security that pays regular interest payments for period of time
and then the pays the principal of the debt at maturity of the debt
 Bond markets are essential part of an economy as they are the markets that
determine interest rates.
 Interest is the cost of borrowing money and is everything is held constant a
reduction in the interest rates will increase investments and consumption for
example spending on housing or holiday trips.
 On the other hand a rise in interest rates can be considered good in that it
encourages savings because the return on investments will be higher but
discourages investors from taking up loans and as a result, consumption and
investments reduce
The Foreign Exchange Market
 The foreign exchange market is where funds are converted from one currency
to another. The foreign exchange rate is the price of one currency in term of
the other
 A strong currency reduces exports as the country’s goods will be more
expensive in another country and fewer foreigners will purchase good but a
strong currency will mean that our spending in another country will become
cheaper
 A weak currency on the other hand increase exports but the countries pending
in other countries becomes more expensive

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The central bank
The central banks plays many important functions in regulating a country’s
financial institutions and markets .A central bank is a government body that
regulates one of the following
 It regulates the financial institutions and controls the supply of money and in
an economy
 The central bank is also in charge of government finances and it serves as the
bank commercial bank
 When commercial banks are short of resources the central bank becomes its
lender and also the excess money that the commercial bank are deposited in
the central bank
 The central bank is also in charge of the monetary policy. The monetary policy
is the management of the supply of money in an economy depending on the
economic activity of a country and the price levels.

Financial ratio analysis

Financial ratio analysis involves the methods and techniques that help organisations
to measure the health of the business. Information for financial ratio analysis is taken
from financial records that the business keeps that is; the income statements and the
balance sheet. Financial ratio analysis helps identify a company’s strong and weak
points. The main financial ratios are:
Liquidity or short term solvency ratios
These ratios measure the firm’s ability to meet its short term obligations in a timely
manner. The ratios used here are the current and quick ratio and they are calculated
as follows

 Current ratio=Total current assets/Total current liabilities


 Quick ratio=Current assets-inventory/Current liabilities
The current ratio is widely used and usually a CR that is above 1 means that the
company is able to meet its financial obligations and a CR less than 1 means the
company is unable to meet its short term obligations.
However if the current ratio is too high this might just mean that the firm may lack
investment opportunities that is why they have a lot of cash on their accounts.

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Activity ratios
Activity ratios simply measure how well or efficiently the firm is managing its assets

 Total asset turnover=Total revenue/Total assets


This measures how well a firm is using total assets to generate revenue. If the ratio is
higher this means in most cases that the firm is using its assets efficiently to generate
revenue. However a ratio that is too high may also mean that the firm can lose
revenue due to limited assets.

 Receivable Turnover=Total Operating Revenue/Receivables


 Average Collection Period=Days in a period(365)/Receivable Turnover
The above two ratios measure how well a firm is managing its investments in trade
receivables. The actual value of these ratios shows the credit policy of a firm, the
higher the receivables the liberal the company’s trade policy.
 Inventory turnover=Cost of goods sold /Inventory
The IT measures how rapidly the company’s inventory is manufactured (Produced)
and sold and is significantly affected by the technology that the company is using to
produce this inventory.

 Account Payable Turnover=Total Purchases/Average account Payables


 Account payable days=Days in a period (365)/Account Payable Turnover
This also measures how well the company is managing its trade payables.
Profitability ratios
These ratios help measure how profitable the firm is.Profit margins show the firms
capacity to produce a product or service at a high price or at a low cost. Trade firm
usually have lower profit margins while service firms have higher margins.

 Net Profit Margin=Net Profit/Total Operating Revenue


 Gross Profit Margin=Earnings before interest and taxes/TotalOperating
Revenue
 Net Return on Assets=Net Income/Average total assets
 Gross Return on Assets=Earnings before Interest and Taxes/Average Total
Assets
 Return on Equity (ROE) =Net Income/Average Stockholders’ Equity

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Financial Leverage Ratios
Financial Leverage ratios show to what extent a firm uses external financing(Debt)
rather than internal financing(Shareholders Equity).It also measures the probability
of a firm to default on its debt contracts.

 Debt ratio=Total debt /Total assets


 Debt to Equity Ratio=Total Debt/Total Equity
 Interest Coverage=Earnings before interest and taxes/Interest expenses
Interest coverage shows the firms capacity to pay its interest obligations to
bondholders and it’s an obstacle that a firm has to overcome to avoid debt default
and to have the ability to gain additional financing when needed.
Value Ratios
These have to do with the overall value of the firm and the shareholders issues like
dividends.

 Market Price:The market price of a share is the price at which buyers and
sellers establish when the trade in shares. The market value of stock is the
market price multiplied by outstanding shares.
 Price to earnings=Current market price/Earnings per Share of the latest year
 Dividend Yield=Dividend per share/Market Price per Share
 Market to book(M/B)=Market price per share/Book value per share
 Dividend per Share=Dividend for the year/number of shares
 Dividend Cover: Calculates the number of times the current dividend would be
paid out from available profits=Profits after tax/Dividend
 Earnings per share: This is how much would be paid out per share if the
company decided to pay out all its profits as dividends=Profits after
tax/number of shares in issue
Benefits and limitations of ratio analysis techniques
The key to obtaining meaningful information from ratio analysis is comparison:
comparing ratios overtime within the same business to establish whether the
business is improving or declining, and comparing ratios between similar businesses
to see whether the company you are identifying is better or worse than the average
within its own business sector
A vital element in effective ratio analysis is understanding the need of the person for
whom the ratio is been undertaken

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 Investors will be interested in the risk and return relating to their investment
,so will be concerned with dividends, market prices levels of debt versus equity
 Suppliers and lenders are interested in receiving the payments due to them ,so
want to know how liquid the business is
 Managers are interested in ratios that indicate how well the business is been
run and how well the business is doing in relation to competitors
Limitations of ratio analysis
Availability of comparable Information

 When making comparisons with other companies in the industry, industry


averages may wide variations in figures. Figures for similar companies may
provide a better guide but then there are problems identifying which are
similar and obtaining enough detailed information about them
Use of historical out of date information
 Comparisons with history of a business may be of limited use if the business
has recently undergone or is about to undergo substantial
Ratios are not definitive

 Ideal levels vary industry by industry and even they are not definitive.
Companies may be able exist without any difficult with ratios that are rather
worse than the industry average
Need for careful interpretations

 For example, if comparing two businesses liquidity ratios, one business may
have higher levels. This might appear to be good but further investigation
might reveal that higher ratios are as a result of higher inventory and
receivable levels which are a result of power working capital management by
the business with better ratios
Manipulation
 Any ratio including profit may be distorted by choice of accounting policies.
For smaller companies ,working capital ratios may be distorted depending on
whether a big customer pays, or a large supplier is paid, before or after the
year end
Other information

 Ratio analysis on its own is not sufficient for interpreting company accounts
,and there are other items of items that should be looked at

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Forecasting and techniques of financial planning and control
Financial planning
The projection of sales, income and assets based on alternative production and
marketing strategies as well as the determination of the resources needed to achieve
these projections
Financial Control
This is phase the in which financial plans are implemented. Controls deals with
feedback and adjustment processes required to ensure adherence to plans and
modifications of plans because of unseen circumstances
Importance of Financial planning and control

 If projected operating results are not satisfactory, management can


reformulate its plans
 If funds required to meet sales forecasts cannot be obtained ,management can
sale back projected level of operations
 If required funds can be raised it better to plan for their acquisition in advance
 Any deviations from projections need to be handled to improve future
forecast.
Financial planning
The sales forecast
A forecast of a firm’s unit and kwacha sale for some future period, generally based on
recent sales trends plus forecast of the economic prospects for the nation, region and
the industry .
Step 2
Projected (pro forma) financial statements
 A method of forecasting financial requirements based on forecasted financial
statements
 AFN is the additional funds needed to support the level of forecasted
operations
Projected Financial statements

 Determine how much money a firm will need in a given period


 Determine how much money the firm will generate internally during the same
period

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 Subtract the funds generated internally from the funds required to determine
external financial requirements
Step 3
Raising the additional funds needed

 Higher sales must be supported by higher assets


 Assets increase can be financed by spontaneous increase in account payables
and accruals and by retained earnings
 A shortfall must be financed by external sources by borrowing or by selling
new stock
Step 4
The effects on the income statement and the balance sheet of actions taken to
finance forecasted increases in assets
How different factors affect the AFN forecast

 Dividend pay-out ratio changes –if reduced ,more retained earnings and
reduces the AFN
 If profit margin changes-if income increased total and retained earnings
increase and reduce AFN
 Plant capacity changes –less capacity used less need for AFN
 Payment terms increased to 60days –account payables would double,
increasing liabilities and reduce AFN

Working Capital Management

Working capital management in an organisation has to do with managing


investments in short term assets and the short term financing of a firm. The main
goal of working capital management is to have sufficient cash flows for operations
and to make the most use of excess financial resources.
The elements of working capital
 Cash: Enough cash is needed in a business to run operations smoothly but
thenit’s important to invest excess cash in short term instruments so that the
company can earn a return on that cash
 Inventory: it’s important to have sufficient inventory to meet demand. But too
much inventory may have additional costs and it’s not wise to keep certain

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types of inventory like perishable goods as they would go bad before they are
sold and this can be a loss to a company
 Trade receivables: allow a firm to have more clients and if a firm doesn’t offer
credit,customers may run away to those competitors that do, however good
trade receivable management is important to ensure that a firm does not run
out of cash which might force them to borrow at an additional cost.
 Trade payables: Trade payables are a form of free financing to a firm and a firm
should take advantage of the trade limit given by suppliers but they should
ensure they pay their trade payables so as to keep a good reputation with
suppliers.

Managing Liquidity
 Liquidity: This is the firm’s ability to meet its short term obligations using
resources that can easily be converted into cash.
 Liquidity Management: Is the ability of a firm to generate cash when and
where it is needed.
 Drags on Liquidity: Theses are factors that cause delays in the collection of
cash for example slow payments by customers and cash that is stuck up in
inventory.
 Pulls on Liquidity: These are decisions that result in paying cash too quickly for
example settling trade receivables too early.
 Sources of Liquidity: Cash, short term funds such as trade credits, short term
bank loans and bank overdrafts.
Operating and cash conversion cycle
This is the time it takes for a firm to buy inventory, manufacture the inventory and
sell the finished good and then collect the money from customers. It is calculated as
follows:

 Operating cycle=Average time it takes to create and sell inventory +Average


time it takes to collect cash on account receivables
 Cash conversion cycle: This is the length of time it takes a firm’s investment in
inventory to generate cash considering that some of the inventory was bought
on credit. It is calculated as follows
 Cash conversion cycles=Average time it takes to create and sell inventory
+Average time it takes to collect cash-Average time it takes to pay suppliers.

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Example
If a company’s has 73 inventory days, 73 receivable days and 57.3 payable days.
What are the operating cycles and the cash conversion cycles?
Operating cycles=73+73=146 days
Cash conversion =73+73-57=88.7 days

 The length of a firms operating and cash conversion cycle will determine how
much liquidity a firm will need. The longer the cycles the greater the firms
need for liquidity.
Overtrading
Overtrading happens when the capital base of an organisation is too little to support
volumes of trade and it can be indicated by:

 Deterioration of key financial ratios


 Loss of liquidity resources
 An increase on the reliance on short term finance
Overtrading can be overcome by employing a better working capital management
policy and introducing more capital to the business plus consolidating business
activity.
Cash Management
 The main goal of cash management is to maintain positive cash balances in a
firm thought the day and a firm maintain a minimum cash balance to maintain
against a negative one.
 It’s the role of financial managers to keep an accurate forecast of the estimates
of cash inflows and outflows. The amount and timing of these flows is
important
 Cash inflows include receipts from operations, maturing investments,debt
proceeds and tax refunds. Cash outflows include payables and payroll
disbursements, debt repayments and tax payments.
A company’s cash management policy include

 Investing cash in excess


 Analysing short term sources of borrowing.
Other factors that affect cash flows include:

 Disposal of assets
 Mergers and Acquisitions
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 Capital expenditure
Investment in short term funds
A firm must try as much as possible to invest its excess cash resources in short term
instruments but before doing this management must make sure that there is no risk
of losing funds.
The choice of these short term investments will greatly depend on:

 The amount of the cash surplus


 When the short term investment will mature
 Any penalties for early encashment

Trade Receivable management


When analysing trade receivable management it important to look at the benefit and
drawbacks of offering credit to customers.
The most important benefit of credit is that it can boost sales
The drawbacks of credit include

 Inability of customers to pay :The risk of non-payment by customers can be


minimised by screening customers before offering credit .This can be done by
getting credit references from other business that have previously offered
credit to the firm
 There are administrative costs that are linked to trade receivable management:
Reducing administrative cost can be done by a process called factoring.
Factoring is when a company decides to hire a third party company to be
responsible for its debt collection.
An example of factoring

 If a company has trade receivables amounting to K166, 000 and hires a


factoring company this is what will happen:
 The factoring company will pay a certain percentage upfront say 80% of the
trade receivables which is K132,800
 At the end of each upcoming month it pays company A 80% of the total
trade receivables raised that month plus 20% of the trade receivable
balance from the previous month less a charge fee of 1.5% of the total
invoice value (166,000*0.015)=K2490

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 The factoring characteristics can vary and the initial payment may range
from 70% to 90% of the total trade receivables and the charge fee for this
exercise was at 1.5% but can be anything between 1% and 3%
 Offering credit can reduce the cash resources available to the business, the
business might have to borrow to finance trade receivables. Factoring helps
solve this problem as it allows advance payment for the substantial part of
the trade receivables total. Those companies that decide to keep trade
receivables internally are at a comparative disadvantage when it comes to
cash resources and should therefore perm a balancing act with the other
elements of working capital to make sure that cash does not run out.They
should ensure they anticipate for any cash shortages and look for other
means of financing.
 Loss of potential interest receivable.

Therefore the management of trade receivables has a lot to do with how well a
firm manages these risks associated with trade receivables.
The Credit control Function
The credits control function has a number of duties including
 Making sure the run checks on customers with trade receivables
 Reviewing customers details and updating them in case of changing
circumstances
 The also set credit limits on customers
 They review customer’s invoices and they chase up on those customers
invoices that are overdue.
 They also advise management on the best possible ways to deal with trade
receivable
Management of Trade Payables
Trade payables are an important part of a business as they are regarded as a form of
freefinancing for the business

 When a firm falls to pay its trade payables for a few day after the credit limit
offered, this is unlikely to bring any major problem but there are situations
where this financing mechanism can be abused and this can cause trade
suppliers to lose confidence in the business and also a firm may earn a bad
name.
 Therefore a firm should be clear about its trade payables limits and know
whether its 30 or 60 days allowed ensuring they don’t delay payments

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 In addition the firm may receive valuable discounts for early payment of trade
receivables and therefore a firm must measure the pros and cons of taking
credit compared to delaying paying.
Inventory Management
 Inventory management is important in an organisation and the big challenge
that companies face is ensuring that they have optimal levels of inventory all
the time.
 Managing levels of inventory is important as it helps a firm to meet its
customers’ demands quickly and without interruptions but again a firm has to
make sure it does not have too much excess inventory as this will bring about
additional holding costs
Holding costs
 Holding cost are costs that are associated to keeping and storing inventory.
These include the warehouses and the insurance costs involved in securing this
inventory and the cost of the staff hired to move and monitor this inventory.
 If inventory is ordered less frequently, the total costs incurred in ordering
processes in reduced too and vice versa
The Economic Order Theory
The economic order theory is a formula that helps firms to calculate the optimum
level of inventory and it is calculated as follows

√2 ∗ D ∗ O
=
H
Where Q=Economic order quantity
D=Demand for the inventory
O=Cost per order
H=Holding costs per unit
Example
If the demand for the period is 5000 units and the cost per order is 25 Kwacha and
the holding cost is 17 kwacha the economic order quantity is

√2 ∗ 5000 ∗ K25
=
17
Q=121 units
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So if the firm orders 121 units of inventory the holding cost will be minimised.
The Limitations of the Economic Order Quantity
The limitations include

 Assuming that the holding costs are constant which is not usually the case
 It also overlooks the changes or in demand and if the demand is seasonal the
application of this model may not provide sufficient frequent ordering to
guarantee an adequate an adequate level of stock during peak periods.

Limiting Management Input

 This method of inventory management is useful if a firm deal in different types


of good. When this is the case intensively managing all levels of stock would be
a waste of time and resources. It involves labelling inventory into high level
usage, mid-level usage and lower level usage so that only the stock with a high
level of usage can be managed consistently
Just In Time

 This method involves only manufacturing goods when there is an order for the
goods. This method aims at getting rid of holding costs completely; the target
is to keep inventory levels at zero.
 The finished good are manufactured in exactly the quantities required and at
the exact time they are needed.
 This method may mean good are delivered more frequently but in small
amounts and therefore the order cost tend to be higher where the holding
costs are reduced to a minimal.

Investment Appraisal Techniques

Capital Budgeting
 Capital budgeting is the decision making in corporate finance that has to do
with the methods and techniques used by firms to decide on long term
investments. Financial managers are often asked to make difficult decisions
involving large sums of money on capital expenditure. Capital expenditure
involves the acquisitions in other business or investments in non-current assets
and investment in financial instruments that will be held for a long time.
 Capital expenditure decision has to do with carrying out investment appraisals
of future cash follows and profits.

20
 Capital expenditure decision has to do a lot with capital rationing which has to
do with how a firm spends its limited resources. Scarce finances in firm force
financial managers to decide on those investments that will yield the most
return in the future and are therefore making these evaluations to make sure
that no loss of funds is incurred.
The Time Value of Money
The time value of money lies on the fact that K1 today is not the same as K1 in 6
month time or in 5 years because of interest and inflation. The time value of money
tries to find the future value of money by compounding or finding the present value
of future values by discounting.
Compounding
Future Value=PV (1+R) ⁿ
PV is the future value
R is the interest rate
N is the time in consideration
(1+R)ⁿ is what is called the compounding factor
Example 1
At the end of year six, K1900 at an annual rate of 17% interest over six years will be?
FV=PV (1+R) ⁿ
FV=1900(1+0.17)⁶
FV=1900(2.565160) =K4, 873.8
Example 2
The compounding factor for an investment over 4 years at 3% per year is?
Compounding factor= (1+R)ⁿ
Compounding factor= (1+0.03)⁴=1.126
Discounting
Discounting is the reverse of compounding and simply helps us to find the present
value of money given some future values.
PV=FV *1/ (1+R) ⁿ OR

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PV=FV/ (1+R) ⁿ
1/(1+R) ⁿ is what is called the discounting factor
Example 1
Assuming a constant discount rate of 12%,the present value of K1300 trade
receivables at the end of 5 years is?
PV=FV/(1+R) ⁿ
PV=1300/ (1+0.12)⁵=737
Example 2
The discounting factor for an investment over 3 years at 10% in three decimal places
is?
Discount factor =1/ (1+R) ⁿ
DF=1/ (1+0.10) =0.751
Perpetuities
Perpetuities are the present value of money that has an infinite time. A perfect
example is that when you retire you are given monthly payments that have no future
ending and to find the present value we deal with perpetuities
Present value=Cash flows/interest
PV= C/R
For example 1
If a pensioner earns K500 yearly perpetuity at 6% interest what is the present value
PV=C/R
PV=500/0.06=K8, 333
Annuities
Annuities help us find the future values of money that is deposited regularly for a
period of time for example savings for retirement or an education policy for a child.it
is found using the formula below
FV= C (1+R)ⁿ-1 /R*(1+R)
FV=Future value

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C= Regular payments/Deposits amounts
N=number of payments
Example
If someone makes yearly deposits of 1000 Kwacha for 18 years at an interest of
5%.What is the future value of these deposits?
C=1000
R=5%=0.05
N=18 Years
FV=1000 (1+0.05)¹⁸-1 /0.05*(1+0.05)
FV=1000((2.40661923371-1)/0.05*1.05
FV=1000(1.40661923371)/0.05*1.05
FV=1000(28.132384673821(1.05)
FV=28,132.384673821(1.05)
FV=29,539 Kwacha
If the person just decided to save without investing, the amount saved will only be
1000*18 years=18,000 only but with interest earned 29,539 Kwacha

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Investment appraisal Methods
The payback period
The payback period is a simple investment appraisal technique that measures the
time it will take for an investment future cash flowto pay back the initial cost of the
investment
Example
The initial cost of two machines and their cash flows are as follows
Time Machine A Machine B
0 (450) (600)
1 160 246
2 160 196.8
3 160 172.2
4 100 102.5
5 100 102.5
5* 50 100

The payback period is found by looking at the accumulative cash flows and finding a
point in which these accumulative cash flows cover the initial cost or reaches the
point zero
Machine A
Time Cash flows Cumulative Cash flows
0 (450) (450)
1 160 (290)
2 160 (130)
3 160 30
4 100 130
5 100+50 280

The cumulative cash flows will reach point zero somewhere in year 3.We can
calculate the exact time in years and months as follows
Payback period=2 years + (130/160*12)

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Payback period=2years and 9 months

Machine B
Time Cash flows Cumulative Cash Flows
0 (600) (600)
1 246 (354)
2 196.8 (157.2)
3 172.2 15
4 102.5 117.5
5 102.5+100 320

Payback Machine B=2 years+(157.2/172.2*12)=2 years and 11 months


From our calculations we can see that machine A pays back the initial investment
cost earlier by 2 months compared to Machine B.
Strengths of payback period

 The payback is a simple concept to understand


 The payback is easy to calculate provided that cash flows have been calculated
 It uses cash not accounting profits
 Takes risk into account (in the sense that earlier cash flows are more certain
Weaknesses

 The payback only considers cash flows within the payback period and ignores
all other cash flows and doesn’t consider the whole value of a project
 Ignores the size and timing of cash flows
 Ignores the time value of money in its calculations(Although discounted cash
flow can be used)
 It does not really take into account risk

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The accounting rate of return
The accounting rate of return (ARR) method uses projections of accounting profits to
calculate the expected rate of return on capital employed into an asset or project .It
is calculated as follows:
Average expected return (Accounting profits)/Average capital employed *100
Steps in calculating the accounting rate of return

 Example
If an investment cash outflow and cash inflows are as follows what the
accounting rate of return is if the residue value of the machinery is 25,000 and
if depreciation is calculated on a straight line basis

Year 0 Year 1 Year 2 Year 3


(150,000) 65000 110000 175000

Step one is to calculate the average accounting profit


(65,000+110000+17500)/3=116,667

Step two is to calculate the depreciation per year for the machinery
Depreciation=initial value-residue value/time
Depreciation= (150000-25000)/3=41,667

Step 3 is to find the average annual profit after depreciation


Average annual profits –Average depreciation
(116,667-41.667)=75000

Step four is to find the average investment


Average investment=Initial value+ residue value/2
(150 000+25000)/2=87,500

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Step 5 Calculating the ARR
ARR=Average expected return (Accounting profits)/Average capital employed *100
ARR=75000/87500*100=0.8571=85.715%
Example 2
Calculate the accounting rate of return a K30000 residue value
Year 0 (240 000)
Year 1 100 000
Year 2 80 000
Year 3 50 000
Year 4 50 000
Year 5 50 000
Year 6 30 000

Step 1 Average annual operating profits=360000/6=60000


Step 2 Average annual depreciation=240000-30000/6=35,000pa.
Step 3 Average annual profits after depreciation=60000-25000
Step 4 Average investment=240000+30000/2=135000
Step 5 ARR 25000/135000=0.1851=18.51%
Strengths of ARR

 It is straightforward to calculate the ARR


 It is a widely used method of investment appraisal
 It is easy for non-financial managers to understand the ARR
Weaknesses

 The problem with the ARR is that it treats all future cash flows in the same
weight; it does not consider the time value of money in its calculations
 The method is calculated using accounting profits rather than cash flows and it
includes depreciation in its calculations, an accounting adjustment in which the
timing and nature is determined by management
 Profit is not directly linked to primary financial objective of shareholder wealth
maximization
 Relative measure and therefore ignores size of initial investment.

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The Net Present Value
The Net Present value method of investment appraisal uses the discounting
technique to express the estimated future cash follows in the same term
The Net Present Value (NPV)=-Initial cost of investment+ discounted cash flows.
Example: Machine A
The initial expenditure of an investment in machine A is K450000 and the cost for
machine B is K600000 and the discount factor is 10%.What is the NPV if we the
estimated cash flows are as follows and which machine should this company invest
in?
Time Cash Flows Discount Factor Discounted Cash
flows
0 (450 000) 1 (450 000)
1 160 000 0.909 145 440
2 160000 0.826 132 160
3 160000 0.751 120 160
4 100 000 0.683 68 300
5 150 000 0.621 93 150
109 210

Machine B

Time Cash flows Discount Factor Discounted Cash


flows
0 (600000) 1 (600000)
1 246 000 0.909 223 614
2 196 800 0.826 162 557
3 172 200 0.751 129 322
4 102 500 0.683 70 008
5 202 500 0.621 125 752
111 253

The decision criteria for the NPV are that if NPV is greater than zero we should accept
that project and if it’s less than zero we reject the project. Where there is more than
one alternative go for the project that has a higher NPV.

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In the case of the two machines we see that machine B would be the best choice
because it has a higher NPV of K111 253compared to the NPV machine A which is
K109 210
Strengths of NPV

 NPV takes into account the time value of money


 NPV uses cash flows not accounting profit
 Takes into account all relevant cash flows over life of a project
 Can take into account conventional and non-conventional cash follows as well
as changes in discount rate during project life
 The NPV gives absolute measure of project value
Weaknesses of NPV
 Project cash flows may be difficult to estimate (But this applies to all projects)
 Accepting all projects with positive NPV is only possible in a perfect capital
market
 Cost of capital may be difficult to find
 Cost of capital may change over project life rather than remain constant

The internal rate of return


The internal rate of return is an investment appraisal method that is closely linked to
the NPV investment appraisal technique. The IRR technique is a project or an
investments discount rate or cost of capital that will yield a NPV of zero when the
future cash inflows are discounted using the IRR. The first step in calculating the IRR
of a project is to find the NPV first.
Example
A company estimates the following net cash inflows and outflows for a capital
investment project that is currently under consideration. The company’s cost of
capital is 12%

 Calculate the NPV for the project


 Calculate the IRR for the project

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Time Cash Flows
0 (680 000)
1 180 000
2 200 000
3 240 000
4 350 000

Time Cash Flows Discount Factor Discounted cash


flows
0 (680 000) 1 (680 000)
1 180 000 0.893 160 740
2 200 000 0.797 159 400
3 240 000 0.712 170 880
4 350 000 0.636 222 600
33 620

The NPV for this project is K33 620


A 12% cost of capital gives a NPV that is positive. Therefore, the cost of capital that
will give a NPV of zero must be higher than 12% and the IRR is calculated as follows
We pick another cost of capital higher than 12% let say 16% and recalculate the NPV
using the same cash flows
Calculating NPV at 16%
Time Cash inflows Discount Factor Discounted Cash
flows
0 (680 0000) 1 (680 0000
1 180 000 0.862 155 160
2 200 000 0.743 148 600
3 240 000 0.641 153 840
4 350 000 0.551 193 200
(29 200)

In this case we know that IRR must be between 12% and 16%
When we calculate NPV with 12% the result is 33,620

30
When we calculate NPV with 16% the result is (29 200)
We the have to find the total distance between the two NPV figures which is 33
620+29 200=62 820
Then Find the distance between 12% and 16% which is equal to 4%
The IRR is calculated as follows
33620/62820*4%=2.14
Note: IRR is 12%+2.14=14.14%
Alternatively we can use the negative NPV in this case IRR is calculated as
29 200/62820*4%=1.859
Note: IRR is 16%-1.859=14.14
The decision criterion is that when IRR is greater than the cost of capital we accept
the project and if IRR is less than the cost of capital then we reject the project.
If a choice has to be made between two possible project pick the project with a
higher IRR
Example 2
Let us say that the NPV are as follows using different discount factors
Interest rate Net Present Value
10% 111 253
12% 79 142
14% 49 093
16% 21625
18% (4 083)
20% (27 989)

We can tell that the IRR is between 16% and 18% where there is a positive and
negative NPV
The total distance between for the two NPVS IS 21625+4083=25 708
The distance between 16% and 18% is 2%
Using the positive NPV,IRR is calculated as follows:
21625/25708*2%=1.68%
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IRR 16%+1.68%=17.68%
Alternatively using the negative NPV,IRR is calculated as follows:
4083/25708*2%=0.325
IRR is 18%-0.32%=17.68%
Strengths of IRR
 The IRR takes into account the time value of money when making calculation
Weaknesses

 The IRR may be difficult to explain to non-financial managers


 IRR ignores absolute values since it is expressed in percentages
 It can be difficult to determine an appropriate discount factor
 It’s not always possible to calculate the IRR
Taxation in investment appraisals

 Tax relief on capital expenditure is given through capital allowances


 Capital allowances can be defined as a reduction in the amount of corporation
tax payable and it is offered as an incentive for those large scale investment
that increase a country’s production capacity for example agriculture
machinery.
 25% reducing balance capital allowance given on plant and machinery in the
UK
 Tax liabilities arises on taxable profits
 Interest payments are not relevant cash flows as these are included in the
discount factor
 After tax cash flows must be discounted using an appropriate cost of capital
 The timing of tax liabilities and benefits is important
Example of capital allowances

 A machine cost 200 000 Kwacha


 25% reducing balance capital allowances
 Expected life of the machine is 4 years
 Scrap value of the machine after 4 years is 20 000 Kwacha
 Corporation tax is 28%,payable 1 year in arrears
 Calculate capital allowances and associated tax benefits
Solution

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Capital Tax benefits 28%
Allowances tax
Year 1 200000*0.25 K50 000 14 000
Year 2 150000*0.25 K37 500 10 500
Year 3 112 5000*0.25 K28 125 7875
Year 4 84 375*0.25 K21 094
Balancing K43 281 12 119
allowance
*(84375-21094- 44 494
20000)

Inflation in investment appraisal


 Inflation can have serious effects on capital investments decisions
 The real value of cash flows can seriously be reduced
 The uncertainty associated with the value of future cash flows is increased
 The real cost of capital is found from the nominal (money) cost of capital by
making an adjustment for inflation
 The formula for adjusting for inflation is
(1 +real cost of capital)*(1+rate of inflation) = (1+nominal cost of capital)
This formula can be rearranged if we know the inflated cost of capital as
follows
1+real cost of capital=1+nominal cost of capital /1+rate of inflation

Example: If investors are looking for a return of 5% and the inflation rate is at
1.6%.What is the nominal return:
1+ (1.05) (1.016) =0.0668
Inflated return is 6.68%
 We can use either a nominal or a real term approach to investment appraisal
 Nominal cash flows are discounted with a nominal cost of capital
 Real cash flows are discounted with a real cost of capital
 Cash flows inflated with specific or general inflation are nominal cash flows
 Nominal cash flows deflated by a general rate of inflation are real cash flows
 The NPV found by discounting real cash flows with real cost of capital is same
as NPV found by discounting nominal cash flows with nominal cost of capital
Risk and Uncertainty in investment appraisal
 Risk refers to a set of unique circumstances that can be assigned probability

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 Uncertainty implies probabilities that cannot be assigned to different set of
circumstances
 In practice risk and uncertainty are often used interchangeably
 Risk increases with variability of returns
 Uncertainty increases with project life

Sensitivity Analysis

 A method of evaluating project risk


 It examines the responsiveness of the project NPV to changes in project
variables
 Only one variable is changed at a time
 One method involves changing variables by a set amount and then
recalculating NPV
 Another method involves finding the change in a variable which gives a zero
NPV
 One way to find sensitivity of project variable is: Project NPV/PV of project
variable%
Example
PV of sales revenue =K1.5m
PV of variable costs =K0.6m
NPV=K0.2m
Sales revenue sensitivity =0.2/1.5=13% this means that if the sales revenue falls by
13% or more the NPV will be zero
Variable cost sensitivity=0.2/0.6=33% this means that if cost increases by 33% or
more the NPV will be zero
Sales volume sensitivity=0.2/0.9=K22% this means that if the sales volumes
reduce by 22% the NPV will be zero

 Sensitivity analysis indicates the key or critical variables for an investment


project
 Key project variables may merit further investigations to check for
assumptions
 Key variables focus attention of managers on factors that might prevent
success

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Problems with Sensitivity Analysis

 Only on variable at a time can be changed


 No indication is given of the probability of changes in key project variables
 Not really a method of analysing project risk, since probabilities are ignored.

Sources of Finance
The availability of finance is often dependent upon the type and the size of the
business. Start-up and small companies do not have access to the amount and type
of finance that well established businesses have.
Therefore, we are going to look at the sources of finance for organisation through
different business stages.
Sources of Finance for new start-up businesses
The need for finance start up business is far different from those of established ones.
Small businesses may need money for one of the following.

 Funds for the purchase of new equipment


 Financial resources for supporting the owner and family while the business
booms and grows
 Money may be needed to pay staff
 Money may be required to pay expenses such as insurance, running cost, rates
and premises.
Sources of Finance for Start-up business

 Already available cash resources-This is what the owner of the business already
has. These can come from saving, from part time work done or by a
redundancy payoff of the owner
 Family and friends-These can provide valuable financial support to the business
through injection of equipment or through injection of cash resources. The
only challenge with this type of financing is that when a business fails,
relationships may suffer.
 Grant Finance-This is another type of funding available to small businesses.
These can be a very good source of funds as a grant doesn’t normally need to
be prepaid. The only realproblem is that these funds are available only for
specific purposes like in the employment of individual in highly unemployed
areas and the grant authority may need to keep a close eye on how the
business is doing.

35
Commercial Borrowing

Commercial borrowing may not be the most ideal type of financing for a start-up
business due to one of the following

 The charges or interest paid on loans can be stress to a start- up business and
can make a difference between success and failure if not properly assessed.
 Banks also need a track record of successful trading for them to give out a loan
which the new start-up businesses do not possess.
 To offer a commercial loan the bank needs security so that if the business fails
to pay they can sell the security such as an asset and to recover their funds.
This can be a great challenge for start-up businesses .A loan that is secured is
less risky from the bankers’ point of view. The nature and the value of the
security is directly linked to the interest rate charged. The higher the risk the
greater the interest rate charged and vice versa
 When requesting for financing the new business usually needs to provide a
detailed business plan which has all the details of the business including
products, market analysis, sales and profit forecast and the investments
required to mention just a few.
Sources of finance for a growing company
As mentioned earlier the needs of start-up business is different from that of a
growing business. The main need for financing for a growing business is to expand
the range of the products or services offered or moving into new markets.
The sources of finance mentioned earlier can also be appropriate for this stage too,
although some may be more appropriate than others for example commercial
borrowing may now be appropriate for this stage as a growing company may have
some records of successful trading. The other sources of finance available at this
stage are:
Venture Capital

 Venture capital-This type of financing involves funding from individuals or large


investors in a growing company that has good growth prospect for the future
 This type of funding is usually provided for the medium and long term from a
period of five to ten years and the funding is provided in exchange for an
equity stake in the business and the venture capitalist usually takes an active
role in the running of the business

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 The management role of the venture capitalist comes in very handy to the
growing business as they bring in experience and contacts into the new
business that would otherwise be difficult to get.
 After their term into the business as finished, the venture capitalist withdraws
out of the business by selling their equity stalk back to the original owners of
the business or by realizing their investments when the successful business is
floated on the stock exchange
Individuals
Rich Individual investors can provide financing into a growing business directly or
through an intermediary such a venture capital. These called business angels.
Another common term is the DRAGON; this refers to the owners of a growing
company pitching their business ideas to owners of well established companies and if
these big companies like their business ideas then the growing company are
rewarded with a financial input in exchange for equity stake in the business plus their
direct management input into the business.
Leasing
The acquisition of non –current assets may require significant cash outflow. One way
to acquire big fixed assets is to lease them. There are two types of leasing

 Operating lease-are for relatively short periods of times and are regular rental
payments for the use of the asset and these types of leases are for assets such
as photocopiers and vehicles
 Finance lease-These cover most or all of the life of an asset and are a way of
purchasing an asset in instalments. The business that leases the asset pays the
provider of the lease regular amounts of cash agreed in advance. The regular
payments include an element both of capital payments in respect of the asset
acquisition and interest payments which is the cost related to the lease.
Sources of Finance for large businesses
Sources of Finance for a large business include

 Commercial borrowing
 Leasing
 Issue of new shares
 Flotation on the stock exchange
 And investment by the venture capitalist
 Debt

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Debt Financing
The Choice between debt and equity
Advantages of debt

 Debt is a cheaper form of finance than shares, as debt interest is tax deductible
in most tax regimes
 Debt should be more attractive to investors because it will be secured against
the assets of the company
 Debt holders rank above shareholders in the event of liquidation
 Issue costs are normally lower for debt than for shares
 There is no immediate change in the existing structure of control, although this
may change overtime if the bonds are convertible to shares
 There is no immediate dilution in earnings and dividend per share
 Lenders do not participate in high profits compared to shares
Disadvantages of debt

 Interest has to be paid to no matter what the company’s profits in a year are.
In particular the company may find itself locked into long term debt at
unfavourable rates of interest .The company is not legally obliged to pay
dividends
 Money has to be made available for redemption or repayment. However
redemption will fall in real terms during times of inflation
 Heavy borrowing increases the financial risk for ordinary shareholders. A
company must be able to pay interest charges and repay the debt from its cash
resources and at the same time maintain a healthy balance sheet which
doesn’t deter would be lenders
 Shareholders may demand a higher return because an increased interest
burden increases the risk that dividends will not be paid
 There might be restrictions on a company’s power to borrow. The company’s
constitution may limit borrowing .The borrowings limits can’t be except with
approval of the shareholders at general meetings of the company

Equity Finance
Issue of new shares (Equity Finance)

 Upon the initial formation of a company, ordinary share capital is issued to the
first shareholders and the number of shareholders is low usually one or two. As
the business grows more shares are issued to other people

38
 Private companies are not permitted to offer shares to the general public or
have their shares quoted on the stock exchange
 Public limited companies are allowed to issue new share
Rights of shareholders

 Ordinary (Equity) share capital entitles its owners the shareholders to vote
which they can exercise at the general meetings
 The other right of shareholders is to receive dividends
 The company directors decide upon the level of dividends to be paid out
 Shareholders can vote on appointments, remuneration and removal of
directors
 Vote on important issues such as allowing repurchase of shares ,using shares in
a takeover bids or change in authorised share capital
 Receive share of the company’s assets after the company has been liquidated

The stock Exchange


The stock market is a place where stock is traded. It trades in principally, the shares
of quoted companies. Quoted companies comprises both local and international
companies
Advantages of being listed
 Raising funds by coming to market
 Access to finance via capital markets
 Shares can be used in acquisitions
Disadvantages of listing

 Cost of gaining and obtaining quotations


 Higher shareholders expectations
 Increased financial transparency
Mergers and Acquisition
 Mergers and acquisitions is a general term which refers to any bringing
together of companies either by agreement or as a result of a hostile bid.
 Where a full-scale effort is made by a company to repurchase a majority of
another company’s shares, this is referred to as a take overbid.
 The existing shareholders do not have to accept the offer unless it is attractive
enough to induce a large number of existing shares to sell.

39
 The purpose of a takeover is to allow better quality management to take on
control of operations of the target company which should lead to improved
efficiency and better return for shareholders of a company which is taking over
the other. Mergers and acquisitions do not always produce the desired effects
The dividend policy
 The dividend policy is closely linked to the financing decision of a company
 The dividend decision must take into account the views and expectations of
shareholders
 Retained earnings are preferred as a source of investments
 Dividend payments reduce the earnings available for investments ,increasing
the need for external funds to meet investments plans
Operating Issues

 Dividend is a distribution of after tax profits made on a cash basis


 Interim and financial divided is equal to the total dividend
 Shareholders must approve final dividend
 When dividend is announced the share price goes ‘cum divided meaning the
buyer of the share also buys the right to receive dividend
 When the share price goes EX dividend means that the buyer of a share no
longer gains the right to receive the next dividend.
Legal Constraints

 Dividend can only be paid from accumulated net realised profits(distributable


profits)
 Regulations such as accounting standards define the meaning of distributable
profits
 Government may also impose restrictions on dividend profits
 Restrictions may be imposed on dividend payments loan agreements or
covenants
Liquidity

 Dividends are cash payments so managers need to consider the effect on


liquidity of proposed dividend payments.
 High level of profits may not mean large dividends as profits are not the same
as cash.
 Interest payment obligations-Funds available for dividend payments will be
reduced if gearing is at a high level
Investment opportunities

40
Where dividends are cut to provide funds for investments depends on

 The attitude of shareholders and markets to cut on dividends


 Availability and cost of external finance
 Amount of funds required compared to amount of distributable profits

The weighted Average Cost of Capital WACC


The weighted average cost of capital is the average cost of both equity and debt
financing for a frim and is calculated as follows

WACC=Wd *Rd (1-T) +We*Re


Wd -is Weight of debt
(1-T)- is the tax effect of debt
Rd- is cost of debt
We- is the weight of equity
Re- is the return on equity
If we have preferred stock WACC= Wd *Rd (1-T) + Wp*Rp
Example 1
A company wants to raise money; the company will sell K10 millions of common
stock and the expected return is 15%.Moreover the company will issue K5 million of
debt and the cost of debt is 12% and the tax rate is 30%.Find the Wacc.
Company total financial requirement=10million +5 million=15 million
Weight of debt 5/15=0.33
Weight of equity 10/15=0.67
Data
Wd=0.33 Rd=0.12 We=0.67 Re=0.15
Wacc=0.33*0.12(1-0.3) +0.67*0.15=12.82%

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If the company had also issued K3 million in preferred stock at a cost of 9%, the Wacc
can be calculated as follows
Company total financial requirement=10+3+5=18
Data
Wd=5/18=0.28 Rd=0.12 T=0.3 We=10/18=0.56 Re=0.15
Wp=3/18=0.16 Rp=0.09
Wacc= WACC= Wd *Rd (1-T) + Wp*Rp+ Wp*Rp
Wacc=0.28*0.12(1-0.3) +0.56*0.15+0.16*0.09=0.1219
Wacc =12.19%

Cost of Equity
The cost of equity is the return that investors are looking for on their investment and
thus because a company has to pay them a return, it is a cost to the business
The cost of equity can be calculated using

 The Dividend Growth Model


 The Capital Asset Pricing Model=CAPM

The Dividend Growth Model is calculated as follows


Po=Do*(1+g)/Re-g
Po=D1/Re-g
Re=D1/Po+ g
Where
Po-The price of a share
Do-The Ex dividend paid
D1-The current dividend
G-The growth rate of the dividend
Re-The return on equity

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Example
Extremity prices shares at K40 per share and it paid a dividend 0f K3 last year and it
expects its dividend to grow at 7% each year. Calculate the cost of equity
Re= Do*(1+g)/Po +g
Re=3(1+0.07)/40+7%=0.15025
Re=15.03%
Capital asset pricing Model (CAMP)
The cost of equity can also be calculated using the CAPM
Rj= Rf +Bj (Rm –Rf)
Where
Rm is return of the market
Rf risk free rate
(Rm-Rf) equity risk premium
Bj is the beta value of ordinary share
Example
The industry beta for a construction company in the UK is 1.3 and the UK market risk
free interest rate and market return are estimated to be at 5% and 9% per year.
Calculate the cost of equity.
Ke=5%+1.3*(9%-5%)=10.2%
Cost of debt
The cost of debt is the interest that a company pay pays on its borrowing. For an item
to be classified as debt it has to meet these three criteria

 It has to give rise to the contractual commitments that has to be meet in good
and bad times
 The commitment is usually tax deductible
 Failure to make the commitment can cost the company control over the
business
The after tax effect of debt
Cost of debt=Rd (1-t)

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A company has a pre-tax cost of debt at 7.13% if the tax rate is at 40%.What is the
effective cost of debt?
Rd=7.13%
Tc=40%
Cost of debt=0.017(1-0.40) =0.0428
Effective cost of debt is 4.28%
The higher the tax rate the higher the tax savings for the company paying interest
Example 2
Suppose a company with 35% income tax issues a bond with 5% stated rate ,the after
tax cost of the bond would be calculated as follows
Cost of debt=Rd (1-t)
0.05(1-0.35) =3.25%
To calculate the annual cost of debt, multiply the after tax interest rate of the debt by
the principle amount of the debt
For example, suppose the principle value of a loan is K100 000 and the adjusted after
tax interest rate is 3% the annual cost of debt will be?
0.03*100 000=3000
Calculating the average cost of debt
If a company had total debt of 100 000.This was divided into 25 000 loan and 75 000
worth of bonds with 3% and 6% after tax cost of debt respectively
Your average cost of debt would be calculated by multiplying cost of debt for the
loan by the share
Average cost of debt =0.25*3%+0.75*6%=5.25%
After tax adjusted interest rate and the company interest rate

 If a company does not disclose the pre-tax interest rate of the loan, but you
need the information, you can still calculate pre-tax cost of debt .For example
suppose a company with 40% tax rate issued a k100 000 bond with an after-tax
cost of debt of K3000
 Express the tax rate as a decimal using the equation 40/100=0.40 and then
subtract the tax rate from 1 (1-0.40) =0.60

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 Calculate the pre-tax cost of debt by the result. Use the equation
3000/0.6=5000
Valuing Fixed interest bonds
Redeemable bonds have several interest payments plus repayment of interest and
are calculated as follows
Po=I/ (1+Kd)¹+I/ (1+Kd) ²+…I+RV/ (1+Kd) ⁿ
I-Interest payment
RV-Redemption value of the principal
Kd=Cost of debt capital
The Portfolio Theory
In 1952 Harry Markowitz presented a paper on modern portfolio theory. His findings
greatly changed the asset management theory.
There are two main concepts in modern portfolio which are
 Any investors goal is to maximise return for any level of risk
 Risk can be reduced by creating a diversified portfolio of unrelated assets
Maximise Return-Minimise Risk
Return is considered to be the appreciation of any asset in stock price and also any
capital inflows such as dividends. Standard deviation is a fair measure of risk as
investors look wants a steady increase on their investments than big swings which
might possibly end up as losses.
Risk is evaluated as the range by which an assets price will on average vary known as
standard deviation.
If an asset has 10% deviation from the mean and an average expected return of 8%
you may observe returns of between -2% and 18%.
In a practical application of Markowitz Portfolio Theory let’s assume there are two
portfolios of assets both with an average return of 10%
Portfolio A has a risk of 8% and portfolio B has a risk of 12%.Both portfolios have the
same return, any investor will choose to invest in portfolio A as it has the same
expected return as B but with a lower risk.

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It is important to understand risk as there would be no expected rewards without it.
Investors are compensated for risk and in theory the higher the risk the higher the
return.
As portfolio B has a higher risk, it may obtain a return of 22%, but it can also
experience a return of -2%.
All things being equal it is still preferable to hold the portfolio that has an expected
range of returns of 2% and 18%, as this is most likely to help you reach your financial
goal.
Diversified Portfolio
Risk as seen above is a welcome factor when investing as it allows us to rip rewards
for taking up possibility of diverse outcomes.
Modern portfolio theory however states that a mixture of diverse assets will
significantly reduce the overall risk of a portfolio.
Assets that are unrelated will also have unrelated risk. This concept is defined as
correlation. If two assets are very similar, then their prices will move in a very similar
pattern. Two assets from the same industry are likely to be affected by the same
macroeconomic factors
This lack of correlation is what helps a diversified portfolio of assets have a lower
risk,measured by standard deviation than the simple sum of the risk of each asset.
Capital structure
Capital structure refers to the way in which an organisation is financed, by a
combination of long term capital (shares, loans convertible loans) and short term
liabilities such as bank overdrafts

Modigliani Miller Theory


MM proposition 1 & 2
Modigliani and Miller (MM)

 Proposition 1:The value of the firm


 Proposition 2:The Wacc

Both propositions are looked at from two points of view capital structure with taxes
and with no taxes

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Both of the proposition use extremely restrictive assumptions
These notions are held in perfect markets

 No taxes
 No transaction cost
 No financial distress
 Many buyers and sellers
 Free entry and exit
Proposition 1: (No taxes) the value of a firm
Capital structure Irrelevance
 The value of the firm is unaffected by its capital structure
 Leveraged firm and unlevered firm have the same value
 Notation: VL=VU
Proposition 2: (No taxes) Wacc unaffected by leverage
 Cost of equity increases linearly as a company increases its proportion of debt
financing
 Wacc affected by capital structure
Both propositions 1 and 2 show that in a world with no taxes the value of a firm for a
levered firm is the same as that of unlevered firm
In addition the Wacc is unaffected by leverage
Next to consider: With taxes and the impact of taxes
MM Proposition 1 with taxes

 Debt creates tax shield


 Debt interest payments are tax deductible
 Tax increases the size of the pie
 As such VL=VU + (Tax rate *value of debt)
 Optimal capital structure=100% debt
 Of course using 100% debt is not practical in the real world because of the risk
of bankruptcy and financial distress
Cost of Financial Distress

 These are costs incurred when a company has trouble paying fixed cost
(interest)

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 These can be direct cost associated with bankruptcy expenses and indirect cost
for example loss of customer trust.

Probability of Financial Distress

 Higher operating or financial leverage leads to higher probability of financial


distress
 Better corporate governance lowers the probability of financial distress

Static Trade-off Theory

 Think tax shield plus cost of financial distress


 At some point the value added by tax shield is exceeded by value reducing cost
of financial distress
 This is the point of optimal capital structure
Actual Verses Optimal Capital structure
 Target capital structure =optimal capital structure
 However ,capital structure may deviate from optimal
 Exploit opportunities in specific financing source (e. g cheap equity)
 Market value fluctuations

Role of debt rating


 The lower the debt rating the higher credit risk
Cost of capital tied to debt rating

 Managers try to maintain certain debt rating in order to minimise the cost of
capital
 An increase in debt rating will lower cost of debt and cost of capital
Factors to consider when evaluating capital structure

 Changes in capital structure overtime


 Capital structure of competitors with similar business risk
 Agency cost, higher quality of corporate governance means lower agency cost
and less debt.

Managing foreign Exchange Risk

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What is Foreign Exchange Risk?
For companies that sell their goods and services internationally and get paid in
foreign currency, foreign exchange risk is the likely hood that a change in exchange
rates will result into a company receiving a lower amount of cash flows for its
international operations than originally anticipated. For local Zambian companies
that import and pay their foreign suppliers in foreign currency, it is the likely hood
that a change in exchange rates will mean that the company has to pay more than
planned
This form of foreign exchange exposure, which impacts the cash flow of a company,
is what is referred to as transaction exposure
Managing foreign exchange risk successfully can bring about a lot of benefits
including:

 Minimise the effects of exchange rates movements on profit margins


 Increase the predictability of future cash flows
 Eliminate the need to accurately forecast the future direction of exchange rate
 Facilitate the pricing of products in export markets

Managing Foreign Exchange Risk


 Hedging is important due to the size of the potential losses from adverse
interest and exchange rates
 Interest rate risk depends on interest rate volatility, gearing and floating rate
exposure
 Exchange rate risk arises from exchange rate volatility and the volume of
foreign currency based trade
 Transaction risk is the risk that the home currency value of foreign currency
transaction may change due to foreign exchange risk
 Caused by exchange rate changes between transaction date and settlement
date
 Transaction risk is cash flow exposure
 Receipts of 22 000Euros is equal to 19 573 pounds at 1.24 Euro/Pound but only
18 212 pounds at 1.208 Euro/Pound in three months’ time.

Future contracts

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 Futures are exchange traded contracts to buy and sell a standard quantity of
financial instruments or foreign currency at an agreed price on an agreed date
 Company taking out futures contracts places initial margins with clearing house
 Contracts are marked to market so variation margins may be needed to meet
losses
Hedging exchange rate risk using US futures
 UK exporters hedge against rising exchange rates by buying currency futures to
guarantee delivery of foreign currency
 UK importers hedge against falling exchange rates by selling currency futures
to guarantee sale of foreign currency
 Future positions closed out by opposite trade
Example of hedging using currency futures
 Company A hedges $300 000 receipt due in 3 months by buying US currency
Futures
 Sterling future prices:$1.535
 Translate exposure at future price:
$ 300000/1.535=195 440 pounds
 Number of contracts =195 440 pounds/62 500 =3.13 so buy 3 currency futures
(under hedge)
 Initial margin :62 500 *1.535*0.03=$2878
 Assume that exchange rate moves to $1.555
Gain =200 ticks*6.25=$1250
 Company A margin account gains $1250,while counterparty has call for
variation margin for same amount

Advantages of future contracts

 Returns marked to market


 Readily tradable
 Prices are transparent
 No upfront premium
Disadvantages

 Imperfect hedge due to over-under-hedging


 Cannot take advantage of favourable rates
Options

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 Gives the holder the right but not the obligation to borrow or lend at a given
rate, or to buy and sell foreign currency at a given rate
 Option premium is paid when the option is bought
 Over the counter options are sold by banks and are tailored to customers’
needs
 Traded options are bought and sold in financial markets
Example of hedging using options

 A company expects the exchange rate to rise so buys sterling US call options to
hedge receipt 0f $1m due in 3 months
 Spot:$1.65 option strike price is $1.65
 Cost of option is 7 cents per pound of contract
 Contract size is 62 500 pounds
 Translate exposure at option strike price:$1000 000/1.65=606 061 pounds
 Number of contract size 606061/62500==9.7 so buy 10 call option\
 Company has over hedged
 Premium :10*62500*0.07=$43 750
 Worst outcome is to exchange dollars at a rate of 1.65+0.07=$1.72/pound
giving 581 395 pounds
 If spot rate on expiry is less than $1.65/pound the company will use spot and
let option elapse
Factors affecting traded option prices
Strike price: Higher strike price for put will reduce their cost

 Changes in rates: depreciation of pound against US dollar increases value of


US pound call option
 Time to expiry: The longer the time to expiry ,the higher the option time value
Advantages of traded option

 Holder has option but not obligation


 Standardised and tradable ,so contracts can be sold on or before expiry
Disadvantages of traded options
Imperfect hedges due to standardised nature of exchange traded contracts

 Cost ,since option premium must be paid


Swaps
General definition of Swap

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 An exchange of one stream of future cash flows for another stream of future
cash flows with different characteristics
 Swaps are used extensively by banks and companies for hedging interest rate
risk and foreign exchange risk over long time periods
 Banks intermediate by warehousing swaps until counterparty is found

Types of currency Swaps

 Fixed rate currency swap also known as vanilla currency swap


 Fixed rate –floating rate currency swap involves an interest rate swap as well
as the swap agreement above
 Floating rate-floating rate currency swap are similar to fixed –floating rate
swap described in the next example
Example of a currency swap
 UK airline buys a new aeroplane, paid for in US$
 Purchase financed with fixed interest dollar loan from US bank
 Airline income is primarily in sterling and it wants to hedge its dollar interest
payment and the dollar loan repayment using a swap
Advantages of Swaps
 Can hedge interest rate and exchange rate exposure for long periods of time
 Arrangements are at a lower fee than options
 Offer flexibility in duration and principal since tailored to company needs
 Allows access to restricted markets
 Can alter currency of expected cash flows,whether income or expenditure

Disadvantages of swaps

 Swaps locks a company into agreed rates so cannot take advantage of


favourable rate changes
 Counterparty risks exists, as legal liability for interest payments stays with loan
signatory
 Company exposed to interest and exchange rate risk if counterparty defaults.

Business Valuation Methods


Businesses need to be valued for a number of reasons such as

 Repurchase and sell


 Obtaining a listing
 For inheritance tax and capital gains tax allowances
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Generally most valuations difficulties are restricted to unlisted companies
because listed companies have their shares quoted on the stock market.
Whenever a company is bought, what the owners go away with depends on
the business.
 The majority shareholders who have about 80% share in the company would
end up with the share of their earnings plus a share of the assets of the
company
 The minority shareholders go away with their dividend and a share of usually
less than 20% of the company assets
In this context we are going to look at three main valuation methods which are:

 Asset-based valuation method


 Income based valuation method
 Cash-flow based valuation methods
Asset-based valuation
Here the business is valued as being worth the value of its net assets .There are three
ways of valuing a company’s these are
 The book value method: This is one way of valuing net asset but the setback it
has is that it uses historical figures and relatively arbitrary depreciation .These
amount can therefore be irrelevant to both the buyer and the seller ,in
addition even current assets may be difficulty to value as inventory figures may
need adjustments too
 Net realisable value minus the company’s liabilities: This amount represents
what the business would remain with if all of its assets were sold and all its
liabilities were settled. However if the business is sold successfully, the
shareholders would demand more as a company is worth more than its net
assets. A company has intangible assets such as a chain of good clients, a good
brand and goodwill which all add value to the value of a company being sold
 Replacement values: This involves valuing a company as though it were being
started now and finding the cost of the new company. The value of successful
business using the replacement method is expected to be lower than its value
unless a good estimate is made on goodwill and intangible assets like the good
brand the company has established. In addition estimating the replacement
cost of variety of assets of different ages

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000 000 000 000
Non-Current 1000 +700-200 1500
Assets
Current Assets
Inventory 500 -100 400
Receivables 300 -50 250
Cash 400 1200 400 1050
2200 2550
Share capital 400 400
Reserves 900 1150
1300 1550
400 400
500 +100 600
2200 2550

Additional information
In the balance sheet non-current assets contain land and building valued at K700 000
above their book value. Plant and machinery would sell for K200 000 less their book
value. Inventory would sell for K400 000 and only K250 000 would be realised from
account receivables and closure cost would add up to a K100 000.

The minimum amount that the shareholders should accept is K1550 000 the amount
of the shareholders equity plus reserves after revaluation (or alternatively K2500
000-400 000-600 000)

Income based approach

This method relies on finding listed companies in similar businesses to the company
being valued (the target company) and looking at the relationship they show
between the share price and the earnings and using that relationship as a model, the
share price of the target company can be estimated.
The price earnings ratio (P/E)
The price earnings ratio is the price per share divided by the earnings per share and
shows how many years’ worth of earnings are paid for in the share price.

54
Let’s say that the market price of a small chain of Zambian based grocery shop has to
be estimated. The company has just enjoyed post tax earnings of K200 000 out of
which it paid K50 000 of dividends
The first task is to identify three Zambian companies in the grocery business then
look at their published characteristics

Supermarket P/E ratio


Spar 10.8
Shoprite 9.9
Pick and Pay 10.0

Here all the P/E are similar, sometimes they are not even in the same sector
because one or more been distorted, for example a company’s market price might
be usually high because of bid speculations or its earnings might be low because of
onetime restructuring cost in the latest year financial statements.
It is also important to look closely at listed companies range of activities as often
large companies have an element of diversification for example Pick and Pay is
regarded as a Zambian supermarket chain, but approximately one third of its revenue
are earned overseas and the importance to the company for selling clothes, electrical
good and financial services is growing rapidly.

The average P/E for selected companies is calculated and in this case its 10.2 and this
represents the relationship that quoted companies are showing between their
earnings per share and their price per share.

Remember 10.2 means that anyone who buys a share is buying it 10.2 times its
published earnings.

10.2*K200 000=K2 040 000

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Assuming that we are happy with a P/E of 10.2 and the earnings of K200 000.Then
the calculated market value is K2 040 000 is the starting point for negotiations.

Cash flow based Valuation Method

This method involves finding the present value of free cash flows for the target firm
and then adding the present value of the terminal value.

A firm’s free cash flow is the actual amount of cash that a company has left from its
operations that would be used to pursue opportunities that enhance shareholders
value.
The free cash flow is derived from the operations of a company after subtracting
working capital, investments and taxes. Free cash flow is measured as follows
Earnings before interest and tax (EBIT)
Less tax on EBIT
Plus non-cash charges (e.g. depreciation)
Less capital expenditure
Less working capital increases
Plus working capital decreases
Plus salvage value received

Example of Free Cash flow Calculation


Timothy Inc. needs to invest K9000 to increase productivity capacity and also
increase working capital by K1000.Earnings before taxes are K90 000 and it sets
against tax of K6000 of depreciation. Profits Are taxed at 40%.What is the free cash
flow

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Solution
K
Earnings before interest and tax(EBIT) 90 000
Less taxes 36 000
Operating income after tax 54 000
Plus depreciation(Non cash item) 6 000
Less capital expenditure 9 000
Less changes to working capital 1 000
Free cash flow 50 000

The Terminal Value


The formula for the terminal value can be illustrated in the following example
Let’s assume that for a 5 year project the free cash inflows are as follows if the Wacc
is 9.5% and the terminal growth rate is 6.00%.What is the value of the target
company?
Year 1 922
Year 2 997
Year 3 1087
Year 4 1186
Year 5 1293

First find the present value of the cash inflow


Discounted cash flows are:
922/1.095¹+997/1.095²+1087/1.095 +1186/1.095⁴+1293/1.095⁵=K4145
The find the terminal value, we assume that the cash inflows will grow in perpetuity
at 6% per annual

Terminal value₅=FCF₅ (1+g )/Wacc-g


Terminal value₅ =1293(1+0.06)/ (0.095-0.06)=39,159

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Find the present value of the terminal value
Terminal value₀=39,159/1.095⁵=24 875
Next add the discounted free flows and the present value of the terminal value
4148+24 875=29023
The target value of this company is K29023 million and is the starting point for
negotiations

58
Bibliography
ACCA P4 Study Kit. (2016-2017).

Arnold, G. (2008). Corporate Financial Management,5th Edition,FT Prentice Hall.

Atrill P. (2008). Financial Management for Decision Makers,5th Edition,FT Prentice Hal.

Lehand, H. (1994). Corporate Debt Value,Bond Convenants,and Optimal Capital StructureJournal of Finance.

Marki-Mason, J. (1990). Do Taxes affect Corporate Financing Decions?Journal of Finance,45.

McLaney E.J. (2009). Business Theory and Practice,8th Edition.FT Prentice Hall.

Myers, S. (1984). Corporate Financing and Investment Decisions When Firms have Information That Investors
Do not Have,Journal of Financial Economics ,5.

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