COURSE MATERIAL

BUSINESS FINANCE

MR ROBERT
Faculty of MANAGEMENT SCIENCES
TABLE OF CONTENTS

MODULE 1 WORKING CAPITAL MANAGEMENT

Unit 1 concept of working capital

Unit 2 Cash Management

Unit 3 Stock Management

MODULE 2 CAPITAL BUDGETING DECISION

Unit 1 Payback Period

Unit 2 Net Present Value

Unit 3 Internal Rate of Return

MODULE 3 CAPITAL RATIONING

Unit 1 The Concepts of Capital Rationing Types and Causes of Capital Rationing

Unit 2 Types and Causes of Capital Rationing

MODULE 4 CAPITAL STRUCTURE DECISION

Unit 1 Concept of Capital Structure

Unit 2 Financing Structure and Capital Structure

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 WORKING CAPITAL MANAGEMENT
CONCEPT OF WORKING CAPITAL MANAGEMENT
Definition of Working Capital
Working Capital is a liquidity ratio that measures a company's ability to pay off its current
liabilities with its current assets. Working Capital is calculated by subtracting current liabilities
from current assets. Working Capital Management is a managerial accounting strategy focusing
on maintaining efficient levels of both components of Working Capital, current assets and
current liabilities, in respect to each other. Working Capital Management ensures a company
has sufficient cash flow in order to meet its short-term debt obligations and operating
expenses. Implementing an effective Working Capital is an excellent way for many companies
to improve their earnings. Working capital is the lifeblood of a business enterprise

Concepts of Working Capital

A Net Working capital
This is the difference between current assets and current liabilities. It epitomize the margin of
safety for meeting current liabilities and climaxes the financial health of the company.
Therefore, Net Working Capital (NWC =CA- CL)
B GROSS WORKING CAPITAL:
This refers to the amount of funds invested in current assets that are employed in the business.
It is these assets that the finance manager concerns himself with in an attempt to bring about
productivity from other assets.

CLASSIFICATION OF WORKING CAPITAL

Working capital may be classified in two ways:
(a) GROSS WORKING CAPITAL: This classification is directly related to the gross concept as
capitals invested in the various components of current assets such as dash, inventories,
receivables and short-term assets.

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(b) PERMANENT OR TEMPORARY WORKING CAPITAL
A second classification alluding to time is also necessary. Using time as a basis, working capital
may be classified either permanent or temporary:
First, unlike fixed assets, which retain their form over a long period of time permanent working
capital is constantly changing from one asset to another. Secondly, permanent working capital
never leaves the business process. Third, as long as a firm experiences growth, the size of the
permanent working capital amount will always increase.
Temporary or variable working capital, like permanent working capital, changes its form from
cash to inventory to receivables and back to cash, but it differs from permanent working capital
in that it is not always gainfully employed. Businesses that are seasonal and/or cyclical in nature
need more temporary working capital than firms that are into real manufacturing of physical
goods.

DETERMINANTS OF WORKING CAPITAL

A firm’s requirement for working capital is primarily affected by the following factors:
a. VOLUME OF SALES
This is the most important factor affecting the size of the firm’s working capital. A firm
maintains current assets because they are needed to support the operational activities that
result in sales. Over time a firm will keep a fairly steady ratio of 20 to 30 percent (between
current assets and sales). This means that a firm realizing constant level of sales will operate
with a fairly constant level of cash, receivables, and inventory if properly managed. Firms
experiencing growth in sales will require additional permanent working capital. If, sales are
declining, a reduction in permanent working capital would usually be the case.
b. SEASONAL AND CYCLICAL FACTORS
Most firms experience seasonal fluctuation in the demand for their products and services.
These variations in sales will affect the level of working capital needed. Similarly, when the
overall economy experiences a varying level of economic activity, with changes in the business
cycle, the need for working capital will also be affected.

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If the economy enters a recession, a firm’s, sales will temporarily decline because customers
will be more cautious in purchasing goods and services. This will decrease the need for working
capital. A boom economy will have the opposite effect.
c. CHANGES IN TECHNOLOGY
Technological changes/developments particularly those related to the production process,
exert a high impact on the need for working capital. If the faster processing requires increased
materials for efficient production runs, the permanent, inventory will increase. Thus, the
working needs of the firm.
d. FIRM’S POLICES
The Firm’s policies will affect the levels of working capital. Assuming the firm changes its credit
policy from net 30 to net 60, additional funds will be permanently tied up in receivables. If it
changes production policies, inventory requirements may be permanently or temporarily
affected, if it changes its safety level of cash on hand, permanent working capital may increase
or decrease. If the level of cash is linked to the level of sales, variable working capital may be
affected.

e. NATURE OF THE BUSINESS

A company’s working capital requirements are basically related to the kind of business it
conducts. Trading and manufacturing concerns require more working capital than concerns
engaged in provision of public utilities and services. A trading concern generally needs
comparatively small working capital, whereas manufacturing cum trading stands between these
two.
f. TYPE OF INDUSTRY
The requirement of working capital also varies from industry to industry. A plant that engages
in producing beans would require more working capital than a firm that manufactures bread.
g. PRODUCTION POLICY ANTI PROCESS
Seasonal industries obviously have varied need for working capital. Here, the working capital
requirements will depend upon the production policy adopted by the particular company.
Where a longer period is required in the manufacturing process, the need for a higher working
capital will be apparent.

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h. GROWTH PROSPECTS OF THE BUSINESS
The expansion and growth of the business will lead to increased demand for finished goods of
the company, which consequently leads to increased need for working capital. Where the
growth prospect is higher, the need for working capital will also increase.

i. Economic Factors and Government Policy

Government policies have great impact on the working capital requirements of a company.
Government policy, particularly in respect of import of raw materials, foods, and spares, control
of prices and distribution, credit control, bank rates and other labour laws, have great effect on
the requirements of working capital of a firm. Besides the above, other factors may affect the
requirement of working capital of a particular company. These include transport, and
communication facilities, social responsibility etc.
Other factors that determine the amount of working capital needed by the firm include:
1. Availability of credit
2. Attitude towards profits and
3. Attitude towards risk.

STRUCTURE OF WORKING CAPITAL

The different elements or components of current assets and current liabilities constitute the
structure of working capital which can be illustrated in the table below.
Structure of Current Assets and Current Liabilities

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Structure of Working Capital
The study of structure of working capital is another name for the study of working capital cycle.
In other words, it can be said that the study of structure of working capital is the study of the
elements of current assets viz. inventory, receivable, cash and bank balances and other liquid
resources like short-term or temporary investments. Current liabilities usually comprise bank
borrowings, trade credits, assessed tax and unpaid dividends or any other such things. The
following points mention below are the elements of working capital:
Inventory–Inventory is the major item of current assets. The management of inventories–raw
material, goods-in-process and finished goods are an important factor in the short-run liquidity
positions and long-term profitability of the company.
Raw material inventories – Uncertainties about the future demand for finished goods, together
with the cost of adjusting production to change in demand will cause a financial manager to
desire some level of raw material inventory. In the absence of such inventory, the company
could respond to increased demand for finished goods only by incurring explicit clerical and
other transactions costs of ordinary raw material for processing into finished goods to meet
that demand. If changes in demand are frequent, these order costs may become relatively
large.
Moreover, attempts to purchase hastily the needed raw material may necessitate payment of
premium purchase prices to obtain quick delivery and, thus, raise cost of production. Finally,
unavoidable delays in acquiring raw material may cause the production process to shut down
and then re-start again raising cost of production. Under these conditions the company cannot
respond promptly to changes in demand without sustaining high costs. Hence, some level of
raw materials inventory has to behold to reduce such costs. Determining its proper level
requires an assessment of costs of buying and holding inventories and a comparison with the
costs of maintaining insufficient level of inventories.
Work-in-process inventory–This inventory is built up due to production cycle. Production cycle
is the time-span between introduction of raw material into production and emergence of
finished product at the completion of production cycle. Till the production cycle is completed,
the stock of work-in-process has to be maintained.

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Finished goods inventory– Finished goods are required for reasons similar to those causing the
company to hold raw materials inventories. Customer’s demand for finished goods is uncertain
and variable. If a company carries no finished goods inventory, unanticipated increases in
customer demand would require sudden increases in the rate of production to meet the
demand. Such rapid increase in the rate of production may be very expensive to accomplish.
Rather than loss of sales, because the additional finished goods are not immediately available
or sustain high costs of rapid additional production, it may be cheaper to hold a finished goods
inventory. The flexibility afforded by such an inventory allows a company to meet unanticipated
customer demands at relatively lower costs than if such an inventory is not held. Thus, to
develop successfully optimum inventory policies, the management needs to know about the
functions of inventory, the cost of carrying inventory, economic order quantity and safety stock.
Industrial machinery is usually very costly and it is highly uneconomical to allow it to lie idle.
Skilled labour also cannot be hired and fired at will. Modern requirements are also urgent. Since
requirements cannot wait and since the cost of keeping machine and men idle is higher, than
the cost of storing the material, it is economical to hold inventories to the required extent. The
objectives of inventory management are:

(1) To minimize idle cost of men and machines caused by shortage of raw materials, stores and
spare parts.

(2) To keep down:

(a) Inventory ordering cost.
(b) Inventory carrying cost,
(c) Capital investment in inventories
(d) Obsolescence losses
Receivables–Many firms make credit sales, and as a result carry receivable as a current asset.
The practice of carrying receivables has several advantages viz., (i) reduction of collection costs
over cash collection, (ii) Reduction in the variability of sales, and (iii) increase in the level of
near-term sales. While immediate collection of cash appears to be in the interest of
shareholders, the cost of that policy may be very high relative to costs associated with delaying

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the receipt of cash by extension of credit. Imagine, for example, an electricity supply company
employing a person at every house constantly reading electricity meter and collecting cash
from him every minute as electricity is consumed. It is far cheaper for accumulating electricity
usage and bill once a month. This of course, is a decision to carry receivables on the part of the
company. It may also be true that the extension of credit by the firm to its customers may
reduce the variability of sales over time. Customers confined to cash purchases may tend to
purchase goods when cash is available to them. Erratic and perhaps cyclical purchasing patterns
may then result unless credit can be obtained elsewhere. Even if customers do obtain credit
elsewhere, they must incur additional cost of search in arranging for a loan costs that can be
estimated when credit is given by a supplier. Therefore, extension of credit to customers may
well smooth out of the pattern of sales and cash inflows to the firm over time since customers
need not wait for some inflows of cash to make a purchase. To the extent that sales are
smoothed, cost of adjusting production to changes in the level of sales should be reduced.
Finally, the extension of credit by firms may act to increase near-term sales. Customers need
not wait to accumulate necessary cash to purchase an item but can acquire it immediately on
credit. This behaviour has the effect of shifting future sales close to the present time.
Therefore, the extensions of credit by affirm and the resulting investment in receivables occurs
because it pays a firm to do so. Costs of collecting revenues and adapting to fluctuating
customer demands may make it desirable to offer the convenience associated with credit to a
firm’s customers. To the extents that near sales are also increased, extension of credit is made
even more attractive for the firm.
Cash and interest-bearing liquid assets–Cash is one of the most important tools of day-to-day
operation, because it is a form of liquid capital which is available for assignment to any use.
Cash is often the primary factor which decides the course of business destiny. The decision to
expand a business may be determined by the availability of cash and the borrowing of funds
will frequently be dictated by cash position.
Cash-in-hand, however, is a non-earning asset. This leads to the question as to what is the
optimum level of this idle resource. This optimum depends on various factors such as the
manufacturing cycle, the sale and collection cycle, age of the bills and on the maturing of debt.

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It also depends upon the liquidity of other current assets and the matter of expansion. While a
liberal maintenance of cash provides a sense of security, a lack of sufficiency of cash hampers
day-to-day operations. Prudence, therefore, requires that no more cash should be kept on hand
than the optimum required for handling miscellaneous transactions over the counter and petty
disbursements etc.
It has not become a practice with business enterprises to avoid too much redundant cash by
investing a portion of their earnings in assets which are susceptible to easy conversion into
cash. Such assets may include government securities, bonds, debentures and shares that are
known to be readily marketable and that may be liquidated at a moment’s notice when cash is
needed.

WORKING CAPITAL POLICY

Working Capital Policy are into three categories as defensive or hedging, aggressive and
conservative Working Capital policy and are discussed as follows:
Defensive policy: Company follows defensive policy by using long term debt and equity to
finance its fixed assets and major portion of current assets. Under this approach, the business
concern can adopt a financial plan which matches the expected life of assets with the expected
life of the sources of funds raised to finance assets. Inventory expected to be sold in 30 days
could be financed with a 30- day bank loan; a machine expected to last for 5 years could be
financed with a 5-year loan; a 20-year building could be financed with a 20 year mortgage
bond; and so forth. Defensive policy reduces the risk by reducing the current liabilities but it
also affects profitability because long term debt offers high interest rate which will increase the
cost of financing. This means a company is not willing to take risk and feel it appropriate to
keep cash or near cash balances, higher inventories and generous credit terms. Mostly
companies that are operating in an uncertain environment prefer to adopt such a policy
because they are not sure about the future prices, demand and short term interest rate. In such
situation it is better to have a high level of current assets. Which means, keeping higher level of
inventory in the stock, to meet sudden rise in demand and to avoid the risk of stoppage in
production. This approach gives a longer Cash Conversion Cycle for the company. It also
provides the shield against the financial distress created by the lack of funds to meet the short

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term liability but as the researcher discussed earlier long term debt have high interest rate
which will increase the cost of financing. Similarly, funds tied up in a business because of
generous credit policy of company and it also have opportunity costs. Hence, this policy might
reduce the profitability and the cost of following this policy might exceed the benefits of the
policy.
Aggressive policy: Companies can follow aggressive policy by financing its current assets with
short term debt because it gives low interest rate. However, the risk associated with short term
debt is higher than the long term debt. In aggressive policy the entire estimated requirement of
current assets should be financed from short- term sources and even a part of fixed assets
financing be financed from short- term sources. This approach makes the finance mix more
risky, less costly and more profitable. Furthermore, few finance managers take even more risk
by financing long term asset with short term debts and this approach push the Working Capital
on the negative side.
Managers try to enhance the profitability by paying lesser interest rate but this approach can
be proved very risky if the short term interest rate fluctuates or the cash inflow is not enough to
fulfill the current liabilities. Therefore, such a policy is adopted by the company which is
operating in a stable economy and is quite certain about future cash flows. A company with
aggressive Working Capital policy offers short credit period to customers, holds minimal
inventory and has a small amount of cash in hand. This policy increases the risk of default
because a company might face a lack of resources to meet the short term liabilities but it also
gives a high return as the high return is associated with high risk.
Conservative policy: Some companies want neither to be aggressive by reducing the level of
current assets as compared to current liabilities nor to be defensive by increasing the level of
current assets as compared to current liabilities. So, in order to balance the risk and return
these firms are following the conservative approach. It is also a mixture of defensive Working
Capital policy and aggressive Working Capital Policy. Moreover, this policy not only reduces the
risk of default but it also reduces the opportunity cost of additional investment in the current
assets. On the other hand apart from the above points the level of Working Capital also
depends on the level of sale, because, sales are the source of revenue for every companies. As

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sales increase Working Capital will also increase with the same proportion so, the length of
Cash Conversion Cycle remains the same. As the sales increase Working Capital increase in a
slower rate. As the sales increase the level of Working Capital rises in misappropriate manner
i.e. the Working Capital might raise in a rate more than the rate of increased in the sale.
Company with stable sale or growing sale can adopt the aggressive policy because it has a
confidence on its future cash inflows and is confident to pay its short term liabilities at maturity.
On the other hand a company with unstable sale or with fluctuation in the sale can’t think of
adopting the aggressive policy because it is not sure about its future cash inflows. In such a
situation adoption of aggressive policy is similar to committing a suicide. Hence, searching other
method might be the best choice.

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Cash Management

Introduction
The importance of cash and liquidity for a business cannot be underestimated as it is very vital
to the going concern of the firm. If a company is unable to pay what it owes at the required
time, a creditor might take legal action to recover the unpaid amount. Even if such extreme
action is not taken, but a company is slow in paying invoices, creditors will be reluctant to
provide additional credit. It is therefore essential for a business to ensure that its cash flows are
well managed and that it has sufficient liquidity.

Definition and importance of Cash Management

Cash management involves not only avoiding insolvency, but also reducing the length of
account receivables (AR), increasing collection rates, selecting appropriate short-term
investment vehicles, and increasing cash on hand to improve a company's cash position and
profitability. This involves shortening of cash collection periods, regular follow ups for
collections, negotiation of favorable terms with suppliers allowing delay in payment periods,
and preparation of cash flow forecasts. Businesses also use of technology to speed up cash
collection process. They must do all of this while maintaining adequate amount of funds to
meet daily operations.
Successfully managing cash is an essential skill for small business developers, because they
typically have less access to affordable credit and have a significant amount of upfront costs to
manage while waiting for receivables. Wisely managing cash enables a company to meet
unexpected expenses, and to handle regularly occurring events such as payroll distribution.

Reasons for holding cash

1. Transaction Motive of Holding Cash
Transaction motive refers to the need to hold cash to satisfy normal disbursement collection
activities associated with a firm's ongoing operation. Transaction means the act of giving and
taking of cash or kinds in the ordinary course of business. A firm frequently involves in purchase
and sales of goods or services. A firm should make payment in terms of cash for the purchase of
goods, payment of salary, wages, rent, interest, tax, insurance, and dividend and so on. A firm

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also receives cash in terms of sales revenue, interest on loan, return on investments made
outside the firm and so on. If these receipts and payments were perfectly synchronized, a firm
would not have to hold cash for transaction motive. But in real, cash inflows and outflows
cannot be matched exactly. Sometimes receipts of cash exceed the disbursement whereas at
other time disbursement exceeds the receipt. Because of this reason, if disbursement exceeds
the receipt, a firm should hold certain level of cash to meet current payment of cash in excess
of its receipt during the period.
2. Precautionary Motive of Holding Cash
Precautionary motive refers to hold cash as a safety margin to act as a financial reserve. A firm
should hold some cash for the payment of unpredictable or unanticipated events. A firm may
have to face emergencies such as strikes and lock-up from employees, increase in cost of raw
materials, funds and labor, fall in market demand and so on. These emergencies also bound a
firm to hold certain level of cash. But how much cash is held against these emergencies
depends on the degree of predictability associated with future cash flows. If there is high
degree of predictability, less cash balance is sufficient. Some firms may have strong borrowing
capacity at a very short notice, so that they can borrow at the time when emergencies occur.
Such a firm may hold very minimum amount of cash for this motive.
3. Speculative Motive of Holding Cash
The speculative motive refers to the need to hold cash in order to be able to take advantage of
bargain purchases that might arise, attractive interest rates and favorable exchange rate
fluctuations. Some firms hold cash in excess than transaction and precautionary needs to
involve in speculation. Speculative needs for holding cash require that a firm possibly may have
some profitable opportunities to exploit, which are out of the normal course of business. These
opportunities arise in conditions, when price of raw material is expected to fall, when interest
rate on borrowed funds are expected to decline and purchase of inventory occurs at reduced
price on immediate cash payment.

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CASH BUDGETS
A cash budget is a detailed plan of cash receipts and cash payments during a planning period.
The planning period is sub-divided into shorter periods, and the cash receipts and payments are
forecast/planned for each of the sub-divisions of time. For an annual master budget, the cash
budget might be prepared on a monthly basis, or possibly a quarterly basis. Some business
entities prepare new cash budgets regularly, possibly forecasting daily cash flows for the next
week, or weekly cash flows for the next month. The main uses of a cash budget are as follows:
To forecast how much cash receipts and payments are expected to be over the planning period.
To learn whether there will be a shortage of cash at any time during the period, or possibly a
cash surplus. If there is a forecast shortage of cash, to consider measures in advance for dealing
with the problem - for example by planning to defer some purchases of non-current assets, or
approaching the bank for a larger bank overdraft facility. To monitor actual cash flows during
the planning period, by comparing actual cash flows with the budget.

Functions of Cash Management

Cash management is the treasury function of a business, responsible for achieving optimal
efficiency in two key areas: receivables, which is cash coming in, and payables, which is cash
going out.
Receivables Management

When a business issues an invoice it is reported as a receivable, which is cash earned but yet to
be received. Depending on the terms of the invoice, the business may have to wait 30, 60 or 90
days for the cash to be received. It is common for a business to report increasing sales, yet still
run into a cash crunch because of slow or poorly managed receivables. There are a number of
things a business can do to accelerate its receivables and reduce payment float, including
clarifying billing terms with customers, using an automated billing service to bill customers
immediately, using electronic payment processing through a bank to collect payments, and
staying on top of collections with an aging receivables report.

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Payables Management
When a business controls its payables, it can better control its cash flow. By improving the
overall efficiency of the payables process, a business can reduce costs and keep more cash
working in the business. Payables management solutions, such as electronic payment
processing, direct payroll deposit, and controlled disbursement can streamline and automate
the payable functions.
Most of the receivables and payables management functions can be automated using business
banking solutions. The digital age has opened up opportunities for smaller businesses to access
the same large-scale cash management technologies used by bigger companies. The cost
savings generated from more efficient cash management techniques easily offsets the costs.
More importantly, management will be able to reallocate precious resources to growing the
business.

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STOCK MANAGEMENT

INTRODUCTION
Understanding what you have, where it is in your warehouse, and when stock is going in and
out can help lower costs, speed up fulfilment, and prevent fraud. Your company may also rely
on stock management systems to assess your current assets, balance your accounts, and
provide financial reporting.

Stock management is also important to maintaining the right balance of stock in your
warehouses. You don’t want to lose a sale because you didn’t have enough stock to fill an
order. Constant stock issues (frequent backorders, etc.) can drive customers to other suppliers
entirely. The bottom line? When you have control over your stock, you’re able to provide better
customer service. It will also help you get a better, more real-time understanding of what’s
selling and what isn’t.
You also don’t want to have excess stock taking up space in your warehouses unnecessarily.
Too much stock can trigger profit losses––whether a product expires, gets damaged, or goes
out of season. Key to proper stock management is a deeper understanding of customer
demand for your products.

WHAT IS STOCK?
The goods or merchandise kept on the premises of a shop or warehouse and available for sale
or distribution. The capital raised by a company or corporation through the issue and
subscription of shares.
TYPES OF STOCK
Everything you use to make your products, provide your services and to run your business is
part of your stock.
There are four main types of stock:
1. Raw materials and components - Ready to use in production

2. Work in progress - Stock of unfinished goods in production

3. Finished goods -Stock of completely processed goods ready for sale.

4. Consumables - For example, fuel and stationery

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STOCK VALUE
You can categorise stock further, according to its value. For example, you could put items into
low, medium and high value categories. If your stock levels are limited by capital, this will help
you to plan expenditure on new and replacement stock.
You may choose to concentrate resources on the areas of greatest value.
However, low-cost items can be crucial to your production process and should not be
overlooked.
WHAT IS MANAGEMENT?
The process of dealing with or controlling things or people.
The organization and coordination of the activities of a business in order to achieve defined
objectives. ... Management consists of the interlocking functions of creating corporate policy
and organizing, planning, controlling, and directing an organization's resources in order to
achieve the objectives of that policy.

Management includes the activities of setting the strategy of an organization and coordinating
the efforts of its employees or volunteers to accomplish its objectives through the application
of available resources, such as financial, natural, technological, and human resources.

WHAT IS STOCK MANAGEMENT?

Stock management is the function of understanding the stock mix of a company and the
different demands on that stock. The demands are influenced by both external and internal
factors and are balanced by the creation of purchase order requests to keep supplies at a
reasonable or prescribed level.
The monitoring and control of goods and stock so that new stock can be ordered as required
and the right numbers and quantities made available at all times
The administrative role of assessing the stock of a business and making sure it is sufficient to
meet consumer demand. The demands that a stock management process seeks to satisfy are
affected by external and internal factors, and can be expressed using purchase order requests
to help maintain appropriate stock levels.

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Definition: Stock management largely refers to when a company works to obtain and preserve
a suitable assortment of goods while also keeping track of all orders, shipping and handling, and
other related costs.

Primarily, stock management is about specifying the size and placement of the goods that a
company has in stock. Stock management is often important for numerous departments within
a facility in order to protect the planned course of production against the possibility of running
out of critical materials or goods.

IMPORTANCE OF STOCK MANGEMENT

If your business requires maintaining a stock, you might sometimes feel like you're walking a
tightrope. Not having enough stock means you run the risk of losing sales, while having too
much stock is costly in more ways than one. That's why having an efficient stock management
system is so important.

AVOIDING STOCK OUTS

One of the worst things you can do in business is to turn away customers -- people who are
ready to give you their money -- because you've run out of the item they want. "Stock outs" not
only cost you money from missed sales, they can also make you lose customers for good, as
people resolve to take their business somewhere that can satisfy their needs. An efficient stock
management system tracks how much product you have in stock and forecasts how long your
supplies will last based on sales activity. This allows you to place orders far enough ahead of
time to prevent stock outs.
OVERSTOCK HAZARDS
When stock isn’t managed well, you can also wind up with overstock -- too much of certain
items. Overstock comes with its own set of problems. The longer an item sits unsold in stock,
the greater the chance it will never sell at all, meaning you'll have to write it off, or at least
discount it deeply. Products go out of style or become obsolete. Perishable items spoil. Items
that linger in storage get damaged or stolen. And excessive stock has to be stored, counted and
handled, which can add ongoing costs.

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WORKING CAPITAL ISSUES
Stock is expensive to acquire. When you pay, say, $15 for an item from a supplier, you do so
with the expectation that you will soon sell the item for a higher price, allowing you to recoup
the cost plus some profit. As long as the item sits on the shelf, though, its value is locked up in
stock. That's $15 you can't use elsewhere in your business. So stock management isn't just
about managing the "stuff" going in and out of your company; it's also about managing your
working capital, keeping you from having too much precious cash tied up in operations.
MANUFACTURER'S ANGLE
Stock management isn't just a concern for companies that deal in finished goods, such as
retailers and wholesalers. It's also critical for manufacturers, who maintain three types of stock:
raw materials, works in process and finished goods. If you run out of an essential ingredient or
component, production will halt, which can be extremely costly. If you don't have a supply of
finished goods on hand to fill orders at they come in, you risk losing customers. Staying on top
of stock is essential if you're to keep the line running and keep products moving out the door.
STOCK CONTROL
A retail store occasionally runs out of certain items. This happens for a number of reasons:
unexpected popularity of a particular item, such as one that has attained fad appeal among
schoolchildren; an unusually large purchase, such as buying up all of a store's hotdog buns for a
party; or a failure by the manufacturer to make and ship on time certain items. Stock control is
a way the retailer avoids running out of stock through tracking what is on hand, what has been
sold and what is on order.
CUSTOMER SERVICE
Good customer service for a retailer consists partly of having adequate supplies of what the
customer wants to buy. If a store runs out of a particular product, the customer buys it
somewhere else -- perhaps establishing a relationship with a competitor. Not only has the
retailer lost a sale; it possibly has lost a good customer as well.
STOCK
Retail stock consists of what products are on the store shelves plus the products in boxes in the
storage room. As customers deplete the stocked shelves, more stock comes out of storage to

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replace what has been sold. Keeping track of the stock on hand allows the store owner or
manager to know when to order additional stock of the items before they sell out.
SALES TRACKING
"Shrinkage" is a term used in retail to designate any mysterious disappearance of stock. It is
derived from a starting count of stock on the shelves and in storage. As goods are sold, the
stock should decline by the amount of sales. Sometimes, there is less stock than expected,
which normally means goods have been stolen or misplaced. Identifying missing stock helps the
retailer know to improve store security or stock tracking procedures. Tracking sales over years
also helps the retailer know how much to order of certain products at different times of the
year. For example: When hot dog buns sell out at the beginning of July, the retailer can figure it
is because of Fourth of July parties, and he will know to order more hot dog buns, and possibly
plan a special Fourth of July promotion of buns, condiments and hot dogs.
ORDERS
Keeping track of goods on order allows a retailer to verify that replacement stock has been
ordered. Monitoring order status alerts the retailer to possible delays in delivery in time to find
another source of those goods from an alternate distributor. Manufacturers and distributors
occasionally face fulfilment problems due to weather, machinery breakdown, labour strikes,
and unexpected demand and transportation problems. A detailed analysis of delivery times can
prompt a retailer to change distributors or to figure seasonal delays into the timing of his
orders. Customers don't care why a product is not available for purchase when they want it;
they only know the retailer failed. A detailed system of stock control keeps the customer
satisfied and the retailer in business.

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 MODULE 2 CAPITAL BUDGETING DECISION

PAYBACK PERIOD

Payback Period – Appraising capital investment on the basis of time that would be taken to get
back your initial investment is called as payback period.
Payback period is one of the easiest methods of capital investment appraisal techniques.
Projects with a shorter payback period are usually preferred for investment when compared to
one with longer payback period.
Discounted Payback Period – Capital Investment Appraisal using discounted payback period is
similar to payback period but here, the time value of money or discounted value of cash flow is
considered for calculation of payback period.

Workings
The formula to calculate payback period of a project depends on whether the cash flow per
period from the project even or uneven. In case they are even, the formula to calculate payback
period is:
Payback Period = 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 ÷ 𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑝𝑒𝑟 𝑃𝑒𝑟𝑖𝑜𝑑
N/B: When cash inflows are uneven, we need to calculate the cumulative net cash flow for each
period and then use the following formula for PBP –
Payback period = A + 𝐵/𝐶
Where:
A = the last period with a negative cumulative cash flow
B = the absolute value of cumulative cash flow at the end of the period A.
C = is the total cash flow during the period after A.
N/B: Payback period uses only cash flows not profit.
Example 1 = Even Cash flow
Ogege’s Company is planning to undertake a project requiring initial investment of
N200,000,000. The project is expected to generate N45, 000,000 per year for 6 years, calculate
the payback period of the project.
Solution:

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Example 2
Akoka Limited is to undertake a project requiring N1, 000,000 outlay.
Required: what is the payback period?
a) The project generates N200,000 annually.

b) The project has the following cash flow profile:

Yr cf(N)
1 2000,000
2 220,000
3 240,000
4 200,000
5 190,000
Solution:

B. A B C
Yrs. Outlays N Cashflows Balance
0 1,000,000 (1,000,000)
1 200,000 (800,000)
2 220,000 (580,000)
3 240,000 (340,000)
4 200,000 (140,000)
5 190,000

= 4 + 140,000÷190,000 = 4.74 years.

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N/B: Decision Rule:
Project B should be taken and A should be rejected since B has short period than A.
Example 3
Samson. Plc is to undertake a project requiring N500,000 outlay, Discounted at 10%
Yr Cash flows
1 200,000
2 220,000
3 240,000
4 200,000
5 190,000
You are required to get the discounted payback period.
Solution Cashflows Df PV Balance
Yrs (10%)(𝟏+𝒓)
𝒕
0 (5000,000) 1 (500,000) (500,000)
1 200,000 0.9091 181,818 (318,182
2 220,000 0.8264 181,808 (136,274)
3 240,000 0.7513 180,312
4 200,000 0.6830 136,600
5 190,000 0.6209 117,975
2 + 𝟏𝟑𝟔,𝟑𝟕𝟒𝟏𝟖𝟎,𝟑𝟏𝟐 = 2.76 years

Decision Rules
A. Independent project

1. Accept if the project has a PBP that equal to or less than that set by the management.

2. Reject if the project has a PB that is greater than the time set by the management.
B. Mutually Exclusive Project
1. Select the project with the least PBP.

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2. Ensure that the project selected has a PBP that is equal to or less than that set by the
management.

Advantages of Payback period

1. It is simple to calculate.

2. It can be a measure of risk inherent in a project since cash flows that occurs later in a projects
life are considered more uncertain, payback period provides an indication of how certain the
project cash inflow are.

3. For companies facing liquidity problems it provides a good ranking of projects that would
return money early.

4. Unlike ARR, it uses cash flows instead of accounting profit, cash profit or inflows is superior
to accounting profit.

5. It serves as a first screening process i.e. as a simple initial screening process for new projects.

Disadvantages of PBP
1. Unless discounted cash flows are used, it is ignored the time value of money.

2. It does not take into account the cash flows that occur after the payback period.

3. It may lead to excessive investment in short term projects.

4. It is unable to distinguish between projects with the same payback period.

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NET PRESENT VALUE (NPV)

This capital investment appraisal technique measures the cash-in-flow, whether excess or
shortfall, after the routine finance commitments are met. All capital investment appraisals have
a single objective drive towards a positive NPV. The NPV is a mathematical calculation involving
net cash flows at a particular present time ‘t’ at discount rate at the same time, i.e. (t – Initial
capital outlay). Thus, there is an inverse proportional relationship between rate and NPV. A high
discount rate would reduce the net present value of capital. A high interest rate increases
discount rates over a period of time and most capital investment appraisal are way of such an
increase.

N/B: If a scrap value occurs, it must be added to the last year inflow because it is one of the
incomes of the firm.

Workings

Where:
R = Cash flow
r = Rate
n = Number of years
Co = Initial Outlay
Example 1: (even cash flows)
Calculate the Net Present Value (NPV) of a project which requires an initial investment of
N243,000 and it is expected to generate a cash flow of N50,000 each month for 12 months.
Assume the salvage value of the project is zero. The target rate of return is 12% per annum.
Solution:
Initial Investment = 243,000
Net cash inflow per period = 50,000
Number of Period = 12 months
Discounted Rate per period = 12% ÷12= 1%

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Net Present Value = ?

Example 2:
Ebiere Plc is to start up a project worth N8m and having the following cash flows:
Yrs Cash flows (N)
1 5,000,000
2 6,000,000
3 8,000,000
If the discount rate is 25% calculate the NPV if the scrap value at the end of 3 years is N100,000.
Solution:
Yrs Cf(N) Df 25% PV (N)
0 (8,000,000) 1 (8,000,000)
1 5,000,000 0.8000 4,000,000
2 6,000,000 0.6400 3,840,000
3 8,100,000 0.5120 4,147,200
NPV + = 3,987,200
N/B: Scrap value was included in the last year.

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Example 3
A project has a cost of N53,500 and its expected net cash inflow are N11,500 per annum for 6
years. If the cost of capital is 5%, what is the projects Net present value?

Advantages of NPV
1. Net present value account for time value of money which makes it a sounder approach than
other investment appraisal techniques which do not discount future cash flows such as Payback
Period and Accounting Rate of Return.

2. Net Present Value is even better than some other discounted cash flow techniques such as
IRR, in situations where IRR and NPV gives conflicting decision, NPV decision should be
preferred.

3. It gives a clear accept/reject recommendation.

4. It makes use of all the cash flow over the project life span unlike Payback Period.

5. NPV gives absolute measures of profit ability which immediately reflects in the shareholder’s
wealth.

6. NPV of projects is additive, it can be summed up.

Disadvantages of NPV
1. It may be difficult to calculate.

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2. Net present Value does not take into account the size of the project. For example say project
A requires initial investment of N4million to generate NPV of N1m while a competing project B
requires N2m investment to generate an NPV of N0.8m. if we base our decision on NPV alone,
we will prefer project A. because it has higher NPV, but project B has generated more
shareholder wealth per Dollar of initial investment (N0.8m/N2m is N1m/4m).

N/B: NPV uses cash flows in the calculation i.e. profit before depreciation so if the net profit is
given i.e. profit after depreciation, we must add back depreciation to make it cash flows.

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INTERNAL RATE OF RETURN – IRR

Internal rate of Return (IRR) is the discount rate at which the NPV of an investment becomes
zero. In other words, IRR is the discount rate at which equates the present value of the future
cash flows of an investment with the initial investment. It is one of the several measure used in
investment appraisal.

The Decision Rule:

A project should only be accepted if its IRR is not less than the target internal rate of return.
When comparing two or more mutually exclusive projects. The project having highest value of
IRR should be accepted.
Steps in Calculating IRR
NPV = 0
Step I: = Guess the value of ‘r’ if not given and calculate the NPV of the
Project at that value.
Step II = If NPV is close to zero then IRR is equal to r.
Step III = If NPV is greater than 0 then increase ‘r’ and jump to step 5.
Step IV = If NPV is smaller than 0 then decrease ‘r’ and jump to step 5.
Step V = Recalculate NPV using the new value of ‘r’ and go back to step 2.

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Workings

Example II

Calculate the projects IRR if the initial outlay is N80,000 and the cash flow are as follows:
Yrs CF (N)
Yr1 10,000
Yr2 12,000

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Yr3 40,000
Yr4 25,000
Yr5 15,000
If the expected scrap value is 5,000 at the end of five years and the discount factor is 15%.
Solution

Advantages of IRR
1. It shows the return on the original money invested.

2. IRR rates are presented in form of familiar figures that can easily be interpreted by the user
of the data.

3. IRR though peculiar to a given project avoids disputes that characterize the choice of the
appropriate cost of capital to use when appraising project.
Disadvantages of IRR
1. It is difficult to compute and interpret.

2. It most times bring conflicting answers with NPV of which NPV will be used for decision
making therefore making IRR more irrelevant.

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 MODULE THREE: CAPITAL RATIONING

Capital rationing is a common practice in most of the companies as they have more profitable
projects available for investment as compared to the capital available.

In theory, there is no place for capital rationing as companies should invest in all profitable
projects. However, a majority of companies follow capital rationing as a way to isolate and pick
up the best project under the exiting capital restriction.

Definition of Capital Rationing

It is the process of putting restriction on the projects that can be undertaken by the company or
the capital that can be invested by the company. This aims in choosing only the most profitable
investments for the capital investment decision.
This can be accomplished by putting restrictive limits on the budget or selecting a higher cost of
capital as the hurdle rate of all the projects under consideration, capital rationing can either be
hard or soft.

CAUSES AND TYPES OF CAPITAL RATIONING

They can be categorized into two:
1. Those that are within the company’s control i.e. artificial, internal/soft capital rationing.

2. Those that are not within the company’s control: Real/External, Hard Capital Rationing.

The two situations can arise as follows:

1. ARTIFICIAL/INTERNAL CAUSE/SOFT CAPITAL RATIONING.

a) When management considers that raising money through the stock market may not be
possible if share prices are at depressed levels.

b) Where management decides to maintain stable dividend payment instead of ploughing back
all the profit to finance expansion.

c) Where the company sets for itself a cut off rate above which it will be unwilling to borrow.

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2. REAL/EXTERNAL CAUSES/HARD CAPITAL RATIONING

a) Where the financial institutions are unwilling to lend at whatever price to a company.

b) Where the company does not belong by the fiscal policy to the priority sectors that are
favoured under the government new fiscal policy guideline.

c) Global policies as they may affect the country where such companies are based.

Advantages of Capital Rationing

1. Budget: The first and an important advantage is that capital rationing introduces a sense of
strict budgeting of corporate resources of a company. Whenever there is an injunction of
capital in the form of more borrowings or stock issuance capital the resources are properly
handled and invested in profitable projects.

2. No Wastage: Capital Rationing prevent wastage of resources by not investing in each and
every new project available for investment.

3. Fewer Projects: It ensures that a smaller number of projects are selected by imposing capital
restriction. This helps in keeping the number of active projects to a minimum and this manage
them well.

4. Higher Returns:
Through Capital Rationing, companies invest only in projects where the expected return in high,
thus eliminating project with lower returns on capital.
5. More Stability: As the company is not investing in every project, the finances are not over-
extended. This helps in having adequate finances for tough times and ensure more stability and
increase in the stock price of the company.

Disadvantages of Capital Rationing

Capital rationing comes with its own set of disadvantages as well. Let us describe the problems
that rationing can lead to.

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1) Effective and efficient Capital Market: Under efficient capital market theory, all the projects
that add to company’s value and increase shareholders wealth should be invested in. However,
by following capital rationing and investing in only certain projects, this theory is violated.
2) The Cost of Capital:
In addition to limits on budget, capital rationing also places selective criteria on the cost of
capital of shortlisted projects. However, in order to follow this restriction a firm has to be very
accurate in calculation the cost of capital. Any miscalculation could result in selecting a less
profitable projects.
3) Un – Maximizing Value: Capital rationing does not allow for maximizing the maximum value
creation as all profitable projects are not accepted and thus, the NPV is not maximized.

4) Small Projects:
Capital rationing may lead to the selection of small project rather than larger scale investment.
5) Intermediate Cash flow:
Capital rationing does not add intermediate cash flows from a project while evaluating the
projects. It bases its decision only the final returns from the project intermediate cash flows
should be considered in keeping the time value of money in mind.

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 MODULE FOUR: CAPITAL STRUCTURE DECISION

CONCEPT OF CAPITAL STRUCTURE

For any business to be initiated, the resource called capital is importantly considered:
Generally, it is referred to as funds used to set up and run a business. It could also be referred
to as unit of ownership any investor invests in a business.
Generally, every source of capital available to a financial manager is known as what could lead
to the success or failure of any business and so the financial manager is faced with the issue of
appropriately deciding which choice or combination of choices to be selected.

CONCEPT OF CAPITAL
There are two possible approaches to the concept of capital. One of them is the ‘fund’ concept
while the other is the ‘asset’ concept of capital. According to the fund concept, the capital of
the firm is the sum total of the funds that have been employed for its operation. It corresponds
to the idea of total capital employed by the firm and may also be described as ‘financial capital’.
The fund concept recognizes the separate entity of a firm and consider capital from the liability
side of the balance sheet.
Accountants generally prefer, to take only the funds originally brought by the owner along with
the funds that have been subsequently ploughed back into the firm out of the retained profits.
From this standpoint, capital represents the sum of share capital, and reserves and surplus.
Funds contributed by the creditor (both long term and short term) are excluded on the ground
that they are claims by parties external to the firm, and are devoid of certain rights and
privileges enjoyed by the proprietor or shareholder. But a firm has a separate entity.
The basic character of all the funds, whether contributed by the owner or by the creditor is to
generate business income. So, long-term borrowings should also be included in the composition
of capital. Hence, capital represents the aggregate of share capital, reserves and surplus, and
long-term debt.
According -to the ‘asset’ concept, capital means money invested in fixed assets and current
assets. In both the cases, the asset may be comprising either tangibles or intangibles including

35
fictitious assets. To an accountant, an asset is a capitalized expenditure and represents claims
to services, it need not always be associated with a material object having a tangible, existence.
Further, though assets in general should possess value, all assets may not have value in
exchange. Thus, insofar as the intangible assets satisfy these criteria, there is no constraint on
the part of the accountant to the inclusion of intangibles among assets. Fictitious assets, such as
debit balance of profit and loss account, balance of securities discount account, are however, to
be treated more as deduction- from relevant liabilities than assets by themselves. Viewed from
this angle, funds represent aggregate of fixed assets (net of depreciation), intangible assets,
investments and current assets.

CAPITAL STRUCTURE
The term ‘structure’ is taken from engineering science. It connotes the arrangements of the
various parts of a building or some other construction. It is common knowledge that corporate
enterprises raise their capital from diverse sources such as the issue of shares, debentures,
long-term loans, short-term loans and ploughing back of profits. Accordingly, in the
procurement of capital from diverse sources, as also in the subsequent commitment of the said
capital to various assets, certain proportions or combinations of various elements have to be
maintained.
This arrangement of capital is called Capital Structure. There are certain objectives for
maintaining a desired capital structure, such as minimization of the cost of capital and
maximization of the value of the share, etc.
Capital structure includes equity capital comprising retained earnings and long-term debt
capital. Short-term liabilities are excluded from the formulation of capital structure.

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FINANCIAL STRUCTURE AND CAPITAL STRUCTURE

Distinction between Capital Structure and Financial Structure.

Sometimes, a distinction is drawn between ‘financial structure’ and ‘capital structure’ of a firm.
The sum of various means of raising funds comprises the financial structure of a firm. That is,
financial structure comprises net worth and all liabilities (long term and short term).
When short-term borrowings are omitted from the list, the remaining claims represent the
capital structure. Thus, the distinction between the two depends on the treatment of short-
term borrowing. However, when a broad view of the matter is adopted to include short-term
liabilities as one of the components of the capital structure (that is, net worth plus all liabilities),
there is no distinction between the terms financial structure and capital structure.

VARIABLES AFFECTING CAPITAL SUPPLY

The decisions of a financial manger to choose a particular form of capital supply available to
him that will be suitable for the firm is often mainly affected by the following:
(1) Relative costs

(2) Prevailing market conditions

(3) Control level to be relinquished

(4) Duration

(5) Risks involved

They will be considered in relation to the financial manager’s influence

(1) Relative Costs: These simply refer to on them the implicit costs or explicit costs that will be
incurred while sourcing, obtaining and repaying borrowed capital. All these factors have to be
considered by a financial manager in relation to what the capital sourced is going to reproduce
for the company. They can be controlled by the financial manager.

(2) Prevailing Market Condition: This factor mainly refers to the interest rates that are
prevailing in the market for capital depending on the forces of supply and demand for capital.

37
These are dependent on the savings of businesses, government and individual in relation to the
money creating activities of banking system. They are exogenous in nature and are not in the
control of the financial manager.

(3) Controlled Leveled to be Relinquished: in this aspect, the financial manager will have to
follow the business owner’s choice in whether or not the ownership structure be

altered thereby leading to control being relinquished. This is the case which arises in whether
or not the capital should be permanent capital or long-term capital. Example deciding whether
or not reserves should be re invested (No Control Relinquished) or whether or not bonds or
preference shares should be issued (Control Relinquished).

(4) Duration: this is a very big important factor to be considered as time can be crucial in
investments. The financial manager will be faced with choosing the right capital source with the
right timeline that could suit the capital finance need of the business at a particular time.

(5) Risks Involved: Risk inherent in a particular capital option and the firm’s market would
definitely influence the choice of capital to be available when financing a business at a
particular time. They are usually gauged by analyzing the current ratios among many others.
Financial risk such as hearing fixed charges on bonds could also be a deciding factor.
Other factors that may affect the supply of capital involve; security, marketability, legal form of
business, dividend pay-out, record of the firm, legal form of business and eligibility of securities
for institutional investment.

CLASSIFICATION OF CAPITAL STRUCTURE

It has already been pointed out that firms acquire their capital from various sources in order to
invest them in different types (If assets. Thus, a capital structure has a double-edged
manifestation-one edge being the finance structure depending on the source, and the other
edge being the asset structure depending on the nature of investment.
There have been various classification of capital structure on different characteristics or bases.
These are discussed in the following section.

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According to Nature
A capital structure may be either: (i) simple, or (ii) complex. A simple structure comprises a
single source, e.g. equity share capital including retained earnings. But as soon as a firm
finances capital from more than one source that is not of an identical or allied nature, it is
called a complex structure.

According to Sources
It may be broadly classified into: (i) internal capital, and (ii) external capital. Internal capital
includes the following:
 Share capital through bonus issue
 Capital reserve
 Reserves and surplus (including balance of profit and loss appropriation account).

External capital comprises the following:

 Share capital (excluding bonus shares)
 Share premium
 Forfeited shares
 Debentures
 Long-term and short-term liabilities

According to Ownership
Capital may also be classified according to ownership, e.g. ownership capital and creditorship or
debt capital. Ownership capital consists of:
 Equity share capital
 Retained earnings

Creditorship or debt capital includes the following: .

 Debentures
 Long-term loans

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  Current liabilities
In the above classification, the concept of preference share capital poses a problem.
There are two approaches regarding its treatment. According to one view, it is considered as a
part of ownership capital, and should, therefore, be added to equity share capital in order to
arrive at the total ownership capital. According to the other view, preference share should be
added to debt capital as, like other debt capital, it enjoys a fixed rate of income and also a
priority over equity in respect of both payment of income and return of capital. There are
reasons to justify both the approaches. Accordingly, preference share capital may be treated as
a part of either ownership capital or debt capital.

According to Cost Behaviour

Capital is not cost free. So, classification is also possible according to the cost behaviour of
various sources of capital such as fixed cost capital, i.e. the rate of dividend or interest
remaining fixed, and variable cost capital, i.e. when the dividend rate varies.
The fixed cost capital includes:
 Preference share capital
 Debentures
 Long-term debt capital

The variable cost capital comprises:

 Equity share capital (when no uniform rate of dividend is maintained)
 Short-term liabilities (when such cost is measurable)

In any case, the study of capital structure, whether in its broad outline or in detail, depends on
the proportional or percentage contribution to the total capital of a firm. At any given point of
time, such percentage contributions cannot be the same in firms of different types within a
particular industry, or in those of different industries but of a particular type.

40