CHAPTER 1

COST OF CAPITAL

1.1 The meaning of cost of capital

Cost of capital: is defined as the minimum rate of return that the corporation must earn in
order to satisfy the overall rate of return required by its investors.

1.2 The component of cost of capital

Each type of capital contained in a corporation’s capital structure- bonds, preferred stock,
common stock, and retained earnings have its own minimum required rate of return. The
costs of the capital vary from most expensive to least expensive in the following order:
 New common stock
 Preferred stock
 Debt
Common stock is most expensive because it has high risk and seeks highest return.
Moreover, it is last in case of dividend and asset distribution at a time of liquidation.
Preferred stock is low risky because it has a preferential right in dividend and asset
distribution at a time of liquidation. Debt is the least expensive cost of capital because
interest is tax deductible. Moreover, creditors have priority claim upon liquidation and
get interest before any dividend is paid to the owners.
Specific cost of capital is computed on an after tax basis and is expressed as annual
percentage. Cost of debt must be adjusted for taxes since interest charge are tax
deductible. The costs of other sources are paid from after tax cash flows. Thus, need not
adjustment for income taxes.
1.2.1 The Cost of Debt and Preferred stock
Cost of debt:
Yield to Maturity: is the bond’s expected rate of return assuming no default and the
bond is held to maturity. It is the compound rate of return an investor will receive from a
bond purchased at the current market price and held to maturity. The yield to maturity is
the periodic interest rate that equates the present value of the expected future cash flows
(both coupons and maturity value) to be received on the bond to the initial investment in
the bond, which is its current price.
The yield to maturity is calculated through try and error process or approximate yield
formula. The trial and error approach involves finding the value of bonds at various rates
until the rate causing the calculated bond value to equal its current value is found. The
approximate yield formula is as follows:

Approximate yield (kd) = I + (Pn-Npd)

n .
Pn+Npd
2
Where, kd= effective before tax cost of a new bond issue
I= annual interest payment in birr
Pn= par or principal repayment required in n periods
Npd= net proceeds from the sale of the bond
N= length of the holding period of the bond in years

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The net proceeds (Npd) from the sale of each bond can be calculated as follows:
Npd= Pd-F, where Pd is the market price of the bond
F is flotation cost
Flotation costs are any costs associated with selling new securities such as sales
commission paid to those selling securities, cost of printing, advertising, and registration
with government agencies, under pricing or discount offered to induce investors to buy
securities.
The relevant cost of debt is the after tax cost of new debt.
Kdt= kd(1-T),
Where, Kdt is firms after tax cost of debt.
Kd is effective before tax cost of debt
T is tax rate

Example,
XYZ Company plans to issue 25 year bonds. Each bond has a par value of birr 1000 and
carries a coupon rate ( i.e the interest rate paid on the bond’s par value) of 9.5%. The
company marginal tax rate is 34%. Assume the following independent cases:
A. The bond sold at par with no flotation costs.
B. The bond is expected to sell for 98% of par value and flotation costs are
estimated to be birr 26 per bond.
C. The bond is expected to sell 104% of par value and flotation costs are
anticipated to be birr 26.
Required: Under each of the above three cases calculate
1. Net proceeds per bond
2. The before tax cost of this bond
3. The after tax cost of this bond
Solution:
Pn= Par value= birr 1000
Coupon rate =9.5%
Tax rate=34%
n =25 years
Case A
1. net proceeds per bond(Npd)
bond sold at par and no floation costs. Therefore, Pd (the market price of the bond)= the
par itself(Pn)
Npd=Pd-F
1000-0 =1000. Note that Pn= Npd=Pd, if there is no floation cost and sold at par
2. Before tax cost of the bond
(kd)= I + (Pn-Npd) I = 9.5%x1000=95 birr and it same
for the three cases.
n . Kd=95+(1000-1000)
Pn+Npd . 25 .
2 1000+1000
2
= 95/1000=9.5%

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 3. After tax cost of the bond
Kdt= Kd(1-T)= 9.5%(1-0.34)=6.27%

Case B
1. net proceeds per bond(Npd)
Pd (market price of bond) =Bond sold at 98%of par value =98%x1000=980 and flotation
costs per bond is 26 birr. Therefore, Npd= Pd-f= 980-26=954

2. before tax cost of the bond

(kd)= I + (Pn-Npd) I = 9.5%x1000=95 birr and it same
for the three cases.
n . Kd=95+(1000-954)
Pn+Npd . 25 .
2 1000+954
2
= 9.91%
3. after tax cost of the bond
Kdt= Kd(1-T)= 9.91%(1-0.34)=6.54%

Case C
1. Net proceeds per bond (Npd)
Pd (market price of bond) =Bond sold at 104%of par value =104%x1000=1040 and
flotation costs per bond is 26 birr. Therefore, Npd= Pd-f= 1040-26=1014
2. before tax cost of the bond
(kd)= I + (Pn-Npd) I = 9.5%x1000=95 birr and it same for the three cases.
n . Kd=95+(1000-1014)
Pn+Npd . 25 .
2 1000+1014
2
= 9.38%
3. after tax cost of the bond
Kdt= Kd(1-T)= 9.38%(1-0.34)=6.19%

Cost of Preferred stock

The specific cost of capital of preferred stock is computed by dividing the value of one
yearly dividend payment by the net proceeds per share to the corporation.

Kp= Dp
Npp
Where, Kp= cost of preferred stock
Dp= Annual dividend per share
Npp=net proceeds from the sale of preferred stock
That is Npp= Pp-f where, Pp is the market price of preferred stock and f is flotation costs

Example, ABC company plans to sell preferred stock for its par value of birr 25 per
share. The company pays 6 percent of par value as a selling cost. The issuer is expected

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to pay quarterly dividends of birr 0.60 per share. Calculate the cost of the preferred stock
to ABC.
Solution:
Po=25 birr. F= 6 %( 25) =1.5 birr. Npp= Po-f, 25-1.5=23.5
Quarterly dividend=0.60. Annual dividend=4x0.60=2.40 birr
Kp= Dp 2.40
Npp 23.5 =10.21%

1.2.2 Cost of Common stock

The specific cost of capital of common stock is the minimum rate of return that the
corporation must earn for its common shareholders in order to maintain the market value
of the firm’s equity. In this case, the assumption is dividends are assumed to grow at a
constant rate each year for indefinite period of time. The specific cost of capital of
common stock is computed as follows:
Ks= D1 + g
Npd
Where, Ks= cost of common stock
Do= Dividend of current year
g= Dividend growth rate
Npd= Net proceeds

Example, XYZ company issued common stock at birr 20 per share. The company incurs
a selling expense of 1.50 per share. The current dividend is birr 1.70 per share and is
expected to grow at a 7 percent annual rate.
Required: compute the cost of capital of this common stock.
Solution:
Npd= Po-f= 20-1.50=18.50
D1=Do(1+g)=1.7(1.07)=1.819

Ks= 1.819 +0.07

18.5
=0.0983+0.07=0.1683
=16.83%

1.2.3 Cost of Retained Earnings

Retained earnings are not securities like stocks and bonds; therefore, it doesn’t have
market prices that can be used to compute cost of capital. Retained earnings represent
profits available to common stockholders that the corporation chooses to reinvest in it
rather than pay out as dividends. Thus, the shareholders expect the corporation to earn a
rate of return on these funds at least equal to the rate or earned on the outstanding
common stock. Therefore, cost of capital of retained earning is equal to cost of capital of
common stock. There is an opportunity cost in retained profits in the business. This
opportunity cost represents the minimum rate of return that the firm’s stockholders could
earn an alternative investment of comparable risk.
Example,
In the above example, the company’s cost of capital of common stock was 16.83%. The
specific cost of capital of retained earnings for the given data is
Npd=Po=20, because there is no flotation cost for retained earnings.
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D1=1.819
g= 7%
Therefore, Kr= 1.819 +0.07
20
=0.09095+0.07=0.16095=16.09%
Strictly speaking, cost of retained earning is exactly equal to cost of common stock when
there is no flotation cost.

1.3 The Meaning and use of weighted Average Cost of Capital (WACC)

Measuring the weighted average cost of capital (WACC)

Once the specific cost of capital of each permanent or long term financing source is
measured, the firm’ weighted average cost of capital can be determined. The weighted
average cost of capital is also called the overall or composite cost of capital.

Ko= wd.kd+wp.kp+ws.ks+wr.kr
Where wd, wp, ws, and wr are weight of Debt, P/stock, C/stock
and retained earnings, respectively.
Kd, kp, ks, and kr are after tax of debt, p/stock, c/stock and retained
earnings, respectively.

As long as common stock of capital is constant proportion, the cost of common stock and
retained earnings is always the same. But the cost of capital of common stock and
retained earning differ when there is a flotation cost. There are two major weighted
schemes used in computing the WACC. These are:
1. Historical weight
2. Target weights
1. Historical weights: historical weights are based on a firm’s existing capital structure.
There are two types of historical weighs. These are:
i. Book value weight
ii. Market value weights

i) Book value weights: measure the actual proportion of each type of permanent capital
in the firm’s capital structure base on accounting values shown on the firm’s balance
sheet.
Example 1,
Suppose a corporation has book value of each type of capital in the capital structure as
follows:

Source of capital Book value Specific cost

Bonds (1000 par, 9.5% coupon) 15,000,000 6%
Preferred stock (200,000 shares at birr 25par) 5,000,000 10%
Common stock (1,000,000 shares at birr 20 par) 20,000,000 13.5%
Retained earnings 10,000,000 13%
Total 50,000,000
Required: Compute the WACC for the corporation if the corporation obtains new capital
in book value proportions.
Solutions:
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Source of capital Book value weight Specific cost Weighted cost
Bonds 0.3 0.06 0.018
Preferred stock 0.1 0.10 0.010
Common stock 0.4 0.135 0.054
Retained earnings 0.2 0.13 0.026
Weighted average cost of capital (ko) 0.108=10.8%

Market value weights

Market value weights measure the actual proportion of each type of permanent capital in
the firm structure at current market prices. The resulting cost of capital reflects the rates
of return currently required by investor rather than the historical rates embodied in the
firm’s balance sheet.

Example 2,
Take the above example and the following current market prices.
Bonds issued at 98% of par value (i.e 98% x1000=980)
Preferred stock issued at birr 25 per share
Common stock issued at birr 45 per share
Required: compute the WACC for the corporation if the corporation obtains new capital
in market values.
Solution:
Source Number of shares Market price Market value
Bonds 15,000 980 14,700,000
Preferred stock 200,000 25 5,000,000
Common stock 1,000,000 45 45,000,000
Total 64,700,000
Note: retained earnings do not have a separate market value because their value is
included in the common stock. Thus, to compute WACC, the common stocks market
value of birr 45,000,000 should divide between common stock and retained earnings in
proportion to the sum of their book values.
Sources Book values
Common stock 20,000,000
Retained earnings 10,000,000
The ratio of common stock: Retained earnings
20,000,000: 10,000,000
2:1
Therefore, common stock = 2/3x 45,000,000=30,000,000

Source Market value weight cost of capital weighted cost

Bonds 14,700,000 0.227 0.06 0.0136
Preferred stock 5,000,000 0.007 0.1 0.0077
Common stock 30,000,000 0.464 0.135 0.6260
Retained earnings 15,000,000 0.232 0.13 0.0301
WACC =0.114
Therefore, Ko=11.4%

Advantage of using book value

1. The weighted average cost of capital is easy to compute.

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 2. The computed cost of capital is generally stable over time because book value
weights are not dependent on market prices.
3. When market prices of the corporation’s securities are being influenced
substantially because of external factors such as inflation and business cycles,
book value weighted average cost of capital.
Limitation of using book value
1. It provide historical weighted average cost of capital that may not yields a cost of
capital value that is useful for evaluating current strategies.
2. Its use is not consistent with the concept contained in the definition of a
corporation’s overall cost of capital. That definition speaks of a minimum rate of
return needed to maintain the firm’s market value, but book value weights ignore
market values.
Advantages of using market value:
1. Its use is consistent with the concept of maintaining market values in the cost of
capital definition.
2. It provides current estimates of investor required rates of return, which are more
relevant than historical book value weights.
Limitation of using market value
1. they are more difficult to use in computing cost of capital than book value weights
2. the market prices of stocks change daily

ii) Target weights: target weight are based on a firm’ desired capital structure. Firms
using target weights establish these proportions on the basis of optimal capital structure
they wish to achieve consequently, the firm raises additional funds so as to remain
constantly on target with its optimal capital structure.
Example,
In addition to the data provided in the previous examples, the corporation has determined
that ist optimal capital structure is 40 % bonds, 10% preferred stock and 50% common
equity( i. e both common stock and retained earnings). The firm expects to have
sufficient retained earnings so that it can use the cost of retained earnings as the common
equity cost component. If the corporation raises new capital in target proportion, what
would be its WACC?
Ko= wd.kd+wp.kp+ws.ks+wr.kr
=(0.4)(0.06)+(0.1)(0.1)+(0.5)(0.13)
=0.099=9.9%

CHAPTER 2
CAPITAL STRUCTURE POLICY AND LEVERAGE

The capital structure question

It is a question of how should a firm go about choosing its debt/equity ratio. Is there an
optimum capital structure that maximizes firm’s value? Capital structure and cost of
capital relationships. The value of the firm is maximized when the WACC is minimized.
WACC is the discount rate that is appropriate for the firm’s overall cash flows and values
and discount rate move in opposite directions, minimizing the WACC will maximize the
value of the firm’s cash flows.

Business and Financial risk

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Business risk is defined as the equity risk that comes from the nature of the firm’s
operating activities. Business risk depends on the systematic risk of the firm’s asset. The
greater a firm’s business risk, the greater R A will be, and, all other things the same, the
greater the will be its cost of equity.

There are two kinds of leverage in finance: operating leverage and financial leverage
Operating leverage.
Operating leverage refers to magnifying gains and losses in earnings before interest and
taxes (EBIT) by changes that occur in sales. This magnification occurs because in
employing assets the firm incurs certain fixed costs, costs unrelated to the sales volume
created by the assets. Operating costs can be divided into variable and fixed costs. As
sales changes, variable costs change proportionally. This means the variable cost ratio to
sales is constant. This is true over some relevant range of sales. Variable cost includes
material, direct labor, repair and maintenance expenses. Fixed operating costs are
independent of sales level in the short run and over the relevant sales range. In the long
run all costs are variable. Fixed costs include depreciation, indirect labor cost, overhead
costs.
Degree of Operating Leverage (DOL)
Degree of operating leverage is computed as:

DOL= %ΔEBIT
%Output where, EBIT is earning before interest and tax
Or
=1+ F
EBIT where, F is fixed operating cost
Or
DOL at base sales level Q = Q(P-V)
Q(P-V)-F where, Q is quantity, P is price ,
V is variable cost and F is fixed cost

Example,
P= 10 birr
V= 4 birr
F= 30,000 birr
Level of out put (Q) is 8,000 and increase to 10,000 units.
Required:
Determine DOL?
Solution:
EBIT= Q(P-V)-F
=8000(10-4)-30,000 = 18,000
EBIT= 10,000(10-4)-30,000=30,000
Percentage change in EBIT= (30,000-18,000)/18,000=66.67%
Percentage change in out puts = (10,000-8,000)/8,000=25%
DOL= %ΔEBIT
%Output
66.67%/25%=2.67
or
1+ F

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 EBIT
1+ 30,000/18,000=2.67
or
= Q(P-V)
Q(P-V)-F
=8,000(10-4)
8,000(10-4)-30,000
=2.67

The coefficient of operating leverage of 2.67 is interpreted as a 1% change in out put

form the current base levels, there will be a 2.67% change in EBIT in the same direction
as the out put (sales) change. If out put (sales) increase by 10%, EBIT will increase by
26.7% (10x 2.67%). Similarly, if out put (sales) decrease by 10%, EBIT will decrease by
26.7%. Other things equal, the higher the fixed costs relative to variable costs, the higher
the operating leverage.
Example,
AA firm has a base level of 150,000 units of sales. The sales price per unit is $10.00 and
variable costs per unit are $6.50. Total annual operating fixed costs are $155,000, and the
annual interest expense is $90,000. What is this firm’s degree of operating leverage
(DOL)?
Solution
DOL = Q(P-V) = 150,000(10-6.50)
Q(P-V)-F 150,000(10-6.50)-150,000
=1.4

Breakeven analysis:
The sales level that corresponds with a zero EBIT level is called the break-even sales
level.
EBIT= SALES- VARIABLE COST- FIXED COST
0 =P.Q-V.Q-FC
0 = Q(P-V)-FC
Q(P-V) = FC
Q = FC
P-V
Example,
P = 10
V=4
FC = 90,000
Required: Determine operating break even in units and sales?
Q = FC
P-V
= 90,000/(10-4) = 15,000 units. Sales = 10x 15,000 =150,000
Note that the coefficient of operating leverage at operating break even has undefined
value.
Example,
Compute EBIT and coefficient of operating leverage when Q is 10,000 units?
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Solution:
EBIT= Q(P-V)-F = 10,000 (10-4)- 90,000= (30,000)
DOL = Q(P-V) = 10,000(10-4)
Q(P-V)-F 10,000(10-4)-90,000
=2
or
DOL =1+ F = 1 + 90,000
EBIT (30,000)
1-3= 2
Note: -Technically, the formula for DOL should include absolute value signs because it is
possible to get a negative DOL when the EBIT for the base sales level is negative. Since
we assume that the EBIT for the base level of sales is positive, the absolute value signs
are not included.
- Because the concept of leverage is linear, positive and negative changes of equal
magnitude
Break even analysis limitation:
1. There is a narrow range of sales over which expects fixed costs to be actually
fixed.
3. It is only helpful when there is linear relationship among variable, EBIT and
sales.

Financial risk and financial leverage

Financial Leverage
Operating leverage refers to the fact that a lower ratio of variable cost per unit to price
per unit causes profit to vary more with a change in the level of output than it would if
this ratio was higher. Financial leverage refers to the fact that a higher ratio of debt to
equity causes profitability to vary more when earnings on assets changes than it would if
this ratio was lower. Obviously, the profits of a business with a high degree of both kinds
of leverage vary more, everything else remaining the same, than do those of businesses
with less operating and financial leverage. Greater variability of profits, of course, means
risk is higher. Therefore, in deciding what the optimum level of leverage is, what is an
acceptable risk/return tradeoff must be determined

Financial leverage is created by financing with sources of capital that have fixed costs.
The major sources of fixed charges financing are debt (requiring interest payment) and
preferred stock require dividend payment and leases which require lease payments. These
financing fixed costs affect the firm’s earning per share (EPS) in the same way that
operating fixed costs affect EBIT. The more fixed charge financing the firm uses, the
more financial leverage it will have.

Degree of Financial leverage:

Degree of financial leverage is defined as the percentage change in EPS divided by the
percentage change in EBIT.
DFL = %Δ in EPS
%Δ in EBIT
Where, EPS is earning per share

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 EPS = (EBIT-I) (1-T)-D
N
Where, N is number of common stock outstanding shares.

Or
DFL = EBIT
EBIT-I-L-D/(1-T)
Where, I is interest payment
L is lease payment
D is dividend payment
T is tax rate

Unlike interest and lease payments, preferred dividends are not tax deductible. Therefore,
dividend payment has to be adjusted by dividing with (1-T) to make it on equivalent
basis.
Example,
A firm has a base level of 500,000 units of sales and increase to 600,000 units. The sales
price per unit is $10.00 and variable costs per unit are $6.50. Total annual operating fixed
costs are $1,250,000, and the annual interest expense is $100,000. The firm paid 80,000
for preferred stock holders and has 60,000 outstanding shares of common stock. The firm
tax rate is 40%.
1. What is the firm’ earning per share?
2. What is the firm’s degree of financial leverage (DFL)?
Solution:
1. EPS = (EBIT-I) (1-T)-D
N
EBIT = 500,000(10-6.50)-1,250,000=500,000
EPS = (500,000-100,000) (1-0.4)-80,000
60,000
=2.67
If sales increases from 500,000 to 600,000 units the resulting EBIT and EPS is:
EBIT = 600,000(10-6.50)-1,250,000=850,000
EPS = (850,000-100,000) (1-0.4)-80,000
60,000
=6.16
DFL = %Δ in EPS
%Δ in EBIT

= (6.16-2.67)/2.67
(850,000-500,000)/500,000
=1.307/0.7= 1.87

or
DFL = EBIT
EBIT-I-L-D/(1-T)
= . 500,000 .
500,000-100,000- 80,000/(1-0.4)
=1.87

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Financial break even
It is defined as the value of EBIT that makes EPS equal to zero. At financial break even,
the firm’s EBIT is just sufficient to cover its fixed financing costs (interest and preferred
Stock dividends) on a before tax basis leaving no earnings for common shareholders.
(EBIT-I)(1-T)-D= EPS
N
(EBIT-I)(1-T)-D= 0 (EBIT-I)(1-T)-D = 0
N EBIT-I = D
(1-T)

EBIT= D +I
(1-T)

2.3.3 Combined leverage

It is defined as the potential use of fixed costs, both operating and financial, to magnify
the effect of changes in sales on the firm’s earnings per shares (EPS). It is a combination
of operating and financial leverage. Combined leverage measures the relationship
between output and EPS.
Degree of combined leverage ( DCL) = %Δ in EPS
%Δ in output
or The DCL is the product of DOL times DFL. That is:
DCL = DOL X DFL
or
DCL = DOL X DFL
or
= Q (P-V) x EBIT
Q (P-V)-F EBIT-I-L-D/(1-T)
= Q (P-V)
Q (P-V)-F-I-L-D/ (1-T)

Example,
A firm has a base level of 15,000 units of sales and increase to 16,500 units. The sales
price per unit is $50.00 and variable costs per unit are $30. Total annual operating fixed
costs are $150,000, and the annual interest expense is $40,000. The firm paid 20,000 for
preferred stock holders and has 10,000 outstanding shares of common stock. The firm tax
rate is 40%.
1. What is the firm’ earning per share at an output level of 15,000 and 16,500 units?
2. What is the firm’s EBIT, Degree of operating leverage (DOL) and degree of financial
leverage at output level of 15,000 (DFL)?
3. What is the firm’s Degree of combined leverage( DCL)?
Solution:
. EPS = (EBIT-I) (1-T)-D
N
EBIT = 15,000(50-30)-150,000=150,000
EPS = (150,000-40,000) (1-0.4)-20,000
10,000
=4.6
if output increased to 16,500 units, EPS increase to:

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EPS = (EBIT-I) (1-T)-D
N
EBIT = 16,500(50-30)-150,000=180,000
EPS = (180,000-40,000) (1-0.4)-20,000
10,000
=6.4
DCL = %Δ in EPS
%Δ in output

= (6.4-4.6)/4.6
(16,500-15,000)/15,000
=3.91

DOL =1+ F = 1 + 150,000

EBIT 150,000
1+1= 2

DFL = EBIT
EBIT-I-L-D/(1-T)
= . 150,000 .
150,000-40,000- 20,000/(1-0.4)
=1.957
Therefore, DCL = DOL X DFL
=2 x 1.957
=3.91
Note: the firm’s DCL describes the effect that sales changes will have on EPS. However,
we must be careful to realize the approximate nature of this calculation. If the anticipated
sales change is beyond the relevant range of sales describe earlier, the variable cost ratio
may change, and if the time period is too long, fixed costs may change.

Overall breakeven
It is defined as the level of output that makes EPS equal to zero.
EPS = (EBIT-I) (1-T)-D
N
0 =[Q(P-V)-F – I)] (1-T)- D
N
Q = I + F+ D/ (1-T)
P- V
Example,
A firm has a base level of 15,000 units of sales. The sales price per unit is $50.00 and
variable costs per unit are $30. Total annual operating fixed costs are $150,000, and the
annual interest expense is $40,000. The firm paid 20,000 for preferred stock holders and
has 10,000 outstanding shares of common stock. The firm tax rate is 40%.
1. What is the overall breakeven unit?
Solution:
Q = I + F+ D/ (1-T)
P- V
= 40,000 + 150,000 + 20,000/(1-0.4)

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 (50-30)
= 11,167 units
Financial leverage and Capital structure
Optimal capital structure is the capital structure that minimizes the firm’s weighted
average cost of capital and maximizes the value of the firm to its investors. If the firm
currently has an optimal capital structure, it will finance new investments by a financing
mix approximately like the current mix. If the current capital structure is not optima, the
firm should finance new asset in such a manner that the capital structure will be moved
toward the optimal position.

Effect of Financial leverage on EPS

Example,
Suppose, a new firm, ABC Company, is just now considering financing plans. The firm
needs birr 100,000 of long term capital to begin operations and has narrowed the choice
to two financing plans:
Alternative 1: sell 1,000 shares of common stock at birr 100 per share.
Alternative 2: sell 500 shares of common stock at birr 100 per share and borrow birr
50,000 from the bank at 5% interest.
Alternative 1 is an all equity plan. The company’s long term debt to equity ratio would be
zero. Alternative 2 involves the sales of equal amounts of debt and equity, and the firm’s
long-term debt to equity ratio to be one. What effect would these plans have on ABC
EPS? It depends on the relationship between the before tax cost of debt and the rate of
return on assets before interest and taxes. Most firm’s EBIT influenced by general
economic conditions. If the economy is strong, EBIT will be favorable, and if the
economy is weak, EBIT will be unfavorable. ABC estimates that if the economy is weak,
EBIT will be 4,000; if the economy is about average, EBIT will be birr 6,000; and if the
economy is strong, EBIT will be birr 8,000. Theses estimates imply that ABC’s return on
asset before interest and tax (EBIT/ Total asset) will be 4%(4,000/100,000) in weak
economy, 6 percent in an average economy, and 8 percent in a strong economy. In
comparison, the before tax cost of debt is 5%.
Economic conditions:
Weak Average strong
Alternative 1: all equity financing( debt: equity ration=0)
EBIT 4,000 6,000 8,000
INTEREST 0 0 0
EBT 4,000 6,000 8,000
TAX(50%) 2,000 3,000 4,000
NI 2,000 3,000 4,000
NO OF SHARES COMMON 1,000 1,000 1,000
EPS 2 3 4

Alternative 2: 50%equity and 50% debt financing( debt: equity ration=1)

EBIT 4,000 6,000 8,000
INTEREST 2,500 2,500 2,500
EBT 1,500 3,500 5,500
TAX(50%) 750 1,750 2,750
NI 750 1,750 2,750
NO OF SHARES COMMON 500 500 500
EPS 1.5 3.5 5.5

14
Gebrie Worku, AAUCC, February 2010
Indifference point EBIT- EPS analysis:
The effect of financial leverage on EPS depends on the relationship between the before
tax cost of debt and the EBIT rate of return on assets.
In a weak economy, EPS is higher under the all equity alternative. But in either an
average or a strong economy, EPS pf alternative 2 is higher. Actually, alternative 2 will
result in higher EPS so long as EBIT/ TA are greater than the before tax cost of debt of
5%

Alternative 2

5
EPS 4 Alternative 1
3
2
1

0 1 2 3 4 5 6 7 8
EBIT( birr 000)
Figure 2.1
We can also algebraically solve for EBIT at the indifference point. By definition:
EPS = (EBIT-I) (1-T)-D
N
Alternative 1: EPS 1 = (EBIT-0) (1-0.5)-0 = 0.0005EBIT
1,000

Alternative 2: EPS 2 = (EBIT-2,500) (1-0.5)-0 = 0.0001EBIT-2.5

500
The indifference point is where the two EPS’ are equal.
0.0005EBIT = 0.0001EBIT-2.5
EBIT= 5,000birr

Effect of financial leverage on financial risk and expected EPS

In this section we relate expected EPS and financial risk to stock price. Let us assume
ABC’s EBIT outcomes are equally likely, and then the probability of each is one third.
EPS
EBIT Probability Alternative 1 Alternative 2
4,000 1/3 2 1.50
6,000 1/3 3 3.50
8,000 1/3 4 5.50
Required: compute expected EPS and standard deviation of each alternative.
Expected EPS = EPS x Probability
Alternative 1: expected EPS= 1/3 x 2 + 1/3x 3 + 1/3x 4 =3
Standard deviation= 1/3(2-3)2 + 1/3(3-3)2 + 1/3(4-3)2
=0.82
Alternative 2: expected EPS= 1/3 x 1.5 + 1/3x 3.50 + 1/3x 5.5 =3.50
Standard deviation= 1/3(1.5-3.5)2 + 1/3(3.5-3.5)2 + 1/3(5.5-3.5)2

15
Gebrie Worku, AAUCC, February 2010
 =1.63
When we see the two alternatives, note that there are two effects of financing with debt.
That is there are two effects of financial leverage:
1. Expected earnings per share increases
2. The standard deviation of earnings per share increases. These two conclusions
have important valuation implications. The firm’s ability to pay dividend is
directly related to its expected EPS. The greater the expected EPS, the greater the
firm’s future expected dividends will be.
Remark: increased financial leverage= increase expected EPS= increase standard
deviation= increase stock riskiness.

The theory of capital structure

There are two views regarding capital structure and firm value: the traditionalists’ view
and modernists’ view.
Traditionalists believe that as a firm moves from a position of zero debt to small amounts
of debt, leverage increases the equity holders’ risk but does not increase significantly the
risk born by debt holders. Traditionalist argued that because debt is cheaper, combining
equity with reasonable amounts of debt results a reduction in the firm’s overall cost of
capital, or rA.
Traditionalists believe that too much debt can be bad thing. Look at what happens to the
cost of debt and equity as debt levels go from low to high. First, the cost of debt, which
initially did not raise much, now starts to rise substantially as debt holders become highly
concerned about the firm’s ability to generate enough income to cover promised debt
payments. Second, at high debt levels, the cost of equity also rise quickly because equity
holders know that high amounts of debt are accompanied by high amounts of fixed
interest payment, increasing the chance that they as residual claimants will end up with
little or no return on their investment, thus, following the traditionalists’ argument, the
overall cost of capital of the firm begins to rise at high levels of debt
rE

Rate of return rA

rD

Optima amount of Debt

D*
Figure 2.2 Debt as percentage of Total asset
Figure 2.2 illustrates the traditionalists’ view on the effect of leverage on the expected
return of both the debt holder and the equity holder. The line rD represents the cost of
debt, the line rA is the expected rate of return on assets, and the line rE is the cost of
equity. D* is debt capacity, the range of debt that minimizes the firm’s cost of capital and
maximizes the firm value.
The modernists’ position on the use of debt and the value of the firm was established by
Franco Modigliani and Merton Miller in the late 1950s. The modernist position states
that, under ideal conditions, all capital structures produce the same total cost of capital to
the firm and the same total firm value. Modernists believe that the financing decision is
irrelevant.

16
Gebrie Worku, AAUCC, February 2010
 rE
Rate of return

rA
rD

Debt as percentage of Total asset

Figure 2.3
There is no dramatic point at which the cost of equity rapidly rises. The required rate of
return on equity rises less quickly when greater debt usage begins to transfer some of the
firm’s risk to the debt holders. The required return on equity (rE) begins to flatten out or
rise less steeply at higher levels of debt. This reflects the fact that as debt holders begin to
bear more and more risk, the increased risk borne by equity holders is reduced. With the
modernist view there is no optimum capital structure and firms do not have debt capacity.

Modigliani and Miller( M&M) Propositions I and II with no taxes

It is a famous argument advanced by two Nobel laureates, Franco Modigliani and Merton
Miller, whom we will hence forth call M&M.

A) M&M Proposition I: The Pie Model

Proposition I states that the value of the firm is independent of its capital structure. M&M
proposition I is to imagine two firms that are identical on the left hand side of balance
sheet. Their assets and operations are exactly the same. The right hand sides are different
because the two firms finance their operations differently. It can be view the capital
structure in pie model. As we can see in figure 2.4, two possible ways of cutting up the
pie between equity slice and debt slice 40%-60% and 60%-40%. However, the size of the
pie is the same for both firms because the value of the assets is the same. This is what
M&M Proposition I states: The size of the pie doesn’t depend on how it is sliced.

Value of firm Value of firm

Stock Stock
40% 60%

Bonds Bonds
60%
40%
Figure 2.4
B) M&M Proposition II: The Cost of Equity and Financial Leverage.
Although changing the capital structure of the firm may not change the firm’s total value,
it does cause important changes in the firm’s debt and equity. Let us see what happens to
a firm financed with debt and equity when the debt/equity ratio is changed.

17
Gebrie Worku, AAUCC, February 2010
M&M proposition II stated that weighted average cost of capital, WACC, is:

WACC= E/V x RE + D/V x RD

Where V= E + D
E= equity
D= debt
RE= cost of equity
RD= cost of debt
WACC is the required return on the firm’s overall assets and it is also labeled as RA
RA = E/V x RE + D/V x RD, if we arrange this to solve for the cost of equity capital
(RE):
RE = RA + (RA- RD) x (D/E)

M&M proposition stated that a firm’s cost of equity capital is a positive linear
function of its capital structure. The cost of equity depends on three things: the
required rate of return on the firm’s assets, RA, the firm’s cost of debt, RD, and the
firm’s debt/equity ration, D/E
RE

Cost of capital

WACC= RA

RD

Figure 2.5 Debt/Equity ratio (D/E)

As shown M&M proposition II indicates that the cost of equity, RE, is given by the
straight line with a slope of (RA-RD). The y-intercept corresponds to a firm with a
debt/equity ratio of zero, so RA=RE. As the firm raises its debt/equity ratio, the
increase in leverage raises the risk of the equity and therefore the required return or
cost of equity (RE). Notice that the WACC doesn’t depend on the debt/equity ratio;
it’s the same no matter what the debt/equity ratio is. The firm’s overall cost of capital
is unaffected by its capital structure. As illustrated in figure 2.5, the fact that the cost
of debt is lower than the cost of equity is exactly offset by the increase in the cost of
equity form borrowing. In other words, the change in the capital structure weights
(E/V and D/V) is exactly offset by the change in the cost of equity (RE), so the
WACC stays the same.

Example,
The RRR Corporation has a weighted average cost of capital (unadjusted) of 12
percent. It can borrow at 8 percent. Assume that RRR has a target capital structure of
80 percent equity and 20 percent debt.
Required:
1. What is its cost of equity?
2. What is the cost of equity if the target capital structure is 50 percent equity?
3. Calculate the unadjusted WACC using your answers to verify that it is the same

18
Gebrie Worku, AAUCC, February 2010
 Solution:
1. According to M&M proposition II,
RE = RA + (RA- RD) x (D/E)
=12% + (12%-8%) x (0.2/0.8)
=13%
2. RE = RA + (RA- RD) x (D/E)
=12% + (12%-8%) x (0.5/0.5)
=16%
3. The unadjusted WACC assuming that the percentage of equity financing is 80%
and the cost of equity is 13%:
WACC= E/V x RE + D/V x RD
= 0.8 x 13% + 0.2 x 8%
=12%
As we calculated, the WACC is 12 percent in both cases.
Exercise1
The FFF company, a major manufacturer of telephone switching equipment, has a
perpetual expected EBIT of birr 200. The interest rate is 12%.
Required:
1. Assuming that there are no taxes or other market imperfections, what is the value
of the company if its debt/equity ratio is 0.25 and its overall cost of capital is
16%? What is the value of the equity? What is the value of the debt?
2. What is the cost of equity capital for the company?
3. Suppose the corporate tax rate is 30%, there are no personal taxes or other
imperfections, and FFF Company has birr 400 in debt outstanding. If the
unlevered cost of equity is 20%, what is FFF’s value? What is the value of the
equity?
4. In question number 3, what is the overall cost of capital?
Solution
1. If there are no taxes, then MM proposition I holds and FFF’s capital structure is
irrelevant, so the value of the firm is (birr 200/0.16)= birr 1250.
If the debt/equity ratio is 0.25, then for every birr 5 in capital, there is birr 4 in
equity. Thus, FFF is 80% equity, and the value of the equity is birr 1000. The value
of the debt is birr 250
2. the cost of equity capital can be computed using MM Proposition II as:
RE = RA + (RA- RD) x (D/E)
=16% + (16%-12%) x 0.25
=17%
Alternatively, we can compute the equity cash flow as (birr 200-0.12(250)) = birr
170, and divide by the value of equity. Since the equity is worth birr 1000, the cost of
capital is (birr 170/1000) =0.17 =17%

3. We can use MM Proposition I with taxes to value FFF.

VL= VU + Tc x D
The value of FFF as an unlevered firm is:
EBIT (1-Tc)/ro= (birr 200 (1-0.3)/0.2= birr 700. The present value of the tax
shield is Tc x D= (0.3(400)) = birr 120. The total value of the levered is therefore
birr 820. The value of the equity is (birr 820- birr 400) = birr 420.
4. Using MM Proposition II with taxes, the cost of equity is:
RE= RU + (RU-RD) x D/E x (1-Tc)
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Gebrie Worku, AAUCC, February 2010
 =20%+ (20%-12%) x 400/420 x (1-0.3)
= 25.33%
Alternatively, the cash flow to equity is:
(Birr 200-0.12(birr400)) (1-0.3) = birr 106.40
Thus, the return on equity is (birr 106.40/ birr 420) = 0.2533 or 25.33%, as
previously calculated.
The over all cost of capital (WACC) is;
WACC= E/V x RE + D/V x RD (1-TC)
= (420/820) x 25.33% + (400/820) x 12% x (1-0.3) = 17.07%
Modigliani and Miller (M&M) Propositions I and II with taxes
Debt has two features. First, interest paid on debt is tax deductible. This is good for the
firm. Second, failure to meet debt obligations can result in bankruptcy. This is not good
for the firm, and it may be an added cost of debt financing. To see the effect of tax on
M&M Propositions let us consider two firms, Firm U (unlevered) and Firm L (levered).
These two firms are identical on the left hand side of the balance sheet, so their assets and
operations are the same. Assume that EBIT is expected to be birr 1000 every year forever
for both firms. The difference between them is that firm L has issued birr 1000 worth of
perpetual bonds on which it pays 8 percent interest each year. Also assume that the
corporation tax rate is 30%.
Firm U Firm L
EBIT birr 1,000 birr 1,000
Interest (8% x 1000) 0 80
EBT 1,000 920
Tax (30%) 300 276
NI 700 644

The interest tax shield

To simplify things, assume that depreciation is zero and that there is no additional capital
expenditure and net working capital. In this case, cash flow from assets is equal to EBIT-
Taxes. For firms U and L the cash flow from assets would be birr (1000-300=700) and
(1000-276=724), respectively. See that the capital structure is now having some effect
because the cash flows from U and L are not the same even though the two firms have
identical assets. The total cash flow to L is birr 24 more. This is because an interest
deductible for tax purposes has generated a tax saving equal to the interest payment
multiplied by the tax rate: 80 x 30% = birr 24. This is interest tax shield, a tax saving
attainted by a firm from interest expense.
A. Taxes and M&M Proposition I
Since the debt is perpetual, the same birr 24 shield will be generated every year forever.
The after tax cash flow to L will thus be the same birr 700 that U earns plus the birr 24
tax shield. Since L’s cash flow is always birr 24 greater, firm L is worth more than Firm
U by the value of this birr 24 perpetuity. Because the tax shield is generated by paying
interest, it has the same risk as the debt, and 8 percent (the cost of debt) is therefore the
appropriate discount rate. The value of the tax shield is thus:
PV= birr 24/0.08 = 0.3 x 1,000 x 0.08
0.08
= 0.3(1000) = 300
The present value of the interest tax shield can be written as:

PV = ( Tc x RD x D)
RD
PV = Tc x D 20
Gebrie Worku, AAUCC,
Where, February
Tc is tax rate, RD2010
is cost of debt and D is debt
We have now come up with another famous result, M&M Proposition I with taxes. We
have seen that the value of levered firm (V L) exceeds the value of unlevered firm (VU) by
the present value of the interest tax shield; Tc x D. M&M Proposition I with taxes
therefore states that:

VL = VU + TC x D
The effect of borrowing in this case is illustrated in figure 2.6. We have plotted the value
of the levered firm, VL, against the amount of debt, D. M&M relationship is given by a
straight line with a slope of TC and a y-intercept of V U. It is also drawn a horizontal line
representing VU. As indicated, the distance between the two lines is T c x D, the present
value of the tax shield.
Value
Of the
Firm VL = VU + TC x D

VL= 7300 TC x D

VU=7000 VU
VU

1000 Total Debt (D)

Figure 2.6

Suppose that the cost of the capital for the firm U is 10 percent (unlevered cost of capital,
RU = 10%). This is the cost of capital that the firm would have if it had no debt. Firm U’s
cash flow is birr 700 every year forever. The value of the unlevered firm, VU, is:

VU = EBIT x (1-TC)
RU

VU = 1000 x (1-0.3)
0.10
= 7,000
The value of the levered firm, VL, is:
VL = VU + TC x D
= 7,000 + 0.3 x 1,000
= 7,300
As indicated in figure 2.6, the value of the firm goes up by birr 0.30 for every 1 birr in
debt. It is difficult to imagine why any corporation would not borrow to the absolute
maximum under these circumstances. The result of the analysis in this section is that, if

21
Gebrie Worku, AAUCC, February 2010
tax is included, capital structure definitely matters. However, we reach the illogical
conclusion that the optimal capital structure is 100 percent debt

B. Taxes, the WACC, and Proposition II

The conclusion that the best capital structure is 100 percent debt also can be seen by
examining the weighted average cost of capital (WACC). If tax is considered, the WACC
is computed as:

WACC = E/V X RE + D/V X RD X (1-TC)

Where V = D + E

To calculate WACC, we need to know the cost of equity. M&M Proposition II with
corporate taxes states that the cost of equity is:

RE = RU + (RU – RD) X (D/E) X (1-TC)

To illustrate, recall that firm L is worth birr 7,300 total (total asset of the firm). Since the
debt is worth birr 1,000, the equity must be worth 7,300-1,000 =6,300 birr. For firm L,
the cost of equity is thus:
RE = RU + (RU – RD) X (D/E) X (1-TC)
= 10% + (0.1-0.08) x (1,000/6,300) x (1-0.30)
=10.22%
Therefore, the weighted average cost of capital is:
WACC = E/V X RE + D/V X RD X (1-TC)
= 6,300/7,300 x 10.22% + 1,000/7,300 x 8% x (1-0.3)
= 9.6%
With out debt, the WACC is 10 percent, and, with debt, it is 9.6 percent. Therefore, the
firm is better off with debt. As the WACC decrease the value of the firm increase.
The following figure summarizes the discussion concerning the relationship between the
cost of equity, the after tax cost of debt, and the weighted average cost of capital. For
comparison, the cost of capital for unlevered firm (R U) is included. In the figure 2.7 the
horizontal axis is represented by debt/equity ratio and notice that how the WACC

declines as the debt/equity ratio rises. This illustrates again that the more debt the firm
uses, the lower is its WACC.
RE

RE = 10.22 %

RU = 10% RU
WACC = 9.6%
WACC
RD X (1-TC)
=8%X(1-0.3 RD X (1-TC)
=5.6%

1000/6,300 = D/E D/E ratio

22
Gebrie Worku, AAUCC, February 2010
 Figure 2.7

Example,
You are given the following information for FAF Corporation:
EBIT = birr 151.52
Tc = 34%
D = birr 500
RU = 20%. The cost of debt capital is 10 percent. What is the value of FAF’s equity? What
is the cost of equity capital for FAF? What is the WACC?
Solution:
Remember that all the cash flows are perpetuities. The value of the firm if it had no debt,
VU, is:
VU = EBIT x (1-TC)
RU
= 151.52 (1-0.34)
0.20
= birr 500
From M&M Proposition I with taxes, we know that the value of the firm with debt is:
VL = VU + TC x D
= 500 + 0.34 x 500
= birr 670
Since the firm is worth birr 670 total and the debt is worth birr 500, the equity is worth
birr 170:
E = VL – D
= 670- 500 = 170
Thus, from M&M Proposition II with taxes, the cost of equity is:
RE = RU + (RU – RD) X (D/E) X (1-TC)
= 0.20 + (0.20-0.10) x (500/170) x (1-0.34)
= 39.4%
Finally, the WACC is:
WACC = E/V X RE + D/V X RD X (1-TC)
= (170/670) x 39.4% + (500/670) x 10% x (1-0.34)
= 14.92%
Notice that this is substantially lower than the cost of capital for the firm with no debt
(RU = 20%), so debt financing is highly advantageous.

Modigliani and Miller Summary

I. The No tax case
A. Proposition I: The value of the firm levered (VL) is equal to the value of the
firm unlevered(VU):
VL=VU
Implication of Proposition I:
1. a firm’s capital structure is irrelevant
2. a firm’s weighted average cost of capital(WACC) is the same no matter what
mixture of debt and equity is used to finance the firm
B. Proposition II: The cost of equity, RE, is:
RE=RA+ (RA-RD)x D/E
Where RA is the WACC, RD is the cost of debt, and D/E is the debt/equity
Ratio.
23
Gebrie Worku, AAUCC, February 2010
 Implication of Proposition II:
1. the cost of equity rises as the firm increases its use of debt financing
2. the risk of the equity depends on two things: the riskiness of the firm’s operations
( business risk) and the degree of financial leverage ( financial risk)
II. The tax case
A. Proposition I with taxes: The value of the firm levered (VL) is equal to the
value of the firm unlevered(VU) plus the present value of the interest tax
shield:
VL= VU + Tc x D
Where Tc is the corporate tax rate and D is the amount of debt.
Implication of Proposition I:
1. Debt financing is highly advantageous, and, in the extreme, a firm’s optimal
capital structure is 100 percent debt.
2. a firm’s weighted average cost of capital (WACC) decreases as the firm relies
more heavily on debt financing
B. Proposition II with taxes: the cost of equity, RE, is

RE= RU + (RU-RD) x D/E x (1-Tc)

Where RU is the unlevered cost of capital, that is, the cost of capital for
the firm if it had no debt. Unlike Proposition I, the general implications

Bankruptcy Costs
One limit to the amount of debt a firm might use comes in the form of bankruptcy costs.
As the debt/equity ratio rises, so too does the probability that the firm will be unable to
pay its bondholders what was promised to them. When this happens, ownership of the
firm’s assets is ultimately transferred form the stockholders to the bondholders.
In principle, a firm is bankrupt when the value of its assets equals the value of its debt.
When this occurs, the value of equity is zero and the stockholders turn over control of the
firm to the bondholders. In a perfect world, there are no costs associated with this transfer
of ownership, and the bondholders don’t lose anything. This idealized view of bankruptcy
is not, of course, what happens in the real world. It is expensive to go bankrupt. The costs
associated with bankruptcy may eventually offset the tax related gains from leverage.
Bankruptcy cost can be: direct bankruptcy cost and indirect bankruptcy costs.

Direct bankruptcy costs:

When the value of a firm’s asset equals the value of its debt, then the firm is
economically bankrupt in the sense that the equity has no value. However, the formal
means of turning over the assets to the bondholders is a legal process, not an economic
one. There is a saying bankruptcies are to lawyers what blood is to sharks. The costs that
are directly associated with bankruptcy, such as legal and administrative expense is called
direct bankruptcy cost. These direct bankruptcy costs are a disincentive to debt financing.
If a firm goes bankrupt, then, suddenly, a piece of the firm disappears. This amounts to a
bankruptcy tax Borrowing saves a firm’s money on its corporate taxes, but the more a
firm borrows, the more likely it is that the firm will become bankrupt and have to pay the
bankruptcy tax

Indirect bankruptcy costs:

When a firm is having significant problems in meeting its debt obligation, it is said to be
experiencing financial distress. Some financial distressed firms ultimately file for

24
Gebrie Worku, AAUCC, February 2010
bankruptcy, but most do not because they are able to recover or otherwise survive. The
costs of avoiding a bankruptcy filing incurred by a financially distressed firm are called
indirect bankruptcy costs. The direct and indirect costs associated with going bankrupt or
experiencing financial distress is called financial distress costs.
Example, the value of the firm lose value because management is busy trying to avoid
bankruptcy instead of running the business, normal operations are disrupted, and sales are
lost, valuable employees leave, potential fruitful programs are dropped to preserve cash

Optimal Capital structure

A firm will borrow because the interest tax shield is valuable. At relatively low debt
levels, the probability of bankruptcy and financial distress is low, and the benefit form
debt outweighs the cost. At very high debt levels, the possibility of financial distress is a
chronic, ongoing problem for the firm, so the benefit form debt financing may be more
than offset by the financial distress costs. Therefore, the optimal capital structure exists
somewhere in between these extremes.

The static theory of Capital structure.

The theory that a firm borrows up to the point where the tax benefit form an extra birr in
debt is exactly equal to the cost that come form the increased probability of financial
distress. The theory is said to be static because it assumes that the firm is fixed in terms
of its assets and operations and it only considers possible changes in the debt/equity ratio.
The static theory is illustrated in figure 2.8 below, which plots the value of the firm, V L,
against the amount of debt, D. In the figure there are three different propositions:
1. M&M proposition I with no taxes (horizontal line extending from VU)
2. M&M Proposition I with corporate taxes ( Upward sloping straight line
3. static theory ( the value of the firm rises to a maximum and then declines
beyond that point.

Value of the firm

Present value of tax

Shield on debt

Financial distress cost

Maximum firm value
V L*
Actual firm value

VU= value of firm with no debt

D*
Optimal amount of debt
Figure 2.8 the static theory of capital structure, the optimal capital structure
and the value of the firm.

25
Gebrie Worku, AAUCC, February 2010
According to the static theory, the gain form the tax shield on debt is offset by financial
distress costs. An optimal capital structure exist just balance the additional gain from
leverage against the added financial distress cost.
The static theory of capital structure, the optimal capital structure and the cost of capital
is illustrated as follows:
Cost of capital RE

RU
RU WACC
WACC RD x (1-TC)

D*/E* Debt/ Equity ratio

Figure 2.9 The optimal debt/equity ratio
According to the static theory, the WACC falls initially because of the tax advantage to
debt. Beyond the point D*/E*, it begins to rise because of financial distress costs.

Note that the difference between the value of the firm in static theory and the M&M
value of the firm with taxes is the loss in value from the possibility of financial distress.
Also the difference between the static theory value of the firm and the M&M value with
taxes is the gain from leverage, net of distress costs.

Optimal Capital structure and the cost of Capital

The capital structure that maximizes the value of the firm is also the one that minimizes
the cost of capital. Figure 2.9 illustrates the static theory of capital structure in terms of
the weighted average cost of capital and the costs of debt and equity. The WACC
declines at first because the after tax cost of debt is cheaper than equity, so, at least
initially, the overall cost of capital declines. At some point, the cost of debt begins to rise
and the fact that debt is cheaper than equity is more than offset by the financial distress
costs. At this point, further increases in debt actually increase the WACC.

The static model that we described is not capable of identifying a precise optimal capital
structure, but it does point out two of the more relevant factors: taxes and financial
distress. We can draw some limited conclusions concerning these.
Taxes. The tax benefit from leverage is obviously only important to firms that are in a
tax paying position. Firms with substantially accumulated losses will get little value from
the interest tax shield. Furthermore, firms that have substantial tax shield from other
sources, such as depreciation, will get less benefit from leverage. Also, not all firms have
the same tax rate. The higher the tax rate, the greater the incentive to borrow.
Financial distress: firms with a greater risk of experiencing financial distress will
borrow less than firms with a lower risk of financial distress. A firm with mostly tangible
assets that can be sold without great loss in value will have an incentive to borrow more.
For firms that rely heavily on intangibles, such as employee talent or growth
opportunities, debt will be less attractive since these effectively cannot be sold.

Signaling theory

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Gebrie Worku, AAUCC, February 2010
Managers may not be able to disclose their information to the firm’s stockholders for a
variety of reasons:
 The information may be valuable to the firm’s competitors.
 Firms run the risk of being sued by investors if they make forecasts that later turn
out to be inaccurate.
 Managers may prefer not to disclose unfavorable information
 The information may be difficult to quantify or substantiate.
If direct disclosures provide imperfect and incomplete information, then investors will
incorporate indirect evidence into their evaluations. Investors will attempt to make sense
of the information content that observable on management decision. This information
revealing decision is called signals. In many instances, an indirect signal can provide
more credible information than a direct disclosure. As it is often said, “Action speaks
louder than words.”
A distinction must be made between management decisions that create value and
decisions that simply signal or convey favorable information to shareholders. In many
cases, value creating decisions signal unfavorable information and result in stock price
declines, and value destroying decisions signal favorable information and result in stock
price increases. For example, a corporation decision to cut its dividend would be
considered value creating if the cash savings were used for positive net present value
investment. However, the dividend cut might signal unfavorable information about the
firm’s ability to generate cash from its existing operations.
The debt- equity choice conveys information to investors for two reasons. First, because
of financial distress costs, managers will avoid increasing a firm’s leverage ratio if they
have information indicating that the firm could have future financial difficulties. Hence, a
debt issue can be viewed as a signal that managers are confident about the firm’s ability
to repay the debt. The second reason has to do with the reluctance of managers to issue
what they believe are under priced shares. Hence, an equity issue might be viewed as a
signal that the firm’s shares are not under priced and therefore may be over priced.
An increase in a firm’s debt ratio is considered a favorable signal because it indicates that
managers believe the firm will be generating taxable earnings in the future and that they
are not overly concerned about incurring financial distress costs. Managers understand
that their firm’s stock price is likely to respond favorably to higher leverage ratios and
may thus have an incentive to select higher leverage ratios than they would otherwise
prefer.
The amount of debt financing a firm must use to credibly signal a high value depends on
its manager’s incentive to increase the firm’s current stock price. To understand this,
consider two chief executive officers, Mahlet and Rebcca. Mahlet, who plans to retire
soon and sell her holdings of her firm’s stock, has a strong incentive to temporarily
increase her firm’s stock price. Rebcca, on the other hand, plans to stay on as CEO for 10
years at her firm. She also is interested in boosting her firm’s current share price, but she
is much more concerned about the firm’s long term success and, in addition, is worried
about losing her jobs if the firm has trouble meeting future interest payments.
The interpretation of the signal offered by a leverage increase depends on whether the
firm one is choosing at is run by a CEO like Mahlet or a CEO like Rebcca. When Rebcca
increases her firm’s leverage, investors will infer that she is confident that the firm will
be able to generate the cash flows to pay back the debt. They understand that she has little
incentive to give a false signal, and she has a lot to lose if the firm subsequently fails to
make the required interest payments. Investors are likely to react much differently to a
leverage increase initiated by Mahlet. They understand that Mahlet has a strong incentive

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Gebrie Worku, AAUCC, February 2010
to appear optimistic, even when she isn’t, and that the cost to her of over leveraging her
firm is not substantial. Hence, an equivalent leverage increase will result in a lower stock
price response to the leverage signal for Mahlet’s firm than for Rebcca’s.

On average, stock prices react favorably to:

 Announcements that firm will be distributing cash to shareholders.
 Announcements that firms will increase their leverage
Stock prices react negatively, on average, to:
 Announcements that firm will be raising cash
 Announcements that firms will decrease their leverage.

Asymmetric information
Asymmetric information results when managers of a firm have more information about
operations and future prospects than do investors. Assuming that managers make
decisions with the goal of maximizing the wealth of existing stockholders, then
asymmetric information can affect the capital structure decisions that managers make.
Suppose, for example, that management has found a valuable investment that will require
additional financing. Management believes that the prospect for the firm’s future is very
good and that the market does not fully appreciate the firm’s value. The firm’s current
stock price is low given management’s knowledge of the firm’s prospects. It would be
more advantageous to current stockholders if management raised the required funds using
debt rather issuing new stock. Such an action by management is viewed as signal that
reflects its view with respect to the firm’s stock value. In this case the use of debt
financing is a positive signal suggesting that management believes that the stock is
“under valued.” If, instead, new stock was issued, when the firm’s positive future outlook
became known to the market, the increased value would be shared with new stockholders
rather than fully captured by existing owners.
If however, the outlook for the firm is poor, management bay believe that the firm’s stock
is overvalued; then it would be in the best interest of existing stockholders for the firm to
issue new stock. Therefore, investors of then interpret the announcement of a stock issued
as a negative signal – bad news concerning concerning the firm’s prospects and the stock
price declines.

i. Using debt financing to constrain managers

The managers of firms typically act as agents of the owners. The owners hire the
managers and give them the authority to manage the firm for the owners’ benefit. The
agency problem created by this relationship is also extend by owners and creditors. When
a lender provides funds to a firm, the interest rate charged is based on the lender’s
assessment of the firm’s risk. The lender – borrower relationship, therefore depends on
the lenders expectations for the firm’s subsequent behavior. If unconstrained, this
arrangement creates incentives for the firm to increase its risk without increasing current
borrowing costs. The borrowing rate is, in effect, locked in when the loans are negotiated.
After obtaining a loan at a certain rate from a bank or through the sale of bonds, the firm
could increase its risk by investing in risky projects or by incurring additional debt. Such
action could weaken the lender’s position in terms of its claim on the cash flow of the
firm. From another point of vie, if these risky investment strategies paid off, the
stockholders would benefit, since their payment obligations to the lender remain
unchanged; the excess cash flows generated by a positive outcome from the riskier action
would enhance the value of the firm to its owners. In other words, if the risky investments

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Gebrie Worku, AAUCC, February 2010
pay off, the owners receive all the benefits, but if the risky investments do not pay off, the
lenders share in the costs.
Clearly, an incentive exists for the managers acting on behalf of the stockholders to “take
advantage” of lenders. To avoid this type of situation, lenders impose certain monitoring
and controlling techniques on borrowers, who, as a result, incur agency cost. The most
obvious strategy is to deny subsequent loan requests or to increase the cost of future loans
to the firm. Lenders typically protect themselves by including provisions that limit the
firm’s ability to significantly alter its business or financial risk. These loan provisions
tend to center on issues such as the level of net working capital, asset acquisitions,
executive salaries, and dividend payments. By including appropriate provisions in the
loan agreement, the lender can both monitor and control the firm’s risk. The lender thus
can protect itself against the adverse consequences of this agency problem and assure
itself adequate compensation for risk. Of course, in exchange for incurring agency costs
by agreeing to the operating and financial constraints placed on it by the loan provisions,
the firm and its owners should benefit by obtaining funds at a lower cost.

CHAPTER 4
DIVIDEND AND DIVIDEND POLICY
Cash Dividends and Dividend Payment
The term dividend usually refers to payment made out of a firm’s earnings to its owners,
either in the form of cash or stock. If a payment is made from sources other than current
or accumulated retained earnings, the term distribution rather than dividend is used.
However, it is acceptable to refer to a distribution from earnings as a dividend and a
distribution from capital as a liquidating dividend.
Dividends can be
A. Cash dividend form
B. Stock dividend form
The basic types of cash dividends are:
1. Regular cash dividends
2. Extra dividends
3. Special dividends
4. Liquidating dividends
The most common type of dividend is a cash dividend. Regular cash dividend is cash
payment made by a firm to its owners in the normal course of business, usually made
four times a year. Cash dividend payment reduces corporate cash and retained earnings,
except in case of liquidating dividend where paid in capital may be reduced.
Commonly, the amount of the cash dividend is expressed in terms of the birr per share
(dividend per share). It is also expressed as a percentage of the market price (the dividend
yield) or as a percentage of earnings per share (the dividend payout).

Dividend payment: A chronology

The terminologies on dividend payments are illustrated with the following example:
Thursday Wednesday Friday Monday
January January January February
15 28 30 16
Declaration date Ex- dividend date Record date Payment date

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Gebrie Worku, AAUCC, February 2010
 1. Declaration date: is date on which the board of directors passes a resolution to
pay a dividend.
Example, on January 15, the board of directors passes a resolution to pay a dividend
of birr 1 per share on February 16 to all holders of record as of January 30.
2. Ex- dividend date: is date four business days before the date of record,
establishing those individuals entitled to a dividend. To make sure that dividend
checks go to the right people, brokerage firms and stock exchanges establish an
ex- dividend date. If you buy the stock before this date, then you are entitled to
the dividend. If you buy on this date or after, then the previous owner will get it.
Example, Wednesday, January 28, is the ex-dividend date. Before this date, the stock
is said to trade “with dividend” or “cum dividend.” Afterwards, the stock trades “ ex
dividend.” The ex- dividend date convention removes any ambiguity about who is
entitled to the dividend. Since the dividend is valuable, the stock price will be
affected when it goes “ex.”

3. Date of record: is date on which holders of record are designated to receive a

dividend. Based on its records, the corporation prepares a list on January 30 of all
individuals believed to be stockholders as of this date.
4. Date of payment: is date that the dividend checks are mailed to shareholders of
record.
Example, the dividend checks are mailed on February 16.

Ex-dividend and stock price

What happens to the stock price when it goes ex, meaning the ex-dividend date arrive?
Example, suppose there is a stock that sells for birr 10 per share. The BOD declares a
dividend of birr 1 per share, and the record date is Tuesday, June 12. The ex-date will be
two businesses (not calendar) days earlier, on Friday, June 8.
If you buy the stock on Thursday, June 7, right as the market closes, you will get the birr
1 dividend because the stock is trading cum dividend. If you wait and buy the stock right
as the market opens on Friday, you will not get the birr 1 dividend. What will happen to
the value of the stock overnight?
If you thing about it, the stock is obviously worth about birr 1 less on Friday morning, so
its price will drop by this amount between close of business on Thursday and the Friday
opening. In general, we expect that the value of a share of stock will go down by about
the dividend amount when the stock goes ex dividend. The stock price will be 10-1 = birr
9 on the ex date.
Does Dividend Policy matter?
The question in dividend policy is whether the firm should payout cash now or invests
the cash and pays it out later. Dividend policy, therefore, is the time pattern of dividend
payout.

An illustration that Dividend Policy is irrelevant

An argument can be made that dividend policy does not matter. It is illustrated as
follows. WWW Corporation is an all equity firm that has existed for 10 years. The
current financial managers plan to dissolve the firm in two years. The total cash flows
that the firm will generate, including the proceeds from liquidation, are birr 10,000 in
each of the next two years.

Current Policy: Dividends set equal to cash flow.

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Gebrie Worku, AAUCC, February 2010
At the present time, dividends at each date are equal to the cash flow of birr 10,000.
There are 100 shares outstanding, so the dividend per share will be birr 100. As we have
discussed in valuation chapter earlier, the value of the stock is equal to the present value
of the future dividends. Assuming a 10 percent required return, the value of a share of
stock today, Po, is:

Po = D1 + D2
(1+r) 1 (1+r) 2
= 100 + 100
1.1 (1.1)2
=173.55
The firm as a whole is thus worth 100 x 173.55 = 17,355
Several members of the board of WWW have expressesed dissatisfaction with the current
dividend policy and have asked you to analyze an alternative policy.

Alternative Policy: Initial Dividend is greater than Cash flow.

Another policy is for the firm to pay a dividend of birr 110 per share on the first date,
which is, of course, a total dividend of birr 11,000. Because the cash flow is only birr
10,000, an extra birr 1,000 must somehow be raised. One way to do it is to issue birr
1000 of bonds or stock at date 1. Assume that stock is issued. The new stockholders will
desire enough cash flow at date 2 so that they earn the required 10 percent return on their
date 1 investment. What is the value of the firm with this new dividend policy? The new
stockholders invest birr 1000. They require a 10 percent return, so they will demand birr
1000 x 1.10 = birr 1,100 of the date2 cash flow, leaving only birr 8,900 to the old
stockholders. The dividends to the old stockholders will be:
Date 1 Date 2
Aggregate dividends to old stockholders Birr 11,000 Birr 8,900
Dividend per share 110 89
The present value of the dividends per share is therefore:
Po = D1 + D2
(1+r) 1 (1+r) 2
= 110 + 89
1.1 (1.1)2
=173.55
This is the same value we had before. The value of the stock is not affected by this switch
in dividend policy even though we had to sell some new stock just to finance the
dividend. In fact, no matter what pattern of dividend payout the firm chooses, the value of
the stock will always be the same. In other words, dividend policy makes no difference.
The reason is any increase in a dividend at some point in time is exactly offset by a
decrease somewhere else, so the net effect, once we account for time value, is zero.

Implications of this example:

 The time patterns of dividends should not matter as long as the investor is fairly
compensated through the return on equity.
 The assumptions required for the results to hold include:
1. markets are perfect and frictionless
2. future investments and cash flows are known with perfect certainity

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Gebrie Worku, AAUCC, February 2010
 3. the investments policy is fixed and is not affected by changed in dividend
policy.
4. no taxes

Home made Dividends and Arbitrage

It is the idea that individual investors can undo corporate dividend policy by reinvesting
dividends or selling shares of stock. The argument is that shareholders will not pay more
for a firm if the shareholder can either replicate or undo the dividend decision.
For example, assume that the firm will pay $110 at t=1 and $89 at t=2. If Investor A
wants $100 in both t=1 and t=2, Can she undo the firm's decision to achieve her desired
consumption? Yes, She can simply reinvest the extra $10 in the company's stock and
receive $89 plus $11 at the end of t=2.
Alternatively, if the firm decides to pay $100 in both t=1 and
t=2 and Investor B desires consumption of $110 in t=1 and $89in t=2, She can simply sell
$10 worth of shares at t=1 and therefore, be out $11 worth of dividends at t=2.

Factors influencing dividend policy

The example used to illustrate the irrelevance of dividend policy ignored taxes and
flotation costs. These factors might lead us to prefer a low dividend payout.

A. Factors favoring a low dividend policy.

1. Taxes
Dividends received are taxed as ordinary income. Capital gains are taxed in much the
same way, but the tax on a capital gain is deferred until the stock is sold. This makes the
effective tax rate much lower because the present value of the tax is less.
A firm that adopts a low dividend payout will reinvest the money instead of paying it out.
This reinvestment increases the value of the firm and of the equity. All other things being
equal, the net effect is that the capital gains are taxed favorably may lead us to prefer a
low dividend policy.
Example,
Suppose all shareholders are in the 28% tax bracket and have a choice between investing
in Firm G which pays no dividend or Firm D that does pay a dividend. Firm G’s stock is
currently birr 100 and has a 20% return on equity. Assume that the investor does not sell
the shares and the capital gain is untaxed. Therefore, the value of the share one year form
now should from now should be birr 120. (100(1.2) =120). On the other hand, Firm D
pays a birr 20 dividend. What’s the value of each of these shares?
Solution:
If markets are efficient, then firms that are equally risky must have the same after tax
value.
Let re = required return on equity
Tg = capital gain tax rate = 0%
Td = Tax rate on dividend income = 28%
Tc = corporate tax rate = 0%, not used in this example
Assume that firm D’s stock will be birr 100 next year after the birr 20 dividend is
paid.
100 + 20 (1-0. 28)
P0 = ______________________
1.20
= birr 95.33

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Gebrie Worku, AAUCC, February 2010
What we see is that firm D is worth less because of its dividend policy.
The difference between the price of Firm D's stock and Firm G's stock is simply the
present value of the taxes that must be paid by the investor, which is ((0.28 x 20)/1.2 =
4.67)
Corporate Taxes
The correct dividend policy depends upon the individual tax rate and the corporate tax
rate. Previously, we ignored the effect of corporate taxation on dividend policy. For
illustrative purposes, suppose a firm has extra cash after all positive NPV projects have
been undertaken.
Example: The Regional Electric Company has $1000 of extra cash (after tax).
It can retain the cash and invest it in T-bills yielding 10% or it can pay the cash to
shareholders as a dividend. Shareholders can also put the money in T-bills with the same
yield. The corporate tax rate is 34% and the individual rate is 28%. What is the amount of
cash that investors will have after 5 years under each of the following scenarios:
Options:
a. Pay dividends
b. Retain the cash for investment in the firm
Solution:
a. Pay dividends
Shareholders receive in 5 years:
$1000 (1 -0.28) (1 + 0.072)5 = birr1,019.31
(0.072 is individual’s after tax return)

b. Retain the cash for investment in the firm

The company retains the cash and invests in T-bills and pays out the proceeds 5 years
from now. (Individuals pay the taxes at the end)
Shareholders receive in 5 years:
$1000 (1 +0.066)5 (1 - .28) = birr 991.188
(0.066 is corporation’s after tax return)
In this case, dividends will be greater after taxes if the firm pays tem now. The reason is
that the firm simply cannot invest as profitability as the shareholders can on their own
( on after tax basis.)
This example shows that for a firm with extra cash, the dividend payout decision will
depend on personal and corporate tax rates.

Conclusions on taxes:
 Pay low (no) dividends if corporate rate is less than the individual rate.
 Pay high dividends (higher tax benefit) when the individual rate is less
than the corporate rate.

2. Flotation costs
In the example used to shoe dividend policy doesn’t matter, we saw that the firm could
sell some new stock if necessary to pay dividend. However, selling new stock can be very
expensive. If we include flotation costs in the argument, then we will find that the value
of the stock decreases if we sell new stock
3. Dividend restrictions
In some cases, a corporation may face restrictions on its ability to pay dividends. A
corporation may be prohibited by law from paying dividends if the dividend amount
exceeds the firm’s retained earnings.
B. Factors favoring a high dividend policy.
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Gebrie Worku, AAUCC, February 2010
In this section, we consider reasons why a firm might pay its shareholders higher
dividends even if it means the firm must issue more shares of stock to finance the
dividend payments.
1. Desire for current income
In the world of no transaction cost it is argued that an individual preferring high current
cash flow but holding low dividend securities could easily sell off shares to provide the
necessary funds. Similarly, an individual desiring a low current cash flow but holding
high dividend securities could just reinvest the dividends. However, in real world the
current income argument have relevance. Here the sale of low dividend stocks would
involve brokerage fees and other transaction costs. Such a sale might also trigger capital
gain taxes. Therefore, these direct cash expense could be avoided by an investment in
high dividend securities.
2. Tax and legal benefits from high dividends
Earlier we saw that dividends were taxed unfavorably for individual investors. This fact
is a powerful argument for a low payout. However, there are also a number of other
investors who do not receive unfavorable tax treatment from holding high dividend yield,
rather than low dividend yield, securities.
3. corporate investors
a significant tax break on dividends occurs when a corporation own stock in another
corporation. A corporate stockholder receiving either common or preferred dividends is
granted a 70% or more dividend exclusion. Since the 70% exclusion does not apply to
capital gains, this group is taxed unfavorably on capital gains. As a result of the dividend
exclusion, high dividend, low capital gains stocks may be more appropriate for
corporations to hold. This tax advantage of dividends also leads some corporations to
hold high yielding stocks instead of long term bonds because there is no similar tax
exclusion of interest payments to corporate bondholders.
4. tax- exempt investors
Large institutions such as pension funds, endowment funds, and trust funds favor high
dividends because of:
- Institutions such as pension and trust funds are often set up to manage money for
the benefit of others. The managers of such institutions haf a fiduciary
responsibility to invest the money prudently. It has been considered imprudent in
courts of law to buy stock in companies with no established dividend record.
- Institutions such as university endowment funds are frequently prohibited from
spending any of the principal. Such institutions might therefore prefer high
dividend yield stocks so they have some ability to spend.
Overall, individual investors may have a desire for current income and may thus be
willing to pay the dividend tax. In addition, some very large investors such as
corporations and tax free institutions may have a very strong preference for high dividend
payouts.
Clientele effects: A resolution of real world factors?
In earlier discussion, we saw that some groups (eg, wealthy individuals) prefer low pay
out( or zero payout) stocks. Other groups (eg, corporation) prefer high payout stocks.
Companies with high payouts will thus attract one group, and low payout companies will
attract another. These different groups are called clienteles. The clientele effect argument
states that different groups of investors desire different levels of dividends. When a firm
chooses a particular dividend policy, the only effect is to attract a particular clientele. If a
firm changes its dividend policy, then it just attracts a different clientele.

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Gebrie Worku, AAUCC, February 2010
Example, suppose 40% of all investors prefer high dividends, but only 20% of firms pay
high dividends. Here the high dividend firms will be in short supply; thus, their stock
prices will rise. Consequently, low dividend firms will find it advantageous to switch
policies until 40% of all firms have high payouts. At this point, the dividend market is in
equilibrium. Further changes in dividend policy are pointless because all of the clienteles
are satisfied
Establishing a Dividend Policy
1. Residual Dividend Approach
It is a dividend policy under which a firm pays dividends only after meeting its
investment needs while maintaining a desired debt-equity ratio. With a residual dividend
policy, the firm’s objective is to meet its investment needs and maintain its desired debt-
equity ratio before paying dividends. Given this objective, firms with many investment
opportunities to pay a small percentage of their earnings as dividends and other firms
with fewer opportunities to pay a high percentage of their earnings as dividends. In the
real world, young, fast growing firms commonly employ a low pay out ratio, whereas
older, slower growing firms in more mature industries use a higher ratio.

Steps in residual dividend policy are:

1. determine the amount of funds that can be generated without selling new equity
2. Decide whether or not a dividend will be paid. To do this, compare the total
amount that can be generated without selling new equity with planned capital
spending. If funds needed exceed funds available, then no dividend is paid. In
addition, the firm will have to sell new equity to raise the needed financing or else
postpone some planned capital spending.
3. If funds are needed is less than funds generated, then a dividend will be paid. The
amount of the dividend is the residual, that is, that portion of the earnings that is
not needed to finance new projects
Example,
A firm has birr 1000 in earnings and a debt/equity ratio of 0.50. The firm capital
structure is thus 1/3 debt and 2/3 equity.
After tax New Additional Retained Additional
Row earnings investment debt earnings Stock Dividends
1 Br. 1,000 Br. 3,000 Br. 1,000 Br.1,000 Br. 1,000 Br. 0
2 Br. 1,000 Br. 2,000 Br. 667 Br.1,000 Br. 333 Br. 0
3 Br. 1,000 Br. 1,500 Br. 500 Br.1,000 Br. 0 Br. 0
4 Br. 1,000 Br. 1,000 Br. 333 Br. 667 Br. 0 Br. 333
5 Br. 1,000 Br. 500 Br. 167 Br. 333 Br. 0 Br. 667
6 Br. 1,000 Br. 0 Br. 0 Br. 0 Br. 0 Br. 1,000

In row 1, the new investment is birr 3,000. Additional debt of birr 1,000 and equity of
birr 2,000 must raised to keep the debt/equity ratio constant. All earnings has to be
retained and additional stock to be raised for birr 1,000. Since new stock is issued,
dividends are not simultaneously paid out.
In row 2 and 3, investment drops. Additional debt needed goes down as well since it is
equal to 1/3 of investment. Because the amount of new equity needed is still greater than
or equal to birr 1,000, all earnings are retained and no dividend is paid.
In row 4, total investment is birr 1,000. To keep debt/equity ratio constant, 1/3 of this
investment (1/3 x 1000 = 333) has to be financed with debt. The remaining 2/3 of 1,000 =

35
Gebrie Worku, AAUCC, February 2010
667, comes from internal funds, implying the residual is birr 1,000 – 667 = 333. The
dividend is equal to this birr 333 residual.
In this case, note that no additional stock is issued. Since the needed investment is even
lower in row 5 and 6, new debt is reduced further, retained earnings drop, and dividends
increase. Again, no additional stock is issued.
2. Dividend stability
A strict residual approach might lead to a very unstable dividend payout. If investment
opportunities in one period are quite high, dividends will be low or zero. Conversely,
dividends might be high in the next period if investment opportunities are considered less
promising. Stable dividend policy is dividends are a constant proportion of earnings over
an earnings cycle. Cyclical dividend policy is dividends are a constant proportion of
earnings at each pay date.
3. A compromise dividend policy
In practice, many firms appear to follow what amounts to compromise dividend policy.
Such a policy is based on five main goals. These goals are ranked more or less in order of
their importance.
1. avoid cutting back on positive NPV projects to pay a dividend
2. avoid dividend cuts
3. avoid the need to sell equity
4. maintain a target debt-equity ratio
5. maintain a target dividend payout ratio
Under the compromise approach, the debt-equity ratio is viewed as a long range goal. It
is allowed to vary in short run if necessary to avoid a dividend cut or the need to sell new
equity. In addition, financial manager has to think divided payment as target payout
ratio, a firm’s long term desired dividend to earning ratio.
One can minimize the problems of dividend instability by creating two types of
dividends: regular and extra. The regular dividend would most likely be a relatively small
fraction of permanent earnings, so that it could be sustained easily. Extra dividends
would be granted when an increase in earnings was expected to be temporary.
Other factors related to cash dividends:
Stock repurchase: An alternative to cash dividends
When a firm to pay cash to its shareholders, it normally pays a cash dividend. Another
way is to repurchase its own stock. Repurchase used to payout a firm’s earnings to its
owners, which provides more preferable tax treatment than dividends.

Cash Dividends versus Repurchase

Imagine an all equity company with excess cash of birr 300,000. The firm pays no
dividends, and its net income for the year just is birr 49,000. The market value balance
sheet at the end of the year is represented below.
Market value balance sheet
( before paying out excess cash) .
Excess cash birr 300,000 Debt birr 0
Other asset 700,000 Equity 1,000,000
Total 1,000,000 Total 1,000,000
There are 100,000 share outstanding. The total market value of the equity is 1 million, so
the stock sells for birr 10 per share. Earning per share(EPS) are 49,000/100,000 =0.49
and the price earnings ratio(PE) is birr 10/0.49 = 20.4

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Gebrie Worku, AAUCC, February 2010
One option the company is considering is a birr 300,000 /100,000 = 3 per share extra cash
dividend. Alternatively, the company is thinking of using the money to repurchase
300,000/10 = 30,000 shares of stock.
If commissions, taxes and other imperfections are ignored, the stockholders shouldn’t
care which option is chosen. What is happening here is that the firm is paying out
300,000 in cash. The new balance sheet is represented below.
Market value balance sheet
(After paying out excess cash) .
Excess cash birr 0 Debt birr 0
Other asset 700,000 Equity 700,000
Total 700,000 Total 700,000
if cash is paid out as a dividend, there are still 100,000 shares outstanding, so each is
worth birr 7.
The fact that the per share value fell from birr 10 to 7 isn’t a cause for concern. Consider
a stockholder who owns 100 shares. At birr 10 per share before the dividend, the total
value is birr 1000.
After the birr 3 dividend, this same stockholder has 100 shares worth birr 7 each, for a
total of birr 700, plus 100 x 3= 300 in cash, for a combined total of birr 1,000. This just
illustrates: A cash dividend doesn’t affect a stockholder’s wealth if there are no
imperfections. In this case, the stock price simply fell by birr 3 when the stock went ex
dividend.
Also, since total earnings and the number of shares outstanding haven’t changed, EPS is
still 0.49. The price earning ratio, however, falls to 14.3 ( birr7/0.49 = 14.3).
Alternatively, if the company repurchases 30,000 shares, there will be 70,000 left
outstanding. The balance sheet looks the same. The company is worth birr 700,000 again,
so each remaining share is worth birr 700,000/70,000 shares = birr 10. The stockholder
with 100 shares is obviously unaffected. For example, if they were so inclined, they could
sell 30 shares and end up with birr 300 in cash and birr 700 in stock, just at they have if
the firm pays the cash dividend.
In the second case, EPS goes up since the total earnings stay the same while the number
of shares goes down. The new EPS will be birr 49,000/70,000 = 0.70 per share. However,
the PE ratio is birr 10/0.7 = 14.3, just as it was following the dividend. This is just
another illustration of dividend policy irrelevance when there are no taxes or other
imperfection.
Stock Dividends and stock Splits
Stock dividend: a dividend payment made by a firm to its owner in the form of stock,
diluting the value of each share outstanding. A stock dividend is not a true dividend
because it is not paid in cash. The effect of a stock dividend is to increase the number of
shares that each owner holds.
Stock split: an increase in a firm’s shares outstanding without any change in owner’s
equity. When a split is declared, each share is split up to create additional shares. For
example, in a three for one stock split, each old share is split into three new shares.

Stock splits and stock dividends have essential the same impacts on the corporation and
the shareholder: they increase the number of shares outstanding and reduce the value per
share. The accounting treatment is not the same however, and it depends on two things:
1. whether the distribution is a stock split or a stock dividend and
2. the size of the stock dividend

37
Gebrie Worku, AAUCC, February 2010
By convention, stock dividends of less than 20-25% are called small stock dividends. A
stock dividend greater than this 20-25% percent is called a large stock dividend.

A. Small stock dividend:

Example, Peterson Corporation has 10,000 shares of stock outstanding, each selling at
birr 66 and the following equity portion of the balance sheet before the stock dividend
declared.

Common stock (birr 1 par, 10,000 shares outstanding) birr 10,000

Capital in excess of par value 200,000
Retained earnings 290,000
Total stockholders equity 500,000
With a 10% stock dividend, each stockholders receives one additional share for each 10
that one owns, and the total number of shares outstanding after the dividend is 11,000.
(10,000 + 10% x 1000)
After the stock dividend, the balance sheet has to be adjusted for 11,000 outstanding
shares of common stock. The common stock will be 11,000 shares x 1 birr par value=
11,000 .The capital in excess of par value is 200,000 plus the excess amount from 1000
shares of stock dividend ((66 -1) x 1000 shares = 65,000). Total capital in excess of par
value is 265,000. Total stockholders equity is unaffected by the stock dividend because
no cash has come in or out, so retained earnings is reduced by the entire birr 66,000.
Thus, the balance of retained earning will be 244,000 (290,000-66,000).
The equity section of the balance sheet would be:
Common stock (birr 1 par, 11,000 shares outstanding) birr 11,000
Capital in excess of par value 265,000
Retained earnings 224,000
Total stockholders equity 500,000

B. Stock split
A stock split is conceptually similar to a stock dividend, but it is commonly expressed as
a ratio. For example in a three for two split, each shareholder receives one additional
share of stock for each two held originally, so a three for two split amounts to a 50%
stock dividend. Again, no cash is paid out, and the percentage of the entire firm that each
shareholder own is unaffected.
Example, suppose that Peterson corporation decides to declare a two for one stock split.
The number of shares outstanding will double to 20,000 and the par value will be halved
to 0.50 per share. The stockholders’ equity after the split is represented as:
Common stock (birr0.50 par, 20,000 shares outstanding) birr 10,000
Capital in excess of par value 200,000
Retained earnings 290,000
Total stockholders equity 500,000

C. Large stock dividend

In the example, above, if a 100% stock dividend were declared, 10,000 new shares (100%
x 10,000) would be distributed, so 20,000 shares will be outstanding. At a birr 1 par value
per share, the common stock account would rise by 10,000 birr, for a total of birr 20,000.
The capital in excess of par account or the retained earnings account would be reduced by
this amount. Here it is reduced the retained earnings account by birr 10, 000, leaving
280,000. The stockholders’ equity section represented as:

38
Gebrie Worku, AAUCC, February 2010
Common stock (birr 1 par, 20,000 shares outstanding) birr 20,000
Capital in excess of par value 200,000
Retained earnings 280,000
Total stockholders equity 500,000

Reverse splits
Stock split under which a firm’s number of shares outstanding is reduced. Example, in a
one for three reverse split, each investor exchange three old shares for one new share.
The par value is tripled in the process.
Given real world imperfections, three related reasons are cited for reverse splits.
1. Transactions costs to shareholders may be less after the reverse split
2. The liquidity and marketability of a company’s stock might be improved when its
price is raised to the popular trading range. Trading range is price range between
highest and lowest prices at which a stock is traded.
3. Stocks selling below a certain level are not considered respectable, meaning that
investors underestimate these firms’ earnings, cash flow, growth, and stability.
Some financial analysts argue that a reverse split can achieve instant
respectability.
There are two other reasons for reverse split:
A. Stock exchanges have minimum price per share requirements. A reverse split may
bring the stock price up to such a minimum
B. Companies some times perform reverse splits an, at the same time, buy out any
stockholders who end up with less than a certain number of shares. This tactic can
be abusive if it is used to force out minority shareholders.
Exercise
1. On July 29, 1992 the xxx corporation declared a regular quarterly cash dividend
of birr 0.72 per share payable on September 10, 1992 to shareholders of record on
Thursday 13, 1992. What is the last day you could by xxx stock and still receive
this dividend?
Solution:
Given the regular five day settlement plan, the stock will go ex-dividend four
business days prior to the record date. Thus, the ex-day is Friday august 7, 1992. To
be on the record books and receive the dividend on September 10th you must buy the
stock no later than Thursday august 6, 1992, five business days before the record
date.
Answer question 2-6 based on the following information:
The balance sheet for SSS Corporation is shown below, in market value terms. There
are 100 shares outstanding.
Assets: Liabilities 0
Cash 100 Equity 1000
Fixed asset 900

2. SSS has declared a dividend of birr 0.50 per share. The stock goes ex-dividend
tomorrow. What is the price of the stock today? What will its price tomorrow?
(assume no taxes)
Solution:
Since the balance sheet shows market values, the stock is worth birr 10 per share
today (cum dividend). The ex-dividend price will be birr 9.50. Notice that once the

39
Gebrie Worku, AAUCC, February 2010
 dividend is paid, SSS has birr 50 less cash, so the total equity is worth birr 950, or birr
9.50 per share.
3. SSS, instead, has declared a 20 percent stock dividend. The stock goes ex-
dividend tomorrow. What will the ex-dividend price be?
Solution:
After the stock dividend is paid, 120 shares will be outstanding. The total value of the
shares is still birr 1000; that is, the total market value of the equity is unchanged.
Therefore, the per share value is (birr 1000/120)=birr 8.33. Notice that this is not
20% less than the old price; rather the old price is 120% of the new price :( birr
8.33 x1.2)= birr 10

4. Instead of paying a cash dividend, SSS has announced that it is going to

repurchase birr 50 of stock. What is the effect of this repurchase? Ignoring taxes,
show how this repurchase is effectively the same as a birr 0.50 dividend per share.
Solution:
SSS will purchase 5 shares, leaving 95 outstanding. The total equity value will be birr
950, so that the market price is still birr 10 per share (950/95=10).
Consider an investor who owns 20 shares. With the cash dividend, this investor
receives birr 10 in cash and has 20 shares (each worth birr 9.50), for a total value of
birr 200. Using the birr 10, the investor could purchase 1.053 more shares and have
21.053 shares worth birr 9.50 each. With the repurchase, the investor has 20 shares
worth birr 10 each, if she does not sell any shares. Alternatively, she could just sell on
share for birr 10. As a result, she would have 19 shares (each worth birr 10), and birr
10 in cash, for a total of birr 200 again.
5. Suppose that dividend is taxed at a 40% rate, and that taxes are withheld at the
same time the dividend is paid. If SSS is going to pay a birr0.60 dividend per
share, what is the ex-dividend price?
Solution:
The price will decrease by the after tax amount of the dividend, or (birr 0.60(1-0.40))
= birr 0.36. The ex-dividend price will be 10-0.36= birr 9.64.
6. S company is in the same risk class as F Company. S has an expected dividend
yield over the next year of 10%, while F pays no dividends. The required return
on F Company is 20%. Capital gains are not taxed, but dividend is taxed at 40%.
What is the required pre-tax return on S company?
Solution:
The 10% dividend yield is equivalent to a 6% after tax return. Since the total expected
after tax return is 20%, the expected capital gain is 14%. The after tax return is thus
‘grossed up’ to a pre tax return of (10%+14%) =24%
7. Now suppose that S company dividend next year will be birr 10. And after paying
the dividend the stock will sell for birr 100. F‘s current stock price is birr 50 per
share, and shareholders expect next year’s price will be birr 60. Assume that
dividends are taxed at 40%, as in question 6, and capital gains are taxed at 20%.
What is S’s current stock price?
Solution:
Since S and F are in the same risk class, they must provide the same after tax return. The
after tax return on F is (birr 60- birr 50) (1-0.2) = birr 8 or 16%. S must provide the same
after tax return. Thus,
0.16=(After tax dividend+ after tax gain)/Po
0.16=((birr 10(1-0.4) + (birr 100- Po)(1-0.2))/Po

40
Gebrie Worku, AAUCC, February 2010
 0.16=(6+80-0.8Po)/Po
Po=birr 89.58
8. You own 20 shares of stock in Abyssinia Aircraft. You are certain that you will
receive a birr 0.50 per share dividend at date 1. At date 2. Abyssinia will pay a
liquidating dividend of birr 13.80 per share. The required return is 20%.
Assuming no taxes, what is the price per share of the common stock? Suppose
that you accomplish this by using homemade dividends?
9. Suppose that in question 8, you wanted only birr 5 at date 1. What is your
homemade dividend at date 2?
Solution:
Your liquidating dividend will be birr 282, which is birr 6 greater than it would have
been.
CHAPTER 5
FINANCIAL FORECASTING
4.1 Over view of financial forecasting
Firms need assets in order to make sales, and if sales are to be increased, assets must also
be expanded. Growing firms require new investments: immediate investment in current
assets and, as full capacity is reached, investment in fixed asset as well. New investments
must be financed.
Financial Planning
Financial planning indicates a firm’s growth, performance, investment and requirement
of fund during a given period of time. The process of estimating the funds requirement of
a firm and determining the sources of funds is called financial planning.
The planning process:
1. Project (estimate) the firm’s sales using time series analysis, regression analysis
or exponential smoothing.
2. Project variables such as expenses
3. Estimate the level of investment in current assets and fixed asset to support
project sales
4. Finally, determine the firm’s financial needs

Forecast the income statement

In developing sales forecast the following factors has to be taken in to considerations.
The factors are:
 Economic activity and overall demand for the product
 Market share for each product line in each market
 How exchange rate fluctuations would impact sales
 The effect of trade agreements, government policies
 Effect of inflation on the firm’s prices
 Advertising campaigns, promotional discounts, credit terms

If the sales forecast is off, the consequences can be serious. First, if the market expands
more than the firm has geared up for, the company will not be able to meet demand. Its
customers will end up buying competitors’ products, and the firm will lose market share,
which will be hard to regain. On the other hand, if its projections are overly optimistic,
the firm could end up with too much plant, equipment, and inventory. This would mean
low turnover ratios, high costs for depreciation and storage, and possibly, write offs of
obsolete inventory. All of this would result in a low rate of return on equity, which in turn

41
Gebrie Worku, AAUCC, February 2010
would depress the company’s stock price. Thus, an accurate sales forecast is critical to
the well-being of the firm.

Forecast the balance sheet.

If firm’s sales are to increase, then its asset must also grow. When the company operates
at full capacity, each asset account must increase if the higher sales level is to be
attained: more cash will be needed for transactions, higher sales will lead to higher
receivables, additional inventory will have to stocked, and new plant and equipment must
be added.
Further, if the firm’s assets are to increase, its liabilities and equity must also increase-
the additional assets must be financed in some manner. Spontaneously generated funds
will be provided by accounts payable and accruals. For example, as sales increase, so will
firm’s purchases of raw materials, and these larger purchases will spontaneously lead to
higher levels of accounts payable. Similarly, a higher level of operations will require
more labor, while higher sales will result in higher taxable income. Therefore, both
accrued wages and accrued taxes will increase. In general, these spontaneous liability
accounts will increase at the same rate as sales.
Retained earnings will also increase, but not at the same rate as sales: the new level of
retained earnings will be the old level plus the addition to retained earnings. Also, notes
payable, long term bonds, preferred stock, and common stock will not rise spontaneously
with sales- rather; the projected levels of these accounts will depend on financing
decisions that will be made later.
In summary, higher sales must be supported by
1. higher asset levels
2. some of the asset increases can be financed by spontaneous increases in
accounts payable and accruals and by retained earnings, and
3. Any short fall must be financed from external sources, either by borrowing
or by selling new common or preferred stock or by some combination of
these sources of financing.

Raising the additional funds needed

Financial manager will base the financing decision on several factors, including the
firm’s target capital structure, conditions in the debt and equity markets, and restrictions
imposed by existing debt agreements. The financial manager after considering all of the
relevant factors he could decide the financing mix to raise the additional funds.

Techniques of determining External Financial Requirement

There are three ways: the constant ratio method (Performa method), additional financial
requirement formula and judgmental analysis.
A. The constant ratio method( Performa method)
This method is also called Percent of sales method. The most important variable that
influences a firm’s financing requirements is its projected volume of sales. A good sales
forecast is an essential foundation for forecasting financial requirements. This method:
- Establish relation between sales and balance sheet items that change with sales
- Find out the level of current asset, fixed asset, current liability and stockholders
equity needed to support the forecast sales. Inputs used in this method are the
preceding year and sale forecast for the following period.
Steps in computing financial requirements:
1. Express balance sheet items that vary directly with sales as a percentage of sales

42
Gebrie Worku, AAUCC, February 2010
 2. Multiply the percentage determined in step one by sales forecast.
3. Insert balance sheet item that don’t vary with sales as they are. Example, long
term liability, common stock.
4. Compute the projected retained earning of the following accounting period.
Projected retained earning= retained earning+ projected net income-dividend
5. Determine the amount of excess of total asset over the sum of total liability and
stockholders equity.

Example,
ABC Company
Balance sheet
December 31, 2005
Asset Liability
Current asset: Current Liability
Cash 10,000 Accounts payable 40,000
A/R 90,000 Notes payable 10,000
Inventory 200,000 Accrued wages 50,000
Total current asset 300,000 Total current liability 100,000
Net fixed asset 300,000 Mortgage bonds 150,000
Total liability 250,000
Stockholders equity:
Common stock 50,000
Retained earning 300,000
Total asset 600,000 Total liability & SHE 600,000

ABC Company
Income statement
For the year ended December 31,2005
Sales 400,000
CGS 280,000
GP 120,000
Operating expense:
Selling expense 20,000
General & administrative expense 27,000 47,000
EBIT 73,000
Interest expense 6,333.33
EBT 66,666.67
Tax expense (40%) 26,666.67
Net income 40,000

Required: Prepare a financial forecast for ABC Company for the year 2006. Assume a
sale increased by 50 percent, net profit margin is expected to be 15 percent of sales and
the dividend payout ratio is 40 percent.
Solution:
Sales: 150%x400, 000=600,000
Net profit margin: 15%x600, 000=90,000
Dividend: 40%x90, 000=36,000
Retained earning: 90,000-36,000=54,000

43
Gebrie Worku, AAUCC, February 2010
Projected retained earnings: 300,000+54,000=354,000

ABC Company
Balance sheet
December 31, 2006(Projected)
Asset Liability
Current asset: Current Liability
Cash 15,000 Accounts payable 60,000
A/R 135,000 Notes payable 15,000
Inventory 300,000 Accrued wages 75,000
Total current asset 450,000 Total current liability 150,000
Net fixed asset 450,000 Mortgage bonds 150,000
Total liability 300,000
Stockholders equity:
Common stock 50,000
Retained earning 354,000
Total asset 900,000 Total liability & SHE 704,000
Excess of total asset over the sum of total liability and stockholder is 196,000.
ABC Company
External financial requirement
Year 2005 Year 2006(Projected)
Asset
Current asset: 300,000 *75%x600,000 450,000
Net fixed asset 300,000 **75%x600,000 450,000
Total asset 600,000 900,000
Liability:
Current liability 100,000 ***25%x600,000 150,000
Long term debt 150,000 No adjustment 150,000
Total liability 250,000 300,000
Stockholders equity:
Common stock 50,000 No adjustment 50,000
Retained earning 300,000 354,000
Total liability and stockholders equity 600,000 704,000
Note: Current asset, fixed asset and current liability as Percent of sales
*300,000/400,000=75%
**300,000/400,000=75%
***100,000/400,000=25%

B. The external financial requirement formula

Although firms’ forecasts of capital requirements are made by constructing pro forma
income statement and balance sheets as described above, the following formula can be
used to obtain the financial requirement.
Additional funds needed = Required increase in assets – Spontanneous increase in
liabilites – Increase in retainded earnings.

44
Gebrie Worku, AAUCC, February 2010
 EFR= (A/So) ΔS- (L/So) ΔS-[(PsXPm) (1-D)]
Where A= total asset of current year
So= sales of the current year
ΔS= change in sales
L= current liability
Ps= Projected sales
Pm= net profit margin
D= dividend payout ratio

EFR= (A/So) ΔS- (L/So) ΔS-[(PsXPm) (1-D)]

=(600,000/400,000)200,000-(100,000/400,000)200,000-[(600,000x15%)(1-0.4)]
=300,000-50,000-54,000
=196,000
To increase sales by 200,000, the formula suggests that ABC must increase assets by
300,000(For every birr 1 increase in sales, assets must increase by about by birr1.5. That
is (A/So). The 300,000 of new assets must be financed in some manner. Of the total,
50,000 will come from a spontaneous increase in liabilities, while another 54,000 will be
obtained from retained earnings. The remaining 196,000 must be raised from external
sources.
Notice what would have happened if the ABC’s sales forecast for 2006 had been
416,000, 4 percent increase. Applying the formula, we find the external funds
requirements as follows:
EFR= (A/So) ΔS- (L/So) ΔS-[(PsXPm) (1-D)]
=(600,000/400,000)16,000-(100,000/400,000)16,000-[(416,000x15%)(1-0.4)]
=24,000-4,000-(62,400x0.6)
=24,000-41,440
= (17,440)
In this case, no external funds are required. In fact, the company will have birr 17,440 in
excess of its requirements, so it should plan to increase dividends, retire debt, or seek
additional investment opportunities. The example shows not only that higher levels of
sale bring about a need for funds, but also that while small percentage increases can be
financed through retained earnings, larger increases cause the firm to go into the market
for outside capital. In other words, a certain level of growth can be financed from internal
sources, but higher levels of growth require external financing.
The percent of sales method is most appropriately used for forecasting relatively short
term changes in financing needs. It is less useful for longer term forecasting.

Inherent in the formula are the assumptions:

1. That each asset item must increase in direct proportion to sales increases
2. That designated liability accounts also grow at the same rate as sales
3. That the profit margin and dividend payout are constant
Obviously, these assumptions do not always hold, so the formula does not always
produce reliable results. Therefore, the formula is used primarily to get rough and ready
forecast of financial requirements

45
Gebrie Worku, AAUCC, February 2010
 Relationship between Growth and Financial Requirements
The faster firm’s growth rates in sales, the greater its need for additional financing. The
following shows ABC’s additional financial requirements at various growth rates, and
these data are plotted in the graph. The figure illustrates the following four important
points:
1. Financial feasibility: at low growth rates ABC needs no external financing, and it
even generates surplus cash. How ever, if the company grows faster than 7.76 percent, it
must raise capital from outside sources. Further, the faster its growth rate, the greater its
capital requirements. If management foresees difficulties in raising the required capital,
then management should reconsider the feasibility of the expansion plans.

Growth rate in sales Increase(Decrease) in Forecasted Additional funds

(1) sales, ΔS sales , PS needed
(2) (3) (4)
50% 200,000 600,000 196,000
10% 40,000 440,000 400
7.76% 31,034 431,034 0
4 16,000 416,000 (17,440)
0% 0 400,000 (36,000)
(10%) (40,000) 360,000 (82,400)

Explanation of columns:
Column1: assumed growth rate in sales, g
Column 2: Increase (decrease) in sales, ΔS = g x So = g x 400,000
Column 3: Forecasted sales: So + g x So = So (1+g) = 400,000(1+g)
Column 4: Additional funds needed = (A/So) ΔS- (L/So) ΔS-[(PsXPm) (1-D)]
= (600,000/400,000) ΔS - (100,000/400,000) ΔS - [Ps x15%) (1-0.4)]
= 1.5 (ΔS)- 0.25 (ΔS) – 0.09 Ps

By setting additional fund need equal to zero, substituting g(So) for ΔS and So + g (So)
for Ps in the EFR equation, and then solving the equation:
0 = 1.5 g (So) – 0.25 g (So) – 0.09[So +g (So)] Additional funds needed
0 = 1.5 g (So) – 0.25 g (So) – 0.09So – 0.09g (So)
0 = 1.5 g (So) – 0.25 g (So) – 0.09g (So)- 0.09So
0 = 1.16 g (So) – 0.09So
1.16 g (So) = 0.09So 196,000
g = 0.09 So
1.16So Funds needed
g = 0.077586 = 7.76%

Sales growth rate 10 7.76 10 50

36,000

Figure 4.1

46
Gebrie Worku, AAUCC, February 2010
2. Effect of dividend policy on financing needs. Dividends policy as reflected in the pay
out ratio also affects external capital requirements- the higher the payout ratio, the
smaller the addition to retained earnings, hence the greater the requirements for external
capital. Therefore, if ABC foresees difficulties in raising capital, it might want to
consider a reduction in the dividend payout ratio. This would lower (or shift to the right)
the line in figure 4.1, indicating smaller external capital requirements at all growth rates.
However, before changing its dividend policy, management should consider the effects of
such a decision on stock prices.
Notice that the line in figure 4.1 does not pass through the origin; thus at low growth rates
(below 7.76 percent), surplus funds will be produced, because new retained earnings plus
spontaneous funds will exceed the required asset increases. Only if the dividend payout
ratio were 100 percent, meaning that the firm did not retain any of its earnings, would the
“funds needed” line pass through the origin.

Note: The higher a firm’s sales growth rate, the greater will be its need for additional
financing. Similarly, the larger a firm’s dividend payout ratio, the greater its need for
additional funds.
3. Capital intensity. The amount of assets required per birr of sales, A/So in the equation,
is often called the capital intensity ratio. This ratio has a major effect on capital
requirement per unit of sales growth. If the capital intensity ratio is low, sales can grow
rapidly without much outside capital. However, if the firm is capital intensive, even a
small growth in output will require a great deal of new outside capital.

4. Profit margin. The profit margin, Pm, is also an important determinant of additional
fund need- the higher the margin, the lower the funds requirements, other things held
constant. In terms of the graph, an increase in the profit margin would cause the line to
shift down, and its slope would also become less steep. Because of the relationship
between profit margins and additional capital requirements, some very rapidly growing
firms do not need much external capital.

Forecasting Financial requirements when the balance sheet ratios are subject o
change.
Both the Additional fund need formula and the constant ratio forecasting method that the
balance sheet ratios of assets and spontaneous liabilities to sales (A/So and L/So) remain
constant over time, which in turn requires the assumption that each “spontaneous” asset
and liability item increases at the same rate as sales. The relationship is linear and passes
the origin. Under these conditions, if the sales increase from 400, 000 to 600,000,
inventory must increase at the same rate, or proportionally from 200,000 to 300,000.
The assumption of constant ratios, which implies identical growth rates, is appropriate at
times, but there are times when it is incorrect. Three such conditions are described in the
following sections.
A. Economies of scale
When economies occur, the ratios are likely to change over time as the size of the firm
increases. For example, firms often need to maintain base stocks of different inventory
items even if current sales levels are quite low. As sales expand, inventories grow less
rapidly than sales, so the ratio of inventory to sales declines. The situation is depicted in
Panel B of figure 4.2. Here we see that the inventory/sales ratio is 1.5 or 150%, when
sales are 200, but the ratio declines to 1.0 when sales climb to 400. The relationship used
to illustrate economies of scale is linear, but nonlinear relationship often exists.

47
Gebrie Worku, AAUCC, February 2010
A. Constant Ratios B. Economies of scale
Inventory Inventory
I/S
I/S
400 100%
300 50%
300 150%
200 50%

Sales
400 600 200 400 Sales

C. Curvilinear relationship D. Lumpy Assets

Fixed assets FA/S
424 I/S Capacity

300

Excess capacity
A B (Temporary)

200 400 Sales 100 200 300 Sales

Figure 4.2

B. Curvilinear relationship
Panel C shows a curved line whose slope decreases at higher sales levels.

C. Lumpy asset
In many industries, technological considerations dictate that if a firm is to be competitive,
it must add fixed assets in large, discrete units; such assets are often referred to as lumpy
assets. In the paper industry; for example, there are strong economies of scale in basic
paper mill equipment, so when a paper company expands capacity, it must do so in large,
lumpy increments. This type of situation is depicted in Panel D of Figure 4.2. Here we
assume that the minimum economically efficient plant has a cost of 75 thousands and
that such a plant can produce enough output to attain a sales level of 100, thousands. If
the firm is to be competitive, it simply must have at least 75,thousands of fixed assets.
Lumpy assets have a major effect on the fixed assets/sales ratio at different sales levels,
and consequently on financial requirements. At point A in figure 4.2, panel D, which
represents a sales level of 50 thousands, the fixed assets are 75 thousands, so the ratio
FA/S = 75/50 = 1.5. Sales can expand by 50 thousands, out to 100 thousands, with no
additions to fixed assets. At that point, represented by point B, the ratio FA/S = 75/100 =
0.75. However, if the firm is operating at capacity (sales of 100 thousands), even a small
increase in sales would require a doubling of plant capacity, so a small projected sales
increase would bring with it a very large financial requirement.

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Gebrie Worku, AAUCC, February 2010
Other Techniques for forecasting financial statement variables
If any of the conditions noted above applies (economies of scale, excess capacity, or
lumpy asset), the A/S ratio will not be constant, and the constant ratio technique should
not be used. Rather, other techniques must be used to forecast income statements items
and balance sheet accounts, and hence additional financing requirements.
Simple linear regression
If we assume that the relationship between a certain item or account and sales is linear,
then we can use simple linear regression techniques to estimate the item or account level
for any given sales increase.
Example, Inventories = -35.7 + 0.186(Sales)
Multiple regressions
If the relationship between a variable such as inventories and sales has points that are
widely scattered about the regression line ( a low correlation), then there is a good chance
that other factors, in addition to sales, affect the level of that variable. For example,
inventory levels might be a function of both sales level and the number of different items
stocked. In this case, the best forecast for inventories might be obtained using multiple
regressions, whereby inventories would be regressed against both sales and the number of
items being stocked.
Specific variable forecasting
It is developing a specific model for each income statement and balance sheet variable to
be forecasted. For example, receivables could be forecasted using historical collections
experience, operating costs using linear regression. Of course, projected sales demand is
still the driving force behind each specific variable forecast, but given the sales forecast,
each variable would be analyzed and forecasted by its own unique technique. This
method is called specific variable forecasting because each income statement item and
balance sheet account is forecasted independently, given the sales forecast.
Comparison of the forecasting methods
A constant ratio method of forecasting financial statements assumes that most income
statement and balance sheet variables vary directly (proportionally) with sales. It is the
easiest method to use, but often their forecasts are less accurate. As we move down the
list from the constant ratio method to specific variables forecasting, accuracy usually
increases, but so does the cost of the forecast. The need to employ more complicated, and
consequently more costly, forecasting methods varies from situation to situation. As in all
decisions, the costs of using more refined techniques must be balanced against the
benefits of increased accuracy.

C. Judgmental analysis
Some times management may determine the minimum level of cash, account receivable
based on the past experience in the firms operation.

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Gebrie Worku, AAUCC, February 2010
 CHAPTER 6
MANAGING CURRENT ASSETS
Working capital Terminologies
Working capital is defined as a firm’s investments in current assets. A related concept is
net working capital, defined as current assets minus current liabilities. The principal
categories of working capital are current asset consists of cash, marketable securities,
accounts receivable and inventory. Current liabilities include accounts payable, banks
loans and notes payable; and current debt (due in one year).
Working capital policy: refers to the firm’s basic policies regarding 1) target levels for
each category of current assets and 2) how current assets will be financed.
Working capital management: involves the administration, with in policy guidelines, of
current assets and current liabilities.

The three tasks of working capital management.

The three tasks or concepts underlying working capital management are:
1. speeding up receipts of cash
2. delaying payments of cash, and
3. investing excess cash
Implicitly these three tasks are to maximize shareholder wealth. Thus, they are to be
performed in a manner that takes advantage of the time value of money in an optimal
way. In other words, receipts should speeded up, payments delayed, and cash invested if
and only if the advantages outweigh the disadvantages.

Alternative Current asset Investment Policies

There are three alternative policies regarding the total amount of current assets carried.
Essentially, these policies differ in that different amounts of current assets are carried to
support any given level of sales. It is illustrated in figure 5.1 below

Current asset Relaxed

40
Moderate
30
Restricted
20

10

0 50 100 150 Sales

Figure 5.1
Policy Current assets to support sales of 100
Relaxed Birr 30
Moderate 23
Restricted 16
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Gebrie Worku, AAUCC, February 2010
 A. Relaxed current asset investment( fat cat) policy
Where relatively large amounts of cash, marketable securities, and inventories are carried
and where sales are stimulated by the use of a credit policy that provides liberal financing
to customers and a corresponding high level of receivables.
B. Restricted current asset investment (lean and mean) Policy
With this policy, the holdings of cash, securities, inventories, and receivables are
minimized.
C. Moderate current asset investment policy.
The moderate current asset investment policy is between the two extremes.

Under conditions of certainty- when sales, costs, lead times, payment periods are known
for sure- all firms would hold only minimal levels of current assets. Any larger amounts
would increase the need for working capital financing without a corresponding increase
in profits, while any smaller holdings would involve late payments to labor and suppliers
and lost sales due to inventory shortages and an overly restrictive credit policy.

With a restricted current asset investment policy, the firm would hold minimal of safety
stocks for cash and inventories, and it would have a tight credit policy even though this
meant running the risk of losing sales. A restricted, lean and mean current asset
investment policy generally provides the highest expected return on investment, but it
entails the greatest risk, while the reverse is true under a relaxed policy. The moderate
policy falls in between the two extremes in terms of risk and expected return.

Cash and marketable security management

Cash and marketable securities are the most liquid of the firm’s assets. Cash is the ready
currency to which all liquid assets can be reduced. Marketable securities are short term,
interest- earning, money market instruments that are used by the firm to obtain a return
on temporarily idle funds. Cash and marketable securities are held by firms to reduce the
risk of technical in solvency by providing a pool of liquid resources for use in making
planned as well as unexpected outlays. The desired balances are determined by carefully
considering the motives for holding them. The higher these balances are, the lower the
risk of technical insolvency, and the lower they are, the higher the risk of technical
insolvency.

Motives for holding cash and near cash balances

There are three motives for holding cash and near cash (marketable securities) balances.
Each motive is based on two underlying questions:
1) What is the appropriate degree of liquidity to maintain? And
2) What is the appropriate distribution of liquidity between cash and marketable
securities?

A) Transaction motive
A firm maintains cash balances to satisfy the transaction motive, which is to make
planned payments for items such as materials and wages. If cash inflows and cash

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Gebrie Worku, AAUCC, February 2010
outflows are closely matched, transaction cash balances can be smaller. While firms must
achieve this motive, they typically try to achieve the following two motives as well.

B) Safety motive
Balances held to satisfy the safety motive are invested in highly liquid marketable
securities that can be immediately transferred from securities to cash. Such securities
protect the firm against being unable to satisfy unexpected demands for cash.

C) Speculative motive
This is a motive of holding cash or near cash to put unneeded funds to work or to be able
to quickly take advantage of unexpected opportunities that may arise. Speculative motive
is the least common of the three motives.
Estimating cash balances
Management’s goal should be to maintain levels of transactional cash balances and
marketable securities investments that contribute to improving the value of the firm. If
levels of cash are too high, the profitability of the firm will be lower than if more optimal
balance were maintained. Firms can use either subjective approaches or quantitative
models to determine appropriate transactional cash balances.
A. Subjective approaches
A subjective approach might be to maintain transactional balances equal to 10 percent of
the following month’s sales. If the forecast amount of sales for the following month is
birr 500,000, the firm would maintain a birr 50,000 ( i.e 0.10 x 500,000) transaction cash
balance.
B. Quantitative models
Two quantitative models that management can use to determine the appropriate
transactional cash balances are the Baumol model and the Miller-Orr model.

Baumol Model
A model that provides for cost efficient transactional cash balances; assumes that the
demand for cash can be predicted with certainty and determines the economic conversion
quantity (ECQ). It treats cash as inventory item whose future demand for settling
transactions can be predicted with certainty. Baumol’s cash management model helps in
determining a firm’s optimum cash balance under certainty. In other words, cash inflows
and cash outflows are assumed to be known with certainty. A portfolio of marketable
securities acts as a reservoir for replenishing transactional cash balances. The firm
manages this cash inventory on the basis of the cost of converting marketable securities
into cash (the conversion cost) and the cost of holding cash rather than marketable
securities (opportunity cost). The economic conversion quantity (ECQ), the cost
minimizing quantity in which to convert marketable securities to cash is

ECQ = 2 x Conversion cost x demand for cash

Opportunity cost (in decimal form)

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Gebrie Worku, AAUCC, February 2010
Conversion cost: includes the fixed cost of placing and receiving an order for cash in the
amount ECQ. It includes the cost of communicating the necessary to transfer funds to the
cash account, associated paper work costs, and the cost of any follow up action. The
conversion cost is stated as birr per conversion.
Opportunity cost: is the interest earnings per birr given up during a specified time period
as a result of holding funds in a non-interest earning cash account rather than having
them invested in interest earning marketable securities.
Total cost: is the sum of the total conversion and total opportunity costs. Total conversion
cost equals the cost per conversion times the number of conversions per period. The
number of conversions per period can be found by dividing the period’s cash demand by
economic conversion quantity (ECQ). The total birr opportunity cost equals the
opportunity cost (in decimal form) times the average cash balance. The average cash
balance is found by dividing ECQ by 2. The total cost equation is
Total cost = Transaction cost + Holding cost
= (Cost per conversion x number of conversions)
+ [Opportunity cost (in decimal form) x average cash balance]
The objective of the Baumol model is to determine the economic conversion quantity
(ECQ) of cash that minimizes total cost. Cash transfer that are larger or smaller than ECQ
result in higher total cost.
Graphically, the Baumol model can be depicted as a saw tooth pattern of cash holdings as
shown in figure 5.2. The initial ECQ cash balance calculated by the equation decreases
steadily to zero as the firm spends the cash. When the cash account reaches a zero
balance, additional ECQ birr are transferred from marketable securities to cash.
Cash balance (Birr)
ECQ

ECQ/2 Average cash balance

Time
Figure 5.2 Baumol model
Example,
The management of Alem Sport, a small distributor of sporting goods, anticipates birr
1,500,000 in cash outlays (demand) during the coming year. A recent study indicates that
it costs birr 30 to convert marketable securities to cash. The marketable securities
portfolio currently earns an 8 percent annual rate or return,
Required: Compute Economic conversion quantity (ECQ)?

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Gebrie Worku, AAUCC, February 2010
 1. Number of conversions?
2. Average cash balance?
3. Total cost?
Solution:
ECQ= 2 x Conversion cost x demand for cash
Opportunity cost (in decimal form)

= 2 x 30 x 1,500,000
0.08 = 33,541 birr
Number of conversion during the year to replenish the account = 1,500,000/33,541= 45
The average cash balance = 33541/2 = Br. 16,770.50
The total cost of managing the cash is
Total cost = (Cost per conversion x number of conversions)
+ [Opportunity cost (in decimal form) x average cash balance]
= (Br.30 x 45) + (0.08 x Br 16,770.50) = Br. 2,692
There are certain assumptions that are made in the model.
1. The firm is able to forecast its cash requirements with certainty and receive a specific
amount at regular intervals.
2. The firm’s cash payments occur uniformly over a period of time i.e. a steady rate of
cash outflows.
3. The opportunity cost of holding cash is known and does not change over time. Cash
holdings incur an opportunity cost in the form of opportunity foregone.
4. The firm will incur the same transaction cost whenever it converts securities to cash.
Limitations of the Baumol model:
1. It does not allow cash flows to fluctuate.
2. Overdraft is not considered.
3. There are uncertainties in the pattern of future cash flows.
MILLER- ORR MODEL
A model that provides for cost efficient transactional cash balances; assumes uncertain
cash flows and determines an upper limit (i.e. the maximum amount) and return point for
cash balances. The return point represents the level at which the cash balance is set, either
when cash is converted to marketable securities or vice versa. Cash balances are allowed
to fluctuate between the upper limit and a zero balance.
Return point: the value for the return point depends on:
1. conversion costs
2. the daily opportunity cost of funds, and
3. The variance of daily net cash flows.
The variance is estimated by using daily net cash flows (inflows minus outflows for the
day). The formula for determining the return point is

Return point = 3 x Conversion cost x Variance of daily net cash flows

3 4 x daily opportunity cost (in decimal form)
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Gebrie Worku, AAUCC, February 2010
Upper limit: the upper limit for the cash balance is three times the return point.
Cash balance reaches the upper limit: when the cash balance reaches the upper limit, an
amount equal to the upper limit minus the return point is converted to marketable
securities.
Cash converted to marketable securities = upper limit – return point

Cash Balance falls to zero: when the cash balance falls to zero, the amount converted
from marketable securities to cash is the amount represented by the return point.
Marketable securities converted to cash = return point – zero balance

Graphically, the Miller- Orr model shown in figure 5.3.

Upper limit

Transfer cash to marketable securities.

Cash balance

Return point
Transfer marketable securities to cash

Figure 5.3 Miller-Orr Model

Example, continuing with the prior example, it costs Alem sport birr 30 to convert
marketable securities to cash, or vice versa; the firm’s marketable securities portfolio
earns an 8 percent annual return, which is 0.0222 percent daily( 8%/360 days). The
variance of Alem sport’s daily net cash flows is estimated to be birr 27,000.

Return point = 3 x Conversion cost x Variance of daily net cash flows

3 4 x daily opportunity cost (in decimal form)

3 x 30 x 27,000
3 4 x 0.000222 = 1,399

The upper limit is 3 x return point

Upper limit = 3 x 1,399 = 4,197
The firm’s cash balance will be allowed to vary between birr 0 and birr 4,197. When the
upper limit is reached, birr 2,798 (4,197- 1,399) is converted from cash to marketable
securities that will earn interest. When the cash balance falls to zero, birr 1,399 (1,399-0)
is converted from marketable securities to cash.

Cash management techniques

To minimize the firm’s financing requirements; financial managers attempt to speed
collections and slow disbursements.

Cash flow synchronization

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Gebrie Worku, AAUCC, February 2010
It is arranging of events that cash receipts coincide with required cash outflows. It
reduces the transaction balances to a minimum, decrease its bank loans, lower interest
expenses, and boost profits.

Float
In the broadest sense, float refers to funds that have been dispatched by a payer ( the firm
or individual making payment) but are not yet in a form that can be spent by the
payee( the firm or individual receiving payment). Float also exists when a payee has
received funds in a spendable form but these funds have not been withdrawn form the
account of the payer. Delays in the collection –payment system resulting form the
transportaion and processing of checks are responsible for float. With electronic payment
system float will disappear. How ever, financial manager must continue to understand
and take advantage of float until that time.

Types of float
1. Collection float: results from the delay between the time when a payer or
customer deducts a payment form its checking account ledger and the time when
the payee or vendor actually receives these funds in a spendable form. Thus
collection float is experienced by the payee and is a delay in the receipt of funds.
2. Disbursement float: results from the lapse between the time when a firm deducts
a payment form its checking account ledger (disburse it) and the time when funds
are actually withdrawn from its account. Disbursement float is experienced by the
payer and is a delay in the actual withdrawal of funds.

Components of float.
Both collection float and disbursement float have the same three basic components:
1. Mail float: the delay between the time when a payer places payment in the mail
and the time when it is received by the payee.
2. Processing float: the delay between the receipt of a check by the payee and the
deposit of it in the firm’s account.
3. Clearing float: the delay between the deposit of a check by the payee and the
actual availability of the funds. This component of float is attributable to the time
required for a check to clear the banking system

Speeding up collections
The firm’s objective is not only to stimulate customers to pay their accounts as promptly
as possible but also to convert their payments into a spendable form as quickly as
possible- in other words, to minimize collection float. Some of the techniques to speeding
up collections are:
1. Concentration banking: a collection procedure in which payments are made to
regionally dispersed collection centers, then deposited in local banks for quick
clearing. Reduces collection float by shortening mail and clearing float.
2. Lockboxes: a collection procedure in which payers send their payments to a
nearby post office box that is emptied by the firm’s bank several times daily; the
bank deposits the payment checks in the firm’s account. Reduces collection float
by shortening processing float as well as mail and clearing float.
3. Direct send: a collection procedure in which the payee presents payment checks
directly to the banks on which they are drawn, thus reducing clearing float.

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Gebrie Worku, AAUCC, February 2010
 4. Preauthorized checks
5. wire transfer.

Receivable Management
Account receivables represent the extension of credit by the firm to its customers. The
extension of credit to customers by most manufacturers is a cost of doing business. By
keeping its money tied up in accounts receivable, the firm loses the time value of the
money and runs the risk of nonpayment by its customers. In return for incurring these
costs, the firm can be competitive, attract and retain customers, and improve and maintain
sales and profits.
Generally, the firm’s financial manager directly controls accounts receivable through
involvement in the establishment and management of
1. credit policy, which includes determining credit selection, credit standards, and
credit terms, and 2) collection policy
A firm’s credit selection activity involves deciding whether to extend credit to a customer
and how much credit to extend. Appropriate sources of credit information and methods of
credit analysis must be developed.

The five C’s of Credit

A firm’s credit analysts often use the five C’s of credit to focus their analysis on the key
dimensions of an applicant’s creditworthiness.

1. Character: the applicant’s record of meeting past obligations- financial,

contractual, and moral. Past payment history as well as any pending or resolved
legal judgments against the applicant would be used to evaluate its character.
2. Capacity: the applicant’s ability to repay the requested credit. Financial statement
analysis with particular emphasis on liquidity and debt ratio is typically used to
assess the applicant’s capacity.
3. Capital: the financial strength of the applicant as reflected by its ownership
position. Analysis of the applicant’s debt relative to equity and its profitability
ratios are frequently used to assess its capital.
4. Collateral: the amount of assets the applicant has available for use in securing the
credit. The larger the amount of available assets, the greater the chance that a firm
will recover its funds if the applicant defaults. A review of the applicant’s balance
sheet, asset value appraisals, and any legal claims filed against the applicant’s
assets can be used to evaluate its collateral.
5. Conditions: the current economic and business climate as well as any unique
circumstances affecting either party to the credit transaction. For example, if the
firm has excess inventory of the item the applicant wishes to purchase on credit,
the firm may be willing to sell on more favorable terms or to less creditworthy
applicants. Analysis of general economic and business conditions, as well as
special circumstances that may affect the applicant or firm is performed to assess
conditions.
The credit analyst typically gives primary attention to the first two C’s – character and
capacity- since they represents the most basic requirements for extending credit to an
applicant. Consideration of the last three C’s – capital, collateral, and conditions- is

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Gebrie Worku, AAUCC, February 2010
important in structuring the credit arrangement and making the final credit decision,
which is affected by the credit analyst’s experience and judgment.

Collection Policy
It is the set of procedures for collecting accounts receivable when they are due. The
effectiveness of this policy can be partly evaluated by looking at the level of bad debt
expenses. This level of depends not only on collection policy but also on the policy on
which the extension of credit is based. If one assumes that the level of bad debts
attributable to credit policy is relatively constant, increasing collection expenditures can
be expected to reduce bad debts. Popular approaches used to evaluate credit and
collection policies include the average collection period ratio and aging accounts
receivable.

Types of collection techniques

A number of collection techniques are employed. As an account becomes more and more
overdue, the collection effort becomes more personal and more strict. The basic
techniques are:
 Letters: after an account receivable becomes overdue a certain number of days,
the firm normally sends a polite letter reminding the customer of its obligation.
Collection letters are the fist step in the collection process for overdue accounts.

 Telephone calls: if letter prove unsuccessful, a telephone call may be made to the
customer to personally request immediate payment

 Personal visits: sending a local salesperson or a collection person to confront the

customer can be a very effective collection procedure.

 Using collection agencies: a firm can turn uncollectible accounts over to a

collection agency or an attorney for collection. The fee for this service are
typically quite high; the firm may receive less than 50% on accounts collected in
this way.
 Legal action: legal action is the most stringent step in the collection process. It is
an alternative to the use of a collection agency. Not only is direct legal action
expensive, but it may force the debtor into bankruptcy, thereby reducing the
possibility of future business without guarantying the ultimate receipt of the
overdue amount.

Inventory Management
Inventory is a necessary current asset that permits the production -sale process to operate
with a minimum disturbance. The three basic types of inventory are raw materials, work
in process, and finished goods.

Techniques for managing inventory

Techniques that are commonly used in managing inventory are:
1. ABC system
2. Economic order quantity (EOQ) model
3. Reorder point
4. Material requirement planning (MRP) system and
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Gebrie Worku, AAUCC, February 2010
 5. Just-in-time (JIT) system

ABC system
Inventory is divided into three groups, A,B, and C. The A group includes those items that
require the largest birr investment. The B group consists of the items accounting for the
next largest investment. The C group typically consists of a large number of items
accounting for a relatively small birr investment. Dividing its inventory into A,B, and C
items allows the firm to determine the level and types of inventory control procedures
needed. Control of A items should be most intensive and the use of perpetual inventory
record keeping that allows daily monitoring of these inventory levels is appropriate. B
items are frequently controlled through Periodic checking- possibly weekly- of their
levels. C items could be controlled by using unsophisticated procedures such as a red ling
method, in which a reorder is placed when enough inventory has been removed from a
bin containing the inventory item to expose a red line that has been drawn around the
inside of the bin.

Economic Order Quantity (EOQ)

It is most commonly cited sophisticated tools for determining the optimal order quantity
for an item of inventory. It takes into account various operating and financial costs and
determines the order quantity that minimizes total inventory cost.
Excluding the actual cost of the merchandise, the costs associated with inventory can be
divided into three broad groups: order costs, carrying costs, and total costs.

Order costs: it includes the fixed clerical costs of placing and receiving an order- the
cost of writing a purchase order, of processing the resulting paperwork, and of receiving
an order and checking it against the invoice. Order costs are normally stated as birr per
order.

Order cost = O x S/Q

Where O is order cost per order
S is usage in units per period
Q is order quantity in units

Carrying costs are the variable costs per unit of holding an item in inventory for a
specified time period. These costs are typically stated as birr per unit per period. Carrying
cost includes storage costs, insurance costs, the cost of deterioration and obsolescence,
and most important, the opportunity, or financial, cost of tying up funds in inventory.

Carrying cost = C x Q/2

Where C is carrying cost per unit per period
Q is order quantity in units

Total cost is defined as the sum of the order and carrying costs. Total cost is important in
the EOQ model, since the model’s objective is to determine the order quantity that
minimizes it.
Total cost = (O x S/Q) + (C x Q/2)

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Gebrie Worku, AAUCC, February 2010
The stated objective of the EOQ model is to find the order quantity that minimizes the
firm’s total inventory cost. The economic order quantity can be found with the following
formula.
EOQ = 2xSxO
C

Example, Assume that XXX Company, a manufacturer of electronic test equipment, uses
1,600 units of an item annually. Its order cost is birr 50 per order, and carrying cost is birr
1 per unit per year..
Required: Determine the economic order quantity?

EOQ = 2xSxO
C

EOQ = 2 x 1600 x 50
1 = 400 units

Reorder Point
Once the firm has calculated its economic order quantity, it must determine when to place
orders. A reorder point is required that considers the lead time needed to place and
receive orders. Assuming a constant usage rate for inventory, the reorder point can be
determined by the following formula

Reorder point = lead time in days x daily usage

For example, if a firm knows that it requires 10 days to place and receive an order, and if
it uses five units of inventory daily, the reorder point would be 50 units ( 10 days x 5
units per day). Thus as soon as the firm’s inventory level reaches 50 units, an order will
be placed for an amount equal to the economic order quantity. If the estimates of lead
time and daily usage are correct, the order will be received exactly when the inventory
level reaches zero. Because of the difficulty in precisely predicting lead times and daily
usage rates, many firms typically maintain safety stocks, which are extra inventories that
can be drawn down when actual outcomes are greater than expected.

MRP system
It is a system to determine what to order, when to order, and what priorities to assign to
ordering materials. MRP uses EOQ concepts and a computer to compare production
needs to available inventory balance. The advantage of the MRP system is that if forces
the firm to more thoughtfully considers its inventory needs and plan accordingly. The
objective is to lower the firm’s inventory investment without impairing production.

Just in time (JIT) system

It is inventory management system that minimizes inventory investment by having
material inputs arrive at exactly the time they are needed for production. Ideally, the firm
would have only work in process inventory. Since its objective is to minimize inventory
investment, a JIT system uses no, or very little, safety stocks. Extensive coordination

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Gebrie Worku, AAUCC, February 2010
must exist between the firm, its suppliers, and shipping companies to ensure that material
inputs arrive on time.
The goal of the JIT system is manufacturing efficiency. It uses inventory as a tool for
attaining efficiency by emphasizing quality in terms of both the materials used and their
timely delivery.

Exercise
1. Namtig industries forecasts cash outlay of birr 1.8 million for its next fiscal year. To
minimize investment in the cash account, management intends to apply the Baumol
model. A financial analyst for the company has estimated the conversion cost of
converting marketable securities to cash to be birr 45 per conversion transaction and the
annual opportunity cost of holding cash instead of marketable securities to be 8 percent.
A. Calculate the optimal amount of cash to transfer from marketable
securities to cash (i.e the ECQ). What will be the average cash balance?
B. How many transactions will be required for the year?
C. Calculate the total cost resulting from use of the ECQ calculated in A.
D. If management makes 12 equal conversions ( i.e one per month), what will
be 1) the total conversion cost, 2) the total opportunity cost, and 3) the
total cost.

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 CHAPTER 6
FINANCING CURRENT ASSETS
Current asset investment policy has to be established with the firm’s production policy
and current asset financing policy.
Current asset financing policy is the manner in which the permanent and temporary
current assets are financed. Permanent current asset: are those current assets that the
firm holds even during slack times, where as temporary current assets are the additional
current assets that are needed during seasonal or cyclical peaks.

Alternative Current asset financing Policies

A. Maturity Matching or “Self-liquidating approach.
The maturity approach calls for matching asset and liability maturities. This strategy
minimizes the risk that the firm will be unable to pay off its maturing obligations. A firm
could attempt to match exactly the maturity structure of its asset and liabilities.
Example, inventory expected to be sold in 30 days could be financed with a 30 day bank
loan; a machine expected to last for 5 years could be financed with a 5 year loan; a 20
year building could be financed by a 20 year mortgage bond and so forth. Actually, of
course, two factors prevent this exact maturity matching: 1) there is uncertainty about the
lives of assets, and 2) some common equity must be used, and common equity has no
maturity.
B. Aggressive approach
An aggressive strategy results in a relatively aggressive firm which finances all of its
fixed assets with long term capital but part of its permanent current assets with short
term, non-spontaneous credit. In this strategy the firm financing at least is seasonal needs,
and possibly some of its permanent needs, with short term funds. The balance is financed
with long term funds
C. Conservative approach
The most conservative financing strategy should be to finance all projected funds
requirements with long term funds and use short term financing in the event of an
emergency or an unexpected outflow of funds. It is difficult to imagine how this strategy
could actually be implemented, since the use of short term financing tools, such as
accounts payable and accruals, is virtually unavoidable.

Example, the following example is used to illustrate the cost and risk consideration on
aggressive and conservative financing strategies.
NCN Company’s estimate of current, fixed, and total asset requirements on monthly basis
for the coming year is given columns 1, 2 and 3 of table 6.1. Columns 4 and 5 present a
breakdown of the total requirement into its permanent and seasonal components. The
permanent component (column 4) is the lowest level of total assets during the period; the
seasonal portion is the difference between the total funds requirement (i.e. total assets)
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for each month and the permanent funds requirement. By comparing the firm’s fixed
assets (column 2) to its permanent funds requirement (column 4), we see that the
permanent funds requirement exceeds the firm’s level of fixed assets. This result occurs
because a portion of the firm’s current assets is permanent. The permanent component of
current assets is found by subtracting the level of fixed assets form the permanent funds
requirements, which is 800 (13,800 – 13,000)

Month Current asset Fixed asset Total asset Permanent Seasonal

1 2 3= 1+2 funds funds
requirement requirement
4 5=3-4
January 4,000 13,000 17,000 13,800 3,200
February 3,000 13,000 16,000 13,800 2,200
March 2,000 13,000 15,000 13,800 1,200
April 1,000 13,000 14,000 13,800 200
May 800 13,000 13,800 13,800 0
June 1,500 13,000 14,500 13,800 700
July 3,000 13,000 16,000 13,800 2,200
August 3,700 13,000 16,700 13,800 2,900
September 4,000 13,000 17,000 13,800 3,200
October 5,000 13,000 18,000 13,800 4,200
November 3,000 13,000 16,000 13,800 2,200
December 2,000 13,000 15,000 13,800 1,200
Monthly average 13,800 1,950

Aggressive strategy
An aggressive strategy may finance the permanent portion of the firm’s funds
requirement (13,800) with long term funds and finance the seasonal portion (ranging
from 0 in May to 4,200 in October) with short term funds. Much of the short term
financing may be in the form of trade credit ( i. e accounts payable).

Cost consideration:
Under the aggressive strategy, average short term borrowing (seasonal funds
requirement) is 1,950 and average long term borrowing (permanent funds requirement) is
13,800. If the annual cost of short term funds needed is 3% and the annual cost of long
term financing is 11%, the total cost of the financing strategy is estimated as follows:
Cost of short term financing = 3% x 1,950 = 58.50
Cost of long term financing = 11% x 13,800 = 1,518.00
Total cost = 1,576.50
The total annual cost of 1,576.50 will become more meaningful when compared to the
cost of the conservative financing strategy. The relatively low cost of short term
financing results from using a high amount of free trade credit.

Risk consideration:
The aggressive strategy operates with minimum net working capital, since only the
permanent portion of the firm’s current assets is being financed with long term funds.
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The level of net working capital is birr 800 (13,800 permanent funds requirement –
13,000 fixed assets)
The aggressive financing strategy is risky not only form the standpoint of low networking
capital but also because the firm must draw as heavily as possible on its short term
sources of funds to meet the seasonal fluctuations in its requirements. The risk associated
with the aggressive strategy results from the fact that a firm has only a limited amount of
short term borrowing capacity.

Conservative strategy
Long term financing of 18,000, which equals the firm’s peak need (during October), is
used under this strategy. Therefore all the required over the one year period, including the
entire 18,000 forecast for October, are financed with long term funds.

Cost consideration:
In the preceding example the annual cost of long term funds was 11%. Since the average
long term financing balance under this strategy is 18,000, the total cost of this strategy is
1,980 (11% x 18,000).

Risk consideration:
The 5,000 of net working capital (18,000 long term financing -13,000 fixed assets)
associated with the conservative strategy should mean a very low level of risk for the
firm. The firm’s risk should also be lowered by the fact that the strategy does not require
the firm to use any of its limited short term borrowing capacity.

Conservative versus aggressive strategy

Unlike the aggressive strategy, the conservative strategy requires the firm to pay interest
on unneeded funds. The lower cost of the aggressive strategy therefore makes it more
profitable than the conservative strategy. However, the aggressive strategy involves much
more risk. For most firms a tradeoff between the extremes represented by these two
strategies should result in an acceptable financing strategy.

Advantages and Disadvantages of short term financing

The three financing policies are distinguished by the relative amounts of short term debt
used under each policy. The aggressive policy called for the greatest use of short term
debt, while the conservative policy called for the least. Maturity matching fell in between.
Although using short term credit is generally riskier than using long term credit, short
term credit does have some significant advantages.
The advantages of short term credit are:
A. Speed: a short term loan can be obtained much faster than long term credit.
B. flexibility: if the needs are for seasonal or cyclical, a firm may not want to commit
itself to long term debt for three reasons:
1. Flotation costs are generally high when raising long term debt but trivial for short term
credit.
2. Although long term debt can be repaid early, provided the loan agreement included a
prepayment provisions, prepayment penalties can be expensive. Accordingly, if a firm
thinks its need for funds will diminish in the near future, it should choose short term debt
for the flexibility it provides.

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3. Long term loan agreements always contain provisions, or covenants, which constrain
the firm’s future actions. Short term credit agreements are generally much less onerous in
this regard.
C. Lower interest rate: the yield curve is normally upward sloping, indicating that
interest are generally lower on short term than on long term debts.

The disadvantage of short term credits is the extra risk that the borrower must bear. Even
though shot term debt is often less expensive than long term debt, short term credit
subjects the firm to more risk than does long term financing. This occurs for two reasons:
1. If a firm borrows on a long term basis, its interest costs will be relatively stable
over time, but if it sues short term credit, its interest expense will fluctuate widely,
at times going quite high. Many firms that had borrowed heavily on a short term
basis simply could not meet their rising interest costs, and as a result bankruptcies
hit record levels during that period.
2. If a firm borrows heavily on a short term basis, it may find itself unable to repay
this debt, and it may be in such a weak financial position that the lender will not
extend the loan; this too could force the firm into bankruptcy.

Sources of short term financing

If a firm does not have the cash and marketable securities to meet its cash budget
shortfalls, it must raise funds externally. Most firms use short term financing to meet
temporary shortfalls, while permanent capital (long term debt and equity) is used to meet
long term capital requirements. The four primary sources of short term financing are:
1. accruals
2. accounts payable
3. bank loans, and
4. commercial paper

Accruals
Firm’s balance sheet show accrued wages, income tax payables. Accruals increase
automatically or spontaneously as a firm’s operations expand. Further this type of debt is
“free” in the sense that no explicit interest is paid on funds raised through accruals.
However, a firm cannot ordinarily control its accruals the timing of wage payments is set
by economic forces and industry custom, while tax payment dates are established by law.
Thus, firms use all the accruals they can, but they have little controls over the levels of
these accounts.

Accounts payable
Firms generally make purchases form other firms on credit, recording the debt as an
accounts payable or trade credit. Trade credit is a spontaneous source of financing in the
sense that it arises form ordinary business transactions. Lengthening the credit period as
well as expanding sales and purchases generates additional financing from accounts
payable.

Short term bank loan

Commercial banks, whose loans generally on firms’ balance sheets as notes payable, are
second in importance to trade credit as a source of short term financing. As a firm’s
financing needs increase, it requests additional funds from its bank. The key features of
bank loans are:
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 A. Maturity: although banks do make longer term loans, the bulk of their lending is
on a short term basis
B. Promissory note: when a bank loan is approved, the agreement is executed by
signing a promissory note.
C. Compensating balances: banks some times require borrowers to maintain an
average demand deposit (checking account) balance equal to 10 to 20 percent of
the face amount of the loan.
D. Line of credit: a line of credit is an agreement between a bank and a borrower
indicating the maximum credit the bank will extend to the borrower.

Commercial Paper
It is a type of unsecured promissory note issued by large, strong firms, and it is sold
primarily to other business firms, to insurance companies, to pension funds, to money
market mutual funds, and to banks.
The use of commercial paper is restricted to larger businesses that are exceptionally good
credit risks. Commercial paper is rarely secured, but all other types of loans are often
secured if this is deemed necessary.

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