CHAPTER ONE

OVERVIEW OF FINANCIAL MANAGEMENT

1.1. FINANCE AS AN AREA OF STUDY
What is exactly managerial finance or finance in general? What are the major
responsibilities and duties of managers of finance? In order to answer these questions,
you need to understand the areas that finance covers. Finance, in general, consists of
three interrelated areas:
1. Money and capital markets, which deal with securities markets and financial
institutions;
2. Investments, which focus on the decision of investors, both individuals and
institutions, as they choose among securities for their investment portfolios;
and
3. Financial management, (or "business finance", "corporate finance", or
"managerial finance"), which involves the actual management of business
firms
The career opportunities within each of the above fields are many and varied, but
managers of finance must have knowledge of all three areas if they are to perform their
jobs well.
1. Money and Capital Markets
Most of the finance professionals go to work for financial institutions, including banks,
insurance companies, investment companies, credits and savings associations.
♣ For you to succeed in doing such jobs, you need a knowledge of the factors that
cause interest rates to rise and fall, the regulations to which financial institutions
are subjected, and the various types of financial instruments such as bonds, shares,
mortgages, certificates of deposits, and so on.
♣ You also need a general knowledge of all aspects of business administration,
because the management of financial institutions involves accounting, marketing,
personnel management, computer science as well as financial management.
♣ An ability to get people to do their job (i.e. people skills) is very critical.
2. Investments
Finance graduates who go into investment areas:
♣ Generally work for brokerage houses in the sales of securities or as security
analysts
♣ Others work for banks and insurance companies in the management of investment
portfolios, or
♣ The rest work for financial consulting firms, which advise individual investors or
pension funds on how to invest their funds
♣ The three major functions in the investment area are:

1
  Sales of securities,
 Analysis of individual securities, and
 Determining the optimal mix of securities for a given investor
3. Financial management-Financial management is the focus of this
course.Financial management is important in all types of businesses, including
banks, and other financial institutions as well as other form of businesses.(See the
chart depicted below)

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 SCOPE OF FINANCIAL MANAGEMENT

ANALYETHICAL WAY OF VIEWING THE

FINANCIAL PROBLEMS OF A FIRM

BALANCE SHEET INCOME STATEMENT

PERSPECTIVE PERSPECTIVE
"How Large should an "How Fast should it Grow?"
Enterprise be?"

USES OF SOURCES TARGET CAPITAL

FUNDS OF FUNDS CAPITAL INTENSITY
"In what "What should STRUCTURE "Sales per
form should be the "Leverage, invested capital,
it hold its composition Retention and Investment
Assets?" of its claims?" Dividend turnover"
policy"

SUSTAINABLE
MIX AND GROWTH RATE
TYPE OF DEBT AND "Sales growth rate
ASSETS EQUITY with out increasing
"Current, Long- USAGE leverage or issuing
term, Real, and "Leverage and new shares"
Financial" Equity financing"

INVESTING FINANCING DIVIDEND

DECISION DECISION DECISION

FUNCTIONS OF FINANCE (Decision Areas) (To be dealt in the first part of the course)

PLUS

MANAGEMENT OF FINANCIAL RESOURCES (To be dealt in the second part of the course)

Multi-national Exchange rate (Currency

Cash Receivables Inventory Financial Valuation), Derivatives,
Management Management Management Management issues and Risks

EQUALS

FINANCIAL MANAGEMENT AS A SPECIALISED FIELD OF STUDY

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Financial management is also important in governmental operations, from schools to
hospitals, from zonal administrative levels to state administrative levels, and even
The type of jobs encountered in financial management range from decisions
regarding plant expansion to choosing what types of securities to issue to finance the
expansion.

KEY ACTIVITIES OF THE FINANCIAL MA

PERFORM BASIC MAKE DECISIONS

TASKS

INVESTME
FIANAN FINANCIA NT
CIAL L DECISION FINANCIN
PLANNIN ANALYSIS S G
G "Transform "Short DECISION
(FORCAS financial term and S "Capital
TING) data in to long-term structure
"Evaluate usable form
investment and
productiv to monitor
financial s Financing
e capacity
and condition" policy
determine
financing
requireme
nt"

"Techniq "Increase "Capital "Financia

ues or budgeting l leverage
(Financia Decrease and and credit
l ratios) capacity; measurem policy
and additional ent of plus
Interpret funds or expected retention /
ations" reduction rate of dividend
of funds" return" policy

Measurem Cost of Capital

ent of Risk (required rate of
return) and
Valuation

♣ Financial managers also have the responsibility for deciding:

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  The credit terms under which customers may buy,
 How much inventory the company should carry,
 How much cash to keep on hand,
 Whether to acquire other company (merger analysis), and
 How much of the firm's earnings to retain in the business versus payout as
dividends
Regardless of which specific area of finance you are emphasizing on, you need
knowledge of all the three areas (i.e. money and capital market, investments, and
financial management).
♣ For example, a banker lending to businesses cannot do his or her job properly
with out a good understanding of financial management, because he or she must
be able to judge how well the businesses are operating.
♣ In the same way, company financial managers need to know what their bankers
consider important and how investors are likely to judge their company
performance and thus, determine their stock prices.
1.2. THE CENTRAL ROLE OF CAPITAL
Capital, as you all know, is essential for the operation of any firm. Financial
Management, in this regard, may be defined in terms of the relationship between capital
and the business firm.
♣ A business firm, whether it is a newly established or an existing one, must obtain
certain amount of capital to finance itself in order to produce and sell goods and
services to its customers.
♣ Initial capital/funds/ of the newly formed firm consists of funds secured from the
owners of the firm in the form of equity capital and from the creditors in the form
of both short-term and long-term loans.
♣ An existing firm may finance itself by retaining part of its earnings in addition to
the two sources indicated.
♣ The capital of the firm, whether it is generated internally from operations or
provided by owners and creditors, constitute the source of the firm's capital and
hence, recorded on the right-hand side of the balance sheet as liabilities and
owners' equity.
The acquired capital is used to employ personnel, to obtain offices and other
manufacturing facilities, inventories, and other assets. The capital is also used for
producing goods and services to meet customers' demands.
♣ The acquired assets constitute the uses of the capital of the firm and are listed in
the left-hand side of the balance sheet (i.e. assets).
♣ The balance sheet of the firm, thus, contains both the uses and sources of the
capital of the firm.
♣ The balance sheet records these values at the particular point in time.

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 ♣ To complete the balance sheet, the firm records the results of its operations during
a given period, such as a year in its income statement.
♣ The income statement, in this regard, lists the firms revenues generated, expenses
incurred, and profit earned over a span of time and provides a measure of the
ability of the firm to manage its capital sources and uses.
These two financial statements, (balance sheet and incomes statement), picture a firm as
an entity that finances itself with capital from various sources and puts this capital into
various uses in order to generate the desired amount of revenues and profits.

1.3. FINANCIAL MANAGEMENT AND CAPITAL

1.3.1. Capital: Sources and Uses
Capital sources and uses must carefully be managed if the firm needs to be profitable for
its financiers. Financial management, in this regard, is the specialized business function
that deals with this problem.
♣ In general, financial management can be defined as the management of capital
sources and uses so as to attain the desired goals of the firm (i.e. maximization of
shareholders' wealth).
♣ A firm's capital consists of items of value that are owned and used and items that
are used but not owned. For example, the office space that a business firm has
rented for doing business and the bank loans that the firm has taken to finance its
operations are items of values that the business firm can use but does not own.
Similarly, inventories and fixed assets purchased by the firm.
♣ Capital sources are those items found on the right-hand side of the balance sheet
(i.e., the liabilities and equity section as stated earlier).
♣ Examples of the uses of capital of the firm are receivables, inventories, and fixed
assets.
1.3.2. Financial Management: Basic Functions
As an area of study, financial management is concerned with two distinct functions.
These are:
♣ The financing function, and
♣ The investing function
The financing function describes the management of the sources of capital. The investing
function, on the other hand, concentrates on the type, size, and percentage composition of
capital uses. It deals with the question "how much of the total capital provided by the
financing sources should be invested in receivables, marketable securities, inventories,
and fixed assets?"

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 ♣ The specialized set of management duties and responsibilities that center around
the financing and investing functions are referred to as financial
management.
1.3.3. Goal of the Firm: Profit vs. Wealth Maximization
One additional concept contained in the definition of financial management is concerned
with the goal directed behavior or goral orientation.
♣ The problems and opportunities that financial managers face and the business
decisions they are required to make entirely depend on the purposes or goals of
their respective organizations.
♣ Profit seeking organizations should actually behave in a way they maximize the
wealth of their shareholders.
 It is very important for you at this point to distinguish between wealth
maximization and profit maximization as goals of business firms.
1. Profit Maximization
Profit-maximization is a traditional microeconomics theory of business firm, which was
historically considered as the goal of the firm.
 Profit maximization stresses on the efficient use of financial/capital resources
of the firm.
 Profit maximization as a goal of the business firm ignores, however, many of
the real world complexities that financial managers try to address in their
decisions.
 Profit maximization functions largely as a theoretical goal; economists use it
to prove how firms behave rationally to increase profit.
 When finance was emerged as a separate area of study, it has retained profit
maximization, which is the new concept.
 Profit maximization looks at the total company profit rather than profit per
share.
 Profit maximization does not speak about the company's dividends as either a
return to shareholders or the impact of dividend policy on stock prices.
In the more applied discipline of financial management, however, firms must deal every
day with two major factors: These are uncertainty and timing.
A. Uncertainty of Returns
Profit maximization as the goal of business firms ignores uncertainty and risks in order to
present the theory more easily.
 Projects and investment alternatives are compared by examining their
expected values or weighted average profits.
 Whether or not one project is riskier than another doesn't enter these
calculations; economists do discuss risk, but tangentially (or imaginatively).

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  In reality, projects differ a great deal with respect to the risk characteristics,
and disregarding these differences can result in incorrect decisions.
To better understand the implication of ignored risks, let us look at two mutually
exclusive investment alternatives (that is, only one of the two can be accepted). The first
project involves the use of existing plant to produce plastic combs, a product with an
extremely stable demand. The second project uses existing plant to produce electric
vibrating combs. The latter product may catch on and do well, but it could also fail. The
optimistic, pessimistic, and expected outcomes are given as follows:
Profit Figures
Plastic Comb Electric Comb
Optimistic outcome $10,000 $20,000
Expected outcome 10,000 10,000
Pessimistic out come 10,000 0
There is no variability associated with the possible outcomes of producing and selling
plastic combs because demand for this product is stable. If things go well (optimistic),
poorly (pessimistic), or as expected, the profit will still be the same, i.e. Birr 10,000.
With that of the electric combs, however, the range of possible profit figures varies from
Birr 20,000, if things go well (optimistic), to Birr 10,000, if things go as expected, or to
the profit figure of zero, if things go wrong (pessimistic). Here, if you look at just the
expected profit figure of Birr 10,000, it is the same for both projects and you conclude
that both projects are equivalent. They are not, however. The returns (profit figures)
associated with electric combs involve a much greater degree of uncertainty or risk.
 The goal of profit maximization, however, ignores uncertainty (risk) and
considers these projects equivalent in terms of desirability as it refers only to
the expected profit figures from the projects.
B. Timing of Returns
Another problem with profit maximization as the goal of business firm is that it ignores
the timing of the returns from projects. To illustrate, let us reexamine our plastic comb
versus electric comb investment decisions. This time let us ignore risk and say that each
of these projects is going to return a profit of Birr 10,000. assume that while the electric
comb can go into production after one year, the plastic comb can begin production
immediately. The timing of the profit from these projects are as follow:

Profit Figures

Plastic Comb Electric Comb

Year 1 $10,000 $0
Year 2 0 10,000

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In this case, the total profit from each project is the same, but the timing of earning the
profits differs. As we will see later in this course, in the chapter dealing with the concept
of "Time Value of Money ", money has a definite time value as people have definite
preference for current benefits over future benefits. Thus, the plastic comb project is the
better of the two. Assume that the Birr 10,000 profit from Plastic comb project during
year 1is invested in a saving account that earns an interest of 5 percent per annum. This
money would have grown to birr 10,500 at the end of the second year as opposed to the
Birr 10,000 profits to be reported by the electric comb project at the end of the second
year.
Since investment opportunities are available for the money on hand, we are not
indifferent to the timing of the returns (profits) from these investment opportunities. In
other words, the returns obtained can be re-invested at the prevailing rate of return.
 Given equivalent cash flows from profits, we want the cash flows to occur
sooner rather than later.
 The financial manager must always consider the possible timing of returns
(profits) in financial decision-making.
Therefore, the real-world factors of uncertainty and timing of returns force financial
managers to look beyond simple profit maximization as the goal of the business firm.
 These limitations of profit maximization as the goal of business firms lead us
to the maximization of the more robust goal of the business firm, that is,
shareholders' wealth.
2. Wealth Maximization
Wealth maximization, on the other hand, is a more comprehensive model dealing with
the goal of the firm. According to this model, it is made clear that there are two ways in
which the wealth of shareholders changes. These are:
 Through changing dividend payments, and
 Through the change in the market price of common shares
Hence, the change in shareholders' wealth, or change in the value of business firms, may
be calculated as follows:
i. Multiply the dividend per share paid during the period by the number of
shares owned.
ii. Multiply the change in shares price during the period by the number of
shares owned.
iii. Add the dividends and the change in the market value of shares, computed
in step 1 and 2 above, to obtain the change in the shareholders' wealth
during the period.
In order to maximize the wealth of shareholders, a business firm must seek to provide the
larges attainable combination of dividends per share and stock price appreciation.
 Nevertheless, the problem is that while a business firm may have some degree of
freedom in setting its dividend policy that is in accordance with wealth

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 maximization goal, it cannot influence the share prices, which are basically set
by the interaction of buyers and sellers in the securities/stock markets.
 Stock prices tend to reflect the perception of the stockholders regarding the
ability of the business firm to earn profits and the degree of risks that the
business firm assumes in earning its profit.
The ultimate risk that the business firm usually faces is the probability that it will fail or
go bankrupt. In such an event,
 The owners/shareholders of the business firm would see their investment
becoming worthless; and
 The creditors would likely see that at least some portion of their loans go
unpaid.
These events have impacts on the market prices of shares, which, in turn, have impacts on
the objective/goal of a business firm, that is, wealth maximization of shareholders.

1.4. MAXIMIZATION OF SHAREHOLDER'S WEALTH

In formulating the goal of maximization of shareholders' wealth, we are doing nothing
more than modifying the goal of profit maximization to deal with the complexities of the
operating environment.
 We have chosen maximization of shareholders' wealth, that is, maximization of
the total market value of the existing shareholders' common stock, because the
effect of all financial decisions is reflected through these prices.
 The shareholders (or investors) react to poor investment or dividend decisions
by causing the total value of the firm's stock to fall and they react to good
decisions by pushing the price of the stock up.
Obviously, there are some series practical problems in direct use of this goal and
evaluating the reaction to various financial decisions by examining changes in the firm's
stock value.
 In reality, different factors/aspects affect stock prices.
 To employ wealth maximization as the goal of your business firm, therefore,
you need not consider every stock price change to be the market interpretation
of the worth of your decision.
 Other factors such as economic expectations, also affect stock price
movements.
Apparently, what you do focus on is the effect that your decision should have on the
stock price if every thing else where held constant.
 The market price of the business firm’s stock reflects the value of the firm as
seen by its owners.

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  The wealth maximization as the goal of a business firm takes into account
uncertainty or risk, time, and other factors that are important to the owners of
the firm.
 Thus, again, the framework of maximization of shareholders' wealth allows for
a decision environment that includes the complexities and complications of the
real world.
1.5. THE AGENCY PROBLEM
While the goal of the business firm is the maximization of shareholders' wealth, in reality
the agency problem may interfere with the implementation of this goal.
 The agency problem is the result of a separation of the management and the
ownership of the firm. For example, a large business firm may run by
professional managers, who are agents and have little or no ownership
position/stake in the firm.
 Because of the separation between the decision makers and owners, managers
may make decisions that are not in line with the goal of the business firm, or
not consistent with the interests of owners, that is outlined as maximization of
shareholders' wealth.
 Professional managers, being mere agents of owners, may attempt to benefit
themselves in terms of salary and perquisites at the expense of shareholders.
 The exact significance of this problem is difficult to measure.
 However, while it may interfere with the implementation of the goal of
maximization of shareholders' wealth in some firms, it does not affect the
goal's validity, however.
 The costs associated with the agency problem are also difficult to measure, but
occasionally we can see the effect of this problem in the marketplace.
♣ For example, if the market feels that the management of a business firm
is damaging shareholders' wealth, we might see a positive reaction in the
stock price to the removal of that management.
1.6. THE OBJECTIVE OF FINANCIAL MANAGEMENT
The financial manager uses the overall company's goal of shareholders' wealth
maximization, which is reflected through the increased dividend per share and the
appreciations of the prices of shares, in formulating financial policies and evaluating
alternative courses of operations. In order to do so, this overall goal of wealth
maximization needs to be related to and/or take the following specific objectives of
financial management into account:
1. Financial management aims at determining how large the business firm
should be and how fast should it grow.
2. Financial management aims at determining the best percentage composition
of the firm's assets (asset part of the decision, or decisions related to capital
uses).

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 3. Financial management also aims at determining the best percentage
composition of the firm's combined liabilities and equity decisions related to
capital sources).
1. Determining the Size and Growth Rate
The size of the business firm is measured by the value of its total assets.
♣ If the book values are used, the size of the firm is equal to the total assets as
indicated in the balance sheet.
♣ When this method of size determination is used, the growth rate of the business
firm is measured by the yearly percentage change in the book values of all the
items in the assets section of the balance sheet.
As a student of financial management, however, you should be able to understand that
a business firm that is large and growing faster & larger does not necessarily produce
increased earnings.
2. Determining Assets Composition (Portfolio)
As indicated earlier, assets represent investments or uses of capital that the business firm
makes in seeking to earn a rate of return for its owners.
♣ The most common asset categories are cash, inventories, and fixed assets.
♣ However, financial institutions, such as banks and insurance companies, have
some what different assets categories. They may list loans, advances, and
negotiable securities as assets.
♣ The percentage composition of the assets of the firm is computed as ratio of the
book value of each asset to total book values of all assets.
♣ The choice of the percentage composition of asset items affects the level of
business risk.
♣ The asset structure decision relate to what products and services the business firm
should produce. The financial manager is directly involved in decisions related to
the assets structure that makes the business firm more successful in a way it will
maximize the wealth of shareholders.
The wealth maximizing assets structure can be described in either of the following ways:
i. The asset structure that yields the larges profit for a given level of exposure
to business risk, or
ii. The asset structure that minimizes exposure to business risk that is needed
to generate the desired profit.
In both of the cases, the financial manager should recognize that the asset structure of the
business firm is the major determinant of the overall risk-return profile of the firm.
3. Determining the Composition of Liabilities and Equity
As it was stated earlier in this chapter, liabilities and equity are the sources of capital of
business firms.

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 ♣ They are the financing sources that business firms use to make investment in
various types of assets.
♣ The most common financing sources are accounts and notes payable; accruals for
items such as taxes, wages, and interests; loans and debt securities of various
maturity dates; and common stocks, preferred stocks, and retained earnings.
♣ Here again, banks and insurance companies might secure funds from liability
accounts such as time deposits, demand deposits, and saving deposits.
♣ As it was done for the percentage composition of assets, the liability and equity
percentage compositions of the business firm is measured by dividing the book
value of each liability or equity item by the total book values of all liabilities and
equity.
♣ The mix of liabilities and equity of the business is what is known as the capital
structure.
When the business firm finances its investment by using debt capital, ("leverage" being
the jargon used in Finance to refer this), the business firm and its shareholders face
added risks along with the possibility of added returns. This is due to the effects of
leverage, which is resulting from using debt capital in financing investments.
♣ The added risk is the possibility that the firm may face difficulty to repay its debts
as they mature. (This is referred to as a negative leverage)
♣ The added returns come from the ability of the firm to earn the rate of return
higher than the interest payments and related financing costs of using liabilities.
(This is referred to as a positive leverage)
♣ The added returns may be paid as dividends and/or re-invested in the firm to
generate more profit. This, in effect, would maximize the wealth of shareholders
of the business firm.
Stock prices, therefore, react to the manner of financing of a business firm as well as to
the subsequent ability or inability of the firm to manage its capital structure.
1.7. EVOLUTION OF THE FINANCE FUNCTION
Finance for the first time became a separate area of study around 1900. Since then, the
duties and responsibilities of the financial managers have undergone continuous change,
and expected to change in the future as well.
The two main reasons for the ongoing change in the functions of finance are:
i. The continuous growth and increasing diversity of the national and international
economy, and
ii. The time to time development of new analytical tools that have been adopted by
financial managers
1. Finance Before 1930
Up to 1900, finance was considered as a part of applied economics.

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 ♣ The 1890s and 1900s were the periods of major corporate mergers and
consolidations in the American economy.
♣ These mergers and consolidations were gradually transmitted to other economics
all over the world.
♣ These activities required unprecedented amount of financing.
♣ The management of the capital structure of companies that had been formed due
to mergers and consolidations become an important task. Hence, finance was
emerged as distinct functional area of business management.
The major technological innovations of the 1920s created entirely new industries such as
radio and broadcasting stations.
♣ These new industries produce not only large quantities of output but also earned
high profit margin.
♣ Financial management was found to be important in dealing with problems
related to planning and controlling the liquidity of the newly emerged industries
of that time.
The stock market crash of 1929 and the subsequent economic depression occurred in the
American economy resulted in the worst economic conditions that occurred in the 20th
century.
♣ Bankruptcy, reorganization, and mere survival become major problems for many
corporations.
♣ The capital structure, which was dominated by debt, aggravated the solvency and
liquidity problems of companies.
♣ Financial management is additionally responsible for the planning of the
rehabilitation and survival of the business firm.
2. Finance Since 1950
These days, large number of people is employed and works in manufacturing and service
industries that didn't exist before.
♣ Much of this rapid economic growth occurred because of the increased rate of
technological advancement.
♣ The computerization process in almost all of these industries is an example of the
extent to which our economy has become dependent on new technologies.
♣ As new industries have arisen and as older industries have sought ways to adapt to
the rapidly changing technologies, finance has become increasingly analytical and
decision oriented.
♣ This evolution of the finance function has been influenced by the development of
computer science, operations research, and isometrics as tools for financial
management functions.
To summarize, the evolution of finance functions contains the following three important
points:

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 1. Finance is relatively new as a separate business management function;
2. Financial management, as it is presently practiced, is decision oriented and
uses analytical tools such as quantitative and computerized techniques,
economics, and managerial accounting;
3. The continuing rapid pace of economic development virtually guarantees that
the finance function will not only continue to develop but also have to
accelerate its pace of development to keep up with the complex problems
and opportunities that corporate manger are facing.

CHAPTER SUMMARY
This first chapter has provided you an introduction to finance as the area of study and to
managerial finance as an important business function.
The chapter also examined the goal of the business firm; the commonly accepted goal of
profit maximization is contrasted with the more complete goal of the maximization of
shareholders' wealth. As the wealth maximization goal deals with uncertainty and time in
a real world environment, it is found to be the proper goal of the firm. In other words,
shareholders' wealth maximization attempts to take into account both risk and return, and
is superior in a number of important ways to that of the traditional economic goal of
profit maximization.
Finance first appeared as a distinct area of study around 1900 and initially focused on
capital structure composition. During the great depression, bankruptcy, and
reorganization, finance became an important consideration. Since 1950, finance became
decision oriented with respect to both asset and capital structure management, and
became increasingly analytical in nature. The tools of the financial manager now include
accounting, economics, computer science, and quantitative analysis of operations
research.

15
 CHAPTER TWO
FINANCIAL STATEMENT ANALYSIS
2.1. BASIC FINANCIAL STATEMENTS
The data used in analyzing financial statements are contained in financial statements such
as income statement, balance sheet, and statement of retained earnings. In explaining
financial statement analysis, financial statements pertaining to Addis Manufacturing
Company are used throughout this chapter, which is an ideal company considered for an
illustrative purpose.
.1. Income Statement
As you know from your previous courses, income statement measures the profitability of
a business firm over a period.
♣ Though the income statements of many multinational companies cover a
European calendar year, Addis Manufacturing Company has adopted fiscal year
that corresponds with the Ethiopian budget year for an accounting purpose.
♣ The Ethiopian budget year runs from Hamle 1 to Sene 30. Income Statement can
also be prepared on a quarterly basis and referred to as interim income statement.
Regardless of the starting and ending dates, or the length of the time covered, the
important point is that income statement summarizes the operations of a business firm
over a given time interval.
♣ As it can be seen from the income statement for Addis Manufacturing Company,
the company's operations generated a flow of revenues (net sales), expenses, and
profits (net incomes) during the two reporting years.
Addis Manufacturing Company
Comparative Income Statement
For the Years Ended Sene 30, 1992 and 1993
(Figure in thousands of Birr)
Items 1993 1992
Net Sales Birr 120,000
Birr 110,000
Cost of goods sold 90,000
83,000
Gross Profit 30,000
27,000
Operating Expenses:
Selling expenses 5,000
4,800
General and administrative expenses 8,000
7,600
Depreciation expense 1,100
800
Lease Payments 1,650
1,600

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 Total operating expenses 15,750
14,800
Earning before interest and taxes 14,250
12,200
Interest expenses:
Interest on bank notes 550
700
Interest on Other debt 3,600
3,960
Total interest expenses 4,150
4,660
Earning before taxes 10,100
7,450
Income taxes (34%) 3,434
2,564
Net Income 6,666
4,976
2. Balance Sheet
A balance sheet summarizes the financial position of the business firm. It usually
contains two sections:
(1) The asset (i.e. uses of funds) section, and
(2) The liabilities and shareholders' equity (i.e. sources of funds) section
The following is the comparative balance sheet for Addis Manufacturing Company, an
ideal business firm, on Sene 30, 1992 E.C. and Sene 30, 1993 E.C.
Addis Manufacturing Company
Comparative Balance Sheet
Sene 30, 1992 and 1993
Items 1993 1992
Current Assets:
Cash 2,500
3,000
Marketable securities 1,000
1,300
Accounts receivable 16,000
12,000
Inventories 20,500
18,700
Total current assets 40,000
35,000
Fixed Assets:
Land and buildings 28,700
24,200
Machinery and equipment 31,600

17
 29,000
Total fixed assets 60,300
53,200
Less accumulated depreciation 18,300
17,200
Net fixed assets 42,000
36,000
Total assets 82,000
71,000
Liabilities and shareholders' equity
Current liabilities
Accounts payable 7,200
6,000
Notes payable 10% bank 5,500
7,000
Accrued liabilities 900
700
Current portion of long-term debt 3,000
3,000
Other current liabilities 1,400
1,200
Total current liabilities 18,000
17,900
Long-term liabilities
Long term debt-12% mortgage bond 27,000
30,000
Total liabilities 45,000
47,900
Shareholders' equity
Common stock, 5Birr par, 2,000,000
Shares authorized; 1,300,000 shares
outstanding in 1993 and 100,000
shares outstanding in 1992 6,500
5,000
Capital in excess of par 14,000
5,350
Retained earnings 16,500
12,750
Total shareholders' equity 37,000
23,100
Total liabilities & shareholders' equity 82,000
71,000
As indicated in the above comparative balance sheet prepared for Addis Manufacturing
Company, total assets equal total liabilities and stockholders' equity.
♣ This statement shows the mix of liabilities and equity that is used to finance
company's assets.

18
 ♣ The assets of the company are the investments it had made in profit-seeking
activities.
 Current assets are most liquid assets of the company, which can be used or
converted in to cash with in a period of one year or less. Hence, the Birr
value of current assets is termed as a gross working capital of the company.
 In contrast to current assets, fixed assets division consists of long-term
financial claims and investments in the physical assets such as properties,
plants and equipment.
♣ The liability and shareholders' equity section of the balance sheet shows how the
company is financed.
♣ Liabilities are values of assets financed by funds from creditors. Current
liabilities, as stated earlier, are to be paid back in less than one year.
♣ The amount of funds provided by the shareholders' directly for Addis
Manufacturing company are represented by the common stock and additional
capital in excess of par portions of the shareholders' equity section of the balance
sheet.
♣ Retained earnings are part of shareholders' equity obtained as a result of the board
of directors decision to retain portion, or entire amount of net profits of the
company for reinvestment.
The accounting procedures used to generate financial statements are not primarily
designed to provide data inputs for financial statements analysis.
♣ As a consequence of this, the financial statements may not always provide the
information that the financial managers need for various types of business
decisions.
♣ For example, the assets are listed in the balance sheet at their historical costs that
do not, most of the time, reflect the current market values, or the replacement
costs of these assets.
♣ Moreover, some difficulties can be expected in interpreting financial statement
figures individually.
♣ For instance, an increase in a balance of an inventory account could mean:
 The individual purchases cost more that ever due to increases in prices and
that the physical inventory levels have not increased, or
 The company is accumulating that it has been unable to sell, or
 The company is producing, or purchasing inventories in large quantities in
anticipation of increases is the volume of sales in the future.
This clearly shows that it is difficult to interpret the balance of a given account separately
as it could mean different things.

3. Statement of the Retained Earnings

19
The statement of retained earnings lists how much of the net profit/income of the
company was paid out as dividends to the shareholders and how much of it was retained
in the company for reinvestments or further expansion of the company.
♣ The statement of retained earnings normally exhibits one important relationship
that exists between the income statement (that summarizes the operation of the
company during a given time period) and the balance sheet (that summarizes the
financial position of the company on the given date).
♣ The retained earning account in the shareholders' equity section of the balance
sheet of the company is the accumulation of the net profit of the company that has
been retained over the life time of the company.
♣ Every the retained earnings account is increased by an amount equal to the excess
of net profit over dividend declared and distributed during that year.
♣ Hence, the ending balance of the retained earnings account that is computed in the
statement of retained earnings links the income statement and the balance sheet.
♣ There are in fact, many other ways in which all of these financial statements
interact with one another.
The following is the statement of retained earnings for Addis Manufacturing Company,
an ideal company, for the year ended Sene 30, 1993 E.C.
Addis Manufacturing Company
Statement of retained earnings
For the Year ended Sene 30, 1993 E.C.
Retained Earnings, Hamle 1, 1993 12,750
Net income 6,666
Sub-Total 19,416
Less: Cash dividends (Common stock) 2,916
Retained Earnings, Sene 30, 1993 16,500
As you can see from the statement of retained earning of Addis Manufacturing Company,
the retained earnings account has a balance of Birr 12,750 on Hamle 1, 1993 that is the
ending balance of Sene 30, 1992 carried forward. This balance wash shown in the
shareholders' equity section of the balance sheet prepared for Addis manufacturing
company on Sene 30, 1992. In the same way, the ending balance of the retained earnings
account shown in the statement of retained earning for Addis manufacturing company for
the year ending on Sene 30, 1993 (i.e. 16500 Birr) was reported in the shareholders'
equity section of the balance sheet for that year.
2.2. RATIO ANALYSIS
The first step in undertaking financial statements analysis is to read and understand the
financial statement and their accompanying notes with care. This is followed by the
computation of ratios (i.e. undertaking ratio analysis) and interpreting what the ratios is to
mean.
♣ The use of financial ratios to analyze financial statements is now a common
practice to the extent that even computerized financial statement analysis
programs prepare financial ratios as part of their overall analysis.

20
 ♣ Both lenders and potential lenders use financial ratios to evaluate loan
applications from borrowing companies.
♣ Investors use financial ratios to assess the future tale of the companies in which
they are contemplating to make investment.
♣ Managers make use of financial ratios in order to judge the performance of their
companies and to control the day-to-day operation of their companies.
♣ Owners make use of financial ratios to evaluate whether their companies are
maximizing their wealth or not.
2.2.1. Financial Ratios: General
Financial ratios can be designed to measure almost any aspect of the performance of the
company.
♣ In general, financial analysts use ratios as one tool in identifying areas of
strengths and weaknesses in the company.
♣ Financial ratios, however, tend to identify symptoms rather than the problems
classing symptoms.
♣ A financial ratio whose value is judged"different" or usually high or low may help
identify a significant event but it does not provide enough information that helps
to identify the reasons for the occurrence of the event.
♣ The financial ratios are judged high, low, or acceptable when they are compared
with standards.
♣ Standard ratios could be:
 Industry standards: These are standard ratios computed for companies
operating in the same industry. For example, average ratio standards can
be developed for textile industry.
 Management plans: These are financial ratios are ratios that the
management of a give company set as goals. These are plans of the
company and standards against which actual financial ratios are compared.
 Historical standards: These are financial ratios developed from the
historical records of the company over say the last 10 years. Historical
standards are, therefore, the average financial ratios for the company for
the last 10 years. These ratios can also be used as standards against which
you compare the computed ratios to judge them of high, low or acceptable.
2.2.2. Types of Financial Ratios
The most common financial ratios used for financial analysis include Liquidity, Activity
(Asset Management), Debt Management (Leverage), and Profitability ratios.
1. Liquidity Ratios
Liquidity ratios measure the ability of business firm to pay its current liabilities and
current portion of long-term debts as they mature. Liquidity ratios assume that current
assets are the principal sources of cash for meeting current liabilities and current portion

21
of long-term loans. There are two most widely used liquidity ratios. These are the
current and quick or acid ratios.
A. Current Ratio
The current ratio is computed by dividing current assets by current liabilities. The
current ratios for Addis Manufacturing Company for 1992 and 1993 are the following:
Current assets
Current Ratio = Current Liabilities
35,000
Current Ratio (for 1992) = 17,900  1.96 times
40,000
Current Ratio (for 1993) = 18,000  2.22 times
The larger the current ratio, the less the difficulty the company faces in paying its
obligations at the right time. In many cases, lenders frequently require the current ratio of
the borrowing company to remain at or above 2.0 times as a condition for grading or
continuing the commercial and industrial loans.
♣ This standard of 2.0 times is an arbitrarily selected figure and many financial
analysts feel that the liquidity position of the company should be questioned if the
current ratio of the company falls below 2.0 times.
♣ This is because of the fact that all current assets cannot be easily converted back
to cash
♣ It is very difficult to collect accounts receivable in full.
♣ It is very difficult of sell all the inventories.
♣ Short-term prepayments are unlikely to be converted to cash.
♣ If the less liquid assets constitute significant portion of the total current asset, you
may need current ratio that is even greater than 2.0 times.
The current ratios of Addis manufacturing Company show that the company has Birr 1.96
in current assets for each Birr of current liabilities during 1992 and Birr 2.22 in current
assets for each Birr of current liabilities during 1993. It is very difficult to say this ratios
are high or low as we don’t have industry standard, or management plan, or historical
standard against we compare these current ratios.
♣ However, one can say that Addis Company is more capable in 1993 to pay its
current liabilities than in 1992.
B. Quick Ratio
Quick ratio is sometimes called "acid test ratio". It serves the same general purpose as
that of the current ratio but more stringent as it exclude less liquid current assets like
inventory from current assets.
♣ It considers only quick current assets such as cash, marketable securities, and
account receivables.
♣ This is done because inventories, prepaid expenses and supplies cannot easily be
converted back to cash.
♣ Thus, the quick (acid test) ratio measures the ability of the company to pay its
current liabilities by converting its most liquid assets to cash, which is easier.

22
 ♣ The quick ratio is computed by subtracting inventories, prepaid expense, and
supplies from current assets and dividing the remainder by total current liabilities.
For Addis Manufacturing Company, the quick ratios are:
Quick Ratio =
Current assets  (Pr epaid epense  Supplies  inventories )
Current liabiities

35,000  (0  0  18700) 16,300

Quick Ratio (for 1992) =   0.91 times
17,900 17,900
40,000  (0  0  20,500) 19,500
Quick Ratio (for 1993) =   1.08 times
18,000 18,000

If the company wants to pay the entire amount of its current liabilities by using its quick
assets (i.e. current assets minus the sum of inventories, prepaid expenses, and supplies),
its quick assets should be equal to or greater than its current liabilities.
♣ Thus, the Company's quick ratio should be 1.0 times or more than that.
In the case of Addis Manufacturing Company, the quick assets of 91 cents are available
to meet each Birr of current liabilities.
♣ This implies that the quick assets are not enough to settle all the current
obligations.
♣ Unless the company converts the non-quick current assets to the extent they
provide cash that is enough to pay the remaining 9 cents for each Birr of current
liabilities, the company will face difficulty in meeting its short-term obligations.
The quick ratio of 1.08 times for 1993, on the other hand, implies that the company has
Birr 1.08 of quick assets for each Birr of current liabilities. Again, the company is in
good liquidity position during 1993 compared to 1992.
2. Activity Ratios (Asset Management Ratio)
Activity ratios measure the degree of efficiency with which the company utilizes its
resources (assets).
♣ Efficiency is equated with rapid resource turnovers.
♣ Some activity ratios concentrate on individual assets such as inventory, or
accounts receivable while others look at the overall company performance, or
activity.
The following activity ratios are discussed for Addis Manufacturing Company:
A. Inventory Turnover Ratio
This ratio is meaningful for companies like Addis Manufacturing Company, which hold
inventories of different kinds. (it could be merchandise, raw material, processed goods,
and so on).
♣ This ratio measures the number of times per year that the company sells its
inventory.

23
 ♣ It is computed by dividing the Birr amount of costs of goods sold by the Birr
amount of inventory at the closing date of the accounting period.
For Addis Manufacturing Company, the inventory turnover ratios are:
Costs of goods sold
Inventory turnover = Inventory balance
83,000
Inventory turnover (f0r 1992) = 18,700  4.44 times

90,000
Inventory turnover (for 1993) = 20,500  4.39 times

In general, high inventory turnover may be taken as a sign of good inventory

management. Other things being the same, inventory turnover ratios computed for Addis
Manufacturing Company indicate that the company was able to sell its inventories 4.44
times and 4.39 time during 1992 and 1993 E.C. respectively.
♣ The performance/efficiency of the company in selling its inventories was nearly
the same during the two years.
♣ However, you cannot say the inventory turnover ratios for Addis Company show
good or bad performance, or high efficiency or low efficiency as long as you do
not have standard inventory turnover ratio to compare with.
Inventory turnover ratio, as a measure of efficiency of business activities, suffers from
both conceptual and measurement problems.
♣ For example, high inventory turnover ratio could indicated the inadequacy of
inventory to meet customer demands which results in loss of sales.
♣ A low inventory turnover ratio, on the other hand, can be caused by an increased
line of new products each of which require some minimum inventory balances,
which, in turn, raises the balance of overall inventory level and lowers the
inventory turnover ratio.
♣ In both of these cases, the inventory turnover ratio, if it is used alone, may lead to
incorrect conclusions.
♣ This is to mean that high inventory turnover ratio may not always be good.

A measurement problem of inventory turnover ratio emanates from the denominator used
in calculating the ratio.
♣ Since the purpose of this ratio is to measure the inventory turnover rate, the
denominator should be a measure of the average amount of inventory that the
company maintained during the year.
♣ However, in most of the cases, the figure used as the denominator is the amount
of inventory on hand at the end of the reporting period because the average
inventory balance is not easily obtainable.

24
 ♣ If the balance of inventory at the end of the year is not a good representative of
the average yearly inventory because of seasonal and/or cyclical production and
selling patterns, the usefulness of this ratio is greatly limited.
B. Total Assets Turnover Ratio
It measures the relationship between a birr of sales and a birr of assets, usually on a
yearly basis.
♣ A firm wants to generate as much birr as possible in the form of sales per a birr of
an investment it made in assets.
♣ The asset turnover ratio is a measure of the overall activity of the company.
♣ It is computed by dividing the total net sales of the company by its total assets on
the closing date of the accounting period.
For Addis Manufacturing co-the total turnover ratios are:
Net Sales
Total assets turnover = Total assets
110,000
Total assets turnover (for 1992) =  1.55 times
71,000
120,000
Total assets turnover (for 1993) = 82,000  1.46 times

The total assets turnover ratio of 1.55 times during 1992 implies that the company was
able to generate Birr 1.55 for a single birr it has invested in its assets during the year.
During 1993, on the other hand, the company was able to make net sales of birr 1.46 for
each birr it has invested in the total assets.
♣ Though the total volume of sales is greater during 1993, the assets turnover ratios
show that the company was efficient in generating higher net sales per birr of
investment in asset in 1992 than in 1993.
♣ The decrease in the asset turnover ratio in 1993 may indicate a decrease in the
utilization of the assets for generating the desired sales revenue.
C. Average Collection Period
This ratio tries to measure the average number of days it takes the company to collect its
account receivables.
♣ The shorter the average collection period, the better the company's activities are.
As you know, account receivable is resulted from credit sales.
♣ Hence, this ratio relates the daily credit sales to its account receivable balance at
the end of the reporting period.
♣ Net sales may be used in the absence of credit sales, though it reduces the quality
of the ratio in measuring the number of days that receivables do take before their
collection.
The average collection period is computed in a two-step procedure.

25
 ♣ First, you compute the average daily credit sales (in the absence of credit sales
you computed the average daily sales) by dividing the 360 days into the total
credit sales, or total sales.
♣ Second, you compute the average collection period by dividing the account
receivable balance at the end of the accounting period (preferably the average
account receivable if available) by daily credit sales, or daily sales in the absence
of the former.
Assuming that all sales are made on account by Addis manufacturing company, the
average collection periods are:
Total credit sales
Step 1: Daily Credit Sales = 360 days
110,00
Daily Credit Sales (for 1992) =  305.56 birr
360
120,000
Daily Credit Sales (for 1992) =  333.33 Birr
360
When total sales used instead of credit sales in the formula, the average collection period
will face measurement problem because the cash sales included in the total sales do not
have any link with average collection period.
Moreover, the use of the account receivable balance at the end of the may not represent
the month average of accounts receivable when there are seasonal fluctuations. In this
case, the average collection period again suffers from the measurement problem.
Account Re cievables
Step 2: Average Collection Period (ACP) = DailyCreditsalss
12,000
ACP (for 1992) =  39.27 Days
305.56
16,000
ACP (for 1992) =  48 Days
333.33
The average collection period requires the analyst to provide careful interpretation even
when these measurement problems are overcame, or at least recognized.
♣ An increase, or decrease in the values of average collection period should not be
used to evaluate the effort the company puts in collecting its receivables.
For example, the average collection period during the year 1992 is nearly 40 days, which
is shorter than that of the year 1993.
♣ If the shorter average collection period during 1992 was caused by the very tight
credit policy adopted during that year, it may not be more desirable than the
average collection period of 48 days achieved during 1993 under, say a liberal
credit policy.
♣ This is because the credit policies themselves can bring changes to the average
collection period.
♣ Stringent credit policy definitely reduces the average collection period.

26
 ♣ If the small average collection period of Addis Manufacturing Company during
1992 was caused by reduced volume of credit sales, it may not be a good
indication of good credit collection condition.
Furthermore, credit granting and the structuring of credit terms are major competitive
tools used by the marketing managers rather than the financial managers.
♣ Many companies are forced to set credit policies that are comparable with the
credit policy of the dominant company in the same industry.
♣ The average collection period, in this regard, has to be interpreted in relation to
the credit terms provided to customers.
3. Debt Management or Leverage Ratios
These ratios measure the extent to which a company finances itself with debt as opposed
to equity financing.
♣ These ratios are also called solvency or capital structure ratios.
♣ They are also termed as financial leverage ratios.
Financial ratios provide the basis for answering two basic questions:
i. How has the company finance its assets using debts?
ii. Can the company afford the level of fixed charges associated with the use of
non-owners-supplied funds such as bond interests and principal payments?
The first question is answered using balance sheet leverage ratios, while the second
question is answered through the use of income statement based ratios, or simply
through the use of leverage ratios.
A. Balance Sheet Leverage Ratios
These ratios provide the basis for answering the question "Where did the company
obtain financing for its investments? The balance sheet leverage ratios include:
i. Debt Ratio or Debt-Asset Ratio
It measures the extent to which the total assets of the company have been financed using
borrowed funds. For Addis Manufacturing Company, the ratios are computed as follows:
Total liabilitie s
Debt-Asset Ratio = Total assets
47,900
Debt-Asset Ratio (for 1992) = 71,000 = 67.46%
45,000
Debt-Asset Ratio (for 1993) = 82,000  54.88%

At the end of 1992, 67.46 percent of the total assets of Addis Manufacturing Company
were financed by funds secured in the form of current and long-term liabilities. The
remaining 32.54 percent was financed by funds contributed by shareholders and retained
from the profits earned by the company. Similarly, debt financing constitutes about 55
percent of the total assets of the company during 1993. This leaves 45 percent of the total
assets to be financed with equity sources.

27
 ♣ The level of debt financing has declined during 1993 compared to 1992 signaling
good condition.
♣ Too much debt financing is riskier to the company.
♣ Addis manufacturing company can borrow much more money during 1993 than it
could do in 1992 because the asset structure of the company was more debt-
dominated in 1992 than in 1993.
♣ Hence, lenders are willing to give loans to the company during 1993, when the
debt-asset ratio is less, than during 1992, when debt-asset ratio is high.
You cannot say much about the capital structure of Addis manufacturing company on the
basis of the debt-asset ratios computed above as you don't have any standard debt-asset
ratio to be used as a bench mark.
♣ In general, creditors prefer low debt-asset ratios, because the lower the ratios,
because the lower the ratios, the lower the chance of losing their money upon
maturity, or liquidation.
♣ The owners, on the other hand, may want higher debt (leverage) ratios because
the cost of borrowed money is usually less than the cost of owners' funds.
The debt-asset ratios calculated above for Addis manufacturing company show that more
than half of the company's assets were financed with funds form creditors during the two
years.
♣ As a result, the company may find it difficult borrow additional funds without
first raising more equity.
♣ Otherwise, creditors would be reluctant to lend more money to the company with
its debt-dominated capital structure.
Though creditors are willing to give loans to debt dominated borrower they are will at
higher interest rate that commensurate with the high risk they are taking as lenders.
The debit-asset ratio of 67.46 percent for 1992 computed fro Addis manufacturing
company can also be interpreted as one birr of investment in the company's assets was
made up of the combination of about 67 cents of the creditors' funds and the remaining
33 cents of the shareholders' funds. During 1993, a birr of investment in the company's
assets was made with about 55 cents of creditors' funds and shareholders contributed the
remaining 45 cents.

ii. Long-Term Debt- Equity Ratio

This ratio measures the extent to which creditors (debt-holders) provided long-term
financing relative to shareholders' financing.
♣ The ratio is computed by dividing long-term debts by stockholders' equity.
The long-term debt to equity ratios for Addis manufacturing company are computed as
follows:-

28
 Lont term debt
Long-Term Debt-Equity Ratio = Shareholders equity
30,000
Long-Term Debt-Equity Ratio (for 1992) = 23,000  1.30 or 130%
27,000
Long-Term Debt-Equity Ratio (for 1993) = 37,000  0.73, or 73%

The long-term debt-equity ratio of the company decreased from 130% in 1992 to 73% in
1993. This decrease may be caused by several factors some of which are:
 Some long-term debts might be matured and paid out, which reduce the balance
of long-term debts,
 Addis manufacturing company might increase the level of its shareholders'
equity either by issuing additional shares at premium, and
 Some amount might be added to the company's retained earnings due to
retention of the portion of full amount of net income.
Your interpretation for the long-term debt-equity ratio of 130 percent achieved during
1992 can be that for a single birr of shareholders' equity in the long-term financing there
is birr 1.30 of long-term debt in the long-term financing.
 In other words, the long-term financing of birr 2.30 was made in a way that
birr 1 from shareholders' equity and birr 1.30 from long-term debt.
 In the same way, a single birr in the long-term equity financing is combined
with 73 cents of long-term debt financing to form a total long-term financing
of birr 1.73 during 1993.
 In other words, for each birr obtained from shareholders' equity, the long-
term debt holders contributed 73 cents in the long-term financing during the
year.
Again, it is very difficult to conclude that the long-term debt-equity ratios computed for
Addis Manufacturing Company show good or bad capital structure of the company as
long as you do not have standard long-term debt-equity ratio to be used as a point of
reference.
iii. Debt-Equity Ratio
This ratio expresses the relationship between the amount of the total assets of the
company financed by creditors (debt) and owners (equity).
 Thus, this ratio reflects the relative claims of creditors and shareholders
against the total assets of the company.
 The debt-equity ratio is computed by dividing the total debts by the total
shareholders' equity.
This ratio provides answer to the question: What are the proportions of debts and equity
in financing the total assets of the company?
The debt-to-equity ratios for Addis manufacturing company are the following:

29
 Total debts
Debt - Equity Ratio = Shareholders ' equity
47,900
Debt- Equity Ratio (for 1992) = 23,100  2.07
45,000
Debt- Equity Ratio (for 1993) = 37,000  1.22

The debt-equity ratio of 2.07 for Addis manufacturing company for 1992 indicates that
the creditors of the company have provided about birr 2.07 in financing the assets of the
company for every single birr contributed from shareholders’ equity. In the same token,
the debt-equity ratio of 1.22 for 1993 shows that the creditors have provided birr 1.22 in
financing the assets of the firm for each birr contributed by shareholders’ equity.
 Whether these types of capital structure (debt and equity mix) are good or bad
depends on the standard set for the debt-to-equity ratio.
 Unless you are told this standard, still you cannot say the debt and equity mix of
Addis manufacturing company is good or bad.
B. Coverage Ratios
These ratios are the second category, i.e. Income Statement-Based, leverage ratios.
 They are used to measure the company’s ability to cover its financing costs
(interest expenses) associated with the use of debt financing.
 These ratios provide the basis for answering the question of whether the company
has used too much financial leverage. The coverage ratios, most of the time for
most companies, include the following.
i. Times Interest Earned Ratio (Interest Coverage Ratio)
This ratio measures the extent to which operating income can decline before the company
is unable to meet its annual interest costs.
♣ Failure to meet this obligation can bring legal action by the company’s creditors,
possibly resulting in bankruptcy.
♣ This ratio is determined by dividing earnings before interest and taxes (EBIT) by
the interest charges during the year.
♣ Note that earnings before interest and taxes (EBIT), rather than net income, is
used as a numerator in the formula because interest is paid with the pre-tax
income and the company’s ability of paying interest charges is not affected by
taxes.
The times interest earned ratios (interest coverage ratios) for Addis manufacturing
company during 1992 and 1993 are:
Earnings before int erest and taxes
Interest Coverage Ratio = Interest exp enses
12,200
Interest Coverage Ratio (for 1992) = 4,660  2.62 times
14,250
Interest Coverage Ratio (for 1993) = 4,150  3.43 times

30
The times interest earned (interest coverage) ratios computed for Addis manufacturing
company reveals that the company’s earnings before interest and taxes are 2.62 times and
3.43 times higher than the respective interest expenses of the company during 1992 and
1993 respectively.
♣ As long as you do not have the industry average, you cannot categorize these
ratios as high or as low.
But, generally speaking,
♣ Lower times interest earned ratio suggests that creditors are at risk in receiving
the interest payments that are due; the creditors may take legal action that may
result in bankrupting the company; and the company may face difficulty in raising
additional financing through debt issues as the company is under risk of paying
interest charges.
♣ A larger interest coverage ratio, on the other hand, suggests that the company has
sufficient margin of safety to cover its interest expenses; and the earnings before
interest and taxes (EBIT) of the company could decline without jeopardizing the
company’s ability to make interest payments.
ii. Fixed Charge Coverage Ratio
This ratio is similar to that of the times-interest-earned ratio, but it is more inclusive as it
recognizes other fixed obligations such as lease payments, principal payments of debts,
and dividend payments on preferred stocks.
♣ Unlike interest expenses and lease payments, the principal payments of debts and
dividend payments on preferred stocks are not tax deductibles, i.e. they are paid
from after tax earnings.
♣ Thus, a tax adjustment should be made for these payments.
For example, the company that is required to effect principal payments amounting to birr
100 from its earnings after taxes (assuming a tax rate of 40 percent) needs its earnings
before taxes to be ( 100 1  0.4), or birr 166.67.
The fixed charges obviously include interest expenses, annual long-term lease
obligations, principal payments of long-term debts, and dividend payments for preferred
stockholders.
The formula for fixed charge coverage ratio is, therefore, defined as follows:
EBIT  Lease payments
 Pr inciple preferred 
Fixed Charge Coverage Ratio = 
Interest  Lease Payment  
payment  dividend


 1  tax rate 

 

 

As you can observe from the above equation, interest expenses and lease payments are
not adjusted for taxes because they are paid from earning before tax, while principal and
preferred dividend payments are adjusted for taxes because they are paid from the after
tax earnings (net income)
Considering the given income tax rate of 34 percent and the principal payments of 2500
birr and 3000 birr during 1992 and 1993 respectively, the fixed charge coverage ratios for

31
Addis Manufacturing Company can be computed by using the above mathematical
equation as follows:
12,200  1,600
Fixed Charge Coverage Ratio (for 1992) = 4,660 1,600   2500  0 
 
 1  0.34 
13,800
= 4,660  1,600  3,789
13,800
= 10,049 1.37 times

14,250 1,650
Fixed Charge Coverage Ratio (for 1993) = 4,150  1,650   3000  0 
 
 1  0.34 
=
15,900 15,900
 1.45times
4150  1650  4,545 10,345

Addis manufacturing company is able to cover its fixed charges, (interests, lease
payments, and principal payments), 1.37 times and 1.54 times using its earnings before
interest and taxes during 1992 and 1993 respectively.
♣ In other words, the earnings before interest and taxes of the company are equal to
1.37 times the fixed charges during 1992 and 1.54 times the fixed charges during
1993.

4. Profit Ability Ratios

Profitability is the net result of a number of policies and decisions.
♣ The profitability ratios provide the overall evaluation of performance of the
company and its management.
♣ These ratios show the combined effects of liquidity, activity, and leverage ratios
on the operating result of the company.
The several ratios falling under this category are discussed in the following paragraphs.
i. Gross Profit Margin
The gross profit margin ratio is calculated as follows:

Gross Profit Margin = Gross profit

Net sales
Gross profit margin of Addis co. (for 1992) = 27,000 = 0.2455, or
24.55%
110,000

Gross profit margin of Addis co. (for 1993) = 30,000 = 0.25, or 25%
120,000

32
Thus, Addis manufacturing company’s gross profit constitutes 24.55% and 25% of the
company’s net sales during 1992 and 1993 respectively.
♣ These ratios reflect the company’s mark-ups on costs of goods sold as well as the
ability of the company’s management to minimize the costs of goods sold in
relation to net sales.
♣ Larger gross margin ratio implies lower costs of goods sold rate and vice versa.
ii. Operating Profit Margin
Moving down in the income statements, the next profit figure following gross profit is the
operating income (or EBIT).
♣ This operating profit figure serves as the basis for computing the operating profit
margin.
♣ The operating profit, as you know, is the excess of gross profit over the total
operating expenses.
For Addis manufacturing company, the operating profit margins are found as follows:

Operating profit margin = Operating Income

Net sales
Operating profit margin (for 1992) = 12,200 = 0.1109, or 11.09%
110,000
Operating profit margin (for 1993) = 14,250 = 0.1188, or 11.88%
120,000
The operating profit margins reflect the company’s operating expenses as well as its costs
of goods sold. Addis manufacturing company remained with 11.09 percent and 11.88
percent of its net sales after covering its cost of goods sold and all operating expenses
during 1992 and 1993 respectively.

iii. Net Profit Margin Ratio

The net profit margin on net sales measures the profitability of the company on a per birr
basis of net sales.
♣ This ratio is calculated by dividing net income by net sale of the company for a
given accounting period.
The net profit margin ratios for Addis manufacturing company are:

Net profit margin = Earnings after taxes

Net sales
Net profit margin (for 1992) = 4,976 = 0.0452, or 4.52%
110,000
Net profit margin (for 1993) = 6.666 = 0.0556
120,000
These net profit margin ratios can be interpreted in such a way that Addis manufacturing
company had earned 4.52 percent, or nearly 5 cents, net income per birr of net sales it

33
made during 1992 and 5.56 percent, or nearly 6 cents, per birr of sales it made during
1993.
♣ The net profit margin of the company is influenced by the amount of interest
expenses/charges and income tax expenses because net profit is an earning after
interest and taxes (EBIT).
iv. Return on Investment (ROI)
It is also known as return on Assets (ROA).
♣ This ratio measures the company’s profitability per birr of investment in the
total assets.
♣ The ROI, or ROA is calculated by dividing earnings after taxes by total assets.
The ROI for Addis manufacturing company for the two years are:

Return on Investment (ROI) = Earnings After Taxes (Net

Income )
Total assets
ROI (for 1992) = 4,976 = 0.0701, or 7.01%
71,000
ROI (for 1993) = 6,666 = 0.0813, or 8.13%
82,000
Thus, Addis manufacturing company generated 7.01 percent, or about 7 cents, in the
form of net income out of each birr it invested in its total assets during 1992, and 8.13
percent, or about 8 cents, in the form of net income out of each birr of investment in its
total assets during 1993.
♣ Whether the indicated returns on investments are good or bad depends on the
industry standards, or the management plans.
♣ What you can say at this point is that the company’s return on investment has
shown slight improvement in 1993 compared to that of 1992.
You can also use a native formula to compute the return on investments (ROI). That is:
Return on investment (ROI) = Net Profit Margin x Total Asset Turnover
= Net Income x Net Sales
Net Sales Total Investment

The ROI for Addis Manufacturing Company during 1993, for instance, is:

ROI for 1993 = 6,666 = 0.1802 or 18.02%

37,000
As it can be deduced form the computed ROE, Addis manufacturing company has
generated 21.54 percent, or about 22 cents, and 18.02 percent, or about 18 cents, for
every birr of shareholders’ equity during 1992 and 1993 respectively.
♣ Since earnings after taxes are the net earnings after covering both interest charges
and tax liabilities, they are available only for the shareholders of the equity capital
of the firm, or company.
5. Market/Book Ratios

34
These are ratios recently introduced into the ratio analysis.
♣ They are primarily used for investment decisions and long-range planning
Included in these ratios are the following:
i. Earning Per Share (EPS)
Earning per share (EPS) expresses the profit earned per common stock outstanding
during the reporting period.
♣ It provides a measure of overall performance and is an indicator of the possible
amount of dividends that may be expected.
The earning per share for Addis manufacturing company are computed as follows:
Earning per share (EPS) = Earnings after tax (net income) – Preferred
dividend
Number of common shares outstanding
Or (EPS) = Earnings available for common stock holders
Number of common shares outstanding
EPS (for 1992) = 4,976-0 = 4,976 = 4.98 Birr/share
1000 shares 1000 shares
EPS (for 1993) = 6,666 - 0 = 6,666 = 5.13 birr/share
1,300 1,300
Addis Manufacturing Company has earned Birr 4.98 per share during 1992 and Birr 5.13
per share during 1993. The earning per share has shown an increase during 1993, which
shows improved performance of the company during the year.
♣ Though the earnings per share were Birr 4.98 and Birr 5.13 per share during
1992 and 1993 respectively, these ratios do not tell you how much of these
earnings per share are paid as dividend and how much is retained in the
business.
♣ Moreover, since you do not have the industry average or the management plan,
you cannot conclude that these earnings per share are indicators of good or bad
performance.
ii. Price -to-Earnings Ratio (P/E)
The price-earning ratio expresses the multiple that the market prices on the company’s
earnings per share and is commonly used to assess the owner’s appraisal of share value.
♣ The price-to-earnings ratio is computed by dividing the market price of a share by
the earning per share computed above.
Assuming the common share of Addis manufacturing company has market prices of Birr
30 and Birr 35 at the end of 1992 and 1993 respectively, compute the P/E ratio of the
company.

P/E ratio = Current market price per share

EPS
P/E ratio (for 1992) = 30 = 6.02 times
4.98

35
 P/E ratio (for 1992) = 35 = 6.82 times
5.13
You can interpret these ratios like this:
♣ The market is willing to pay about birr 6 in 1992 and about birr 7 in 1993 for
every birr in the company’s earnings. Again, the P/E ratio has shown a slight
improvement during 1993.
Since the industry standard or management plan is lacking, it is very difficult for you to
categorize Addis manufacturing company as highly valued or low valued company.
♣ However, you can say, in general, that a high P/E ratio reflects the market’s
perception of the company’s growth prospects.
♣ Thus, if the investors in the stock markets believe that a company’s future
earnings potential is good, they are willing to pay higher prices for the stock and
further boast the P/E ratio.
♣ The problem with P/E ratio is that the market price for a share of common stock
may not be available when there is no’ stock market.
iii. Book Value Per Share
It is the value of each share of common stock based on the company’s accounting
records.
♣ It is computed by dividing the excess of total stockholders' equity over preferred
stock to the number of common shares outstanding.
The book values per share ratios for Addis manufacturing company are computed as
follows:
Book value per share = Total stockholders' equity – preferred
stock
Number of common shares
outstanding

Book value per share (for 1992) = 23, 100 – 0

1,000 shares
= 23,100 = 23.10
1000 shares
Book value per share (for 1993) = 37,000 – 0
1,300 shares
= 37,000 = 28.46
1,300 shares
The book value of a share of common stock of Addis manufacturing company is Birr
23.10 in 1992 and Birr 28.46 during 1993.
♣ This shows that the book value of a share is less than the market value of a share
during the two years, assuming the market prices used earlier in the example.
♣ Hence, the value of a share in the market during the two years is better than the
book value.

36
Since we don’t have industry average or management goal, we cannot say the book
values per share ratios are above or below the industry average, or management plan,
however.
iv. Dividends Per Share (DPS)
It shows the birr amount of dividends paid on a share of common stock outstanding
during the reporting period.
♣ It is determined by dividing the total cash dividends on common shares by the
number of common shares outstanding.
Assuming Addis manufacturing company distributed a cash dividend to common
shareholders of Birr 1,900,000 during 1992 and Birr 2,600,000 during 1993, the dividend
per share for the two years are:

Dividend per share = Total dividends on common share

Number of common shares outstanding

Dividend per share (for 1992) = 1,900 = Birr 1.9/ share

1000 Shares

Dividend per share (for 1993) = 2600 = Birr 2/ share

1,300 shares

Addis manufacturing company paid Birr 1.9 dividend per common share during 1992 and
Birr 2 per common share during 1993.
v. Dividend Payout Ratio
It shows the percentage of earnings paid to shareholders.
♣ It expresses the cash dividend paid per share as a percentage of EPS.
♣ Dividend payout ratio is computed by dividing cash dividend per share by
earnings per share.
The dividend payout ratios of Addis manufacturing company are computed as follows:

Dividend payout ratio = Cash dividend per share , or

Earning per share
= Total dividend to common stock
Total earnings available for common stock hold

Dividend payout ratio (for 1992) = 1.90 = 38.15%

4.98

Dividend payout ratio (for 1993) = 2.0 = 39%

5.13
Or else
Dividend payout ratio (for 1992) = 1900 = 38.18%

37
 4,976
Dividend payout ratio (for 1993) = 2,600 = 39%
6,666

The dividend payout ratios indicate that Addis manufacturing company paid about 38
percent of its earnings in the form of dividends for its common shareholders during 1992
and paid 39 percent of its earnings in the form of dividends during 1993.
vi. Dividend Yield
It shows the rate earned by shareholders from dividends relative to the current market
price of shares.
♣ Dividend yield is computed by dividing cash dividend per share by current market
price per share.
The dividend yields for Addis manufacturing company for 1992 and 1993 are:

Dividend yield = Cash dividend per share

Market price per share

Dividend yield (for 1992) = 1.9 = 6.33 %

30
Dividend yield (for 1993) = 2 = 5.71%
35
Addis manufacturing company paid 6.33 percent and 5.71 percent in the form of
dividends to common shareholders per birr of the current market prices of its shares
during 1992 and 1993 respectively.
♣ Unless we do have industry average, it is difficult to say these ratios indicate good
or bad situation. However, what we can say, in general, is that the higher dividend
rate (yield) may reflect fewer investment opportunities on the part of Addis
manufacturing company.
2.3. APPROACHES TO USING RATIOS IN THE FINANCIAL STATEMENTS
ANALYSIS
These are two basic approaches in analyzing a set of financial statements using financial
ratios. These are the cross sectional analysis and the time series analysis. These two
approaches complement each other and both should be used as part of the analysis of
financial statements.
2.3.1 Cross-Sectional Analysis
This approach enables you to evaluate company’s financial conditions at a given point in
time and compare company’s current performance against that of the previous year.
♣ Under cross-sectional analysis, you compare the ratios of your company against
those of its competitors.

38
 ♣ The first step in cross-sectional analysis of Addis manufacturing company is to
evaluate its financial position at the end of 1993. In order to do so, the company’s
financial statements are needed.
♣The second step is to compare the current performance of the company against
that of the previous year by comparing the financial ratios computed for 1992 and
1993, which are summarized in the following table.
Summary of Financial Ratios of Addis manufacturing company:

Ratio 1992
1993
Liquidity:
Current ratio ------------------------------------ 1.96 2.22
Quick ratio ------------------------------------ 0.91 1.08
Activity:
Inventory turnover --------------------------- 4.44 4.39
Total assets turnover -------------------------- 1.55 1.46
Average collection period -------------------- 39 days 48
days
Leverage:
Total debt to assets --------------------------- 67.46%
54.88%
Long term debt to equity --------------------- 130% 73%
Total debt-to-equity --------------------------- 2.07 1.22
Time interest earned --------------------------- 2.62 times 2.26
times
Fixed charges coverage ----------------------- 1.37 times 1.54
times
Profitability:
Gross profit margin ---------------------------- 24.55% 25%
Operating profit margin ----------------------- 11.09%
11.88%
Net profit margin ------------------------------ 4.52 % 5.56%
Return on investment (ROI) ------------------ 7.01 % 8.13%
Return on shareholders’ equity (ROE) ------- 21.54%
18.02%
 Comparing the liquidity ratios of 1992 and 1993 of Addis manufacturing
company, both the current ratio and quick ratio show improvement during 1993.
 The activity ratios of Addis manufacturing company imply that the company was
less efficient in utilizing its assets in 1993 compared to what it had done during
1993.
 The leverage (debt management) ratios of Addis manufacturing company show
that the capital structure has been improved during 1993 compared to that of 1992,
where the capital structure had been a debt-dominated one.

39
  The profitability ratios also suggest that the company’s performance was more
profitable during 1993 than it had been in 1992.
 The final step in the cross-sectional analysis is comparing the financial ratios
computed for Addis manufacturing company against the average financial ratios
computed for all competing companies in the industry.
The result of this comparison tells you the position of Addis manufacturing company
regarding its liquidity, activity, leverage and profitability.
 Unfortunately, we do not have industry averages in our country to use for
comparison purposes.
2.3.2. Time series Analysis
This approach is used to evaluate the performance of the company over several years. It
looks for three factors:
 Important trends in the data of the company
 Shifts in trends, and
 Values that deviate substantially form the other data
2.4. ADVANTAGES AND LIMITATIONS OF RATIO ANALYSIS
2.4.1. Advantages of Financial Ratio Analysis:
The following are the major advantages of financial ratio analysis:
1. Ratios are easy to compute
2. Ratios provide standards of comparison at a point in time and comparisons to be
made with industry average, if available.
3. Ratios can be used to analyze company’s time series in order to discover trends,
shifts in trends, and values that deviate form other similar values.
4. Ratios are useful in identifying problem areas of a company.
5. When combined with other tools, financial ratios analysis makes important
contributions to the task of evaluating the company’s financial performance.

2.4.2. Limitations of Ratio Analysis

The following are the major limitations of financial ratio analysis:
1. Taken by themselves, financial ratios provide information very little in its use.
2. Ratios seldom provide answers to questions they raise because generally they do
not identify the causes for the difficulties that the company faced.
3. Ratios can easily be misinterpreted for instance; a decrease in the value of a given
ratio does not necessarily mean that something undesirable has happened.
4. Very few standards exist that can be used to judge the adequacy of a ratio or set of
ratios.

40
 5. Industry average cannot be relied upon exclusively to evaluate a company’s
performance because most of the companies in an industry may perform far below
the acceptable level of performance, which lowers the industry average.
6. In some cases, the industry average ratios may not be available at all, which is the
problem we encounter in the case of Ethiopian industries.
7. Many large companies operate a number of different industries and in such cases,
it is difficult to develop a meaningful set of ratios to compare against industry
average. This makes ratio analysis more useful for smaller and narrowly focused
companies than for large and multi divisional ones.
8. Inflation severely distorts balance sheets of companies (recorded values are
usually different from ’true’, or ‘market’ value). Again, since inflation affects
both depreciation charges and inventory costs, profits are also affected. Ratios do
not consider these distortions unless balance sheet and income statement figures
are adjusted for the effect of inflation.
9. Seasonal fluctuations can also distort the analysis of financial statements through
the use of ratios. These problems can be minimized by using monthly averages
for inventories and receivables when calculating turnover ratios.
10. Companies can employ ‘window dressing’ techniques to make the financial
statements look stronger. For instance, the company might borrow on a long-term
basis huge amount of cash to wards the end of the accounting period for few days
but back paid in the first week of the subsequent accounting period. This action
did improve the company’s current and quick ratios and made the balance sheet of
the company look good. However, as you clearly understand, the improvement
was strictly due to the “window dressing” technique the company had employed.
Under such situation, it is highly likely to misinterpret both the current and quick
ratio as they signal good liquidity position of the company, which in fact is not.
11. It is difficult to generalize whether a particular ratio is ‘good’ or ‘bad’. For
example, a high current ratio may indicate a strong liquidity position, which is
good, or the availability of excess cash, which is obviously bad as the excess cash
is a non-earning (idle) asset. Similarly, a high fixed asset turnover ratio may
denote either a company that uses its fixed assets efficiently, or one that is under
capitalized and cannot afford to buy enough fixed asset whose value is used as a
denominator when calculating the ratios.
CHAPTER SUMMARY
Analysis of the financial data contained in the company’s income statements and balance
sheets is aided by the use of ratios analysis. Ratio analysis is used to obtain measures of
company’s liquidly, activity, debt, and profitability.
The cross-sectional approach to ratio analysis, supplemented with industry averages, can
help in evaluating the financial position of a company at a given point in time. The time
series approach, together with the preparation of common size income statements, can
help in showing recent financial trends, shifts in trends, and values that deviate from
other data.

41
The use of financial ratios cannot do adequate job of financial statement analysis. The
use of financial ratios alone will not provide a complete understanding of the company’s
activities. Rather the use of financial ratios will raise question that, when pursued, will
provide the information needed to reach an informed judgment about the financial
condition of the company.

Chapter - 3
Time value of Money
Time value of Money:

The concept of interest is one of the core ideas in financial management. Individuals, as
well as, business organizations frequently encounter situations that involve cash receipts
and disbursements over several period of time. When this happens, interest rates and
interest payments become important considerations.

Business organization deals with interest rates when it makes both financing and
investment decisions. Short-term commercial and industrial loans may be obtained at
reasonably lower interest rates while long-term investments in assets like real estate,
machinery and equipment are evaluated on the basis of the profit that the investor
(company) expects out of them. Since, such investment require the commitment of funds
over several yeas, the expected profits need to be measured in terms of the rates of

42
returns which are equivalent to the interest returns that can be received on the invested
funds.

A company can, therefore, earn a rate of return on its invested funds and a rate of interest
on the funds it lent to borrowers. The key concept that under lies this is the time value of
money: that a birr today is worth more than a birr received a year from now. This is
because of the fact that the value of one birr after a year will grow to one birr and an
interest earned on it for it can be invested, or given as loans during the year.

Interest is the price paid for the use of money overtime. The rate of return/interest can be
stated explicitly as it is the case for commercial and mortgage loans provided by the
commercial Bank of Ethiopia (CBE) and Construction and Business Bank (CBB)
respectively. The interest rates are explicitly expressed/stated for both loans though the
rates are subjected to changes from time to time as the CBE has done is the recent past.
Some times, the interest rate is implicitly applicable. For instance, if the commercial
Bank of Ethiopia (CBE) offers free checking accounts to customers who are willing to
keep a minimum balance 100 Birr in their account, there is an implicit interest rate for the
checking account opened by a given customer since the 100 Birr is tied up as long as the
checking account is active.

General Assumptions Needed in Computing Interest

In order to focus on interest rate and to avoid complications that would tend to hide the
essential concepts, the following three general assumptions are needed to be made.
These are:

Certainty: - It is the most restrictive assumption. All current and future data values are
assumed to be known with certainty, or a set of techniques exists for estimating all
unknown variables. Certainty also applies to the accuracy of future events and their
occurrences. This assumption is used for simplicity since uncertainty requires the
introduction of techniques that cannot be easily understood.

Discrete Time Period: - Time is divided into yearly intervals. The time that elapses
between the last days of two consecutive years is expressed as one year. For example,
year 3 is the time that elapses from the last day of year 2 and to the last day of year 3.
This assumption doesn't require cash flows to occur on the last day of each year. What is
required is that cash flows have to occur only at points of time that are separated by one
year intervals. The assumption, thus, allows us to abstract from specific calendar dates
and to measure time from the point at which a particular investment or financing program
begins.

Yearly Interest Computations: - interest is computed once a year and the computation
is made at the end of the year. This assumption is thus, consistent with the discrete time
period assumption made above. In reality, many situations involve monthly, daily, and
even continuous interest computation where by many commercial banks and savings and
credit associations offer daily or continuous interest compounding on depositors' money.

43
Compounding Method
There are two ways of depositing payments (money) into an interest bearing account.
These are single payment and series of payments.

Future (compound) value of single payment

A birr you deposited in an interest - bearing account today worth's you more in the future
because the account earns you an interest on the money you have deposited. The process
of going from today's values, or present values (PV) to future values (FV) is called
compounding. To illustrate this, suppose you deposited 100 Birr at the Commercial Bank
of Ethiopia (CBE) that pays 5 percent interest each yea. How much would you have at
the end of one year? To begin, it is very wise to define the following terms:
PV = Present value, or the beginning amount, in your account.
Here
PV = 100 Birr.
i = interest rate that the bank pays per year. The interest earned is
based on the balance at the beginning of each year and it is assumed paid
at the end of the year. Here, i = 5%, or expressed as a decimal, i = 0.05.
INT = Birr of interest you earn during the year, which is equal to the
beginning amount multiplied by i. Here, INT = 100 x 0.05 = 5 Birr for the
first year.
FVn = Future value, or ending amount, in your account at the end of n
years. Where as the PV is the value now or the present value, FV is the
value of the money after n years into the future, after the earned interests
have been added to the account balance every year.
n = number of periods involved in the analysis, Here n = 1.
In our example here, where n = 1, the future (compound) value can be calculated as
follows:
FV = FV1 = PV + INT (interest)
= PV + PV (i)
= PV (1 + I)
0 5%= 100 1 (1+0.05)2= 100 (1.05)3 = 105 Birr.
4 5
Thus, the future value (Fv) at the end of year one, Fv 1, equals the present value (Pv)
Initial deposit
multiplied by =1.0 - plus
100 the interest
Fv1=? rate,Fvso2=?you Fv 3=?have 105
will Fv4=? Fv5one
Birr after =? year.
Interest
Extending our analysis, what would you end up with if you kept your 100 Birr Birr
Earned 5 Birr 5.25 Birr 5.51 Birr 5.79 Birr 6.08 in your
FV(end of the year) 105 Birr 110 Birr 110.25 Birr 115.76 Birr
bank account four five years? Here is the time line to show the amount at the end of 127. 63each
Birr
year during the five years period.

Note the following points

Note the following Points

1) You start by depositing 100 Birr in the bank account which is shown as an out
flow of 100 Birr (-100) at year zero (n = 0)

44
 2) You earn (100) (0.05) = 5 Birr of interest during the first year resulting in 105
Birr at the end of year one (n = 1).
3) You start the second year with 105 Birr, and earn 5.25 Birr on the larger balance,
and then end the second year with 110.25 Birr which is 105 Birr beginning
balance plus 5.25 Birr interest earned during year two (n = 2), 5.25 Birr is higher
than the interest you had earned during year one (n = 1) because you earned (5)
(0.05) = 0.25 Birr, or 25 cents interest on the interest earned during the first year.
4) This process continues, and because the beginning balance is higher in each
succeeding year, the annual interest earned increases as we move from year one
(n=1) to year five (n=5).
5) The total interest earned over the five years, 27.63 Birr, is reflected in the final
balance at year five (n=5), 127.63 Birr as indicate on the time line above.

Note that the value at the end of year two (n=2), 110.25 Birr, is computed as follows:
FV2 = FV1 (1+i)
= PV (1+i) (1+i), because FV1 = PV1 (1+i)
= PV (1+i)2 = 100 (1.05)2 = 110.25 Birr

Continuing the analysis, the balance at the end of year three (n = 3) is:
FV3 = FV2 (1+i)
= PV (1+i) 2 (1+i), because FV2 = PV (1+i) 2
= PV (1+i) 3
= 100 (1 + 0.05)3
= 115.76 Birr and
FV5 = PV (1+i) 5
= 100 (1 + 0.05)5 = 100 (1.05)5 = 127.63 Birr

In general, the future value of an initial sum at the end of n years can be found by
applying the following general equation.

Pv = PV (1+i) n
Interest Table
The future value interest factor for i and n (FV1F i,n,) is defined as (1+I)n, and this factor
can be found by using a regular calculator. Interest table is the table that is constructed
by using the future value interest factors. It contains future value interest factors
(FV1Fi,n,) values for the wide range of I and n values. Since the term (1+i) n is equal to the
FV1Fi,n, the future value equation for single payment can be re-written as:

FVn = PV (FV1Fi,n,)

To illustrate how to use future value interest factors (FV1F) in computing future
(compound) value of any single payment, consider our five-year, 5 percent interest rate
deposit of 100 Birr in the previous example. The future value of the 100 Birr at the end
of year 5 can be determined by looking for the FV1F5%,5 in the interest table. This is done
by looking down the first column to period 5, and looking across that row to the 5 percent

45
column, where we read the value of 1.2763 which corresponds to FV1F 5%,5. This value is,
then, plugged into the above equation. That is:

FVs = PV (FV1F5%,5)
FVs = 100 (1.2763)
FVs = 127.63 Birr.

Therefore, the future value at the end of years (n=5) computed by using the future value
interest factor from the interest table, 127.63 Birr, is exactly the same as the future value
we have found by using the general future value equation for single payment.

Portion of future value table for single payment (FV1F5%,5)

Period (n) 4% 5% 6%
1 1,0400 1.0500 1.0600
2 1.0816 1.1025 1.1236
3 1.1249 1.1576 1.1910
4 1.1699 1.2155 1.2625
5 1.2167 1.2763* 1.3382
6 1.2653 1.3401 1.4185

 It is the future value interest factor that corresponds to five periods (n=5) and
interest rate of 5 percent (i = 5%). You can refer to the complete future value
table of single payment in the appendix to this material.

Other Application of future value amount of single payment:

The future value equation for single payment stated in this material can also be used to
find interest rates, as well as, members of years that will be needed for the compounded
amount to equal the desired value.

Finding the Interest rate - Estimating the interest rate on the deposited money is a
recurring problem when it is not explicitly stated. A useful approach is to treat the interest
rate as an implicit interest rate and found by using the interest table (future value table of
single payment).

To illustrate, assume that you have invested 15,000 Birr today at a bank where it can
grow to the future value of 17,000 Birr within three years from now into the future. What
is the interest rate that the bank should pay for your account in order to fulfill your
desire?

To answer this question, treat the 15,000 Birr as present value which you have deposited
into an account that pays an unknown interest rate but grows to the compound (future)
amount of 17,900 Birr after three years. Substituting these values into the future value of
single payment equation, you get:
FV3 = PV (1+i)3
17900 = 15,000 (1+i)3

46
 17,900
(1+i)3 = FVIFi,3 = 15,000  1.193
The future value interest factor in the interest (future value of single payment table)
corresponding to the unknown interest rate (i) and a period of 3 years 9n = 3) is 1.193.
Hence, look up the three year (n=3) row and read horizontally until you find the table
value (future value interest factor) that is equal or the closest to the computed value of
1.193. There is no table value that is exactly equal to 1.193. The table value of 1.191 is
found to be the closest value to 1.193 and it corresponds to 6 percent. Thus, the interest
that the bank actually has to pay to your account is slightly greater than 6 percent.

Finding the number of years:- The future (compound) value of single payment
equation can be used to estimate the number of years that are required for a given amount
of money deposited at a specific interest rate to produce or desired compound amount.
Assume, for example, a deposit of 1000 Birr is made in an interest bearing account that
pays 10 percent compounded yearly. Your goal as a depositor is to collect 1,500 Birr
after an unknown number of years. How many years should you wait for the desired
amount to be realized?

By substituting the values into the future value of single payment equation, you get:

FVn = 1000 (1+I) n

1,500 =1000 (1+0.1) n =1000 (1.1) n
(1.1) n = 1500 = 1.5, by using logarithm
1000
n = log1.1 1.5 = log 1.5 = 0.176 = 4.29 years
Log 1.1 0.041

Again it is possible to look up the 10 percent column in the future value interest factors
(future value) table and read vertically until you find a table value that is equal to 1.5 or
closest to it. The closest table value is 1.611, which corresponds to five years (n =5).
That means if the 1000 Birr is kept in the account that pays 10 percent for five years; the
resulting compounding amount will be 1,611 Birr. This amount exceeds the desired
amount of 1,500 Birr. If the 1000 Birr is kept in the account only for four years, the table
value is 1.464 Birr. Hence, the 1000 Birr has to be kept in the account for a period
slightly greater than 4 years.
Present (Discount) value;
Suppose that you have some extra cash, you have a chance to buy a low risk security
which will pay 127.63 Birr at the end of 5 years. Assume that Awash International Bank
(AIB) is currently offering 5 percent, on 5-year time deposit. How much should you
deposit today in the time deposit account in order to get the indicated amount of 127.63
Birr at the end of year 5 9n=5).

From the future value example presented in the previous section, we saw that an initial
amount of 100 Birr invested at 5 percent per year would worth 127.63 Birr at the end of
year 5. You are definitely indifferent to the choice between 100 Birr today and 127.63
Birr at the end of the five years, and 100 Birr is defined as the present value, or PV of the

47
127.63 Birr that is due in 5 years time when the interest rate or opportunity cost rate is 5
percent.

In general, the present value of a cash flow due n years into the future is the amount
which, if it were on hand today, will grow to equal the future value. Since 100 Birr today
would grow to 127.63 Birr in 5 years at 5 percent interest rate, 100 Birr is the present
value of 127.63 Birr due 5 years in the future.

Finding the present value of the future cash receipts, or payment is called discounting,
and it simply the reverse of the compounding process. If you know present value, PV,
you compound it to find the future value, FV. In the same way, if you know the future
value, Fv, you discount it to find the present value, PV. When discounting future value,
you follow these steps.
Time Line. Show the cash flow on the time line

0 5% 1 2 3 4 5

Pv =?
Fv5 = 127.63 Birr
Equation:
To develop the discounting equation, we begin with the compounding equation used in
the previous section.
FVn= PV(1+I)n = Pv (FV1Fi,n)
and by solving for PV in several equivalent form, we arrive at:
FVn  1 
PV =  FVn  
n  substituting PV1Fi,n for
(1  i ) n
 (1  i ) 
1
the term , are get Pv = FVn (PV1 Fi,n)
(1  i) n
Hence, you can insert the figures into the present value equation in order to determine the
present value of 100 Birr as indicated here:
 1   1 
 FVs     (127.63)    (127.63) (0.78353)
 1  i   1.05
n 5
PV =  
 100 Birr
Tabular Solution:-
1
The term
1  i  n is called the present value interest factor for i and n (PV1F i,). The
present value table can be developed from the present value interest factors which are the
1
values of for different values for i and . The present value interest factor for i=
(1  i) n
5% and n=5 is found by looking down the first column to period 5, and then moving
across the row to 5%, where the present value interest factor is read us 0.7835, so the
present value of the 127.63 Birr to be received after 5 years when the rate of interest is 5
percent is 100 Birr. That is PV = (FVs) (PV1F5%, 5) = (127.63) (0.7835) = 100 Birr.

48
A Portion of present value table for single payment
Period (n) 4% 5% 6%
1
2
3
4
5 0.7835*
6
 0.7835 is the present value interest factor corresponding to 5 percent, and 5
periods.

Other Application of Present Value of the Single Payment

With the help of present value equation and table you can solve for any one variable in
the equation when the other three variables are known:

Finding the Interest Rate: Although the term of contract may clearly state that all the
relevant cash flows, the problem of determining the interest rate or the rate of return to
the lender, or investor may still remain unsolved. When single payments are involved,
the implied interest rate approach used for compounding problem can be adopted for use
in determining the interest rate in the present value table. To illustrate this, suppose that
you have taken a loan of 1200 Birr to day which is to be paid after three years together
with its interest by making a payment of 1500 Birr. What is the rate of interest on the
loan that you have taken?

To answer this question, first of all you need to identify variables which are know. In
this illustration, the present value, PV is equal to 1,200 Birr; the future value, FV is 1500
Birr, the period of the loan, n is equal to 3 years. Then you substitute the given variables
into the equation and solve for the table value:
 1 
Pv =  FVn   
n 
 1  i  
 1   1  1200
1500    
3 

3 
 1  i    1  i   1500
1200 =
 1 
    PV 1Fi ,3  0.08
3 
 1  i  

Looking at the year three (n=3) row in the present value table; try to locate the present
value interest factor (table value) that is equal to or closest to 0.80. The resulting table
values are 0.816 corresponding 7 percent and 0.794 corresponding to 8 percent. Thus,
the interest rate is between 7 percent and 8 percent.

Finding the Number of Years:- The present value table and the present value equation
for single payment can be used to determine the number of years required for the present
value to equal its future value at a given rate of yearly compounding. For instance, how
many years do you need to wait for your deposit of 1000 Birr to grow to 1,200 Birr in a
saving account that pays interest compounding yearly at 6 percent?

49
To answer this question, let the 1000Birr be the present value of the future value of 1200
Birr at an interest rate of 6 percent per year. By substituting into the present value
equation for single payment and solving for the desired table value, you get.
PV = FVn (PV1Fi,n)
1000 = 1200 (PV1F6%,n)
1000
PV1F6%,nn =  0.833
1200
Then look at the 6 percent column in the present value table of single payment and read
down the present value interest factors till you arrive at the value that is equal of falls
below the computed table value, 0.8333. The table value that meets the stated
requirement is 0.792, and it corresponds to 4 years, (n=4). Therefore, the 1000 Birr will
have to be kept in the saving account for 4 years (and compounded four times) before it
grows to the desired value of 1200 Birr.
Annuities
An annuity is an equal amount of Birr payment for specified number of years. Since
annuities occur frequently in finance, such as bond interest payments, you have to be able
treat them accordingly. although compounding and discounting of annuities can be dealt
with for single payment, these processes are time consuming, specially for longer
annuities. The annuity payments can occur at either the beginning or the end of period.
If the payments are made at the beginning of each period, the annuity is known as annuity
due. If the payments, on the other hand, occur at the end of each period, as they typically
do, the annuity is called an ordinary, or deferred annuity.
Since ordinary annuities are more common in finance, when the term annuity is used in
this material you should assume that the payments occur at the end of each period unless
stated, other wise.

Future Value of an Annuity

An ordinary or deferred annuity consists of a series of equal payment made at the end of
each period. If you deposit 100 Birr at the end of each year for three years in a saving
account that pays 5 percent per year, how much will you have at the end of year three
(n=3)? To answer this question, you must find future value of an annuity, FVA n. Each
payment has to be compounded out to the end of period n, and the sum of the
compounded payments gives you the future value of an annuity, FVA n. This can be
shown by using the following time line.

0 1 2 3
100 Birr 100 Birr 100 Birr
105.00 Birr = (100) (1.05)1

110.25 Birr = (100) 1.05)2

FVA3 = 315.25 Birr

The time line shows each cash flow compounding and the sum of the compounded cash
flows which gives the future value of an annuity at the end of year three (n3), FCA 3 of
315.25 Birr. Representing the single payment in a series of equal payments of an annuity

50
with PMT (Payment), the future value of an annuity at the end of year three (n=3), FVA 3
of 315.25 Birr. Representing the single payment in a series of equal payments of an
annuity with PMT (payment), the future value of an annuity for n years can be designated
with the following equation:

FVAn = PMT(1+i)0 + PMT(1+i)1 + PMT(1+i)2+----+ PMT (1+i)n

In this equation the first term (i.e. PMT (1+i)0) is the compounded value of the payment
at the end of last year, or year n of the annuity payments while the last term in the
equation (i.e. PMT (1+i)n-1) is the compounded amount of the payment made at the end of
year one (n=1).

The above equation can further be simplified to:

n n 1 
FVAn= (PMT) (   (1  i )  where PMT is an annuity payment deposited, or
 t 1 
received at the end of each year.
The equation can be re-written as:

 (1  i ) n  1
 (1  i ) n  1 by substituting  
 i 
FVAn = (PMT)  
 i 
n n t 
for   (1  i) 
 t 1 
Using this future value of an annuity equation, the future value of the 100 Birr deposits
made at the end of each year for three years at an interest rate of 5 percent would be:
 (1  0.05) n 1
FVA3= (100)   =(100) (3.1525) = 315.25Birr
 0.05 

Tabular Solution:
The future value for an annuity is formed from the future value interest factor for an
 (1  i ) n  1
annuity (FVIFAi,n), which are the values of the term   in the above future
 i 
value of annuity equation. The future value for an annuity table contains a set of future
value interest factor for an annuity for various combination of I and n. To find an answer
to 3-years, 100 Birr annuity problem by using future value of annuity table, look down 5
percent column to the third period; the future value interest factor for annuity
(FVIFA5%,3) is 3.1525. Thus, the future value of the 100 Birr annuity is 315.25 Birr.
FVAn = (PMT) (FVIFAi,n)
FVA3 = (100) (FVIFA5%, 3) = (100) (3.1525) = 315.25 Birr
A portion of the future value of annuity table
Period (n) 4% 5% 6%
1

51
 2
3
4 3.1525*
5
6
* 3.1525 is the table value ( the future value annuity interest factor for an annuity)
corresponding
to 5 percent and 3 period. The complete future value of annuity table is included in
the appendix
to this material.

Other Applications Future value of Annuity

The future value of an annuity equation and table can be used to solve for the interest
rate variable, as well as the number of payment variable, in the manner that is quite
similar to that used handing compound amount, single payment problems.

Finding the Interest Rate: Some financial contracts and certain types of investments by
business firms can be described as yielding a future sum in terms of a specific number of
annuity –payment received. The interest rate is an important determinant in accepting or
rejecting such opportunities, but it is rarely stated explicitly. The implied rate can be
obtainained by treating the future sum as the compound of annuity payments and solving
for the interest future value of an annuity table.
To illustrate interest rate computation, three equal payments of 3,000 Birr are offered in
return for 9,800 Birr to be received upon making the last annuity payment. What is the
implied interest rate?

To answer this question, first identify the variables in the compounding annuity equation
that are known and plug these known values in to this equation. The compound amount
of annuity, FVA in the illustration above is 9,800 Birr and the annuity payment made at
the and of each year, PMT is 3000 Birr. The, substituting these figures into the equation,
and solving the required table value.
 (1  i ) n 1
FVAn = PMT  
 i 
 (1  i ) n 1
9,800 = 3,000  
 i 
 (1  i ) 1 
n
9,700
   3.266
 i  3,000
 (1  i n 1
As indicated earlier,   is the future value interest factor for an annuity,
 i 
FVIFAi,n for a given interest rate I and a given number of years, n. To determine the
interest rate, look up the three payment row (n=3) in the table for the table values that is
equal, or closest to 3.266. The table value corresponding to 9 percent is 3.246, and the
table value corresponding to 9 percent is 3.278. Since the computed value of 3.266 lies
between these two table values, the implied interest rate is greater than 8 percent and less
than 9 percent.

52
Finding the Number of Payment:- If the interest rate, the size of the desired future
value of an annuity, and the size of each annuity payment are given, you can compute
the number of payments required to attain the future sum of an annuity by using the
future value of an annuity equation and table.

For example, how many annual deposits of 1000 Birr each must be made into an account
that pays 6 percent interest compounded yearly in order to accumulate 5,500 Birr
immediately after the last deposit? Here, the 5,500 Birr is the future value of an annuity,
and 1000 Birr is the annual payment deposited at the end of every year fill the term ends.
If you substitute the futures into the future value of an annuity equation, the desired
annuity table value will be:
 (1  i ) n  1
FVAn = PMT  
 i 
(1  i ) n  1
5500 = 1000 (FVIFAi,n) because is equal to FVIFAi, n.
i
5500
FVIFA6%, n =  5.5
1000
In order to compute the number of annual deposits to be made, look at the 6percent
column in the future value of an annuity table and read down until a table value equals,
or exceeds the computed value of 5.5. The compute value falls between 4.375 and 5.637
which correspond to 4 and 5 periods respectively. The correct answer is 5.637 or five
periods (n=5) not 4.375 which corresponds to the value of only 4 payments whose future
value fall behind 5,500 Birr.

A Portion of the \Future Value of an Annuity Table

Periods (n) 6% 7% 8% 9% 10%
1 1.000 1.000 1.000 1.000 1.000
2 2.060 2/070 2.080 2.090 2.100
3 3.184 3.215 3.246 3.278 3.310
4 4.375* 4.440 4.506 4.573 4.641
5 5.637+ 5.751 5.866 5.985 6.105
 4.375 is the future value interest factors for four payments of an annuity at 6
percent interest rate.
+ 5.637 is the future value interest factor of five payments of an annuity at 6 percent
interest rate.

Present (Discounted) value of an Annuity:

Suppose that you are offered two alternatives: (1) a three-annuity with payment of 100
Birr at the end of each year over the coming three years, or (2) a :ump-sum payment
today. You have no need for the money during the next three years, so if you accept the
annuity, you would simply deposit the payments in the saving account at Dashen Bank
that pays 5 percent interest rate compounded yearly. Similarly the Lump-Sum payment
would be deposited in the same account as you don't have other option. How large
should the Lump-sum payment today in order for it be equivalent to the annuity?
To answer this question, let us start-up with the aid of the time line.

53
 0 1 2 3
100 100 100

95.24
90.70
86.38
PVS3=272.32

The present value of the series of payments of 100 Birr for three years annuity, PVA 3 is
272.32 Birr as shown with the help of the time line.

The same problem can be expressed by using mathematical equation. The general
mathematical equation that can be used to find the present value of an ordinary annuity is
shown below:
1 2 n
 1   1   1 
PVAn = (PMT)    PMT         PMT  
1 i  1 i  1 i 
Since PMT is common for all terms, the above equation can be re-written as:
 1 
1
 1 1  1  2  1  
n

PVAn = (PMT)           

1 i   1  i  1 i   1  i  
Again the equation can be rewritten as:
 n  1 t 
PVAn = (PMT)   
 t 1  1  t  
The summation term in this equation is called the present value interest factor for an
1
1_ 1  (1  i )  n
annuity (PVIFA) and it equivalent to: (1  i) n , or
i
i

Hence, the above equation can be stated as:

PVAn = (PMT) (PVIFAi,n) , or
 1 
1  (1  i )  n  1  ( i ) n 
PVAn = (PMT)   , or PMT  
 i   i 

 


By using this mathematical equation, the present value of an annuity of the problem
under consideration can be computed as follows. You are given an annuity payment,
PMT of 100 Birr, interest rate, I of percent compounded yearly and an annuity period, n
of three years. Substituting these values into the above equation, you get the present
value of an annuity of 272.32 Birr, which was the same as the amount computed by
summing the individual discounted valued on the time.

54
  1 
1  (1  0.05)  3  1  (1  0.05) n 
PVA3 = (100)  , or (100)  
 0.05   0.05 

 

= (100) (2.7232)
= 272.32 Birr

Tabular Solution
1
n
1
The term = 1  (1  i ) (1  i ) n in the general equation of present value of an
or
i i
annuity which is the present value interest factor for an annuity (PVIFA) is used to
construct the present value of an annuity table. The present value table of an annuity is
the tabulation of the present value interest factors for an annuity of different
combinations of I and n arranged I an order beginning with -=1% and n=1 period.
Hence, the present value of an annuity equation as stated already, can be re-written in a
way it is suitable for using table values.
PVAn = (PMT) (PVIFAi,n) where PV|IFAi,n is the present value interest factor for an
annuity for a given interest rate (i) and for a given number of years (n).
To find an answer to the three-year, 100 Birr annuity problem under consideration,
simply refer to a present value of an annuity table, which is partly shown below, and look
the 5 percent column down to the third period. The PVIFA 5%,3 is 2.7232, yielding the
present value of 272.32 Birr for the three annuity payments of 100 Birr at the end of each
year.
PVA3 = (100) (PVIFA5%,3) = (100) (2.72.32) = 272.32 Birr
A portion of present value of an Annuity Table
Period (n) 5% 6% 7% 8%
1 0.943 0.935 0.926
2 1.833 1.808 1.783
3 2.7232* 2.673 2.624 2.577
4 3.465 3.387 3.312
5 4.212 4.100 3.993
* The present value interest factor for an annuity when interest rate is 5 percent
for three
Payments is 2.7232.

Other Applications of Present Value Annuity

As it was presented in this material for future value of annuity and other values (both
present and future) of single payment equations the present value annuity can be used to
solve for any one of its four variables (i.e. present value of an annuity, PVA; the size of
an annuity payment at the end of each period, PMT; the number of years, or periods for
which the annuity will last, n; and the annual interest (discount rate, I) given the values
for any three variables.

Finding the Annual Interest (Discount) Rate, i

55
If you are given the number of annuity payments, n the amount of single payment, PMT,
and equivalent present value, PVA, you can determine the interest (discount) rate, I that
is applicable while compounding the present value of an annuity, PV, or while
discounting the series of annuity payments, PMTS.

Consider the following that clarifies the computation of interest (discount) rate per year,
i.
Assume that NIb International Bank (NIB) accepted an application for 200,000 Birr
commercial loan and proposes the following payment schedule for the borrower. For
equal annual payments of 63,100Birr, what rate of interest is the commercial loan
applicant is willing to pay?
The three variables in the present value of annuity equation that are known in this
example are: the present value of annuity of 200,000 Birr, the size of an annuity payment
at the end of each year of 63,100 Birr, and the number of years for which the annuity lasts
of 4 years. The unknown variable in this example is an annual interest (discount rate, i.
Inserting the figures for the known variables in the present value of annuity equation, you
can obtain the associated value as follows:
PVAn = (PMT) (PVIFAi,n)
PVA4 = (63,100) (PVIFAi,4)
200,000 = (63,100) (PVIFAi,4)
200,000
(PVIFAi,4) = 63,100  8.169 it is approximately equal to 3.170.
The look at the four payments (n=4) column in the present value of annuity table and try
to locate the table value that is equal or closest to 3.170 computed above for PVIFA i,4.
This value is exactly equal to the table value corresponds to 10 percent. Therefore, if the
present value of 200,000 Birr is placed now in the saving account that pays 10 percent
rate compounded annually, it will be enough to make four equal payments of 63,100 to
be made at the end of each year four the coming four years. In other words, the four-
years, 63,100 Birr annuity payments are equivalent to the present value of 200,000 Birr
when the annual interest rate per year is 10 percent.
Finding the Number of Payments, n:- When financial contracts such as a lowan is
arranged, it is sometimes convenient to agree on the size of equal payments. One th rate
of interest is known, the number of payments, n required to pay the loan in full can be
easily determined with the help of the present value of annuity equation and table. But
this approach of determining the number of payments, n has to problems.
1. If the first payment is less than the interest payment on the entire present
balance (loan amount), this first payment goes to the payment of only the
interest charge without aying part of the principal.
2. Sometimes the computed required number of payments may be turned out to
be an integer values. As a result, most loans negotiated in this manner will
have a final payment that is larger than the other equal payments.
To illustrate how to determine the required number of an annuity payments, n assume
that a 50,000 Birr loan is to be repaid in yearly equal installments of 14,000 Birr. The
loan carries as 6 percent annual interest (discount) rate. How many payments are
required to fully repay this loan?

56
As this first stem in answering this question, you must make sure that the interest charge
on the loan during the first year is less than 14,000 Birr, the first annuity payment. Since
6 percent of 50,000 Birr principal amount of the loan is only 3000 Birr, the 14,000 Birr
payment at the end of the first year (n+1) will provide some cash for the partly payment
of the principal amount.
In this example, the present value of an annuity, PVA is 50,000 Birr, the annual interest
(discount) rate is 6 percent, and the size of annuity payments at the end of each period
(year) is 14,000 Birr. The number of the required annuity payments is unknown. By
inserting the figures for the known variables into the present value of an annuity
equation, you get the following:
PVAn = (PMT) (PVIFAi,n)
50,000 = (14,000) (PVIFA6%, n)
50,000
PVIFA6%, n = 14,000  3.571
Then look at the 6 percent column in the present value of an annuity table, and read the
column down until you arrive at a table value that is equal, or exceed the computed value
of 3.571. The desired table value lies between 3.465 which corresponds to four payments
(n=4) and 4.212 which corresponds to five payments (n=5). So the table value that
exceeds the computed value is 4.212 and the number of payments is going to be five.
However, since the computed value is less than the table value of 4.212, the loan payment
schedule doesn't require the fifth payment to be as large as 14,000 Birr, which was
indicated as a second problem of using this approach of determining the number of
annuity payments. The payment schedule for the loan payment with five payments is
shown below. Payments schedule of 50,000 Birr loan, with five payments at 6 percent
(Loan Amortization).

Period Un paid Interest on Total amount Yearly Interest Principal New

Principal Principal unpaid payment payment payment balance
1 50,000 3,000 53,000 14,000 3,000 11,000 39,000
2 39,000 2,340 41,340 14,000 2,340 11,660 27,3340
3 27,340 1,640 28,980 14,000 1,640 12,360 14,980
4 14,980 899 15,879 14,000 899 13,101 1,879
5 1,879 113 1,992 14,000 113 1,879 0

As it can be seen from the above payment schedule (loan amortization table), each loan
payment annuity is divided into payment of interest and payment of principal. Since the
balance of principal keeps on decreasing, the interest charge is also declining year after
year because the 6 percent interest rate is applied on an decreasing balance of the
principal of the loan. On the other hand, the amount of yearly payment that goes for the
payment of the principal is increasing from year to year. The 14,000Birr payment at the
end of year one, for instance, is used first to pay the interest charge of the same year, that
is 3,000 Birr. This leaves the remaining 11,000 Birr (i.e. 14,000 Birr - 3000 Birr) which
will be used to reduce the unpaid principal balance from 50,000 Birr to 39,000 Birr. At
the end of year two, 6 percent annual interest rate is applied on the balance of the
principal at the beginning of the year of 39,000 Birr that is unpaid and it is 2,340Birr as

57
indicated in the schedule. Out of the 14,000 Birr payment at the end of year two,
2,340Birr is used to pay the interest charge on the unpaid principal during the year and
the remaining 11,660 Birr (i.e. 14,000 Birr - 2,340 Birr) is used to further reduce the
unpaid principal from 39,000 Birr at the beginning of year two to a value of 27,340 Birr
at the end of the year.

The payment process is repeated I the same way until year five, at the end of which the
balance of the unpaid is zero. There is no need to pay 14,000 Birr at the end of year five
as the total unpaid amount of both the principal and interest charge is only 1,992 Birr.
Hence, the borrower needs to pay only this amount at the end of years 5. Hence, the
payment at the end of year five is very small compared with payments at the end of the
first four years. This small payment at the end of year five can be avoided by making
larger payment at the end of year four. That is by paying the un paid principal balance at
the beginning of the year plus the interest charge on the balance during the year. The
unpaid principal balance at the beginning of year four is 14,980 Birr and the interest on
this is 6 percent which comes to 899 Birr and a total of 15,879 Birr to be paid at the end
of year four. This produces a larger payment at the end of the year compared with other
annuity payments during the first three years (i.e. 14,000 Birr each year).

Uneven, or Un equal Cash flows:

By definition an annuity includes the words 'constant amount' , which is to underscore
that an annuity involves payments, or receipts that equal in every period, or at the end of
every over the life of the annuity. Although many financial decisions do involve
annuities, some important decisions involve unequal or non-constant payments, or
receipts, or cash flows. For example, common stock as you know, pay fluctuating level
of dividends overtime, and fixed assets investments such as machinery do not generate
constant cash flows over their lives as they depreciate. As a result, it is very necessary to
extend the time value of money analysis to include unequal payments, or receipts, or cash
flows.
Throughout this chapter, we have used the term payment (PMT) for the annuity situation
(i.e when the cash flows are uniform) and we have to use cash flow (CF) to do note
unequal, or non-constant cash flows.
Present Value of Unequal Cash flows
Unequal cash flows are the same as that of the combination of many single cash flows
(payments). Hence, the present value, PV of unequal cash flows is found as the sum of
the present values, PV5 of the individual payments, or cash flows.

For example, suppose you are required to find the present value, PV of the following cash
flow stream, discounted at 6 percent as shown with the help of the time line.
0 6% 1 2 3 4 5 6
7
100 200 200 200 200 0
1000

58
How, the can find the present value, PV of individual cash flows by using the present
value equation for single payment, and sum these values to find the present value of the
entire cash flow stream. Here is what it looks like:
0 6% 1 2 3 4 5 6
7
100 200 200 200 200 0
1000

PV1 : 94.34 discounted

PV2 : 178.00 discounted
PV3: 167.92 discounted
PV4:158.42 discounted
PV5: 149.46 discounted
PV6: 0 discounted
PV7: 665.10 discounted
PV1 1,413.34

The individual present values, as well as, the present value for the entire cash flow stream

can be computed by using this general mathematical equation:

1 2 n
 1   1   1 
PV = CF1 (    CF2    ........  CF n  
1 i  1 i  1 i 
Where:
CF1 = the cash flow, or payment, or receipt at the end of year or period one.
CF2 = the cash flow, or payment, or receipt at the end of year, or period two.
CFn = the cash flow, or payment, or receipt at the end of year, or period n, and.
1
 1 
  
CF1  1  i  the value of the cash flow at the end of year one converted to the
equivalent
value at the end of year zero (i.e PV of cash flow at the end of year one).

Each one of the above present values was found by suing the respective individual
present value equation. For instance, the present value of year one's cash flow was found
by the present value equation of cash flow at the end of year one (i.e. CF 1
1 1
 1   1 
   (100)    (100) (0.9434)  94.34 Birr and the present value, PV
1 i   1.06 
2 2
 1   1 
of the cash flow at the end of year two is (CF 2)    ( 200)   = (200)
1 i   1.06 
(00.8900) = 178 Birr, and so on.

The present values of the cash flow stream over the 7 years can always be found by
adding the present values of individual cash flows as indicated above. However, the

59
pattern of the cash flow within the stream may allow you to use short-cut method. For
example, the cash flows during year two through year five are in an annuity form because
the cash flows during these years are uniform, you can use these fact and solve the same
problem in a slightly different manner but a bit simpler. That is:

0 1 2 3 4 5 6
7
100 200 200 200 200 0
1000
94.34
693.00

658.80
0.00
665.10
1413.24

The cash flows during year two through year five, as it was mentioned, represent the
pattern of annuity. The present value of annuity, PVA of the cash flows at the end of
year one (i.e. one year before the first annuity payment at the end of year two) by using
the mathematic equation for the present value of an annuity that was already discussed.
To remind you, how to find the present value of these cash flows at the end of year one, it
is shown below:
PVAn = (PMT) (PVIFAi,n)
PVA4 = (200) (PVIFA6%,4)
PVA4 = (200) (3.465), here 3.465 is the present value interest factor
corresponding to 6 percent interest rate and four payments or cash flows. Finalizing the
above computation, you arrive at:
PVA4 = (200) (3.465) = 693.00 Birr

After determining the present value of the four annuity payments, or cash flows of 200
Birr each at the end of year one, you have to determine the present value of 693.00 Birr at
the end of year zero by using the mathematical equation for present value computation
for single payment, future value. That is
 1 
PV = (FV)  n  . In this case, the future value is the 693.00 Birr which is
 (1  i) 
the present value of the four annuity payments during year two through year five at the
end of year one, the annual interest (discount) rate is 6 percent, and the period is only one
year (n = 1) Therefore,
 1   1 
 1
 (693) 1.06   (693) (0.9434)
PV = (693)  (1  0 .06 )   

= 653.80 Birr as it was indicated on the time-line before.

Future value of unequal or uneven cash flow stream:

60
The future value of unequal cash flows, or payments, or receipts, some times called the
terminal values) is found by compounding each individual payment to the end of the
payment period, or end of cash flow stream. Then the individual compounded values
(future values) are added, to obtain the overall compounded value of the entire cash flows
in the stream. The following general compounding formula can be used to determine
both the individual compounded values and the compounded, or future value of the entire
cash flow stream.
FVn = CF1 (1+i)n-i + CF2 (1+i)n-2 +……+ CFn (1+i)n-n
Where,

CF1 (1+i)n-1is the future value of the cash flow at the end of the first year at the
end of the nth year.

CF2 (1+i)2 is the compound amount of the cash flow at end of the second year at
the end of the nth year, an CFn (1+i)n-n is the compound amount of the cash flow at
the end of nth year at t he end of the same year, which is the same. CF n = CFn
(1+i)n-n
= CFn (1+i)0 = CFn (1) =
CFn.
To illustrate the future value of unequal cash flow stream, consider the following cash
flow pattern shown with the aid of the time-line.

The individual future values are computed by using the mathematical equation for future
value of single payment. For instance, the future value for the cash flow during year one
was computed using its won compounding formula, i.e:
FV1 = (CF1) (1+i)n-1
FV1 = (100) (1+0.06)7-1 = (100) (1.06)6 = (100) (1.4185)
In the same way, the future value of the cash flow occurred at the end of year two is:
FV2 = (200) (1+0.06)7-2
= (200) (1.06)5 = (200) (1.3382) = 267.64 Birr, and so on.

The future values of the cash flow stream over the seven years can always be found by
adding the future values of individual cash flows as shown with the help of the time-line.
However, the cash flow pattern within the stream may allow you to use a method which
is less time consuming and simpler. The cash flows are in an annuity amount of 200 Birr
every year during these four years. You can take this fact into account and compute the
future values of the cash flows over the seven years in a slightly different manner as
follows.

61
0 1 2 3 4 5 6 7
100 200 200 200 200 0 1000.00 =
FV7
0.0
=
FV6
224.72 =
FV5
238.20 =
FV4

252.50 =
FV3
267.65 =
FV2
141.85 =
FV1
FVT = 2,124.92

0 1 2 3 4 5 6 7
100 200 200 200 200 0 1000 = FV7
0 = FV6

874.02
983.6 = FV2,
3,4, 5
141.85 = FV1
FVT = 2,124.91 Birr

As you can see from the above timeline, the cash flow during year 2, 3,4, and 5 are in the
annuity form. Hence, their future values at the end of year 5 can be found by using the
mathematical equation for future value of an annuity. In order to use the future value of
an annuity equation, you need to identify the variables that are known. In this case, the
cash flow, or payment (PMT) is 200 Birr at the end of each year, the annual interest is 6
percent, and the number cash flows, or payments is four (n=4).
FVAn = (PMT) (FVIFAi,n)
FVA4 = (200) (4.3746) = 874.92 Birr

The future value of the four 200 Birr annuity cash flows at year 5 is, therefore, equals to
874.92 Birr. This future value has to be further compounded for two more years in order
to obtain its future value at the end of at the end of year 7 by using the future value
equation for single payment (cash flows). The 874.92 Birr is treated as the present value,
PV at the beginning of year 6, or at the end of year 5, and it is to be compounded for two
years (i.e. year 6 and year 7) which implies the value of 2 for n, and the annual interest
(discount) rate was said 6 percent. Therefore,

62
 FV = (PV) (1+i)n - substituting the figures for the known variables, you get:
FV = (874.92) (1+0.06)2
= (874.92) (1.06)2
= (874.92) (1.1236)
= 983.06 Birr

The computed future value of 983.06 Birr is the future value of the four 200 Birr cash
flows occurred during year 2 through 5, at the end of year 7.

Semi-annual and Other Compounding Periods

In all of the illustrative examples considered in this chapter, it was assumed that interest
is compounded once a year, or annually. This is called annual compounding. Suppose,
however, that you placed 100 Birr into the bank account that pays a 6 percent interest rate
but the interest rate is compounded each six months. This what is commonly known as
Semi-annual compounding. How much would you accumulate at the end of three years?

Whenever payments occur more frequently than once a year, or if interest is stated to be
compounded more than once a year, then you must convert the stated interest rate per
annum into a 'periodic rate' and the number of years in to 'the number of periods' as
follows.
Periodic rate = Stated rate/Number of payment per year.
Number of periods = Number years x compounding periods per year.
In our example, in here, where we must find the value of 100 Birr after three years when
the stated interest rate is 6 percent and compounded semi annually (or twice a year), you
would begin by making the following conversion:
Periodic rate = 6% /2 = 3%
Periods = 3x 2 = 6

In this situation, the investment will earn 3% every 6 months for 6 periods. There is a
significant difference between these two procedures.

You should make the above conversion before you start solving the problem, because
compounding should generally be done using number of periods and the periodic rate,
not the number of years and not the stated annual interest rate. The periodic rate and the
number of periods, not yearly rate and number of year 5, should be shown on the time-
line and used in the future value computation equation as well. Here is the time-line.
0 1 2 3 4 5
6
-100
FV = ?
Each period covers value of single payment equation, the future value of the 100 Birr
placed in the bank account will be:
FVn = (PV) (1+i)n, Here, i = 3% or 0.03; PV = 100; and n = 6
Therefore,
FV6 = (100) (1.03)6

63
 = (100) (1.1941)Birr, or the tabular solution is FV n = (PV) (FVIFi,n) ,
where FVIFi, n is the future value of single payment table value for a given i and n.

FV6 = (100) (FVIF3%, 6)

The table value for period 6 under the 3% columns is 1.1941. Substituting this value into
the equation, you get:
FV6 = (100) (1.1941) = 119.41 Birr

Perpetuities
A perpetuity is an annuity that continues for ever; that every year from its establishment
this investment pay the same birr amount. The very good example of perpetuity is a
preferred stock that yields a constant dividend birr dividend infinitely as the life of the
preferred stock is unlimited. Determining the present value of perpetuity is delightfully
simple you merely need to divide the constant cash flow by the prevailing interest
(discount) rate. For example, the present value of 100 Birr perpetuity discounted back to
the present time at 5 percent is 100Birr / 0.05 = 2000 Birr. Thus, the mathematical
equation to compute the present value of perpetuity is:
PV = PP
i
Where PV = the present value of perpetuity
pp = the constant birr amount provided by perpetuity
i = the annual interest (discount) rate.

Fractional Time Periods:

In all the examples used so far in this chapter, it was assumed that payment occurs once
in a year either at the beginning or end of the year, but not at the same time within a year.
However, sometimes fractional periods are involved. for example, suppose you have
deposited 100 Birr in the bank account that pays 10 percent interest, compounded
annually. How much would be in your account at the bank after a months, or 75 (9
months divided by 12 months in the year) percent of the way through the year. Your
answer to this question must be 100 Birr; since interest is compounded annually and
interest is added only at the end of the year. Hence, there is no interest that would have
been added after only nine months. Years ago, before computer made daily
compounding an easy task, banks did compound interest only annually, but today most f
them have started compounding interests monthly and even daily.

Now let the question be modified like this: If the bank adds interest daily to your account
daily, that is, uses daily compounding and if the nominal rate is 10 percent with a 360-
day year, how much will be in your account after 9 month? Assume that all months are a
30-day months. The answer is 107.79 Birr computed as follows.

First, you have to convert the annual interest rate to the daily interest rate and the number
of months into the number of days.
Daily rate = 0.10 = 0.00027 =i
360
Number of days (periods) = 9 months x 30 days = 270 days = n

64
Future value after 9 months, or 270 days = (PV) (1+i)n
= (100) (1+0.00027)270
= (100) (1.00027)270
By using a scientific calculator or a computer, the term (1.00027) 270 is equal to 1.0779.
Therefore,
FV = (100) (1.0779) = 107.79 Birr
This is to mean that the 100Birr will grow to 107.79 Birr after 9 months at an annual
interest rate of 10 percent compounded daily.

Now, Suppose that you have borrowed 100 Birr from a bank which charges you 10
percent per year 'simple interest' which means annual rather than daily compounding, but
you have borrowed the money for only 270 days. How much interest will you have to
pay for the use of the money for 270 days?

Here, you also need to calculate the daily interest rate as you did for the previous
example, and you multiply the daily interest rate by 270 instead of using 270 as an
exponent because the daily interest rate is a simple interest rate. Therefore,
The interest charges during 270 days = (100) (0.00027) (270
= 7.50 Birr

It means, you owe the bank a total of 107.50 Birr, of which 100 Birr is the principal you
have borrowed and 7.50 Birr is the interest accrueded during the 270 days.

Finally, consider a somewhat different situation. Suppose that your company has 100
customers at the end of 1993 E.C., and you have observed that the customer base of your
company has been expanding at the rate of 10 percent per year. Assuming the same trend
of growth, what is the estimated total customer of your company at end of the ninth
month of the new year, that is, 1994 E.C.?

This problem would be treated exactly like the bank account with daily compounding.
Therefore the total customers of your company after 9 month is the new year would be
107.79. Since 0.79 customers doesn't make since, it has to be rounded up to one
customer and the total customers would be 108, which means 8 more customers are
expected to come newly during the 9 month in the year 1994.

Bond Valuation
Bond valuation requires the combination of several discounting, or present value
computation techniques and procedures, in duding that of single payment and annuity
with annually or semiannually compounded discount rates. As you will see, the present
value of a given bond can change dramatically as interest (discount) rate changes.

When the bond is purchased, the holder (owner) of the bond receives two things : (1)
interest payments, which are a series of equal payments usually made semiannually, and
(2) repayment of the full principal at its maturity, regardless of the price the bondholder
paid for the bond.

65
 For example, consider the bond that pay 45 Birr every six-months, and comes due in
twenty years time; that is at the end of the twenty years the bondholder will receive 1000
Birr which is usually the principal amount of the bond, and will terminate. How much
does this bond worth?

Generally speaking, the bond worth the present value of the cash flows it provides. Thus,
whenever the market discount rate, or interest rate changes, the value of the bond
changes. Let us now examine the value of this bond assume three cases: medium, low
and high market interest rates say10 percent, 6 percent and 14 percent respectively.

Case 1: Bond Value at 10 percent Market Interest Rate:

The bond value is the sum of the present value of interest payments and the present value
of the repayment of bond principal at maturity to the bondholder. The present values are
computed by using the market interest rate of 10 percent paid semiannually in this case.

Bond value at Present value of Present value of

10% compounded = interest payment the repayment of
Semiannually annuity + bond's principal

Before you use the present value of annuity and single payment equations, you need to
convert the annual interest rate to the semiannual rate, or periodic rate and the twenty
year bond life into payment periods as follows:

Semiannual interest rate = 0.10 = 0.05 or 5%

2
Payment periods = 20 years x 2 periods = 40 periods

Bond value (using table values) = (PMT) (PVIFAi,n) + (FV) PVIFi,n)

where,
PMT = is the interest payment at the end of every 6 months
PVIFAi,n = the table value from the present value of an annuity table
for an interest
rate, I and number of payments, n.
FV = the repayment of the bond's principal at the end of the
twenty years.
PV1Fi,n = the table value from the present value of single payment table for
an
interest rate, i and the number of compounding period, n.
Bond value (present value of cash flows) = (45) (PVIFA5%, 40) + (1000) (PVIF5%, 40)
= (45) (17.1591) + (1000) ( 0.1420)
= 772.16 + 142.00
= 914.16 Birr

66
Hence, the value of the bond that pays 45 Birr of interest semiannually when the market
interest (discount) rate is 10 percent per annum is 914.16Birr. Since the bond carries a
coupon rate of 9 percent per annum of 4.5 percent per six months, it will be sold at
discount when the market interest rate is greater than this coupon rate. (i.e 10 percent
market interest rate, which is 5 percent per six months).

Case 2: Bond value at 6 percent Market Interest Rate:

If the market rate drops to 6 percent paid semiannually, the procedure of computing the
bond value remains the same, and the only change is the annual interest rate, i which is
now equal to 6 percent. Logically since the value of interest rate, i appear as a
denominator of the mathematical equations for present value computation, the bond
valued should increase as the market interest rate, i drops. In other words, if the bond
pays more interest rate (coupon rate) than the market interest rate, i, then the demand for
the bond increase. This increase in the demand for the bond will rise the bond's value.
Bond value (6% annual interest rate) = (45) (PVIFA3%. 40) + (1000) (PVIF3%, 40)
compounded semiannually
Bond value (6% market interest rate) = (45) (23.1148) + (1000) (0.3066)
= 1040.17 + 306.60
= 1,346.77 Birr
Or else, you can use the mathematical equation, which, infact leads you to the same final
result:
Bond value (6% annual market interest rate) = (45)
1  (1.03) 
40
 1 
   (1000)  40 
 0.03   (1.03) 
= (45) (23.11480 + (1000)
[0.3066]
= 1040.17 + 306.60
= 1346.77 Birr
If the market interest rate drops from 10 percent to 6 percent, the value of the bond will
climb from 914.16 Birr to 1,346.77 Birr.

Case 3: Bond value at the Market Interest Rate of 14 percent

If the market discount rate climbs from 10 percent to percent compounded semiannually,
the bond value will drop, as the future cash flows to the bondholders are now discounted
back to present at a higher discount rate. The argument here is that if the market pays
more interest rate than what the bond pays (that is 9 percent per year), the demand for the
bond decline. If the demand for the bond declines, the value of the bond will fall. At a
market interest rate of 14 present, ,it is intuitively possible to guess that the value of the
bond is less than its principal amount even before computing it.
Bond value (at annual market interest rate of 14% = (45) (PVIFA7%, 40) + (1000)
(PVIF7%, 40)
= (45) (13.3317) + (1000) (0.0668)
= 599.93 + 66.80
= 666.73 Birr

67
or else, you can use the market equation of present values of the cash flows from the
bond:
1  (1.07) 40   1 
Bond value = (45)    (1000)  40 
 0.07   (1.07) 
= (45) (13.3317) + (1000) (0.0668)
= 599.93 + 66.80
= 666.73 Birr.

If the market interest (discount) rate climbs from 10 percent up to 14 percent, the value of
the bond will drop from 914.16Birr down to 666.73 Birr. This clearly shows that there is
an inverse relationship between the market interest (discount) rate and the value of the
bond. When the market interest (discount) rate goes up, the value of the bond value goes
down, and vice versa.
Summary

To make decisions, financial managers must compare the costs and benefits of
alternatives that do not occur during the same time period. Whether to make profitable
decisions or investments or to take advantage of favorable interest rates, financial
decision making requires an understanding of the time value of money. Managers who
use the time value of money in all of their financial calculations assure themselves of
more logical decisions. The time value process first makes all Birr values comparable;
since money has time value, it moves all Birr flows either back to their value in the future
period.

When dealing with single payment problems, the four variables involved are: (1) initial
payment (PV); (2) the annual interest rate (i) (3) the number of years (n) and (4) the
future value (FV) Given any three of these variables, we can solve for the unknown
fourth variable by using an appropriate mathematical equation discussed in the chapter.

The compound amount of annuity problems use the following variables: (1) the number
of payments in the annuity (n), (2) the value/size of each annuity payment (PMT) (3) the
annual interest (discount) rate (i) and (4) the compound amount of an annuity (FVA). If
any three of these variables are given, the value of the fourth variable can be obtained by
using the future value of an annuity equation.

The present value of annuity problems involves the following variables. (1) The annual
interest (discount) rates (i); (2) present value of annuity (PVA), (3) the size of each
payment (PMT), and (4) the number of payments (n). The present value for an annuity
equation is used to solve for the value of any one variable, given values for the other
three variables.

The time value of money techniques have several applications, which include: 91)
computation of the implied interest rate in the situation where the rate is not clearly
stated, (2) loan repayment schedule (loan amortization), (3) bond pricing (valuation) and
soon. Perpetuities are introduced as special form of an annuity. Perpetuities do not
require present value tables in order to obtain their present values perpetuities have very

68
limited applications by themselves but can serve as good approximations to long-lived
annuities.

CHAPTER 4
COST OF CAPITAL
4.1. THE CONCEPT OF COST OF CAPITAL
4.1.1. Prelude
The concept of capital is based on the assumption that the core goal of profit-Seeking
business firms is to maximize the wealth of shareholders. This assumption makes it
possible to formulate several equivalent definitions of cost of capital that pinpoint some
important implications in the concept of cost of capital.
The concept of cost of capital has its roots in the items on the right-hand-side of the
balance sheet, which includes various types of debt, preferred stock, common stock, and
retained earnings. These items are called the capital components. An increase in total
asset must be financed by an increase in one or more of these capital components.
Capital is one of the necessary components of production/operation of a business firm,
and like any other factor it has a cost of its own. The cost of each component of capital is
called component/specific cost that particular capita.
Every profit-making/seeking business firm has its own risk-return characteristics. Each
group of investors in the business firm such as bondholders, preferred stockholders, and
common stockholders requires a minimum rate of return that commensurate with the
risks the group accepts as a result of investing in the firm. From the standpoint of the
firm, these groups provide the capital (financial resources) needed to finance the firm’s
investments in its total assets. The minimum rate of return that the business firm must
earn in order to satisfy the overall rate of return required by its financers is called the
firm’s cost of capital.
4.1.2. Definition of cost of capital and its implications
The most important implication of the definition of cost-of-capital can be stated as
follows:
If the actual rate of return that the business firm earns exceeds its cost-of-capital, and if
this rate of return is earned without increasing the risk characteristics of the firm, than the
shareholders’ wealth is increased, which further implies the achievement of the basic goal
of the business firm (i.e. the maximization of shareholders’ wealth).
The reasoning behind this implication is that when the rate of return of the firm exceeds
its cost of-capital, the bondholders and preferred stock holders will basically receive their
fixed rate of return. Then, the remaining portion of the firm’s rate of return that is
available to common stockholders will definitely exceed their required rate of return.
The excess earnings, then, may be treated in several ways of which some are:

69
  The business firm may distribute these excess earnings to common stockholders
in the form of increased dividends, or
 The business firm may retain and reinvest these excess earnings to further
increase it subsequent rate of return, or
 The business firm may divide the excess earnings between the increased
dividends and retained earnings (i.e. part of the excess earnings may be
distributed to common stockholders in the form of increased dividends, and other
portion of the earnings may be retained for further expansion of firm’s operation.)
As the consequence of the decision made in relation to the excess earnings, the common
shares will become more demanded in the stock market and the increased demand for
common share ownership will increase the resale prices of common shares. In such a
way, shareholders wealth will be maximized, thus, meeting the basic goal of the business
firm.
An alternative definition of cost-of-capital considers cost-of-capital as the minimum rate
of return that the firm must earn on its invested capital if the market value of the firm is
to remain unchanged. This definition, as you can understand, assumes cost-of-capital as a
“break-even” rate. According to this definition, cost-of-capital is the rate that maintains
the current market value of the firm. If this cost of capital (rate of return) is not earned,
the market value of the firm will decline.
A second implication of cost-of-capital definition links cost-of-capital with the firm’s
capital-budgeting process. The cost-of-capital is the rate that serves as a discount rte
used in evaluating in evaluating capital-budgeting alternatives. Accepting project
alternatives with rate of returns that the firm. In the same taken, the firm’s market value
is decreased when the rate of return on its investment projects falls below its cost – of –
capital. Hence, using cost-of-capital (discount rate) to evaluate capital budgeting
alternatives is consistent with the firm’s goal of share holders’ wealth maximization.
4.2. Measuring Specific (component) Cost-of-capital
As it was indicated at the beginning, the capital structure of the business firm contains
debts (bonds), preferred stocks, common stocks, and retained earnings and has its own
minimum required rate of return, and consequently its own cost-of-capital (the average
cost-of capital). The cost-of-capital has to be computed for each capital source and
security issue. The cost-of-each capital source or component is called the specific cost-
of-capital, or the component cost of that particular type of capital.
Since the measurement of specific cost-of-capital is a difficult process, the resulting costs
must be looked upon as approximations. The difficulty arises primarily because the
market value of the firm changes constantly and a good deal of this fluctuation is caused
by external factors such as inflation, over which the firm has no control. As a result,
some relatively simple approximation equations are used to determine the specific cost of
capital.
4.2.1. Specific cost of Debt
Since most long-term debts of the firm are in the form of bonds, computation of the cost
of debt capital is based on the characteristics of bonds and the interest charges the bonds

70
impose on the firm. Estimating this specific (component) cost of debts (bonds) requires
computing the effective cost of debt to the firm and stating this effective cost of debt to
the firm and stating this effective cost of debt as an annual compounding rate.
The computation of the specific (component) cost of debts (bonds) involves three steps:
Step 1: Determine the net proceeds per bond to the firm issuing the value of the bond
(usually 1000 Birr) after the costs of selling the bond to the firm are deducted. For
instance, the bonds in the particular bond issue may have 1000 Birr par value. If the
bonds are sold at par and the issuing company pays a 20 Birr selling (flouting) costs per
bond, the net proceed. Per bond is 980 Birr.
Step 2: Determine the effective before-tax cost-of-debt (bond) use the net proceed form
the bond issue as a time zero cash inflows. Use the annuity of interest payments and the
repayment of the bonds principal (par value) at maturity as the cash outflow. The
effective before-tax cost of debt (bond) is the rate at which the sum of the present values
of the interest payments annuity and the present values of the principal (par value)
payment at maturity is equal to the proceeds form the bond issue. If the net proceed is
equal to the par value (face value) of the bond, the effective before-tax cost of debt is
exactly equals to the interest rate attached to the bond (coupon rate of the bond).
Step3: Since the interest payments are deductible for income tax purpose, you need to
convert the computed before-tax cost of capital into the after-tax cost-of-capital. This is
done by deducting the tax-savings rate from the before-tax cost of capital. The resulting
value is the specific cost-of-capital.
Let:
Kd= Effective before-tax cost of debt
T= Company tax rate, then
After-tax component cost of debt = Kd (1-T)

To illustrate the specific cost of capital of debt (bond0,assume that the Ethiopian
Government (National Bank of Ethiopia) sells bond issues for Birr 20 million that is to
mature in 25 years time. Each bond is expected to have a par value of 1000 Birr and
carries a coupon interest rate of 12 percent. The income tax rate is assumed to be 40
percent. The government (NBE) nets for Birr 985 per bond. Compute the specific
(component) cost of debt (bond) capital to the government.
The proceeds per bond that the government (NBE) collects is 985 Birr. Since the proceed
form the sale of the bond is less than its par value (face value), the before-tax cost of
capital of debt should be different form the coupon rate of the bond. When proceeds
form sales of the bond less than par, it is said to be sold at a discount. Hence, the
government is to pay the coupon rate plus the discount amount (which is 15 Birr per bond
in this case). This implies that the effective before tax cost of bond is greater than the
coupon rate of 12 percent because of the addition cost paid in the form of discount on
issue.

71
In this case we have to compute the discounting rate that will equate the sum of the
present values of interest payments annuity and the present value of the principal
repayment at maturity of the bond. This rate, as it was stated, the effective before-tax
cost of capital of debt (bond). This rate is computed by trial and error hint. Begin with
the coupon rate and move to the next higher rate.
The annual interest payment equals 1000x12% = 120 Birr per bond per year. Thus, the
120 Birr will be paid as an interest per bond for the coming 25 years. In addition, the
principal (face) value of the bond (i.e. 1000Birr) will be paid at the end of the 25 years
9at maturity).
Net present value=(Proceed from sale of bond). (Present value of interest payments
annuity)-(present value of principal payment at maturity)
NPV 12% = 985 – [120 (PVIFA12%,25)] – 1000 (PVlF 12%,25)
=985 – [120(7.8431)] – 1000 (0.0588)
=985 – 941.17 – 58.80 = 985 – 1000
= -15
Since the sum of the present values of cash outflows is greater than the proceed (cash
inflow), the net present value is negative 15 Birr. In other words, at the rate of 12 percent
the sum of the present values of the interest payments and principal payment is greater
than the amount of proceed at the time of issue. Hence, you need to try the next higher
discount rate, that is 13 percent.
NPV 13% = 985 – [120 (PvlFA 13%,25) – 1000 (PVlF 13%,25)
= 985 – [120 (7.330)] – 1000 (0.047)
=985 – 879.60 – 47 = 985 –927
= +58
As you move from the discount rate of 12 percent to 13 percent the net present value
(NPV) jumps form negative 15 Birr to positive 58 Birr. This shows that the discount rate
that equalizes the sum of the present value of interest payments annuity and the present
value of the principal payment and the proceed form bond issue lies between 12 percent
and 13 percent. In order to determine the exact discount rate, the specific cost of capital
of debt, that makes the net present value of zero, you add the absolute values of the net
present values corresponding to 12 percent and 13 percent:
1-151 + 1+581 = 15+58 = 73
The 1 percent gap between 12 percent and 13 percent corresponds to the 73 Birr
difference between the net present values computed for the two discount rates.
Hence, the cost of debt before-tax = Kd = 12% + 15/73%
=12% + 0.21% = 12.21%, or
Kd = 13% -58/73%
= 13% - 0.79% = 12.21%

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After-tax specific cost of capital of debt=Kd(1-T)
=12.21% (1-0.40)
=12.21 %( 0.60)
=7.33%
Therefore, the Ethiopian Government is required to pay an effective cost-of-capital of
debt after-tax of 7.33 percent on the bond it has issued.
On the other hand, if the Ethiopian Government (i.e. NBE) sells the bonds at a net
proceed of Birr 1000 per bond, which is equal to the principal (par value) of the bond, the
sum of the present values of the series payments and the present value of the principal
payment at maturity of the bond is equal to the proceed at time zero at the discounting
rate that is equal to the bond’s coupon rate, that is 12 percent. Hence, the specific
(component) cost of capital of debt 9bond) is 12 percent. At a discount rate of 12
percent, the net present value of cash inflows (proceeds) and the cash out flows (interest
payments and the repayment of the principal0 is zero as shown below:
Net, present value (12%) = 1000 – [120 (PVIFA 12%25)] – 1000 (PVIF 12%,25)
= 1000 – [120(7.8431)] – 1000 (0.0588)
= 1000 – [941.17-58.80
= 1000 – 1000 = 0
Since the net present value at a discount (interest0 rate of 12 percent, is 0, the specific
cost of capital of debt (bond) before-tax (Kd) is 12 percent. As a general rule, when the
proceeds from the sales of bonds are equal to the par values of the bonds, the specific
cost-of-capital of debts (bonds) before-tax is equal to the coupon rate attached to the
bonds.
After-tax specific cost of debt (bond)of capital = Kd - Kdt
= 12% -(12%)(0.40)
= 12% -4.8%
=7.2%
Therefore, the Ethiopian Government (NBE) is required to pay an effective cost of capital
of debt (bond) after-tax of 7.2 percent if it sells its bonds for a net proceed of 1000 Birr
per bond. The reason for using after-tax cost of debt capital of debt is as follows. The
value of firm’s capital stock, which the financial manager wants to maximize, depends on
the after-tax cash flows. As interest on debts or bonds is a tax deductible expense, it
produces tax savings which reduce the net cost of debt, making the after-tax cost of debt
less than the before-tax cost of debt.
4.2.2. The specific cost of preferred stock
When a business firm sells preferred stock, it expects to pay fixed dividends to investors
(preferred stock holders) in the return for their money capital. The dividend payments
are basically the cost of the firm preferred stock. In order to express these dividends as
yearly rated, the firm uses the net proceeds if receives after deducting whatever costs

73
incurred in selling 9 floating) the issue. If, for example the firm sells the preferred stock
for 40 Birr per share and pays a 2 Birr selling (flotation costs per share, the firm has to
use 38 Birr (40-2) net proceeds per share in computing the specific (component) cost of
capital of preferred stock.
The specific cost of capital of preferred stock, Kps, is the preferred dividends, Dps,
divided by the net proceeds from the issuance of the share Pn, or the price of the share
that the firm accepts after deducting the flotation costs.
D ps
In general, specific cost of Preferred share = Kps =
P.n
For example, suppose that Bontu Share Company has preferred sock that pays a 10 Birr
dividend per share and sells for 100 Birr per share in the market. If Bontu share company
issues new shares of preferred stock, it will incur an underwriting 9or flotation) cost of
2.5 percent of the selling price, or 2.50 Birr per share, so it will net 9.50 Birr per share.
Therefore, the specific cost of capital of preferred stock for Bontu Share Company would
be:
Specific cost of capital of preferred stock = Kps =Dps/Pn = 10/97.50 = 10.26%
No tax adjustments are made when calculating the specific cost capital of preferred stock
(Kps) because preferred dividend unlike interest expenses on debt, are non-tax deduct
able, hence there are not tax saving associated with use of preferred stock as a source of
capital.
4.2.3. Specific cost of common stock
The specific (component) cost of capital of common stock is the minimum rate of return
that the business firm most earn for its common shareholders in order to maintain the
market value of the firm’s equity. When the firm sells its common stock issue and nets
for Pn Birr amount per share, it can set the net proceeds equal to the stocks’ intrinsic
value because investors have been willing to acquire the security at the price that nets the
firm an amount of Pn Birr. The intrinsic value of common stock is estimate by using an
equation:
V = Do (1+9) Where Do = Current dividend per share
K-9 g = Compound dividend growth rate
K = the rate of return required by common stockholders
(investors).
This equation is used to compute the intrinsic value of the share of common stock that
returns an indefinite dividend stream. In addition, dividends on common shares are
assumed to grow at a given growth compound rate each year. The business firm that
issue the share of common stock can estimate the specific cost of capital of common
stock by setting the proceeds form sales of common shares equal to the firms intrinsic
value (v)
Then the market interest (discount) rate (k) is a measure of specific (component) cost of
capital of common stock is given by the symbol Ke.

74
To determine the value of Ke, we equate Pn and v
Pn = Do (1+9) because V = Do (1+9)
K-9 K-9
Substituting Ke K in the above equation, you get;
Pn = Do (1+9)
Ke-9
Solving for specific cost of capital of common stock (ke) from the above equation, you
arrive at:
Pn (Ke – 9) = Do (1+9)
Ke – g =Do (1+90
Pn

Ke = Do (1+9) +9
Pn

This is the equation that is used most frequently to measure the specific cost of capital of
common stock. However, it is based on the assumption of the dividend stream that
increases indefinitely at a given compound rate of ‘9’. This compound rate, ‘9’, is the
compound rate of growth of common stock dividend that might be determined from the
records in the past related to dividend growth. Therefore, the use of this equation is
limited to those business firms whose expected future dividend stream at least
approximates this assumption.
For instance, assume that Nib international Bank (N/B) sells an issue of common stock to
potential investors in the country. The selling price per the common share of the bank is
20 Birr. The bank incurs a selling (flotation) cost of 2.50 Birr per share. The current
dividend of the bank’s common share is 2.00 Brr per share. The current dividend of the
bank’s common share is 2.00 Birr per year and it is expected to grow a 5 percent annual
compound rate. Compute the specific cost of capital of common stock of Nib
International Bank.
The net proceeds per share = Pn = Selling price – Flotation cost
= 20 - 2.50
= Birr 17.50 per share
Annual dividend = Do = 2.00 Birr per share.
Dividend growth rate per year = 9 = 5%, or 0.05
Therefore,
Ke = Do (1+9) + 9 = (2.00)(1+0.05) + 0.05

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 Pn 17.50
= (2.00)(1.05) + 0.05
17.50
= 2.10 + 0.05
17.50
= 0.12 + 0.05 = 0.17 or 17%
There is no need to make income tax adjustment to the computed specific cost of capital
of common stock of 17 percent because common stock dividends, unlike interest on debts
(bonds), are not tax deductible, hence there is no tax-savings associated with the use of
common stock financing.
4.2.4. Specific Cost of Retained Earnings
There are two difficulties with computing the specific (component) cost of capital of
retained earnings. Both of these difficulties arise from the nature of the retained earnings.
Retained earnings are an internal, as opposed to external source of funds. First, retained
earnings are not securities, like that of stocks and bonds. Thus, they do not have market
values/prices that can be used to compute their specific cost of capital. Second, since
retained earnings do not represent funds provided directly by common stock holders
(investors), there may be a tendency to equate the specific cost of capital of retained
earnings with zero.
The approach that is used to measure the specific cost of capital of retained earnings is to
realize that retained earnings represent profits earned during the current year and
available to common shareholders that the business firm decides to reinvest in itself
rather than payout as dividends. Thus, the shareholders are made to reinvest part of their
earnings in the firm. In return, the shareholders expect the firm to earn a rate of return on
this retained fund which is at least equal to the rate earned on the outstanding common
stock. Once, the business firm has earned net profit after tax, it is available for the
common shareholders in the form of dividend. If the net profit after-tax is decided to be
reinvested in the business it is equivalent to the existing common stock capital. Both the
outstanding common stock and the retained earnings belong to the common stock
holders’ equity and the shareholders expect similar returns on both capital sources.
Therefore, the specific cost of capital of retained earnings is estimated on the bases on the
specific cost of capital of common stock. However, since no selling (floating) costs are
incurred in relation to the retention of earnings, the current market price of common
stock, instead of net proceed, is used in the computation of cost of capital.
The other logic behind attaching the specific cost of capital of retained earnings to that of
common stock is that the market price of common stock is the reflection of the
performance of the business firm which is, to the same extent, measured by the amount of
net profit after tax that is retained for further expansion. If the trend of the business firm
shows a continuous growth, the firm would, in most cases, retain larger portion of its
earnings after-tax and at the same time the market price of the firm’s common shares will
either increase or be maintained at the current level. This clearly shows the existence of
strong correlation between retained earnings and common stock. Therefore, it is

76
reasonable to estimate the specific cost of capital of retained earnings based on the
market value of common share (Po), current dividend per common share (Do), and
compound dividend growth rate per year (9) but ignoring the selling (flotation) costs
since retained earnings are not marketable securities.
Hence,
Specific cost of capital of retained earnings = Kr = Do (1+9) +9
Po
Where, Do = Current dividend per common share
G = Compound dividend growth rate
Po = Current market price of the firm’s common share
Kr = Specific cost of capital of retained earnings.
The only difference between the specific costs of capital equations of retained earnings
and common stock is that the specific cost of capital of retained earnings equation uses
the current market price of the firm’s common stock as a denominator, while the specific
cost of capital of common stock equation uses the proceeds form sales of common stock
(i.e. the current market price of common share less any selling (floating) cost involved in
the issuing process of the common shares. Referring back to the example on the specific
cost of capital of common stock was computed to be 17 percent. The specific cost of
capital of retained earnings for the same data set is:
Kr = Do (1+9) + 9 = 2.00 (1+0.05) + 0.05
Po 20
= 2.00 (1.05) + 0.05 = 2.1 +0.05 = 0.105 + 0.05
20 20 = 0.11 or 11%
Therefore, the specific cost of capital of retained earnings is only is 11 percent. Here, the
specific cost of capital of retained earning (11percent) is less than the specific cost of
capital of common stocks (17percent) because common stock issuance involves selling
(flotation) cost while retaining earnings after-tax doesn’t involve any costs.
4.3. Weighted Average Cost-of-Capital
Once the specific 9component costs of capital for each firm’s long term financing source
has been measured, it is possible to measure the firm’s overall cost-of-capital. It has been
defined as a rate of return that must be earned by the firm in order to satisfy the
requirements of the individual specific (component) costs of capital. The overall cost of
capital (weighted average cost of capital) that is computed form the firm’s existing
capital structure allows the firm to obtain a measure of a minimum rate of return that
must be earned on its entire investments. The overall cost of capital (weighted average
cost of capital) of the firm can be of help in identifying the discount rate to be used in
evaluating the capital-budgeting decisions.
The overall cost of capital (weight average cost of capital) is obtained as follows:

77
 1. Multiply the specific cost of capital of each source by its percentage composition
in the capital structure of the firm
2. Add the products you have computed under (1) above. The resulting sum is called
the firm’s weighted average cost of capital.
The percentage compositions (weights) that is used under (1) above can be based either
on the book values of the sources of capital or on their market values. The use of both
values to determine the percentage composition of each capital source of the capital
structure has both advantages an limitations.
5.3.1. Book Value Weights
The firs approach to measuring firm’s weighted average cost of capital is to use the
balance sheet book values of the individual source of long term and permanent capital.
These book values reflect the amount of capital the firm has raised by selling securities as
well as the amount of capital that has been generated by reinvesting earnings that were
not paid out as common stock dividends Since each source of capital has its own cost of
capital, the following three steps are needed to compute the overall, weighted average,
cost of capital on the basis of book value weights:
1. Find the percentage of long-term capital provided by each financing source. The
Birr values for each capital sources are taken from the firm’s balance sheet.
2. Multiply each capital percentage by its specific (component) cost of capital.
3. Add the products you have computed under step 2.
To illustrate the use of book values of sources of capital as the basis of determining the
overall cost of capital (weighted average cost of capital), assume Lemlem company
whose capital structure contains the following book values and specific costs of capital of
its capital sources.
Lemlem Company
Book values and specific cost of capital for a Given Capital Structure
Source of capital Book value
Specific cost of capital
9% bonds, 1000Birr par 15,000,000 Birr 5.4%, or 0.054
50,000 Shares, 8 Birr preferred Stocks 5,000,000 Birr 8.0%, or 0.080
Common stock, 400,000 shares
Outstanding 20,000,000 Birr 11.0%, or 0.110
Retained earnings 10,000,000 Birr 10.5%, or 0.105

The specific costs of capital given for Lemlem Company are assumed to have been
computed using the equations for each type of specific costs of capital indicated earlier.
The book value weights are obtained by dividing the book value of each financing source
by the total book values of all financing sources (i.e. 50,000,000 Birr in the case of this
example). The book value weight is then multiplied by the corresponding specific cost of

78
capital to give the weighted costs. The sum of these weighted costs equals 8.92 percent.
This sum of the weighted costs of the company is what we call the weighted average cost
of capital (WACC). The computation of the WACC on the basis of the book value
weights is shown below.
Lemlem Company
Computation of weighted Average cost of capital

Book value Specific cost Weighted

Source of capital Weights of capital costs
9% bond, 1000Birr par……. 0.30 ……… 0.054 ……………. 0.0162
50,000 shares, 8 Birr
Preferred Stock -------------- 0.10 -------- 0.080 ---------------- 0.0080
Common Stock, 400,000
Outstanding shares ---------- 0.40 -------- 0.110 ---------------- 0.0440
Retained earnings ----------- 0.20 -------- 0.105 ---------------- 0.0210
Total 0.0892

The total (sum) of weighted costs is equal to 0.0892 which means 8.92 percent. This is to
mean that Lemlem company is required to earn a minimum of 8.92 percent on its total
funds obtained form all long-term sources, if the company is to satisfy the minimum
requirements of its financers (such as bondholders, preferred stockholders, and common
stockholders).
The advantages of using book-value weights in computing a company’s weighted
average cost of capital are as follows:
1. The weighted average cost of capital (WACC) computation is as simple as book
values are available in the balance sheet of the company.
2. The computed weighted average cost of capital (WACC) using book value
weights is generally stable overtime because book value weights are not
dependent on market value which is highly volatile.
3. When the market values/prices of firm’s securities are being influenced by
external factors like inflation, book.
Value weights may provide the only usable estimates of the firm’s weighted average cost
of capital.
There are two principal limitations in using the book value weights for the computation
of weighted average cost of capital (WACC) .These are:

79
 1. Book values provide an historical (based on past data) weighted average cost of
capital that may not yield a cost-of-capital value that is useful for evaluating
current strategies.
2. Their use is not consistent with the concept contained in the definition of the
overall cost of capital of the business firm. That definition, as we have touched
upon, speaks of a minimum rate of rate of return needed to maintain the firm’s
market value, but the book value weights ignore market values. As a result, the
weighted average cost of capital of the firm that is determined on the basis of
book value weights can be used only to provide a quick estimate of the rate of
return that investors require form their firm. Otherwise, the weighted average
cost of capital calculated by using book value weights can’t reflect what is going
on in the market at present accurately.
5.3.2. Market value weights
A second approach of measuring weighted average cost of capital is to use the market
values of the firm’s securities as weights in the computational process. The resulting cost
of capital from this process reflects the rate of return currently required by investors
rather than the historical rate embodied in the firm’s balance sheet.
The computation of the weighted average cost of capital of a firm using the market value
weights requires you to go through the following four steps:
1. Find the market value of each financing sources, using the current market prices
of the securities.
2. Divide each of the market values by the total market values of all capital sources
in order to obtain the market value weight.
3. Multiply the specific costs of capital (already determined0 by their corresponding
market value weights (for example, the specific cost of capital of debts (bonds) is
multiplied by the market value weight of debts (bond) ). The resulting products
are the weighted costs.
4. Add the products (weighted costs) you have computed under step 3 above. The
sum of the products is what is called the weighted average cost, of capital (overall
costs of capital) (based on market values).
To illustrate, the computation of weighted average cost of capital of the firm using the
market values of the financing sources, assume the same information provided for
Lemelem company with the necessary market values for each sources which are observed
to be the following: Bond prices are 95 percent of their par values, preferred stocks are
100 Birr per share, and common stocks sell for 75 Birr per share.
The firs step is to determine the market value for each financing sources. The market
values for bonds, preferred stocks, and common stocks are available in the market at any
point in time since these are securities that are exchanged in the stock exchange markets.
But in countries, like ours, the market value for these securities are hardly available
because there is no a formally organized stock exchange market that sets prices for these
securities. Even if there exists the stock exchange market for these securities, the market
value is not available for retained earnings which are not securities but sources of firm’s

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funds. As you remember from our previous discussions, the specific cost of capital of
retained earnings was estimated on the basis of the specific cost of capital of common
stock. In the same way, the market value of retained earnings is derived from the market
value of common stock. The Market value of common stock is divided between common
stock and retained earnings in the same proportion of their book values.
The market values of each financing sources are:
(0.95) (15,000,000) = 14,250,000 for the bonds
(100) (50,000 shares) = 5,000,000 for the preferred stock
(75) (400,000 shares) = 30,000,000 for the common stock
49,250,000 for the total capital structure
Then, as stated above, the market value of common stock of 30,000,000 Birr is divided
between common stock and retained earnings on the bases of their book values in the
balance sheet. Their book values are 20,000,000 Birr for common stock and 10,000,000
Birr for retained earnings and 30,000,000 in total for both.

Thus, 20,000,000 x 30,000,000 = 20,000,000 Birr (the market value of common

30,000,000 stock allocated to common stock, and

10,000,000 x 30,000,000 = 10,000,000 Birr (the market value of

30,000,000 common stock allocated to retained
earnings.
The resulting market values and the market value weights computed from the market
values themselves are indicated below for the company.
Lemlem Company
Market values and their weights for the company’s capital structure
Source of capital Market value Market value weight
9% bond, 1000 Birr par ---------- 14,250,000 ---------------- 0.289
50,000 shares, 8 Birr preferred
Stock ------------------------------- 5,000,000 ----------------- 0.102
Common stock, 400,000 shares
Outstanding -------------------- 20,000,000 ---------------- 0.406
Retained earnings ------------ 10,000,000 ---------------- 0,203
Total 49,250,000 1,000
The market value weight for bonds of 0.289 is determined by determined by dividing the
market value of bonds (i.e. 14,250,000) by the total market values (i.e. 49,250,000). The
other market value weights are determined in the same manner.

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 Next to the determination of market value weights, these weights are multiplied by the
corresponding specific cost of capital of the financing sources and the resulting products
are added. The sum of 0.0898 or 8.98 percent which represents the company’s weighted
average cost of capital, computed by using market value weights as shown below.
Lemlem Company
Weighted Average cost of capital using market value weights
Source of capital Market value weight x specific cost = weighted
Cost

9% bonds, 1000 Birr par 0.289 0.054 0.0156

50,000 shares, 8 Birr Preferred stock 0.102 0.080 0.0082
Common Stock, 400,000
Shares outstanding 0.406 0.110 0.0447
Retained earnings 0.203 0.105 0.0213
Total 0.0898
Therefore, the average cost of capital that reflects the current conditions in the market is 8.98
percent for Lemlem Company.
The advantages of using the market value weights in computing a company’s weighted average
cost of capital are:
1. The use of market value weights is consistent with the concept of maintaining
market values in the cost-of-capital definition.
2. They provide current estimates of financers (investors) required rate of return,
which are more relevant than historical book value weights in evaluating current
capital budgeting alternatives.
3. To the extent that business firm has attained its targeted or desired capital
structure, market value weights will yield good estimate of cost of capital that
would be incurred in case the firm needs additional financing.
The limitations of using market value weights in computing cost-of-capital are:
1. Market value weights are more difficult to use in computing the overall cost of
capital of the firm than the book value weights which are readily available. It is
difficult not only to obtain the market value of the financing sources but also to
allocate the market value of the common stock between common stock and
retained earnings when the specific cost of capital of retained earnings is if the
selling costs (flotation costs) of common shares are insignificant and to be
ignored, the specific costs-of-capital of common stock and retained earnings are
the same and there is no need to allocate the market values of common stock
between the two.

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 2. Since the market values/ prices of the firm’s securities change daily, the market
value of the firm and its corresponding cost daily, the market value of value
weights also change daily of capital using market value weights also change daily
and highly instable to make use of them.
3. Market value weight can seriously distort the overall cost of capital of the
business firm when the prices of its securities are significantly influenced by
external factors/forces such as inflation. Inflation can depress bond prices
severely for a period of time. This has an effect of increasing the specific cost of
capital bonds beyond what it would have been. If market value weights are to
relied upon the computed weighted average cost of capital may have to be
adjusted subjectively for what have been thought to be distortions by external
forces.
4.4. Marginal Cost of Capital (MCC)
In the previous section, it was tried to analyze cost-of-capital when the firm’s total
financing remained constant. In reality, the desire of the firm to finance new investment
proposals using internal and/or external funds requires that the firm has to increase its
total capital base. When this happens the cost of capital of the additional financing is
called Marginal Cost of Capital (MCC). Thus, the marginal cost of capital, MCC, is
defined as the cost of the last Birr of new capital the firm raises, and this cost (i.e MCC)
rises as more and mo9re capital is raised during a given period. If the additional
financing uses more than one type of funds, such as a combination of retained earnings
and debts, the weighted average cost of capital of the new financing is called the
weighted marginal cost of capital.
4.4.1. Calculating the Marginal Cost of Capital
The firm’s marginal cost of capital (MCC) is a function of several variables. Because of
this, calculating the marginal cost of capital is often a difficult task that yields only
approximations of true is often a difficult task that yields only approximations of true
values. The four variables that impact on MCC do so by influencing the specific cost of
capital of the new financing sources. These variables are:
1. Investors may perceive that the firm’s business risk will increase as a result of new
investment decisions that require additional financing.
2. If new financing changes the percentage composition of the financing sources
(composition of capital structure), its financial risk may increase. Increases in
financial and business risks will be reflected in higher MCC.
3. The investment alternatives that are available and desirable to the firm may require a
large amount of financing relative to its existing total capital. In this case, the size
of the desired financing may increase the firm’s MCC and thus may reduce the
importance of some of the investment alternatives.
4. External forces such as inflation may increase the firm’s MCC to the point where it
delays raising long-term external capital and forcing the firm to finance its new
investment proposals with funds from retained earnings source.

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The Marginal Cost of Capital (MCC) calculation procedures followed in this material are
based on the following assumptions.
1. The new financing decision has a minimum impact on the existing capital decision
has a minimum impact on the existing capital structure of the firm. This
assumption implies that the percentage composition of new financing is specified
by the financial managers of the firms.
2. The second assumption is that the firm can reasonably forecast the specific costs
of capital of the new financing which are wither the same as the specific cost of
capital of the existing capital structure or total different. This implies the need for
some ability to estimate the impact of some added business risk and the external
variables on the specific cost of capital.
3. Market value weights are used. The choice of weights is based on the realizations
that new capital is obtained by paying the cost-of –capital which is a good estimate
of the current market price of capital that market value weights based MCC is
more relevant than the MCC that is computed on the basis of book values of the
existing capital structure.
4.4.2. Financing New Investment Proposal With Retained Earnings
When the business firm is able to finance its new investment alternative completely with
retained earnings the marginal cost of capital (MCC) equals the specific cost of capital of
retained earning.
To illustrate, suppose that the existing capital structure composition and specific costs of
capital of each financing source of Selam Share Company are as follows:
Source of Capital Percentage Composition Specific-cost-of-Capital
Bonds…………………….. 0.30 ………………………… 0.06
Common Equity (Common
Stock & retained earning).. 0.70 ………………….. …… 0.13
As it was discussed earlier, the weighted average cost of capital (WACC) for this capital
structure of Selam Share Company is:
(0.3) (0.06) + (0.70) (0.13) = 0.018 + 0.091 = 0.109, or 10.90%.
Assume also that Selam Share Company has decided to finance the new investment
proposal that requires a start-up cost of 2.5 million Birr entirely with funds retained
earnings source. The question here, is, “What is the cost of capital to finance new
investment proposal (MCC) by retaining form the earnings of the company during the
current year?”
Assume also that the given specific cost of capital are constant, the marginal cost of
capital (MCC) of additional financing is 13 percent which is the specific cost of capital of
retained earnings. Though the weighted average cost of capital (WACC) of the existing
capital structure of Selam Share Company is 10.9 percent the marginal cost of capital of
the additional capital is 13 percent because the financing of new investment proposal was
not made in the same pattern of the existing capital structure (i.e 30 percent bonds, and 70

84
percent common equity including both common stock and retained earnings). Rather the
additional capital requirement to finance the new investment proposal was raised 100
percent from retained earnings. Hence, the marginal cost of capital (MCC) of additional
financing of 2.5 million Birr is equal to the specific cost of capital retained earnings that
is 13 percent.
4.4.3. Financing New Invest Proposal with Constant Cost of Capital
If the specific costs of capital in the new financing equal the specific costs of the existing
capital structure of the firm, and if the new financing doesn't change the existing capital
structure proportion, then the marginal cost of capital equals the weighted average cost of
the existing capital structure of the firm.
To illustrate this case, assume the existing capital structure composition and the specific
cost of capital of each financing sources of Ture Share Company is as follows:
Percentage Specific Cost
Capital Source Composition of Capital
Bonds……………………………….. 0.10……………………………….. 0.05
Common Stocks …………………… 0.50 ………………………………. 0.10
Retained earnings …………………. 0.40 ……………………………… 0.09
The weighted average cost of capital (WACC) of the existing capital structure of Ture
Share Company is 9.1 percent computed as follows:
WACC = (0.10) (0.05) + (0.5) (0.10) + (0.4) (0.09)
= 0.005 + 0.05 + 0.036
= 0.091 or 9.1%
Ture Share Company proposes to finance a 4 million Birr capital project by using
retained earnings of 1.6 million Birr generated during the current the current accounting
period, by raising 400,000 Birr through bonds issues, and 2 million Birr through common
share issues. The company estimates the specific cost of capital of the new source of
funds and found that they are equal to the specific costs of the existing capital structure
for each capital sources. Of the total new financing each source provides the following:
Retained earnings: 16 million Birr / 4 million Birr = 0.40, or 40%
Bonds : 400,000 Birr/ 4million Birr = 0.10, or 10%
Common Stock : 2 million Birr/ 4 million Birr = 0.50, or 50%
The percentage composition of the new financing is the same as that of the percentage
composition of the existing capital structure (i.e. both of the capital structures, new and
existing, are formed from 10 percent bonds, 50 percent common stock, and 40 percent
retained earnings.) Therefore, the marginal cost of capital (MCC) under such conditions
(i.e. when the new financing decision doesn't entails any change in the composition of the
existing capital structure, and when the specific cost of capital of the new financing
sources are the same as that of the specific costs of capital in the existing capital

85
structure) is equal to the weight average cost of capital of the existing capital structure
(WACC), or it can be computed as:
The weighted MCC = (0.40) (0.09) + (0.10) (.0.05) + (0.50) (0.10)
= 0.036 + 0.005 + 0.05 = 0.091, or 9.10%
Thus, the weighted marginal cost of raising the additional 4 million Birr financing is
equal to the weighted average cost of the existing capital (i.e. before the new financing)
which is 9.1 percent. Here, you can make a general conclusion that:
 When the specific costs of capital of each source in the new financing are equal to
their corresponding specific costs of capital in the existing capital structure of the
firm, and
 When the new financing decision (additional fund raising decision) doesn't
change the composition of the existing capital structure of the firm, you can
conclude that the weighted cost of capital of additional (new) financing MCC, is
equal to the weighted average cost of capital of the existing capital structure
(WACC).
4.4.4 Financing New Investment Proposal with Constant Specific Cost of Capital
These are situations where the specific cost of capital will not be affected by the amount
of funds raised as we assumed the preceding examples. If the percentage composition of
new financing remain constant, and then the firm's weighted cost of capital remains
constant. When on the other hand, the weighted marginal cost of capital exceeds the
weighted average cost of capital of the existing capital exceeds the weighted average
cost of capital of the existing capital structure, raising additional funds will increase the
weighted average cost of the new capital structure (i.e. the capital structure of the existing
plus new financing). To illustrate the impact of a new financing with different weighted
marginal cost of capital (MCC) on the weighted average cost of capital (WACC) of the
existing capital structure, consider the current capital structure of Misrak Share Company
that contains a total of 50 million Birr and the following components.
Source of Capital Percentage Composition Specific cost of Capital
Bonds 0.25 0.055
Common Stock 0.50 0.110
Retained earnings 0.25 0.105

The weighted average cost of capital for this capital structure is:
WACC = (0.25) (0.055) + (0.50) (0.110) + (0.25) (0.105)
= 0.01375 + 0.055 +0.02625
= 0.095, or 9.5%
The company expects to generate 2 million Birr in retained earnings from current
operations. Total expenditures for the proposed capital investment of the company range
from 5 million to 10 million. In order to keep its capital structure composition constant,

86
realizing that 2 million Birr will be provided by retained earnings, the company would
have to raise exactly 8 million Birr in new capital as follows:
Bonds : 2 million Birr which constitute 25 percent
Common Stock : 4 million Birr which constitute 50 percent
Retained earnings : 2 million which constitute 25 percent
The specific cost of capital of raising the 8 million Birr is estimated as follows:
Source of capital Specific cost of capital
Bonds 0.06
Common Stock 0.12
Retained earnings 0.105
As you can observe the specific costs of capital of bonds and common stocks issues for
the new financing are slightly different from the specific costs of capital of bonds and
common stock issues in the existing capital structure (i.e. before the new financing).
Though the new financing doesn't change the company's existing capital structure
composition, the differences that exist between the specific costs of capital of bonds and
common stock for the existing and new capital of the company results in the weighted
marginal cost of capital (MCC) that is different from the weighted average cost of capital
of the existing capital structure (WACC).
The weighted marginal cost of capital (MCC) of raising the additional funds of 8 million
Birr to finance the newly proposed investment alternative is:
Weighted MCC = (0.25) (0.06) + (0.50) (0.12) + (0.25) (0.105)
= 0.015 + 0.06 + 0.02625
= 0.1013 or 10.13%
Therefore, Misrak Share Company has to pay an average cost of 10.13 percent, or about
10 cents on each Birr, on the additional 8 million Birr its needs to rise to finance the new
capital investment proposal, which is greater than the weighted average cost of capital of
the existing capital structure, 9.5 percent.
If Misrak share company raises the additional 8 million Birr funds as per the indicated
composition (i.e. 25 percent from selling bonds, 50 percent from issuing common shares
and the remaining 25 percent from retaining earnings), the weighted average cost of
capital of the new 58 million Birr (i.e. 50 million existing capital plus 8 million Birr from
additional financing) capital structure is 9.59 percent as computed below.
Source of Capital Birr Amount Percentage Composition x Specific Cost =
Weighted Cost
Bonds (existing)…… 12,500,000 0.2155 0.055
0.0119
Bonds (new)………. 2,000,000 0.0345 0.060
0.0021

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Common Stock
(existing)……….. 25,000,000 0.4310 0.110
0.0474
Common Stock (new) 4,000,000 0.0690 0.120
0.0083
Retained earnings
(existing) 12,500,000 0.2155 0.105
0.0226
Relined earnings(new) 2,000,000 0.0345 0.105
0.0036
Total 58,000,000 1,0000 WACC
0.0959

Therefore, the new financing of 8 million Birr with its associated weighted marginal cost
of capital of 10.13 percent has increased the weighted average cost of capital (WACC)
from 9.5 percent to 9.56 percent. Assume further that the research conducted by Misrak
Share Company indicates that the additional 2 million Birr need to finance the entire 10
million Birr of the proposed capital investment could be raised by issuing additional
common stock without changing its specific cost from 12 percent. The weighted
marginal cost of capital (MCC) of raising the 10 million is different from the weighted
marginal cost of capital of raising 8 million Birr in the new financing, and it would be:
Source of Capital Birr Amount Percentage Composition
Bonds 2,000,000 0.20
Common Stock 6,000,000 0.60
Retained earnings 2,000,000 0.20
Total 10,000,000 1.00
Hence, the r=weighted marginal cost (MCC) of raising the 10 million Birr in the new
financing is:
= (0.2) (0.026) + (0.6) (0.12) (0.2) (0.105)
= 0.012 + 0.072 + 0.021
= 0.105, or 10.5%
Again the marginal cost of capital is different from the weighted average cost of the
existing capital structure (50 million Birr existing capital structure) which is only 9.5
percentages.
If Misrak Share Company raises the entire 10 million Birr as indicated above, the
weighted average cost of capital of the new 60 million Birr capital structure (i.e. 50
million Birr existing capital plus 10 million Birr new financing) then becomes:
Percentage Specific cost Weighted

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Source of Capital Birr Amount Composition of capital cost
Bonds (existing)…. 12,500,000 0.2083 0.055 0.0115
Bonds (new) ……. 2,000,000 0.0333 0.060 0.0020
Common Stock
(existing)……… 25,000,000 0.4167 0.110 0.0458
Common Stock(new). 6,000,000 0.1000 0.120 0.0120
Retained earnings
(existing)……….. 12,5000,000 0.2083 0.105 0.0219
Retained earnings(new) 2,000,000 0.0333 0.105 0.0035
Total …………. 60,000,000 1.0000 WACC 0.0967
The weighted average cost of capital (WACC) of the company increases from 9.5 percent
to 9.67 percent as a result of its 10 million Birr additional financing. The percentage
composition of its capital structure also changes and is now:
Source of Capital Birr Amount Percentage Composition
Bonds ……………………. 14,500,000 0.24
Common Stock…………… 31,000,000 0.52
Retained earnings………… 14,500,000 0.24
Total………………….. 60,000,000 1.00
In this illustrative example, the company’s weighted marginal cost of capital is 10.13
percent for 8 million Birr financing and 10.5 percent for 10 million Birr financing eve
though the specific costs of capital remain constant for both amounts of additional
financing decisions. This increase in the weighted MCC occurs because the percentage
composition of each financing package is different. Hence, in evaluating the capital
investment proposal of 8 million Birr, the financial analyst has to use a discount rate
(MCC) of 10.13 percent. Similarly, the discount rate for evaluating the 10 million Birr
capital investment proposal is the 10.5 percent, which is again the corresponding MCC.

Chapter 5
Capital Budgeting Project Evaluation Techniques:

6.1. INTRODUCTION

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Long-term investments are also called capital budgeting. The term capital according to
Weston and Brigham, 1985, refers to the fixed assets used in production, while a budget
is a detailed plan of projected cash flows during some future period. Thus, the capital
budget of the firm outlines the planned expenditures of the fixed assets, and capital
budgeting is the whole process of analyzing projects whose returns are expected to
extend beyond the period of one year and deciding which project should be included in
the capital project. Capital budgeting expenditures include expenditures for land,
building, equipment, and for permanent additions to working capital associated with plant
expansion, for advertising and promotion campaigns, and for research and development
programs.
The optimum capital budget is simultaneously determined by the interaction of supply
and demand forces under conditions of uncertainty. The forces of supply refer to the
supply of capital to the firm, or its cost of capital schedule. The forces of demand on the
other hand, refer to the investment opportunities available for the firm, as measured by
the stream of revenues that will result from an investment decision. Uncertainty of
conditions enters the decisions because it is impossible to know exactly either the cost of
capital or the stream of revenues that will be derived from a project.
6.1.1. Importance of Capital Budgeting
The following are some of the importance of capital budgeting:
1. It has along-term effects. The result of capital budgeting decisions continues
over an extended period. This enables the firm to be competitive in the market
by keeping its existing customers.
2. Effective capital budgeting will improve both the timing of assets
acquisitions and the quality of the acquired assets. Capital assets must be
ready at the time they are needed. If the firm forecasts its demand properly and
plans its required capacity increases, it will be able to maintain its market, (even
to obtain a larger share of the market). A firm, which forecasts its capital assets
requirements in advance, will have the opportunity to purchase and install the
asset before its sales exceeds its capacity.
3. Capital budgeting enables the firm to raise funds early before the sales
approach the maximum capacity levels. Before the firm spends a large
amount of money, it must take the proper plans. Large amounts of funds are not
available over night. A firm that contemplates a major capital expenditure
program may need to arrange its financing several years in advance to be sure of
having the funds required for the program.
6.1.2. Approaches to Capital Budgeting
A systematic approach to capital budgeting requires the following procedures to follow:
1. The formulation of long-term strategy and goals
2. The creative search and identification of new investment opportunities
3. The estimation and forecasting of current and future cash-flows

90
 4. A set of decision rules that can differentiate acceptable from unacceptable
alternatives.
5. The building of suitable administrative framework that is capable of
transferring the required information to the decision level.
6. The controlling of expenditures and the careful monitoring of project
implementation.
If financial managers undertake all the 6-steps under the capital budgeting approach, they
are able to make effective capital budgeting decisions.
1. Formulation of Long-term Goals
Long-term goals serve as the guide for managerial decisions. A systematic approach to
capital budgeting decisions, thus, requires the formulation of a set of long-term goals.
Management will be concerned with both the expected returns and the risks assumed on
its capital investment.
2. Generating Investment Proposals (Ideas)
A good investment proposal is not just born; some one has to suggest it. In addition,
someone within the firm must be willing to listen to such proposals. In the absence of
creative search for new investment opportunities, even the most sophisticated evaluation
techniques may be worthless. In a firm with well equipped research and development
division, sophisticated new products, or processes are created by the division. In a small
firm, the search for investment possibilities may be less structured. It often takes the
form of employee suggestion box, or informal discussions during a coffee break.
The search for opportunities should include the acquisition of existing production and
marketing facilities by means of a merger with another company, as well as, the
expansion of the company's own facilities or the creation of an entirely new division.
The long-term investment proposals may be classified as follows:
a) Replacement (Maintenance of Business): This refers to the expenditures
necessary to replace worn out or damaged fixed assets of the business firm.
b) Replacement (Cost Reduction): It refers to expenditures that are made to replace
serviceable but obsolete (outdated) equipments in order to lower the cost of labor,
materials, or other items such as electricity.
c) Expansion of Existing Products or Markets: These are expenditures necessary
to produce new product or to expand into a geographic area not currently being
served.
d) Safety and/or Environmental Projects: These are expenditures necessary for
complying with government orders, labor agreements, and insurance policy terms.
These expenditures are often called mandatory investments, non-revenue
producing investment.
In general, capital budgeting projects can be classified into three categories:
A. Cost Reduction Projects:

91
These projects are intended to reduce the firm's operating costs such as cost of labor,
materials electricity and so on. Cost reduction is achieved through the replacement of
plants or fixed assets. The benefit from cost reduction projects is cost savings.
B. Revenue Expansion Projects:
The main purpose of these projects is to increase the volume of sales (revenue) through
the increased level of output of the existing product, expanding product distribution
outlets the markets current served, introducing new products (product development,
expanding (searching) the market into new geographical areas (market development),
and/or introducing new products for new markets (diversification). The benefits are
realized in the form of increased net cash inflows.
C. Non-Revenue Producing (Mandatory) Investments:
These projects are safety and/or environmental protection projects are safety and/or
environmental protection projects that are necessary for complying with government
orders, labor agreements, or insurance policy terms.
3. Forecasting Cash Flows
Once the investment proposals are identified, the next step is to forecast the cash flows
(for revenue expansion or cost saving projects). This is accomplished by determining
expected revenues and costs for each project. Even though the timing and size of future
cash flows usually remain uncertain throughout the budgeting process, the proper
estimation of the cash flows is vital. In the analysis of capital budgeting decisions, annual
cash flows are used instead of the accounting profits. Cash flows and accounting profits
can be very different because accounting profits include non-cash revenues and non-cash
expenses.
In fact, accounting profits are important, but cash flows are often more important for the
purpose of setting a value of a firm. In the entire capital budgeting procedures, probably
nothing is of greater importance than a reliable estimate of the cost savings of revenue
increase that will be achieved from the prospective outlays of capital funds. All the
subsequent analysis's we will discuss in this chapter are based on the cash flow figures
not the accounting profit figures. All the capital budgeting analyses are as successful as
the data input you are using. Capital budgeting procedures are performed by the group of
experts such as engineers, accountants, economists, cost analysts, and other qualified
persons. The method of determining the cash flows of the project will be discussed in
this chapter later.
4. Ranking Investment Proposals
This activity involves the setting of decision rule(s) that help us to differentiate projects
that are acceptable and unacceptable. Then, we choose and/or make decision to accept
the project alternative that is ranked first as it will maximize the value of the firm. The
main objective of the financial manager while undertaking capital budgeting is to answer
the following questions:
1. Which of the several mutually exclusive investment alternatives have to
be chosen for implementation? and

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 2. How many independent projects, i.e. projects that are not mutually
exclusive, have to be accepted?
Different techniques are used to rank and choose among many project alternatives. Some
of these techniques are the payback period, the accounting rate of return, the net present
value method, the internal rate of return, and the profitability index. Each one of these
techniques will be discussed in detail in Chapter 15 of this text book.
5. The Administrative Framework
Capital budgeting is a multi-dimensional activity that demands a high degree of
cooperation among various departments. The final approval of major capital
expenditures, however, rests on the shoulders of the board of directors of the company.
6. The Post-Completion Audit (Monitoring)
This step pertains to implemented project alternative(s). The post-completion audit
involves careful monitoring of project implementation and is a necessary managerial tool.
A careful analysis of deviations of actual performance from planned levels enables to
take feedback and may prevent poor performance history from repeating itself in future
projects. The post-completion audit can be a better and rewarding experience for
decision makers. The post-completion audit has two principal objectives. These are to
improve the accuracy of forecasts and to improve the firm’s operations.
6.1.3. Assumptions that underlie Capital Budgeting
A number of assumptions must be introduced in order to concentrate on the managerial
aspect of capital budgeting. The effect of these assumptions is to exclude non-financial
considerations and to remove some complications that obscure the major points under
capital budgeting. These assumptions constitute a general set of conditions within which
the financial aspects of long-term alternatives can be evaluated. You can use any one of
the capital budgeting/cash flow evaluation/ criteria and techniques presented in the next
chapter only when the following assumptions are fulfilled:
 Shareholders' Wealth Maximization is the Basic Motive of Capital
Budgeting Decision. All capital budgeting alternatives considered here are
accepted or rejected on the basis of their effect on shareholders' wealth. No other
company's goals influence the investment selection decisions.
 Costs and Revenues are known With Certainty. The costs and revenues
associated with each investment alternative are known with certainty, or there
exists a forecasting technique that can generate the values with a very small error.
It may be very difficult to estimate revenues and costs more than two or three
years into the future. However, if a proposed investment has a ten year economic
life, accurate forecasts must be available for all ten years.
 Inflows and Outflows of Cash Occur once a Year. This assumption is
important in order to compute the present and future values of cash flows,
because capital budgeting criteria use discounting techniques. Cash inflows or
outflows are assumed to occur only once a year (i.e. either at the end of a given
year or at discrete yearly intervals. Hence, compounding and/or discounting
occur only once a year.

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  Inflows and Outflows are based on Cash. The data required for evaluating
investment proposals must be stated in cash as opposed to the accounting income.
This is because of the fact that the company uses cash to pay its bills and to pay
cash dividends on common and preferred stock. If the business firm does not
generate cash returns from its investments, it will sooner or later become
insolvent.
 Cash Flows Exhibit a Conventional Pattern. The fund that is required to
undertake an investment represents inflows to the company, and the returns from
the investment represents outflows from the company. If we represent the cash
outflows with the minus "-" sign and the cash inflows with the plus "+" sign,
then the conventional cash flows under capital budgeting is defined as the time
series of cash flows that contains only one change in sign. For example, if an
investment alternative has one cash outflow followed by three cash inflows can
be represented as: -, +, +, +. This is considered to have a conventional cash
flow pattern. Investment alternatives are assumed to exhibit conventional cash
flows. Evaluating an investment alternative that violates this assumption can
become very difficult.
 The Required Rate of Return is known and constant. The required rate of
return is generally looked at as the minimum rate of return that the company must
earn if shareholders' wealth is not to decrease. Here, the minimum required rate
of return on investment alternatives is assumed to be known and constant over
the life of the proposed investment. Arriving at the required rate of return is
important for two reasons:
1. If the rate is too high, the company will end up in rejecting quite
profitable projects, and
2. If the rate is too small or low, the company will end up in accepting
projects that are not profitable and decrease shareholders wealth.
 Capital Rationing doesn't exist. Whenever a company is not able to finance its
entire capital budgeting (investment), capital rationing is said to exist. In such a
situation, some investments will have to given up. The cash flow evaluation and
accept/reject decisions to be made in the next chapter considers that there is no any
capital problem or limitation. However, capital rationing or capital shortage does
contain important implications for financial managers. Chapter 15 also discusses
capital budgeting decisions when rationing exists.
6.2. Parts of Investment and Cash Flow Concept
Investment has been defined as a long-term commitment of economic resources made
with the objective of producing and obtaining net gains in the future. The conventional
methods of investment appraisal basically evaluate the expected net profit (sales income
less costs and incomes taxes) against the capital invested. For the purpose of investment
appraisal, it is necessary to assess and evaluate over a certain period, all inputs required
and all outputs produced by the project. That is why the concept of cash flows is
developed.

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In this regard, the cash-flow concept is needed for planning of the flow of financial
means, in other words, the sources and application of funds. The appraisal of long term
investments is made in terms of cash flows that occur at different stages in the capital
budgeting process. Literally, there are three parts of cash flows in long-term investments.
These are:
1. The initial investment. The initial investment is an outlay of cash that takes
place at the beginning of the life of the project.
2. The operating cash flows. The operating cash inflows from revenue sources
and the cash outflows for different expenditures.
3. The terminal cash flows. These are the cash inflows and outflows that take
place at the end of the project life.
In addition, the discounted cash-flow concept has become the generally accepted method
for investment appraisal. The basic assumption underlying the discounted cash-flow
concept is that money has a time value, in so far as a given sum of money available now
is worth more than an equal sum available in the future. One Birr today is more valuable
than one Birr a year hence. This is because:
 Individuals, in general, prefer current consumption to future consumption.
 Capital can be employed productively to generate positive returns. An
investment of one Birr today would grow to (1 + r) a year; where (r is the rate
of return earned on the investment).
 In an inflationary period, one Birr today represents a greater real purchasing
power than one Birr a year after.
Many financial problems involve cash flows occurring at different points of time. For
evaluating such cash flows an explicit consideration of time value of money is required.
This difference can be expressed as a percentage rate indicating the relative charge for a
given period, which is usually a year. Considering a project may obtain a certain amount
of funds “F”, if this sum is repaid after one year including an agreed interest “I”, the total
sum to be paid after one year would be (F + I), where:
F + I = F (1 + r)
And r is defined as the interest rate (in % per year) divided by 100. If the interest rate is,
for example, 12%, then r equals 0.12.
Suppose that “CFn” is the nominal value of a future cash flow in the year “n”, and
“CFpv” is the value at the present time (present value) of this expected inflow or
outflow, then (assuming r is constant):
n
CFpv = CFn/ (1 + r) or
CFpv = CFn (1 + r) –n
The general formula for the future value of a single amount is:
FV = PV (1+k) n
Where: FV = Future value after “n” years
PV = Amount today (present value)

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 K = Interest rate per year
n = Number of years for which compounding is done.
6.3. Fundamentals of Cash Flow Projection
6.3.1. General
 Estimating cash flows: Estimating project cash flows, i.e. investment outlays and
subsequent cash inflows after the project is commissioned, is the most important
but also the most difficult step in capital budgeting.
 Forecasting project cash flows involves numerous variables and different
professionals may participate in this exercise.
 Capital outlays are estimated by engineering and product development
departments.
 Revenue projections are provided by the marketing group.
 Operating costs are estimated by production people, cost accountants,
purchase managers, personnel executives, tax experts, and others.
 The role of the finance manager is to:
 Coordinate the efforts of various departments and obtain information from
them,
 Ensure that the forecasts are based on a great deal of consistent economic
assumptions,
 Keep the exercise focused on relevant variables, and
 Minimize the biases inherent in cash flow forecasting.
6.3.2. Elements of the Cash Flow Stream
To evaluate a project, you must determine the relevant cash flows, which are the
incremental after tax cash flows associated with the project.
A. Cash Flow Stream
i. Initial investment cash flows:
Includes the after tax cash outlays on capital expenditures and net working capital when
the project is set up.
 Leasing of land
 Machinery, equipment, tools, etc
 Installation, testing, and start-up costs
 Additional investment in NWC.
[NB. Often government units encourage investors by providing various investment
incentives. One of these incentives is the investment tax credit that is netted against the
initial investment outlay, since it is an inflow to the firm.]
ii. Operating Cash Flows:

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 The after tax cash inflows resulting from the operations of the project during its
economic life are called operating Cash Flows. The net operating cash flows could be
positive or negative. If we assume conventional cash flow pattern, the net operating
cash flow will be positive.
iii. Terminal Cash Flows:
The after tax cash flows resulting from the termination of the project and the disposal of
its assets at the end of its economic life.
 Salvage proceeds from disposal of assets net of tax (inflow)
 Recovery of net working capital (inflow)
 Liquidation and disposal costs (outflow)
 Tax paid on gain on disposal of old assets (outflow)
 Tax saving/tax shield due to loss on disposal of old assets ( benefit/treated as
an inflow)
B. Time Horizon for Analysis
The time horizon for cash flow analysis is generally the minimum of the following:
i. Physical life of the machineries and equipments/Technical life of plant Asset
 Period during which the plant remains in a physically usable condition
 The number of years the machineries & equipments in the plant would
perform the functions for which they had been acquired
 It depends on the wear and tear which the plant is subject to
 Suppliers of the plant’s machineries and equipments may provide information
on the physical life under normal operating conditions
 While the concept of physical life may be useful for determining the
depreciation charge, it is not very useful for investment decision making
purposes
ii. Technological life of the machineries and equipments in the plant
 New technological developments tend to render existing machineries and
equipments in the plant obsolete.
 The technological life of a plant refers to the period of time over which the
present plant would not be rendered obsolete by a new plant.
 It is very difficult to estimate because the pace of new developments is not
governed by any law. Yet, an estimate of the technological life has to be
made.
iii. Product Market life of the plant (Product Life Cycle):
 A plant may be physically usable, its technology may not be obsolete, but the
market for its products may disappear or shrink and hence, its continuance may
not be justified.

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  The product market life of a plant refers to the period over which the product of
the plant enjoys reasonably satisfactory market
iv. Investment Planning Horizon of the firm:
It refers to the time period for which a firm wishes to look ahead for purpose of
investment analysis. It naturally tends to vary with the complexity and size of the
investment. For Example, the following rough estimate can be used:
 Small investment, (Replacement decisions), may be 5 years
 Medium size investments, (Expansion of plant capacity), may be 10 years
 Large size investment, (Setting up a new division), may be 15 years
6.3.3. Basic Principles of Cash Flow Estimation
1. Principle of Cash Flow
Project evaluation should be based on its cash flows instead of accrual income
measurement concept.
Rationale:
 It is cash that can be reinvested in other projects.
 The accounting data (i.e. income) is difficult to understand because it is full of
technical jargons.
 Different accounting approaches & treatments would result in different net income
figures even in the absence of differences in operations.
2. Financial Cost Exclusion principle
There are two sides of a project: the investment (or asset) side and the financing side.
The cash flows associated with these sides should be separated.
Projects

Investment side Financing Side

side outflows
Investment Financing inflows (Funds)
Return on investment Financing costs & expenses
(outflows)
[It is an inflow] [Included in the cost of
capital]
Note that the cash flows on the investment side of the project should exclude financing
costs and expenses (i.e. interests & dividends).The financing costs are included in the
cash flows on the financing side and reflected in the cost of capital. In this regard, the
cost of capital is the hurdle rate with which the rate of return on the investment side will
be judged or evaluated. Since the financing costs are included in the cost of capital, any

98
inclusion of these costs in the investment cash flows will result in double counting of
costs.
Therefore, while defining the cash flows on the investment side, financing costs should
not be considered because they are already reflected in the cost of capital figure against
which the rate of return figure will be evaluated. If interest is deducted in the process of
arriving at profit after tax, an amount equal to “Interest X (1-Tax rate)” should be added
to the “profit after tax”. Below is the adjustment to be made on the after tax operating
profit:
EBIT (1 – T) = Operating Profit After Tax (OPAT)
(EBT + Interest) x (1 – T) = Adjusted Operating Profit After Tax /PAT
(EBT)(1-T) + Interest (1-T) = PAT ; [Note that EBT x (1-T) = EAT]
EAT + Interest (1-T) = Adjusted Operating Profit After Tax (or Operating Earning After Tax)
[Note that the after tax balance of interest is added back as per the adjustment because
the tax advantage from paying interest, i.e. the tax shield, is already considered in the
computation of the net cost of debt capital.]
3. Incremental principle
The cash flow of a project must be measured in incremental terms. Look at what happens
to the cash flows of the firm with and with out the project:
Project cash Flows = Cash Flows for the firm – Cash Flows for the
for year (t) with the project for firm without the
[Incremental cash flows] Year (t) project for year
(t)
Guidelines:
A. Consider all Incidental effects
In addition to the direct cash flows of the project, all its incidental effects on the rest of
the firm must be considered. The project may enhance the profitability of some of the
existing activities of the firm because it has a complementary relationship with them or it
may detract from the profitability of some of the existing activities of the firm because it
has a competitive relationship with them. Such incidental effects should be taken in to
account.

B. Ignore sunk costs

A sunk cost is an outlay already incurred in the past or already committed irrevocably.
Sunk costs cannot be recovered and hence, are not relevant. So, it is not affected by the
acceptance or rejection of the project or do not influence the project related decisions.
Sunk costs are not differential, i.e. they do not vary among alternatives.
C. Include Opportunity costs

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If a project uses resources already available with the firm, there is a potential for an
opportunity cost. It is a cost created for the rest of the firm as a consequence of
undertaking the project. The opportunity cost of a resource is the benefit forgone that
would have been derived from it by putting it to its best alternative use. That is, the
resource might have been rented out, sold, or required else where in the firm
D. Estimate working capital properly
Apart from fixed costs, a project requires working capital investment. Outlays on
working capital have to be properly considered while forecasting the project cash flows.
Working capital (or more precisely, net working capital) is defined as:
[Current assets] - [Current liabilities]
The requirement of working capital is likely to change over time.
 While fixed asset investments are made during the early years of the project and
depreciate overtime, working capital is renewed periodically and hence, is not
subject to depreciation
 Thus, the working capital at the end of the project life is assumed to have a
salvage (or recovery) value equal to its book value. Sometimes, the net working
capital may not be fully recovered due to uncollectible balances.
E. Post – Tax Principle
Cash flows should be measured on an after-tax basis. Some firms may ignore tax
payments and try to compensate this mistake by discounting the pre-tax cash flows at a
rate higher than the cost of capital of the firm. Since there is no reliable way of adjusting
the discount rate, you should always use after – tax cash flows along with after tax
discount rate.
F. Treatment of losses
Because the firm as well as the project can incur losses, let us look at various possible
combinations and the ways to deal with them:
Scenario Project Firm Action
1 Losses Losses Defer tax savings
2 Losses Profit Take tax savings in the year of loss
3 Profits Losses Defer taxes until the firm makes profit
4 Profits Profit Consider taxes in the year of profit
Stand Alone Losses _ Defer taxes savings until the project makes profits
G. Effect of Non-Cash Charges
Non cash charges can have impacts on cash flows if they affect tax liability, for example,
depreciations. Tax benefit of depreciation is computed as: [Amount of Depreciation x
Tax rate]
H. Consistency Principle

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Cash flows and the discount rates applied to these cash flows must be consistent with
respect to the investor group & choices for valuation.
i) Investor group:
Case 1: The cash flow available to all investors after paying taxes and meeting
investment needs of the project. Cash flow to all investors is computed as:

= EBIT (1 – T)
+ Depreciation/other non-cash charges
Case - Capital expenditures 2: The cash flow of a project
from the point of view equity
share - Changes in net working capital holders is the cash flow
available to equity share holders after paying taxes, meeting investment needs, and
fulfilling debt related commitments.
Cash flow to equity shareholders = Profit After Tax (PAT)
+ Depreciation & other non cash charges
- Preference dividend
- Capital expenditures
- Changes in net working capital
- Repayment of debts
+ Proceeds from debt issues
- Redemption of preference capital/stocks
+ Proceeds from new preference issues

The discount rate must be consistent with the definition of the cash flow.
Cash Flow Discount Rate
Cash flow to all investors Weighted average cost of capital (WACC)
Cash flow to equity holders Cost of equity capital
ii. Choices:
Incorporate expected inflation in the estimates of future cash flows and apply a nominal
discount rate to the same .Or else, estimate the future cash flows in real terms and apply a
real discount rate to the same.
Relationship between nominal and real values:
Nominal Cash Flow (t) = Real cash flow (t) x (1 + Expected inflation rate) t
Nominal discount rate = (1 + Real discount rate) x (1 + Expected Inflation rate) –
1
Therefore, a match should also exist between the type of the cash flow and the discount
rate used.

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 Cash Flow Discount Rate
Nominal cash flow Nominal discount rate
Real cash flow Real discount rate
Generally, in capital budgeting analysis, nominal cash flows are estimated and nominal
discount rates are used.
6.4. Determining Project Cash Flows
6.4.1. Component Cash Flow Determination
1. Net Initial Investment (NINV):
The net initial investment, (NINV,) in a project is defines as the project’s initial net cash
outlays, that is, the outlays at time period zero/now. It is calculated using the following
steps:
Step 1: The new project cost plus any installation and shipping costs, import
tariffs, and other costs associated with acquiring the asset and putting it in to
service,
[The asset cost plus installation and shipping costs from the basis up on which
depreciation is computed]
Plus
Step 2: Any increase in Net working capital initially required as a result of the
new investment,
Minus
Step 3: Gross proceeds from the sale of existing assets, i.e. selling price of old
assets, when the investment is a replacement decision,
[This normally is computed as the actual salvage value of the asset being replaced
less any costs associated with physically removing or selling it].
Plus or minus
Step 4: Taxes associated with the sale of the existing assets,
[Taxes associated with gain on disposal of the old asset or tax savings due to loss
on disposal. The total tax effect may be either positive or negative, that is why it
is either added to or subtracted from the new project cost].
2. Net (Operating) Cash Flows (NOCFs)
The process of estimating incremental cash flows associated with a specific project is an
important part of the capital budgeting process. Capital budgeting is concerned primarily
with the after tax (net) operating cash flows, (NOCFs), of a particular project, or change
in cash inflows minus change in cash outflows.
For any year during the life of a project, the NOCF may be defined as the change in
operating earnings after taxes, (∆OEAT), plus the change in depreciation, (∆

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Depreciation), minus the change in the net working capital investment required by the
firm to support the project, (∆ NWC).
NOCF= ∆OEAT +∆ Depreciation - ∆ NWC
Operating earnings after tax, (OEAT), differ from earnings after tax, (EAT), because
OEAT does not consider interest expenses in its calculations. Net Operating Cash Flows,
NOCFs, as used for capital budgeting purposes, normally do not consider financing
charges, such as interest, because these financing charges will be reflected in the cost of
capital that is used to discount project cash flows.
In years when a firm must increase its investment in net working capital (NWC)
associated with a particular project, this increased investment in NWC reduces NOCF.
Normally, however, at the end of the life of the project, the NWC investment
accumulated over the life of the project is recovered (for example, as inventories are sold
and accounts receivable are collected). Thus, ∆ NWC is negative (a reduction) at the
operating stage. If a decline in the net working capital is expected over the life of the
project, the effect would be to increase the NOCF of the project, however.
Thus, the NOCF of a project is computed as follows:
Change in Revenue -------------------------------------------------------- ∆R
Less: Change in operating costs---------------------------------------- – ∆OC
Change in depreciation---------------------------------------- – ∆
Depreciation
Equals: Change in Operating earnings before tax ------------------- ∆ OEBT
Less: Taxes---------------------------------------------------------------- – T (∆OEBT)
Equals: Change in operating earnings after tax -------------------- ∆OEAT
Plus: change in depreciation-----------------------------------------------
+∆Depreciation
Less: Change in Net working capital (Increase) ------------------------ – ∆NWC
Equals: Net operating cash flow (Annual)------------------------------- NOCF
[NB. ∆ NWC can occur as part of the net investment at time zero (0) or at any time
during the life of the project. Furthermore, the NOCF of the final year of the project is
characterized by cash flows associated with disposal of old assets of the project and
recovery of the cumulative NWC].
In this regard, the disposal price of the old assets and the associated gain or loss would
affect the amount of the after tax cash proceeds obtained.
Cases
 Old assets are sold for more than their original cost. The amount in excess of
the original cost is treated as capital gain and hence, taxed at capital gain tax
rate. The amount in between original cost and book value is taxed at ordinary
tax rate.

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  Salvage proceeds (selling price) of the old assets is less than the current book
value. The loss incurred would reduce the taxable income and brings a tax
saving, which is an implicit cash inflow to be recognized. The NOCF should
include the salvage proceeds plus the tax saving arise.
 Salvage proceeds (selling price) of the old assets is equal to the current book
value. There will be no gain or no loss and hence, only the salvage proceeds
will be included as an inflow of cash.
6.4.2. Summary of Project Cash Flow Determination
1. Investment Phase: Determination of net initial investment (NINV):
A. New project case:
NINV= Cost of project + Investment in NWC
- Investment tax credit
B. Replacement (Cost Reduction) projects:
NINV = Cost of replacement assets - Net disposal proceeds of old assets
Where: Net disposal proceeds = Selling price of OA – Taxes on gain on
disposal
Or Selling price of OA + Tax savings (shield) on loss on
disposal
[In general, replacement projects do not require additional investment in net working
capital].
C. Expansion projects:
NINV= Cost of New Assets + Increase in NWC
- Net disposal proceeds on OA
2. Operating Phase: Determination of net operating cash flows (NOCFs):
New project Replacement or Expansion
Case 1 Case 2 Case 1 Case 2
Revenue Revenue ∆ Revenue ∆ Revenue
- Operating costs - Operating costs - ∆Operating - ∆Operating costs
costs
- Depreciation - Depreciation - ∆Depreciation
- ∆Depreciation
EBIT EBIT ∆EBIT ∆EBIT
- Interest - - Interest -
EBT OEBT ∆ EBT ∆ OEBT
- Tax - Tax - ∆Tax - ∆Tax
= EAT = OEAT = ∆EAT = ∆OEAT

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Adjustments: Adjustments: Adjustments: Adjustments:
+ Depreciation + Depreciation + ∆Depreciation + ∆Depreciation
+ Interest (1-T) __ + Interest (1-T) -
- ∆NWC - ∆NWC - ∆NWC -
(Expansion) ∆NWC(Expansion)
∆NOCF ∆NOCF ∆NOCF ∆NOCF

[Note: Case 1 here shows the process of adjustment needed in the determination of
project cash flows if interest is initially deducted as an expense; and Case 2 shows
the adjustment if interest charges were not deducted. T is the tax rate and the after
tax balance of interest is obtained by multiplying it by (1 – T)].
3. Termination Stage:
Terminal Cash Flows = NOCF of the final year
Add: + Recovery of NWC
Net disposal + Selling price of old assets
proceeds from old
+ Tax savings on loss on disposal, or
assets
- Additional taxes on gain on disposal
+ Tax savings on bad debt losses/uncollectible accounts/, if any

This topic is concerned with the ranking of projects for the decision of whether or not
they should be accepted for inclusion in the capital budget. It is assumed that projects to
be covered in this topic are equally risky. All cash flows are assumed to occur at the end
of the designated year. Generally, the project evaluation techniques are classified into
two categories. These are:
1. The Traditional Criteria (technique)
They are called the traditional techniques because they do not consider the time
value of money concepts in ranking investment proposals. Two methods are
included under the traditional technique, namely the payback period and the
accounting rate of return.
a) The payback period: - The payback period is the number of years that is
required for the business firm to recover from the project the amount of the
initial investment in total. If the cash flows from the project are in an annuity
form, the payback period can easily be determined by dividing the initial
investment by the annual cash flow in the annuity. That is,
Payback period (in years) = Initial investment
Annual Cash flows
When the cash flows from the project are not in an annuity, the payback period is
computed as follows:

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Payback period = year before full recovery + Un recovered cost
Annual flow during the next year
To illustrate the computation of the payback period when the cash flows from the project
is an annuity form, suppose the project requires an initial investment of 24,000Birr and
the annual after-tax cash flows of 6,000 Birr for five years. The payback period is,
therefore,
Pay back period = 24,000/6000 = 4 years
This is to mean that the initial investment amount of this particular project will be
recovered with in the first four years of the project life (i.e. 6,000 for four years is
24,000).
To illustrate the computation of the payback period when the cash flows from the project
are not in an annuity form, assume the project requires an initial investment of 60,000
Birr. The after-tax cash flows from the project are 8,000Birr during year 1, 15,000Birr
during year 2 22,000Birr during year 3, 20,000Birr during year 4, and year 5 each. Here,
the cash flows are not uniform. In this case, we first need to compute the cumulative.
Year Annual Cash flow Cumulative cash flow
1 8,000 8,000
2 15,000 23,000
3 22,000 45,000
4 20,000 65,000*
5 20,000 85,000
Looking at the cumulative cash flows, the cumulative cash flows at the end of year 3,
which is 45,000 is less than the initial investment where as the cumulative cash flows at
the end of year 4 that is 65,000 is slightly greater than the initial investment. This implies
that the payback period for this project is greater than 3 years but less than 4 years. the
exact payback period can be computed as follows:
Payback period = 3 years + (15,000/20,000) years
= 3 years + 0.75 years = 3.75 years, or
= 3 years + (0.75) (12 months) = 3years
and
9months.
This is true if the cash flows of 20,000Birr during year four are uniformly distributed
over the entire year. Otherwise, the payback period is different from 3 years and 9
months. For instance, if the cash flow of 20,000Birr is expect to occur only once at the
end of year 4, the payback period will be 4 years.
As a general rule, the shorter the payback period, the better the project is. Thus, the
project is accepted if its payback period is less or equal to the period required by the
management of the business firm. If two projects are mutually exclusive (i.e. if the
acceptance of one project precludes the acceptance of the other), a project with the
shorter payback period is selected even if both of them fulfill the acceptance criteria. On
the other hand, if two project are independent (i.e. the cash flows of one of the project do
not influence the cash flows of the other), both the projects can be accepted as long as
their pay back periods are less than the planned pay back period.

Advantages of Payback Period:

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The payback period is an easy and an inexpensive method to evaluate and rank project
alternatives

Disadvantage of Payback Period

The disadvantages of the payback period are:
1. It ignores the cash flows beyond the computed pay back period though they are
important for acceptance or rejection decisions.
2. It ignores the time value of money which is an important variable that demands
consideration in evaluating the desirability of a given project.
b) The Accounting Rate of Return (ARR)
The accounting rate of return (ARR) is the rate of return that is calculated by dividing
the project’s expected annually net profit by the average investment outlays. The
average investment outlay, on the other hand, is computed by dividing the sum of
original cost of the project and the salvage value of return (ARR) can be expressed
with an algebraic equation as follows.

Expect Average AnnualNet Pr ofit

ARR = Average Cost of Investment

Average cost of Investment = Original costs + salvage value

2
To illustrate the accounting rate of return consider the project that has the original
investment of 70,000Birr, the life of 4 years, and the salvage value of 6,000 Birr at the
end of year 4. The straight line method of depreciation is used. Income before
depreciation and taxes are 40,000Birr for year 1, 42,000Birr for year 2, 36,000 Birr for
year 3, and 50,000 Birr for year 4. Determine the accounting rate of return if income tax
rate on the project is 40 percent. To compute the accounting rate of return (ARR) for this
project, first we have to determine the average investment and the annual depreciation
amount.
Average investment = (70,000 + 6000)/2 = 38,000Birr
Annual depreciation = (70,000 - 6,000)/4 = 16,000Birr
Then compute the new profit for each year during the four years.
Year 1 Year 2 Year 3 Year 4
Income before depr. & taxes 40,000 42,000 36,000 50,000
Less: Annual depreciation 16,000 16,000 16,000 16,000
Income before taxes 24,000 26,000 20,000 34,000
Less: Income taxes (40%) 9,600 10,400 8,000 13,600

Then we compute the average Net Profit during the four years.
That is:
Average net profit = (14,400 + 15,600 + 12,000 + 20,400)/4
= 15,600 Birr
Hence, ARR = Average Annual net profit = 15,600 = 0.41 or
41%.
Average cost of investment 38,000

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This is to mean that for an average of 1 Birr invested in this project, there is an average
return of 41 cents in the form of net profit per year over the entire four years of the life of
the project.
The accounting rate of return method of project evaluation, like the payback period
method, ignores the timing of cash flows or the time value of money. Moreover, the
accounting rate of return ignores the fluctuations of the cash flows over the life of the
project as it assumes an average cash flows every during the project's life.
2. The Discounted Cash flow (DCF) Criteria (Techniques):
The discounted cash flow techniques are other methods of evaluating and ranking
investment project proposals. These techniques employ the time value of money concept,
unlike the traditional methods. Four DCF techniques are discussed in the section that
follows.
a) The discounted Payback period
The discounted payback period is defined as the number of years that is required to
recover the amount of money invested in a project at the beginning after discounting the
future cash flows to their present values. Discounted payback period is computed in the
same manner as that of the regular payback period except the discounted cash flows are
used in the case of the former on. The expected future cash flows are discounted by the
projects cost of capital.
To illustrate the computation of the discounted payback period, suppose that a given
capital budgeting alternative is expected to have an initial investment of 30,000Birr and
the life of 5 years. The after-tax cash flows from the project during years 1,2,3,4 and 5
are 15,000Birr, 18,000Birr, 12,000Birr, 20,000Birr, and 22,000Birr respectively. The
cost of capital (the required rate of return) is 10 percent. What is the discounted payback
period for this project? To answer his question, first we have to compute the discounted
cash flows and the cumulative cash flows for each year which help buys to locate the
discounted payback period of this project. Hence, the discounted cash flows and the
cumulative cash flows year by year are show as follows.
Year Cash flows Discount Factor Present Value
Cumulative CF
1 15,000 0.909 13,635
13,635
2 18,000 0.826 14,868
28,503
3 12,000 0.751 9,012

4 20,000 0.683 13,660

5 22,000 0.621 13,662

As you can see from the cumulative discounted cash flows the discounted payback period
for project is between 2 and 3 years. This is because the cumulative discounted cash flow
at the end of year 2 is less than the initial investment of 30,000Birr and the cumulated
discounted cash flows at the end of year 3 is greater than the same initial net investment.
The exact payback period (discounted) can be computed as:
Discounted Pay back period = 2 years + (1,497/9, 0120) years
= 2 years + 0.17 years = 2.17 years

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 = or 2 years + (0.17) (12 months)
= 2 years and 2 months.
It requires the project a period of 2 years and 2 months to recover its initial net
investment taking the time value of money into account. This is true only if the cash
flows assumed to occur uniformly throughout the year. But the cash flows are discounted
back to their present cash equivalents by considering that the cash flows are occurring at
the end of every year. Hence, the project needs to wait for one more years after year 2 in
order to recover the remaining present value equivalent amount of 1,497Birr at the end of
year 2. Therefore, the discounted pay back period of this project is 3 years instead.
b) The Net Present Value (NPV) Method
The net present value (NPV) method is an investment project proposals evaluating and
ranking method using the net present value, which is the difference between the present
values of future cash inflows and the present value of cash outflows, discounted at the
given cost of capital, or opportunity cost of capital.
In order to use this method properly, the following procedures are followed.
1. Find the present value of each cash flow, including both inflows and out
flows using the cost of capital of the project for discounting.
2. Sum the discounted cash outflows and the discounted cash outflows
separately.
3. Obtain the difference between the sum of the cash inflows and the sum of the
cash flows.
If all the cash outflows for the project occur at time zero, i.e. at the beginning of year 1,
the present value of the cash our flows is the same as to the net investment amount.
Decision Rule for the Net Present Value (NPV) Method:
If the projects are independent, the projects with positive net present values are the ones
whose implementation maximizes the wealth of shareholders. Hence, such projects
should be accepted for implementation. If the projects, on the other hand, are mutually
exclusive, the one with the higher positive NPV should be accepted leading to the
rejection of the projects with lower positive NPV. Projects with negative NPV should
not be considered for acceptance in the first place.
The rationale for the NPV method is that an NPV of zero signifies that the cash flows of
the project are just sufficient to repay the invested capital and to provide the required rate
of return, no more no less. If the project has a positive NPV, it is generating more cash
than needed to service its debts and to provide the require rate of return to the
shareholders, and this excess cash accrues solely to the firm's shareholders. Therefore, if
the firm takes on a project with a positive NPV, the wealth of the shareholders will be
improved as indicated above.
To illustrate the NPV as a method of project proposals ranking assume that a given
project is expect to have an initial investment and project life of 40,000Birr and 5 years
respectively. The annual after-tax cash flow is estimated at 12,000Birr for each one of
the five years. Using the required rate of return of 10 percent, what is the net present
value (NPV) of the project? How do you judge the acceptability of this project?
In order answer these question, it is wise to identify the cash inflows and outflows. In the
case of this project, there are annuity cash inflows of 12,000 every year for five years and
single cash out flow of 40,000 at time zero.
The present value of the annuity cash outflows is:

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 Present value of annuity = (12,000) Annuity factor)
The annuity factor given the period of 5 years and discount rate of 10 percent is 3.791
substituting the factor I the equation above
PVA = (12,000) (3.791) = 45,492Birr
Present Value of Cash out flows = 40,000Birr
Hence,
The Net Present value (NPV) = Present Value of inflows less present value o
of out flows
= 45,492 - 40,000 =
5,492Birr
Since the project makes the net present value (NPV) of positive 5,492Birr, it should be
accepted. Consequently, the wealth of the shareholders would increase by 5,492Birr in
total as the result of accepting and running this project. Thus, the project can be judged
as an acceptable one.
To further illustrate the NPV method, consider the following mutually exclusive project
alternatives, together with their cash flows.

Alternative Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

A (80,000) 20,000 25,000 25,000 30,000 20,000

B (100,000) 25,000 20,000 30,000 35,000 40,000

The required rate of return on both projects is 12 percent. Then, evaluate these projects
using the net present value method.
The evaluation of these two projects requires the computation of the net preset
values for both projects. As you can see the cash flows from both projects are not in
annuity forms. The cash flows are irregular for both projects. Hence, we need to
discount each of the cash flows individually. Then the individual discounted cash
flows are added. The cash out flows at time zero will be deducted from the sum of
the discounted cash inflows in order to get the net present value of the project. The
net present value (NPV) for project A is:
Year Cash flows Discount Factor (12%) Present Values
1 20,000 0.893 17,860
2 25,000 0.797 19,925
3 25,000 0.712 17,800
4 30,000 0.636 19,080
5 20,000 0.567 11,340
Present values of cash inflows (sum) 86,005
Present values of cash outflows 80,000
Net Present Value (NPV) 6,005 Birr

The net present value (NPV) for project B is:

Year Cash flows Discount Factor (12%) Present Values

1 25,000 0.893 22,325
2 20,000 0.797 15,940

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 3 30,000 0.712 21,360
4 35,000 0.636 22,260
5 40,000 0.567 22,680
Present values of cash inflows (sum) 104,565
Present values of cash outflows 100,000
Net Present Value (NPV) 4,565 Birr

Since the two projects are mutually exclusive, the one with the higher NPV has to be
accepted. Thus, project A is selected as its NPV is higher than that of project B. Had the
two project been independent of one another, both of them would be accepted because
both projects have positive net present values (NPVs)
The NPV Profile
As indicated above, the net present value of the project depends solely on the size and
timing of the cash flows, the investment out lays, and the discount rate. A simple graphic
device that visualizes this dependence is called the NPV profile.
To illustrate the NPV profiles suppose that a project is expected to have an initial
investment of 200Birr and the first year cash flow of 230Birr. The net present value
of this simplified project using four alternative discount rates of 0, 10,, 15, and 20
percents is shown as follows.
Present value Net Present
Discount Rate Discount Factor of 230Birr Less net Investment Value
0 1.000 230.00 200 30.00
10% 0.909 209.07 200 9.07
15% 0.870 200.01 200 0.00
20% 0.833 191.59 200 -8.41

The NPV profile can e shown with the help of the X-y coordinate plane where the Y-axis
is to represent the NPVs and the X-axis is to represent the discount rates.

30*
20
10 *
*
-10 10 15 20 25
*

The discount factor is 1 when the discount rate is zero. This reflects the fact that 0 Birr
received tomorrow is equal to a birr received today in a world where there is no other
profitable alternative of using money. At the discount rate of 15 percent the NPV is zero,
which means that this project is earning exactly 15 percent returns.
The above graph indicates that the NPV of the project under consideration is positive
when the discount rates are less than 15 percent, and negative when the discount rates are

111
greater than 15 percent. Therefore, this project should be accepted if and only if the
opportunity cost of is below 15 percent.
C) The Internal Rate of Return (IRR)
The internal rate of return is the discount rate which equates the present value the
expected cash flows with the initial investment outlays. In other words, IRR is a method
of ranking investment project proposals using the rate of return on an asset (investment).
At IRR, the sum of the present values of all cash inflows is equal to the sum of the
present values of all cash outflows. That is:
Pv (cash inflows) = PV (cash outflows). Hence, the net present value of any
project at a discount rate that is equal too the IRR is zero.
Computing the Internal Rate of Return
1. Uniform Cash Inflows over the Life of the Project:

In this case, the present value table of an annuity can be used to calculate the IRR
since the cash inflows are in annuity form. The following steps can be followed to
calculate IRR for constant cash inflows.
Step 1: Find the critical value of discount factor
Discount factor = Initial investment
Annual Cash inflow
Step 2: Find the IRR by looking along the appropriate line (year) of the present
value of
annuity table until the column which contains the critical discount factor
(i.e.
the discount factor computed under step 1) is located.
To illustrate the calculation of IRR when the cash flows are in an annuity form, assume
that a project has a net investment of 26,030 Birr and annual net cash inflows of 5000Birr
for seven years. What is the IRR of this project? In order to answer this question, we
need to follow the two steps discussed above.
Step 1 Compute the critical discount factor. That is
Discount factor = 26,030 = 5.206
5,000
Step 2 After determining the critical discount factor, we look for the value that is equal
to this factor in the present value of annuity table across the line
corresponding
to 7 years (i.e n =7). The discount factor of 5.206 appears in the 8 percent
column on the line/row of 7 years. Therefore, the IRR is 8 percent.
2. Fluctuating Cash Inflow over the Life of the Project
When the cash inflows from the project are not in an annuity form, IRR is calculated
through an iterative process or through "trial and error". It may be difficult to identify
from which discount rate to start. A good first guess can be made by estimating the
discount factor.
In general, the following procedures are used to calculate the IRR of the non-uniform net
cash flows.
Step 1:Find the estimated discount factor. In fact, if the fluctuations I the cash inflows is
very large, the estimated discount factor doesn’t help you much in locating the IRR in the

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 present value of annuity table. Estimated discount
factor =Net investment
Average cash inflows
Step 2:Look at the present value of annuity table to obtain the nearest discount rate for
the estimated discount factor determined in step 1.
Step 3:Calculate the NPV using the discount rate identified in step 2.
Step 4:If the resulting NPV is positive, choose the higher discount rate and repeat the
procedure. Choose the lower discount rate if the NPV is negative, and repeat the same
procedure until you find the discount rate that equates the NPV to zero.
To illustrate the IRR computation under fluctuating cash inflows from the project assume
a project that has an initial investment of 40,000 Birr and the following net cash inflows:
Year 1, 15,000Birr;
year 2, 10,000Birr;
Year 3, 10,000 Birr;
year 4, 15,000 Birr; and
year 5, 15,000Birr.

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 What is the IRR of this project?
In order to estimate the discount factor, you need to give weight to the cash flows over the life of the
project. Larger weights should be given to the cash flows towards the beginning of the life of the
project than to the cash flows that occur to wards the end of the project life.
Hence,
Year Weight Cash flow x weight
1 5 75,000
2 4 40,000
3 3 30,000
4 2 30,000
5 1 15,000
190,000
Average net cash flow= 190,000 = 12,667
15
Estimated discount factor = 40,000 = 3.158
12,667
By looking up in the present value table for annuity, the approximate the discount factor of 3.158
online 5 (n=5) is 18 percent. Thus, the starting point of the iterative process is 18 percent. The NPV
of the project using the discount rate of 18 percent is:
NPV = (15,000) (0.847) + (10,000) (0.718) + (10,000) (0.609) + (15,000) (0.516) +
(15,000) (0.437) - 40,000 = 40,270 - 40,000 = 270
Since the NPV computed using a discount rate of 18 percent is positive, are have to take a discount
rate higher than 18 percent in search for the NPV of zero. So the second guess can be 19 percent. The
NPV of the project using the discount rate of 19 percent is:
NPV = (15,000) (0.840) + (10,000) (0.706) + (10,000) (0.593) + (15,000) (0.499) +
(15,000) (0.419) - 40,000 = 39,260 - 40,000 = -640
As per the above calculations, NPV is negative when the discount rate of 19 percent is used and
positive when the discount rate of 18 percent is used. Thus, the IRR for this project falls between 18
percent and 19 percent. If the exact IRR is needed, the interpolation method is can be used. That is:
Step 1: Obtain the NPV of the smaller rate by the absolute sum and add the resulting
quotient to the smaller rate, or divide the NPV of the larger rate by the absolute sum
and subtract the resulting quotient from the larger rate.
Step 2: Divide the NPV of the smaller rate by the absolute sum and add the resulting
quotient to the smaller rate, or divide the NPV of the larger rate by the absolute
sum and subtract the resulting quotient from the larger rate.
By following the above two steps, the exact IRR for this project is thus:
The absolute sum of the NPVs = |270| + |-640| = 270 + 640 = 910
Then, dividing the NPV of the smaller rate by the absolute sum, you get 270/910 = 0.30 to the nearest
two digits after the decimal point, and add this figure to the smaller rate
IRR = 18% + 0.30% = 18.30%
or you can divide the NPV of the larger rate by the absolute sum, and you get:
-640/910- 0.70 to the nearest two digits after the decimal point, and subtract this figure
from the larger rate to obtain the exact IRR.
IRR = 19% - 0.70% = 18.3%
In both cases, you arrive at the same IRR value of 18.3 percent.
The rational for the IRR method is that the IRR on a project is its expected rate of return. If the IRR of
a given investment project exceeds the cost of the funds used for financing the project (cost of capital),
there is the remaining surplus after paying for the capital, and this surplus adds up on the wealth of the
shareholders of the firm. Therefore, selecting the project whose IRR exceeds its cost of capital

114
increase the share holders' wealth. On the other hand, the project with the IRR less than the cost of
capital imposes an unnecessary cost on current shareholders. The return from the project will to cover
even the cost of capital.
Decision Rule for IRR
A project whose IRR is greater than its cost of capital, or Required Rate of Return (RRR) is accepted
and whose IRR is less than the RRR of the project is rejected.
d. Profitability Index (PI):
Profitability index is the ratio of the present value of the expected net cash flow of the project and its
initial investment outlay.
PI = PV/IO
where
PV = Present value of expected net flows
IO = Initial investment outlay
PI = Profitability Index
Profitability index provides or measure of profitability in a more readily understandable terms. It
simply converts the NPV criterion into a relative measure.
NPV VS Profitability Index
The NPV and the profitability index criteria reach the same acceptance-rejection decisions for
independent projects. The profitability index is greater than 1 if the net present value of the project is
positive. However, in the case of mutually exclusive projects, NPV and profitability index will result
in different acceptance-rejection decision. One advantage of NPV in this case is that it reflects the
absolute size of alternative investment proposals profitability index does not reflect difference in
investment size. Therefore, the NPV is more appropriate for mutually exclusive projects than
profitability index.
Consider the following two mutually exclusive projects.
Present Value Initial Profitability
of cash Flow Investment NPV Index
Project A 200 100 100 2.0
Project B 3000 2000 1000 1.50
From the above example project A is accepted using profitability index because its PI is greater than
that of project B. However, NPV of project B is greater than that of the NPV of project A. Thus, even
though the profitability index of a project is a very useful tool, it should not be used as a decision rule
when mutually exclusive projects of different size are being considered.

NPV Vs IRR
The NPV and the IRR project ranking techniques lead to the same acceptance-rejection decisions for
independent projects. However, these methods may lead to different decisions when it is impossible to
undertake all investment opportunities. In other words, when investment opportunities are mutually
exclusive, NPV and IRR may result in contradicting decisions. If this is the case, which one of the
two methods should be used to select between/among the mutually exclusive projects? What are the
reasons for the difference between the two methods? Let us first discuss the reasons for the difference.
These reasons can be classified into two. These are:
1. Difference in the Size of investment
All investments do not usually require the same amount of initial outlay. One investment may have
larger initial investment than its alternatives. In this case, NPV leads to better investment decision
because it ensures that the firm will reach the optimal scale of investment. NPV automatically
examines and compares the incremental cash flows against the cost of capital. The IRR criterion
ignores this important aspect of an investment decision because the return is expressed in a percentage.

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To illustrate, the difference between the NPV and IRR as project ranking techniques consider the
following mutually exclusive projects, project A and project B.
0 1 2 3 4 5
Project A (50,000) 17,000 17,000 17,000 17,000 17,000
Project B (32,000) 12,000 12,000 12,000 12,000 12,000
The required rat e of return for this project is B percent. Which one of these two projects should be
selected? From the above illustrative example, we can see that the lives of both projects are the same.
However, the initial investment of project A is larger than that of project B. Thus, one can learn that
there is a difference in the size or scale of investment. In order to identify the project to be selected,
the NPV and IRR for both projects have to be calculated. Since the cash flows for both projects are in
an annuity form, the IRR can be easily determined from the present value table of annuity after
determining the discount factors. Therefore, the discount factor for project A = 50,000 = 2.941
17,000
Looking in the present value table of annuity in the raw of 5 years, the discount factor of 2.941
corresponds to 20.8 percent.
The discount factor for project B = 32,000 = 2.667
12,000
Looking in the present value of annuity table across the 5 year (n=5) row, the discount factor of 2.667
corresponds to 25.5 percent and
The NPV of project A = (17,000) (the discount factors of annuity at the required
rate of 8 percent) - 50,000.
= (17,000) (3.993) - 50,000
= 17,881Birr.
The NPV of project B = (12,000) (the discount factor of annuity at the required rate of return of 8
percent) - 32,000
= (12,000) (3.993) - 32,000 = 15,916
The above calculations indicate that both projects are acceptable if they are independent projects.
However, those projects are mutually exclusive. As a result, IRR ranks project B first, but NPV ranks
project A first. Thus, there is a paradox between the two methods.
In order to clarify such paradoxical result, it is advisable involved. Then the internal rate of return
(cross over rate) is determined on the incremental cash flows and additional investment. Additional
investment is the difference between the investment outlays of the two projects. Cross over rate is the
discount rate at which the NPV profiles of the two projects cross, and thus, at which the projects'
NPVs are equal. Thus, the internal rate of return on incremental cash flows is the same as the cross
over rate. The cross over rate for the illustration under consideration is calculated in the same,
procedures as IRR for the project, i.e.
Discount factor = 18,000 = 3.600
5,000
From the present value of an annuity table, the discount factor of 3.600 corresponds to the 12 percent
column. Thus, the cross over rate is 12 percent. The cross over rate indicates that the NPV gives
priority to project A at discount rates below cross over rate of 12 percent, but IRR supports project B
for a discount rate above the cross over rate.
Since the cost of capital is 8 percent, the incremental cash flow represents a profitable opportunity.
Therefore, the larger project which incorporates these additional cash flows should be accepted.
If the cross over rate is less than the cost of capital (RRR), the project with the smaller investment
should be selected because the additional commitment of resources will not be compensated.
Therefore, by examining and comparing the incremental cash flows against the cost of capital, the
NPV method ensures that the firm will reach the optimal scale or size of investment.
2. Difference in Timing of Cash flows:

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The NPV and the IRR can still give contradictory rankings even when initial investment outlays are
the same because of the difference in the timing of the cash flows. Most of the cash flows from one
project may occur in the early years and most of the cash flows from the other project may occur
during the later years. The critical issue is that "how useful is the project if it generates cash flows
sooner than later?" So, which method should be sued?
Basically, the cash flows that occur sooner are better than the cash flows that occur later because early
cash flows can be reinvested. In fact, we cannot use the scale of investment project argument
discussed earlier to justify the preference of NPV to IRR. However, we can still use the same
incremental cash flow technique. So, how can we justify the use of NPV as a project ranking and
evaluating method when differences in the scale of investment do not exist?
In order to justify the superiority of NPV rule over that of the IRR, we need to consider the
reinvestment rate assumption of early cash flows. According to the reinvestment rate assumption,
NPV method implicitly assumes that the cost of capital (RRR) is the rate of which cash flows can be
reinvested, where as the IRR method assumes that the business firm has the opportunity to reinvest at
the IRR. Which assumption do you think is better?
The best assumption is the one that considers the reinvestment of cash flows at the cost of capital, i.,e.
NPV method, The IRR method incorrectly penalizes the receipts of more distant years by using high
discount rate (IRR) because IRR is greater than required rate of return (RRR). Thus, the best
reinvestment rate assumption is the cost of capital which is consistent with NPV method.
To illustrate, let us assume that project A and project B have the same initial investments, 10,000 birr.
The RRR is for the firm 10 percent.
Year Project A Project B
0 (10,000) (10,000)
1 - 6,000
2 13,924 7,200
IRR 18% 20%
NPV 1501 1401
Which project should be selected?
IRR singles that project B is better than project A, where as NPV signals that project A is better than
project B. Since NPV method is the superior top the IRR method in selecting between two mutually
exclusive projects, project A is selected. Project A will provide the most wealth to the shareholders.
To prove the soundness of this decision, we can calculate the terminal value of each project using
future value technique. Thus, terminal value of:
Project A = 13,924Birr
Project B = 7,200 Birr + (6000) (1.1) Birr = 13,800Birr

Since the terminal value of project A is greater than the terminal value of project B, the former project
is selected which is in line with the NPV decision rules.
Projects with Unequal Lives
Earlier in this chapter, we assumed that mutually exclusive projects have equal lives. But there are
many situations in which alternative investments have unequal lives. The most common example of
such situation is unequal replacement decision. Since it is not appropriate to compare projects of
unequal lives, adjustment must be made. Even though there are different methods (approaches) of
dealing with mutually exclusive alternatives with different lives, three of them are introduced in this
chapter.
1. The Replacement Chain Approach:
Replacement chain, which is called common life approach, is the method of comparing projects of
unequal lives which assumes that each project can be repeated as many times as necessary to reach a
common life span. Then, the NPV or the other method is used to evaluate the project.

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 To illustrate the comparison of projects with unequal lives consider two mutually exclusive projects
whose cash flows are summarized below. The discount rate for both projects is 10 percent.
0 1 2 3 4 5 6
Project A (40,000) 10,000 12,000 15,000 11,000 9,000 11,000
Project B (30,000) 12,000 14,000 13,000 - - -

The two projects are incomparable. Thus, according to replacement chain approach, project B will be
repeated in three years. Assuming that annual cash flow and the discount rates will not change. Thus,
if project B is repeated, its year 4, years, and year 6 cash flows are 12,000 birr, 14000 birr, and 13,000
birr respectively. In this way, the two projects have the same life. If project B is repeated, its cash
flows will be:
0 1 2 3 4 5 6
(30,000) 12,000 14,000 13,000 12,000 14,000 13,000
The present value computation of the repeated project B requires a two-step process. These are:
Step 1: you compute the present values at t=o for project B and at t=3 for the repeated project B.
Present value at time zero (t=o) = (12,000) (0.909) + (14,000) (0.826)+(13,000) (0.751) =
32,235 birr present value at time 3 (t=3) = (12,000) (0.909)+(14,000) (0.826) + (13,000)
(0.751) =32,235 birr
Step 2: Discount the present value of the repeated project B at time 3 (t=3) to the present value at
time zero (t=o). That is, present value of repeated project B at time zero = (32,235)
(0.751) = 24,208 birr.
Then, add the present value of the first three years cash flows to the present value of the repeated
project after three years. That is:
Total present value = 32,235 + 24,208 = 56,443 birr. Hence, the NPV of the repeated project B =
56,443 – 30,000 – 26,443 birr.
The NPV of project A is calculated as follows.
Year Discount factor Cash flow present value
1 0.909 10,000 9,090
2 0.826 12,000 9,912
3 0.751 15,000 11,265
4 0.683 11,000 7,513
5 0.621 9,000 5,589
6 0.564 11,000 10,204
Present value of cash flows 49,573
Less: Present value of initial investment 40,000
NPV of project A 9,573
Therefore, using the NPV method for project comparison of the two projects, project B should be
selected.
Under the replacement chain approach of comparing projects with unequal lives, the least common
factor of the projects lives is used to find the common useful life. For instance, if the life of project A
is 5 years and that of project B is 3 years, project A is repeated 3 times and project B is repeated 5
times because the least common factor for the two project lives (i.e. 3 and 5) is 15 years.
1. Equivalent Annual Annuity (EAA) Method:
This method enables us to calculate the annual payments a project would provide if it were an annuity.
When comparing projects of unequal lives, the one with higher equivalent annual annuity should be
chosen. Three steps are flowed under this method.
Step 1: Find each project’s NPV over its initial life. The NPV for the above projects are as
follows:
Project A = 9573 birr (as computed before)

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 Project B = (12,000) (0.909) + (14,000) (0.826) + (13,000) (0.751) – 30,000
= 32,235 – 30,000 = 2,235 birr
Step 2: Find the equivalent annual annuity that has the same present value as the projects’ NPV.
Equivalent annual annuity can be calculated as follows.
For project A:
NPV = pv of cash flows – pv of initial out lays.
9573 = pv of cash flows – 40,000
9,573 + 40,000 = PV of cash flows
PV of cash flows = 49,573. By looking up in the present value of annuity table at n=6 and I=10%, the
discount factor is 4,355. As you know pv of cash flows = cash flows x Discount factor. 49,573 =
(4.355) (x) where x is the equivalent annual annuity.
X = 49,573/4.355 = 11,383 birr
For project B:
NPV = pv of cash flows – pv of initial out lays
2,235 = pv of cash flows – 30,000
pv of cash flows = 2,235 + 30,000 = 32,235
By looking up in the present value of annuity table for the discount factor that corresponds to n=6 and
I=10% is 2.487. Hence
(y) = 32,235 where y represents the equivalent annual annuity amount for the project. Solving for y
we get.
Y = 32,235/2.487 = 12,961 birr
Step 3: The project with the higher equivalent annual annuity will always have the higher NPV
when extended out to any common life. Therefore, project B’S equivalent annual annuity
(EAA) is larger than project A’S, project B would e chosen.
2. Abandonment Value Approach.
This approach presumes that the larger-lived investment alternative is prematurely terminated at the
end of the life of the shorter project alternative. This presumption requires us to estimate an
abandonment value for long-lived investment at the end of the life of the shorter project alternative.
Assume the above example and the estimated abandonment value of 5,000 birr for project A at the end
of year 3, which is the end of the life of project B. Then, compute the NPV for both projects at the
required rate of return of 10 percent. Hence,
The NPV for project A if it abandoned at the end of year 3 is:
NPV = (10,000) (0.909) + (12,000) (0.826) + (30,000) (0.751)-
(40,000). Here the cahs flow of 30,000 birr considered for year 3 is the sum of the cash flow
during the year from project A (i.e 25,000) and the abandonment value of the project of 5000 birr.
The NPV for project A = 41,532 – 40,000 = 1,532 birr.
The NPV for project B = (12,000) (0.909) + 914,000) (0.826) + (13,000)
(0.751) – 30,000 = 32,235 – 30,000
= 2,235 birr
According to the above analysis, therefore, project B is better than project A.
Capital Rationing
Capital rational is a situation in which a constraint is placed on the total size of the firm’s capital
budget. Capital ration is said to exist when we have profitable (positive NPV) investments available
but we can’t get the needed find to under take all of them. Two main reasons can be mentioned. One
is what is called soft rationing which is the situation that occurs when units are allocated a certain
amount of financing for capital budgeting. Such allocation is primarily a means of controlling and
keeping track of overall spending. Soft rationing doesn’t mean that the business firm as a whole is not
short of capital. The other reason is hard rationing. Hard rationing is the situation that occurs when a

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business can not raising finance or funds for a project under any circumstances. A business firm with a
sound financial status does not face hard rationing.
Consider the following assumptions:
1. The timing and magnitude of the cash flows of all projects (all project alternatives) are known.
2. The cost of capital is known
3. All projects are strictly independent
4. The total investment outlay of all those projects that have a positive NPV exceeds the firm’s
budget constraints.
Taking these assumptions into account, the problem under capital rationing is as to how to choose a
subset of desirable projects in such a way that total investment does not exceed the budget. .In order
to solve this problem, the sound procedures are as follows:
1. Rank all projects with positive NPVs in accordance with their profitability indeed.
2. Select projects from the top of the list (with the highest profitability index) until the fixed
budget are exhausted.
To illustrate how to select project alternatives when the company has a limited capital amount (i.e.
when there is capital rationing) suppose that a firm has a fixed capital budget of 600,000 birr and has
the following investment alternatives.
Project Initial Investment NPV Profitability Index
A 150,000 40,000 1.50
B 190,000 40,000 1.40
C 120,000 70,000 1.80
D 180,000 50,000 1.30
E 330,000 60,000 2.00
The question is that which of these projects should the firm select and implement give the fixed
amount of capital budget indicated above?
To answer this question, first we have to rank these project based on the value of their profitability
index. Hence, their arrangement according to their profitability index is F-C-A-B-D. This is to mean
that project F is with the highest profitability index and project D is with the lowest profitability index.
Therefore, given the capital budge constraint of 600,000 birr, projects F,C and A are selected. The
initial capital requirements for these projects are the sum of the initial investment costs of these
projects F,C and A are selected. The initial capital requirement for these projects is 600,000. (i.e.
330,000 + 120,000 + 150,000 = 600,000). So the total initial investment cost of the three projects is
exactly equal to the total capital budget of the firm. This implies that the rest of the project
alternatives can not be implemented be cause of the lack of capital though they are all acceptable ones.
The total net present value (NPV) of the projects that were selected is 60,000 birr + 70,000 birr +
40,000 birr = 170,000 birr.
Capital Budgeting Under Risk
Up to this point, we have ignored risk in capital budgeting; that is we have discounted expected cash
flows back to their present values and ignored any uncertainty that might surround the expected cash
flows. In reality, the future cash flows associated with the introduction of a new sales outlet or a new
product are estimates of what is expected to happen in the future, not necessarily what will happen in
the future. But, these cash flows discounted to their present values have only been our best estimate of
the expected cash flows.
In this section, we will assume that under conditions of risk we don’t know before hand what cash
flows will actually result from the new project. However, we do have expectations concerning the out
comes and are able to assign probabilities to these outcomes. Staled in another way, although we do
not know the exact cash flows resulting from the acceptance of a new project, we can formulate the
probability distributions from which the flows will be drawn. Risk, here, is defined as the potential
variability in the future cash flows.

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 Relevant Risks in Capital Budgeting
In capital budgeting, a project’s risk can be looked at in three levels. First, there is a total project risk,
which is a project’s risk ignoring the fact that much of this risk will be diversified away as the project
is combined with the firm’s other projects and risks. Second, we have the project’s contribution to
firm’s risk, which is the amount of risk that the project contributes to the firm as a whole; this measure
considers the fact that some of the project’s risks will be diversified away as the project is combined
with the firm’s other projects and assets, but ignores the effects of diversification of the firm’s
shareholders. Finally, there is what is known as a systematic risk, which the risk of the project from
the viewpoint of a well diversified shareholder; this measure considers the fact that some of the
project’s risk will be diversified away as the project is combined with the firm’s other projects, and in
addition some of the remaining risk will be diversified away by shareholders as they combine this
stock with other stocks in the portfolio.
Risk, Return and Net Present Value
When a financial manger is considering a set of risky alternatives, one important consideration
involves the choice of the required rate of return. Given the risk aversion nature of mangers, the
required rate of return of each project is the function of its risk. The riskier the project, the higher the
required rate of return is.
Selecting the appropriate required rate of return involves subjective judgments. Given the general
patterns of managerial risk aversion, which shows the direct relationship between risk and return, the
following guidelines can be established.
1. The coefficient of variation can be used as the measure of risk per birr of return. As such, it
can be used to rank the risky ness of probability distributions of cash values.
2. The required rate of return can be set to the sum of the risk-free rate plus some additional
return to compensate for risk.
The Risk Adjusted Net Present Value (RANPV):
The risk adjusted net present value (RANPV) service as a capital budgeting decision criterion under
conditions of risk and is defined as the sum of the present values of the expected cash values
discounted at the required rate of return.
The RANPV coefficient that is positive or zero indicates that the project earns at least the risk adjusted
required rate of return and that adopting such a project can increase the value of the firm and thus the
shareholders’ wealth.
When a risky investment is to be evaluated on an accept or reject basis, the RANPV criterion provides
the following decision rule: Accept the risky project if its RANPV is positive or zero; reject it if the
project’s RANPV is negative.
To illustrate how to evaluate a project under a condition of risk (i.e. when the cash flows are not
certainly know rather given probability distributions under different state of the economy) suppose a
risky project that has a life of four years.
The estimated risk adjusted rate of return is 10 percent. The initial investment of the project is 29,000
birr
Year State of Economy Cash flow Probability
1 Boom 12,000 0.20
Average 10,000 0.50
Recession 7,000 0.30
2 Boom 18,000 0.10
Average 15,000 0.50
Recession 13,000 0.40
3 Boom 15,000 0.30
Average 14,000 0.40
Recession 12,000 0.30

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 4 Boom 19,000 0.30
Average 16,000 0.50
Recession 14,000 0.20
Compute the payback period for this risky project. What is the RANPV of the project? Compute the
IRR of the project. Calculate the profitability index of the project. Before we answer each one of the
questions, let us computed the expected cash flows for each year of the project life as follows:
Year 1: (12,000) (0.20) + (10,000) (0.50) + (7,000) (0.30) = 9,500 birr
Year 2: (18,000) (0.10) + (15,000) (0.50) + (13,000) (0.40) = 14,500 birr
Year 3: (15,000) (0.30) + (14,000) (0.40) + (12,000) (0.30) = 13,700 birr
Year 4: (19,000) (0.30) + (16,000) (0.50) + (14,000) (0.20) = 16,500 birr
Using these expected cash flows for the project, the payback period can be computed as follows:
Year Expected Cash flow Cumulative cash flows
1 9,500 9,500
2 14,500 24,000
3 13,700 37,700
4 16,500 54,200
The payback period for this project is longer than 2 years and shorter than 3 years because the initial
investment of 29,000 birr is greater than the cumulative cash flows at the end of year 2 of 24,000 birr
and less than the cumulative cash flows at the end of year 3. If the cash flows are expected to occur
only at the end of years, the payback period of the project will be 3 years. This because the amount of
the initial investment not paid back at the end of year 2 (i.e. 29,000 birr less 24,000 birr which is 5,000
birr) will not paid back till the end of year 3. On the other hand, if the expected cash flows occur
uniformly throughout the year, the payback period will be between 2 year and 3 years. The exact
payback period is computed as follows.
Payback period = 2 years + Amount of initial investment not paid back
Expected cash flow during year 3
= 2 years + 5,000 years
13,700
= 2 years + 0.36 years = 2.36 years, or
2 years + (0.36) (12 months) = 2 years and 4 months
The Risk adjusted Net present value (RANPV) of the project can be computed by using the expected
cash flows determined above. These expected cash flows are discounted at the risk adjusted
discounting rate of 10 percent. The initial investment amount is subtracted from the sum of the
discounted expected cash flows and difference is what is know as the risk adjusted net present value
(RANPV).
RANPV = (9500) (0.909) + (14,500) (0.826) + (13,700) (0.751) +
(16,500) (0.683) – 29,000 = 8,635.50 + 11,977 + 10,288.70
+ 11,269.50 – 29,000 = 42,170.70 – 29,000 = 13,170.70
The IRR of this project is determined through an iterative process because the expect cash flows are
not in an annuity form. To identify the starting point, we assign a weight, the highest weight to the
cash flows of the first year and the lowest weight to the cash flows of the last year in the project life.
Year Expected cash flows Weight Expected cash flow X weight
1 9,500 4 38,000
2 14,500 3 43,500
3 13,700 2 27,400
4 16,500 1 16,500
10 125,000
The weighted average cash flows = 125,400/10 =12,540
The estimated discount actor = 29,000

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 12,540
The estimated discount factor of 2.313 is near to the present value of annuity table value of 2.320
which is found in the 26 percent column in year 4 row. Hence, the first guess is 26 percent.
The RANPV using 26 percent as the risk adjusted discounting factor:
(9,500) (0.794) + (14,500) (0.630) + (13,700) (0.500) + (16,500) (0.397)
– 29,000 = 7,543 + 9,135 + 6,850 + 6,550.50 – 29,000
= 30,078.50 – 29,000 = 1,078.50 birr.
Since the RANPV using a discount rate of 29 percent is a large positive, we have to try larger discount
rates. Second guess: Let us try 2 percent because the NPV corresponding to 26 percent is far from
zero. Hence, it seems reasonable to consider 29 percent than 27 or 28 percent.
RANPV (29%) = (9,500) (0.775) + (14,500) (0.601) + (13700) (0.446)
+ (16,500) (0361) – 29,000 = 7,362.50 + 8,714.50
+ (6384.20 + 5956.50 – 29,000 = 28,417.70 – 29,000
= -582.30 birr
Since the Net present value at a discount rate of 29 percent is negative, the IRR for this project must be
less than 29 percent and greater than 26 percent. Therefore, the interactive process continues. The
third guess can be either 27 percent or 28 percent let the third guess be 28 percent.
RANPV (28%) = (9500) (0.781) + (14,500) (0.610) + (13,700) (0.477)
+ (16,500) (0.373) – 29,000 = 7,419.50 + 8845 + 6534.90 + 6,154.50 – 29,000 = 28,953.90 –
29,000 = -46.10 birr
Still the NPV of the project is negative at the discount rate of 28 percent, which implies that the IRR is
between 28 percent and 26 percent. There is a difference of 2 percent between these two percentages.
Hence, the IRR of this project can be computed as follows.
The sum of the absolute sum of the RANPV of
the two rates is = /1078.50/ + /-46.20/ = 1,124.60
IRR = 26% + 2 (1078.50) % = 26% + 2(0.959) %
1,124.60 = 26% + 1.92%
= 27.92%
or, we can make the fourth guess, that is 27% and compute RANPV using 27% as the discount rate.
That is:
RANPV (27%) = (9,500) (0.787) + (14500) (0.620) + (13,700) (0.488) +(16500) (0.384) – 29,000 =
7,476.50 + 8990 + 6685.60 + 6336 – 29,000 = 29,488.10 – 29,000 = 488.10 birr
Therefore, IRR of this project is between 27 percents and 28 percent because when we move from 27
percents to 28 percent, the NPV moves from positive 488.10 to negative 46.10. This implies that at
some point between 27 percent and 28 percent, the NPV touched upon the value of zero that is the IRR
of the project. In order to determine the exact IRR, we may use the following steps.
Step 1: obtain the absolute sum of the net present values.
The absolute sum = /-46.10/ + /488.10/ = 534.20
Step 2: Divide the RANPV of the smaller rate by the absolute sum and add the quotient to the smaller
rate or divided the RANPV of the larger rate by the absolute sum and subtract the quotient
from the larger rate.
IRR = 27% + 488.10 % or 28% - 46.1 %
534.20 534.20
= 27% + 0.91% or 28% - 0.09% = 27.91%
Chapter summary
Capital budget is a set of investment alternatives the returns of which occur over a period of two or
more years. Capital budgeting is the process of generating capital budget, and this process consists of
several different types of procedures. The three most widely used capital budgeting criteria are 1) the
payback period, 2) the net present value, and 3) the internal rate of return. Each of these criteria has its

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advantages and disadvantages. Even though NPV is the most conceptually difficult of the three
criteria, it is the preferred on because it takes into account the time value of money and it is measured
in birr amount unlike the payback period which is measured in years and the IRR which is measured in
terms of rate.
The payback period, NPV, and IRR capital budgeting criteria can be used in making accept/reject,
replacement, mutually exclusive, and capital rationing investment decisions. Each one of this
investment decisions has its own decision rules.
The payback criterion is included among decision rules because it continues to be used in investment
decisions. However, since payback does not measure profits or the time value of money it cannot be
relied upon to produce capital budgets that maximize the financial welfare of the owners of a business
firm.
NPV and IRR decision rules produces identical and correct results when making accept/reject and
replacement decisions. But when investment alternatives are evaluated with in a mutually exclusive
framework the NPV and IRR decision rules can produce conflicting rankings. When conflicting
rankings do occur, decision should be made in accordance with the result of the NPV criterion.
The presence of a capital constraint shifts the emphasis from alternatives within a given project to the
contribution of shareholders wealth made by the entire capital budget. The decision rule used for
capital-rationing situations selects the feasible set of investment alternatives that promises the largest
total NPV subject to the capital constraint.
Capital budgeting under condition of risk is concerned with the evaluation of capital budgeting
alternatives when the net investments of the projects and the subsequent cash flows from these projects
are known only to the extent of their probability distribution. The probability distribution shows the
expected cash flows and initial investments under different states of the economy. Risky projects
should be evaluated by taking their risks and returns into account. In principle, the project that
exposes the business firm to higher risk should generate higher returns in order to be acceptable. In
order to develop capital budgeting criteria for risky projects, financial managers are assumed to be risk
averts. This is to mean that financial managers do not want to take any risks with projects. If they are
to take risk, the projects should be the kinds of projects that are capable of generating higher returns,
which is more than offsetting the risks to be assumed.

CHAPTER – 6
Long term financing

LEVERAGE, OPERATING, FINANCIAL AND COMBINED

THE CONCEPT OF LEVERAGE:

The leverage concept is very general. It is not limited to finance, or business, in general. It can be
used to analyze different types of problems. For instance, other disciplines, such as economics and
engineering use the same concept in treating/analyzing problems related to their specific areas. In
economics, leverage is referred to as elasticity. When used in financial setting, leverage measures the
behavior of interrelated variables, such as units sold, sales revenue, earnings before interest and taxes
(EBIT), and earnings per share (EPS).
The material in this chapter will be easily understood if you keep two points in your mind. These are:
1. Leverage measures the relationship between two variables, as opposed to measuring
variables independently. The value of one variable must depend on the value of the second
variable.

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 2. In order for the leverage coefficients to have useful application you have to be able to
identify which variable is the depend variable and which is independent. In other words, the
cause-effect relationship between the variables must be known. When two variable are
related one as cause and the other as effect the degree of leverage describes the
responsiveness of the dependent variable to changes in the independent variable.
Leverage Defined:
Consider that Y and X represent two variables. When the values taken by Y are determined/influenced
by the values taken by X, then you can say that Y depends on X. Accordingly, Y is the dependent
variable and X is the independent variable. The algebraic statement of the dependence of Y on X is.
Written as:
Y = F(X), and read as "y" is the function of "x".
Suppose that you know the initial values of X and Y. The independent variable X now takes on a new
value. Then you compute the change in the value X and its percentage change. Based on this, you can
also determine the resulting change and the percentage change in the dependent variable, Y. Leverage
is then defined as the percentage change in the dependent variable (i.e. Y) divided by the percentage
change in the independent variable, X. In algebraic terms, the definition of leverage is developed as
follows.
Suppose:
  the change in the independent var iable, x.
  the change in the dependent var iable, Y .

 the percentage change in X  % .


 the percentage change in Y  % 



L(Y ) % Y you read the left  hand side of this equation as : the leverage
Then,  
L( X ) % X 
x
of Y with respect to X .

To illustrate, the sales of Hadaas Trading depend, among other, things on the size of the company's
budget allotted for advertisement. Suppose the company spends 10,000Birr on advertising (the
independent variable and sells 400 units of output (the dependent variable). During the next time, the
budget allotted to advertisement will in crease to 100,000Birr and the company expects the volume of
sales of 500 units. What is the leverage of sales with respect to the budget for advertisement.

To answer the question, you use the above leverage equation. The change in the advertising budget is
1000Birr (i.e.  = 11,000-10,000), and the percentage change of advertising budget (i.e. %  )
is 1000/10,000/whih is 10 percent. The change in units sold is 100 units (i.e.  = 500-400), and the
percentage change in units sold (i.e. %  ) is 100/400, which is 25 percent. By substituting these
percentages of changes into the leverage equation, you get the coefficient of leverage of 2.5. That is :
L(Y ) % 0.25
   2 .5
L( X ) % 0.10

The leverage coefficient of 2.5 means that the resulting percentage in number of units sold is 2.5 times
greater than the percentage change in the advertising budget.

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 Leverage in Financial Setting
Income statement and balance sheet provide the variables and the functional relationships among these
variables. These variables and relationships are more explained by using leverage as a tool of
financial analysis. The functional relationships are made explicit by expressing the income statement
in algebraic terms. You can use symbols to represent income statement items/accounts, and write the
relationships among the accounts in symbolic form.
The algebraic equivalent of an income statement can be quite complicated when the company markets
several products. For purpose of simplicity, the following assumptions are made concerning the
output, production costs, financing costs and federal income taxes paid.
1. The company produces only one product and sells it for a constant price. (All output is
sold, so output equals sales).
2. Production and operation costs consist of a variable cost per unit of output and a fixed cost
incurred over the accounting period.
3. The company pays the amount of interest required on any out sanding debt.
4. The company pays dividend on preferred stock out standing.
5. Company's income tax rate is assumed 40 percent of taxable income, unless stated to be
different.
Of all expenses reported in the income statement, some of them such as rents, utilities, and some
salary and maintenance expenses, are essentially fixed over the accounting period. Other costs, such
as costs of purchases and wages, tend to vary with the level of output. Some costs, called semi
variable costs have both fixed and variable components. For example, overtime payroll expenses and
additional repair and maintenance costs may be incurred when the level of production approaches
plant capacity. the most common way of reporting semi variable costs in the income statement is t
separate the fixed and variable components and added to the fixed and variable expense accounts.
Interest expense and preferred stock dividends are considered to be fixed financing costs reported in
the income statement. Although interest must be paid when due, the payment of preferred stock
dividends is not a legal requirement.
Operating Leverage:

Operating leverage measures the relationship between output and earnings before interest and taxes
(EBIT). More specifically, operating leverage measures the effect of changing levels of output on
EBIT. Hence, a high degree of operating leverage, other things held constant, means that a relatively
small change in sales will result in a large change in operating income (EBIT). The functional
relationship between these two variables is:
Y = F (T), which means earnings before interest and taxes (EBIT) depends upon the number
of units produced and sold. When the level of output change from its initial value, the initial value of
EBIT also changes. Thus, operating leverage is defined as a resulting percentage change in EBIT
dividend by the percentage change in output. Symbolically, operating leverage is expressed as:
Y
L(Y ) Y %  EBIT
 
L( X )  %  output
x
To illustrate, assume that the price per unit of output (P) is 10Birr, the variable cost per unit of output
(V) is 4 Birr, the fixed cost (F) is 30,000 Birr, and the level of output (T) is 8000 nits. Now assume
further that the level of output increases to 10,000 units. What is the coefficient of operating leverage
for this case?
Before computing the coefficient of operating leverage, you have to compute EBIT at 8000 units and
10,000 units level of output. In general,

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 EBIT = sales - variable cost - Fixed costs
EBIT = (T) (P) - (T) (V) - F. Therefore,
EBIT at 8000 units output level = (8000) (10) - (8000) (4) - 30,000
= 80,000 - 32,000 - 30,000
= 80,000 - 62,000
= 18,000Birr, and
EBIT at 10,000 units output level = (10,000) (10) - (10,000) (4) - 30,000
= 100,000 - 40,000 - 30,000
= 30,000Birr
Using the above algebraic equation for operating leverage, the coefficient of operating leverage is
computed as follows:
Percentage change in output = % T  2000
8000 = 25%
12,000
Percentage change in EBIT = %   18,000 = 66.7%

L(Y ) %  0.667
Then   = 2.67
L(T ) % T 0.250

The coefficient of operating leverage of 2.67 is interpreted as follows: A 1 percentage change in

output from an initial value of 8,000 units produces a 2.67 percent change in EBIT. Since output
increased by 25 percent from its initial value of 8000 units, EBIT increases by (0.25) (2.67) equal to
66.7 percent.

The above equation is the definitional equation for operating leverage. You need to use a
measurement equation that is equivalent to the definitional equation for the explanation of the
properties of operating leverage. We said that, EBIT = Y = (T) (P) - (T) (V) - F
= T (P-V)- F
Hence, the measurement equation for operating leverage is:
 OL  T (P  V )
 
 T  T (P  V )  F

The left-hand side of this equation is read as: operating leverage given the value of output. By taking
the data of the previous example and putting them into the above measurement equation, you get the
same coefficient of operating leverage of 2.67. That is:
OL T  8000  8,000(10  4)
8,000(10  4)  30,000
 2.67

Our next discussions on the operating leverage center around this measurement equation of the
operating leverage. This measurement equation for operating leverage is correct only when earnings
before interest and taxes (Y) is equal to sales revenue, (T) (P) minus the sum variable costs, (T)(V)
and fixed cost (F). Different measurement equation for operating leverage should be used when
company's costs are non-linear and/or when the company uses multiple product line.
Properties of Operating Leverage:
The properties of operating leverage determine its use as a tool of financial analysis. These properties
are best explained by using operating breakeven and EBIT. Operating breakeven is defined as the
level of output that makes the value of EBIT equal to zero. At this level of output total sales revenue,
(T) (P) is just sufficient to pay operating variable (T) (V) and fixed (F) costs, and no earnings are
available to cover financial costs (i.e. interest expenses). When the level of output exceeds operating

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breakeven, the company generates total revenue that provides the positive level of EBIT. On the other
hand, the level of output that is below the breakeven level, company incurs an operating loss. In an
equation form, the operating breakeven is expressed as:
(T) (P) = (T) (V) + F
(T) (P) - (T) (V) - F = 0
T (P-V) - F = 0
T (P-V) = F, and solving for T yields
T= F
(P-V) where T=level of output
P=the selling price per unit of output
V=the variable cost per unit of output

In order to illustrate the operating breakeven, assume that Shewa Trading sells its product for 25Birr.
The variable cost per unit of output is 10Birr. The total fixed operating expenses during a given
reporting period equal 60,000Birr. At what level of output (in units) does the company reaches its
operating breakeven?
The operating breakeven is calculated by using the above equation for operating breakeven
computation. That is
F
T = (P  V )
60,000 60,000
T =  = 4,000 units
25  10 15

Therefore, Shawa Trading reports earnings before interest and taxes (EBIT) of zero if it produces and
sells 4,000 units of its products. If operating leverage is calculated at operating breakeven, the
coefficient of operating leverage will be:
4000(25  10) ( 4000)(15) 60,000 60,000
(OL/T=4000) = 4000(25  10)  60,000  4000(15)  6000  60,000  60,000  0
= undefined

Note that the coefficient of operating leverage at the point of operating leverage is undefined, not zero.
Using the same data given for Shawa Trading, the coefficient of operating leverage at the following
different level of output are:
1000(25  10)
(OL  1000)    0.33
T 1000(25  10)  60,000
3,000( 25  10)
(OL  3000)    3.00
T 3,000( 25  10)  60,000

6,000( 25  10)
(OL  6000)   3.00
T 6,000( 25  10)  60,000

10,000( 25  10)
(OL  10,000)   1.67
T 10,000( 25  10)  60,000

30,000( 25  10
(OL  30,000)   1.15
T 30,000( 25  10)  60,000

128
Plotting these coefficients of operating leverage on the X-Y plane where Y-axis represents the
coefficient of operating leverage and X-axis represents the level of outputs.
Y
3.0

2.0

1.67

1.0
0 X
-0.33% 2000 4000 6000 8000 10000
-1.0

-2.0

-3.0

The graph for the coefficients of operating leverage for the levels of output less that the operating
breakeven of 4000 units lies below the X-axis because the coefficients of operating leverage are
negative. The graph for the coefficients of operating leverage for the levels of output greater than the
operating breakeven 4000 units on the other hand, lies above the x-axis because all the coefficients of
operating leverage are positive.
The vertical broken line is plotted at operating breakeven of 4000 units and it indicates that operating
leverage is undefined at the level of output. The horizontal broken line drawn through the value of 1.0
for y-axis indicates the limiting value of operating leverage. for values of output greater than
operating breakeven of 4,000 units, the coefficient of operating leverage is greater than 1.0, decreasing
with increasing lees of output and approaches 1.0 as a limit but never touch. this because to whatever
amount the level of output increases beyond the operating breakeven, the coefficient of operating
expense can not be exactly equal to1.0.
When the level of output is below the operating breakeven of 4000 units, the coefficient of operating
leverage has a negative value and approaches zero as output goes to zero. Thus, the coefficient of
operating leverage can clearly indicates where the value of output is in relation the operating
breakeven. If the coefficient of operating leverage is a small negative, the level of output is very small
and full for be lined the operating breakeven. If the coefficient of operating leverage is undefined, the
level of output corresponds to the point of operating breakeven. If on the other hand, the coefficient of
operating leverage is a small positive near to 1.0, the level of output is very large and far beyond the
operating breakeven.
The value of the coefficient of operating leverage at various levels of output depend on the relative
mix of fixed and variable costs. The above graph was drawn for the coefficients of operating leverage
computed under the assumption that the selling price per unit, the variable cost per unit, and the fixed
cost during a given period are constant. If any one or all of the values of these variables change,
operating breakeven as well as the coefficients of operating leverage do change and a new set of
operating leverages occur over different levels of output. For the special case sheer fixed costs for the
company equal zero, the coefficient of operating leverage equals 1.0 for all level of output. This
property of operating leverage is demonstrated by setting F=0 in the measurement equation for
operating leverage indicated earlier.
T (P  V ) T (P  V )
( OL T )  when F  0 (OL / ) 
T
 1 .0
T (P  V )  F T (P  V )

129
But it is not realistic to think of business firm without fixed operating costs. That is why the
coefficient of operating leverage can not be 1.0 for any level of output. As long as the company incurs
some amount of fixed operating costs, the coefficient of operating leverage can not be 1.0.
Interpretation of Operating Leverage:
There are fundamental and related interpretations for operating leverage. Although the interpretation
of the coefficients of operating leverage is a straight forward and simple task, there are situations
where their algebraic signs and/or values of output with respect to operating breakeven require added
while interpreting them.
Fundamental Interpretation:
For general purpose, you can interpret any coefficient of operating leverage as the percentage change
in EBIT that results from a 1 percent change in the level of output.
To illustrate this way of interpretation, assume that general Merchandise Store sells its product at a
selling price per unit of 40Birr and the variable cost of selling the product per unit is 25 Birr. The
fixed operating expense of the department amounts to 105,000Birr per month (the reporting period).
What is the EBIT and the coefficient of operating leverage at the output level of 8000 units?
EBIT = Y = Total revenue - variable operating costs - Fixed operating costs.
= (T) (P) - (T) (V) - F
= (8000) (40) - (8000) (25) - 105,000 or
= 8000 (40-25) - 105,000
= 8000 (15) - 105,000
= 120,000 - 105,000 = 15,000Birr
(OL/T = 8000)= T (P-V) = 8,000 (40-25)_____
T (P-V) = F 9,000 (40-25) - 105,000

= 8,000 (15)______ = 120,000____= 120,000

8,000 (15) - 105,000 120,000-105,000 15,000
= 8.0
If the level of output increases by 1 percent (from8000 units to 8,080 units) in the next accounting
period, what happens to EBIT?
The fundamental definition of operating leverage as computed here, says that EBIT will increase by 8
percent when the level of output increases by 1 percent. In order to prove that the percentage increases
I EBIT is 8 percent when the level of output increase by 1 percent, compute the amount of EBIT when
the level of output is 8,080 units (after a 1 percent increases).
EBIT = Y = (T) (P) - (T) (V) - F
= 8080 (40-25) - 105,000
= 8080 (15) - 105,000 = 121,200 - 105,000 = 16,200 Birr
EBIT (at the initial level of output of 8000 units) = 15,000 Birr.
The percentage in EBIT caused by the 1 percent increases in the level of output, therefore, is:
16,200  15,000 1200
  0.08, or 8%
15,000 15000
This the same percentage change obtained by using the measurement equation for operating leverage
(coefficient of operating leverage). The fundamental interpretation of operating leverage can be
further generalized as follows:
"The percentage change in EBIT that results from a given percentage change in output is
equal to the value of operating leverage at the initial value of output multiplied by the
Percentage change in output."
To illustrate this general fundamental interpretation using the same data for General Merchandise,
suppose that the initial output of 8000 units decreases by 12 percent (i.e. from 8000 units to 7,040

130
units). What is the percentage change (decreases) in EBIT resulting from this decrease in the level of
output.
The resulting percentage change in EBIT can easily be computed by multiplying the coefficient of
operating leverage at the initial level of output by the percentage change (decrease) in the level of
output. That is: The percentage change in EBIT = (8) (-0.12) = -0.96 or -96 percent. The percentage
decrease can be verified by computing both the value of EBIT when the level of output (T) is 7,040
(which is 12 percent below the initial amount of 8,000 units) and the resulting percentage change in
EBIT.
EBIT = Y = (T) (P) - (T) (X) - F
= (7,040) (45) - 7,040 x 25) - 105,000
= 600 Birr
EBIT (when the level of output is 8000 units) = 15,000 birr
The percentage change in EBIT, therefore, is
600  15,000  14,400
% EBIT  %     0.96, or  96%.
15,000 15,000

Therefore, the decrease the output level by 12 percent, or 960 units causes 96 percent, or 14,400Birr
decrease in EBIT.
Related Interpretations of Operating Leverage:
The following are some of the related interpretations that are based on properties of operating
leverage:
1. A positive coefficient of operating leverage indicates that leverage is being computed at a
level of output greater than operating breakeven.
2. A negative coefficient of operating beverage indicates that leverage is being computed at a
level of output below operating breakeven.
3. A large absolute value of operating leverage (the coefficient of operating leverage without
algebraic sign) indicates that output is close to the operating breakeven and that the
absolute size of EBIT is close to zero, or relatively small.
4. A positive coefficient of operating leverage to 1.0 indicates that output is relatively for
above operating leverage breakeven and that the amount of EBIT is relatively large.
The implication of the higher degree of operating leverage is that the smaller change in the level of
output (units sold) will bring higher change of profit before interest and taxes (EBIT). Thus, operating
leverage is definitely an attribute of the business risk that confronts business firms. Business risk is
defined as the relative dispersion or variability in the company's expected earnings before interest and
taxes (EBIT). As we have seen with the illustrative examples, the degree of operating leverage falls as
the level of output (sales) past the company's breakeven point.
Application of operating leverage:
The application of operating leverage are the extension of its properties and interpretations. The basic
applications discussed below.
1. It Explains the Magnification of Percentage Changes in EBIT:
The fundamental application of operating leverage lies in explaining why changes I the level of
output (sales) can produce disproportionate changes in EBIT. The measurement equation of
operating leverage indicates that as long as fixed costs are greater than zero, a 1 percent change
in output (sales) can produce a different percentage change in EBIT. In particular, for values of
output, (sales), great than the breakeven quantity the percentage change in EBIT, which result
from a 1 percent change in output (sales) is always greater than 1 percent.

131
2. It explains Errors in EBIT Forecast:- The other important application of operating leverage
deals with that explanation of errors in EBIT forecasts. Though there are many causes of such
errors, the magnification of percentage change in EBIT provides one reason why actual can
deviate significantly from its forecast value.
When the company is forecasting its expected level of output (sales) or the coming accounting
period, it must first determine the selling price (p), variable cost per unit (V), and fixed costs (F).
The company then forecasts its expected EBIT and computes the coefficient of operating
leverage at the forecast value of output (sales). For each 1 percent that actual output (sales)
deviates from forecasted output (sales), the percentage deviation of actual from forecasted EBIT
is equal to the coefficient of operating leverage multiplied by the percentage error in forecasted
output (sales volume)
3. It measures business risk: Business risk is the measure of probability or likelihood that the
company will go out of business because it is unable to learn a positive level of EBIT. There are
many approaches of measuring business risk. The use of operating leverage provide one such
measure by combining the first two applications presented above as 1and 2. When you forecast
output (sales) and EBIT for a given accounting period, the forecasts are said to be made under
conditions of business risk whenever the actual levels of output (sales) and EBIT. The larger the
deviation, the riskier the situation is. The coefficient of operating leverage can be used to
measure business risk since it indicated the extent to which forecasting error will produce
magnified percentage error in EBIT. The larger the coefficient of operating leverage, the greater
the risk since it indicates the extent to which forecasting error will produce magnified
percentage error in EBIT. The larger the coefficient of operating leverage, the greater the risk
surrounding the forecast value of EBIT and as the consequence the greater the risk that the
actual EBIT will turnout to be negative.
The degree of business risk also changes when the firm makes asset composition decisions that
alter the fixed and variable costs of the company. If changing the company's production costs
alters its operating breakeven point, it results in a new set of operating leverage coefficients and
the company's business risk changes. In general, increasing the company's breakeven increases
its degree of business risk; and decreasing breakeven reduces the degree of business risk.
To illustrate the effect of the change in the composition of the assets of the company on the
breakeven quantities, operating leverage coefficients and business risk, assume Alem
Manufacturing company whose manufacturing costs include fixed portion of 4,800,000Birr and
variable port of 26 Birr per unit. The selling price is 51 birr per unit of the company. The
company is considering to automate a portion of its production process. Because of the
automation process, the fixed manufacturing costs of the company increase to 5,400,000Birr,
but variable manufacturing costs per unit decreases to 25Birr compute the breakeven quantities
before automation and after automation. Calculate the operating leverage coefficients given the
levels of output (T) of 225,000 units, 250,000 units, and 275,000 units. Comment on the degree
of business risk. The operating breakeven quantity before automation is computed by using cost
date before the automation decision: Hence;
F
T (before automation) =
P V
4,800,000 4,800,000
T (before automation) =   192,000 units.
51  26 25
The operating breakeven quantity after automation is computed by using cost data after the
F
automation decision. Hence, T(after automation) =
P V
5,400,000 5,400,000
=   207,692 units
51  25 26

132
 The coefficients of operating leverage for the given values of output (T) are contained in the
following table. All the coefficients are computed by using the general equation for the coefficient
or operating leverage. That is,
OL T  
T (P  V )
T )P  V )  F
Output quantity (OL/T) before (OL/T) after
(T) Automation automation
225,000 6.82 13.00
250,000 4.31 5.91
275,000 3.31 4.09
As you can see from this table, the coefficients of operating leverage after automation are greater
than the coefficients of operating leverage before automation. Moreover, the breakeven quantity
after automation is greater than the breakeven quantity before automation. Since the operating
breakeven quantity and the coefficients of operating leverage have increased as a result of
automation, the company's operating risk, as it is measured using the operating leverage
coefficients, has also increased. This illustrative example, therefore, reveals that the financial
manager of a given company can change the operating risk (either increase or decrease) by altering
the composition of composition of company's assets.
Financial Leverage:
Operating leverage and financial leverage are application of the same concept. As a result, the
definition and properties of financial leverage are parallel to those of operating leverage. Financial
leverage can be defined as the practice of financing a portion of the company's assets with securities
bearing a fixed rate of return in hope of increasing the ultimate return to the common shareholders,
Earning Per Share (EPS).

Financial leverage measures the relationship between EBIT and EPS. More specifically, it reflects
the effect of changing levels of EBIT on EPS (earning per share). The functional relationship
between the two variables is:
EPS = F (EBIT)
The relationship can be more specific as follows:
(Y  I )(i  t )  E
EPS = where,
N
Y = EBIT
I = interest costs of the company
t = income tax rate
E = preferred stock dividend
N = Number of common shares
When the level of EBIT changes from its initial value, the initial value of EPS also changes. Financial
leverage can also be defined as the resulting percentage change in EPS divided by the percentage
change in EBIT. Algebraically, financial leverage is expressed as:
L( EPS ) EPS / EPS % EPS
 
L( EBIT ) EBIT / EBIT %  EBIT
Note that EBIT is the independent variable when measuring financial leverage, but it the dependent
variable when measuring operating leverage. As a result, EBIT is sometimes called the linking
variable with respect to leverage applications in finance.
Let us assume that Ediget Enterprise is a share company with the outstanding common shares of
60,000. The enterprise incurs interest expenses amounting to 100,000Birr. The fixed preferred stock

133
dividend amounts to 80,000Birr. The enterprise's EBIT is 500,000Birr. Income tax rate is 40percent.
What is the EPS at this level of EBIT using the given information?
(Y  I )(i  t )  E (500,000  100,000)(1  0.4  80,000
EPS  
N 60,000

( 400,000)(0.60)  80,000

60,000

240,000  80,000

60,000

160,000
  2.67 birr per share
60,000

Assume that EBIT of the enterprise increases from 500,000Birr to 600,000Birr. This increase in EBIT
affects the EPS of the enterprises. Using the EBIT of 600,000 Birr, the resulting EPS is:

(600,000  100,000) (1  04)  80,000

EPS 
60,000

(500,000)(0.60)  80,000

60,000

300,000  80,000

60,000

220,000

60,000

 3.67 Birr Per Share

Using the equation indicated for financial leverage above, the coefficient of financial leverage is
computed as:
600,000  500,000 100,000
Percentage change in EBIT =  0.2 or 20%
500,000 500,000

3.67  2.67 1.00

  0.3745 or 37.45%
Percentage Change in EPS = 2.67 2.67

L( EPS ) 0.3745
  1.87
L( EBIT ) 0.2000

The coefficient of financial leverage of 1.87 is interpreted as follows:

A 1 percent change (increase or decrease) in EBIT from the initial value of 500,000 Birr produces a
1.87 percent change (increase or decrease) in EPS. Since EBIT has increased by 20 percent from
500,000Birr to 600,000, EPS has to increase by 1.87 (0.20) = 0.374, or 37.4 percent from 2.67 birr to
3.67 Birr.

134
 Measurement of Financial Leverage:
The measurement equation used to calculate the coefficient of financial leverage is:
L( EPS ) EBIT
L ( EBIT ) EBIT  Interest Costs  Pr eferred shares dividend
1  tax rate

Y
( FL ) 
Symbolically Y E
Y I
i t

The left-hand side of the above equation (i.e FL/Y) is read as : financial leverage, given the value of
EBIT.

By plugging the data for Edget Enterprise before the increase in EBIT. the coefficient of financial
leverage can be computed by using the above measurement equation for financial leverage. That is:
 FL  500,000 500,000

 500,000  80,000 500,000  100,00  133,333
500,000  100,000 
1  04

 1.87
The coefficient of financial leverage of 1.87 computed by using the measurement equation for
financial leverage is exactly the same as the coefficient you have computed by dividing the percentage
change in EPS by the percentage change in EBIT earlier.

These financial leverage equations are appropriate in situations where company's EBIT involves
multiple product lines and/or nonlinear production and operation costs. the term financial leverage is
used because this type of leverage focuses on the EPS impacts resulting from the financing decisions
of a company. Financial leverage is sometimes called balance sheet leverage or capital structure
leverage.

In order to see the applicability of financial leverage equations in the situation where EBIT is obtained
from the production and sell of multiple products and non-lier operation costs, assume Odaa Share
Company which produces and sells several different products. In financing this activities, the
company has floated two issues each of the following bonds an deferred stock, and has 1 million
shares of common stock outstanding. consider the income tax rate of 40 percent.

Bond issue A = 10,000,000 birr at 8% interest rate

Bond issue B = 20,000,000 birr at 10% interest rate
Preferred stock series A = 200,000 shares, 4.50Birr dividend per share
Preferred Stock Serie B = 300,000 shares, 7.00 Birr dividend per share.

Compute the EPS and the value of financial leverage at the EBIT level of 10,000,000Birr.

First you have to compute the total interest changes on bonds and the total preferred stock
dividend on, all preferred shares.
I (interest charge) = (0.08) (10,000,000) + (0.10) (20,000,000)
= 800,000 + 2,000,000 + 2,800,000Birr

135
 E (Preferred stock dividend) = (4.5) (200,000) + (7) (300,000)
= 900,000 + 2,100,00 = 3,000,000Birr

( EBIT  I )(i  t )  E
EPS 
N
(10,000,000  2,800,000)(1  0.4)  3,000,000

1,000,000

4,320,000  3,000,000

1,000,000

1,320,000

1,000,000
 1.32 Birr

After setting the fixed interest costs on bonds and the fixed dividend payments to preferred
shareholders, the remainder of the earnings to the common shareholders is equal to 1.32 Birr per share.

Then, you can compute the value of the financial leverage by using the general measurement
equation. That is:
 FL Y  10,000,000 
10,000,000
3,000,000
10,000,000  2,800,000 
1  0 .4

10,000,000

10,000,000  2,800,000  5,000,000

10,000,000
  4.55Birr
2,200,000

Again your interpretation for the financial leverage of 4.55 is that a 1 percent change (increase or
decrease) in the EBIT of the company causes a change (increase or decrease) in the EPS of the
company if other things remain the same.

Properties of Financial Leverage

The properties of financial leverage can be well explained by using the concept of financial breakeven
amount of EBIT. Financial breakeven amount of EBIT is defined as the value of EBIT that makes
EPS equal to zero. At the point of financial breakeven, the company's EBIT is just sufficient to cover
its fixed financing costs (bond interest and preferred stock dividends) on a before-tax basis, leaving no
earning for common shareholders. Above this breakeven amount of EBIT, the company produces a
positive level of earnings available to common shareholders and a positive EPS. Below this breakeven
point, profit available to common shareholders and EPS are both negative. It is thus possible for the
company to report positive level of EBIT even though its EPS is negative. This will happen when the
EBIT of the company is less is positive but less than the EBIT that leads to financial breakeven. In
other words, EPS is negative when the positive EBIT is not sufficient to cover the fixed financial costs
(costs of bonds and dividends on preferred stock).

136
Based on the definition given for financial breakeven, we can express leverage EPS is equal to zero.
Hence,
(Y-I) (I-t)-E = 0
N
Solving for Y, or EBIT, in this equation, you get:
E
Y = I +
I t

The value of Y, or EBIT that you get by using this equation will result in the EPS of zero which is
referred to as the point of financial breakeven.

To illustrate the point of financial breakeven assume that the total interest costs (I) and total fixed
dividends on preferred stock (E) for Birr a share company are 2,000,000 birr and 1,300,000
respectively. Then, the financial breakeven amount of Y, or EBIT is calculated as:

E
Y = I + inserting the values into the equation and using the income tax
I t
rate of 40percent , you get:

1300,000
Y = 2,000,000   2,000,000 + 2,166,667 = 4,166,667 Birr
1  0.4

If the company's EBIT is exactly 4, 166,667Birr, it can just cover its fixed financing costs (interest on
bonds and dividends on preferred stock). Nothing remains for common shareholders as earnings. The
EPs is zero as indicated as follows.

(Y  I ) (1  t )  E (4,166,667  2,000,000) (1  0.04)  1,300,000

EPS  
N N

( 2,166,667) (0.6)  1,300,000 1,300,000  1,300,000 O

   O
N N N

Since zero divided by any number is zero, the EPS is zero for any number of outstanding common
shares. since the EPs at the level of EBIT of 4,166,667Birr is zero, this level of EBIT is the financial
breakeven amount.

If financial leverage is calculated at financial breakeven, the resulting coefficient of financial leverage
has undefined value,. computed as:

4,166,667
( FL  4,166,667) 
Y 1300,000
4,166,667  2,000,000 
1  0 .4
4,166,667 4,166,667
 
4,166,667  2,000,000  2,166,667 0
= Undefined

Using the same data for Birra share company, the measurement equation for financial leverage can be
used to compute the coefficients of financial leverage for different values of EBIT.

137
 2,000,000
( FL  2000,000)    0.92
Y 1,300,000
4,166,667  2,000,000 
1  0.4

 FL   3,000,000
   2.57
 Y  3,000,000  1300,000
3000,000  2000,000 
1  0.4

 FL   6,000,000
  3.27
 Y  6,000,000  1,300,000
3000,000  2,000,000 
1  0.4

 FL Y  10,000,000  
10,000,000
1,300,000
 1.71
10,000,000  2,000,000 
1  0.4

These coefficients of the financial leverage can be plotted in the X-Y plane where the Y-axis
represents the coefficients of financial leverage and the a-axis represents the values of EBIT of the
company as follows.

y-axis
5.0

4.0
Coefficient of financial leverage

3.0
4,166,667 birr
2.0

1.0

0 1 2 3 4 5 6 7 8 9 10 11 x-axis

-1.0
EBIT (in millions of birr)
-2.0

-3.0

The smooth curves I the above graph indicate that there are a unique value of financial leverage for
each amount of EBIT. The vertical broken like is drawn at the financial breakeven amount of EBIT of
4,166,667 Birr and indicates that the coefficient of financial leverage is undefined at this point. The
horizontal broken line that passes through the coefficient of financial leverage of 1.0 that is for the
values of EBIT greater than financial breakeven, the coefficients of financial leverage is greater than
1.0, but never be equal to1.0.

138
When EBIT of the company falls below the financial breakeven, the coefficients of financial leverage
al negative and approaches zero as EBIT goes to zero.

The above graph reveals the relationship between EBIT and the coefficient of financial leverage when
bond interest rates, preferred stock dividend's and income tax rate are held constant. If any open or all
of these variables change, it alters the coefficients of financial leverage for different level of EBIT
since it also changes the financial breakeven. In a very special case where the sum of interests on
bonds and dividends on preferred stock equals to zero, the coefficient of financial leverage equals 1.0
for all values of EBIT greater than zero. This will happen when both interest on bonds (I) and
dividends on preferred stock (E) are zero. When this is the case, the equation for financial leverage
will be reduced to:
FL
Y
 
Y
E

Y
0

Y
Y
 1
Y I  Y 0
i t 1 t

But such a situation, where both interest on bonds and dividends on preferred stock are zero is very
rare. Hence, it is unlikely that the coefficient of financial leverage is equal to 1-0.

Interpretation of Financial leverage:

As with operating leverage, there are fundamental and related interpretations of financial leverage.
The size of the coefficient of financial leverage and the value of EBIT with respect to financial
breakeven point help interpret the coefficient in specific situations.

Fundamental Interpretation:- The fundamental interpretation of the coefficient of financial leverage is

that it is the percentage change in EPS that results from a 1 percent change in EBIT.

To illustrate the fundamental interpretation of the coefficient of financial leverage, assume that Aga
Share company's interest on bonds and dividends on preferred stock are 1,000,000 Birr and
500,000Birr respectively. The income tax rate is 40percent. When the level of EBIT equals
4,000,000Birr, the value of EPS and coefficient of financial leverage are:

( 4,000,000  1,000,000)1  0.4   500,000

EPS 
100,000

(3,000,000)(0.6)  500,000 1,800,000  500,000

 
100,000 100,000

 13Birr

=
 FL Y  4,000,000  
4,000,000
500,000
4,000,000  1,000,000 
1  0.4

4,000,000
= 4,000,000  1,000,000  833,3330

139
 4,000,000
=  1.85
2,166,667

The computed coefficient of financial leverage of 1.85 indicates that the decrease I EBIT by 1 percent
(from 4,000,000Birr to 3,960,000Birr) will result in the fall of by 1.85 percent. To prove the
correctness of this interpretations solve for EPS when EBIT decreases to 3,960,000Birr.

3,960,000  1000,000) (1  0.4)  500,000

EPS 
100,000

( 2,960,000) (0.60)  500,000

  12.76 Birr
100,000

Hence, the percentage change in EPS (i.e. %  EPS) is computed as:

12.76  13  0.24
%EPS     0.0185 or 1.85%
13 13

The percentage change (decrease) in EPS computed here is the same as to the percentage change
(decrease) in EPS we had computed earlier by using the measurement equation of financial leverage.

The fundamental interpretation of financial leverage can be further generalized as the percentage
change in EPS their results from a given percentage change in EBIT multiplied by the percentage
change in EBIT. Therefore, you can determine the percentage change in EPS given the percentage
change in EBIT and the coefficient of financial average. The percentage change in EPS is the product
of the percentage change in EBIT and the coefficient of financial leverage.

For example, assume the same data for Aga Share Company and the increase I the initial value of
EBIT by 10 percent (from 4,000,000 Birr to 4,400,000 Birr). We have already computed the
coefficient of financial leverage given the initial level of EBIT to be 1.85 percent. Hence, the
percentage change in EPS share can be computed by multiplying the percentage change in EBIT by
the coefficient of financial leverage.

% EPS  (% EBIT ) ( FL Y  4,000,000)

= (0.100) (1.85) = 0.185, or 18.5%

This computed percentage change in EPS (%  EPS) of 18.5 can be verified by calculating the values
of EPS both at the levels of EBIT of 4,000,000 Birr and 4,400,000Birr (i.e.10 percent above the
initial value of EBIT of 4,000,000Birr).

The EPS when the level of EBIT is 4,000,000Birr is 13Biir, and

when EBIT amounts to 4,400,000Birr the EPS is:
( 4,400,000  1,000,000)(1  0.4)  500,000
EPS 
100,000

(3,400,000) (0.6)  500,000 1,540,000

   15.40 Birr
100,000 100,000

140
Then, the percentage change in EPS
EPS 15.40  13.00 2.40
( % EPS  EPS (initial )  13.00

13.00
 0.185, or 18.5%

Related Interpretations:

The following related interpretations are based on the properties of financial leverage:
1. A positive coefficient of financial leverage means that leverage is being computed for a value of
EBIT that is greater than financial breakeven amount.
2. A negative coefficient of financial leverage, on the other hand, indicates that leverage is being
computed for a value of EBIT below financial breakeven amount.
3. A large absolute value of financial leverage indicates that leverage is being computed for the
value of EBIT that is close to the breakeven and that the absolute value of EPS is relatively
small.
4. A positive coefficient of financial leverage that is close to 1.0 indicates that leverage is being
computed for the value of EBIT that is relatively for above financial breakeven amount and that
the corresponding value of EPS is relatively large.

Applications of Financial Leverage:

The applications, or uses of financial leverage are based on its properties and on the fundamental
interpretation of financial leverage. These applications occur repeatedly in managerial finance. The
following are some of applications of financial leverage.
1. It Magnifies the percentage change EPS:- The fundamental application of financial leverage
is to explain why changes in EBIT can produce magnified percentage changes in EPS. The
measurement equation for financial leverage indicates that as long as fixed financing costs
(interests on bonds and dividends on preferred stock) are greater than zero, a 1 percent in EBIT
produces the percentage change in EPS that is different from 1.0.

2. It explains errors in EPS forecasts:- a second application of financial leverage occurs in

explaining errors in forecasting EPS. It is common that companies forecast their expected EBIT
and EPS for a particular accounting period. They also compute the coefficients of financial
leverage at the forecasted levels of EBIT. For each percent that t he actual values of EBIT
deviate from the forecast values, the percentage deviations of actual values of EPS from the
forecast values are computed by multiplying the coefficients of the company's' financial
leverage by the percentage errors I forecasting EBIT.

For instance, XYZ corporation forecasts its EBIT for the coming accounting period to be
30,000,000Birr. The relevant values of the corporation's income statement items are: interests
on bonds (I) is 4,000,000Birr; dividends on preferred stock (E) is 1,500,000 and the number of
common shares outstanding is 2,000,000; and the income tax rate is 40 percent. The EPS and
the coefficient of financial leverage for the forecasted amount of EBIT are:
EPS = (30,000,000-4,000,000) (1-0.4) - 1,500,000
2,000,000

= (26,000,000) 0.6) -1,500,000

2,000,000

= 15,600,000-1,500,000 = 14,100,000 = 7.05Birr, and

141
 2,000,0000 2,000,000

30,000,000 30,000,000
( FL  30,000,000)  
Y 1,500,000 30,000,000  4000,000  2,500,000
30,000,000  4,000,000 
1  0.4

30,000,000
  1.28
23,500,000

If the actual EBIT is turned to be 10 percent above the forecasted EBIT, value, actual EPS will
be (1.28) (0.10) = 0.128 or 12.8 percent above the forecasted EPS value. Hence, the actual
EBIT of 33,000,000 birr will yield an EPS value of (7.05Birr) (1.28) = 9.02Birr.

This application of financial leverage suggests that it may be possible to anticipate EPS
forecasting errors because one component in generating these errors is the coefficient of
financial leverage at forecasted level of EBIT. The larger the value of the coefficient of
financial leverage, the larger the range of possible EPS forecasting errors.

3. It Measure Financial Risk: Financial risk is a direct result of the company's financing decision.
In the context of selecting proper financing mix, this applies to (1) the additional variability to
the company's common shareholders and (2) the additional chance of solvency borne by the
common shareholder caused by the use of financial leverage. In other words, financial risk is
the probability or likelihood of serious fluctuations in EPS because of company's choice of a
particular capital structure. Financial leverage is one of the several approaches to measuring
financial risk. Forecasted values of EBIT and EPS are said to be risky whenever the actual
EBIT and EPS value deviate from their estimated values. The larger the deviations, the riskier
the situations. Financial leverage can be used to measure financial risk because it indicates the
size of EPS forecasting error that a 1 percent EBIT forecasting error can produce. the larger the
coefficient of financial leverage, the greater the degree of financial risk. This is because large
values of financial leverage require relatively small EBIT forecasting errors in order to produce
negative EPS values. The company's degree of financial risk changes whenever the company
alters its fixed financing costs. Shifts in financial risk also occur when the firm substitutes one
type of financing for another if new values for I and/or E emerge. The change in common share
doesn't alter the degree of financial risk as measured by finance leverage because common stock
dividends are not contained in the measurement equation for financial leverage. Change in the
income tax rate can also affect the company's financial leverage as it is one of the inputs to the
financial leverage equation.

The change in the values of the fixed financing costs produces a new financial breakeven amount of
EBIT, and a new set of financial leverage coefficients. Increasing the financial breakeven amount
increases a company's degree of financial risk; decreasing the financial breakeven decreases the
degree of financial risk.

For example. Ayat House Construction Company has a4 million Birr EBIT, 1.2 million in interest
payment on debt, a 40 percent tax rate, and no other fixed financing costs. The company's financial
breakeven is:

Y = I+ E = 1.2 million + 0__ = 1.2 million + 0 = 1.2million

1-t

142
Suppose that the company has decided to expand and will finance the expansion by selling additional
shares of common stock or by floating an initial issue of preferred stock that requires 600,00 Birr
dividend payment.

If common stock issuance is chosen as the financing alternative; financial breakeven amount and the
degree of financial risk are not affected. Financial leverage coefficients for selected EBIT values are
computed in the following table. All the coefficient of financial leverage are computed by applying
the general measurement equation; i.e.

EBIT
( FL )  Hence,
Y E
EBIT  I 
1 t

( FL ) ( FL )
Y Y

EBIT Common Stock issued Preferred stock issued

4.0 million Birr* 1.43* 2.22**
4.5 million Birr 1.36 1.96
5.0 million Birr 1.32 1.79
* (FL/Y = 4 million) = 4,000,000 = 4000,000 = 1.43
4000,000-1,200,000 2,800,000

** (FL/Y = 4 million) = 4000,000 = 4,000,000 = 2.22

4000,000-1200,000-600,000 1,800,000
1-04

If the company decides to finance the new expansion with preferred stock, the financial breakeven
amount increases to:

Y = 1,200,000 + 600,000 = 1200,000 + 1000,000 = 2,200,000Birr

1-0.4

If the company, on the other hand, decides to finance the expansion with common stock issuance, the
financial breakeven amount does not change as indicated earlier. Hence, the decision doesn't have any
impact on the financial risk. The increase in the financial breakeven amount resulting from the initial
issuance of preferred stock increase the firms financial risk as financial risk is measured by the
coefficients of financial leverage.

Combined leverage
Combined leverage is not a distinct type of leverage. It is the combination of both the operating and
financial leverages. Combined leverage measures the relationship between outputs (units sold) and
EPS. The functional relationship between these two variables is:
EPS = f(T)
The relationship can be made more specific as:
EPS = [T (P-V) - F-I] (1-t) - E
N

143
When the level of output (sales), T changes from its initial value, the initial value of EPS also changes.
Combined leverage is nothing but the percentage change in EPS divided by the percentage change in
output (sales), T. The definitional equation of combined leverage is:

L( EPS ) EPS / EPS

=
L (T ) T / T

To illustrate the computation of the combined leverage, assume that Shala Share Company. Sells its
product at 50Birr per unit. The unit variable cost of sales is 30birr and the fixed operating expenses
equal 150,000 Birr for the accounting period. The fixed costs of financing include the fixed interest
cost on bonds of 50,000 Birr and the fixed dividends on preferred stock of 20,000 Birr. What is the
company's EPS of the company, if it level of output or sales is 15,000 units?

EPS = [T(P-V) - F-I) (1-t) - E Substituting value for know

N

Variables, you get : EPS = [15,000 (50-30) - 150,000 - 40,000] (1.0.4) - 20.000
10,000

= [(15,000) (20) - 190,000] (0.6) - 20,000

10,000

= (3,00,000-190,000) (0.6) - 20,000

10,000

= 66,000-20,000 = 46,000 = 4.60Birr

10,000 10,000

If the volume of output or sales increases to 16,500 units, EPS increases to:
EPS = [[16,000 (50-30) - 150,000 - 40,000] (1.0.4) - 20.000
10,000

= (330,,000-190,000) (0.6) - 20,000 = 84,000-20,000 = 64,000

10,000 10,000 10,000

= 6.40 Birr

By using the general algebraic equation for the combined leverage indicated, the coefficients of the
combined leverage is computed as:

Percentage change in output = 16,500-15,000 = 1,500 = 0.10, or 10%

15,000 15,000

Percentage change in EPS = 6.40 - 4.60 = 1.80 = 0.391 or 39.1%

4.60

144
 %EPS 0.391
(CL/T) = L(EPS) =   3.91
%T 0.100

This computed coefficient of coefficient of combined leverage of 3.91 percent is interpreted in such a
way that 1 percent change in output or volume of the sales from a level of 15,000 units produces a
3.91 percent change in EPS. Since output (Sales volume) is assumed increased by 10 percent, the
resulting percentage change (increases) in EPS is (0.1) (3.91) or 39.1 percent.

Measurement of combined Leverage

The following two measurement equations can be used to compute the coefficient of combined
leverage: These are:
T( p V
(CL/T) = , and
T ( P  V )  F  I  E /(1  t )

(CL/T) = (OL/T) (FL/Y)

The left-hand sides of these equations (i.e. CL/T) are read as combined leverage, given the value of
output or sales.

The first measurement equation of combined leverage can be used to compute the coefficient of
combined leverage directly from a set of data. The second equation is used when the separate
coefficients of operating and financial leverage are computed. The coefficient of combined leverage is
the product of the coefficient of financial and operating leverages as indicated by second equation
above.

The equivalence of the definitional and measurement equations for the combined leveraged can be
demonstrated by using the previous data given for Shola Share Company.

At the level of output (sales volume) of 15,000 units, the values of EBIT, operating Leverage (OL/T),
and financial leverage (FL/Y) equal.

EBIT = Y T(P-V) - F
= 15,000(50-30) - 150,000 = 150,000Birr

(OL/T) = T(P-V)
T(P-V)-F

(OL/T =15,000) = 15,000 (50-30) = (15,000) (20) = 2.0

15,000(50-30) - 150,000 (15,000)(20) - 150,000

Y
(FL/Y) = Y  I  E /(1  t )

(FL/Y = 150,000) =
150,000 150,000

150,000  40,000  20,000 /(1  0.4) 150,000  40,000  33,333

145
 = 150,000 = 1.957
76,667

Now, you can use the second of equation of the combined leverage to compute the coefficient of the
combined leverage. That is:
(LC/T = (OL/T) (FL/Y) = (2.0) (1.957) - 3.914 or 3.91.

The first equation can also be used as an alternative of computing coefficient of combined leverage.
That is:
T (P  V )
(CL/T) = T ( P  V )  F  I  E /(1  t then by plugging the

Values for the variables, you get:

15,000(50  30)
CL / T 
(15,000)(50  30)  150,000  30,000  20,000 /(1  0.4)

(15,000)(20)
= (15,000)(20)  150,000  40,000  33,333

= 300,000 = 3.91
76,667

Note the both the measurement equations produce the same coefficient of combined leverage that was
obtained from the previous definitional equation (i.e. CL/T = % EPS / % T .
Properties of Combined Leverage

The properties of combined of combined leverage are similar to those of operating and financial
leverages because combined leverage is a combination of the two distinct types of leverage. These
properties can be explained by using the concept of overall breakeven. The overall breakeven is
defined as the level of output (volume of sales) that makes EPS equal to zero. From the income
statement of a company:

EPS = [T-P-V) - F-I] (1-t) - E , by equating EPS to zero and solving for output
N (volume of sales) T, you get:

O = [T (P-V) - F-I) (1-t) - E

N

[ T(P-V) - F-I ] (1-t) - E = 0

T (P-V) - F-I = E ; T(P-v) = E + F+ I

1-t 1-t
T = I+F + E/(1-t)
(P-V)

Using the data set of Shola Share Company considered in previous examples, the overall breakeven
amount of output is:
T = 30,000 + 150,000 + 20,000/(1-0.4) = 30,000+ 150,000 + 33,333

146
 50.30 20

= 223,333 = 11,167 units

20

You can use the first measurement equation for combined leverage to compute the coefficients of
combined leverage at different levels of output (volume of sales ) as follows:
5000 (50  30)
(CL / T  5000    0.811
5000(50  30)  150,000  40,000  20,000 /(1  04)

10,000(50  30)
(CL / T  10,000)   8.57
10,000(50  30)  150,000  40,000  20,000 /(1  04)

20,000 950  30)

(CL / T  20,000)   2.26
20,000 (50  30)  150,000  40,000  20,000 /(1  0.4)

25,000 950  300)

(CL / T  25,000)  1.81
25,000(50  30)  150,000  40,000  20,000 /(1  04)

As we have done for operating and financial leverage coefficients, the coefficients of the combined
leverage computed above can be plotted on the X-Y plane where the Y-axis represents the coefficient
of the combined leverage and X-axis represents the volume of output (sales).

5.0-
4.0-
3.0-
2.0-
1.0- --------------------------------------------------------------------------

-1.0- *5 10 15 20 25
-2.0- output (volume of sales) in thousands of units
-3.0-
-4.0-
-5.0-
-6.0-
*

The vertical broken line drawn through 11,167 units (the overall breakeven) indicates that the
combined leverage (CL/T) is undefined at this level of output (volume of sales). The horizontal
broken line drown through the coefficient of combined leverage of 1.0 indicates that for the output
levels greater than the overall breakeven, the coefficient of combined leverage is always greater than
1.0, but decreases with increasing levels of output (volume of sales) and approaches 1.0, and never be
1.0.

When the level of output (volume of sales) is below the overall breakeven, the coefficient of combined
leverage is negative and approaches zero as output level ()sales volume) goes to zero. In the special
case where fixed operating costs and fixed financing costs are all zero (F=I = E=0), the coefficient of
comb9iend leverage is equal to 1.0 for all levels of output (sales volume greater than zero.

147
Interpretation of Combined Leverage:

Interpreting the coefficient of combined leverage rests on the properties that wee just explained. The
fundamental interpretation of the coefficient of combined leverage is:

The coefficient of combined leverage is the percentage change in EPS that results from a 1
percent change in output. It is also possible to generalize this interpretation in such a way
that results from a given percentage change in output (sales volume)

To further explain this fundamental interpretation of the coefficient of combined leverage, assume, the
same data set for Shola Share company used in previous examples. At the initial level of output (sales
volume) of 15,000 units, we have computed EPS of 4.60 birr and the coefficient of combined leverage
(CL) of 3.91 for the company. The fundamental interpretation states that if output increases by 15
percent, for example (from 15,000 units to 17,250 units), the percentage change in EPS will be (3.91)
(0.15) or 0.587 or 58.7 percent. Thus, EPS will increase by (4.60) (0.587) or 2.70 birr. The resulting
value of EPS is 4.60 Birr plus 2.70 birr which equals 7.30 birr. In the same way, if output level
(volume of sales) decreases by 5 percent (from 15,000 units to 14,250 units). EPS would also fall by
(3.91) (0.05), or 0.196, or 19.6 percent. The birr decrease in EPS would be (4.60) (0.196) or 0.90 birr
or 90 cents and the resulting value of EPS would be (4.60 birr – 0.90 birr) 3.70 birr.

The following are the related interpretations that are based on the properties of combined leverage:

1. A positive coefficient of combined leverage indicates that leverage is being computed for a
level of output greater than the overall break even quantity of output (sales volume).
2. A negative coefficient of combined leverage indicates that leverage is being computed at a
level of output below the overall breakeven quantity of output (sales volume.)
3. A large absolute value of the coefficient of combined leverage indicates that the corresponding
output level (sales volume) is close to the overall breakeven quantity of output (sales), and the
absolute value of EPS is minimal
4. A positive coefficient of combined leverage that is close to 1.0 indicates that output level (sales
volume) is relatively far greater than the overall breakeven quantity and that the value of EPS
is sizable. Therefore a 1 percent increase in output level (sales volume) will increase EPS by
relatively small percentage.

Applications of combined Leverage:

The combined leverage can be applied or used to:

i) Explain why changes in the level of output produce magnified percentage changes in EPS,
ii) Explain EPS forecasting errors, and
iii) Provide a measure of an overall company risk.

i) Combined leverage explains why changes in output level produce magnified percentage
change in EPS. As already indicated, combined leverage tries to explain why a 1 percent
change in output produces a disproportionate percentage change in EPS as long as fixed

148
 financing costs are greater than zero. Increases in the fixed financing cost components
used to measure operating leverage and/or financial leverage can produce greatly increased
coefficient of combined leverage because combined leverage is the product of the
coefficients of operating and financial leverage.
ii) Combined leverage can be used to explain errors in EPS forecasts. A company usually
forecasts its expected level of output (sales volume) and the corresponding EPS and
computes the coefficient of combined leverage at the forecasted level of output (sales
volume). Other things kept constant, for each percentage of deviation in actual level of
output (sales volume) form its forecasted level, this percentage deviation of actual EPS
from its forecasted EPS is equal to the coefficient of combined leverage multiplied by the
percentage error in forecasted output level.

iii) Combined leverage can be used to provide a measure of overall company risk. The overall
company risk that the company assumes is the possibility that it will go out of business and
that its shareholders’ investment will become worthless. In such an event, the price of the
share of the company will go down (i.e. the wealth of shareholders’ will be minimized).
Since combined leverage is the product of operating leverage (which measures operating
risk) and financial leverage (which measures financial risk), it measures the overall
(combined) risk. In general, the larger the coefficient of combined leverage for a
forecasted level of output, the greater the overall risk. That the company and its
shareholders encounter.

Any investment-financing decision that results in an altered company’s overall breakeven quantity of
output will change the degree of overall riskness of investing in that particular company. A decrease
in unit selling price, or increases in fixed production costs, unit variable production costs, or fixed
financing costs increase the overall breakeven quantity of output (sales volume) and the coefficient of
combined leverage. This further indicates that the increase in the overall risk of investing in the
company. An increase in the unit selling price, or decreases in production or financing costs, on the
other hand, decrease the overall breakeven quantity of output and the coefficient of combined
leverage. This will further decrease the overall company risk.

Chapter Summary

The chapter has discussed leverage (operating, financial and combined) as a tool for financial analysis.
The chapter has tried to explain you the definitions, properties, interpretations, and applications of
operating financial, and combined leverage.

Operating leverage is the responsiveness of the company’s EVIT to changes in the quantity of output
or sales. It arises from the company’s use of fixed operating costs. When fixed operating costs are
presented in the company’s cost structure, changes in the level of output, or sales are magnified into
even greater changes in EBIT. The company’s degree of operating leverage from the initial level of
output (sales volume) is the percentage change in EBIT divided by the percentage change in the level
of output/ sales. Operating leverage provides a measure of operating risk.

A company employs financial leverage when it finances a potion of its assets with securities bearing a
fixed rate of return (bonds and preferred stock). The presence of bonds and/or preferred stock in the
company’s capital structure means that it is using financial leverage. When financial leverage is used,
changes in EBIT lead into larger changes in EPS.

149
The concept of financial leverage dwells on the sensitivity of EPS to changes in EBIT. The degree of
financial leverage is defined as the percentage change in EPS divided by the percentage change in
EBIT. All other things equal, the more bonds and preferred shares the company employs in its
financial structure, the larger is the degree of financial leverage. Financial leverage provides a
measure for financial risk of investing in fixed rate securities.

Companies use operating and financial leverages in various degrees. The joint use of operating and
financial leverage can be measured by computing the combined leverage coefficient, defined as the
percentage change in EPS divided by the percentage change in the level of out put (sales).

Combined leverage explains how operating and financial leverage interact to make changes in the
level of output (sales) produce magnified changes in the level of EPS. Mathematically, combined
leverage is the product of operating and financial leverage at any given level of output/sales.
Combined leverage helps to measure the overall company risk.

150