Management Management Management Management

Open University of Mauritius - Fundamentals of Finance 1
OPEN UNIVERSITY
of MAURITIUS
Fundamentals of
Finance
OUbs002113
OUbs003113
OUbs009113
Open University of Mauritius - Fundamentals of Finance i

Project coordination
Open University of Mauritius
© Open University of Mauritius, May 2013

First published 2013
All rights reserved. No part of this work may be reproduced in any form or by any means, without
prior written permission from the Open University of Mauritius. Commercial use and distribution of this
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ii Open University of Mauritius - Fundamentals of Finance

MODULE OUbs002113
OUbs003113
FUNDAMENTALS
OUbs009113
OF FINANCE
Aim of the Module
The aim of this module is to help students appreciate the logic for making better financial
decisions and hence, equip them with the basic knowledge of risk, return and investment
and of the different techniques used to minimize losses.
Teaching and learning strategy

The teaching and learning strategy is designed to enable the students to develop an
understanding of the theories and concepts underlying finance and investment and
how to apply the different tools available in a financial decision making process. They
shall also be able to demonstrate their analytical knowledge in assessing an investment
proposal and to evaluate their implications for the shareholders and the company.
Assessment Strategy
The assessment strategy is designed to assess the extent to which students have
understood, and are able to apply, the theories, concepts and formulae.
Unit(s) of Assessment Weighting Towards Module Mark (%)

Continuous assessment 30%
Written Examination 70%
Learning objectives of the module

Module Outline: The accounting equation- the double entry system of bookkeeping -
books of original entry-preparing financial statements- reconciling the bank balance
- adjustments to final accounts-depreciation, disposal and revaluation of non-current
assets-errors affecting and not affecting the trial balance agreement.
By the end of the semester, you will be able to do the following:
Units Learning Objectives
Unit 1 • Differentiate between financial statement and cash flow statement
• Elaborate on the users of financial analysis
• Explain the nature of ratio analysis
• Describe the concept of financial planning and strategy
Unit 2 • Understand the factors that gives money its value
• Explain the methods in calculating the present and future values
• Apply formulae relating to present value and future value of annuities.
Unit 3 • Understand the different concepts and importance of investment
decisions
• Explain the NPV, IRR, payback and profitability Index as tools for
investment decision.
• Show the implications of NPV and IRR
• Describe the non discounted cash flow evaluation criteria.
Unit 4 • An introduction to the different sources of finance available to
management
• An overview of the advantages and disadvantages of the different
sources of funds
• Elaborate on the factors governing the choice between different
sources of funds.
Open University of Mauritius - Fundamentals of Finance iii

Unit 5 • Define Bond Analysis
• Describe the fundamental characteristics of Bonds
• Analyse Pricing of Bonds
• Explain the steps in measuring the Return on Bonds
Unit 6 • Explain the concept of risk and return
• Evaluate the risk and expected return of an investment under risky
conditions.
• Explain the uses of CAPM
• Explain what are an Efficient Frontier, Security Market Line and
Capital Market Line.
• Elaborate on the assumptions and limitations of CAPM
Unit 7 • Define Efficient Market Hypothesis (EMH).
• Distinguish between the different forms of efficiency, mainly weak
form, semi-strong form and strong form.
• Elaborate on the criticisms of EMH
Unit 8 • Define working capital management
• Explain the concepts of working capital management
• Assess the importance of working capital management
Guidelines for self-study

This manual aims at fulfilling the preciously identified learning objectives. Despite the
fact that this manual is self-contained, you are expected to do some additional research
in books and academic articles to deepen your understanding of quantitative techniques
and research methodology.
Manual:
Open University of Mauritius OUbs002113, OUbs003113 & OUbs009113: Fundamentals
of Finance
References
Financial Theory and Corporate Policy – Thomas Copeland and Fred Weston
Corporate Finance and Investment – Decision and Strategies – Richard Pike and Bill Neale
Capital Markets – Institutions and Instruments – Frank Fabozzi and Franco Modigliani
Students will need to thoroughly search the numerous journals. Articles in reputable journals
often deal with a topic in much more detailed than textbooks. Moreover, because articles are
generally peer reviewed, they are likely to have more credibility. Some of the frequently cited
business journals are:
Finance/Accounting
• Financial Management
• Journal of Finance
• Journal of Financial Research
• Journal of Financial Economics
• Management Accounting
Video:
How to use the Manual

l Read the overview and learning objectives of each Unit. This will help you in
identifying the knowledge and skills that is required to successfully complete
the study of the Unit.
l Use the accompanying video.
l E-mail the tutor in case you don’t understand any part of the manual.
iv Open University of Mauritius - Fundamentals of Finance

How to study
l Plan your study time carefully
l Read the Unit thoroughly. Prepare a list of questions that you may ask your
tutor. Note that the questions should be relevant to the Unit studied.
l Be a critical thinker
l Work your activities. It is important for you to attempt all activities as this will
give you an idea of concepts that you have not understood.
l Re-work your corrected activities later.
l You are expected to study regularly as there is no ‘easy’ way to pass the
examination.
Open University of Mauritius - Fundamentals of Finance v

vi Open University of Mauritius - Fundamentals of Finance
Table of Contents
UNIT 1 - Financial Statement and Planning 1
UNIT 2 - The Time Value of Money 9
UNIT 3 - Capital Budgeting Decisions 21
UNIT 4 - Sources of Finance 29
UNIT 5 - Valuation of Bonds and Other Securities 39
UNIT 6 - Risk and Return and Capital Asset Pricing Model 45
UNIT 7 - Introduction to Stock Market 55
UNIT 8 - Working Capital Management 61
Solutions to Activities 67
Open University of Mauritius - Fundamentals of Finance vii

viii Open University of Mauritius - Fundamentals of Finance
1
UNIT FINANCIAL STATEMENT AND
PLANNING
Unit Structure
1.0 Overview
1.1 Learning Objectives
1.2 Financial statement and cash flow analysis
1.3 Ratio Analysis
1.3 .1 Profitability Ratios
1.3 .2 Liquidity Ratios
1.3 .3 Activity Ratios
1.3 .4 Long Term Solvency and Leverage Ratios
1.4 Strategic and Financial Planning
1.5 The Strategic Planning and Decision Making Process
1.6 Activities
1.7 Summary
1.0 OVERVIEW
Management of any business requires a flow of information to make informed, intelligent
decisions affecting the success or failure of its operations. Investors need statements to
analyze investment potential. Banks require financial statements to decide whether or
not to lend money, and many companies need statements to ascertain the risk involved in
doing business with their customers and suppliers. Financial statements are customarily
prepared on a quarterly, biannual or annual basis. The date of a financial statement is
of considerable importance. Most are drawn up on a yearly (fiscal) basis. Statements
provided that are outside of the fiscal closing are known as interim statements.
1.1 LEARNING OBJECTIVES

By the end of this Unit, you should be able to do the following:
(i) Differentiate between financial statement and cash flow statement
(ii) Elaborate on the users of financial analysis
(iii) Explain the nature of ratio analysis
(iv) Describe the concept of financial planning and strategy
1.2 FINANCIAL STATEMENTS AND CASH FLOW

ANALYSIS
There are four main financial statements. They are: (1) balance sheets; (2) income
statements; (3) cash flow statements; and (4) statements of shareholders’ equity. Balance
sheets show what a company owns and what it owes at a fixed point in time. Income
statements show how much money a company made and spent over a period of time.
Cash flow statements show the exchange of money between a company and the outside
world also over a period of time. The fourth financial statement, called a “statement of
shareholders’ equity,” shows changes in the interests of the company’s shareholders
over time.
Balance Sheets
A balance sheet provides detailed information about a company’s assets, liabilities and
shareholders’ equity.
Assets are things that a company owns that have value. This typically means they can
either be sold or used by the company to make products or provide services that can be
sold. Assets include physical property, such as plants, trucks, equipment and inventory.

It also includes things that can’t be touched but nevertheless exist and have value, such
as trademarks and patents.
Liabilities are amounts of money that a company owes to others. This can include all
kinds of obligations, like money borrowed from a bank to launch a new product, rent for
use of a building, money owed to suppliers for materials, payroll a company owes to its
employees, environmental cleanup costs, or taxes owed to the government. Liabilities
also include obligations to provide goods or services to customers in the future.
Shareholders’ equity is sometimes called capital or net worth. It’s the money that would
be left if a company sold all of its assets and paid off all of its liabilities. This leftover
money belongs to the shareholders, or the owners, of the company.
A balance sheet shows a snapshot of a company’s assets, liabilities and shareholders’
equity at the end of the reporting period. It does not show the flows into and out of the
accounts during the period.
Income Statements
An income statement is a report that shows how much revenue a company earned over a
specific time period (usually for a year or some portion of a year). An income statement
also shows the costs and expenses associated with earning that revenue. The literal
“bottom line” of the statement usually shows the company’s net earnings or losses. This
tells you how much the company earned or lost over the period.
Income statements also report earnings per share (or “EPS”). This calculation tells how
much money shareholders would receive if the company decided to distribute their net
earnings for the period.
Cash Flow Statements

A cash flow statement, along with the balance sheet and income statement, are the three
most common financial statements used to gauge a company’s performance and overall
health. The same accounting data is used in preparing all three statements, but each
takes a company’s pulse in a different area. The cash flow statement discloses how a
company raised money and how it spent those funds during a given period. It is also an
analytical tool, measuring an enterprise’s ability to cover its expenses in the near term.
Generally speaking, if a company is consistently bringing in more cash than it spends,
that company is considered to be of good value.
A cash flow statement is divided into three parts: operations, investing and financing.
Cash from operations: This is cash that was generated over the year from the company’s
core business transactions. The statement starts with net earnings and works backward,
adding in depreciation and subtracting out inventory and accounts receivable. In simple
terms, this is earnings before interest and taxes (EBIT) plus depreciation minus taxes.
Cash from investing: Some businesses will invest outside their core operations or
acquire new companies to expand their reach.
Cash from financing: The third part of a cash flow statement shows the cash flow
from all financing activities. Typical sources of cash flow include cash raised by selling
stocks and bonds or borrowing from banks. Likewise, paying back a bank loan would
show up as a use of cash flow.
1.3 RATIO ANALYSIS

Financial statement analysis is defined as the process of identifying financial strengths
and weaknesses of the firm by properly establishing relationship between the items of the
balance sheet and the profit and loss account. There are various methods or techniques
that are used in analyzing financial statements, such as comparative statements, schedule
of changes in working capital, common size percentages, funds analysis, trend analysis,
and ratios analysis.
Financial statements are prepared to meet external reporting obligations and also for
2 Open University of Mauritius - Fundamentals of Finance

decision making purposes. They play a dominant role in setting the framework of
managerial decisions. But the information provided in the financial statements is not an
end in itself as no meaningful conclusions can be drawn from these statements alone.
However, the information provided in the financial statements is of immense use in
making decisions through analysis and interpretation of financial statements.
The ratios analysis is the most powerful tool of financial statement analysis. Ratios
simply mean one number expressed in terms of another. A ratio is a statistical yardstick
by means of which relationship between two or various figures can be compared or
measured. Ratios can be found out by dividing one number by another number. Ratios
show how one number is related to another.
1.3.1 Profitability Ratios:

Profitability ratios measure the results of business operations or overall performance
and effectiveness of the firm. Some of the most popular profitability ratios are as under:
• Gross profit ratio
• Net profit ratio
• Return on shareholders investment or net worth
• Return on equity capital
• Return on capital employed (ROCE) Ratio
• Dividend yield ratio
• Earnings Per Share (EPS) Ratio
• Price earning ratio
1.3.2 Liquidity Ratios:

Liquidity ratios measure the short term solvency of financial position of a firm. These
ratios are calculated to comment upon the short term paying capacity of a concern or the
firm’s ability to meet its current obligations. Following are the most important liquidity
ratios.
• Current ratio
• Liquid / Acid test / Quick ratio
1.3.3 Activity Ratios:

Activity ratios are calculated to measure the efficiency with which the resources of
a firm have been employed. These ratios are also called turnover ratios because they
indicate the speed with which assets are being turned over into sales. Following are the
most important activity ratios:
• Inventory / Stock turnover ratio
• Debtors / Receivables turnover ratio
• Creditors / Payable turnover ratio
• Working capital turnover ratio
• Fixed assets turnover ratio
1.3.4 Long Term Solvency or Leverage Ratios:

Long term solvency or leverage ratios convey a firm’s ability to meet the interest costs
and payment schedules of its long term obligations. Following are some of the most
important long term solvency or leverage ratios.
• Debt-to-equity ratio
• Ratio of fixed assets to shareholders funds
• Ratio of current assets to shareholders funds
• Interest coverage ratio
• Capital gearing ratio
Although financial statement analysis is a highly useful tool, it has two limitations.
These two limitations involve the comparability of financial data between companies
and the need to look beyond ratios.

There are various advantages of financial statements analysis. The major benefit is
that the investors get enough idea to decide about the investments of their funds in
the specific company. Secondly, regulatory authorities like International Accounting
Standards Board can ensure whether the company is following accounting standards or
not. Thirdly, financial statements analysis can help the government agencies to analyze
the taxation due to the company. Moreover, company can analyze its own performance
over the period of time through financial statements analysis.
1.4 STRATEGIC AND FINANCIAL PLANNING

In order to succeed in its industry or field, a corporation, institution or organization
has to know where it is going. A strategic plan can help define and set the course.
A strategic plan is the result of strategic planning. It is during this process that the
organization decides, in finite, simple terms, its place and where it ultimately would
like to go. In other words, a business provides a certain service. The plan defines what
the institution does, for whom, and how they intend to excel and beat the competition.
Most importantly, why does the organization want to go where it's going, and how is
it going to get there? This is strategic planning. It's a survival method, the cornerstone
of an organization, and the voice that informs the company culture, or overall "feel,"
philosophy and code of an organization.
Strategic planning is essentially the "why" that drives an operation. Once it knows the
"why," it can figure out the "how" by outlining the requirements to get there, including
where to place financial resources, how to forecast human resource needs, and where
to place investments, otherwise known as financial planning. Financial planning is all
about allocating finite resources -- such as money, employees and equipment -- over
time, to reach the broad goals set out in strategic planning. To do so involves measuring
current performance against past data and trends for the future.
1.5 THE STRATEGIC PLANNING AND DECISION

MAKING PROCESS
Any person, corporation, or nation should know who or where they are, where they
want to be, and how to get there. The strategic-planning process utilizes analytical
models that provide a realistic picture of the individual, corporation, or nation at its
“consciously incompetent” level, creating the necessary motivation for the development
of a strategic plan. The process requires five distinct steps and the selected strategy must
be sufficiently robust to enable the firm to perform activities differently from its rivals
or to perform similar activities in a more efficient manner.
A good strategic plan includes metrics that translate the vision and mission into specific
end points. This is critical because strategic planning is ultimately about resource
allocation and would not be relevant if resources were unlimited.
The Strategic-Planning and Decision-Making Process

1. Vision Statement
The creation of a broad statement about the company’s values, purpose, and future
direction is the first step in the strategic-planning process. The vision statement must
express the company’s core ideologies—what it stands for and why it exists—and its
vision for the future, that is, what it aspires to be, achieve, or create.
2. Mission Statement
An effective mission statement conveys eight key components about the firm:
target customers and markets; main products and services; geographic domain; core
technologies; commitment to survival, growth, and profitability; philosophy; self-
concept; and desired public image. The finance component is represented by the
company’s commitment to survival, growth, and profitability. The company’s long-
term financial goals represent its commitment to a strategy that is innovative, updated,
unique, value-driven, and superior to those of competitors.

3. Analysis
This third step is an analysis of the firm’s business trends, external opportunities,
internal resources, and core competencies. For external analysis, firms often utilize
Porter’s five forces model of industry competition, which identifies the company’s level
of rivalry with existing competitors, the threat of substitute products, the potential for
new entrants, the bargaining power of suppliers, and the bargaining power of customers.
4. Strategy Formulation
To formulate a long-term strategy, Porter’s generic strategies model is useful as it helps
the firm aim for one of the following competitive advantages: a) low-cost leadership; b)
differentiation; c) best-cost provider; d) focused low-cost; or e) focused differentiation
5. Strategy Implementation and Management
A balanced scorecard is used which ensures that the strategy is translated into objectives,
operational actions, and financial goals and focuses on four key dimensions: financial
factors, employee learning and growth, customer satisfaction, and internal business
processes
1.6 ACTIVITIES
ACTIVITY 1
Mr Xavier, the Managing Director of Xavier International is making plans for next year.
He estimates that his company will be utilising total assets worth MUR1,500,000 out
of which 60% will be financed by borrowed funds at a cost of 9.25% per annum. The
direct costs for the year are estimated at MUR530,000 and other operating expenses at
MUR175,000. The goods will be sold at 150% of direct costs and the corporate tax rate
is 15%.
Calculate:
(i) Net profit margin
(ii) Return on assets
(ii) Asset turnover
(iv) Return on owners’ equity
ACTIVITY 2
Vix Ltd (VL) is a private equity company which wishes to invest in the winter sports
equipment sector. VL has identified two potential acquisition targets: Mads Ltd and
Macs Ltd.
The following are very brief corporate profiles:
• Mads Ltd specialises in high quality equipment and has retail outlets in some of the
major ski resorts. It also sells to the shops in 5-star hotels. The directors of Mads
Ltd have sports and leisure marketing backgrounds and the company was originally
financed by wealthy individual investors. The key strategy of the company is to
develop a leading quality brand position.
• Macs Ltd sells by distributing to dealerships based in mid-range department
stores and supermarket chains. The directors of Macs Ltd have general retailing
and finance backgrounds. The strategy of the company is to develop wide ranging
markets within a sound financial framework.
Profit and loss accounts for the year ended 30th June 2011
Mads Mac Ltd
$m $m
Turnover 960 1,200
Cost of sales (717) (975)
Gross profit 243 225
Other costs (148) (117)

Operating profit 95 108
Interest (9) (14)
Profit before tax 86 94
Taxation (25) (30)
Profit for the year 61 64
th
Balance sheets as at 30 June 2011
Mads Ltd Macs Ltd

$m $m $m $m
Fixed assets
Freehold land & buildings 548 274
Equipment and vehicles 67 150
615 424
Current assets
Inventories 210 240
Trade debtors 45 41
255 281
Creditors: amounts due within one year
Trade creditors (112) (61)
Taxation (25) (30)
Bank overdraft (128) (5)
(265) (96)
Net current assets/liabilities (10) 185
Total assets less current liabilities 605 609
Creditors: amounts due after one year

Loans - (150)
605 459
Capital and reserves
Ordinary share capital (50p shares) 400 250
Retained earnings 205 209
605 459
REQUIRED
th
(a) Compute eight accounting ratios for the year ended 30 June 2011 which provide
insights into the financial position and performance of the two companies, as
follows:
i. Profitability (Earnings per share and two other ratios).
ii. Working capital control (three ratios).
iii. inancial risk (two ratios)
N.B. Show all calculations. Answers to one decimal place.
(b) For each of i. ii. and iii. explain how the ratios illustrate the company profiles
given above.

(c) Based on the information available briefly evaluate the financial position and
performance of each company from the perspective of the prospective purchaser,
Vix Ltd .

ACTIVITY 3
Explain the need for financial analysis. How does the use of ratios help in financial
analysis?
1.7 SUMMARY
The balance sheet is a statement of the firm’s assets, liabilities and equity on a specific
date. Assets are economic resources that help generating revenues. Liabilities are the
firm’s obligations to creditors and equity is the investment made by the owners in the
firm. Both the balance sheet and the profit and loss statement do not explain the changes
in assets, liabilities and owner’s equity. The statement of changes in financial position
is prepared to show these changes and these are the funds flow statement and the cash
flow statement.
Financial planning of a company has close links with strategic planning. The company’s
strategy establishes an effective and efficient match between its resources, opportunities
and risks and provides a mechanism of integrating the goals of the shareholders.
Sound decision making requires that the cashflows which a company expects to derive
over a certain time period should be comparable. However, absolute cashflows which
differ in timing and risk are not directly comparable. When the differences in timing
and risk are adjusted in the cashflows, the latter can more easily be used in making
a decision. Thus, the recognition of the time value of money and risk is essential in
financial decision making. In the next chapter, we shall elaborate on the aspects of time
value of money.

2
UNIT
The Time Value of Money
Unit Structure
2.0 Overview
2.2 Time Value 0f Money
2.3 Interest and Compound Interest
2.3.1 Simple Interest
2.3.2 Compound Interest
2.4 The Rule of 72
2.5 The Effective Annual Rate (EAR)
2.6 Discounting and Present Value
2.6.1 Periodic Uneven Cash Flow
2.7 Annuity
2.7.1 Types of Annuities
2.8 Future Value of Annuity
2.8.1 Future Value of a Due Annuity
2.9 Activities
2.10 Summary
2.0 OVERVIEW
In the previous chapter, we looked at the basis for financial planning analysis and
decision making. Financial information is needed to predict, compare and evaluate a
company’s financial performance. It is also required in economic and financial decision
making. Most financial decisions affect a company’s cash flow positions during different
time periods. This chapter explains why most individuals will value the opportunity to
receive more money today higher than waiting for one or more time period to receive
the same amount. More emphasis will also be laid on the three reasons attributed to this
time preference of money, namely risk, preference for consumption and investment
opportunities.

1. Understand the factors that gives money its value
2. Explain the methods in calculating the present and future values
3. Apply formulae relating to present value and future value of annuities.
2.2 TIME VALUE OF MONEY

Rational decision making requires that the cash flow streams which a company is willing
to receive or give up during a certain period of time to be logically comparable. However,
the absolute cash flows which differ in timing and risk are not directly comparable and
same being logically comparable when adjustments are brought for their difference.
Hence, the recognition of the time value of money and risk is crucial in financial
decision making. A firm may deviate from maximizing its shareholders’ wealth if no
consideration is brought to the aspect of timing and risk. The welfare of the shareholders
will be maximized when net present value is being created from a financial decision.
Time value of money is therefore a process that shows what a future cash flow would
worth now. The value of the money depends on when the cash flow occurs and is
influenced by the following reasons:

Inflation.
If inflation is expected, the purchasing power of money and therefore its value or utility
falls over time.
Risk
There is likely to be greater risk associated with future cash flows than with present ones
because of its possible consequences of intervening events.
Individual’s consumption preferences
In general, people appear to prefer consumption now to consumption in the future. In
fact, the main belief is that in the future, we may not be around to do the consumption.
Opportunity costs
Having $100 now is much preferred and better now than having $100 in one year’s
time because we would have the opportunity of investing the funds. For example, if the
interest rate shall be 7%, the $100 today will be worth $107 in one year’s time. In other
words, the sooner your money can earn interest, the faster the interest can earn interest.
2.3 INTEREST AND COMPOUND INTEREST
2.3.1 Simple Interest

Interest is the return you receive for investing your money. For instance, simple interest
is calculated only on the principal amount or on that portion of the principal amount
which remains unpaid.
Illustration:
For example, suppose you want to invest $ 10,000 for 4 years @ 5% simple interest per
annum.
Future value (FV) = 10,000 + 10,000 x 0.05 + 10,000 x 0.05 + 10,000 x 0.05 + 10,000
x 0.05
= 10,000 [ 1 + (1 x 0.05) + (1 x 0.05) + (1 x 0.05) + (1 x 0.05) ]
= 10,000 [1 + (0.05 x 4) ]
= $12,000
Generalising, we can therefore state:

FV = PV [ 1 + (r x n) ]
Where:
FV = Future value
PV = Present value
r = Proportional rate of interest per period
n = Number of periods
2.3.2 Compound Interest

Compound interest is the interest that your investment earns on the interest that your
investment previously earned.
Illustration 1:
Suppose you want to invest the $10,000 for 4 years @ 5% compound interest per annum.
FV = 10,000 + (10,000 x 0.05) + [ 10,000 + (10,000 x 0.5) ] x 0.05 + [ 10,000 + (10,000

x 0.05) x 0.05 ] x 0.05+ [ 10,000 + (10,000 x 0.05) x 0.05 x 0.05] x 0.05

= 10,000 (1 + 0.05) + 10,000 (1 + 0.05) x 0.05 + 10,000 (1 + 0.05) x 0.05 x 0.05+
10,000 (1 + 0.05) x 0.05 x 0.05 x 0.05
= 10,000 (1 + 0.05) [ 1 + 0.05] [ 1 + 0.05] [ 1 + 0.05]
= 10,000 (1 + 0.05)4
Generalising we can write:

FV = PV (1 + r )n
Illustration 2:
Suppose you make an investment of $1,000. This first year the investment returns 12%,
the second year it returns 6%, and the third year in returns 8%. How much would this
investment be worth, assuming no withdrawals are made?
Answer:
=1000*(1.12) x (1.06) x (1.08) = $1,282
Illustration 3:
You borrow $80,000 to be repaid in equal monthly installments for 30 years. The
Annualized Percentage Rate (APR) is 9%. What is the monthly payment?
PV = $80,000 I = 0.75%,
t = 360 PMT = ?
$80,000 = PMT x 124.282

PMT = $643.70
Illustration 4:
Shares in an ethanol plant sell for $2,000 today and will be worth $2,500 in 3 years.
What is the rate of return expressed as an annually compounded interest rate?
r = (FV/PV)(1-t) - 1 = (2,5000/2,000)1/3 - 1 = 7.72%
2.4 THE RULE OF 72

The Rule of 72 estimates how many years it will take for an investment to double in
value.
The number of years to double = 72/ annual compound growth rate
For example, 72/8 = 9, implies that it will take p years for an investment to double in
value if it earns 8% annually.
2.5 THE EFFECTIVE ANNUAL RATE (EAR)

The APR annualizes interest rates using a simple interest basis whereas the EAR
annualizes interest rates using a compound basis.
Example
Suppose the semi annual interest rate is 5%.
12 months = 10%
The APR is: 5% x _________
6 months
Generalizing we can write: APR = r x n
Where: r is the interest rate per period
n is the number of interest period in one year

The EAR is: (1 + ½ yearly) 2 - 1
( 1 + 0.05)2 - 1 = 0.1025 or 10.25%
Generalizing we can write: EAR = (1 + r)n - 1
Where: r is the interest rate per period
n is the number of interest periods in one year
For instance, we now generalize the formula using the APR and EAR where
APR = 10% and interest is being compounded half yearly. The formula is:
⎛ APR ⎞ n
EAR = ⎜1 + ⎟ − 1
⎝ n ⎠
Where n is the number of interest periods in one year.
Note: The length of the annual compounding period and the effective annual interest
€ rate are inversely related. Therefore, the shorter the compounding period, the quicker
the investment grows.
Illustration 1:
The annual rate is 12%. Calculate the EAR if interest is compounded on a quarterly
basis.
EAR = (1 + 0.03)4 - 1 = 12.5%
Illustration 2:
You plan to retire with a million dollars at the age of 65. How much must you deposit
monthly in an account paying 6% a year [APR], compounded monthly, to accumulate
$1,000,000 by age 65, assuming you are 30 years old?
FV35 = $1,000,000

FV35 = PMT x _______________
[(1+0.005)420 – 1]
0.005
$1,000,000 = PMT (1,424.704)
PMT = $701.90
2.6 DISCOUNTING AND PRESENT VALUE

Discounting is compounding in reverse. It is the interest rate used in bringing future
dollars back to the present. The compound interest rate used for discounting cash flows
is also called the discount rate.
Illustration 1:
Suppose that company has $10,000 to invest in a project. If the funds could be invested
at 10% compound interest, the value of the investment with interest would build up as
follows:
After 1 year: $10,000 x 1.10 = $11,000
After 2 years: $10,000 x 1.102 = $12,100
After 3 years: $10,000 x 1.103 = $13,310
This process is called compounding and compound interest is the interest earned on
both the principal and the re-invested interest. The formula for the future value of an
investment plus accumulated interest after n periods is:
Future value = Present Value (1+r)n

FV = PV (1+r)n
Discounting starts with the future value and converts a future value to a present value.

Illustration 2:
For example, if a company expects to earn a compound rate of return of 10% on its
investments, how much would it need to invest now to have an investment of:
(a) $11,000 after 1 year
(b) $12,100 after 2 years
(c) $13,310 after 3 years
The answer is $10,000 in each case and we can calculate it by discounting the future
cash flows as follows:
(a) $11,000 x 1/1.10 = $10,000
(b) $12,100 x 1/1.102 = $10,000
(c) $13,310 x 1/1.103 = $10,000
Present value is therefore a process that shows what a future cash flow would be worth
today. The discounting formula to calculate the present value of a future sum of money
at the end of n periods is:
PV = FV = FV x 1
(1+r)n
(1+r)n
Discount factor = 1 = (1+r)-n

(1+r)n
Notes:
To use discounting, we must attach precious times to the cash flow and the following
guidelines must be applied:
• A cash outlay to be incurred at the beginning of an investment period occurs in
year 0 and the present value of $1 now, that is in year 0 is (1+r)-0 = $1, regardless
of the value of cost of capital (r)
• A cash outlay which occurs during the course of a year is assumed to occur all
at once at the end of the year and therefore a receipt of $100 spread over the first
year are taking to occur at year 1, that is the time one year from n0w.
• A cash outlay which occurs at the beginning of a year is taken to occur at the
end of the previous corresponding period. Therefore, a cash outlay of $100 at
the beginning of the second year is taken to occur at the end of the first year,
that is at year 1.
2.6.1 Periodic Uneven Cash Flows

What is the value of the following set of cash flows today? The interest rate is 5% for
all cash flows.
Year and Cash Flow

1: $ 200 2: $ 300 3: $ 500 4: $ 1000
Solution: Find Each Present Value and Ad
200 300 500 1000

+ + + =
1.05 1.05 1.05 3 1.05 4
1 2

190.48 272.11 431.92 822.70 = 1,717.21

2.7 ANNUITY
An annuity is a stream of equal cash flows that occur at equal intervals for a given period
of time. In other words, where there is a constant cash flow for several years, we can
calculate the present value by adding together the discount factors for the individual
years. These total factors are known as cumulative present value factors or annuity
factors. Some common examples of annuities are wages and salaries, monthly pensions
and monthly loan repayments.
Illustration
Example what is the present value of an annuity of $100 a year at the end of year for 5
years if interest rates are 10%?
To solve this we could add each individual present value up:
Now Year 1 Year2 Year 3 Year 4 Year 5
$100 $100 $100 $100 $100
Discount factor (10%) 0.909 0.826 0.751 0.683 0.621
Present value 90.0 82.6 75.1 68.3 62.1
Total PV = $379
or can use the following discount factor and then multiply by the cash flow.
PVIFA(r,n) = PVAF(r,n) = 1 - 1 = 1- (1+r)-n
r r (1+r)n r
Thus if interest rates are 10% and you will receive 5 payments, the discount factor is
3,791. Thus the Present Value (PV) of 5 payments of $100 if interest rates are 10% is
PV = PVAF(r,n) * CF
= 3.791 * $100
= $379.10
2.7.1 Types of Annuities

An ordinary annuity is one where the fixed equal payments/receipts occur at the END
of the time interval e.g. salaries paid at the END OF THE MONTH each month.
An important assumption in using the annuity discount factors is that the cash flows
occur at the END of each year. If the cash flows are occurring at the beginning of each
year, the cash flows are called a due annuity, that is the first cash flow occurs today.
Thus, the present value of the first cash flow is equal to the cash flow. One year from
now you will receive another cash flow. This second cash flow occurs at the same time
than the first cash flow of a regular annuity. The present value of an annuity due is
PV = CF + PVAF(r,n-1) * CF
A perpetual annuity - whether ordinary or due - is one which carries on indefinitely. In
other words, a perpetuity pertains to a cash flow that will continue forever and the cash
flow must be equal and forequal interval. Therefore, perpetuity cash flow = equal cash
flow for equal interval for indefinite period of time (starting from Year 1).
Formula for a perpetuity is as follows:
Present value of a perpetuity = Perpetuity
Interest rate
P = A
r

Present value of an ordinary annuity 'A'
Let 'P' denote present value and let 'n' denote the number of terms
A A A A
P = + + + ..................+
(1+r)1 (1+r)2 (1+r) 3 (1+r) n [1]
1
Multiply [1] by gives:
(1+r)
€
P A A A A A
= + + + ..................+ +
(1+r )€ (1+r)2 (1+r) 3 (1+r) 4 (1+r) n (1+r) n+1
[2]
Taking [1] - [2] gives:

€
P A A
P - = -
(1+r) (1+r)1 (1+r) n+1
[3]
Multiplying [3] by (1+r) gives:

€
A
P (1+ r) - P = A -
(1+r ) n
A
P + Pr - P = A -
(1+r) n
⎡ ⎤
1 ⎥
Pr = A 1 -
⎢
⎢ (1+r) n ⎥
⎣ ⎦
⎡ 1 ⎤
⎢1 -
1+r) n ⎥
⎥
€
P = A ⎢ (
⎢ r ⎥
⎢ ⎥
⎣ ⎦
[4]
Present value of an ordinary annuity 'A' to infinity

€
From equation [4] above as n tends to infinity [5]

Present value of a due annuity 'A'  
 
 
A A A A
P = A + + + + ..................+
(1+r)1 (1+r)2 (1+r) 3 ( 1+r n−1
)
[6]

⎡ 1 ⎤
⎢1 -
1+r) n−1 ⎥
⎥
P = A + A ⎢ (
⎢ r ⎥
⎢ ⎥
⎣ ⎦ (b) [7]
Illustration 1:
Find the present value of an ordinary annuity of $ 10,000 per year for 4 years if the
€ interest rate is 10% per year.
⎡ 1 ⎤
⎢1 -
1+0.10) 4 ⎥
⎥
P = 10,000 x ⎢ ( = $ 31,698.65
⎢ 0.10 ⎥
⎢ ⎥
⎣ ⎦
Note: The annuity factor can also be viewed from the annuity table (refer to appendix 1)
€ Illustration 2:
What is the present value of a due annuity of $ 10,000 per year for 5 years if the interest
rate is 10% per year.
⎡ 1 ⎤
⎢1 -
1+0.10)5−1 ⎥
⎥
P = 10,000 + 10,000 x ⎢ ( = $ 41,698.65
⎢ 0.10 ⎥
⎢ ⎥
⎣ ⎦
2.8 FUTURE VALUE OF AN ANNUITY

€
The future value (F) of an annuity invested each period (at interest per period r) starting
one period from now for n periods is:
1 2 3 n-2 n−1
1. F = A + A (1+r) + A (1+r) + F = A (1+r) + ............... A (1+r) + A (1+r)
€
Last annuity 2nd Annuity 1St Annuity
Multiply throughout by (1 + r)
2. F (1+ r ) =
A(1+r)1 + A (1+r) 2 + A (1+r) 3 + ..................+ A (1+r) n-1 + A (1+r) n
Take (2) – (1)

€ F (1+ r) – F = A (1+ r ) n - A
F + Fr – F = A (1+ r ) n - A
⎡(1+r) n - 1⎤
F=A ⎢ ⎥
⎢⎣ r ⎥⎦


Example:
What is the future value of a 4-year annuity, if the annual interest is 5%, and the annual
payment is $1,000?
i = 5%; PMT = $1,000; t =4; FV = ?
$1,000x [1+ (1.05) + (1.05)2 + (1.05)3] =

$1,000 x [FVIFA (4,5%)] =
$1,000 x [4.3101] = $4,310.10
2.8.1 Future Value of a Due Annuity

The future value (F) of an annuity invested each period (at interest per period r) starting
now for n periods is:
F = A(1+ r) + A (1+r) 2 + A (1+r) 3 + ...............+ A (1+r) n

Multiply throughout by (1 + r )
F = A (1+r) 2 + A (1+r) 3 + A (1+r) 4 + ............... A(1+r) n + A (1+r) n+1

€
Take (2) – (1) Term before last term
€
F (1+ r) – F = A(1+r) n+1 - A(1+ r)
F + Fr – F = A(1+r) n+1 - A(1+ r)

€ ⎡(1+r) n - 1⎤
F = A(1+ r) ⎢ ⎥
€ ⎢
⎣ r ⎥⎦

For example if you invest $1000 a year for three years how much will you have at the
end of three years? If r=10%, n=3
€
FV = CF * (FVAF(r,n))
= $1000 * 3.3100
= $3,310.00
Illustration:
Suppose you retire at the age of 70, with the life expectancy of 20 years. You expect to
spend $ 55,000 at the end of each year during your retirement. How much money do you
need to save by the age of 70 (lump sum) to support your post retirement consumption
expenditure? Assume an interest rate 7%.

Lump sum at P70 = 55,000 + 55,000 + 55,000 + ----- + 55,000
(1 + 0.07) (1 + 0.07)2 (1 + 0.07)3 (1 + 0.07)20
⎡ 1 ⎤
⎢1 - 20 ⎥
⎢ (1.07) ⎥
= 55,000
⎢ 0.07 ⎥
⎢ ⎥
⎣ ⎦
= $ 582,670.78
€
2.9 ACTIVITIES
Activity 1
1) You are considering an investment in a 6-year annuity. At the end of each year
for the next six years you will receive cash flows of $90. The initial investment is
$414.30. To the nearest percent, calculate the rate of return are you expecting from
this investment? (Annual Compounding)
2) Your mortgage payment is $600 per month. There is exactly 180 payments
remaining on the mortgage. The interest rate is 8.0%, compounded monthly. The
first payment is due in exactly one month. Calculate the loan balance.
[Note: Balance = PV of remaining payments.]
3) (a) What is the net present value (NPV) for a berry patch that costs $3,000
to plant in year 1, then generates a net return of $2,500 in year 2 and 3
and $1,000 in year 4, assuming a 10% discount rate? As part of your
calculations, fill in the two columns in the table below:
Year Net Return Present Value

1
2
3
4
NPV

(b) What is the annuity equivalent to the time varying returns from the
berry patch?
 
The annuity factor formula is K = 1 1 – 1 , so that the
annuity is C = NPV/K r (1 + r)t
2.10 SUMMARY
• Individual investors prefer cash now rather than the same amount at some future
time.
• This time preference for money is due to (a) uncertainty of cash flows, (b) subjective
preference for consumption and (c) availability of investment opportunities.
• FV = PV [1+ (r * n) ] for simple interest.
FV = PV [1+ r]n for compound interest.
• APR = r * n
EAR = (1 + r) n – 1
APR
=[ 1 +
n
]n – 1
• Present value of an ordinary annuity
⎡ 1 ⎤
⎢€1 -
1+r) n ⎥
⎥
P = A ⎢ (
⎢ r ⎥
⎢ ⎥
⎣ ⎦

€
• Present value of an ordinary annuity to infinity
A
P=
r
• Present value of a due annuity
€ ⎡ 1 ⎤
⎢1 -
1+r) n−1 ⎥
⎥
P = A + A ⎢ (
⎢ r ⎥
⎢ ⎥
⎣ ⎦

• Future value of an ordinary annuity
⎡(1+r) n - 1⎤
€ F=A ⎢ ⎥
⎢⎣ r ⎥⎦

• Future value of a due annuity
⎡ n - 1⎤
F = A(1+ r) ⎢(1+r)
€
⎥
⎢⎣ r ⎥⎦
In the next chapter, we shall be looking at how a company will make use of its funds.
An efficient allocation of capital is most important and it involves decisions to commit
the company’s
€ funds to long term assets. Capital budgeting or investment decisions are
of considerable importance to the company since they tend to determine its value by
influencing its growth, profitability and risk.

3
UNIT
CAPITAL BUDGETING DECISIONS
Unit Structure
3.0 Overview
3.2 Capital Budgeting Decision process
3.3 Payback Period
3.3.1 Discounted Payback Method
3.4 Net Present Value
3.5 Internal Rate of Return
3.6 Profitability Index
3.7 Activities
3.8 Summary
3.0 OVERVIEW
In the previous chapter, we explained the importance of time value of money and risks in
financial decision making. Thus, shareholders’ wealth will be maximised when wealth
or net present value is created from making a decision. An efficient allocation of capital
is the most important finance function of a company. It involves decisions to commit
the firm’s funds to the long term assets. Hence, capital budgeting is the most significant
financial activity of the firm. It determines the core activities of the firm over a long term
future and capital budgeting decisions must be made carefully and rationally. Capital
budgeting is of considerable importance to the firm since it tends to determine its value
by influencing its growth, profitability and risks.

1. Understand the different concepts and importance of investment decisions
2. Explain the NPV, IRR, payback and profitability Index as tools for investment
decision.
3. Show the implications of NPV and IRR
4. Describe the non discounted cash flow evaluation criteria.
3.2 THE CAPITAL BUDGETING DECISION PROESS

Investment decisions require special attention because of the following reasons:
• They influence the business’ growth in the future
• They affect the risk of the firm
• They involve the commitment of large amount of funds
• They are among the most difficult decisions to make.
The capital budgeting process involves three basic steps:
(i) Generating long term investment proposals
(ii) Reviewing, analysing and selecting proposals that have been granted
(iii) Implementing and monitoring the proposals that have been selected.
The main capital budgeting decisions used are:
• Payback period – commonly used
• Discounted payback period
• Net Present Value (NPV) – best technique theoretically but difficult to calculate
realistically
• Internal Rate of Return (IRR) – widely used with strong intuitive appeal
• Profitability Index (PI) – related to the NPV.

Of note, in view to maximising the return, managers should separate investment and
financial decisions. A capital budgeting process should therefore:
• Account for the time value of money
• Account for risk
• Focus on cash flow
• Rank competing projects appropriately
• Lead investment decisions that maximise shareholders’ wealth.
When a company is considering any investment projects, it will have to consider the
following useful concepts which are:
• Mutually exclusive projects – A set of projects where only one can be selected
• Independent Projects – Projects whose cash flows are not affected by the
acceptance or rejection of other projects
• Unlimited funds vs. Capital Rationing – This means that whether the company
will be able to raise any amount of funds to finance any profitable projects or
will it have only a fixed amount of funds available?
• Accept-Reject Vs. Ranking – Approaches to capital budgeting depends on the
supply of funds available.
3.3 PAYBACK PERIOD

The payback method is one of the most popular and widely used methods of evaluating
investment proposals. The payback period is the amount of time required for the firm to
recover its initial investment. That is, the payback period can be calculated by dividing
the cash outlay or initial investment by the annual cash inflow.
Payback = Initial Investment = C0
Annual Cash flow C
Illustration 1
For example, ABC company decides to invest in 2 projects (Project A and Project B)
with the following cash flows:
Project A ($) Project B ($)
Initial Investment (1,000) (1,000)
Year 1 500 200
2 400 200
3 300 700
4 100 900
Suppose now that the management of the company set the maximum payback period to
be 2.5 years, advise which project to be chosen.
Payback Project A = 2.33 years
Payback Project B = 2.86 years
Based on above, the company will choose Project A since it will breakeven in 2.33 years
as compared to Project B. However, we note that Project B will derive much return in
the fourth year as compared to Project A.
Illustration 2:
Peters Communications Ltd is evaluating the launching of 2 projects, X and Y and the
investments costs and returns to be derived are as follows:
Project X ($’000) Project Y ($’000)
Initial Outlay (250) (50)
Year 1 35 18
2 80 22
3 130 25
4 160 30
5 175 32

The management of Peters Communications Ltd selects a payback period of 2.75 years.
Advsie which project to be selected.
Payback Project X > 3 years
Payback Project Y = 2.40 years
Hence, the company will choose Project Y.Payback is a popular investment criterion in
practice and it is considered to have certain virtues:
• Computational simplicity;
• Easy to understand;
• Focus on cash flow and liquidity.
However, it has been criticized for the following reasons:

• Does not account properly for the time value of money;
• Does not account properly for risk;
• The cut off period is arbitrary;
• Doesn’t lead to vale maximizing decisions .
3.3.1 Discounted Payback Method

One of the serious criticisms to the payback method has been that the method does not
discount the cash flows for calculating the payback period. The discounted payback
method is the number of periods taken in recovering the investment outlay on the
present value basis. However, the discounted payback period still fails to consider the
cash flows occurring after the payback period.
Illustration 3:
We consider the previous example of Peters Communications Ltd and assuming a
discount rate of 10%. The discounted payback period will be calculated as follows:
Project X ($’000) Discounted Project Y ($’000) Discounted

Value X Value Y
Initial Outlay (250) (250) (50) (50)
Year 1 35 31.8 18 16.4
2 80 66.1 22 18.2
3 130 97.7 25 18.8
4 160 109.3 30 20.5
5 175 108.7 32 19.9
Based on the discounted values of X and Y,

Discounted Payback Project X > 3 years
Discounted Payback Project Y = 2 years and 10 months
3.4 NET PRESENT VALUE

The Net Present Value (NPV) method is the most commonly used method in evaluating
investment proposals. It is a discounted cash flow technique that recognizes the time
value of money. It states that cash flows arising in different time periods differ in value
and are comparable only when their present value equivalents are found. The following
steps are involved in the calculation of NPV:
• The cash flows should be forecasted based on realistic assumptions
• Appropriate discount rate should be identified to discount the forecasted cash
flows. The discount rate is the project’s opportunity cost of capital which is
equal to the required rate of return expected by investors for bearing risks on
similar investments.
• The present value of cash flows should be calculated using the opportunity cost
of capital as the discount rate.
• The project should be accepted if NPV is positive.

NPV = CF0 + CF + CF2 + CF3 + …. + CFn
––––1 ––––– ––––– –––––
(1+r) (1+r)2 (1+r)3 (1+r)n
Illustration:
Assuming that Peters Communications Ltd uses a discount rate of 18%,
NPV Project X = $75,300
NPV Project Y = $25,700
Given that both projects derives positive cash flows, both projects to be chosen.
NPV is the gold standard of investment decision rules. It is the true measure of investment
profitability and provides the most acceptable investment rule for the following reasons:
• NPV focuses on cash flows and not accounting earnings
• It makes appropriate adjustment to time value of money
• It can properly account for risk differences between projects.
The NPV method is a theoretically sound method. However, though being the best
measure, it has some drawbacks:
• Lacks the intuitive appeal of payback
• Does not capture managerial flexibility well.
3.5 INTERNAL RATE OF RETURN (IRR)

The Internal Rate of Return (IRR) method is another discounting cash flow technique
which takes account of the magnitude and timing of cash flows. This method is a one
period project and the IRR is the discount rate that results in a zero NPV for the project.
NPV = 0 = CF0 + CF + CF2 + CF3 + …. + CFn

––––1 ––––– ––––– –––––n
(1+r) (1+r)2 (1+r)3 (1+r)
It can be noticed that the IRR equation is the same as the one used for the NPV method.
In the NPV method, the required rate if return, r, is known and the net present value is
found while in the IRR method, the value of r has to be determined at which the net
present value becomes zero. The IRR is found by computer / calculator or manually by
trial and error. The IRR decision rule is:
• If IRR greater than the cost of capital , accept the project
• If IRR is less than the cost of capital, reject the project.
Illustration:
Assume that Peters Communications Ltd will accept all projects with at least 18% IRR.
Advise which project(s) the company will choose.
IRR Project X = -250 + 35 + 80 + 130 + 160 + 175 = 27.8%

–––– ––––– ––––– –––– –––––
(1+r) (1+r)2 (1+r)3 (1+r)4 (1+r)5
IRR Project Y = -20 + 18 + 22 + 25 + 30 + 32 = 36.7%

–––– ––––– ––––– –––– ––––
(1+r) (1+r)2 (1+r)3 (1+r)4 (1+r)5
Hence, both projects to be selected since their IRR is greater than the minimum required
by Peters Communications Ltd.
The IRR method is like the NPV method. It is a popular investment criterion since it
measures profitability as a percentage and can easily be compared with the opportunity
cost of capital. The IRR method has the following merits:
• Properly adjusts for time value of money
• Uses cash flows rather than earnings
• Accounts for all cash flows
• Project IRR is a number with intuitive appeal

Like the NPV method, the IRR method is also theoretically a sound investment
evaluation criterion. However, IRR rule can give misleading and inconsistent results
under certain circumstances. The disadvantages of IRR are:
• Mathematical problems, we can have multiple IRRs and no real solutions
• Scale problem
• Timing problem
3.6 PROFITABILITY INDEX (PI)

The profitability Index (PI) is the ratio of the present value of cash inflows at the
required rate if return to the initial cash outflow of the investment. The formula for the
profitability index ia as follows:
PI = PV of cash inflows
Initial cash outlay
Illustration:
Calculate the Profitability Index for the 2 projects to be considered by Peters
Communications Ltd.
Projects Present value of cash flows Initial Investment PI
X $325,300 $250,000 1.3
Y $75,700 $50,000 1.5
Both projects PI > 1, hence both projects are acceptable if they are independent. Like the
IRR, PI suffers from the scale problem.
Illustration:
Consider the two following mutually exclusive projects (Mad and Vik):
Project Cash flows ($)
Yr0 Yr1 Yr2 Yr3
Mad -16,000 +8,000 +7,000 +2,000
Vik -16,000 0 +4,000 +15,000
(i) Assuming an opportunity cost of capital of 8%, what is the NPV of the two
projects? Which project would you choose?
(ii) What is the IRR of the two projects? Which project would you choose if the
hurdle rate is equal to the opportunity cost of capital (8%)
(iii) What is the discount rate in the IRR method and in the NPV method? Discuss
the underlying assumption.
(iv) Discuss the limits of the evaluation of mutually exclusive projects by using the
IRR method.
Solutions:
(a) The NPV of project Mad is - $1,003.56
NPVMad = 8,000 + 7,000 + 2,000 - 16,000 = -$1,003.56

(1.08)1 (1.08)2 (1.08)3
The NPV of project Vik is - $663.16
NPVVik = 0 + 4,000 + 15,000 - 16,000 = -$663.16
(1.08)1 (1.08)2 (1.08)3
As the NPV of project Mad and Vik is negative, no project should be accepted.
(b) The IRR of project Mad is the rate in the equation:
NPV = 8,000 + 7,000 + 2000 - 16,000 = 0
(1 + IRR)1 (1 + IRR)2 (1 + IRR)3

At 5 per cent discount rate, the NPV becomes positive. Therefore, the NPV must be
higher than 5 per cent. IRR is about 4.21 per cent.
The IRR of project Vik is the rate in the equation:
NPV = 0 + 4,000 + 15,000 - 16,000 = 0
(1 + IRR)1 (1 + IRR)2 (1 + IRR)3
IRR is about 6.61 per cent.
The IRR of both projects is lower than the hurdle rate (equal to 8 per cent), and
thus none of the projects is accepted.
(c) In the IRR method, the discount rate is not the market-determined opportunity
cost of capital as in the NPV: the discount rate is the IRR.
The IRR assumption is that shareholders can reinvest their money at the
project’s own internal rate, which is the same IRR. In contrast, the NPV
assumes that shareholders can reinvest their money at the opportunity cost
of capital determined by the market. Under the IRR, this assumption on the
reinvestment rate implies that different rates can exist for project with the same
risk. Actually, in well-functioning capital markets, investors are not able to
do so. These suggest that in the presence of perfect capital markets, it is the
NPV and not the IRR method that makes the correct assumption about the
reinvestment rate.
(d) In the evaluation of mutually exclusive projects, the IRR can lead to choices not
maximising shareholders’ wealth.
3.7 ACTIVITIES
ACTIVITY 1
As financial analyst for Oysters Ltd, you are asked to analyze the following investment
proposals. Each project has an initial investment of $10,000 and the WACC for Oysters
Ltd is 12 percent.

Expected Net Cash Flows
Year Project X($) Project Y($0
0 (42,000) (45,000)
1 14,000 28,000
2 14,000 12,000
3 14,000 10,000
4 14,000 10,000
5 14,000 10,000
1. Calculate the payback period, discounted payback period, NPV, IRR and PI for
these two projects.
2. Which project(s) would you select if the projects are mutually exclusive? What if
they are independent?
ACTIVITY 2
What is the net present value (NPV) for a Hybrid Car Engine that costs $5,000 to
manufacture in 2 years’ time, which will then generates a net return of $2,500 in year 3
and 4 and $1,000 in year 5, assuming a 10% discount rate?
What is the annuity equivalent to the time varying returns from the Hybrid Car Engine?
ACTIVITY 3
Critically explain the important steps in the capital budgeting process.

3.8 SUMMARY
• The profitability of an investment is determined by evaluating its cash flows.
• The NPV, IRR and PI are the discounted cash flow criteria for appraising the
worth of an investment project.
• The Net Present value method is the process if calculating the present value of
the project’s cash flows, using the opportunity cost of capital as the discount
rate and find out the net present value by subtracting the initial amount invested.
• The Internal Rate of Return is that discount rate at which the project’s net present
value is zero. Under the IRR rule, the project will be accepted when its internal
rate of return is higher than the opportunity cost of capital.
• Both IRR and NPV methods account for time value of money and are generally
consistent with the wealth maximization objectives.
• The Profitability Index is the ratio of the present value of cash inflows to initial
outlay. It specifies that a project should be accepted when it has a profitability
index greater than 1.
• A conflict of ranking can arise between the NPV and PI rules in case of mutually
exclusively projects. Under such a situation, the NPV rule should be preferred
since it is consistent with the wealth maximization principle.
The upcoming chapter elaborates on the various sources of finance, namely internal and
external sources of finance. We also analyze the costs and benefits derived from each
source and how they affect financial planning.

4
UNIT
Sources of finance
Unit Structure
4.0 Overview
4.2 Sources of Finance
4.2.1 Internal sources of Finance
4.2.2 External sources of Finance
4.3 Costs associated with the different sources of finance
4.4 Advantages and disadvantages of each form of finance
4.5 Choice of financing option
4.6 Financial planning
4.7 Activities
4.8 Summary
4.0 OVERVIEW
In the preceding chapter, we elaborated on the different investment appraisals available
to an investor in taking a decision. We made an insight on payback period, discounted
payback period, net present value, internal rate of return and profitability index. There
are a number of ways of raising finance for a business. Sourcing money may be done for
a variety of reasons. Companies may be needing funds for acquiring capital assets or for
research and development. Development projects are financed internally while capital
for the acquisition of assets may come from external sources. The type of finance chosen
depends on the nature of the business. Large organizations are in a better position to seek
external sources of finance and are able to use a wider variety of finance sources than
are smaller ones. Savings are an obvious way of putting money into a business. A small
business can also borrow from families and friends. In contrast, companies raise finance
by issuing shares. Large companies often have thousands of different shareholders.
With a tight liquidity position, companies look for short term finance in the form of
overdraft or loans in order to ease their cash flow positions and ensure smooth running
of the business operations. Interest rates can vary pending on the purpose and borrowers.

• An introduction to the different sources of finance available to management
• An overview of the advantages and disadvantages of the different sources of
funds
• Elaborate on the factors governing the choice between different sources of funds.
4.2 SOURCES OF FINANCE

Capital or finance is crucial in the good running of a business’s operation, development
and expansion. For instance, finance is usually the main limiting factor for most
companies and therefore it is crucial for businesses to manage their financial resources
properly. It is available to a business from a variety of sources both internal and external
and the businesses need to put much emphasis on the choice of the most appropriate
source of finance so as to gain the maximum benefit and bear the least costs. Sources
of financed can be classified based on a number of factors. They can be classified as
Internal and External, Short-term and Long-term or Equity and Debt.

4.2.1 Internal Sources of Finance
Internal sources of finance are the funds readily available within the organization and
consist mainly of:
• Personal savings
• Retained profits
• Working capital
• Sale of fixed assets
Personal savings
Personal savings represent the money the owner or proprietor has at his disposal. When
same funds are being injected in the business to ensure its business needs, this source of
finance is normally known as personal savings.
Retained profits
Retained profits are the undistributed profits of a company. Not all the profits made by
a company are distributed as dividends to its shareholders and are ploughed back in the
company and is utilized as a back-up in times of financial needs and maybe used later
for a company’s development or expansion. Retained profits are a very valuable no-cost
source of finance
Working capital
Working capital refers to the sum of money that a business uses for its day to day
operations. Working capital is the difference of current assets and current liabilities.
A company needs to manage its working capital efficiently so as to ensure its smooth
running and as such working capital management is also vital as it is also a source of
finance for a business
Current assets
Current assets are also known as cash equivalents because they are easily convertible
to cash. Current assets consist of Stock, Debtors, Prepayments, Bank and Cash. These
assets are used up, sold or keep changing in the short run. It is very important to maintain
the right amount of stock of goods for a business. If stock levels are too high it means
that too much of money is being tied up and if stock levels are too low, the business will
lose possible opportunities of higher sales. Further, if a business has cash flow problems
it can maintain a low level of debtors by encouraging the debtors to pay as early as
possible. On the other hand, having too much of money in the form of cash is also not
good for a business since it could have used that money to invest and earn a return.
Current liabilities
Current liabilities are short-term debts that are in immediate need of settlement.
Some examples of current liabilities are creditors and accruals. These are short term
obligations for the company and have to be paid within a year. Paying the creditors as
late as possible will ease cash flow requirements for a business.
Sale of fixed assets
Fixed assets are the assets a company that do not get consumed in the process of
production. Some examples of fixed assets are land and building, plant and machinery
and fixtures and fittings. At times, in need of finance, businesses usually dispose of the
fixed assets that are not in use or that are in excesses for the business operations. Of
note, selling fixed assets reduces the production capacity of a business thereby affecting
its return.
4.2.2 External Sources of Finance

External sources of finance are from sources that are outside the business. External
sources of finance can either be:
• Ownership capital known as Equity
• Non-ownership capital known as Debt

Ownership capital
Ownership capital is the money invested in the business by the owners themselves. It
can be the capital funding by owners and partners or it can also be share bought by the
shareholders of a company. There are mainly two main types of shares. They are:
• Ordinary shares
• Preference shares
Ordinary shares
Ordinary shares give their shareholders the privilege of receiving a part of company
profits via dividends. They also have the right to vote at general meetings of the company
and companies normally issue ordinary shares in order to raise finance for long-term
financial needs
Preference shares
Preference shareholders receive a fixed rate of dividends before the ordinary shareholders
are paid and they do not have the right to vote at general meetings of the company.
Preference shares are also an ownership capital source of finance.
Non-ownership capital
Unlike ownership capital, non-ownership capital does not allow the lender to participate
in profit-sharing or to influence the business operations. The main obligations of non-
ownership capital are to pay back the borrowed sum of money along with the interest.
Different types of non-ownership capital:
• Debentures
• Bank overdraft
• Loan
• Hire-purchase
• Lease
• Factoring
• Invoice discounting
Debentures
Debentures are issued in order to raise debt capital. Debenture holders are not owners
but long-term creditors of the company. They receive a fixed rate of interest annually
whether the company makes a profit or loss. Debentures are issued only for a time
period and thus the company must pay the amount back to the debenture holders at the
end of the agreed period.
Bank overdraft
Bank overdraft is a short term credit facility provided by banks meant for the business
working capital requirements for its current account holders. This facility allows
businesses to withdraw more money than their bank account balances hold. This facility
is often operated through a current account. Interest has to be paid on the amount
overdrawn.
Loan
Businesses usually avail loan facilities to finance long term business projects and
developments. These loans carry an interest element which the businesses will need
to pay along with the capital repayment of the loan over an agreed time period without
default. Loans can be substituted by other alternative sources of finance which are more
suitable.
Hire purchase
Hire purchase allows a business to use an asset without paying the full amount to
purchase the asset. The hire purchase firm buys the asset on behalf of the business
and gives the business the sole usage of it and the latter pays a monthly installment
amounting to the total value of the asset and charges of the hire purchase firm. At the
end of the payment period, the business has the option of purchasing the asset for a
nominal value.

Lease
In the case of a lease, the leasing company buys the asset on behalf of the business
and the asset is then provided for the business to its use. Unlike a hire purchase, the
ownership of the asset remains with the leasing company. The business pays a rent
throughout the leasing period. The leasing firm is known as the lessor and the customer
as lessee. Leasing is of two types, namely Finance lease and Operating lease. Finance
Lease is where the lessee’s monthly payments add up to at least 90% of the total value
of the asset. Operating Lease is where the lease does not run for the full life of the asset
and the lessee is not liable for the full value of the asset.
Factoring
This is where the factoring company pays a proportion of the sales invoice of the
business within a short time-frame to the business. The remainder of the money is paid
to the business when the factoring company receives the money from the business’s
debtor. The remainder of the money will be paid only after deducting the factoring
company’s service charges. Factoring is of two types: Recourse factoring and Non-
recourse factoring. Recourse factoring – In this type of factoring the client company is
liable for bad debts. Non-recourse factoring – is where the factor takes responsibility for
the payment of the debtors. The client company is not liable if debtors do not pay back.
Non-recourse factoring is usually more expensive because of the high risks experienced
by the factor.
Invoice discounting
In invoice discounting, the client company sends out a copy of the invoice to the invoice
discounting firm. The client then receives a portion of the invoice value. In contrast to
factoring, the client company collects the money from its debtors. Once the payment
is received, it is deposited in a bank account controlled by the invoice discounter. The
invoice discounter will then pay the remainder of the invoice less any charges to the
client
4.3 COSTS ASSOCIATED WITH THE DIFFERENT

SOURCES OF FINANCE
When a company seeks finance, either internally or externally, it will have to calculate
the financial costs associated therewith. The financial costs of the different sources
of finance are:
Personal savings have low costs since they are provided by an owner of the business
and based on the company’s financial position, the owner may charge the company a
rate of interest for the funds being lent out.
There are no other costs associated with retained profits except that they have an
opportunity cost in that the money could have been used elsewhere for some other
purpose.
Working capital also does not have any costs other than opportunity cost.
Sale of assets sometimes helps the company in deriving additional capital which can be
used for development and expansion projects. At times, the sale of fixed asset may reduce
the company’s production capacity unless these assets were unused or abandoned.
Further, dividends have to be paid out of profits to Ordinary and Preference
shareholders as a return for their investment in the business. There are costs associated
with the issue of these shares and for transactions carried out in these shares.
The cost associated with debentures is that they have to be paid a fixed or floating
interest depending on the type of debenture that is issued.
For bank overdraft, the company will need to pay for interest on the amount used and
the interest may be a little higher than for bank loans and interest is calculated on a daily
basis.

Interest on loans is usually fixed for short term loans or import loans and variable
rate of interest is applicable for long-term loans and these may be lower than for bank
overdrafts.
For hire-purchase, the business ends up paying more than the original value of the asset
for its purchase.
When a company avails a Lease facility, the ownership of the asset remains with the
leasing company and at the end of the leasing period, the company is provided with the
option of buying the asset at a nominal value.
With factoring facilities, the Factors charge a rate of interest of about 1.5% to 3% of
the invoice value as finance charges and the interest is calculated on a daily basis. Other
charges like credit management and administrative fees are also levied and same ranges
from about 0.75% to 2.5% of turnover.
Invoice discounting also charges a rate of interest of about the same but its credit
management and administrative charges are lower than a factor because only finance is
provided and sales ledger is not maintained by an invoice discounting firm.
4.4 ADVANTAGES AND DISADVANTAGES OF

EACH FORM OF FINANCE
There are several advantages and drawbacks associated with the different sources of
finance. These can be elaborated as below:
Personal savings
Advantages Disadvantages
Unlike like bank borrowing, the owner will When large amount of capital is needed
not want collateral to lend money to his in the company, personal savings might
business. not be the right option.
There is no paperwork required. If the owner wants to withdraw his
funds from the business at short notice,
that might disrupt the cash flow position
of the company.
Can be interest free or carry a lower rate of
interest since the owner provides the loan.
Retained profits
No need for the company to pay back since Retained profits are not available for
they are the company’s profits earned in starting up businesses or for those
the previous years. businesses that have been making losses
for a long period.
Unlike borrowings, no interest to be paid There maybe opportunity costs involved.
The company’s debt capital does not
increase and thus gearing ratio is
maintained.
No costs in raising the funds
The plans of what is to be done with the
money need not be revealed to outsiders
because they are not involved and therefore
privacy can be maintained.


Sale of assets
Funds are raised by the business itself The asset may be able to generate more
and therefore need not be paid back. income than being sold
No interest payments are required. If the business wants to buy a similar asset
later on, it may cost more than it was sold
for.
Large amounts of finance can be raised If the asset is sold, production may be
depending on the fixed asset sold. affected and may decrease resulting in lost
of opportunities to generate income.

Ordinary share issue
The amount need not be paid back since it Issuing shares is time consuming and is
is a permanent source of capital. costly
A company is able to raise large amounts There are legal and regulatory issues to
of finance. comply with when issuing shares.
If the company follows a rational dividend Possible chances of takeover where an
policy, it can create huge reserves for its investor buys more than 50% of the total
development program. issued shares value and can manipulate the
control and management of the company.
The dividends need to be paid only if the Once issued the shares may not be bought
company makes a profit. back and therefore the capital structure
cannot be changed.
No collateral is required for issuing shares.
It helps reduce gearing ratio

Preference share issue
Have no voting rights and thus the Even if the company makes a very small
management can retain control over the profit it will have to pay the fixed rate of
business operations dividend to its preference shareholders.
Dividends are payable only if the company Preference shares are usually cumulative
makes profits and thus twice the amount must be paid
the following year if dividends are not
paid on the year they need to be paid.
Even if the company makes large profits .
preference shareholders need to be paid
only a fixed rate of interest.
Redeemable preference shares can be
redeemed.


Debentures
Debenture holders do not have rights to Debenture interests have to be paid
vote at the company’s general meetings. regardless the company makes a profit or
loss.
Tax benefits – debenture interests are The money borrowed has to be paid back
treated as expenses and charged against on an agreed date.
profits in the profit and loss account.
Debentures can be redeemed when the
company has surplus funds.
Bank overdraft
Ideal for short-term cash flow deficits and There is a limit to the amount that can be
working capital needs overdrawn.
Interest is only paid when overdrawn and Interest has to be paid on an overdraft
on the exact amount utilised that is calculated on a daily basis and
sometimes the bank charges an overdraft
facility fee too.
Overdrafts are meant to cover only short-
term financing and are not a permanent or
long-term source of finance
Interest is calculated on a variable rate
and therefore it is difficult to calculate the
cost of borrowings.
Overdrafts can be recalled by the bank at
any time, that is on demand

Loans
Large amounts can be borrowed. The amount borrowed has to be repaid at
the agreed date.
Suitable for long-term investments. Loans will affect a company’s gearing
ratio.

Hire purchase
The business gains use of the asset before Ownership remains with the lender until
paying the asset’s value in full. the last payment is made.
The payment is made in installments. The asset will cost the company more
than the original value.
At the end of the payments ownership of If payments are not made on time the
the asset is transferred to the company lender has the right to repossess the asset.
Payments can be made from the asset’s If the asset is required to be replaced due
usage and return derived thereon. to breakdown or because it is out-dated
in which case the payment may still have
to be made and the asset replaced.

Lease
The amount in full need not be paid in The ownership of the asset remains with
order to start using the asset. the lessor and at end of lease of period,
the company is provided with the option
to buy the asset at a nominal value.
The total cost and the lease period is pre- Lease cannot be terminated whenever at
determined and thus helps in preparation lessee’s will.
of cash flow
In an operating lease, payments are made In a finance lease the lessee ends up
only for the usage duration of the asset. paying more than the value of the asset.
Factoring
A large proportion of money is received The business has to pay interests and
within a short time-frame. fees for the factor for its services.
The money collections from debtors are The cost will be a reduction on the
undertaken by the factoring company. company’s profit margin.
The sales ledger of the business can be Lack of privacy since the sales ledger is
outsourced to the factor. maintained by the factor.
Helps a business to have a smooth cash
flow operation.
Non-recourse factoring protects the client
company from bad debts.
Invoice discounting
The company receives the money in a Debt should be collected by the client
short period. company itself and thus resources and
time are wasted in debt collection.
Unlike factoring, customers are not aware Sales ledger has to be maintained by the
of invoice discounting since the debt client company itself
collection is undertaken by the client firm.
There is some amount of privacy since the
sales ledger is maintained by the client
company and only some invoices are
submitted for immediate cash.
Less costly than factoring since the sales
ledger is maintained by the client company
4.5 CHOICE OF FINANCING OPTION

There are many sources of finance available to a business and is needed for several
purposes. As such the company will choose the best option to suit its requirements.
When choosing an appropriate source of finance some factors have to be considered.
The amount of money needed
It is necessary to identify the amount of money needed by the company to choose a
suitable source of finance since not all sources of finance provide all amounts of funds.


The urgency of funds
This refers to the amount of time the business can spend oncollecting funds. If the
business has plenty of time before its financialneeds need to be met then it can spend time
searching for cheapalternatives of sources of finance. On the other hand if the business
wantsthe money as soon as possible then it would have to make some costsacrifices and
accept a source of finance that may even cost higher. Theurgency of funds needs to be
identified also because certain sources of finance need more time to be raised than other
sources of finance
The cost of the source of finance
It is always more profitable to a business to seek and obtain cheaper sources of finance.
Due to some time constraints, some businesses are not able to look for cheaper sources
of funds and has to avail facility at higher costs. Internal sources of finance are always
cheaper than external sources of finance.
The risk involved
The risk involved is the certainty of receiving returns for the lender on the investment
made using the finance. In this case the money can be secured against an asset as
collateral which will encourage the lender to lend.
The duration of finance
This is the time period for which the money is needed. It can be for a short-term
(within one year), medium-term (one to five years) or long-term (five years and more)
time period. By identifying the length of requirement of finance the organization can
eliminate inappropriate sources of finance and choose a source of finance that is more
suitable for the required timeframe.
The gearing ratio of the business
The gearing ratio plays an important role in the availability of the sources of finance
since the gearing ratio shows the ratio of debt capital to the total capital of a business.
If a business is high geared, then commercial lenders will be unwilling to give loans
because the business is already operating on more loans than equity capital. A high
geared company will have to pay more of its profits as interests on loans and other debt
capital.
The control of the business
The existing shareholders of a company would be reluctant to issue shares
because this would cause a dilution in control of the business. Issuing shares in
public limited companies also gives opportunity of takeovers to outside parties.
4.6 FINANCIAL PLANNING

A company has recourse to financial planning in view of having a good feasibility
indicator on the costs involved and benefits to be derived upon availing finance for
maintaining ongoing business operations and for expanding or embarking on new
projects.
A financial plan not only help the business to understand what it wants to do but also
helps the business understand how to achieve it. A healthy financial plan consists of the
following:
• The basic financial statements
• Ratio analysis
• Budgets
• Break-Even analysis
• Pricing formulas and policies
Short and long term planning considerations are necessary to maximize profits.
The business manager who understands these concepts and uses them effectively to
control the evolution of the business is practicing sound financial management thereby
increasing the likelihood of success of the company.

4.7 ACTIVITIES
ACTIVITY 1
“Short-term financing plans must be developed by trial and error where the manager
will think on different assumptions on financing and investment alternatives.” Critically
elaborate on the alternative sources of short-term borrowing.
ACTIVITY 2
“Bank loans often extend for several years. Interest payments on these loans are
sometimes fixed for the term of the loan but more commonly they are adjusted up or
down as the general level of interest rates changes.” Assess the costs associated with
the different sources of finance.
ACTIVITY 3
How does a firm’s sources and uses of cash relate to its need for borrowing?
4.8 SUMMARY
Sources of finance is available from variety of sources but each source has its own cost
and benefits. An appropriate choice of finance will help a business to maximize the
benefit and simultaneously reducing the charges associated therewith.
Further, assets can be classified as real or financial. Shares and bonds are called
financial assets while physical assets like plant and machinery are called real assets.
The determination of value of bonds and the factors affecting the price will be discussed
in the forthcoming chapter.

5
UNIT VALUATION OF BONDS AND
OTHER SECURITIES
Unit Structure
5.0 Overview
5.2 Definition of Bonds
5.3 Types of securities
5.4 Bond Valuation
5.4.1 Interest Yield
5.4.2 Redemption Yield
5.5 Yield to Maturity
5.6 Term Structure of Interest rate
5.7 Activities
5.8 Summary
5.0 OVERVIEW
We previously looked at the sources of finance, their advantages and costs associated
with each method. We also explained how they help in financial decision making and
planning. Assets can be classified as financial and real assets. Examples of financial
assets are shares and Bonds while physical assets like plant and machinery are called
real assets. Bonds are important investment alternatives in the portfolio asset allocation
process. The tradeoff between risk and return is a determinant of value and is as
fundamental and valid to the valuation of securities.

• Define the fundamental characteristics of Bond
• Understand the use of the present value concepts in bonds valuation
• Make use of the different formulae in analysing the pricing of Bonds
• Explain the steps in measuring the Return on Bonds
5.2 DEFINITION OF BONDS

A bond is a long term instrument or security. Bonds are also called fixed income
securities and pay a fixed interest to the bond holder up to maturity when the nominal
amount of the bond is redeemed. Bonds are also called gilt edged securities or gilt when
issued by the government since it is free from default since the government will always
honor its obligations on its bonds. The private sector companies also issue bonds which
are known as debentures and in the case of bonds or debentures, the rate of interest is
generally fixed and is known to the investor. The principal of a redeemable bond or bond
with maturity is payable after a specified period, called maturity period.
In other words, a bond is a promissory note issued by a firm or government. Some bonds
are relatively short lived, but most have an initial maturity of 10 to 30 years. It is a long
term contract under which the borrower agrees to make specific payments of interest on
specific dates for a specified length of time and to repay the loan on its maturity to the
holder of the bond. For example, treasury Bills are short term government bonds.
The main features of a bond or debenture are as follows:
Face Value – A bond is generally issued at its face value, known as the par value and
interest is paid on the face value.
Coupon – The interest rate on the nominal amount is known as the coupon of the bond.

Such interest payments are usually made in two equal six monthly installments over two
pre specified dates.
Maturity – Maturity is the date at which the nominal amount borrowed by the
government or company will be repaid.
Redemption value – the value that a bondholder will get at maturity is called the
redemption value. A bond may be redeemed at par, at a premium or at a discount.
Market value – Some bonds are traded on stock exchanges and the price at which they
are traded is called the market price and same may be different from the par value or
redemption value.
5.3 TYPES OF SECURITIES

There are many types of fixed income financing instruments like issue of shares, bonds
and availing products from a financial institution. Bonds are issued by the government
and the private sector companies. Government bonds may be short term bonds like
Treasury bills are may be gilt edged securities which are long term bonds. These binds
are free of default risk.
The private sector companies issue corporate bonds and the companies can issue secured
or unsecured bonds. These bonds can be classified as:
Mortgage Bonds – under a mortgage bond, the company pledges specific assets as
security for payment.
Debenture – it is an unsecured bond and as such, provides no lien against specific
property as security for the obligation. In practice, its use depends on the nature of the
firm’s assets and on its general credit.
Callable bond – bond containing a provision, which gives the issuing company the
right to call the bonds for redemption.
Convertible bonds – these are securities that are convertible into shares of common
stock, at a fixed price at the option of the bondholder. Basically, convertibles provide
investors with a chance for capital gains in exchange for a lower coupon rate, while the
issuing firm gets the advantage of that lower rate.
5.4 BOND VALUATION

Essentially, there are two main return measures for bonds; interest yield and yield to
maturity.
5.4.1 Interest Yield

C
Interest Yield = ×100
P
The above equation can be rearranged as follows as:
= C R ×100
Price€
The above equation states that the price of an undated fixed interest stock is equal to its
coupon divided by the required yield
€
The lower the coupon relative to the required yield, the lower the price.
However, Interest yield ignores capital gains and losses.

5.4.2 Redemption Yield
1. This is the rate of return achieved if the gilt is held until it is redeemed by the issuer.
2. It takes account of both interest and the capital gain or loss which would occur if the
stock was held until redemption.
3. It also takes account of the time value of money.
4. For a gilt to be redeemed in n years, paying a coupon rate of C, having a market
value of P, the internal rate of return is given by:
⎡ 1 1 1 ⎤ 100
P =C ⎢ + + …… + ⎥+
M ⎢(1+ i) (1+ i) 2 n
(1+ i) ⎥⎦ (1+ i)
N
⎣
M = number of coupon payments per year

C = Annual Coupon
€ I = yield for the period concerned
Illustration:
You are given the following details of a number of risk free coupon bonds.
Price of Bond Year 1 Year 2 Year 3

100 105 - -
99 5 105 -
98 5 5 105
Suppose you can borrow 100 at the end of year 1 and repay 108 at the end of year 3.
Is this borrowing opportunity attractive? How much would you be prepared to pay for
entering into such an agreement? Explain your answer carefully.
Solution:
The discount factor for year 1 cash flow is d1 = 100/105 = 0.952; the discount factor for
year 2 cash flow is d2 = (99 - 5d1)/105 = 0.988; the discount factor for year 3 cash flow
is d3 = (98 - 5d1 - 5d2)/105 = 0.845
The value of the borrowing opportunity - in terms of today's money - is 100d1 - 108d3 =
3:94. Given this is positive, candidates should take the borrowing regardless of whether
one needs the money or not - if the investor doesn't need the money, he can undertake
(through a forward agreement) to invest 100 for two years in one year's time which
grows to 100d1/d3 = 112.66 in year 3. After repaying his loan, he will have 4.66 left over,
which in today's money is worth 4.66d3 = 3:94
There are several risks associated with investing in bonds. These can be classified as
follows:
Default risk – It is the risk that the company which had issued the bonds will not pay
interest and principal on a bond is higher than the risk of the government not meeting its
obligations. This additional risk is referred to as default risk.
Credit Spread risk – This is measured by the amount of yield differential above the
return on a benchmark, a default free security demanded by investors to compensate
them for the risk of buying risky securities.
Downgrade risk – This is the risk that a bond will be classified as a riskier security by
a credit rating agency, such as Standard and Poor’s and in the process will be assigned a
lower rating. When an agency raises its opinion, it may assign a higher rating (upgrade)

or lower rating (downgrade). For downgrades, the yield increases and for upgrades, the
yield decreases.
5.5 YIELD TO MATURITY

The Yield To Maturity (YTM) is the measure of a bond’s rate of return that considers
both the interest income and any capital gain or loss. YTM is the bond’s internal rate
of return. It indicates the fully compounded rate of return promised to an investor who
buys the bond at prevailing prices, if two assumptions are met:
• The investor holds the bond to maturity
• The investor reinvests all the interim cash flows at the YTM rate.
The Yield to Maturity is also known as redemption yield or coupon rate of return.
Illustration 1:
Calculate the Yield to Maturity of a 5 year bond, paying 6% interest on the face value of
$1,000 and currently selling for $883.40.
Solution:
883.40 = 60 + 60 + 60 + 60 + 60 + 1,000
(1+YTM)1 (1+YTM)2 (1+YTM)3 (1+YTM)4 (1+YTM)5
YTM = 10%.
Illustration 2:
Calculate the YTM if the rate of interest on $1,000 par value perpetual bond is 8% and
its price is $800.
Solution:
YTM = INT = 80 = 10%
Bo 800
5.6 TERM STRUCTURE OF INTEREST RATE

The term structure of interest rates refers to the relation between the interest rates on
short-term bonds versus those on medium- and long-term bonds. It is important while
considering investment in bonds since the interest rates on the short term; medium term
and long term bonds are likely to be different. The term structure is also important
to monetary policymakers, because business investment depends mainly on long-term
interest rates, whereas the government has its most direct control over extreme short-
term interest rates like the funds rate, which is an overnight lending rate.
The Yield curve shows the relationship between the yields to maturity of bonds and their
maturities. It is also called the term structure of interest rates. There are three theories
that explain the yield curve or the term structure of interest rates:
(i) The Expectation Hypothesis
The expectation hypothesis supports that the upward sloping yield curve since
investors always expect short term rates to increase in the future. As such, long
term rates will be higher than short term rates but in the context of present value
terms, the return from investing in a long term security will equal to the return
in investing in a series of a short term security. Also, the expectation theory does
not assume that capital markets are efficient, there are no transaction costs and
that the investor’s main aim is to maximise his return.
(ii) The Liquidity Premium Theory

The Liquidity or Risk Premium theory provides an explanation for the
expectation of the investors. Given that the price of long term bonds are more

sensitive than the prices of short term bonds due to changes in the market rates
of interest, the investor will prefer short term bonds to long term bonds. The
investor will be compensated for this risk by offering higher returns on long
term bonds. This extra return, which is called the Liquidity premium, gives the
yield curve its upward bias. However, the yield curve may still be inverted if
the declining expectations and other factors have more effect than the liquidity
premium. The liquidity premium theory therefore means that rates on long term
bonds will be higher than on short term bonds.
(iii) The Segmented Market Theory

The segmented markets theory assumes that the debt market is divided into
several segments based on maturity of debt. The investor’s preference of each
segment arises because he wants to match the maturities of assets and liabilities
to reduce the susceptibility to interest rate changes. The segmented markets
theory assumes investors do not shift from one maturity to another in their
borrowings – lending activities and therefore, the shift in yields are caused by
changes in the demand and supply for bonds of different maturities. Overall, it
implies that investors strongly prefer to invest in assets with maturities matching
their liabilities and borrowers prefer to issue liabilities that match the maturity
of their assets.
5.7 ACTIVITIES
ACTIVITY 1
You are given the following details of a number of risk free coupon bonds.
Price of Bond Year 1 Year 2 Year 3

100 105 - -
99 5 105 -
98 5 5 105
Suppose you can borrow 100 at the end of year 1 and repay 108 at the end of year 3.
Is this borrowing opportunity attractive? How much would you be prepared to pay for
entering into such an agreement? Explain your answer carefully.
ACTIVITY 2
You are given the following data from the bond market.
Bond Price Coupon Maturity
A 99 5.5% 1
B 100 5.6% 2
C 102 5.7% 3
D 103 5.9% 4
Work out the spot rates for years 1 through 4. Suppose you have the option of borrowing
100,000 in one year’s time to repay 105,000 in two years’ time. Would you take the
deal? How much money would you make or lose on the deal? Explain.
ACTIVITY 3
(a)
• What is the price of a $1,000 par value bond with a 6% coupon rate paid
semiannually, if the bond is priced to yield 5% YTM, and it has 9 years to
maturity?
• What would be the price of the bond if the yield rose to 7%.
• What is the current yield on the bond if the YTM is 7%?

(b) Explain how bond prices are quoted in the financial pages. Suppose you are looking
at a 3 year and 40 day bond with an annual coupon of 6% of nominal capital of
$100. State the expressions for the actual price of this bond, and the quoted price,
given a yield of 5%.
5.8 SUMMARY
Bonds and debentures are debt instruments or securities. The steam of cash flows
consists of annual interest payments and repayment of principal. These flows are fixed
and are known to the investors. The value of the bond can be found by capitalizing
these flows at a rate of return, which reflects the risk. The market interest rate or yield is
used as the discount rate. Moreover, when the price of the bond is given, a bond’s yield
to maturity or internal rate of return can be found by equating the present value of the
bond’s cash outflows with its price.
We shall, in the next chapter, explain the most important concept in finance; risk and
return. We will elaborate on the risk and return on a single portfolio, two asset portfolios,
the Beta factor and the Capital Asset Pricing Model (CAPM).

6
UNIT RISK AND RETURN AND CAPITAL
ASSET PRICING MODEL (CAPM)
Unit Structure
6.0 Overview
6.2 Portfolio Theory
6.2.1 Factors in the Choice of Investments
6.3 Calculating Risk and Return
6.3.1 Single asset portfolio
6.3.2 Two asset portfolio
6.4 Efficient Frontier
6.5 Capital Market Line
6.6 Definition of Capital Asset Pricing Model
6.7 Beta factor, Co-variance and market risk premium
6.8 Assumptions and limitations of CAPM
6.9 Activities
6.10 Summary
6.0 OVERVIEW
After having applied the concept of present value to explain the value of bonds and shares
in the previous chapter, we shall now explain how financial and investment decisions
are made whereby the investors are willing to hold the optimal portfolio. It provides an
insight on the relationship between risk and return and considers the financial risks of
investment. This chapter also elaborates on the Capital Asset Pricing Model which helps
in establishing the correct equilibrium market value for a share.

1. Explain the concept of risk and return
2. Evaluate the risk and expected return of an investment under risky conditions.
3. Explain the uses of CAPM
4. Explain what are an Efficient Frontier, Security Market Line and Capital Market
Line.
5. Elaborate on the assumptions and limitations of CAPM
6.2 PORTFOLIO THEORY

A portfolio is defined as a collection of different investments that make up an investor’s
total holding. A portfolio might be investments in stocks and shares or the investments
in capital projects of a company.
Portfolio theory, which is a concept developed by Markowitz, is concerned with
establishing guidelines for building up a portfolio of stocks and shares, or a portfolio of
projects. The same theory applies to both stock market investors and to companies with
capital projects to invest in.
6.2.1 Factors in the Choice of Investments

There are five major factors to be considered when an investor chooses investments,
whether the investor is an institutional investor, a company making an investment or a
private individual investor. These are:
(a) Security. Investments should at least maintain their capital value.

(b) Liquidity. Where the investments are made with short term funds, they should
be convertible back into cash at short notice.
(c) Return. The funds are invested to make money. The highest return compatible
with safety should be sought.
(d) Spreading risks. The investor who puts all his funds into one type of
security risks everything on the fortunes of that security. If it performs badly,
his entire investment will make a loss .A better (and more secure) policy is to
spread investments over several types of security, so that losses on some may be
offset by gains of others.
(e) Growth prospects. The most profitable investments are likely to be in business
with good growth prospects.
6.3 CALCULATING RISK AND RETURN

Every investment is made in view of deriving a profit. The return from holding an
investment in a stock over a single period, is simply the sum of dividend received (Dt)
and the capital gain or loss (Pt – Pt-1 ) during that period expressed as a percentage of the
price of the share at the start of the period (Pt-1):
Dt + Pt - P t-1
R =
P t−1
6.3.1 Single Asset Portfolio

The above formula is used to calculate the return on an investment held for a single
period model. €
It helps to evaluate the return for an investment already made and benefits
already derived.
However, investors also want to make investment decisions about the future. The future
is uncertain since share prices in the future are unknown. For instance, if the investor
does not know the future share prices, will he be able to calculate the return he will
derive from his investment? Under such circumstances, can he rationally undertakes to
invest in shares when he does not know the share's future return?
Indeed knowledge about the share's PAST annual returns can enable the investor to
construct a probability distribution of the share's possible returns. Thus, return in a share
is not always certain. There is always an element of uncertainty attached with it and
same can be measured by a probability of occurrence.
Illustration
Suppose an investor is willing to consider buying a share with the following
characteristics:
Year Return Probability Expected Return (%)

1 20% 0.3 (20x0.3) =6
2 14% 0.5 (14x0.5) = 7
3 10% 0.2 (10x0.2) = 2
Therefore, expected return = 6 + 7 + 2 = 15%

The expected return is the weighted average of possible returns with the weights being
the probabilities of occurrence.
N
The expected return is given by, R = E (R :) = ∑ a R
it it
i is the security t=1
a is the probability of occurrence
Rt is the return for time t.
After having calculated€the return on the investment, the investor must now calculate

the risk associated with the return. The risk and return trade off stipulates that the higher
the return the investor wants, the higher the risk he will have to take and vice versa.
Hence, risk is defined as the variability of the actual return from the expected return.
The more the actual return fluctuates and deviates from average return, the more risky
the investment.
The variability in returns can be measured by the standard deviation which is denoted
by s called sigma.
The standard deviation measures the average deviation by which an actual return can
deviate from the expected return. It is the square root of variance (s 2).
Variance of return, s 2 = (standard deviation of return)2

n 2
s = ∑ a it (R it - R) OR s = E(R i 2) - E(R i ) 2
i=1
N N 2
− ⎡N ⎤
€ s= ∑a it (Rit − R ) 2 € = ∑a it R − ⎢∑a it Rit ⎥
2
t=1 t=1 it ⎣ t=1 ⎦
For the above example, the variance is 13% and the standard deviation is 3.61%.
€ 6.3.2 Two Assets Portfolio

€
So as to diversify the risk, the investor will try to make a selection of investment assets
that has collectively lower risk than any individual asset. This is so because the different
types of assets often change in value in opposite ways. For example, the price of a share
may drop while that of a bond may rise. Thus, a collection of both types of assets can
therefore have lower overall risk than either individually.
In other words, when an investor has a portfolio of securities, he will expect the
portfolio to provide a certain return on his investment. The expected return of a portfolio
will therefore be a weighted average of the expected returns of the investments in the
portfolio, weighted by the proportion of total funds invested in each.
The risk in the portfolio of investments is the risk that the actual return will not be
the same as the expected return. The actual return may be higher or lower. A cautious
investor will try as far as possible to avid too much risk and will hope that the return
he is deriving from his portfolio to be the same as what he expected them to be. Risk is
therefore measured by the standard deviation of expected returns.
Mathematically, in general
n
• Expected return: E(Rp) = ∑ wiE(Ri)

i
Where Wi is the amount invested on asset i and E(Ri) is expected return on asset i.
• Portfolio variance
Portfolio volatility
€ or risk is thus,
p s = s2
p

For a two asset portfolio: (Asset A and Asset B), portfolio return will be:
€ E(R p ) = W A E(RA ) + W B E(RB )

Where E(RA) and E E(RB) is expected return on asset A and B respectively.
€
Portfolio variance will be:
s 2 p = W 2 As 2 A + W B s 2 B + 2W AW Bs AB
2

= W A s A + W B s B + 2W AW Bs As B1ΓAB
2 2 2 2

€ Where s and s is the risk of asset A and B respectively s is the covariance
A B AB
between asset A and asset B. s AB is the correlation coefficient between asset A and
asset B.€
€ Portfolio
€ theory states that individual investments cannot
€ be viewed simply in terms
of their risk and return. The relationship between return from one investment and the
€
return from another investment is just as important and is measured by the correlation
coefficient. It measures the degree of association between the shares of two companies
and ranges from –ve 1 to +ve 1.
Therefore, the relationship between investments can be one of the three types:
(i) Positive correlation – When there is positive relationship between investments,
if one investment performs well, the other investment is expected to do likewise.
(ii) Negative correlation – IF one investment does well, the other will do badly an
vice versa.
(iii) No correlation – The performance of one investment will be independent of
how the other investment performs.
Further, the covariance ( s AB ) represents the co-movement of asset returns. It can be

positive or negative, weak or strong. A positive covariance will normally implies that
the asset returns will tend to move in the same direction while a negative covariance will
indicate that asset returns move in the opposite direction.
€
The formula for covariance is as follows:

s AB = s A × s B × ΓAB

Illustration:
Consider the following information about two stocks, Niz and Mads:
€
Stock Expected return Variance
Niz 7% 12%
Mads 4% 6%
The correlation between the two securities returns is 0.4.
(i) Calculate the expected return and standard deviation of the following three
portfolios:
Portfolio Proportions (%)
Portfolio Niz Mads
1 30 70
2 75 25
3 100 0
Solutions:
Portfolio Niz Mads
1 30 70
2 75 25
3 100 0

 
 
6.4 EFFICIENT FRONTIER
The efficient frontier as illustrated below is a combination of portfolios for which there
is lowest risk for a given level of return and same should be along the line. Every
possible asset combination can be plotted in risk-return space, and the collection of
all such possible portfolios defines a region in this space. Therefore, the line along the
upper edge of this region is known as the efficient frontier. Conversely, for a given
amount of risk, the portfolio lying on the efficient frontier represents the combination
offering the best possible return and the Efficient Frontier is often described as the
intersection of the Set of Portfolios with Minimum Variance and the Set of Portfolios
with Maximum Return. This is the tangency portfolio, or the efficient portfolio, or more
commonly known as the market portfolio.
The region above the frontier is unachievable by holding risky assets alone. No portfolios
can be constructed corresponding to the points in this region. Points below the frontier
are suboptimal. Hence, a rational investor will hold a portfolio only on the frontier.
The Efficient Frontier
6.5 CAPITAL MARKET LINE

In order to further diversify their portfolios, investors also invest in risk free assets
such as Treasury Bills and Government Bonds. The risk-free asset has zero variance in
returns and is uncorrelated with any other asset. As a result, when it is combined with
any other asset, or portfolio of assets, the change in return and also in risk is linear.
Because both risk and return change linearly as the risk free asset is introduced into a
portfolio, this combination will plot a straight line in risk return space. The line starts at
100% in cash and weight of the risky portfolio = 0 (i.e., intercepting the return axis at
the risk free rate and goes through the portfolio in question where cash holding = 0 and
portfolio weight = 1).

When the market portfolio is combined with the risk-free asset, the result is the Capital
Market Line. All points along the CML have superior risk-return profiles to any
portfolio on the efficient frontier. Additions of cash or leverage with the risk-free asset
in combination with the market portfolio are on the Capital Market Line.
The Capital Market Line
6.6 DEFINITION OF CAPITAL ASSET PRICING

MODEL
The Capital Asset Pricing Model (CAPM) is concerned with how systematic risk is
measured by using the beta factor and how it affects required returns and share prices.
The CAPM therefore provides a basis for determining the investor’s expected rate of
return from investing in common stock.
CAPM tries to establish the correct equilibrium market value of a company’s shares
and tries to establish the cost of a company’s equity and the company’s average cost of
capital, while taking into account the risk characteristics of a company’s investments.
Therefore, CAPM provides an approach to establishing a cost of equity capital which is
an alternative to the dividend valuation model.
Whenever an investor is considering investment in some shares, there will be some
risks involved and the actual return derived on the investment might be better or worse
than that expected. To some extent risk is unavoidable unless the investor places all his
money in risk free securities such as treasury bills. Provided that the investor diversifies
his investments in a suitably wide portfolio, the investments which perform well and
those which perform badly should tend to cancel each other out and as such much risk
is being diversified away.
For instance, total risk comprises of two elements of risk: unique (or unsystematic) risk
and market (or systematic risk).
• Unique Risk (or specific risk) is the variability in return due to factors unique to
the individual firm. For example, management team, workforce, equipment used
are some factors specific to the company. It is also known as diversifiable risk
since it can be eliminated by increasing the number of shares in the portfolio. No
risk premium is paid on specific risk.
• Market Risk is the variability in return due to market-wide or macroeconomic
factors that affect all firms in the economy to a greater or lesser extent. It is also
known as non-diversifiable risk. It cannot be diversified away. Hence, a risk
premium is paid on market risk.

Systematic risk must be accepted by any investor and in return for accepting such risk,
he will expect to earn a return which is higher than the return on a risk free investment.
The amount of systematic risk in an investment therefore varies between different types
of investments.
There are several implications of bearing systematic and unsystematic risk on the
outcome of the investment. Firstly, If an investor holds shares in a few companies,
there will be some systematic and unsystematic risk in his portfolio since he has not
spread away his risk enough to diversify the unsystematic risk. Hence, to eliminate the
unsystematic risk, the investor must buildup a well diversified portfolio of investment.
Secondly, if the investor holds a balanced portfolio of all stocks and shares on the
stock market, he will incur systematic risk which shall be exactly equal to the average
systematic risk in the market.
6.7 BETA FACTOR, CO-VARIANCE AND MARKET

RISK PREMIUM
By holding a portfolio of assets, the investor is prone to take additional risk and in
his pursue to beat and earn above average return, he will try to diversify away the
unsystematic risk and bears only systematic risk. The latter is the covariance between a
single asset or portfolio and the market portfolio itself. The market portfolio is defined
as the portfolio of all risky assets, where the weight on each asset is simply the market
value of that asset divided by the market value of all risky assets. Thus, the market
portfolio is a market value-weighted average of all risky assets. Since the weight on
each asset is equal to its percentage share of the total market value, the sum of all
weights is 1.
Hence, we note that all investors will optimally hold the market portfolio and the non-
risky asset regardless of their risk preferences. The relative share of the two will depend
on the relative risk preferences of each individual investor.
In order to evaluate a given asset i’s contribution to the risk of a given portfolio P, we
divide the covariance between i and P by the overall variance of the portfolio: d2m. This
gives us the normalized indication of asset i’s share of the total portfolio risk.
The contribution of asset i to the risk of the market portfolio is measured by the beta
factor ( b ): The share’s beta factor is the measure of its volatility in terms of market
risk. The beta factor of the market as a whole is 1.0. Market risk makes market returns
volatile and the beta factor is simply a basis against which the risk of other investments
can be measured.
Cov(Ri ,Rm ) dim
For Asset i, ( b i = = 2 ) (1)
Var(Rm ) dm
The beta of an individual security measures its sensitivity to market movements. It ranges
from –ve 1 to +ve 1 where b >1, indicated that the shares have more systematic risk
than€the stock market average. b <1 indicates the shares have less systematic risk than
the stock market average while b = 0, implies that the shares have no systematic risk.
The market risk premium is equal to the difference in the expected rate of return for the
market as a whole, that is, the expected rate of return for the average security minus the
risk free rate (Rm – Rf)
The Capital Asset Pricing Model therefore provides a basis for determining the investor’s
expected or required rate of return from investing in common stock. The model depends
on three things:
(i) The risk free rate, Rf
(ii) The systematic risk of common stock’s returns relative to the market, that is the
beta factor, b
(iii) The market risk premium, (Rm – Rf)

Thus, the CAPM equation will be as follows:
E(Ri) = rf + Bi(E(Rm) – rf) –5
Where E(Ri) = expected return on asset i
E(Rm) = expected return on the market portfolio
Bi = Befa of stock i
rf = risk free rate
6.8 ASSUMPTIONS AND LIMITATIONS OF CAPM

The Capital Asset Pricing Model has been built up on certain specific assumptions and
same have been questioned to be unrealistic. Some of the main assumptions of CAPM
are:
• CAPM assumes that the investor holds a well diversified portfolio of assets.
• CAPM considers returns for a single period model while investments are usually
multi periods
• CAPM relies on the perfect market assumptions, which are not observed in the real
world.
• CAPM assumes that the investment opportunities are the same for every investor
• CAPM assumes that at least one asset in the portfolio is a risk free asset.
The validity of CAPM has often been debated and the main limitations are:
• CAPM is based on a number of unrealistic assumptions.
• There are other factors in additional to systematic risk that might influence expected
return
• Inputting data in the model might be inaccurate and complex.
• CAPM tends to overstate expected return for investment having high beta securities.
6.9 ACTIVITIES
ACTIVITY 1
Consider the following information about two stocks, ABC and XYZ:
Stock Expected return Variance
ABC 8% 13%
XYZ 3% 5%
The correlation between the two securities returns is 0.3.
(a) Calculate the expected return and standard deviation of the following three
portfolios:
Portfolio ABC XYZ
1 30 70
2 75 25
3 100 0

(b) What are the assumptions under the CAPM? What is the expected risk premium?
ACTIVITY 2
Under the CAPM framework, what is the tangency portfolio? What is the security
market line? Support your answer with graphical evidence.
ACTIVITY 3
(i) Discuss the theoretical and practical limitation of the CAPM.
(ii) How can investors identify the best set of efficient portfolios of common stocks?
What does ‘best’ mean?

6.10 SUMMARY
Dt + (Pt − Pt−1 )
• Return, R =
Pt−1
• Expected return: E(Ri ) = ∑a it Rit , where

€ t=1 i is security
s is the probability occurrence
Rt is the return for time t.
• Risk is€measured by s, the standard deviation. The square of the standard deviation
is the variance.
N −
s= ∑a it (R it − R ) 2
t=1
2
= ∑ E (R 2
i ) − [ E (R i ) ]
• Total risk is made up of specific risk and market risk. Specific risk can be made
eliminated via diversification. Market risk cannot be diversified.
€ The CAPM is a set of predictions concerning equilibrium expected returns on risky
•
assets.
• CAPM stipulates that the equilibrium rates of return on all risky assets are a function
of their covariance with the market portfolio
• CAPM equation:
E(Ri) = rf + Bi(E(Rm) – rf) –5
Where E(Ri) = expected return on asset i
E(Rm) = expected return on the market portfolio
Bi = Beta of stock i
rf = risk free rate
We shall now explain the notion of market efficiency and differentiate on the three forms
of efficiency under the efficient market hypothesis: Weak form efficiency, Semi- Strong
form efficiency and Strong form efficiency. We also highlight how investors try to beat
the market through the use of stock market anomalies and the tests used to that effect.

7
UNIT Introduction to Stock
Market
Unit Structure
7.0 Overview
7.2 The Efficient Market Hypothesis
7.3 Forms of Efficiency
7.4 Validity of the EMH
7.5 Stock Market Anomalies
7.5.1 January Effect
7.5.2 Holiday Effect
7.5.3 Size Effect
7.5.4 P/E Ratio Effect
7.6 Test of market efficiency
7.7 Activities
7.8 Summary
7.0 OVERVIEW
We previously showed that the risk and return concepts are basic to the understanding
of the valuation of assets or securities, efficient frontier, security and capital market
line and the CAPM. The aim of this chapter is to explain the notion of efficiency of
stock market returns and to evaluate how fast information is being incorporated in share
prices. The primary concern about stock markets is how volatile the market is and if
the market is really efficient or it can be beaten. Stock return volatility represents the
variability of stock price changes during a period of time. Generally it is said that if
returns are predictable then the market cannot be efficient otherwise the prices move
randomly.

1. Define Efficient Market Hypothesis (EMH).
2. Distinguish between the different forms of efficiency, mainly weak form, semi-
strong form and strong form.
3. Elaborate on the criticisms of EMH
7.2 THE EFFICIENT MARKET HYPOTHESIS

When money is put into the stock market, it is done with the aim of generating a return
on the capital invested. Many investors try not only to make a profitable return but
also to surpass or “beat” the market. However, market efficiency, which has been
formulated by Eugene Fama in 1970 and detailed in the Efficient Market Hypothesis
(EMH), suggests that, at any time period, prices fully reflect all available information on
a particular stock market. Therefore, according to EMH, no investor has an advantage
in predicting a return on a stock price since no one has access to information not already
available to everyone else.
The primary condition for a market to be efficient is the existence of investors, security
analysts, brokers, financial reporters and market observers who are numerous in
trying to discover which prices are under or overvalued. Thus, in their competition for
information, they enable the current price to be at least close to its intrinsic price. It is to
be noted that the absence of perfect conditions for efficiency in the real world provides
potential sources of inefficiency and they encourage investors to continue to search for
over and undervalued securities.

An efficient market is a market in which prices provide accurate signals for resource
allocation, that is, the market in which firms can make production-investment decisions
and investors can choose among the securities that represent ownership of firm’s
activities under the assumption that security prices at any time fully reflect all the
available information (Fama, 1970).
It is important that stock markets are efficient for at least three reasons:
1. To encourage share buying – accurate pricing is required if individuals are going
to be encouraged to invest in private enterprise. If shares are incorrectly priced,
many savers will refuse to invest because of fear that when they come to sell the
share, price may perverse and may not represent the fundamental attractions of the
firm. This will seriously reduce the availability of funds to companies and reduce
growth. Investors need to know they are paying a fair price since the market is a
“fair game”.
2. To give correct signals to company managers since the maximisation of shareholder
wealth can be represented by the share price in an efficient market where sound
financial decision-making relies on the correct pricing of the company’s shares.
In applying a shareholder wealth-enhancing decision, the manager will need to be
assured that the implication of the decision is accurately signalised to shareholders
and to management through a rise in the share price.
3. To help allocate resources – allocation efficiency requires both operation efficiency
and pricing efficiency. If a poorly run company in a declining industry has highly
valued shares because the stock market is not pricing correctly then this firm will
be able to issue new shares and thus attract more of society’s savings for use within
its business.
Efficient Market Hypothesis (EMH) is a controversial issue as financial economists still
dispute whether it holds in practice. The term efficiency in finance refers to informational
efficiency, which is used to describe a financial market in which relevant information
is impounded into the price of financial assets. A financial market is a market for the
exchange of capital and credit, which consists the money markets and the capital
markets. Money market being the short term debt securities while capital market where
long term debt are traded.
In short, market efficiency refers to a condition, in which current prices reflect all
the publicly available information about a security. When this condition is satisfied,
investors cannot earn an unusual profit by exploiting available information.
For instance, the Efficient Market Hypothesis roots in the pioneering work of Gibson
(1889) who writes, “when shares become publicly known in an open market, the value
which they acquire may be regarded as a judgement of the best intelligence concerning
them”.
The Efficient Market Hypothesis may be articulated in a number of different ways and
their differences can become rather difficult. The general idea behind the EMH is that
assets prices are determined by the supply and demand in a competitive market with
rational investors. The latter gather relevant information very rapidly and immediately
included this information into stock prices. The nature of information does not have
to be limited to financial news and research alone. Indeed information about political,
economic and social events combined with how investors perceive such information,
whether true or rumoured, will be reflected in the stock price. If this information is
immediately incorporated into prices, only new information, that is news, should cause
change in prices.
7.3 FORMS OF EFFICIENCY

From Fama (1970), there are three recognized classification of market efficiency which
is aimed at reflecting the degree to which it can be applied to markets.

For instance, the strong form of the efficient market hypothesis states that an equity
market efficiently adapts all information into accurate security prices such that no
information of any kind, public or private, will help investors realise higher returns.
The semi strong form of the hypothesis states that equity markets accurately process all
publicity available information. This renders techniques such as fundamental analysis,
utilising differences between discounted expected earnings and current prices unless for
predicting future returns.
The weak form of the efficient market hypothesis states that past stock market
information is irrelevant for predicting future movement in stock prices.
In fact, market efficiency does not require prices to be equal to fair value all the time.
Prices may be over or undervalued only in random happenings. So, they eventually
resort back to their mean value. As a result, because the deviations from a stock’s price
are in themselves random, investment strategies that result in beating the market cannot
be consistent phenomena.
7.4 VALIDITY OF THE EMH

In the real world of investment, there are evident arguments against the Efficient Market
Hypothesis. There are investors who have beaten the market, Warren Buffet, whose
investment plan focuses on undervalued stocks, made millions and set an example for
others to follow. There are portfolio managers that have better track records than others
and there are investment houses with more prominent research analysis than others. So,
how can performance be random when people are clearly profiting from beating the
market?
Moreover, volatility is a vital variable every market participant needs to consider. For
speculators, volatility determines how much money to place on each trade relative to
commence stake and stop point. For investors, it determines how much to allocate
between stocks and how much to invest for a safe retirement.
Investors are argued to overreact to whatever moves in stock price. This phenomenon
is also known as the ‘winner-loser effect’. The fact that an investor can earn abnormal
profit by selling past losers and selling past winners short, a trading strategy using past
prices as the information set, means that the market is not efficient in its weakest form.
7.5 STOCK MARKET ANOMALIES

Investors can earn abnormal profits in the stock markets by using patterns which have
repeated over time and these are referred to as anomalies. Some of the main stock market
anomalies are as follows:
7.5.1 January Effect

Counter arguments to the Efficient Market Hypothesis declare that reliable patterns
are present. A well-known calendar effects is the January Effect. Index returns are on
average higher in January than in other months.
This hypothesis states that there is a serious selling pressure at the end of the tax year,
since in some countries the sale of securities that have experienced price declines, that
is capital losses, can be offset against taxable income. For instance, small shocks are
more likely to be used for this, as they are riskier in general, so that they have a higher
likelihood of large price declines. In the beginning of the new tax year, investors usually
reinvest in these (or similar) stocks, leading to a relative high return in January. An
alternative explanation is “window dressing” which means that investment managers
might sell “loser” securities at the end of the year to present a nice portfolio at the
beginning of the next year

7.5.2 Holiday Effect
The well-documented holiday effect implies that prices rise on average more on the
day(s) preceding holidays. This effect holds more universally since it is present in
international stock markets. Typically, the holiday effect is only present for the local
holiday. Due to transaction costs, it is in general, not profitable to trade on the basis of
these anomalies.
7.5.3 Size Effect

Apart from these seasonal effects, there is the small firm effect known as the ‘size
effect’. This means that excess returns would have been earned by holding stocks of
low capitalisation companies. If the market is efficient, one would expect the prices of
these companies to go up to a level where the risk adjusted returns to future investors
will be normal.
7.5.4 P/E Ratio Effect

The P/E Ratio Effect shows that stocks of companies with low P/E ratios received a
premium for their investors. An investor who held the low P/E ratio portfolio earned
higher returns than an investor who held the whole sample of stocks. These results also
challenge the Efficient Market Hypothesis. Fama and French (1995) find that market
and size factors in earnings help explain market and size factors in returns. Short sellers
position themselves in stocks of firms with low earnings to price ratios since they are
recognised to have lower future returns.
7.6 TESTS OF MARKET EFFICIENCY

Weak form studies are more likely to spot market efficiency than those which conduct
tests for strong or semi-strong market efficiency. In weak form, the question is whether
knowledge of past price movements provide information about future prices. Studies of
the weak form comprise filter tests, trading rules, relatives’ strength as well as technical
analysis indicators.
Moreover, weak form efficiency states that predictable price movements unconnected to
risk would be removed by investors buying at troughs and selling at peaks. Specifically,
if Pt is the natural log at the stock price at t, then
Pt = Pt-1 + Rt + εt where
(i) expected return Rt over (t-1, t) would depend on past prices but is known at t-1;
while
(ii) εt reflects new information after t-1, and is uncorrelated with all functions of Pt – 1
where i > 0.
Also, weak form efficiency denies that technical analysis can deliver profits that are
abnormal relative to the risk that is being borne. It does not claim past stock price
movements are irrelevant for predicting future price movements. Price increases can
affect risk and thus the expected return, Rt. However, the unpredictable performance
of technical analysis suggests this form holds, hence telling that past prices or returns
reflect future prices or returns.
Weak form tests assume that only information on past returns is available, that the
expected return is constant, as is the variance. In effect, these are tests for autocorrelation
of rate of returns.

7.7 ACTIVITIES
ACTIVITY 1
What is the essential content of the efficient market hypothesis? We normally distinguish
between three forms of this hypothesis – what are these three forms? For each form,
describe in one paragraph the defining characteristics. Explain what factors are used to
argue that the efficient market hypothesis may not be true by some researchers.
ACTIVITY 2
The January effect is sometimes explained by tax-loss selling. Investors who have
unrealized losses in December sell their stock to realize losses to make them tax-
deductible, thus depressing stock prices. The stocks are then repurchased in January,
and this pushes prices back up. Could tax-loss selling have an impact on the optimal
timing of the sale or repurchase of equity? Which firms could take advantage of the
January effect, and how? Explain.
ACTIVITY 3
Analyse the strengths and weaknesses of the Stock Exchange of Mauritius. What
measures can be taken to boost its trading activities?
7.8 SUMMARY
Understanding the concept of stock price movements is an important factor in portfolio
selection and asset pricing where it is used as a measure of risk. There are three forms of
efficiency, weak form, semi strong form and strong form efficiency under the Efficient
Market Hypothesis. These defining characteristics having been challenged whereby
investors have been able to beat the market to earn abnormal returns.
In the last chapter, we shall elaborate on short term finance which is used to finance
working capital and management of the latter. Two main sources of short term finance
are Bank borrowings (Overdraft and Import loans) and trade credit (Letter of credit)

8
UNIT
WORKING CAPITAL MANAGEMENT
Unit Structure
8.0 Overview
8.2 Definition of working capital
8.3 Aspects of working capital management
8.4 Objectives of working capital management
8.5 Working capital cycle
8.6 Sources of additional capital
8.7 Receivables Management
8.8 Cash Management
8.9 Inventory Management
8.10 Principles of working capital management
8.11 Activities
8.12 Summary
8.0 OVERVIEW
In the preceding chapter, we explained the notion of efficient market hypothesis and the
forms of efficiency as well as the tests used to measure the degree of efficiency. We also
stated how investors operate in a view to beat the market by using well known stock
market anomalies. Managing assets and liabilities is one of the most important jobs for
business managers and accountants. Small businesses in particular must strike a perfect
balance between the two to successfully continue operations, because they lack the
necessary capital to absorb large losses. Therefore, proper working capital management
proves essential in the avoidance of bankruptcy by helping a business to balance its
needs with its obligations. Working capital plays an important role in firm’s growth
and profitability and is tightly interlinked with the concept of liquidity. Working
capital management is one of the cornerstones of business continuity and acts as a hedge
against tightening credit and access to additional capital.

1. Define working capital management
2. Explain the concepts of working capital management
3. Assess the importance of working capital management
8.2 DEFINITION OF WORKING CAPITAL

Working capital is defined as the difference between all short-term assets and short-term
liabilities. Assets in business refer to anything of value a company owns. Liabilities are
outstanding debts, such as loans and credit. Working capital, also known as net working
capital, represents operating liquidity available to a business. Along with fixed assets
such as plant and equipment, working capital is considered a part of operating capital.
It is calculated as current assets minus current liabilities. If current assets are less than
current liabilities, an entity has a working capital deficiency.
Working Capital = Current Assets − Current Liabilities
A company can be endowed with assets and profitability but short of liquidity if its assets
cannot readily be converted into cash. Positive working capital is required to ensure
that a firm is able to continue its operations and that it has sufficient funds to satisfy
both maturing short-term debt and upcoming operational expenses. The management of

working capital involves managing inventories, accounts receivable, payable and cash.
These components provide the sources of income for the business, whether in the form
of profit from the sale of products and services, or interest earned from securities. The
current liabilities consist mainly of accounts payable which is of prime importance as
management of payables can significantly affect cash flows of the company.
Effective working capital management ensures sufficient cash flow to fund operations
while reducing debt. Working capital management is the responsibility of all the
departments in the organization and is also known as the cash conversion cycle.
8.3 ASPECTS OF WORKING CAPITAL

MANAGEMENT
Working capital management entails the process of balancing the needs of short-term
assets and short-term liabilities. Aspects of working capital management include short-
term loans, goods purchased on credit, goods and services provided on credit, goods
and services paid for upon delivery. Managing working capital essentially entails
managing the cash flow of a business on a daily, weekly and monthly basis in such a
way that satisfies all debts while reserving enough capital to continue operations and the
generation of profits.
Several methods of improving working capital and working capital management exist.
Methods of improving working capital management begin with simple tasks such as
monitoring expenditures and upcoming debts and planning in advance how to balance
the two. Lowering production costs while maintaining sales revenue increases profits,
thus providing more cash for working capital management. Short term working capital
management problems can be solved by swapping short-term debt for long-term debt
and putting money allocated for short-term debt into the generation of profits for paying
off long-term debt. The four aspects of working capital management are:
(i) Planning - Companies should begin by determining what their working capital
requirements should be and tune the working capital model accordingly. The
model could be aggressive or moderate based on the market situation affecting
the company. Assessing the risks also plays an important part in planning for the
working capital requirements.
(ii) Reassess internal working capital policies such as credit periods for customers,
suppliers, short term finance, long term finance, equity participation and
inventory.
(iii) Benchmarking-Companies should benchmark their requirements against
similar companies in their industries to have information on working capital
requirements.
(iv) Balance growth and profitability- Companies should balance growth with
profitability with sound working capital policies.
8.4 OBJECTIVES OF WORKING CAPITAL

MANAGEMENT
For smooth running a company, adequate amount of working capital is very essential.
Efficiency in this area can help to utilize fixed assets gainfully, to assure the firm’s long-
term success and to achieve the overall goal of maximization of the shareholders’ fund.
Shortage or bad management of cash may result in loss of cash discount and loss of
reputation due to non-payment of obligation on due dates. Insufficient inventories may
be the main cause of production held up and it may compel the enterprises to purchase
raw materials at unfavorable rates.
Working Capital Management is an important part of financial management and
its primary task is concerned with the matching of asset and liability movements over
time. This leads to the two main purposes of Working Capital Management; liquidity

and profitability. Profitability refers to the shareholders’ wealth maximization and
liquidity is concerned with fulfilling financial obligations.
8.5 WORKING CAPITAL CYCLE

The Working Capital Cycle makes it clear that the amount of cash is obtained mainly
from issue of shares, borrowing and operations. Cash funds are used to purchase fixed
assets, raw materials and used to pay to creditors. The raw materials are processed;
wages and overhead expenses are paid which in result produce finished goods for sale.
The sale of goods may be for cash or credit. In the former case, cash is directly received
while in later case cash is collected from debtors. Funds are also generated from
operation and sale of fixed assets. A portion of profit is used for payment of interest,
tax and dividends while remaining is retained in the business. This cycle continues
throughout the life of the business firm.
8.6 SOURCES OF ADDITIONAL WORKING CAPITAL

Sources of additional working capital include the following:
• Existing cash reserves
• Profits
• Payables (credit from suppliers)
• New equity or loans from shareholders
• Bank overdrafts or lines of credit
• Long-term loans
If a company has insufficient working capital and try to increase its sales, it can easily
over-stretch its financial resources. This is called overtrading. Early warning signs
include:
• Pressure on existing cash
• Exceptional cash generating activities e.g. offering high discounts for early cash
payment
• Bank overdraft exceeds authorized limit
• Seeking greater overdrafts or lines of credit
• Part-paying suppliers or other creditors
• Paying bills in cash to secure additional supplies
• Management pre-occupation with surviving rather than managing
• Frequent short-term emergency requests to the bank
8.7 RECEIVABLES MANAGEMENT

Accounts receivables can be seen as assets of the firm or as loans given to customers
by the company. When there is a build-up of receivables, funds are unavailable that
could otherwise be put to more efficient use within the company and earn a return. The
credit period illustrates the time that it takes for the company to transform receivables
into cash. After the delivery time, the time that receivables are tied up in can usually be
divided into three categories. The first one is concealed credit time which is the time the
company has given the customers to pay. The second is authorized credit time, which
consists of the time between delivery of goods and invoicing. The last category is when
credit falls due.
To minimize this risk companies should always try to shorten these credit times and if
that cannot be done an adjustment of the price of the goods or services should be made to
compensate for the added risk. It is common practice by corporations to shorten the credit
arrow in order to speed up collections. One reason for this is that the creditworthiness
of customers can change over time and therefore needs to be revaluated.

8.8 CASH MANAGEMENT
Cash management is one part of Working Capital Management and usually concerns the
different processes and procedures of handling a company’s liquidity and the monitoring
and planning of it. The different items included within this area are: payables systems,
receivables system, management of liquid funds, currency management and risks, short
term financing, accounts payables and accounts receivables. Improving a company’s
cash management can result in better profit margins and higher turnover ratio which in
turn can lead to higher profitability.
8.9 INVENTORY MANAGEMENT

Inventory management is one area which can significantly improve the cash flow of a
company as it portrays pools of cash. One easy way of improving inventory management
is to focus on sales forecasting and adapting a control system for this area. By accurately
forecasting sales, inventory levels can be cut down and cash levels can improve.
When evaluating the efficiency of inventory management, it is very common to calculate
the days inventory held´ (DIH) period, which expresses the average time that a good
is held in inventory before it is sold to customer. Since goods laying idle in inventory
represents costs for the company, the shorter the DIH are more efficiently assets are
managed.
8.10 PRINCIPLES OF WORKING CAPITAL

MANAGEMENT
The four principles of working capital management are:
1. Principles of the risk variation─ If working capital is varied relative to sales,
the amount of risk that a firm assumes is also varied and the opportunity for
gain or loss is increased. In other words, there is a definite relationship between the
degree of risk and the rate of return. As a firm assumes more risk, the opportunity
for gain or loss increases. As the level of working capital relative to sales decreases,
the degree of risk increases. When the degree of risk increases, the opportunity for
gain and loss also increases. Thus, if the level of working capital goes up, amount
of risk goes down, and vice-versa, the opportunity for gain is like-wise adversely
affected.
2. Principle of equity position─ According to this principle, the amount of working
capital invested in each component should be adequately justified by a firm’s equity
position. Every dollar invested in the working capital should contribute to the net
worth of the firm.
3. Principle of cost of capital─ This principle emphasizes that different sources of
finance have different cost of capital and the latter moves inversely with risk. Thus,
additional risk capital results in decline in the cost of capital.
4. Principle of maturity of payment─ A company should make every effort to relate
maturity of payments to its flow of internally generated funds. There should be the
least disparity between the maturities of a firm’s short-term debt instruments and its
flow of internally generated funds, because a greater risk is generated with greater
disparity. A margin of safety should, however, be provided for any short-term debt
payment.

8.11 ACTIVITIES
ACTIVITY 1
Critically explain the concept of working capital cycle and cash conversion cycle. Why
are these concepts important in working capital management? Give an example to
illustrate.
ACTIVITY 2
Explain the risk-return trade off of current assets financing.
ACTIVITY 3
Elaborate on the factors that determine the working capital requirements of a firm.
8.12 SUMMARY
It is difficult trying to achieve and maintain an optimal level of working capital for
a business. Working capital management is the administration of current assets and
current liabilities. Effective management of working capital ensures that the company
is maximising the benefits from net current assets by having an optimal level to meet
working capital demands.

SOLUTIONS TO ACTIVITIES
Unit 1 – FINANCIAL STATEMENT AND PLANNING
ACTIVITY 1
Workings:
MUR
Sales (150% x 530,000) 795,000
Interest (60% x 1,500,000 x 9.25%) 83,250
Shareholders Equity (40% x 1,500,000) 600,000
MUR
Sales 795,000
Less Direct Cost (530,000)
Gross Profit 265,000
Less:
Operating Expenses 175,000
Interest 83,250
Net Profit before tax 6,750
Corporate Tax (1,013)
Net Profit after Tax 5,738
(i) Net profit margin = Profit x 100%

Sales
5,738 x 100% 0.72%
=
795,000

(ii) Return on Assets = Net Income before Tax

Total Asset
6 ,750
= 0.0045
1,500,000

(iii) Asset Turnover = Sales

Assets
795,000
= 0.53
1,500,000
(iv) Return on Owner’s Equity = Net Income after Tax

Shareholders Equity
5,738
= 0.00956
600,000

ACTIVITY 2
(A)
Computation of ratios
i. Profitability (EPS + 2) Mads Ltd Macs Ltd
l Earnings per share

61 × 100 = 7.62c
400 × 2
64 × 100 = 12.8c
250 × 2
l Return on capital employed

95 × 100 = 15.7%
605
108 × 100 = 17.7%
459 + 150
l Net margin
95 × 100 = 9.9%
960
108 × 100 = 9.0%
1200
l Asset turnover
960 = 1.6 times
605
1200 = 2.0 times
609
l Gross profit margin

243 × 100 = 25.3%
960
225 × 100 = 18.75%
1200
ii. Working capital control (3 only) Mads Ltd Macs Ltd
l Current ratio
255 : 265 1:1
281 : 96 2.9:1
l Quick ratio
45 : 265 0.2:1
41 : 96 0.4:1
l Stock turnover
717 = 3.4 times
210

975 = 3.4 times
240 4.1 times
Period (days) = 107 days 90 days
l Debtor collection period

45 × 365 = 17 days
960
41 × 365 = 12 days
1200
l Creditor payment period

112 × 365 = 57 days
717
62 × 365 = 23 days
975
iii. Financial risk (2 only)
l Debt to capital employed *

(excluding overdraft) Nil
150 x 100 = 24.6%
150 + 459
l Debt to capital employed *

(including overdrafts)
128 x 100 = 17.5%
128 + 605
5 + 150 x100 = 26.1%
155 + 459
l Interest cover
95 = 10.5 times
9
108 = 7.7 times
14
(B)
i. Profitability ratios show that Mads Ltd has higher GP% and lower asset turnover.
This illustrates the sale of high quality and margin products. Macs Ltd, on the other
hand, are selling lower margin but higher volumes. The net margin of Mads Ltd
at 9.9% compared to the GP% of 25.5% means that ‘other costs’ are 15.4% of
turnover whereas Macs Ltd ‘other costs’ are only 9.75% which, again, is probably
due to the business model of selling in expensive locations.
ii. Macs Ltd has a much better set of working capital ratios showing positive working
capital, a reasonable (if a little low) quick asset position and sound debtor/creditor
management. This reflects the strategy of ‘a sound financial framework’ and the
business background of management. Mads Ltd is in a weak current position with
an exposed quick assets position due to the high creditors and overdraft. This reflects
the lack of financial management experience and the strategy of concentrating on
brand/marketing without due consideration of short-term finances. Mads Ltd takes
a significantly longer period to pay creditors and are likely to suffer worse terms of

trade as a consequence. Mads Ltd is also likely to be paying higher interest rates on
the bank overdraft as the bank may believe there is more risk.
The respective stockholding strategy also reflects the different management styles
and also the different product range. Macs Ltd aims for quicker stock turnover of
cheaper products.
iv. Although Mads Ltd has no long-term liabilities, this may not be the best policy as
they are using short-term finances, as discussed above. However, if bank overdrafts
are treated as part of longer term finance they do have a degree of gearing. Mads Ltd
does have significant freehold land and buildings and these could be used as security
for reasonably cheap debt finance. This again illustrates the lack of sound financial
management experience.
(C)
Mads Ltd
• In terms of a profitable business, this is an attractive investment. If the other
operating costs could be brought under control, net margins would be on a par with
Macs Ltd
• The risk is in terms of the current/working capital position. However, if VL could
introduce more effective financial management this could be turned around.
• In terms of financial structure an introduction of loans secured on the property
assets could improve the position.
Macs Ltd
This is a sound, low-risk investment as it is a company with reasonable profit levels,
sound current position and financial structure.
Conclusion
Macs Ltd is the safer bet, but even though a higher risk Mads Ltd has the potential
to become more successful if VL can introduce better financial management. The
investment will depend on VL’s own risk strategy and management strengths.
ACTIVITY 3
The financial aspects of all organizations are critical to the long term viability of that
organization. Every self-employed and Compnaies need to prepare their financial
statement in order to analyse them to know the trend of their businesses. Although
government/non-profit organizations are not required to make a profit, they still have to
manage their funding to provide the required services. However, they need to increase
their efficiency just to continue to provide a constant level of services.
Financial statement analysis is used to identify the trends and relationships between
financial statement items. Both internal management and external users (such as analysts,
creditors, and investors) of the financial statements need to evaluate a company’s
profitability, liquidity, and solvency. The most common methods used for financial
statement analysis are trend analysis, common-size statements, and ratio analysis. These
methods include calculations and comparisons of the results to historical company data,
competitors, or industry averages to determine the relative strength and performance of
the company being analyzed.
The main purpose of preparing financial statements is that anyone who looks at the
financial statements of a firm will be automatically performing some form of analysis.
For instance, a banker will quickly analyze them to determine your capability for
paying back a loan ; investors will always perform a financial statement analysis to
determine if your business is a good investment, or whether you have been performing
according to plan and suppliers will analyze your financial statements to determine your
credit worthiness.

On the other hand, the use of ratios help in analysis the financial position of a business
in more details. Common ratios that are used are :
• Balance Sheet ratios
• Profit and Loss ratios
• Management ratios
1. Balance Sheet ratios

Balance Sheet ratios are ratios used to analyse the position of the assets and liablities of
the business. For example :
(a) Current ratio = Current Assets/Current Liabilities. This type of ratio is widely
used as tests of financial strength. It is used to determine if a business is likely
yo pay its bills. However, a minimum acceptable ratio is 1 :1, otherwise the
company would not be expected to pay its bills on time. A ratio of 2:1 is much
more acceptable, and the higher, the better.
(b) Quick Ratio also known as acid test ratio = Cash and recevables/Current
Liabilities. It concentrates on only the more liquid assets of your business. It
excludes inventories or any other current asset that might have questionable
liquidity. Depending on the history for collecting receivables, a satisfactory ratio
is 1:1.
(c) Working Capital= Current Assets – Current Liabilities. This ratio is very
important for bankers especially as it deals more with cash flow than just a simple
ratio. Very often a banker will tie a loan approval amount to a minimum Working
Capital requirement.
(d) Inventory Turnover Ratio = Net Sales/Average Inventory. In general, not every
business has an inventory that needs to be of concern This ratio tells if a company’s
inventory is turning over fast enough.
(e) Leverage Ratio = Total Liabilities/Net Worth(Assets-Liabilities). Another of the
analyses used by bankers to determine if a business is credit worthy. It basically
shows the extent a business relies on debt to keep operating. The higher the
ratio is, the more risky it becomes to extend credit to your business. Also, the
calculation a supplier to your business will make before extending credit to you.
2. Profit and Loss ratios

Profit and Loss ratios in financial statements analysis also have some importance
in a business. In most businesses, these types of ratios are used:
(a) Gross Profit ratio = Gross Profit/Sales. This is the most commonly used ratio on
a Profit and Loss account. It is normally calculated to anaylse and the trend of
a company. However, this number shall not move too far from the company’s
target.
(b) Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) =
EBITDA/Sales. It indicates how well the business is actually operating, without
the inclusion of non-operating costs. This ratio should be looked at as one of the
most important ratios of a business operations.
(c) Net Profit ratio = Net Profit before Tax / Net Sales * 100%. Net profit ratio is a
useful tool to measure the entire profitability of a business. The higher the ratio,
it shows the efficient management of the affairs of business. In most cases, to
determine the improvement of a business, an analyst should compare the ratio
with the previous years’ ratio. The use of net profit in conjunction with the assets
turnover ratio helps in ascertaining how profitably the assets have been used
during the year.
3. Management Ratios
This type of ratio is normally used for third parties as they would like to know

the position of the business as a whole before initiating any investment in the
company. It normally includes ratios such as the following:
(a) Return on Assets = Net Profit before tax / Total Assets. It is used to indicate how
efficiently a company is utilizing its assets. Usually bankers and investors use this
ratio. However, this ratio is normally compared with other companies in the same
line of business. Additionally, this ratio gives an indication of the capital intensity
of the company, which will depend on the industry, companies that require large
initial investment will generally have lower return on assets.
(b) Return on Investment = Net Profit Before Tax / Net worth. This ratio is supposed
to make an investor understand if he is investing his time and money properly in
the business or should liquidate the business and saves his money in the bank.
Unit 2 – THE TIME VALUE OF MONEY
ACTIVITY 1
1. Rate of return = 5.5%
2. Loan balance = $7,500
3. (a)

1 (5,000) (4,132.23)
2 2,500 1,878,29
3 2,500 1,707.53
4 1,000 620.92
NPV 74.51
PV = FV [1/(1+r)t]
 
(b) The annuity factor formula is K = 1 1 – 1 ,so that the annuity is C = NPV/K
r (1 + r)t
Show your work for potential partial credit.

   
Annuity factor K = K = 1 1 – 1 = 1 1– 1 = 3.169865
r (1 + r)t 0.1 (1+0.1)4
Annuity = C/K = 74.51 / 3.169865 = 23.51
Unit 3 – CAPITAL BUDGETING DECISIONS
ACTIVITY 1
1. (i) Payback Period X = 3yrs

Y = 2 and 1/2 yrs

(ii) Discounted Payback period – X = $ 33,625.63
Y = $ 41,684.13
(iii) NPV – X = $ 8466.8646
Y = $ 8713.5787
(iv) IRR - X = 18.60%

Y = 19.91%
(v) PI – X =0.20
Y = 0.19
3. Project Y, since it has a short repay back period and has a high NPV.
ACTIVITY 2
1. (a)

1 (5,000) (4,132.23)
2 2,500 1,878,29
3 2,500 1,707.53
4 1,000 620.92
NPV 74.51
PV = FV [1/(1+r)t]
 
(b) The annuity factor formula is K = 1 1 – 1 ,so that the annuity is C = NPV/K
r (1 + r)t
Show your work for potential partial credit.

   
Annuity factor K = K = 1 1 – 1 = 1 1– 1 = 3.169865
r (1 + r)t 0.1 (1+0.1)4
Annuity = C/K = 74.51 / 3.169865 = 23.51
ACTIVITY 3
Capital Budgeting Analysis is a process of evaluating how to invest in capital assets; i.e.
assets that provide cash flow benefits for more than one year.
Capital Budgeting Basics

A company undertakes capital budgeting in order to make the best decisions about
utilizing its limited capital. For example, if an investor is considering opening a
distribution center or investing in the development of a new product, capital budgeting
will be essential. It will help to decide if the proposed project or investment is actually
worth it in the long run.

Identify Potential Opportunities
The first step in the capital budgeting process is to identify the opportunities that have.
Many times, there is more than one available path that a company could take. An
investor has to identify which projects he wants to investigate further and which ones
do not make any sense for the company. If he overlooks a viable option, it could end up
costing him quite a bit of money in the long term.
Evaluate Opportunities
Once identified the reasonable opportunities, the investor needs to determine which
ones are the best. Look at them in relation to the overall business strategy and mission.
See which opportunities are actually realistic at the present time and which ones should
be put off for later.
Cash Flow
Next, the investor needs to determine how much cash flow it would take to implement
a given project. He also needs to estimate how much cash would be brought in by such
a project. This process is truly one of estimating--it takes a bit of guesswork. He needs
to try to be as realistic as he can in this process. Most of the time, an investor needs to
use a fraction of that number to be realistic. If the project takes off and the best-case
scenario is reached, that is great. However, the odds of that happening are not the best
on new projects.
Select Projects
After looking at all of the possible projects, it is time to choose the right project mix for
the company. Evaluate all of the different projects separately on their own merits. The
investor needs to come up with the right combination of projects that will work for his
company immediately. Choose only the projects that mesh with the company’s goals.
Implementation
Once the decisions have been made, it is time to implement the projects. Implementation
is not really a budgeting issue, but an investor will have to oversee everything to be sure
it is done correctly. After the project gets started, he will need to review everything to
make sure the finances still make sense.
Thus, three stages within Capital Budgeting Analysis:

- Decision Analysis for Knowledge Building
- Option Pricing to Establish Position
- Discounted Cash Flow (DCF) for making the Investment Decision
Decision-making is increasingly more complex today due to uncertainty. Additionally,

most capital projects will involve numerous variables and possible outcomes. For
example,
estimating cash flows associated with a project involves working capital requirements,
project
risk, tax considerations, expected rates of inflation, and disposal values. We have to
understand existing markets to forecast project revenues, assess competitive impacts of
the
project, and determine the life cycle of the project. If a capital project involves production,
we have to look into operating costs, additional overheads, capacity utilization, and
startup costs. Consequently, capital projects cannot be managed by simply looking at
the
numbers; i.e. discounted cash flows. The entire decision must be looked and assessed all
relevant variables and outcomes within an analytical hierarchy.

Unit 4 – SOURCES OF FINANCE
ACTIVITY 1
A basic commercial bank loan is called a bank term loan. A bank term loan has a
particular term or length of maturity and usually a fixed interest rate.
The repayment of the principal of bank term loans are usually amortized, which means
that the principal and interest are set up as periodic payments designed to pay off the
loan in a certain period of time.
In the past, small businesses have lived and died on the strength of bank loans, their
primary source of small business financing. During the Great Recession, this somewhat
changed as banks became more reticent to lend and banks had to start looking at
alternative sources of financing.
Types of Bank Term Loans

The American Bankers Association generally recognizes two types of bank term loans.
The first is the intermediate term loan which usually has a maturity of one to three years.
It is often used to finance working capital needs. Working capital refers to the daily
operating funds that small business owners need to run their businesses.
Working capital loans, however, can be short-term bank loans and often are. Companies
often want to match the maturities of their loans to the life of their assets and prefer
short-term bank loans.
Intermediate Bank Loans

Intermediate bank term loans can also be used to finance assets such as machinery
that have a life of around one to three years, like computer equipment or other small
machinery or equipment. Repayment of the intermediate term loan is usually tied to the
life of the equipment or the time for which you need the working capital.
Intermediate term loan agreements often have restrictive covenants put in place by the
bank. Restrictive covenants restrict management operations during the life of the loan.
They ensure that management will repay the loan before paying bonuses, dividends, and
other optional payments.
Long-term Bank Term Loans

Banks seldom provide long-term financing to small businesses. When they do, it is
usually for the purchase of real estate, a large business facility, or major equipment. The
bank will only lend 65% - 80% of the value of the asset the business is buying and the
asset serves as collateral for the loan.
Other factors that small businesses have to deal with in bank term loan agreements are
interest rates, creditworthiness, affirmative and negative covenants, collateral, fees, and
prepayment rights. Creditworthiness has become particularly important since the Great
Recession.
In reality, bank term loans are actually short-term, but because they are renewed over
and over, they become intermediate or longer term loans. Bankers prefer self-liquidating
loans where the use of the loan money ensures an automatic repayment scheme. For
instance, in the USA, most term loans are in amounts of $25,000 or more. Many have
fixed interest rates and a set maturity date. Payment schedules vary. Term loans may be
paid monthly, quarterly, or annually. Some may have a balloon payment at the end of
the term of the loan.

ACTIVITY 2
The cost of debt financing, i.e. loans, is interest. The cost of equity financing
(investments) could include dividends or a share of the profits. Comparing the two may
involve a cost of capital calculation and analysis. An investor would in effect compare
the interest charges on a loan with the percentage of his company’s retained earnings or
accumulated profits that really belong to the investor.
If loans can be obtained from different banks, compare the interest rates and payment
terms they offer. An investor may want to determine the total interest cost over the life
of each loan to have a comparable base. Small differences in the interest rate can add up
to significant amounts over a long-term loan. Keep in mind that short-term unsecured
loans, such as lines of credit, generally carry a higher interest rate than long-term secured
loans, such as mortgages.
These are equity types of financing, so the investor will be obtaining funds in exchange
for part of the ownership of his business. An angel investor is generally an individual
who is willing to invest in higher-risk, start-up companies, in exchange for a higher
rate of return than on other investments. Venture capital, or risk capital firms are also
interested in investing in a business with good earnings and growth potential. Typically,
angel investors are more likely to invest in a smaller, entrepreneurial company, while
venture capital firms deal in larger amounts. An angel investor may also be able to
contribute significant knowledge and experience, and could become a good advisor for
your business.
ACTIVITY 3
When talking of working capital, it all comes down to a firm’s ability to raise and
utilize cash flow on an ongoing basis. When an investor understands what working
capital is, he is obviously in a better position to source it. He therefore needs to know
how to measure working capital in terms of his overall business needs. That’s part of
the problem and challenge, because when sitting down and working with clients on
working capital and cash flow needs he quickly determines that working capital and
cash flow mean different things to different business owners.
The problem usually starts with the business owner assessing his working capital needs
by looking at the ‘Total Cash ‘line in his bank account. That is of course cash on hand,
and doesn’t reflect working capital, which is the funds he has tied up in receivables,
inventory, prepaid, etc.
The best way to measure working capital efficiency is on a regular basis to calculate
the receivable and inventory turnover. They are either getting better or worse, and his
working capital improves or deteriorates in the same relation.
However, an investor should also focus on business liquidity because suppliers and
creditors will bear the brunt of his inability to fund his business - and deterioration in
supplier / creditor relations is the worst thing that can happen to the business.
It should be clearly recognized that cash on hand and growing inventory does not help
a cash flow at all - external financing is needed. An investor achieve external financing
by the profits generated from his business, plus working capital facilities via a bank or
independent finance company.

Unit 5 – VALUATION OF BONDS AND OTHER SECURITIES
ACTIVITY 1
(a) The discount factor for year 1 cash flow is d1 = 100/105 = 0.952; the discount
factor for year 2 cash flow is d2 = (99 - 5d1)/105 = 0.988; the discount factor for
year 3 cash flow is d3 = (98 - 5d1 - 5d2)/105 = 0.845
The value of the borrowing opportunity - in terms of today’s money - is 100d1

- 108d3 = 3:94. Given this is positive, candidates should take the borrowing
regardless of whether one needs the money or not - if the investor doesn’t need
the money, he can undertake (through a forward agreement) to invest 100 for
two years in one year’s time which grows to 100d1/d3 = 112.66 in year 3. After
repaying his loan, he will have 4.66 left over, which in today’s money is worth
4.66d3 = 3:94.
The net present value of the borrowing opportunity is 3.94 and, therefore, the
maximum amount you are prepared to pay for entering into the borrowing
opportunity today.
ACTIVITY 2
The spot rates are 6.57%, 5.57%, 4.91%, and 5.02%, respectively for year 1 through
4, which are worth 4 marks. The present value of borrowing (using year 1 spot rates)
is 93,839, and the present value of repayment (using year 4 spot rates) is 94,212. The
deal should not be effected as the present value of repayment is greater than the present
value of the borrowing. This calculation is worth 2 marks, and a calculation of the net
present value is worth 4 marks. Candidates may also use forward rates, where the 1 year
borrowing rate of the loan is 5% should be measured against the implied 1 year forward
rate from year 1 to year 2 which is 1.05572 divided by 1.0657 which yields 4.58%
which is lower than 5%.
The immunisation approach should be illustrated, where the investors invested an

amount x in today’s bond market to offset the repayment of the loan, and shorted an
amount y in today’s bond market to be repaid by the borrowing. This yields (1.05572)x =
105,000 and (1.0657)y = 100,000. This would immunise the future position completely,
so that the profit can be measured by y-x, which is exactly the NPV of the borrowing
transaction.
ACTIVITY 3
(a) (i) Price (fair value) = $1,000

Coupon (semi annual) = 3%
YTM (semi annual) = 2.5%
T = 9yrs
Price of bond = 30 + 30 + .....…......….. + 30
2
(1.025) (1.025) (1.025)18
= $1,142.0889

(ii) Price (fair value) = $1,000
Coupon (semi annual) = 3%
YTM (semi annual) = 3.5%
T = 9yrs
Price of bond = 30 + 30 + .....…......….. + 30
2 18
(1.035) (1.035) (1.035)
= $934.0516
(iii) Current yield = Coupon amount x 100%

Price
= 60 x 100%
934.0526

= 6.42%
(b) Prices are normally quoted net of the first coupon – the clean price is the dirty price
(the actual price you pay) net of accrued interest (coupon times days since last
coupon divided by days between coupon payments). This is worth 2 marks. The
dirty price of the 3 year 40 day bond is 6 (1.05(−40/365) + 1.05(−365−40/365) +
… + 1.05(−2*365−40/365)) + 106 (1.05(−3*365−40/365)), and the clean price is
the dirty price less 6(365−40/365). This is worth 3 marks.
The clean price is equal to the dirty price when the accrued interest is exactly
zero, which happens when a coupon payment has just been made. Therefore,
the dirty price is equal to the present value of next coupon payment plus the
present value of the clean price at the time of the next coupon payment: Dirty =
PV (coupon) + PV (Clean). Therefore, the accrued interest is Dirty – Clean = PV
(coupon) – (Clean – PV (Clean)). As we get closer to the next coupon payment,
the second term vanishes so we are left with the PV(coupon) which also becomes
close to the coupon payment itself. Therefore, accrued interest is in the limit
equal to the coupon payment itself.
At the other end, it is noted that as the time to the next coupon payment becomes
maximally large, the difference between the clean price and the present value
of the clean price at the date of the next coupon payment must be equal to the
present value of the coupon payment itself. Therefore, accrued interest must go
to zero. The formula used is an approximation to the ‘true’ accrued interest, and
will be fairly accurate unless the yield is very high.
Unit 6 – RISK AND RETURN & CAPITAL ASSET PRICING

MODEL (CAPM)
ACTIVITY 1
(a)

(b) Assumptions for Capital Asset Pricing Model (CAPM)
(i) The use of CAPM and its assumptions can be helpful in estimating the
expected return of a stock. The basic assumptions of CAPM include:
(ii) The model aims to maximize economic utilities.
(iii) The results are risk-averse and rational.
(iv) The results are price takers. This implies that they cannot influence prices.
(v) The model can lend and borrow unlimited amounts under the risk free rate of
interest.
(vi) The model presumes that all info is available at the same time to all investors.
(vii) The model trades without taxation or transaction costs.
(viii) The model deals with securities all of which are highly divisible into small
parcels.
(ix) The results are widely diversified across a range of investments.

Market risk premium is the variance between the predictable return on a market portfolio
and the risk-free rate. Market Risk Premium is equivalent to the incline of the security
market line (SML), a capital asset pricing model.
There are three concepts that are a part of Market Risk Premium and used to determine
the market risk premium

• Required market risk premium - the return of a portfolio over the risk-free rate
(such as that of treasury bonds) required by an investor;
• Historical market risk premium - the historical differential return of the market
over treasury bonds; and
• Expected market risk premium - the expected differential return of the market
over treasury bonds.
The historical market risk premium will be similar for all the investors as the value is
the actual value of what happened. The required risk premium and the expected market
risk premium can differ from one investor to the other based on how much an investor
can invest and the risks these investors can take.
How to calculate a Market Risk Premium
Market Risk Premium allows an investor to find out if the investments they are about to
make are worth it based on these calculations. The formula used to calculate the Market
Risk Premium is as follows:
Market Risk Premium = Expected market return – Risk-free rate
It is important to understand the concept of Market Risk Premium. It is a role of supply

and demand, which when in equilibrium would not need the premium to be paid. If the
demand increases, the supply also cannot meet the demand and the price of the said
asset increases. The difference in the price is premium. This is called the Market Risk
Premium.
Risk-free assets are the assets of the government, which is why the treasuries are used
as representation for risk-free rate of return. You can then determine the risk-free rate,
which can be used as the baseline. Then you can determine the rate of return for the
market. The difference between the average market rate of return and risk free rate would
provide you with a market risk premium. It is therefore very important to determine
market risk premium when you have to make a big investment. The investment the
investor can make by investing in the financial products that can have risks and they
won’t have problems facing the setbacks.

ACTIVITY 2
A good answer would define the tangency portfolio as follow – under the CAPM, in
equilibrium the tangency portfolio of risky assets must be the market portfolio.
A good answer would define the security market line – the linear relationship between
the expected return and β.
 
Security market line
ACTIVITY 3
(i) We shall discuss the theoretical and practical limitations of the CAPM. Answers
would also mention the relevant empirical evidence to support / contrast each
limitation. We shall demonstrate their ability to handle opposing views / theories.
Answers shall begin with the main theoretical limitation of the CAPM – that the
implementation of the CAPM requires the use if proxies for the market portfolio
because the exact composition of the market portfolio is unobservable.
Excellent answers would discuss the empirical evidence provided by Roll (1977)
(i.e. the unobservability of the market portfolio makes the CAPM untestable).
Specifically, given that the quality of the proxies used for the market portfolio
cannot be guaranteed, it is not possible to test the CAPM. Answers shall also
elaborate further on this: there could be two alternative situations:
• It might be the case that the market portfolio is efficient (and hence the
CAPM is valid), but the proxy chosen is inefficient (and hence the empirical
tests incorrectly reject the CAPM)
• The proxy for the market portfolio might be efficient (and hence the empirical
tests validate the CAPM), but the market portfolio itself is not efficient (and
hence the validation is false)
We should then make clear that academics have been debating whether the
CAPM is testable for many years without arriving at a consensus. Answers would
then discuss these tests. Overall, there tests provide broad support for the CAPM
by showing that the expected return increased with beta over the period 1931 –
1991, even if less rapidly than the CAPM predicts. However, critics of the CAPM
pointed out two problematic pieces of empirical evidence.
• In recent years the slope of the security market line has been much flatter
than one would expect from the CAPM. This means that high-beta stocks
performed better than low-beta stocks, but the difference in their actual
returns was not as great as the CAPM predicts.
• Factors other than beta (such as firm size, book-to-market ration, price-to-
earnings ratio, and dividend yield) have all contributes to explain ex-post
realised returns (after controlling for beta). This contrast with the CAPM,
which predicts that beta, is the only factor that expected returns differ.

(ii) • We shall identify the best set of efficient portfolios of stocks in the present of
risk-free assets. Nevertheless answers not considering risk-free assets have
been considered equally fine.
• We should first provide the graph and state that the optimal portfolio is
represent by point K
• We should then explain more in depth the meaning of point K. The optimal
portfolio lies on the tangency between the indifference curve of the investor
and the capital marker line. By choosing both the risky portfolio K and the
risk-free asset, the investor lies on the capital market (CML1) that dominates
in utility terms and other capital market line (such as CML2). In the presence
of a risk-free asset and N risky assets, the efficient set is exactly the optimal
capital market lime (CML1).
• We must also mention the two-fund separation theorem; any risk-averse
investor can form the optimal portfolio by combining two funds. The first
is the risk-free assets; the second is the risky asset portfolio K. The degree
of risk-aversion determines the portfolio weights places on the two funds.
For example, investor A is more risk-averse than investor B, and thus A puts
more weight on the risk free asset. The two-fund separation theorem forms
the launch point for the important Capital Asset Pricing Model.
 
 
Mean-standard deviation frontier (risk-free asset and N risky assets
• A good answer would define the tangency portfolio as follow – under the
CAPM, in equilibrium the tangency portfolio of risky assets must be the
market portfolio.
• A good answer would define the security market line – the linear relationship
between the expected return and β.
 
 
Security market line
Unit 7 – THE EFFICIENT MARKET HYPOTHESIS

ACTIVITY 1
The efficient market hypothesis is about asset prices having the so called martingale
(or random walk) property: that the expected future discounted prices are just today’s

prices and that it is impossible to predict future price deviations on the basis of current
information. This is worth 2 marks. There are three ‘forms’ of this hypothesis depending
on what we mean by today’s information: The weak form (information is current price
history); the semi-strong form (information is current public information);and strong
form (information is current public and private information). These are worth 2 marks
each.
Cognitive bias in human information processing (e.g. framing causing underreaction,
or overemphasis to most recent observation causing overreaction), can violate the
martingale property (regardless of which ‘form’ of the efficient market hypothesis we
are considering). We could also expect you to comment on the unreasonable nature of
the strong form efficient market hypothesis due to the lack of incentives to invest in
private information which should give partial credit if you do not already have a full
score.
It is essential the students recognise that the three forms of the efficient market
hypothesis are just three versions of the same idea: that current prices are expected
future discounted prices – so that all price innovations are unpredictable, conditional on
the information set. You should also be clear about the information sets: all information
sets talk about current information (which includes the past by default since we are
normally aware of what has happened, but not the future as we are not aware of what
will happen), but they make various assumptions about what type of information is
included in the current information.
From experience, there appears to be some confusion on this issue, where the most
common mistake is to assume that the weak form EMF states that current prices include
past information, that the semi-strong form states that current prices include current
information, and that the strong form states that current prices include future information
as well (which may be known privately today).
ACTIVITY 2
Since the January effect causes predictable price changes it should have an impact on
the optimal timing of the sale or repurchase strategies of equity (worth two marks). The
firms that want to sell equity should sell when prices are high – i.e. January (worth one
mark), and the firms that want to repurchase equity should buy when prices are low – i.e.
December.
However, this applies only to firms that have experienced a reduction in their stock
price over the year, as these are the only firms that are subject to tax-loss selling. Firms
that have increased in value over the same period will not be traded for tax reasons, as
investors are better off keeping the capital gains unrealised.
ACTIVITY 3
Strengths: - Well known firms are listed on SEM
- Since 1999-2008, developing of an online system
Weaknesses : - How many Mauritians invest on the SEM?
- Our savings are rather banking savings
- Foreign investors buying shares in Mauritius. If the financial crisis
continues, they can SEM and convert their shares into cash.
Measures: - To expand the SEM regionally.
- Growth opportunity

Unit 8 – WORKING CAPITAL MANAGEMENT
ACTIVITY 1
A company puts in place various procedures to lend its tactics and strategies operational
legitimacy. These procedures also play a key role in maintaining or improving the
organization’s financial standing and competitive prognosis -- especially when it comes
to evaluating working capital, reining in waste and monitoring the corporate cash
conversion cycle.
Working Capital
Working capital equals corporate short-term assets minus short-term liabilities. In
financial terminology, “short term” refers to a time frame of 12 months or fewer. For
example, a short-term debt becomes due within 365 days, and cash -- a short-term asset
-- will serve in a company’s operations for the next 52 weeks. Working capital is a
liquidity indicator that provides a glimpse into how much cash a business will have in
its coffers for the next 12 months. When finance people talk about current assets and
liabilities, they mean short-term resources and debts.
Cash Conversion Cycle
A company’s cash conversion cycle consists of the operational journey a transaction
takes to generate money for the business. It starts with the review and background
check of a potential customer, the evaluation of the client’s financial standing and
creditworthiness, and the credit approval for a specific transaction or a series of deals.
After a company ships merchandise to the patron, accounting managers record the
underlying receivable, also known as a customer receivable or account receivable. The
corporate cash conversion cycle also goes through the receipt of customer funds as
well the collection and recovery efforts -- when it comes to customers’ default, near
insolvency or bankruptcy.
While they’re distinct concepts, working capital and a cash conversion cycle interact in
a company’s operating machine. The business needs cash to soldier on, build strategic
commercial alliances, make money and propose items that will elevate its competitive
stature over time. Cash is a permanent fixture in business management, but it often
is more critical in the short term because an organization must pay its bills and earn
revenue to be around in the future -- say, one, two, five or 10 years. In the corporate
context, working capital discussions help top leadership sow the seeds of commercial
success, running efficient activities by the day to put the business on solid operational
footing.
ACTIVITY 2
The concept that the higher the return on yield, the larger the risk; or vice versa. All
financial decisions involve some sort of risk-return trade-off. The greater the risk
associated with any financial decision, the greater the return expected from it. Proper
assessment and balance of the various risk-return trade-offs available is part of creating
a sound financial and investment plan. For example, the less inventory a firm keeps,
the higher the expected return (since less of the firm’s current assets is tied up). But
there is also a greater risk of running out of stock and thus losing potential revenue. In
an investment arena, you must compare the expected return from a given investment
with the risk associated with it. Generally speaking, the higher the risk undertaken, the
more ample the return; conversely, the lower the risk, the more modest the return. In the
case of investing in stock, you would demand higher return from a speculative stock to
compensate for the higher level of risk. On the other hand, U.S. T-bills have minimal
risk so a low return is appropriate. The proper assessment and balance of the various
risk-return trade-offs is part of creating a sound investment plan.

ACTIVITY 3
The working capital requirements of any firm are determined by various factors as
mentioned below:
1. Nature of business
2. Production policies
3. Manufacturing process
4. Turnover of circulating capital
5. Growth and expansion of business
6. Business cycle fluctuations
7. Terms of purchase and sales
8. Conditions of supply
9. Market conditions
10. Dividend policies
11. Seasonality of operations
12. Other factors consisting of:
• Absence of coordination in production and distribution policies resulting in a
high demand for working capital
• Absence of specialization in the distribution of products which may enhance
the need for working capital for the concern, as it will have to maintain an
elaborate organization of its own for marketing the goods
• Sourcing of raw materials due to lack of infrastructure facilities such as roads,
good transportation facilities etc, which may force higher requirement of
working capital
• The import policy of the government
• The hazards and contingencies specific to the line of activity
• The working capital needs depending on the nature of business e.g. service
industry, trading, manufacturing etc.,
• Strong seasonal movements having special working capital needs
• Manufacturing process which is comparatively longer and complex in nature
with wide variations in financial needs
• Dependence on the assets conversion cycle
• Requirement of larger amount of working capital when the company envisages
growth with expansion
• Varying working capital requirements with the business cycle fluctuations
like recession, depression etc.,
• Terms of sale and purchase
Individual Assignment Number 1
“Most developed and developing countries have a stock market where individual and
institutional investors buy or sell shares, and other financial products”. Discuss the
above statement with respect to the different trading structures and products on offer on
the Sub-Saharan African stock exchanges.
Words Limit: 5000

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Open University of Mauritius - Fundamentals of Finance 1

Open University of Mauritius - Fundamentals of Finance i

© Open University of Mauritius, May 2013

ii Open University of Mauritius - Fundamentals of Finance

Teaching and learning strategy

Unit(s) of Assessment Weighting Towards Module Mark (%)

Learning objectives of the module

Open University of Mauritius - Fundamentals of Finance iii

• Explain the concepts of working capital management

• Assess the importance of working capital management

Guidelines for self-study

How to use the Manual

iv Open University of Mauritius - Fundamentals of Finance

Open University of Mauritius - Fundamentals of Finance v

UNIT 2 - The Time Value of Money 9

UNIT 3 - Capital Budgeting Decisions 21

UNIT 4 - Sources of Finance 29

UNIT 5 - Valuation of Bonds and Other Securities 39

UNIT 6 - Risk and Return and Capital Asset Pricing Model 45

UNIT 7 - Introduction to Stock Market 55

UNIT 8 - Working Capital Management 61

Open University of Mauritius - Fundamentals of Finance vii

1.1 LEARNING OBJECTIVES

1.2 FINANCIAL STATEMENTS AND CASH FLOW

Open University of Mauritius - Fundamentals of Finance 1

Cash Flow Statements

1.3 RATIO ANALYSIS

2 Open University of Mauritius - Fundamentals of Finance

1.3.1 Profitability Ratios:

1.3.2 Liquidity Ratios:

1.3.3 Activity Ratios:

1.3.4 Long Term Solvency or Leverage Ratios:

Open University of Mauritius - Fundamentals of Finance 3

1.4 STRATEGIC AND FINANCIAL PLANNING

1.5 THE STRATEGIC PLANNING AND DECISION

The Strategic-Planning and Decision-Making Process

4 Open University of Mauritius - Fundamentals of Finance

Open University of Mauritius - Fundamentals of Finance 5

Mads Ltd Macs Ltd

Creditors: amounts due after one year

6 Open University of Mauritius - Fundamentals of Finance

Open University of Mauritius - Fundamentals of Finance 7

2.1 LEARNING OBJECTIVES

2.2 TIME VALUE OF MONEY

Open University of Mauritius - Fundamentals of Finance 9

2.3 INTEREST AND COMPOUND INTEREST

2.3.1 Simple Interest

= 10,000 [ 1 + (1 x 0.05) + (1 x 0.05) + (1 x 0.05) + (1 x 0.05) ]

Generalising, we can therefore state:

2.3.2 Compound Interest

FV = 10,000 + (10,000 x 0.05) + [ 10,000 + (10,000 x 0.5) ] x 0.05 + [ 10,000 + (10,000

10 Open University of Mauritius - Fundamentals of Finance

= 10,000 (1 + 0.05) [ 1 + 0.05] [ 1 + 0.05] [ 1 + 0.05]

Generalising we can write:

$80,000 = PMT x 124.282

r = (FV/PV)(1-t) - 1 = (2,5000/2,000)1/3 - 1 = 7.72%

2.4 THE RULE OF 72

2.5 THE EFFECTIVE ANNUAL RATE (EAR)

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2.6 DISCOUNTING AND PRESENT VALUE

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Discount factor = 1 = (1+r)-n

2.6.1 Periodic Uneven Cash Flows