Financial Management & Risk Appraisal BCM331

FINANCIAL MANAGEMENT AND RISK APPRIASAL

BCM 331

MULUNGUSHI UNIVERSITY
INSTITUTE OF DISTANCE EDUCATION

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 Financial Management & Risk Appraisal BCM331

Contents
Course Title: Financial Management & Risk Appraisal ........................................................... 4
Course Code: BCM 372 ............................................................................................................ 4
Course description .................................................................................................................... 4
Course objectives ...................................................................................................................... 4
Chapter I: Introduction to Financial Management .................................................................... 5
1.1: Meaning and areas of finance, and meaning of financial management ......................... 5
1.2: Financial management decisions and the scope of financial management ................... 8
1.3: The goals of financial management ............................................................................. 12
1.4: Organization Structure of the Finance Function .......................................................... 14
1.5: Agency Relationships ................................................................................................. 15
1. 6: Financial Markets ....................................................................................................... 16
I. Capital Market .......................................................................................................... 17
II. Money Market ...................................................................................................... 17
Chapter II: Financial Analysis ................................................................................................ 18
2. 1: Definition, Objectives, and Methods of Financial Analysis ....................................... 18
2. 2: Ratio Analysis: Liquidity Ratios................................................................................. 20
2.3: Ratio Analysis: Asset Management Ratios .................................................................. 26
2.4: Ratio Analysis: Debt Management Ratios ................................................................... 32
2.5: Ratio Analysis: Profitability Ratios ............................................................................. 40
2.6: Ratio Analysis: Marketability Ratios ........................................................................... 46
2. 7: Limitations of ratio analysis ....................................................................................... 48
Chapter III: Financial planning and forecasting ................................................................... 50
2.1: Nature of financial planning ........................................................................................ 50
Financial Forecasting .............................................................................................................. 50
3.2: Methods of forecasting financial statements ............................................................... 51
Financial Statement Forecasting: The Percentage of Sales Method (PCM) ....................... 51
3.3: Methods of forecasting financial statements: AFN formula and excess capacity
adjustment ........................................................................................................................... 53
Chapter IV: Risk and Return................................................................................................... 57
4.1 The Concept of Risk ..................................................................................................... 57
4.2. Probability Distribution and Expected Rates of Returns ............................................. 57
4.3. Measuring Stand – Alone Risk .................................................................................... 59
4.4 Risk in a portfolio context............................................................................................. 60
4.5 Diversifiable risk versus market risk ............................................................................ 64
4.6 Systematic risk and Beta ............................................................................................... 65
4.7 The security market line (SML) and capital asset pricing model ................................. 66
(CAPM)............................................................................................................................... 66
Chapter V: Time Value of Money valuation of financial assets ............................................. 70
5.1: Accounting and the time value of money .................................................................... 70
The time value of money .................................................................................................... 70
Uses of present and future values in financial accounting .................................................. 71
Simple interest and compound interest ............................................................................... 71

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Future and present values.................................................................................................... 72

Annuities ............................................................................................................................. 75
Present Value of an annuity ................................................................................................ 78
5.2: Valuation of common stock ........................................................................................ 80
Financial Assets ...................................................................................................................... 80
The basic valuations model ................................................................................................. 81
a) Zero growth model.......................................................................................................... 81
b) Constant Growth Model ................................................................................................. 82
c) Multiple-Growth Model .................................................................................................. 83
5. 3: RRR on common stock .............................................................................................. 89
5.4: Valuation of preferred stock ........................................................................................ 92
The Nature of Preferred Stocks............................................................................................... 92
Valuation of Preferred Stocks ................................................................................................. 92
5.5: Valuation of Bonds ...................................................................................................... 95
Definition of Bond .................................................................................................................. 95
Types of Bonds ....................................................................................................................... 95
The value of Bonds ................................................................................................................. 96
Yield to maturity ................................................................................................................. 98
Chapter VI: Long Term Investment Decisions..................................................................... 104
6.1: Nature of long-term investment decision................................................................... 104
6.2: Procedures in capital budgeting decisions ................................................................ 106
6.3: Investment evaluation criteria /appraisal techniques- PB & ARR ........................... 108
6. 4: Appraisal techniques –Net present value .................................................................. 110
Net Present Value ............................................................................................................. 110
6.5: Appraisal techniques –IRR ....................................................................................... 112
6. 6: Appraisal techniques- profitability index ................................................................. 114
Profitability Index Method / Benefit Cost Ratio B/C Ratio .............................................. 114
6.7: Capital Rationing and project selection ..................................................................... 115
6.8 Capital Budgeting Under Uncertainty ........................................................................ 116
6.9 Incorporating Project Risk into Capital Budgeting ..................................................... 117
6.10 Certainty Equivalents ................................................................................................ 120
6.11 Sensitivity and Scenario Analysis ............................................................................. 121

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 Financial Management & Risk Appraisal BCM331

Course Title: Financial Management & Risk Appraisal

Course Code: BCM 372

Course description
This course is intended to introduce the basic concepts of financial management. It addresses
issues like the difference between finance and financial management, financial management
decisions, the scope and goal of financial management, the organization structure of the
finance function, agency relation ship, and the financial markets. It also covers financial
analysis, financial planning and forecasting, Risk and Return valuation of financial assets,
and capital budgeting.

Course objectives
After completing this course, students will be able to:
 Understand the basic concepts of financial management
 Evaluate the financial performance of the business
 Plan and forecast the financial performance of the company
 Explain the relationship between risk and return
 Determine the value of financial assets
 Identify and evaluate capital projects

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Chapter I: Introduction to Financial Management

1.1: Meaning and areas of finance, and meaning of financial

management

Meaning of Finance
Finance is the study of money. Finance means to arrange payment for. It is basically
concerned with the nature, creation, behavior, regulation and problems of money. It focuses
on how the individuals, businessmen, investors, government and financial institutions deal.
We need to understand what money is and does is the foundations of financial knowledge. In
this content it is relevant to study the structure and behavior of financial system and the role
of financial system in the development of economy and the profitability of business
enterprises.

Meaning of Financial Management

Financial management involves the management of finance function. It is concerned with the
planning, organizing, directing and controlling the financial activities of an enterprise. It
deals mainly with raising funds in the most economic and suitable manner; using these funds
as profitably as possible; planning future operations; and controlling current performance and
future developments through financial accounting, cost accounting, budgeting, statistics and
other means. It is continuously concerned with achieving an adequate rate of return on
investment, as this is necessary for survival and the attracting of new capital. Thus, financial
management means the entire gamut of managerial efforts devoted to the management of
finance – both its sources and uses – of the enterprise.

Areas of finance
The areas of finance can be referred to as the parts that are included in finance. And these
major areas of finance are:

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1. Corporate finance or financial management

Finance is regarded as the lifeblood of a business enterprise. It is the guide for regularizing
investment decisions and expenditure, and endeavors to squeeze the most out of every
available Kwacha. It is the sinew of a business activity. And, it has been rightly said that
business needs money to make more money. However, it is also true that money begets more
money only when it is properly managed. Hence, efficient management of every business
enterprise is closely linked with efficient management of its finances; i.e.; Corporate Finance/
Financial Management.

In every organization, where funds are involved, sound financial management is necessary. It
helps in monitoring the effective deployment of funds in fixed assets and in working capital.
Hence, it can be said that sound financial management is indispensable for any organization,
whether it is profit oriented or non-profit oriented. It helps in profit planning, capital
spending, measuring costs, controlling inventories, accounts receivable etc., In addition to the
routine problems, financial management also deals with more complex problems like
mergers, acquisitions and reorganizations.

2. Investments
The success of a business unit depends upon the investment of resource in such a way that
bring in benefits or best possible returns from any investment. The investment in general
means an expenditure in cash or its equivalent during one or more time periods in
anticipation of enjoying a net cash inflows or its equivalent in some future time period or
periods.
The investment in any project will bring in desired profits or benefits in future. If the
financial resources were in abundance, it would be possible to accept several investment
proposals which satisfy the norms of approval or acceptability. Since, we are sure that
resources are limited, a choice has to be made among the various investment proposals by
evaluating their comparative merit.

3. Financial Institutions

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The financial institutions include banks, development banks, investing institutions at national
and international level that provide financial services to the business organizations. These
financial institutions provide long-term, short-term finances and extend under writing,
promotional and merchant banking services

4. International Finance
When the parties to an international transaction are well known to each other and the
countries involved are politically stable, sales are generally made on credit, as is customary
in domestic business operations. However, if a foreign importer is relatively new or the
political environment is volatile, or both, the possibility of nonpayment by the importer is
worrisome for the exporter. To reduce the risk of nonpayment, an exporter may request that
the importer furnish a letter of credit. The importer's bank normally issues the letter of credit,
in which the bank promises to subsequently pay the money for the merchandise. For
example, assume Archer Daniels Midland (ADM) is negotiating with a South Korean trading
company to export soybean meal. The two parties agree on price, method of shipment, and
timing of shipment, destination point, and the like. Once the basic terms of sale have been
agreed to, the South Korean trading company (importer) applies for a letter of credit from its
commercial bank in Seoul. The Korean bank, if it so desires, issues such a letter of credit,
which specifies in detail all the steps that must be completed by the American exporter
before payment is made. If ADM complies with all specifications in the letter of credit and
submits to the Korean bank the proper documentation to prove that it has done so, the Korean
bank guarantees the payment on the due date. On that date the Korean bank, not by the buyer
of the goods, pays the American firm. Therefore all the credit risk to the exporter is absorbed
by the importer's bank, which is in a good position to evaluate the creditworthiness of the
importing firm.

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1.2: Financial management decisions and the scope of financial

management

Financial Management Decisions

Financial management decisions may be divided in to three:

1. Investment Decision
The investment decision relates to the selection of assets in which funds will be invested by a
firm. The assets which can be acquired fall into two broad groups: (i) long-term assets which
will yield a return over a period of time in future, (ii) short-term or current assets defined as
those assets which are convertible into cash usually within a year. Accordingly, the asset
selection decision of a firm is of two types. The first of these involving fixed assets is
popularly known as ‘Capital Budgeting’. The aspect of financial decision-making with
reference to current assets or short-term assets is designated as ‘Working Capital
Management.’

Capital Budgeting: Capital budgeting refers to the decision making process by which a firm
evaluates the purchase of major fixed assets, including buildings, machinery and equipment.
It deals exclusively with major investment proposals which are essentially long-term
projects. It is concerned with the allocation of firm’s scarce financial resources among the
available market opportunities. It is a many-sided activity which includes a search for new
and more profitable investment profitable investment proposals and the making of an
economic analysis to determine the profit potential of each investment proposal.
Working Capital Management: Working Capital Management is concerned with the
management of the current assets. The finance manager should manage the current assets
efficiently for safe-guarding the firm against the dangers of liquidity and insolvency.
Involvement of funds in current assets reduces the profitability of the firm. But the finance
manager should also equally look after the current financial needs of the firm to maintain
optimum production. Thus, a conflict exists between profitability and liquidity while

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managing the current assets. As such the finance manager must try to achieve a proper trade-
off between profitability and liquidity.

2. Financing Decision:
In this context, the financial manager is required to determine the best financing mix or
capital structure of the firm. Then, he must decide when, where and how to acquire funds to
meet the firm’s investment needs.
The central issue before the finance manager is to determine the proportion of equity capital
and debt capital. He must strive to obtain the best financing mix or optimum capital structure
for his firm. The use of debt capital affects the return and risk of shareholders. The return on
equity will increase, but also the risk. A proper balance will have to be struck between return
and risk.

3. Dividend Decision:
In this context, the finance manager must decide whether the firm should distribute all profits
or retain them, or distribute a portion and retain the balance. Sometimes, the profits of the
company are fully diverted towards its capital expenditure or establishment of new projects
so as to minimize further borrowings. While there may be some justification in diverting
profits to some extent, the claims of shareholders for dividends cannot be completely
overlooked.
The finance manager has to develop such a dividend policy which divides the net earnings
into dividends and retained earnings in an optimum way to achieve the objective of
maximizing the market value of firm. He should also concentrate his attention on issues like
the stability of dividend, bonus issue etc.
Scope of Financial Management
Financial management has undergone significant changes over the years as regards its scope
and coverage. As such the role of finance manager has also undergone fundamental changes
over the years. In order to have a better exposition to these changes, it will be appropriate to
study both the traditional concept and the modern concept of the finance function.

Traditional Concept:

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In the beginning of the present century, which was the starting point for the scholarly
writings on Corporation Finance, the function of finance was considered to be the task of
providing funds needed by the enterprise on terms that are most favorable to the operations
of the enterprise. The traditional scholars are of the view that the quantum and pattern of
finance requirements and allocation of funds as among different assets, is the concern of non-
financial executives. According to them, the finance manager has to undertake the following
three functions:
a) arrangement of funds from financial institutions;
b) arrangement of funds through financial instruments, Viz., shares, bonds, etc
c) looking after the legal and accounting relationship between a corporation and its
sources of funds
The traditional concept evolved during 1920s continued to dominate academic thinking
during the forties and through the early fifties. However, in the later fifties many scholars
including James C. Van Horne, Pearson Hunt, Charles W. Gerstenberg and Edmonds Earle
Lincoln due to the following reasons criticized the traditional concept:

1. The emphasis in the traditional concept is on raising of funds, This concept takes into
account only the investor’s point of view and not the finance manager’s view point.
2. The traditional approach is circumscribed to the episodic financing function as it
places overemphasis on topics like types of securities, promotion, incorporation,
liquidation, merger, etc.
3. The traditional approach places great emphasis on the long-term problems and
ignores the importance of the working capital management.
4. The concept confined financial management to issues involving procurement of
funds. It did not emphasis on allocation of funds.
5. It blind eye towards the problems of financing non-corporate enterprises has yet been
another criticism.
In the absence of the coverage of these crucial aspects, the traditional concept implied a very
narrow scope for financial management. The modern concept provides a solution to these
shortcomings.

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Modern Concept

The traditional concept outlived its utility due to changed business situations since mid-
1950’s. Technological improvements, widened marketing operations, development of a
strong corporate structure, keen and healthy business competition – all made it imperative for
the management to make optimum use of available financial resources for continued survival
of the firm.

The finance manager, under this concept, has to see that the company maintains sufficient
funds to carry out the plans. At the same time, he has also to ensure a wise application of
funds in the productive purposes. Thus, the present day finance manager is required to
consider all the financial activities of planning, organizing, raising, allocating and controlling
of funds. In addition, the development of a number of decision making and control
techniques, and the advent of computers, facilitated to implement a system of optimum
allocation of the firm’s resources.
The modern approach replaced “Corporate Finance” with the term “Financial Management”
in a broad sense and provides a conceptual and analytical framework for financial decision-
making. According to it, the finance function covers both acquisitions of funds as well as
their allocation.

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1.3: The goals of financial management

Goals of Financial Management

Financial management, as an academic discipline, is concerned with decision-making in
regard to the size and composition of assets and structure of financing. To make wise
decisions, a clear understanding of the objectives that are sought to be achieved is necessary.
The objectives provide a framework for optimum financial decision-making. The well known
and widely discussed approaches available in financial literature are, (a) Profit Maximization
and (b) Wealth Maximization.

Profit Maximization:

According to this approach, actions that increase profits should only be undertaken. Here, the
term “Profit” can be used in two senses: (1) As owner – oriented concept it refers to the
amount and share of national income which is paid to the owners of business, i.e., those who
supply equity capital; (2) A variants for the term is profitability. It is an operational concept
and signifies economic efficiency. In other words, profitability refers to a situation where
output exceeds input, i.e., the value created by the use of resources is more than the total of
the input resources. Used in this sense, profitability maximization would imply that a firm
should be guided in financial decision-making by one test – select assets, projects and
decisions which are profitable and reject those which are not. In the current financial
literature, there is a general agreement that profit maximization is used in this sense.

The profit maximization theory is based on the following important assumptions:

(a) This theory is bases purely on the rationality of the individuals and the firms.
(b) It promotes the use of resources to the best of their advantage of gain maximum out
of them.
(c) It leads to the economic selection of the resources.’

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(d) It enhances the National Income of the country through efficient and increased
production.
However, the profit maximization objective has been criticized in recent past it is argued that
profit maximization is a consequence of perfect competition and in the context of today’s
imperfect competition; it cannot be taken as a legitimate objective of the firm. It is also
argued that profit maximization, as a business objective, developed in the early 19th Century
when the characteristic features of the business structure were self-financing, private property
and single entrepreneurship.
Apart from the aforesaid objections, the other important technical flaws of this criterion are:

a. There is a lack of unanimity regarding the concept of profit. There are various terms
such as gross profit, net profit, earnings, short-term profit and long-term profit.
b. Profits while enhancing the national income, may not contribute to the welfare of the
poor, because they may lead to concentration of income and wealth.
c. The assumptions on which it is based are untenable. There exists no perfect
competition in the market.
d. This theory is also criticized for ignoring the timing of returns and risk. It doesn’t take
the returns in terms of their present value.
Wealth Maximization:

This approach is also known as Value Maximization or Net Present Wealth Maximization.
Wealth maximization means maximizing the net present value (NPV) of a course of action.
The NPV of a course of action is the difference between the gross present value (GPV) of the
benefits of that action and the amount of investment required to achieve those benefits. The
GPV of a course of action is found out by discounting or capitalizing its benefits at a rate
which reflects their timing and uncertainty. A financial action which has a positive NPV
creates wealth and therefore, is desirable. A financial action resulting in negative NPV
should be rejected. Between a number or desirable mutually exclusive projects, the one with
the highest NPV should be adopted. The wealth or NPV of the firm will be maximized if this
criterion is followed in making financial decisions.

The objective of shareholders’ wealth maximization has a number of distinct advantages. It is

conceptually possible to determine whether a particular financial decision is consistent with

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this objective or not. If a decision made by a firm has the effect of increasing the long-term
market price of the firm’s stock then it is a good decision. If it appears that certain action will
not achieve this result then the action should not be taken. The wealth maximization
objective acceptable as an operationally feasible criterion to guide financial decisions only
when it is consistent with the interests of all those groups such as shareholders, creditors,
employees, management and the society.

1.4: Organization Structure of the Finance Function

Organization Structure of Finance Function

A well-organized finance department is absolutely essential for the efficient financial
management of an enterprise. If finance department does not operate well, the whole
organizational activity will be ruined. Hence, it is essential that the finance department
should be well organized with nucleus staff from the time of project stage, so that expert
guidance and advice regarding the various proposals are available to the management in
planning and managing the project.
A self-explanatory organization structure of finance department in a large organization is
given below.

PRESIDENT

V.P V.P V.P HUMAN V.P

PRODUCTION FINANCE RESOURCES MARKETING

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Controller Treasurer

Functions Functions

1. Accounting 1. Cash and Bank management

2. Cost Accounting 2. Investments
3. Budgeting 3. Tax matters
4. Internal Audit 4. Insurance
5. Collections creditors 5. Investor Relations.
6. Financial planning
7. Profit planning
8. Investment decisions
9. Assets management
10. Economic Appraisal

1.5: Agency Relationships

Agency Relationships
It has been recognized that managers may have personal goals that compete with shareholder
wealth maximization. Managers are empowered by the owners of the firm- the shareholders-
to make decisions, and that creates a potential conflict of interest known as agency theory.

Agency relationship arises whenever one or more individuals called principals, hires another
individual or organization, called an agent, to perform some service and then delegates
decision-making authority to that agent. Within the financial management context, the
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primary agency relationships are those (1) between stockholders and managers and (2)
between managers and debt holders.

A potential agency problem arises whenever the manager of a firm owns less than 100
percent of the firm’s common stock. If the firm is a proprietorship managed by its owner, the
owner-manager will presumably operate so as to maximize his or her own welfare, with
welfare measured in the form of increased personal wealth, more leisure, or perquisites.
 Agency relationship is said to exist if one party (delegator) gives decision making
authority to another party (delegate).
 Agency relationship exists between managers and owners, employer and employees etc
 The delegate is expected to act in the best interest of the delegator
 Agency problem arises when the delegate acted against the interest of the delegator
 Agency problem causes agency costs, such as:
 Direct agency costs
 Indirect agency costs
 Means in reducing potential conflict of interest between managers and owners include:
 Tie managerial compensation to financial performance and stock price
 The threat of firing (proxy fight
 The threat of takeovers

1. 6: Financial Markets

Financial Markets
Financial market is a place where the business houses can raise their long and short-term
financial requirements. The development of financial markets indicates the development of
economic system. For mobilization of savings and for rapid capital formation, healthy growth
and development of these markets are crucial. These markets help promotion of investment

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activities; encourage entrepreneurship and development of a country. The financial markets

are broadly divided as
I. Capital market and
II. Money market

I. Capital Market
Capital market is defined as a place where all buyers and sellers of capital funds as well as
the entire mechanism for facilitating and effecting long term funds. It provides the long-term
funds that are needed for investment purpose. Thus, the capital markets are concerned with
long-term finance. This also includes the institutions, facilities and arrangements for the
borrowing and lending of long-term funds.

II. Money Market

Money market deals with short-term requirements of borrowers. It is concerned with the
supply and demand for a commodity or service. It handles transactions in short-term
government obligations, bankers’ acceptances and commodity papers. In money market
funds can be borrowed for short period varying from a day to a year. It is a place where the
lending and borrowing of short-term funds are arranged and it comprises short-term credit
instruments and individuals who participate in the lending and borrowing business.

Financial markets may also be divided into two categories:

I. Primary market and
II. Secondary market.

Primary Market – In the primary market only new securities are issued to the public. It is a
place where borrowers exchange financial securities for long-term funds. It facilitates the
formation of capital. The securities may be issued directly to the individuals, institutions,
through the underwriters etc.
Secondary Market – The shares subsequent to the allotment are traded in the secondary
market. Any body can either buy or sell the securities in the market. Secondary market

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consists of stock exchange. In the stock exchange outstanding securities are offered for sale
and purchase.

Chapter II: Financial Analysis

2. 1: Definition, Objectives, and Methods of Financial Analysis

Definition of Financial Analysis

Financial statement analysis is a process of synthesis of summarization of financial
statements and operative data (presented in financial statements) with a view to getting an
insight into the operative activities of a business concern. It is a technique of investigating the
financial positions and progress of the unit. By establishing some relationship between
balance sheet and income statement, analysis attempts to reveal the meaning and importance
of various items contained in the financial statements.

Objectives of Financial Analysis

The main objective of financial analysis is to reveal the fact and relationships among the
managerial expectations and the efficiency of the business unit. The financial strengths and
weaknesses, its credit worthiness can also be known through such an analysis. The safety of
funds invested in the firm, the adequacy or otherwise of its earnings, the ability to meet its
obligations etc. can also be examined through an analysis of their financial statements. Of
course, the financial analysis reveals only what has happened in the past. But, we can predict
future basing on past.

Methods of Financial Analysis

In the process of financial analysis various tools are employed. The most prominent amongst
them are listed as below:
1. Ratio Analysis

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2. Common size statement Analysis

3. Trend Analysis
4. Index Analysis

Ratio Analysis: Ratio analysis is a tool which establishes a numerical relationship of between
two figures normally expressed in terms of percentage. This has been discussed in detail in
the next unit.

Common Size Statement Analysis: Under this technique the individual items of income
statement and balance sheet are expressed as percentages in relation to some common base.
In income statement, sales are usually taken as hundred and all items are expressed as
percentage of sales. Similarly, in balance sheet the total of assets or liabilities treated
equivalent to hundred and all individual assets or liabilities are expressed as percentage of
this total.

Trend Analysis: It is highly helpful in making a comparative study of the financial

statements for several years. The calculation of trend percentages involves the calculation of
percentage relationship that each item bears to the same item in the base year. Any year may
be taken as base year. Usually, the first year will be taken as the base year. Any intervening
year may also be taken as the base year. Each item of the base year is taken as 100 and on
that basis the percentage for each of the item of each of the years are calculated. These
percentages can also be taken as the index numbers showing the relative changes in the
financial data over a period of time.

Index Analysis
It is a type of financial statement analysis where by for each items of the base year figure we
have 100 percent and for each item of the subsequent financial statement of year are
expressed in terms of the base year.

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2. 2: Ratio Analysis: Liquidity Ratios

Definition of Ratio
The term, ‘ratio’, refers to the numerical or quantitative relationship between items or
variables. It shows an arithmetical relationship between two figures. It is also defined as “the
indicated quotient of two mathematical expressions” and as “the relationship between two or
more things”. The relationship between two accounting figures expressed mathematically is
known as ‘financial ratio’ or ‘accounting ratio’ or simply as a ratio. These ratios are generally
expressed in three ways. It may be a quotient obtained by dividing one value by another, a
percentage, or it can be expressed as so many ‘times’ or ‘fraction’.

Types of Standards of comparison

When computing and interpreting analysis measures as part of out financial statement
analysis, we need to decide whether these measures suggest well, bad or average
performance to make these judgments, we need standards for comparison that can include:
Intra Company. The company under analysis provides standards for comparisons base on
prior performance and relations between its tenacity items.
For example a company’s current net income, for instance, can be compared with prior year’s
net income and its relation to revenues.
Competitor. One or more direct competitors of the company under analysis can provide
standards for comparisons. A company’s profit margin for instance, can be compared with
the profit margin of another company.
Industry. Industry statistics can provide standards of comparisons published industry
statistics are available from several services.
Guidelines (rules of thumb). General standards of comparisons can develop from past
experiences. These guidelines, or rules of thumb, must be carefully applied since their
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context is often crucial. All of these standards of comparisons are useful when properly
applied; yet analysis measures taken from a selected competitor or group of competitors are
often the best. Also, Intra Company and industry are important part of all analysis.
Guidelines should be applied with care, and then only it can seem reasonable in light of past
experience and industry norms.

Categories of Ratio
There are five categories of ratio. These are
a. Liquidity ratios
b. Asset management ratios
c. Debt management ratios
d. Profitability ratios
e. Marketability ratios

A. Liquidity Ratio
Liquidity is the ability of a firm to meet its current or short-term obligations when they
become due. Every firm should maintain adequate liquidity. Liquidity is also known as short-
term solvency of the firm. The short-term creditors of the firm are interested in the short-term
solvency or liquidity of the firm. The liquidity position is better known with the help of cash
budgets and cash flow statements. But liquidity ratios also provide a quick measure of the
liquidity of the firm.
The liquidity ratios or short-term solvency ratios establish a relationship between cash and
current assets to current liabilities. A firm’s liquidity should neither be too low nor too high
but should be adequate. Low liquidity implies the firm’s inability to meet its obligations. This
will result in bad credit rating, loss of the creditors’ confidence or even technical insolvency
ultimately resulting in the closure of the firm. A very high liquidity position is also bad; it
means the firm’s current assets are too large in proportion to maturity obligations. There are
two ratios under liquidity ratio:

1) Current Ratio

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Current ratio is the ratio of total current assets to total current liabilities. It is calculated by
dividing current assets by current liabilities.
Current assets
Current ratio =
Current liabilities
This ratio is also called ‘working capital ratio’ because it is related to the working capital of
the firm. The current ratio is an important and most commonly used ratio to measure the
short-term financial strength or solvency of the firm. It indicates how many Kwacha of
current assets are available for one Kwacha of current liability. The higher the current ratio,
the more is the firm’s ability to meet its current obligations and the greater the safety of the
funds of the short-term creditors. Thus the current ratio, in a way, provides a margin of safety
to the (short-term) creditors..

2) Quick Ratio or Acid Test Ratio

This ratio measures the relationship between Quick assets (or liquid assets) and current
liabilities. An asset is considered liquid if it can be converted into cash without loss of time
or value. Cash is the most liquid asset. Other assets which are considered to be relatively
liquid and include in the quick assets are accounts receivable (i.e. debtors and bills
receivable) and short term investments in securities. Stock or inventory is excluded because it
is not easily and readily convertible into cash. Similarly, prepaid expenses, which cannot be
converted into cash and be available to pay off current liabilities, should also be excluded
form liquid assets.

The quick ratio is calculated by dividing quick assets by current liabilities:

Quick assets
Quick Ratio =
Current liabilities
Generally, a quick ratio of 1:1 is considered to be satisfactory. But this ratio also should be
used cautiously. It should also be subjected to qualitative tests, i.e., quality of the assets
included should be assessed.

Example (1)

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The assets and liabilities of a firm as on the 31st of Dec., 2000 were as under. Calculate the
current ratio and its net working capital and the quick ratio.

Assets Kwacha Liabilities & Capital Kwacha

Plant 4, 000, 000 Share Capital 3, 000, 000
Buildings 2, 000, 000 Reserves & Surplus 800, 000
Stock 1, 500, 000 Debentures 3, 000, 000
Receivables 1, 000, 000 Creditors 600, 000
Prepaid Expenses 250, 000 Bills Payable 200, 000
Marketable Securities 750, 000 Accrued Expenses 200, 000
Cash 250,000 Provision for Taxation 650, 000
Long Term Loan 1, 300, 000
Solution
Current ratio and its networking capital
For calculating the current ratio we need to know the current assets and current liabilities
Current Assets Kwacha Current Liabilities
Kwacha
Cash 250, 000 Creditors 600, 000
Mkt. Securities 750, 000 Bills Payable 200, 000
Debtors 1, 000, 000 Accrued Expenses 200, 000
Stock 1, 500, 000 Provision for Taxation 650, 000
Prepaid Expenses 250, 000 _________
3, 750, 000 1, 650, 000
Current assets
Current Ratio = = 2.75:1
Current liabilities
Net working capital = Current Assets – Current Liabilities
= Kwacha 3, 750, 000 – Kwacha 1, 650, 000 = Kwacha 2, 100, 000
Quick ratio
Quick Assets Kwacha Current Liabilities
Kwacha
Cash 250, 000 Current Liabilities 1, 650, 000

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 Financial Management & Risk Appraisal BCM331

Securities 750, 000

Debtors 1, 000, 000
2, 000, 000
Quick assets K 2,000,000
Quick Ratio =  = 1.21:1
Current liabilities K 1,650,000

Synopsis
 Ratio is the indicated quotient of two mathematical expression
 Four types of standards
a. Absolute standards (Accepted generally as being desirable)
b. Horizontal standards (Use of the performance of other firm in the industry or
average of the industry)
c. Historical standards (use past performance)
d. Budgeted standards ( use of forecasted performance)
 five categories of ratios
A. Liquidity ratios
B. Asset management ratios
C. Debt management ratios
D. Profitability ratios
E. Marketability ratios
 Liquidity ratios measure the ability of the firm to meet short term obligations without
undue stress
 the major liquidity ratios are current ratio and quick ratio
 Current ratio measures a firm’s ability to pay its current liabilities from its current
assets.
Current ratio = Current assets / Current liabilities
 A higher current ratio is desirable
 Quick (acid) test ratio measures a firm’s ability to pay its current liabilities without
relying on the sale of its inventory.
Quick ratio = Quick assets / Current liabilities
 A higher quick ratio is desirable

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Review questions
a. Define ratio
b. Mention the different types of standards
c. Mention the five categories of ratios
d. What do we measure with liquidity ratios?
e. What are the two major liquidity ratios?
f. If total current assets and current liabilities are K 20000 and K 8000 respectively,
what is current ratio?
g. Total current assets of the firm are K 50000, of which inventory represents 20%.
If current liabilities are K 15000, determine quick ratio

Exercises
a. Given; current ratio of 2:1 and total current assets of K 10000. determine total
current liabilities
b. Given: current ratio of 2.5: 1 and total current liabilities of K 12000, determine
total current assets
c. Given:
Cash .................................. 60000
As/R .................................... 20000
Inventory............................. 40000
As/p ..................................... 30000
Accruals ............................... 10000

Required: Determine the following:

a. total current assets
b. total current liabilities
c. Current ratio
d. quick ratio

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2.3: Ratio Analysis: Asset Management Ratios

Asset Management Ratios

The finances obtained by a firm from its owners and creditors will be invested in assets.
These assets are used by the firm to generate sales and profits. The amount of sales generated
and the obtaining of the profits depend on the efficient management of these assets by the
firm. Asset management ratios indicate the efficiency with which the firm manages and used
its assets. That is why these activity ratios are also known as ‘efficiency ratios’. They are also
called ‘turnover ratios’ because they indicate the speed with which assets are being converted
or turned over into sales. Thus the activity or turnover ratio measures the relationship
between sales on one side and various assets on the other.
The underlying assumption here is that there exists an appropriate balance between sales and
different assets. A proper balance between sales and different assets generally indicates the
efficient management and use of the assets. Many activity ratios can be calculated to know
the efficiency of asset utilization. The following are some of the important activity ratios or
turnover ratios:

1) Accounts Receivable Turnover

This ratio indicates the number of times on an average the debtors or receivables turnover
each ear are created. The higher the value of accounts receivable turnover, the more efficient
is the management of assets.
Account receivable turnover is calculated by dividing credit sales by average receivables
Credit sales
Account Receivables turnover =
Averagereceivables
If the information about credit sales opening and closing balances of receivables is not
available in the financial statements, the receivables turnover can be calculated by taking the
total sales and closing balance of receivables.
Total sales
Account Receivables turnover =
End . Re ceivables

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2) Average Collection Period (ACP)

The average collection period ratio is another device for indicating the quality of receivables.
This ratio shows the nature of the firm’s credit policy also. The average collection period is
calculated by dividing days (or months) in a year by the receivables’ turnover.
Days in a year / 12 months
Average Collection Period =
Re ceivables' Turnover

The average collection period indicates the rigidity or slowness of their collectibility. The
shorter the period, the better the quality of debtors, since the shorter collection period implies
prompt payment by debtors. An excessively long collection period implies a too liberal and
inefficient credit and collection performance while a too short period indicates a very
restrictive or strict credit and collection policy. The firm’s average collection period should
be reasonable and not totally different from that of the industry’s average.

3) Inventory Turnover
This ratio indicates the efficiency of the firm’s inventory management and rapidity with
which the stock is turning into receivables through sales. It is calculated by dividing the cost
of goods sold by the average inventory.
Cost of goods sold
Inventory Turnover =
Average stock
Cost of goods sold = Sales – Gross Profit or
Opening Stock + Purchases + Mfg. Costs – Closing Stock.
Average Stock = (Opening Stock + Closing Stock)  2.
If the particulars of cost of goods sold and average stock are not available in the published
financial statements the stock turnover can be calculated by dividing sales by the stock at the
end, i.e.,
Sales
Inventory Turnover =
Closing Stocks
Between the two formulae given above for calculating the stock turnover the former is more
logical and more appropriate than the latter.

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Generally, low inventory turnover implies the maintenance of excessive stocks, which are not
warranted by production and sales activities. It also may be taken as an indication of slow
moving or non-moving and obsolete inventory. A too high inventory turnover also is not
good. It may be the result of a very low level of stocks, which may result in frequent stock-
outs. Therefore the inventory turnover should be neither too high nor too low.

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4) Inventory period
This ratio indicates how long inventory item sits in the store before it is sold. It is obtained by
dividing 360 days by inventory turnover
Inventory period= Days in year
Inventory turnover

5) Total Assets turnover (TATO)

This ratio measures the overall performance and efficiency of the business enterprise. It
points out the extent of efficiency in the use of assets by the firm. This ratio is calculated by
dividing the annual sales value by the value of total assets.
Total.Sales
Total Asset Turnover =
Total Assets
Normally, the value of sales should be considered to be twice that of the assets. A lower
ratio than this indicates that the assets are lying idle while a higher ratio may mean that there
is overtrading. Sometimes, intangible assets (goodwill, patents, etc) are excluded from the
total assets and the total tangible assets-turnover ratio is calculated. For calculating this ratio
fictitious assets (P & L A/c debit balance, deferred expenditure, etc) should be ignored.

6) Fixed Assets Turnover (FATO)

This ratio measures the firm’s efficiency in utilizing its fixed assets. Firms which have large
investments in fixed assets usually consider this ratio important. It indicates the extent of
capacity utilization in the firm. The ratio is calculated by dividing the total value of sales by
the amount of fixed assets invested.
Total sales
Fixed Assets Turnover=
Fixed Assets
A high ratio is an indicator of overtrading, while a low ratio suggests idle capacity or
excessive investment in fixed assets. Normally, a ratio of five times is taken as a standard.
Some analysts suggest the exclusion on intangible assets like goodwill, patents, etc., for
calculating this ratio. For calculating this ratio, the gross fixed assets figure is preferred to the
net value figure.

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Example 1
The sales of a firm amounted to Kwacha 600, 000 in a particular period on which it had a
gross margin of 20%. The stock at the beginning of the period was worth Kwacha 70, 000
and at the end of the period of Kwacha 90, 000. Calculate the inventory turnover ratio.

Solution
Cost of goods sold
Inventory turnover =
Average inventory

K 600,000  120,000 K 480,000

=   6 times
( K 70,000  K 90,000)  2 K 80,000

Inventory period= Days in year

Inventory turnover
= 365/6
= 60.83 days

Example 2
The total sales of a firm amounted to Kwacha 600, 000 during a year out of which the cash
sales amounted to Kwacha 200, 000. The outstanding amounts of debt at the beginning and at
the end of the year were Kwacha 30, 000 and Kwacha 40, 000 respectively. Calculate the
receivables turnover ratio.

Solution
Credit sales
Receivables Turnover =
Average debtors

K 400,000 K 400,000
=  = 11.4 times
( K 30,000  K 40,000)  2 K 35,000
the average collection periods may be calculated thus:
365
Average Collection Period = = 32 days.
11.4

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Synopsis
 Asset management ratios measure the extent to which the firm used its assets in
generating sales
 Asset management ratios are also called activity ratios, or turnover ratios
 The major asset management ratios include:
a. Accounts receivable turnover: Indicates the number of times that a firm collects
its accounts receivable each year.
As/R turnover = Credit sales/ Ending As/R
b. Average collection Period (ACP): Indicates the number of days that the firm
should wait before collecting from its credit customers.
ACP = 360/As/R turnover
c. Inventory turnover: Indicates the number of times that a firm sells its inventory
each year. It is computed as the ratio of sales to ending inventory
d. Inventory period: Indicates how long inventory item sits in the store before it is
sold. It is obtained by dividing 360 days by inventory turnover
e. Total assets turnover (TATO): Measures the extend to which total assets was
used in generating sales. It is obtained as the ratio of sales to total assets
f. Fixed assets Turnover (FATO): Measures the effectiveness with which fixed
assets were used in generating sales. It is computed by dividing sales by fixed
assets.

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Review question
a. If sales for the year (all on credit) and ending accounts receivable are K 360,000
and K 18,000 respectively, determine As/R turnover and ACP
b. If sales and ending inventory are K 500,000 and 50,000 respectively, determine
inventory turnover and inventory period
c. Total assets and total sales are K 1000000 and 1500000 respectively, determine
TATO
d. If total sales and fixed assets are K 600000 and 250,000 respectively, determine
FATO

Exercises
a. If ending As/R and As/R turnover are K 20000 and 8 times, determine credit sales
and ACP
b. If sales and inventory turnover are K 400000 and 10 times respectively, determine
ending inventory and Inventory period
c. If total sales and TATO are K 800000 and 3 times, determine total assets
d. If fixed assets and FATO are K 200000 and 4 times respectively, determine total
sales

2.4: Ratio Analysis: Debt Management Ratios

Debt Management (Leverage) Ratios

These ratios are also known as ‘long term solvency ratios’ or ‘capital gearing ratios.’ The
long-term creditors (debenture holders, financial institutions, etc) are more concerned with
the firm’s long-term financial position than with others. They judge the financial soundness
of the firm in terms of its ability to pay interest regularly as well as make repayment of the
principal either in one lump sum or in installments. The long-term solvency of the firm can
be examined with the help of the debt management or leverage or capital structure ratios.
These ratios indicate the funds provided by owners and creditors.
Leverage ratios can be calculated from the Balance Sheet items to determine the proportion
of debt in the total capital of the firm and from the income statement items to determine the
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extent to which operating profits are sufficient to cover the fixed charges. The most
commonly calculated leverage ratios include:

1) Debt (Debt to Asset) Ratio (D/A)

The ratio of total debt to total assets, generally called the debt ratio, measures the percentage
of funds provided by creditors. It is calculated using the following formula:
Debt ratio= Total debt
Total assets
Total debt includes both current liabilities and long-term debt. Creditors prefer low debt
ratios because the lower the ratio, the greater the cushion against creditors’ losses in the event
of liquidation, stockholders, on the other hand, may want more leverage because it magnifies
expected earnings.

2) Debt to equity ratio (D/E)

This is one of the measures of the long-term solvency of a firm. This reveals the relationship
between borrowed funds and the owners’ capital of a firm. In other words, it measures the
relative claims of creditors and owners against the assets of the firm. This ratio is calculated
in different ways. One way is to calculate the debt equity ratio in terms of the relative
proportions of long-term debt (non-current liabilities) and shareholders’ equity (i.e., common
shareholders equity and preference shareholders equity).
Long term liability
Debt-Equity ratio =
Shareholders' equity

Past accumulated losses and deferred expenditure should be excluded from the shareholders
equity. The shareholders equity is also known as the Net worth. Accordingly, this ratio is also
called “debt to net worth ratio.”
Another approach to the calculation of the debt-equity ratio is to divide the total debt (i.e.,
long term liabilities plus current liabilities) by the shareholders’ equity.
Total debt
Debt-equity ratio =
Shareholders' equity
A high debt-equity ratio indicates a large share of financing by the creditors in relation to the
owners or a larger claim of the creditors than those of owners. The D-E ratio indicates the

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margin of safety to the creditors. A very high D-E ratio is unfavorable to the firm and
introduces an element of inflexibility in the firm’s operations. A low debt-equity ratio implies
a smaller claim of the creditors or a greater claim of the owners.

An ideal D-E ratio is 1:1. However, much will depend on the nature of the enterprise and the
economic conditions in which it is operating.

3) Equity Multiplier (EM)

This is one of the debt management or leverage ratios, which calculates the ratio of Total
Assets to Common Equity.
Equity Multiplier (EM)= Total Assets
Common Equity
Note that firms which use a large amount of debt financing (more leverage) will necessarily
have a high equity multiplier - the more the debt, the less the equity, hence the higher the
equity multiplier, Assets/Equity. For example, if a firm has $1,000 of assets and is financed
with $800, or 80 percent debt, then its equity will be $200, and its equity multiplier will be
$1,000/$200 = 5. Had it used only $200 of debt, then its equity would have been $800, and
its equity multiplier would have been only $1,000/$800 = 1.25.

4) Times Interest Earned (TIE) Ratio

Times interest earned ratio is used for knowing the firm’s debt servicing capacity. This ratio
shows how many times the interest charges are covered by the EBIT which are ordinarily
available for paying the interest charges. It indicates the extent to which the earnings of the
firm may fall without adversely affecting its debt servicing capacity.
TIE ratio is obtained by dividing earnings (or Net Profit) before interest and taxes (EBIT) by
the fixed interest charges on loans.
EBIT
Interest Coverage =
Interest
A higher coverage ratio is desirable form the point of view of creditors. But too high a ratio
indicates that the firm is very conservative in using debt. On the other hand, a low coverage
ratio indicates excessive use of debt or inefficient operations.

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5) Fixed Charge Coverage (FCC) Ratio

This ratio has a wider coverage than the earlier ratios. It takes into account all the fixed
obligations of the firm, viz., interest on loans, preference dividend and repayment of the
principal. This ratio is calculated by dividing the Earnings Before Interest and Taxes (EBIT)
by the total fixed charges.
EBIT
Total Coverage =
Total fixed charges
The higher the coverage, the better is the ability of the firm to service debt. It is difficult to
establish a norm for the coverage of fixed charges. Much depends upon the trade custom and
the nature of the business. However, a ratio of 6 to 7% of net profit before tax or 3% of net
profit after tax is taken standard for industrial firms. For utility undertakings the ideal ratio is
4% of the net profits before tax and 2% of the net profits after tax.

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Example 1
From the following balance sheet calculate the leverage ratios:

Balance Sheet as on 31-12-2000

Kwacha Kwacha
Share capital Plant and Machinery 200, 000
Equity share capital 700, 000 (-) Accumulated depn. 500, 000
(70, 000 shares) 400, 000 1,500, 000
8% Preference share capital 400, 000 Goodwill 280, 000
Reserves & Surplus 200, 000 Inventory 300, 000
Long term loan (7%) 500, 000 Receivables 200, 000
8% debentures 120, 000 Prepaid Expenses 50, 000
Creditors 40, 000 Marketable Securities 150, 000
Bills Payable 170, 000 Cash 50, 000
Accrued Expenses 2,530, 000 2,530, 000

Solution
Debt (Debt to Asset) Ratio (D/A): this ratio can be calculated by taking the total liabilities
and total assets.
Debt ratio= Total debt
Total assets

= K 200,000 + 500,000 + 120 000 + 40,000 + 170,000

2,530,000

= 1,030,000
2,530,000

=0.407 or 40.7%
Debt-equity ratio: This ratio can be calculated by taking long-term debt or total debt into
account. If the long-term debt alone is considered:

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Long term debt

DE Ratio =
Shareholders' equity

K 200,000  500,000 700,000

 = 0.467: or 46.7%
K 700,000  400,000  400,000 1,500,000

This indicates a low debt-equity ratio. It suggests that for every one rupee of the owners’
funds the firm has raised Kwacha 0.467 of long-term debt.
Total debt
If the total debt is considered: the D-E Ratio =
Shareholders' equity

K 200,000  500,000  120,000  40,000  170,000 1,030,000

=  =0.687:1 or 68.7%
K 70,000  400,000  400,000 1,500,000

Debt to Total Capital Ratio

This ratio can be calculated by taking only the long-term debt or total debt and dividing it by
permanent capital (plus current liabilities).
Long Term debt
(a) Debt to Total Capital Ratio =
Total capitalisation or permanent capital

Permanent capital = Equity capital + Preference capital + Reserves and surplus +

Long Term Debt
K 200,000  500,000
Debt to Total Capital Ratio =
K 700,000  400,000  200,000  500,000

700,000
= = 0.318:1 or 31.8%
2,200,000
Total Debt
(b) Total Debt to Total Capital Ratio =
Permanent capital  Current liabilities

Total debt = Permanent Capital + Current Liabilities

200,000 = 2,200,000 + 330,000
500,000 = 2,530, 000
120,000
40,000
170,000

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 Financial Management & Risk Appraisal BCM331

1,030,000
K 1,030,000
= = 0.407:1 or 40.7%
K 2,530,000

Fixed Assets
Fixed Assets to Net worth Ratio =
Networth or Shareholders' Funds

2,000,000
= = 1.33:1
1,500,000
In some cases the fixed assets are compared to the total long-term funds, i.e., Net Worth plus
long-term debt in which case the ratio would be
Fixed Assets 2,000,000
 = 1:1
Long term funds 2,000,000

Example 2
From the following particulars calculate the coverage ratios:
Net Profit Kwacha 300, 000
Income tax Kwacha 252, 000
Interest Kwacha 46, 000
Preference dividend Kwacha 32, 000

Solution
EBIT
Interest Coverage Ratio =
Interest
K 300,000  K 252,000  K 46,000 K 598,000
=  = 13 times
K 46,000 K 46,000

Earnings After Tax

Dividend Coverage =
Preference Dividend

K 300,000
= = 9.37 times
K 32,000

EBIT
Fixed Coverage =
Total Fixed Ch arg es

K 598,000 K 598,000
=  = 7.67 times
K 46,000  K 32,000 K 78,000

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Synopsis
 Debt management (leverage) ratios measure the total debt burden of the firm
 debt management ratios include
a. Debt ratio (or Debt to asset ratio or D/A): indicates the extent to which assets
were financed by debt. it is determined as the ratio of debts to total assets. A
lower debt ratio is desirable
b. Debt to equity ratio (D/E): Indicates the proportion of debts in terms of equity. it
is obtained as debts divided by common equity. Common equity is the difference
between total stockholders equity and preferred stock. A lower debt to equity ratio
is desirable. If the firm does not have preferred stock, D/E ratio may be computed
as:
D/E = D/A
1 - D/A
c. Equity Multiplier (EM): Measures the financial leverage. It is determined by
dividing total assets by common equity. A lower EM is desirable. Alternatively,
EM = 1 + D/E
d. Times Interest Earned (TIE) ratio: measures the number of times interest is
available to cover interest obligations. it is obtained as the ratio of EBIT to
interest expense. A higher TIE ratio is desirable
e. Fixed Charge Coverage (FCC) ratio: Measures the ability of the firm to meet
all fixed obligations (interest, lease, and periodic repayment of debt principal). A
higher FCC ratio is desirable
FCC = Earning before Fixed obligations
Fixed obligations

Review question
a. If total liabilities and total assets are K 20000 and K 50000, determine D/A
ratio
b. If total debts and equity are K 60000 and K 80000 respectively, determine
debt to equity ratio

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 Financial Management & Risk Appraisal BCM331

c. If the EBIT and interest expense are K 80000 and K 10000 respectively,
determine TIE ratio
d. The EBIT of the firm is K 60000. Interest expense and lease payments are K
5000 and K 15000 respectively. Determine FCC ratio.

Exercise
a. Given: D/E = 0.60. Determine D/A
b. Total assets = 820000, debt ratio =55%, what is total liabilities?
Determine stockholders' equity
c. If D/A ratio is 0.30, D/E =?
d. Given: Interest expense, K 30000; TIE ratio, 10 times. determine
EBIT
e. Given: EBIT = 90000, Interest = 5000, lease = 1000, annual debt
payment = 20000. Determine Times interest earned ratio, and FCC
ratio
f. Given: D/E = 0.80. What is Equity multiplier? What is debt ratio?
g. Given: EM = 1.50. Determine D/A, and D/E

2.5: Ratio Analysis: Profitability Ratios

Profitability Ratios
Every firm should earn adequate profits in order to survive in the immediate present and
grow over a long period of time. In fact, the profit is what makes the business firm run. Profit
is also stated as the primary and final objective of a business enterprise. It is also an indicator
of the firm’s efficiency of operations.
Profitability means the ability to make profits. Profitability ratios are calculated to measure
the profitability of the firm and its operating efficiency. They relate profits earned by a firm
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 Financial Management & Risk Appraisal BCM331

to different parameters like sales, capital employed and net worth. But while making
financial ratio analysis relating to profits, it should be noted that there are different concepts
of profits such as contribution (sales revenue minus variable costs), gross profit, profit before
tax, profit after tax, profit before interest and taxes, operating profit.
Profitability of the firm can be measured by calculating several interrelated ratios demanded
by the aims of the analyst. The profitability of a firm can be measured and analyzed from the
point of view of management, owners (i.e., shareholders in the case of companies) and
creditors. The most commonly calculated profitability ratios include:

1) Net profit Margin (NPM) Ratio

This is one of the very important ratios and measures the profitableness of sales. This ratio
measures the ability of the firm to turn each Kwacha of sales into net profit. It also indicates
the firm’s capacity to withstand adverse economic conditions.

It is calculated by dividing the net profit by sales. The Net profit is obtained by subtracting
operating expenses and income tax from the gross profit. Generally, non-operating incomes
and expenses are excluded for calculating this ratio.
Net Pr ofit
Net Profit Margin=
Sales
A high net profit margin is a welcome feature to a firm and it enables the firm to accelerate
its profit at a faster rate than a firm with a low net profit margin. In order to have a more
meaningful interpretation of the profitability of a firm, both gross margin and net margin
should jointly be evaluated. If the gross margin has been on the increase without a
corresponding increase in net margin, it indicates that the operating expenses relating to sales
have been increasing.

2) Return on Assets (ROA)

This Return on Assets ratio measures the profitability of the total assets (or investment) of a
firm. But this ratio does not throw any light on the profitability of the different sources of
funds which have financed the total assets.
This ratio is calculated by dividing net profit after tax by total assets:

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 Financial Management & Risk Appraisal BCM331

Net Profit After Tax

Return on Assets (ROA) =
Total Assets

3) Return on Equity (ROE)

The shareholders of a company may comprise equity shareholders and Preference
shareholders. Preference shareholders are the shareholders who have a priority in receiving
dividends (and in the return of capital at the time of winding up of the company). When the
company earns profits it may distribute all or a part of the profits as dividends to the equity
shareholders or retain them in the business itself. But the profit after taxes and after
Preference Shares dividend payment presents the return as equity of the shareholders.
A return on shareholders’ equity is calculated to assess the profitability of the owners’
investment. The shareholders’ equity is ascertained by adding up equity Share capital,
Preference share capital, share premium, reserves and surplus. If any accumulated losses are
there, they should be deducted from this amount. The shareholder’s equity is also called net
worth.
Return on shareholders’ equity or return on net worth is calculated as follows.
Net Profit After Taxes
Return on shareholders’ equity =
Shareholders' Equity

Example 1
Sales: Kwacha 1, 000, 000; Gross profit: Kwacha 500, 000; Operating expenses excluding
depreciation: Kwacha 100, 000; Depreciation: Kwacha 10, 000.
K 500,000  K100,000
Gross operating margin = = 40%
K 1,000,000

the net operating margin may be calculated as follows:

Gross Operating Margin  Depreciation  100
Net Operating Margin =
Sales
K 400,000  K 10,000
= = 39%
K 1,000,000

For this ratio no standard norm is evolved. The ratio of a firm may be compared with that of
sister concerns to measure the relative position.

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 Financial Management & Risk Appraisal BCM331

Example 2
Taking the particulars given here under, the shareholders’ equity and return on it are
calculated here:

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Balance Sheet as on …
Kwacha Kwachas
Plant & Machinery 1, 200, 000 Equity Share Capital
Goodwill 150, 000 (50, 000 shares) 500, 000
Current Assets 350, 000 8% Preference Capital 300, 000
Reserves & Surplus 200, 000
8% Long-term Loans 200, 000
8% Debentures 300, 000
Current Liabilities 200, 000
1,700, 000 1, 700, 000

Net profit after tax: Kwacha 200, 000; interest: Kwacha 40, 000

Operating Profit
Return on Assets =
Operating Asstes
= 200,000 + 40,000
1,700,000
= 240,000 = 0.141 = 14.1%
1,700,000
Shareholders’ equity = Equity share capital + Pref. Share Capital + Res. & Surplus
= K 500, 000 + K 300, 000 + K 200, 000+ K 1, 000, 000
Net Profit After Taxes
Return on shareholders’ equity =
Shareholders' Equity

K .200,000
Return on shareholders’ equity =  20%
K .1,000,000

Synopsis
 Profitability ratios measure the overall performance of the firm
 Profitability ratios show the combined effect of liquidity, asset management and debt
management on the profitability of the firm
 The major profitability ratios include:

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a. Net profit Margin (NPM) ratio: measures the operating efficiency of the firm. It
is obtained by dividing net income available to common stockholders by net sales.
A higher NPM is desirable.
b. Return on Assets (ROA): Measures the profitability per Kwacha invested in
assets. It is computed as the ratio of net income available to common stockholders
to total assets. A higher ROA is desirable. ROA is also called Return on
investments(ROI)
c. Return on Equity (ROE): Measures the profitability per Kwacha invested by
shareholders. It is obtained as the ratio of net income available to common
stockholders to common equity.
ROE may also be computed using the Du pont identity:
ROE = NPM x TATO x EM
ROE may also be determined as follows:
ROE = ROA
1-D/A

Review question
a. If net income available to common stock holders and net sales are K 20,000
and K 1,000,000 respectively, determine NPM
b. if net income and total assets are K 20,000 and K 200,000 respectively,
determine ROA

c. If net income and common equity are K 20,000 and 500,000 respectively,
determine ROE
d. If ROA and equity Multiplier are 10% and 1.8 respectively, determine ROE

Exercise
A. Given. Net income = 60,000, sales = K 500,000, Sales return and
allowances = 20,000, sales discount = 30000. The company has 5000
shares of K 2 preferred stock. Determine NPM
B. If ROA and D/A are 0.15 and 0.40 respectively, determine ROE

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C. If NPM, TATO, and EM are 0.10, 1.2, and 1.5, determine ROE

Given: Net sales…………………… 800000

Cost of merchandise sold…………… 300000
Operating expenses …………….. 200000
Income tax rate …………………. 40%
Total assets ……………………… 500000
Common stock………………… 100000
Preferred stock (entitled par value)….. 60000
Retained earnings …………………. 90000
Required: Compute the following:
a. Net income
b. Common equity
c. ROA
d. ROE

2.6: Ratio Analysis: Marketability Ratios

Marketability Ratios
Marketability ratios relate the firm’s stock price to its earnings and book value per share.
These ratios give management an indication of what investors think of the company’s past
performance and future prospects. If the liquidity, asset management, debt management, and
profitability ratios are all good, then the market value ratios will be high, and the stock price
will probably be as high as can be expected.

1) Price–Earnings (P/E) Ratio

This is reciprocal of earnings yield. This ratio is widely used by security analysts to evaluate
the firm’s performance and what is expected by the investors. It indicates the investor’s
expectations in respect of the firm’s performance.

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Market value per share

P/E Ratio = ,
EPS
Profit After Tax - Pref. Dividend
Where, EPS =
No. of Equity Share Outs tan ding
The profitability of a firm can be assessed from the point of view of creditors also. The
suppliers of funds, i.e., the creditors are interested in the profits as they constitute the sources
from which regular payment of interest and repayment of loan (in a lump sum or in
installments) will be made. They measure the profitability for the interest and fixed charges
and also debt servicing.

2) Market-to-Book (M/B) Ratio

The ratio of a stock’s market price to its book value gives another indication of how investors
regard the company. Companies with relatively high rates of return on equity generally sell at
higher multiples of book value than those with low returns. It is calculated using the
following formula.
Market/book ratio= Market price per share
Book value per share
Where, Book value per share= common equity
Shares outstanding

Synopsis
 Marketability ratios measure how investors see the past performance and future
prospect of the firm
 The major profitability ratios are:
 Price–Earnings (P/E) ratio: Measures how much the investors are willing to pay
for one Kwacha current earnings. It is computed as the ratio of market price per
share to earnings per share. A higher P/E ratio is desirable. However, care must be
exercised in interpreting this ratio.
 Market-to-Book (M/B) ratio: measures whether the firm has created value to its
shareholders. It is computed as the ratio of market price per share to book value

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per share ( or equity per share). If M/B ratio is greater than 1, the firm has created
value to the shareholders.

Review question
a. What do we measure with marketability ratios?
b. If market price per share and earning per share are K 50 and K 30 respectively,
determine P/E ratio. Interpret the result.
c. If Market price share and book value per share are K 60 and K 40 respectively,
determine M/B ratio and interpret the result.

Exercises
a. Assume that Market price per share, earning per share, and book value per share are
K 80, K 100, and K 120 respectively, determine P/E ratio, and M/B ratio, and
interpret the results.
b. If P/E ratio and earning per share are 6 and K 30 respectively, determine market price
per share.
c. If M/B ratio, and Market price per share are 1.5 and K 80 respectively, determine
book value per share.

2. 7: Limitations of ratio analysis

Limitations of ratio analysis

At the outset it should be noted that ratio analysis is not an end in itself but a means to the
answering of specific questions which the users of the financial statements have in relation to
the financial condition and results of operations of the firm.
Ratios are derived from financial statements. The financial statements suffer from a number
of limitations and ratios which are derived form these statements are also subject to these
limitations. Some of them are pointed out as follows.
 Ratios are meaningless, if detached form their source.
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 Ratios, as they are, are not of much significance. They become useful only when
they are compared with some standards.
 Ratio analysis should be made with caution in the case of inter-firm comparison.
Unless the firms in question follow identical accounting methods for items like
depreciation, inventory valuation, deferred revenue expenditure, the writing off of
capital items, etc., ratios will not reflect the figures which are truly comparable.
 Ratio analysis may give misleading results if the effect of changes in price level is
not taken into account.
 The social, economic and political conditions which form the background for the
firm’s operations should be understood so as to make ratio analysis meaningful and
so on.
These limitations, to a considerable extent, can be eliminated or corrected:
1) if the analysis is related to one firm over a period of time;
2) if the analysis is limited to a few well chosen ratios which can answer specific
questions;
3) if the results of the firm are compared with suitable norms or standards;
4) if the ratios are used primarily for the identification of areas for further
managerial analysis and formulation of alternatives available to the management
in solving such problems;
5) if the ratios are interpreted in the light of social, political, economic,
technological and business conditions under which the firm operates.
If ratio analysis is done mechanically it will be not only misleading but also positively
dangerous. If it is used with a measure of caution, reason, and logic it can be a powerful
management tool not so much for providing answers but for highlighting management issues
and for identifying possible alternatives.

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Chapter III: Financial planning and forecasting

2.1: Nature of financial planning

Learning objectives:
At the end of this Chapter, students will be able to:
 Define financial planning
 Discuss models of financial planning
 Understand the role of financial forecasting in financial planning
 Describe factors that determine sales forecast.

Financial Forecasting
Well-run companies generally base their operating plans on a set of forecasted financial
statements. The process begins with a sales forecast for the next five or so years. Then the
assets required to meet the sales targets are determined, and a decision is made concerning
how to finance the required assets. At that point, income statements and balance sheets can
be projected, and earnings and dividends per share, as well as a set of key ratios, can be
forecasted.
Sales forecasts
A forecast of a firm’s unit and dollar sales for some future period; it is generally based on
recent sales trends plus forecasts of the economic prospects for the nation, region, industry,
and so forth.
The sales forecast generally starts with a review of sales during the past five to ten years. By
a definition a sales forecast is actually the expected value of a probability distribution of
possible levels of sales. Because any sales forecast is subject to a greater or lesser degree of
uncertainty, financial planners are often just as interested in the degree of uncertainty
inherent in the sales forecast (the standard deviation in sales) as in the expected value of
sales.
Synopsis

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 Financial planning is the process of estimating the required finance of a firm for its
business decisions.
 The model of financial planning involves three phases: namely, need for funding, terms
of funding, and sources of funding
 Financial forecasting is the basis for financial planning
 Sales forecast is the starting point for financial forecasting
 Sales forecast is affected by various factors such as Past sales pattern, expected economic
conditions, inflation, competitor’s, action ns etc

Review questions
Answer the following questions
i. Define financial planning
ii. Mention the three phases in financial planning.
iii. Indicate the different purposes why the business needs funds
iv. Explain the various sources of getting funds
v. What factors determine sales forecast?

3.2: Methods of forecasting financial statements

Financial Statement Forecasting: The Percentage of Sales Method (PCM)

Once sales have been forecasted, we must forecast future balance sheets and income
statements. The simplest technique, and the one that is most useful for explaining the
mechanics of financial statement forecasting, is the percentage of sales method. There are
also other forecasting methods, these are:
1. The AFN formula
2. Simple linear regression, and
3. Excess capacity adjustment

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Generally, PCM is a method of forecasting future financial statements, and future financial
requirements that assume certain financial ratios will remain constant. The steps in this
procedure are:
First, to forecast Income Statement: The income statement for the coming year is
forecasted in order to obtain an estimate of reported income and the amount of retained
earnings the company will generate during the year. This requires assumptions about the
operating cost ratio, the tax rate, interest charges, and the dividend payout ratio. In the
simplest case, the assumption is made that all costs will increase at the same rate as sales; in
more complicated situations, specific costs will be forecasted separately. The primary
objective of this part of the forecast is to determine how much income the company will earn
and retain for reinvestment during the forecasted year.
Second, to forecast the Balance Sheet: If a company’s sales are to increase, then its assets
must also grow. And when a company is operating at full capacity, each asset account must
increase if the higher sales level is to be attained: More cash will be needed for transactions,
higher sales will lead to higher receivables, additional inventory will have to be stocked, and
new plant and equipment must be added. Therefore, in order to find the above changes
among other changes in all balance sheet items the forecasted balance sheet should be used.
When there exists a difference between the forecasted total assets and, the total liabilities and
capital, for a given forecasted year, that difference amount is called Additional Funds Needed
(AFN). AFN is funds that a firm must raise externally through borrowing or by selling new
common or preferred stock.
Third, raising the Additional Funds Needed: When there exists AFN for the forecasted
year, a company’s financial staff will base the financial mix on several factors, including the
firm’s target capital structure, the effect of short-term borrowing on its current ratio,
conditions in the debt and equity markets, and restrictions imposed by existing debt
agreements to raise the fund needed.
Under percentage of sales method, AFN is determined as follows:
AFN: in FA + in CA-SGF – IGF

Synopsis
 There are four methods of forecasting financial statements;

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Namely, percentage of sales method (PCM), Additional funds needed formula, simple
linear regression, and excess capacity adjustment.
 Under percentage of sales method, the forecast of financial statement items is primarily
based on sales forecast
 Two assumptions should hold true under percentage of sales method
 There is direct relation between sales and most financial statement items such as assets,
current liabilities, and costs and expenses
 There is no idle capacity
 Under percentage of sales method, AFN is determined as follows:
AFN: in FA + in CA-SGF – IGF

3.3: Methods of forecasting financial statements: AFN formula and

excess capacity adjustment

The AFN formula

Most firms forecast their capital requirements by constructing pro forma income statements
and balance sheets as described above. However, when the ratios are expected to remain
constant then the following formula is sometimes used to forecast financial requirements: -

Additional Required Spontaneous Increase in

Funds = increase - increase in - retained

Needed in assets liabilities earnings

AFN= (A
A*/So) S - (L */So) S - MS1(1-d)

Here AFN = additional funds needed.

A * = assets that are tied directly to sales, hence which must increase if sales are to
increase. Note that A designate~ total assets and A* designates those assets that must
increase if sales are to increase. When the firm is operating at full capacity, as is the

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case here, A* = A. Often, though, A* and A are not equal, and the equation must be
modified or else the projected financial statement method must be used.

So = sales during the last year.

A*/So = percentage of required assets to sales, which also shows the required dollar
increase in assets per $1 increase in sale.

L * = liabilities that increase spontaneously; L * is normally much less than total

liabilities (L).

L */So = liabilities that increase spontaneously as a percentage of sales, or spon-

taneously generated financing per $1 increase in sales.

S1 = total sales projected for next year. Note that So designates last year's sales.

S = change in sales = S1 - So

M = profit margin, or profit per $1 of sales.

d = percentage of earnings paid out in common dividends, or the dividend payout

ratio

Inherent in the formula are the assumptions (1) that each asset item must increase in direct
proportion to sales increases, (2) that accounts payable and accruals also grow at the same
rate as sales, (3) and that the profit margin is constant. Obviously, these assumptions do not
do not always hold, so the formula does not always produce reliable results. Therefore, the
formula is used primarily to get a rough-and-ready forecast of financial requirements, and as
a supplement to the projected financial statement method.

Other techniques for forecasting Financial Statements

If any of the conditions noted above apply (economies of scale, excess capacity, or lumpy
assets), the A*/So ratio will not be a constant, and the constant growth forecasting methods
as discussed thus far should not be used. Rather, other techniques must be used to forecast

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asset levels and additional financing requirements. Two of these methods -linear regression
and excess capacity adjustments - are discussed in the here under.

a. Simple Linear Regression

If we assume that the relationship between a certain type of asset and sales is linear, then we
can use simple linear regression techniques to estimate the requirements for that type of asset
for any given sales increase. Estimated regression equations determined using a financial
calculator is also shown with graph.( Refer to the regression Analysis in your Mathematical
Course)

b. Capacity Adjustments
This is a situation where excess capacity exists in any type of asset, but as a practical manner,
excess capacity normally exists primarily with respect to fixed assets and inventories.
Assume that fixed asset in 19x1 were being utilized to only 96 percent of capacity. If fixed
assets had been used to full capacity, 19x1 sales could have been greater than the actual sales.
This is justified in the following formula.
Suppose 19x1 actual sales were 3,000, and then 19x2’s sales would be 3,125.
Full capacity sales = Actual Sales = $ 3,000 = $3,125
%age of capacity 0.96
at which fixed assets
were operated

Give the following data, determine AFN

A = K 1, 000,000 Net profit margin = 10%

So = 4,000,000 Dividend payout ratio = 40%
S = 500,000
L = 1,600,000
Exercise

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Consider the following data:

Capital intensity ratio = 0.80 AFN = 35,00
Increase in sales = 200, 000
L/So = 0.03
Net profit margin = 15%
Retention Ratio = 40%
Instruction:
a) Determine projected sales
b) Determine current sales

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Chapter IV: Risk and Return

4.1 The Concept of Risk
Risk is defined as “a hazard; a peril; exposure to loss or injury”.
It refers to the chance that some unfavorable event will occur.
If you invest in speculative stock, you are taking a risk in the hope of making an appreciable
return.
Risk analysis ca be confusing, but it will help if you remember the following
1. All financial assets are expected to produce cash flows, and the risk of an asset is judged in
terms of the risk of its cash flow.
2. The risk of an assets can be considered in two ways:
(a). On a stand-alone basis – the asset’s cash flows are analyzed by themselves
(b). In a portfolio context – the cash flow from a number of assets are combined and then the
consolidated cash flows are analyzed.
3. In a portfolio context, an asset’s risk can be divided in to two components.
(a) Diversifiable risk- can be diversified away and thus is of little concern to diversified
investors.
(b) Market risk, which reflects the risk of a general stock market decline and which cannot be
eliminated by diversification, hence does concern investors. Only market risk is relevant.
Diversifiable risk is irrelevant to rational investors because it can be eliminated.
4. An asset with a high degree of relevant (market) risk must provide a relatively high-
expected rate of return to attract investors. Investors in general are averse to risk, so they will
not buy risky assets unless those assets have high expected return.
5. In this chapter, we focus on financial assets such as stocks and bonds, but the concepts
discussed here also apply to physical assets such as computers, trucks or even whole assets.

4.2. Probability Distribution and Expected Rates of Returns

With most investments, an individual or business spends money today with the expectations
of earning even more money in the future. The concept of return provides investors with a
convenient way of expressing the financial performance of an investment.

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Return can be expressed in dollar or Kwacha terms or in rates of percentages.

1. Dollar or Kwacha returns = Amount received – Amount invested
Problem. It does not show scale and timing of the return
2. Rates of return = Amount received – Amount invested
Amount invested
- Solves the problem of scale and timing
Risk relates to the probability of earning a return less than the expected return, and
probability distributions provide the foundation for risk management.
A profitability distribution is defined as a set of possible out comes, with a probability of
occurrence attached to each outcome. Probability is the chance that the event will occur.
Expected rate of return- the return on the risky asset expected in the future. It is determined
by multiplying each possible outcome by its probability of occurrence and then sum these
products.

Expected Rates of Return (K) =  PiKi

Illustration
Suppose you are the financial manager of a firm which has K. 100,000 to invest for a period
of one year. Three investment alternatives as shown in the following table are considered.
Investment Rates of Return if state occurs
State of Probability of Transfer Project 1 Project 2
economy occurrence bills
Deep recession 0.05 8% (3%) (2%)
Mild recession 0.20 8% 6% 9%
Average economy 0.50 8% 11% 12%
Mild boom 0.20 8% 14% 15%
Strong boom 0.05 8% 19% 26%
1.00

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4.3. Measuring Stand – Alone Risk

We know that risk is present when the probability distribution has more than one possible
outcome, but how should risk be measured and quantified?

A. Variance and Standard deviation

Variance is a measure of the dispersion of possible outcomes around the expected value: the
larger the variance, the greater the dispersion.

Variance = 2 =  (Ki – K) 2 Pi

Where: Ki is the return of asset under ith state of economy

K expected rate of return
Pi is probability of occurrence of ith state of economy
Example: the variance for project 2 above can be computed as follows:
2 for project 2 = (-2 – 12)2(0.05) + (9 – 12)2(0.20) + (12 – 12)2(0.50) + (15 – 12)2(0.20)
+ (26– 12)2(0.05) = 23.2%
Since it is difficult to attach meaning to a squared percentage, standard deviation is often
used as the measure of stand-alone risk.
Standard deviation =  = 2
For project 2 = 23.2 = 4.82%
The larger the standard deviation, the greater the dispersion, and hence the greater the stand-
alone risk.

B. Coefficient of Variation (CV)

As a general rule, the higher the expected return, the larger the standard deviation. Most of
the time, investments with higher expected returns and lower standard deviation are choosen.
But how do we choose between two investments if one has the higher expected return but the
other the lower standard deviation? To help answer this question, we often use another
measures of risk, CV, which is the standard deviation divided by the expected return.
CV= standard deviation
Expected return

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CV provides a more meaningful basis for comparison when the expected returns on two
alternatives are not the same.
The following table summarizes the results of the three investments.
T- bills Project 1 Project 2
1. Expected Return 8% 10.3% 12%
2. Variance 0 19.31% 23.2%
3. Standard deviation 0 4.39% 4.82%
4. Coefficient of variation 0 0.43 0.40

As can be seen, project 2 is riskier than project 1 using the standard deviation, but the
opposite is true when we correct for return differences and measure risk by the coefficient of
variation.

4.4 Risk in a portfolio context

An asset held as part of a portfolio is generally less risky than the same asset held in
isolation. An asset that would be quite risky if held in isolation may not be risky at all if it is
held in a well-diversified portfolio.
In a portfolio context, the risk and return of an individual security should be analyzed in
terms of how that security affects the risk and return of the portfolio in which it is held.

Expected Return on a portfolio

The expected rate of return on a portfolio is simply the weighted average of the expected
return of the individual securities on the portfolio.

Kp =  XiKi

Where: Xi is the fraction of portfolio invested in the ith asset

Ki is the expected rate of return on the ith asset .

Illustration
Assume that in September 2006, a security analyst estimated that the following returns could
be expected on the stocks of four companies:

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Expected return
MITATextile 12%
National Brewery 11.5%
BXC Tannery 10%
Finance Bank 9.5%

Assume you formed a K. 100,000 portfolio, investing K. 25,000 in each stock. The expected
portfolio return

Kp = 0.25(12%) + 0.25(11.5%) + 0.25(10%) + 0.25(9.5%) = 10.75%

Portfolio Risk
Unlike the situation with returns, the variance or standard deviation of a portfolio is generally
not a weighted average of the variance or SD of the individual securities in the portfolio.
It is theoretically possible to combine two stocks which are individually, quite risky as
measured by their standard deviations, and to form from these risky assets a portfolio which
is completely riskless, with p = 0
To know whether risk can be reduced or not by forming portfolio, their correlation or
relationship as measured by correlation coefficient(r) must be seen.
If two stocks which are perfectly correlated ( r = -1) are combined to form a portfolio, a risk
less, portfolio is created ( with p = 0).There returns more counter cyclically to one another.
If two stocks which are perfectly positively correlated ( r = +1) are combined, the portfolio
risk is the same as the risk of individual stocks. Their returns would more up and down
together
For perfectly negatively corrected stocks, all risk could be diversified away.
For perfectly positively correlated stocks, no risk could be diversified.

Portfolio Standard Deviation

p =  (Kpi – Kp) Pi

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Where: Kpi is the return on the portfolio under the ith state of economy
Kp is the expected rate of return on the portfolio
Pi is the probability of occurrence of the ith state of economy

Illustration
The following portfolio has 50% in the stock A and 25% in each of stocks B and C.

State of Probability of Rate of Return if state occurs

Economy state of economy Stock A Stock B Stock C
Boom 0.4 10% 15% 20%
Bust 0.6 8 4 0

Portfolio of return if the economy booms is

0.5 x 10% + 0.25 x 15% + 0.25x 20% = 13.75%
Portfolio of return if the economy goes bust is
0.5 x 8% + 0.25 x 4% + 0.25 x 0% = 5%
Expected Rate of return on the portfolio is
0.4 x 13.75% + 0.6 x 5% = 8.5%
Variance of the portfolio is
0.4 x (13.75% - 0.085)2 + 0.6x (0.05 – 0.085)2 = 0.0018375
Standard deviation of the portfolio is
0.0018375 = 0.043 or 4.3%

Covariance and Correlation Coefficient

Covariance is a measure which combines the variance (or volatility) of a stock’s returns with
the correlation between returns on this stock and returns on some other stock or stocks. For
example, the covariance between stocks A and B tells us whether the returns of the two
stocks tend to rise and fall together, and how large those movements tend to be.

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Cov (AB) =  (KAi – KA) (KBi –KB) Pi

Note:
1. If stocks A and B tend to move together, their covariance (COV(AB)) will be positive,
while if they tend to move counter to one another, COV(AB) will be negative. If their returns
fluctuate randomly, COV(AB) could be either positive or negative and close to zero.
2. COV(AB) will be large and positive if two assets have large standard deviations and tend
to move together, it will be large and negative for two high standard deviations assets which
move counter to one another; and it will be small if two assets’ returns move randomly,
rather than up or down with one another, or if either of the assets has a small standard
deviation.
It is difficult to interpret the magnitude of the covariance term, so a related statistic, the
correlation coefficient, is often used to measure the degree of co-movement between two
variables.
Correlation Coefficient = rAB = COV(AB)
AB

The sign of rAB is the same as the sign of COV(AB). So, a positive sign means that the
variables move together and a negative sign indicates that they move in opposite directions,
and if r is close to zero, they move independently of one another. r is between -1 and +1
Illustration
Probability of Rate of return distribution
Occurrence E F G H
0.1 10% 6% 14% 2%
0.2 10 8 12 6
0.4 10 10 10 9
0.2 10 12 8 15
0.1 10 14 6 20
K= 10% 10% 10% 10%
 = 0% 2.2% 2.2% 5%

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COV(FG) = (KFi - kF) (KGi – KG)Pi

=(6-10)(14-10)(0.1)+(8-10)(12-10)(0.2)+(10-10)(10-10)(0.4)+(12-10)(8-10)(0.2)+
(14-10)(6-10)(6-10)(0.1)=-4.8
rFG = -4.8 = -1.0 (perfectly negatively correlated)
2.2x2.2
Cov(FH) = (6-10)(2-10)(0.1)+(8-10(6-10)(0.2)+(10-10)(9-10)0.4)+(12-10-(15-10)(0.2)+(14-
10)(20-10)(0.1)=+10.8
rFG = +10.8 = +1.0 (perfectly positively correlated)
2.2x5
Ě’s return is always 10%; therefore, E = 0%, so the covariance of E with any other stock
must be zero. That means there is no relationship between E and other stocks.

4.5 Diversifiable risk versus market risk

Diversifiable risk is part of a stock’s risk that can be eliminated. It is caused by such random
events as lawsuits, strikes, successful and unsuccessful marketing programs, winning or
losing a major contract, and other events that are unique to a particular firm. Because these
events are random, their effects on a portfolio can be eliminated by diversification bad events
in one firm will be offset by good events in another. Diversifiable risk is also called
unsystematic risk, unique risk, or asset specific risk.

Market risk is part of a stock’s risk that cannot be eliminated. It influences a large number of
assets. It stems from factors that systematically affect most firms: war, inflation, recessions,
and high interest rates. Market risk is also called systematic risk or undiversifiable risk .
Average annual SD (%) (Portfolio risk)
Standard lone risk

Diversifies risk

Market risk

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 Financial Management & Risk Appraisal BCM331

Total risk: systematic risk + unsystematic risk

4.6 Systematic risk and Beta

The expected return on an asset depends only on that asset’s systematic risk. Because
unsystematic risk can be eliminated at virtually no cost (by diversifying), there is no reward
for bearing it. The level of systematic risk for different investments is measured by beta
coefficient (ß). It is the amount of systematic risk present in a particular risky asset relative to
that in an average risky asset. It is the amount of risk that the stock contributes to the market
portfolio. An average-risk stock is defined as one that tends to move up and down in step
with the general market. This stock has beta of 1.
This indicates that if the market moves up by 10%, the stock will also moves up by 10%, if
the market falls by 10%, it will fall by 10%. If ß=0.5, the stocks is only half as volatile as the
market-half as risky s a portfolio of ß= 1 stocks. If ß= 2, the stock is twice as volatile as the
average stock.

Thus, the expected return and the risk premium on an asset depends only on its systematic
risk. Because assets with larger betas have greater systematic risks, they will have greater
expected returns.

Illustration -1
Consider the following information on two securities
Standard derivations Beta
Security A 40% 0.50
Security B 20% 1.50
Required
Which of the securities has greater total risk, systematic risk, and unsystematic risk?
Security B has greater market risk as measured by beta
Security A has greater diversifiable risk-total risk is the sum of market risk and diversifiable
risk.

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Illustration -2
Suppose we had the following investments
Security Amount invested Expected return Beta
Stock A K. 1000 8% 0.80
Stock B K.2000 12 0.95
Stock C K.3000 15 1.10
Stock D K.4000 18 1.40
Required
a. what is the expected return on this portfolio
b. what is the beta of this portfolio
c. Does this portfolio have more or less systematic risk than an average asset.
Solution
a. Of the K. 10,000 total investment, 10% is invested in stock A, 20% in stock B, 30%
in stock C, and 40% in stock D.
Expected rate of return (Kp)=(0.1x8%)+(0.2x12%)+(0.3x15%)+(0.4x18%)=14.9%
b. ßp= (0.1x0.8)+(0.2x0.95)+(0.3x1.1)+(0.4x1.4)=1.16
c. Because the beta is larger than 1, this portfolio has greater systematic risk than an
average risk stock.

4.7 The security market line (SML) and capital asset pricing model

(CAPM)
A risk-free asset is an asset that has no risk (no systematic and unsystematic risk. So it has a
beta of zero.
A risk premium is the expected rate return of the asset minus risk free rate.
Example 1
Suppose asset A has an expected return of 20% and a beta of 1.6 and the risk free rate (RF) is
8%.
1. 25% of the portfolio is invested in A and the remaining in risk free asset

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KP = (0.25x20%) + (1-0.25) x 8%=11%

= (1.5x20%)-(0.5x8%)=26%
ßp = (0.25x1.6) +(1-0.25)x0 = 0.4
2. suppose the investor has K.100 and borrows an additional K.50 at 8% (RF) and invested
the money in asset A.

The reward- to -risk ratio

Is the ratio of an assets risk premium to its beta. It is “the rise over the run”. It is the slope of
the line indicating the relationship between expected return and risk
Reward to risk ratio (slope) = Ki - KRF
ßi
Example –for asset A above
RTRR = 20%-8% = 7.5%
1.6
It means, asset A has a risk premium of 7.5% per unit.
This ratio can be used to compare two assets which have different expected returns and betas.
The asset with higher RTRR is better.
Example – asset B has expected retune of 16% and beta of 1.2. Is this asset better than asset
A above or not?
RTRR of ß = 16%-8% = 6.67%
1.2
This asset is not better than asset A since it has lower RTRR (6.67%) than asset A (7.5%).

Asset A
ERA=20%
=KA-RF=7.5%
ßA
ER=16%
= Asset ß
Rf= 8% K-Rf=6.6%

ßB=1.2 ßA=1.6 Portfolio beta

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This situation we have described for assets A and B could not persist in a well-organized,
active market, because investors would be attracted to asset A and away form asset B. as a
result, asset A’s price would rise and asset B’s price would fall. Because prices and return
more in opposite directions, A’s expected return would decline and B’s would rise.
This buying and selling would continue until the two assets plotted on exactly the same line,
which means they would offer the same reward for bearing risk.
So, in an active, competitive market, the reward-to-to-risk ratio must be the same for all
assets in the market.

KA-KRF = Kß-KRF
ßA ßB

The security market line (SML)

In a well-functioning market, since the assets in the market have the same RTRR, all assets
plot on the same line called the security market line. It is a positively sloped straight line
displaying the relationship between expected return and beta. A market portfolio is made of
all assets in the market which must plot on the SML. This portfolio has market return (KM)
and average systematic risk with beta (Bm) of 1.
SML slop = Km-KRF = Km-KRF = Km-KRF
ßm 1
- “Km-KRF” is called market risk premium and is the slope of the
SML.

The capital asset pricing model (CAPM)

If we let Ki and ßi stand for the expected return and beta respectively, on any asset in the
market, then we know that asset must plot on the SML. As a result, we know that its reward –
to-risk ratio is the same as the overall market’s.
Ki - KRF = Km –KRF
ßi
If we rearrange this, then we can write the equation for the SML as:
Ki = KRF + (Km –KRF)x ßi

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This result is identical to the famous capital asset pricing model (CAPM). CAPM provides a
logical specification for the relationship between risk and required returns on assets held in a
well-diversified portfolios. The equation describes SML. CAPM shows that the expected
return depends on 3 things
1. The pure time value of money measured by the risk free rate. This is the reward
for merely waiting for your money without taking any risk.
2. the reward for bearing systematic risk- measured by market risk premium- the
reward the market offers for bearing an average amount of systematic risk in
addition to waiting
3. The amount of systematic risk- measured by ßi .
The CAMP works for portfolio of assets just as it does for individual assets.
Asset expected return
SML

=Km-KRF-market premium slope

Km
KRF

Illustration
Suppose the risk free rate is 8 percent. The expected return on the market is 14 present. If a
particular stock has a beta of 0.7, what is its expected return based on the CAPM? If another
stock has an expected return of 20%, what must its beta be?

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Chapter V: Time Value of Money valuation of financial assets

5.1: Accounting and the time value of money

The time value of money

In general business terms, interest is defined as the cost of using money overtime. This
definition is in close agreement with the definition used by economists, who prefer to say that
interest represents the time value of money.
Ignoring the effects of inflation, a dollar today is worth more than a dollar to be received a
year from now. In other words, we would all prefer to receive a specific amount of money
now rather than on some future date. This preference rests on the time value of money. When
payments for the time value of money are made or accrued interest expense is incurred, when
payments for the time value of money are received or accrued, interest revenue is realized.
Inflows of dollars on various future dates should not be added together as if they were of
equal value. These future cash inflows must be restated at their present values before they are
aggregated. The concept of the time value of money tells us that more distant cash inflows
have a smaller present value than cash inflows to be received within a shorter time span.
Similar reasoning applies to cash outflows. Before we add together cash outflows on various
future dates, we must restate these outflows at their present values. The more distant the date
of a cash outflow, the smaller is its present values.
As a simple example of this concept of present value, assume that you are trying to sell your
car and you receive offers from three prospective buyers.

Buyers A offers you K. 8000 to be paid immediately. Buyer B offers you K. 8,200 to be paid
one year from now. Buyer C offers the highest price, K. 9,200 but this offer provides that
payment will be made in five years. Assuming that the offers by B and C involves no credit
risk and that money may be invested at 5% interest compounded annually, which offer would
you accept?
You should accept the offer of K. 8000 to be received immediately, because the present value
of the other two offers is less than K. 8000. if you were to invest K. 8000 today, even at the

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modest rate of interest of 5%, your investment would be more than K. 8200 in one year and
considerably more than K. 9,200 in five years.
This example suggests that the timing of cash receipts and payments has an important effect
on the economic worth and the accounting values of both assets and liabilities. Consequently,
investment and borrowing decisions should be made only after a careful analysis of the
relative present values of the prospective cash inflows and outflows.

Uses of present and future values in financial accounting

Accountants find many situations in which a reliable measurement of a transaction depends
on the present value of future cash inflows and outflows. Some of the more prominent
applications of the present and future value concepts are:
- Receivables and payables
- Asset valuation
- Bonds
- Leasing
- Pension and other post retirement benefits

Simple interest and compound interest

Interest is the excess of resources (usually cash) received or paid over the amount of
resources loaned or borrowed at an earlier date. Business transactions subject to interest state
whether simple or compound interest is to be calculated.
Simple interest is the return on a principal amount for one time period. We may also think of
simple interest as a return for more than one time period if we assume that the interest itself
does not earn a return, but this kind of situation occurs rarely in the business world. Simple
interest usually is applicable only to short-term investment and borrowing transactions
involving a time span of less than one year.
Interest generally is expressed in terms of an annual rate. The formula for simple interest is:
I = p.r.t (interest = principal x annual rate of interest x number of years or fraction of a year
that interest accrues). For example, interest on K. 10,000 at 8% for one year is expressed as
follows:
I = p.r.t

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I = K. 10,000 x 0.08 x 1
I = K. 800
Compound interest is the return on a principal amount for two or more time periods,
assuming that the interest for each time period is added to the principal amount at the end of
each period, and earns interest in all subsequent periods. Because most investment and
borrowing transactions involve more than one time period, business executives evaluate
proposed transactions in terms of periodic returns, each of which is assumed to be reinvested
to yield additional returns.
For example, if interest at 8% is compounded quarterly for one year on a principal amount of
K. 10,000 the total interest (compound interest) would be K. 824.32, as computed below:

Period Principal x Rate x Time = Compound Interest Accumulated Amounts

1st quarter--------- K. 10,000 x 0.08 x ¼ K. 200.00 K. 10,200.00
2nd quarter -------------10,200 x 0.08 x ¼ 204.00 10,404.00
3rd quarter -------------10,404 x 0.08 x ¼ 208.08 10,612.08
4th quarter ---------10,612.08 x 0.08 x ¼ 212.24 10,824.32
Interest 824.32

N.B, In the computation of compound interest, the accumulated amount at the end of each
period becomes the principal amount for purposes of computing interest for the following
period.

Future and present values

Future value involves a current amount that is increased in the future as a result of compound
interest accumulation. Present value, in contrast, involves a future amount that is decreased to
the present as a result of compound interest discounting. Discounting, in effect, extracts the
interest from a future value thereby returning to the principal amount.
The fact that investment has starting points and ending points makes it easier to understand
present and future values. Present value in general refers to dollar (Kwacha) values at the
starting point of an investment, and future value refers to end-point dollar (Kwacha) values.

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If the dollar (Kwacha) amount to be invested at the start is known, the future value of that
amount at the end can be projected, provided the interest rate and numbers of interest
compounding periods are also specified. Similarly, if the dollar (Kwacha) amount available
at the end of an investment period (future value) is known, the amount of money needed at
the start of the investment period (present value) can be determined, again if the interest rate
and number of interest compounding periods are known.
Present value and future value apply to interest calculations on both single payment amounts
and periodic equal payment amounts (annuities)

a. Future value of a single sum

The accumulated amount (small a) of a single amount invested at compound interest may be
computed period by period by a series of multiplication.
If n is used to represent the number of periods that interest is to be compounded, I is used to
represent the interest per period, and p is the principal amount invested, the series of
multiplications to compute the accumulated amount a
a = p (1 + i)n

The symbol a n i is the amount to which 1 will accumulate at i rate of interest per period for
n periods.
This symbol is read as “small a single n at i”.
Tables are available that give the value of a n i
Use of these tables involves reference to a line showing the number of periods and a column
showing the rate of interest per period.

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b. Present Value of a single sum

Many measurement and valuation problems in financial accounting require the computation
of the discounted present value of a principal amount to be paid or received on a fixed date.
The present value represents the discounted amount (interest excluded) that will accumulate
to the future amount (interest included). The present value of a future amount is always less
than that future amount.
The computation of the present value of a single future amount is a reversal of the process of
finding the amount to which a present amount will accumulate. We know that a = p (1 + i) n,
and when we solve for p by dividing both sides of the equation by (1 + i) n,
a
we have p =
1  i n
Therefore, the formula for the present value of a due in n periods at i rate of interest per
period is
a
P ni = a = future amount
1  i n P = present value
i = interest rate per period
n = number of compounding period

Discussion questions
A. Assuming that the annual rate of interest is specified as 12%, what would
simple interest rate be for the following periods:(a) semiannual, (b)
quarterly, (c) monthly?
B. Assume that K.100,000 is borrowed on a two year, 10% note payable.
Compute the total amount of interest that would be paid on this note
assuming (a) simple interest (b) compound interest
C. What are the future and present values of a single sum?

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Annuities
Many measurement situations in financial accounting involve periodic deposits, receipts,
withdrawals, or payments (called rents), with interest at a stated rate compounded at the time
that each rent is paid or received. These situations are considered annuities if all the
following conditions are present:
1. The periodic rents are equal in amount
2. The time period between rents is constant, such as a year, a quarter of a year or a
month
3. The interest rate per time period remains constant
4. The interest is compounded at the end of each time period

In general, an annuity is a series of uniform payments or receipts (sometimes called rents)

occurring at uniform intervals over a specified investment time frame, with all amounts
earning compound interest at the same rate.
When rents are paid or received at the end of each period and the total amount on deposit is
determined at the time the final rent is made, the annuity is an ordinary annuity (or annuity in
arrears). When rents are paid or received at the beginning of each period, and the total
amount on deposit is determined one period after the final rent, the annuity is annuity due (or
annuity in advance). When the amount of an ordinary annuity remains on deposit for a
number of period beyond the final rent, the arrangement is known as a deferred annuity.
The difference between the three types of annuity is illustrated below:

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Period (Example: years) 0 1 2 3 4 5

R R R R R
Ordinary annuity
P A
R R R R R
Annuity due
P A
Deferred annuity R R R
P A

Amount of Annuity
Amount of an annuity is future values of a series of equal receipts or payments (rents) made
at regular time intervals and at the same rate of interest compounded each time the receipts or
payments are made.
A typical accounting application of the future value of an annuity is the establishment of a
fund by equal annual contribution perhaps for the future expansion of a facility or payment of
a debt.

a. Amount of Ordinary Annuity

The amount of an ordinary annuity (or annuity in arrears) consists of the sum of the equal
periodic rents and compound interest on the rents immediately after the final rent. Unless
otherwise stated, all annuities are assumed to be ordinary annuities, meaning that every
payment occurs at the end of the interest period.
The amount A of an ordinary annuity of n rents at I interest rate per period is determined by
 1  i n 1
A=R   where R = the amount of each periodic rent
 i 
I = the interest rate per period
N = the number of rents
A = the amount of the ordinary annuity

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b. Amount of an Annuity Due

The amount of an annuity due (or annuity in advance) is the total amount on deposit one
period after the final rent.

c. Amount of Deferred Annuity

When the amount of an ordinary annuity remains on deposit for a number of periods beyond
the final rent, the arrangement is known as a deferred annuity. When the amount of an
ordinary annuity continues to earn interest for one additional period, we have an annuity due
situation, when the amount of an ordinary annuity continues to earn interest for more than
one additional period, we have a deferred annuity situation.

The amount of a deferred annuity may be computed by multiplying the amount of the
ordinary annuity by the amount of 1 for the period of deferral to accrue compound interest.
Alternatively, we may take the amount of an ordinary annuity for all periods (including the
period of deferral) and subtract from this the amount of the ordinary annuity for the deferral
period when rents were not made, but interest continued to accumulate.

Discussion questions
A. What are the characteristics of an annuity? Explain what would happen if any of these
characteristics were changed.
B. Explain the ways of computing the amount of annuity due and deferred annuity

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Present Value of an annuity

The present value of an annuity is the value of a series of equal future receipts or payments
(rents) made at regular time intervals and discounted at the same compound interest rate on
each date rents are due.
Present value of annuities are used more frequently in financial accounting. For example, the
computation of the proceeds of bond issues, the value of plant assets acquired in purchase
type business combination or through capital leases, the amount of past service pension costs,
the amount of debt or receivables under installment contracts, and the amount of mortgage
debt or investments in mortgage notes all require the application of the present-value- of
annuity concept.

a. Present value of ordinary annuity

Present value of ordinary annuity is the discounted value of a series of future rents on a date
one period before the first rent.
A diagram depicting the present value (P) of an ordinary annuity of five rents (R) is given
below:
Present value of an ordinary annuity of 5 rents of 1
in table 4 of Appendix is for this point in time.
Rents R R R R R
1st 2nd 3rd 4th 5th

0 1 2 3 4 5

The present value of an ordinary annuity of five rents depicted above is the value of the rents,
discounted at compound interest, at a point in time one period before the first rent. The
present value of an ordinary annuity is computed as the total of the present values of the
individual rents, but the use of a table, such as Table 4 in the Appendix at the end of this
chapter is more efficient. The present value of an ordinary annuity may be computed using
the following formula.

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 1 
1  1  i n 
P=R  
 i 
 
 

b. Present value of Annuity Due

Present value of annuity due is the discounted value of a series of future rents on the date the
first rent is received or paid. That is, the present value falls on the date the first rent is made.
For this reason, an annuity due often is referred to as an annuity in advance.
The difference between the present value of an ordinary annuity and the present value of an
annuity due is illustrated below:

Present value of ordinary annuity of 5 rents

Present value of annuity due of 5 rents

Rents R R R R R
1st 2nd 3rd 4th 5th

0 1 2 3 4 5

Time periods (n)

The diagram above indicates that the present value at time period 1 of an annuity due of five
rents may be computed
(1) By adding interest for one period to the present value of an ordinary annuity of five
rents, or
(2) By obtaining the present value of an ordinary annuity of four rents and then adding 1,
representing the ‘extra’ rent at time period 1.

c. Present Value of Deferred Annuity

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Present value of deferred annuity is the discounted value of a series of future rents on a date
that is more than one period before the date that the first rent is received or paid. The present
value of deferred annuity may be computed by using two different methods as follows:
1) Discount the present value of the ordinary annuity portion at compound interest for
the period the annuity is deferred, or
2) Determine the present value of an ordinary annuity equal to the total number of
period involved and subtract from this the present value of the “missing” ordinary
annuity for rents equal in number to the number of periods the annuity is deferred.

Discussion questions
Discuss the alternative ways of computing the present value of annuity due
 Discuss the alternative ways of computing the present value of deferred annuity
 Explain the present value of ordinary annuity

5.2: Valuation of common stock

Financial Assets
Financial assets are generally categorized in to two, these are: debt securities and equity
securities. Debt securities include Bonds, Long-term notes, and the like while equity
securities comprise Preferred Stock, Common Stock, etc.
Valuation of Financial Assets
Most investors look at price movements in security markets. They perceive opportunities of
capital gains in such movements. All would wish if they could successfully predict them and
ensure gains. Few, however, recognize that value determines price and both change
randomly. It would be useful for an intelligent investor to be aware of this process.

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The basic valuations model

Value of a security is a fundamental variable and depends on its promised return, risk and the
discount rate. You may recall the basic understanding of present value concept, with the
mention of fundamental factors like returns and discount rate. In fact the basic valuation
model is none else than present value procedure. Given a risk adjusted discount rate and the
future expected earnings flow of security in the form of interest, dividend, earnings, or cash
flow, you can always determine the present value of follows.

PV = CF1 __ + CF2 + CF3 + ……. CFn

1+r (1 + r)2 (1 + r)3 (1 + r)n
PV = Present value
CF = Cash flow interest, dividend, earnings per time period up to ‘n’ number
of years
r = Risk adjusted discount rate

Valuation of Common Stock

In case of equity shares, the future streams of earnings or benefits pose two problems. One, it
is neither specified nor perfectly known in advance as an obligation. Resulting this, future
benefits and their timing have both to be estimated in a probabilistic framework. Two, there
are at least three are three elements which are positioned as alternative measures of such
benefits namely dividends, cash flows and earnings.
The valuation of common stock has three methods.
a) zero growth model
b) constant growth model
c) multiple growth model

a) Zero growth model

Under this the assumption is the growth of dividend is zero or constant.

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Vc = D__
K
Vc = Value of common stock
D = Dividend paid
K = The required rate of return
Example-1 A company pays a cash dividend of Kwacha 9 per share on common share for an
indefinite period of future. The required rate of return is 10% and the market price of the
share is Kwacha 80. Would you buy the share at its current price?

Vs = D
K
= 9_
.10
= 90
Yes, the price is more than value, you would consider buying the share.

b) Constant Growth Model

The dividend payable to common stock holders will grow at a uniform rate is future. It can be
written as below.
Vc = Do (1 + g)
k–g
Do = Dividend paid
g = growth rate
k = desired rate of return.
Example-2 Alfa Company paid a dividend of Kwacha 2 per share on common stock for the
year ending March 31, 2003. a constant growth of 10% per annum has been forecast for an
indefinite future. Investors required rate of return is 15%. You want to buy the share at
market price quoted on July 31, 2003 is stock market at Kwacha 60 what would be your
decision?

Vs = Do (1 + g)

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k–g
= 2 (1 + .10)
15 - .10
= 2 (1.10)
.05
= 2.20
.05
= 44
Value is less than price, so you do not buy.
Example-3 Nissan Ltd paid a dividend of Kwacha 4 per share for the ending march 31, 2003.
The growth rate is 10% forever. The required rate of return is 15%. You want to buy the
share at a market price of Kwacha 80 in stock exchange. What would you do?
Vc = Do (1 + g)
k–g
= 4 (1 + .10)
15 - .10
= 4.40
.05
= 88
Here the price is more than value. Hence, you prefer to buy.

c) Multiple-Growth Model
The multiple growth assumption has to be made in a vast number of practical situations. The
infinite future time period is viewed as divisible into two or more different segments.
The investor must forecast the time ‘T’ up to which growth would be variable and after
which only the growth rate would show a pattern and would be constant. This mean that
present value calculations will have to be spread over two phases viz. one phase would last
until time ‘T’ and the other would begin after ‘T’ to maturity.

Growth Rate1 = D1 – D0
D0

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Growth Rate2 = D2 – D1
D1
VT(1) = Dt
(1 + k)t
VT(2) = DT + 1
(k – g) (1 + k)T
Combined equation for VT(1) + VT(2)
= Dt + DT + 1
(1 + k)t (k – g) (1 + k)T

Example-4 Zambia Power Corporation paid dividend of 0.75 cents per share during the last
year. The company is expected to pay Kwacha 2 per share during next year. Investors tore
cast is a dividend of Kwacha 3 per share after that. At this time, the forecast is that dividends
will grow at 10% per year into an indefinite period. Would you buy/sell the share if the
current price is Kwacha 54. The required rate of return is 15%.

Solution:
This is a case of multiple growth. The growth rates for the first phase must be worked out
and time partition. Growth rates before T are

g1 = D1 – D0
D0
= 2.75
.75
= 1.25
.75
= 167%

g2 = D2 – D1
D1
=3–2

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2
=1
2
= 50%
VT(1) = Dt___
(1 + k)t
= 2 __ + 3___
(1 + .15) (1 + .15)2
VT(2) = DT + 1____
(k – g) (1 + k)T
= 3.30_________
(.15 – 10) (1 + .15)2
= 3.30___
(.05) (1 + .15)2
= 3.30___
(.05) (1 + .15)2
= 49.91
V0 = VT(1) + VT(2)
= 4.01 + 49.91
= 53.92
The current price is 54 Kwacha, the share is fairly and priced you can buy it.

Synopsis
 Financial assets are divided in to debt securities (eg. Bonds, long-term notes etc) and
equity securities (eg. Common stock, preferred stock etc)
 The valuation of financial assets is based on present value technique
 The value of financial asset is equal to the present value of future cash benefits
 The cash benefits associated with holding common stock are:
 Periodic dividend Po = PV of periodic dividend +PV of sale price
 Sale price

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The value of the common stock depends on how long the investor will hold the stock i.e.
 One period valuation model(PO= D1+ P1
(1+I)
 Two periods valuation model Po= D1 + D2+P2
(1+i) (1+i) 2
 More than two periods valuation model
 No growth in dividend model (Po = D/i)
 Constant growth in dividends model Po = D1
i- g
 Supernormal growth model

Exercises
a. Assume that investor A is contemplating to buy the common stock of Grace Corporation.
He plans to hold the stock for one year and sell it for K. 100l He expects to get a dividend
of K. 50/share at the end of year. If the RRR is 10%, determine the value of stock today.
b. The stock is expected to hold the stock for five years. Dividends are expected to be
K. 50, K. 60, K. 80, K. 90, and K. 120. If the RRR is 9%, what is the value of the stock?
c. Assume that investor Y is contemplating to invest in the common stock of Banda
Company which paid just a dividend of K. 200 per share. He plans to hold the stock for
indefinite period of time. The dividend is expected to grow at the late of 5% forever. If
the RR is 8%, determine the value of a stock today.
d. Assume that investor Y is contemplating to invest in the common stock of Banda
Company which paid just a dividend of K. 600 per share. He plans to hold the stock for
indefinite period of time. The dividend is expected to remain the same forever. If the RR
is 5%, determine the value of a stock today.
e. Assume that investor Y is contemplating to invest in the common stock of Banda
Company which paid just a dividend of K. 100 per share. He plans to hold the stock for
indefinite period of time. The dividend is expected to grow at the late of 15% in the first four
years and 5% thereafter. If the RR is 8%, determine the value of a stock today.

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f. Assume that investor Y is contemplating to invest in the common stock of Banda

Company which paid just a dividend of K. 200 per share. He plans to hold the stock for
indefinite period of time. The dividend is expected to grow at the late of 20%in the first three
years, 10% in year 4 and year 5 and 4% thereafter. If the RR is 8%, determine the value of a
stock today.

g. Assume that investor Y is contemplating to invest in the common stock of Banda

Company which paid just a dividend of K. 200 per share. He plans to hold the stock for
indefinite period of time. The current stock price is K. 5000, determine the RRR.

Exercises
a) Consider that you are planning to buy the common stock of Banda Company and
hold it for two years. Dividends are expected to be K.100 and K. 120 at the end of
year 1 and year 2 respectively. The required rate of return is 10%, what is the
today’s value of the stock

b) Considering that you are planning to invest in the common stock of Lidia Company.
You are planning to hold the stock for 5 years. Dividends in each year and sale
price at the end of year 5 are shown below

Year 1 2 3 4 5
Dividend 80 120 180 210 290
Sale price __ __ __ ___ 15600
If the PPP is 10%, determine the value of a stock
Exercise

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a) ABC Company just paid a dividend of K. 100 per share and expected to pay the same
forever. The investor expects to hold the stock forever. If the PPP is 10%, what is the
value of a stock today?
b) Investor B is contemplating to invest in the common stock of XYZ Company who
just paid a dividend of K.200/share. This is 10% what is the stock price today?
Exercise
Investor M is planning to invest in the common stock of ABC Company ABC Company has
paid dividend of K.500/share. In the current period and expected to increase at 15% in the
coming 5 years and at a constant rate of 5% there after. the PPP is 8%
a) Determine the price of stock at the end of year %
b) Determine dividend at the end of year 1,2,3,4.5.and year 6
c) Determine stock price to day
Exercise
Assume that investor Y is contemplating to invest in the common stock of Banda Company
which paid just a dividend of K. 800 per share. He plans to hold the stock for indefinite
period of time. The dividend is expected to grow at the late of 25% in year 1 and year 2, 20%
in year 3 and year 4, 10% in year 5 and year 6 and 3% there after forever. If the RR is 10%,
determine the value of a stock today.
Exercise
Assume that investor Y is contemplating to invest in the common stock of Banda Company
which paid just a dividend of K. 800 per share. He plans to hold the stock for indefinite
period of time. The dividend is expected to grow at the late of 30% in year 1 and year 2, 10%
in year 3 and year 4, 8% in year 5 and year 6 and 3% there after forever. If the RR is 12%,
determine the value of a stock today.

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5. 3: RRR on common stock

RRR on common stock

GORDON MODEL

The constant growth model as set forth in the equation is often called the Gordon Model,
after Myron J. Gordon, who did much to develop and popularize it. The constant Growth
Model is used to find the value of a constant growth stock.

Using this method for estimating future dividends, we can determine the current stock value -
in other words, we can find the expected future cash flow stream (the dividends), then
calculate the present value of each dividend payment, and finally sum these present values to
find the value of the stock. Thus, the intrinsic value of the stock is equal to the present value
of its expected future dividends.

If g is constant, an equation can be written as follows:

Po= Do(1 + g)1 + Do(1 + g)2 + … +Do(l + g)

(1 + ks)1 (1 + ks)2 (1 + ks)

= Do(l + g) = D1

ks-g ks-g

Note that the above equation is sufficiently general to encompass the zero growth case
described earlier: If growth is zero, this is simply a special case of constant growth. Note also
that a necessary condition for the derivation of the equation is that ks be greater than g. If the
equation is used in situations where ks is not greater than g, the results will be both wrong
and meaningless.

If we summed the present values of each future dividend, this summation would be the value
of the stock, Po. When g is a constant, this summation is equal to D1/(ks - g), as shown in the

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equation. Growth in dividends occurs primarily as a result of growth in earnings per share
(EPS). Earnings growth, in turn, results from a number of factors.

Capital Assets Pricing Model (CAPM)

Capital Asset Pricing Model (CAPM) is an important tool used to analyze the relationship
between risk and rates of return. The primary conclusion of the CAPM is this: The relevant
riskiness of an individual stock is its contribution to the riskiness of a well-diversified
portfolio. The stock might be quite risky if held by itself, but if half of its risk can be
eliminated by diversification, then its relevant risk, which is its contribution to the portfolio's
risk, is much smaller than its stand-alone risk.

In general Capital Asset Pricing Model (CAPM) is a model based on the proposition that any
stock’s required rate of return is equal to the risk-free rate of return plus a risk premium,
which reflects only the risk remaining after diversification.

A simple example will help make this point clear. Suppose you are offered the chance to flip
a coin once; if a head comes up, you win $20,000, but if it comes up tails, you lose $16,000.
This is a good bet-the expected return is 0.5($20,000) + 0.5(-$16,000) = $2,000. However, it
is a highly risky proposition, because you have a 50 percent chance of losing $16,000. Thus,
you might well refuse to make the bet. Alternatively, suppose you were offered the chance to
flip a coin 100 times, and you would win $200 for each head but lose $160 for each tail. It is
possible that you would flip all heads and win $20,000, and it is also possible that you would
flip all tails and lose $16,000, but the chances are very high that you would actually flip
about 50 heads and about 50 tails, winning a net of about $2,000. Although each individual
flip is a risky bet, collectively you have a low risk proposition because most of the risk has
been diversified away. This is the idea behind holding portfolios of stocks rather than just
one stock, except that with stocks all of the risk cannot be eliminated by diversification -
those risks related to Koad, systematic changes in the stock market will remain.

Are all stocks equally risky in the sense that adding them to a well-diversified portfolio
would have the same effect on the portfolio's riskiness? The answer is no. Different stocks
will affect the portfolio differently; so different securities have different degrees of relevant

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risk. How can the relevant risk of an individual stock be measured? As we have seen, all risk
except that related to Koad market movements can, and presumably will, be diversified
away. After all, why accept risk that can be easily eliminated? The risk that remains after
diversifying is market risk, or the risk that is inherent in the market, and it can be measured
by the degree to which a given stock tends to move up or down with the market.

Synopsis
 These are two common methods of determining the RRR on common stock, namely,
Gordon Modes and capital assets pricing model (CAPM)
 Under Gordon model, the RR on common stock will be determined as follows:
I=d1 + g
Po
Where:
I=RRR on common stock
D1 = dividend for year1
Po=current stock price
G=growth rate
 Under CAPM, the RRR on common stock is determined as follows:
Kx= krf+ (km-krf) bx
Where:
Kx=RRR on common stock
Krf= Risk free rate of return
Km=required rate of return on average stock
Bx = Risk coefficient

Exercise
(a) Assume the investor expects a dividend of K.50 per share at the end of year1 that is
expected to grow at 5%. The current stock price is K.1000. Determine the RRR on
common stock.
(b) Given
Risk free rate of return is 10%, required rate of return of average

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Stock: 12% risk coefficient =1.5

Required: Determine the RRR on common stock using CAPM

Exercise
(A) Assume that the expected dividend yield and capital gain yield on Common stock is
6% and 4 respectively. What is the required rate of return on common stock?
(B) Assume that market risk premium is 4% and risk free rate of return is 7% what is the
RRR on common stock using CAPM?

5.4: Valuation of preferred stock

The Nature of Preferred Stocks

Preference shares are hybrid security. They have some features of bonds and some of equity
shares. Theoretically, preference shares are considered a perpetual security but there are
convertible, callable, redeemable and other similar features, which enable issuers to terminate
them within the finite time horizon.
Preference dividends are specified like bonds. This has to be done because they rank prior to
equity shares for dividends. However, specifications doesn’t imply obligation, failure to
comply with which may amount to default several preference issues are cumulative where
dividends accumulate over a period of time and equity dividends require clearance of
preference arrears first.
Preference shares are less risky than equity because their dividends are fixed and all arrears
must be paid before equity holders get their dividends. They are however, more risky than
bonds because the latter enjoy priority in repayment and in liquidation.

Valuation of Preferred Stocks

Since dividends from preference shares are assumed to be perpetual payments, the intrinsic
value of such shares will be estimated from the following equations.

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Vp = C_ + C__ + Cn__
(1 + k) (1 + k)2 ( 1 + k)n
Vp = Value of perpetual today
C = Constant dividends received
K = Required rate of return appropriate
Vps = D__
Kps
Example. A preference share of Kwacha 100 each with a specified dividend of Kwacha 11.5
per share. Now, if the investors’ required rate of return corresponding to the risk level of a
company is 10%, what would be the value of share today?

Vps = D_
Kps
= 11.5
0.10
= 115.00

Should be required return increase to 12% what would be the value?

Vps = D_
Kps
= 11.50
.12
= 95.83

If the market price of the preference share is Kwacha 125 what would be the yield?
Vps = D__
Kps
Kps = D_
Vps
= 11.50
125

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= 9.2%

Synopsis
 Preferred stock is a hybrid security in the since that it has similarity with bonds in
some respects.
 Like bonds, preferred stock has par value and fixed amount of dividend
 Like common stock, failure to pay dividend on preferred stock does not lead to
bankruptcy
 Preferred stock may be maturing or perpetual
 The valuation of maturing preferred stock is accomplished in the same way as
maturing common stock
 Perpetuating preferred stock is valued using no growth in dividend modes i.e.
Up= Dp
Kp
Where,
Vp=value of preferred stock
Dp= preferred dividend
Kp= RRR on preferred stock

Review question
Assume that investor x is considering purchasing preferred stock of ANC company which
is expected to pay a dividend of K.120 per year for ever. If the RRR is 10% what is the value
of stock?

Exercises
Assume that investor y is considering purchasing preferred stock of XYZ
Company for K 1500 purchase. If the RRR is 10% what annual dividend is expected?

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5.5: Valuation of Bonds

Definition of Bond
A bond is a long-term contract under which a borrower agrees to make payments of interest
and principal, on specific dates, to the holders of the bond. It is an instrument or
acknowledgement issued by a business unit or government the amount of loan, rate of
interest and the terms of loan repayment.

Types of Bonds
Investors have many choices when investing in bonds, but bonds are classified into four main
types: Treasury, Corporate, Municipal, and Foreign. Each type differs with respect to
expected return and degree of risk.

Treasury Bonds

These bonds are sometimes referred to as government bonds, are issued by the federal
government. It is reasonable to assume that the federal government will make good on its
promised payments, so these bonds have no default risk. However, Treasury bond prices
decline when interest rates rise, so they are not free of all risks.

Corporate bonds

As the name implies, they are issued by corporations. Unlike Treasury bonds, corporate
bonds are exposed to default risk - if the issuing company gets into trouble, it may be unable
to make the promised interest and principal payments. Different corporate bonds have
different levels of default risk, depending on the issuing company's characteristics and on the
terms of the specific bond. Default risk is often referred to as "credit risk" and, the larger the
default or credit risk, the higher the interest rate the issuer must pay.

Municipal bonds

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These bonds are sometimes called "munis", which are issued by state and local governments.
Like corporate bonds, munis have default risk. However, munis offer one major advantage
over all other bonds: the interest earned on most municipal bonds is exempt from federal
taxes, and also from state taxes if the holder is a resident of the issuing state. Consequently,
municipal bonds carry interest rates that are considerably lower than those on corporate with
the same default risk.

Foreign bonds

These bonds are bonds issued by foreign governments or foreign corporations. foreign
corporate bonds are, of course, exposed to default risk, and so are some foreign government
bonds. An additional risk exists if the bonds are denominated in a currency other than that of
the investor's home currency. For example, if you purchase corporate bonds denominated in
Japanese yen, you will lose money-even if the company does not default on its bonds-if the
Japanese yen falls relative to the dollar.

The value of Bonds

The intrinsic value of a bond is equal to the present value of its expected case flows. The
coupon interest payments and principal payments are known and the present value is
determined by discounting these future payments from the issuer at an appropriate discount
rate or market yield. The usual present value calculating are made with the help of the
following equation.
C TV

n
PV = 
t 1
(1  r ) (1  r ) n
t

PV = Present value of the bond today

C = Coupon rate of interest
TV = Terminal value repayable
R = Appropriate discount rate or market yield
N = Number of years to maturity

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Example-1 A 10% bond of Kwacha 1,000 issued with a maturity of five years at par. The
discounted rate of marketing 10%. The interest is paid annually. What would be the bond
value.
PV = 100 __ + 100__ + 100___ + 100___ + 100+ 1000
(1 + .10) (1 + .10)2 (1 + .10)3 (1 + .10)4 (1 + .10)5
= 100 x .9091 + 100x .8264 + 100 x .7513 + 100x .6830 + 1100 x .620
= 90.91 +| 82.64 + 75.13 + 68.30 + 682.99
= 999.97

Relationships between coupon rates, required yield and price

You are aware that yields change in market place, price of bonds change to reflect the new
required yield. When the required yield on a bond rises above its coupon rate, the bond sells
at a discount. When the required yield on a bond equals its coupon rate, the bond sells at par.
When the required yield on a bond falls below its coupon rate, the bond sells at a premium.

Current yield:
The current yield relates the annual coupon interest to the market price. It is expressed as
Current yield = Annual Interest
Price

Example-2 A Kwacha 1000 Bond issued at 12% at par for a period of ten years. Now the
market price of the bond is Kwacha 950 what is the current yield of
Current yield = Annual interest
Price
= 120
950
= 0.1263
or
12.63 %

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Yield to maturity
The yield to maturity (YTM) of a bond is the interest rate that makes the present value of the
cash flows receivable from owning the bond equal to the price of the bond. Mathematically,
it is the interest rate (r), which satisfies the equation.

P= C1 + C2__ + C3__ + Cn___ + TV_

(1 + r) (1 + r)2 (1 + r)3 (1 + r)n (1 + r)n
P = Price of the bond
C = Annual interest
M = maturity value
N = Number of years left to maturity
Any time the calculations of bond required the trial and error method to know the rate of
interest, which equates the price of bond.

Example-3 A bond Kwacha 1000 is issued at par carrying coupon rate of interest of 9
percent. The bond matures after 8 years. The bond is currently selling for Kwacha 800. What
is the YTM on this bond?
Given:
800 = 90__ + 1000_
(1 + r)t (1 + r)8
= 90 (PVFAr 8 years) + 1000 (PVFr 8 years)

We have to begin with trial and error base.

Let us begin with discount rate of 12 percent.

= 90 (PVFA 12 8 years) + 1000 (PVF12 8 years)
= 90 (4.968) + 1000 (0.404)
= 851.0

This is more than Kwacha 800 so we may have to try higher value of discount rate. Let us
take 14 percent.

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= 90 (PVFA14 8 years) + 1000 (PVF12 8 years)

= 90 (4.639) + 1000 (0.351)
= 768.1

The value is less than Kwacha 800, so let us try at 13 percent.

= 90 (PVFA13 8 years) + 1000 (PVF12 8 years)
= 90 (4.800) + 1000 (0.376)
= 808

Therefore, it lies between 13% and 14 percent.

= 13 + 808 – 800_ x 1
808 – 768.1
= 13 + 8
40
= 13 + .2
13.2%

Yield to call
As explained earlier is the same unit, some bonds carry a feature that entitles the issuer to call
(buy back) the bond prior to the stated maturity date in accordance with a call schedule
(which specifies a call price for early call date). For such bonds, it is a practice to calculate
the yield to bill (YTC) as well as the YTM.
n
C m
P= 
t 1

(1  r ) (1  r ) n
t

P = Price
C = Coupon rate of interest
m= maturity value i.e. call price
n= Number of years

The calculation of YTC is also same as YTM and we have to start with trial and error
method.
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Synopsis
* Bonds
 Are long-term contracts
 Involve borrower and lender
 Are interest bearing instruments
*The different types of bonds include:
 Treasury bonds
 Corporate bonds
 Municipal bonds
 Foreign bonds
*The different types of corporate bonds include Coupon bonds, floating bonds, callable
bonds, in come bonds, regular Bonds, indexed bonds etc
The value of a bond (VB) is determined using present value techniques i.e.
VB= PV of periodic + PV of principal
Interest payment Maturity

In bond valuation interest may be paid

 Annually
 Semi-annually
 Quarterly
 Monthly
 Yield to maturity (YTM) and Yield to call (YTC) may be determined on bonds as
follows:
YTM: F + P – Vb
N____
0.6 (Vb) + 0.4 (P)
Where:
F = periodic interest payment
P = Principal
Vb = Value of the bonds

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N= Number of periods to maturity

YTC = F + CP – Vb
N____
0.6 (Vb) + 0.4 (CP)
Where:
F = periodic interest payment
CP = Call Price
Vb = Value of the bonds
N= Call Period

Discussion questions
Exercise
a. What is a bond?
b. What are the two parties to a bond?
c. What are the different types of bonds
Exercise
a. What are the different types of corporate bonds
b. How often interest is paid on the bonds?
c. What are the major cash benefits of holding bonds?
Exercise
a. Assume that investor X is considering to invest in ABC Company’s K. 100,000, 10%,
10 years bonds. The market interest rate is 12%. Determine the value of bonds if
interest is paid:
(a) Annually
(b) Semi-annually
b. Assume that investor Y is considering to invest in ABC Company’s K. 1,000,000, 12%,
10 years bonds. The market interest rate is 10%. Determine the value of bonds if interest
is paid:
(a) Annually
(b) Semi-annually

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Exercise
a. If the market price of a K. 20000, 5%, 5 years bonds is K. 25000. Interest is paid
annually. Determine YTM.
b. If the market price of a K. 20000, 5%, 5 years bonds is K. 25000. Interest is paid
annually. The bonds can be called four years from now. If the call price is K. 23000,
determine YTC
Exercise
Read two or more books on financial management and write, in brief, the different types of
corporate bonds.
Exercise
A K.500, 000 par value bound, which bear nominal interest rate of 12%. will mature after 12
years. Interest is paid annually. Determine the vale of bonds if market interest rate is:
(a )10% ( b)12% ( c) 14%
Exercise
a. Consider a K1,000,000, 10%,10 years bonds which pay interest semi-annually. The market
rate is 8%.
Required
A. Identify
I. par value
II. Coupon rate
III. RRR on bonds
IV. Term of bonds
B. Determine periodic interest payment
C. Determine the value of bonds.
b. If the market price of a K. 40000, 12%, 7 years bonds is K. 36000. The bonds can be
called four years from now. Call price is K. 45000.
Required
1. If interest is paid annually, determine:
a. Call premium

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b. YTM
c. YTC
2. If interest is paid semi-annually, determine:
a. YTC
b. YTM

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Chapter VI: Long Term Investment Decisions

6.1: Nature of long-term investment decision

Capital budgeting

Definition

The term capital refers to long-term assets used in production, while a budget is a plan which
details projected inflows and outflows during some future period. Thus, the capital budget is
an outline of planned investments in fixed assets, and capital budgeting is the whole process
of analyzing projects and deciding which ones to include in the capital budget. In general
Capital Budgeting is the process of planning expenditures on assets whose cash flows are
expected to extend beyond one year.

Importance

A number of factors combine to make capital budgeting perhaps the most important function
financial managers and their staffs must perform. First, since the results of capital budgeting
decisions continue for many years, the firm loses some of its flexibility. For example, the
purchase of an asset with an economic life of ten years "locks in" the firm for a ten-year
period. Further, because asset expansion is based on expected future sales, a decision to buy
an asset that is expected to last ten years requires a ten-year sales forecast. Finally, a firm's
capital budgeting decisions define its strategic direction, because moves into new products,
services, or markets must be preceded by capital expenditures.
An erroneous forecast of asset requirements can have serious consequences. If the firm
invests too much, it will incur unnecessarily high depreciation and other expenses. On the
other hand, if it does not invest enough, two problems may arise. First, its equipment may not
be sufficiently modern to enable it to produce competitively. Second, if it has inadequate
capacity, it may lose market share to rival firms, and regaining lost customers requires heavy
selling expenses, price reductions, or product improvements, all of which are costly.
Timing is also important - capital assets must be available when they are needed. Edward

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Ford, executive vice-president of Western Design, a decorative tile company, gave the
authors an illustration of the importance of capital budgeting. His firm tried to operate near
capacity most of the time. During a four-year period, Western experienced intermittent spurts
in the demand for its products, which forced it to turn away orders. After these sharp
increases in demand, Western would add capacity by renting an additional building, then
purchasing and installing the appropriate equipment. It would take six to eight months to get
the additional capacity ready, but by then demand had dried up - other firms with available
capacity had already taken an increased share of the market. Once Western began to properly
forecast demand and plan its capacity requirements a year or so in advance, it was able to
maintain and even increase its market share.
Effective capital budgeting can improve both the timing and the quality of asset acquisitions.
If a firm forecasts its needs for capital assets in advance, it can purchase and install the assets
before they are needed. Unfortunately, many firms do not order capital goods until existing
assets are approaching full-capacity usage.

Capital budgeting in decision-making

The terms in financial management like investment decisions, investment projects, and
investment proposals are generally associated with application of long-term resources. What
is long-term? There is no hard and fast rule to define it, but by common practice and
accordance with the financing policies, practices and regulations of the financial institutions
and banks a period of ten years and above may be treated as long period. The decisions
related to long-term investment are also known as capital budgeting techniques. It is
important because of the following reasons:
1) The investment decisions are the vehicles of a company to reach the desired destiny of
the company. An appropriate decision would yield spectacular results whereas a wrong
decision may upset the whole financial plan and endanger the very survival of the firm.
Even firm may be forced into bankruptcy.
2) Capital budgeting techniques involve huge amounts of funds and imply permanent
commitment. Once you invest in the form of fixed assets it is not easy to reverse the
decision unless you incur heavy loss.

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3) A capital expenditure decision has its effect over a long period of time span and
inevitably affects the company’s future cost.
4) Investment decisions are among the firm’s most difficult decisions. They are the
predictors of future events, which are difficult to predict. It is a complex problem
investment. Economic, political, social and technological forces cause the cash flow
uncertainty.

Synopsis
- Capital budgeting is the process of planning and managing a firm’s long-term
investments.
- The useful way of classifying investments (capital budget decisions) is accept-reject
decisions, mutually exclusive decisions, capital rationing.
- Capital budgeting decisions require special attention because of the various reasons
such as commitment of large amount of funds, irreversible decisions, and long-term
implication for the firm etc.

Review questions
- What is capital budgeting?
- Do people actually use capital budgeting in the Zambian context?
- What are the three kinds of capital budget decisions?

6.2: Procedures in capital budgeting decisions

Major steps in capital budgeting decision making process

Proposal generation
People at all levels within a business organization make proposals for capital expenditures.
To stimulate a flow of ideas that could result in potential cost savings. Many firms offer cash
rewards to employees whose proposals are ultimately adopted. Capital expenditure proposals
typically travel from the originator to a reviewer at a higher level in the organization. Clearly,
proposals requiring large outlays will be much more carefully scrutinized than less costly

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ones.

Review and analysis

Capital expenditure proposals are formally reviewed (1) to assess their appropriateness in
light of the firm's overall objectives and plans and. more important, (2) to evaluate their
economic validity. The proposed costs and benefits are estimated and then converted into a
series of relevant cash flows to which various capital budgeting techniques are applied to
measure the investment merit of the potential outlay. In addition, various aspects of the risk
associated with the proposal are either incorporated into the economic analysis or rated and
recorded along with the economic measures. Once the economic analysis is completed. A
summary report, often with a recommendation, is submitted to the decision maker(s).

Decision-making
The actual dollar outlay and the importance of a capital expenditure determine the
organizational level at which the expenditure decision is made. Firms typically delegate
capital-expenditure authority on the basis of certain dollar limits. Generally, the board of
director’s reserves the right to make final decisions on capital expenditures requiring outlays
beyond a certain amount, while the authority for making smaller expenditures is given to
other organizational levels. Inexpensive capital expenditures such as the purchase of a
hammer for $1-5 are treated as operating outlays not requiring formal analysis. Generally,
firms operating under critical time constraints with respect to production often find it
necessary to provide exceptions to a strict dollar-outlay scheme. In such cases the plant
manager is often given the power to make decisions necessary to keep the production line
moving. Even though the outlays entailed are larger than he or she would normally be
allowed to authorize.

Implementation
Once a proposal has been approved and funding has been made available, the implementation
phase begins. For minor outlays, implementation is relatively routine; the expenditure is
made, and payment is rendered. For major expenditures, greater control is required to ensure
that what has been proposed and approved is acquired at the budgeted costs. Often the

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expenditures for a single proposal may occur in phases, each outlay requiring the signed
approval of company officers.

Follow-up
Involves monitoring the results during the operating phase of a project. The comparisons of
actual outcomes in terms of costs and benefits with those expected and those of previous
projects are vital. When actual outcomes deviate from projected outcomes, action may be
required to cut costs, improve benefits, or possibly terminate the project.

Synopsis
 There are two types of income in financial dealing; namely, cash flow income and
accounting income.
 The cash flow do have many advantages over accounting income
 There are three types of cash flows applied to examine the proposed capital budgeting
projects such as initial investment, operating and termination cash flows.
 Procedures:
1. Generations of investment proposals,
2. Estimation of cash flow, evaluation,
3. Selection based on criterion and
4. Reevaluation.

6.3: Investment evaluation criteria /appraisal techniques- PB & ARR

Types of investment decision criteria

There are two important methods of evaluating the investment proposals
Traditional methods
 Pay back period(PB)
 Accounting rate of return(ARR)
Discounted cash flow method
 Net present value

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 Profitability Index method / Benefit cost Ratio

 Internal Rate of Return

Pay Back Period (PB):

This is one of the widely used methods for evaluating the investment proposals. Under this
method the focus is on the recovery of original investment at the earliest possible. It
determines the number of years to recoup the original cash out flow, disregarding the salvage
value and interest. This method does not take into account the cash inflows that are received
after the pay back period. There are two methods in use to calculate the pay back period
Where annual cash flows are not consistent vary form year to year
Where the annual cash flow are uniform

Unequal cash flows

B
P=E+
C
where, P stands for pay back period.
E stands for number of years immediately preceding the year of final recovery.
B stands for the balance amount still to be recovered.
C stands for cash flow during the year of final recovery..

Uniform cash flows

Where the annual cash flows are uniform
Original Investment
PB =
Annual cash flows
Shorter payback period is considered to be good for the project.

Average Rate of Return (ARR)

The ARR is compared to the predetermined rate. The project will be accepted if the actual
ARR is higher than the desired ARR. Otherwise it will be rejected.

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Synopsis
- Investment evaluation criteria are methods or techniques of appraising a project or
appraising the attractiveness of a project.
- There are two important methods of evaluating the investment proposals such as;
 Traditional / non-discounted cash flow methods- pay back period and Accounting
rate of return
 Discounted cash flow method- net present value, profitability index method/
benefit cost rate, internal rate of return.
- Pay back method (PB): Computes the amount of time required to recoup the initial
investment
- Accounting (average) rate of return method based on the financial Accounting practices
of the company working out the annual profit or Average cash flow after tax.

Review question
- In words, what is the payback period? The payback period rule?
- What is an average accounting rate of return?

6. 4: Appraisal techniques –Net present value

Discounted cash flow techniques:
This concept is based on the time value of money. The flow of income is spread over a few
years. The real value of Kwacha in your hand today is better than value of Kwacha you earn
after a year. The future income, therefore, has to be discounted in order to be associated with
the current out flow of funds in the investment. Two methods of appraisal of investment
project are based on this concept. These are net present value and internal rate of return
method.

Net Present Value

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Net present value may be defined as the total of present value of the cash proceeds in each
year minus the total of present values of cash outflows in the beginning
n
CFt Sn  Wn
NPV =  (1  K ) t

(1  K ) n
 Co

Where; NPV = Net present value

CFt = Cash inflows at different periods
Wn = Working capital adjustments
Co = Cash outflow in the beginning
K = Cost of capital
Sn = Salvage value at the end
The decision rule here is to accept a project if the NPV is positive and reject if it is negative
NPV > Zero accept
NPV = Zero accept
NPV < Zero reject

Synopsis of lecture:
- Net present value refers to getting the initial investment, which is negative and the
present value of the subsequent cash flow after tax.
- The cash inflows are discounted back over the life of the investment.
- The basic discount rate is usually the firm’s cost of capital (WACC)
n ACFt -IO
NPV = ∑ (1+k)t
t=1
Where:
ACFt= after tax cash flow of time t.
K is the appropriate discount rate
IO=initial outlay
N= the projects expected life.
NPV ≥0 then accept, NPV <0 then Reject.

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Exercise
T. CFAT
0. (10,000)
1. 4000 What is NPV? DO we Accept /reject?
2. 4000
3. 3000
4. 3000

Exercise;
- If we say an investment has an NPV of K 1000, what exactly do we mean?

6.5: Appraisal techniques –IRR

Internal Rate of Return (IRR)

The internal rate of return is also known as yield on investment, marginal efficiency of
capital, marginal productivity of capital, rate of return time adjusted rate of return and so on.
Internal rate of return is nothing but the rate of interest which equates the present value of
future earnings with the present value of present investment. Therefore, IR depends entirely
on the initial outlay and the cash proceeds of the project which is being evaluated for
acceptance or rejection. The computation of IRR is difficult one; you have to start equating
the two values i.e., present value of future earnings and present value of investment. It is
possible through trial and error method.

IRR can be calculated basing on the pay back period where annual cash flows are uniform, in
case the annual cash inflows are different for the periods, the fake pay back period is
calculate then adopt trial and error procedure.
PB  DFr
IRR = r 
DFrL  DFrH
where; PB = Pay back period

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DFr = Discount Factor for interest

DFrL = Discount Factor for lower interest rate
DFrH = Discount Factor for higher interest rate
r = Either of the two interest rates used
or
NPVL
IRR = LRD + R
PV
where; IRR = Internal Rate of Return
LRD = Lower Rate of Discount
NPVL = Net present value at lower rate of discount
(i.e., difference between present values of cash)
PV = The difference in present values at lower and higher discount values at
lower.
R = The difference between two rates of discount.

Synopsis
- Internal rate of return is defined as the discount rate which equals the present value of
the project’s future net case flows with the projects initial cash outlay.
i.e. rate of return that sets NPU=0
n ACFt
IO= ∑ (1+IRR) t
t =1
IRR ≥ required rate of return then Accept
IRR < Required Rate of Return then Reject
- RR represents a yield on an investment or an interest rate.

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6. 6: Appraisal techniques- profitability index

Profitability Index Method / Benefit Cost Ratio B/C Ratio

Profitability index method is the relationship between the present values of net cash inflows
and the present value of cash outflows. It can be worked out either in unitary or in percentage
terms. The formula is
Present value of cash inflows
Profitability Index =
Pr esent value of cash outflows

PI > 1 Accept
PI = 1 indifference
PI < 1 reject
Higher the profitability index more is the project preferred.

Synopsis:
- The profitability index or cost /benefit ratio, is the ratio of the present value of the
future of cash flow s to the initial outlay
- Provides a relative measure of the investment proposals desirability
n
Pl= ∑ ACF
t= 1 (1+k)t
IO
Where:
ACFt = after tax cash flow at time t
K is the appropriate discount rate (cost of capital)
IO = initial outlay
n = the projects expected life
PI ≥ 1 then Accept, PI< 1 then Reject.
- This criterion will yield the same accept- reject decision as does the NPV criterion.

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6.7: Capital Rationing and project selection

Capital Rationing in Capital budgeting decision
Capital Rationing

At times management may place an artificial constraint on the amount of funds that can be
invested in a given period. This is known as capital rationing. The executive planning
committee may emerge from a lengthy capital budgeting session to announce that only $5
million may be spent on new capital projects this year. Although $5 million may represent a
large sum, it is still an artificially determined constraint and not the product of marginal
analysis, in which the return for each proposal is related to the cost of capital for the firm,
and projects with positive net present values are accepted. A firm may adopt a posture of
capital rationing because it is fearful of growth or hesitant to use external sources of
financing (perhaps debt). In a strictly economic sense, capital rationing hinders a firm from
achieving maximum profitability. Acceptable projects must be ranked, and only those with
the highest positive net present value are accepted.

Project Investment total investment NPV

A $2,000,000 $400,000

B 2,000,000 380,000
Capital
rationing C 1,000,000 $5,000,000 150,000
Solution

D 1,000,000 100,000

E 800,000 6,800,000 40,000

Best
Solution F 800,000 (30,000)

Under capital rationing, only Projects A through C, calling for $5 million in investment, will

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be accepted. Although Projects D and E have returns exceeding the cost of funds, as
evidenced by a positive net present value, they will not be accepted with the capital rationing
assumption.
An interesting way to summarize the characteristics of an investment is through the use of
the net present value profile. The profile allows us to graphically portray the net present
value of a project at different discount rates.
In, smaller firms, new firms, and firms with dubious records may have difficulties raising
capital, even for projects that the firm’s capital includes have positive NPV’s. In such
circumstances, the size of the firm's cap budget may be constrained. This circumstance is
called capital rationing. Therefore, capital rationing is a situation in which a constraint is
placed on the total size of the firm’s capital budget. In such situations capital is scarce, and it
should be used in the most efficient way possible. Procedures are available for allocating
capital so as to maximize the firm’s aggregate NPV subject to the constraint that the capital
rationing ceiling is not exceeded, but due to its complexity, the details of this process are best
left, advanced finance courses.

Review question
- What is capital rationing?
- How we select the project if a capital constraint exists?

6.8 Capital Budgeting Under Uncertainty

In Financial Management (capital budgeting), it was assumed that projects will produce a
given set of cash flows and those cash flows were analyzed to decide whether to accept or
reject the project. Obviously, those cash flows are not known with certainty. We now turn
to risk in capital budgeting, examining the techniques firms use to determine a project’s
risk and then to decide whether its profit potential is worth the risk.

There are three distinct types of risk: standalone risk, corporate risk, market risk. Given
that the firm’s primary objective is to maximize stockholder value, what ultimately
matters is the risk that a project imposes on stockholders. Because stockholders are

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generally diversified, market risk is theoretically the most relevant measure of risk.
Corporate risk is also important for three reasons:
1) Undiversified stockholders, including the owners of small businesses, are more
concerned about corporate risk than about market risk.
2) Empirical studies of the determinants of required rates of return generally find that
both market and corporate risk affect stock prices. This suggests that investors, even
those who are well diversified, consider factors other than market risk when they
establish required returns.
3) The firm’s stability is important to its managers, workers, customers, suppliers, and
creditors, as well as to the community in which it operates. Firms that are in serious
danger of bankruptcy, or even of suffering low profits and reduced output, have difficulty
of attracting and retaining good managers and workers. In addition, both suppliers and
customers are reluctant to depend on weak firms. Such firms have difficulty borrowing
money at reasonable interest rates. These factors tend to reduce risky firms’ profitability
and hence their stock prices, and this makes corporate risk significant.

6.9 Incorporating Project Risk into Capital Budgeting

Capital budgeting can affect a firm’s market risk, its corporate risk, or both, but it is
extremely difficult to quantify either type of risk. Although it may be possible to reach
the general conclusion that one project is riskier than another, it is difficult to develop a
really good quantitative measures of project risk. This makes it difficult to incorporate
differential risk in to capital budgeting decisions.

Two methods are used to incorporate project risk in to capital budgeting. One is called
the certainty equivalent approach. Here every cash inflow that is not known with
certainty is scaled down, and the riskier the flow, the lower its certainity equivalent value.
The other method is the risk –adjusted discount rate approach under which differential
project risk is dealt with by changing the discount rate. Average risk projects are
discounted at the firm’s average cost of capital, higher risk projects are discounted at a
higher cost of capital, and lower risk projects are discounted at a rate below the firm’s
average cost of capital.

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Risk - Adjusted Discount Rates

Discount rates may vary from one project to another in order to account for the riskiness
of a project. Relatively risky projects would have relatively high discount rates , and
relatively safe projects would be assigned relatively low discount rates. These differential
rates are called risk-adjusted discount rates. As project risk increases, the discount rate
(the required rate of return) used on the project should also increase.

Discount rate

Project risk

There are many ways to estimate risk-adjusted discount rates. Two of these methods are
1. Use the Capital Asset Pricing Model (CAPM)
2. Use the firm’s average cost of capital, KAVG, adjusted for risk

The first method refers to our work in chapter 1 and 2 using CAPM. The second method
relates to the project discount rate to how much the firm pays, on average, for new
investment in capital.

1. Capital Asset Pricing Model

The CAPM theoretically links up an asset’s risk with its required rate of return. So, the
CAPM may be used to estimate the risk adjusted rate of return for an asset:

Risk-adjusted
Discount rate for X = KX = KRF + ( KM – KRF )x
Where: KRF is the risk free interest rate
KM is the required rate of return on the market index
x is the risk of asset X

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The riskier the project, the greater the discount rate, applied to the project’s expected cash
flows by the market. Similarly the less risky the project, the smaller the discount rate
applied to the projects expected cash flows. If a proposed project had a beta of zero, there
would be no risk associated with the project, and the appropriate discount rate for
evaluating the project would be the risk free rate, KRF.
KX

KX = KRF + ( KM – KRF )x

KRF x
2. KAVG Adjusted for Risk
KAVG (average cost of capital) represents what it costs to raise new investment capital in
proportions the firm establishes for new projects whose collective risk level is of a
particular amount.

A particular asset being evaluated may have risk considerably different from those of the
“typical” project upon which KAVG is based. Adjusting KAVG for differential riskiness
allows the asset’s risk-adjusted discount rate to be expressed as follows:
Risk-adjusted
Discount rate for X = KX = KAVG + risk adjustment for asset X
That is, a project’s required rate of return can be thought of as the company’s average
cost of capital plus or minus a risk adjustment. If we think of K AVG as being an
appropriate required rate of return for a firm’s projects of “Normal” risk, then projects
with greater (less) risk would have required rates of return greater (less) than KAVG .

Unfortunately, we have little guidance as to procedures for estimating the risk

adjustments for projects. Most firms would estimate those adjustments with only rough
approximations.

Expected Net Present Value

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Once the risk-adjusted discount rate is estimated, it may be used to evaluate the
desirability of the proposed project:
NPV =  CFATt
(1+k)t
where: NPV = expected Net Present Value
CFATt is expected cash flow after tax in year t.
K is the risk-adjusted discount rate

Expected CFAT
In generating cash flow estimates for use with above equation, it is often useful to relate
these estimates to the economic climates that may prevail. At the simplest level, we can
think of the outcomes as “bad” , “average”, and “good”. A “bad” year may indicate
recession, an “average” year normal economic activity, and a “good” year may indicate
an economic boom. We also attach probabilities to these economic states.

6.10 Certainty Equivalents

Some books object to using the risk-adjusted discount rate as was just done. The
objection goes like this. There are two important things to account for in the valuation
process, the time value of money and risk. But these concepts should be separated.
Specifically, use of discount rate that lumps together the risk-free rate and a risk premium
is unacceptable way of discounting since the futurity of cash flows should only include
time value consideration and not risk considerations. Adding the risk premium into the
discount rate leads to a compounding of risk over time.
Proponents of this argument prefer an alternative evaluation method that avoids the
problem of including a risk premium in the discount rate. This approach is called
certainty equivalent method (CE); the riskiness of the project is handled, not by adjusting
the discount rate, but by adjusting the expected cash flows.

The certainty equivalent in any year represents the CFAT that investors would be
satisfied to receive for certain in lieu of the distribution of CFAT’s that are possible for
that year. In effect, the certainty equivalent converts the project’s expected CFAT for the

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year into a certain amount investors consider equivalent to the project’s calculated CFAT
for the year.

Once the certainty equivalents have been estimated, the certainty equivalent method
computes NPV:
NPV=  CEt
(1+ KRF)t
Where: CEt is certainty equivalent CFAT in year t
KRF is the risk-free interest rate
NPV decision rules here are the same as with the risk-adjusted discount rate above.
Recall that the risk free interest rate, KRF, can be approximated by the interest rate on
government bonds or treasury bills.

6.11 Sensitivity and Scenario Analysis

1. Sensitivity Analysis
All the evaluation methods we have discussed involved estimating three general classes
of project parameters: expected cash flows, required rate of return, and project life. These
parameters are only estimates of what will occur in the future and are subject to error.
Presumably, more experienced financial analysts will make better estimates of the future
than less experienced analysts, but since the future is always uncertain, there will always
be estimation errors. One way to investigate the effect of estimation errors systematically
is through sensitivity analysis. In the context of NPV and IRR, sensitivity analysis
provides information regarding the sensitivity of the calculated NPV or IRR to possible
estimation errors in expected cash flows, the required rate of return, and project life. It is
a technique that indicates how much NPV or IRR will change in response to a given
change in an input variable, other things held constant.

Suppose a proposed project has an estimated initial cost (after tax) K.75,000 and an
estimated expected CFAT stream of K.20,000 per year for seven years. The expected K is
15%.
NPV = -75,000 + (20,000) (ADF15,7)
= -75,000 + (20,000) (4.160)

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= K.8,200
The project should be accepted. Now, what if the analyst overestimated expected CFAT
by K.3,000? That is, what if expected CFAT were K.17,000 per year?
NPV = -75,000 + (17,000) (ADF15,7)
= -75,000 + (17,000) (4.160)
= -K.4,280
If the analyst overestimated expected CFAT by K.3,000 per year, the project will have
negative NPV. Similarly, the analyst can determine the sensitivity of NPV to estimation
errors in life and discount rate. A sensitivity analysis would be particularly helpful on
large projects that would have a substantial impact on the firm.

In a sensitivity analysis, we usually change each variable by several specific percentages

above and below its expected value, holding other things constant, then the calculated
new NPVs, and finally plot the derived NPVs against the variable that was changed.
The following figure shows the graphs indicating how sensitive NPV is to changes in
inputs or variables. The slopes of the lines in the graphs show how sensitive project’s
NPV is to changes in each of the inputs: the steeper the slope the more sensitive the NPV
is to a change in the variable.
NPV

Deviation from the base case

The downward sloping line (negative slope) shows the sensitivity of variables that have
indirect relationships with NPV, i.e, as the variables increase, the NPV decreases. These
variables include variable costs per unit, fixed costs, WACC, etc.
The upward sloping line (positive slope) shows the sensitivity of variables for which their
positive deviation will have positive impact on NPV, i.e, as the variables increase, the
NPV increases. These variables include sales price, units sold, growth rate, etc.

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If we were comparing two projects, the one with the steeper sensitivity lines would be
riskier, because for that project a relatively small error in estimating a variable unit sales
would produce a large error in the project’s expected NPV. Thus, sensitivity analysis can
provide useful insights into the riskiness of a project.

Although sensitivity analysis is probably the most widely used risk analysis technique, it
does have some limitations. A project’s stand-alone risk depends on both
1) the sensitivity of its NPV to changes in the key variables and
2) the range of likely values of these variables as reflected in their probability
distributions.
Because sensitivity analysis considers only the first factor, it is incomplete.
2. Scenario Analysis
A stand-alone risk analysis technique that considers both the sensitivity of NPV to
changes in key variables and the range of likely input values is scenario analysis. Here
the financial analyst asks operating managers to pick a “bad” set of circumstances (low
unit sales, low sales price, high variable cost per unit, high construction cost, and so on),
an average, or “most likely” set, and “good” set. The NPVs under the “bad” and “good”
conditions are then calculated and compared with the “most likely” NPV.

Illustration
Shao Industries is considering a proposed project for its capital budget. The company
estimates that the project’s NPV is K.12,075. The estimate assumes that the economy and
the market conditions will be average over the next few years. The company’s CFO,
however, forecasts that there is only a 50% chance that the economy will be average.
Recognizing this uncertainty, she has performed the following scenario analysis.
Scenario probability of outcome NPV
Worst case 0.25 (K.10,079)
Most likely case 0.50 12,075
Best case 0.25 41.752
Required:
A. what is the project’s expected NPV?
B. Calculate the project’s standard deviation and coefficient of variation.

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