Unit 1F.M

UNIT 1: THE NATURE AND SCOPE OF FINANCIAL MANAGEMENT
Contents
1.0 Aims and Objectives
1.1 Introduction
1.1.1 What is Finance?
1.1.2 Major Areas of Finance
1.1.3 Meaning of Financial Management
1.1.4 Why Study Financial Management?
1.2 Historical Development of Financial Management
1.3 Finance and Related Fields
1.3.1 Finance Versus Economics
1.3.2 Finance Versus Accounting
1.4 The Scope of Financial Management
1.5 The Functions of Financial Management
1.5.1 Investment Decisions
1.5.2 Financing Decisions
1.5.3 Dividend Decisions
1.6 Jobs of the Financial Staff
1.7 An Overview of the Financial Environment
1.7.1 Financial Institutions
1.7.2 Financial Instruments
1.7.3 Financial Markets
1.8 Summary
1.9 Answers to Check Your Progress Questions
1.10 Model Examination Questions
1.11 Selected References
1.12 Glossary
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1.0 AIMS AND OBJECTIVES
This unit aims at presenting the meaning, nature, scope and evolutions of finance.
Management of finance includes certain executives and routine functions which are
discussed in detail in this unit.
After completing this unit, you will be able to:
 understand the meaning and importance of finance,

 explain the evolutions of financial management,
 narrate the relationship of financial management with other disciplines like
accounting, economics etc.,
 list out the functions of financial management,
 recognize the role of financial manger,
 distinguish between ownership and loan financial instruments,
 identify the constituents of financial markets,
1.1 INTRODUCTION
To have a good understanding of financial management, you need to understand first

what finance is. Literally, finance means the money used in day-to-day activities of an
individual or a business for exchange of goods and services. But here our focus rather
should be to consider finance as a separate and distinct field of study like accounting,
economics, mathematics, history, geography etc..
1.1.1 What Is Finance?
Finance is a distinct area of study that comprises facts, theories, concepts, principles,
techniques and practices related with raising and utilizing of funds (money) by
individuals, businesses, and governments.
Finance is a very wide and dynamic field of study. It directly affects the decisions of all
individuals and organizations that earn or raise money and spend or invest it. Therefore,
finance is also an area of study that deals with how, where, by whom, why, and through
what money is transferred among and between individuals, businesses, and governments.
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It is concerned with the processes, institutions, markets, and instruments involved in the
transfer of funds.
In addition to principles and techniques, finance requires individual judgment of the

person making the financial decision. Hence, finance can also be defined as the art and
science of managing money.
1.1.2 Major Areas of Finance
Since the concepts and areas of finance are very broad, the academic discipline of finance
can be viewed as made of specialized areas. There are several ways to summarize the
major areas of finance. One way is to review the career opportunities under it. Another
way is based on the differences in the objectives of different organizations. For the sake
of simplifying our discussion, we summarize the major fields of finance based on career
opportunities in finance.
The career opportunities again can be divided into different categories. For our
convenience, these opportunities can be categorized into two broad areas.
i) Financial Services
This is a part of finance which involves personal career opportunities as a loan officer,
financial planner, stockbroker, real estate agent, and insurance broker. It is generally
concerned with the design, development, and delivery of these financial services to
individuals, business organizations, and governments.
ii) Financial Management

Financial management is concerned with the financial decisions of a business firm. This
firm can be large or small, private or public, financial or non-financial, profit seeking or
not-for-profit. It involves specific financial functions of the firm.
1.1.3 Meaning of Financial Management

Financial Management can be clearly defined by viewing it as a subject, a process, or a
function.
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Financial management is one major area of study under finance. It deals with decisions
made by a business firm that affect its finances. Financial management is sometimes
called corporate finance, business finance, and managerial finance. These terms are used
interchangeably in this material.
Financial management can also be defined as a decision making process concerned with
planning for raising, and utilizing funds in a manner that achieves the goal of a firm.
There are many specified business functions performed by a business unit. These include
marketing, production, human resource management, and financial management.
Financial management is one of the important functions of a firm. It is a specified
business function that deals with the management of capital sources and uses of a firm.
1.1.4 Why Study Financial Management?
If you are approaching financial management for the first time, you might wonder why
students like you study the field of financial management and what career opportunities
exist.
Many business decisions made by firms have financial implications. Accordingly,

financial management plays a significant role in the operation of the firm. People in all
functional areas of a firm need to understand the basics of financial management.
Accountants, information systems analysts, marketing personnel and people in
operations, all need to be equipped with the basic theories, concepts, techniques, and
practices of managerial finance if they have to make their jobs more efficient and achieve
their goals. That is why the course Financial Management is offered to students in the
fields of accounting, management, business administration, and management
informations systems.
If you develop the necessary training and skills in financial management, you have career
opportunities in a good deal of positions as a financial analyst, capital budgeting, project
finance, cash, and credit manager, financial manager, banker, financial consultant, and
even as a general manager. The author hopes you will appreciate the importance of
financial management as you learn it more.
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Check your progress I
1. What makes financial management distinct from other fields of finance?

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2. Why is financial management important to people even in other functional areas of a
firm?
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1.2 HISTORICAL DEVELOPMENT OF FINANCIAL MANAGEMENT
Finance emerged as a field separate and distinct from economics around 1900. The first
major focus of financial management during its early years of development was the
meanses how large corporations of the time could raise capital. This was a period when
the establishment of very large companies like the Rockefeller oil and Morgan steel was
marked.
The economic depression of the 1930s made financial management to shift to topics like
preservation of capital, maintenance of liquidity, reorganization of financially troubled
companies, and the bankruptcy process.
Until 1950s, the study of financial management had been descriptive or definitional in
nature. But in the mid 1950s, more analytical, decision oriented approach began to
evolve. These include capital budgeting, cash and inventory management, capital
structure formulation, and allocation of income as dividends and retained earnings.
Starting the late 1960s, the primary focus of financial management has been on the
relationships between risk and return of a firms financial decision. That is financial
management has focused on the maximization of earnings (return) for a given level of
risk; or minimization of risk for a given level of return.
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Check your progress II
What is the most important focus of financial management today?

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1.3 FINANCE AND RELATED FIELDS
Though finance had ceded itself from economics, it is not totally an independent field of
study. It is an integral part of the firms overall management. Finance heavily draws
theories, concepts, and techniques from related disciplines such as economics,
accounting, marketing, operations, mathematics, statistics, and computer science. Among
these disciplines, the field of finance is closely related to economics and accounting.
1.3.1 Finance versus Economics
Finance and economics are closely related in many aspects. First, economics is the
mother field of finance. Second, the economic environment within which a firm operates
influences the decisions of a financial manger. A financial manger must understand the
interrelationships between the various sectors of the economy. He must also understand
such economic variables as a gross domestic product, unemployment, inflation, interests,
and taxes in making financial decisions.
Financial mangers must also be able to use the structure of decision-making provided by
economics. They must use economic theories as guidelines for their efficient financial
decision making. These theories include pricing theory through the relationships between
demand and supply, return analysis, profit maximization strategies, and marginal
analysis. The last one, particularly, is the primary economic principle used in financial
management.
Basic Differences between Finance and Economics

i) Finance is less concerned with theory than is economics. Finance is basically
concerned with the application of theories and principles.
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ii) Finance deals with an individual firm; but economics deals with the industry
and the overall level of the economic activity.
1.3.2 Finance Versus Accounting
Accounting provides financial information through financial statements. Therefore, these

two fields are closely linked as accounting is an important input for financial decision-
making. Besides, the accounting and finance functions generally overlap; and usually it is
difficult to distinguish them. In many situations, the accounting and finance activities are
within the control of the financial manager of a firm.
Basic Differences Between Finance and Accounting

i) Treatment of income: - in accounting income measurement is on accrual
basis. Under this method revenues are recognized as earned and expenses as
incurred. In finance, however, the cash method is employed to recognize the
revenue and expenses.
ii) Decision-making: - the primary function of accounting is to gather and
present financial data. Finance, on the other hand, is primarily concerned with
financial planning, controlling and decision-making. The financial manger
evaluates the financial statements provided by the accountant by applying
additional data and then makes decisions accordingly.
iii) Accounting is highly governed by generally accepted accounting principles.
Check your progress III
How do you exactly describe the relationship between finance, economics, and
accounting?
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1.4 THE SCOPE OF FINANCIAL MANAGEMENT
The scope of financial management refers to the range or extent of matters being dealt
with in financial management.
Traditionally, financial management was viewed as a filed of study limited to only raising
of money. Under the traditional approach, the scope and role of financial management
was considered in a very narrow sense of procurement of funds from external sources.
The subject of finance was limited to the discussion of only financial institutions,
financial instruments, and the legal and accounting relationships between a firm and its
external sources of funds. Internal financial decision makings as cash and credit
management, inventory control, capital budgeting were ignored. Simply stating, the old
approach treated financial management in a narrow sense and the financial manager as a
less important person in the overall corporate management.
However, the modern or contemporary approach views financial management in a broad

sense. Corporate finance is defined much more broadly to include any business decisions
made by a firm that affect its finance. According to the modern approach, financial
management provides a conceptual and analytical framework for the three major
financial decision making functions of a firm. Accordingly, the scope of managerial
finance involves the solution to investing, financing, and dividend policy problems of a
firm. Besides, unlike the old approach, here, the financial managers role includes both
acquiring of funds from external sources and allocating of the funds efficiently within the
firm thereby making internal decisions.
The increased globalization of business has expanded the scope of financial management
further to include financial decisions pertaining to the international financial
environment.
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1.5 THE FUNCTIONS OF FINANCIAL MANAGEMENT
This refers to the special activities or purposes of financial management. The functions of
financial management are planning for acquiring and utilizing funds by a firm as well as
distributing funds to the owners in ways that achieve goal of the firm.
In general, the functions of financial management include three major decisions a firm
must make. These are:
Investment decisions
Financing decisions
Dividend decisions
1.5.1 Investment Decisions
They deal with allocation of the firms scarce financial resources among competing uses.
These decisions are concerned with the management of assets by allocating and utilizing
funds within the firm. Specifically, the investment decisions include:
i) Determining the asset mix or composition: - determining the total amount of
the firms finance to be invested in current and fixed assets.
ii) Determining the asset type: - determining which specific assets to maintain
within the categories of current and fixed assets.
iii) Managing the asset structure,
structure, i.e., maintaining the composition of current
and fixed assets and the type of specific assets under each category.
The investment decisions of a firm also involve working capital management and capital
budgeting decisions. The former refers to those decisions of a firm affecting its current
assets and short term liabilities. The later, on the other hand, involves long term
investment decisions like acquisition, modification, and replacement of fixed assets.
Generally, the investment decisions of a firm deal with the left side of the basic
accounting equation: A = L + OE (Assets = Liabilities + Owners Equity).
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1.5.2 Financing Decisions
The financing decisions deal with the financing of the firms investments, i.e., decisions
whether the firm should use equity or debt funds in order to finance its assets. They are
also concerned with determining the most appropriate composition of short term and
long term financing. In simple terms, the financing decisions deal with determining the
best financing mix or capital structure of the firm.
The financing decisions of a firm are generally concerned with the right side of the basic
accounting equation.
1.5.3 Dividend Decisions
The dividend decisions address the question how much of the cash a firm generates from
operations should be distributed to owners in the form of dividends and how much should
be retained by the business for further expansion. There are trade offs on the dividend
policy of a firm. On the one hand, paying out more dividends will make the firm to be
perceived strong and healthy by investors ; on the other hand, it will affect the future
growth of the firm. So the dividend decision of a firm should be analyzed in relation to its
financing decisions.
Check your progress IV
What are the main activities of a firm with which financial management is involved?
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1.6 JOBS OF THE FINANCIAL STAFF
Key activities of the finance people can be related to the firms basic financial statements.
The primary jobs of the financial staff are:
i) Performing Financial Analysis: - financial analysis is concerned with
obtaining of the basic financial statements, applying some tools and
techniques, and converting the raw information into a standardized form. The
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purpose here is to give the finance person a better opportunity to understand
the firms financial affairs, the results of its operations, and its cash flows.
ii) Performing Financial Forecasting: - financial forecasting is concerned with
forecasting of the firms sales for a given future period upon which the firm
projects its assets needs, and finally, it will evaluate whether additional
finance is required.
iii) Making Investment Decisions: - include credit management, inventory
control, cash management, capital budgeting and other investment activities of
a firm.
iv) Making Financing Decision: - include any activities associated with
procurement or acquisition of funds. Examples include borrowing decisions,
decisions to issue shares of common stock and preferred stock, bonds, and
other securities.
Check your progress V
Give some examples of the specific jobs of the finance people

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1.7 AN OVERVIEW OF THE FINANCIAL ENVIRONMENT
Finance people must understand not only the internal environment, but also the financial
environment and markets within which the firm operates. They need to know where
capital required is raised, where the financial instruments are traded, and how stock
prices are determined.
1.7.1 Financial Institutions
Financial institutions are financial intermediaries, which are specialized financial firms,
that facilitate the transfer of funds from savers to demanders of capital. They accept
savings form customers and lend this money to other customers or they invest it. In many
instances, they pay savers interest on deposited funds. In some cases, they impose service
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charges on customers for the services they render. For example, many financial
institutions impose service charges on current accounts.
The key participants in financial transactions of financial institutions are individuals,

businesses, and government. By accepting the savings from these parties, financial
institutions transfer again to individuals, business firms, and governments. Since financial
institutions are generally large, they gain economies of scale in the transfer of money
between savers and demanders. By pooling risks, they help individual savers to diversify
their risk.
The major classes of financial institutions include commercial banks, savings and loan
associations, mutual savings banks, credit unions, pension funds and life insurance
companies. Among these, commercial banks are by far the most common financial
institutions in many countries worldwide. In Ethiopia too, commercial banks are the
major institutions that handle the savings and borrowing transactions of individuals,
businesses, and governments.
1.7.2 Financial Instruments
Financial instruments are written and formal documents of transferring funds between
and among individuals, businesses, and governments. They include loans and borrowing
contracts, promissory notes, commercial papers, treasury bills, bonds, and stocks.
Under normal circumstances, two parties are involved in any financial instrument. For
holders, who have invested their money, financial instruments are financial assets. A
financial asset gives the holder the right to claim against the income and assets of its
issuer. For the issuer, on the other hand, financial instruments represent either liabilities
or equity items. For instance, if you consider a bond, it represents an investment
(financial asset) for the holder, and a debt item for its issuer. Similarly, if you consider a
common stock, it represents an investment and equity item for the holder and issuer
respectively.
The issuer gives the financial asset to the purchaser (holder) in exchange for some
valuable consideration, usually in the form of cash or another financial asset.
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1.7.3 Financial Markets
Financial markets are markets in which financial instruments are bought and sold by
suppliers and demanders of funds. They, unlike financial institutions, are places in which
suppliers and demanders of funds meet directly to transact business.
1.7.3.1 Functions of Financial Markets
Generally, financial markets play three important roles in functioning of corporate

finance.
1. They assist the capital formation process. Financial markets serve as a way
through which firms can obtain the capital they need for their operations and
investment.
2. Financial markets serve as resale markets for financial instruments. They create
continuous liquid markets where firms can obtain the capital they need from
individuals and other businesses easily.
3. They play a role in setting the prices of securities. The price of a financial
instrument is determined through the interaction of demand and supply of the
security in the financial markets.
1.7.3.2 Classification of Financial Markets
There are many types of financial markets and hence several ways to classify them. For
our purpose, here we shall consider the following two classifications.
1. Classification on the basis of maturity
This is based on the maturity dates of securities

i) Money Markets - are financial markets in which securities traded have
maturities of one-year or less. Examples of securities traded here include
treasury bills, commercial papers, short term promissory notes and so on.
ii) Capital Markets - are financial markets in which securities of long-term funds
are traded. Major securities traded in capital markets include bonds, preferred
and common stocks.
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2. Classification on the basis of the nature of securities
This is based on whether the securities are new issues or have been outstanding in the
market place.
i) Primary Markets - are financial marketers in which firms raise capital by
issuing new securities.
ii) Secondary Markets - are financial markets in which existing and already
outstanding securities are traded among investors. Here the issuing
corporation does not raise new finance.
Check your progress VI
Identify the main factor why finance people must understand the external financial
environment.
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1.8 SUMMARY
This unit has provided an introduction to financial management. The key points covered
are listed below:
- Finance is a very wide separate and distinct field of study.
- Financial management is an area of study under finance, which deals about the
financial problems of an individual firm.
- The functions of managerial finance include three interrelated decisions: (1)
investment, (2) financing, and (3) dividend.
- The jobs of the firms financial staff are related to the basic financial statements.
- Financial people must understand the financial institutions, financial instruments,
and financial markets.
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1.9 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS
I.
1. Financial management deals with financial issues of a single company.
2. Because almost all actions in all of the firms functional areas have financial
implications.
II. The relationship between risk and return of any activity.

III. Finance is a subject that links economic theories with the numbers of accounting.
IV. Investment, financing, and profit allocation activities.
V. Cash and credit management, inventory control, planning and budgeting, financial
analysis, borrowing etc.
VI. A firm operates within a financial environment and it is directly and indirectly
affected with the components and activities of the external financial environment.
1.10 MODEL EXAMINATION QUESTIONS
Part I. Select the best answer from the given alternatives
1. Which of the following statement is true about financial management?

A) It is a general business function that deals with the management of all functional
areas of a firm.
B) As a subject of study, it had long been existing before accounting.
C) It is highly governed by generally accepted standards and principles.
D) Internal decision-makings are among the areas of focus of financial management.
2. Which one of the following statements is correct about economics and financial
management?
A) Revenues are recorded as earned and expenses as incurred by the latter.
B) As a field of study, the earlier is very much younger than the latter.
C) Financial management is more focused on application of theories
D) None of the above
3. One of the following is not among the investment functions of a firm.
A) Cash management
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B) Inventory control
C) Capital budgeting
D) Borrowing from a bank
4. In Ethiopia no organized stock markets are established yet. But currently there is an
initiative to establish at least one. Concurrently, the Ethiopian Government issues
treasury bills to the public. Which of the following statement is / are correct about
financial markets in Ethiopia?
A) There is no money market.
B) Secondary securities markets are under way to be established.
C) Secondary securities markets have already taken their roots.
D) A and C.
Part II. Explain briefly the following questions
1. What do you think is the reason why financial management is sometimes called
corporate finance?
2. What are some of the career opportunities available for someone studying financial
management?
3. Compare and contrast financial analysis and financial forecasting.
4. How do financial markets help setting the price of a financial assets like bond?
5. Why is it not possible for an issuing firm to raise new finance in secondary securities
markets?
1.11 SELECTED REFERENCES
1. Eugene F. Brigham (1997). Fundamentals of Financial Management. 7th edition, the

Dryden press Harcourt Brace College publishers, Florida.
Finance. 6th edition, Harper
2. Lawrence J. Gitman (1991). Principles of Managerial Finance.
Collins Publishers, San Diego.
Finance. 2nd edition.
3. Raymond P. Neveu (1985). Fundamentals of Managerial Finance.
Southwestern publishing company.
4. Stanley B. Block and Geoffrey A. Hirt (1994). Foundations of Financial
Management. 7th edition, Irwin.
Management.
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1.12 GLOSSARY
Firm a group of people working together for business or commercial purposes; a

business company.
Economic depression a state of the economy when there is little economic activity and
many people are unemployed
Liquidity the ability of a business to generate sufficient cash from its operations to
cover its obligations
Risk the probability that the outcome of an activity will differ from the expected
activity. A variation or deviation from the expected outcome.
Industry group of firms in the same line of business
Capital structure the composition fo debt and equity as well as short-term and long-
term financing.
Bankruptcy the state when a firm is unable to pay its debts.
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UNIT 2: THE GOAL OF A FIRM IN FINANCIAL MANAGEMENT
Contents
2.1 The Need for a Goal
2.2 The Characteristics of a Good Goal
2.3 Profit Maximization as a Decision Rule
2.3.1 Meaning of Profit Maximization
2.3.2 Limitations of Profit Maximization
2.4 Wealth Maximization as a Decision Rule
2.4.1 Meaning of Wealth Maximization
2.4.2 Limitations of Wealth Maximization
2.5 Conflict of Goals Between Management and Owners and Agency Problem
2.6 Summary
2.10 Glossary
After completing this unit, students should be able to address the following questions.
- What is it meant by a goal; and what is the significance of having it?
- How can a decision maker establishes a goal that best suites to the interest of his
firm?
- What are the two most common decision criteria that are highly emphasized in
financial management?
- Why is wealth maximization considered to be superior to profit maximization as a
goal of a firm?
- What are the threats to the wealth maximization goal of a firm?
- What is agency problem and how can it be dealt with?
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2.1 THE NEED FOR A GOAL
Recall that financial management is concerned with decision making to achieve the goal
of a firm. But the question is what is this goal of a firm? Before trying to address the
question, let us first describe the meaning of a goal.
A goal or an objective provides a framework for the decision maker. In most cases, the
goal is stated in terms of maximizing or minimizing some variable. A goal, therefore, is
an explicit operational guide or decision rule for the decision maker.
A firm might have a number of alternative goals at a point in time when evaluating a
given course of action. These goals include maximization of profits, size, value, social
welfare or minimization of costs, risk etc. Although it is very difficult, a firm should be
able to have a specific goal for the following two basic reasons.
1. If a goal is not chosen, there is no way to select among alternative decision criteria.
With out an objective to achieve, there would be a number of approaches to select
from available decision rules.
2. If multiple goals are chosen, it is hardly possible to prioritize the decision criteria; and
the firm might end up achieving none of them.
2.2. THE CHARACTERISTICS OF A GOOD GOAL
If a firm cannot choose its right goal, it can suffer severe consequences even to the extent
of going out of business. The failure of many public enterprises in Socialist Ethiopia, for
example, can be attributed to their failure to follow clear objectives. They were
considered as successful for they created job opportunities for thousands of people. But
they had failed to produce products accepted by the general public.
In fact, selecting the right goal is not such a simple task; but a good objective has the
following characteristics.
1. It is clear and unambiguous a clear goal will lead to decision criteria that do not vary
from case to case and from person to person.
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2. It provides a clear and timely measure to evaluate the success or failure of decisions.
There should be some means to measure the objective.
3. It does not affect the specific benefits of a firm.
4. It does not affect the welfare of the society.
5. It is based on long-term success of the firm.
Even though there are many alternative decision rules, in the sections that follow, we
describe and evaluate the decision criteria for financial management which are widely
discussed in many finance literature.
2.3 PROFIT MAXIMIZATION AS A DECISION RULE
2.3.1 Meaning of Profit Maximization
Profit maximization is a function of maximizing revenue and /or minimizing costs. If a

firm is able to maximize its revenues for a given level of costs or minimizing costs for a
given level of revenues, it is considered to be efficient.
Profit maximization focuses on the total amount of benefits of any courses of action. This
decision rule as applied to financial management implies that the functions of managerial
finance should be oriented to making of money. Under the profit maximization decision
criteria, actions that increase profit of a firm should be undertaken; and actions that
decrease profit should be rejected. Similarly, given alternative courses of actions,
decisions would be made in favor of the one with the highest expected profits.
Profit maximization, though widely professed, should not be used as a good goal of a
firm in financial management. This is because it fails to meet many of the characteristics
of a good goal.
2.3.2 Limitations of Profit Maximization
1. Ambiguity. The term profit or income is vague and ambiguous concept. It is very
illusive and has no precise quonotation. Different people understand profit in different
several ways. There are many different economic and accounting definitions of profit,
each open to its own set of interpretations. Even in accounting profit might refer to short-
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term or long-term profit, total profit or profit on a per share basis (earnings per share),
and before or after text profit. Then, the question or the problem would be which profit is
to be maximized? Maximizing one may lead to minimizing the other.
Furthermore, problems related to inflation and international currency transactions

complicate the issue of profit maximization.
2. Cash flows. The profit a firm has reported does not represent the cash flows to the
business. Firms reporting a very high total profit or earnings per share might face
difficulty of paying cash dividends to stockholders. Sometimes, companies might even
declare bankruptcy though reporting a positive income
3. Timing of Benefits. The profit maximization criterion ignores the differences in the
time pattern of benefits received from investment proposals. This criterion does not
consider the distinction between returns (benefits) received in different time periods and
treats all benefits as equally valuable irrespective of the time pattern differences in
benefits. In other words, the profit maximization ignores the time value of money, i.e.,
money today is better than money tomorrow. Also it does not consider the sooner, the
better principle.
To understand this limitation better let us consider the following example.

Example Akaki Manufacturing Share Company wants to choose between two projects:
project X and project Y. both projects cost the same, are equally risky and are expected to
provide the following benefits over three years period.
BENEFITS (PROFITS)
YEAR PROJECT X PROJECT Y
1 Br. 25,000 Br. 0-
2 50,000 50,000
3 0- 25,000
TOTAL Br. 75,000 Br. 75,000
The profit maximization criterion ranks both projects as being equal. However, project X
provides higher benefits in earlier years and project Y provides larger benefits in latter
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years. The higher benefits of project X in earlier years could be reinvested to earn even
higher profits for later years. Profit seeking organizations must consider the timing of
cash flows and profits because money received today has a higher value than money
received tomorrow. Cash flows in early years are valued more highly than equivalent
cash flows in later years.
4. Quality of Benefits (Risk of Benefits). Profit maximization assumes that risk or

uncertainty of future benefits is of on concern to stockholders. Risk is defined as the
probability that actual benefit will differ from the expected benefit. Financial decision
making involves a risk-return trade-off. This means that in exchange for taking
greater risk, the firm expects a higher return. The higher the risk, the higher the
expected return.
Example Nyala Merchandising Private Limited Company must choose between two
projects. Both projects cost the same. Project A has a 50% chance that its cash flows
would be actual over the next three years. Project B, on the other hand, has a 90%
probability that its cash flows for the next three years would be realized.
BENEFITS
YEAR PROJECT A PROJECT B

1 Br. 60,000 Br. 45,000
2 65,000 50,000
3 95,000 85,000
TOTAL Br. 220,000 Br. 180,000
Under profit maximization, project A is more attractive because it adds more to Nyala
than project B. However, if we consider the risk of the two projects, the situation would
be reversed.
Expected benefit of project A = Br. 220,000 x 50% = Br. 110,000

Expected benefit of project B = Br. 180,000 x 90% = Br. 162,000
In fact, risk can be measured in different ways, and different conclusions about the
riskness of a course of action can be reached depending on the measure used. In addition
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to the probability distribution, illustrated above, risk can also be measured on the basis of
the variation of cash flows.
The more certain the expected cash flow (return), the higher the quality of benefits (i.e.,
low risk to investor). Conversely, the more uncertain or fluctuating the expected benefits,
the lower the quality of benefits (i.e., high risk to investors).
Consider a choice between the following two projects that are having equal cost but with
different variability in expected returns.
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
BENEFITS
YEAR PROJECT C PROJECT D
1 Br. 2,700 Br. 0
2 3,000 3,000
3 3,300 6,000
TOTAL Br. 9,000 Br. 9,000
1. Which project is preferable under profit maximization criterion?

________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
2. Which project is more risky?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
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2.4 WEALTH MAXIMIZATION AS A DECISION RULE
2.4.1 Meaning of Wealth Maximization
Wealth maximization means maximization of the value of a firm. Hence wealth

maximization is also called value maximization or net present value (NPV)
maximization.
To understand and appreciate the essence of wealth maximization, we need to consider

the various stakeholders in a given corporation. Stakeholders are all individuals or group
of individuals who have a direct or indirect interest in the firm. They include
stockholders, debtors, managers, employees, customers, governmental agencies and
others. But among these, managers should give priority to stockholders. In fact, the
overriding premise of financial management is that a firm should be managed to enhance
the well-being or wealth of its existing common stockholders. Stockholders welbeing
depends on both current and expected dividend payments and market price of the firms
common stock.
Wealth maximization as a decision criterion is considered to be an ideal goal of a firm in

financial management. There are several reasons why wealth maximization decision
criterion is superior to other criteria. First, it has an exact measurement unlike profit
maximization. It depends on cash flows (inflows and outflows). Second, wealth
maximization as a decision criterion consider the quality as well as the time pattern of
benefits. Third, it emphasizes on the long-term and sustainable maximization of a firms
common stock price in the financial market. Fourth, wealth maximization gives a
recognition to the interest of other stakeholders and to the societal welfare on the long-
term basis.
Technically, wealth maximization as a decision rule involves a comparison of value to

cost. Thus, an action that has a discounted value that exceeds its cost can be said to create
value and such action should be undertaken. Whereas an action with less discounted
value than cost reduces wealth and, therefore, should be rejected. The discounted value is
a value which takes risk and timing of benefits into account.
24
Sehaba Agro Industry Company intends to open a branch either in Goba or Jijiga.
Opening of both branches cost Br. 135,000 each and the expected cash inflows from each
branch over the next ten years is Br. 25,000 per year. However, the required rates of
return are 9% and 10% respectively for Goba and Jijiga respectively.
1. Under profit maximization decision rule, where should Sehaba open a branch?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
2. If the goal of Sehaba is wealth maximization, which town is providing more value?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
2.4.2 Limitations of Wealth Maximization
The limitations of wealth maximization refer to the potential side costs of wealth
maximization if adopted as a decision criterion.
1. If wealth maximization is taken as the sole decision rule, there is a possibility that the
benefits of the society at large might be forgone. Fortunately, however, this problem is
not unique to wealth maximization. Even if an alternative goal is used, still this problem
continues to persist.
2. When managers of a corporation are separate from owners, there is a potential for a
conflict of interest between them. This conflict of interest can lead to the maximization of
manages interest instead of the welfare of stockholders.
3. When the goal of a firm is stated in terms of stockholders wealth, actions that increase
the wealth of stockholders could be taken as the expense of other stakeholders like
debthodlers.
4. Wealth maximization is normally reflected in the firms stock price. But if there are
inefficiencies in financial markets, wealth maximization decision rule may lead to
misallocation of scarce resources.
25
Check your progress III.
The wealth maximization goal is generally preferred to other decision criteria regardless
of the above limitations. What short and precise explanation do you have for this?
________________________________________________________________________
________________________________________________________________________
2.5 CONFLICT OF GOALS BETWEEN MANAGEMENT AND OWNERS AND

AGENCY PROBLEM
As you understand, in a corporate form of business organization owners (stockholders) do

not run the activities of the firm. Rather, the stockholders elect the board of directors,
who in turn assign the management on behalf of the owners. So, basically, managers are
agents of the owners of the corporation and they undertake all activities of the firm on
behalf of these owners. Managers are agents in a corporation to maximize the common
stockholders well-being.
However, there is a conflict of goals between mangers and owners of a corporation and
mangers may act to maximize their interest instead of maximizing the wealth of owners.
Managers are interested to maximize their personal wealth, job security, life style and
fringe benefits.
The natural conflict of interest between stockholders and managerial interest create
agency problems. Agency problems are the likelihood that mangers may place their
personal goals a head of corporate goals. Theoretically, agency problems are always there
as long as mangers are agents of owners.
Corporations (owners) are aware of these agency problems and they incur some costs as a
result of agency. These costs are called agency cost and include:
1. Monitoring expenditures are expenditures incurred by corporations to monitor or

control the activities of managers. A very good example of a monitoring expenditure
is fees paid by corporations to external auditors.
26
2. Bonding expenditures are cost incurred to protect dishonesty of mangers and other
employees of a firm. Example: fidelity guarantee insurance premium.
3. Structuring expenditures expenditures made to make managers fell sense of
ownership to the corporation. These include stock options, performance shares, cash
bonus etc.
4. Opportunity costs unlike the previous three, these costs are not explicit expenditures.
Opportunity costs are assumed by corporations due to hindrances of decisions by them as
a result of their organizational structure and hierarchy.
On top of the above costs assumed by corporations, there are also other ways to motivate
managers to act in the best interest of owners. These ways include to make know
managers that they would be fired if they do not act to maximize shareholders wealth and
that the corporation could be overtaken by others if its value is very much lower than
other firms.
2.6 SUMMARY
The primary purpose of this unit were (1) to indicate the basic characteristics of a good
objective, (2) to discuss profit maximization and wealth maximization as decision rules,
and (3) to give an overview of agency problem. The key concepts covered are listed
below:
- A good objective of a firm is not vague and ambiguous, provides timely measure,
does not affect specific benefits of a firm nor does it affect societal welfare, and is
based on long-term achievement.
- The primary goal of firms in financial management should be to maximize the
wealth of stockholders
- Wealth maximization goal of a firm is reflected in maximizing the price of the
firms common stock
- Wealth maximization is a superior decision criterion because it is based on cash
flows, it considers the timing and quality of benefits
- An agency problem is the likelihood that mangers give priority to their personal
interest ahead of corporate goals.
27
I.
1. Under profit maximization criterion the focus is on total profits. Since both projects
have a total of Br. 9,000 benefits each over the three years period, both are ranked
equally.
2. The variability in project D is higher than the variability in project C. You can measure
the variability by computing the statistical standard deviation of the two projects, or
you can simply compute the gap in the cash flows for both projects. The gap for project
C is Br. 300 and for project D it is Br. 3,000. Hence, project D is more risky than
project C.
II.
1. The total benefits (cash flows) over a period of ten years is Br. 250,000 (Br. 25,000 x
10) for each project. Therefore, it is all the same for Sehaba Agro Industry whether it
opens its branch in Goba or Jijiga under profit maximization decision rule.
2. Both projects have equal cash flows and costs; but the required rate of return for
investment in Jijiga (10%) is higher than that of investment in Goba (9%). In financial
management, the more return expected from investments of equal cost and cash flows
indicates it is more risky. Hence, under wealth maximization criterion, investment in
Goba provides more value than investment in Jijiga.
III.
Generally, the problems of wealth maximization decision criterion is also persistent even
if other criteria are used.
Part I. For each of the following multiple choice questions, select the best answer
from the given alternatives.
1. One of the following is not among the characteristics of a good goal of a firm
A) It provides a timely measure to evaluate performance.
28
B) It provides a clear decision criterion.
C) It gives priority to stockholders at the expense of the society.
D) It is based on long-term success.
2. The goal of a firm in financial management is:
A) To maximize profits
B) To minimize costs
C) To maximize societal welfare
D) To maximize common stock prices
3. Given alternative investment choices, an investment that should be selected under
wealth maximization goal of a firm is the one that:
A) Provides the most fluctuating cash flows for a given level of cost.
B) Has the lowest required rate of return for a given level of expected cash flows.
C) Provides the highest earnings per share.
D) Has the lowest costs.
4. Which of the following factors tend to help corporations to manage agency problems?
A) Agency costs
B) Mangers reaction to the threat of losing jobs
C) Managing corporations by stockholders themselves
D) A and B
Part II. Give short answers for the following questions
1. What is the difference between profit maximization and wealth maximization? Under
what conditions might profit maximization lead to wealth maximization?
2. Which action is better under wealth maximization decision criterion? An action that
increases a firms stock price from a current level of Br. 40 to Br. 50 in 5 years, or an
action that keeps the stock at Br. 40 for 5 years after which time it increases to Br. 80?
29
Exercise: ABC Company intends to invest in either project A or project B. both projects
cost Br. 105,000 and the expected cash inflows are given below:
EXPECTED CASH INFLOWS

YEAR PROJECT A PROJECT B
1 Br. 55,000 Br. 0
2 43,000 0
3 61,000 159,000
TOTAL Br. 159,000 Br. 159,000
The required rate of return is 9% for each project. Assume only one of the two projects is
to be chosen. In which project should ABC Company invest if it uses
1. Profit maximization as a decision rule?

2. Wealth maximization as a decision rule?
1. Aswath Damondaran (1997). Corporate Finance: Theory and Practice John Wiley
and Sons, Inc. New York.
Management. 7th edition, the
3. Eugene F. Brigham (1997). Fundamentals of Financial Management.
Dryden Press Harcourt Brace College Publishers, Florida
2.10 GLOSSARY
Variable a varying thing or quantity that can often be measured. Examples inlcude cost,
revenue, etc
Earnings Per Share (EPS) the total profits divided over each share of a firms common
stock outstanding.
Probability Distribution A listing of all possible outcome, or events, with a chance
assigned to each outcome.
Overriding Premise the most important idea of reasoning of all other ideas considered.
30
Discounted Value the present value of future cash inflows less the present value of
costs.
Fringe Benefits additional benefits to managers and employees such as insurance
coverage, transposition facilities, post employment benefits etc.
31
UNIT 3: FINANCIAL ANALYSIS
Contents
3.1 Introduction
3.2 Meaning and Objectives of Financial Analysis
3.3 Tools and Techniques of Financial Analysis
3.4 Stages in Financial Analysis
3.5 Types of Financial Ratios
3.5.1 Liquidity Ratios
3.5.2 Activity Ratios
3.5.3 Leverage Ratios
3.5.4 Profitability Ratios
3.5.5 Marketability Ratios
3.6 Comparing Financial Ratios
3.7 Limitations of Ratio Analysis
3.8 Summary
3.12 Glossary
The primary purpose of this unit is to enable students understand more and evaluate the
financial statements of a firm. At the end of the unit, students are expected to answer the
following questions.
 How do finance people generally begin performing financial analysis? What

are the basic objectives of financial analysis?
 What are some of the common methods used in financial management in
order to understand about a firms performance and future conditions?
32
 Why are financial ratios discussed under major categories? What are the
major categories and what does each category measure about a firm?
 How do you confirm whether a given financial ratio is good or bad?
 What are some of the uses as well as the limitations of ratio analysis?
3.1 INTRODUCTION
In the previous accounting courses you have learned that financial statements report both
on a firms financial position and financial performance. The four basic financial
statements present about different aspects of financial conditions, operating results, and
cash flows. The balance sheet shows a firms assets and claims against assets at a
particular point in time time. The income statement, on its part, reports the results of the
firms operations over a period of time. Similarly, the statements of retained earnings and
cash flows show the change in retained earnings and cash between two balance sheet
dates.
However, financial statements by themselves do not give aq complete picture about a

companys financial condition, operating results, and cash flows. Neither can a real value
of financial statements could be derived in themselves alone. Therefore, to predict the
future and to help anticipate future conditions, financial statements should be analyzed
further. This analysis helps to identify current strengths and weakness of the firm. It
facilitates planning the future, and helps to control the firms financial activities better. To
have all this benefits, however, a finance person should perform a financial analysis.
3.2 MEANING AND OBJECTIVES OF FINANCIAL ANALYSIS
Financial analysis refers to analysis of financial statements and it is a process of

evaluating the relationships among component parts of financial statements.
The focus of financial analysis is on key figure in the financial statements and the
significant relationships that exist between them. Financial analysis is used by several
groups of users like managers, credit analysts, and investors.
33
The analysis of financial statements is designed to reveal the relative strengths and
weakness of a firm. This could be achieved by comparing the analysis with other
companies in the same industry, and by showing whether the firms position has been
improving or deteriorating over time. Financial analysis helps users obtain a better
understanding of he firms financial conditions and performance. It also helps users
understand the numbers presented in the financial statements and serve as a basis for
financial decisions.
3.3 TOOLS AND TECHNIQUES OF FINANCIAL ANALYSIS
A number of methods can be used in order to get a better understanding about a firms
financial status and operating results. The most frequently used techniques in analyzing
financial statements are:
i) Ratio Analysis is a mathematical relationship among money amounts in the financial

statements. They standardize financial data by converting money figures in the financial
statements. Ratios are usually stated in terms of times or percentages. Like any other
financial analysis, a ratio analysis helps us draw meaningful conclusions and
interpretations about a firms financial condition and performance.
ii) Common size Analysis expresses individual financial statement accounts as a
percentage of a base amount. A common size status expresses each item in the
balance sheet as a percentage of total assets and each item of the income statement as
a percentage of total sales. When items in financial statements are expressed as
percentages of total assets and total sales, these statements are called common size
statements.
iii) Index Analysis expresses items in the financial statements as an index relative to
the base year. All items in the base year are assumed to be 100%. Usually, this
analysis is most appropriate for income statement items.
According to users of financial information, there are two techniques of financial
analysis. These are:
i) External Analysis an analysis performed by outsiders to the firm such as creditors,

investors, suppliers etc.
34
ii) Internal Analysis an analysis performed by corporate finance and accounting
departments for he purpose of planning, evaluating, and controlling operating
activities.
3.4 STAGES IN FINANCIAL ANALYSIS
Financial analysis consists of the following three major stages.
i) Preparation. The preparatory steps include establishing the objectives of the analysis
and assembling the financial statements and other pertinent financial data. Financial
statement analysis focuses primarily on the balance sheet and the income statement.
However, data from statements of retained earnings and cash flows may also be used.
So, preparation is simply objective setting and data collection.
ii) Computation. This involves the application of various tools and techniques to gain a
better understanding of the firms financial condition and performance. Computerized
financial statement analysis programs can be applied as part of this stage of financial
analysis.
iii) Evaluation and Interpretation.
Interpretation. Involves the determination fo the meaningfulness of
the analysis and to develop conclusions, inferences, and recommendations about the
firms performance and financial condition. This is the most important of all the three
stages of financial analysis.
Although we have briefly seen what is meant by the three most common types of
financial analysis, our focus on this material will be on ratio analysis. So in the section
that follows, we will discuss major types of financial ratios with illustrative examples.
3.5 TYPES OF FINANCIAL RATIOS
There are several key ratios that reveal about the financial strengths and weaknesses of a
firm. We will look at five categories of ratios, each measuring about a particular aspect of
the firms financial condition and performance.
35
3.5.1 Liquidity Ratios
Liquidity ratios measure the ability of a firm to meet its immediate obligations and reflect
the short term financial strength or solvency of a firm. In other words, liquidity ratios
measure a firms ability to pay its current liabilities as they mature by using current
assets. There are two commonly used liquidity ratios: the current ratio and the quick ratio.
The following financial statements pertain to Zebra Share Company. We will perform the
necessary ratio analyses using them, and then evaluate and interpret each analysis.
Zebra Share Company
Comparative Balance Sheet
December 31, 2001 and 2002
(In thousands of Birrs)
Assets 2002 2001
Current assets:
Cash 9,000 7,000
Marketable securities 3,000 2,000
Accounts receivable (net) 20,700 18,300
Inventories 24,900 23,700
Total current assets 57,600 51,000
Fixed assets:
Land and buildings 33,000 27,000
Plant and equipment 130,500 120,000
Total fixed assets 163,500 147,000
Less: accumulated depreciation 67,200 61,200
Net fixed assets 96,300 85,800
Total assets 153,900 136,800
Liabilities and stockholders equity
Current liabilities:
Accounts payable 20,100 17,100
Notes payable 14,700 13,200
Taxes payable 3,300 3,000
Total current liabilities 38,100 33,300
Long-term debt:
Mortgage bonds 5% 60,000 60,000
Total liabilities 98,100 93,300
Stockholders equity:
Preferred stock 5% (Br. 100 par) 6,000 -
Common stock (Br. 10 par) 33,000 30,000
Capital in excess of par value 7,500 4,500
Retained earnings 9,300 9,000
Total stockholders equity 55,800 43,500
Total liabilities and stockholders equity 153,900 136,800
36
Zebra Share Company
Income Statement
For the Year Ended December 31, 2002
________________________________________________________________________
Net sales Br. 196,200,000
Cost of goods sold 159,600,000
Gross profit Br. 36,600,000
Operating expenses* 26,100,000
Earnings before interest and taxes (EBIT) Br. 10,500,000
Interest expense 3,000,000
Earnings before taxes (EBT) Br. 7,500,000
Income taxes 3,600,00
Net income Br. 3,900,000
* Included in operating expenses are Br. 6,000,000 depreciation and Br. 2,700,000 lease
payment.
Zebra Share Company

Statement of Retained Earnings
For the Year Ended December 31, 2002
Retained earnings at beginning of year Br. 9,000,000

Add: Net income 3,900,000
Sub-total Br. 12,900,000
Less: Cash dividends
Preferred Br. 300,000
Common 3,300,000
Sub-total Br. 3,600,000
Retained earnings at end of year Br. 9,300,000
i) Current ratio measures the ability of a firm to satisfy or cover the claims of short-
term creditors by using only current assets. This ratio relates current assets to current
liabilities
37
Current ratio = Current assets
Current liabilities
Zebras current ratio (for 2002) = Br. 57,600 = 1.51 times
Br. 38,100
Interpretation: Zebra has Br. 1.51 in current assets available for every 1 Br. in current
liabilities.
Relatively high current ratio is interpreted as an indication that the firm is liquid and in
good position to meet its current obligations. Conversely, relatively low current ratio is
interpreted as an indication that the firm may not be able to easily meet its current
obligations. A reasonably higher current ratio as compared to other firms in the same
industry indicates higher liquidity position. A very high current ratio, however, may
indicate excessive inventories and accounts receivable, or a firm is not making full use of
its current borrowing capacity.
ii) Quick ratio (Acid test ratio)- measures the short-term liquidity by removing the
least liquid current assets such as inventories. Inventories are removed because they are
not readily or easily convertible into cash. Thus, the quick ratio measures a firms ability
to pay its current liabilities by using its most liquid assets into cash.
Quick ratio = Current assets Inventory

Current liabilities
Zebras quick ratio (for 2002) = Br. 57,600 Br. 24,900 = 0.86 times
Br. 38,100
Interpretation: Zebra has Br. 0.86 in quick assets available for every one birr in current
liabilities.
Like the current ratio, the quick ratio reflects the firms ability to pay its short-tem
obligations, and the higher the quick ratio the more liquid the firms position. But the
quick ratio is more detailed and penetrating test of a firms liquidity position as it
considers only the quick asset. The current ratio, on the other hand, is a crude measure of
the firms liquidity position as it takes into account all current assets without distinction.
38
What is the amount of inventory for a firm whose current assets and current liabilities are
Br. 400,000 and Br. 100,000 respectively and whose quick ratio is 2 times?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
3.5.2 Activity Ratios
Activity ratios measure the degree of efficiency a firm displays in using its assets. These
ratios include turnover ratios because they show how rapidly assets are being converted
(turned over) into sales or cost of goods sold. Activity ratios are also called asset
management ratios, or asset utilization ratios, or efficiency ratios. Generally, high
turnover ratios are associated with good asset management and low turnover ratios with
poor asset management.
Activity ratios include:

i) Accounts Receivable turnover measures how efficiently a firms accounts receivable
is being managed. It indicates how many times or how rapidly accounts receivable are
converted into cash during a year.
Accounts receivable turnover = Net sales

Accounts receivable
Zebras accounts receivable turnover (for 2002) = Br. 196,200 = 9.48 times
Br. 20,700
Interpretation: Zebras accounts receivable get converted into cash 9.48 times a year.
In general, a reasonably higher accounts receivable turnover ratio is preferable. A ratio

substantially lower than the industry average may suggest that a firm has more liberal
credit policy, more restrictive cash discount offers, poor credit selection or in adequate
cash collection efforts.
39
There are alternate ways to calculate accounts receivable value like average receivables
and ending receivables. Though many analysts prefer the first, in our case we have used
the ending balances. In computing the accounts receivable turnover ratio, if available,
only credit sales should be used in the numerator as accounts receivable arises only from
credit sales.
ii) Days sales outstanding (DSO) also called average collection period. It seeks to
measure the average number of days it takes for a firm to collect its accounts
receivable. In other words, it indicates how many days a firms sales are outstanding
in accounts receivable.
Days sales outstanding = 365 days

Accounts receivable turnover
Zebras days sales outstanding = 365 days = 39 days

9.48
Interpretation: Zebras credit customers on the average are paying their bills in almost
39 days. If Zebras credit period is less than 39 days, some corrective actions should be
taken to improve the collection period.
The average collection period of a firm is directly affected by the accounts receivable
turnover ratio. Generally, a reasonably short-collection period is preferable.
iii) Inventory turnover measures how many times per year the inventory level is sold
(turned over).
Inventory turnover = Cost of good sold

Inventory
For Zebra Company (2002) = Br. 159,600 = 6.41times

Br. 24,900
Interpretation: Zebras inventory is on the average sold out 6.41 times per year.
In computing the inventory turnover, it is preferable to use cost of goods sold in the
numerator rather than sales. But when cost of goods sold data is not available, we can
40
apply sales. In general, a high inventory turnover is better than a low turnover. But
abnormally high inventory turnover might result from very low level of inventory. This
indicates that stock outs will occur and sales have been very low. A very low turnover, on
the other hand, results from excessive inventory levels, presence of inferior quality,
damaged or obsolete inventory, or unexpectedly low volume of sales.
iv) Fixed assets turnover measures how efficiently a firm uses it fixed assets. It shows
how many birrs of sales are generated from one birr of fixed assets
Fixed assets turnover = Net sales___

Net fixed assets
Zebras fixed assets turnover = Br. 196,200 = 2.04X

Br. 96,300
Interpretation: Zebra generated Br. 2.04 in net sales for every birr invested in fixed
assets.
A fixed assets turnover ratio substantially lower than other similar firms indicates under
utilization of fixed assets, i.e., idle capacity, excessive investment in fixed assets, or low
sales levels. This suggests to the firm possibility of increasing outputs without additional
investment in fixed assets.
The fixed assets turnover may be deceptively low or high. This is because the book
values of fixed assets may be considerably affected by cost of assets, time elapsed since
their acquisition, or method of depreciation used.
v) Total assets turnover indicates the amount of net sales generated from each birr of
total tangible assets. It is a measure of the firms management efficiency in managing
its assets.
Total assets turnover = Net Sales
Total assets
Zebras total assets turnover = Br. 196,200 = 1.27X

Br. 153, 900
41
Interpretation: Zebra Share Company generated Br. 1.27 in net sales for every one birr
invested in total assets.
A high total assets turnover is supposed to indicate efficient asset management, and low
turnover indicates a firm is not generating a sufficient level of sales in relation to its
investment in assets.
Ogaden Company has sales of Br. 5 million, out of which 75% are credit sales. The year-
end accounts receivable balance is Br. 475,000. What is the days sale outstanding?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
3.5.3 Leverage Ratios
Leverage ratios are also called debt management or utilization ratios. They measure the
extent to which a firm is financed with debt, or the firms ability to generate sufficient
income to meet its debt obligations. While there are many leverage ratios, we will look at
only the following three.
i) Debt to total assets (Debt) Ratio measures the percentage of total funds provided by
debt.
Debt ratio = Total liabilities

Total assets
Zebras debt ratio = Br. 98,100 = 64%

Br. 153,900
Interpretation: At the end of 2002, 64% of Zebras total assets was financed by debt and
36% (100% - 64%) was financed by equity sources.
A high debt ratio implies that a firm has liberally used debt sources to finance its assets.
Conversely, a low ratio implies the firm has funded its assets mainly with equity sources.
42
Debt ratio reflects the capital structure of a firm. The higher the debt ratio, the more the
firms financial risk.
ii) Times interest earned measures a firms ability to pay its interest obligations.
Times interest earned = Earnings before interest and taxes (EBIT)

Interest expense
Zebras times interest earned = Br. 10,500 = 3.50X
Br. 3,000
Interpretation: Zebra has operating income 3.5 times larger than the interest expense.
The times interest earned ratio implicitly assumes a firms operating income (EBIT) is
available to meet its interest obligations. However, earnings before interest and taxes is
an income concept and not a direct measure of cash. Hence, this ratio provides only an
indirect measure of the firms ability to meet its interest payments.
iii) Fixed charges coverage measures the ability of a firms to meet all fixed obligations
rather than interest payments alone. Fixed payment obligations include loan interest and
principal, lease payments, and preferred stock dividends.
Fixed charges coverage = Income before fixed charges and taxes

Fixed charges
For Zebra Company, the other fixed charge payment in addition to interest is lease
payment. Therefore,
Zebras fixed charges coverage = Br. 10,500 + Br. 2,700 = 2.32X

Br. 3,000 + Br. 2,700
Interpretation: the fixed charges (interest and lease payments) of Zebra Share Company
are safely covered 2.32 times.
Like times interest earned, generally, a reasonably high fixed charges coverage ratio is
desirable. The fixed charges coverage ratio is required because failure of the firm to meet
any financial obligation will endanger the position of a firm.
43
Zemedkun Merchandising Company has reported operating income of Br. 120,000. T he

Companys interest expense and total fixed charges are Br. 30,000 and Br. 80,000
respectively. What are the times interest earned and fixed charges coverage ratios?
________________________________________________________________________
________________________________________________________________________
3.5.4 Profitability Ratios
These ratios measure the earning power of a firm with respect to given level of sales,
total assets, and owners equity. The following ratios are among the many measures of a
firms profitability.
i) Profit Margin shows the percentage of each birr of net sales remaining after
deducting all expenses.
Profit margin = Net income

Net Sales
Zebras profit margin = Br. 3,900 = 2%

Br. 196,200
Interpretation: Zebra generated 2 cents in profits for every one birr in net sales.
The net profit margin ratio is affected generally by factor as sales volume, pricing
strategy as well as the amount of all costs and expenses of a firm.
ii) Return on investment (assets) measures how profitably a firm has used its
investment in total assets.
Return on investment = Net income

Total assets
Zebras return on investment = Br. 3,900 = 2.53 %

Br. 153,900
Interpretation: Zebra earned more than 2 cents of profits for each birr in assets.
44
Generally, a high return on investment is sought by firms. This can be achieved by
increasing sales levels, increasing sales relative to costs, reducing costs relative to sales,
or efficiently utilizing assets.
iii) Return on equity indicates the rate of return earned by a firms stockholders on
investments made by themselves.
Return on equity = Net income___

Stockholders equity
Zebras return on equity = Br. 3,900 = 6.99%

Br. 55,800
Interpretation: Zebra earned almost 7 cents of profit for each birr in owners equity
We can also use the following alternative way to calculate return on equity.
Return on equity = Return on investment

1 Debt ratio
A high return on equity may indicate that a firm is more risky due to higher debt balance.
On the contrary, a low ratio may indicate greater owners capital contribution as compared
to debt contribution. Generally, the higher the return on equity, the better off the owners.
Muhammed Fertilizers Company has assets amounting to Br. 1,200,000. The firm has
generated Br. 3,000,000 in annual net sales, with a 5% net profit margin. What is the net
income and return on assets for Zemedkun?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
45
Dupont System of Analysis
It is an approach to assess that a firms return on assets and return on equity show not
only the firms earning power but also efficiency and leverage. This analysis breaks down
these two ratios as follows:
Return on assets = Profit margin X Total assets turnover
Return on equity =Profit margin X Total assets turnover X Total assets/equity
= Profit Margin X Total assets turnover X Equity Multiplier
Zakir Beverage Corporations profit margin for year 2002 is 4% and its total assets
turnover is 1.5 times. The debt ratio for the same year is 40%. What are return on
investment and return on equity ratios of Zakir for 2002?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
3.5.5 Marketability Ratios
Marketability ratios are used primarily for investment decisions and long range planning.
They include:
i) Earnings per share (EPS) expresses the profits earned on each share of a firms
common stock outstanding. It does not reflect how much is paid as dividends.
Earnings per share = Net income Preferred stock dividend

Number of common shares outstanding
Zebras Eps for 2002 = Br. 3,900 Br. 300 = Br. 1.09
Br. 33,000  Br. 10
Interpretation: Zebras common stockholders earned Br. 1.09 per share in 2002.
ii) Dividends Per Share (DPS) represents the amount of cash dividends a firm paid on
each share of its common stock outstanding.
46
Dividends Per Share = Total cash dividends on common shares
Number of common shares outstanding
Zebras DPs for 2002 = Br. 3,300 _ = Br. 1.00

Br. 33,000  Br. 10
Interpretation: Zebra distributed Br. 1 per share in dividends.
iii) Dividend pay-out (pay-out) ratio shows the percentage of earnings paid to
stockholders.
Dividends pay-out = Dividends per share

Earnings per share
= Total dividends to common stockholders
Total earnings to common stockholders
stockholders
Zebras pay-out ratio = Br. 1.00 = Br. 3,300 = 92%

Br. 1.09 Br. 3,600
Interpretation: Zebra paid nearly 92% of its earnings in cash dividends.
3.6 COMPARING FINANCIAL RATIOS
To address whether a given ratio is high or low, good or bad, a meaningful basis is needed
for comparison. Two types of ratio comparisons can be made.
i) Cross sectional analysis is the comparison of a firms ratios to those other firms in
the same industry at the same point in time. Here, the firm is interested in how well it has
performed in relation to other firms. Generally, cross sectional analysis is preformed
based on industry averages of different financial ratios.
ii) Time series analysis is an evaluation of a firms financial ratios over time. Here,
the current period ratios are compared with those of the past years. The purpose is to
determine whether the firm is progressing or deteriorating.
47
To obtain the highest possible information about a firm, usually, a combination of both
cross sectional and time-series analyses are applied.
3.7 LIMITATIONS OF RATIO ANALYSIS
Even though ratio analysis can provide useful information about a firms financial
conditions and operations, it has the following problems and limitations.
1. Generally, any single financial ratio does not provide sufficient information by itself.
2. Sometimes a comparison of ratios between different firms is difficult. One reason
could be a single firm may have different divisions operating in different industries.
Another reason could be the financial statements may not be dated at the same point in
time.
3. The financial statements of firms are not always reliable, particularly, when they are
not audited.
4. Different accounting principles and methods employed by different companies can
distort comparisons.
5. Inflation badly distorts comparison of ratios of a firm over time.
6. Seasonal factors inherent in a business can also lead us to deceptive conclusion. For
example, the inventory turnover ratio for a stationery materials selling company will be
different at different time periods of a year.
3.8 SUMMARY
The primary purpose of this unit was to learn how to analyze financial statements.
The basic points discussed are:

- There are several techniques of financial analysis; but ratio analysis is common.
- Financial ratios are classified into different categories, measuring about a firms
liquidity, activity, leverage, earning powers, and other related aspects.
- Current and quick ratios are the two commonly used liquidity ratios.
- Activity ratios include turnover ratios like accounts receivable turnover, inventory
turnover, fixed assets turnover, and total assets turnover.
48
- Leverage ratios reveal two information associated with debt of a firm. These
ratios include debt ratio, times interest earned, and fixed charges coverage.
- Profitability ratios indicate the earning power of a firm. Ratios under this category
include profit margin, return on assets, and return on investment.
- Marketability ratios, unlike the other categories, do not measure specific aspect of
a firm. Earnings per share, dividends per share, and pay-out ratio are among the
most common types.
- To compare ratios, cross sectional or time series analyses can be employed.
- Financial ratios, though are important and useful analyses, have many problems
and limitations.
I. Quick ratio = Current assets Inventory

Current liabilities
2 = Br. 400,000 Inventory
Br. 100,000
Inventory = Br. 400,000 Br. 200,000 = Br. 200,000
II. Credit sales = Br. 5,000,000 X 75% = Br. 3,750,000
Accounts receivable turnover = Br. 3,750,000 = 7.89X
Br. 475,000
Days sales outstanding = 365 days = 46 days
7.89
III. Times interest earned = Operating income = Br. 120,000 = 4X
Interest expense Br. 30,000
Fixed charges coverage = Earnings before fixed charges
Fixed charges
= Br. 120,000 + (Br. 80,000 Br. 30,000) = 2.13X
Br. 80,000
IV. Net income = Net sales X Net profit margin = Br. 3,000,000 X 5% = Br. 150,000
Return on assets = Net income / Total assets = Br. 150,000 / Br. 1,200,000 = 12.5%
V. Return on investment = Net profit margin X Total assets turnover
49
= 4% X 1.5 = 6%
Return on equity = Return on investment / 1 Debt ratio
= 6% / 1 40% = 10%
Part I. Multiple choice

1. Identify the factor that contributes for shorter days sales outstanding
A) Longer credit periods C) Strong cash collection policy
B) Limited cash discount offers D) Poor credit selection
2. If new shares of common stock are issued in exchange for the existing debt of a firm,
then
A) Return on investment increases.
B) Times interest earned ratio will decrease.
C) Return on stockholders equity will decrease.
D) Current and quick ratios will increase.
3. A relatively lower return on assets is always an indicator of poor asset management.
A) True B) False
Part II. Exercises
1. A company has current liabilities of Br. 75,000, mortgages notes payable of Br.
200,000, and long-term bond of Br. 225,000. If the total stockholders equity of the
company amounts to Br. 750,000, what is the debt ratio?
2. A firm has a current ratio of 1.5 and a quick ratio of 1.0. If the current assets other than
cash amount to Br. 2,500,000, what is the mathematical relationship between
inventories and current liabilities for this firm?
3. ABC companys return on investment was 25% last year, and the net profit margin was
10%. What are the total net sales for the year if total assets are Br. 20 million?
4. XYZ corporation has Br. 1,000,000 of debt outstanding of 10% interest rate. The firms
annual net sales are Br. 4,000,000; its tax rate is 40%; and its net profit margin is 5%.
What is XYZ Companys times interest earned ratio?
50
Part III. Problem
Complete the balance sheet and sales information in the following table for Abay
Transport Ltd. Using the financial ratios that follow.
BALANCE SHEET
_______________________________________________________________________________________________________
Cash Accounts payable
Accounts receivable Long-term debt 120,000
Inventories Common stock
Fixed assets ________ Retained earnings 195,000
Total assets Br. 1,000,000 Total liabilities and equity _______
Sales Cost of goods sold
Debt ratio: 50% Days sales outstanding: 36days
Quick ratio: 0.80X Cost of goods sold/sales: 75%
Total assets turnover: 1.5X Inventory turnover: 5X

Dryden Press Harcourt Brace College Publishers, Florida
2. Lawrence J.Jitman (1991). Principles of Management Finance.
Management.
3.12 GLOSSARY
Acid test a detailed, rigorous, and more penetrating test.

Turnover the rate at which assets are replaced during a period; or the rate at which
sales are generated against assets.
Leverage the relationship between a firms debt balance and its earnings.
51
Margin a markup over costs. The difference between the cost of something and the
price for which it is sold.
Return the total gain or loss experienced by owners on their investment over a given
period of time.
52
UNIT 4: FINANCIAL FORECASTING
Contents
4.1 Introduction
4.2 Meaning and Purpose of Financial Forecasting
4.3 Procedures in Financial Forecasting
4.4 Methods of Forecasting Financial Requirements
4.4.1 The Performa Financial Statements Method
4.4.2 The Formula Method
4.5 Factors that Affect Additional Financial Requirements
4.6 Excess Capacity and Additional Financial Requirements
4.7 Summary
4.11 Glossary
At the end of this unit you should be able to answer the following questions:
 What are the basic purposes of financial forecasting?

 How are the three main procedures of financial forecasting interrelated?
 What are the most common methods used in forecasting financial
requirements?
 Why does the formula method of forecasting additional funds needed not
produce reliable results?
 What are the factors that affect additional financial requirements of a firm?
 How does excess capacity existing in assets affect the firms additional
financial requirements?
53
4.1 INTRODUCTION
In the first unit, we discussed that financial management involves planning for raising
and utilizing funds. Financial mangers should be able to plan before hand in making
investment and financing decisions. So, financial forecasting helps financial mangers to
predict events before they occur. This, particularly, is true when they plan to raise funds
externally. Because a firms profit is often insufficient to finance assets in the normal
course of business, additional sources of finance should be considered.
Financial forecasting also forces financial mangers to develop financial statements before
hand. These financial statements are called Pro forma financial statements. They include
forecasted sales and forecasted expenses, forecasted assets, forecasted liabilities, and
forecasted stockholders equity. Based on these forecasted items, the financial manger is
able to determine the amount of finance to be obtained from external sources.
4.2 MEANING AND PURPOSE OF FINANCIAL FORECASTING
Financial forecasting is one of the four major jobs of a firms financial staff, namely
performing financial forecasting and analysis, making investment decisions, and making
financing decisions. It is generally a planning process which involves forecasting of sales,
assets, and financial requirements. In other words, financial forecasting is a process
which involves:
- evaluation of a firms need for increased or reduced productive capacity and

- evaluation of the firms need for additional finance
Generally, financial forecasts are required to run a firm well. Their base, in almost all
circumstances, are forecasted financial statements. An accurate financial forecast is very
important to any firm in several aspects:
- It helps a firm to predict appropriate demand for its products.

- It helps a firm to project its sales and accordingly to predict its assets properly.
- It contributes significantly to the firms profitability.
- It plays a crucial role in the value maximization goal of a firm.
54
Financial forecasts are also meanses for forecasted financial statements. By their virtue, a
firm can forecast its income statement, balance sheet and other related statements.
Besides, key ratios can be projected. Once financial statements and ratios have been
forecasted, the financial forecast will be analyzed. Finally, the firms management will
have an opportunity to make some decisions before hand.
So, all in all, financial forecasting is a prerequirment for the investment, financing, as
well as dividend policy decisions of a firm.
4.3 PROCEDURES IN FINANCIAL FORECASTING
The financial forecasting process generally involves the following procedures:

i) Forecasting of sales for the future period
ii) Determining the assets required to meet the sales targets, and
iii) Deciding on how to finance the required assets.
The above three procedures are very important in projecting the financial statements and
key financial ratios. However, among the three procedures, the first one, i.e, sales forecast
is the most crucial.
Sales forecast is a forecast of a firms unit and birr sales for some future period. It is
generally based on recent sales trends and forecast of the economic prospects of the
nation, region, industry and other factors. This procedure starts usually by reviewing the
sales of the recent pasts. The whole crucial points of a financial forecasting process lies in
an accurate forecast of sales. If this procedure is off, the firms profitably as well as its
value will be negatively affected. So in forecasting sales, several factors should be
considered:
1. the historical sales growth pattern of the firm at both divisional and corporate levels,
2. the level of economic activity in each of the firms marketing areas,
3. the firms probable market share,
4. the effect of inflation on the firms future pricing of products,
5. the effect of advertising campaigns, cash and trade discounts, credit terms, and other
similar factors alike on future sales,
55
6. individual products sales forecasts at each divisional level.
Forecast of sales is a base for forecasting of the firms income statement which in turn
helps to project retained earnings. In forecasting the income statement assumptions about
the costs, tax rates, interest charges and dividends are required.
Sales forecasts are also grounds for determination of the firms assets requirement.
If sales are to increase, then assets must also grow. The amount each asset account must
increase depends whether the firm was operating at full capacity or not. If higher sales are
projected, more cash will be needed for transactions, higher sales will create higher
receivables. Similarly, higher sales require higher inventory and higher plant and
equipment.
Finally, the firm will face the question of financing its required assets. Some of the
required finance can be covered by the increased retained earnings. The retained earnings
increment will result from increased sales and profit. Still some other portion of the
finance can be covered by some liabilities which will grow by the same proportion with
that of sales. The remaining finance must be obtained from available external sources.
The third procedure of the financial forecasting process, i.e. forecast of financial
requirements involves again three sub procedures. These are:
1. Determining how much money (finance) the firm will need during the forecasted
period. This will be done based on sales and assets forecast.
2. Determing how much of the total required finance, the firm will be able to generate
internally during the same period. There are two types of finance that will be
generated under normal operations. The first is portion of the net income retained in
the firm (retained earnings). The second one is the increase in the firms liabilities as a
direct and automatic result of its decision to increase sales. This finance is called
spontaneous finance. For example, if sales are to increase, inventory must increase.
The increase in inventory requires more purchases which in turn causes the accounts
payable to be increased. The accounts payable will increase spontaneously with the
increase in sales. Other examples include accruals like salaries and wages payable
and income tax payable.
56
3. Determining the additional external financial requirements. Any balance of the total
finance that cannot be met with normally generated funds must be obtained from
external sources. This finance is called the additional funds needed (AFN).
Required increase Required increase in
AFN = in assets __ normally generated funds.
Additional funds needed (AFN) are funds that a firm must raise externally through
borrowing (bank loans, promissory notes, bonds, etc.) or by issuing new shares of
common stock or preferred stock.
4.4 METHODS OF FORECASTING FINANCIAL REQUIREMENTS
There are two methods to determine the additional financial requirements. These are:
1. The proforma financial statements method and

2. The formula method
4.4.1 The Pro-Forma Financial Statements Method
The pro-forma financial statements method is simply a method of forecasting financial

requirements based on forecasted financial statements. As a result, this method is also
called the projected financial statements method. Under this method, the asset
requirements are first projected for the fore coming future period. The forecast of assets
helps to determine the total financial requirements. Then, the liabilities and equity that
will be generated under normal operations are projected. Finally, the additional funds
needed will be estimated.
The pro-forma financial statements method of determining additional financial

requirements involve the following steps.
1. Developing the Pro Forma Income statement

The proforma income statement provides a projection of the firms net income for the
forecasted period. This enables the firm to estimate the amount of retained earnings it will
generate during the period. In developing the projected income statement, first, a forecast
of sales should be established. Second, cost of goods sold should be determined. Third,
57
other expenses (operating and non-operating) should be computed. Next, the net income
should be determined. Finally, based on the amount of dividends, the amount of addition
to retained earnings should be determined.
2. Constructing the Pro Forma Balance Sheet

Higher sales must be supported by higher asset amounts. Some of the assets increase can
be financed by retained earnings, and spontaneous finance. The remaining blanc must be
financed from external sources. In the forecast of the firms balance sheet, first, those
balance sheet items that are expected to increase directly with sales are forecasted. Next,
the spontaneously increasing liabilities are forecasted. Then, the liability and equity items
that are not directly affected by sales are set. Next, the value of retained earnings for the
forecasted period is obtained. Finally, the AFN will be raised.
Example
Blue Nile Share Company is a medium sized firm engaged in manufacturing of various
household utensils. The financial manger is preparing the financial forecast of the
following year. At the end of the year just completed, the condensed balance sheet of the
company has contained the following items.
Assets Liabilities and Equity

Cash ----------------------------Br. 10,000 A/payable --------------------------Br. 90,000
A/receivable -----------------------70,000 Accruals --------------------------------40,000
--------------------------------40,000
Inventories -----------------------150,000
-----------------------150,000 Current liabilities -------------Br. 130,000
Current assets -------------Br. 230,000 Long-term debt -----------------------200,000
Net fixed assets -----------------370,000 Common stock ------------------------120,000
_________ Retained earnings --------------------150,000
--------------------150,000
Total assets -------------Br.
-------------Br. 600,000 Total laibs. and equity ------Br.
------Br. 600,000
During the year just completed the firm had sales of Br. 1,800,000. In the following year,
due to increased demand to the firms products the financial manger estimates that sales
will grow at 10%. There are no preferred stock outstanding during the year. The firm s
dividend pay-out ratio is 60%. It is also known that the firms assets have been operating
at full capacity. During the same year, Blue Niles operating costs were Br. 1,620,000 and
58
are estimated to increase proportionately with sales. Assume the companys interest
expense will be Br. 40,000 during the next year and its tax rate is 40%.
Required: Determine the additional funds needed (AFN) of Blue Nile Share Company
for the next year using the proforma financial statements method.
Solution
First, we develop the proforma income statement
Pro Forma Income Statement

____________________________________________________________________________________________________________
Sales (Br. 1,800,000 x 1.10) ------------------------------------------------------------------------------Br. 1,980,000
Operating costs (Br. 1,620,000 x 1.10) ----------------------------------------------------------------------1,782,000
----------------------------------------------------------------------1,782,000
Earnings before interest and taxes (EBIT) ----------------------------------------------------------------Br. 198,000
Interest expense -----------------------------------------------------------------------------------------------------40,000
-----------------------------------------------------------------------------------------------------40,000
Earnings before taxes (EBT) --------------------------------------------------------------------------------Br. 158,000
Taxes (Br. 158,000 x 40%) ---------------------------------------------------------------------------------------63,200
---------------------------------------------------------------------------------------63,200
Net income -----------------------------------------------------------------------------------------------------Br.
-----------------------------------------------------------------------------------------------------Br. 94,800
Dividends to common stock (Br. 94,800 x 60%) ---------------------------------------------------------Br.
---------------------------------------------------------Br. 56,880
Addition to retained earnings (Br. 94,800 Br. 56,880) ------------------------------------------------Br. 37,920
Then, we construct the proforma balance sheet
Pro Forma Balance Sheet

____________________________________________________________________________________________________________
Assets Liabilities and Equity
Cash (Br. 10,000 x 1.10) ----------------Br. 11,000 A/Payable (Br. 90,000 x 1.10) -------------Br. 99,000
A./receivable (Br. 70,000 x 1.10) ----------77,000 Accruals (Br. 40,000 x 1.10) --------------------44,000
--------------------44,000
Inventories (Br. 150,000 x 1.10) ----------165,000
----------165,000 Current liabilities ----------------------------Br. 143,000
Current assets ---------------------------Br. 253,000 Long-term debt (the increase is unknown)----200,000
Net fixed assets (Br. 370,000 x 1.10) ----407,000 Common stock (as long-term debt) ------------120,000
_______ Retained earnings (Br. 150,000 + Br. 37,920) 187,920
Total assets -----------------------Br.
-----------------------Br. 660,000 Total liabilities and equity -------------Br.
-------------Br. 650,920
Blue Niles forecasted total assets as shown above are Br. 660,000. However, the
forecasted total liabilities and equity amount to only Br. 650,920. Since the balance sheet
must balance, i.e. A = L + OE, the difference must be covered by additional funds.
Therefore, AFN = Br. 660,000 Br. 650,920 = Br. 9,080.
59
Or AFN = increase in Increase in normally
assets generated funds
= [Br. 660,000 Br. 600,000] [(Br. 99,000 Br. 90,000) + (Br. 44,000 Br.
40,000) + Br. 37,920]
= Br. 60,000 Br. 50,920
= Br. 9,080
1. Briefly explain why an accurate financial forecast is crucial to the wealth maximization
goal of a firm.
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
2. In the illustration above, the amount of interest expense is assumed to be Br. 40,000.
What do you think are the basic factors that affect the amount of interest expense?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
3. Taha Private Limited Company (PLC) had sales of Br. 5 million and total assets of Br.
4.5 million in 2002. The current liabilities during the end of the same year were Br.
1,250,000. The PLCs net profit margin and dividend pay-out ratios are 6% and 30%
respectively. All assets and current liabilities will vary directly with sales. Determine
the additional funds needed (AFN) for 2003 if sales are projected to grow by 5% only.
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
4.4.2 The Formula Method
60
This is a much easier method of determining additional financial requirements than the
pro forma method. The formula method is a shortcut to financial forecasting. However,
many companies use the pro forma method of forecasting their financial requirements
because the output of the formula method is less meaningful. Under the shortcut method,
we make the following assumptions.
1. Each asset maintains a direct proportionate relationship with sales

2. Accounts payable and accruals increase in direct proportion to sales increase.
3. The profit margin and the dividend pay-out ratios are constant.
The formula that can be used as a shortcut to determine external capital requirements is
given as:
Additional Required Spontaneous Increase in
funds = increase increase in retained
needed in assets liabilities earnings
AFN = (A/S) S (L/S) S MS1 (1 d)

Where
AFN = Additional funds needed
A/S = Percentage relationship of variable assets to sales = Capital intensity ratio.
S = change in sales = S1 S0 = S0 x g
S1 = Total Sales projected for the next period
S0 = Total sales of the current period
L/S = Percentage relationship of variable (spontaneous) liabilities to sales
M = Net profit margin
d = Dividend payout ratio
g = The expected sales growth rate
To illustrate the formula method, consider the example given for the previous method.
But assume that Blue Niles net profit margin is 5%.
 Br .600,000   Br.130,000 
AFN =    Br.180,000*     (Br. 180,000) 5% x
 Br.1,800,000   Br.1,800,000 
61
Br 1,980,000** (1 60%)
= Br. 60,000 Br. 13,000 Br. 39,600
= Br. 7,400
To increase sales by 10% (Br. 180,000), the formula suggests that Blue Nile must
increase its assets by 60,000. In other words, the firm will require a Br. 60,000 more fund
for the forecasted year. Out of this, Br. 13,000 will come from spontaneous increase in
liabilities. Another Br. 39,600 will be obtained from retained earnings. The remaining Br.
7,400 must be raised from external sources like by issuing new shares of stocks or by
borrowing.
* S = S1 S0 = S0 x sales growth rate (g) = Br. 1,800,000 x 10% = Br. 180,000

** S1 = S0 + S0g = S0 (1 +g) = Br. 1,800,000 (1 + 0.10) = Br. 1,980,000.
1. Why do not the pro forma and the formula methods of forecasting financial
requirements result in the same AFN?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
2. Selam Manufacturing Company has the following ratios: A/S = 1.6; L/S = 0.4; M =
10%; and d = 45%. Sales last year were Br. 10 million. If these ratios will remain
constant next year, what is the maximum sales growth rate (g) Selam can achieve without
having to use additional funds needed (AFN)? (Use the formula for AFN).
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
4.5 FACTORS THAT AFFECT ADDITIONAL FINANCIAL REQUIREMENTS
62
The external financial requirements of a firm during any given period are affected by
several factors.
1. Financial Planning. Refers to the growth rates of sales a firm has projected. Sales
growth rates and additional funds needed are positively related. At low growth rates of a
sale, a firm needs small or no external financing. The firm might even generate surplus
funds at low growth rates. As the growth rates increase, the AFN will also increase. So
other factors being constant, the higher the sales growth rates, the higher the AFN.
2. Capital Intensity. This is the amount of assets required to support each birr of sales. In
the formula, this is designated as A/S. Generally, firms with higher capital intensity ratios
are with greater capital requirements. Highly capital-intensive firms generally require
more external funds than labor intensive firms.
3. Profit Margin.
Margin. Profit margin, as you might well recall from unit 3, is the net income
per each birr of net sales. It is evident from the very formula of computing AFN that
external capital requirements and net profit margin are related in opposite directions.
Other factors held constant, the higher the profit margin, the lower the external funds
requirements.
4. Dividends policy. Dividend policy refers to the percentage of a firms net earnings
paid out as cash dividends. It is reflected in the firms payout ratio. The higher the
dividend payout ratio, the smaller the addition to retrained earnings, and hence the greater
the requirements for external finance.
What is the impact on the AFN of a firms decision of beginning to pay employees on a
monthly basis dropping the previous practice of paying at the end of every week?
________________________________________________________________________
________________________________________________________________________
4.6 EXCESS CAPACITY AND ADDITIONAL FINANCIAL REQUIREMENTS
63
Previously, when we were dealing with Blue Niles financial forecast, our assumption had
been that assets were operating at full capacity (100% capacity). Now lets relax this
assumption that excess capacity exists in the firms fixed assets. In fact, theoretically
excess capacity exists with all types of assets. But as a practical matter, excess capacity
normally exists primarily with respect to fixed assets.
Assume that Blue Nile was operating at only 98% its fixed assets capacity. How does this
affect the firms AFN? Some procedures are involved to see the effect.
i) Determine the full capacity sales, i.e., sales that could have been produced had fixed
assets been utilized 100%.
Full Actual sales______________
capacity = Percentage of capacity at which
sales fixed assets were operated
= Br. 1,800,00 = Br. 1,836,735

98%
ii) Determine the target fixed assets/sales ratio
Target fixed assets/sales ratio = Actual fixed assets
Full capacity sales
= Br. 370,000 = 20%
Br. 1,836,735
iii) Determine the new required level of fixed assets.
Required level of = (Target fixed assets/sales ratio) X (Projected sales)
fixed assets
= 20% X Br. 1,980,000 = Br. 396,000
Previously Blue Nile forecasted it would need to increase fixed assets at the same rate as
sales or by 10%. That means, the firm forecasted an increase from Br. 370,000 to Br.
407,000. Now we see that the actual required increase is only from Br. 370,000 to Br.
396,000. Thus, the capacity adjust forecast is Br. 11,000 (Br. 407,00 Br. 396,000) less
than the earlier forecast. Therefore, the projected AFN would decline from an estimated
64
Br. 9,080 to Br. -1,920 (Br. 9,080 Br. 11,000). The negative AFN indicates the firm
would even produce excess funds of Br. 1,920 than it requires.
4.7 SUMMARY
The key concepts covered in this unit are summarized below

- Financial forecasts are very important for both profitability and value
maximization of a firm.
- Financial forecasting is a planning process which includes forecast of sales,
determining of capacities, and deciding on how to finance capacities (assets).
- The two most common methods of forecasting the financial requirement of a firm
are: (1) the projected financial statement method and (2) The formula method.
- The external capital requirement of a firm is affected by its sales growth rate,
capital intensity ratio, net profit margin, and dividend payout ratio.
- Adjustments must be made to the additional funds needed (AFN) of a firm if
excess capacity exists in the use of its fixed assets.
I. 1. An accurate financial forecast enables a firm to forecast sales accurately. An accurate

forecast of sales then allows appropriate forecasts of assets, costs, and expenses.
This in turn would affect the profitability as well as the wealth maximization goal.
2. The basic factors that affect the amount of interest expense are the amount or the
balance of the debt and the prevailing interest rate.
3. AFN = increase Increase in normally
in assets generated funds
Increase in assets = Br. 4,500,000 x 5% = Br. 225,000
Increase in normally Increase in Increase in

generated funds = spontaneous liabilities + retained earnings
= Br. 1,250,000 x 5% + (6% x Br. 5,000, 000 x 1.05) x (1 30%)
= Br. 62,500 + Br. 220,500
= Br. 283,000
65
Therefore, AFN = Br. 225,000 Br. 283,000 = -Br. 58,000. This tells us that Taha PLC
could generate Br. 58,000 more funds than it requires for achieving its sales plan; and that
is does not require any AFN.
II. 1. Because in the pro forma method all costs and expenses are forecasted in detail, but
in the formula method assumptions which might not hold practical are made.
2. If Selam Company has to increase sales without having to use additional funds
needed, AFN will be zero. Hence,
(A/S) S (L/S) S MS1 (1 d) = 0
 1.6 gs0 0.4gs0 Ms0 (1 + g) (1 d) = 0
 1.6gs0 0.4gs0 0.10s0 (1 + g) (1 0.45) = 0
 1.6gs0 0.4gs0 (0.10s0 0.10gs0) = 0
 1.2gs0 (0.055s0 0.055gs0) (0.55) = 0
 1.2gs0 0.055s0 + 0.055gs0 = 0
 1.255gs0 = 0.055s0
 1.255g = 0.055
 g = 0.055/1.255 = 4.38%.
III. When the firm starts paying at the end of each month, its balance of salaries payable
would be more than when it was paying weekly. The increase in salaries payable is an
increase in accruals which is a spontaneous finance. Finally, the increase in
spontaneous finance would cause the AFN to be smaller.
4.9
1. In determining the additional financial requirements (AFN) of a firm for a given period
under consideration,
A) The fixed assets are always forecasted to incase proportionally with sales.
B) The addition to retained earnings is forecasted as a specified percentage of sales.
C) AFN is simply computed by deducting spontaneous liabilities from the required
increase in the current level of assets
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2. Which of the following statement(s) is (are) true for a firm having sales expansion
plan, if its fixed assets operate below full capacity?
A) Fixed assets increase at a rate faster than sales growth rate.
B) Fixed assets increase at a rate slower than the growth of sales
C) Fixed assets are not affected by sales expansion plan
D) Fixed assets increase until full capacity sales are achieved
3. Which one of the following factors causes the AFN of a firm to be high?
A) Lower sales growth rate
B) Higher dividend payout ratio
C) Higher net profit margin
D) Lower capital intensity ratio
Part II. Problem

You are given below the condensed balance sheet and income statement of Addisalem
Auto Spare Parts, PLC for 2002
Balance sheet as of December 31,2002

Cash -------------------------Br. 90,000 Accounts payable -----------------Br. 180,000
Receivables -------------------180,000 Notes payable (10% interest) ----------78,000
Inventories --------------------360,000
--------------------360,000 Accruals ----------------------------------90,000
----------------------------------90,000
Current assets ------------Br. 630,000 Current liabilities -----------------Br. 348,000
Net fixed assets ------------720,000 Common stock --------------------900,000
_________ Retained earnings ---------------------102,000
---------------------102,000
Total assets ---------Br.
---------Br. 1,350,000 Total liabilities and equity ---Br.
---Br. 1,350,000
Income statement for year ended December 31, 2002

Sales -------------------------------Br. 1,800,000
67
Operating costs -----------------------1,625,000
-----------------------1,625,000
EBIT ---------------------------------Br. 175,000
Interest ------------------------------------25,000
------------------------------------25,000
EBT--------------------------------- Br. 150,000
Taxes (40%) -----------------------------60,000
-----------------------------60,000
Net income --------------------------Br.
--------------------------Br. 90,000
The firms common stock price during 2002 was Br. 24. Similarly earnings per share
(EPS) and dividends per share (DPS) were Br. 1.80 and Br. 1.08 respectively. Sales are
projected to increase by 10% in 2003. It is learned that assets are operating at full
capacity.
Required:
a) Determine the AFN using the pro forma method.
b) Assume 50% of the AFN will be financed by common stock and the common stock
price remains unchanged in 2003, how many share should Addisalem issue in 2003?
c) How does the financing of AFN through common stock affects the firms dividend as
well as its retained earnings?
d) Assume also that the remaining 50% is to be financed by notes payable, how does this
affect interest expense?
e) Determine the AFN using the formula method
f) If fixed assets were operating at only 96% of capacity during 2002, how does this
affect AFN? (Use the formula method)

1. Eugene F. Brigham (1997). Fundamental of Financial Management.
Dryden press Harcourt Brace College Publishers, Florida.
Finance. 3rd edition,
2. Halpern, Weston, and Brigham (1989). Canadian Managerial Finance.
Holt, Rinehart and Winston of Canada, Limited.
Management.
68
4.11 GLOSSARY
Proforma financial statements financial statements prepared for forecasted periods.

Sales targets a forecast of a firms sales in terms of both units and amounts.
Full capacity a situation where by all the assets of a firm are being utilized 100%.
Spontaneous finance a finance available to a firm as a direct or indirect result of a
sales increment decision of the firm.
Labor intensive highly utilizing labor force
Excess capacity a situation whereby some portion of a firms assets, particularly fixed
assets, are not currently utilized.
Fixed assets / Sales ratio the amount of fixed assets required per birr of sales.
69
UNIT 5: THE TIME VALUE OF MONEY
Contents
5.1 Introduction
5.2 Future Value
5.2.1 Future Value of a Single Amount
5.2.2 Future Value of an Annuity
5.2.3 Future Value of Uneven Cash Flows
5.3 Present Value
5.3.1 Present Value of a Single Amount
5.3.2 Present Value of an Annuity
5.3.3 Present Value of Uneven Cash Flows
5.3.4 Present Value of a Perpetuity
5.4 Summary
5.8 Glossary
5.0 AIMS AND OBJECTIVE
After completing this unit, students should be able to:
 appreciate the concept of the time value of money,

 understand the meaning of interest and differentiae between simple and
compound interests,
 differentiate among a single cash flow, an annuity and uneven cash flows,
 understand future and present values of various types of cash flows, and
 understand the techniques and applications of future and present values.
70
5.1 INTRODUCTION
Many decisions in finance involve choices of receiving or paying cash at different time
periods. As you recall from the discussions of the second unit, the goal of a firm is wealth
maximization. This goal recognizes the difference in the value of equal cash flows
received at different time periods. So the concept of the time value of money is that
money received now is generally better than the same amount of money received some
time later. This is because there is an opportunity to invest the money we have now and
earn a return on it. For example, if you have Br. 1,000 today, you could save it in a bank
and earn interest.
The time value of money is a very important concept in financial management. It has
many applications in financial decisions like loan settlements, investing in bonds and
stocks of other entities, acquisition of plant and equipment. Therefore, understanding the
time value of money concept is essential for a financial manager to achieve the wealth
maximization goal of a firm.
The first basic point in the concept of the time value of money is to understand the
meaning of interest. Interest is the cost of using money (capital) over a specified time
period. There are two basic types of interest: simple interest and compound. Simple
interest can be understood in two different ways. One is that simple interest is an interest
computed for just a period. If interest is computed for one period only, the interest is
always simple interest. Another way to understand simple interest is that it is an interest
computed for two or more periods whereby only the principal (original) value would earn
interest. In simple interest the previously earned interests do not produce another interest.
Compound interest, on the other hand, is an interest computed for a minimum of two
periods whereby the previous interests produce another interest for subsequent or next
periods. Here both the principal and previous interests bring additional interest.
Though we have discussed both simple and compound interest, in financial management
we are largely interested on compound interest. So in the sections that follow we shall
71
discuss the concepts and techniques of the time value of money in the context of
compound interest.
5.2 FUTURE VALUE
To understand future value, we need to understand compounding first. Compounding is a

mathematical process of determining the value of a cash flow or cash flows at the final
period. The cash flow(s) could be a single cash flow, an annuity or uneven cash flows.
Future value (FV) is the amount to which a cash flow or cash flows will grow over a
given period of time when compounded at a given interest rate. Future value is always a
direct result of the compounding process.
5.2.1 Future Value of a Single Amount
This is the amount to which a specified single cash flow will grow over a given period of
time when compounded at a given interest rate. The formula for computing future value
of a single cash flow is given as:
FVn = PV (1 + i)n
Where:
FVn = Future value at the end of n periods
PV = Present Value, or the principal amount
i = Interest rate per period
n= Number of periods
Or
FVn = PV (FVIFi,n)
Where:
(FVIFi, n) = The future value interest factor for i and n
The future value interest factor for i and n is defined as (1 + i)n and it is the future value
of 1 Birr for n periods at a rate of i percent per period.
72
Example: Hana deposited Br. 1,800 in her savings account in Meskerem 1990. Her
account earns 6 percent compounded annually. How much will she have in Meskerem
1997?
To solve this problem, lets identify the given items: PV = Br, 1,800; i = 6%; n = 7
(Meskerem 1990 Meskerem 1997).
FVn = PV (1 + i)n
= Br. 1,800 (1.06)7
= Br. 2,706.53
The (FVIFi,n) can be found by using a scientific calculator or using interest tables given
at the end of this material. From the first table by looking down the first column to period
7, and then looking across that row to the 6% column, we see that FVIF6%,7 = 1.5036.
Then, the value of Br. 1,800 after 7 years is found as follows:
FVn = PV (FVIFi,n)
FV7 = Br. 1,800 (FVIF6%, 7)
= Br. 1,800 (1.5036) = Br. 2,706.48
5.2.2 Future Value of an Annuity
An annuity is a series of equal periodic rents (receipts, payments, withdrawals, deposits)

made at fixed intervals for a specified number of periods. For a series of cash flows to be
an annuity four conditions should be fulfilled. First, the cash flows must be equal.
Second, the interval between any two cash flows must be fixed. Third, the interest rate
applied for each period must be constant. Last but not least, interest should be
compounded during each period. If any one of these conditions is missing, the cash flows
cannot be an annuity.
Basically, there are two types of annuities namely ordinary annuity and annuity due.
Broadly speaking, however, annuities are classified into three types:
i) ordinary annuity,
ii) annuity due, and
iii) deferred annuity
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i) Future value of an Ordinary Annuity An ordinary annuity is an annuity for which
the cash flows occur at the end of each period. Therefore, the future value of an
ordinary annuity is the amount computed at the period when exactly the final (nth) cash
flow is made. Graphically, future value of an ordinary annuity can be represented as
follows:
0 1 2 ------------------ n
PMT1 PMT2 ---------------PMTn
The future value is computed at point n where PMTn is made.

 (1  i )  1
n
FVAn = PMT  
 i 
Where:
FVAn = Future value of an ordinary annuity
PMT = Periodic payments
n = Number of periods
Or
FVAn = PMT (FVIFAi,n)
Where:
(FVIFAi, n) = the future value interest factor for an annuity
(1  i ) n  1
=
i
Example: You need to accumulate Br. 25,000 to acquire a car. To do so, you plan to
make equal monthly deposits for 5 years. The first payment is made a month from today,
in a bank account which pays 12 percent interest, compounded monthly. How much
should you deposit every month to reach your goal?
Given: FVAn = Br. 25,000; i = 12%  12 = 1%; n = 5 x 12 = 60 months; PMT = ?

FVAn = PMT (FVIFAi, n)
 Br. 25,000 = PMT (FVIFA, %, 60)
 Br. 25,000 = PMT (81.670)
74
 PMT = Br. 25,000/81.670
 PMT = Br. 306.11
ii) Future value of an Annuity Due.

Due. An annuity due is an annuity for which the
payments occur at the beginning of each period. Therefore, the future value of an
annuity due is computed exactly one period after the final payment is made.
Graphically, this can be depicted as:
0 1 2 --------------------- n
PMT1 PMT2 PMT3 ----------------------- PMTn + 1
The future value of an annuity due is computed at point n where PMTn + 1 is made
FVAn (Annuity due) = PMT (FVIFAi, n) (1 + i)
Or
 (1  i ) n  1
= PMT   ( 1 + i)
 i 
Example: Assume that pervious example except that the first payment is made today
instead of a month from today. How much should your monthly deposit be to accumulate
Br. 25,000 after 60 months?
FVAn (Annuity due) = PMT (FVIFAi, n) (1 + i)

 Br. 25,000 = PMT (FVIFAi, n) (1 + i)
 Br. 25,000 = PMT (81.670) (1.01)
 PMT = Br. 25,000/82.487
 PMT = Br. 303.08
iii) Future value of Deferred Annuity is an annuity for which the amount is computed
two or more period after the final payment is made.
0 1 2 ------------------n --------------n + x
PMT1 PMT2 PMTn
The future value of a deferred annuity is computed at point n + x

FVAn (Deferred annuity) = PMT (FVIFAi, n) (1 + i)x
75
 (1  i ) n  1 x
= PMT   (1 + i)
 i 
Where x = The number of periods after the final payment; and X  2.
Example: Henock has a savings account which he had been depositing Br. 3,000 every
year on January 1, starting in 1990. His account earns 10% interest compounded
annually. The last deposit Hencok made was on January 1, 1999. How much money will
he have on December 31, 2003? (No deposits are made after 1999 January).
Jan.
1990 1991 1992 93 94 95 96 97 98 99 2000 2001 02 03 2004
3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000
The future value is computed on December 31, 2003 (or January 1, 2004).
Given: PMT = Br. 3,000; i = 10%; n = 10; x = 5
FVAn (Deferred annuity) = PMT (FVIFAi, n) (1 + i)x
= Br. 3,000 (FVIFA 10%, 10) (1.10)5
= Br. 3,000 (15.937) (1.6105)
= Br. 76, 999.62
5.2.3 Future Value of Uneven Cash Flows
Uneven cash flow stream is a series of cash flows in which the amount varies from one
period to another. The future value of an uneven cash flow stream is computed by
summing up the future value of each payment.
Example: Find the future value of Br. 1,000, Br. 3,000, Br. 4000, Br. 1200, and Br. 900
deposited at the end of every year starting year 1 through year 5. The appropriate interest
rate is 8% compounded annually. Assume the future value is computed at the end of year
5.
76
0 1 2 3 4 5
1,000 3,000 4,000 1,200 900

FVIF8%, 4 Br. 1,000 (1,3605) = Br. 1,360.50
FVIF8%, 3 Br. 3,000 (1.2597) = 3,779.10
FVIF8%,2 Br. 4,000 (1.1664) = 4,665.60
FVIF8%, 1 Br. 1,200 (1.0800) = 1,296.00
Br. 900 (1.0000) = 900.00
FV = Br. 12,001.20
1. How much must you deposit now on January 1,1999 to have a balance of Br. 10,000
on December 31, 2003? Interest is compounded at an 8% annual rate.
2. XYZ company plans to accumulate Br. 500,000 to retire its long-term debt on
December 31, 2010. To achieve the plan, the company has just deposited Br. 100,000
today January 1,2003. But the company knows that this deposit alone would not
enable to achieve the target and wants to make equal annual deposits starting January
1,2005 until January 1,2010. Assuming the appropriate interest rate is 6%
compounded annually, how much should XYZ deposit every January so as to achieve
its plan?
5.3 PRESENT VALUE
Present value is the exact reversal of future value. It is the value today of a single cash
flow, an annuity or uneven cash flows. In other words, a present value is the amount of
money that should be invested today at a given interest rate over a specified period so that
we can have the future value. The process of computing the present value is called
discounting.
77
5.3.1 Present Value of a Single Amount
It is the amount that should be invested now at a given interest rate in order to equal the
future value of a single amount.
n
FVn  1 
PV =  FVn  
1  i  n  1 i 
Where:
PV = Present Value
FVn = Future value at the end of n periods
n = Number of periods
Or
PV = FVn (PVIFi, n)
Where:
(PVIFi, n) = The present value interest factor for i and n = 1/ (1 + i)n
Example: Zelalem PLC owes Br. 50,000 to ALWAYS Co. at the end of 5 years.
ALWAYS Co. could earn 12% on its money. How much should ALWAYS Co. accept
from Zelalem PLC as of today?
Given: FV5 = Br. 50,000; n = 5 years; i = 12%; PV = ?

PV = FV5 (PVIF12%, 5)
= Br. 50,000 (0.5674) = Br. 28,370
On January 1,1998, Moon Corporation sold a motor vehicle to Sun Company. Sun signed
a Br. 200,000 non-interest bearing promissory note due on January 1, 2001. The
prevailing interest rate for a similar note on January 1, 1998, was 9%. How much is the
selling price of the motor vehicle for Moon Corporation?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
78
5.3.2 Present Value of an Annuity
i) Present value of an Ordinary Annuity is a single amount of money that should be

invested now at a given interest rate in order to provide for an annuity for a certain
number of future periods.
 1 
1  1  i  n  1  1  i   n 
PVAn = PMT    PMT   = PMT (PVIFAi, n)
 i   i 
 
 
Where:
PVAn = The present value of an ordinary annuity
(PVIFAi, n) = The present value interest factor for an annuity
1  1  i 
n
=
i
Example: Ato Mengesha retired as general manager of Tirusew Foods Company. But he
is currently involved in a consulting contract for Br. 35,000 per year for the next 10 years.
What is the present value of Mengeshas consulting contract if his opportunity costs is
10%?
Given: PMT = Br. 35,000; n = 10 years; i = 10%; PVAn = ?

PVA10 = Br. 35,000 (PVIFA10%, 10)
= Br. 35,000 (6.1446) = Br. 215,061.
215,061. This means if the required rate of
return is 10%, receiving Br. 35,000 per year for the next 10 years is equal to receiving Br.
215,061 today.
How large must each annual payment be for a Br. 100,000 loan to be repaid in equal
installments at the end of each of the next 5 years? The interest rate is 10%, compounded
annually.
________________________________________________________________________
________________________________________________________________________
ii) Present value of an Annuity Due is the present value computed where exactly the
first payment is to be made. Graphically, this is shown below:
79
0 1 2 3 ---------------- n
PMT1 PMT2 PMTn
The present value of an annuity due is computed at point 1 while the present value of an
ordinary annuity is computed at point 0.
1  (1  i )  n 
PVAn = (Annuity due) = PMT   (1 + i) = PMT (PVIFAi, n) (1 + i)
 i 
Example: Ruth Corporation bought a new machine and agreed to pay for it in equal
installments of Br. 5,000 for 10years. The first payment is made on the date of purchase,
and the prevailing interest rate that applies for the transaction is 8%. Compute the
purchase price of the machinery.
Given: PMT = Br. 5,000; n = 10 years; i = 8%; PVAn (Annuity due) = ?

PVA (Annuity due) = Br. 5,000 (PVIFA 8%, 10) (1.08)
= Br. 5,000 (6.7101) (1.08) = Br. 36,234.54. So the cost of the
machinery for Ruth is Br. 36,234.54. We have identified the case as an annuity due rather
than ordinary annuity because the first payment is made today, not after one period.
Assume the above example except that the first payment is to be made after 1 year from
the date of purchase. How much would be the cost of the machinery now for Ruth
Corporation?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
iii) Present value of a Deferred Annuity is computed two or more periods before the first
payment is made.
1  (1  i )  n  -x -x
PVAn (Deferred annuity) = PMT   (1 + i) = PMT (PVIFAi, n) (1 + i)
 i 
80
Where x is the number of periods between the date when he first payment is made and
the date the present value is computed.
Example: Sefa Chartered Accountants has developed and copyrighted an accounting

software program. Sefa agreed to sell the copyright to Steel company for 6 annual
payments of Br. 5,000 each. The payments are to begin 5 years from today. If the annual
interest rate is 8%, what is the present value of the six payments?
0 1 2 3 4 5 6 7 8 9 10
PVAn = ? 5,000 5,000 5,000 5,000 5,000 5,000

X
Given: n = 6; PMT = Br. 5,000; X = 4; PVA6 (Deferred annuity) = ?

i = 8% PVA6 (Deferred annuity) = Br. 5,000 (PVIFA8%, 6) (1.08)-4
= Br. 5,000 (4.6229) (0.7350) = Br. 16,989.16
5.3.3 Present Value of Uneven Cash Flows
The present value of an uneven cash flow stream is found by summing the present values
of individual cash flows of the stream.
Example: Suppose you are given the following cash flow stream where the appropriate
interest rate is 12% compounded annually. What is the present value of the cash flows?
Year 1 2 3
Cash flow Br. 400 Br. 100 Br.300
Br. 400 (0.8929) PVIF12%, 1
81
= Br. 357.16
Br. 100 (0.7972) PVIF12%, 2
= Br. 79.72
Br. 300 (0.7118) PVIF12%, 3
= Br. 213.54
Br. 650.42
5.3.4 Present Value of a Perpetuity
A perpetuity is an annuity with an indefinite cash flows. In a perpetuity payments are

made continuously forever. The present value of a perpetuity is found by using the
following formula:
PV (Perpetuity) = Payment = PMT
Interest rate i
Example: What is the present value of a perpetuity of Br. 7,000 per year if the
appropriate discount rate is 7%?
Given: PMT = Br. 7,000; i = 7%;, PV (Perpetuity) = ?

PV (Perpetuity) = PMT = Br. 7,000 = Br. 100,000.
100,000. This means that
i 7%
receiving Br. 7,000 every year forever is equal to receiving Br. 100,000 now.
What do you think are some of the applications of the present value of a perpetuity?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
5.4 SUMMARY
- The time value of money analysis recognizes the difference among birrs received
or paid at different points in time.
- Future value is a direct result of the compounding process
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- Present value is a direct result of the discounting process
- Future value can be computed for a single cash flow, an annuity, and an uneven
cash flow stream.
- Present value can be computed for a single cash flow, an annuity, uneven cash
flows, and a perpetuity.
- Formulas are available for computing both present values and future values of
various types of given cash flows.
- A scientific calculator or interest tables can be applied to solve time value of
money questions.
- The longer the time period and the higher the interest rate, the larger the future
value. But the opposite is true for present values.
- The concepts and techniques of the time value of money have many applications
in financial management.
I.
1. Given: FV5 = Br. 10,000; n = 5 (January 1, 1999 to December 31, 2003); i= 8%; PV
=?
FV5 = PV (FVIF8%, 5)
 Br. 10,000 = PV (1.4693)
 PV = Br. 10,000 / 1.4693 = Br. 6,805.96
2. 2003 04 05 06 07 08 09 2010 2011 N.B. December21,2010 = January
1,2011
Br. 100,000 PMT PMT PMT PMT PMT PMT Br. 500,000
Br. 100,000 (FVIF6%, 8) + PMT (FVIFA6%, 6) (1.06) = Br. 500,000
 Br. 100,000 (1.5938) + PMT (6.9753) (1.06) = Br. 500,000
 Br. 159,380 + PMT (7.3938) = Br. 500,000
 PMT (7.3938) = Br. 340,620
 PMT = Br. 340,620  7.33938 = Br. 46,068.33
II.
The selling price of the motor vehicle is the present value of the promissory note.
83
Given: FV3 = Br. 200,000; i = 9%; n = 3 (Jan. 1,1998 to Jan. 1,2001); PV = ?
PV = FV3 (PVIF9%, 3)
= Br. 200,000 (0.7722) = Br. 154,440
III. The loan of amount of Br. 100,000 is the present value of the five equal annual
payments.
Given: PVA5 = Br. 100,000; n = 5; i = 10%; PMT = ?
PVA5 = PMT (PVIFA10%, 5)
 Br. 100,000 = PMT (3.7908)
 PMT = Br. 100,000  3.7908 = Br. 26,379.66
IV. Given: PMT = Br. 5,000; n = 10; i = 8%; PVAn = ?
When the payment is to start one year from the date of purchase, the cost of the
machinery would be the present value of an ordinary annuity rather than annuity due.
PVA10 = Br. 5,000 (PVIFA8%, 10)
= Br. 5,000 (6.7101) = Br. 33,550.50
V. Some of the applications of the present value of a perpetuity are when we compute the
value of an asset whose future cash flows are expected for an indefinite period like a
preferred stock and a common stock.
Problems
1. Meron started saving on January 1, 1996. Every month, she deposits Br. 150 in her
bank account, which earns 12% interest compounded monthly. On December 31, 1999,
she withdrew half of the balance in her bank account to invest somewhere else. How
much will Meron have in her bank account on December 31, 2004? (Meron has not
interrupted her monthly deposits).
2. Solomon decided to start a savings account on January 1, 1995. After making a yearly
deposit of Br. 15,000 for 3 years (Jan. 1, 1995 through Jan. 1, 1997); he left for abroad.
He returned home late 1998 and resumed his savings plan with quarterly deposits of Br.
3,000 each beginning January 1, 1999. The banks interest rate was 9% compounded
annually from January 1, 1995, through January 1, 1998, and 12% compounded
84
monthly there after. What is the balance in Solomons savings account on January 1,
2002?
3. You have just taken a 30-year mortgage loan for Br. 200,000. The annual interest rate
on the loan is 6% compounded monthly. How large is your monthly payment if the first
payment is to be made three months after you have taken the loan?
4. Nahom invests in a Br. 180,000 annuity insurance policy at 6% compounded monthly
on January 1, 1999. The first of 48 receipts from the annuity is payable to Nahom 12
months after the annuity is purchased. What will be the amount of each of the 48 equal
monthly receipts?
5. Mr. Atila acquired Demmy Textile Factory agreeing to pay Br. 1.5 million per year for
17 years starting the date of acquisition. Local newspapers reported Atila acquired
textile factory for Br. 25.5 million (1.5 million x 17). The appropriate interest rate is 9%
compounded annually. Do you agree with the newspapers? Why or why not?
6. You are trying to assess the value of a small merchandising company that is for sale.
The firm is expected to generate an annual cash flow of Br. 25,000 for an indefinite
time period. The rate of return required from the company is 10%. How much is your
assessment of the value of the company?
1. Aswath Damodaran (1997). Corporate Finance: Theory and Practice.

Practice. John Wiley
and Sons, Inc., New York.
Accounting. 9th edition,
2. Donald E. Kieso and Jerry J. Weygandt (1998). Intermediate Accounting.
John Wiley and Sons, Inc, New York.
3. Eugene F. Brigham (1997). Management. 7th edition, the
(1997). Fundamentals of Financial Management.
Dryden Press Harcourt Brace College Publishers, Florida.
5.8 GLOSSARY
Cash flow a cash inflow or a cash outflow. It is a periodic rent.
85
Rent a cash receipt, deposit, withdrawal, payment, cost etc.
Interest table a table in which the future or present values of just 1 birr are given at
different interest rates and over varying time periods.
Opportunity cost rate the rate of return on the best available alternative investment of
equal risk.
Payment (PMT) a series of equal cash flows at regular intervals
Uneven cash flow stream a series of cash flows in which the amount varies from one
period to another.
86
UNIT 6: VALUATION
Contents
6.1 Introduction
6.2 Bond Valuation
6.2.1 Basic Bond Valuation Model
6.2.2 Interest Rate on a Bond
6.3 Preferred Stock Valuation
6.3.1 Preferred Stock Valuation Model
6.3.2 Rate of Return on a Preferred Stock
6.4 Common Stock Valuation
6.4.1 Zero Growth Stock
6.4.2 Constant Growth Stock
6.4.3 Variable Growth Stock
6.5 Summary
6.9 Glossary
The main purpose of studying this unit is to achieve the following objectives:
 to appreciate one of the main applications of the concept of the time value of
money,
 to differentiate among a bond, a preferred stock, and a common stock,
 to identify the basic inputs in valuation of an asset,
 to understand the techniques of computing the value of a bond, a preferred stock,
and a common stock,
 to be able to interpret the values of financial assets,
87
 to understand how to determine the expected rate of return from investments in
bonds, preferred and common stocks.
6.1 INTRODUCTION
As you have seen in the previous accounting courses, the value of an asset is determined
based on its cost (historical cost). That means all the necessary expenditures incurred
from the time the asset is acquired until it is placed in operation will be the cost of the
asset. However, in financial management, the value of an asset is quite different.
Since finance is interested more on decision making rather than recording, the value of an
asset is determined before it is purchased. The purpose is to decide whether to acquire or
not to acquire the asset. Therefore, here the historical cost cannot be used as the value of
the asset. Rather, the value of the asset is determined by valuation.
Valuation is the process of determining the worth of any asset whose value is obtained
from future cash flows. Look, the value here is not historical cost. The value of any asset
in finance is the present value of all future cash flows it is expected to provide over the
relevant time period. This value is called intrinsic value. In the remainder of this unit, we
shall emphasize the intrinsic value of an asset.
The intrinsic value of an asset is determined based on three basic inputs: cash flows
(returns), time pattern of the returns, and the discount rate. The value of an asset is,
therefore, determined by discounting the expected cash flows to their present value. To
determine the present value, we use a discount rate appropriate based on the assets risk.
Value can be determined for any kind of asset like buildings, machineries, factories,
bonds, stocks etc. But in this unit, we will discuss the value of three financial assets:
bonds, preferred, and common stocks.
6.2 BOND VALUATION
Bond is a long-term debt instrument or security issued by businesses and governmental

units to raise large sums of money. Investment in a bond provides two types of cash
flows. One is the periodic interest payment by the issuing party. Another is the price paid
88
to the investor upon maturity. The first, i.e., the interest payment is based on the par value
of the bond and the coupon interest rate. The par value is the face value of the bond
which will be paid to the investor upon maturity. Par value is also called maturity value.
For instance if the par value of a bond is Br. 1,000, the issuer should pay the investor Br.
1,000 when the maturity date of the bond arrives. The coupon interest rate is the rate
which the issuer pays to the investor on the par value of the bond. If A Company invests
in a Br. 1,000 par value, 10-year, 8% coupon bonds of B Company, A shall receive Br. 80
(Br. 1,000 x 8%) per year for 10 years.
6.2.1 Basic Bond Valuation Model
The value of a bond is the present value of the periodic interest payments plus the present
value of the par value. The value of a bond can be computed using the following
equitation:
Bo = I(PVIFA kd,n) + M(PVIF kd,n)
where:
Bo = the value of the bond
I = interest paid each period = Par Value x Coupon interest rate
Kd = the appropriate interest rate on the bond
n = The number of periods before the bond matures
M = the par value of the bond
(PVIF kd,n) = The present value interest factor for an annuity at interest rate of kd per
1
1
period for n periods = (1  k d ) n
kd
(PVIFkd,n) = The present value interest factor at interest rate of kd per period for n
1
periods =
(1  k d ) n
Notice that we have used kd instead of i. This is because, generally, in financial

management k designates rate of return and the subscript d denotes debt security. So kd
designates the rate of return on a debt security.
89
Illustration: Tebaber Berta Corporation has a Br. 1,000 par value bond with an 8%
coupon interest rate outstanding. Interest is paid semiannually and the bond has 12 years
remaining to its maturity date.
Required: What is the value of the bond if the required return on the bond is 8%?
Solution:
Given: M = Br. 1,000; kd = 8% per year or 4% (8%2) per semiannual period; I = Br. 40
(Br. 1,000 x 4%); n = 24 semiannual periods (12 x 2); Bo =?
Bo = I(PVIFA kd,n) + M(PVIF kd,n)
= Br. 40(PVIFA4%, 24) + Br. 1,000(PVIF4%, 24)
= Br. 40 (15.2470) + Br. 1,000 (0.3901)
= Br. 1,000
If the appropriate discount rate (kd) remains constant at 8% (4% per semiannual period),
the value of the bond will not be changed. It will remain Br. 1,000. Suppose the
appropriate discount rate is 8% 2 years from now, what would be the value of the bond?
Solution: now n is reduced to 20[24-(2 x 2)]

Bo = Br.40 (PVIFA4%, 20) + Br. 1,000 (PVIF4%, 20)
= Br. 40 (13.5903) + Br. 1,000 (0.4564)
= Br. 1,000
Suppose the interest rate in the economy when Tebaber Bertas bonds were issued was
6% rather than 8%, what would be the value of the bond? Since Tebaber Bertas bond
now will be paying more interest than do other bonds in the market, the companys bond
will be selling at a larger price. Such bonds which are selling more than their par value
are called premium bonds. Here, kd is 6% (3% per semiannual payment), but other things
are not changed. So
Bo = Br. 40 (PVIFA3%, 24) + Br. 1,000 (PVIF 3%, 24)
= Br. 40 (16.9355) + Br. 1,000 (0.4919)
= Br. 1,169.32
90
So when the market interest rate (kd) is less than the coupon interest rate, the value of a
bond is always larger than the par value. An investor by deciding to invest his money on
Tebaber Bertas bond, he will receive a 1% (4% - 3%) more interest payment than he
would receive if he invested somewhere else. This allows the investor to receive Br. 10
[Br. 1,000 x (4% - 3%)] more every semiannual period. As a result, the investor would be
willing to give more price to the bond. The additional price is the present value of each
Br. 10 he is going to receive for the next 24 semiannual periods. Therefore, the value of a
premium bond can also be computed as:
Bo = Br. 1,000 + Br. 10 (PVIFA3%, 24)
= Br. 1,000 + Br. (16.9355)
= Br. 1,169.36*
1,169.36*
* The previous value was Br. 1,169.32. The difference is due to rounding problem.
Assuming the interest rate remains constant at 6% for the next 11 years (12 periods),
what would happen to Tebaber Bertas bond?
Bo = Br. 40 (PVIFA3%, 22) + Br. 1,000 (PVIF3%, 22)
= Br. 1,159.38
Thus, the value of the bond would fall form Br. 1,169.32 to Br. 1,159.38. If you calculate
the value of the bond at other future dates, the price would continue to fall as the maturity
date approaches.
Had the interest rate (kd) was 10% when Tebaber Bertas bond was selling, the value of
the bond would be:
Bo = Br. 40 (PVIFA5%, 24) + Br. 1,000 (PVIF5%, 24)
= Br. 40 (13.7986) + Br. 1,000 (0.3101)
= Br. 862.04.
862.04. Since Tebaber Bertas bond now will be paying less interest than
do other bonds in the market, they are selling at a smaller price (discount bond).
If the interest rate remain constant at 10% for the next 11 years (22 periods), the value of
Tebaber Bertas bond would be Br. 868.32. Thus, the value of the bond will have risen
from Br. 862.04 to Br. 868.32. If you further calculate the value of the bond at other
future dates, the price would continue to rise as the maturity date approaches.
91
Check Your Progress 1
1. When is a bond selling at premium, at par value, and at discount?

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2. Amha Corporation issued a new series of bonds on January 1, 1985. The bonds were
sold at their par of Br. 1,000, have 12% coupon, and mature in 20 years. Coupon
payments are made quarterly. What was the price of the bond on December 31, 1989,
assuming that the level of interest rate had fallen to 8%?
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6.2.2 Interest Rate on a Bond
So far we have been seeing how to determine the value of a bond if we are given the par
value, the coupon interest rate, the number of periods, and the interest rate on the bond.
Next, we shall discuss on how to find the interest rate on a bond, i.e., k d if we are given
the value of the bond. We will consider yield to maturity and yield to call.
Yield to Maturity (YTM) is the rate of return investors earn if they buy a bond at a
specific price Bo and hold it until maturity. The approximate YTM can be found using the
following approximation formula:
M  Bo
I
n
Approximate YTM =
M  Bo
2
Example: Zebra Company has a Br. 1,000 par value, 10% coupon interest rate, and 15
years to maturity. The bond is currently selling at Br. 1,090. Compute the YTM.
Solution:
Given: M = Br. 1,000; I = Br. 100 (Br. 1,000 x 10%); n = 15; Bo = Br. 1,090; YTM = ?
92
Br.1,000090
Br.100 
15  9%
Approximate YTM =
Br.1,000  Br.1,090
2
If an investor buys Zebras bond at Br. 1,090 and holds it for 15 years, the approximate
yield or rate of return per year is 9%.
Yield to call (YTC) is the rate of return earned by an investor if he buys a bond at a
specified price, Bo, and the bond is called before its maturity date. YTC, therefore, is
computed only for callable bonds. A callable bond is a bond which is called and retired
prior to its maturity date at the option of the issuer. A bond is called by an issuer when the
market interest rate falls below the coupon interest rate. The YTC can be found by
solving the following equation.
Call Pr ice  Bo
I
n
Approximate YTC =
Call Pr ice  Bo
2
Example: X Company is intending to purchase Y Companys outstanding bond which
was issued on January 1, 1997. Y bond is a Br. 1,000 par value, has a 10% annual
coupon, and a 30 year original maturity. There is a 5-year call protection, after which
time the bond can be called at 108. X company is to acquire the bond on January 1, 1999
when it is selling at Br. 1,175.
Required: Determine the yield to call in 1999 for Y company bond.

Solution:
Given: I = Br. 100 (Br. 1,000 x 10%); Bo = Br. 1,175; call price = Br. 1,080 (Br.
1,000 x 108%);
n = 3 (call protection 2 years elapsed since the bond was issued); YTC
=?
Br.1,080  Br.1,175
Br.100 
3  6.06%
Approximate YTC =
Br.1,080  Br.1,175
2
If X Company buys Y Company bond and holds the bond until the bonds are called by Y
Company, the approximate annual rate of return would be 6.06%.
93
Check Your Progress 2
1. The Salem Company bond currently sells for Br. 955, has a 12% coupon interest rate
and Br. 1,000 par value, pays interest annually, and has 15 years to maturity. Calculate the
yield to maturity on this bond.
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2. Allied Company has just issued 10,000 bonds of Br. 1,000 par value each. The bonds
have original maturity of 50 years and an annual coupon rate of 15%. There is a 10 year
call provision on the bonds. 3 years after the bonds had been issued, they were selling at
Br. 1,300 each. The call price for each bond is 109 ¾. Calculate the yield to call on Allied
bonds.
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6.3 PREFERRED STOCK VALUATION
Preferred stock is a type of equity security that provides its owners with limited or fixed
claims on a corporations income and assets. Investment in a preferred stock provides a
single cash flow, i.e., constant periodic dividend payments. Preferred stock has
similarities to both a bond and a commn stock. As to similarities to a bond, preferred
dividends are fixed in amount and are like interest payments. As to a common stock, the
preferred dividends are paid for an indefinite time period.
6.3.1 Preferred Stock Valuation Model
The value of a preferred stock is the present value of all future preferred dividends it is
expected to provide over an infinite time horizon. Most preferred stocks entitle their
owners to regular and fixed dividend payments. If the payments last forever, the issue is a
perpetuity. Therefore, the value of a preferred stock is found by the following formula:
Dps
VPS = Kps
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Where:
Vps = Value of the preferred stock
Dps = Preferred stock dividends
Kps = The required rate of return on the preferred stock
Example: Abebe wishes to estimate the value of its outstanding preferred stock. The
preferred issue has a Br. 80 par value and pays an annual dividend of Br. 6.40 per share.
Similar-risk preferred stocks are currently earning a 9.3% annual rate of return. What is
the value of the outstanding preferred stock?
Solution:
Given: Dps = Br. 6.40; Kps = 9.3%; Vps =?
Br.6.40
Vps = = Br. 68.82
9.3%
So the Br. 6.40 annual dividend an investor receives for an infinite years is equal to
todays Br. 68.82 if the required rate of return is 9.3%.
6.3.2 Rate of Return on a Preferred Stock
To evaluate the worthiness of investment in a preferred stock in comparison to other

investment opportunities, we should be able to compute the rate of return on a preferred
stock. If we know the current price of a preferred stock and its dividend, we can compute
the expected rate of return on the preferred stock. This can be done using the following
formula:
Dps
Kps = Vps
Where
Kps = The expected rate of return on the preferred stock
Dps = Preferred stock dividends
Vps = Value or current price of the preferred stock
Example: A preferred stock pays an annual dividend of Br. 9 and the current market price
is Br. 81. Compute the required rate of return from the preferred stock.
Solution:
95
Given: Dps = Br. 9; Vps = Br. 81; Kps =?
Br.9
Kps = = 11.11%
Br.81
For an investor to invest Br. 81 in this preferred stock and to receive an annual dividend
of Br. 9, his minimum required rate of return is 11.11%.
6.4 COMMON STOCK VALUATION
The value of a share of common stock is the present value of the common stocks
dividend expected over an infinite time horizon. The value of a share of common stock is
also equal to the sum of the present value of the expected dividends and the present value
of the expected selling price of the stock. The selling price in turn will depend on the
dividends to be received by the purchasing party.
To understand the value of a common stock we should keep in mind two points. First, the
dividends are expected for an infinite time period. Second, the dividends are not constant.
Therefore, the value of a common stock is found by summing the present values of
annual dividends.
D1 D2 D
Po =  
(1  ks) 1
(1  ks) 2
(1  ks) 
Where:
Po = Value of the common stock at time zero (as of today)
D1, D2, , D = Pre share dividend expected at the end of each year
Ks = the required rate of return on the common stock.
The common stock valuation equation can be simplified by redefining each years
dividend. The dividends are defined in terms of anticipated dividends growth. Generally,
there are three cases accordingly. These are:
1. Zero growth common stock,
2. Constant growth common stock, and
3. Variable growth common stock.
Hence, common stock valuation approaches are developed under each of the above
dividend growth models. Next sections will discus each model one by one.
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6.4.1 Zero Growth Stock
A zero growth stock is a common stock whose future dividends are not expected to grow
at all. The expected growth rate (g) is zero. This is the simplest model to common stock
valuation. It assumes a constant, non-growing annual dividend. So here the annual
dividends are all equal. That is D1 = D2 = = D = D.
A common stock with zero growth rate is a security that is expected to provide a fixed
dividend each year. Hence, a zero growth common stock is a perpetuity. Therefore, the
value of a zero growth stock is given as:
D
Po =
Ks
Example: The most recent common stock dividend of Shalom Manufacturing
Corporation was Br. 3.60 per share. Due to the firms maturity as well as stable sales and
earnings, the dividends are expected to remain at the current level of the foreseeable
future.
Required: Determine the value of Shaloms common stock for an investor whose
required return is 12%.
Solution:
Given: D = Br. 3.60; Ks = 12%; Po =?
Br.3.60
Po = = Br. 30
12%
The maximum price the investor would be willing to pay for a share of Shaloms common
stock is Br. 30 for he to receive a Br. 3.60 annual dividend for an indefinite years.
6.4.2 Constant Growth Stock
Constant growth stock is a common stock whose future dividends are expected to grow at
a constant dividend growth rate (g). It is sometimes called normal growth stock. The
97
constant (normal) growth common stock valuation model is the most widely cited
approach to common stock valuation.
The value of a constant growth stock is the present value of the expected future dividends
growing at a constant rate of g. Here the value can be found by using the following
formula:
D1
Po = ; Ks > g
Ks  g
Where:
D1 = The expected dividend at the end of year 1.
g = The expected growth rate in dividends.
D1 = Do(1+g), where Do is the most recent dividend. Similarly D2 = D1 (1+g) and so on.
To find the value of a common stock (constant growth) at one year, first, find the
expected dividend at the end of next year.
Example: Zeila Motor Corporations common stock currently pays an annual dividend of
Br. 5.40 per share. The dividends are expected to grow at a constant annual rate of 5% to
infinity. Estimate the value of Zeilas common stock if the required return is 12%.
Solution:
Given: Do = Br. 5.40; g = 5%; Ks = 12%; Po =?
D1
Po = ; D1 = Do (1+g0) = Br. 5.40 (1.05) = Br. 5.67
Ks  g
Br.5.67
= = Br. 81
12%  5%
For an investor to receive an annual dividend of Br. 5.40 growing at 5% constantly to
infinity, the maximum price he would pay today is Br. 81.
If we are given the value of a constant growth stock, the most recent dividend, the
expected dividend growth rate, we can compute the expected rate of return as follows.
D1
Ks = g
P0
Where:
Ks = The expected rate of return on a constant growth stock
98
D1/P0 = Expected dividend yield.
g = Expected dividend growth rate = capital gains yield.
Example: Assume the above example except that you are given the value of common
stock of Br. 81 instead of the required return. Compute the expected rate of return?
Br.5.40 (1.05)
Ks = + 0.05
Br.81
= 12%
6.4.3 Variable Growth Stock
Variable growth stock is a stock whose dividends are expected to grow at variable or non-
constant rates. The model of common stock valuation that allows for a change in the
dividend growth rate is called Variable (non constant) Growth Model. It sometimes is
also called supernormal growth model.
The value of a share of variable growth stock is determined by following 4 procedures.

1. Find the value of the dividends at the end of each year during the initial growth period.
2. Find the present values of the dividends found in step 1.
3. Find the value of the stock at the end of the initial growth period
4. Add the present value of the dividends found in step 2 and the present value of the
value of the stock found in step 3 to determine the value of the stock at time zero, i.e.
po.
Example: Addis Companys most recent annual dividend, which was paid yesterday, was
Br. 1.75 per share. The dividends are expected to experience a 15% annual growth rate
for the next 3 years. By the end of 3 years growth rate will slow to 5% per year to
infinity.
Stockholders require a return of 12% on Addis stock
Required: Calculate the value of the stock today.

Solution:
99
Given: Do = Br. 1.75; g1 = 15% for 3 years; g2 = 5% from year 3 to infinity; k 5 = 12%; p0
=?
g1 = 15% g2 = 5%
Year 0 1 2 3 
D0 = Br. 1.75 D1 = Br. 2.01 D2 = Br. 2.31 D3 = Br. 2.66
PV of D1 = Br. 1.79 PVIF 12%, 1
PV of D2 = 1.84 PVIF 12%, 2
PV of D3 = 1.89 PVIF 12%, 3
PV of P3 = 28.40 PVIF 12%, 3 P3 = Br. 39.90
P0 = Br. 33.92
D1 = D0 (1 + g1) = Br. 1.75 (1.15) = Br. 2.01
D2 = D1 (1 + g1) = Br. 2.01 (1.15) = Br. 2.31
D3 = D2 (1 + g1) = Br. 2.31 (1.15) = Br. 2.66
D4 D3 (1  g 2 ) Br.2.66 (1.05)
P3 =    Br.39.90
k5  g 2 k5  g 2 0.12  0.05
Therefore, the value of Addis Companys common stock today is Br. 33.92
Check Your Progress III
1. You are considering the purchase of Zemen company common stock that paid dividend
of Br. 2 yesterday. You expect the dividend to grow at the rate of 5% per year for the
next 3 years, and, if you buy the stock, you plan to hold it for 3 years and then sell it.
Calculate the value of the common stock if your required rate of return is 15%
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2. Melat computers Incorporated is experiencing a period of rapid growth. Earnings and
dividends are expected to grow at 15% rate during the next 2 years, at 13% in the third
year, and at a constant rate of 6% thereafter. Melats last dividends was Br. 1.15, and the
required rate of return on the stock is 12%. Calculate the value of the stock today.
100
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3. Can we compute the value of a common stock whose future dividends are expected to
decline at a constant rate?
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6.5 SUMMARY
The main points covered in unit 6 are the following:

- Valuation determines the value of an asset based on its future cash flows, their
timing and associated risk.
- The value of an asset is the present value of expected future cash flows discounted
by an appropriate required rate of return.
- The value of a bond is the present value of interest payments and maturity value
- The value of preferred stock is the present value of expected preferred dividends.
- The value of a zero growth stock is the present value of expected fixed dividends.
- The value of a normal growth stock is the present value of expected dividends
which are growing at a constant rate.
- The present value of a variable growth stock is computed by following 4 basic
steps.
- In a constant growth stock, the required rate of return should always be greater
than the expected dividends growth rate. That is ks > g
I.
1. A bond is selling at premium when the market interest rate or required rate of return
(kd) is less than the coupon interest rate, at discount when kd is greater than coupon
interest rate, and at par value when kd is equal to coupon rate.
101
2. Given: M = Br. 1,000; kd = 2% (8%  4); I = Br. 30 (Br. 1,000 x 12%/4); n = 60 (15 x
4) five years have passed (Jan. 1, 1985 to Dec. 31, 1989) since the bond was issued B0 = ?
B0 = Br. 30 (PVIFA 2%, 60) + Br. 1,000 (PVFI2%, 60)
= Br. 30 (34.7609) + Br. 1,000 (0.3048)
= Br. 1,347.63
II.
1. Given M = Br. 1,000; I = Br. 120 (Br. 1,000 x 12%); n = 15; B0 = Br. 955; YTM = ?
Br.1,000  Br.955
Br.120 
15  12.58%
Approximate YTM =
Br.1,000  Br.955
2
2. Given: I = Br. 150 (Br. 1,000 x 15%); B 0 = Br. 1,300; call price = Br. 1,097.50 (Br.
1,000 x 109 ¾%) n = 7 (10 3); YTC = ?
Br .1,097.50  Br .1,300
Br.150 
Approximate YTC = 7  10.10%
Br.1,097.50  Br .1,300
2
III.
1. Value of common stock = PV of D 1 + PV of D2 + PV of D3 + PV of P3. But P3 i.e. the
selling price at the end of 3 years = the PV at the end of year 3 of D 4, D5, ----, D.
Therefore, the value of common stock = PV of D1 + PV of D2 + ---- + PV of D.
Whether you hold the common stock for 3 years of for indefinite, the value of common
stock is the same.
Given: D0 = Br. 2; g = 5%, ks = 15%; P0 = ?
D1 D (1  g ) Br.2 (1.05)
P0 =  0   Br.21
Ks  g Ks  g 15%  5%
2. Given: D0 = Br. 1.15; g1 = 15%; g2 = 13%; g3 = 6%; Ks = 12%; P0 = ?

g1 = 15% g2 = 13% g3 = 6%
Year 0 1 2 3 
D0 = Br. 1.15 D1 = Br. 1.32 D2 = Br. 1.52 D3 = Br. 1.72
PV of D1 = Br. 1.18 PVIF12%, 1
102
PV of D2 = Br. 1.21 PVIF12%, 2
PV of D3 = 1.22 PVIF12%, 3
PV of P3 = 21.63 PVIF12%, 3 P3 =
D4 P0 = Br. 25.24
 Br.30.39
Ks  g
D1 = Br. 1.15 (1.15) = Br. 1.32; D2 = Br. 1.32 (1.15) = Br. 1.52; D3 = Br.
1.52(1.13) = Br. 1.72
P3 = Br. 1.72 (1.06) = Br. 30.30
12% - 6%
3. Yes we can compute using the constant growth stock model. The only thing new here is
that the expected growth rate (g) will be negative.
Exercise
1. Selam Household Utensils Manufacturing Company is currently selling its common
stock at Br. 108. the firms last earnings per share was Br. 18 and its dividend payout ratio
was 60%. The required rate of return on the stock is 12%. Selams dividends are expected
to grow at a constant rate.
Required: Determine:
a) The expected dividends growth rate (g)
b) The expected stock price of Selam Company after 3 years
2. Bonds issued by Berhan Company have a par value of Br. 5,000. The bonds are
currently selling for Br. 4,250. They have 10 years remaining to maturity. The annual
interest payment is 9%.
3. A firm pays Br. 2.45 dividend per share at the end of next year on a common stock that
has a selling price of Br. 35. The dividends of the firm are expected to grow at a
constant rate of 6%. Compute the required rate of return on the stock (ks).
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4. Ibex Motor corporation issued bonds with a 20-year maturity, a Br. 1,000 par value, a
10% coupon rate, and semiannual interest payments. Two years after the bonds were
issued, the market interest rate dropped to 6%.
Required: Determine the value of each bond

a) at the time the bonds were sold
b) two years after issuance
1. Aswath Damodaran (1997). Corporate Finance: Theory and Practice.

Practice. John Wiley
and Sons, Inc., New York
Dryden Press Harcourt Brace College Publishers, Florida.
3. Halpern, Weston and Brigham (1989). Canadian Managerial Finance. 3rd edition,
Holt Rinehart and Winston of Canada, Limited
Policy. 8th edition, Prentice
4. James C. Van Horne (1989). Financial Management and Policy.
Hall.
Finance. 8th edition, Addison
Wesley Longman, Inc.
6. Belayneh, Endale, Fasil and Hassen (2003). The impact of Ordinary Shares
Valuation on the Capital Structure of Ethiopian Companies: A Case Study on
Four Private Financial Institutions.
Institutions. Unpublished Material, Addis Ababa University.
6.9 GLOSSARY
Intrinsic value the present value of expected future cash flows discounted by an
appropriate discount rate.
Discount rate a rate based on the riskness of an asset used to determine the present
value.
Maturity date a specified date on which the par value of a bond must be repaid.
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Coupon rate a rate of interest payment specified on a bond.
Market interest rate the interest rate on bonds available in the market whose risk is
similar to the bond under consideration. It is a discount rate on a bond issue.
Premium bond a bond selling at a price above its par value.
Discount bond a bond selling at a price below its par value.
Yield the rate of return on any investment
Supernormal growth a growth which is more than the average of normal companies in
the industry.
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UNIT 7: CAPITAL STRUCTURE AND LEVERAGE
Contents
7.1 Introduction
7.2 The Target Capital Structure
7.3 The Concept of Leverage
7.3.1 Operating Leverage
7.3.2 Financial Leverage
7.4 Capital Structure Theory
7.4.1 Trade-Off Theory
7.4.2 Signaling Theory
7.5 Factors in Capital Structure Decisions
7.6 Summary
7.9 Glossary
At the end of this unit you should be able to understand the following:
 the meaning and concept of capital structure
 the impact of capital structure on value of a firm
 the concept of operating and financial leverage
 the interpretation and properties of operating and financial leverage
 how to determine the optimal capital structure
 two basic theories of capital structure
 factors to be considered in setting capital structure
7.1 INTRODUCTION
In unit 8 when we will calculate the weighted average cost of capital for use in capital
budgeting, we will take the capital structure weights, or the mix of securities the firm
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uses to finance its assets, as a given. However, if the weights are changed, the calculated
cost of capital and thus the set of acceptable projects, also will change. Further changing
the capital structure will affect the riskness of the firm common stock, and this will affect
Ks and Po. Therefore, the choice of a capital structure is an important decision.
7.2 THE TARGET CAPITAL STRUCTURE
A firm analyzes a number of factors, and then it establishes a target capital structure. This
targest may change over time as conditions vary, but at any given moment the firm s
management has a specific capital structure in mind. If the actual debt ratio is become the
target level, expansion capital will probably be raised by issuing debt, whereas if the debt
ratio is above the target, equity will probably be used.
Capital structure policy involves a trade-off between risk and return:

 Using more debt raises the riskness of the firms earnings stream
 However, a higher debt ratio generally leads to a higher expected rate of return
Higher risk tends to lower a stocks price, but higher expected rate of return raises it.
Therefore, the optimal capital structure strikes a balance between risk and return so as to
maximize a firms stock price.
Four primary factors influence the capital structure decision

1. Business risk,
risk, or the riskness inherent in the firms operations if it used no debt.
The greater the firms business risk, the lower its optimal debt ratio.
2. The firm s tax position . A major reason for using debt is that interest is
deductible, which lowers the effective cost of debt. However, if much of a firm s
income is already sheltered from taxes by depreciation tax shields or tax loss
carry-forwards, its tax ratio will be low, so debt will not be as advantageous as it
would be to a firm with a higher effective tax rate.
3. Financial flexibility,
flexibility, or the ability to raise capital on reasonable terms under
adverse conditions.
conditions. Corporate treasures know that a steady supply of capital is
necessary for stable operations, which is vital for long-run success. They also
know that when money is tight in the economy, or when a firm is experiencing
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operating difficulties, suppliers of capital prefer to provide funds to companies
with strong balance sheet. Therefore, both the potential further need for funds and
the consequences of a funds shortage have a major influence on the target capital
structure the greater the probable future need for capital, and the worse the
consequences of a capital budget, the stronger the balance sheet should be.
4. Managerial conservatism or aggressiveness.
aggressiveness. Some managers are more
aggressive than others, hence some firms are more inclined to use debt in an effort
to boost profits. This factor does not affect, the optimal, or value- maximizing,
capital structure, but it does influence the target capital structure.
These four points larger determine the target capital structure, but operating conditions
can cause the actual capital structure to vary from the target.
Check your progress 1
In what sense does capital structure policy involve a trade-off between risk and return?
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7.3 THE CONCEPT OF LEVERAGE
The leverage concept is very general. It is not unique to business or finance, and it can be
used to analyze many different types of problems. For example, other disciplines, such as
economics and engineering, use the same concept, and refer to it as elasticity. When used
in a financial setting, leverage measures the behavior of interrelated variables, such as
output, revenue, earnings before interest and taxes (EBIT), and earnings per share (EPS).
The material in this chapter will be easier to understand if two points are kept in mind.
1. Leverage measures the relationship between two variables, as opposed to

measuring variables independently, and the value that one variable assumes must
depend on the values assume by the second variable.
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2. In order for leverage coefficients to have any useful applications, it must be
possible to identify which variable is the dependent variable. In other words, the
direction of casualty must be known. When two variables are so related, the
degree of leverage describes the responsiveness of the dependent variable to
change in the independent variable.
Let Y and X represent two variables. When the values taken by Y are determined by the
values taken by X, Y is said to be dependent on X. accordingly, Y is called the dependent
variable and X is referred to as the independent variable. The algebraic statement of Y s
dependence on X is written as:
Y = f (x)
And is read as: Y is a function of X
Suppose that the initial values of Y and X are known. The independent variable X now
takes on a new value. The change in the value of X and its percentage change are
computed. The resulting change and percentage change are also computed. Leveraged is
then defined as the percentage change in the dependent variable Y divided by the
percentage change in the independent variable X. in algebraic terms, the definition of
leverage is developed as follows:
Let x = the change in the independent variable x

y = the change in the dependent variable y.
x
= the percentage change in x = % x
x
y
y
= the percentage change in y = % y
Then,
L ( y) y / y

L ( x) x / x
The left hand side of the above equation is read as: the leverage of y with respect to x.
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7.3.1 Operating Leverage
Operating Leverage measures the relationship between output and Riming before interest
and tax (EBIT), specifically; it measures the effect of changing levels of output on EBIT.
The functional relationship between these two variables is:
y = f (T),
Where, y = earning before interest and tax
T = number of units of output produced and sold
Earning before interest and tax = Total revenue Total variable cost fixed cost.
When the level of output changes from its initial value, the initial value of EBIT also
changes. Thus, operating leverage is defined as the resulting percentage change in EBIT
divided by the percentage change in output, symbolically, operating leverage is expressed
as:
L ( y) y / y %  EBIT
 
L (T ) T / T %  output
Example: Assume that the price per unit of output (p) is Br. 10, and variable cost per unit
of output (y) is Br. 4, and fixed cost (F) is Br. 30,000, and the level of output (T) is 8000
units. By using the formula EBIT is computed as follows:
y = Total revenue Total variable cost fixed cost
y = TP TV F
or y = T (P V) F
y = 8000 (Br. 10 Br. 4) Br. 30,000
= Br. 18,000
Now assume that the level of output increases from 8000 to 10,000 units. The resulting
EBIT is computed as:
y = 10,000 (Br. 10 Br. 4) Br. 30,000
= Br. 30,000
The coefficient of operating leverage is computed as follows:

Percentage change in output = 2000/8000 = 25%
Percentage change in EBIT = Br. 12000/Br. 18000 = 66.7%
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L( y ) y / y

L (T ) T / T
L ( y) .667
 = 2.67
L (T ) .25
The coefficient of operating leverage of 2.67 is interpreted as follows. A 1 percent change

in output from an initial value of 8000 units produces a 2.67 percent change in EBIT.
Since output increased by 25 percent from its initial value of 8000 units, EBIT increases
by (2.67) (.25) = .667 or 66.7 percent.
Measurement equations equivalent to the definitional equations are used to compute and
to explain the properties of operating leverage. The measurement equation used when the
income statement relationship is describes as follows:
T (P  V )
(OL/T) = T ( P  V )  F
The left hand side of the equation is read as: operating leverage, given the value of
output.
B1 putting the date of the previous example the above equation can be illustrated as
follows:
8000 ( Br.10  Br.4)
(OL/T = 8000) = 8000 ( Br.10  Br.4)  30,000  2.67
Properties of Operating Leverage
The properties of operating leverage determine its use and a tool of financial analysis.
These properties are best explained by using operating breakeven and EBIT, operating
breakeven is defined as the value of output that makes EBIT equal to zero. At this level of
output, total revenue is just sufficient to pay operating variable and fixed costs, and no
earnings are available to cover financial costs, when output exceeds operating breakeven,
the total revenue that is generated provides a positive level of EBIT; below operating
breakeven, the firm incurs an operating loss. The operating breakeven is expressed as
follows:
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T (P V) F = 0
and solving for T yields
F
T = P V
Example Assume that P = Br. 25, V = Br. 10, and F = Br. 60,000. Operating breakeven
is calculated as follows:
Br.60,000
T = Br.25  Br.10  4000 units
If operating leverage is calculated at operating breakeven, the coefficient of operating

leverage would be:
4000 ( Br.25  Br.10)

4000 ( Br.25  Br.10)  60,000
(OL/T = 4000)
Br.60,000
  undefined
0
Note that the coefficient of operating leverage at operating breakeven has undefined
value, not a value of zero.
Interpretations of operating leverage

 Fundamental interpretation: - The percentage change in EBIT that results from a
given percentage change in output it equal to the value of operating leverage at
the initial value of output multiplied by the percentage change in output.
 Related interpretations: -
1- A positive coefficient of operating leverage indicates that the leverage is
being computed at a level of output greater than operating breakeven.
2- A negative coefficient of operating leverage indicates that leverage is being
computed at a level of output below operating breakeven
3- A large absolute value of operating leverage (the coefficient of operating
leverage without regard to its algebraic sing) indicates that output is close to
operating breakeven and that the absolute size of EBIT is relatively small
4- A positive coefficient of operating leverage close to 1.0 indicates that
output is relatively far above operating breakeven and that the amount of
EBIT is relatively large.
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5- If a high percentage of a firms total costs are fixed, the firm is said to have
a high degree of operating leverage.
A high degree of operating leverage, other things hold constant, means that a
relatively small change in sales will result in a large change in operating
income.
1. A firms production costs are as follows:

F = Br. 4,800,000
V = Br. 26
What is the operating breakeven with a selling price of Br. 51 per unit?
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2. Coefficient operating leverage for selected values of output are contained in the first
two columns of the following table
T OL/T OL/T
before after
authomation authomation
225,000 6.82 13.00
250,000 4.31 5.91
275,000 3.31 4.09
A firm decides to automate a portion of its production process. As a result, fixed costs
increases to Br. 5,400,000, but the unit variable cost decreases to Br. 25. What is the new
operating breakeven?
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7.3.2 Financial Leverage
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Financial leverage measures the relationship between EBIT and earning per share (EPS).
Specifically, it reflects the effect of changing levels of EBIT on EPS. The functional
relationship between these two variables is:
EPS = f (EBIT)
and the income statement relationship is: -
Profit before taxes:
EBIT interests on debt = Y I
Federal income taxes:
(profit before taxes) (tax rate) = (Y I) (t)
profit after tax:
profit before taxes federal income taxes
(Y I) (Y I) (t) or
(Y I) (1 t)
Earning available to common shareholders
profit after taxes preferred stock dividends
(Y I) (1 t) E
Earning per share of common stock:
Earning available to common shareholders
number of common shares issued
EPS = (Y I) (1 t) E
N
The algebraic equivalent of the complete income statement is obtained by substituting the
symbolic form of EBIT as follows:
[T ( P  V )  F  I ] (1  t )  E
EPS =
N
When the level of EBIT changes from its initial value, the initial value of EPS also
changes. Financial leverage is thus defined as the resulting percentage change in EPS
divided by the percentage change in EBIT. Symbolically, financial leverage is expressed
as:
L ( EPS ) EPS / EPS % EPS
 
L ( EBIT ) EBIT / EBIT % EBIT
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Note that EBIT is the independent variable when measuring financial leverage, but the
dependent variable when measuring operating leverage. As a result, EBIT, is sometimes
called the linking pin variable with respect to leverage application in finance.
Example Assume that I = Br. 100,000, t = 0.4, E = Br. 80,000

N = 60,000, and EBIT = Br. 500,000. the EPS at this level of EBIT is
computed as:
EPS = (Br. 500,000 Br. 100,000) (1 0.4) Br. 80,000
60,000
= Br. 2.67
If EBIT increases from Br. 500,000 to Br. 600,000, the resulting EPS is:
EPS = (Br. 60,000 Br. 100,000) (1 0.4) Br. 80,000
60,000
= Br. 3.67
The financial leverage is computed as:

Percentage change in EBIT = Br. 100,000/Br. 500,000 = 20%
Percentage change in EPS = Br. 1/Br. 2.67 = 37.45%
L ( EPS ) 0.3745
  1.87
L ( EBIT ) 0.2
The coefficient of financial leverage of 1.87 is interpreted as follows: A 1 percent change

in EBIT from an initial value of Br. 500,000 produces a 1.87 percent change in EPS.
Since EBIT increased by 20 percent from its initial value, EPS increased by 1.87 (0.20) =
0.374 or 37.4 percent.
The measurement equation used to compute the coefficient of financial leverage when the
income statement relationship is:
Y
(FL/Y) = Y  I  E
1 t
The left hand side of the above equation is read as: financial leverage, given the value of
EBIT.
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By putting the data of the pervious example, equation is illustrated as:
500,000
 1.88
(FL/Y = Br. 500,000) = Br.500,000  Br.100,000  Br.80,000
1  0.4
Financial leverage is sometimes called balance sheet leverage or capital structure

leverage.
A corporation produces and sells different product lines. In financing these activities, the
firm has floated two issues of the following bonds and preferred stock, and has one
million shares of common stock outstanding.
Bond issue A : Br. 10,000,000 at 8% interest rate

Bond issue B : Br. 20,000,000 at 10% interest rate
Preferred stock series A : 200,000 shares, Br. 4.50 dividends per share
Preferred stock series B : 300,000 shares, Br. 7 dividend per share
At the EBIT level of Br. 10,000,000, determine the values of EPS and of financial
leverage. Assume 40% tax rate.
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Properties of financial leverage
The properties of financial leverage can be explained by using the concept of financial
breakeven. Financial breakeven is defined as the value of EBIT that makes EPS equal to
zero. At financial breakeven the firms EBIT, the form produces a positive level of
earnings available to common shareholders and a positive EPS. Below this level, profit
available to common shareholders and EPS are both negative. It is thus possible for a
firm to earn a positive level of EBIT even though its EPS is negative. This will happen
when the firms EBIT is positive but less than its financial breakeven level. Financial
breakeven is expressed as:
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(Y  I ) (1  t )  E
0
N
Solving this equation for Y, or EBIT, yields:
E
Y = I + 1 t
Example Assume I = Br. 2,000,000 and E = Br. 1,300,000. Financial breakeven is

calculated as: Assuming 40% tax rate.
Y = Br. 2,000,000 + Br. 1,300,000 / (1 0.4) = Br. 4,166,667
If financial leverage is calculated at financial breakeven, the resulting coefficient of

financial leverage has an undefined value, computing by using the above equation:
Br.4,166,667
( FL / Y  Br.4,166,667) 
Br.4,166,667Br.2,000,000  Br.1,300,000 /(1  0.4)
Br.4,166,667
  undefined
0
Interpretations of financial leverage
 Fundamental interpretation: the coefficient of financial leverage is the percentage

change in EPS that results from a 1 percent change in EBIT.
 Related interpretations:
1. A positive coefficient of financial leverage means that leverage is being computed
for a value of EBIT that is greater than financial breakeven.
2. A negative coefficient of financial leverage indicates that leverage is being
computed for a value of EBIT below financial breakeven
3. A large absolute value of financial leverage indicates that leverage is being
computed close to financial breakeven and that the absolute value of EPS is
relatively small.
4. A positive coefficient of financial leverage close to 1.0 indicates that leverage is
being computed for a value of EBIT that is relatively far above financial
breakeven and that the corresponding value to EPS is relatively large.
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5. Financial leverage refers to the use of fixed-income securities-debt and preferred
stock.
7.4 CAPITAL STRUCTURE THEORY
Capital structure theory has been developed along two main lines
- tax benefit bankruptcy cost trade-off theory
- signaling theory
Trade-off theory
Modern capital structure theory begins in 1958, when professors Franco Modigliani and
Merton Milles (hereafter MM) published what has been called the most influential article
ever written. MM proved, under a very restrictive set of assumptions, that because of the
tax deductibility of interest on debt, a firms value rises continuously as it uses more debt,
and hence its value will be maximized by financing almost entirely with debt. MM s
assumptions included the following:
1. There is no brokerage costs
2. There is no personal taxes
3. Investors can borrow as the same rate as corporations
4. Investors have the same information as management about the firms future
investment opportunities
5. All the firms debt is riskless, regardless of how much debt of uses
6. EBIT is not affected by the use of debt.
Since several of these assumptions were obviously unrealistic, MMs positions was only
the beginning of capital structure research.
Subsequent researchers, and MM themselves, extended the basic theory by relaxing the
assumptions. Other researchers attempted to test the theoretical model with empirical data
to see exactly how stock prices and capital costs are affected by capital structure. Both
the theoretical and empirical results have added to our understanding of capital structure,
but none of these studies has produced results that can be used to identify precisely a
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firms optimal capital structure. A summary of the theoretical and empirical research are
the following.
1. The fact that interest is deductible expense makes debt less expensive than
common or preferred stock. That is debt provides tax shelter benefits. As a result,
using debt causes more of the firms operating income (EBIT) to flow through to
investors, so the more debt a company uses, the higher its value and the higher the
price of its stock.
2. The MM assumptions do not hold in the real world. First interest rate rises as the
debt ratio rises. Second, EBIT declines at extreme level of leverage. Third,
expected tax rate fall at high debt levels, and this reduces the expected value of
the debt tax shelter. And, fourth, the probability of the bankruptcy, which brings
with it lawyers fee and other costs, increases as the debt ratio rises.
3. Both theory and empirical evidence support the preceding discussion. However,
statistical problems prevent researchers from identifying points of threshold debt
level where bankrupt costs become material and optimal capital structure where
marginal tax shelter benefits and marginal bankruptcy related costs are equal.
4. Another disturbing aspect of capital structure theory is the fact that many large,
successful firms use far less debt then the theory suggests. This point led to the
development of signaling theory.
Signaling theory
MM assumed that investors have the same information about a firms prospects as its
managers this is called symmetric information. However, managers often have better
information than outside investors. This is called asymmetric information, and it has an
important effect on the optimal capital structure. To see why, consider two situations, one
in which the companys managers know that its prospects are extremely favorable (Firms
F), and one in which the mangers know that the future looks unfavorable (Firm U).
Suppose, for example, that Firm Fs have just discovered a nonpatentable cure for the
common cold. They want to keep the new product a secret as long as possible to delay
competitors entry into the market. New plant must be built to make the new product, so
capital must be raised. How should Firm Fs management raise the needed capital? If the
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firm sells stock, then, when profits from the new product start flowing in, the price of
stock will rise sharply, and the purchasers of the new stock will have made a bonanza.
The current stockholders (including the managers) will also do well, but not as well as
they would have done of the company had not sold sock before the price increased,
because then they would not have had to share the benefits of the new product with the
new stockholders. Therefore, one would expect a firm with very favorable prospects to
try to avoid selling stock and rather, to raise any required new capital by other means,
including using debt beyond the normal targest capital structure.
Now, lets consider Firm U. suppose its managers have information that new orders are
off sharply because a competitor has installed new technology which has improved its
products quality. Firm U must upgrade its own facilities, at a high cost, just to maintain
in recent sales level. As a result, in return on investment will fall (but not as much as if it
took no action, which would lead to a 100 percent loss through bankruptcy). How should
Firm U raise the needed capital? Here the situation is just the reverse of that facing Firm
F, which did not want to sell stock so as to avoid having to share the benefits of future
development. A firm with unfavorable prospects would want to sell stock, which would
mean bringing in new investors to share the losses.
The conclusion from all this is that firms with extremely bright prospect prefer not to
finance through new stock offerings, whereas firms with poor prospects do like to finance
with outside equity. How should you, as an investor, react to this conclusion?
7.5 FACTORS IN CAPITAL STRUCTURE DECISIONS
Firms generally should consider the following factors which influence capital structure
decisions.
1. Sales stability: - A firm whose sales are relatively stable can safely take on more debt
and incur higher fixed charges than a company with unstable sales.
2. Asset structure: - Firms whose assets are suitable as security for loans tend to use
rather heavily. General purpose assets which can be used by many businesses make good
collateral, whereas special-purpose assets do not. Thus, real state companies are usually
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highly leveraged, whereas companies involved in technological research employ less
debt.
3. Operating leverage: - Other things the same, a firm with less operating leverage is
better able to employ financial leverage because, as we saw, the interaction of operating
and financial leverage determines the overall effect of a decline in sales on operating
income and net cash flow.
4. Growth rate: - Other things the same, faster-growing firms must rely more heavily on
external capital.
5. Profitability: - One often observes, that firms with very high rates of return on
investment use relatively little debt. Although there is no theoretical justification for this
fact, one practical explanation is that very profitable firms simply do not need to do much
debt financing. Their higher rates of return enable them to do most of their financing with
retained earnings.
6. Taxes: - Interest is a deductible expense, and deductions are most valuable to firms
with high tax rates. Hence, the higher a firms corporate tax, the greater the advantage of
debt.
7. Control: - The effect of debt versus stock on managements control position can
influence capital structure. If management currently has voting control (over 50 percent
of the stock), but is not in a position to buy any more stock, it may choose debt for new
financing. One the other hand, management may decide to use equity if the firms
financial situation is so weak that he use of debt might subject it to serious risk of default
because, if the firms gores into default, the mangers will almost surely lose their jobs.
8. Management attitudes: - Since no one can provide that one capital structure will lead
to higher stock prices than another, management can exercise its own judgment about the
proper capital structure. Some management tend to be more conservative than others, and
thus use less debt than the average firm in their industry, whereas aggressive management
use more debt in the quest for higher profits.
9. Lender and rating agency attitude: - Regardless of mangers own analyses of this
proper leverage factors for their firms, lenders and rating agencies attitudes frequently
influence financial structure decisions. In the majority of the cases, the corporations
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discusses its capital structure with lenders and rating agencies and gives much weight to
their advice.
10. Market conditions: - Conditions in the stock and bond market undergo both long-and
short-run changes that can have an important bearing on a firms optimal capital structure.
11. The firm s internal conditions: - A firms own internal condition can also have a
bearing on its target capital structure.
12. Financial flexibility: - maintaining financial flexibility, which from an operational
view point, means maintaining adequate reserve borrowing capacity. Determining an
adequate reserve borrowing capacity is judgmental, but it clearly depends on the factors
mentioned previously in the unit, including the firm forecasted need for funds, predicted
capital market conditions, managements confidence in its forecasts, and the
consequences on a capital shortage.
7.6 SUMMARY
The key concepts covered are summarized below

 A firms optimal capital structure is that mix of debt and equity which maximizes
the price of the firms stock. As any point in time, the firms management has a
specific target capital structure in mind, presumably the optimal one, although this
target may change over time.
 Several factors influence the firms capital structure. These include the firms (1)
business risk (2) tax position (3) need for financial flexibility, and (4) managerial
conservatism and aggressiveness.
 The degree of operating leverage shows how changes in sales affect operating
income, whereas the degree of financial leverage shows how changes in operating
income affect earnings per share.
 Financial leverage is the extent to which fixed-income securities (debt and
preferred stock) are used in a firms capital structure.
 Modeigliani and Miller developed a trade-off theory of capital structure. They
showed that debt is useful because interest is that deductible, but also that debt
brings with its costs associated with actual or potential bankruptcy. Under MMs
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theory, the optimal capital structure strikes a balance between the tax benefit of
debt and the costs associated with bankruptcy
 An alternative (or, really, complementary) theory of capital structure relates to the

signals given to investors by a firms decision to use debt or stock to raise new
capital. The use of stock is a negative signal, while, using debt is a positive, or at
least a neutral, signal. As a result, companies try to maintain a reserve borrowing
capacity, and this means using less debt in normal times the MM trade-off
theory would suggest.
7.7 ANSWERS TO CHECK YOUR PROGRESS
1. Capital structure policy involves a trade-off between risk and return since using more
debt raises the riskness of the firms earning stream. However, a higher debt ratio
generally leads to a higher expected rate of return
2. 1 with a selling price of Br. 51 per unit, the operating breakeven is:
T = Br. 4,800,000/ (Br. 51 Br. 26)
= 192,000 units
2. The new operating breakeven is
T = Br. 5,400,000/ (Br. 51 Br. 25)
= 207,692 units
3. At the EBIT level of Br. 10,000,000, the values of EPS and Financial leverage are:
I = 0.08 (Br. 10,000,000) + 0.10 (Br. 20,000) = Br. 2,800,000
E = Br. 4.5 (200,000) + Br. 7 (300,000) = Br. 3,000,000
EPS = (Br. 10,000,000 Br. 2,800,000) (1 0.4) Br. 3,000,000 = Br. 1.32
1,000,000
(FL/Y = Br. 10,000,000) = Br. 10,000,000____________
Br. 10,000,000 Br. 2,800,000 Br. 3,000,000 / (1 04)
= 4.55
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Exercises
1. GIZACEW Co. manufactures ladies; watch which are sold through discount houses.
Each watch is sold for Br. 25; and fixed costs are Br. 140,000 for 30,000 watches or
less; variable costs are Br. 15 per watch
a. What is the firms gain or loss at sales of 8000 watches?
b. What is the companys degree of operating leverage at sales of 8000 units? Of
1800 units?
c. What is the companys degree of operating leverage at sales of 8000 units? Of
18000 units?
d. What happens to the breakeven point if the selling price rises to Br. 31? What is
the significance of the change to the financial manager?
e. What happens to the breakeven point of the selling rises to Br. 31 but variable
costs rise to Br. 23 unit?
2. TSEHAY Co., producer of turbine generators; is in this situation: EBIT = Br. 4 million;
tax = T = 35%; debt outstanding = D = Br. 2 million; kd = 10%; ks = 15%; shares of
stock outstanding = No = 600,000; and book value per share = Br. 10. Since the
companys product market is stable and the company expects no growth, all earnings
are paid out as dividends. The debt consists of perpetual bonds.
a. What are the earnings per share (EPS) and its price per share (Po)?
b. What is the weighted average cost of capital (WACC)?
c. The company can increase debt by Br. 8 million, to a total of Br. 10 million using
the new debt to buy back and retire some of its shares at the current price. Its
interest rate on debt will be 12 percent (it will have to call and refund the old
debt), and its cost of equity will rise from 15 percent to 17 percent. EBIT will
remain constant, should the company change its capital structure.
d. If the company did not have to refund the Br. 2 million of old debt, how would
this affect thing? Assume that the new and the still outstanding debt are equally
risky, with kd = 12%, but that the coupon rates on the old debt is 10 percent.
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3. ALEMU Co. produces Building materials which sell for p = Br. 100. Olinde s fixed
costs are Br. 200,000; 5000 components are produced and sold each year; EBIT is
currently Br. 50,000; and the assets (all equity financed) are Br. 500,000. The company
estimates that it can change its production process, adding Br. 400,000 to investment and
Br. 50,000 to fixed operating costs. This change will
(1) Reduce variable cost per unit by Br. 10 and (2) increase output by 2000 units, but (3)
the sales price on all units will have to be lowered to Br. 95 to permit sales of the
additional output. The company uses no debt and its average cost of capital is 10 percent
a) Should the company make the change
b) Would the company degree of operating leverage increase or decrease if it
made the change? What about its breakeven point?
c) Suppose the company were unable to raise additional, equity financing
and had to borrow the Br. 400,000 to make the investment at an interest
rate of 10 percent, use the DU pont equation to find the expected ROA of
the investment. Should the company make the change if debt financing
must be used
7.9 GLOSSARY
 Target capital structure.

structure. The mix of debt, preferred stock and common equity
with which the firm plans to raise capital.
 Business risk.
risk. The risk associated with projections of a firms future returns on
assets.
 Operating leverage.
leverage. The extent to which the fixed costs are used in a firms
operations.
 Breakeven point.
point. The volume of sales at which total costs equal total revenue,
causing operating profit (EBIT) to equal zero.
 Financial leverage.
leverage. The extent to which fixed income securities (debt and
preferred stock) are used in a firms capital structure.
 Financial risk.
risk. An increase in stockholders risk, over and above basic business
risk, resulting from the use of financial leverage.
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 Degree of operating leverage. The percentage change in EBIT resulting from a
given percentage change in sales.
 Degree of financial leverage.
leverage. The percentage change in EPS associated with a
given percentage change in EBIT.
 Symmetric information.
information. The situation in which investors and managers have
identical information about the firms prospects.
 Asymmetric information.
information. The situation in which managers have different (better)
information about their firms prospects than do investors.
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UNIT 8: THE COST OF CAPITAL
Contents
8.1 Introduction
8.2 Meaning of the Cost of Capital
8.3 Measuring the Specific Cost of Capital
8.3.1 The Cost of Debt
8.3.2 The Cost of Preferred Stock
8.3.3 The Cost of Common Stock
8.3.4 The Cost of Retained Earnings
8.4 Weighted Average Cost of Capital
8.5 Marginal Cost of Capital
8.6 Summary
8.10 Glossary
After completing this unit, students should be able to understand:

 the meaning of cost of capita
 the implications of the cost of capital on the value of a firm,
 four major sources of capital to a firm and their cost,
 that the weighted average cost of capital is used in investment decisions,
 that the marginal cost of capital increases with raising of more and more capital
during a given period,
 the point where the costs of debt, preferred stock, common stock, or retained
earnings increases.
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8.1 INTRODUCTION
As you well understand, two parties are involved in a financial asset under normal
circumstances. One is the party issuing the financial asset. Another is the one that buys or
invests on the financial asset. In unit 6, when we were discussing about valuation, we
emphasized on the investor. That is, how much is the maximum price the investor would
pay for the financial asset? To decide on this, the investor would discount the expected
future cash flows. The discounting is done based on the investors required rate of return.
The rate of return required by the investor should definitely be provide by some other
party. The party which should provide the investor its required rate of return is the issuing
party. For example, if the required rate of return by an investor on a given bond is 10%,
the issuing company should provide this 10% to the investor. This required rate of return
that should be met by the issuing company becomes its cost. This is a cost on the capital
the issuing company wants to raise.
Therefore, the required rate of return on investments in financial assets by the investor is
the cost of capital for the company issued the financial assets. But, generally, the cost of
capital for the issuing company is higher than the required rate of return by the investor.
This is because when the issuing company issues a financial asset, it must incur some
costs. These costs incurred by the issuer in relation to issuance of financial assets are
called flotation costs. Examples include advertising costs, commissions paid to those
selling the financial assets, cost of printing documents, costs of registration with
government agencies, discounts to encourage the sale of securities, and so on.
8.2 MEANING OF THE COST OF CAPITAL
The cost of capital is the minimum rate of return that a firm must earn in order to satisfy
the overall rate of return required by its investors. It is also the minimum rate of return a
firm must earn on its invested capital to maintain the value of the firm unchanged. The
second definition considers the cost of capital as a break even rate.
If a firms actual rate of return exceeds its cost of capital, the value of the firm would
increase. If on the other hand, the cost of capital is not earned, the firms market value
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will decrease. So the cost of capital is the rate of return that is just sufficient to leave the
price of the firms common stock unchanged.
The cost of capital serves as a discount rate when a firm evaluates an investment
proposal. Suppose a firm is considering investment on a plant. The finance required for
this investment is to be raised by selling a common stock issue. Now, after raising capital,
the firm is expected to provide required rate of return to those who invest on the common
stock. This in effect is the firms cost of capital. So to decide to invest on the plant, the
minimum rate of return from the investment at least should be equal to the required rate
of return by the common stockholders. If the required rate of return by the firms common
stockholders is 13%, then the firm should earn a minimum of 13% on its investment on
the plant. The 13% minimum rate of return that should be earned by the firm is, therefore,
its cost of capital.
8.3 MEASURING THE SPECIFIC COST OF CAPITAL
The cost of capital for any particular capital source or security issue is called the specific
cost of capital. It is also called individual cost of capital or component cost of capital.
Each type of capital contained the capital structure of a firm include:
1. Debt
2. Preferred stock
3. Common stock
4. Retained earnings
Two important points you should bear in mind about the specific cost of capital. One is
that it is computed on an after-tax basis. Meaning, if there would be any tax implication
on the individual source of capital, it should be considered. In almost all circumstances,
the tax implication is only on debt sources of finance. The second point is that the
specific cost of capital is expressed as an annual percentage or rate like 6%, 9%, or 10%.
The cost of capital is not stated in terms of birrs.
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8.3.1 The cost of debt
This is the minimum rate of return required by suppliers of debt. The relevant specific
cost of debt is the after-tax cost of new debt. Generally, debt is the cheapest source of
finance to a firm and, hence, the cost of debt is the lowest specific cost of capital. There
are two basic explanations for this. First, debt suppliers, generally, assume the lowest risk
among all suppliers of capital. They receive interest payments before preferred and
common dividends are paid. Since they assume the smallest risk, their return is the
lowest. Their lowest return would be the lowest cost of capital to the firm. Second,
raising capital through debt sources entails interest expense. The inters expense in turn
reduces the firms income which ultimately would cause tax payment to be reduced. So
raising money in the form of debt results in the smallest tax burden, and finally, the firms
cost of debt would be the lowest.
Debt sources of finance may take several forms like bonds, promissory notes, bank loans.
Here, for our convenience we consider bond issue to illustrate the cost of debt.
Computing the cost of new bond issue involves three steps:

i) Determine the net proceeds from the sale of each bond
NPd = Pd f
Where:
NPd = The net proceeds from the sale of each bond
Pd = The market price of the bond
f = Flotation costs
ii) Compute the effective before tax cost of the bond using the following approximation
formula:
Pn  NPd
I
n
Kd =
Pn  NPd
2
Where:
Kd = The effective before tax cost of debt
I = Annual interest payment
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Pn = The par value of the bond
n = Length of the holding period of the bond in years.
iii) Compute the after-tax cost of debt

Kdt = Kd (1 t)
Where:
Kdt = The after-tax cost of debt
t = The marginal tax rate
Example: Currently, Abyssinia Industrial Group is planning to sell 15-year, Br. 1,000
par-value bonds that carry a 12% annual coupon interest rate. As a result of lower current
interest rates, Abyssinia bonds can be sold for Br. 1,010 each. Flotation costs of Br. 30
per bond will be incurred in the process of issuing the bonds. The firm s marginal tax rate
is 40%.
Required: Calculate the after tax cost of Abyssinias new bond issue:
Solution:
Given: Pn = Br. 1,000; I = Br. 120 (Br. 1,000 x 12%); n = 15; Pd = Br. 1,010; f = Br. 30;
t = 40%; Kdt = ?
Then apply the three steps:
i) NPd = Br. 1,010 Br. 30 = Br. 980
Br.1,000  Br.980
Br.120 
15  12.26%
ii) Kd =
Br.1,000  Br.980
2
iii) Kdt = 12.26% (1 40%) = 7.36%
Therefore, the after tax cost of Abyssinias new bond issue is 7.36%. That is, Abyssinia
should be able to earn a minimum of 7.36% to satisfy bondholders. Otherwise, the firms
value will decline.
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Ayenew Companys financing plans for next year include the sale of long-term bonds
with a 10% coupon. The company believes it can sell the bonds at a price that will
provide a yield to maturity of 12% to investors. If its marginal tax rate is 35%, what is
Ayenews after-tax cost of debt?
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8.3.2 The cost of preferred stock
The cost of preferred stock is the minimum rate of return a firm must earn in order to
satisfy the required rate of return of the firms preferred stock investors. It is also the
minimum rate of return a firms preferred stock investors require if they are to purchase
the firms preferred stock.
When a firm raises capital by issuing new preferred stock, it is expected to pay fixed
amount of dividends to the preferred stockholders. So it is the dividend payment that is
the cost of the preferred stock to the firm stated as an annual rate.
The cost of a new preferred stock issue can be computed by following two steps:
i) Determine the net proceeds from the sale of each preferred stock.
NPpf = Ppf f
Where:
NPpf = Net proceeds from the sale of each preferred stock
Ppf = Market price of the preferred stock
f = Flotation costs
ii) Compute the cost of preferred stock issue
Kps = Dps__
NPpf
Where:
Kps = The cost of preferred stock
DPs = The pre share annual dividend on the preferred stock
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Example: Sefa Computer Systems Company has just issued preferred stock. The stock
has 12% annual dividend and Br. 100 par value and was sold at 102% of the par value. In
addition, flotation costs of Br. 2.50 per share must be paid. Calculate the cost of the
preferred stock.
Solution:
Given: Pps = Br. 102 (Br. 100 x 102%); Dps = Br. 12 (Br 100 x 12%); f = Br. 2.50;
Kps =?
Then apply the two steps:
i) NPpf = Br. 102 Br. 2.50 = Br. 99.50

ii) Kps = Br. 12 =12.06%
=12.06%
Br. 99.50
Therefore, Sefa Company should be able to earn a minimum of 12.06% on any

investment financed by the new preferred stock issue. Otherwise, the firms value will
decrease.
Sattelite Share Company plans to sale preferred stock with par value of Br. 50 per share.
The issue is expected to pay quarterly dividends of Br. 1.25 per share and to have
flotation costs of 6% of the par value. The preferred stock sells at 95% of its par.
Required: Calculate the cost of preferred stock to Satellite Share Company.
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8.3.3 The cost of common stock
The cost of common stock is the minimum rate of return that a firm must earn for its
common stockholders in order to maintain the value of the firm. A firm does not make
explicit commitment to pay dividends to common stockholders. However, when common
stockholders invest their money in a corporation, they expect returns in the form of
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dividends. Therefore, common stocks implicitly involve a return in terms of the dividends
expected by investors and hence, they carry cost.
Generally, common stock dividends are paid after interest and preferred dividends are
paid. As a result, common stock investors assume the maximum risk in corporate
investment. They compensate the maximum risk by requiring the highest return. This
highest return expected by common stockholders make common stock the most
expensive source of capital.
The cost of common stock can be computed using the constant growth valuation model.
Ks = D1 + g
NPo
Where:
Ks = The cost of new common stock issue
D1 = The expected dividend payment at the end of next year
NPo = Net proceeds from the sale of each common stock
g = The expected annual dividends growth rate
The net proceeds from the sale of each common stock (NPo) is computed as follows:
NPo = Po f
Where:
Po = The current market price of the common stock
f = flotation costs
Example: An issue of common stock is sold to investors for Br. 20 per share. The issuing
corporation incurs a selling expense of Br. 1 per share. The current dividend is Br. 1.50
per share and it is expected to grow at 6% annual rate. Compute the specific cost of this
common stock issue.
Solution
Given: Po = Br. 20; Do = Br. 1.50; g = 6%; f = Br. 1; Ks = ?
Then apply the two steps:
i) NPo = Br. 20 Br. 1 = Br. 19
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ii) Ks = D1 + g = Br. 1.50 (1.06) = 14.37%
Npo Br. 19
Therefore, the firm should be able to earn a minimum return of 14.37% on investments
that are financed by the new common stock issue.
Repentance Corporations share of common stock is currently selling at Br. 75. The firm s
projected dividend per share during the next year is Br. 3.38 and the expected dividend
growth rate is 8%. Because of competitive nature of the market a Br. 3 per share under
pricing is necessary. In addition, the sale of new common stock involves underwriting fee
of Br. 0.60 per share and other flotation costs of Br. 0.90 per share.
Required: Calculate the cost of common stock for Repentance Corporation.
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8.3.4 The cost of Retained Earnings
Retained earnings represent profits available for common stockholders that the
corporation chooses to reinvest in itself rather than payout as dividends. Retained
earnings are not securities like stocks and bonds and hence do not have market price that
can be used to compute costs of capital.
The cost of retained earnings is the rate of return a corporations common stockholders
expect the corporation to earn on their reinvested earnings, at least equal to the rate
earned on the outstanding common stock. Therefore, the specific cost of capital of
retained earnings is equated with the specific cost of common stock. However, flotation
costs are not involved in the case of retained earnings.
Computing the cost of retained earnings involves just a single procedure of applying the
following formula:
Kr = D1 + g
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Po
Where:
Kr = The cost of retained earnings
D1 = The expected dividends payment at the end of next year
Po = The current market price of the firms common stock
g = The expected annual dividend growth rate.
Example: Zeila Auto Spare Parts Manufacturing company expects to pay a common
stock dividend of Br. 2.50 per share during the next 12 months. The firms current
common stock price is Br. 50 per share and the expected dividend growth rate is 7%. A
flotation cost of Br. 3 is involved to sale a share of common stock.
Required: Compute the cost of retained earnings
Solution
Given: Po = Br. 50; D1 = Br. 2.50; g = 7%; Kr = ?
Then apply the formula:
Kr = D1+ g = Br. 2.50 + 7% = 12%
Po Br. 50
Zequala Textiles Share Company wishes to measure its cost of retained earnings. The
firms stock is currently selling for Br. 57.50. The firm expects to pay Br. 3.40 dividend at
the end of the year. The expected dividend growth rate is 8%.
Required: Determine th cost of retained earnings.
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8.4 WEIGHTED AVERAGE COST OF CAPITAL (WACC)
In the previous section we have seen how to compute the cost of capital for each
individual source of capital. The specific cost of capital is used in evaluating an
investment proposal to be financed by a particular capital source. Practically, however,
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investment are financed by two or more sources of capital. In such a situation, we cannot
make use of the individual cost of capital. Rather we should use the average cost of
capital employed by the firm.
The firms capital structure is composed of debt, preferred stock, common stock, and
retained earnings. Each capital source accounts to some portion of the total finance. But
the percentage contribution of one source is usually different from another. So we must
compute the weighted average cost of capital rather than the simple average.
The weighted average cost of capital (WACC) is the weighted average of the individual
costs of debt, preferred stock and common equity (common stock and retained earnings).
It is also called the composite cost of capital.
If the weights of the component capital sources are all given, the weighted average cost
of capital can be computed as:
WACC = WdKdt + WpsKps + WceKs
Where:
WACC = The weighted average cost of capital
Wd = The weight of debt
Wps = The weight of preferred stock
Wce = The weight of common equity
Kdt = The after tax cost of debt
Kps = The cost of preferred stock
Ks = The cost of common equity
The WACC is found by weighting the cost of each specific type of capital by its
proportion in the firms capital structure. Weights of the individual capital sources can be
calculated based on their book value or market value.
To illustrate the computation of the WACC, look at the following example.
Muna Tools Manufacturing Companys financial manager wants to compute the firms
weighted average cost of capital. The book and market values of the amounts as well as
specific after-tax costs are shown in the following table for each source of capital.
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Source of capital Book value Market value Specific cost
Debt Br. 1,050,000 Br. 1,000,000 5.3%
Preferred stock 84,000 125,000 12.0
Common equity 966,000 1,375,000 16.0
Total Br. 2,100,000 Br. 2,500,000
Required: Calculate the firms weighted average cost of capital using:

1) book value weights
2) market value weights
Solution:
1) Total book value = Br. 2,100,000
Wd = Br. 1,050,000 = 0.5; Wps = Br. 84,000__ = 0.04; Wce = Br. 966,000 = 0.46
Br. 2,100,000 Br. 2,100,000 Br. 2,100,000
WACC = WdKdt + WpsKps + WceKs
= 0.5 (5.3%) + 0.04 (12.0%) + 0.46 (16.0%)
= 2.65% + 0.48% + 7.36%
= 10.49%
The minimum rate of return on all projects should be 10.49%. Meaning, Muna should
accept all projects so long as they earn a return greater than or equal to 10.49%
2) Total Market value = Br. 2,500,000

Wd = Br. 1,000,000 = 0.4; Wps = Br. 125,000 = 0.05; Wce = Br. 1,375,000 = 0.55
Br. 2,500,000 Br. 2,500,000 Br. 2,500,000
WACC = 0.4 (5.3%) + 0.05 (12.0%) + 0.55 (16.0%)
= 2.12% + 0.60% + 8.80%
= 11.52%
If the market value weights are used, Muna should accept all projects with a minimum
rate of return of 11.52%
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On January 1, 2002, the total assets of Zway share company were Br. 54 million. There
was no short-term debt. The firms optimal capital structure is given below.
Long-term debt Br. 27,000,000
Common equity 27,000,000
Total liabilities and equity Br. 54,000,000
New bonds will have a 10% coupon rate and will be sold at Par. Common stock currently
has a market price of Br. 60 and can be sold with a flotation cost of Br. 6 per share.
Dividend yield is estimated to be 4% and the expected dividend growth rate is 8%
Required: Calculate:
1) the cost of debt assuming s 40% marginal corporate tax rate
2) the cost of common equity (50% common stock and 50% retained earnings)
3) the weighted average cost of capital
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8.5 MARGINAL COST OF CAPITAL (MCC)
As a firm tries to have more new capital, the cost of each birr will rise at some point.
Thus, the marginal cost of capital (MCC) is the cost of obtaining additional new capital.
Technically speaking, the MCC is the weighted average cost of the last birr of new capital
obtained. So the concept of marginal cost of capital is discussed in the context of the
weighted average cost of capital.
As a firm raises larger and larger amounts of capital, the weighted average cost of capital
also rises. But the question would be at what point the firms costs of debt, preferred stck,
and common equity as well as WACC increase?
The first point, therefore, in computing the MCC is to determine the breaking points
where the cost of capital will increase.
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The technical aspects of the MCC can be better understood using an example.
Example: The target capital structure of Shala Corporation and other pertinent data are
given below.
Long-term debt ------------------ 40%; cost of preferred stock (Kps) = 12.06%
Preferred stock -------------------10% cost of retained earnings (Kr) = 14%
Common equity ----------------- 50% cost of common stock (Ks) = 15%
Shala Corporation has Br. 900,000 available retained earnings. But when the firm fully
utilizes its retained earnings, it must use the more expensive new common stock
financing to meet its equity needs. In addition, the firm expects that it can borrow up to
Br. 1,200,000 of debt at 7.3% after-tax cost. Additional debt will have an after-tax cost of
9.1%.
Required
1) What is the breaking point associated with the
a. exhausting of retained earnings?
b. Increment of debt between Br. 0 to Br. 1,200,000?
2) Determine the ranges of total new financing where the WACC will rise
3) Calculate the WACC for each range of finance.
Solutions
1) a. Breaking point (BP) common equity = Br. 900,000 = Br. 1,800,000
50%
b. Breaking point (BP) long-term debt = Br. 1,200,000 = Br. 3,000,000
40%
The breaking points computed above can be interpreted as:
Shala can meet its equity needs using retained earnings until its total finance need is Br.
1,800,000. But when total capital required is more than Br. 1,800,000, its equity needs
should be met with common stock. Similarly, until the firms total finance need reaches
Br. 3,000,000, shala can raise any debt at 7.3% cost. Any further finance need beyond Br.
3,000,000 will cause the cost of debt to rise to 9.1%.
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2) There are three ranges of finance that could be identified on the basis of the breaking
points:
1st Range : Br. 0 to Br. 1,800,000,
2nd Range : Br. 1,800,000 to Br. 3,000,000, and
3rd Range : Br. 3,000,000 and above
3) WACC (1st range) = 0.40 (7.3%) + 0.10 (12.06%) + 0.50 (14%)

= 2.92% + 1.21% + 7.00%
= 11.13%
WACC (2nd range) = 0.40 (7.3%) + 0.10 (12.06%) + 0.50 (15%)
= 2.92% + 1.21% + 7.50%
= 11.63%
WACC (3rd range) = 0.40 (9.1%) + 0.10 (12.06%) + 0.50 (15%)
= 3.64% + 1.21% + 7.50%
= 12.35%
Check your progress VI
In the example above why have we used 14% for cost of common equity in the 1 st range
and 15% in the 2nd and 3rd ranges respectively?
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8.6 SUMMARY
This unit showed the concept of the cost of capital. The key points covered are:
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- the cost of capital is the minimum rate of return a firm should earn on its invested
capital.
- the individual cost of capital is computed on an after-tax basis and is stated as an
annual percentage.
- generally, the cost of dept is the cheapest and the cost of common stock is the
most expensive among all other component costs of capital.
- the cost of capital to be used in evaluating investment proposals is the WACC.
- the WACC of a firm increases as the firm raises more and more new capital.
- a break point will occur each time one of the specific costs of capital increases.
I. Given: yield to maturity (YTM) = 12%; t = 35%; Kdt = ?

Since no flotation cost is indicated here, the YTM of 12% to investors represents the
effective before tax cost of debt for Ayenew company, i.e. Kd = 12%,
Therefore, Kdt = 12% (1 35%) = 7.80%
II. Given: Pps = Br. 50 x 95% = Br. 47.50; Dps = Br. 5 (4 x Br. 1.25); f = Br. 3 (Br. 50 x
6%); Kps
Kps = ?
Then, apply the two steps:
- NPps = Br. 47.50 Br. 3 = Br. 44.50
- Kps = Br. 5 = 11.24%
Br. 44.50
III. Given: Po = Br. 75; D1 = Br. 3.38; g = 8%; f = Br. 4.50 (Br. 3 + Br. 0.60 + Br. 0.90);
Ks = ?
Then, apply the two steps:
- Npo = Br. 75 Br. 4.50 = Br. 70.50
- Ks = D1+ G = Br. 3.38 + 8% = 13%
Npo Br. 70.50
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IV. Given: Po = Br. 57.50; D1 = Br. 3.40; g = 8%; Kr = ?
Then, apply the formula:
Kr = D1 + g = Br. 3.40 + 8% = 14%
Po Br. 57.50
V. 1. Since no flotation cost is involved here and the bonds are sold at par value, the
effective before tax cost of debt (Kd) = coupon rate = 10%.
Kdt = 10% ( 1 40%) = 6%
2. Given: Po = Br. 60; f = Br. 6; dividend yield (D1/po) = 4%; g = 8%
Cost of retained earnings (Kr) = D1 + g = 4% + 8% = 12%
Po
Cost of common stock (Ks) = D1 + g = Br. 2.40* + 8% = 12.44%
Npo Br. 60 Br. 6
* D1= 4%  D1 = 4%  D1 = Br. 2.40
Po Br. 60
VI. Because until the firms total new financing amounts to Br. 1,800,000, it can meet its
equity needs using retained earnings whose cost is 14%. But in the 2 ndand 3rd ranges the
total financing is more than Br. 1,800,000 and the firm should use new common stock
issue in place of retained earnings; and the cost of common stock is 15%.

1. Which of the following statement is always true about a cost of capital?
A) If the cost of capital is earned by a firm on investment of its available funds, the
value of the firm will increase
B) Generally, the cost of retained earnings is cheaper than the cost of debt.
C) Wherever the cost of capital exceeds the rate of return on the firms invested
capital, the value of the firm is reduced.
D) The weighted average cost of capital (WACC) of a firm remains constant as long
as the firms target capital structure remains unchanged.
2. Normally, debt is the cheapest source of finance. This is because
A) debt suppliers expect implicit returns from a firm
143
B) other sources of capital have opportunity costs rather than explicit costs
C) firms are forced by government to use debt source of finance
3. Identify the most expensive source of finance to a firm under normal circumstances
A) Common stock
B) Preferred stock
C) Retained earnings
D) Debt
Part II. Exercises

1. Zegha Technologies Companys common stock currently sells for Br. 46 per share. The
companys most recent dividends was Br. 4, and it expects a dividend of Br. 4.28 to be
paid at the end of the current year. The firm also expects to incur a flotation cost of Br.
5 to sell each share of common stock issue.
Required: calculate the cost of new common stock issue and retained earnings.
2. Sidco Merchandising Companys stock is currently selling for Br. 300 a share. The firm
is expected to earn Br. 27 per share this year and to pay a year-end dividend of Br. 18.
The firms investors require a 9% return on their common stock investment.
Required: What rate of growth must be expected for sidman?
3. Nile Share Company has a debt ratio of 40% and a dividend payout ratio of 50%. The
firm expects net income of Br. 5 million next year. Nile can borrow Br. 6 million at an
interest rate of 11%, another Br. 6 million at a rate of 12%, and any additional debt at a
rate of 13%. The firms marginal tax rate is 35%.
Required: Determine
1) The breaking point associated with the exhausting of retained earnings.
2) The points where the cost of debt will increase.
144
1. Engene F. Brigham (1997). Fundamentals of Financial Management.
Dryen press Harcourt Brace College Publishers, Florida.
Finance. 8th edition, Addison-
Wesley Longman Inc.
Management.
8.10 GLOSSARY
Flotation costs any costs necessary for selling new securities

Break even to complete a business or any other undertaking without incurring a loss.
After-tax cost the cost of capital net of any tax impact.
Net proceeds the cash collection from selling of securities after deducting flotation
costs.
Implicit cost a cost, which is not explicit and not clearly defined.
Breaking point the point where the cost of individual source of capital will rise.
Weighted average an average computed on the basis of the relative weights
(proportions) of the given data.
145
146

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UNIT 1: THE NATURE AND SCOPE OF FINANCIAL MANAGEMENT

After completing this unit, you will be able to:

 understand the meaning and importance of finance,

To have a good understanding of financial management, you need to understand first

1.1.1 What Is Finance?

In addition to principles and techniques, finance requires individual judgment of the

1.1.2 Major Areas of Finance

ii) Financial Management

1.1.3 Meaning of Financial Management

1.1.4 Why Study Financial Management?

Many business decisions made by firms have financial implications. Accordingly,

1. What makes financial management distinct from other fields of finance?

1.2 HISTORICAL DEVELOPMENT OF FINANCIAL MANAGEMENT

What is the most important focus of financial management today?

1.3 FINANCE AND RELATED FIELDS

1.3.1 Finance versus Economics

Basic Differences between Finance and Economics

1.3.2 Finance Versus Accounting

Accounting provides financial information through financial statements. Therefore, these

Basic Differences Between Finance and Accounting

Check your progress III

However, the modern or contemporary approach views financial management in a broad

1.5.1 Investment Decisions

1.5.3 Dividend Decisions

Check your progress IV

1.6 JOBS OF THE FINANCIAL STAFF

Check your progress V

Give some examples of the specific jobs of the finance people

1.7 AN OVERVIEW OF THE FINANCIAL ENVIRONMENT

1.7.1 Financial Institutions

The key participants in financial transactions of financial institutions are individuals,

1.7.2 Financial Instruments

1.7.3.1 Functions of Financial Markets

Generally, financial markets play three important roles in functioning of corporate

1.7.3.2 Classification of Financial Markets

1. Classification on the basis of maturity

This is based on the maturity dates of securities

Check your progress VI

II. The relationship between risk and return of any activity.

1.10 MODEL EXAMINATION QUESTIONS

Part I. Select the best answer from the given alternatives

1. Which of the following statement is true about financial management?

Part II. Explain briefly the following questions

1.11 SELECTED REFERENCES

1. Eugene F. Brigham (1997). Fundamentals of Financial Management. 7th edition, the

Firm  a group of people working together for business or commercial purposes; a

2.0 AIMS AND OBJECTIVES

2.2. THE CHARACTERISTICS OF A GOOD GOAL

2.3 PROFIT MAXIMIZATION AS A DECISION RULE

2.3.1 Meaning of Profit Maximization

Profit maximization is a function of maximizing revenue and /or minimizing costs. If a

2.3.2 Limitations of Profit Maximization

Furthermore, problems related to inflation and international currency transactions

To understand this limitation better let us consider the following example.

4. Quality of Benefits (Risk of Benefits). Profit maximization assumes that risk or

YEAR PROJECT A PROJECT B

Expected benefit of project A = Br. 220,000 x 50% = Br. 110,000

Check your progress I

1. Which project is preferable under profit maximization criterion?

Firm a group of people working together for business or commercial purposes; a

1. Monitoring expenditures are expenditures incurred by corporations to monitor or

i) Ratio Analysis is a mathematical relationship among money amounts in the financial

i) External Analysis an analysis performed by outsiders to the firm such as creditors,

Quick ratio = Current assets Inventory

Zebras days sales outstanding = 365 days = 39 days

Zebras fixed assets turnover = Br. 196,200 = 2.04X

Zebras total assets turnover = Br. 196,200 = 1.27X

Zebras debt ratio = Br. 98,100 = 64%

Zebras fixed charges coverage = Br. 10,500 + Br. 2,700 = 2.32X

Zebras profit margin = Br. 3,900 = 2%

Zebras return on investment = Br. 3,900 = 2.53 %

Zebras return on equity = Br. 3,900 = 6.99%

Earnings per share = Net income Preferred stock dividend

Zebras DPs for 2002 = Br. 3,300 _ = Br. 1.00

Zebras pay-out ratio = Br. 1.00 = Br. 3,300 = 92%

I. Quick ratio = Current assets Inventory