CHAPTER ONE

THE MEANING AND FUNCTIONS OF FINANCE

Finance is the word used to describe both the resources available to

government, firms, or individuals, and the management of these monies.

Finance, according to Maness (1988) is the study of acquisition and investment

of cash for the purpose of enhancing value and wealth.

Financial Management is the acquisition, management, and financing of

resources for firms by means of money, with due regard for prices in external
economic markets (Pinches in 1990).

Financial Management /corporate finance also deals with proper acquisition of

cash and the efficient allocation of that cash within the company (Maness, 1988)

Financial management is that managerial activity which is concerned with the

planning and controlling of the firm’s financial resources. The subject of financial
management is of immense interest to both academicians and practicing
managers. It is of great interest to academicians because the subject is still
developing and there are still certain areas where controversies exist for which
no unanimous solutions have been reached as yet. Practicing managers are
interested in the subject because among crucial decisions of the firm are those
which relate to finance and an understanding of the theory of financial
management provides them with conceptual and analytical insights to make
these decisions skillfully.

What are firms’ financial activities? How are they related to the firm’s other
activities? Firms create manufacturing capacities for production of good; some
provide service to consumers. They sell their goods or services to earn profit.

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They raise funds to acquire manufacturing and other facilities. Thus, the three
most important activities of a business firm are: Finance, Production and
Marketing. A firm secures whatever capital it needs and employ it (finance
activities) in activities which generate returns on invested capital (Production and
marketing activities).

FINANCE AND OTHER FUNCTIONS OF CORPORATE GOVERNANCE

There exist an inseparable relationship between finance on the one hand and
production, marketing and other functions on the other hand. Almost all kinds of
business activities directly or indirectly, involve the acquisition and use of funds.
For example, recruitment and promotion of employees in production is clearly a
responsibility of the production department, but requires payment of wages and
salaries and other benefits, and thus involves finance. Similarly, buying a new
machine or replacing an old machine for the purpose of increasing productivity
affects the flow of funds. Sales promotion policies can within the purview of
marketing, but advertising and other sales promotion activities requires outlays of
cash, and therefore, affect financial resources. The finance function of raising
and using money, although, has a significant effect on other function, yet it needs
not necessarily limit or constraint the general running of the business. A
company in a tight financial position will of course, gives more weight to financial
considerations, and device its marketing and production strategies in the light of
the financial constraint. On the other hand, management of a company, which
has regular supply of funds, will be more flexible in formulation its production and
marketing policies. In fact, financial policies will be devised to fit production and
marketing decisions of a firm in practice.

THE FUNCTIONS OF FINANCE

Although it may be difficult to separate the finance functions from production,
marketing and other functions, yet the functions themselves can be readily
identified. The functions of raising funds, investing them to assets and distributing

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returns earned from assets to shareholders are respectively known as financing,
investment and dividend decision. While performing these functions, a firm
attempts to balance cash inflows and outflows. This is called liquidity decision
and we add it to the list of important finance decisions or functions. Finance
functions or decisions include:
 Investment or long-term asset-mix decision
 Financing or capital-mix decision
 Dividend or profit allocation decision
 Liquidity or short-term asset-mix decision.
A firm performs finance functions simultaneously and continuously in the normal
course of business. They do not necessarily occur in sequence. Finance
functions call for skillful planning, control and execution of a firm’s activities. It
should be noted at the outset that shareholders are made better off by a financial
decision, which increased value of their shares. Thus, while performing the
finance functions, the financial manager should strain to maximize the market
value of shares.

INVESTMENT DECISION
Investment decision or capital budgeting involves the decision of allocation of
capital or commitment of funds or long-term assets, which would yield benefits in
future. Its one very significant aspect is the task of measuring the prospective
profitability of new investments. Future benefits are difficult to measure and
cannot be predicted with certainty. Due to future uncertainties, capital budgeting
decision involves risk. Investment proposals should be evaluated in terms of
both expected returns. Besides the decision to commit funds in new investment
proposals, capital budgeting also involves decision of recommitting funds when
an asset becomes less production or non-profitable. Other major aspect of
investment decision is the measurement of a standard or hurdle rate against
which the expected return of new investment can be compared. There is broad

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agreement that the correct standard to use for this purpose is the required rate of
return or the opportunity cost of capital.

FINACING DECISION
It is the second important function to be performed by the financial manager.
Broadly, the manager must decide when, where and how to acquire funds to
meet the firm’s investment needs. The central issue before the practitioner is to
determine the proportion of equity and debt. The mix of debt and equity is known
as the firm’s capital structure. The financial manager must strain to obtain the
best financing mix or the optimum capital structure for the firm. The firm’s capital
structure is considered to be optimum when the market value of shares is
maximized.

The use of debts affects the return and risk of shareholders it may increase the
return on equity funds but it always increase risk. A proper balance will have to
be struck between return and risk. When the shareholders’ return is maximized
with minimum risk, the market value per share will be maximized and the firm’s
capital structure would be considered optimum. Once the financial manager is
able to determine the best combination of debt and equity, the manger must raise
the appropriate amount through best available sources.

In practice, a firm considers many other factors such as control, flexibility, loan
convenience, legal aspects, etc in deciding the capital structure.

DIVIDEND DECISION
Dividend decision is the third major financial decision. The financial manager
must decide whether the firm should distribute all profit, or retain them or
distribute a portion and retain the balance. Like the debt policy, the dividend
policy should be determined in terms of its impact on the shareholders value.
The optimum dividend policy is one, which maximizes market value of the firm’s

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shares. Thus, if shareholders are not indifferent to the firm’s dividend policy, the
financial manager must determine the “optimum dividend payout ratio”. The
dividend payout ratio is equal to the percentage of dividends distributed to
earnings available to shareholders. The financial manager should also consider
the question of dividend stability, bonus diaries and cash dividends in practice.
Most profitable companies pay cash dividends regularly. Periodically, additional
shares, called bonus shares, are also issued to the existing shareholders in
addition to the cash dividends.

LIQUIDITY DECISION
Current assets management which affects a firm’s liquidity is yet another
important finance function, in addition to the management of long term assets
current assets should be managed efficiently for safeguarding the firm against
the dangers of illiquidity and insolvency. Investment in current asset affects firm’s
profitability, liquidity and risk. A conflict exists between profitability and liquidity
while managing current assets. If the firm does not invest sufficient funds in
current assets, it may become illiquid. But it would lose profit, as idle current
assets would not earn anything.
Thus, proper trade-off 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 or
managing current assets. He should estimate firms needs for current assets and
make sure that would be made available when needed.
It would be thus clear that financial decisions directly concern the firm’s decision
to acquire or dispose off assets and require commitment or commitment of funds
on a continuous basis. It is in this content that finance functions are said to
influence production, marketing and other functions of the firm. This, in
consequence, will affect the size, growth, profitability and risk of the firm and
ultimately the value of the firm.

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 THE FINANCIAL MANAGEMENT FUNCTIONS
The FM cycle is a recurring of activities and related processing operations
directed at securing a study flow of financial resources to an organization.

Closely related to FM cycle is the financial reporting cycle which is the

accounting cycle that processes all economic transactions of an organization to
prepare financial status and performance of the organization and its operating
units.
The economic transactions that originate in the revenue cycle, procurement
cycle, processing cycle, personnel and pay-roll cycle and FM cycle all become
inputs to the financial reporting cycle.
For the understanding of the decision making, responsibilities and related
information required of financial managers, it is useful to begin by examine the
organization structure of the FM function with typical entity.

THE ORGANISATIONAL STRUCTURE OF MANAGEMENT FUNCTION

C.F.O

TREASURE DIRECTOR OF CONTROLLER

INTERNAL AUDITING

DIRECT. OF DIRECT. OF DIRECT. OF DIRECT. OF DIRECT. OF DIRECTOR

INVESTMEN CREDIT BUDGET PLANNING COST MGT. OF
T RELATION COLLECTION A/TING GENERAL
A/TNG

DIRECTOR CASHIER
OF
INSURANCE

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In an organizational sense, the FM functions include the Treasure who is
responsible for administration of the finances and the Controller who administers
the accounting functions.
In many businesses, the treasure and the controller are combined organizational
unit under the authority of a top financial executive often called the chief financial
officer (CFO)

1.The CFO is responsible for both administrative functions and for making
decision and recommendation about the most important aspect of the finance
section, the latter task includes decision about long-term financing, dividend
policy, capital expenditures and resources allocation within the firm.

2. Another important responsible of CFO involves monitoring, analysis and report

on the firm operating performance.

The decisions about long-term financing are made infrequently in most business
organization perhaps, only once every few years. Each major decision in this
area, however, will have a significant impact on the firm’s success and growth
over an extended period of time. Perhaps, the most important strategic decision
involves selecting the best mix of debt and equity financing in order to gain the
advantages of financial leverage while minimizing financial risk and interest
charges.
Once this selection has been selected, decision has to be made about best
sources of long term and equity financing and about the timing and marketing of
new security issues. Selecting the sources of long-term financing involves
choosing among such alternatives as loans, common stock, and other financial
influences. Planning the timing of financing involves determining when to enter
into the capital market in order to achieve terms most favuorable to the firm.
Dividend policy is also closely related to long-term financing, because another
source of long term funds is retained earnings that are not paid out as dividends.

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3. The CFO is also deeply involved in the planning and control of capital
expenditure for the acquisition of property, plant and equipment and other assets
having long-term benefits to the firm. Planning capital expenditures include
determining the total amount the firm will spend on the capital expenditures for
each year or quarter and deciding among the alternative capital investment.
4. The decisions established how the firm financial resources will be allocated
among its division, functions and other operating units and are so crucial to the
firm’s growth and success.

TREASURER
The treasurer’s responsibilities includes managing working capital and short term
cash flows and advising the CFO on long term financial decisions on capital
nature and the firm’s participation in capital market and administering the various
treasurer-ship staff functions.
The separation of treasurereship staff functions into investment relations, credits
and collections, insurance and cashiering as shown in the diagram above is
representative of the way in which this responsibility are financially allocated in
many large business organization. The primary responsibilities of each of these
staff functions are briefly reviewed below.

The director of investment relations administer the process of communicating the

firm’s financial resources to the investment community including not only the
firm’s own stock holders but also security analyst, stock exchange through which
the securities are traded. To fulfill this responsibility the director must maintain a
database of information on current firm’s stockholders transactions and must
maintain contact with other key persons in the investment community.

The director of credit and collections or credit controller is responsible for

developing and administering policies on the granting of credits and their
collections accounts. Credit granting policies, credit units and collection

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procedures must be tight enough to avoid tying up of funds on accounts
receivable unnecessary since this funds could be profitable if invested
somewhere. On the other hand, credit policies and procedures must be lose
enough to avoid the lost of sale and customers.
The director must find the optimal trade off between these two conflicting
objectives.

Director of insurance is responsible for identifying and evaluating potential losses

to the firm that needs insurance, selecting the appropriate mix of insurance
coverage and other methods for dealing with this rock, obtaining insurance
coverage on terms favourable to the firms and administering the firm various
insurance contracts.
In order to administer the organization’s insurance programs, the director needs
information concerning payment of premiums, execution of new insurance
contract in accordance with established policies and maintenance of funds of
resources for self insurance and reporting and collection of claims.

The cashier establishes and maintains banking arrangement for the organization.
This function involves selecting the firm’s banks and banking location,
establishing bank account, negotiations on the terms and conditions relating to
that account and arranging a line of bank credits to cover short term borrowing
requirement. The cashier is also responsible for endorsing, depositing and
maintaining a record of cash receipts, reviewing and approving disbursement
authorization, signing and distributing cheques and maintaining a record of cash
disbursement.

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CONTROLLER
The controller’s responsibilities includes designing systems to effectively process
large volume of accounting transaction data, ensuring that effective internal
controls are in place throughout the organization, preparing and interpreting
financial information used by management to evaluate the economic
performance of the business organization and individual managers within the
organization, assessing the financial implications of alterations made on
management plans and strategies use to administering the various controllership
staff functions located under the Controller’s authority.
Another important part of the controller’s role is to serve as financial consultant to
the top management and other managers within the organization. In this role,
The Controller must address a variety of questions, example, what causes the
company’s net income to decrease? Why did certain key financial ratio increase
or decrease in the company’s recent financial statement? And what does it need
for the company health and future prospect? What steps should the company
take to improve its earnings, reduces its taxes, improves its key financial ratio,
reduce its cost and improve its cash flows.

To address questions like these, the controller must have a thorough

understanding of the company financial strength and weakness and of its
position within the industry that it serves and the company as a whole. The
separation of controllership staff functions into budgetary, tax planning cost and
management accounting and general accounting as showed in the above
diagram is the representative of the way in which these responsibilities are
functionally allocated in many large business organizations. The primary
responsibilities of each of the functions are briefly reviewed below:
The director of cost and management accounting supervises those accounting
activities directly relating to manufacturing operations, this information includes
the determination of standard cost for material, labour and overhead for each of
the company products. It also include the establishment of accounting systems

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to record and process accounting data on manufacturing work-in-progress and to
generate report comparing actual and standard production cost for each
manufacturing department or product and so on.
The director of general accounting is responsible for supervising the routine
operating functions of the operating department which include account
receivable, accounts payable, inventory, payroll and general ledger.
This function includes establishing systems for processing accounting data and
maintaining accounting records in each of these areas. It also includes
establishment of internal control procedures and monitoring the execution of
those procedures.

DIRECTOR OF INTERNAL AUDITING

The director of budgeting is responsible for preparing three kinds of budgets i.e.
Operation, cash and capital expenditure budget. The operating budget serves as
a standard for evaluating the performance of unit mangers. The cash budget is
prepared to specify the timing of the organization’s operating cash inflows and
outflows.
In addition, the directors work with operating managers to develop cash flow
estimates to support request for capital expenditure and participate in the
prioritizing this request. Thus the director of budgeting plays an important role in
assisting management to plan and control the organization operating investment
and financial activities.
The director of the tax planning makes recommendation of how the organization
can minimize its tax liabilities and administers the organization’s reporting
activities to ensure compliance with applicable laws and regulations. The
director must advice management the tax effect on alternative management
decision and is responsible for preparation and submission of tax returns.

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CHAPTER TWO
SOURCES OF FINANCE
The Choice of Finance
A company in need of additional finances has a wide choice, its final option being
influenced by the following considerations:
a) The relatives cost of borrowing by different methods:
i) The cost of capital is the interest, which has to be offered on
debentures, the dividends of preference shares and yields on ordinary
shares to attract investors’ capital.
Obviously the opportunity cost of capital is relevant, but in addition it is
influenced by investor’s attitude towards risk, reward and control
offered by various securities. For instance, lenders will demand higher
rewards on ordinary shares and unsecured loan stock than on
preference or secured debentures, to compensate for the higher risks.
But they will demand less if they confer control with its attendant
advantages.
ii) The administrative costs involved in raising the capital.
b) The term of the finance projects which mean that if expenditure will not be
recouped in the short term suggest a long term finance, which is generally
more expensive. However, in times of high interest rates, a company
should consider financing a long-term project by redeemable securities
and short-term borrowing when there is a good chance that it can be re-
financed when rates are lower.
c) The effects of taxation e.g. interest are allowable against profits (unlike
dividends) in the assessment of corporation tax.
d) The value and nature of corporate assets available as security.
e) The nature of conditions imposed by lenders on a company’s freedom of
action, eg. Restrictions on the future borrowing ability if the assets are
pledged.

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 f) The company’s ability to earn a sufficient cash flow to pay fixed charges
and repay loans, e. g. redeemable debentures.
g) The company existing capital structure and the effect of new borrowings
on capital and vote gearing.
h) Market conditions, e.g. a severe ‘credit squeeze’ may make it difficult to
obtain short-term bank finance or the capital market may already be
‘saturated’ with new shares.

(1) LONG TERM CAPITAL

(a) Equity Capital: This is the amount contributed by members of that company
and is normally supplemented by retained profit or undistributed profit. We have
two types of shares: Ordinary and Preference shares:
Preference shares are usually irredeemable i.e. They provide permanent capital
which does not have to be repaid. If the preference shareholders wishes to
dispose of his holding he must sell the share in the stock market. Company
whose regulations authorized them to do so can however, issue redeemable
preference shares.

FEATUES OF ORDINARY SHARES

Claim on Income: Ordinary shareholders have a residual ownership claim. They
have a claim to the residual income which is, earnings available for ordinary
shareholders, after paying expenses, interest charges, taxes and preference
dividend, if any. Dividends are immediate cash flows to shareholders. Retained
earnings are reinvested in the business, and shareholders stand to benefit in
future in the form of the firm’s enhanced value and earnings power and ultimately
enhanced dividend and capital gain.
Claim on assets: ordinary shareholders also have a residual claim on the
company’s asset in the case of liquidation. Liquidation can occur on account of
business failure or sale of business. Out of the realized value of assets, first the
claims of debt holders and then preference shareholders are satisfied and the

13
remaining balance, if any, is paid to ordinary shareholders. In liquidation, the
claims of ordinary shareholder may generally remain unpaid.

Right to control: Control in the context of a company means power to determine

its’ polices. The company’s major policies and decisions are approved by the
BODS while day to day operations are carried out by managers appointed by the
board. The control may be defined as the power to appoint directors. Ordinary
shareholders have the legal power to elect directors on the board. If the board
fails to protect their interests they can replace directors. They are able to control
management of the company through their voting rights and right to maintain
proportionate ownership.
Voting Rights; Ordinary shareholders are required to vote on number of
important matters.
Preemptive right: This right entitles a shareholder to maintain his proportionate
share of ownership in the company. The law grants shareholder the right to
purchase new shareholders in the same proportion as their current ownership.
The shareholder may decline to exercise this right.
Pros and Cons of Equity Financing: The equity capital is the most important
long-term source of financing. It offers a number of advantages to the company.
Permanent Capital: since ordinary shares are not redeemable, the company has
not liability for cash outflow associated with its redemption; it is a permanent
capital and is available for use as, long as the company grows.
Borrowing Base; The equity capital increases the company’s financial base, and
thus its borrowing limit. Lenders generally lend in proportion to the company’s
equity capital. By issuing ordinary shares the company increases its financial
capability. It can borrow when it needs additional funds.
Dividend Payment Direction: A company is not legally obliged to pay dividend.
In times of financial difficulties, it can reduce or suspend payment of dividend.
Thus it can avoid cash flow associated with ordinary shares. In practice,

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dividend cuts are very common and frequent. A company tries to pay dividend
regularly. It cuts dividend only when it cannot manage cash to pay dividends.

Equity capital has some disadvantages to the firm compared to other sources of
finance. They are as follows:
Cost: Shares have a higher cost at least for two reasons. Dividends are not tax
deductible as are interest payments, and floatation costs on ordinary shares are
higher than those on debt.
Risk: Ordinary share are riskier from investors point of view as there is
uncertainty regarding dividend and capital gains. Therefore, they require a
relatively higher rate of return. This makes equity capital as the highest cost
source of finance.
Earning dilution: The issue of new ordinary shares dilutes the existing
shareholders earinings per share if the profits do not increase immediately in
proportion to the increases in the number of ordinary shares.
Ownership dilution: The issuance of new ordinary shares may dilute the
ownerships control of the existing shareholders. While the shareholders have a
preemptive right to retain their proportionate ownership, they may not have funds
to invest in additional shares. Dilution of ownership assumes great significance
to the case of closely-held companies.

PREFERENCE SHARES FEATURES

i) Claims on income and asset
iii) Fixed dividend
iv) Cumulative dividends
v) Redemption
vi) Participation feature
vii) Voting rights
viii) Convertibility

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Pros and Cons
1) Riskless leverage advantage
2) Dividend postponability
3) Fixed dividend
4) Limited voting rights

Limitations
1) Non-deductibility of dividends. Commitment to pay dividend

TYPES OF REDEEMABLE PREFERENCE

a) Convertible redeemable preference shares: These have the right to be
converted into ordinary shares at some future date. They are similar to
convertible debentures.
b) Cumulative redeemable preference shares: If C R P Shares receives no
dividend in one year because the company has failed to make profit, it will
receive it in another year when company’s finances has improved. The
dividend accumulated until the company can afford to pay and the
shareholder then receive the accumulated and the current dividend for the
year in which dividend is paid.

(2) DEBENTURES/LOAN STOCK: Usually a debenture is a bond given in

exchange for money lent to the company. Debentures and loan stock can be
secured or unsecured. Debenture or loan stock can also be convertible. The
characteristics of convertible loan stock issues are that while they are sold
initially as loan stock receiving appropriate rate of interest , the holder is given
the option of converting this loan stock within a given time period to equity shares
at a specify price. Convertibles are seen as a way of issuing deferred equity.
The advantage to the company of this form of capital is that, initially, the loan
stock assists the capital gearing and the interest with advantage of the tax shield
reduces cost of capital in the years when it remains loan capital. The advantage

16
to the shareholders is that he can wait to see how the share of the company
moves before deciding whether to invest in equity. If the company is successful
and the share price rises the investor will be keen to exercise the option, if not he
is free to retain the loan investment. The holder is usually given the opportunity
to convert in at least two dates in each year on which the option is exercisable.

FEATURES OF DEBENTURES
1) Interest rate: The interest rate on a debenture is fixed and known. It is
called the contractual of coupon rate of interest.
2) Maturity: Debentures are issued for specific period of time. The maturity
of a debenture indicates the length of time until the company redeems the
par value to debenture holder and terminates the debentures.
3) Redemption: As indicated earlier, debentures are mostly redeemable;
they are generally redeemed on maturity. A redemption of debentures
accomplished either through a sinking funds or buying back (call)
provision. Buy back (call) Provision: Debenture issues include buy-back
provision. They enable the company to redeem debenture at a specified
price before the maturity date. The buy-back (call) price may be more
than the par value of the debenture. The difference is called call or buy
back premium.
4 Indenture: An indenture or debenture trust deed is a legal agreement
between the company issuing debenture and the debenture trustee who
represents the debenture holders. It is the responsibilities of the trustee to
protect the interest of debenture holders by ensuring that the company
fulfills the contractual obligation. Generally a financial institution or a bank
or an insurance company or a firm of attorney is appointed as a trustee.
The indenture provides the specific terms of the agreement, including a
description of debentures, rights of debenture holders, rights of issuing
company and responsibilities of trustee.

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 5 Security
6 Yield
7 Claims on assets and income.

Pros and Cons: Debentures has a number of advantages as a long-term source

of finances.
a. Less costly
b. No ownership
c. Fixed payment of interest
d. Reduced real obligation

Debenture has some limitations also.

i. Financial risk
ii. Cash outflows
iii. Restricted covenants

Features of long term Loans:

1) Maturity
2) Direct negotiation
3) Security
4) Restrictive covenants
5) Convertibility and;
6) Repayments schedules

(b) Zero or Low Coupon loan stock (Bonds)

Zero coupon bonds are bonds, which do not attract interest payment, if the
coupon is zero the bond returns will be embodied entirely in the price
appreciation to maturity. In the case of a zero coupon bond each return is the
difference between the prices paid and the face value received at maturity.

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Example if an initial prices paid for a bond $516 and the face value receive on
maturity is $2000 then the difference of $1484 will be the returns or interest.
This return is not a capital gain rather a discount must be amortized and the
yearly amortize amount reported as taxable income.

A zero bound has these advantages to the investor:

j) The bond will not be called or cancelled.
ii) The exact return is assured if the bond is held to maturity.

Advantages to the Company

iii) By satisfying certain condition for some investors of zero or low coupon
bonds, a company may be able to lower its interest cost.
iv) Another possible advantage to the company is that no cash is required
to service the debt until final maturity.

The major disadvantage of the low or zero coupon bonds is that the company
gives out the ability to call or refund the issue in the future should interest rate
move lower.

WARRANTIES: A further type of issue is the sale of loan stock, which cannot in
itself be converted into equity but which gives the holder the rights to subscribe at
fixed future date for ordinary shares at a predetermined price. A number of
issues have been offered in these terms. The subscription rights called
“warranties” entitle the bondholder to obtain a certain number of company
ordinary shares at an agreed price. This is different from a convertible issue of
loan stock where the loan stock is given out if the conversion right is exercised
with a warrant bond holder keeps the original loan stock and has choice of using
the warrant to obtain ordinary shares in addition.

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The advantage to the company of this form of issue is that the loan stock is
maintained until the date of redemption. The warrants also enable the company
to raise new equity capital i.e. there is no need to substitute one form of capital
for another as there is for convertible loan. The company retains both forms of
capital up to the date of redemption. As long as the company is sure that it will
need a new inflow of external capital in the future when the warrant are exercise,
this type of issue will have advantages both to the company and the investor.

SHORT AND MEDIUM TERM SOURCES OF FINANCE

Leasing; Is a form of medium or short-term finance. A very important financing
alternative provided by the non-bank finance sector is equipment leasing,
example, manufacturing equipment, mining construction, offices, corporate
vehicle and hospital equipment.
There are two kinds, of lease: finance leases and operating leases. A finance
lease is a contract between two parties, whereby the lessor supplies an item of
equipment to the lessee for a specify period (primary lease term) in return for a
series of periodic payments. Between the parties to the transaction, it is agreed
that title will remain vested in the lessor, who will recover the full cost of the
assets plus profit during the period.

Finance leases are essentially long-term loans. These have to be shown in the
lesee’s account as assets and liabilities and the depreciation and financing
charged against profits. The term of the lease normally extends over the full
useful life of the asset. The lessor therefore receives lease payments, which will
fully cover the cost of the asset. The agreement will usually not be cancellable
and will not provide for any maintenance of the assets. The leasing company is
not normally involved in dealing with the assets themselves being a bank or
finance company. The assets are selected by the firm who will use it, who
negotiates price, delivery, etc.

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The leasing company simply buys the asset and arranges a lease contract with
the lessee, at the end of the lease period, there will usually be an agreement
where the sale proceeds from the asset shared between the lessor and the
lessee or if the lessee desires it can carried out using the asset for payment of a
nominal amount each year called pepper corn rent.

Operating leases has significantly shorter primarily lease term than the
equipment lifetime expectancy. The terms for such leases, typically ranks
anywhere from a few months to a few hours. Examples here include the hire of
operating assets such computer, busses and aircraft etc. Operating leases are
treated very much like contract hire. They do not appear on the lessee’s bank
statement and the fee for the hire is charged directly against profit. These
agreements will usually not last for the full life of the asset. They are offered by
company who manufacture or deal in the particular product often incorporating
maintenance and other services. The lessor will not recover his full investment
on any lease but will hope to lease a particular asset several times over its life.
Advantages
Leasing has a host of benefits to all who take advantage of it.
1. One of the most obvious is the initial capital saving enjoyed by the lessee.
When the decision to lease is taken, apart from the initial deposit and the first
rental payment required no other immediate financial outflow is required. The
outflows are spread over the primary lease term and unutilized funds are used to
enhance the efficiency of the company in other areas.

2. Leasing has very attractive taxation benefits. Rental payable by the lessee is
fully tax deductible. The lessee can also benefit any unutilized capital allowance
available when the primary lease term is concluded and the title in the equipment
is transferred.
3. Leasing could be an off balance finance. This is usually the case with
operating lease, under such arrangements there are no depreciation charges for

21
the lessee as the lessor will be required to disclose the assets on his balance
sheet.
4. Leasing will be used as a hedge against inflation and obsolescence.
ILLUSTRATION 1
KESSBO LTD. is considering the acquisition of an item of plant. The company
can either borrow the necessary funds from its bankers and purchase the plant or
enter into a finance lease involving four annual payments of ¢285,000. Whether
purchase by KESSBO LTD or the lesser the plant will cost ¢750, 00. It will attract
capital allowance of 30% on a reducing balance over its four year life.
Corporation tax is 25% payable in the year of the relevant profit. Assumed the
purchase of the machine and raising of the loan will occur at the beginning of
year one and that all lease and cash payments and tax cash flows occurred at
the end of relevant year. The company cost of capital is 12%.

REGOUIRED:
Calculate which of the two options: leasing or borrowing is financially more
advantages for KESSBO LTD.

ILLUSTRATION II

All is over Limited have decided to acquire some new plant and machinery and is
now considering whether to buy or lease it. The machinery in question has a
useful life of four years with a residual value of six million cedis at the end of that
time. It will cost seventeen million six hundred thousand to buy which will be
financed by borrowing.
Alternatively it could be leased for four years at an annual rent of four million five
hundred thousand payable annually in advance. The company tax rates is 33%.
If purchase, the machine will attract a written down allowance of 25% (reducing
balance basis per annum). A balance allowance or charge will be made on
disposal. If leased the rental will be allowed fully against company tax, tax is

22
paid and allowances received one year in arrears. The after tax cost of
borrowing to ALL IS OVER LTD. is estimated to be 13%.

REQUIRED:
(a) Advice ALL IS OVER LTD whether to buy or lease the machine on the
assumption that the company has sufficient taxable profit to fully absorbed all tax
allowances rising from the buy or lease decision.

(b) Advice the company whether to buy or lease the machine on the basis that
the company is on permanent non-tax pay position.

SOLUTION:

(a) lease option

YEAR GCF TAX RELIEF NCF DCF PV

¢000 ¢000 ¢000 ¢000

0 (4,500) (4500) 1.00 (4,500)

1 (4,500) 1485 (3015) 0.885 (2668)

2 (4,500) 1485 (3015) 0.783 (2361)

3 (4,500) 1485 (3015) 0.693 (2089)

4 - 1485 1485 0.613 910

Net present value (10,708)

23
Computation of Capital Allowance

Year ¢000 Tax relief

1 17600
Cost
Capital allowance (4,400) 1452

2 Residual value 13,200

Capital allowance (3,300) 1089

3 residual value 9,900

Capital allowance (2475) 817

4 residual value 7425

Capital allowance (1856) 613

5 Residual value 5569

Disposal 6000 (142)
Balance charge 431

24
PURCHASE OPTION:

YEAR GCF TAX RELIEF NCF DCF PV

¢000 ¢000 ¢000 ¢000

0 (17600) (17600) 1.00 (17600)

1 0.885 -

2 1452 1452 0.783 1137

3 1089 1089 0.693 755

4 6000 817 6817 0.613 4179

5 471 471 0.543 256

Net present value (11273)

The NPV cost of leasing is lower than buying outright using bank loan and it
therefore financially more advantageous to the company.

25
(b) (i) Purchase Option

YEAR GCF TAX RELIEF NCF DCF PV

¢000 ¢000 ¢000 ¢000

1 (17600) 1.0 (17600)

2
3
4 6000 0.613 3678
NPV (13922)
(ii) Lease Option

YEAR GCF DCF PV

0 (4,500) 1.00 (4500)
1 (4,500) 0.885 (3983)
2 (4,500) 0.783 (3524)
3 (4,500) 0.693 (3119)
NPV (15126)
The advise that should be given to the company is the vice versa of the solution
(A) above.

SALE AND LEASE BACK:

It is possible to convert certain assets which a company owns into funds and yet
for the company to still continue to use the asset. For example, a building is sold
to an insurance company or some other financial institution and then leased back
from the purchaser, the company has secured immediate cash inflow. The only
cash outflow is the rental payments the company has to make. These rental
payments are allowed as a tax-deductible expense.

26
However, the company may be subjected to capital gains tax which will arise if
the sale price is in excess of the written down value as agreed by the tax
authorities. With sale and lease back funds are released for use elsewhere in
the business. It must be remembered, however, that the leased asset no longer
belongs to the company. The lease may one day come to an end and then
alternative assets will have to be obtained. Also the company is no longer
obtaining the possible capital appreciation on the asset therefore there is costs to
its process in addition to lease payment that have to be made. Another
disadvantage is that, the company no longer has that asset as a security i.e.
collateral security.

(3) FACTORING
It involves raising funds on the security of the company debts so that cash is
received earlier than if the company waited for the debtors to pay. Basically most
factors offer three services.
Sales ledger accounting, dispatching invoices and making sure the bills are paid.

Having purchased the debt, the factor providing sales ledger administration will
take responsibility for the sale ledger accounting records creating control and the
collection of the debt. It is claimed that with his experience, the factor will be able
to obtain payment from customers more quickly than if the company were to be
responsible for the collection. The cost of this administrative service is a fee
based on the total value of debt assigned to the factor. The fee is usually
between 1 to 3%. If a debt turns out to be bad and no insurance has been
obtained, the factor will have to call on the clients for repayment of the funds in
advance on the invoice.

Credit management including guarantees/insurance against bad debt for a fee,

the factor can provide 100% protection against non-payment on approved sales.
Of course, the factor has to decide, whether the debt is worth covering. The

27
credit standing of the company individual customers will be analyzed carefully
before a guarantee can be obtained.

The provision of finance advancing clients up to 80% of the value of the debt that
is to be collected. Provision of finance is the main reason why companies use
the services of factors. For a small fast growing company, a factor is a good
means of releasing funds tired in debts. It provides a good source of working
capital. The factor usually allows 80% of the debt to be borrowed when the
invoices is dispatched to the customer. The remaining 20% less charge will be
paid either after a specify period or when the invoice is paid by the customer.
The charge is based on the amount borrowed at a particular time.

Advantages of factoring: The main advantage of a firm using the services of a

factor may be summarizing as follows:

a) These are clerical and administrative savings, particularly for firms selling
repetitively on credit as follows:

b) In effect the firm has one customer only, the factor, Even if there is
undisclosed to the firm’s customers, it is a simple matter for the firm to endorse
cheques and pass them on.
ii) The firm is no longer concerned with bad-debts controls
iii) There are economics in management and staff salaries, since fewer
supervisors and clerical for the workers are needed. Also there are
corresponding savings in recruitment and training.

There are also the following financial benefits:

Capital locked up in sundry debtor balances is available for use within the
business as all sales become in effect cash sales.

28
With this improved liquidity it can offer improved credit terms to its customers in
order to increase orders.

It can take advantage of suppliers’ cash discounts and make prompt payments.

This improves its credit rating

The turnover of stocks into cash is speeded up and this allows a larger turnover
on the same investment.

Undisclosed factoring does not prejudice on customer goodwill.

vii) Since factoring is not borrowing, the company balance sheet liquidity is not
weakened nor its borrowing potential impaired.

c) The company is free to concentrate on the main jobs of producing and selling.

TRADE CREDIT:
One of the most important forms of short-term finance in the economy is trade
credit extended by one company to another on the purchases and sales of goods
and equipment. To receive goods and delayed payments of the account is a
recognized form of short-term financing. The goods can be used to provide
returns or benefits throughout the period that elapses before the bill has to be
settled. For receiving company, this is similar to buying goods with a bank
overdraft except that an overdraft carries the obvious interest charge, when the
finance is provided by another company the cost is not so obvious.

HIRE PURCHASE
It is a source of medium term credits sometimes use for the purchase of plant
and machinery equipment. Initially, a hire purchase company purchases the

29
required equipment but it can be immediately be used by the hiree, who after a
series of regular payments which includes an interest charges, becomes the
owner of the equipment. The hiree has the advantage over the use of the
equipment over the period he is making the payment and so obtains the benefits
from using the equipment without having to incur a large capital outlay. In terms
of cash flow, the hiree has to make an initial payment and a series of installment
rather than a large cash outlay at the time of first using the equipment. The cedis
that he saves at the beginning of the period, rather than the full purchases price
are available for investment elsewhere. Advocates of hire purchase financing
point out the following advantages;
a) Hire purchase encourages firms to take a longer-term view of
investment requirement since they no longer have to buy only when
they have sufficient funds for outright purchase.
b) It is the use of equipment, which is important for profits, and this is
gained on payment or the first installment.
c) Since capital is not tied up immediately, it may find alternative
profitable employment.
d) The installment charge is predetermined. Fixed installments are
advantageous in inflation.
e) A variety of flexible Hire Purchase agreements are available to suit
the customer
f) If the goods qualify for capital allowances grant, these benefits
retained by the user.

BILL OF EXCHANGE:
Post-dated cheque is a simple example of a bill of exchange. When a cheque
signed on January 1st is dated April, 1st or July 1st the signatory is asking the
bank to pay the prescribed amount in three or six months time. The signatory, a
buying company can send this cheque to a supplier who will dispatch goods.
The supplier is in fact, giving three or six months credit and choose either to

30
retain the cheque or present it for payment on the due date or to sell it to a bank
or discount house.

BANK OVERDRAFT
Short term borrowing of this kind made available principally by the clearing Banks
(commercial) in the form of overdraft is very flexible. When the borrowed
amounts are no longer required it can quickly and easily be repaid. It is also
comparatively cheap because the risk to the lender is less than on long-term
loans and all interest are tax deductible expenses. The banks issue overdraft
with the right to call them in at short notices. However, the borrower must be
careful of what he does with the money he has obtained on those terms. If it is
re-called the company has to be able to repay, which will be awkward if the funds
has been used to purchase fixed assets.

DEFER TAX PAYMENT

Another source of short-term funds similar in character to trade credit is the credit
supplied by the tax authority. This is credited by the interval that elapses between
the earnings of the profit by the company and the payment of the taxes due on
them. As long as the company continues to earn stable or expanding profit, tax
payment deferred in this way comprises a virtually permanent source of finance.
Provisional assessment and payment of deposit on account by Ghana Tax
Authorities has rendered this source of finance non-effective.

RETAINED EARNNNINGS
It is also another source of finance to a company. It has sometimes been
suggested that the retained earnings of a company provided a free sources of
finance.

31
INVOICE DISCOUNTING AND CREDIT INSURANCE
Invoice discount is purely a finance arrangement, which benefits the liquidity
position of the user. Again it is designed to overcome the problem of tying up
working capital in book debt. A company can convert an invoice through
specialized finance company like First Atlantic Merchant Bank Ltd. Either a
separate invoice or a proportion of a company books debt can be discounted.
Although the full face value of the invoice is not usually advance, the company
makes an offer to the Finance House by sending the respective invoices and
agreeing to quarantee payment of any debt that are purchased. If the Finance
House accepts the offer, it makes an immediate first payment of about 75% of
the value of the invoices. The company then accepts as collected security, a bill
exchange for this 75% which means that at a specify future date, say, after 90
days the loan must be repaid. The company is responsible for collecting the debt
and for returning the amount advance, whether the debts is collected or not.

The cost of this service depends upon the risk and administrative cost involves, it
includes an interest charge on the amounts advanced plus a service charge, the
cost is not cheap.
A potential borrower offering a book debt as security will find that lending
institutions will be more willing to make advance if the debt is insured. The
clients pay(s) a premium to the insurance company in returns for the amount of
the invoice if the debt goes bad. The cost of the insurance will depends on the
amount involved and the risk attached to the debt.

INVESTMENT DECISION
The efficient allocation of capital is the most important finance function in the
modern times. It involves decisions to commit the firm’s funds to the long-term
assets. Such decisions are of considerable importance to the firm since they
tend to determine its value and size by influencing its growth, profitability and
risk.

32
The investment decisions of a firm generally known as capital budgeting or
capital expenditure decisions. A capital budgeting decision may be defined as
the firm’s decision to invest its current funds most efficiently in the long-term
assets in anticipation of an expected flow of benefit over a series of years. Long-
term assets are those which affect the firm’s operations beyond the one year
period. The firm’s investment decision would generally include expansion,
acquisition, modernization and replacement of the long-term assets. Sales of a
division or business (divestment) are also analyzed as an investment decision.
Activities such as changes in the methods of sales distribution or undertaking an
advertisement campaign or a research and development programme have a long
term implications for the firm’s expenditure and benefits, and therefore, they may
also be evaluated as investment decisions.

The following are the features of investment decisions

i). the exchange of current funds for future benefits.
ii). the funds are invested in long-term assets.
iii). the future benefit will occur to the firm over series of years.

It is significant to emphasis that expenditures and benefits of an investment

should be measured in cash. In the investment analysis it is cash flow which is
important not the accounting profit.

WHY ARE INVESTMENT DECISIONS IMPORTANT?

Investment decisions require special attention because of the following reasons:
1) They have long-term implication for the firm, and can influence the risk
complexion.
2) They involve commitment of large amount of funds
3) They are irreversible decisions
4) They are among the most difficult decisions to make

33
TYPES OF INVESTMENT DECISIONS
There are many ways to classify investments. Such classification is as follows:
 Expansion of existing business
 Expansion of new business
 Replacement and modernization
Another useful way to classify investments is as follow:
1) Mutually exclusive investment serves the same purpose and competes with
each other. If one investment is undertaken, others will have to be excluded. A
company may, for example, either use a more labour intensive, semi-automatic
machine, or employ a more capital intensive, highly automatic machine for
production, choosing the semi-automatic machine precludes the acceptance of
the highly automatic machine.

2) Independent investment serves different purposes and do not compete with

each other.

3) Continent investment is dependent projects, the choice of one investment

necessitates that one or more other investments should also be undertaken. For
example, if a company decides to build a factory in remotes, backward areas, it
may have to invest in houses, roads, hospitals, or schools, etc, for employees to
attract the work force. The building or factory requires investment on facilities for
employees. The total expenditure will be treated as single investment.

34
T IME VALUE OF MONEY
Simple interest is that! Simple interest is the interest income that is earned on a
principal sum over an investment period. This normally applies when an
investment is for only one investment period, for example one year fixed deposit
or when the investor collects the interest accruing on the investment at the of
each investment period. In the case of the later the investor will only have the
principal on which the interest will be calculated. For example if we invest GH
¢15,000 at an interest rate of 15% per annum, the investment will be worth GH
¢17,250 at the end of the year. This means that the interest on the GH¢15,000
over the year is GH¢2,250. How do we determine the interest? It is computed as:
1=Pxkxn
Where I is the interest, P is the principal, K is the interest rate, N is the
investment period.

Example
J. B. borrowed GH¢12,000 from his father to start a business. J.B was ask to
pay only 10% interest on the loan. If the loan is taken for three years:
i) Determine the interest on the loan
ii) How much will JB pay at the end of the period?

Solutions
i) I=Pxkxn
=GH¢12,000 x 0.10 x 3
GH¢3,600
ii) At the end of the third year JB will owe his father
GH¢12,000 + ¢3,600 = GH¢15,600

The amount to be paid at the end of the period (interest + the principal can also
be calculated straight away using the formula:
A = PV (1+k) Equation 2
Where A is the amount to be paid
Where PV is the amount (principal)
K is the interest rate
35
Example 2
Kofi Mensah loan GH¢ 2,000 to his friend at the rate of 17% for one year.
Determine the amount to be paid at the end of the year.
Solution
Amount to pay is A = PV(I + k)
A = GH¢2,000(1 + 0.17
A = GH¢2,340
Example 3
James Osei borrowed GH¢10,000 from a friend. At the end of the year James
paid GH¢12,500. If the loan was for one year, what was the interest on the loan?
Solution
In this case, the question ask for k. the formula A = PV(1 + k) will have to be
manipulated to make k the subject of the formula.

K= -1

K= -1

K = 1.25 – 1
K = 0.25 or 25%
Compound Interest
Compound interest is where interest is earned on the principal and any prior
interest that has not been withdraw. Compound interest is what is normally
earned on investment.
If you deposit/borrow for one year.
A1 = PV + PVk
= PV (1 + k)
If you borrow/deposit for periods
A2 = PV(1+k)(1+k)
A2 = PV(1 +k)2
If you borrow/deposit for three periods

36
A3 = PV(1+k)(1 +k) (1+k)
A3 = PV(1+k)3
For n periods
An = PV(1+k)n
Example
James Benson borrowed GH¢10,000 from a bank for four years. If the interest
rate charged by the bank is 20%, how much will be paid by James at the end of
the period?
Solution
A = PV(1+k)4
A = GH¢10,000 (1+0.20)4
A = GH¢20,736
Compounding Once a Year
Future value is the value, which a present amount will grow to at a compounding
interest. In other words how much a cedi (dollar) today would be given the
interest rate? This amount is arrived at taking into consideration timing
differences (and risk)
Future value can also be fined as “the use of compounding techniques to find the
future value of a known amount at the end of the investment’s life. In general the
formula for calculation future values when compounding is once a year is:
FV = PV (1 + k)n
Where FV is future value at the end of the n th year.
PV is the present amount (sometimes written PMT in some textbooks)
k is the interest rate, and
n is number of periods
Example 1: You deposited GH¢10.000 in a fixed deposit with your bank, if the
bank pays 15% on such deposits, calculate how much the money will grow to in:
i) A year’s time
ii) Two years time
iii) Five years time

37
Solution
FV = PV(1 +k)n
i) FV = GH¢10,000(1+0.15)
FV = GH¢11,500
ii) FV = GH¢10,000(1+0.15)2
FV = GH¢13,225
iii) FV = GH¢10,000(1+0.15)5
FV = GH¢20,114

Compounding more frequently than one a year

The above formula (equation 1) assumes that interest is compounded annually.
However, interest may compound more than once a year. In practice interest may
compound daily, weekly, monthly, quarterly or semi-annually. If you take Treasury
Bills as an example, we have 90 day, 190 day and one year Treasury Bills. The
first two pay interest more than once a year if the holder decides to hold it for
more than one period.
When interest accrues more than once a year, the general formula is:
FV = PV (1+k/m) nm
Where m is number of times interest is accrued. All the other variables are as
before.
Example 2
Kwame deposited $1000 at a bank, which gives interest rate of 9%. How much
will he have in two years if interest rate is paid?
a) Semi - annually
b) Quarterly
c) Monthly

Solution
FV = PV (1 + k/m)nm
PV = $1000
n=2
k = 0.09
a) m = 2
FV = $1000 (1 + 0.09/2)2x2
38
 FV = $1000 (1.045)4
FV = $1192.50
b) m = 2
FV = $1000(1 + 0.09/4)2x4
FV = $1000(1.0225)8
FV = 1194.80
c) m = 12
FV = $1000(1 +0.09/12)2x12
FV = $1000(1.0075)24
FV = $1196.40

The future value can also be determined using tables. These tables contanin
values already calculated using interest rates and number of years.
When using tables future values is calculated as
FV = PV (FVIFk,n)
Examples 3
Find the future value of GH¢5,000 deposited for 5 years at the rate of 15%
Solution
FV = GH¢5,000(FVIF15%,5)
GH¢5,000(2.011)
GH¢10,055
Continuous compounding
In some extreme cases interest can be compounded continuously. Continuous
compounding involves the calculation and accumulation of interest on an ongoing
basis. In this case interest is accrued over the smallest time period imaginable
and continues to do so for an infinite period of time. In this case, m from equation
three approaches and through the use of calculus this equation can be extended
to the following:
FV = PVekn Equation 4
Where e is an exponential function, which has a value of 2.7183
Example 4
Find the value of $100 in your one year if the interest rate is 9% per annum
compounded continuously.
Solution
39
FV = PVekn
FV = $100(2.7183(0.09 x 1) )
FV = $109.42
Example 5
Twum is a businessman who deposits huge sums of money in his bank account.
On January, 2007 he deposited GH¢2,000,000 in his bank account for two years.
The bank agreed to pay an interest of 15%. If interest is compounded
continuously, how much will the money grow to at the end of the two year?
Solutions
FV = PVekn
FV = GH¢200,000(2.7183 (0.15 x 2) )
FV = GH¢200,000 (1.34861515)
FV = GH¢69,972.30
Nominal and effective Interest Rates
To date we have assumed that the interest rate is given. This interest rate may
be the contractual rate charged by a lender or charge to a borrower. This called
nominal interest rate:
The effective interest rate is the interest rate that is actually paid or earned. The
main difference between the nominal and effective interest rate is that the later
takes into consideration timing differences and the impact of compounding
frequency. The general expression for calculating effective interest rate is:
Keff = (1 + k/m)m – 1 Equation 5
Example 5
What is the effective interest rate if you deposit $100 at a bank today and earn
interest rate of 8% compounded semi-annually?
Solution
Keff = (1 + k/m) m – 1
Keff = (1 + 0.08/2)2 – 1
Keff = 8.16%
Another way is to find the FV and divide it by the PV and subtract 1 to get keff

40
FV = $100 (1 + 0.08/2)2
FV = 108.16
Keff = (FV/PV) – 1
Keff = (108.16/100) – 1
Keff = 0.0816 or 8.16%
If compounding is continuous, then keff is ek + 1
Using the previous example
Keff = e k – 1
Keff = 2.7183 0.08 – 1
Keff = 0.083 or 8.3%
Future values of mixed streams
The approach to calculating future values of a known mixed stream of cash flows
involves a two step process:
1) calculate the future value of each cash flow
2) sum up all the individual future values to determine the total future value of
cash flow

FV = CF1 (1+k)n + CF2(+k)n – 1 + …………CFn(1 + k)n – n Equations 6

Example 7
Calculate the future value of the following yearly cash flows at the end of the fifth
year assuming a 10% return per annum
Year Cash flow
0 500
1 300
2 200
3 100
4 50
Solution
FV = CF1 (1+k) 5 + CF2 (1+k) 4 + ………. +CF1 (1+k)
FV = $500(1+0.1)5 + $300(1+0.1)4 + $200(1+0.1)3 + $100(1+0.1)2+$50(1+0.1)
FV = $805.26 + $483.15 + $266.20 + $121 + $55
FV = $1686.69
Meaning of annuity
41
An annuity is a stream of equal periodic cash flows (inflow or outflow) over a
fixed time span. An annuity is a fixed payment or receipts each period for a
specific number of periods. These cash flows can be can be inflows of returns on
investments or outflows of funds invested in order to earn future returns. For
example if you rent an apartment and promise to make to make a monthly
payment of rent, you have created an annuity.
There are two basic types of annuity namely Ordinary Annuity and Annuity Due.
An Ordinary annuity is the one that pays/receives a constant amount at the end
of each period for a specified number of periods.
An annuity due, on the other hand, is annuity, which pays//receives a constant
amount at the beginning of each period for a finite number of periods.
Future value of Ordinary Annuity
The future value of annuity looks at how much an equal amounts (PMT)
deposited into an account at the end of each year for n years and if the deposits
earns interest rate I compounded annually, will grow to at the end of the n years
In this situation, we think of the end figure as derived from the following:
FVAn = PMT (1 + k)n – 2 + ………… + PMT(1+k)

When this equation

When this equation is simplified we get the formula for ordinary annuity as
FVAn = PV/k [(1 + k) n – 1] Equation 2
Example 1
Mr. Osei Agyei Bonsu is planning his child university education education. He has
therefore decided to make periodic contribution towards that. If he deposits GH
¢2,000 at the end of every year into a special account for seven years and grow
to at the end of the seventh year?
Solution

FVA7 = FV = [(1+k) 7 – 1]

42
FVA7 = [(1+0.15)7 – 1]

FVA7 = GH¢13,333 (1.66)

= GH¢22,132
Using Tables
Future value of annuity can also be determined using the annuity tables. If the
annuity table is used, the future value of annuity will be determined by multiplying
the fixed payments/receipts (cash flows) by the annuity factor read from the
table.
In using the annuity table the future value of annuity is:
FVAn = PMT (FVIFk,n) Equation 3
Example 2
John deposits $3,000 in an investment fund at the end of each year for five
years. If the investment yields 18% return, how much will John have at the end of
the fifth year?
Solution
FVAn = PMT(FVIFAk,n)
FVA5 = $3,000 (7.154)
=$21,462
Future value of annuity due
Sometimes payments/receipts in respect of annuity are made at the beginning of
the year and not the year end. In this case, the annuity formula changes slightly.
We take into consideration compounding effect of the beginning
payments/receipts. The future value of annuity due is computed as:

FVA = {1+k) n – 1|)/ (1+k)}

Example 3
Suppose you deposit$1000 per year for three years at the beginning of the year
in an account earning 6% interest. What is the account at the end of the third
year?

43
Solution

FVAn = {(1+k) n – 1)(1+k)}

FVA = [({1.06}3 – 1)(1.06)]

FVA = 16.667 (0.2025)

FVA = $3375.07
Future value of annuity due can also be calculated using table. Using table,
annuity due can be computed as
FVAn = PMT (FVIFAk,n)
Example 4
Suppose you deposit GH¢6,000 in a bank account at the beginning of cash year
for four years. If the bank pays interest of 10%, what will be the value of your
account at the end of the years?
Solution
FVA4 = PMT (FVIF10%, 4) (1+k)
FVA4 = GH¢6,000 (4.641) (1+0.10)
= GH¢6,000(5.1051)
= GH¢30,630.60
Present values
Present values are the discounted amount of future cash flows. It is “the use of
discounting techniques to find the current value of a future amount i.e. the
amount of money that would have to be invested today at a given interest rate in
order to obtain a required future amount”
Present value of a single amount
The process of finding present values is the reversal of finding future values.
Therefore, whereas finding future involves the use of compounding techniques,
finding present values involves the use of discounting technique.
The following is the general formula for finding present values.

44
PV = or FC Equation 1

Example 1
You have won a context as the best financial management student. Your prize for
the context is GH¢4,500 to be received in four years’ time. If the current interest
rate is 19% what is the value of your prize in today’s terms?
Solution

PV =

PV =

= GH¢2,321.05
Using tables
The present value of a future cash flow also be determined using tables. If tables
are used to determine the present value, then it is determined by multiplying the
cash flow by the discount factor read from the table.
PV = PMT (PVIFk,n) Equation 2

Example 2
John Mensah has invested in a business hoping to receive GH¢5,000 in three
tears time. The current interest rate is 15%. Determine the present value of this
investment using the present value interest factor (PVIF) table
Solution
PV = PMT (PVI k,n)
PV = GH¢5,000(0.756)
= GH¢3.780

Example 3

45
You have borrowed $5000 from a friend and you are required to pay back $6802
in four years’ time. If interest is compounded annually, what is the rate of the
loan?
Solution
PV = FV/(1+k)n or FV = PV(1+k)n
$5000 = $6802/(1+k)4
$6802/$5000 – (1+k)4

4 =1+k

4 -1 = k

K = 8%

Present value of mixed stream

To find the present value of a mixed stream.
1) Calculate the present values of cash future amount to be received using
discounting technique
2) Sum up all the individual PVs to get the total PV
Therefore the general formula for calculating PV for mixed stream of cash
flows is:

PV = + + + …………+

46
CAPITAL BUDGETING TECHNIQUES
Companies need to invest in wealth-creating assets in order to renew, extend or
replace the means by which they carry on their business. Capital investment
allows companies to continue to generate cash flows in the future or to maintain
the profitability of existing business activities, typically, capital investment projects
will requires significant cash flows at the beginning and will then produce cash
flows over several years. Capital investment projects require careful evaluation
because they will determine whether the company is profitable in the future.
A company seeks to select the best or most profitable investment projects so that
it can maximize the return to its shareholders. It also seeks to avoid the negative
strategic and financial consequences which could follow from poor investment
decisions.
Question. Identify six capital budgeting decisions and describe the
characteristics of capital budgeting decisions
Since capital investment decision affect a company over a long period of time, it
is possible to view a company and its balance sheet as the sum of the previous
investment and financing decisions taken by its directors and managers.

Techniques used for Capital budgeting decision

1. Discounted Cash flow techniques
i. Net present Value
ii. Internal Rate of return
iii. Profitability index
iv. Discounted Cash techniques
2. Non discounted Cash flow techniques
i. The payback period
ii. Return on capital employed

Question: How are the discounted Cash flow techniques different from the
non-discounted cash flow techniques?
The payback method

47
The payback period is the number of years it is expected to take to recover the
original investment from the net cash flows resulting from a capital investment
project.
The decision rule when using the payback method to appraise investment
is to accept a project if its payback period is equal to or less than a
predetermined target value. It is possible to obtain an estimate of the payback
period to several decimal places if cash flows are assumed to occur evenly
throughout each year, but a high degree of accuracy in estimating the payback
period is not desirable since it does not offer information which is especially
useful. A figure to the nearest year or half-year is usually sufficient.
Example
Consider an investment project with the cash flows given below
The cash flows of this project are called conventional cash flows and the project
is called a conventional project. A conventional project can be defined as one
showing a significant initial investment followed by a series of cash inflows over
the life of the projects
Year 0 1 2 3 4 5
Cash flow (450) 100 200 100 100 80
(¢)

Table of cumulative cash flows for the conventional project of the previous
exhibit, showing that the payback period is between three and four years
Year Cash flow(¢) Cumulative cash flow
(¢)
0 (450) (450)
1 100 (350)
2 200 (150)
3 100 (50)
4 100 50
5 80 130

48
We can see that, after three years, the project has generated total cash inflows of
¢400. During the fourth year the remaining ¢50 of the initial investment will be
recovered. As the cash inflows in this year is ¢100, and assuming that it occurs
evenly during the year, it will takes a further six months or 0.5 years for the final ¢
50 to be recovered. The payback period is therefore 3.5 years.
The advantage of the payback method
i. The advantage of the payback method is that it is simple and easy to
apply and a concept, it is straightforward to understand.
ii. The payback period is calculated using cash flows, not accounting
profits, and so should not be open to manipulation by managerial
preferences for particular accounting policies.
iii. If we accept that more distant cash flows are more uncertain and that
increasing uncertainty is the same as increasing risk, it is possible to
argue that a further advantage of the payback method is that it takes
account of risk in that it implicitly assumes that a shorter payback
period is superior to a longer one.
iv. It has been argued that payback period is a useful investment
appraisal method when a company is restricted in the amount of
finance it has available for investment since the sooner cash is
returned by a project, the sooner it can be reinvested into other
projects. While there is some truth in this claim, it ignores the fact that
there are better investment appraisal methods available to deal with
capital rationing as explained in s

The disadvantages of the payback method

i. One of the major disadvantages is that the payback method ignores
the time value of money, so that it gives equal weight to cash flows
whenever they occur within the payback period. The problem of
ignoring the time value of money is partly remedied by using the
discounted payback method discussed latter on

49
 ii. Another serious disadvantage of the payback method is that it ignores
all cash flows outside the payback period and so does not consider the
project as a whole. rable to any other. Why should a project with a
payback period of three years be accepted while one with a payback
period of three and a half years be rejected?

The general conclusion that can be drawn from this discussion is that the
payback method does not give any real indication of whether investment projects
increase the value of a company. For this reason it has been argued that, despite
its well documented popularity, the payback method is not really an investment
appraisal method at all, but rather a means of assessing the effect of accepting
an investment project on a company’s liquidity position.
The Return on Capital Employed Method
There are several different definitions of return on capital employed (ROCE),
which is also called return on investment (ROI) and accounting rate of return
(ARR). All definitions relate accounting profit to some measure of the capital
employed in a capital investment project. One definition that is widely used is:

ROCE =

The average investment must take account of any scrap value. Assuming
straights line depreciation from the initial investment to the terminal scrap value,
we have

Average investment =

Another common definition of return on capital employed use the initial or final
investment rather than the average investment, for example

ROCE =

50
It is important to remember that return on capital employed is calculated using
accounting profiles, which are operating cash flows adjusted to take account of
depreciation. Accounting profits are not cash flows, since depreciation is an
accounting adjustment which does not correspond to an annual movement of
cash.
The decision rule here is to accept an investment project if its return on
capital employed is greater than target or hurdle rate of return set by the
investing company. If only one of two investment projects can be undertaken
(i.e. if the projects are mutually exclusive), the project with the higher return on
capital employed should be accepted.
Calculation of return on capital employed
Obaa Plc. is considering the purchase of a new machine and has found two
which meet its specification. Each machine has an expected life of five years.
Machine A would generate annual cash flows (receipts less payment) of
¢210,000 and would cost ¢ 570,000. Its scrap value at the end of five years
would be ¢70,000. Machine 2 would generate annual cash flow of ¢510,000 and
would cost ¢1616, 000. The scrap value of this machine at the end of five years
would be ¢301,000. Obaa plc. uses the straight line method of depreciation and
has a target return on capital employed of 20 per cent.
Calculate the return on capital employed for both machine 1 and machine 2 on
an average investment basis and state which machine you would recommend,
giving reasons.
Suggested answer
For machine 1:
Total cash profit = 210 000 5= 1050,000

Total depreciation = 570 000 – 70 000 = 500,000

Total accounting profit 550,000
Average annual accounting profit = 550,000/5 = ¢110,000 per year
Average investment = (570 000 + 70 000)/2 = ¢320 000
Return on capital employed = 100 (110,000/320,000) = 34.4%
51
For machine 2:
Total cash profit = 510 5= 2,550,000

Total depreciation = 1616 000 – 301000= 1315 000

Total accounting profit 1235 000
Average annual accounting profit = 1235 000/5= ¢247 000 per year
Average investment = (1616 000 + 301 000)/2= ¢958 500
Return on capital employed = 100 (247000/958 000) 25.8%

Both machine have a return on capital employed greater than the target rate and
so are financially acceptable, but as only one machine is to be purchased, the
recommendation is that machine 1 should be chosen, as it has higher return on
capital employed than machine 2
Advantages of the Return on Capital Employed Method
i. It gives a value in percentage terms, a familiar measure of return which
can be compared with the existing ROCE of a company, the primary
accounting ratio used by financial analyses in assessing company
performance.
ii. It is also a reasonably simple method to apply and can be used to
compare mutually exclusive projects.
iii. Unlike the payback method, it considers all cash flows arising during
the life of an investment project and it can indicate whether a project is
acceptable by comparing the ROCE of the project with a target rare,
for example a company’s current ROCE or the ROCE of a division.

Disadvantage of the return on capital employed method

i. It is not based on cash, but uses accounting profile, which is open to
manipulation and is not linked to the fundamental objectives of
maximizing shareholder wealth.
ii. Because the method uses average profit, it also ignores the timing of
profits. Consider the two projects A, both projects have the same initial
investment and zero scrap value and hence the same average
investment:
52
¢45 000/2 = ¢22 500
Both projects have the same average annual accounting profit:
Project A: (- 250 + 1000 + 20 750)/4 =¢5625
Project B: (6000 + 6000 + 5500 + 5000)/4 = ¢5625
Illustration of how return on capital employed, which uses average accounting
profit, ignores the timing of project cash flows
Year 0 1 2 3 4
#000 #000 #000 #000 #000
Project A
Cash flows (45 000) 11 000 12 12 32 000
Depreciation 11 250 250 250 11 250
Accounting profit (250) 11 11 20 750
250 250
100 1
000
Project B
Cash flows (45 000) 11 250 17 16 16 250
Depreciation 11 250 250 750 11 250
Accounting profit 6 000 11 11 5 000
250 250
6 5
000 500

So their return on capital employed values is identical too:

ROCE = (100 5625)/22 500 – 25%

But Project has a smooth pattern of returns, whereas Project A offers little in the
first three years and large return in a final year. We can see that, even though
they both have the same ROCE, Project B is preferable to Project A by virtue of
the pattern of its profits.

53
 iii. A more serious drawback is that the return on capital employed
method does not consider the time value of money and so gives equal
weight to profits whenever they occur.
iv. It also fails to take into account the length of the project life and, since
it is expressed in percentage terms and is therefore a relative
measure, it ignores the size of the investment made.

For these reasons, the return on capital employed method cannot be seen as
offering sensible advice about whether a project creates wealth or not. In
order to obtain such advice, we need to use discounted cash flow methods,
the most widely accepted of which is not present value.
The Net Present Value Method
The net present value (NPV) method of investment appraisal uses discounted
cash flows to evaluate capital investment projects and is based on the sound
theoretical foundation of the investment – consumption model development by
Hirschleifer (1958). It uses a cost of capital (see or target rate of return to
discount all cash inflows and outflows to their present values, and then compares
the present value of all cash inflows with the present value of all cash outflows. A
poisitive net present value indicates that an investment project is expected
to give a return in excess of the cost of capital and will therefore lead to an
increase in shareholder wealth.
We can represent the calculation of NPV algebraically as follows

NPV = - 10 +

Where 10 is the initial investment

C1, C2 ......., Cn are the project cash flows occurring in years 1, 2, ...., n r is the
cost of capital or required rate of return.
By convention, in order to avoid the mathematics of continuous discounting, cash
flows occurring during a time period are assumed to occur at the end of that time
period. The initial investment occurs at the start of the first time period. The NPV
decision rule is to accept all independent projects with a positive net
54
present value. If two capital investment projects are not independent but
mutually exclusive, so that of the two projects available only one project
can be undertaken, the project with the higher net present value should be
selected.
Calculation of the net present value
Maxine Ltd. is evaluating three investment projects, whose expected cash flows
are given in below calculate the net present value for each project if Maxine’s
cost of capital is 10 per cent. Which project should be selected?
Project A
The cash inflows of this project are identical and so do not need to be discounted
separately. Instead, we can use the cumulative present value factor (CPVF) or
annuity
Three investment projects with different cash flow profiles to illustrate the
calculation of net present value

Carter Ltd: cash flows of proposed investment projects

Period Project A Project B Project C
(¢000) (¢000) (¢000)
0 (5000) (5000) (5000)
1 1100 800 2000
2 1100 900 2000
3 1100 1200 2000
4 1100 1400 100
5 1100 1600 100
6 1100 1300 100
7 1100 1100 100

Factors for seven years at 10 per cent (CPVF 10,7), which is found from CPVF
tables to have a value of 4.868. We have
¢ 000

55
Initial investment (5000)
Present value of cash inflows = ¢1100 4.868 5355

Net present value 355

Project A has a positive net present value of ¢ 355000.

Project B
Because the cash inflows of this project are all different, it is necessary to
discount each one separately. The easier way to organize this calculation is by
using a table
Using a table to organize net present value calculation is especially useful when
dealing with the more complex cash flows which arise when account is taken of
taxation, inflation and a range of cost or projects variables. A tabular approach
also aids clear thinking and methodical working in examinations. From table, we
can see that Project B has a positive net present value of ¢18 000.
Project C
The cash flows for the first three years are identical and can be discounted using
the cumulative present value factor for three years at 10 per cent (CPVF0 10,3),
which is found from cumulative present value fact (CPVF) tables to be 2.487. The
cash flows for years 4 to 7 are also identical and can be discounted using a
cumulative present value factor. To find this, we subtract the cumulative present
value factor for three
Calculation of net present value of Project B using tabular approach. This
approach organizes the calculation and information used in a clear, easily
understood format which helps to avoid errors during the calculation process
Year Cash flow 10% present value Present
(¢000) factors value
(¢000)
0 (5000) 1.000 (5000)
1 800 0.909 727

56
 2 900 0.826 743
3 1200 0.751 901
4 1400 0.683 956
5 1600 0.621 994
6 1300 0.564 733
7 1100 0.513 564
Net present value 619

Years at 10 per cent from the cumulative present value factor for seven years at
10 per cent. From the CPVF tables, we have:
CPVF10, 7 – CPVF10, 3 = 4.868 – 2.487 – 2.487 = 2.381
¢000
Initial investment (50,000)
Present value of cash inflows, years 1 to 3 = ¢2000 2.487= 4,974

Present value of cash inflows, years 4 to 7 = ¢100 2.381 = 238

Net present value 212

Project C has a positive net present value of ¢212 000. If the annual cash flows
are discounted separately, the NPV is ¢ 209 000, the difference being due to
rounding
The decision on project selection
We can now rank the projects in order of decreasing net present value:
Project B NPV of ¢618 000
Project A NPV of ¢355 000
Project C NPV of ¢212 000
Which project should be selected? If the projects are mutually exclusive, then
Project B should be undertaken since it has the highest NPV and will lead to the
largest increase in shareholder wealth. If the projects are not mutually exclusive
and there is no restriction on capital available for investment, all three projects
should be undertaken since all three have a positive NPV and will increase
shareholder wealth. However, the cash flows in year 4 to 7 of project C should be
57
investigated, they are not very large and they are critical to the project, since
without them it would hence a negative NPV and would therefore lead to a
decrease in shareholder wealth.
Advantage of the net present value method
i. The net present value method of investment appraisal, being based on
discounted cash flows, takes account of the time value of money,
which is one of the key concepts in corporate finance.
ii. Net present value uses cash flows rather than accounting profit, takes
account of both the amount and the timing of project cash flows, and
takes account of all relevant cash flows over the life of an investment
project.

For all these reasons, net present value is the academically preferred method of
investment appraisal. In all cases where there are no constraints on capital, the
net present value decision rule offers sound investment advice.
Disadvantage of the net present value method
i. It has been argue that net present value is conceptually difficult to
understand, but this is hardly a realistic criticism.
ii. It has also been pointed out that it is difficult to estimate the values of
the inflows and outflows over the life of a project which are needed in
order to calculate its net present value, but this difficulty of forecasting
future cash flows is a problem of investment appraisal in general and
not one that is specific to any particular investment appraisal
technique.
iii. A more serious criticism is that it is only possible to accept all projects
with a positive NPV in a perfect capital market since only in a perfect
market is there no restriction on their amount of finance available. In
reality, capital is restricted or rationed and this can limit the applicability
of the NPV decision rule.

When calculating the NPV of an investment projects, we tend to assume not only
that the company’s cost of capital is known, but also that it remains constant over

58
the life of the project. In practice, the cost of capital of a company may be difficult
to estimate and so the selection of an appropriate discount rate for use in
investment appraisal is also not straightforward. The cost of capital is also likely
to change over the life of the project, since it is influenced by the dynamic
economic environment within which all business is conducted. However, if these
changes can be forecast the net present value method can accommodate then
without difficulty.
The internal rate of return method
If the cost of capital used to discount future cash flows is increased, the net
present value of an investment project with conventional cash flows will fall.
Eventually, as the cost of capital continues to increase, the NPV will become
zero, and then negative. This is illustrated in Exhibit 6.6
The relationship between the net present values of a conventional project and
the discount rate. The internal rate of return produces a net present value of zero

The internal rate of return (IRR) of an investment projects is the cost of capital or
required rate of return, when used to discount the cash flows of a project,
produces a net present of value of zero. The internal rate of return method of
investment appraisal involves calculating the IRR of a project, usually by linear
interpolation, and then comparing it with a target rate of return or hurdle rate.
The internal rate of return decision rule is to accept all independent
investment projects with an IRR greater than the company are cost of
capital or target rate of return.
We can restate the expression for net present value in terms of the internal rate
of return as follows:

59
Where C1, C2 ....Cn are the project cash flows occurring in years 1, 2, ...., n r* is
the internal rate of return 1o is the initial investment
Calculation of internal rates of return
Maxine Ltd is evaluating three investment projects, whose expected cash flows
are given in above; calculate the internal rate of return for each project. If Carter’s
cost of capital is 10 per cent, which project should be selected?
Project A
In the previous example we found that (all values in ¢000).
(¢1100 CPVF10,7) - ¢5000 = (¢1100 4.868) – ¢5000 = ¢355

Where project cash inflows are identical, we can determine the cumulative
present value factor for a period corresponding to the life of the project and a
discount rate equal to the internal rate of return. If we represent this by (CPVF r*,
7 ), then from our above expression:
(¢1100 CPVFr*, 7) - ¢5000 = 0

Rearranging:
(CPVFr*, 7) = 5000/1100 = 4.545
From CPVF tables, looking along the row corresponding to seven year, we find
that the discount rate corresponding to this cumulative present value factor is
approximately 12 per cent, project A, then, has an internal rate of return of 12 per
cent.
Interpolating:

IRR = 10 + = 10 + 2.3 = 12.3 per cent

The internal rate of return of Project C is approximately 12.3 per cent

The decision on project selection
We can now summaries our calculations on the three projects
Project A IRR of 12.0 per cent NPV of ¢355 000
Project B IRR of 13.9 per cent NPV of ¢618 000
Project C IRR of 12.3 per cent NPV of ¢209 000

60
All the three projects have an IRR greater than Maxine’s cost of capital of 10 per
cent, so all acceptable if there is no restriction on available capital. If the projects
are mutually exclusive, however, it is not possible to choose the best project by
using internal rate method, notice that, although the IRR of Project C is higher
than that of Project A, its NPV is lower. This means that the projects are ranked
differently using IRR than they are using NPV. The problem of mutually exclusive
investment projects is discussed in Section 6.5.1.
A comparison of the NPV and IRR method
There is no conflict between these two discounted cash flow methods when a
single investment projects with conventional cash flows is being evaluated. In the
following situations, however, the net present value method may be preferred:
 Where mutually exclusive projects are being compared:
 Where the cash flows of a projects are not conventional;
 Where the discount rate changes during the life of the project.

61
Capital Budgeting- Further Aspects
To make optimal capital investment decisions, the investment appraisal process
needs to take account of the effects of taxation and inflation on project cash flows
and on the required rate of return since the influence of these factors is
inescapable. In addition, expected future cash flows are subject to both risk and
uncertainty. In this section we consider some of the suggested methods for the
investment appraisal process to take them into account.
Relevant project cash flows
In the first part we gave little thoughts to which costs and revenue should be
included in project appraisal, beyond emphasizing the use of cash flows rather
than accounting profits. A key concept to grasp is that only relevant cash
flow should be included. One test of cash flow relevance is to ask whether
a cash flow occurs as a result of undertaking a project. If the answer is no,
the cash flow is not relevant. It is useful to think in terms of incremental
cash flows, which are the changes in a company’s cash flow that result
directly from undertaking an investment project. Cash flows such as initial
investment, cash from sales and direct cost of sales are clearly incremental. The
following cost, however, need careful consideration.
Sunk cost
Cost incurred prior to the start of an investment project are called sunk cost and
are not relevant to projects appraisal, even if they have not yet been paid, since
such cost will be incurred regardless of whether the projects is undertaken or not.
Examples of such costs are market research, the historical cost of machinery
already owned, and research and development expenditure.
Apportioned fixed cost
Cost which will be incurred regardless of whether a project is undertaken or not,
such as apportioned fixed cost (e.g. rent and building insurance) or apportioned
head office charges, are not relevant to project evaluation and should be
excluded. Only incremental fixed costs which arise as a result of taking on a
project should be included as relevant project cash flows.
Opportunity cost
An opportunity cost is the benefit forgone in using an asset for one purpose
rather than another, if an asset is used for an investment project, it is important to
ask what benefit has thereby been lost since this lost benefit or opportunity cost
is the relevant cost as far as the project is concerned.
Example: Suppose we have in stock 1000kg of raw material A, which cost ¢2000
were purchased six months ago. This bill has been settled and the supplier is
now quoting a price of ¢2.20 per kg for this material. The existing stocks could be
sold on the second hand market for ¢1.90 per kg, the lower price being due to
slight deterioration in storage. Two-thirds of the stock of material A is required for
a new project which begins in three weeks’ time. What is the relevant cost of
material A to the project?
Suggested Answer: Since material A has already been bought, the original cost
of ¢2000 is irrelevant: it is a sunk cost. If the company has no other use for
material A and uses it for the new project, the benefits of reselling it on the
62
second-hand market is lost and the relevant cost is the resale price of ¢1.90 per
kg. if material A is regularly used in other production activities, any material used
in the new project will have to be replaced and the relevant cost is the
repurchase price of ¢2.20 per kg.
Incremental working capital
As activity levels rise as a result of investment in fixed assets, the company’s
levels of debtors, stock of raw materials and stocks of finished goods will also
increase. These increases will be financed in part by increases in trade creditors.
This incremental increase in working capital will represent a cash outflow
for the company and is a relevant cash flow which must be included in the
investment appraisal process. Further investment in working capital may be
needed, as sales levels continue to rise, if the problem of undercapitalization or
overtrading is to be avoided. At the end of a project, however, levels of debtors,
stocks and trade creditors will fall (unless) the project is sold as a going concern)
and so any investment in working capitals will be recovered. The recovery of
working capital will be a cash inflow either in the final year of the project or
in the year immediately following the end of the project.
Taxation and capital investment decisions
At the start of the chapter it was pointed out that the effects of taxation on capital
investment decisions could not be ignored, in order to determine the net cash
benefit gained by a company as a result of an investment project, an estimate
must be made of the benefits or liabilities that arise as a result of corporate
taxation. The factors to consider when estimating these benefits or liabilities are
now discussed.
Capital allowances
In financial accounting, capital expenditure appears in the profit and loss account
in the form of annual depreciation charges. These charges are determined by
company management in accordance with relevant accounting standards. For
taxation purpose, capital expenditure is written off against taxable profits in a
manner laid down by government and enforced by the authorities. Under this
system, companies write off capital expenditure by means of annual capital
allowances (also known as writing down allowances or tax-allowable
depreciation).
Capital allowances are a matter of government policy and in Ghana it calculated
per the Ghana Revenue Authority Act.

Tax allowable cost

Tax liabilities will arise on the taxable profits generated by an investment project
Liability to taxation is reduced by deducting allowable expenditure from annual
revenue when calculating taxable profit. Relief for capital expenditure is given by
deducting capital allowance from annual revenue, as already discussed. Relief
for revenue expenditure is given by deducting tax-allowable cost. Tax-allowable
costs include the cost of materials, components, wages and salaries, production
over heads, insurance, maintenance, lease rentals and so on.
Are interest payments a relevant cash flow?
63
While interest payments on debt are an allowable deduction for the purpose of
calculating taxable profit, it is a mistake to include interest payment as a relevant
cash flow in the appraisal of a domestic capital investment project. The reason
for excluding interest payments is that the required return on any debt finance
used in an investment projects is accounted for as part of the cost of capital used
to discount the project cash flows.
If a company has sufficient taxable profits, the tax-allowability of interest
payments is accommodated by using the after-tax weighted average cost of
capital to discount after-tax net cash flows.
The timing of tax liabilities and benefits
In Ghana tax on taxable profits is payable six months after the end of the
relevant accounting year. In investment appraisal, cash flows arising during
period are taken as occurring at the end of that period, so tax liabilities are taken
as being paid one year after the originating taxable profits. Any tax benefits, for
example from capital allowances, are also received one year in arrears. There is
some variation in the way that different authors include the benefits arising from
capital allowances in investment appraisal calculations. The method used here is
follows.
 Capital investment occurs at Year 0
 The first capital allowance affects cash flows arising in Year 1
 The benefits from the first capital allowance arise in Year 2
 The number of capital allowances is equal to the number of year in the life
of the project.

NPV calculation involving taxation

Obaa Yaa plc is considering buying a new machine costing ¢200 000 which
would generate the following pre-tax profits from the sale of goods produced.
Year Profits before tax
1 85 000
2 65 000
3 75 000
4 70 000

The Company pays corporation tax of 30 per cent per year one in arrears and is
able to claim capital allowances on a 25 per cent reducing balance basis. The
machine would be sold after four years for ¢20 000. If the after-tax cost of capital
is 10 per cent, should the company buy the machine in the first place?

64
Calculation of net cash flows and net present value for Lark plc
Capital Net cash flows
Year (¢) Operating cash flows (¢) Taxation (¢) (¢)
0 (200 000) (200 000)
1 85 000 85 000
2 65 000 (10 500) 54 500
3 75 000 (8 250) 66 750
4 20 000 70 000 (14 062) 75 938
5 (1 688) (1 688)

Net cash flows Present value

Year (¢) 10% discount factor (¢)
0 (200 000) 1 000 (200 000)
1 85 00 0.909 77 265
2 54 500 0.826 45 017
3 66 750 0.751 50 129
4 75 938 0.683 51 866
5 (1 688) 0.621 (1 048)
Net Present value 23 229

Suggested answer
The capital allowances were calculated and the tax liabilities can be found by
subtracting the capital allowances from the profits before tax to give taxable
profits and then multiplying taxable profits by the tax rate:
¢
Year 1 (taken in Year 2): (85 000 – 50 000) 0.30 = 10 500
Year 2 (taken in Year 3): (65 000 – 37 500) 0.30 = 8 250
Year 3 (taken in Year 4): (75 000 – 28 125) 0.30 = 14 062
Year 4 (taken in Year 5): (70 000 – 64 375) 0.30 = 1 688

The calculation of the net cash flows and the net present value of the proposed
investment are shown above. . The NPV is a positive value of ¢23 229 and so
purchase of the machine by Obaa Plc is recommended on financial grounds.
Can taxation be ignored?
If an investment project is found to be viable using the net present value method
introducing tax liabilities on profits is unlikely to change the decision, even if
these liabilities are paid one year in arrears (Scralett 1993, 1995). Project viability
can be affected, however, if the profit on which tax liability is calculated is
different from the cash flows generated by the projected. This situation arises

65
when capital allowances are introduced into the evaluation, although it has been
noted that the effect o project viability is still only a small one. The effect is
amplified under inflationary conditions since capital allowances are based on
historical investment costs and their real value will therefore decline over the life
of the project. This decline in the real value of capital allowances is counteracted
to some extent, in the case of plant and machinery, by the use of substantial (i.e
100 per cent, 50 per cent or 40 per cent) first year capital allowances.
We may conclude our discussion of taxation; therefore, by noting that, while
introducing the effects of taxation into investment appraisal makes calculations
more complex, it also makes the appraisal more accurate and should lead to
better investment decisions.

Inflation and capital investment decisions

Inflation can have a serious effect on capital investment decisions, both by
reducing the real value of future cash flows and by increases their uncertainty.
Future cash flows must be adjusted to take account of any expected inflation in
the prices of goods and services in order to express them in nominal (or money)
terms, i.e in terms of the actual cash amounts to be received or paid in the future.
Nominal cash flows are discounted by a nominal cost of capital using the net
present value method of investment appraisal.
As an alternative to the nominal approach to dealing with inflation in investment
appraisal, it is possible to deflate nominal cash flows by the general rate of
inflation in order to obtain cash flows expressed in real terms, i.e with inflation
stripped out. These real cash flows can then be discounted by a real cost of
capital to determine the net present value of the investment project. Whichever
method is used, whether nominal terms or real terms, care must be taken to
determine and apply the correct rates of inflation to the correct cash flows.

Real and nominal cost of capital

The real cost of capital is obtained from the nominal (or money) cost of capital by
removing the effect of inflation. Since:
(1 + Nominal cost of capital) = (1 + Real cost of capital) (1 +Inflation rate)
Rearranging gives

(1 + Real cost of capital) =

For example, if the nominal cost of capital is 15 per cent and inflation is 9 per
cent, the real cost of capital will be 5.5 per cent
(1+0.15)/(1 + 0.09) – 1.055

66
General and specific inflation
It is likely that individual cost and prices will inflate at different rates and so
individual cash flows will need to be inflated by specific rates of inflation. These
specific rates will need to be forecast as part of the investment appraisal process.
There will also be an expected general rate of inflation, calculated for example by
reference to the consumer price index (CPI), which represents the average
increase in consumer prices. The general rate of inflation can be used to deflate
a nominal cost of capital to a real cost of capital and to deflate nominal cash
flows to real cash flows.

Inflation and working capital

Working capital recovered at the end of a project will not have the same nominal
value as the working capital invested at the start. The nominal value of the
investment in working capital needs to be inflated each year in order to maintain
its value in real terms, if the inflation rate applicable to working capital is known,
we can include in the investment appraisal an annual capital investment equal to
the incremental annual increase in the nominal value of working capital. At the
end of the project, the full nominal value of the investment in working capital is
recovered.

The golden rule for dealing with inflation in investment appraisal

The golden rule is to discount real cash flow with a real cost of capital and to
discount nominal cash flow with a nominal cost of capital. Cash flows which have
been inflated using either specific or general rates of inflation are nominal cash
flows and so should be discounted with a nominal cost of capital. Nominal cash
flows may, if desired, be discounted with a general with a real cost of capital. A
little though will show that the net present value obtained by discounting real
cash flows with a real cost of capital is identical to the net present value obtained
by discounting nominal cash flows with a nominal cost of capital. After all the real
cost of capital is obtained by deflating the nominal cost of capital by the general
rate of inflation and the same rate of inflation is also used to deflate the nominal
cash flows to real cash flows.

NPV calculation involving inflation

Acey Ltd is planning to sell a Gameboxes. Fixed assets costing ¢700 000 would
be needed, with ¢500 000 payable at once and the balance payable after one
year. An initial investment of ¢330 000 in working capital; would also be needed.
Acey Ltd expects that, after four years. The Gamebox will be obsolete and the
disposal value of the fixed assets will be zero. The project would incur
incremental total fixed cost of ¢545,000 per year at current prices, including
annual depreciation of ¢175,000. Expected sales of Gameboxes are 120 000 per
year at a selling price of ¢ 22 per unit following annual increases because of
inflation:
67
 Fixed cost 4 per cent
Selling price 5 per cent
Variable costs 7 per cent
Working capital 7 per cent
General prices 6 per cent
If Acey real cost of capital is 7.5 per cent and taxation is ignored, id the project
viable?
Suggested answer
Depreciation is not a cash flow: we must deduct it from fixed cost to find cash
inflating by 4 per cent year:
Year 1 cash fixed cost = 370 000 1.04 = ¢384 800
Year 2 cash fixed cost = 384 800 1.04 = ¢400 192
Year 3 cash fixed cost = 400 192 1.04 = ¢416 200
Year 4 cash fixed costs = 416 200 1.04 = ¢432 848

Net operating cash flows and net present value for Wren plc

Year 1 2 3 4
Selling price per unit (¢) 23.1 24 25 25.47 25.74
19.
Variable cost per unit (¢) 17.12 18.32 60 20.97
Contribution per unit (¢) 5.98 5.93 5.87 5.77
704 692
Contribution per year (¢) 717 600 711,600 400 400
416 432
Fixed costs per year (¢) 384 800 400,192 200 848
Net operating cash flows 288 259
(¢) 332 800 311,408 200 552

Year 0 1 2 3 4
Capital (£ (500 000) (200 000)
Working capital (£) (330 000) (23 100) (24 717) (26 447) 404,264
Operating cash flow
(£) 332 800 311 408 288 200 259 552
Net cash flow (£) (830 000) 109 700 266 691 261 753 663 816
14% discount factors 1 000 0.877 0.769 0.675 0.592
Present value (£) (830 000) 96 207 220 465 176 683 392 979
NPV = 96 207 + 220 46 + 176,683 + 392,979 - 830,000 = ¢56, 334
68
The contribution per unit is the difference between the sales price and the
variable cost per unit, inflated by their respective inflation rates.
Investment is working capital in Year 0 = ¢ 330 000
Cumulative investment in working capital in Year 1 = ¢377 817, a further increase
of ¢23 100
Cumulative investment in working capital in Year 2 = ¢377817, a further increase
of ¢24 717
Cumulative investment in working capital in Year 3= ¢404 264, a further increase
of ¢26 447
Cumulative investment in working capital in Year 4 = ¢ 404 264

We could deflate the nominal cash flows by the general rate of inflation to obtain
real cash flows and then discount them by Acey’s real cost of capital. It is simpler
and quicker to inflate Acey;s real cost of capital into nominal terms and use it to
discount our calculated nominal cash flows. Wren’s nominal cost of capital is 1.07
1.06 = 1.1395 = 14 per cent.
The nominal (money terms) not present value calculation is given is above since
the NPV is positive, the project can be recommended on financial grounds. The
NPV is not very large, however, so we must take care to ensure that forecasts
and estimates are as accurate as possible. In particular, a small increase in
inflation during that life of the project might make the project uneconomical.

INVESTMENT APPRAISAL AND RISK

While the words risk and uncertainty tend to be used interchangeably, they do
have different meaning. Risks refer to sets of circumstances which can be
qualified and to which probabilities can be assigned. Uncertainty implies that
probabilities cannot be assigned to sets of circumstances. In the context of
investment appraisal, risk refers to the business risk of an investment, which
increases with the variability of expected returns, rather than of financial risk,
which since it derives from a company’s capital structures is reflected in its
weighted average cost of capital. Risk is thus distinct from uncertainty, which
increase proportionately with project life. However, the distinction between the
two terms has little significance in actual business decisions as managers are
neither completely ignor5ant not completely certain about the probabilities of
future events, although they may be able to assign probabilities with varying
degrees of confidence (Grayson 1967). For this reason, the distinction between
risk and uncertainty is usually neglected in the practical context of investment
appraisal.
A risk averse company is concerned about the possibility of receiving a return
less than expected i.e with downside risk, and will therefore want to assess the
69
risk of an investment project. There are several methods of assessing project risk
and of incorporating risk into the decision making process.

Sensitivity analysis
Sensitivity analysis is way of assessing the risk of an investment project by
evaluating how responsive the NPV of the project is to changes in the variable
from which it has been calculated. There are several ways this sensitivity can be
measured. In one method, each project variable in turn is changed by a set
amount, say 5 per cent, and the NPV is recalculated. Only one variable is change
at a time. Since we are more concerned with downside risk, the 5 per cent
changes is made so as to adversely affect the NPV calculation. In another
method, the amounts by which each projects variable would have to change to
make the NPV become zero are determined. Again, only one variable is change
at a time.
Both methods of sensitivity analysis gives an indication of the key variable
associated with an investment project. Key variable are those variables where a
relatively small change can have a significant adverse effect on project NPV.
These variable merit further investigation, for example to determine the extent to
which their values can be relied upon, and their identification will also serve to
indicate where management should focus its attention in order to ensure the
success of the proposed investment project.
Both methods suffer from the disadvantage that only one variable at a time can
be changed. This implies that all project variables are independents, which is
clearly unrealistic. A more fundamental problem is that sensitivity analysis is not
really a method of assessing the risk of an investment project at all. This may
seen surprising since sensitivity analysis is always included in discussions of
investment appraisal and risk, but the method does nothing more than indicate
which the key variable are. It gives no information as to the probability of
changes in the key variable, which is the information that would be needed if the
risk of the project were to be estimated. If the values of all project variables are
certain, a project will have zero risk, even if sensitivity analysis has identified its
key variables. In such a case, however, identifying the key variables will still help
managers to monitor and control the project in order to ensure that the desired
financial objectives are achieved.

Application of sensitivity analysis

Swift has cost of capital of 12 per cent and plants to invest ¢7m in an improved
moulding machine with a life of four years. The garden ornaments produced will
have a selling price of ¢9.20 each and will cost ¢6.00 each to make. It is
expected that 800 000 ornaments will be sold each year. By how much will each
variable have to change to make the NPV zero? What are key variables for the
project?
Suggested answer
70
The net present value of the project in terms of the project variable is as follows:
NPV = (S – VC) N CPVF12,4) – I0
Where: S = Selling price per unit
VC = Variable cost per unit
N = Number of units sold per year or sales volume
CPVF12.4 = Cumulative present value factor for four years at 12 per cent
I0 = initial investment

Inserting this information and finding the cumulative present value factor from the
table on page 488. We have:
NPV = (9.20 – 6.00) 800 000 3.037) – 7000 000 = ¢774 720
Alternatively:
£
Present value of sales revenue = 9.20 800 000 3.037 = 22,352,320
Present value of variable cost 6.00 800 000 3.037 = 14,577,600
Present value of contribution 7774720
Initial investment (7000000)
Net present value 774 720

We can now calculate the change needed in each variable to make the NPV zero
Initial investment
The NPV becomes zero if the initial investment increase by an absolute amount
equal to the NPV (¢774 720), which is a relative increase of 11.1 per cent:
100 (774720/7000 000) = 11.1%

Sales price
The relative decrease is sales revenue or selling price per unit that makes the
NPV zero is the ratio of the NPV to the present value of sales revenue:
100 (774 720 / 22 352 320) = 3.5%
This is an absolute decrease of ¢ 9.20 0.035 = 32 pence, so the selling price
makes the NPV zero is 9.20 – 0.32 = ¢8.88.

Variable cost
Since a decrease of 32 pesewas in selling price makes the NPV zero, an
increase 32 pesewas or 3.3 per cent in variable cost will have the same effect.

Sales volume
The relative decrease in sales volume that makes the NPV zero is the ratio of a
NPV to the present value of contribution:
100 (774 720/7774 720) = 10.0%

71
This is an absolute decrease of 800 000 0.1 = 80 000 units, so the sales
volume that makes the NPV zero is 800 000 – 80 000 = 720 000 units

Project discount rate

What is the cumulative present value factor that makes the NPV zero? We have
((9.20 – 6.00) 800 000 CPVD) – 7 000 000 = 0
And so:
CPVF = ( 7 000 000/9.20 – 6.00) 800 000) = 2.734
Using the table of cumulative present factors on page 488, and looking along the
row of values for a life of four years (as project life remains constant), we find that
2.734 corresponds to a discount rate of almost exactly 17 per cent, an increase
in the discount rate if 5 per cent in absolute terms or 41.7 per cent in relative
terms. Note that this is the method for finding the internal rate of return of an
investment project describe is section 6.4
Our sensitivity analysis is summarized in Exhibit 7.4. the project is most
sensitivity to changes in selling price and variable cost per unit and so these are
the key project variables.

Sensitivity analysis of the proposed investment by Swift

Variable Change to makes NPV zero Sensitivity
Selling price per unit -32p -3.5% High
sales volume - 80 000 units - 10.0% Low
Variable cost per + 32p +5.3% High
unit +£774 720 +11.1% Low
Initial Investment +5% +41.7% Very low
Project Discount
rate

72
CAPITAL RATIONING
We have seen that the decision rule with DCF techniques is to accept all projects
which result in positive NPVs when discounted at the company’s cost of capital.
If a business is in a capital rationing situation it will not be able to enter into all
projects with positive NPVs because there is not enough capital for all the
investments. Managers are therefore faced with the problem of deciding which
projects to invest in. The decision technique to be applied will depend on the
type of capital rationing situation.
a) Single period capital rationing is where capital is limited for the current period
only but will be freely available in the future.
b) Multi period capital rationing is where capital will be limited for several
periods.

Before we look at some examples of capital rationing we need to distinguish

between divisible projects and non-divisible projects.
a) Divisible projects are those which can be undertaken completely or in fraction.
Project can be taken into part
b) Non-divisible projects are those which must be undertaken completely or not
at all. It is not possible to invest in a fraction of the project.

SINGLE PERIOD RATIONING WITH DIVISIBLE PROJECTS:

With single period capital rationing investment funds are effectively a limiting
factor in the current period. Returns will be maximized if management follows

73
the decision rule of maximizing the return from the limiting factor. They should
therefore select those projects which earn the highest NPV per ¢1 of capital
invested.

Example: single period rationing with divisible projects

Short 0’ Funds limited has capital of ¢130,000 available for investment in the
forth-coming period, at a cost capital of 20%. Capital will be freely available in
the future.
Details of the six projects under consideration are as follows.

Project Investment Require NPV

¢000 at 20%
P 40 16.5
O 50 17.0
R 30 18.8
S 45 14.0
T 15 7.4
U 20 10.8

Solution
The first step is to rank the projects according to the return achieved from the
limiting factor of investment funds.

Project NPV Investment NPV per Ranking

¢000 ¢000 ¢ 1 invested
P 16.5 40 0.41 4
O 17.0 50 0.34 5

74
R 18.8 30 0.63 1
S 14.0 45 0.31 6
T 7.4 15 0.49 3
U 10.8 20 0.54 2

The available funds of ¢130,000 can now be allocated.

Project Investment Require NPV
¢000 ¢000
R 30 18.8
U 20 10.8
T 15 7.4
P 40 16.5
Q (balance) 25 8.5
130 Maximum NPV 62.0

Projects S should not be undertaken and only half of project Q should be

initiated.

SINGLE PERIOD RATIONING WITH NON-DIVISIBLE PROJECTS

If the projects are not divisible then the method shown in the last paragraph may
not result in the optimal solution. Another complication which arises is that there
is likely to be small amount of under-utilized capital with each combination of
projects.
The best way to deal with this situation is to use trial and error and test the NPV
available from different combinations of projects available. We will continue the
previous example to demonstrate the technique.

75
Example:
Short O funds Ltd Now discovers that the funds in the forth coming period are
actually restricted to ¢95, 000. The directors decide to consider projects P, Q and
R only. They wish to invest only in whole projects, but surplus funds can be
invested to earn 25% per annum perpetuity.
Which combination of projects will produce the highest NPV at a cost of capital
20%.

Solution:
We have seen that the cumulative PV of ¢ 1 received per annum in perpetuity is
¢1 / r. Therefore at cost of capital of 20% the PV of the interest on ¢1 in
perpetuity is at 25%;

¢ 1 - 0.75 = ¢1 .25
0.20
Therefore the NPV per ¢1 invested is ¢1.25 less the original investment of ¢1.
The NPV per ¢1 invested = 0.25.

The NPV from all possible combinations of the three projects can now b tested.
Project Required Funds remaining NPV NPV Total
Investment for external of Invst’nt from Pjt NPV
Investment
¢000 ¢000 ¢000 ¢000 ¢000
P and Q 90 5(0.25) 1.25 33.5 34.75

P and R 70 25 6.25 35.3 41.55

Q and R 80 15 3.75 35.8 39.55

76
The highest NPV will be achieve by undertaking projects P and R and investing
the under utilized funds of ¢25,000 externally.

Multi – period capital rationing with divisible projects

If capital rationing is expected to continue past the current period then the timing
of the cash flows for each project becomes important. Management will still be
attempting to maximizing the return from the limited factor and some projects are
divisible it is possible to use linear programming to find the optimal solution.

Example:
AFRAPA Ltd. Has the following three investment opportunities open to it.
Project: Year 0 Year 1 Year 2 Year 3 Year 4 NPV at 15%
¢000 ¢000 ¢000 ¢000 ¢000 ¢000
X (20) (10) 25 30 35 30.05
Y (18) (25) 32 38 45 27.70
Z (30) (20) 35 25 30 12.80

The company wishes to place a limit of ¢35,000 on the amount invested in

projects in any one year. Projects are divisible but cannot be repeated more than
once. Project timings cannot be advanced or delayed.
Required
Formulate the linear programmed on the company
Solution:

Objective function
Maximize 30.05 x + 27.70Y + 12.80Z
Where X, Y, Z are the proportions of each of the projects to be undertaken.

Constraints

77
Year 0 capital 20X + 18 Y + 30Z < 35

Year 1 capital 10X + 25 Y + 20Z < 35

Non negativity. X > O, Y>O, Z>O

Once the objective function and the constraints have been established the
problem can be solved using the simplex technique.

We have compared various appraisal techniques and have shown that the NPV
method is generally regarded as the most reliable and suitable

There are other important concepts in project appraisal we have not yet
considered.

78
THE CAPITAL STRUCTURE DECISION
The capital structure will be planned initially when company is incorporated. The
initial capital structure should be designed very carefully. The management of
the company should set a target capital structure and the subsequent financing
decisions should be made with a view to achieve the target capital structure. The
capital structure decision is a continuous one and has to be taken whenever a
firm needs additional finances.
Capital structure refers to the mix of long-term sources of funds, such as
Debentures, long –term debt, preference share capital and equity shares capital
including reserves and surpluses (retained earnings). Some companies do not
plan their capital structure, and it develops as a result of the financial decision
taken by the financial manager without any formal planning.

The companies may prosper in the short-term run, but ultimately they may face
considerable difficulties in raising funds to finance their activities. With
unplanned capital structure, these companies may also fail to economize the use
of their funds. Consequently, it is being increasingly realized that company
should plan its capital structure to maximize the use of the funds and to able to
adapt more easily to the changing conditions.
Theoretically, the financial manager should plan an optimum capital structure for
the company.
The optimum capital structure is obtained when market value per share is at the
maximum. The value will be maximized when the marginal real cost of each
source of funds is the same. In practice, the determination of an optimum capital

79
structure is affordable task, and one has to go beyond the theory. Since a
number of factors influenced the capital structure decisions plays a crucial part.
Two similar companies can have different capital structures if the decision-
makers differ in their judgments of the significance of various factors.

A totally theoretically model perhaps cannot adequately handle all those factors,
which affect the capital structure decision. These factors are highly
psychological, complex and qualitative and do not always follow accepted theory
since capital markets are not perfect and the decisions have to be taken under
imperfect knowledge and risk.

FEATURES OF AN APPROPRIATE CAPITAL STRUCTURES

The BOD or the CFO of a company should develop an appropriate capital
structure, which is most advantageous to the company. This could be done only
when all factors which are relevant to the company’s capital structure decision
are properly analyzed and balanced.
The capital structure should be planned generally by keeping the view of the
interest of the equity shareholders and the financial requirements of a company.
Its equity shareholders being the owner of the company and the providers of risk
capital (equity) would be concerned about the ways of financing a company’s
operation. However, the interest of other groups, such as employees, customers,
creditors, society and government, should also be given reasonable
consideration.
A sound or appropriate capital structure should have the following feature:
 Profitability: The capital structure of the company should be most
advantageous. Within the constraints, maximum use of leverage at a
minimum cost should be made.
 Solvency: The use of excessive debt threatens the solvency of the
company. To the point debt does not add significant risk, it should be
used, otherwise its use be avoided.

80
  Flexibility: The capital structure should be flexible to meet the changing
conditions. It should be possible for a company to adapt its capital
structure with a minimum cost and delay if warranted by a changed
situation; it should also be possible for the company to provide funds
whenever needed to finance its profitable activities.
 Capacity: The capital structure should be determined within the debt
capacity of the company and depends on its ability to generate future cash
flows. It should have enough cash to pay creditor’s fixed charges and
principal sum.
 Control: The capital structure should involve minimum risk of loss of
control of the company. The owners of closely held companies are
particularly concerned about dilution of control. The above mentioned are
the general features of an appropriate capital structure. The particular
characteristics of company may reflect some additional specific features.
Further, the emphasis given to each of these features will defer from
company to company. For example a company may give more
importance to flexibility than control, while another company may be more
concerned about solvency than any other requirement. Furthermore, the
relative importance of these requirements may change with shifting
conditions. The company’ structure should therefore, be easily adaptable.
The following are the three most common approaches to decide about a firm’s
capital structure.
 Operating and financial leverage approach for analyzing the impact of
debt on EPS.
 Cost of capital and valuation approach for determines the impact of debt
on the shareholder’s value.
 Cash flow approach for analyzing the firms ability to service debt.
In addition to these governing the capital structure decisions, many other factors
such as control, flexibility, or marketability are also considered in practice.

81
Operating and financial Leverage Approach EBIT – EPS Analysis
The use of fixed cost sources of finance such as debt and preference share
capital to finance the assets of the company is known Financial leverage or
trading on equity.
If the assets financed with the use of debt yield a return greater than the cost of
debt, the EPS also increases when the preference share capital is used to
acquire asset. But the leverage impact is more pronounced in case of debt
balance because;
i. the cost of debt is usually lower than the cost of preference share capital and
ii. The interest paid on debt is tax deductible.

Because of its effect on the earnings per share, financial leverage is an important
consideration in planning the capital structure of a company. The company with
high level of the EBIT can make profitable use of the high degree of leverage to
increase return on the shareholder equity, one common method of examining the
impact of leverage is to analyses the relationship between EPS and various
possible levels of EBIT under alternative methods of financing.

ILLUSTRATION 1
Suppose that a firm has an all equity capital structure consisting of 100,000
ordinary shares of ¢10 per share.
The firm wants to rise ¢250, 000 to finance its investment and is considering
three alternative methods of financing.
i) To issue 25,000 common shares at ¢10 each
ii) To borrow ¢250,000 at 8% rate of interest

82
iii) To issue 2,500 preference shares at ¢100 each at 8% rate of dividend. If the
firm’s earning before interest and taxes after additional investment are ¢312,500
and the tax is 50% the effect of earnings per share under the three financing
alternatives will be as follows:

EPS UNDER ALTERNATIVE FINANICING FAVOURABLE EBIT

Equity Debt Preference
¢ ¢ ¢
EBIT 312.500 312,500 312,500
Less: Interest 0 20,000 0
PBT 312,500 292,500 312,500
Less: Tax 156,250 146,250 156,250
PAT 156,250 146,250 156,250
Less: Preference dividend 0 0 20,000
Earnings available to common
Shareholders 156,250 146,250 136,250
Shares outstanding 125,000 100,000 100,000
EPS 1.25 1.46 1.36

The firm is able to maximize the earnings per share when it uses debt financing.
Though the rate of preference dividend is equal to the rate of interest EPS is high
in the case of debt financing because interest charges are tax deductible while
preference dividends are not.

The EBIT – EPS analysis is one important tool in the hands of the financial
manager to get an insight into the firm’s capital structure management. He can
consider the possible fluctuation in EBIT and examine their impact on EPS under
different financial plans. If the probability of earning a rate of return on the firm’s
assets less than the cost of debt is insignificant, a large amount of debt can be

83
used by the firm in its capital structure to increase the earnings per share. This
may have favourable effect on the market value per share.

On the other hand, if the probability of earning a rate of return on the firm assets
less than the cost of debt is very high, the firm should refrain from employing
debt capital.

It may be concluded that the greater the level of EBIT and lower the probability of
down ward fluctuation, the more benefit it is to employ debt in the capital
structure. However, it should be realized that the EBIT-EPS is a first step in
deciding about a firm’s capital structure.

The major shortcoming of the EPS criterion is that it does not consider risk. It
ignores the variability about the expected value of EPS. Investors in valuing the
shares of the company consider both expected value and variability.

COST OF CAPITAL AND VALUATION APPROACH

The cost of source of finance is the minimum return expected by its suppliers.
The expected return depends on the degree of risk assumed by investors. A high
degree of risk is assumed by shareholders than debt-holders. In the case of debt
holders, the rate of interest is fixed and the company is legally bound to pay
interest whether it makes profits or not, for shareholders the rate of dividends is
not fixed and BODS has no legal obligation to pay dividends even if the profits
are made by the company. The loan of debt-holders is returned within a
prescribed period. One can conclude that debt is cheaper source of funds than
equity. The tax deductible of interest of charges further reduces the cost of debt.
The preference share capital is also cheaper than equity capital but it is not as
cheap as debt is. Thus, using the component, or specific, cost of capital criterion
for financing decision, a firm would always like to employ debt since it is the
cheapest source for funds. The cost of equity includes the cost of issue of

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shares and the cost of retained earnings. Between the cost of new issues and
retained earnings the latter is cheaper.

The cost of retained earnings is less than the cost of new issue because the
personal taxes have to be paid by shareholders on distributed earning while no
taxes are paid on retained earnings and because no floatation cost are incurred
when the earnings are retained. As a result, between the two sources of equity
funds, retained earnings are preferred. It has been found in practice that firms
prefer internal finance. If the internal finances are not sufficient to meet the
investment outlays, firms go for external source of finance, issuing the safest
security first. They start with debt, then possibly hybrid securities such as
convertible debentures, then perhaps equity as a last result.

TRADE-OFF THEORY
The specific cost of capital criterion does not consider the entire issue. It ignores
risk and the interest on equity value and cost. The impact of financing decision
of capital should be evaluated and the criterion should be to minimize the overall
cost of capital, or maximize the value of the firm. It should be realized that
company cannot continuously minimize its overall cost of capital by employing
debt. A point or range is reached beyond which debt becomes more expensive
because of the increased of excessive debt to creditors as well as to
shareholders financial distress. When the degree of leverage increases, the risk
of creditors increases and they demand a higher interest rate and do not grant to
the company at all once its debt has reached a particular level. Further, the
excessive amount of debt makes the shareholders position very risky. This has
effect of increasing the cost of equity. Thus, up to a point the overall cost of
capital decreases in debt, but beyond that the cost of capital start increasing and
therefore, it would be advantageous for any debt further.

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So there is a combination of debt and equity which minimizes the firms average
cost for one is generally a range of debt equity rather than which the cost of
capital is minimized as the value is maximized.

The valuation framework makes it clear that debts reduces the share price, for
increase the cost of equity and thereby lower the overall return to shareholders
despite the increase in the EPS. Thus, the impact of debt equity ratio should be
evaluated in terms of value rather than EPS. The difficulty with the valuation
framework is that, managers find it difficult to put into practice. It is not possible
to quantify all variables. Also, the operations of financial market are so
complicated that it is not easy to understand. But this kind of analysis does
provide insights and qualitative guidance to the decision-making. The trade off
between cost of capital and EPS set the maximum limit to the use of debt.
However, other factors be evaluated to determine the appropriate capital
structures for a company.

CASH FLOW APPROACH

One of the features of a sound capital structure is conservatism. Conservatism
does not mean employing no debt or small amount of debt. It is related to the
fixed charges created by the use of debt or preference capital in the capital
structure and the firm’s ability to generate cash to create those charges. In
practice, the question of the optimum (rather appropriated) debt, equity mix boils
down to the firm’s ability to service debt without any threat and operating
inflexibility. A firm is considered prudently finance if it is able to service its fixed
charged under any reasonable predictable conditions.

The fixed charges of a company include payment of interest, preference

dividends and principal; and they depend on both the amount of senior securities
and the terms of payment. The amount of fixed charges will be high if the
company employs a large amount of debt or preference capital with short-term

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maturity. Whenever a company thinks of raising additional debt, it should
analyses its expected future cash flows to meet the fixed charges. It is
mandatory to pay interest and return the principal amount of debt. If a company
is not able to generate enough cash to meet its fixed obligation, it may have to
face financial insolvency. The companies expecting larger and stable cash
inflows in the future can employ a large amount of debt in their capital structure.
It is quite risky to employ fixed charges sources of finance by close companies
whose cash inflows are unstable and unpredictable. It is possible for a high
growth profitable company to suffer from cash shortage if its liquidity (working
capital) management is poor.

One important ratio which should be examined at the time of planning the capital
structure is the ratio of net cash inflows to fixed charges debt servicing ratio. It
indicates the number of times the fixed financial charges are covered by the net
cash inflows generate by the company. The greater the coverage, the greater
the amount of debt a company can use. However, a company with a small
coverage also employ a large amount of debt if there are not significant yearly
variance in its cash inflow and small probability of the cash inflows being
considerably less to meet fixed charges in a given period. Thus it is not the
average cash inflows but the yearly cash inflows which are important to
determine the debt capacity of a company. Fixed financial obligation must be
met when due, not on average and not most years but always. This requires a
full cash inflow analysis.

Debt capacity: The technique of cash flow analysis is helpful in determining the
firm’s debt capacity.
Debt capacity is the amount which a firm can service easily when under adverse
conditions: it is the amount which the firm should employ. There are lenders
who are preparing to lend to you. But should borrow only if the company can
service the debt without problems. A firm can overcome its financial distress if it

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can maintain its debts for payment. Debt capacity therefore should be in terms of
cash flows rather than debt ratios.
A high debt ratio is not necessarily bad. If you can expect high debt without any
risk it will increase shareholders wealth. On the other hand, a low debt ratio have
to be burdensome for a firm which has liquidity problem. It is dangerous to
finance a capital interest project out of borrowings, which has built in certainty
about the earns and cash flows.
Component of cash flow the cash flows should be analyzed over a long period of
time, which can cover various adverse phases, for determining the firm’s debt
policy.

The cash flow analysis can be carried out by prepared preference cash flow
statements to show the firm financial conditions under adverse conditions such
as a reversion. The expected cash can be categorized into three groups.
1) Operating cash flows which relate to the operations of firm and can be
determined from the predicted profit and loss statements. The behavior of sales
may be output price and input price over the period of analysis should be
examined and predicted.
2) Non-operating cash flows which is generally include capital expenditures and
working capital charges. During a recessionary period, the firm may have to
specially spend for the promotion of the product. Such expenditures should be
included in the non-operating cash flows. Certain types of capital expenditure
cannot be avoided even during most adverse conditions. They are necessary to
maintain the minimum operating efficiency. Such irreducible minimum capital
expenditure should be clearly identified.
3) Financial flows include interest; dividends. lease rentals, repayment of
debts etc. They are further divided into contractual obligations and policy
obligation. Contractual obligations include these financial obligation, like interest,
lease, and principal payment, that are matter of contract and should not be
defaulted. Policy obligations consist of those financial obligations, like dividends,

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that are dissertation of the BODS. Cash flow analysis versus EBIT – EPS
analysis. Is cash flow analysis superior to EBIT? - EPS analysis? How does it
translate the insights of the finance theory? The cash flow analysis has the
following advantages over the EBIT-EPS analysis.

1) It focuses on the liquidity and solvency of the firm of over a lend period of
time, even encompassing adverse circumstances. Thus, it evaluates the firm’s
equity to meet fixed obligations.
2) It goes beyond the analysis of profits and loss statement and also considers
changes in the balance sheet items.
3) It identifies discretionary cash flows. The firm can thus prepare an action plan
to face adverse situations.
4) It provides a list of potential financial flows which can be utilized under
emergency.
5) It is long-term dynamic analysis and does not remain confirmed to a single
period analysis. The most significant advantage of the cash flow analysis is that
it provides a practical way of incorporating the insights of the finance theory. As
per the theory, debt financing has an advantage. But it also involves risk of
financial distress. Therefore, the optimum amount of debt depends on the trade
off between tax advantage of debt and risk of financial distress. Financial
distress occurs when the firm is not in position to meets its contractual
obligations.
The cash flow analysis indicates when the firm will find it difficult to service its
debt. Therefore, it is useful in providing good insight to employ the debt capacity
which helps to maximize the market value of the firm.

CASH FLOW ANALYSIS VERSUS DEBT EQUITY RATIO

The cash flow analysis clearly reveals that a higher debt-equity ratio is not risky if
the company has the ability of generation substantial cash inflows in the future to
meet financial obligations. Financial risk in this sense is indicated by the

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company’s cash flow ability, not by the debt-equity ratio. To quote van Horne the
analysis of that equity ratio above can be deceiving and analyses of the
magnitude and stability of cash flows relative to fixed stages is externally
important in determining the appropriate capital structure for the firm.

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