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CONTENTS Pages

Introduction......................................................................................................i

I. Balance Sheet and Profit and Loss Account..................................................... 1

II. Financial Ratios............................................................................................ 7

III. Profit Planning............................................................................................. 13

IV. Financial Forecasting and Budgeting............................................................. 18

V. Working Capital Management........................................................................ 23

VI. Current Assets Management.......................................................................... 29

VII. Sources and Forms of Short-term Financing................................................ 33

VIII. Sources and Forms of Long-term Financing................................................. 37

IX. Financial Structure and Financial Leverage......................................................49

X. The Interest Factor in Financial Decisions........................................................ 54

XI. The Capital Budgeting Decision..................................................................... 57

Appendix I............................................................................................... 80

Appendix II.............................................................................................. 81

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 SCOPE OF THE COURSE
The aim of this course is to give the students a thorough introduction to financial
management. A basic understanding of financial management is crucial to anyone employed at
the managerial levels of a firm. This is because of the essential role financial management
plays in the efficient operations of a firm, i.e. the efficient use of its scarce resources, among
which is its capital. Moreover, financing basically sets the stage on which the production and
distribution of goods and services takes place. It organizes the capital required and strictly
controls its use, resulting in an overall assessment of the firm's operations in terms of
efficiency, or to be more specific, how profitable its operations are conducted.
Course Description
Financial Management studies corporate finance and capital markets, emphasizing the financial
aspects of managerial decisions. It touches on all areas of finance, including the valuation of
real and financial assets, risk management and financial derivatives, the trade-off between risk
and expected return, and corporate financing and dividend policy. The course draws heavily on
empirical research to help guide managerial decisions.
Basic Concepts
In this course, we assume the existence of a relatively free capital-market. In a free-capital
market there is an unrestricted allocation of saving among competing uses. The participants in
this allocation process (investors) are supposed to follow a rational behaviour, which is
maximizing their expected returns and minimizing their risk. In reality, however, there are
many limitations to such a concept. It depends entirely on the actual organization of the
economy, how "free" the market is and which constraints we have to incorporate in the
concept. Nevertheless, this concept may be very useful as a general guide to how effective
decisions, resulting in an efficient use of resources, should be made. It does not make much
difference, for example, whether the capital- as a principal source - is provided by private
individuals or by the government, since both (should) require an efficient use of their capital
and consequently highest return, as an overall measure of efficiency, possible. The objective of
a firm in the above conception should be the generation of maximum returns to its owners, i.e.
the suppliers of its capital. These returns may take a straight monetary form i.e. dividends but
may also be increase in value (price) of the ownership shares (stock) resulting in a capital gain
when the shares are sold. If a firm is not able to accomplish such an objective it will ultimately
loose its (potential) suppliers of capital in a competitive market, since they will invest money in
more efficient and therefore more profitable enterprises. (One could even argue that, putting
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money in unprofitable, inefficient enterprises by government is to a certain extent a social
irresponsibility, since it is a waste of public funds.) The principal focus of financial
management therefore, is on decisions and actions that affect the value of the firm as it is
reflected in the price of its stock.
The aim of financial management is then to maximize the value of the firm to its stockholders
(owners).
The valuation of the firm is based upon the stream of earnings that investors (suppliers of
capital) expect the firm to generate in the future, as well as the risk of these projected future
earnings.
Valuation is the process of estimating the potential market value of a
financial asset or liability. Valuations can be done on assets (for example, investments in
marketable securities such as stocks, options, business enterprises, or intangible assets such
as patents and trademarks) or on liabilities (e.g., Bonds issued by a company). Valuations are
required in many contexts including investment
analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable
events to determine the proper tax liability, and in litigation.
Every (financial) decision made in the firm will subsequently affect both size of its future
earnings or future profitability as well as its risk position.
Some of these decisions are:
Firm Environment
(Potential investors)

Marketing mix (which products)

Size of the firm (growth) Profitability
Type of equipment (capital assets)
use of debt/credit Value of the firm
Working capital/liquidity
dividend/retention of earnings etc
Risk

In these decisions, one should seek to strike a balance between risk and profitability so that it
maximizes the value of the firm. This risk-return trade off - as it is called - should therefore be
based on how these factors are perceived by the investors.

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Outline of the Course
In this course emphasis is placed on those aspects of financial management relevant to the
prevailing conditions in the Nigerian economy. The following aspects are treated more
extensively:
a. Financial Analysis in order to track down inefficient (too costly) areas of operations,
i.e. those areas depressing the overall result of the firm.
b. Efficient Working Capital Management in order to minimize (short-term) capital
requirements and consequently capital costs (especially for smaller firm).
c. Capital Budgeting or investment decisions, especially important for engineers often
dealing with the conception (design) and/or purchase of capital intensive equipment, or
with the decisions on entire projects.
However, other aspects of financial management are treated to the extent to which they make
the key issues understandable and for the purpose of building a complete picture.
The standard balance sheet serves as the basic framework for treating the several topics listed
in the contents.
Literature:
The following textbooks covering most of the topics more extensively, should be consulted
when necessary,
1. Essentials of Managerial Finance (1974) Weston, J. F. and Brigham, E. F., The Dryden
Press, Hinsdale, Illinois
2. The Capital Budgeting Decision (1971), Bierman, H. and Smidt, S., Maccmillan.
3. Managerial Accounting (1972), Moore, C. L. and Jaedicke, R. K., South Western
Publishing Co. Chicago.
4. Cost Accounting (1972), Hongreen, C. T., Prentice Hall International Inc.
5. Financial Management and Policy, Horne, J. V., Prentice Hall International Inc.
6. Brealey and Myers, Principles of Corporate Finance

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I THE BALANCE SHEET AND PROFIT AND LOSS ACCOUNT
Top management is responsible for the financial statements that are published and distributed
to stockholders and to the public at large. The statements are the basis for the evaluation of
the firm and its management (to evaluate the firm). The financial statements contain
summarized information on the financial performance of the company.
The basic financial statements
Financial statements and reports are prepared from the accounting records according to the
needs of the business. Most important statements are:
a. the balance sheet
b. the income statement or profit and loss account.

a. The balance sheet is a listing of the resources of a business together with the equities
or interests of creditors and owners in those resources. The resources of a business
are the properties and the property rights possessed and are called ASSETS of the
business. An individual (stockholder) or a group (bank) having a claim against the
assets is said to be LIABILITY to the business. The interest of the owner in the assets
is called the owners' EQUITY. Creditor's interest in the assets is called DEBT of the
business. The balance sheet (staffle form) is divided into columns. The left hand side
is specification of the ASSETS, the items in which the capital of the firm has been tied
up. The right hand side contains LIABILITIES

The balance sheet is a statement of the financial position of an enterprise at a given

date and it reflects the result of all recorded accounting transactions since the
enterprise was formed (cumulative record). The balance sheet for a particular date
tells what the assets and liabilities are at that time, but it does not give any information
on changes in the specified items over previous periods.

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 Example of a two sided balance sheet with standard classification
BALANCE SHEET (as at .............. 20......)

ASSETS LIABILITIES

FIXED ASSETS: Land and Building Plant EQUITY shares reserves (revaluation)
Machinery Other fixed assets retained earnings (deficit)

CURRENT ASSETS inventories:

- raw materials, finished LONG TERM DEBT: bonds convertibles deferred
goods, work in progress. liabilities
- debtors and prepayments.
- cash in bank and in hand SHORT TERM DEBT: bank overdrafts,
- marketable securities creditors,
dividends (to be
INTANGIBLE ASSETS patents, goodwill paid)
taxation (to be paid)

TOTAL TOTAL

The Income Statement

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The income statement, sometimes called a STATEMENT OF INCOME, a STATEMENT OF
INCOME AND EXPENSES, a PROFIT AND LOSS STATEMENT (ACCOUNT), or AN
OPERATING STATEMENT, is dynamic. It shows the results of operations for a company during a
certain interval of time. The inflow of assets resulting from selling products and services to customers
is measured in REVENUE ACCOUNTS. The outflow of assets identified with the products and
services provided to customers is measured in EXPENSE ACCOUNTS. The net increase or decrease
in net assets resulting from this activity (difference between revenue and expenses) is designated as
NET INCOME or NET LOSS. This difference increases or decreases the owners' equity on the
balance sheet at the end of the measured time interval. Neither the balance sheet nor the income
statement stands alone; the statements INTERLOCK and items appear on both statements.

The Interlocking Effect

The relation of the balance sheet and income statement is derived from the balance sheet equation:

Balance Sheet Income Statement

+
1. Measurement of net increase or decrease in owner's equity from rendering goods/services
(Revenue-expense)
2. Asset =debts
Measurement + inflow
of net equity or outflow of assets as a result of rendering goods and services.

Example: assets, such as cash or accounts receivable are usually increased at the time sales revenue is
1
recorded. At the same time, cost of goods sold is recorded as an expense and the inventory (asset) is
2 affect both statements
reduced, so any transaction

Example of a standard income statement:

INCOME STATEMENT (from ................... to .........................)
Sales
Cost of goods sold
Basic Concept in the Preparation of Financial Statements.
1. The going concern: The assumption is made that a business will continue in the future
2. Cost: Cost is conventionally used as the basis for accountability. The cost of an asset is the
PRICE that has to be paid.
3. The realization concept: Profits and losses of a business are measured as the difference
between the consideration received from customers and the cost attached to the products or
services given in exchange. In conventional accounting, profits are not recognized unless they

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 are REALIZED. This depends upon an agreement with a customer to pay a stipulated amount
for the product.
4. Periodicity: Ordinarily, revenues and expenses are measured over period of one year. This
year does not necessarily correspond with the natural cycle of the business activity (seasonal
fluctuations). Logically, such a year should end with the close of a business cycle that is, when
inventories and accounts receivable are at minimum. The year chosen for financial
measurement is called the FISCAL YEAR or FISCAL PERIOD
5. Matching: A reasonable accurate measurement of the net income/loss for a fiscal period
depends upon the matching of expenses against RELATED revenues recorded.
6. Consistency: There should be consistency in the method applied for accounting, for example,
inventories may be accounted for on a first-in, first-out (FIFO) basis, or last-in, first-out
(LIFO) basis, or by some other means.
7. The accrual principle: Revenues and expenses are accounted for on the accrual basis.
Revenue/expense are not necessarily recognized at the time cash is collected (cash inflow). For
example, goods are often sold on credit terms. At the moment that the goods are DELIVERED
revenue is recorded, that means an increase of the asset "accounts receivable". At the time cash
collection is made the "accounts receivable" will decrease and asset "cash" will increase with
the same amount (Note: This is in contrast with the "cash-flow" concept).

Notes on the income statement

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1. Sales are the revenue recorded with an exchange of produced goods/services.
2. Cost of goods sold can be computed as follows:
Inventory of finished Cost of goods
(i) goods at the beginning of + manufactured of Cost of goods
The fiscal period. Purchased during this = available for sale
Period during f.p.
(ii) Cost of goods available + Inventory of finished Costs of goods
For sale during f.p goods = sold

3. Operating expenses include expenses for selling (advertising, sales commissions, travels, etc.)
and the general expenses of administrating the business (officers' salaries, insurances, etc.).
4. Other revenues and expenses: all those not covered by other income statement items.
5 Interest (paid and received): paid on current liabilities (bonds, loans, credit, etc.) and received at
interest bearing assets (cash, debtors).
6 Depreciation: the provisions made for the economic loss of assets. This item does not always
appear apart, sometimes it is included as "overhead" n the cost of goods sold.
7. Tax is the amount due o government: Tax = Tax * P.B.T.

The tax environment

An important item appearing on the financial statement is the amount of tax paid or to be paid (in
reserve). Income of most forms of business is subject to tax rates ranging from 20% up to 70%. Tax is
received by government: federal, state or local government are imposing tax rates on business. With
such a large percentage of business income going to the government, it is not surprising that taxes play
an important role in financial decisions.
The federal government uses both monetary policy and fiscal policy to influence the level of economic
activity. Monetary policy deals with actions to influence the availability and cost of credit. Fiscal
policy deals with altering the level and composition of government receipts and expenditures. Since tax
constitute an important receipt, it is the main element of fiscal policy.
Three principal methods have been employed to change tax receipts:
1. changing tax rates
2. changing methods permitted for calculation of tax-deductible depreciation: the larger the
depreciation charge the lower the actual tax liability (accelerated depreciation methods).
3. providing for an investment tax credit for expenditures on new industrial equipment; a specified
percentage of a new investment can be deducted as a credit against the income tax.
Income tax
Corporate (business) taxable income consists of two components:

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 Profit or losses from the sales of capital assets.
 Ordinary income, which is all other income.

1. Gains and losses on the sale of capital assets are defined as capital gains and losses and received
under certain circumstances, special treatment. A capital gain may occur when an asset is sold at a
higher price than its tax-cost or trade-value, which is the original purchase price less accumulated
depreciation. However, if the asset is sold for more than its book value, it may incur either a capital
gain or ordinary income for tax purposes. If the gains is a recuperation of depreciation, the gain is
ordinary income and taxed accordingly since this amount of depreciation has been deducted for tax
reasons before. There is only a capital gain for tax purposes if the total gain exceeds the amount of
depreciation taken. The surplus (in fact the real capital-gain for tax purposes) will be taxed at a special
rate (for example 30%), mostly lower than the tax rate on ordinary income. If an asset is sold under its
book value, it incurs a capital loss. This loss can be deducted from ordinary income and reduces thus
the amount of tax to be paid.
2. Ordinary income is to be taxed fully (x%). If losses are incurred the may be carried back or
forward. This means that the loss can be deducted from the tax due in some previous years and in a few
years ahead (mostly first back and then forward). These arrangements are made to avoid penalizing
firms whose income fluctuate widely. These firms are allowed to average their losses over the years and
so average their tax liabilities. Furthermore, interest payments as well as depreciation re deductible
expenses. It should be noted however that depreciations are not a real cash out-flow. Dividends paid on
its own stock are mostly not deductible.
Depreciation methods
It is already noted that depreciation may influence largely the amount of tax to be paid and consequently
the profit to be recorded in the income statement. There are several methods of depreciation:
1. Straight line
2. Sum of years digits and
3. Double declining balance.

1. Straight line: a uniform annual depreciation charge per year. This figure is arrived at by simply
dividing the economic life of the asset into its total cost minus the estimated salvage value
(disposal value).
cost salvage value
= depreciation charge per year
economic life
2. Sum of years' Digits: the yearly depreciation charge is determined as follows
- calculate the sum of the years digit: for example gives 1+2+3+.....+10 = 55 digits.

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 - divide the number of remaining years by the sum of years digits and multiply this
fraction by the depreciable cost (total cost minus salvage value) of the asset.
3. Double Declining Balance: this method (DDB) requires the application of a constant rate of
depreciation (mostly double the annual straight line rate) each year to the remaining
undepreciated value of the asset at the close of the previous year. This rate initially applies to
the full purchase price of the asset (not the depreciable cost of the asset).
The last two depreciation methods are providing for accelerated depreciation which enables the firm to
have much greater tax deductions (so bigger cash-flow) in the early life of the asset.
Depreciation is an accounting expense, not a cashflow

II FINANCIAL RATIOS
To evaluate the financial condition and performance of a firm, the financial analyst needs certain
yardsticks. The yardstick frequently used is a ratio or index, relating the figures of a balance sheet and
the profit and loss account to each other. Analysis and interpretation of various ratios should give a
better understanding of the financial condition and performance of the firm. The analysis of financial
ratios involves two types of comparison:
1. Comparison of a present ration with past and expected future ratio for the same company. In
such a way an improvement or deterioration in the financial condition of the firm over time can
be measured.
2. Comparison of the ratios of one firm with those of similar firms or with industry averages at the
same point in time. Such a comparison gives insight into the relative financial condition of the
firm.
The ratios to be used will depend on the purpose for which analysis is being made. The ratios can be
classified as follows:
1. Liquidity ratios: which measure the firm's ability to meet its short-term obligations.
2. Leverage ratios: which measure the extent to which the firm has been financed by debt.
3. Activity ratios: which measure how effectively the firm is using its resources.
4. Profitability ratios: which measure management's overall effectiveness as shown by the returns
generated on sales and investments.

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1. Liquidity ratios
From liquidity ratios much insight can be obtained into the present cash solvency of the firm and its
ability to remain solvent in the event of adversities. Essentially we compare short-term obligations with
short-term resources available to meet these obligations. We define liquidity as the ability to realize
value in money - the most liquid assets. Liquidity has two dimensions: (1) the time required to convert
the asset into money, and (2) the certainty of the price realized. To the extent that the price realized on
receivables is as predictable as that realized on inventories, receivables would be more liquid asset than
inventory, owing to the shorter time required to convert the asset into money
Two liquidity ratios are commonly used:
a. The current ratio: This ratio is computed by dividing current assets by current liabilities.
Current assets normally include cash, marketable securities, accounts receivable and
Inventories. Current liabilities consist of accounts payable, short-term notes payable, accrued
income tax, etc. (short-term debts)
current assets
Current ratio = >1
current liabilitie s
b. Quick ratio or Acid test: This ratio is similar to the current ratio only that inventories are
deducted from current assets. Inventories are typically the least liquid of a firm's current assets
according to the two dimensions mentioned above. Therefore, this ratio is a more accurate guide
to the real liquidity position of a firm.
current assets inventory
Quick ratio =
current liabilities
2. Leverage ratios
Leverage ratios measure the funds supplied by owners as compared with the financing provided by the
firm's creditors. In essence it measure the Long term liquidity of the firm (that is, its ability to meet
long-term obligations). Leverage ratios are important because:
a. Creditors look to it to measure the risk of supplying funds. If the equity part is relatively big
compared to the debt, it provides a margin of safety to future creditors. From the investors
point view the leverage ratio is important because
b. A relatively big debt financing (high leverage ratio) gives the owners (equity) the benefit of
maintaining control of the firm with a limited investment.
c. If the firm earns more on the borrowed funds than it pays interest, the return to the owners is
magnified. If it loses however, it cuts heavier in the earnings of the owners (the interest has to
be paid). Firms with low leverage ratios have less risk of loss when the economy is in a
recession, but they have also lower expected returns when the economy booms.
Two ratios can be distinguished:

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a. Debt ratio: This ratio determines the extent to which borrowed funds have been used to finance
the firm (debt financing): it measures the percentage of total funds that has been provided by
creditors. Debt include current liabilities (short-term debt) and long-term debt (bond etc.).
total debt
Debt ratio =
total assets (investment)
Creditors prefer moderate debt ratios; while owners tend to prefer higher debt ratios (to magnify
their earnings or to limit control).
b. Times interest earned ratio: This ratio measures the extent to which earnings can decline
without problems to the firm because of inability to meet annual interest costs.
P.B.T. + interest (profit before tax + interest)
Times interest earned ratio =
interest

3. Activity ratios
These ratios all involve comparison between the level of sales and the investment in various asset
accounts. The activity ratios presume that a "proper" balance should exist between sales and these
assets.
The following ratios can be distinguished related to the various assets (inventory, accounts receivable,
fixed assets, total assets).
a. Inventory turnover is defined as sales divided by the average inventory
sales
Inventory turnover =
average inventory
The inventory turnover thus gives the rapidity with which the inventory is turned over into
receivables through sales. Generally, the higher the inventory turnover, the more efficient
the inventory management of a firm. However, a relatively high inventory turnover ratio
may be the result of a too low level of inventory and frequent stockouts. Caution is necessary in
interpreting the ratio.
b. Average collection period: The average collection period is a measure of the accounts receivable
turnover. It is calculated as follows:
receivables x 365 (days in a year)
Average collection period =
annual (credit) sales
When credit sales figures are not available we use the total sales figure. The average collection
period indicates the rate of collection of receivables and thus the related credit policy of the firm.
A too low an average collection period may suggest an excessively restricted credit policy. On
the other hand, too high an average collection period may indicate a too liberal credit policy.
c. Fixed asset turnover: The ratio of sales to fixed assets measures the turnover of plant and
equipment.

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 sales
Fixed asset turnover =
net fixed assets
It indicates up to which level the firm uses its capacity generated through its fixed assets.
d. Total assets turnover relates the volume of business with the total investment.
sales
Total assets turnover =
total assets
This ratio gives a general assessment of the business activity i.e. the relative efficiency with
which the firm utilizes its resources in order to generate output.
4. Profitability ratios
Profitability ratios are of two types: those showing profitability in relation to sales, and those showing
profitability in relation to investment. Together they give an indication of the firm's efficiency of
operation.
1. Net profit margin on sales
P.A.T. (profit after tax)
Profit margin =
sales
The ratio gives the profit per Naira of sales.
2. Return on total assets: (Return on Investment: R.O.I.) This ratio gives the "earning power" of
the firm.
P.A.T.
Return on total assets ratio =
total assets (total investment)
For the sake of comparison, this ratio may be inadequate because it is related to the capital
structure of the firm i.e. the amount of interest to be paid. To get an idea of the "earning power"
independent of the capital structure of the firm, thus only concentrating on the efficiency of
operation, we define the net operating profit rate of return.
P.B.T. + Interest (Earnings before interest and tax)
Total assets (investment)
3. Return on equity (net worth). This ratio gives the rate of return on the share holders investment:
P.A.T.
R.O.E. =
Equity (Networth)
In fact this ratio gives the "earning power" on the shareholder's book investment. The figure for
net worth used in the ratio may be expressed in terms of market value instead of book value.
When we use market value we obtain the so called earning/price ratio of the stock, which is an
important figure for potential investors in stock.
Du Pont System of Financial Analysis
The Du Pont System of financial analysis is an excellent tool to analyze the relations between the several
ratios and their impact on each other. It brings together the activity ratios and profit margin on sales and

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shows how these ratios interact to determine the profitability of assets. The right side of the figure
develops the turnover ratio. The left side of the figure develops the profit margin on sales. Multiplying
the turnover ratio with the profit margin on sales (sales/earning ratio) gives the return on total
investment (assets).
Ssles Pr ofit  Pr ofit 
x x ROI  
Investmeny Sales  Investment 

Profit margins on sales

Turnover

(Earnings as a percent of sales)

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The above chart is especially helpful in evaluating the effect of changes in one or more items in the
financial statements on the final Return on Investment (ROI).

III PROFIT PLANNING

With the ratio analysis we discussed an important tool of the financial manager to control the operations
of he firm. However, more tools are available to aid the financial manager in this process. Two of the
most important are:
1. break-even analysis, which is especially useful when considering expansion of operations.
2. the funds-flow analysis (statement), which is an important aid in monitoring how the firm has
obtained funds and how these funds have been used.0
1. Break-even analysis
Break-even analysis is basically an analytical technique for studying the relations among fixed costs,
variable costs and profit. It is a device for determining the point at which sales will just cover total
costs. If a firm is to avoid losses, its sales must cover all costs - those which vary directly with
production (variable costs) and those which do not change with production levels (fixed costs). The
following costs fall into each of these categories:

Fixed Costs Variable Costs

- Depreciation on pl;ant and equipment - Factory labour
- Rentals - Materials
- Interest - Sales commissions
- Salaries of research and executive staff
- General office expenses
The nature of break-even analysis can be shown in the basic break-even chart.

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Total cost
and
revenues 140 Net profit
(N1000)
120

80 Profit Variable costs

40
Fixed Loss
20 40 50 60 70

Units produced and sold (volume) (000)

This chart is on a basis, with volume produced shown on the horizontal axis and costs and income
(revenue) measured on the vertical axis. Fixed costs of N40,000 are represented by a horizontal line;
they are same regardless of the number of units produced. Variable costs are assumed to be N1.20 a
unit. Total costs rise by N1.20, the amount of the variable costs, for each additional unit produced.
Product is assumed to be sold at N2 a unit which also increases with production. The slope of the total
income line is steeper than that of the total-cost line, which is of course true because the firm is gaining
N2 of revenue for every N1.20 paid out for labour and materials, the variable costs. Up to the break-
even point, found at the intersection of the total-income and total-cost lines, the firm suffers losses.
After that point, the firm begins to make profits. Our example indicates a break-even point at sales and
cost level of N100,000 and a production level of 50,000 units. More exact calculations of the break-
even point can be carried out algebraically.
Fixed Costs

Contribution M arg in

Break-even point (volume)

Fixed Cost

( Sales price / unit )  (var iable cos ts / unit )

It should be noted that this is an operating break-even volume.

Break-even analysis can be used in three separate but related ways:
1. To evaluate a new product decision. How large must the sales volume be to break-even? If sales
are not expected to reach the break-even point, attempts could be made to reduce either the fixed
– or the variable costs.
2. To study the effect of a general expansion in the level of operations. Now the break-even point is
calculated on the basis of the amount of naira sold instead of on units of output. This enables us
to determine a general break-even point for a firm that sells many products at varying prices.
Only three figures are needed: Sales, fixed costs and variable costs. Sales and total-cost data are
readily available from annual reports. The major fixed charges (rent, interest, depreciation and
general expenses) have then to be deducted from the total-costs to find the variable costs. The
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 formula we use to calculate the breakeven point is now a little different:
total fixed cos ts
 BEPcark  total var iabl e cos t
1  (total sales

[This can be understood when we realise that the ratio: (total variable costs/total sales volume) is fixed
for any level of sales].

3. To analyse the degree of operating leverage to be employed in a firm. Operating

leverage reflects the extent to which fixed costs are used in operations. The operating
leverage can be explained in the following graphs:
A B
Cash or Cash or 
Revenue  Revenue

0.3 0.75
BA Units BB
Units

     Indicating the deg ree of

C 
operating leverage

1.0
Bc Unit

Three firms A, B and C with differing degrees of leverage, are compared. Firm A has a relatively small
amount of fixed charges (it does not have much automated equipment), its variable cost line, however,
has a relatively steep slope, denoting that its variable costs per unit are higher than those of the other

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firms. On the other hand, firm C has the highest fixed costs. It is highly automated, using expensive
machines that require very little labour per unit produced. With such an operation, its variable costs rise
slowly. Because of the high overhead C reaches its break-even point, however, its profits rise faster than
do those of the other firms.
The degree of operating leverage is now defined as follows: “The percentage change in operating
income (profit) that results from a percentage change in units soild”.

Percentage change in operating income

Degree of operating leverage  or:
percentage change in sales

Q( P _ V ) S  VC
Degree of operating leverage at point Q  
Q( P _ V ) S  VC  F
where Q: operating level
P: price/unit
V: variable cost/unit
F: fixed cost
S: total sales (given Q)
VC: total variable cost (given Q).
In summary, the calculation of the degree of operating leverage indicates how sensitive the
operation income (profit) reacts to changes in sales volume.
Proof Change in output = Q; Fixed costs are constant, thus the change in profit is Q(P-V).
The initial profit is (QP - V) E therefore present change in profit is
 Q( P  V )
Q (P  V )  F

Percent change in output is Q/Q, therefore the ratio of change in profit to change in output to
Q ( P  V )  F Q (P  V )

Q (P _V )  F Q (P _V )  F
Q / Q

The cash break-even analysis

Some of the firm’s fixed costs are non-cash outlays, and for a period some of its revenues may
be in receivables. We can now construct a cash – break-even chart by deducting the non-cash
outlays and revenues from the total costs and revenue lines. In particular when the depreciation
is a large part of the fixed costs, this will reduce the cash break-even dramatically.

Cost or
Revenue

ADEFILA & JAJU 12

Depreciation

B CASH B Units
Fixed Cost  ( Non Cash Outlays )
Thus ( BEV )c 
Contributi on M arg in

A cash break-even analysis is useful to present a picture of the flow of funds from operations. A firm
could incur a level of fixed costs that would result to losses during periods of poor business but in large
profits during upswings ( a high degree of operating leverage). If cash outlays are small, even during
period of losses, the firm might still be operating above the cash break-even point. Thus, the risk of
insolvency in the sense of inability to meet cash obligations, would be small.

2. The funds flow analysis

The funds flow analysis is another important tool in evaluating the firm’s operations. It gives insight
into the “flow of funds”, i.e. where they came from and where they have gone or are going to. Two
important aspects of the funds flow analysis are here to be recognized:
- The funds flow analysis can cover past data: it reflects the flow of funds in the past. It then
evaluates past operating performance (a control device)
- The funds flow analysis can be used to show how a firm plans to acquire and employ funds
during some future period. It then projects the flow of funds into the future (a so called pro
forma funds flow analysis), and serves as a planning device.

A funds flow analysis can be based on the funds flow chart: “a systematic list of all sources (ins) and
employments (outs) of the financial means”.
To construct a funds – flow chart, the changes in balance sheet items from one year to the next must be
tabulated. Each change in the balance sheet may be classified as either a source or a use of funds,
according to the following pattern:

Source of funds: 1. Decrease in asset item

2. Increase in liability item
Use of funds: 1. Increase in asset item
2. Decrease in liability item.
The sources and uses of funds can be classified into short-term and long terms. The difference between
the long-term sources and uses will add to the working capital (to be discussed later).
Lets take an example:
ADEFILA & JAJU 13
 A. Long-term:
1. Sources: expected profit (P.A.T.) N125.=
depreciation N275.=+
cash flow N400.=
increased long-term dept N100.=+
N500.=+

2. Uses: dividend to be paid N 40.=

expected investments N200.=
redemption of long-term debt N125.=+
N365.=
increased working capital:
N135.=

B. Short-term
1. Sources: bank loan N 90.=
Increased creditors N220.= +
N310.=+

2. Uses: increased inventory N175.=

increased receivables N120 +
N295.=-
Increase in cash N15

The funds flow chart shows you now how for example growth in operations (higher fixed assets,
increased receivables, etc.) is financed by increase or a liability item (bank loans, other creditors). To
construct a pro forma funds flow chart a forecast of the several balance sheet items are required. This is
more difficult of course, but provides management and future lenders with much more interesting
information. The funds flow analysis becomes especially important if the firm’s liquidity position is not
too strong, since any decrease in working capital cab turn the firm into a state of insolvency.

IV. FINANCIAL FORECASTING AND BUDGETING

It is important for a financial manager to have a reasonably good estimate of its total needs for funds for
the next few years. Therefore it’s useful to know methods of forecasting the firm’s overall needs for
funds.
The Cash Flow Cycle
Recognizing that firms must have assets in order to make sales and that if sales are to be increased new
assets have to be required, we see that a growing firm is likely receivables, inventories) as well as long-
term (investments in fixed assets). Such a firm requires cash to provide for this investment, it can
therefore have a cash flow problem. The cash flow problem can be explained with the following
example
1. Suppose somebody invests a total sum of N50,000 to start the manufacturing of shirts. He has to rent a
plant, equipment etc. The financial situation can be shown in a balance sheet.

ADEFILA & JAJU 14

 ASSETS LIABILITIES____________
Fixed assets: Capital stock 50,000
Plant and equipment 30,000
Current assets:
Cash 20,000 ___ __
Total Assets 50,000 Total Liabilities 50,000

2. The firm receives an order t manufacture 10,000 shirts. The receipt of an order itself has no effect on
the balance sheet. However, in preparation for the manufacturing activity, the firm buys N20,000 worth
of cotton on terms of net 30 days. Without additional investment by the owners, total assets increase by
20.00, financed by the trade accounts payable to the supplier of the cotton. After the purchase, the firm
spends N20,00 on labour for cutting the cloth etc. Of the N20,000 total cost, N10,000 is paid in cash
and N10,000 is owed in the form of accrued wages. This is reflected in the balance sheet as follows:

ASSETS LIABILITIES____________
Fixed assets: 30,000 Capital stock 50,000
Current Assets Current liabilities
Work in process 10,000 Account payable 20,000
Cash 40,000 Accrued wages 10,000
TOTAL 80,000 TOTAL 80,000

3. In order to complete the shirts, the firm incurs additional labour costs of N20,000 and pays in cash.
Assuring that the firm wants to maintain a minimum cash balance of \n5,000 and additional N15,000
has to be borrowed from the bank to meet the wage bill.

ASSETS LIABILITIES ____________

Fixed assets 30,000 Capital stock 50,000
Current assets: Current liabilities
Cash 5,000 Accounts payable 20,000
Inventory of finished goods 60,000 Notes payable 15,000
Accrued wages 10,000
TOTAL 95,000 TOTAL 95,000

4. The firm ships the shirts on the basis of the original order, invoicing the buyer for N100,000
ADEFILA & JAJU 15
 within 30 days. Accrued wages and accounts payable have to be paid now, so the firm has to
borrow an additional N30,000 in order to maintain the N5,000 minimum cash balance.

______ ASSETS LIABILITIES____________________

Fixed assets: 30,000 Capital stock
50,000
Current Assets Retained earnings (profit) 40,000
Cash 5,000 Current liabilities:
Account receivable 100,000 Notes payable 45,000
TOTAL 135,000 TOTA 135,000

Note: The financial position of the firm is quite critical when the accounts receivable are not
settled. So the financial position of the firm depends now really on the credit worthiness
of the buyer.

5. The firm receives payment for the accounts receivable, pays off the bank, and is in a highly
liquid position.
________ASSETS LIABILITIES______________
Fixed assets 30,000 Capital stock 50,000
Current assets 60,000 Retained earnings 40,000
TOTAL 90,000 90,000

In the above example a basic business cycle is described, which will repeat if new orders are received.
Throughout the cycle a different amount of funds is needed to finance the operations. The cycle of
activities represents in fact also a cycle of cash flows. Over the course of several cycles, the fluctuation
in sales will be accompanied by a rising long-term trend. This can be shown as

Total permanent assets increase steadily in the form

ADEFILA & JAJU 16

of current and fixed assets. Increases of this nature should be financed by long-term debt, by equity, or
“spontaneous” increases in liabilities like accounts payable, accrued wages, etc., which naturally
accompany increasing sales. Temporary increases in assets, however, can be covered by the short-term
liabilities (bank loans etc.) Short-term financing for long-term needs is dangerous. A firm may become
unable to meet its cash obligations if fund borrowed on a short-term basis have become tied up in
permanent asset need.

Percent-of-Sales Method
The most important variable that influences a firm’s financing requirements is its projected sales volume.
So a good sales forecast is an essential foundation for forecasting financial requirements. Assuming we
know the sales forecast, the financial requirements can be derived as follows:
Consider the following balance sheet:

ASSETS LIABILITIES_________
Fixed assets 150,000 Common stock 100,000
Inventory 100,000 Retained earnings 100,000
Receivables 85,000 Bonds 70,000
Cash 10,000 Accounts payable 50,000
Accrued tax 25,000
TOTAL 345,000 TOTAL 345,000

From the profit and loss account we know that sales are N500,000 a year, the profit margin
after tax on sales is 4%. The P.A.T. was N20,000 and N10,000 was paid on dividends (50%). The
question now is, how much additional financing will be needed if sales expand to N800,000 during the
next year.
First, all those balance sheet items which can be expected to vary directly with sales, are
selected. Then, cash asset and liability item that necessarily moves with sales is divided by the total
sales volume. In percentage, this gives us the value of change of each item, with a change in the sales
volume. In our example this gives:

ASSETS LIABILITIES
Fixed assets 30.0% Common stock n.a
Inventory 20.0% Retained earnings n.a
Receivables 17.0% Bonds n.a
Cash 2.0% Accounts payable 10.0%
Accrued tax 5.0%
ADEFILA & JAJU 17
TOTAL ASSETS 69.0% TOTAL 15.0%
(n.a. = not applicable).
For every N1 increase in sales, assets much increase by 69 kobo; this 69 kobo must be financed in some
manner. A spontaneous rise of 15% in the liabilities will supply 15 kobo for each N1 increase in sales.
Subtracting the 15% for spontaneously generated funds from the 69% funds requirement leaves
54% i.e. 54 kobo to be financed from either retained earnings or from external resources. In our
example an expected increase of N300,000 in sales leads to the conclusion that N162,000 (54% of
300,000) will be needed. Some of this need will be met by retained earnings. Since 4% is earned on its
sales, the profit for the next year will be N32,000. An assumed 50% dividend pay out gives us N16,000
as retained earnings. This leaves a figure of N146,000 to be financed externally.
Similarly
Total funds needed = 69% of 300,000 = N207,000; 3 sources can be identified
1. Spontaneously generated funds = 15% of 300,000 = N45,000
2. Retained Earnings = 4% of 800,000(1-50/100) = N16,000
3. External financing = 207000-(45000+16000) = N146,000
This figure can also be found with the following expression:
A
External funds needed =  DS   L  DS  M .S 21  d 2 
S S
Where A = assets
S = sales
A/S = % increases in assets
L/S = % of spontaneous increase in liabilities
M = profit margin
S2 = projected sales
∆S = increase in sales
d = dividend payout percentage

If the sales forecast for the next year was only N515,000 (a 3% increase), we find with the above
formula an external; funds need of (21,200), which means that no external funds are required.
This shows that small increases of the sales volume can be financed internally, but that higher levels of
sales bring about need for external funds. Larger increases cause a firm to go into the market for
outside capital. In other words, a certain level of growth can be financed from internal sources, but
higher levels of growth require external financing. The percent-of sales method is most appropriately
used for forecasting because this method assumes a linear relation that passes through the origin
between sales and any of the balance sheet items. For longer term forecasts, this method would cause
too big errors.
Linear – Multiple Regression Method
ADEFILA & JAJU 18
This method gives a more exact relation between changes in the sales volume and changes in the balance
sheet items. With the help of these methods it is therefore possible to extrapolate over longer future
periods and so to calculate future financial needs, following the same approach as above.
Financial Planning and Control:

A budget is simply a financial plan. It is a plan detailing how funds will be spent on labour, raw
materials, capital goods, and so on: as well as how funds for these expenditures will be obtained. A
budget is a management tool used for both planning and control. Depending on the nature of the
business, detailed plans may be formulated for the next few months, the next year, the next five years or
even longer. Fundamentally, budgeting is a continuous process of improving operations; it is a
continuous effort to specify what should be done and to get the job done in the best possible way.
Historically, budgeting was treated as a device for limiting expenditures. The more modern approach is
to view the budgeting process as a tool for obtaining the most productive and profitable use of the
company’s resources.
The budget forces management
(1) To plan
(2) To coordinate activities
(3) To keep adequate records and
(4) pin-point inefficiency.
The budget requires a set of performance standards or targets. Budgets are reviewed to compare plans
and results. It is a continuous monitoring procedure; reviewing and evaluating performance with
reference to the previously established standards (feed back process). One of the most important
budgets is the “cash budget”. The cash budget indicates not only the total amount of financing that is
required but its timing as well. This statement shows the amount of funds needed monthly, week by week
or even on a daily basis. Another important type of budget is the flexible budget. This type of budget is
regularly (monthly, 2 months, etc) reviewed and adjusted for changes (especially changes which are
beyond management control).

V. WORKING CAPITAL MANAGEMENT

Working Capital Management deals with the items on the lower part of the balance sheet: the current
assets and current liabilities and the inter-relationship between these two sets of accounts. Working
Capital as such refers to a firm’s investment in short-term assets: Cash, short-term securities, accounts
receivable and inventories. Net working capital is defined as current assets minus current liabilities.
Current asset holdings should be expanded to the point where marginal returns on increases in such
assets are just equal to the cost of capital required to finance these increase, while current liabilities
should be used in place of long-term debt whenever their use lowers the average cost of capital.

ADEFILA & JAJU 19

The Importance of Working Capital Management
Working capital management is an important aspect of financial management. Several reasons can be
mentioned:
- characteristically, current assets represent more than one-half the total assets of a business
firm. Because they represent a large investment and because this investment tends to be
relatively volatile, current assets are worth careful attention.
- Working capital is particularly important for small firms. A small firm may minimize its
investment in fixed assets, (renting equipment) but there is no way it can avoid an
investment in cash, receivables and inventories. Further, because a small firm has relatively
limited access to the long-term capital markets, it must necessarily rely heavily on trade
credit, and short-term bank loans, both of which affect net working capital by increasing
current liabilities.
- There is a close relationship between sales growth and the need to finance current assets.
Sales increases produce similar immediate needs for additional cash. All these needs must
be financed, and since they arise so quickly, it is important that the developments in the
working capital segment of the firm are kept under close control.

The Concept of “Working Capital”

The term working capital originated from the time that most industries were closely related to
agriculture. Processors would buy crops in the fall, process them, sell the finished product and end up
just before the next harvest with relatively low inventories. Short-term bank loans are used to finance
both the purchase and the processing costs, and these loans were retired with the proceeds the firm
obtained from the sale of the finished products. (the cash flow cycle concept).

ADEFILA & JAJU 20

Financial need
Short tem credit

Long term debt plus

Fixed Asset equity capital

Time

The picture illustrates the general nature of the production and financing process, and working capital
management consist of decisions relating to the top section of the gap – managing current assets and
arranging the short-term credit used to finance them. In the more modern business the production and
financing cycles changed, as we have seen before.
Although, seasonal patterns still exist and business cycles also caused asset requirements to fluctuate, it
is very rare in modern business that current assets drop to zero. This leads to the idea of “permanent
current assets”.

The Problem of Working Capital Management

Working capital management focuses now on two policy questions, one is related to the asset side of the
balance sheet and one to the liability side:

ADEFILA & JAJU 21

1. The level of current assets to be held (assets management).
2. The relation between types of assets and the way they are financed (liabilities management)

The level of current assets to be held is determined by two factors:

- The minimum required amount of each type of current asset (cash, marketable securities,
inventories, etc).
- A “safety stock” to account for the fact that forecasts are imperfect.
If it could forecast perfectly, a firm would hold exactly enough cash to make disbursements as required,
exactly enough inventories to meet production and sales requirements, etc. The current Assets holding
under the perfect forecast case would be the theoretical minimum for a profit maximizing firm. Any
larger holdings would increase the firm’s assets without a proportional increase in its returns, thus
lowering its rate of return on investment. Any smaller holdings would mean the inability to pay bills on
time, lost sales and production stoppages because of inventory shortages. However, forecasting
perfectly is impossible and a firm always has to deal with uncertainties in its sales, production and other
conditions, and consequently in the related asset items. Therefore, a “safety stock” is required to prevent
the company running out of money, inventory, etc. and to be able to respond directly to unexpected
change in any condition (the market, competition, etc.) “Safety stock” reduces the risk of operations but
at the same time reduces its returns. On the other hand, low levels of safety stock or no safety stock at
all will increase its returns (no unproductive assets) but increases its risk as well. So the financial
manager has to make a risk-return trade off for the level of current assets it wants to maintain. Two
extreme policies can be chosen:
1. A conservative policy: a relatively high level of current assets: low risk low returns
2. An aggressive policy a relatively low level of current assets: high risk, high returns

This becomes clear in the following example:

Conservative Average Aggressive
Sales 100 100 100
Earnings before interest and tax (E.B.I.T.) 15 15 15
Current assets 61 50 38
Fixed assets 50 50 50
Total assets 111 100 88
Rate of return on assets 13..5% 15.0% 17.0%
Under the aggressive policy the highest rate of return is realized. However, we know that this policy is
the most risky one, since lost sales, lost customer good will, and bad credit ratings caused by poor
liquidity ratios could combine to bring the actual realized rate of return well below the anticipated 17%.

ADEFILA & JAJU 22

After establishing the level of current assets, we have to look at the policy decision on how to finance
these assets (liabilities management). As we have seen, part of the current assets could be regarded as
permanent and can be financed by short-term as well as long-term debt. The question now is which part
to finance with short-term debt and which part to finance with long-term debt. In other words, where to
draw the dashed line in the figure. In considering such a debt policy the financial manager again, has to
make a risk-return trade off involving the following aspects of the two types of debt.

1. Flexibility: Short-term debt can be laid off when the financing need is gone. Short-term debt
therefore provides for flexibility. It enables the company to match its financing exactly with its
current needs.
2. Costs: Interest rates on short-term debt are generally lower than on long-term debt. Therefore a
firm’s capital will be probably less costly if it borrows short-term rather than long-term.
3. Risk: The use of short-term debt usually subjects the firm to more risk than does long-term
debt. This risk effect occurs for two reasons.

(a) If a firm borrows on a long-term basis, its interest costs will be relatively stable over
time, but if it borrows on a short-term basis, its interest expenses will fluctuate widely.
(b) If a firm borrows heavily, on a short-term basis it may find itself unable to repay this
debt or in such a shaky financial position that the lender will not extend the loan and,
thus, may be forced into bankruptcy.

In particular, the risk to run into temporary difficulties (recession in demand, competition, etc.), likely to
affect the firm’s ability to repay its debt, has to be considered very seriously. In such cases new loans
have to be negotiated with its creditors on very unfavourable terms. Because of the increased risky
position of the firm, creditors will raise the interest rate charged. In the extreme, they will refuse to
renew the loan. In this latter event, the firm will be forced to raise funds needed to pay off the loan by
selling assets at bargain basement prices, borrowing from other sources at exorbitant interest rates or
going bankrupt.

The risk-return tradeoff created by the above aspects (using short-term debt is less costly than long-term
debt but entails greater risk than does using long-term debt) can be shown in the following example:

ADEFILA & JAJU 23

 Conservative Average Aggressive
Current assets 50.0 50.0 50
Fixed assets 50.0 50.0 50
Total assets 100.0 100.0 100.0
Short-term credit (6%) - 25.0 50.0
Long-term credit (8%) 50.0 25.0 -
Current ratio  2:1 1:1
Earnings before interest and taxes (E.B.I.T.) 15.0 15.0 15.0
Interest 4.0 3.5 3.0
Taxable income 11.0 11.5 12.0
Tax (50%) 5.5 5.75 6.0
Earnings on common stock 5.5 5.75 6.0
Rate of return on equity (%) 11.0 11.5 12.0
(R.O.E.)

Again, two extreme policies are shown, a policy which bases its financing extremely on long-term debt is
called a conservative policy, (less risk, low earnings); a policy based on a short-term debt financing is
called aggressive (high risk, high earnings). Our example shows that the aggressive policy gives relative
higher earnings on equity. What happens however if uncertainty is introduced? Suppose the interest
rate for short term debt increases with 4%. This rise would not affect the firm using the conservative
policy, but would increase the interest expense under the average policy to N4.5 million and under the
aggressive policy to N5 million. The R.O.E. for the three policies would consequently be 11.0%, 10.5%
and 10% respectively - a reversal in relative ranking by R.O.E. Of course, a decline in the interest rate
would have the opposite effect. It should be clear however that the variability of the return under an
aggressive policy is more than that under a conservative policy. Fluctuations in earnings before interest
and taxes (E.B.I.T.) can pose even more severe problems - if EBIT declines, lenders may simply refuse
to renew short-term debt or agree to renew it only a very high rates of interest, which jeopardizes the
firm's future even more and, at the same time, compound the effects of the declining EBIT on
stockholders return.

ADEFILA & JAJU 24

The Working Capital Policy
The working capital policy relates the management of the current assets with that of the current
liabilities and involves both policy decisions discussed above. In fact neither of the policy decisions can
be considered independently of each other, because it is their combination that influences the total picture
(i.e. ratios) of the firm's financial condition. Again two extreme policies can be distinguished:

1. a conservative policy providing for a large investment in current assets financed by long-term
debt.
2. and aggressive policy using minimal investment in current assets, all financed by short-term
debt.

The effect of both policies on R.O.E. and the current ratio can be illustrated by the following example:

Conservative Average Aggressive

Current assets 61 50 38
Fixed assets 50 50 50
Total assets 111 100 88
Short-term debt (6%) - 25 44
Long-term debt (8%) 55.5 25 -
Total debt 55.5 50 44
Equity 55.5 50 44
Total liabilities 111 100 88
Sales 100 100 100
EBIT 15 15 15
Less: Interest 4.4 3.5 2.64
P.A.T. 10.6 11.5 12.36
Tax 5.3 5.75 6.18
P.A.T. 5.3 5.75 6.18
R.O.E. 9.6% 11.5% 14.0%
Current Ratio  2 .86

ADEFILA & JAJU 25

A conservative policy calling for no short-term debt and large holdings of current assets results in a
9.6% R.O.E. and a very high () current ratio. An aggressive policy, with minimal holdings of current
assets and short-term rather than long-term debt, raises the expected return to 14%. But the current
ratio under this policy is only .86, a dangerously low level for most industries (the current ratio is one of
the most important ratios on which the firm's credibility is assessed). Simultaneously, the increasing risk
associated with the aggressive policy might adversely affect stock market opinion about the company, so
that even with high rates of return the net effect still might be to lower stock prices.

VI. CURRENT ASSETS MANAGEMENT

In the preceding chapter we viewed working capital management in a general, overall sense. Now we
focus our attention on a firm's optimal investment in specific current assets: cash, marketable securities,
accounts receivable and inventories.

Cash
Cash consists of the firm's holdings of currency and demand deposits, with demand deposits being far
the more important for most firms. There are three primary motives for holding cash:
1. The transactions motive: cash enables the firm to conduct its ordinary business-making
purchases and sales. The amount of cash to be held depends on the type of business. Hence the
cash-to-revenue ratio and cash-to-total assets ratio will vary with type of business.
2. The precautionary motive: relates primarily to the predictability of cash inflows and outflows.
If the predictability is high, less cash must be held against any emergency or any other
contingency. Secondly the borrowing ability on short notice is an important factor in holding
cash. Borrowing ability is primarily a matter of strength of the firm's relation with its bank(s)
or other credit sources.
3. The speculative motive, to hold cash in anticipation of profit-making opportunities that may
arise.
There are still two other important reasons;
4. To meet "terms of sale", i.e. discounts in paying the bills within certain terms.
5. To maintain its credit standing, in order to meet the standards of the line of business in which it
is engaged. It is important for a firm to maintain its current and acid test ratios as they are key
items in credit analysis.

Cash holding can be minimized by the following measures:

(a) Synchronization of cash flows, i.e. matching of cash holdings with the need for funds. This can
be realized by frequent requisitioning of funds by divisional offices from the firm's main or
central office. Also effective forecasting can reduce the investment in cash.

ADEFILA & JAJU 26

(b) Expediting collections and cheque clearing. Speeding up the process of collection and clearing
of cheques can reduce the amount of cash required substantially.
(c) Slowing disbursement. Just as expediting the collection process conserves cash, slowing down
disbursements accomplishes the same thing by keeping cash on hand for longer periods.
Delaying payment is of course legally restricted.
(d) Using float. Float is the difference between the balance shown in a firm's (or individuals)
cheque book balance and the balance on the bank's books. If a firm's own collection and
clearing process is more efficient than that of the recipients of its cheques, then the firm could
show a negative balance on its own records and a positive balance on the books of its bank.

Marketable Securities
There are two main reasons why firms might hold marketable securities:
(a) As a substitute for cash. Some firms hold portfolios of marketable securities in lieu of larger
cash balance, liquidating part of the portfolio to increase the cash account when cash outflows
exceed inflows.
(b) As a temporary investment. Firms engaged in seasonal operations invest their surplus cashflows
during part of the year and liquidate these securities when cash defects occur. Firms may also
accumulate their short-term investments to meet predictable financial requirements.
Criteria in selecting security portfolios are:
1. Risk of default. The marketable securities portfolio is generally confined to securities with a
minimal risk of default.
2. Marketability. Securities held in port-folio must be readily marketable to provide cash at any
time.
3. Maturity. Because long-term bonds fluctuate much more with changes in interest rates than
does the price of short-term securities, they are much riskier for a firm's marketable security
port folio.

Accounts receivable (credit policy)

The level of accounts receivable is determined by two factors:
1. the volume of credit sales and
2. the average collection period (period between sales and collections).

The following controllable factors or credit policy variables are here involved:

(a) Credit standards. The optimal credit standard involves equating the marginal costs of credit to
the marginal profits on the increased sales. Cost of credit is related to the "quality" of the
ADEFILA & JAJU 27
 accounts; that is the chance of default or bad debt losses, higher collection costs and probably
delay of payment. In the evaluation of the credit "quality" of a customer the following five C's
are considered: character, capacity, capital, collateral and conditions. These five C's of credit
represent the factors by which the credit risk is judged. To evaluate the risk properly, viable
information of the customer is required.

(b) Terms of credit. The terms of credit specify the period for which credit is extended and the
discount if any, given for early payment. Lengthening the credit period stimulates sales, but
consequently a cost is incurred in tying up funds in receivables.

(c) Collection policy. This policy refers to the procedures the firm follows to obtain payment of
past-due accounts.

Inventory
Manufacturing firms generally have three kinds of inventories: raw materials, work in progress, and
finished goods. The level of raw material inventories are influenced by anticipated production, reliability
of sources of supply and the efficiency of scheduling purchases and production operations.
Work-in-process inventory is strongly influenced by the length of the production period. Inventory
turnover can be increased by decreasing the production period (perfecting engineering techniques). The
level of finished good inventories is a matter of coordinating production and sales. The financial
manager can stimulate sales by changing credit terms. Although wide variations occur, inventory-to-
sales ratio are generally concentrated in the 12-20% range and inventory - to - total assets ratios are
concentrated in the 16 to 30% range. The major determinants of investment in inventory are:
1. level of sales,
2. length and technical nature of the production processes,
3. durability versus perishability or style factor in the end product.

Managing assets of all kinds is basically an inventory problem. The same methods (for example in
calculating the optimal level) of analysis applies to cash and fixed assets as applies to inventories
themselves. First, a basic stock must be on hand to balance inflows/outflows of the items, with the size
of the stock depending upon the patterns of flows, whether regular or irregular. Second, because the
unexpected may always occur, it is necessary to have safety stocks on hand. They represent the little
extra to avoid the costs of not having enough to meet current needs. Third, additional amount may be
required to meet future growth needs. These are anticipation stocks. Furthermore, we have to recognize
optimum purchase sizes, defined as economical ordering quantities. It is generally cheaper to purchase

ADEFILA & JAJU 28

big lots than small ones (this is true for raw materials, money, parts, etc.). (Note recall our discussion
on inventories in production Management).

VII. SOURCES AND FORMS OF SHORT-TERM FINANCING

Having discussed several ways to minimize the investment in current assets, we will now have a closer
look at how this investment can be financed. Accordingly, we take up the main forms of short-term
credit, considering both the characteristics and the sources of this credit.

Short-term credit is defined as debt originally scheduled for repayment within one year. Ranked in
descending order by volume of credit supplied to business, the main sources of short-term financing are:
1. trade credit between firms.
2. loans from commercial banks
3. commercial paper.

Trade Credit
In the ordinary course of events, a firm buys its supplies and materials on credit from other firms,
recording the debt as an account payable. Accounts payable or trade credit - as it is called - is the
largest single category of short-term credit, and it represents about 40% of the current liabilities of non-
financial firms. This percentage is somewhat larger for smaller firms, because these may not qualify for
financing from other sources (banks) and therefore have to rely heavily on trade credit. Trade credit is a
"spontaneous" source of financing in that it arises from ordinary business transactions. If its sales and
consequently its purchases, double, accounts payable will also double. Similarly, if the terms of credit
are extended from say thirty to forty days, accounts payable will expand proportionally.

The terms of sales, or the credit terms, describe the payment obligation of the buyer. The four main
factors that influence the length of credit terms are as follows:

1. the economic nature of the product. Commodities with high sales turnover are sold on relatively
short credit terms; the buyer resells the products rapidly, generating cash that enables him to pay
his supplier.
2. seller circumstances. Financially weak sellers must require cash or exceptionally short credit
terms; they cannot afford to give credit. Financially strong seller on the other hand are
frequently suppliers of funds to small firms.
3. buyer circumstances. Financially strong seller who sell on credit may receive - in turn - longer
credit terms from their suppliers.

ADEFILA & JAJU 29

4. cash discount. A cash discount is a reduction in price based on payment within a specified
period. The cost of not taking cash discount often exceeds the rate of interest at which the buyer
can borrow. One should be very careful in using trade credit as a source of financing - it could
be quite expensive.

Concept of "Net Credit"

As we can seen from above and the previous chapter, trade credit has double-edged significance for the
firm. It is a source of credit for financing purposes and a use of funds to the extent that the firm
finances credit sales to customers. The difference between the accounts receivable and accounts payable
is called the net credit.
Net Credit = Accounts Receivable - Accounts Payable.
This concept can be visualized in the following figure:

Large and well-financed firms tend to be net suppliers of trade credit (N.C.>0); small firms and under
capitalized firms tend to be net users of trade credit (N.C. < 0).

ADEFILA & JAJU 30

The following advantages and disadvantages can be stated on trade credit:

Advantage Disadvantage
flexible often more expensive
informal (it can even be dangerous if one is not aware of
always available this).

Sometimes however trade credit represents a virtual subsidy or sales promotion device offered by the
seller to introduce - for example - a new product.

Short-term Credit from Commercial Banks

Commercial bank lending appears on the balance sheet as notes payable. Banks occupy an important
position in the short and intermediate-term money markets. Their influence is greater than appears from
the amounts they lend, because they provide non-spontaneous funds. As the financing needs of a firm
increases due to extra growth or new activities it requests the banks to provide the additional funds. If
denied, the only alternative is to slow down growth rate or to cut back operations.

Characteristics of Bank Loans

(a) The Form of Loans. A loan can take many forms, determined by (1) the signing of a promissory
note (2) a repayment schedule (3) and an interest rate (4). In a promissory note the terms of the
loan are defined. The repayment can be made in a lump sum at the end of the loan (maturity) or
in regular installments throughout the life of the loan. The interest rate depends on many
factors: prime rate, life of the loan, repayment schedule, risk (creditability), etc.

(b) The line of credit; establishes the loan ceiling (maximum loan balance) up till which the
borrower is allowed to borrow on a more or less permanent basis.

(c) Size of customer. The size of the customer is an important determinant in the amount he can
borrow (the height of the loan ceiling).

(d) Security. Forms of security may be required, if a potential borrower is a questionable credit risk
(credit ratios) or if his financing needs exceed the amount that the loan officer considers to be
prudent. If possible it's better to borrow on an unsecured basis, but frequently a loan has to be

ADEFILA & JAJU 31

 secured by some form of collateral to be claimed in the event of default (about 2/3 of the bank
loans are secured). Several types of collateral can be employed. Especially inventories and
accounts receivable are important collateral for short-term loans, also a third party may secure
the loan (taking over the risk of default).

(e) Compensating balances. Banks require that a regular borrower maintains an average checking
account balance equal to 15-20% of the total outstanding loan. These balances, which are
called compensating balances, are a method of raising the effective interest rate.

(f) Repayment of bank loans. Because the bulk of bank deposits (as an important source from
which loans are financed) is subject to withdrawal on demand, banks can not afford to provide
bank credit for permanent financing (for example to finance fixed assets). A bank may therefore
require its borrowers to "clean up" their short-term bank loans for at least one month/week each
year.

(g) Cost of bank credit. This depends totally on the economic situation and the characteristics of
the firm.

Commercial Paper
This is the smallest category of short-term credit. It's something like a bank loan, but its an arrangement
between individual firms (no bank is involved). It consists of promissory notes from especially large
firms. The buyer of these notes can claim money in return, eventually from this firm. There is an open
market for these notes, so they can be sold any time additional finance is required. The use of the open
market however is restricted to firms that are exceptionally good credit risks. Interest rates of
commercial paper are the lowest available, but the related risk is substantial (especially if no personal
relation exists, as it does with bank relation).

VIII. SOURCES AND FORMS OF LONG-TERM FINANCING

In this chapter we will move to the higher right hand side of the balance sheet, discussing the various
types of long-term funds available to a firm when it seeks financing of its more permanent capital needs;
like the purchase of fixed assets.
Basically two types of funds are available: LONG TERM
FINANCING
(1) Funds originating from a firm's sale of its equity and the retention of its earnings;
(2) Through its ability to assume debt.
EQUITY DEBT

RETAINED
STOCKS BONDS LONG TERM LOAN VENTURE FINANCE LEASING
EARNINGS

ADEFILA & JAJU 32

COMMON STOCK
CONVERTIBLES

PREFERED STOCKS
EQUITY
Equity constitutes the first source of funds to a new business and the base of support for borrowing by
existing firms. Equity represents the ownership of the firm and may take several forms:
Common Stock
The most common type of equity is the common stock. The owners of common stock carry certain
rights and responsibilities. They have associated positive and negative considerations. The positive
consideration are income potential and control. The negative considerations are loss potential, legal
responsibilities and personal liability. In fact these positive and negative considerations are two sides of
the same coin: the right to income carries risk of loss, control also involves responsibility and liability
(risk-return trade off). The rights of the stockholders of a firm are established by the law and by the
terms of the charter granted to the firm. The characteristics of charters are relatively uniform on basic
matters, including the following two:
Collective Rights:
Certain collective rights are usually given to the holders of common stock. Some of the more important
rights allow stockholders
(1) to amend the charter
(2) to adopt and amend by-laws,
(3) to elect directors of the corporation,
(4) to authorize the sale of fixed assets,
(5) to enter into mergers
(6) to change the amount of authorized common stock,
(7) to issue preferred stock, bonds, etc.
Specific Rights
Holders of common stock also have specific rights as individual owners. They have the right:
(1) To vote,
(2) to sell their stock certificate (and in this way transfer their ownership interest to other
persons,
(3) to inspect the corporate books,

ADEFILA & JAJU 33

 (4) to share residual assets of the corporation on dissolution; however the holders of
common stock are last among the claimants to the assets of the corporation.

Other rights will differ from firm to firm, but we have to mention here one more right which is nearly
always part of a corporate charter the so called preemptive right.

The Preemptive Right

This right gives the holders of common stock the first option to purchase additional issues of common
stock. The purpose of this right is two fold: First, it protects the power of control of the present
stockholders. It is impossible for management under stockholders criticism, to issue large numbers of
low priced shares and buy it themselves thereby securing control of the firm and frustrating control of
the current stockholders. The second, and by far the more important, protection that the preemptive
right affords stockholders regards dilution of value. Assume that 4,000 shares of common stock each
with a price (market value) of N100 are outstanding, making the total market value of the firm
N400,000. An additional 1,000 shares are issued and sold at N50 a share or for N50,000. Under
assumption that the market value of the shares exactly reflects the new funds brought in, the total market
value of the common stock after the issue will be N450,000. When the total market value is divided by
the new total shares outstanding a value of N90 a share is obtained. Thus selling common stock at
below market value will dilute the price of common stock and will be detrimental to present stockholders
and beneficial to those who purchased the new shares.
The preemptive right prevents this, by giving the existing stockholders the option to buy a certain
number of the new shares. The terms of the option are contained on a piece of paper called a "right".
Each stockholder receives one right for each share of stock he owns. The number of rights necessary to
buy a new issued share depends on the number of shares. In our example we wanted to raise N50,000
in new equity funds selling 1000 shares of new stock at a price of N50 a share. If there were originally
4,000 shares, each stockholder will have to surrender:
old shares 4,000
= = 4 rights plus N50 to receive one of the newly issued
new shares 1,000
shares.

It is clearly worth something to be able to buy for N50 a share of stock which after the issue will have a
market value of N90. The "right" provides this priviledge, so the right must have value. At the first
glance we would say that the right in our example would have a value of N40 (market value after issue-
sales value or book-value), but since we need 4 rights to buy a new share each right is worth only N10.
If a stockholder doesn't want to exercise his rights, he is able to sell the rights which protects him from
suffering a loss due to the drop in value of his property after the issue. However if he exercises his

ADEFILA & JAJU 34

rights, he will have no extra gain, since his old property decreases in value the same amount as his new
shares are bought under their market value.
Suppose a stockholder has 4 shares with a total market value before the issue of 4 x 100 = N400.
Exercising his rights and buying one new share brings the value of his stock to N450 (N400 + N50 or 5
x N90). Not exercising his rights and selling them leaves him with his original stock, which has now a
value of 4 x N90 = N360, and the revenue of the sale of 4 x N10 = N40 totalling N400, the original
value of his stock. The advantage of using "rights" in financing new capital requirements is, that it
increases the likelihood of a favourable reception of the new issue. By their ownership of common stock
in the firm, these investors have already indicated a favourable evaluation of the company and they may
be receptive to the purchase of additional shares.

Common Stock as a Source of Funds

From the point of view of the issuer of shares, common stock has the following advantages and - the
other side of the coin - disadvantages.
Advantages:
1. Common stock doesn't entail fixed charges. If the firm generates earnings it may pay common
stock dividends, however there is no legal obligation to do so. It is entirely up to the
management, the board of directors, the stockholders and the Federal law, if and how much
dividend should be paid.
2. Common stock carries no fixed maturity date. So there is no obligation to pay back the money
the stockholder put into the firm, any time unless the firm is dissolved.
3. Since common stock provides a cushion against losses for creditors, the sale of common stock
increases the credit - worthiness of the firm.
4. Common stock may be at times an easier source of funds than debt for two reasons:
- it typically carries a higher expected return than does debt.
- it provides the investor with a better hedge against inflation, because it represents the
ownership of the firm.

Disadvantages:
1. The sale of common stock extends voting rights or control to the additional stock owners who
are brought into the company. For this reason additional equity financing is often avoided by
small and new firms.
2. Common stock gives more owners the right to share in income. The use of debt may enable the
firm to utilize funds at a fixed cost, whereas common stock gives equal rights to new
stockholders to share in the net profits of the firm.

ADEFILA & JAJU 35

3. The cost of issuing new stock is usually high, because they are more risky to buy. This means
that the risk has to be diversified i.e the stock has to be sold to a greater number of purchasers
than the same amount of debt.
4. Common stock dividends are not deductible from tax, in contrast to interest paid on debt.

Preferred Stock (PS)

Preferred stock is a variant of common stock. It represents ownership having certain rights which rank
it ahead of common stock, but behind debt. Therefore preferred stock is sometimes not regarded to be
equity, but a hybrid type of fund between equity and debt. The preference may be a prior claim on
earnings, it may take the form of a prior claim on assets in the event of liquidation or a preferential or
backward position with regard to a say in the firm's affairs (voting privileges). In the case of a prior
claim on assets there is usually an indicated fixed dividend, which makes it look like debt. However if
the fixed dividends are not earned, the company is not obliged to pay them (as it is with interest on debt),
so there is no danger of bankruptcy, Very often dividends on preferred stock is cumulative i.e. all past
preferred dividends must be paid before common dividends may be paid. The cumulative feature is
therefore a protective device. Another important feature of preferred stock is a possible arrangement to
convert it into common stock at the option of the preferred shareholder (see "convertibles").
An important advantage of preferred stock from the view point of the issuer is that, in contrasts to debt,
the obligation to make fixed interest payments is avoided. Also, a firm wishing to expand because its
earning power is high may obtain higher earnings for the original owners by selling preferred stock with
a limited return rather than by selling common stock. Even so the common stock holder will receive the
advantage (or disadvantage) of leverage.
An important disadvantage is that, though preferred stock may look like debt the fixed dividend is not
deductible for tax purposes. Furthermore preferred stock carries generally higher rates than does debt
because of the greater risk inherent in preferred stock from the holder's point of view (no security and no
legal interest obligation).

Retained Earnings
An important source of funds considered to be equity is the retained earnings. "Retained earnings" here
refers to that part of the current earnings (P.A.T.) which is not paid out in dividends but, rather is
retained and reinvested in the business. On the balance sheet the item retained earnings or earned
surplus, consists of all the earnings retained in the firm throughout its history and adds up to the total
capital reserves of the company.
Retained earnings are one of the most significant sources of funds for financing corporate growth, so
called "internal financing". The amount of the earnings retained depends on the dividend policy of the
firm. The dividend policy should be considered in the light of two desirable but conflicting goals: a

ADEFILA & JAJU 36

higher dividend rate (pay-out ratio) mean less retained earnings and, consequently, a slower rate of
growth in earnings and stock prices (reflecting the value of the firm). Factors influencing the allocation
of profits between dividends and retained earnings (i.e. the dividend policy) are:
1. Legal rules
A company is not allowed to pay out dividends while it is insolvent i.e. when liabilities exceed
assets. Paying out dividend under such conditions would mean giving stockholders funds that
rightfully belong to the creditors.
2. Liquidity position
Current profits held as retained earnings are generally invested in working capital, especially if
operations are expanding.
3. Required reserves
If a company assumed debt (for example to finance expansion) and it doesn't want to renew the
debt when it comes due, it will generally require the retention of earnings to create reserves for
paying off the debt.
4. Growth rate
If a firm expects rapid growth, the greater its needs for financing asset expansion will be and
consequently the more likely the firm is to retain earnings.
5. Stability of earnings
A relatively stable earnings record enables a firm to maintain a higher pay-out ratio. An
unstable firm has to provide for unexpected down fall of earnings through the creation of
reserves (retention of earnings) if it wishes to maintain a stable dividend policy.
6. Access to capital markets
Small, new or risky firms will have restricted access to capital markets and therefore have to
rely heavily on internal financing.
7. Stockholders attitude
May be the most crucial factor in a firm's dividend policy are its stockholders. Their preference
of a high dividend rate to have quick gains on their investment (less risk), or a growth in the
firm's value resulting in capital gains when selling their stock. Also the tax treatment of
dividend earnings and capital gains might influence their preference.

Generally, a stable dividend policy gives the greatest confidence in a firm's operations and therefore a
stable market price of its stock. This might become important, when a firm wants to raise new capital
through the issuing of new stock.

LONG-TERM DEBT

ADEFILA & JAJU 37

Assuming debt by using borrowed money is the second important type of funds generally available to a
company. Two major classes of long-term debt can be distinguished: bonds and long-term loans.

Bonds
A bond is a long-term promissory note. A long-term relation between borrower and lender is established
in a document called an indenture. Such an indenture may be a document of several hundred pages
covering a large number of factors that will be important to the contractual parties. It discusses the form
of the bond, gives a complete description of the property - if any - pledged and all regulations governing
the relation between borrower and lender (bond holder).

Bonds are sold, through a trustee in specific denominations to a large number of purchasers. The trustee
is the representative of the bond holders and is presumed to act at all times for the protection of the bond
holders and on their behalf. Typically the duties of the trustee are handled by a department of a
commercial bank. The responsibilities of a trustee are three fold:
(1) it certifies the issue of bonds;
(2) it policies the behaviour of the firm according to the responsibilities set forth in the
indenture; and
(3) it is responsible for taking appropriate action in case of defaults.
There are two major ways of ending the relation between borrower (bond holder) and lender (the issuing
firm):

(a) The call provision

A call provision gives the issuing firm the right to call in the bond for redemption. If it is used, the call
provision generally states that the firm must pay an amount greater than the 'par' value (book value) of
the bond, with this additional sum being defined as the call premium. The call priviledge is valuable to
the firm but potentially detrimental to the borrower, so a new issue of non-callable bonds (with a fixed
maturity date) will generally carry a lower interest than a callable bond.

(b) The Sinking fund provision

This provision facilitates the orderly retirement of a bond issue. Typically, the sinking fund
provision requires the firm to buy and retire a portion of the bond issue each year. The sinking
fund can be handled in either of two ways:
(1) it may call a certain percentage of the bonds at a stipulated price each year, where the
actual bonds to be called are determined by a lottery; or
(2) it may spend the funds provided by the sinking fund payment to buy the bonds on the
open market.

ADEFILA & JAJU 38

Types of Bonds
There are many types of bonds. The type of bond that will attract the most potential investors depends
totally on the existing capital structure of the firm and the investors market thereby keeping the cost of
capital of the firm to a minimum. A first classification of bonds can be made along the line
secure/unsecured bonds.
Secured bonds may be classified again according to:
1. The priority of claims
A senior mortgage bond has prior claims on assets and earnings than a junior one. Here a
mortgage represents a pledge of designated property for the bond (or generally speaking: a loan).
A mortgage bond is therefore secured by real property.
2. The right to issue additional securities
In the case of a closed end mortgage, a firm may not sell additional bonds beyond those already
issued, secured by the property specified in the mortgage. If the bond indenture is silent on this
point, it is called an open mortgage and additional bonds may be sold and secured by the same
property.

ADEFILA & JAJU 39

Unsecured bonds - usually called debenture bonds:
1. Provide no lieu on specific property as security for the obligation. Debenture holders are
therefore general creditors whose claim is protected by property not otherwise pledged. The
advantage of debentures from the stand point of the issuer is that he leaves his property
unencumbered for subsequent financing. However in practice the use of debentures depends on
the nature of the firm assets and its general credit strength. Debenture bond may be ranked in
order of priority on claims on assets in the event of liquidation (so called subordinated debt).

2. Another type of unsecured bond is the so called income bond. These bonds pay interest only if
income is actually earned by the firm; the principal, however, must be paid when due. Income
bonds are like preferred stock. However they differ from preferred stock in that if interest has
been earned it has to be paid and also in that interest paid on income bonds is tax deductible
while preferred dividends are not.

Bonds as a Source of Funds

Using bonds as a source of funds has the following advantages:
1. The cost of debt is definitely limited. Bond holders do not participate in extra profit if earned.
2. The owners of bonds do not share control of the firm.
3. The interest payment on bonds (and other debt) is deductible for tax purposes.
4. Flexibility in the financial structure of the corporation may be achieved by inserting a call
provision in the bond indenture.

On the other hand there are a number of disadvantages related to bond financing:
1. Bonds - like any debt - represents a fixed charge; there is greater ris if the earnings of the firm
fluctuate, because the firm may be unable to meet these fixed charges.
2. Bonds usually have a definite maturity date. Because of the fixed maturity date provisions for
repayment of the debt have to be made.
3. Since bonds (long-term debt) is a commitment for a long period it involves risk; the
expectations and plans on which the bond was issued may change and it may become a heavy
burden to the firm.
4. There is a limit on the extend to which funds can be raised through long-term debt. Some of
the generally accepted standards of financial policy dictate that the debt ratio shall not exceed
certain limits.
An overall appraisal of the characteristics of bonds from the point of view of the (potential) bondholder
indicates that they bear less risk (priority in both earnings and liquidation), have limited advantages
with regard to income (a fixed return) and is weak with respect to control (no voting rights).

ADEFILA & JAJU 40

Convertibles
Convertible securities (commonly called "convertibles") are bonds or preferred stock that are
exchangeable into common stock at the option of the holder and under specified terms and conditions.
The conversion ratio gives the number of shares of common stock the holder of the convertible receives
when he surrenders his security on conversion, and the conversion price is the effective price paid for
the common stock when conversion occurs. The conversion price and ratio are established at the time
the convertible is sold. Generally these values are fixed for the life of the convertible. Convertibles
offer advantages to the issuing firm as well as to individual investors.
First of all a convertible functions as a "sweetener" when selling debt. The firm might therefore be able
to sell debt with lower interest rates and less restrictive covenants by giving investors a chance to share
in potential capital gains.
Secondly it enables firms to sell common stock at prices higher than those now prevailing. If
management predicts the price of common stock to go up, they set the conversion price a certain
fraction above the current stock price. If conversion occurs they are able to raise the required funds
with less shares than would have been necessary if they raised the funds through selling stock right out.
However if conversion doesn't occur the firm is saddled with dent. To make sure that conversion occurs
when the price of the stock rises above the conversion price, convertibles may have a provision that
gives the issuing firm the opportunity of calling the convertible at a specified price.

The biggest disadvantages and danger of using convertibles is that if the firm truly wants to raise equity
capital and if the price of the stock declines after the bond is issued, then it is stuck with debt and the
debt ratio might rise above accepted standard, making the firm extremely vulnerable.

Long-Term Loans
A long-term, or just term-loan is a business loan with a maturity of more than one year. Ordinarily,
term loans are retired by systematic repayments (often called amortization payments) over the life of
the loan, although there are exceptions to the rule.

Security, generally in the form of a mortgage on equipment, is often employed; but the larger stronger
companies are able to borrow on an unsecured basis.

The primary lenders of term credit are commercial banks, life insurance companies and pension funds.
For large loans some banks may form a consortium.

ADEFILA & JAJU 41

The purpose of the amortization schedule is to have the loan repaid gradually over its life rather than
fall due all at once. Amortization forces the borrower to retire the loan slowly, thus protecting both the
lender and the borrower against the possibility that the borrower will not make adequate provisions for
retirement during the life of the loan. The amortization schedule can be determined on several basis,
some of them will be discussed later (see chapter X). The interest cost of term loans, like rates on other
credits, varies with the size of the loan and the strength of the borrower. For small loans to small
companies rate may go up as high as 15 percent, for large loans to large firms, the rate will be close to
the prime rate. Since term loans run for long periods, during which interest rates can change radically,
many loans have variable interest rates, with the rate set at a certain level above the prime rate.
Another aspect of term loans is the series of protective covenants contained in most loan agreements.
The lender's funds are tied up for a long period, and during this time the borrowers situation can change
remarkably. To protect himself, the lender may include in the loan agreement stipulations that the
borrower will maintain his current ratio at a specified level, limit acquisitions of additional fixed assets,
keep his debt ratio below a stated amount, and so on. These provisions are necessary from the lender's
point of view, but they necessarily restrict the borrower's actions.
Venture Finance (Special Schemes)
This is in form of International credit from foreign bodies. Nigeria has been able to source significant
levels of foreign finance from institutions like International Finance Corporation (IFC), United Nations
Industrial Development organization (UNIDO), and the Africa Development Bank (ADB).
Some are mostly export stimulation loans denominated in foreign currency. Because of the
disadvantaged position of the Naira against other currencies, projects with export potentials are given
priority.
Institutions in Nigeria that provide similar funds are the Nigerian Industrial Development Bank Limited
(NIDB), the Nigerian Agricultural and Co-operative Bank (NACB), the National Economic
Reconstruction Fund (NERFUND) and the Small and Medium Scale Enterprises Loan Scheme (SME)
administered by the Central Bank of Nigeria (CBN) through participating banks, and other
developmental agencies.
Leasing company of Nigeria Limited was admitted as the only non-banking financial institution to draw
up to USS15 m under the World Bank SME II Scheme. Indeed LECON took advantage of this and
approved few leases under this scheme (Electrical Paints Manufacturing, Polytene Products
Manufacturing and Services Sector).
Leasing
A relatively new form of financing fixed assets is called leasing. Since firms are generally interested in
using buildings and equipment and not in owning them per se, an alternative to borrowing money and
buy the asset is to lease the asset: making regular rental payments for the use of the fixed asset the
owner (lessor) of the asset.

ADEFILA & JAJU 42

Possible advantages and disadvantages of lease financing are determined by the comparison of the cost
of leasing the asset with the cost of owning it. A lease is a sort of debt arrangement and contributes
therefore to the financial leverage. Also tax considerations have to be included.
Furthermore, leasing may provide an advantage by increasing the overall availability of non equity
financing to the firm.

Some Considerations on the Use of Long-term Debt

The conditions favouring the use of long-term debt (bonds and term loans) when other alternative
methods of long-term financing are also under consideration include the following:

1. Sales and earnings are relatively stable, or a substantial increase is expected to provide a
substantial benefit from the use of leverage.
2. A substantial inflation is expected, making it advantageous to incur debt that will be repaid
with cheaper money.
3. The existing debt ratio is relatively low for the line of business.
4. Management thinks the price of the common stock in relation to that of bonds is temporarily
depressed.
5. Sale of common stock would involve problems of maintaining the existing control pattern in the
company.

Decisions about the use of debt affecting the capital structure, should also be considered in terms of
minimizing the average cost of capital. We will come back on this issue later (see cost of capital).

The Market for Long-term Securities

There are two basic types of security markets - the organized exchanges typified by for
example, the Lagos Stock Exchange, and the less formal over-the-counter markets.
The organized security exchanges are tangible, physical entities, where buyers and sellers of
securities meet each other. Buyers and sellers are officers of brokerage firms (constituting out of one or
more brokers) which own a "seat" in the market and are called members of the stock exchange. These
seats, which are bought and sold, represent the right to trade on the exchange. Like other markets, a
security exchange facilitates communication between buyers and sellers. The officers in the Exchange
get orders from customers via their brokerage firm. Members with sell orders offer the shares for sale
and they are bid for by members with buy orders. Thus, the exchange operates as an auction market.
Securities that are traded on the organized security exchange are called listed securities. Quite a lot of
information is available dealing with transactions among listed securities, and the very existence of this
information reduces the uncertainty inherent in security investments. This reduction of uncertainty make
ADEFILA & JAJU 43
listed securities relatively attractive to investors and lowers the cost of capital to those firms. Most
important information concerning trade in the Exchange is concentrated in the Stock Exchange Journal.
From all the listed securities the following information is provided daily: highest/lowest price during the
year, expected dividend, P/E ratio (current price over earnings per share during last year), volume of
the trade on a certain day, highest/lowest price on a certain day.

From the stock Exchange Journal excerpts are published in the newspapers in order to inform
(potential) investors about the latest moves of their stock.

The following straight benefits are provided by the security exchange:

1. Security exchanges facilitate the investment process. Investors are assured that there is a place
to sell their securities. The increased liquidity results in a lower rate of return on securities,
which lowers the cost of capital to business.
2. The exchange creates an institution in which continuous transactions test the value of
securities. Firms whose prospects are judged favorable have higher values, facilitating new
financing and growth.
3. A continuous market improves liquidity that stabilizes security prices. Price changes are more
frequent but relatively small.
4. Security markets aid in the digestion of new securities issues.

These benefits are important, but not all firms are in a position to utilize the Exchange. Such firms
can, however, get many of the same benefits by having their securities traded in the over-the-counter
market.

The over-the-counter market is a more or less unorganized market. All facilities that provide for
security transaction not conducted at the formal Exchange are considered as over-the-counter markets.
These facilities consist primarily (1) of the relatively few brokers who hold inventories of unlisted
securities and who are said to make a market in these securities and (2) of the brokers who act as
agents in bringing these dealers together with investors. The over-the-counter market is especially for
those securities which are new or relatively infrequently traded (the matching of buy and sell orders is
relatively difficult).

As is said not every firm is entitled to use the facilities provided by the Stock Exchange. A firm must
meet certain requirements formulated by the Council of the Exchange before their stock can be listed.
These requirement relate to size of the company, number of years in business, earning record, etc.

ADEFILA & JAJU 44

Furthermore, there should be a reasonable degree of assurance that the security for which the company
is seeking listing will have a satisfactory auction market if it is admitted to trading on the Exchange.

Assuming a company qualifies, listing is beneficial both to the firm and to its stockholders. Listed
companies receive a certain amount of free advertising and publicity, and their stock as a listed
company enhances their prestige and reputation. This may have a beneficial effect on its sales, it may
increases the liquidity of its stocks, which may both lower the firm's cost of capital'.

Lease Financing
According to Equipment Leasing Association of Nigeria (ELAN),
"Lease is a contract between the owner of a specific capital asset simply referred to as
Lessor and the user of the asset also referred to as the Lessee, giving the latter quiet
possession and right to the use of the asset for an agreed rental payment over an agreed
period of time".
The separation of ownership and usage is central to the whole concept of Equipment Leasing and
distinguishes it from any other source of external financing. Promoters of viable projects often find that
it is better to pay for the use of an equipment than buying it with cash. Most companies have thus
accepted the fact that there is no harm in making use of an asset owned by someone else, except when
sentiments or strategy dictate otherwise. From the virtual monopoly enjoyed by a few Merchant Banks
in the early 70's, the Nigerian Leasing industry has today expanded to accommodate well over 100
Lessors.

We shall now see the different ways in which the lease option has proven to be the most innovative and
most convenient. Essentially, there are two types of leases: Direct Finance Lease and Operating Lease.
When a strict separation of the two is not easy, the legal rights of the Lessor and the Lessee, their Tax
Benefits and Accounting positions constitute the factors which distinguishe them.
(a) Direct Finance Lease
A Direct Finance Lease is a lease contract which involves payment of some specified sums over
a lease period sufficient in total to amortize the capital outlay of the Lessor and leave some
profit margin.
Such leases are structured over a period that is usually close to the economic life of the leased
asset. They are also called full payout leases as they enable a lessor to recover his investment
in the lease and also derive a profit.
(b) The Operating Lease
An operating Lease has been defined by the International Accounting Standards, (IAS 17), as a
lease arrangement, the cost of the leased asset is not fully recovered by the Lessor out of the
ADEFILA & JAJU 45
 rentals from a single lessee as is the case with the Direct Finance Lease. The lease is usually
for a period that is significantly shorter than the economic life of the equipment and is subject
to cancellation by both parties. The Lessor is likely to lease the asset to many Leases over its
economic life or he may resort to a market sale to recover the investment. Operating Leases
are therefore lease arrangement which should be of particular interest to entrepreneurs who
require specific equipment to carry out specific contracts. The Lessors usually provide
services such as maintenance, sometimes Insurance, Support staff, Fuel and other running costs
of the equipment.

LEASE CLASSIFICATION AND PRACTICES

Given the two basic types of leases, a number of lease classifications and practices exist:-
i) Sale and Leaseback
This is an arrangement in which an equipment owner sells the equipment to a Leasing company
or a Bank. The Leasing Company then leases the equipment to the seller who uses the
equipment. The transaction can be for new equipment when the equipment is sold before it is
put to use or for an equipment that has already been put to use. The lessee’s desire is mainly to
utilize his assets to raise fund, while he continues to enjoy the use of the assets.
ii) Sale Aid Leading
Not all lease arrangements are marketed directly to potential equipment users. Sales Aid
Leasing recognizes that a finance programme supports the sales process and this improves
customer services. This arrangement involves the manufacturer or vendor of equipment, the
Lessor and the Lessee. The Lessor offers a lease package as an alternative form of finance to
assist the manufacturer or vendor in selling its products to the user (Lessee) who do not want
outright purchase. Sales Aid Leasing may be arranged under a Direct Finance Lease or an
Operating Lease.
iii) Leveraged Lease
This is a Direct Finance Lease that involves at least three parties; the Lessee. the Lessor or
"Equity Participant" and one or more long-term creditors or lenders. The equity participant
(Lessor) invests about 20 to 30 percent of the asset value while the lender (s) provide the
balance. The part funding provided by the lender is on a non-recours basis to the Lessor or
equity investor but with full recourse to the lessee. The Lessor acquires the asset and gives it
on lease, however the lease rental is assigned to the Lender. A Trustee is usually appointed to
look after the interests of the parties involved. The Lessee therefore pays the rental to the
trustees, who first apportions the rental towards debt servicing to the lender and makes
available the balance to the Lessor.
iv) Syndicated Lease

ADEFILA & JAJU 46

 For Equipment requiring very high capital outlay or where a Lessor wishes to share the risk
elements with others, two or more Lessors may come together to jointly lease finance such
equipment.
v) Cross Border Lease
This practice comes into existence when the Lessor and Lessee reside in different countries.
Cross Border Leasing is widely used as a "Foreign Sales Aid" technique by Domestic
Equipment Manufacturers. It aids in sales promotion as the entire cost of the asset can be
financed through leasing. Here, the Lessee may like to take advantage of the low cost of funds
available in the Lessor's country and also benefit from other essential services like maintenance
and support staff.

WHY LEASE?
The popularity of this creative financing alternative is of the many and varied benefits that leasing
provides, particular advantages leasing offers are as follows:-
i) New Source of Fund
Leasing provides diversification of sources of financing. This is important in a situation where
a company pledges all its assets to one or more financial institution and in the face of tight
credit terms, bank lending restrictions, or other economic factors.
Lease Financing spares the use of other credit sources and conserves existing lines of credit for
other purposes while it allows full use of borrowing capacity.
ii) Smooth Cash-Flow and Affordable means of Acquiring Equipment
Many companies do not have the cash to pay for new equipment whose cost prices are usually
high. Rental payment offers a cash flow superior to that of outright purchase.
iii) Provision of 100% Financing
Banks and other Financial Institutions usually provide 60 to 70 per cent of the capital value of
the asset as loan facility, the balance being equity contribution by the promoters of the project.
Leasing, generally, can offer 100 percent financing, covering additional procurement costs such
as clearing, transportation, installation and insurance costs, which would otherwise be financed
by the Lessee if he had taken a loan.
iv) Provision of Lower Lease Payment
Leases can also attract fixed implicit interest charges. This is of particular importance in our
financial environment where cost or funds have witnessed an unprecedented rise in the recent
times.
Further to this, a company that cannot take advantage of such tax benefits as capital
allowances and investment allowances is compensated through low rental payment. The Lessor

ADEFILA & JAJU 47

 can purchase the equipment, claim the tax benefits, and pass the savings along to the Lessee
via low lease rentals.
v) Flexibility in Lease Rental Payment
Many companies have a seasonal cash flow, e.g. Agricultural and Agro-Allied Industrial
concerns.
Lease rentals can be structured to coincide with earnings generated from the use of the
equipment. During those seasons of low cash flow, Lessors are willing to provide skip
payment leases to accommodate the cash flows. Start-Up companies, for instance, will benefit
from utilizing a step-up lease where the periodic payments increases during the lease tenure.
Companies that are already established may have more than adequate cash revenue now, but an
uncertain future. Such companies would benefit from a step-down lease where payments
decrease during the lease period. For those with uniform cash flow, leasing offers the comfort
of level rental payment.
vi) Longer Payment Terms
Lease rental payments can be spread over longer period than with most other forms of
financing.
vii) Financial Reporting Consideration
Asset acquired through operating Lease is not recorded as an asset in the books of the Lessee
since it is an off-balance sheet financing. This enhances the financial performance ratios of the
company and improves its return on assets (ROA), thus providing better prospects for
additional credit facilities to the company.
viii) Exclusive Tax Advantage
Leasing shelters both the Lessor and the Lessee from taxes. Depending on the lease
arrangement, the Lessor sometimes claim capital allowance which shields it from some tax
liabilities. From the Lessee's viewpoint, the lease rental is allowed as an expense in the
calculation of taxable income. This affords more shelter from taxes every year.
ix) Budgetary Constraints on Capital Expenditure
In the face of the present gloomy economic environment, most economic units are faced with
tight budgetary constraints. This makes Equipment Leasing a better option for acquiring
capital asset outside the capital budget.
Lease rentals are viewed as usage charges not payments on capital equipment. As a result,
rental payments are most often made from operating budgets and not from capital budget.
Thus, the rigor of getting the necessary approvals for capital expenditure would have been
avoided.
x) Technological Change

ADEFILA & JAJU 48

 Leasing provides a definite hedge against technology and usually at no extra cost. At various
level of operation, a highly technical equipment becomes obsolete to the Lessee. Changes in
the company's operations and/or changes in equipment technology cause the company to seek
for new equipment.
In this situation, the Lessor is willing to take the Lessee out of existing equipment and place it
into a new modern one. The Lessor's specialization in the secondary market will enable it
remarket the used equipment to another user to whom it may not necessarily be obsolete.
xi) Lessor's Specialization in Lease Financing
A number of Financial Institutions such as the Leasing company of Nigeria Limited (LECON),
are mono-product, specializing only in Leasing.
Lessors whose line of business is solely the provision of equipment leasing specialize in certain
types of equipment, increase their knowledge and expertise and thereby reduce the market risk
of the equipment. They also provide better maintenance services, prompt replacement of
equipment in the event of leased equipment breaking down, procurement of insurance at
favourable rates, and many other services.

In this manner, the Lessee stands to benefit for Lessor's economics of scale, since the Lessor
provides such services to many customers.
xiii) Higher Level of Certainty and More Rapid Turn-Around Time
Lease facilities are often easier to obtain than term loans. The equipment under lease serves
the dual purpose of being the facility and collateral, since ownership actually remains with the
Lessor, not the lessee.
This serves as the main reason why financial institutions embrace equipment leasing as it is
safer and in the event of rental defaults by Lessee, the equipment can be withdrawn by the
Lessor.
The above list of benefits is not conclusive. These benefits vary from case to case.
IX. FINANCIAL STRUCTURE AND THE LEVERAGE EFFECT

In the previous chapter we examined the characteristics of several forms of capital. The question is
now which particular form or which mix, is the best one to use in a given situation. Therefore, we have
to examine the firm's financial structure and especially the effect of financial leverage.
The Financial Leverage
The financial leverage or the leverage factor is defined as the ratio of total debt to total assets
(sometimes also called the debt ratio):
total debt
Leverage factor = x 100%
total assets
ADEFILA & JAJU 49
For example, a firm having total assets of N100 million and a total debt of N50 million would have a
leverage factor of 50 percent. The effect of the financial leverage is now that it magnifies the ROE
(Return on Equity), if the firm's economic rentability - or in other words its Return on Investment (ROI)
before interest and tax - is higher than the interest percentage it has to pay over its total debts. In such
a case the debt financing is a lever to raise the ROE to the shareholders. The concept of the financial
leverage can be easily understood from analyzing its impact on profitability under varying conditions:
Suppose there are three firms in a particular industry and these firms are identical except for their
financial policies. Firm A has used no debt and consequently has a leverage factor of zero; Firm B,
financed half by equity and half by debt, has a leverage factor of 50 percent; Firm C has a leverage
factor of 75 percent.

The liability side of their balance sheets are accordingly:

A B C
Total debt (6%) 0 100 150
Equity 200 100 50
Total liabilities 200 200 200

How do these financial patterns affect the ROE for different states of the industry's economy i.e. the
ROI.

Economic Conditions
Very Poor Indifference Normal Good Very
Poor good
ROI (before interest and tax) 2% 5% 6% 8% 11% 14%

EBIT (earnings before N 4 10 12 16 22 28

interest and tax)
Firm A
Interest Expense (6%) 0 0 0 0 0 0
P.B.T. 4 10 12 16 22 28
Tax (50%) 2 5 6 8 11 14
P.A.T. 2 5 6 8 11 14
ROE 1% 2.5% 3% 4% 5.5% 7%
Firm B.
Interest Expense (6%) 6 6 6 6 6 6
P.B.T. (2) 4 6 10 16 22
ADEFILA & JAJU 50
 Economic Conditions
Very Poor Indifference Normal Good Very
Poor good
Tax (50%) (1) 2 3 5 8 11
P.A.T. (1) 2 3 5 8 11
ROE -1% 2% 3% 5% 8% 11%
Firm C.
Interest Expense (6%) 9 9 9 9 9 9
P.B.T. (5) 1 3 7 13 19
Tax (50%) (2.5) 0.5 1..5 3.5 6.5 9.5
P.A.T. (2.5) 0.5 1.5 3.5 6.5 9.5
ROE -5% 1% 3% 7% 13% 19%

This example demonstrates how the use of financial leverage magnifies the impact, of changes in the
ROI on the ROE. When economic conditions go from norma; to good, for example ROI go from 8 to
11 percent, an increase of 37.5%. Firm A uses no leverage, gets no magnifications and consequently
experiences the same 37.5% increase in ROE.

However, firm B enjoys a 60% rise in ROE as result of the 37.5% rise in ROI, due to its leverage.
Firm C which uses still more leverage, has an 85.7% increase. Just the reverse holds in economic down
turns, of course: a 37.5% drop in ROI results in a ROE decline of 37.5%, 60% and 85.7% for firms A,
B and C respectively.

The effect of financial leverage can also be seen from a graphical; presentation of the above results.

R O E (%)
Leverage factor = 75%
1.5
Leverage factor = 50%
1.0

Leverage factor = 0
5

------------------------------------------------------------------

5 6 10 15

ADEFILA & JAJU 51

 -5 R O I (%) Therefore interests are tax

It should be noted that the intersection of the three lines is at the point where the ROI is 6%, the interest
cost of the debt. At this point, the ROE is 3% (due to 50% Tax deduction) regardless of the degree of
leverage. When the ROI is higher than 6%, debt-financed assets can pay their interest costs and still
leave something over for the stockholders, but the reverse holds if assets earn less than 6%. In general,
whenever the ROI exceeds the cost of debt, financial leverage is favourable, and the higher the leverage
factor the (bigger &) the higher the rate of return on common equity.
This can also be seen directly, when we express ROE as a function of ROI:
Debt
ROE = (i t) [R O I * (R O I i)* ]
Equity
where: t = tax rate
i = interest rate
ROI = return on total assets before interest and tax (5)
ROE = return on equity (%).

Another way of expressing the financial the financial leverage effect is relating the absolute figures of
Earnings per share (EPS = ROE x EQUITY) to Earnings before interest and tax (EBIT = ROI x TOT,
ASSETS). We define the degree of financial leverage then as:

ADEFILA & JAJU 52

 % EPS
 % EBIT
This degree of financial leverage can be calculated as follows:
(EBIT I) . (1 t)
EPS = , because I is constant
N
 EBIT . (1 t)
ΔEPS = , so the percentage increase is
N
 EPS  EBIT
Δ%EPS = x 100% = x 100% , then
EPS EBIT I
 EBIT
 % EPS EBIT SVCF
Degree of financial leverage = = EBITI = =
 % EBIT  EBIT EBITI SVCFI
EBIT
The Combined Leverage Effect
Remembering our discussion on the operating leverage (chapter III) we defined the defined the degree
of operating leverage as:
% EBIT S VC
=
% SALES S VC F
The higher the degree of operating leverage the higher the breakeven point, the stronger magnification
of profits (in the case sales > breakeven point) as well as losses (sales < breakeven point). In fact the
operating leverage affects earnings before interest and tax, while the financial leverage effects earnings
after interest and tax. Combining both leverage effects we are able to determine the impact of a change
in the sales volume on the ROE (or EPS). The combined leverage effect is defined as the product of the
factors.

Combined leverage effect = Operating leverage X Financial leverage

or:
% EBIT % EPS % EPS S VC
C.L.E. = x = =
% SALES % EBIT % SALES S VC F I

ADEFILA & JAJU 53

The combined leverage effect shows the interrelationship between operating and financial leverage or in
other words the interrelationship between two important decisions i.e the decision on the level of fixed
and variable costs directly related to the decision on the type of equipment to be used (affecting the
asset side of the balance sheet), and the decision on the amount of debt to be used in financing the
equipment, affect the financial structure of the firm (the liability side of the balance sheet).

The combined leverage affect can also be shown in a graph:

Debt financing

EPS
Common stock

Advantage of debt

Break-even point

Sales

Advantage of common stock

Drawing graphs for several amounts of debt - financing gives a breakeven point on their intersection,
above which it is profitable to use more debt, under which it is advisable to use equity. Also for the
combined leverage effect, it holds that the higher the leverage factors, the higher the break-even sales
volume - to earn the necessary interest costs - but also the greater the magnifying effect.

Factors influencing the financial structure

Thus far we have been discussing important factors that are generally considered when a firm
formulates basic policies relating to its financial structure. The final decisions however on the
magnitude of the several factors (how much operating e.g. financial leverage) depends among others on
the following determinants:

ADEFILA & JAJU 54

1. Growth rate of future sales. This is the most important measure of the extent to which EPS are
likely to be magnified by leverage. However, favourable expectations commands high stock
prices on the Exchange, thus it sometimes appears that equity financing is possible and
desirable to broaden its equity base.

2. Stability of future sales. With greater stability in sales and earnings, a firm can incur the
interest costs of debt relatively low risk, which means cheaper debt and higher financial
leverage. There is less danger for liquidity problems, which would arise if ROI easily falls
below the interest rate. (Such problems would be more serious with higher leverage factors).

3. Competitive Structure. Debt-servicing ability is dependent upon the profitability, as well as the
sales volume. Profit margins will be bigger in less competitive industries.

4. Asset structure. Firms with many fixed assets use relatively long-term debt extensively. Firms
whose assets consist mostly of receivables and inventory (trade) rely less on long-term debt
financing and more on short-term.

5. Management and investors' attitude towards risk and control. Raising capital through the
issuing of shares (equity) dilutes control over the firm. On the other hand more debt (higher
leverage) result in greater risk.

6. Lenders attitude towards the firm. Lenders require a minimum amount of equity, to serve as a
buffer in difficult situations. Furthermore, the higher the leverage (debt ratio) the higher the
risk and consequently the higher the charged interest rate (as a premium for the high risk).

X. THE INTEREST FACTOR IN FINANCIAL DECISIONS

Finally, we will look - in the following chapters - at the investment in fixed assets, the upper left hand
side of the balance sheet. However, the long-term nature of such investment makes it necessary to
consider first the theory of compound interest and related topics - the so called "math of finance".

Compound Value

ADEFILA & JAJU 55

We will tackle the problem of compound value with some easy examples. Suppose a person deposits
N1,000 in bank savings account that pays 4 percent interest compounded annually. How much will be
have at the end of years? We first define the following terms:

Po = principal, or beginning amount at time 0

r = interest rate
I = total amount of interest earned
Pn = principal value at the end of n periods.

Now P1 = Po + I = Po + Po.r = Po (1 + r) (X.1)

P2 = P1(1 + r) = Po(1 + r)(1 + r) = P o(1 + r)2 (X.2)
Pn = Po (1 + r)n (X.3)
Compound Interest = Pn - Po = Po[(1 + r) -1] n
(X.4)
So in our example: Pn = 1,000 (1.04)n
for n = 5 Pn = 1.217
To easen such calculations tables have been constructed for values of (1 + r) n sometimes called the
interest factor IF - for wide ranges of r and n. The behaviour of interest factors for compounding is
illustrated below:

(P. V. = 1)

R = 10%

4.0 IF = (1.05)”
3.0 IF = 1. (1-10)”
2.0 r = 5%
1.0 IF = (1)”
r = ()%

2 4 6 8 10
n (years)

ADEFILA & JAJU 56

ADEFILA & JAJU 57
Present Value

When we want to find the present value of an amount due in n years when the applicable interest rate is r
percent we have to work the other way around:

Pn 1
Present value (P.V.) = P o = n
= Pn . (x.5)
( 1+ r ) ( 1 + r )n
1
and Compound discount = Pn - Po = { 1 } . Pn (x.6)
( 1 + r )n
The meaning of the Present value is that it represents the value of an amount of money for which you
would be indifferent to get it now (t = o) or after n years, assuming that the interest rate you would be
able to obtain depositing this amount in a savings account is r percent. In our example, this means that
it makes no difference to obtain N1,000 now or N1,217 at the end of five years assuming that your
interest rate is 4%.

Finding present values - or discounting as it is commonly called - is made easy with tables for the term
in brackets (F-factor) in Equation (X.6) for various values of r and n. The discounting process can also
be illustrated diagrammatically:

ADEFILA & JAJU 58

ADEFILA & JAJU 59
Compound value of an annuity

An annuity is defined as a series of payments (receipts) of a fixed amount for a specified number
of years. For example, a promise to pay N1,000 a year for three years is a three-year annuity. If
one were to receive such an annuity and were to deposit each annual payment in a savings
account paying 4% interest how much would you have at the end of n years.

Years 0 1 2 3 n-1 n
Payments 1,000 1,000 1,000 1,000

1,040 1,000(1+r)n2

1,082 1,000(1+r)n-1

Compound Sum: 3,122 1,000{(1+r)n-1 + (1+X)n-2… +(1+x)0}

General if Sn = the compound sum

R = annual payment
 1  r  n  1  componud int erest
then: Sn  R   R 1
 r  int erest rate1

Again the values for the expression between brackets are given in tables for several n and r.

Present value of an annuity

The present value of an annuity gives the value now (t = 0) of future payments or receipts over a
period of n years.

ADEFILA & JAJU 60

 0 1 2 3 ….. n

1,000 1,000 1,000 1,000

1,000 1 = 962
1+r
1,000 1 =925
889

1,000 1

(1+r)n

P.V. of Annuity= 2,775

Generally if P.V.A. = the present value of the annuity over n years and r%,
then
2
again the expression between brackets is given in tables (A factor).

Appropriate Interest Rate

The appropriate interest rate to use in compounding and discounting payments or receipts is the
basis for these calculations. There are several approaches to determine the interest rate. First of
all we can take the general level of interest rates in the economy as a whole (prime-rate).
However there is no one interest rate, the applicable rates it depend on the investment
opportunities - their risk, maturing date, etc. Another approach is to take the opportunity cost
of not taking an alternative investment possibility. For example, if we have the choice between
an investment X and putting the available capital on a savings-account paying r% interest, r
would be the opportunity cost when opting for the investment X, and therefore serve as a proper
interest rate in discounting the returns of the investment. In fact we used this concept in our
previous examples.

The most important approach in capital budgeting however, is to use the so called Cost of
Capital (C.O.C.) as the interest rate in the calculations of present value etc. The C.O.C. is the
average 'cost' of a firm's capital or liabilities it uses to finance it's operations. (see chapter XII).

ADEFILA & JAJU 61

XI. CAPITAL BUDGETING

Capital Budgeting is the making of long-term planning decisions for investments and their
financing. In fact it is the allocation of available or raised capital over alternative uses. These
are mostly expenditures for plant, equipment and other long-live assets affect operations over a
series of years. They are large, permanent commitments that influence long-run flexibility and
earning power of the company. Decisions in this area are among the most difficult, primarily
because the future to be foreseen is distant and hard to perceive. Because the unknown factors
are many, it is imperative that all the known factors be collected and properly measured before a
decision is reached

ADEFILA & JAJU 62

Types of Capital Budgeting Decisions.

Depending on the firm involved, investment proposals can emanate from a variety of sources.
For the purpose of analysis projects may be classified into the following categories:

1. New products or Expansion of Capacity

Proposals for such projects usually originate in the marketing section of the company. Most
often there will be several alternatives, which can be compared with each other to find the
best one. It should be noted however, that also if there seems to be no physical alternative
there is always the "alternative" of doing nothing, i.e. taking the available money to a bank
account. (This of course, holds only if no special funds have to be raised for the project).

2. Replacement of Equipment or Buildings

Proposals to replace a piece of equipment with a more sophisticated model usually comes from
the production area of the firm. In this case there is always the alternative of keeping the
old equipment.

3. Lease or Buy
Such a choice has to be made sometimes when very expensive equipment has to be acquired
(like planes, computers, etc.).

4. Others
This category comprises miscellaneous items such as the expenditure of funds to comply with
certain health standards, safety, research and development, etc.

In evaluating a group of investment alternatives, a further distinction has to be made. It is

important to determine whether the proposals are independent of each other. A proposal is said
to be mutually exclusive if the acceptance of it precludes the acceptance of one or more other
proposals. Two mutually exclusive proposals can not both be accepted at the same time. A
contingent or dependent proposal in one whose acceptance depends upon the acceptance of one
or more other proposals. For example a contingent proposal might be an investment in a large
machine, which depends upon the extension of a plant. When an investment proposal isn't
independent of other proposals, this must be recognized and decisions made accordingly.

ADEFILA & JAJU 63

The Cash Flow Concept

One of the most important tasks in capital budgeting is estimating future cashflows for a project.
The reason we express the benefits expected to be derived from a project in terms of cash flows
rather than in terms of income (in the accounting sense), is that cash is what is central to all
decisions of the firm. A firm invests cash now with the hope of receiving cash returns in a
greater amount in the future. Only cash receipts can be reinvested in the firm or paid to
stockholders in the form of dividends.

For each investment proposal, we need to provide information on expected future cash inflows
and outflows on an after-tax basis. Two important sources for such information are:
1.the engineers which have to give cost figures on operations, maintenance etc., and the
expected life of the projects,
2.the marketing department which has to provide estimates on sales.

In estimating cash in - and outflows especially two problems have to be considered.

First of all cash inflows are often difficult to calculate if they represent no quantitative revenues,
like results of an advertising campaign, training programmes, hospital care etc. This doesn't
mean however that they shouldn't be considered in evaluating the investment proposal.
Secondly there is a lot of uncertainty involved in estimating future cash flows. This is essentially
what introduces risk to the capital budgeting decision. It may affect the overall riskiness of the
firm and consequently the risk assessment by its capital suppliers and their required rate of return
(we will come back on this later).

It should be emphasized that in the entire capital budgeting decision, probably nothing is of
greater importance than a reliable estimate of the cash flows that will be achieved from the
proposed outlay of capital funds. All the subsequent procedures for ranking projects are no
better than the data input. Above all, the data formulation requires good judgement in
expressing the amounts of the several cash flow items. It requires continuous monitoring and
evaluation of estimates by those competent to make such evaluations - engineers, accountants,
cost analysts, etc.

The basic procedure in calculating the net cash flow (difference between all cash inflow's and
cash outflows) over a certain period from (expected) account data is as follows:
Net Cash Flow = PAT + D
ADEFILA & JAJU 64
 = (1+t).(Sales - Costs) + t.D
where: PAT = PBT - T or (1-t). PBT
PBT = Sales - Cost of Sales - Depreciation
D = Depreciation
PAT = Profit After Tax
PBT = Profit Before Tax
T = Tax paid, t = tax rate.

It is important to note that in the determination of the cost of sales only those costs which are
directly assignable to the investment proposal under decision should be considered.

The stream of cash flows over the project's life time can be represented as follows

0 1 2 3 - n

-I C1 C2 C3 Cn

with I = original cash outlay or investment

Ci = net cash flow for period i.
n = life time of the project.

Very often - and especially in the case of typically engineering projects - the original cash outlay
(or neg. net cash flow) will cover several years, before a positive net cash flow is generated.
Visualizing such annual cash flows in a graph might give the following result:

ADEFILA & JAJU 65

Capital Budgeting Techniques

The object of capital budgeting and in fact, the object of all financial analyses - is to make
decisions that will maximize the value of the firm's common stock. The capital budgeting
decision should give an answer to two questions:
1. Which of several (mutually exclusive) investments should be selected?
2. How many projects, in total, should be accepted?

An answer to these questions is basically given by the application of a classic proposition from
the economic theory of the firm "a firm should operate at the point where its marginal revenue is
just equal to its marginal costs".

When this rule is applied to capital budgeting decision, marginal revenue is taken to be the
percentage rate of return (see further discussion on I.R.R.) on investments while marginal cost is
the firm's cost of capital. If we put the investments with their percentage return in descending
order on a row all those investment projects which percentage return exceeds the percentage
cost of capital are acceptable.
In figure:

The shape of the M.C.C. curve is explained by the fact that after G additional stock has to be
sold to finance more projects. In our further discussion we assume however that the cost of
capital (or the minimum required rate-of-return) will be constant.

ADEFILA & JAJU 66

At the applied level, the capital budgeting decision is a little more complicated. We will discuss
four major techniques used, in business, to rank investment proposals using different methods to
measure the relative investment worth.

The Pay-back Method

The pay-back method, sometimes called payout or payoff, is a rough - and - ready model, widely
used because its simplicity and therefore easy application. Although it has many short-comings
which make it - at least theoretically - inferior to other techniques, it may be a handy device:
(1)where precision in estimates of profitability is not crucial and preliminary screening of a
number of proposals is necessary;
(2)where a weak working capital position has a heavy bearing on the selection of investment
proposals;
(3)where the contemplated project is extremely risky.

The pay back period can be calculated as follows:

P = I/C where P = pay back periods;
I = original cash-outlay;
C = uniform annual cash-flow.

p
or  Ci 3
ii 1
= I in the case the cash-flows are not uniform.

Essentially, payback is a measure of the time it will take to recoup in the form of cash from the
project only the original money invested. Given the useful life on an asset and uniform cash
flows, the less the payout period the greater the profitability; or given the payback period, the
greater the useful life of the asset, the greater profitability. The payback period may give an idea
of the profitability, it does not, however, measure profitability. This is one of its major
weaknesses.
To illustrate, consider two mutual exclusive projects A and B with the following cashflows:

A B
0 1 2 3 4
- 10 10 10 150
PA = 2 years
300 0 0 0
PB = 3 years

ADEFILA & JAJU 67

Following the payback method, we should decide in favour of project A with the quickest
recommend of the original outlay. However, this method doesn't take into consideration
possible earnings after the pay back period. Considering these after pay back-period earnings,
this would favour the choice of project B. Another weakness of the pay back method is the
ignorance of the possible differences in the timing of the proceeds earned prior to the pay back
period, consequently ignoring the "time value" of money.

The Accounting Rate of Return (R.O.I)

The accounting rate of return, also known as the unadjusted rate of return or the book-value
rate of return, is the quotient of the (increase in) expected future average net income and the
initial (increase in) or average investment:

()c  () d
ROI  x 100% 4
() I
or in the case of nonuniform cashflows:

 Ci  I
ROI  i
x 100%
n.I
Sometimes the denominator is the average (increase in) investment (I/2) rather than the initial
increase.

This method applied to the previous examples would result in:

400  300
ROI ( A)  x 100%  8.33%
4 x 300
450  300
5
ROI ( B )  x 100%  12.5%

or over the average investment: 16.75 and 25% respectively.

This would result in a choice in favour of B. Note that the accounting rate-of-return model at
least has profitability as an objective. However, its most serious draw back is again the
ignorance of the time value of money. Using the accounting rate of return as decision criterion,
the same criterion is used for decision purposes (dealing with the future) as the appraisal (audit)
of the profitability performance of the project afterwards (dealing with the past). This may look
efficient from the auditing point of view, but may lead to sub-optimal decisions over the longer
run.

ADEFILA & JAJU 68

Discounted Cashflow Techniques

The previous two methods for evaluating investment proposals (measuring their relative worth)
did not take into account the timing of the future cash proceeds. A naira in the hand to-day is
worth more than a naira to be received five years in future. For instance, in the interim a naira
can be put in a savings account and will grow substantially during the five year period because of
the interest it would earn. The interest recognizes that the use of money has a cost - just like the
use of a house has a cost (rent) - and expresses the "time value" of money. The following two -
so called "discounted cashflow" or D.C.F. - techniques do explicitly and routinely wights the
time value of money and are therefore the best methods to use for long-range investment
decisions.

The Net Present Value Method (NPV)

The NPV method is based on the discounted cashflow concept and assumes some minimum
desired rate of return. All expected cashflows are discounted to the present using the minimum
desired rate. If their sum exceeds the initial outlay (NPV > O) the project is desirable because its
return exceeds the desired minimum, i.e. the return of a similar amount put into a bank account
(or elsewhere) on an interest rate similar to the minimum desired rate. If the result is negative,
the project is undesirable. The NPV can be calculated from:

n
 Ci 6
NPV   I 
i  I (1  r )1

with r = the minimum desired rate of return.

ADEFILA & JAJU 69

For each combination of n and r we are able to find the value of 1/(1 + r)i in the F n/r table (see
previous chapter) or the A n/r table if the cashflows are an annuity. In our example the N.P.V.
with an r = 5% rate would be (use tables):

NPVA = -I + C1 x 0.9524 + C2 x 0.9070 + C3 x 0.8638 + C4 x 0.8227

= -300 + 150 x 1.8594 + 50 x 1.6865 = 63.24
NPVB = -300 + 100 x 2.7232 + 150 x 0.8227 = 95.73

The project with the highest NPV would be chosen, provided that its NPV > O. In comparing
the two mutually exclusive projects we discounted the cashflow's separately, which is called the
total project approach. The incremental approach considers the relative cashflows and results in
one N.P.V. of the incremental flows. If this incremental N.P.V. > O the first project is chosen, if
< O the second; provided that both projects have a NPV > O. In our example the incremental
cashflow would be:
A - B:
0 1 2 3 4

0 50 50 -50 -100

NPVA-B(r=5%) = 50 x 0.9524 x 50 x 0.9070 - 50 x 0.8638 - 100 x 0.8227

= 32.49; resulting in a choice for B.

Suppose now the minimum rate of return to be 30% the incremental NPV would be:
NPVA-B (r = 30%) = 10.28

At the first glance this would result in a choice for A. However, computing the NPV for A at a
rate of 30% results in a neg. NPVA and in an entire rejection of the project!

Consequently the N.P.V. approach to investment decisions can be applied relatively easy to any
projected cashflow if a minimum rate of return is known. This might, however, entail sometimes
difficulties. The NPV method has also the disadvantage of being a sum of money. Additional
information is needed before its significance can be appreciated. The ratio between the NPV
and the original cash outlay - the capital rate-of-return ratio or profitability index - forestalls this
problem.

ADEFILA & JAJU 70

An extension to the NPV method is the Cumulative NPV, which computers the net present value
of the project up till each year in its life. In formula:
7
(Note that CNPV(n) = NPV).
Applied to our example:

CNPVA:
0 1 2 3 4

-300 -157 -21 22 63

CNPVB: 0 1 2 3 4

-300 -205 -114 -28 95

Visualizing the discounted cashflow's in a graph gives:

From the graph we can easily obtain the discounted pay back period: the time it takes to recoup
the original outlay including the time-value of money. Beyond this (breakeven) point, the
invested capital is no longer at risk, and any positive cashflow above the horizontal line CNPV =
ADEFILA & JAJU 71
0, is in excess of the return on an equivalent amount of capital invested at an interest rate of 5%.
Thus the greater the area above the base line, the more profitable the project. Note that the DP
is longer than the original pay back period (without discounting).

The Internal Rate of Return Method (IRR)

The internal rate of return or the time-adjusted rate of return may be defined as "the maximum
rate of interest that could be paid for the capital employed over the life of an investment without
loss on the project". In other words the IRR is the interest rate for which the present value of
the total net positive cashflows equals the present value of the net of the cash outlays required
by the investment.

In formula:

n
Ci
 I   (1  IIR)i
i 1
 08

where IRR is the internal rate of return. The computation of the IIR is a matter of iterative trial
and error or interpolation. For our examples this results in:

project A; IIR = 16%

project B: IIR = 17%

The decision criterion here is to choose the project with the highest IIR, provided that this one
exceeds the minimum required rate of return. If the minimum required rate of return would, for
example, exceed the 17% the cash in-flow of the project will be insufficient to pay interest and
repay the principal of a (hypothetical) loan used to finance that project. Very often management
uses a minimum required rate as the cut-off rate i.e all project with a IIR above the out-off rate
are acceptable, below they are rejected.

In practice, the IIR method is used more widely, than the NPV method. Most managers seem to
be able to interpret the IIR more easily; moreover with this method they are not forced to
specify a minimum required rate as a pre-requisite to the NPV method. An important and
sometimes confusing disadvantage is, that no impression is obtained of the size of the required
investment. The size of the required investment is very important since - no matter how
profitable the project - the matter is academic if the company is unable to raise the money to
undertake the project.

ADEFILA & JAJU 72

Along the same lime as with the Cumulative NPV we can extend the IRR concept, by
computing the IRR for every year of the project's life. Although, a tedious job, this will give us
an idea how long at least a project has to be carried on before its IRR will exceed a certain out-
off rate.

The NPV and IRR Methods compared in the light of unequal project lives.

Generally, the NPV and IRR methods lead to the same decisions regarding the relative
desirability of mutually exclusive project proposals. However, some crucial differences in the
assumptions underlying the methods may lead to conflicting ranking when project with unequal
lives are considered. Essentially, differing assumptions are made with respect to the rate of
return on the reinvestment of the cash proceeds at the end of the shorter investment's life.

The IRR method assumes that the reinvestment rate is equal to the indicated rate of return for
the shorter-lived project. The NPV method assumes that proceeds can be reinvested only at the
rate of the firm's minimum required rate of return. That the two methods will give different
rankings becomes evident from the following comparison:

ADEFILA & JAJU 73

It can be understood that at the end of 15 years the original investment in project A will
accumulate to more than that in project B under the IRR method. Therefore, the IRR method
will favour project A. Under the NPV method, project will accumulate substantially less since
its proceeds are assumed to be reinvested only at the 5% minimum rate of return. The NPV
method will consequently favour project B. As long as projects under consideration promise
internal rates in excess of the cut-off rate, the IRR method has a built-in assumption in favour of
short-lived projects, whereas the NPV method has a built-in minimum rate of return that would
favour longer-lived projects. If we look upon the minimum required rate of return as an
approximation of the opportunity rate for reinvestment, the NPV method should be used rather
than the IRR method.

There are several other ways to deal with unequal lived projects:

1. The liquidation approach

This assumes the liquidation of the longer lived project at the end of the shorter lived project,
after which both are discounted over the same period. For example (r = 5%):
Project A (n=3): with NPVA = 224.
0 1 2 3

-1000 450 450 450

0 1 2 3 4 5
-1500 500 500 500 500 500
Project B(n=5):

With a liquidation value (disposal) of 500 after 3 years a substitute project with n=3 gives a
cashflow of:

Project B* (n=3): 0 1 2 3 + 500

-1500 500 500 500

NPVB* = 1500 + 2.72 x 500 + 0.86 x 500 = 290;

Resulting in a choice for project B.

2. The Yearly Equivalent Approach

The yearly equivalent of a certain project is the annuity that would generate the same NPV over
the live of the project as would have done the original project.
In formula:
ADEFILA & JAJU 74
 NPV
Y .E .  9
Anr

Compare two projects (r=5%):

0 1 2 2 4
-300 150 150 50 50
Project A: with NPVA = 63

0 1 2 3 4 5 6 7 8
Project C: -300 60 60 60 60 60 60 60 60 with NPVC = 88

63
The Y.E. for A: 3.54  17.8 ( A45%  3.54) 10

for B: 88 = 13.6 (A 8 5% = 6.46)

Although the NPVC > NPVA we will choose A when we consider the Y.E. Note that a project
with yearly cashflows equal to Y.E. and no investment would result in the same NPV as the
original project:
Project A*: with NPVA* = 63

0 1 2 3 4
0 17.8 17.8 17.8 17.8 With NPVA* = 63

The Payback period, ROI and IRR compared

Looking at the formula for the IRR and doing some calculus yields some interesting results:

n
Ci
IRR from: I =  (1  IIR)
i 1
11
i

Suppose we are dealing with uniform cashflows this can be restated as (IIR = R):

ADEFILA & JAJU 75

 n
1
I  C.
i 1 (1  IIR)i
12
the term behind the summation sign represents a geometric sum (without the term i = 0) resulting in:

1 1
I  C. .[1  ] 13 or
R (1  R ) n

C C 1
R  [1  ] 14
I I. (1  R ) n

Given the formula for the payback period:

I
P  15 (uniform cashflows):
C

we see that R (IRR) is approximated by the reciprocal of the payback period if either n or R is
large. A project with an infinite life would have an IRR exactly equal to its payback reciprocal.
In practice, the payback reciprocal is a helpful tool in quickly estimating the IRR where the
project life is at least twice the payback period. However, in any event the payback reciprocal
will always exceed the IRR.

As the payback reciprocal gives a better approximation of the IRR for projects with a high IRR
(R) and n (life of the project), the ROI approximates the IRR better for low IRR (<20%) and
long n and the RO. Average Investment (ROAI) gives better approximation for high IRR and
very short n.

Summary of Factors for Money computations:

Symbol Factor Description

fi (1  i) n Compound interest factor
fd 1 Discount factor
16
(1  i) n

fAF 1 Annuity future worth factor

17
(1  i n  1

fAP i (1  i ) n Annuity present worth factor

18
(1  i ) n  1

ADEFILA & JAJU 76

 Symbol Factor Description
fK (1  i ) n Capitalised cost factor
19
(1  i ) n  1

n n Number of years
i I Interest rate
P F
; Ffd Present worth of a future sum of
20
fi money
F A Future worth of a sum of money
21
f AF

A A Annual cost of payment

The following graph indicates the area where the several models give the best approximation of
the IRR:

) A: ROAI gives best approximation

% T: ROI gives best approximation
R( 50 P: Payback reciprocal gives best approximation.
40 P
R.
I.
30
20 T

10
A

2 4 6 8 10 20 30
years

Consider for example the following two projects both with a live N=10 years and annual
cashflows of N1000:
I.R.R.(%)
ADEFILA & JAJU 77
 Project A: I = 4,500; C = 1,000; IRR = 18.0%
Payback reciprocal = 22.2%
ROI = 12.2% Payback reciprocal
ROAI = 24.4% gives closest approximation

Project B: I = 6,700; C = 1,000; IRR = 8.0%

Payback reciprocal = 14.9%
ROI = 4.9% ROAI gives closest
ROAI = 9.8% approximation.

This comparison of models illustrate how intuitively used simple models may give "good
enough" results for quick and rough evaluation of investment proposals.

Analysis of typical items under discounted cashflow

1. Future disposal values

The disposal value at the date of termination of a project is an increase in the cashflow in the
year of disposal.

2. Current disposal values and required investment

How does the current disposal value effect the computations in the case if a reckacenebt
decusuib? There are a number of ways to analyse these items, however generally the
required investment is reduced with the disposal value of the old asset to obtain the
required cash outlay for the replacement.

3. Book value and Depreciation

Depreciation is a typical phenomena of accrual accounting that entails an allocation of cost,
not a specific cash outlay. Depreciation and book value are as such ignored in discounted
cash-flow approaches.
However, they may have an important impact on relative cashflows since depreciation is tax
deductible and generates therefore a tax saving (so called tax shield) which can be
considered as a relative cash inflow equal to t x D. Under discounted cashflow techniques,
quick depreciation methods (high depreciation during the early life of the project)
generating higher cash inflows during the early life of the project, are favoured due to the
time value of money. This might become clear from the following example, where there are
two depreciation methods applied to a capital asset worth 10,000 with an estimated life of 5
years and no salvage (disposal ) value.
1 2 3 4 5
ADEFILA & JAJU 78
2000 2000 2000 2000 2000
 A: Straight line depr.

B:Dubbel decline Balance 1 2 3 4 5

(40% of book value)
Incremental cashflows from both systems under consideration is given by:
CSHF (A)i = (1-t).(S-C)i + t D(A)i
CSHF (B)i = (1-t).(S-C)i + t D(B)i
_________________________
CSHF (A)i - CSHF (B)i = t(D(A)i - D(B)i)
which gives for our example an incremental cashflow of:

0 1 2 3 4 5
A-B

-2000,t -400.t +560.t +1136.6 +704.t

If t = 0% there would be no difference between the two systems. Also if the discount rate is r =
0% the difference would be levelled out although system B would yield a better liquidity
position in the early life of the project. The difference becomes significant, however, if r > 0%
and the more significant the higher the discount rate. In our example with r = 10% and t = 48%
the difference would be:

NPVA-B = 0.48(-2000 x 0.9091 - 400 x 0.8264 + 560 x 0.7513 + 1136 x 0.683 + 704 x 0.6209)
= 0.48 x 515 = 247; in favour of the quicker depreciation method B.

4. Income Tax
In practice, comparison between alternatives is best made after considering tax effects. All
incremental costs to a particular project reduce essentially the amount of tax which has to
be paid. As a result tax savings are generated which can be regarded as a relative cash
inflow to the project. Depreciation has already been mentioned but also capital losses
(losses on the sale of fixed assets under their book value) and other charges reduce the tax
cash outflow.

ADEFILA & JAJU 79

 It is important to note here, that interest costs as such are not considered in discounted
cashflow approaches since the discounting itself takes care of this!

5. Overhead analysis
In the relevant cost analysis of overhead, only the overhead that will differ between
alternatives is pertinent. There is need for careful study of the fixed overhead under the
available alternatives. In practice this is an extremely difficult phase of cost analysis,
because it is often difficult to relate the individual costs to any single project.

Capital rationing

Many companies specify an overall limit on the total budget for capital spending. There is no
conceptual justification for such a budget ceiling. Any project with a positive NPV should be
accepted, because the discount rate should reflect any additional capital cost resulting from extra
financing. If capital rationing exist, however, the combination of projects that yield the highest
overall NPV should be selected. Just selecting the projects with the highest IRR or profitability
index within the capital constraints doesn't always result in the optimum choice, since available
capital might be left unused. Suppose the following projects and an amount of N10,000 are
available:

Project I P.V. (1Y) IRR

V 6000 8400 .40

W 3000 4050 .35
X 2000 2600 .30
Y 2000 2560 .28
Z 1000 1000 .00

Two alternative programmes are possible within the budgetary constraint:

I P.V I P.V
A: V 6000 8400 B: V 6000 8400
ADEFILA & JAJU 80
 W 3000 4050 X 2000 2600
(Z 1000 1000) Y 2000 2560
10,000 13,450 10,000 13,560
NPVA = 3,450 NPVB = 3,560

Resulting in a choice for programme B.

(Note: Omitting Z in alternative A would yield the same result). Generally the procedure for
selecting projects under capital rationing is:

(a)Select those projects with the highest IRR or profitability index and establish
alternative combinations within the budgets constraints.

(b)Compute for each combination the overall NPV and select the programme with the
highest NPV.

ADEFILA & JAJU 81

Dealing with Uncertainty

So far, we have been working with the expected values (single amounts) of cashflows in order
to simplify the explanations. If a manager estimates future cashflows, he should have at least
an idea of the possible probability distribution of these cashflows. The shape of the probability
distributions (especially the variance) determines he risk related to the investment opportunity,
in other words the possibility that the actual cashflows will deviate from the expected
cashflows. If there is only a vague idea of the risks involved, i.e. no data is available on
probabilities of cashflows, a sensitivity analysis is the best approach to asses the importance of
those risks to the overall decision. A sensitivity analysis measures the effect of changes in
critical data input on the outcome of a (decision) model. In the context of capital budgeting,
sensitivity analysis answers two questions:

1."How will the IRR or NPV be changed if the useful life or the cashflows used for its
computation are changed? and
2"How far are these input data allowed to change (in other words: how inaccurate are the
initial estimates allowed to be), before the original decision has to be reconsidered.

This concept can be illustrated by the following example:

I = 3791, C(annual cashflow) = 1000, n = 5 years and r = 8%.

Under these conditions the investment would yield a NPV of: (1000 x 3.993 - 3791) = 202.
Suppose now the cashflow to be 900 instead of 1000 (a 10% decrease), this would result in a
NPV: (900 x 3.993 - 3791) = 197, a 20% decrease and resulting in an overall loss and
consequently a rejection of the proposal.

To know how far cash in-flows will have to fall, i.e. how accurate estimates have to be per se,
to breakeven on the investment or to arrive at the point of indifference, the cashflow is
computed for which the project's NPV = 0:
NPV = C x 3.993 - 3791 = 0  C = 950

Thus, cash in-flows can only drop 50 annually to reach the point of indifference regarding the
investment.

Another critical factor is the useful life. If the life of the above project were only four years
the NPV would be 1000 x 3.312 - 3791 = 479 resulting in a rejection of the project. These
calculations are also applicable to testing the sensitivity of rates of return. The fall of an
ADEFILA & JAJU 82
annual cashflow from 1000 to 900 results for example in a 4% drop in the IRR i.e. from 10%
to 6%. With a cut-off rate of 8%, this would also result in a change in the decision, i.e.
rejection of the project. Of course, sensitivity analysis works both ways. It can measure the
potential increases in NPV or IRR as well as the decreases. The major contribution of
sensitivity analysis is that it provides an immediate financial measure of the possible errors in
forecasting. Therefore, it helps focus on those factors (decisions) that may be very sensitive
indeed and it allows relaxation on those not so sensitive.

Limitations of Discounted Cashflow Methods

As already is said, no profitability estimate is better than the inherent accuracy of data. This is
true whether the method is highly sophisticated or relatively crude. Nobody, at least of all top
management is going to appreciate poor data camouflaged in a mass of sophisticated
calculations. When dealing with the risk connected with the ability or inability of the manager
to forecast correctly, the probabilities used are clearly subjective. However, it is often nearly
impossible to produce reliable (cost) figures in the light of rapidly changing conditions (think
of governmental restrictions to imports, etc.). Clearly this might impose serious errors on any
kind of profitability estimate. It should, therefore, be noted that no single index or
measurement of profitability is a substitute for a continuing and overall consideration of a
project. The above described evaluation techniques can only serve as very helpful tools in
such a process. Clearly, overall common sense is needed in making all necessary assessments
and the final decision.

XII. MINIMUM DESIRED RATE OF RETURN: COST OF CAPITAL

In the previous chapter a "minimum desired or required rate of return" has been assumed for
use in the analysis of investment proposals. The problem of identifying this minimum desired
rate or, out-off rate, target rate, or hurdle rate is however one of the most complicated factor
facing financial management. The minimum desired rate of return on a project should at least
cover the cost of the capital required for the project. Most theorist in finance agree that this
cost should be equal to the minimum required return expected by its investors i.e.
stockholders, bond holders, etc. In other words the return that leaves the value of their
investment (and that of the firm) i.e. the price of the firm's securities unchanged. There is
however a lot of disagreement regarding how to exactly measure (compute) the cost of
capital. Nevertheless if we want to make proper investment decisions we cannot avoid the
problem, and we have to settle for some framework for computing the cost of capital.
ADEFILA & JAJU 83
Basic Approach

There are really two basic approached to computing the cost of capital. The "piecemeal"
approach considers each financing as a separate problem; the other develops an average cost
of capital.

The principal objection to the piecemeal approach is the insidious effect of low-cost debt
financing on projects over a series of years. For example, if debt could be arranged on an after
tax cost of 3%, any project with an after-tax return of over 3% would be acceptable. Soon,
however the debt limit for an optimum capital structure would be reached, and extra financing
may show a cost as high as 20% after tax. This would mean that any further project that
could not produce such a high rate would be automatically rejected.

The reasoning underlying the weighted-average cost of capital is that by financing in the
proportions specified by the existing capital structure and accepting investment proposals that
yield more than the average cost, the firm can increase its value i.e. the market price of its
stock. Three important factors are held constant under this approach:
1. The complexion of business risks of the firm as a whole is unaffected by the
acceptance of any investment project.
2. The firm intends to maintain a constant dividend-pay out ratio.
3. The firm finances in the proportions as specified in the capital structure.

To measure the overall cost of capital, the explicit costs of specific sources of funds must be
computed. It should be noted that, although the historical costs of existing financing may
yield insight, we seek to predict the costs of new financing in the proportions that the firm
intends to use over of time.

Common Stock

The cost of common stock is extremely difficult to measure. In concept, it is defined as the
minimum rate of return that the firm must earn on the common-stock-financed portion of an
investment project so that the market price of the stock is unaffected. An example may clarify
this fundamental approach. Suppose the required rate of return on common stock was 10
percent after tax and that the cost of debt (see next topic) was 4 percent after tax. Suppose all

ADEFILA & JAJU 84

financing was 50% debt and 50% equity. The minimum desired rate of return on a project
would be:
debt .5 x .04 = 0.02 )
common stock .5 x 0.10 = 0.05 ) 7%

Consider a project costing N1,000 with an expected after-tax return of N70 per year forever:

total return after tax N70

less interest(.04 x 500) N20

R.O.E. N50

The expected rate of return on common stock is 10%. This just equals the rate of return
required by the investors. If the project failed to yield 7% or N70 per year, the market price of
the stock would decline. How do we now obtain the cost of common stock? The cost of
common stock is the rate of discount that equals the present value of the stream of expected
future dividends per share, as perceived by the investors in the market, with the market price
of the stock. In general it is inappropriate to use the ratio of earnings per share to market
price as the cost of common stock. The focus should be on future dividends (if information is
available), which also means that a growth rate must be assumed.

22....(P.V. of future dividends)

where: Pc = current market price of stock
Di = yearly dividend
k = cost of capital (discount rate)

Now suppose a constant growth rate (g) of the dividends (Di), then
D1 = Do(1+g), D2 = Do(1+g)2 etc.
with Do = Current dividend per share

1 g n
then Pc = D  (
1 k
) ( geometric row )
o n 1

D1
or P c 
kc  g
23
where: D1 =dividend per share expected to be paid at the end of the next year.

ADEFILA & JAJU 85

 From this the cost of common stock can be expressed as:

D1
kc   g . 24
Pc
For example, suppose a company's expected dividend per share is N2, the current market price
is N40 and earnings and dividends are expected to grow about 4% per annum, the company's
cost of common stock is:

N2
25 kc   0.04  0.09 or 9%
N 40
It should be noted that for kc to be realistic, expectations in the market place must be such
that dividends per share are thought to grow in fact at rate of g. The crucial factor and the
biggest difficulty becomes then the measuring of the growth in dividends as perceived by the
investors.

Retained Earnings

There are diverse views as to how to compute the cost of retained earnings. If one would
stick to the notion that the cost of capital is the mere out of pocket cost arising from the
interest and dividend payments, it would imply that any retained earnings are cost free. This is
a dangerous position because it ignores the alternative earnings that could be had from this
funds. To clarify this, suppose you would have a car on a car loan, paying each year a 3%
interest charge i.e. there is an actual 3% cost of capital a year. If you would have bought the
car your own money you would not have had these interest cost. On the other hand, however,
you could have put the same amount of money you spent for the car, on a savings account
giving a 3% interest a year.

In other words you are sacrificing this 3% interest earnings for the possession of the car i.e
this sacrifice represents a opportunity cost equal to the original interest payments. From this
example we see that there is also a cost on the use of retained earnings. This cost is equal to
the opportunity cost as determined by what the firm can obtain on external investment of these
funds. Generally this return should approximate k c, assuming equilibrium in the market
between expected return and risk.

Debt and Preferred Stock

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The effective interest rate for a bond (long term debt) or preferred stock is the rate of discount
that equates the market price of the security to the present value of the amount due at maturity
(in the case of a bond) plus the present value of the series of annual interest payment.

The cost of debt is essentially tax-deductible. Therefore, if the before tax cost (the effective
interest rate) is 8%, the after tax cost at a 40% income tax rate is (1 - 0.4) x 0.08 = 0.048 is
4.8%. The cost of preferred stock, however, is not tax deductible, because it's dividend is paid
after tax.

Weighted Average Cost of Capital (C.O.C.)

Suppose that the capital structure at the latest statement date is indicative of the proportions
of financing that the company intends to use over time. The weighted average cost of capital
is then the sum of the proportional weighted after-tax costs of each individual type of capital.
Amount Proportion Cost Weighted cost
(millions)

common stock 20 .20 9% 1.8%

preferred stock 10 .10 8 .8

retained earnings 40 .40 9 3.6

debt 30 .30 4 1.2 +

weighted-average cost of capital 7.4%

If measured correctly, a weighted-average cost of capital can lead to optimal capital-budgeting

decisions. It should be noted, however, that the cost of capital is only a means to an end: the
maximizing of the overall value (i.e. market price of the common stock) of the firm.

Degree of Risk or Uncertainty

The preceding calculation of the cost of capital assumed that the acceptance of a project or
projects did not change the total risk complexion of the firm as a whole. Capital budgeting
would be simplified if all projects bore the same degree of risk. Then a single cost of capital
could be used for judging all projects. However, different investments bear different degrees
of risk. If the acceptance of an investment proposal(s) alters the risk complexion of the firm,
ADEFILA & JAJU 87
the potential investors may value the company differently before and after acceptance. The
greater the perceived risk, the lower the valuation.

Because it is very hard to evaluate the overall risk of the firm at the operating level, the
evaluation of risk is often confined to the individual proposal. Methods for allowing risk
include: adjusting the minimum desired rate of return; calculation of the expected cash flows
(pay offs) with their probability distributions; and many others. The most frequently
encountered approach in practice is to boost the minimum required rate as risk increases. For
example, a petroleum company may use 8 percent for marketing facilities, 12 percent for
refining facilities and 20 percent for the most uncertain i.e. the development facilities. Other
practical ways of allowing for risk include the use of extremely short payback periods or useful
lives and the ignoring of potential salvage values.

Of all the methods for dealing with risk, the direct use of probability distributions is probably
the most sophisticated and will give management the soundest basis to evaluate the dispersion
of possible outcomes for an investment proposal and its expected pay offs. This method is
better than the use of haphazard techniques such as employing higher arbitrary minimum
desired rates, but depends totally on the availability of sufficient information regarding the
cashflows.

A more penetrating analysis of risk will explicitly consider the relationship of a given
investment proposals. If a project is highly correlated with existing investments, the total risk
of the firm will increase more than if a project is added that has nearly no relation with others,
all other things being equal. Management should be aware of the potential benefits of
diversifying investments to obtain the best combination of expected net present value and risk.

ADEFILA & JAJU 88