See discussions, stats, and author profiles for this publication at: https://www.researchgate.

net/publication/352827258

BASIC FINANCIAL MANAGEMENT

Book · June 2021

CITATIONS READS

0 10,059

1 author:

Sunday OSEIWEH Ogbeide

Elizade University
38 PUBLICATIONS 147 CITATIONS

SEE PROFILE

All content following this page was uploaded by Sunday OSEIWEH Ogbeide on 29 June 2021.

The user has requested enhancement of the downloaded file.

 BASIC
FINANCIAL
MANAGEMENT

Sunday Oseiweh Ogbeide, Ph.D.

Basic Financial Management
Copyright © 2021 S. O. Ogbeide +234-8132490958 /+234-8059117049

Email: [email protected]

Copyright

All rights reserved. No part of this book may be reproduced, stored in a retrieval system or transmitted
in any form or by any means, electronic, mechanical, photocopying, recording or otherwise without
the prior permission of the copyright owner. This book may not be lent, resold, hired out or otherwise
disposed -off by way of trade in any form of binding or cover, other than that in which it is published
without the prior consent of the publisher and copyright owner.

ISBN: 978-978-987-933-5

The book is available in all leading book shops nation -wide and in electronic form

Published and Printed in Nigeria by:

Giegie Nigeria Innovations,

Suite 77, S & T Barracks Road,
Opp. Mountain of Fire and Miracles Ministries
Uselu, Benin City, Edo State.
+234-7034623544, +234-8034602197, +234-8076342217
 TABLE OF CONTENT

Pages

Title Page i

Dedication iii

Acknowledgement iv

Foreword v

Table of Content vi

Chapter One
Fundamentals of Finance 1

Chapter Two
Mathematics of Finance 8

Chapter Three
Depreciation 42

Chapter Four
Forms of Business Organization 55

Chapter Five
Sources of finance to Businesses 65

Chapter Six
Working Capital 72

Chapter Seven
Cash Management 81

Chapter Eight
Cash Forecasting 87

Chapter Nine
Inventory Management 94

Chapter Ten
Cash flow Statement 101

Chapter Eleven
Management of Debtors and Creditors 117

Chapter Twelve
Investment Appraisal Decision 129

Chapter Thirteen
Inflation and Taxation in Investment Appraisal Decision 153
Chapter Fourteen
Risk and Uncertainty in Investment Appraisal Decision 165

Chapter Fifteen
Financial Leverage 178

Chapter Sixteen

Capital Structure Decision and Theories 187

Chapter Seventeen
Cost of Capital 201

Chapter Eighteen
Dividend and Dividend Policy 220

Chapter Nineteen
Ratio Analysis 232

Chapter Twenty
Break Even Analysis 260

Chapter Twenty-One
Mergers and Acquisitions 276

Bibliography 294

Appendices 299
 SUMMARY OF THE BOOK

Chapter one explained the fundamentals of finance. Chapter two examined mathematics of
finance. Chapter three focused on depreciation of assets while chapter four discussed about
the various forms of business organization and objectives of business firms as well. Sources
of finance to businesses were examined in chapter five. Chapter six dwelt on working capital
management. Cash management and models for cash management werex-rayed in chapter
seven while chapter eight considered cash forecasting in businesses. Chapter nine evaluated
inventory management. While chapter ten examined cash flow statement, chapter eleven
considered management of debtors and creditors in a business enterprise. Investment
appraisal decision was critically examined in chapter twelve. Inflation and taxation in
investment appraisal decision was explained with clear examples and illustrations in chapter
thirteen. Risk and uncertainty in investment appraisal decision was examined in chapter fourteen.
Chapter fifteen focused on financial leverage. Chapter sixteen examined capital structure decision and
theory. Chapter seventeen focused on cost of capital while chapter eighteen x-rayeddividend and
dividend policy. Financial ratio analysis took the focus of chapter nineteen. While chapter twenty
examined break even analysis, chapter twenty one critically examined mergers and acquisitions in
corporate organizations.
 C hapter O ne

Fundamentals of Finance
Learning Objectives
After reading this chapter, the reader should be able to:
 Discuss the fundamentals of finance
 Explain the meaning of finance
 Identify and explain types of finance
 Discuss who a financial manager is
 Identify the functions of a financial manager
 Explain the difference between finance and financial management
 Explain finance as a concept and field of study
 Define what financial management is
 Identify the objectives of financial management
 Discuss the scope of financial management
 Examine the relationship between finance and other fields of study
 List and explain career opportunities in the field of finance

Introduction
Finance is central to human existence from cradle to grave. It is fundamental for business
establishment, management, performance, growth and survival. It takes a center stage in the affairs of
businesses, government and humanity. Finance is highly essential for any government to meet the
basic needs of the citizenries, which include provision of hospitals, schools, roads, among others and
also for societal development. It is a major part of every persons, whether as a worker, an investor, an
entrepreneur, a housewife, a husband, the newly wedded couple, the job seeker, the beggar on the
street, the politicians which include the governors, the senators, the presidents and the local
government chairmen.

Finance is involved right from when we lose a loved one and prepare to say our final goodbyes in
whatever style we choose. For example, if you are born, it involves finance. If you are alive, it
involves finance. If you are wealthy or poor, it is because of finance at your disposal or not. Joining
politics involves finance. If a politician wins or loses an election, finance is fully or partly responsible
for it. The choice to attend the best schools in the world rests on finance. A good and colourful
ceremony such as birthday, wedding and funeral, all require finance.

The survival of an individual or a nation and the larger economy largely depends on finance. The
fundamental of finance to individuals, corporate bodies and societal existence cannot be over
emphasized. The size of your finance consciously and unconsciously attracts friends and dignitaries
to you, even when unsolicited. When friends and relatives know that you are not financially endowed,
they easily avoid you and even come up with multiple excuses for their behaviour. One of the
measures of your worth in our contemporary society is the amount of finance you control. Finance is
the all of all business entities and human existence on earth.

There is no individual person (s) or government (s) today in the world that does not cherish finance.
Finance is very fundamental to building an edifice for God by a Christian or Muslim and also
equipping it with state-of-the-art facilities. In the same vein, spiritual heads in churches or mosque
need finance to propagate their beliefs. There is no much achievement we can make in life without
setting our finances straight. Thus, finance forms a fundamental aspect of human existence,
establishment of a business firm and running government‟s affairs in a county.

Finance
Literarily, finance is referred to money. Finance either exists in form of cash or near cash. An example
of near cash is a bank cheque and Treasury bill. Finance is commonly referred to as the cash used to
achieve three primary motives by man which include transaction, precautionary and speculative
motives. Finance is a major prerequisite in undertaking the day- to- day activities by an individual
person and in the operation of business firms. For example, the buying and selling of goods and
rendering of services involves finance. Finance is also a requirement for obtaining physical resources,
such as buying raw materials needed for production and also for carrying out business operation
which include payment of wages and salaries, repair of business and household items, settling cost of
transportation, among others.

Types of Finance
Personal Finance: It refers to the practice of managing one‟s own daily expenses. It is also concerned
with the raising of money to undertake financial needs of individuals in order to achieve a desired
financial objective.

Corporate Finance: This type of finance dwells on sources of financing a corporate organization,
which could be through equity or debt. The debt could be short term or long term debt. Furthermore,
corporate finance is a type of finance which deals with investing decision, financing decision and
management of funds of corporate organizations, although small and medium firms also carry out
investment decision and financing. Corporate finance is also type of finance which is associated
with investment banking. One of the roles of an investment bank is to evaluate a company's financial
needs and then helps to raise the appropriate type of capital that best fits those needs based on defined
terms of agreement. On the overall, the primary goal of corporate finance is to increase shareholders‟
wealth.

Public Finance: This type of finance involves the practice of getting funds to achieve the needs of
government bodies such as government ministries, departments and parastatals. Public finance is also
a type of finance which deals with the collection and disbursement of revenues of tiers of government
with a view to settling financial matters and providing the needs of citizens which among others
include construction of roads, bridges, airports, railways, hospitals, schools just but to list a few.
Public finance is commonly taught in accounting and economics especially under public sector
accounting and public sector finance in tertiary institutions of learning.

A Financial Manager
A financial manager is an integral part of the management team in modern corporate organizations. A
financial manager is a person who manages the finances of a business firm. In a lay man‟s view,
anybody who knows how to carefully manage money is a financial manager. The essence of
managing money is to reduce expenses and increase revenue in a corporate organization. A financial
manager is a person who is responsible in shaping the financial future of a corporate organization.

A financial manager is someone who is skillful on how to get funds in a least costly manner and
utilize it profitably to achieve the financial goal of a corporate organization. We can also referred to a
finance manager as someone who has the requisite financial training, knowledge and frequently
applies financial tools to solve real business problems in order to maximize profit, shareholders‟
wealth and satisfy other stakeholders of a corporate organization.

Functions of a Financial Manager

 The financial manager helps to ensure that the finances required by a business firm are
obtained from cheap and reliable sources.
 The financial manager helps to plan the use of funds and its safety in a business.
 The financial manager is responsible in preparing financial statements to show the financial
performance, financial position and adequacy of cash flow of a corporate organization for a
period.
 The financial manager is responsible in assessing a company‟s financial status and seeks ways
to reduce costs in order to increase revenue.
  The financial manager is actively involved in the three critical decisions in a corporate
organization. These three critical decisions are investment decision, financing decision and
dividend decision.

Finance versus Financial Management

A lot of persons often mistake finance for financial management. Although the two concepts are
connected, they are however different. Finance takes precedence over financial management.
Logically, an individual person or a corporate organization should have finance (money) at his/her/its
disposal, before engaging in a financial management decision. Following this, finance can be seen as
both a concept and a field of study.

Finance as a Concept
Finance as a concept means money. It could exist in the form of gold money or paper money which
must be generally accepted as a legal tender within and across national boundaries. Finance as a
concept is the cash commonly used to achieve varying needs by persons, business firms and the
government.

Finance as a Field of Study

Finance is a field of study which deals with the studying and working of money geared towards
achieving a financial and non- financial objective by an individual, by a corporate body and by a
government. As a field of study, finance deals with how to analyze and undertake investments
profitably. Decisions concerning finance itself, techniques for assessing and undertaking profitable
investments are central to the field of finance.
A lot of subjects which deal with various aspects of investing, financing, dividend decisions and
financial management are taught and learnt, leading to the award of diploma certificates or degrees in
colleges, polytechnics and universities. A significant number of institutions all over the world, offer
undergraduate and graduate degree programmes in Finance leading to the award of Bachelors, Master
and Doctorate degrees.

Financial Management
Financial management is a major area in the field of finance. It is one of the key areas commonly
examined in finance. Financial management deals with the management of money and other valuables
which can easily be converted into cash. Financial management is the acquisition and effective use of
money in meeting the overall financial objective of an individual, corporate organization, the
government and non-governmental organizations. The goal of financial management is to reduce costs
and other possible risks associated with management of corporate organizations. Financial
management implies evaluating investment risk level with the associated gain.

Objectives of Financial Management

 Financial management helps to ensure the regular and sufficient availability of cash in carrying
out several obligations in a corporate organization.
 Financial management helps to ensure the resource-owners of a corporate organization are
rewarded for their investment.
 Financial management helps to promote a company‟s profitability and wealth of the
shareholders.
 Financial management helps to ensure cash is best sourced and used in a least cost manner.

Scope of Financial Management

There are three main scopes of financial management decision making. These include investment,
financing and dividend decisions. These scopes constitute three critical areas in financial
management.
 C hapter T wo

Mathematics of Finance
Leaning Objectives
After studying this chapter, you should be able to:
 Explain what mathematics of finance is.
 Explain time value of money.
 Carry out simple interest calculation
 List, explain and undertake calculation of simple interest rate using the two types of interest
rates.
 Undertake computation of simple interest where interest rate and number of periods involved
are unknown.
 Explain compound interest and its calculation, annually, quarterly and semi-annually.
 Undertake calculation of compound interest where interest rate and number of periods involved
are unknown.
 Undertake continuous compounding.
 Carry out present value of continuous compounding
 Undertake present value discounting and its calculation
 Undertake future value discounting and its calculation
 Carry out future value discounting where interest rate and number of periods involved are
unknown
 Explain ratios and proportions and apply them to solve finance problem (s).
 Explain discounts and percentages and apply them to solve finance problem (s)
 Define annuity, list and explain its types
 Apply annuity and its types to solve real life finance problem (s).
 Define sinking fund and loan amortization and apply them to solve finance problem
 Define effective annual interest rate and apply it to solve finance problem (s).
 Explain what mark up and mark down are all about and apply them to solve finance problem

Introduction
Mathematics of finance is the application of quantitative methods in estimating if the benefit from an
investment opportunity will be more than the current sum of money committed into it. Mathematics of
finance also entails the application of logic or reasoning in a quantitative manner towards ascertaining
gains from investments in a period of time, which could be in the future or at a current period. Areas
mathematics of finance are commonly applied to, include but are not limited to simple interest
investment, compound interest investment, present value of an investment, future value discounting of
an investment, ratios and proportion, discount and percentages, annuity investments, loan
amortization, sinking funds investment, among others. Application of mathematics of finance is
connected with time value of money. For instance, the present value or future value of money with
passage of time is commonly analyzed using mathematics of finance.

Time Value of Money

Money increases or decreases in value within passage of time. This is the whole essence of time value
of money. Time value of money implies that one naira received today is more valuable than one naira
received tomorrow. For instance, some persons may prefer to receive N500 today than to wait to
receive it in the future because they feel the value is likely to fall tomorrow or the purchasing power
may reduce in the future. This might be due to certain factors such as inflation.

For example, the level of inflation in an economy could affect the purchasing power in the market
place. This is because inflation erodes the value of money over time. Moreover, assessment of the
future value and present value of an investment are obviously based on periods involved, inflationary
factors, political instability, prevailing interest rate, the size of the capital invested, unexpected
occurrence in an economy such as natural earth quake, drought, outbreak of serious epidemics and
pandemics like corona virus (Covid-19), among others.

Simple Interest Investment

Interest charges are a payment, cost or fee associated with money borrowed for a specified period of
time. Interest rate is the price paid for a sum of money borrowed per unit of time. The unit of time
could be half a year, a year, etc. Prevailing interest rate is used by commercial banks and other
financial institution is the rate set by the central bank of a country.

The value of interest charges is commonly determined by three factors, namely, the amount of money
borrowed otherwise referred to as the principal (P), the interest rate (I) and the number of interest
payment period (n). Simple interest investment is calculated as: principal (P) multiplied by interest
rate (I), multiplied by number of periods (n). That is, simple interest (S.I) = P x I x N. The sum of the
simple interest investment is the principal amount plus the computed simple interest charges.

Illustration 2.1
What is the simple interest investment and sum on N9000 for (a) 2 years (b) 6 months at 6% per
annum?

Suggested Solution
S. I = P x I x N
(i) Principal = N9000
Interest = 6% = 0.06
Number of period = 2 years
I = N9000 x 0.06 x 2
I = N1080
(ii) S = P + Pin
S = N9000 + 1080
S = N10, 080
Sum = P + Pin
6
Principal = N9000; Interest = 6% = 0.06; number of period = 6 months = 12 = 0.5; I = Pin; I
= N9000 x 0.06 x 0.5; I = N270; S = P + Pin (i.e, principal x interest x number of interest
payment period. S = N900 + N270. S = N9270.

Types of Interest Rates Charges

Ordinary Interest Rate
Interest rate charge computed on the basis of 360 days in one calendar year is known as ordinary
interest rate charge. The ordinary interest rate charge is also known as the banker‟s rule and is
commonly used by deposit money banks.

Exact Simple Interest Rate Charges

Interest rate charge computed on the basis of 365 days in one calendar year and 366 days in the case
of a leap year is called exact interest rate charge. The exact interest rate charge is generally used by
the Central Bank in computing interest payment on government obligation (debt) and rediscounting
note for commercial banks.

Illustration 2.2
Find
(i) The ordinary interest rate charge
(ii) Exact interest rate charge
On N8000 for 90 days at 8% per annum

Suggested Solution
(i) S. I = P x I x N
 Principal = N8000; Interest rate = 8% = 0.08; and number of period = 90/360 days.
S. I = N8000 x 0.08 x 90/360. I = N160. S = P + Pin. S = N800 + N160. S = N8160
(ii) Exact simple interest rate charge
Principal = N8000; Interest rate = 8% = 0.08; number = 90/365 days
S. I = N8000 x 0.08 x 90/365; I = N157.80. S = P + Pin. S = N8000 + 157.80. S = N8157.80

Unknown Interest Rate and Number of Period Associated with Simple Interest Rate Investment
Sometimes, there is need to find out the interest rate charges or number of period implicit in simple
interest rate investment. This is practically demonstrated in illustrations 2.3 and 2.4.

Illustration 2.3
Mrs. Charity lent out N10, 000 for three years to Miss Unique. After the three years period, the fund
yielded N15, 000. You are required to calculate the interest rate charges per annum.

Suggested Solution
S. I = P x Rx N
S. I=N 15, 000
P= N10, 000
T= 3years
R=?
15,000 = 10,000xRx3
15,000 = 30,000R
15,000
R
3,000
R= 0.5X100= 50%

Illustration 2.4
Alhaji Musa lent out N7, 000 at the rate of 5% to Alhaji Muhammed which yielded a simple interest
of N16, 000. How many years was the money lent out?

Suggested Solution
S. I = P x R x N
S. I=N16, 000
P= N7000
R= 5%
T=?
16,000 = 10,000x0.05xT
16,000 = 350T
16,000
T
350
T=46 years
 C hapter T hree

Depreciation

Learning Objectives
At the end of this chapter, the reader should be able to:
 Explain what depreciation is
 Identify and explain causes of depreciation of assets
 List and explain at least three terminologies associated with depreciation
 List and explain various methods of computing depreciation of assets
 Apply each methods presented to compute depreciation of assets

Meaning of Depreciation
Depreciation may be defined as a decrease in the economic value of an asset due to wear and tear in
the passage of time. Depreciation is a continuous reduction in the quality and value of an asset due to
usage over time. As assets depreciate, the monetary value also decreases. Depreciation of assets is an
expense to a business or an individual who owns the assets. Conventionally, as assets depreciate in a
business, the business owner makes provision for its replacement in the future. In this case, the
business owner ensures an amount is set aside as depreciation expenses for the asset replacement in
the future. The asset‟s useful life therefore, is the period between when it was produced, used and
eventually wear out and no longer useful to the business or the owner.

Causes of Depreciation
Depreciation of an asset is caused by some factors which include:
i. Wear and Tears: These referred to the frequent usage of an asset for a period of time. For
example, the tyre of a motor vehicle often wears out within passage of time due to frequent
usage by the owner or business firm. The wear and tear of an asset are commonly caused by
erosion, rusting, heat, decay and regular exposure to air and water.
ii. Passage of Time: An asset does not depreciate in vacuum. It occurs in the process of time.
The process of time is the period of time over which the asset is used by the business firm.
The time could be a month or year (s).
iii. Depletion: This referred to a decrease in the value of natural assets such as gold, oil, tin or
coal deposits. Depletion of these natural assets makes them worthless when they have fully
exhausted their life span. The more they are used, the less the reserve of these natural assets.
This is one of the reasons they are often seen as wasting assets. Moreover, because these
assets are irreplaceable through human intervention. That is, they are depletable and non-
renewable, their loss is permanent. This is one of the reasons they are often seen as wasting
assets.

Basic Terminologies Associated with Depreciation

i. Original Cost: This referred to the initial amount with which the asset was bought. The
amount the asset was bought may include cost of purchase, cost of installation and cost of
carriage.
ii. Estimated Value: This is also referred to as a residual value or scrap value. It is the amount
which can be recovered from the asset at the end of its useful life or when the asset is finally
sold after its depreciation for a period. For example, if a motor vehicle was bought at N2, 000,
000 four years ago and it is being sold now, say at N300, 000, the N300, 000 becomes the
scrap value or estimated value or residual value.
iii. Estimated Useful Life: This referred to the expected number of years an asset can last. In
developed countries such as Japan, UK and Canada, when a new vehicle is produced, the
useful life is instantly estimated. So, the useful life could be 10 years or 15 years. However,
the useful life of an asset varies from one asset to the other.
iv. Depreciation Rate: This referred to the percentage the asset is observed to reduce in value
within the passage of time. Assets depreciation rate is always predetermined in accordance
with the policy of a business firm. The predetermined depreciation rate could be 10%, 15% or
20%. The size of the asset and frequency of its use are factors influencing the choice of the
rate of the asset‟s depreciation in a corporate organization.

Methods of Depreciation
There are at least ten (10) methods which can be used to compute depreciation of assets. The method
(s) used by a business firm is a function of its policy. However, there is need for consistency in the
method applied in the asset depreciation. Each of these methods is stated and explained as follows:
i. Straight Line Method
ii. Reducing Balance Method
iii. Sum of the Digit Method
iv. Annuity Method
v. Sinking Fund Method
vi. Insurance Policy Method
vii. Production Hour Method
viii. Revaluation Method
ix. Renewals Method

Straight Line Method

Under this method, an equal amount of money is charged as depreciation expense for each year of the
asset‟s life. One of the problems with this method is that it uses historical value instead of future cost
value. The historical cost is often not realistic in that it does not reflect rapid variation in prices of
assets. Both the scrap value and useful life are mere estimates by the accountant and as such are quite
subjective. This method is computed with the formula:
𝐶𝑜𝑠𝑡 – 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑠𝑐𝑟𝑎𝑝 𝑣𝑎𝑙𝑢𝑒
Depreciation =
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑢𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒

Illustration 3.1
Jacobson Enterprises bought a motor vehicle worth N1,500,000 on January 1st 2013. The
Accountant estimated that the vehicle would have a residual value of N300, 000 after 6 years. The
Accountant recommended to the managing director that depreciation on the motor vehicle be charged
using straight line method on a yearly basis. Required:
a. Find the yearly depreciation expense
b. Estimate the depreciation rate
c. Show the results of (a) above in a tabular form, indicating the annual depreciation expenses,
accumulated depreciation and the net book value on a yearly basis to the end of the asset‟s
useful life.

Suggested Solution
Jacobson Enterprises
𝐶𝑜𝑠𝑡 – 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑠𝑐𝑟𝑎𝑝 𝑣𝑎𝑙𝑢𝑒
a. Depreciation Expense =
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑢𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒

1500,000 – 300,000
Depreciation Expense =
6
1200,000
=
6

= 𝑁200, 000
 C hapter F our

Forms of Business Organization

Learning Objectives
After reading this chapter, the reader should be able to:
 Define a business
 List and explain three forms of business organizations, their advantages and disadvantages
 List and explain types of partners in a partnership business
 Define a corporation, list and explain types of corporation, discuss memorandum of
understanding and article of association
 List and explain the different statutory books companies are required to keep
 List and explain five (5) objectives of a business firm
 Explain who stakeholders are in a business firm
 List and explain different types of stakeholders in a business firm

Introduction
A business is an establishment where commercial activities such as production, selling of goods and
rendering of services are carried out with the aim of profit or non-profit making. The nature of
ownership of a business influences the form it is organized. There are three main forms of business
organizations. They are:
 Sole proprietorship Business
 Partnership Business
 Corporation

Sole proprietorship
Sole proprietorship is also referred to as one-man business. It is a business owned by one man. This
does not mean there is only one worker in the business. The one-man owner can employ a number of
workers to work for him. Sole proprietorship is very commonest in the retail trade, motor mechanic,
welding, hair stylist, vulcanizing, restaurant, fashion designing, photography, and among others.

Advantages of Sole Proprietorship

i. One’s own master: Under this, it means the sole proprietor has no sole boss to control him.
He does not seek the permission of anybody before taking any action. For example, he can
choose to go to work when he feels like doing so and closes at his personal convenience. He
is his own personal master and enjoys freedom of action in all areas of the business.
ii. Quick decision making: Since the sole proprietor has no boss whose permission he must
seek before taking any decision; he is at liberty to make quick decisions. He takes actions as
occasion and times demand.
iii. Close personal relationship with workers and customers: Because the one-man business is
usually small, the owner is able to have a close personal knowledge of his workers as well as
his customers. Such knowledge enables him to know how to treat each of his workers and
customers cordially as well as understand their feelings and needs. He, at all times, gives
personal help to his workers when they are in difficulty. This type of relationship makes the
workers to work hard for him.
iv. Self-interest: Because all the profits of the business belong to the sole proprietor, he has self
interest in the business. If he works hard he will reap the entire fruits of his hard work. This
often motivates him to be very hardworking and careful. He makes sure that waste of
financial, material and physical resources is avoided at all cost.
v. Privacy: The sole proprietor is not under any law to disclose his financial records or reports
to members of the public to see.
Disadvantages of Sole proprietorship
i. Small capital: The capital of sole proprietorship is often very small. This makes the growth
of the business very slow. It also makes it difficult for him to enter into manufacturing
industries where heavy capital investment is a requirement.
ii. Absence of specialization: Most of the times, a sole proprietor does so many things by
himself. For example, he may be in charge of making the products of the business, selling
them, keeping record of sales and going to the bank for cash lodgment. These handlings of
multi-tasks by the sole proprietor do results in ineffectiveness, inefficiency and lack of
specialization in a definite area in the business.
iii. Death: Commonly the death of a sole proprietor does lead to the end of the business unless he
has somebody like wife, capable children or relations to take over the management of the
business in a profitable manner.
iv. Unlimited liability: This means that the sole proprietor bears the risk of losing the business
property, cash and even his private property if the business collapses. For instance, his
personal house (s), furniture, car (s), etc., may be sold to settle the debts of the business.
v. Inability to employ well-trained staff: A lot of one-man businesses cannot afford to employ
well trained staff such as chartered accountants, highly educated persons who may have
master degree and doctorate degree in different areas of specializations. What they do is to
engage the service of ill-trained, or inefficient mediocre such as primary and secondary school
certificates holders to manage the business.

Partnership Business
At times, a number of persons may combine to legally form a business either for profit or non- profit
making purposes. The main purpose of coming together is often to secure adequate capital for the
business they wish to run. A business organized and operated by more than one person is referred to
as a partnership business. The conduct of the partnership is regulated by a document called deed of
partnership which is drawn by a lawyer or a solicitor. Partnership businesses are more common
among close friends or members of the same family such as father and son, two brothers or between a
husband and wife.

Partnership Deed
This is also referred to as partnership agreement. It is a document which states clearly the rights and
responsibilities of all parties to a business operation. It has the force of law and is designed to guide
the partners in the conduct of the business.

Contents of Partnership Deeds

1. Name of the partners
2. Name of the partnership business
3. Capital contributed by each partner
4. Address of the partnership business
5. Nature of business the partnership is into such as production, buying and selling of product
XYZ or rendering of services such as XYZ.
6. Date of commencement of the partnership business
7. Duties of the partners
8. Rights of partners
9. Profit/loss sharing ratio
10. Interest on capital payable to partners
11. Salary payable to partners, if any
12. The procedure for admitting or retiring a partner
13. Mode of settlement of dues with a deceased partner‟s executors
14. The procedure followed in case disputes arise between partners

However, if the partners do not have a partnership deed, the following rules may apply:
 The partners share profits and losses equally
 Partners will not get a salary.
  Interest on capital will not be payable.
 Drawings will not be chargeable with interest.
 Partners will get 6% per annum interest charges on loans to the firm if they mutually agree to
it.

Types of Partners in a Partnership Business

There are several partners in a partnership business. However, the commonest ones are:
 Active Partner: An active partner is also referred to as a managing partner. An active partner
takes active interest in the conduct and management of the partnership business on a day to
day basis. An active partner commonly carries on business on behalf of the other partners in
the business.
 Sleeping Partner: A sleeping partner is a partner who „sleeps‟. What this means is that he
does not take active part in the management of the business. He can only contribute to the
capital of the business.
 Nominal Partner: This type of partner does not have any real interest in the business. What
he does is just to give out his name to the business enterprise. His name is used in the
business perhaps because of his reputation, wealth and strong political status. He does not
contribute any capital and doesn‟t share the profits of the business. He also does not usually
have a voice in the management of the business of the firm.

Advantages of Partnership
 Larger capital: Partnership businesses have larger capital than sole proprietorship
businesses. This enables them to expand faster. However, their capital is still much smaller
than that of public limited liability companies.
 Specialization among partners: In a partnership business, each partner takes up that aspect
of the business in which he has knowledge, experience or training. For example, a partner
who has previous training in accountancy will take up the accounting aspect of the business.
A partner who has experience in salesmanship becomes the sales manager. A partner who
read and practices law may take up the legal aspect of the partnership business. This type of
specialization goes a long way to making the partnership business very effective and
successful.
 Wiser decisions: In partnership business, each partners put heads together when making
decisions. This often make them to take a decision better than those made single handedly by
a sole proprietor.
 Personal knowledge of customers: Partners in a partnership business do have very close
personal knowledge of their customers and even workers. For instance, they know where
some of their customer‟s work and can easily determine which of them can be granted credit
without much risk.

Disadvantages of Partnership
 Distrust and Quarrels: very often partners demonstrate attitudes of no trust among
themselves perhaps due to dishonest or attempting to play smart at other partners with the
finances or assets of the business. Sometimes, there could be persistent acrimony, quarrels
and even fights among the partners due to certain unresolved issues, undefined approach to
managing the business or any other socio-psychological reasons. When all these factors linger
on among the partners, eventual folding up of the partnership business is sure.
 Collective Responsibility: In the eyes of the law, all partners to a partnership business are
joint and severally liability for any offence (s). The implication of this is that all the partners
may pay for the foolish behaviour of any of its member (s). For example, one of the partners
may enter into an unwise contractual or non- contractual relationship with another business
concern or person (s) all in the name of the partnership primarily and without the awareness
of the other partners. In this case, all the partners would be required to bear the grave
consequence occasioned by the silly behavior of only one of the partners in the partnership
business.
  Unlimited Liability: Just like the one- man business, partners in a partnership business do
suffer from unlimited liability. What this portends is that each of the partners can be called
upon to use their private property to settle the debts of the partnership any time such
development occurs. If the partnership business has incurred huge debts, the partners may
lose everything (both cash and physical properties) they have both in the business and at
home.
 Death: In a partnership business, the death of one partner may lead to the final closure. This
however is subject to the detailed contents of the partnership deed. Where the deceased
partner contributed significant percentage of capital towards the formation of the business, at
the occurrence of his death, the beneficiaries may ask for the withdrawal of his investment
into the partnership business. This may adversely affect the partnership business such that it
cannot continue operation after such withdrawal.

How Sole Proprietorship and Partnership Raise Capital

 Through Personal Savings: This is the most common way in which the sole proprietorship
business and partnership business obtain their capital. The saving is usually done over a long
period of time.
 Loan from Friends and Relations: Very often, a prospective sole proprietor obtains a small
loan from a friend or relation when starting a small business.
 Loans and Overdrafts from Banks: Sole proprietorship business and partnership business
can also obtain small loan and overdraft from banks. Some of the sole proprietors and partners
may have houses which they can use as collateral (security) on the loan from the bank.

Meaning of Corporation
A corporation is a legal entity to itself. This means it is different from its owners. Meaning it can sue
and can be sued as well as engage in contracts and acquisition of properties legitimately. A
corporation comes into existence in accordance with the law. For example, the formation of a
company is done by adhering to the contents of the memorandum of association and article of
association stipulated by the Company and Allied Matters Acts (CAMA, 1990 as amended).

A corporation is otherwise referred to as a company and is usually owned by shareholders.

Shareholders are the owners of the company by reason of the unit of shares they bought and have in it.
The investments and interest of shareholders in a corporation are managed by board of directors and
senior managers. Board of directors are usually appointed by the shareholders to help manage the
resources of the company on their behalf. The board of directors may appoint key management
personnel in the different sub-committees in the company to ensure proper and strategic management.

Conventionally, board of directors consist of executive and non- executive directors. The non-
executive directors are otherwise referred to as independent directors. Independent directors owe it a
duty to serve in stewardship capacity as far as the company is concerned. In the same vein,
independent directors may be liable for the mismanagement of the firm as well as the
misappropriation of funds by the executive directors.
It is mandatory by law for a company to pay tax on its income for a period. After payment of tax, a
company may choose to pay all or part of the profits made to the shareholders as dividends or keep
part of it as reserve. The reserve kept aside is called retained earnings and is often used for
reinvestment and future expansion of the company. For these reasons, a corporation enjoys more
benefits than a sole proprietorship or partnership business.

One of the problems in companies is agency problem. Although agency problem is common in a sole
proprietorship and partnership business, the degree of its occurrence is higher in a corporation.
Agency problem arises when managers run the corporation in their interest to the detriment of the
shareholders who appointed them. In other words, agency problem occurs in a company principally as
a result of separation of ownership between the principal (i.e the shareholders) and the agents (board
of directors and managers).
 C hapter S ix

Working Capital

Learning Objectives
After studying this chapter, you should be able to:
 Explain in detail what working capital is
 Explain gross and net concepts of working capital
 List and explain the determinants of working capital
 Explain working capital policy
 List and explain three classification of working capital in a business firm
 Explain what short versus long term financing of working capital entails in a business firm
 Explain cash operating cycle and solve a business firm problem with it
 Identify and explain types of working capital ratios
 Explain overtrading, identify signs of trading and the solutions to it
 Explain the meaning of working capital management
 Identify the advantages and disadvantages of working capital management in business firms.

Introduction
Working capital is the fund available for the day to day operation of a business enterprise. Working
capital is the excess of current asset over current liabilities. Current assets are assets whose life span is
less than a year. They are used to operate a business on a daily basis. Examples of current assets are
cash at hand and at bank, short term investments, inventories which could be raw materials, work in
progress, finished goods, prepayment and dues collectible from debtors. Current liabilities are what
the business owes to outsiders of the business which are payable within a year. Current liabilities
include amount owed to creditors of a business, expenses payable within a year; bank overdraft and
short term loan payable in not more than twelve months. The difference between current assets and
current liabilities is referred to as net working capital.

Gross Concept of Working Capital

This referred to the firm‟s investment in current assets. Gross concept of working capital helps a
business enterprise to avoid over liquidity and illiquidity.

Net Concept of Working Capital

This referred to the difference between current assets and current liabilities of a business enterprise.

Hypothetical Example of Gross and Net Concepts of Working Capital

Gross Working Capital
Current Assets N, 000
Inventory 300
Trade receivable 200
Cash 100
Total gross working capital 600

Less: Current Liabilities

Trade payable 200
Bank overdraft 200
Net Working Capital 200

Determinants of Working Capital

 Size of a Business Enterprise: The working capital need of a firm is directly influenced by
the size of its business operation. Big manufacturing business organizations require more
 working capital than the small manufacturing business organizations. Therefore, the size of
organization is one of the major determinants of working capital.
 Nature of Business: The nature of a business a firm is into, contributes to the working capital
required. For example, manufacturing and trading businesses need more working capital than
service businesses such as commercial banks.
 Storage Space and Processing Time: A business that has large storage space and storage
period will need huge working capital such as inventories. If storage period is big, a firm will
keep more quantity of goods in store and require more working capital. If the processing time
is long, more inventories may be held in store or warehouse.
 Credit Period: Usually, longer credit period require more investment in debtors and hence
more working capital is needed. However, a firm which allows less credit period to customers
may need less working capital.
 Seasonal Requirements: Some seasons in a year influence a business enterprise to keep
more of working capital such as raw materials to ensure uninterrupted supply, production
level and sales. In Nigeria for instance, during dry/harmattan season when the weather is hot,
a lot of persons do demand for ice cream and cold plastic/sachet water unlike during rainy
season of the year. A business firm producing ice cream or plastic/sachet water will always
keep more of materials for the production of these products in dry season period than in
raining season. The implication of this would be increase in working capital requirements in
such a firm. The working capital required to meet seasonal requirements is referred to as
seasonal variation working capital.
 Potential Growth and Expansion of Business: A business enterprise seeking for expansion
and growth in the future will definitely need more working capital.
 Changes in Price Level: During period of persistent rise in the price of goods, some
businesses will prefer to keep more of working capital components like inventories for sales
or production.
 Access to Money Market: If a firm has good access to money and capital markets, it can
raise loan from bank and financial institutions to be able to meet working capital need.

Advantages of Working Capital

 Enabling a business to make payment for salaries and wages as they fall due and other
expenses on daily, weekly and monthly basis.
 Enabling a business to constantly meets customers‟ demands for its products
 Encouraging debtors‟ patronage and thus helping the business gain advantages over its
competitors in the market place.
 Assisting a business to easily meets up with its short term obligation to trade creditors and
suppliers and remain in business
 It helps the business to balance up the problems of stock-out and over stocking

Disadvantages of Working Capital

 It may contribute to idle funds, especially in a situation where the financial manager lacks
short run investment ideas.
 Affecting liquidity and profitability of the business.
 Depletion of the cash position of the business.

Annual Cost of Working Capital Investment

It is sometimes necessary to ascertain the costs of working capital investment in a business enterprise.
Annual cost of working capital is the average investment in working capital times interest rate
charges. If the interest rate charges are high and investment in working increases in the period, the
annual cost of working capital investment will be high also.
 C hapter S even

Cash Management

Learning Objectives
After studying this chapter, you should be able to:
 Explain what cash management entails
 Identify objectives of cash management
 List and explain factors to consider in cash management
 List and explain functions of cash management
 Identify and explain the motives for holding cash
 List and explain factors contributing to efficient cash management
 List the areas commonly involved in cash management
 Explain cash management model
 Explain Baumol model of cash model and list its assumptions
 Explain the advantage and disadvantage of the Baumol cash
 Explain the Miller-Orr cash model

Cash Management
Cash management entails the efficient and effective collection, disbursement and investment of cash
in liquid and profitable assets. Some of the main objectives of cash management are to avoid shortage
of cash balance in a business and to prevent excess cash. Excess cash often leads to idle cash which
could be employed for other profitable investments and other economic benefits.

Factors to Consider in Cash Management in a Business Firm

Avoiding Cash Deficit: Under this, certain amount of cash is kept aside to avoid cash deficit in the
business. Cash deficit can negatively affect a business in undertaking periodic payments for expenses
such as payment of wages and salaries to workers, payment to creditors/suppliers, and settlement of
rents, among others.
Preparation for Cash Contingency: Here certain amount of cash is set aside to cushion the adverse
effect of unforeseen calamities which the business firm may not have prepared for in the normal
course of operation. For example, preparation for cash contingency helps to overcome the crippling
effect of bad debts and fire outbreak that could stamp the business out from existing competition.
Percentage of retained earnings kept as reserve could help to take care of contingency occurrences.
Cheap and Availability Cash from External Sources: This entails ensuring cheap funds are made
available from external sources in order to achieve defined financial objective in a corporate
organization.
Taking a Deliberate Step to Increase Cash Receipts: This involves exercising caution when
granting discounts to customers, minimizing the cost of borrowing. Cash could also be increased in a
business firm by ensuring customers pay their dues for example through point of sales (POS) and
through other means. Another way a corporate organization can maximize cash is by reducing credit
period extension to customers.

Importance of Cash Management

It Promotes Cash Planning: Cash planning involves making a forecast of the amount of cash
required in the future by a corporate organization. To achieve this, cash budgeting table, preparation
of sales collection schedule, preparation of purchases payment schedule and other budgeting tools
become very essential.
It promotes Cash flow Position: Cash management enables a corporate organization to easily
ascertain its net cash flow position. Net cash flow position is the difference between cash inflow and
cash outflow in a business firm.
It Promotes Sound Liquidity Position: The purpose of maintaining sound liquidity position is to
ensure funds are enough to settle obligations in time and still remain for the day to day operations of
the business firm.
It Promotes Investment of Idle Cash: Through cash management, a corporate organization is able to
judiciously invest idle cash to generate further income.

Motives for Holding Cash

Transaction Motive: Under this motive, cash is held to carry out financial obligations on a day to
day, week to week and month to month basis by individual persons and a business firm. Financial
obligations also involve payment for raw materials, payment for wages and salaries and payment for
other operating expenses. The inflow of cash goes a long way in achieving the transaction motive in a
business firm.
Precautionary Motive: Under this, cash is held by individual persons and businesses to carry out any
unforeseen, unpredicted or unexpected expenses. For individuals, cash could be held for the purpose
of meeting up with unexpected hospital bills and accident occurrences. For businesses, cash could be
held to settle unforeseen cash loss through theft and fire outbreak.
Speculative Motive: In speculative motive, cash is held to undertake speculative investment
opportunities and to also invest in a hit and run type of unexpected business opportunities. With
speculative motive, cash could be held to buy securities when the interest rate is low and to buy cheap
landed properties.

Areas Normally Involved in Cash Management

1. Cash Flow Forecasting: This is carried out through cash budgeting.
2. Investing Idle Cash: Idle cash could be invested in short – term investment channels such as
buying Treasury Bills
3. Taking a Critical Decision on Cash: Under this, a corporate organization consciously
engages in a decision on how much cash to save and how much cash to keep into short – term
liquid investments.

Cash Management Models

A cash model is used to estimate the amount of cash to hold and how much to put into short – term
investments for a defined period. Cash model is helpful in managing cash surplus and cash deficiency
for a period of time by a business firm.

Types of Cash Management

There are two models of cash management. They are the:
- Baumol Cash Model
- Miller – Orr Cash Model

Baumol Cash Model

The principles and application of the Baumol cash model is not different from that of the economic
order quantity (EOQ) model in inventory management. The Baumol cash model is used to estimate
the optimal amount of cash that needs to be received every time short – term investments are sold. In
Baumol cash model, the belief is that a business firm spends cash frequently to undertake short term
investment. The short – term investments are treasury bills, certificate of deposits, etcetera. The stance
of Baumol model is that frequent sales of investments are a requirements to get cash for operating
expenses payments.

Assumptions of Baumol Cash Model

1. Firm employs cash at a fixed rate every day throughout each year.
2. Payments involving cash are spread evenly over time and at a fixed amount each period.
3. A business firm refills its cash very fast, as soon as it runs out of the cash at its disposal.
4. Cash can immediately be replaced by selling short – term investment, e.g Treasury bills.
These short – term investments are expected to earn interest income. Note that the amount of
 the short – term investment sold and the amount of cash realized from the investment may be
denoted with, 𝑥.
5. There is a cost associated with holding cash. The cost is commonly referred to as opportunity
cost. That is, it is the cost incurred in not investing the cash in order to earn interest income.
The opportunity cost may be denoted as,𝐶𝐻 , and it represents interest rate. Imagine your
investment in Treasury Bills fetched 3% per year. Thus, the annual cost of holding the cash is
the 3% (i.e 0.03).
6. Sales of short – term investments attracts a transaction cost, denoted as,𝐶𝑜 .
𝑥
7. Annual cost of holding cash as = 2 × 𝐶𝐻 .
8. If the annual demand for cash is D, the annual transaction costs of disposing short – term
𝐷
investments may be denoted as, 𝑥 × 𝐶𝑜 . The total annual cost of holding cash and annual
demand for cash is expressed as:
𝑥 𝐷
× 𝐶𝐻 + × 𝐶𝑜
2 𝑥
2𝐶𝑜 𝐷
It can be reduced to: 𝑋 = 𝐶𝐻
. This is now the Baumol cash model.
 C hapter E ight

Cash Forecasting
Learning Objectives
After studying this chapter, you should be able to:
 Explain what cash forecasting entails
 Explain how cash forecasting can be achieved
 Identify purposes of cash flow forecasting
 List and explain some common problem of cash flow in a business firm
 Identify and explain some methods that could be used to reduce cash shortages in a business
firm
 Discuss what a cash budget is
 Identify some items that are usually not considered in preparing a cash budget schedule
 Explain some functions of a cash budget
 How to prepare a cash budget for a business firm
 Explain the meaning of free cash flow

Introduction
Cash forecasting referred to the anticipation of cash inflow, revenue and cash expenses required to be
incurred in a defined period of time. Cash forecasting takes into consideration the expected cash
inflow and cash outflow in a business firm for a specified period of time.

Cash flow Problems

Making Losses: A business firm that constantly makes losses will always have cash flow issues. To
avert this kind of problem, there has to be an efficient expense/liquidity management skill on the part
of the managers.
Inflation: Most businesses usually suffer from cash flow problem during periods of inflation in an
economy. The level of cash at the disposal of the business firm may be chasing few items in the
market. The demand for its products and services may also suffer a setback due to hjike in prices. The
business firm will unconsciously find itself struggling to meet certain financial obligations.

Seasonal Business Activities: A lot of businesses do have cash flow problem during certain periods
of the year. For example, when yuletide season is approaching, it is conventional for some businesses
to stock – pile enough inventories at a cheaper price to meet the demands of customers. This always
makes them to have shortage of cash. Before the yuletide season, business activities may be at low
ebb, but would increase during the yuletide period. So, cash flow gets higher during the yuletide
season, unlike in the pre – yuletide period of the year.

Methods of Reducing Cash Shortages in a Business Enterprise

Postponing Capital Expenditure: Capital expenditure usually involve huge cash. If embarking on a
capital project would drastically affect the level of cash in the business, it is always advisable to
postpone such project in order to meet up with the day – to – day administrative cost.
Increasing Cash inflows of the Business: This can be achieved by encouraging debtors to pay up
their debts in time, by giving discounts to them. This should be done carefully to avoid damage to the
profit objective of the business firm.
Selling off Assets Initially Invested in: The business firm can choose to sell off some assets
considered to be redundant in terms of income generation. For example, assets like motor vehicles
initially acquired but not producing adequate cash for the business could be sold off. This would help
that business to gather enough cash at free cost, than resorting to external borrowing which may
attract high fixed interest charges.
Cash Budget
Cash forecasting is mainly achieved through a cash budget. A cash budget shows the difference
between cash receipt, purchases payments and other general and administrative expenses for a
monthly or quarterly period. A cash budget demonstrates planned receipt of cash and cash payments
for a defined period of time which could be monthly or quarterly. Cash budget assists a firm to
determine its minimum or maximum cash balance for a period. If the expected cash balance for a
month or quarter falls below the standard minimum cash balance, the firm can resort to either internal
or external financing sources.

Internal financing implies using the retained earnings to achieve the standard minimum cash balance.
External financing is taking up loan from banks or any other external source to achieve the minimum
cash balance. At the end of a period, the closing cash balance becomes the opening cash balance in the
next period. It should be noted that maintaining a fixed minimum or maximum cash balance is a
matter of policy of the business firm.
In preparing a cash budget, there are certain non- cash items that should not be taken into
consideration. Some of these items include depreciation, good will amortized, provisions for
depreciation, provision for bad and doubtful debts, provision for goodwill and provision for taxes. All
these do not involve physical cash inflows and cash outflows. The vital information usually required
in cash budgeting are opening cash balance, cash receipts and cash expenses for a period. These are
the segments to a cash budget table. It should be noted that the estimated amount of cash collections
from debtors is usually based on the cash collection experience and debtor management policy of a
business firm.

Cash Receipt
The pattern of cash receipt from anticipated sales may be on monthly or quarterly basis. The policy of
collecting cash from sales could be, for instance, 20% is collectable in the month of sales, 50%
collectible in the following month and the remaining 30% collectable the third month. Sometimes, in
order to facilitate quick payment from debtors, a discount is given to debtors. Cash receipt pattern can
be determined through cash collection schedule.

Cash Payment
This is commonly associated with cash payment for inventory bought, payment for general
administrative expenses, payment for interest charges, payment for taxes, dividend paid for a defined
period. Analysis of purchases payment can be carried out through purchases payment schedule. The
purchases payment schedule spells out the pattern and policy of paying creditors/suppliers. The
pattern could be on a monthly basis. The purchases payment policy could be 30% is paid to the
creditor in the month of the purchase, 40% in the second month and the remaining 30% in the third
month. However, the cash receipt policy of the business must be very effective enough to guarantee
payment for credit purchases.

Functions of a Cash Budget

- It assists to forecast expected cash receipts and cash payments over a planned period.
- It helps to determine likely short fall of cash at any time in a planned period.
 C hapter N ine

Inventory Management

Learning Objectives

After studying this chapter, you should be able to:

 Explain what inventory is
 Explain the meaning of inventory management
 Discuss the difference between stock out and overstocking in a business firm
 List some implications of stock out and overstocking
 Explain the concepts of re-order inventory level, minimum and maximum stock levels
 Explain what is lead time and factors that can affect it in a business firm
 List and explain types of lead time
 Identify and explain some other likely costs associated with inventory
 Define economic order quantity and state its assumptions

Introduction
Inventories are commonly used in the production of goods, for sales or rendering of services by
business enterprises. Inventory is one of the components of working capital. Inventory could be in
form of raw materials or work- in –progress a business firm uses to produce goods. Inventories could
also be in form of finished goods a business enterprise sells or uses to render services for the purpose
of income generation or for actualization of other purposes.
Any item, tangible or intangible, a business enterprise sells or uses to manufacture product or renders
services for profit or non- profit making purpose is inventory. Generally, different inventories have
different life span. There are perishable and non- perishable inventories. Examples of perishable
inventories are tomatoes, fresh pepper, pawpaw, oranges, just but to list a few. Examples of non-
perishable items include note books, pen, pencil, calculator, and among others. An inventory in one
business enterprise can become inventory for other business firms. For example, hides and skin of
animals as inventories from a particular business enterprise can be become another inventories for the
production of leather shoes, leather bags and leather belts in a different business enterprise such as a
shoe factory.

Inventory Management
Inventory management deals with maintaining the desired quantity of stocks in order to minimize cost
with a view to maximizing revenue. Poor inventory management affects the operation and success of
a business enterprise. In Nigeria, some business enterprises into the production of goods for instance,
have stopped from operations perhaps due to poor inventory management. Sometimes, most firms
may keep stocks above the required level in warehouses or they may experience drastic shortage of
stocks in the store. This kind of development is mostly because of poor inventory management. There
are two effects of poor inventory management in a business enterprise, and they include stock out and
over stocking.
Stock out: This referred to a situation where a business enterprise does not have enough stocks
needed for production for sales or for rendering of services.

Consequences of Stock-out in a Business Enterprise

 The business enterprise will pay salaries and wages to the employees for time not used.
 The machines may develop some peculiar problems such as rusting because the machines
have not been usedin production by the business enterprise for some times.
 The business enterprise may not have products to supply its customers who need the product
at a particular point in time.
 It may cause the business enterprise to lose its customers to other business competitors.
 There may be a gradual loss of goodwill in the business enterprise.
 The business may experience a reduction in sales revenue and profit
 Over-stocking: This referred to a situation where a business enterprise maintains more than
the required level of inventories either for production, for sales or for rendering of services.
Consequences of Over-stocking in a Business Enterprise
 Over stocking may cause the capital invested in a business enterprise to remain idle.
 Since the quantity of the inventories maintained by a business enterprise are in excess, the
deterioration of the inventories is likely.
 Over stocking increases the cost of keeping the inventories in a store/warehouse.
 Overstocking could cause certain unpredictable and unwanted behaviour such as stealing the
inventories by the employees.

Inventory Control
Inventory control has to do with setting up reliable standard for inventories usage, provision of
appropriate storage facilities, locating alternative source of supply, and estimating the level or
quantity of inventories required in a business enterprise. There are three inventory control levels in a
business enterprise. They include the re-order inventory level; the minimum inventory level and the
maximum inventory level.
Re-order Inventory Level: This is the level at which it becomes necessary to place an order for new
supply of stocks to the business enterprise. The re-order inventory level is usually made by the
purchasing department of a business firm. To effectively carry out re-order inventory level, the
quantity to order for, from a supplier, the lead time and the consumption rate [usage] must be known.
Re-order inventory level is computed with the formula: Re-order inventory level = maximum usage x
maximum lead time. Lead time is the same as procurement time. Lead time is the length of time
period between when a new order for stocks is requested from a supplier and the time period the
stocks are finally supplied to the business enterprise. For example, the lead time could be ten days,
fifteen days, a month, a quarter or half-yearly. The rate of usage of the inventory in a business
enterprise does contribute to lead time.

There are three (3) types of lead time that can occur in a business enterprise. They include maximum
lead time, minimum lead time and average lead time. Maximum lead time is the highest number of
days, weeks, months or periods it takes goods ordered for, from a supplier and the time period the
goods were delivered by the supplier to the business enterprise. Minimum lead time can be considered
as the lowest number of days, weeks or period it takes inventories ordered from a supplier to be
delivered to the business enterprise a supplier. Average lead time is the addition of the maximum lead
time and minimum lead time divided by two. There are some factors which can affect lead time in a
business enterprise. Some of these factors include distance, source of supplies and socio-economic
factors. Inventory usage in a business firm referred to the quantity of inventories used by a business
firm. There are two types of inventories usages in a business enterprise. They are maximum
inventories usage and minimum inventories usage. In a business enterprise, maximum usage of
inventories referred to the highest quantity of inventories used or consumed in a defined period. The
minimum usage is the lowest quantity of inventories used or consumed in a business firm for a period.
Reorder inventory level can be computed with the formula: maximum usage x maximum lead time.
Minimum Inventory Level: This is the level of inventories kept and maintained in a business firm
which sends warning signals to managers that inventories are almost being exhausted. Minimum
inventory level can be calculated with the formula: Re-order level – [average usage x average lead
time].
Maximum Inventory Level: This is the level of inventory kept and maintained in a business
enterprise which sends warning signals to the managers that inventories kept are above the required
units.
 C hapter T en

Cash flow Statement

Learning Objectives
After studying this chapter, you should be able to:
 Explain what cash flow statement is
 List and explain the three major activities usually considered in a cash flow statement
 Explain what cash equivalent is
 Identify the purposes of a cash flow statement
 List and explain methods of preparing a cash flow statement
 Prepare a cash flow statement for business firms

Introduction
Cash flow statement is a tool used to investigate the ability of a business to generate adequate cash
and cash equivalent. Cash and cash equivalents are highly liquid investments, which can easily be
converted into cash. Examples include treasury bills and certificates of deposits with a maturity date
not beyond three months or six months.

Cash flow statement seeks to reveal the implication that all the three major activities undertaken by a
business firm has on its cash level for a given period. The three major activities of a business firm are
operating, investing and financing activities. Activities under each of these three major tasks are
highlighted separately. They are then combined to evaluate the variation between cash position at
beginning of the period and cash position at end of the period also.

The Importance of Cash flow Statement

1. It reveals the capacity of a business or firm to finance its operations comfortably and also
generate adequate cash.
2. It shows the ability of a firm to generate enough cash flow from operation. Adequate cash
generated in a business operation enables it pay its debts and also pay for taxes, dividend and
meet other obligations as they fall due.
3. It enables a business to generate sufficient cash to achieve the objective of asset replacement
and business expansion.
4. A cash flow statement helps to reveal a firm‟s level of liquidity, financial strength and
stability for a period. This is because cash is the very instrument to determine the liquidity of
a business from time to time.
5. It enables users of accounting information to meaningfully compare a firm‟s level of
profitability and cash level in a particular sector with firms in other sectors.

Major Activities in Cash flow Statement

A typical cash flow statement has three major activities. These are:
(i) Operating activities
(ii) Investing activities
(iii) Financing activities

Operating Activities
These are activities that are carried out on day – to – day basis in the business firm. Operating
activities mainly comprise of daily cash receipts and cash payments in the business enterprise. Cash
receipts and cash payments in operating activities are referred to as cash inflows and cash outflows.
The following table presents a non- exhaustive list of cash inflows and cash outflows under operating
activities in a cash flow statement.

Cash inflows with sign of inflow Cash outflows with sign of outflow
1. Cash received from customers (debtors) (+) 1. Cash paid to suppliers/creditors (–)
2. Increase in account receivable (debtors) (+)2. Payment of wages and salaries to employees and
payment of commissions to agents (–)
3. Dividend received from subsidiaries and other
3. Payment for administrative and other operating
associates (+) express (–)
4. Increase in creditors (+) 4. Prepared decrease in creditors (–)
5. Decrease in inventory (+) 5. Increase in inventory (–)
6. Other income received e.g interest income 6. Decrease in prepared insurance expenses (–)
received (+)
7. Decrease in prepared expenses (+) 7. Increase in prepared expenses (–)
8. Increase in accrued expenses (+) 8. Decrease in debtors (–)
9. Decrease in dividend payable (+) 9. Decrease in accrued expenses (–)
10. Decrease in income tax paid (+) 10. Income tax paid (–)
11. Cash refunded from debtors, agents, employees
11. Increase in dividend payable (–)
and other sources (+)

Cash flow from Investing Activities

Unlike the cash flow from operating activities, cash flow from investing activities are concerned with
the purchases and sales of assets and other investments of a business firm for a period. Investing
activities consist of cash inflows and cash outflows in a business firm. Examples of cash inflows and
cash outflows from investing activities are indicated in the table below:

Cash inflows with sign of inflow Cash outflows with sign of outflow
1. Sales of fixed assets (+) 1. Purchases of fixed assets (–)
2. Sales / disposal of other operating assets (+) 2. Purchases of other operating assets (–)
3. Sales of investment securities such as stocks, and3. Purchases of securities such as stocks are bonds (–)
bonds (+)
4. Income received from bills of exchange and4. Payment for bills of exchange and promissory notes
promissory notes (+) (–)
5. Receipts from loan repayment (+) 5. Loans paid to other organizations eg banks (–)
6. Receipts from interest payment on loan (+) 6. Payment of interest changes on loan (–)
7. Dividend received from other source apart from7. Purchase of other short – run investment (–)
subsidiary and associate of a payment company (+)

It should be noted that the plus sign in the bracket indicates income received (cash inflows) while the
minus sign means cash paid out (cash outflows).

Cash flow from Financing Activities

Financing activities relate the receipts of income from projects financed by a business firm for a
period. Financing activities deal with cash generated from long – term financing sources such as
debentures, long – term loans, mortgages and finance leases, amongst others. However, cash paid to
trade creditors are not a part of financing activities of a business firm. Examples of cash inflows and
cash outflows from financing activities are indicated in the table below:

Cash inflows and sign of inflow Cash outflows and sign of outflow
1. Issue of shares (+) 1. Repayment of borrowed loans (–)
2. Issue of debentures (+) 2. Interest paid (–)
3. Premium for share issued (+) 3. Dividend paid (–)
4. Borrowed funds (+) 4. Discounting acceptance (–)
5. Issue of bond and other debt securities (+) 5. Draw down on overdraft and loan (–)
6. Redemption of shares (–)
7. Discount on redemption (–)
 C hapter E leven

Management of Debtors and Creditors

Learning Objectives

After studying this chapter, you should be able to:

 Explain who debtors and creditors are in a business firm

 List and explain some specific costs of allowing credit to customers in a business firm
 Use a hypothetical example to buttress the implication of allowing credit to customers in a
business firm
 List and explain some key areas a business firm should critically consider in debtor
management
 Identify and explain some elements of credit policy in a business firm
 List and explain the main sources of information in assessing credit worthiness of a customer
of a business firm
 Explain some effective methods of a business firm can use to collect debts from customers
 Employ a hypothetical example to buttress the effect of strict credit terms on the profit of a
business firm
 Explain debt factors
 List and explain some services of a debt factoring organization
 List some advantages and disadvantages of using the service of a debt factor
 Distinguish between a factor and an invoice discounter
 Explain what settlement discount is and its main purpose
 Apply a hypothetical example to calculate cost of a settlement discount in a business firm

Introduction
Debtors and creditors management is a part of working capital issue. Debtor are customers of a
business enterprise who buy goods on credit, or who services are rendered to on credit basis or who
loans are extended to for repayment in a defined period of time. The quick payment of cash by debtors
has implications for the smooth operation of a business enterprise and in maintaining sound
relationship with creditors / suppliers. Virtually all business enterprise sell goods or render services to
individual and corporate customers on credit basis. The credit period allowed to customers to pay the
cash they owe a business enterprise varies, and could range from 30 days, 60 days to 90 days.

Allowing credit sales or period to customers by a business enterprise requires skills and effective
policies since giving credit attracts benefits and costs. Credit allowed to customers increases sales
volume and number of debtors in a business enterprise. Sometimes, allowing credit to customers may
lead to a competitive advantage. For example, a business enterprise that refuses to allow credit sales
to customers may lose those customers to other businesses which grant credit sales and also maintain
effective and efficient credit policy.

Specific Costs of Allowing Credit to Customers in a Business Enterprise

Occurrence of bad debt: Bad debt occurs when some customers refuse to pay for the goods sold to
them on credit basis. Some of the reasons that could lead to bad debt include weak credit collection
policy of the business enterprise, the individual customer‟s exposure to chronic ill – health and fatal
accident. Other cause of bad debt include specific and general bad economic situations in country
which may include war, famine as well as weak– psychological behaviour of the debtor. All these
factors contribute to inability of the business firm to collect cash from goods sold to customers on
credit basis. The remedy for any debt suspected to be bad debt is to write it off. This then becomes an
expense to the business firm.
Administrative Costs: These are costs incurred in monitoring and assessing the credit worthiness of
potential and existing customers of a business firm. Such costs may include transport cost, telephone
cost and cost of obtaining information about the credit worthiness of the customer.
Finance Cost: Usually, the risk appetite of a business enterprise influences the cost of credit and
credit period allowed to customers for a defined period. The cash a business uses to buy the goods it
sells on credit to customers may be borrowed from financial institutions. As such, cautions cannot be
thrown into the air by allowing credit sales and credit period to customers in an arbitrary manner.
Interest charges (costs) can only be meaningfully off-set through effective cash collection firm
debtors, otherwise, the business would run out of cash and face liquidity and profitability crises.

Estimation the Cost of Allowing Credit to Customers in a Business Firm

Cost of allowing credit to customers can be estimated as average debtors in a period x cost of capital
for the period. Where average debtor is, credit period allowed to customers divided by 360 days x
average annual sales.

Illustration 11.1
Goddy Enterprises deals on cosmetics and provision items on wholesale basis in Onitsha main
market, Anambra State, Nigeria. It allows 30 days credit period to customers. Assessment of the
historical sales figures of the business indicates that it maintains an average of N30, 000,000 annually,
with sales ratio of 20% and incurs bad debts of 2% sales revenue. The managing director of the
business firm is contemplating of increasing credit period allowed to customers to 90 days. The
management of the enterprise envisaged that this decision will increase sales by 20% at least, but
would cause bad debt to escalate to 4% of sales revenue. The cost of capital the firm operates with is
put at 6%. You are required to estimate the impact this decision will have on the firm‟s yearly profit.

Suggested Solution
Goddy Enterprises
Effect of increasing credit period from 30 days to 90 days.
We assume there are 360 days in a year.
Average annual sales N30, 000,000
Increase in annual sales by 20% = 20% x N30, 000,000 N6, 000,000
N36, 000,000
Current Average debtors:
30
360
× N30,000,000 N2500, 000
Average debtors with credit of 90 days
90
360
× N36,000,000 N9000, 000
Increase in average debtors N11, 500,000
Annual finance cost of increase in debtors = 11,500,000 x 6% =N690, 000

Analysis of the implication of increasing credit period from 30 days to 90 days

N N
Annual contribution with 30 days‟ credit:
20% x N30, 000 6,000,000
Annual contribution with 90 days‟ credit:
20% x N36, 000,000 7200,000
Difference in increase on annual contribution 1,200,000
 C hapter T welve

Investment Appraisal Decision

Learning Objectives

After studying this chapter, you should be able to:

 Discuss what investment appraisal is all about

 List and explain the nature of capital budgeting
 Identify and explain some processes involved in capital budgeting
 List and explain the methods commonly used in investment appraisal
 Apply each of the components of the methods to undertake investment appraisal
 List the advantages and disadvantages of each components of investment appraisal
 Apply both present value of perpetuities and sinking fund to investment appraisal
 Explain the difference between relevant cost and opportunity cost in investment appraisal
 Define capital rationing in investment appraisal
 Apply capital rationing method to assess the viability of a capital project
 Explain the varying circumstances under which capital rationing can be applied to appraise a
project
 List and explain methods of capital rationing

Introduction
Investment appraisal is a product of investment decision. Investment appraisal is the evaluation of a
proposed investment project, involving huge capital to undertake. Investment appraisal is about
capital expenditure. Capital expenditure is related to spending huge sums of money to buy fixed assets
such as plant and machinery, land and building, as well as undertaking promising investment
opportunities. Hence, investment appraisal is referred to as capital budgeting. Appraisal of an
investment project is necessary due to the huge capital outlay involved, the risk and uncertainty
prevalent in business environments. There are a lot of investment projects which have experienced
huge capital loss due to weak appraisal prior to embarking on them.

Nature of Investment Appraisal

 Funding: Investment appraisal usually involves huge cash. The funds required to undertake
capital investment projects may be sourced from medium and long term sources.
 Time: The time period involved in capital projects ranges from medium to long term. Caution
is required to avoid taking decisions that could destroy the expected profitability of the
project.
 Cost of waiting: Closely related to time of a project is cost of waiting to recoup the initial
sum of money invested into it. It usually requires patience and deployment of strategies to
reduce possible risks which may adversely affect future cash flows of the projects.
 Risk: Because capital project involves a relatively long period, there is tendency for swings in
the cash flow to occur; due to systematic and unsystematic risks. These factors contribute to
increase the uncertainty in the investment project.
 Irreversibility: Once cash is committed into purchase of assets, it is difficult to reverse the
decision. Doing this will result to loss in the value of the asset. For example, if the asset was
bought at N3, 000,000, it can only be disposed -of at a scrap value.

Investment Appraisal Processes

(a) Identifying the objective of the investment project: This normally involves a statement
indicating the main aim of the project. The objective could be to replace an asset or expand
the business in order to increase the market value.
(b) Identifying the investment project opportunity: Discovering an investment opportunity
normally precedes commitment of resources to an identified project. Thereafter, the identified
project which is a promising investment opportunity is then subjected to critical analysis
through investment appraisal methods.
(c) Identifying the investment project’s likely outcome: This involves the assessment of the
project pay – off and payback period, given the limited resources at the disposal of the firm.
(d) Project selection: At this stage, all identified promising projects based on evaluation
technique are selected for investment purpose.
(e) Project authorization: Every project selected is subject to management authorization and
approval. This facilitates the commitment of funds allocated to such investment project.

Methods of Investment Appraisal

1. Traditional method
2. Modern method

Traditional Method
This method involves the use of rule of thumb to evaluate the cost and benefits of an investment
project. It is commonly used by the layman to assess the success or failure of any capital investment.
The components of this method include:
(i) Payback period (PBP). This is further divided into non-discounted payback period and
discounted payback period.
(ii) Accounting rate of return (ARR)

Payback period
This is the period it takes to get back the money invested in a project. It is also a period in which the
money invested is equal with the money realized from an investment project.

Illustration 12.1
Mrs. Charity is considering a project investment that will cost N500, 000 with annual cash inflow of
N100, 000. Find the payback period of the project.

Mrs. Charity
Suggested Solution
𝑖𝑛𝑖𝑡𝑖𝑎𝑙𝑜𝑢𝑡𝑙𝑎𝑦
Payback period =
𝐴𝑛𝑛𝑢𝑎𝑙𝑐𝑎𝑠 𝑕𝑓𝑙𝑜𝑤
𝑁500,000
PBP =
𝑁100,000
= 5 years
Miss Charity‟s payback period for the project is 5 years

Non- discounted payback period:

This method involves deducting the future stream of cash flow from the initial capital outlay with a
view to ascertaining the payback period of an investment project. The non- discounted payback period
𝑖𝑛𝑖𝑡𝑖𝑎𝑙𝑜𝑢𝑡𝑙𝑎𝑦
of an investment project may be computed with the formula: Payback period =
𝐴𝑛𝑛𝑢𝑎𝑙𝑐𝑎𝑠 𝑕𝑓𝑙𝑜𝑤
 C hapter T hirteen

Inflation and Taxation in Investment Appraisal Decision

Learning Objectives

After studying this chapter, you should be able to:

 Explain the meaning of inflation and its implication on firms
 Distinguish between money cash flows and real cash flows
 Discuss the relationship between money cost of capital and real cost of capital
 Apply both money cost of capital and real cost of capital to appraise a capital project
 Explain some methods of computing capital allowance for tax purposes

Introduction
Inflation is the persistent general rise in the price of goods and services in an economy. It is a key
factor usually considered in macro-economics, monetary and fiscal policy analyses. It has a telling
effect on the time value of money, profitability, investment and financing decision of individual
investors, corporate organizations and the governments, in a country.
In business firms, inflation affects the selling price of goods, deplete the value of cash with time, and
affects cost of capital. Inflation increases cost of capital. This often make investors (creditors) and
shareholders to expect higher rate of return to reward them for depletion in the value of their capital
invested. One of the best ways to mitigating this is to adjust for inflationary factor with the prevailing
discount rate. To adjust for inflation in capital budgeting, the basic step is to take cognizance of the
difference between money cash flows (MCFs) and real cash flows (RCFs).

Money Cash flows (MCFs)

The money cost of capital is interchangeably used with nominal rate of return or the market rate or the
market discount rate. Money cash flows recognize the existence of inflation in the movement of cash.
Money cash flow is the cash received or paid at varying period in the future, with full recognition of
inflation. Conventionally, the money cash flows are evaluated first, by ascertaining cash flows using
current (today‟s) price and then adjusting it with the expected inflation rate.

Real Cash flows (RCFs)

These are cash flows that do not take inflation into account. In other words, real cash flows are items
which can be bought with or sold, through today‟s price without necessarily taking inflation into
account. Take for instance, Mrs. Olarinde chooses to buy a vehicle at a cost of N4, 000,000 using
today‟s price (current price). This price does not take cognizance of inflation because the car was
bought at a prevailing (current) price of N4, 000,000. Hence, the cash flow involved is referred to as
real cash flow. But if Mrs. Olarinde buys a car worth N4, 000,000 at today‟s price (current price) and
inflation rate is expected to grow at 2%, and she decides to sell the car in two year time, the value of
the car would be worthN4, 161,600. That is, N4,000,000 × 1.02 × 1.02 . This is the real cash
flows but adjusted for through a specific rate of inflation.

Money Cost of Capital versus Real Cost of Capital

Cost of capital is the required rate or return expected by investors on their investment in a particular
project or investment because of the risk involved in it. Following this, money cost of capital is the
rate of return expected by investors on a project due to inflation. Money cost of capital is always
higher than real cost of capital because of the inflationary effect. Real cost of capital is the required
rate of return expected by investors in a project without taking inflation into consideration. One of the
reasons money cost of capital is always higher than real cost of capital is because investors want to be
rewarded for the risk inherent in an investment project. Investors are sometimes pessimistic that after
investing in a project, the value of money may fall within passage of time. Hence they expect an extra
return (gain) to reward them for such possible deviation from expected investment returns.
Relationship between Money Cost of Capital, Real Cost of Capital and Inflation
The association between money cost of capital, real cost of capital and presence of inflation in an
investment project can be demonstrated with Fisher equation: 1 + 𝑚 = 1 + 𝑟 1 +
𝑖 …………..………………(1)
Where 𝑚 = money cost of capital; 𝑟 = real cost of capital; 𝑖 = inflation rate. With the
Fisher equation above, money cost of capital can be converted to real cost of capital and real cost of
capital also converted to money cost of capital. For instance, if 𝑟 and 𝑖 are stated, then m can be
1+𝑚
determined as: 𝑚 = 1 + 𝑟 1 + 𝑖 − 1. Where 𝑚 and 𝑖 are given, 𝑟 can be computed as= 1+𝑖
−
1+𝑚
1. If 𝑚 and 𝑟 are given, 𝑖 can be determined as:𝑖 = 1+𝑟
− 1. It should be noted that the money cost
of capital is applicable in DCF (capital budgeting) analysis. Where the cash flows are in future dates,
say years 1, 2, 3; then the money cost of capital is used. But where the cash flows are in year zero (0),
the real cost of capital is used.

Illustration 13.1
Eboigbe Ltd recently held its second quarter‟s board of director meeting. In the meeting, a decision
to acquire water processing machine project was made. The project would cost N700, 000. The
estimated actual cash flows from the project for the next five years are indicated as follows,
Years Actual cash flows
1 N260, 000
2 N284, 000
3 N305, 000
4 N420, 000
5 N240, 000
The firm‟s money cost of capital was put at 20.4% and inflation rate is currently at 12% per annum.
The management of Eboigbe Ltd has requested that you kindly assist to the estimate the viability of
investing in the water processing machine project using
i. Money cash flow approach
ii. Real cash flow approach

Suggested Solution
Eboigbe Ltd
Determination of Net Present Value
i. Using money cash flow approach
Years Cash flows MCC @ 20.4% Present
value
0 (N700, 000) 1.000 (N700, 000)
1 N260, 000 0.83 N215, 950
2 N284, 000 0.69 N195, 960
3 N305, 000 0.57 N173, 850
4 N420, 000 0.48 N201, 600
5 N240, 000 0.40 N 96, 000
Positive Net present value N183, 260
 C hapter F ourteen

Risk and Uncertainty in Investment Appraisal Decision

Learning Objectives
After studying this chapter, you should be able to:
 Explain the difference between risk and uncertainty
 List and explain some factors responsible for risks in investment appraisal
 Identify and discuss some methods of handling risks and uncertainty in investment appraisal
 Apply the methods to appraise a capital project under risk and uncertainty

Introduction
Cash flows from a project may deviate from its forecasted values, perhaps due to variability in
macroeconomic factors. For example, in a period of favourable economic situation in a country, firms
find it attractive to invest more in a capital project with the probability of having positive net present
value from it. However, in a period of economic downturn, it is quite difficult to realize positive net
present value from a capital project. It is because of this that forecasted cash flows and cost of capital
of an investment project are subjected to risk and uncertainty analysis.

Risk
Risk is the tendency for actual return from a capital project to deviate from its expected return for a
defined period of time. Risk in capital projects is commonly analyzed using probability estimate for
each possible future outcome.

Uncertainty
Uncertainty emanates from inadequate information about the future outcome of a capital project.
Insufficient information about future occurrences in business environment often bring about
uncertainty. Most of the forecasted cash inflows from a capital project are based on uncertainty. One
of the distinguishing factors between risk and uncertainty is that risk in capital project can be
determined through probability distribution, while uncertainty is merely through guesswork. It is
therefore important for financial managers and accountants to critically examine the risk in capital
projects in order to achieve positive net present value, consequently the maximization of shareholders
wealth in the firm.

Factors Responsible for Risks in Investment Appraisal

Basically, the factors likely to contribute to risk in capital budgeting are systematic in nature.
Systematic risk factors are those variables that are not within the control of a finance manager,
particularly with respect to capital project investment decision in a firm. Some of these systematic risk
factors include inflation, exchange rate fluctuation, political policies requirements and instability and
natural disasters.
i. Inflation: In a period of persistent inflation, the net present value expected from capital
project is not accurately predictable. During period of inflation, cost of capital always
increases. This tends to affect the present value from the investment project.
ii. Exchange Rate Fluctuation: Unstable exchange rate always affects net present value
especially from international capital projects undertaken by multinational corporation
(MNCs). This further increases cost of capital and reduces the expected rate of return from
investment projects.
iii. Political Requirements and Instability: Every regime of government comes with its varying
fiscal and monetary policies requirements. Inconsistencies in these policies not only heighten
the fear of investors towards undertaking capital projects, but affect the investment
environments. For instance, a government that lacks sound macroeconomic and monetary
policy management skill may make decisions that increase interest rates, which further affects
cost of investment in the general economy.
iv. Natural disasters: Natural phenomena have great chances of adversely affecting expected
returns and net present values (NPVs) of investment projects. Natural occurrences such as
earthquake, floods, outbreak of epidemics and pandemics often make an economy gloomy.
During a downturn in the economy, there is always high degree of risk and uncertainty over
expected returns from investment projects. Take for instance, during the COVID – 19
outbreak globally, a lot of firms lost huge expected returns from investment projects. Some
firms even folded – up while others experienced huge lose from different capital projects
already embarked on.

Methods of Handling Risks and Uncertainty in Investment Appraisal

 Payback Period Method
Payback period refers to the time period it takes to recoup the initial capital committed into a
capital project. In payback period, the quicker it takes to recoup the initial outlay committed
into a project, the better for a firm. Only projects with elements of liquidity can employ
payback period method. There are two types of payback period. These are the ordinary and
discounted payback period. While the ordinary payback period does not use discount factor in
converting future cash flow from a project, the discounted payback period does. The
discounted payback period is preferred to the ordinary payback period since the cash flows
expected from project in the nearest future are unpredictable. The discounted payback period
helps to convert future cash inflows to their present value using appropriate discount factor.
This enables a firm to discontinue with projects considered to have negative net present value.
The reason is because negative net present value (NPV) projects have high chances of
decreasing wealth of shareholders in a business firm.

Illustration 14. 1
Izekor Ltd is considering investment in two projects that would require initial outlay of N400, 000
each. The estimated future cash inflows from the project are stated as follows:

Project A
Year Cash inflows
1 N120, 000
2 N180, 000
3 N204, 000
4 N90, 000
5 N100, 000

Project B
Year Cash inflows
1 N60, 000
2 N130, 000
3 N160, 000
4 N300, 000
5 N210, 000

The prevailing discount factor in the firm is 12%. The financial manager of the firm has requested that
you kindly advise which of the projects is riskier and capable of jeopardizing the wealth of the
resource – owners.

C hapter F ifteen

Financial Leverage
Learning Objectives

After studying this chapter, you should be able to:

 Explain what leverage is
 List and discuss the different types of leverages common to business firms
 Apply the different types of financial leverages to examine their effects on firms

Meaning of Leverage
Leverage is the increased ability, force, and support to achieve some gains. It is the use of sources of
finance by a firm which it pays fixed cost. Leverage is a firm‟s ability to use fixed costs fund (debt) to
increase the gains of its owners (shareholders). Employment of leverage may influence a firm‟s profit
or loss. This is why leverage is commonly said to have dual effects (gains or loss) on shareholders.

Types of Leverage
Based on specific effects, leverage is grouped into five types, namely;
 Financial leverage
 Degree of financial leverage
 Operating leverage
 Degree of operating leverage
 Degree of combined leverage

Financial Leverage
Financial leverage is related to the financing decision of a firm. A firm is more financially leveraged
or levered if it uses more debts to finance its operation. On the other hand a firm is financially
unlevered if it does not use debts to finance its operation. Financial leverage is the use of fixed cost
finance rather than equity financing in the operation of a business. Example of fixed cost finance is
debt and preference shares. Additionally, a company is said to be financially leveraged if it uses high
level of debts and preference shares in its operation.

Financial leverage contributes to the financial risk since it has a direct link with a firm‟s financing
decision. Financial risk reflects a variation in earnings to resource owners also increases probability of
bankruptcy occurrence due to high debts employed in business. Therefore, critical assessment of
financial leverage by managers in a firm is essential since leverage influences gain and risk (loss) of
resource owners as well as market value of a business firm. Financial leverage is the fundamental
upon which the ordinary share capital of a firm is employed to raise debt capital from the bond
market. Conventionally, financial institutions are willing to extend credit (loan) facility based on the
value of equity capital of firm. This is why financial leverage is otherwise referred to as trading on
equity.
Financial leverage has dual effects. Firstly, it can magnify the wealth of the resource owners.
Secondly, it can increase financial risk of a firm. The financial risk encompasses low earnings due to
high fixed interest charges to be serviced and the eventual implication of bankruptcy costs.

Operating leverage
This type of leverage expresses the relationship between a firm‟s sales revenue and its earnings before
interest and taxes (EBIT). Operating leverage is also referred to as changes in a firm‟s earnings before
interest and tax as a result of variations in sales or gross revenue. It normally occurs because of fixed
cost (that is, fixed interest charges) inherent in a business operation. Absence of fixed interest charges
in a firm‟s operation implies absence of operating leverage. Operating leverage varies from one firm
to another. For instance, a firm is said to have a high degree of operating leverage if it has higher
fixed cost and small amount of variable costs. Firms with high degree of operating leverage are
commonly predisposed to high risk (loss), unlike those with low operating leverage.

Degree of Operation Leverage (DOL)

Degree of operating leverage is a percentage variation in earnings before interest and tax due to
%∆𝑖𝑛 𝐸𝐵𝐼𝑇
percentage variability in gross revenue or sales. It can be estimated as: 𝐷𝑂𝐿 =
%∆ 𝑖𝑛 𝑠𝑎𝑙𝑒𝑠
OR
𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝑏𝑒𝑓𝑜𝑟𝑒 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
𝐷𝑂𝐿 =
𝐸𝐵𝐼𝑇
OR
𝑄 𝑆−𝑉
𝐷𝑂𝐿 =
𝑄 𝑆−𝑉 −𝐹
OR
𝑆.𝑝/𝑢𝑛𝑖𝑡 −𝑉𝑐/𝑢𝑛𝑖𝑡
𝐷𝑂𝐿 =
𝑆−𝑉𝐶−𝐹
OR
𝑆−𝑉𝐶
DOL =
𝐸𝐵𝐼𝑇
Where, S.P / unit = selling price per unit
VC / unit = variable cost per unit.
F = fixed cost
S – VC = contribution
Q = number of units sold
S = selling price per unit
F = total fixed cost

Illustration 15.1
Diagi Ltd sells 50,000 units of Eleganza brand pens at a price of N30 per unit. The variable cost per
unit is N10. Estimated annual fixed operating cost is N18, 000.

(a) Estimate the degree of operating leverage

(b) If the company increases it sales price per unit by 12%, and variable cost per unit by 4%
while fixed cost remain constant and what is the degree of operating leverage?

Suggested Solution
Diagi Ltd
Computation of degree of operating leverage
𝑄 𝑆−𝑉
(a) 𝐷𝑂𝐿 =
𝑄 𝑆−𝑉 −𝐹
Q = 50,000 units
S = N30
V = N10
F = N18, 000
 C hapter S ixteen

Capital Structure Decision and Theories

Learning Objectives

After studying this chapter, you should be able to:

 Explain what capital structure is

 Identify some assumptions of capital structure
 Explain what market value of a firm
 List and explain some capital structure of school thought and their assumptions
 Apply each capital structure school of thought to determine market value of a firm
 Explain arbitrage process
 List and explain some criticisms against Miller and Modigliani capital structure school of
thought
 Explain M-M proposition 1
 Explain M-M proposition under corporate tax rate
 List and explain some determinants of capital structure
 List and explain some capital structure theories

Introduction
The start – up and also the day – to – day operation of a business firm often require varying securities
such as debts and equity in order to increase the overall market value. This is the whole essence of
capital structure.

Capital Structure versus Financial Structure of a Firm

Capital Structure of a Firm
Capital structure is different from the financial structure of a firm. Capital structure is the long term
sources of funds appearing in a firm‟s statement of financial position. Capital structure is the mix of
different sources of finance in a business firm. It is the aggregation of loan stock (debentures),
preference shares and equity capital in a firm‟s statement of financial position. Prominently, the two
capital mixes commonly used by a business firm are debt and equity (ordinary shares).

Financial Structure of a Firm

Financial structure on the other hand, represents the combination of short-term and long term sources
of fund. It is the claim side of the statement of financial position of a firm. It is the claim side of the
statement of financial position because both the short and long term creditors will always demand for
loan facility repayment and fixed interest charges from the borrower(s).

Assumptions of Capital Structure

In applying capital structure by a firm, certain assumptions are taken into consideration. Although
some of these assumptions are not realistic in practice. Some of these assumptions are:
i. There is no personal income tax
ii. There is no company income tax
iii. There is no bankruptcy cost.
iv. Firms may choose to use only debt and equity in financing its operation.
v. It is the policy of a firm to pay out 100% of its yearly profits as dividend.
vi. There are no retained earnings.
vii. The ratio of debt to equity of a business firm can be varied by borrowing to buy equity
(shares) or using equity to pay off loan.
viii. There are no transaction costs.
ix. The future operating earnings for firms are similar for all investors in the market place.
x. The current operating earnings of a firm are expected to remain the same with future
operating earnings.

Market Value of a Firm

Based on the assumptions of capital structure, the total market value of a firm equals market value of
debt plus market value of ordinary shares (equity). Through mathematical representation, let V = t
𝐸𝐵𝐼𝑇
Total market value of the firm.𝑉 = 𝐷 + 𝐸 𝑜𝑟 , 𝑉 = 𝐾𝑜 . Where D = Market value of debt and E =
Market value of equity. Since the use of debt and equity capital attracts cost, the cost of capital can
therefore be denoted as K0, and further estimate with the formula: Cost of capital (Ko) =
𝑁𝑒𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒 𝐸 𝐷
. That is, 𝐾𝑜 = 𝐾𝑒 𝐸+𝐷
+ 𝐾𝑑 𝐸+𝐷
. Where cost of debt capital is
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡𝑕𝑒 𝑓𝑖𝑟𝑚
represented as Kd, and calculated as:
𝐴𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐𝑕𝑎𝑟𝑔𝑒𝑠 𝐼
Kd = . That is,𝐾𝑑 = . While cost of equity capitalis denoted as Ke, and
𝐷
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑡𝑜 𝑠𝑕𝑎𝑟𝑒 𝑕𝑜𝑙𝑑𝑒𝑟𝑠 𝐸𝐵𝐼𝑇−𝐼
calculated as: Ke = . That is, 𝐾𝑒 = .
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠𝑕𝑎𝑟𝑒𝑠 𝑜𝑢𝑡 𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝐸

Capital Structure School of Thoughts

Flowing from the assumptions of capital structure, four school of thoughts emerged to explain the
implication of applying debt capital and equity capital in a firm‟s operation. These school of thoughts
are the:
i. Net income school of thought(approach)
ii. Net operating income school of thought(approach)
iii. Traditional school of thought(approach)
iv. Miller and Modigliani income school of thought(approach)

Net income approach

This school of thought or approach holds the view that a firm can systematically change its total
market value by either increasing or reducing it through the ratio of debt to equity. Here the total
market value of a firm is affected (changed) by either increasing / decreasing its debt-equity ratio. The
implication is that this decision goes a long way either increasing or decreasing the wealth of
shareholders of the firm. Also, the net income approach states that optimum capital structure occurs at
the point where the value of the firm is maximum (high) and the overall cost of capital (that is the
weighted average cost of capital) is minimum (low).

Assumptions of Net Income Approach

i. Cost of equity (Ke) is greater than cost of debt (Kd). That is, 𝐾𝑒 > 𝐾𝑑 𝑜𝑟 𝐾𝑑 < 𝐾𝑒.
ii. Cost of equity (Ke) and cost of debt (Kd) are constant with changes in debt.
iii. Corporate tax does not exist.

Illustration 16.1
Accra Ltd expects a yearly net operating income of N1000, 000 with a cost of equity of 20% and N1,
600,000 16% debenture stock.

Required
i. Estimate the market value of the firm and its cost of capital (Ko).
ii. Assuming the debenture stock is raised to N2, 000,000 and other items remain constant,
what do you think will be the market value of the firm?
 C hapter S eventeen

Cost of Capital

Learning Objectives

After studying this chapter, you should be able to:

 Explain the meaning of cost of capital

 Identify importance of cost of capital
 List and explain some concepts associated with cost of capital
 Define cost of equity
 Calculate cost of equity capital using different valuation models
 Estimation of cost of equity with floatation costs
 Estimate dividend growth rate
 Explain capital asset pricing model and list its assumptions
 Apply CAPM to estimate cost of equity capital of a firm
 Estimate cost of preference shares
 Estimate cost of debt capital
 Compute weighted average cost of capital

Meaning of Cost of Capital

Cost of capital has become an important issue in financing and investment decision making. The start-
up, survival and growth of business firms largely depend on cost of capital. Capital employed by a
firm to carry out its operation, no doubt attracts a cost. Investments made by individual and corporate
investors attract a cost also. To the individual investors, cost of capital is the minimum return
expected on investments. To the corporate investors, cost of capital is the minimum required rate of
return on an investment that maximizes the wealth of shareholders in a firm. Similarly, cost of capital
is the minimum return expected on its investment that will enable it pay its numerous investors their
desired rate of return.
Cost of capital is both a financing and investment matter. For instance, cost of capital is a critical
factor often taken into consideration in the course of taking financing decision in a business firm. Cost
of capital is crucial under investment decision, especially when a firm sets the minimum return that it
will give to its shareholders on their investment in a satisfactory manner, without necessarily
jeopardizing its short and long term objectives.

Importance of Cost of Capital

(i) It is used to evaluate an investment: Cost of capital makes it easier for a firm to consider if an
investment is risky or not.
(ii) Cost of capital is one of the yardsticks for examining the cost of the various sources of
funding at the disposal of a firm.
(iii) Cost of capital is one of the basis commonly used by investors to assess the risk associated
with an asset.

Basic Concepts Associated with Cost of Capital

1. Specific cost: The individual cost of equity, cost of preference shares and cost of debt is
referred to as specific cost of capital.
2. Average cost of capital: This is otherwise referred to as weighted average cost of capital. It
is the average of the cost of equity, cost of preference shares and cost of debt. The weights are
the proportions of each components of capital a firm employs in its capital structure.
3. Marginal cost of capital: It is the cost of every new capital raised by a firm to finance its
operation.
4. Explicit cost of capital: It is otherwise referred to as the internal rate of return of the cash
flows of financing opportunity. Explicit cost of capital is the discount rate that is common to
cash flow generated from projects that are opportunistic in nature.
5. Implicit cost of capital: It mainly arises when a company takes a look at alternative
deployment of funds that have been raised from the capital market.

Types of Cost of Capital

1. Cost of equity capital
2. Cost of preference shares capital
3. Cost of debt capital
4. Weighted average cost capital (WACC)

Cost of Equity Capital

Cost of equity capital is the return shareholders are expected to get from their investment in the shares
of listed firms if cash flows were paid out to them in the form of dividend. Cost of equity capital is the
annual return anticipated by equity holders. The anticipated annual return are in form of dividends
paid to the equity holders and capital gain on a firm‟s shares in the stock market. Capital gain arises
from shares price appreciation (growth).
Share price growth is a function of several factors, which include expectation of increase in future
dividend payout in a firm, a firm‟s profitability, effective corporate governance and other publicly
available favourable information in the stock market. These factors act as signals and influence share
price growth in the stock market.

Methods of Estimating Cost of Equity Capital

1. Dividend valuation model
2. Dividend growth model
3. Capital asset pricing model

Estimating Cost of Equity through Dividend Valuation Model Method

The dividend valuation model (method) assumes that dividends are expected to remain fixed into the
nearest future. Dividend valuation model associate the market value of shares (MV) with the expected
dividend on the shares. The market price of shares is a function of the expected dividend from a firm.
Dividend valuation model is further segmented into dividend valuation model without growth rate in
dividend and dividend valuation model with growth rate in dividend.

Assumptions of Dividend Valuation Model

1. All shareholders have homogenous expectations concerning dividend payment.
2. There is no taxation cost.
3. All shareholders are well informed about the future of the firm.
4. Cost of equity (Ke) is always greater than dividend growth rate.
5. There is no difference between lending cost and borrowing cost.

Dividend Valuation Model without Growth Rate in Dividend

This model assumes that dividend pay-out is not expected to grow into the foreseeable future. The
model holds the view that dividends are paid annually and that the first dividend can be expected in a
year‟s time.
 C hapter E ighteen

Dividend and Dividend Policy

Learning Objectives

After studying this chapter, you should be able to:

 Explain what dividend and dividend policy is

 List and explain different types and forms of dividend policy
 Identify and discuss some common forms of dividend policies in practice among firm
 Explain the difference between stock split, reverse split and share repurchase
 List and explain some important dividend dates in firms
 Define dividend pay -out ratio
 List and explain determinants of dividend pay out
 Distinguish dividend irrelevance theory from dividend relevance theory
 State the assumptions of dividend irrelevance theory
 Identify and discuss some criticisms of M – M dividend irrelevance theory
 State some of the assumptions of Myron Gordon‟s model
 State some of the assumptions of James Walter‟s model
 Determine the impact of dividend policy on the market price of shares of firms using
Professor James Walter‟s model
 List the criticisms of both the Myron Gordon and James Walter models
 Explain the meaning and implication of residual dividend theory, active dividend theory,
hybrid dividend theory, tax preference theory, dividend signaling theory and bird-in- hand
theory
 Discuss clientele effect and information effect of dividend payments by firms

Dividend and Dividend Policy

Dividend is a proportion of the earnings after tax distributed to shareholders as a reward for their
investments in a firm for a defined period of time. The value of dividend shareholders get in a firm is
based on the units of shares (stocks) they have. Dividend policy of a company is a policy on whether
to pay small, large or zero percentage of the profit earned in a year as dividend to shareholders or to
retain all or smaller percentage of the profit for future investment purpose. Furthermore, dividend
policy is also concerned with a firm‟s choice of whether to pay its shareholders cash dividend, how
much of the cash it should pay as dividend and the frequency of dividend payments, that is whether
half – yearly or annually. Dividend policy is one of the critical functions of a financial manager in a
firm. It is critical because a low dividend payment to shareholders may cause them to take a decision
to withdraw their investment resources from a particular firm and reinvest it in another firm which
they expect a higher dividend payout from.

Types of Dividend
Dividends pay out by a firm to shareholders take four forms. These include proposed dividend, paid
dividend, interim dividend and final dividend.
Proposed Dividend: This referred to the value declared and intends to be paid as dividend by the
board of directors and latter approved by the shareholders during an annual general meeting (AGM).
Interim Dividend: This is the value a firm declares as dividends and actually paid to the shareholders
before the end of the financial year. The interim period could be first quarter of the year or half of the
year depending on the policy of the firm.
Final Dividend: Is the amount of dividend that is actually approved and paid at the company‟s annual
general meeting (AGM). If interim dividend is not declared by the directors of the company, the
proposed dividend may be taken as the final dividend. However, most companies do have a policy of
paying final dividends to the shareholders. In this case, the proposed and interim dividends are
regarded as final dividends.
Common Dividend Policies in Practice
(i) Residual Policy: This is a policy in which the dividend payment is set equal to the actual
earnings available less the amount of retain earnings necessary to finance the firm capital
projects. In other words, under this dividend policy practice, a firm can only pay dividends
out after financing capital projects.
(ii) Constant Payout Dividend Policy: This involves paying a certain constant percentage of
earnings to the shareholders in each dividend period.
(iii) Stable Dividend Policy: This policy involves payment of a specific amount of dividend per
share each year; and periodically increasing the dividend at a constant rate.
(iv) Low Regular Plus Extra Dividend Policy: This policy involves payment of low regular
dividend plus end of year extras (bonus) particularly in a good year. This policy is based on
paying a low regular dividend, supplemented by an additional dividend when earnings are
higher than normal in a given period.

Forms of Dividend Policy

A. Cash Dividend: Cash dividend payout is a function of the adequacy of cash at the disposal of
a firm. Cash dividend is a part of the net worth of a business firm. So, the amount of cash
dividend a firm pays out to its shareholders contributes to the value of such a firm‟s net
worth. This is why firms in most cases prefer stock dividend payment to shareholders.
B. Property Dividends: These are also referred to as dividends in “kind”. Property dividends
are those dividends paid out in the form of assets from the issuing firm. Property dividends
are rare in contemporaries.
C. Structured Finance Dividends: In this form of dividend, financial asset such as warrants
with a known market value are distributed as dividends to shareholders by a firm.
D. Stock Dividend: This involves paying out dividend in form of shares (stocks) by a firm to its
shareholders. Stock dividend is also referred to as scrip dividend. Under this form of
dividend, a firm chooses to distribute shares as dividend instead of cash dividend to its
shareholders. Similarly, stock dividend may also be distributed to shareholders in addition to
cash dividend. This may only occur if a firm needs cash for future reinvestment purpose.
Moreover, in stock dividend, shares are distributed to shareholders on pro – rata basis. Pro –
rata basis involves a firm giving out one unit of shares for every 4 units of shares to
shareholders, 2 units of shares for 5 units of shares, or 100 units of shares for every 10,000
units held by a shareholder. Stock dividend has the propensity of increasing the outstanding
number of ordinary shares in a business firm. It will however decrease the firm‟s reserves
since the stock dividend is given out to the shareholders from reserve account.

Stock Split: Stock split involves splitting older shares to allow a room for the creation of additional
units of shares in a company. In stock split, a – one – for – every 4 units of shares held, the older
shares are further splitted into one more unit. That is, one more new unit of the shares is further issued
to the current shareholders. In this way, stock split makes shares of firm very attractive to investors,
especially to the low income earner - type – investors who often form majority of the market. Stock
split increases the dividend paid to shareholders, consequently their wealth in a firm.
Reverse Split: This occurs if a firm wants to reverse or increase the market price of its shares;
particularly at a time when share prices are dwindling in the stock market. Reverse split is used to
increase the market price of the shares, especially when a firm finds itself in a financial difficulty.
 C hapter N ineteen

Ratio Analysis

Learning Objectives

After studying this chapter, you should be able to:

 Explain what ratio analysis is and its aims

 List different users of financial statements and identify their information need
 Explain the difference between cross-sectional ratio analysis, time series ratio analysis and
combined ratio analysis
 State some of the cautions in using ratio analysis
 List and discuss types of ratio analysis, their various components and implications
 Compute ratios from the financial statement of firms, both financial and non-financial firms
 Explain the application and implication of Altman Z-score model

Introduction
Ratio analysis is one of the analytical tools used in assessing the financial statement of business firms
by managers and investors for decision making purposes. The aim of ratio analysis is to identify
certain variations in trends in items disclosed in the financial statements of a firm and the reason
behind such variations over time. Ratio analysis enables an investor to engage in a judgmental process
of a firm‟s performance, asset utilization, liquidity and efficient use of debt.
We can also see ratio analysis as the quantitative factor which expresses the association between two
or more figures in a firm‟s financial statements. Most times, the performance of a business enterprise
is compared with other business enterprise in the same industry; using the industry benchmarks for
necessary decision making. Industry performance does serves as a bench mark for some users of a
company‟s financial statement towards making meaningful decisions.

Users of Financial Statements and their Information Needs

The financial statements of a company are analyzed and used by different users who need the
information for a specific purpose. Some of the different users and their information needs are
examined as follow.

The Managers
Managers are concerned about the firm‟s financial performance in all areas. Their intention is to
produce financial ratios that are favourable to both shareholders and other users of financial
statements. Additionally, through financial ratios computed, managers are able to discover certain
weaknesses of a firm, and then come up with measures to monitor the performance of that firm with a
view to satisfying the interest of shareholders and other stakeholders.

The Shareholders
Shareholders are the owners of the business. Their primary interest is to see that managers maximize
their wealth. Shareholders wealth is maximized through increase in dividend received and capital
appreciation. Capital appreciation occurs when there is regular increase in price of a company‟s
shares. Shares are units of ownership in a company. Both potential and existing shareholders are
keenly interested in a firm‟s current and future level of risk and return, which may directly affect the
price of the shares in the stock market.

Creditors
Creditors are interested in the ability of the company to meet its short term and long term obligations
as they fall due. If a creditor such as a bank extends loan to a business enterprise, it will be interested
in the ability of such a business enterprise to pay the fixed interest charges as well as the principal
sum of money borrowed. Creditors are interested basically in the short – term liquidity of a firm and
its ability to fulfill interest and principal payments obligation. Another area creditors may be
interested in, is the profitability of a business enterprise. The profitability of a firm gives full
assurance to creditors that such a firm is healthy to extend credits (loan) or supply materials to for the
purpose of repayment in the short – run.

Suppliers
Suppliers are interested in knowing the length of period it takes a business enterprise to easily pay for
goods supplied. The shorter the period, the better it is for suppliers. A lot of suppliers do not like
waiting for a long period of time before getting paid for the goods they supplied to a business
enterprise.

Employees
These are persons employed to work in a company and in turn receive salary or wages. Employees are
interested in financial statement analysis of a business firm in order for them to know their wages
level, if to demand higher pay, or resign and seek employment from another high paying company.
Through financial statement analysis, employees are able to ascertain the level of their job security in
a business enterprise. No employee is willing to stay and work in a company that cannot guarantee
their job security or salary payment all the time.

The Financial Analysts

These group of users are interested in all the aspects of financial statements of companies to assist in
guiding investors on key investment decision making.

The government
The government is interested in the profit before tax of the business. This will enable it knows how
much the business should pay as tax for a period.

Types of Ratio Analysis

It is one thing to compute for financial ratios, while it is a different ball game entirely to interpret the
ratio values computed. The computed ratios may be too high or too low, good or bad for a firm in
relation to other firms‟ ratios and the industry ratios in general. There are three types of ratio analyses.
They include cross – sectional, time series ratio analysis and combined ratio analysis.

Cross – Sectional Analysis

This entails computing ratios of a company and comparing them with the average of the industry it
belongs. It also involves computing and comparing a firm‟s ratio with those of other firms in the same
industry. Most times, the industry average ratios become the benchmark for comparisons. Cross-
sectional analysis also involves the analysis and comparison of other firms‟ financial ratios at the
same point in time in the same industry. Cross – sectional financial ratio analysis enables financial
analysts to meaningfully ascertain how well a firm has performed in relation to other firms in its
sector. Computed financial ratios assist a firm to compare its historical performance with those of key
competitors in the same sector it wishes to emulate. Cross – sectional analysis is always a
benchmarking basis for a firm to gauge its performance over time in relation to other firms‟
performance in the same industry.
 C hapter T wenty

Break Even Analysis

Learning Objectives

After studying this chapter, you should be able to:

 Explain breakeven analysis

 List and Explain components of breakeven analysis
 List assumptions of breakeven analysis
 Explain margin of safety
 Carry out computation of breakeven point in units and sales revenue using formula and chart
 Undertake multi-product breakeven point analysis

Meaning of Break Even Analysis

Breakeven analysis is also referred to as cost-volume-profit analysis. Cost – volume – profit (CVP)
analysis reveals the relationship between costs, volume and profit over a product in a business firm.
Breakeven analysis is the point where total cost is equal to total revenue. Breakeven analysis is the
point at which losses cease and beyond that point, profit begins.

Advantages of Break Even Analysis

i. Break even analysis enables a business enterprise to know how many units it must produce
and sell in order to be able to absorb the total cost of production. That is, break even
analysis assists a business enterprise to ascertain breakeven point in unit.
ii. Break even analysis helps a business enterprise to determine the total turnover it makes.
That is, break even analysis assists a business enterprise to ascertain breakeven point in
sales value.
iii. Breakeven analysis helps to show the associated fixed cost, variable cost and their impact
on profit or loss in a business enterprise.
iv. Break even analysis helps to reveal to a business enterprise, the lowest sales units or
revenue it must maintain in order to avoid losses.
v. Break even analysis helps a business enterprise to estimate the turn over it requires for the
purpose of achieving a predetermined level of profit.
vi. For a business enterprise which has set its target profit, breakeven analysis enables it to
estimate how many units it must produce and sell in order to achieve the targeted profit.

Assumption of Breakeven Point Analysis

1. There is no uncertainty
2. Costs are segmented into fixed and variable cost.
3. Profits are computed on a variable cost basis.
4. Fixed costs remain constant within the relevant range.
5. Methods of manufacturing, amount of technology used and efficiency applied remain the
same.

Components of Breakeven Analysis

Costs: These are expenses incurred by a business firm in the course of producing or selling a product
or rendering services. The costs are mainly variable costs and fixed costs.
Variable Costs: These are costs that change with respect to increase or decrease in the units of
products produced in a business firm. Examples of variable costs are material costs, labour costs and
overhead costs which often change with the number of units produced or the level of activities carried
out. For instance, if 1000 units of product XYZ are required to be produced by a business firm, the
material cost, labour cost and overhead cost involved will vary compared to when 3000 units are
required to be produced.
Fixed Costs: These are costs which do not charge irrespective of the number of units produced. For
instance, the monthly rent of the building where productions are carried out and the salary of the
production engineer are fixed in the short – run, irrespective of the units of that product produced.
Total Cost: This is the addition of variable costs and fixed costs.
Contribution: This reflects the difference between the sales revenue and variable costs from the
product of a business firm. The contribution from a product is the difference between sales revenue
and variable costs associated with it. Contribution and profit from a product can be evaluated through
the following formula: Contribution = Sales revenue – variable cost. Net profit = Contribution – Fixed
cost. Unit contribution = Unit price – Unit variable rate. Net profit = Contribution – Fixed cost

Breakeven Analysis Method

𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡
1. Unit required to breakeven = 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 OR
𝑝𝑟𝑖𝑐𝑒 /𝑢𝑛𝑖𝑡 −𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 / 𝑢𝑛𝑖𝑡
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 ×𝑆𝑎𝑙𝑒𝑠 𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 ×𝑆𝑎𝑙𝑒𝑠
2. Sales revenue required to breakeven = OR
𝑆𝑎𝑙𝑒𝑠 −𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝐶𝑜𝑛𝑡𝑟 𝑖𝑏𝑢𝑡𝑖𝑜𝑛
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 / 𝑢𝑛𝑖𝑡 100
3. Contribution to sales ratio (CS ratio)= ×
𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 / 𝑢𝑛𝑖𝑡 1
𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑝 𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 −𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
4. CMR (unit) =
𝑆𝑒𝑙 𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
𝑇𝑜𝑡𝑎𝑙 𝑠𝑎𝑙𝑒𝑠 −𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡
4. CMR (Total) =
𝑇𝑜𝑡𝑎𝑙 𝑠𝑎𝑙𝑒𝑠
5. Sales revenue required to earn a desired operating profit before tax
𝐹𝐶+𝑑𝑒𝑠𝑖𝑟𝑒𝑑 𝑝𝑟𝑜 𝑓𝑖𝑡
=
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 𝑅𝑎𝑡𝑖𝑜
𝑃𝐴𝑇
1−𝑡𝑎𝑥 𝑟𝑎𝑡𝑒
6. Sales revenue required to earn desired operating profit after tax = 𝐹𝐶 +
𝐶𝑀𝑅

Illustration 20.1
Odianosen Enterprises specializes in the production of kids shoes. The data below relate to the
production of some pair of kids shoes in the month of June, 2020.
Variable cost per unit N20
Selling price per unit N45
Fixed cost N140, 000
You are required to calculate:
i. The number of units of the kids‟ shoes required to be produced in order to breakeven.
ii. The sales revenue required to breakeven.
iii. The contribution to sales ratio.
iv. The units to be sold to make a target profit of N40, 000.
v. The sales revenue needed to make a target profit of N40, 000.
vi. Units required in order to making a profit after tax of N30, 000. Assume tax rate is 30%.

Suggested Solution
Odianosen Enterprises
i. Units needed to breakeven
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡
=
𝑆. 𝑃 / 𝑢𝑛𝑖𝑡 − 𝑉. 𝐶 / 𝑢𝑛𝑖𝑡
𝑁140,000 𝑁140,000
= =
𝑁45 − 𝑁20 𝑁25
 C hapter T wenty-One
Mergers and Acquisitions

Learning Objectives

After studying this chapter, you should be able to:

 Explain the meaning of mergers with examples

 List and explain forms of mergers
 List and explain types of mergers with examples
 Explain the difference between strategic and financial mergers
 Explain the difference between an acquiring firm and a target firm
 Explain the difference between friendly mergers and hostile mergers
 List and explain the motives for mergers decision by firms
 Discuss the process involves in mergers negotiation
 Discuss what tender offers entail
 List and explain some defense mechanisms against hostile mergers
 Explain the meaning of hubris
 Define acquisitions
 Identify and explain types of acquisitions and the risks also involve in acquisitions
 Explain demerger
 Define divestment and explain various methods of carrying it out
 Define business failure
 List type of business failure
 Explain the causes of business failure
 Discuss the difference between capital reconstruction and business reorganization
 List, explain and apply various methods of valuing mergers and acquisitions

Mergers
Mergers occur when two or more companies are combined and the resulting company retains the
identity of one of the companies merged. In mergers, the assets and liabilities of the smaller company
are merged into that of a bigger firm. A merger is a combination of two firms in which only one
survives. In other words, the merged firm goes out of existence. For example, the merging of firm A,
B and C will lead to cessation of firm B and C, if firm A is the biggest among the three merged firms.
Firm A will retain its identity after the merger process. Mergers can be defined as an arrangement
whereby the assets of the merging firms become vested in or under the control of one firm, usually the
bigger or biggest firm in the merging process, which may or may not be one of the original firms.

Merger is a form of business combination in which the combining business lose their operational
identity to another firm, formed for that purpose. It basically involves the transfer of the assets and
liabilities of one firm to another and the subsequent cessation of the transferee firm. Notable examples
of mergers occurrences in the Nigerian corporate clime include the merging of Sterling Health Plc
with Smith Kline Beecham, where Smith Kline Beecham had to maintain its identity and eventual
cessation of Sterling Health Plc; the merger of A.G. Leventis, Leventis technical and Leventis stores,
the merger of United Bank for Africa PLC and Standard Trust Bank PLC and among others.

It should be noted that the primary objective of firms engaging in mergers scheme is to increase the
wealth of the shareholders. Another prime objective would be to satisfies the firm itself; in terms of
growth.

Forms of Mergers
Occurrence of mergers takes any of the two forms below:
i. Mergers by Absorption: This is where two or more firms merged to form existing firm
which retains its identity after the merging process. Mergers through absorption is said to take
place when one powerful firm absorbs one or two small firms, and still retains its identity
after the merging process. A clear example of mergers through absorption was when Union
Bank Plc absorbed Broad Bank Plc, Universal Trust Bank Plc and Union Merchant Bank Plc.
ii. Mergers through consolidation: This occurs when two or more firms are combined into one
legal entity. Unlike mergers through absorption, where after the merging process, the larger
firm retains its identity, mergers through consolidation ensures the combination of two or
more firms produces a new firm entirely. In other words, in mergers through consolidation, all
firms involved are legally dissolved and a new firm is created.

The new firm usually absorbs the assets and liabilities of the firms from which it is formed. A good
example of mergers through consolidation was in the banking sector of Nigeria; where the emergence
of Skye bank PLC through the consolidation of cooperative bank PLC, prudent bank PLC, Bond bank
PLC and EIB PLC respectively. Another example of mergers through consolidation was the coming
together of Trust Bank PLC, Magnum Trust Bank PLC, NBM Bank PLC and NAL Bank PLC to form
Sterling Bank Plc.

Types of Mergers

i. Horizontal merger
ii. Vertical merger
iii. Congeneric merger
iv. Conglomerate merger
i. Horizontal merger: This occurs when two firms in the same line of business combined
(merged). A good example of horizontal merger is when two beverages manufacturing firms
merged. Horizontal merger often occurs because of the need for expansion and elimination of
competitors.
ii. Vertical merger: This type of mergers occurs when a firm acquires a supplier or a customer.
An example of vertical merger is when a beverage manufacturing firm merges with a cocoa
supplying firm or a beverage producing firm merging with a major beverage distributing firm.
One of the aims of firms engaging in vertical mergers is to have control over purchase of bulk
raw materials used for production or to have strategic control of distribution of finished
products.
iii. Congeneric merger: This occurs when two or more firms are in the same general industry
but they are neither in the same line of business nor a supplier or customer. For example,
when Dangote Cement Plc and Dangote Salt Plc both in the same manufacturing industry but
not in the same line of business merged, then this will results to congeneric merger. One of
the benefits of a congeneric merger is that it enables the merging firms to properly use the
same sales and distribution outlets to reach customers of the businesses.
iv. A conglomerate merger: This involves the merging of firms in different businesses. When a
textile manufacturing firm merges with a plastic table water producing firm, this will results
to a conglomerate merger. The purpose of a conglomerate merger is to be able to minimize
risk by the merging firms which are deemed to have different seasonal pattern of sales and
earnings.

Strategic versus Financial Mergers

Strategic mergers: The primary aim of strategic mergers is to enable a firm to eliminate redundant
functions, increasing market share, improving raw material sourcing and finished product distribution.
Strategic mergers sometimes involve the purchase of specific product lines rather than a whole firm
for strategic reasons. In strategic mergers, the operations of the acquiring firm and target firm are
combined in order to be able to achieve economies of scale, thus enabling the performance of the
merged firm to exceed that of the pre merged firms. A good example of strategic mergers was the
mergers of Daimler – Benz and Chrysler, which are both auto manufacturers, the mergers between
Norwest and Wells Fargo, which are both commercial banks in the banking industry in the US.
View publication stats