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1. Profit maximization.
Objective: - to get large amount of profits in short period of time.
- It is short term goal
Advantages
- easy to calculate profits
- easy to determine the link between financial decisions and profits.
Disadvantages
- emphasis only on short-term
- ignores risk and uncertainty
Disadvantages
- offers no clear link between financial decisions and stock price
- Leads to anxiety of management and frustrations.
A firm performs finance functions simultaneously and continuously in the normal operation. Finance
functions used to skilful planning, control and execution of a firm’s activities.
Investment decisions
Investment decisions or capital budgeting involves the decision of allocation of capital or commitment
of funds to long term assets that would yield benefits in the future.
Investment process should be evaluated in terms of both expected return and risk
Financing decisions
Financing decisions is the second important function to be performed by the finance manager
Deals with when, where, and how to acquire funds to meet the firm’s investment needs
The mix of debt and equity is known as the firm’s capital structure. The financial manager
must strive to obtain the best financing mix or the optimum capital structure for his or her firm.
The firm’s capital structure is considered to be optimum when the market value of shares is
maximized.
The use of debt affects the return and risk of shareholders, it may increase the return on equity
funds but it always increases risk. A proper balance will have to be struck between return and
risk.
Dividend decisions
The financial manager must decide whether the firm should distribute all profits or
retain them or distribute a portion and retain the balance
Like the capital structure policy, the dividend policy should be determined in terms of
its impact on the shares holders’ value. The optimum dividend policy is one that
maximizes the market value of the firm’s shares.
Liquidity decisions
Current assets must be managed efficiently for safeguarding the firm against the dangers of illiquidity
and insolvency.
An investment in current assets affects the firm’s profitability, liquidity and risk. A conflict exists
between liquidity and profitability while managing current assets. Example, if the firm does not invest
sufficient funds in current assets, it may become illiquid. But it would lose profitability as idle current
assets would not earn any thing. Therefore, a proper tradeoff must be achieved between profitability
and liquidity.
In order to ensure that neither insufficient nor unnecessary funds are invested in current assets, the
financial manager should develop sound techniques of managing current assets.
Financial manager should estimate firm’s needs for current assets and make sure that funds would be
made available when needed.
3. Ratio analysis
"A single figure by itself has no meaning but when expressed in terms of a related figure, it yields
significant inferences".
Ratio analysis standardizes financial data by converting birr figure in the financial
statements into ratios. A financial ratio is a mathematical relationship among several
numbers usually stated in the form of percentage or times
Ratio analysis helps us to draw meaningful conclusions and make interpretations about
a firm's:
-Financial conditions, and
- Performance
2.3 Basis of comparisons:
-Ratio, as yardsticks or financial flags of a firm’s overall performance, is meaningful only when compared
with other information.
Comparisons can be made in the following ways:
1. Industry standards /comparisons: are standards used to compare a firm’s financial conditions to that of the
industry average as a whole and reflects its performance in relation to its competitors.
E.g. Comparison of Ethiopian air lines performance with air lines industry average
1.liquidity ratios
“are a firm’s current assets sufficient to pay its current liability “
Liquidity ratios measure the ability of a firm to meet its short term obligations and reflect the short term
financial strength/solvency of a firm.
Two commonly used ratios are:
A. Current ratio:- measures a firm’s ability to satisfy or cover the claims of short term creditors by using
only current assets. That is, it measures a firm’s short term solvency or liquidity.
The current ratio is a crude measure of a firm’s liquidity position as it takes into account all current assets
with out any distinction in their composition.
2) Activity ratios
Overall liquidity ratios generally do not give an adequate picture of company’s real liquidity due to
differences in the kinds of current assets & liabilities the company holds. Thus, it is necessary to evaluate
the activity ratio.
Example:-
ABC Café XYZ Café
(Birr) (Birr)
Cash 0 7000
Marketable security 0 17,000
AIR 0 5,000
Inventories 35,000 6,000
Total current asset 35,000 35,000
Current Liabilities
A/P 0 6,000
N/P 14,000 6,000
Accruals 0 2,000
Total current liability 14,000 14,000
The two cafeterias have the same liquidity (current ratio) but their composition is different.
CR = CA CR = CA
CL CL
=35000 =35000
14,000 14,000
= 2.5 times = 2.5 times
Interpretation :- ABC’s A/R are converted into cash 2.14 times in year. A reasonably high A/R turnover
is preferable.
A ratio substantially lower than the industry average may suggest that a firm has:
♦ More liberal credit policy (i.e longer time credit period), poor credit selection, and
inadequate collection effort or policy which could lead.
A/R to be too high
Bad debts or uncorrectable Receivables
♦ More restrictive cash discount (i.e no or little cash discount) that could make sales to be too low.
A/R turnover = Net sales
A/R
= 1 X Average A/R
net sales
360
1 X Average A/R
Average sales per day
= Average A/R
Average sales per day
Note:- The average inventory is the average of beginning and ending balances of inventory.
Interpretation:- ABC’s inventory is sold out or turned over 0.7 times per year. It general, a high inventory
turnover ratio is better than a low ratio.
An Inventory turnover significantly higher than the industry average indicates:
• Superior selling practices
• Improved profitability as less money is tied-up in inventory.
Possible problems of high inventory turnover
• Very low level of inventory (i.e under investment in inventory)
• Lost sales due to insufficient inventory (i.e risk of out of stock)
• Stoppage of production process for manufacturing firms.
A very low inventory turn over suggests:
• Excessive inventory or over investment in anticipation of strike or price decreases.
• Inferior quality goods, stock of un salable / obsolete goods.
Possible problems of a very low inventory turnover
- Cost of funds locked-up or tied up in inventory (opportunely cost)
- Deterioration
- Rental of space
- Insurance cost, properly tax, and other inventory carrying costs.
Average age of inventory (AAI):- The number of days inventory is kept before it is sold to customers.
Interpretation :- ABC takes 682 days to convert inventory and receivables to cash.
A short operating cycle is desirable.
4) Fixed Asset turnover: - measures the efficiency of a business firm with which the firm has been using its
fixed assets to generate revenue
Fixed Assert turnover = Net sales
Net fixed asset.
Fixed Asset turnover = 1500
ABC (for 2000) 1250
=1.2 times
Interoperation:-ABC generated birr 1.20 in net sales for every birr invested in fixed assets.
Other things being equal, a ratio substantially below the industry average:
-Shows underutilization of available fixed assets. (i.e presence of idle capacity) relative to the industry.
-Indicates possibility to expand activity level without requiring additional capital investment.
Shows over investment in fixed assets, low sales, or both.
-helps the financial manager to reject funds requested by production managers for new capital investments.
Suggests that sales should be increased, some fixed asses
Should be disposed of , or both.
♦ Other things being equal, a ratio higher than the industry average:
- Requires the firm to make additional capital investments to operate a higher level
of activity.
- Shows more efficiency in managing and utilizing fixed assets.
A firms fixed asset turnover is affected by:
- The cost of the assets.
- The time elapsed since their acquisition.
- The depreciation methods used
5. Total Asset turnover:- measures a firms efficiency in managing its total assets to generate sales.
=Net sales
Net total assets
(For year 2000) =1500
4000
= 0.375 times
4. Profitability ratio
These ratios are used to measure the management effectiveness. Besides management of the company,
creditors and owners are also interested in the profitability of the company. Creditors want to get interest
and repayment of principal regularly. Owners want to get a required rate of return on their investment. The
ratio includes:
A. Gross profit margin
B. Operating profit margin
C. Net profit margin
D. Return on investment
E. Return on equity
F. Earning per share
A. Gross profit margin
This ratio indicates management effectiveness in pricing policy, generating sales and controlling
production costs.
Or using Dupont formula: ROA= net profit margin X Total asset turnover
= Net income X Net sales
Net sales Total assets
E. Return on equity( ROE): measures the rate of return realized by stockholders on their investment.
Leverage ratio measures how the firm finances its assets. Basically, firms can finance with either debt or
equity. ROA= ROE, with only equity financing that asset is equal to stockholders equity and leverage
multiplier is 1.
For ABC (yr 20000=249/2750=9.05%
Interpretation: ABC generates about 9 cents for every birr in shareholders equity.
F. Earning per share (EPS) represents the amount of birr earned on behalf of each outstanding shares of
common stock.
5. Market Value ratio: these ratio are primarily used for investment decisions and long range planning
and include:
Or
P/E ratio= D1/E1
k-g
Where, D1/E1, is the expected dividend payout ratio
K, is the required rate of return for the stock
g, is expected growth rate in dividends.
Assume, that ABC year end Dec 31, 2000 market price of common stock is birr 115 per share.
P/E ratio=115/12.45=9.24 times.
Interpretation: the market is willing to pay 9.24 birr for every birr in earnings.
A high P/E multiplier often reflects the market’s perception of the firm’s growth prospects. Thus, if investors
believe that a firm’s future earnings potential is good and they may be willing to pay a higher price for the
stock.
B. Book value per share: is the value of each share of common stock based on the firm’s accounting records.
Chapter Three
Future Values
Interest: When A borrows money from B, then A has to pay certain amount to B for the use of the money.
The amount paid by A is called Interest.
Principal:- The amount borrowed by A from B is called principal.
Amount :( Total Amount):- the sum of the interest and principal is usually called the amount.
A). Simple Interest and the future Value:-
Example 1. Find the future value if birr 20, 000 is borrowed at 6 percent simple interest for 3 months.
Here, 3 months is 3/12 = 1/4 of a year, so n = 1/4
Hence, Fv = p+pnr
=20,000 + 20,000 (3/12x 6%)
= 20,000+300 = birr 20,300
Example 2 Mamush has placed birr 500 in an employees’ savings account that pays 8% simple interest. How
long will it be, in months, until the investment amount to birr 530?
Fv= P (1+nr)
530 =500(1+nx8%)
530= 500(1+0.08n)
n=0.75 Years
N= 0.75x12 months
= 9 month
Example 3 At what annual rate of simple interest will an investment of birr 1000 for 2 years grow to the
amount of birr 1100?
F= p (1+nr)
1100= 1000 (1+2r)
r=5%
Simple Discount: present value
P= F
(1+ nr)
Example 1 How much will Mimi have to invest now in the 8% simple interest savings account in order to
have birr 600 a year from now ?
P= F
(1+nr)
= 600
(1+ 1x8%) = birr 555.56
Example 2 Find the present value of birr 1000 at 9% simple interest due 8 months from now.
P= F
(1+nr)
= 1000
(1+ 8/12 x 9%) = birr 943.40
Example 1 If you deposited birr 10,000 in NIB bank which was paying a 6% rate of interest compounded
annually on a ten year time deposit, how much would the deposit grow at the end of ten years?
Fv = P (1+) n
= 10000(1.06)10
= 10000(1.7908)
=Birr 17,908.48
Example 2
If Sara deposited birr 10,000 in Awash Bank which was paying a 6 percent rate of interest
compounded semi- annually, on a ten year time deposit, How much would the deposit grow at the end of ten
years?
I=6%/2= 3%, since it is compounded semiannually,
n= 10x2 =20
Fv= p (1ti) n
= 10,000 (1.03)20
= 10,000(1.8061)
=birr 18,061.11
Exercise
If Fekadu deposited birr 8,000 in Dashen Bank which was paying a 4% rate of interest compounded quarterly
on an 8 year time deposit ,how much the deposit grow at the end of 8 years?
Fn =10,999.53
Example 3
A sum of money may double itself in n years, compounded at 12 percent interest annually. Find n ?
Fv= p(l+i)n
2P= P(l+i)n
2=(l+0.12)n
2=(1.12)n
log 2 = log 1.12n
Exercise
Find the rate of interest that, compounded annually, will result in tripling a sum of money in 10 years.
Solution i=11.61%
Compound Discount: present Value
F= P (l+i) n
Dividing both sides of the future value formula by (l+i) n leads to
F = P
(l+i) n
By The definition of negative exponent,
P=F (l+i)-n
Example 1 Suppose that an investor wants to find out the present value of birr 20,000 to be received after 5
years. Her interest rate is 12% compounded annually. Find the present value?
P= F (l+i) -n
= 20,000(1.12)-5
20,000(0.5674)
Birr 11,348.54
Example 2 How much must be deposited now in an account paying 8% compounded monthly in order to
have just enough in the account 5 years from now to make a birr 10,000 down payment on a home?
Which is equivalent to the amount of birr 1 at a rate of 8.192 percent for one year.
0 1 2 3 n
Example. Supposes Martha deposits birr 1000 at the end of each year for 3 years at 6 % rate of interest. How
much would this annuity accumulate at the end of the third year?
Fu= R[(1+i)n-1]
i
=1000[(1.06)3-1]
0.06
=1000(3.1836)
Fv =birr 3183.60
Example 2: If birr 100 is Deposited in an account at the end of every quarter for the next 5 years, how much
will be in the account at the time of the final deposit if interest is 8 % compounded quarterly?
i=8%=2%
4
n=5x4=20
Fv=100[(1.02)20-1
0.02
=100[24.2974
= 2429.74
Exercise: When Derartu was born, her parents decided to deposit birr 500 every 6 months at the end for 15
years in an account earning 6% compounded semiannually. How much will be in account after the last
deposit is made?
F=R[1+i)n-1] i=6%/2=3%
i n=15X2=30
=500[(1.03)30-1]
0.03
=birr 23787.71
Ordinary Annuities: Sinking fund
Example: How much should be deposited in a sinking fund at the end of each quarter for 5 years to
accumulate birr 10,000 if the fund earns 8 % compounded quarterly?
N=5x4=20
i= 8%/2=2%
R=F[ i ]
(1+i)n-1
R=10,000 [ 0.02 ]
(1.02)20-1
=10,000(0.0411567) = birr 411.57
P=R[1-(1+i)-n]
i
Example 1
What sum deposited now in an account earning 8% interest compounded quarterly will provide quarterly
payments of birr 1000 for 10 years, the first payments to be made 3 months from now?
n=10x4=40
i=8%=2%
4
p=R[1-(1+i)-n]
i
=1000[1-(1.02)-40]
0.02
=1000(27.35548)
=birr 27355.48
Example 2.a) The directors of a company have voted to establish a fund that will pay a retiring accountant,
birr 1000 per month for the next 10 years , the first payment to be made a month from now. How much
should be placed in the fund if it earns interest at 12% compounded monthly?
b) How much interest will the fund earn during its existence?
a) p=R[1-(1+i)-n] n=10x12=120
i i=12%/12=0.01
a) P=R[1-(1+i)-n] I=12%=1%
i 12
5,000=R[1-01)-36 n=3x12=36
0.01
5,000=R[30.107505]
R=5,000
30.107505
R= 166.07
b) Ato Ayailkebet pays birr 166.07 a month for 36 months. The total paid will be
= 36x166.07 =5978.52 of which interest is 5978.52-5000=978.52
Exercise: A birr 70,000 car is to be purchased by paying birr 10,000 in cash and mortgage for 30 years at 12%
compounded monthly. The payment is made at the end of each month.
a) Find the monthly payment on the mortgage
b) What will be the total amount of interest paid?
a) P=R[ 1-(1+i)-n] i=12%/12=1%
i n=30x12=360
360
60,000=R[1-1.01)- ]
0.01
R=617.17
b) The total amount paid in 360 months will he
360x617.17=222,181.20
Interest paid will be 222,181.20-60,000
=162,181.20
ii. Annuity due: future value
Annuity due is a series of equal periodic payments in which each payment is made at the beginning of the
period.
P=R[1-(1+i)-n](1+i)
i
=1000[1-(1.02)-40](1.02)
0.02
=27,902.59
Example 2:
On September 1,2002 Zerfie borrowed birr 5,000 to buy a house. She will amortize the loan by monthly
payment of birr R starting from September 1,2001each over a period of 3 years. Find the monthly payment if
interest is 12% compounded monthly?
i=12%=1% n=3X12=36
12
-n
P=R[1-(1+i) ](1+i)
i
5000=R[1-(1.06)-36](1.01)
0.01
5000=R[30.40858]
R=164.43
Present value of a mixed stream
ABC company has been offered an opportunity to receive the following mixed stream of cash flows over the
next five years.
Year Cash flows
1 Birr 400
2 800
3 500
4 400
5 300
If the firm earn 9 Percent on its investment,
Perpetuities: Perpetuity can be defined as an annuity that has an indefinitely long life. Any perpetuity can be
discounted by dividing the value of one payment by the required rate of return. An important special case of
an annuity arises when the level stream of cash flow continues forever. Perpetuities are also called Consol.
Perpetuity present value X Rate = Cash flow
Pv x r = C
Therefore, given a cash flow and a rate of return, we can compute the present value very easily.
Pv for a perpetuity = C
r
Example, An investment offers a perpetual cash flow of birr 500 every year. The return you require on such
an investment is 8 percent, what is the value of this investment? The value of this perpetuity is:
Pv = C/r = 500/0.08=6250
Loan Amortization
Loan amortization refers to the determination of equal periodic loan payments necessary to provide a lender
with a specified interest return and repay the loan principal over a specified period.
Loan amortization schedule is a schedule of equal payments to repay loan . It shows the allocation of each
loan payment to interest and principal.
Example,
An individual borrow birr 6,000 at 10 percent and agree to make equal annual end of year payments over four
years.
Required: Prepare loan amortization schedule?]
Present value formula should apply to find the periodic loan payment.
Pv=R[1-(1+i)-n]
i
Chapter Four
Risk, Return and Financial Asset Portfolios
Return: if you buy an asset of any sort, your gain (or loss) from that investment is called the return on your
investment. This return will usually have two components: income component and capital gain or capital loss
on the investment.
The rate of return can be calculated with the following formula:
Kt= Pt – Pt-1 + D
Pt-1
Where, kt, required rate of return
Pt, Price of asset at time t
Pt-1, Price of asset at time t-1
D, dividend paid
Example,
End of year Price of asset Dividend
1 birr 21 0
2 19 1
3 18 1
4 21 1.05
5 24 1.05
6 26 1.10
Required: calculate rate of return?
Year Pt Pt-1 D Kt
1 21 - 0 -
2 19 21 1 19-21+1/21= -0.0476
Mean:
The mean of rate of return is calculated as follows:
Mean=∑r
n
Example,
The mean for the above example is 0.0476+0+0.225+0.1929+0.1292
5
=0.0999
=10%
Probabilities: Probabilities can be used to more precisely assess an asset’s risk. The probability of a
given outcome is its chance of occurring.
The expected value of a return: is the most likely return on a given asset
- n
K=∑ ki X Pri
i=1
Where, Ki= return for the ith outcome
Pri= probability of occurrence of the ith out come
n= number of out comes considered
K= the expected value of a return
Standard Deviation: The most common statistical indicator of an asset’s risk is the standard deviation.
It measures the dispersion around the expected value. The expression for the standard deviation of
returns, حk, is given as:
n
حk= ∑(Ki-K)2 X Pri
Coefficient of variation
It is a measure of relative dispersion used in comparing the risk of assets with differing expected returns.
Cv= حk
K
Where, حk is standard deviation
K is expected value of return.
Covariance: statistical representation of the degree to which the returns on two assets move together over
time; calculated as the sum of the product of each asset’s deviation from its expected value over time divided
by the number of time periods. The covariance of asset A and B can be computed as follows:
Risk Preference
The three basic preference behaviors are
Risk averse: the attitude toward risk in which an increased return would be required for an increase
in risk.
Risk indifferent: the attitude toward risk in which no change in return would be required for an
increase in risk.
Risk seeking: the attitude toward risk in which a decreased return would be accepted for an
increase in risk
= -0.0005
(0.0346)(0.0265)
= -0.54
Exercise
ABC corporation owns a portfolio which consists of two common stocks: stock M and stock E. The amount
invested in each stock is birr 120,000 and birr 280,000, respectively. The rates of returns on each stock in
three economic conditions are given below.
2
حP=
Where wl and w2 are the proportion of the components of asst 1 and asset 2
1 حand 2 حare standard deviations of the components of asset 1 and 2
r1,2 is the correlation coefficient between the returns of component assets 1 and 2
Example, you are trading in a market that has only two securities available. Security A has an expected return
of 8 % and a standard deviation of 40 %. Security B has an expected return of 20% and a standard deviation
of 120%.
1. If you place 40 % of your money in A and the remaining 60% in B, what is your expected return?
2. If the correlation between the returns of securities A and B is 0.8, what is the variance and the standard
deviation of the portfolio?
You must remember that the variance of a security’s return is the square of the standard deviation so:
2
حA=(0.4)2=0.16 and 2 حB=(1.2)2=1.44
and the proportion wl =40% and w2=60%
Therefore, Variance of portfolio= (0.4)2(0.16)+(0.6)2(1.44)+2(0.4)(0.6)(0.4)(1.2)(0.8)
=0.0256+0.5184+0.1843=0.7283
Standard deviation= square root of variance
= (0.7283)1/2=0.853=85.3%
Diversification and risk reduction
Increasing the number of financial assets in a portfolio is referred to as diversification. The portion of a
portfolio’s risk that can be reduced or eliminated by diversification is called diversifiable risk.( unsystematic
risk). It is unique to a particular firm and/or the industry in which it operates. The goods and services provided
by the industry, action of competitors, the quality of the firm management, operating leverage, capital
structure, financial leverage, and marketing strategies are some of the factors that combine to produce
unsystematic risk.
The portion of a portfolio’s risk that can not be eliminated by diversification is called non- diversifiable risk
(Systematic risk). It represents portion of total portion risk caused by factors that affect the prices of all
securities. Example, national economic and political development, business cycle, inflation, unemployment,
fiscal and monetary policy.
A portfolio that contains a large number of securities exhibits only systematic risk. An investor’s expected
rate of return holding a portfolio of risky financial assets is thus based on the expected rate of return and the
systematic risk contained in the portfolio and not on the risk-return characteristics of individual assets.
The beta coefficient
It is the slope of the security characteristic line, which shows the volatility of a security’s returns relative to
that of the market portfolio. It is index of systematic risk. This index measures the amount of systematic risk
Example, the following presents estimates of market returns and hypothetical security A.
Year Market risk (rm) Return of asset A (rA)
1 0.0830 0.115
2 0.2216 0.24
3 0.0089 0.0975
4 0.0306 -0.0652
5 0.1275 0.1123
6 0.2057 0.1879
7 0.13 0.1443
8 -0.007 0.1234
Required: compute
A. Variance of the market and asset A
B. Covariance of asset A and market
C. Beta coefficient
Solution:
Year (rm) (rA) (rA-rA) (rm-rm) (rm-rm)2 (rA-rA) (rm-rm)
1 0.0830 0.115 -0.0044 -0.0170 0.0003 0.0001
Bp= ∑wi X Bi
i
Where, wi is the proportion of security
Bi is the beta value of each security
It states that the weighted average of the financial asset beta contained in portfolio.
Example, four financial assets are purchased with birr 50,000. The percentage composition of the portfolio
and its corresponding betas are:
Diversifiable risk
Risk
Non diversifiable risk Total risk
SML
13 ………………………….
11 …………………
Return
7 ……Market risk…………Risk Premium……
premium
0 1 1.5 2
Beta(risk)
Po= a1 + a2 + a3 +…. An .
(1+r1) (1+r1)(1+r2) (1+r1)(1+r2) (1+r3) (1+r1)(1+r2) (1+r3)…..(1+rn)
Po= a1 + a2 + a3 +…. An .
(1+r1)1 (1+r1)2 (1+r3)3 (1+rn)n
po= 80 + 80 + 80 + 1000
(1.12)1 (1.12)2 (1.12)3 (1.12)3
=903.92
Or
P= 80 [1-(1.12)-3] +1000(1.12)-3
0.12
=903.92
2. Price with a 10% yield
Po= 80 + 80 + 80 + 1000
(1.1)1 (1.1)2 (1.1)3 (1.1)3
=72.73+66.12+60.11+751.31
=950.27
Exercise,
You are trying to decide between purchasing birr 1000 face value bonds with 10% annual coupons and one
year or two years to maturity. The expected real rate of interest is 3% and the expected inflation rate is 6%.
Required:
1. Compute the nominal yield for the one year bond
2. What is its price?
3. Compute the nominal yield for the two year bond
4. What is its price?
Solution,
1. The nominal interest rate is determined by the expected real rate and the expected inflation rate:
(1+R)= (1+r)(1+h)
(1+R)=(1.03)(1.06)
R=9.18%
2. The price of the one year bond is just the present value of the terminal payments, 0.1(1000)=100 in interest,
plus the face value:
P= 1100 =1,007.51
(1.0918)1
3. The two year nominal rate is determined by compounding the annual relationships:
(1+R)2= (1+r)2(1+h)2
(1+R)2=(1.03)2(1.06)2
(1+R)= (1.192)1/2=9.18%
Notice that this is identical to the nominal one year yield since the same interest rates are expected to hold ove
the two year interval.
4. The price of the two year bond is the present value of the two payments discounted at 9.18%
=91.59+922.80=1014.39
Po = D1 + D2 + . . . .+ Doo
(1+ks)1 (1+ks)2 (1+ks)oo
where, po= value of common stock
Dt= per share dividend expected at the end of year t
Ks= required return on common stock
Po= D1
Ks
The equation shows that with zero growth the value of a share of stock would equal the present value of
perpetuity of D1 birrs discounted at a rate Ks
Example,
The dividend of ABC company is expected to remain constant at birr 3 per share indefinitely. If the required
return on its stock is 15 percent.
Required: Determine the value of the stock?
Po= D1/ks= 3/0.15=birr 20
Since preferred stock typically provides its holders with a fixed annual dividend over its assumed infinite life.
This equation can be used to find the value of preferred stock.
2. Constant growth
The most widely cited dividend valuation approach, the constant growth model,assumes that dividends will
grow at a constant rate, g, that is less than the required return, ks (g<ks). Letting Do represent the current
dividend the equation can be rewritten as follows:
Po= Do(1+g)1 + Do(1+g)2 + …+ Do(1+g)oo
(1+ks)1 (1+ks)2 (1+ks)oo
If we simplify the equation it can be rewritten as follows:
Po = D1
Ks-g
Chapter six
Capital budgeting: is the process of evaluating and selecting long term investments that are consistent with
the firm’s goal of owner wealth maximization. Capital budgeting and financing decisions are treated
separately. Once a proposed investment has been determined to be acceptable, the financial manager then
chooses the best financing method.
Capital expenditure motives
A capital expenditure is a plan for an outlay of funds by an enterprise that is expected to provide benefit over
a period more than one year, such as purchase of fixed assets. A current expenditure is an outlay resulting
in benefits received within one year. Fixed asset outlays are capital expenditures, but not all capital
expenditures are classified as fixed assets. Example. A 100,000 birr outlay for advertising that produces
benefit over a long period is a capital expenditure. How ever, it is not a fixed asset.
The basic motives for capital expenditure are to expand, replace, or renew fixed assets or to obtain some other
less tangible benefit over a long period.
- These expenditures have long- term effects and, once made, are not easily reversed.
- Sound capital investment decisions can lead to higher earnings and stock prices, which help the firm to
achieve its goal of maximizing share holder wealth. Capital budgeting is a dynamic process because
the firm’s changing environment may affect the desirability of current or proposed investments.
The capital budgeting process involves five major steps:
1. Generating project proposals
Proposals for capital expenditures are made by people at all levels with in the organization.
Investment proposals may be classified in to four distinct types
3) Decision making.
The actual birr outlay and the importance of a capital expenditure determine the organizational level at which
the expenditure decisions is made.
4). Implementation
Once a proposal has been approved and funding has been made available, the implementation phase begins.
Implementing and reviewing projects
Implementation stage- involves developing formal procedures for authorizing the
expenditure of funds for capital projects
5). Follow up
Involves monitoring the results during the operating phase of a project. The comparisons of actual outcomes
in terms of costs and benefits with those expected and those of previous projects are vital. When actual
outcomes deviate from projected out comes, action may be required to cut costs, improve benefits, or possibly
terminate the project.
Basic terminologies
Some of the basic terminologies are
Independent versus mutually exclusive projects
The two most common project type are:
1) Independent projects and
2) Mutually exclusive projects.
Initial investment= Installed cost – after tax proceeds ± Change in Net working capital
Example
ABC Company is considering the purchase of a new grading machine to replace the existing one. The
existing machine was purchased three years ago at installed cost of birr 50,000; it was being depreciated
by the straight line method using an economic life of 5 years and scrap value of birr 3,000. The new
machine costs Birr 60,000 and requires birr 5,000 in installation costs is expected to have a useful life of
6 years and scrap value of birr 2,000. And with this new machine the firms current asset and current
liabilities will rise by birr 6500 and birr 4000, respectively. The old machinery could be sold at birr
25,000. The firm is under 40% tax bracket. Determine initial investment?
Solution
Initial investment = Installed cost- after tax proceeds + Net working capital.
Old machine
Cost =50,000
Scrap value = 3,000
ELF= 5 years
Depreciation = 50,000-3000
5
= 9400
Accumulated depreciation = 9400x 3
28,200
Book value= 50,000 -28,200
=21,800
Sale 25,000
Book value 21,800
Gain 3200
Tax (40%) 1280
After tax gain 1920
Note: tax rate for capital gain and ordinary gain may be different.
Case ii) Selling price is less than original cost but greater than book value
Gain = proceeds- Book value
After tax proceeds from sales of P/A = BV+ After tax gain
Case iii) selling price equal to Book value
After tax proceeds= Book value (or proceeds), since no gain or no loss.
Case iv) selling price less than Book value
After tax proceeds= proceeds + tax shield
Assume, Book value= 40,000
Selling price = 30,000
Tax = 40%
Loss= 30,000-40,000
(10,000)
Tax shield = 40 % x 10,000
=4,000
After tax proceeds= 30,000 +4,000
=34,000
Note: if the net proceeds from the sale are expected to exceed the book value, a tax payment shown as an
outflow (deduction from sale proceeds) would occur. When the net proceeds from the sale are below book
value, a tax rebate shown as a cash inflow (addition to sale proceeds) would result.
2. Incremental Cash flow
The incremental cash flows represent the additional cash flows-outflows or inflows that are expected to result
from a proposed capital expenditure. Given estimates of the revenue, expenses, and depreciation associated
with both the old and new asset, it is possible to estimate the operating cash flows for a replacement decision.
Accounting Income Vs cash flow
Depreciation expense is considered when we determine the net income but it is not out lay of cash on the
business organization.
2) Deduct the cash inflows after tax result from the old asset from the cash inflow generated by the
new asset.
Or
Method 2
Incremental cash flow = (Increase in Revenue – Increase in cash charge) (1-Tax)
+ (increase in depreciation expense) (Tax rate)
Example 1
A new plant Asset:
Original cost = 80,000 with a useful life of 10 years
Annual revenue = 60,000
Annual operating cost = 25,000
An old plant Asset:-
Annual Depreciation expense = 7,000
Annual revenue = 50,000
Annual operating cost & expense = 30,000
Tax= 40%
Required: Determine incremental cash flow?
Method 1
New P/A Old P/A
Revenue 60,000 Revenue 50,000
Cost 25,000 Cost 30,000
Depreciation exp 8,000 33,00 Depreciation 7,000 37,000
EBT 27,000 EBT 13,000
Income tax (40%) 10,800 Tax (40%) 5,200
Net Income 16,200 Net income 7,800
Add: Depreciation exp 8,000 Add: Depreciation exp 7,000
Cash inflow from new Asset=24,200 Cash inflow from old Asset 14,800
Terminal cash flow= after tax proceeds from sale of new asset
– After tax proceeds from sale of old asset
± Change in net working capital
After tax proceeds from sale of new asset= proceeds from sale of new asset ± tax on sale of new asset
After tax proceeds from sale of old asset= proceeds from sale of old asset ± tax on sale of old asset
Example 1
A company expects to be able to liquidate a new office equipment at the end of its useful life at birr 60,000.
The office equipment will have a book value of birr 25,000.The old machine can be liquidated at the end of
the year to net zero because it will completely obsolete. The firm expects to recover its birr 15,000 net
working capital investment up on termination of the project. Assume a tax rate is 40%.
Required: Determine terminal cash flow?
Solution
After tax proceeds from sale of new Equipment Birr 60,000
Less: Book value 25,000
Taxable income (gain) 35,000
Tax (40%) 14000
After tax proceeds from new equipment 46,000
Less: After tax proceeds from sale of old Equipment 0
Add: Recovery net working capital 15,000
Terminal cash flow 61,000
:
Example 1: Assume that initial investment of a project is 120,000 birr and yields after tax cash inflow of
25,000 for 10 years and the maximum pay back period set by firm’s managements is 5 years. The pay back
period of the project is
PBP= 120,000
25,000
=4.8 Years
Accept Reject Rule
Accept the project if the actual or computed pay back period is less than the maximum payback period
set by the firm otherwise the project is rejected. In ranking two projects having the same maximum allowable
payback, the project with shorter pay back period should be chosen because it pays for itself more quickly.
Therefore, accept the project because the payback period (4.8 years) is less than the Maximum allowable
payback period (5 years).
Example 2
Compute the pay back period for the following cash flows, assuming a net investment of birr 25,000 and
target payback period of 3 years?
Year Net investment Cash in flows
0 25000 0
1 10000
2 7000
3 6000
4 2000
5 2000
Solutions
Year Net cash inflows Commutative net cash inflows
1 10,000 10,000
2 7,000 17,000
3 6,000 23,000
4 2,000 25,000
5 2,000 27,000
Payback period= 4 years
Reject the project as the computed payback period of 4 years is greater than the target payback period of 3
years.
Example 3
2. Accounting Rate of Return (ARR):- measure profitability of the capital investment from conventional
accounting stand point by relating or associating accounting NI with initial investment.
- Tells us the percentage of net income that has already generated a result of commitment of certain
money.
- It is based on accounting information rather than on cash flows.
- Depreciation is a non-cash flow expense, so, it should be added with net income to come up with the
cash flow(NI=CF- Depreciation )
ARR = NI .
Average investment
.
Example 1,
Anwar Company is considering an investment in x- project based on the following information:
Initial Investment= 15,000
Annual net income = 3,000
Useful life= 5 years
Target ARR= 30 %
ARR= NI
Average investment
= 3,000
15,000 Average
2
ARR= 40%
NI .
ARR= Average Investment
=1500
15,000 Average
2
=15,000
7,500
ARR= 20%
Asteway co should reject the investment in project X because the actual ARR (20%) is less than the target
ARR of 30%
Exercise
A project will cost 60,000 birr. Its stream of earnings before deprecation and taxes during first year through
five years is expected to be birr 20,000, 22,000, 25,000, 27,000& 29,000, respectively. Assume estimated life
and salvage value is 5 years & 500 birr, respectively. Again assume income tax rate is 55% .Target ARR is
15%. Depreciation is to be computed on straight line method.
Required: Determine ARR?
Solution
Year Profit before deprn & tax Deprn.exp Profit after deprn Tax (55%) NI
1 20,000 11,000 9,000 4950 4050
2 22,000 11,000 11,000 6050 4950
3 25,000 11,000 14,000 7,700 6,300
4 27,000 11,000 16,000 8,800 7,200
5 29,000 11,000 18,000 9,900 8,100
Total Net income 30,600
Average Annual net income=30600
5
= 6120
B) Discounted methods
3) Net present Value (NPV)
It is one of the discounted cash flow (DCF) techniques explicitly recognizing the time value of money.
NPV should be found out by subtracting initial investment from present Value of cash inflows.
Steps in the calculation of NPV
1. Net cash flows of the investment project should be forecasted based on realistic assumptions.
2. Appropriate discount rate should be identified to discount the forecasted cash flows. The
appropriate discount rate is the firms opportunity cost of capital which is equal to the required rate
of return expected by investors on investments of equivalent risk.
3. Compute the present value of net cash flows & summing up to come up the present value of the
net cash flows generated by the project
4. Compute the excess of sum of present value over the initial investment.
NPV=∑ of PV- Initial Investment.
Project B
Year NCF PVAT 12% Pv of cash inflows
1 5400 (1.12)-1= 4,821.43
2 8,000 (1.12)-2= 6,377.55
-3
3 10,000 (1.12) = 7117.80
4 12,000 (1.12)-4= 7626.22
Present Value= 25943
Less: Initial invest=25,000
NPV= 943
Therefore, both project A & B are acceptable since their NPV Positive.
If the risk free-rate of return is 8 percent, the NPV statistics for this project are calculated as follows. The
expected NPV is computed
* The values were calculated by using the corresponding annual cash inflows. A 10 percent cost of capital and
a 15 year life for the annual cash inflows were used.
NPV=∑et X CFt - I
(1+Rf)t
Where, et is certainity equivalent factor in year t (0≤ et≤1)
CFt is relevant cash inflow in year t
Rf is risk free rate of return
The equation is shows that the project is adjusted for risk by first converting the expected cash inflows to
certain amounts, etXCFt, and discounting the cash inflows at the risk free rate, Rf.
Example, ABC Company wishes to consider risk in the analysis of two projects, A and B. The cost of capital
is 10 percent when considering risk. The project cash flows are as follows
Project A Project B
Initial investment Birr 42,000 Birr 45,000
Year Cash flows
1 14,000 28,000
2 14,000 12,000
3 14,000 10,000
4 14,000 10,000
5 14,000 10,000
By ignoring risk differences and using net present value at 10 percent cost of capital, project A is preferred
over project B, since its NPV of birr 11074 is greater than N’s NPV of birr 10,914. Assume however, that on
further analysis the firm found that project A is actually more risky than project B. to consider the deferring
risks; the firm estimated the certainty equivalent factors for each project’s cash inflows for each year.
Certainty equivalent for project A and B are as follows:
Year Project A Project B
1 0.90 1.00
2 0.90 0.90
3 0.80 0.90
4 0.70 0.80
Project B
year Cash flows Certainty equivalent Certainty cash Present value
factor inflows
1 28,000 1.00 28,000 X(1.06)-1=26,404
2 12,000 0.90 10,800 X(1.06)-2=9612
3 10,000 0.90 9,000 X(1.06)-3=7560
4 10,000 0.80 8,000 X(1.06)-4=6336
5 10,000 0.70 7,000 X(1.06)-5=5229
Present value of cash inflows=55141
Less: initial investment =45,000
NPV =10,141
Note that as a result of the risk adjustment, project B is now preferred. The usefulness of the certainty
equivalent approach for risk adjustment should be quite clear, the only difficulty lies in the need to make
subjective estimates of the certainty equivalent factors.