Financial Management-I

Course Code: ACFN 3041

Cr/hr :-3
 CHAPTER -1
Introduction to Financial Management
 Definition of Finance
 Functions Of Financial Management
 Forms of Businesses
 Goals of the Corporation
 Conflicts Between Managers and Shareholders
 Over View Of Finance
 Finance is the application of economic principles to
decision-making that involves the allocation of money
under conditions of uncertainty.
 In other words, in finance we worry about money and

we worry about the future.

 Investors allocate their funds among financial assets in

order to accomplish their objectives, and businesses

and governments raise funds by issuing claims against
themselves and then use those funds for operations
 Definition of Finance
 Finance- Money
 Finance is the art and science of managing money .
 ‘Finance’ connotes ‘management of money’.
 Finance as “the Science on study of the management of

funds’ and the management of fund as the system that

includes the:
 Circulation of money,
 Granting of credit,
 Making of investments, and
 Provision of banking facilities.
FUNCTIONS OF FINANCIAL MANAGEMENT

Investment Decision:

The investment decision relates to the selection of assets in which

funds will be invested by a firm. The assets which can be acquired

fall into two broad groups:

 long-term assets which

 will yield a return over a period of time in future,

 short-term or current assets defined as those assets which are

convertible into cash usually within a year.

Dividend Decision
It is a fact that in spite of the various other factors which
influence the market value of shares, dividend payment has
been considered to be the foremost. In this context, the finance
manager must decide whether the firm should distribute all
profits or retain them, or distribute a portion and retain the
balance. Sometimes, the profits of the company are fully
diverted towards its capital expenditure or establishment of
new projects so as to minimize further borrowings.
Financing Decision
In this function, the finance manager has to estimate carefully
the total funds required by the enterprise, after taking into
account both the fixed and working capital requirements. In
this context, the financial manager is required to determine
the best financing mix or capital structure of the firm. Then,
he must decide when, where and how to acquire funds to
meet the firm’s investment needs.
Liquidity Decision
Is concerned with the management of the current
assets, which is a pre-requisite to long-term success of
any business firm.
Alternative Forms of Business Organization
 Sole -Proprietorship
 Partnership
 Corporation
Proprietorships & Partnerships
 Advantages
◦ Ease of formation
◦ Subject to few regulations
◦ No corporate income taxes
 Disadvantages
◦ Difficult to raise capital
◦ Unlimited liability
◦ Limited life
Corporation
 Advantages
◦ Unlimited life
◦ Easy to transfer of ownership
◦ Limited liability
◦ Ease of raising capital
 Disadvantages
◦ Double taxation
◦ Cost of set-up and report filing
Objectives Of Financial Management

Objectives of Financial Management may be broadly

divided into two parts such as:-
1. Profit Maximization
2. Wealth Maximization
Financial Goals of the Corporation

The primary financial goal is shareholder wealth

maximization, which translates to maximizing stock
price.
◦ Do firms have any responsibilities to society at large?
◦ Should firms behave ethically?
Conflicts Between Managers and
Stockholders
Managers are naturally inclined to act in their own best
interests (which are not always the same as the
interest of stockholders).But the following factors
affect managerial behavior:
 Managerial compensation plans
 Direct intervention by shareholders
 The threat of firing
 The threat of takeover
End of chapter one Thank You!
 Chapter-two

Analysis of financial statement

Basic Financial Statements And Analysis
2.1. Introduction to financial statements
 Financial statements are official documents of the firm.
 The two basic financial statements prepared for the
purposes of external reporting are:
 Balance sheet and income statement.
2.2 Financial Analysis Meaning And Importance

 Is the process of examining relationships among

elements of the company's financial statements and
making comparisons with relevant information.
 Analysis and interpretation are closely inter-linked and
they are complementary to each other.
 Analysis without interpretation is useless and
interpretation without analysis is impossible.
2.3. TECHNIQUES OF FINANCIAL STMT ANALYSIS

1. Trend /Horizontal Analysis

2. Common Size/Vertical Analysis
3. Ratio Analysis
RATIO ANALYSIS
 It is the technique of interpretation of financial statements with the
help of accounting ratios derived from the Balance Sheet and Income
Statement.
 Financial ratio analysis is the most common form of financial
statements analysis
 Advantages of Ratios Analysis:
 Simplifies financial statements
 Facilitates inter-firm comparison

 Help in investment decisions

 Helps in planning

Limitation of Ratio Analysis

Limitations of financial statements

Comparative study required

Ratios alone are not adequate

Lack of adequate standard


Classification of Ratio
A. Liquidity Ratio
B. Activity Ratio
C. Solvency Ratio
D. Profitability Ratio
A. Liquidity Ratios
 Liquidity ratios measure a firm’s ability to meet short
term obligations with short-term assets.
The most commonly used liquidity ratios are
the following:
Current Ratio
Quick ratio/Acid test ratio
Cash ratio
 Current Ratio
 It is the relationship between CA & CL
 Current ratio measures the ability of the firm to meet its

short-term obligations with its current assets.

 The higher the ratio, the more liquid the firm is
 A low current ratio indicates that the firm is having

difficulty in meeting short-term commitments and the

liquidity position of the firm is not safe
Current Ratio = Current Assets = CA
Current Liability CL
Interpretation of Current Ratio
 Acceptable current ratio values vary from industry to
industry
 As a conventional rule, current ratio of 2:1 is considered

satisfactory for merchandising firms.

NB. Current ratio is a test of quantity, not test of
quality.
 Quick Ratio (QR) (Acid Test Ratio) (ATR)

 QR uses all current assets except inventory for measuring

the liquidity of the firm.
 The ratio measures the firm’s ability to meet CLs from its

most liquid assets.

 As a convention, generally, a quick ratio of "one to one"

(1:1) is considered to be satisfactory.

Quick Ratio (QR) = CA – Inventory- Prepayment
Current Liability
Cash Ratio interpretation
 Cash Ratio is an indicator of company's short-term
liquidity.
 It measures the ability to use its cash and cash

equivalents to pay its current financial obligations.

 A cash ratio of 0.5:1 or higher is preferred.

Cash Ratio = Cash + Marketable securities

Current Liability
Activity 1

Calculate
a. Current Ratio
b. Quick/Acid Test Ratio
c. Cash ratio and interpret the results
Activity Ratio (Asset Utilization Ratios)

 These ratios are also called measures of Efficiency

ratios.
 They show the intensity with which the firm uses its

assets in generating sales.

The following are the most important
asset utilization ratios:
 Inventory turnover ratio.
 Receivables turn over ratio.
 Fixed Assets turn over ratio.
 Total Assets turnover ratio.
Inventory Turnover Ratio (ITOR)
 Measures the velocity of conversion of stock into sales
 Indicates the number of times stock has been turned into

sales
Inventory Turnover = Cost of Goods Sold
Average of Inventory
2. Receivables Turnover Ratio (RTOR)
 Measures Company’s efficiency in collecting its sales on credit
and collection policies.

Receivables Turnover (RTO) = Credit Sales

Account Receivable
3. Fixed Assets Turnover
 It indicates how intensively the fixed assets of the firm are being

used.
Fixed Assets Turnover = Sales
Fixed Assets
 In such a case, the firm might be better off to liquidate some of the

fixed assets and invest the proceeds productively.

 4. Total Assets Turnover (TATO)
 TATO helps measure the efficiency with which firms use
their assets.
 It reflects how well the company’s assets are being used

to generate sales
Total Assets Turnover = Sales
Total Assets
 A low ratio indicates excessive investment in assets.
 Generally firms prefer to support a high level of sales

with a small amount of assets, which indicates efficient

utilization of assets.
Leverage Ratios Or Capital Structure Ratios

 These ratios are also known as ‘long term solvency

ratios’ or ‘capital gearing ratios.’

 Indicatethe ability of the company to survive over a

long period of time
The most commonly calculated leverage
ratios include:
 Debt to total Assets ratio
 Debt to total equity ratio
 Debt to total asset ratio (Debt Ratio)
 The debt ratio indicates the percentages of a firm’s total
assets that are financed with borrowed funds.
Debt Ratio = Total Debts
Total Assets
 Creditors usually prefer a low debt ratio since it implies a

greater protection of their position.

 Debt-Equity Ratio
 Debt to Equity is the ratio of total debt to total equity.
 As more debt is used, the Debt to Equity Ratio will increase.

Debt-equity ratio = Long-term debt

Shareholder’s Equity
Interpretation of Debt-Equity ratio
 Long-term creditors generally prefer to see a modest debt-

equity ratio.
 The D-E ratio indicates the margin of safety to the creditors.
 A very high D-E ratio is unfavorable to the firm and creates

inflexibility in operations.
 An ideal D-E ratio is 1:1
 Profitability Ratios
Profitability Ratios indicate the success of the firm in earning a net
return on sales, and also show the combined effects of liquidity,
asset management and debt management on operating results.
The following are the main profitability ratios:
 Gross profit Margin
 Operating Margin
 Net profit Margin
 Return on investment
 Return on Equity
 Gross Profit Margin
 GPM indicates the percent of each sales dollar remaining after cost
of goods sold has been subtracted.
 It also reflects the effectiveness of pricing policy and of production

efficiency.
Gross Profit Margin = Sales - CGS
Sales
Operating Margin (NOM)
 The net operating margin indicates the profitability of sales before
taxes and interest expenses.
 This ratio measures the effectiveness of production and sales of the

company’s product in generating pre-tax income for the firm.

 Generally the higher the net operating margin the better the

company is.
Net Profit Margin (NPM)
 NPM is a measure of the percent of each dollar of sales
that flows through to the stockholders as net income.
 It shows what percent of every sales dollar the firm was

able to convert into net income.

 Generally the stockholders always like to have a

higher net profit margin.

Net Income
Net Profit Margin = .
Sales
Return on Investment
It is also referred to as Return on Assets.

Net Income
ROI = .
Total Assets
Managers generally prefer this ratio to be
very high for their firms.
 However, a high ratio can also mean that the
firm is failing to replace worn-out assets.
A low return on assets shows that the firm is
not utilizing its assets profitably.
Return on Equity (ROE)

 This ratio measures the return earned on the owners'

(both preferred and common stockholders) investment
in the firm.

Return on equity is calculated as follows:

Return on Equity (ROE)=

 Common Stockholders prefer ROE to be very high, since it

indicates high returns relative to their investment
 Thank You!!!
End of Chapter Two
 Chapter Three
Time Value of Money and Its Application in Finance
Chapter learning objectives:

After studying this unit, students will be able to:

 Understand the concept of interest.

 Apply the concept of simple interest and compound interest .

 Compute the future value and present value of single deposit

and Annuities.
 3.1. Introduction: the Concept of time value of
Money and interest
 Suppose some one asked you, "Would you rather have 1000 Birr
today or 1000 Birr next year?"
 If you are rational economic decision maker, definitely your
answer would be "give it to me only today.“
 There is difference in worth between the two amounts, the timing
difference. This is termed as the time value of money.
 A Birr today worth more than the same amount that will be
received in future. Because of the opportunity to invest today’s
Birr and receive interest on the investment.
The concept of interest
 Interest is payment or the charge for the use of money for
a specified period of time and is sometimes referred as the
objective measurement for the time value of money.
 Interest is the cost of the use of money over time. It is an
expense to the borrower and revenue to the lender.
 To measure interest, three important factors must be
known; these are
 The principal(P),
 Time(n), and
 Rate(i).
 Two types of interest may be assumed in a transaction;
a) simple interest and
b) compound interest
Simple interest
An interest is said to be simple interest when it is computed on
principal only or when an interest is computed only for a single
period of time. The following equation expresses simple interest
computation.

Interest = P*i*n; Where P: principal i: interest rate

per period and n; number of time periods

 Compound interest: compound interest is computed on principal

and on any interest earned that has not been paid or withdrawn.
 It is the return on (or growth of) the principal for two or more
time periods.
 3.2. The Future Value and Present Value: Compounding and
Discounting
 The concept of future value of an amount (amounts) in a
compound interest is used to describe the original sum plus
compound interest, stated as of specific future date.
 The process of determining the equivalent future value of
present amount (amounts) is termed as compounding.
 For the sake of achieving the objective of this topic, we
classify the time value of money concepts in to four as
follows.
1. The Future value of single sum
2. The present value of single sum
3. The Future value of Annuities and
4. The present value of annuities
3.2.1. The Future Value of single Sum
 The future value of a single sum at compound interest is
the original sum plus the compound interest, stated as of a
specific future date.
 It is also often referred to as the future amount of a single

sum.
 The process of computing the future value of single sum is

depicted in the following diagram.

 E.g. The future value of single amount which is received,

deposited, borrowed or lent at the end of December 31,

2010 is computed at the end of December 31, 2014, where
P = 1000, n = 4 and i= 6 % compounded annually.
 Cont…
 Notes:-The formula to compute the future value of a
single sum at compound interest is:
 FV = PV(1+i)n
 Where : p is principal (present value), i is interest rate,

n is number of time periods.

FV=1000(1+0.06)4
=1262.6 Birr
 3.2.2. The present Value of single Sum
 The present value is the amount needed to invest now, to
produce a known future value.
 In determining the future value, a company moves

forward in time using a process of accumulation whereas,

in determining present value, it moves backward in time
using a process of discounting.
 Discounting is the process of converting the future value

to the present value.

PV= FV
(1+i)n
3.2.3. The Future Value of Annuities
 Our previous discussion was focused only on the
accumulation or discounting of a single principal sum. But,
many situations arise in which a series of dollar amounts are
paid or received periodically, such as : installment loans or
sales; regular deposits, partially recovered invested funds;
etc…, which are technically referred as Annuities.
 An annuity, is a series of equal cash flows (deposits, receipts,
payments, or withdrawals), referred to as rents, and made at
regular intervals with interest compounded at a certain rate.
 The regular intervals between the cash flows may be any
time period. E.g., one year, a six-month period, one month, or
even one day.
Cont…
 In solving measurement problems involving the use of
annuities, these four conditions must exist:
(1) The periodic cash flows are equal in amount,
(2) The time periods between the cash flows are the same
length,
(3) The interest rate is constant for each time period, and
(4) The interest is compounded at the end of each time period.
 Types of annuities:
 Ordinary Annuity- when the initial PMT starts at the
end of the period.
 Annuity Due –when the initial PYM starts at the
beginning. Of the year.
A) Future Value of Ordinary Annuity
 In the case of ordinary annuity rents (periodic payments,
receipts, withdrawals or deposits) occur at the end of periods.
 The future value of ordinary annuity is determined

immediately after the last cash flow in the series is made.

Remember that we use the term rent to describe the periodic
cash flows/equivalent cash flow assumptions.
A = R(1+i)n-1

i
What would be the future value of where n = 3 and R=2000 and
i=6% is
And where n = 5 and R=2000 and i=6% ?
Answer
1. A = 2000(1+6%)3-1 = 6366.66 Birr
6%

2. A = 2000(1+6%)5-1 = 11274.19 Birr

6%
 Future Value of Annuity Due
 The preceding analysis of an ordinary annuity assumed that
the periodic rents occur at the end of each period.
 Where as, Annuity Due, supposed that either rents (periodic

payments, receipts, withdrawals or deposits) occur at the

beginning of periods or the amount of ordinary annuity stays
on deposit to bear interest for one additional period.
The formula to compute the future value of annuity due at

compound interest is:

 A = R(1+i)n-1 (1+i),

i
Example: The Future value of annuity due, given n = 4 and
R=2000 and i=6% is
Answer
A = 2000(1+6%)4-1 (1.06 =2000(1.06)4-1 (1.06)
6% 0.06
=2000(4.3746) (1.06)

= 9274.18 Birr
 End of chapter 3

Thank you for listening

 Chapter Four
4. RETURN AND RISK

A return is the ultimate objective for any investor. But a relationship

between return and risk is a key concept in finance. As finance and
investments areas are built upon a common set of financial
principles, the main characteristics of any investment are
investment return and risk.

Many investments have two components of their measurable

return:
 A capital gain or loss
 Some form of income
Cont…
The rate of return is the percentage increase in returns
associated with the holding period:

Measures of historical rates of return:

If you commit $4000 to an investment at the beginning of the
year and you get back $4200 at the end of the year, what is
your return for the period?
Cont…
The period during which you own an investment is
called its holding period, and the return for that period
is the holding period return (HPR).
In this example, the HPR is calculated as follows
HPR= Ending Value Of investment
Beginning Value of investment

= $4200 =1.05
$4000
 Cont…
 This value will always be zero or greater
 A value greater than 1.0 reflects an increase in your
wealth, which means that you received a positive rate of
return during the period.
 A value less than 1.0 means that you suffered a decline in
wealth, which indicates that you had a negative return
during the period.
 An HPR of zero indicates that you lost all your money.
Cont..
 Although HPR helps us express the change in value of an
investment, investors generally evaluate returns in percentage
terms on an annual basis.
 the holding period yield (HPY). The HPY is equal to the HPR
minus 1.
HPY= HPR-1
1.05-1=0.05 or 5%
Investment Diversification and Portfolio Analysis

DIVERSIFICATION

On the broad sense, diversification can best expressed by a

proverb “do not put all of your eggs in one basket.” It means
purchasing different investments that all have the expectation
based on analysis that they will go up in value over the long
term. For instance bonds, stocks, and real estate do not change
value together at the same time but over time we could expect
them to gain value. This concept of having a mixture of
investments is called diversification.
Cont…
Diversification means purchasing a larger number of different assets. It is natural
to view diversification as a means of reducing risk

Market Risk And Firm Risk

The principle of diversification tells us that spreading an investment across many

assets (diversifying) will help in minimizing, even in eliminating some of the

risk. However, diversification cannot eliminate all risks.

There is a minimum level of risk that cannot be eliminated simply by diversifying.

Thus, diversification reduces risk, but up to a point. Put another way, some risk is

diversifiable and some is not.

Total Risk = Market Risk( systematic risk/ Non diversifiable Risk) + Firm Risk /un

systematic risk/ Diversifiable Risk

Cont…
The total risk of a security can be viewed as consisting of two
parts:
Diversifiable Risk
 Diversifiable risk represents the portion of an asset’s risk that
is associated with random causes that can be eliminated
through diversification.
 Diversifiable risk is also called unsystematic risk. It is also
referred to as unique risk, or Firm’s specific risk.
Cont…
Non diversifiable Risk
This part of the risk arises on account of war and the economy-wide
uncertainties like changes in GDP, inflation, and interest rates and the
tendency of individual securities to move together with changes in the
market
This part of the risk cannot be reduced through diversification, and it is
called systematic, or markets, risk and it is measured by beta.

The unsystematic risk can be reduced as more and more

securities are added to a portfolio
Investment Portfolio

An investment portfolio is a set of financial assets owned

by an investor that may include bonds, stocks,
currencies, Cash and cash equivalent, and
commodities. Further, it refers to a group of
investments that an investor uses in order to earn a
profit while making sure that capital or assets are
preserved.
Expected portfolio return
 To calculate a portfolio’s expected rate of return, we weight
each individual investment’s expected rate of return using the
fraction of money invested in each investment.
Example: If you invest 25% of your money in the stock of Citi
bank (C) with an expected rate of return of 32% and 75% of
your money in the stock of Apple (AAPL) with an expected
rate of return of 120%, what will be the expected rate of return
on this portfolio?
Expected rate of return = .25(32%) + .75 (120%) = 98%
Cont…
Example :2
Asset Weight Expected Return

A 45% 16%

B 35% 17%

C 50% 20%
Cont…
Therefore, the expected return of the portfolio is
E(r portfolio)=W1X E (r1) + W2 X E (r2) + W3 X E(r3)

[(45% * 16%) + (35% * 17%) + (50% * 20%)]

= 23.15%
Standard Deviation of a Portfolio
For simplicity, let’s focus on a portfolio of 2 stocks:
Evaluating Portfolio Risk
 Unlike expected return, standard deviation is not generally equal to
the a weighted average of the standard deviations of the returns of
investments held in the portfolio. This is because of diversification
effects.
 The diversification gains achieved by adding more investments

will depend on the degree of correlation among the investments.

 The degree of correlation is measured by using the correlation

coefficient ( p )
 Correlation and diversification
 The correlation coefficient can range from -1.0 (perfect
negative correlation), meaning two variables move in
perfectly opposite directions to +1.0 (perfect positive
correlation), which means the two assets move exactly
together.
 A correlation coefficient of 0(zero) means that there is no

relationship between the returns earned by the two assets.

 As long as the investment returns are not perfectly positively

correlated, there will be diversification benefits.

 However, the diversification benefits will be greater when the

correlations are low or negative.

 The returns on most stocks tend to be positively correlated.
Example
Determine the expected return and standard deviation of the
following portfolio consisting of two stocks that have a
correlation coefficient of .75.
Portfolio Weight Expected Standard
Return Deviation

Apple .50 .14 .20

Coca-Cola .50 .14 .20

Solution
 Expected Return = .5 (.14) + .5 (.14)= .14 or 14%
 Standard deviation

√ (.52x.22)+(.52x.22)+(2x.5x.5x.75x.2x.2)}
= √ .035= .187 or 18.7%
Lower than the weighted average of 20%.
 Capital Asset Pricing Model (CAPM): Risk and expected (Required) Return

The capital asset pricing model (CAPM) defines the relationship between risk and

expected return.

If we know an asset’s systematic risk, we can use the CAPM to determine its

expected return.

The CAPM equation quantifies risk and defines a risk/expected return relationship based

on the idea that investors accept a higher risk only for a higher return
Capital Asset Pricing Model or the CAPM provides a relatively simple measure of risk.

CAPM assumes that investors choose to hold the optimally diversified portfolio that includes all

risky investments. This optimally diversified portfolio that includes all of the economy’s assets is

referred to as the market portfolio.

According to the CAPM, the relevant risk of an investment relates to how the investment

contributes to the risk of this market portfolio.

 End Of Chapter Four

Thanks for listening

 Chapter Five
Cost of Capital
Cost of capital refers to the opportunity cost of making a
specific investment. It is the rate of return that could
have been earned by putting the same money into a
different investment with equal risk. Thus, the cost of
capital is the rate of return required to
persuade/convince/ the investor to make a given
investment.
Cont…
Cost of capital is determined by the market and
represents the degree of perceived risk by investors.
When given the choice between twoinvestments of
equal risk, investors will generally choose the one
providing the higher return.Cost of capital is an
important component of business valuation work.
Because an investor expects his or her investment to
grow by greater than cost of capital, cost of capital can
be used as a discount rate to calculate the fair value of
an investment's cash flows.
Cont…
 Investors frequently borrow money to
make investments, and analysts commonly make the
mistake of equating cost of capital with the interest rate
on that money. It is important to remember that cost of
capital is not depending upon how and where the
capital was raised.
 Cont…
 Cost of Capital: is the required rate of return from some
investment activity.
 It is the return that firm’s investors could expect to earn
if they invest in other equally risky securities. Most
companies are financed by a mixture of securities.
Including common stock, preferred stock and long-term
debt and other securities. These securities have different
risks and returns; therefore, investors’ behavior is
different based on different risk and return status of
securities.
Classification/ type/ of capital in real world are:

 Financial capital: Money

 Physical capital: Property and equipment capital
 Human capital: Intellectual capital , knowledge

capital
 Cont…
 Financial capital since it is the base of all capital and universal medium of
exchange of every thing for buying and sell is money.
 All companies/ firm/ need to raise capital for operation purposes via different
sources of capital raising mechanism.
 A/ Short-term capital sources: is capital, which may generate capital within
short range.
 Such as: Money market instruments generate capital within short time. Example:
Commercial deposit, commercial paper Treasury bill, inters bank loan etc.
 B/ long term capital sources: is capital that generates with in long rage
Example: capital market instruments generates capital within long period of time
such as: bond, mortgage and stock
 Sources of long-term capital are further divided in to:

 Long term debt :

This long-term debt is a means of borrowing within long range.

Example: issuing bond, which has face value of 1,000,000 to pay

back 10 % interest rate after 10 year is means of raising long-

term debtor borrowing money within long range.

Long-term debt has certain amount of interest rate unless no one

buys our bond.

 Preferred stock

When firms sell preference share and raising money, it is called preferred stock

fund raising. Holder of preference share is entitled by preferred stock holder.

Preferred stock holder expects some higher dividend income from some firm, being

purchasing the preference share of that firm, unless dividend income is high to

investor, they do not purchase the preference share of some firm.

Example: we may sell our preference of 1000 face value with 12% dividend

bearing that means the preferred stock holders share the dividend of our company

by 12% even though our company produces tremendous/incredible/ amount of

profit .In this case the preferred stock holders share only 12% of dividend from

our company. For this reason they only share less risk from company as well

their return is low. I.e. low risk low return.

 Common stock :
 When firm sell common shares to raise capital, the buyer of common share

is entitled by common stock holder. Example: if we want to open and

operate some company and if the entire company’s activity required us

50,000,000 million birr, if we only have 30,000,000 birr of our own capital

or equity capital and it is better to sell common shares to investors to raise

capital of 20,000,000 birr for operation purposes. Therefore, the buyers of

this common share equally likely share the profit of our company if it

registers. If not they, do not get profit. Fore this reason common stock

holder share high risk from some firm as well as share high profit when

company‘s profit increases via time period.

Specific Components Of Cost Of Capital

The specific components of cost of capital include cost of

debt, cost of preferred stock, cost of new common
stock, and cost of retained earnings.
COST OF DEBT
 Cost of debt is the after tax cost of long-term funds

through borrowing. Debt may be issued at par, at

premium or at discount and also it may be perpetual
or redeemable./exchangeable/
Relationship between required yield and price:
A basic property of a bond is that its price varies inversely
with yield. The reason is simple. As the required yield
increases, the present value of the cash flow decreases;
hence the price decreases. Conversely, when the required
yield decreases, the present value of the cash flow
increases; hence the price increases. The price of the
bond will then approximately equal to its par value.
When bond is sold below its par value, it is said to be
discount. On the contrary, when the price is higher than
the par value, it is said to be selling at a premium and
when bond is sold at its par value price it is said to be
par value bond.
 Relationships among Yield Measures:
1. For premium bonds: Coupon rate > current yield > YTM.
2. For discount bonds: Coupon rate < current yield < YTM.
3. For par value bonds: Coupon rate = current yield = YTM.
The cost of debt is measured by the interest rate or yield paid
to bondholders. For example, a bond, which has face value
of birr 1,000-bond pays 100-birrannual interest, provides a
10% yield. rate of return is frequently called yield to
maturity.
Cost Of Preferred Stock

It refers to the required rate of return on investment of the

preferred shareholders of the company. Cost of preferred
stock is similar to that of debt in that a constant annual
payment is made, but dissimilar in that there is no maturity
date in which principal payment is made. In truth, the
determination of the yield on preferred stock is simpler
than determining the yield on debt.
The Required Rate Of Return, KP

Dp
Kp = Pp

 Where, Kp = The required rate of return on the

preferred stock
 DP = the annual dividend on preferred stock
 Pp = The Price of preferred stock
 Thus, cost of preferred stock, Kpr, is given by the

formula
Cont…
Thus, cost of preferred stock, Kpr, is given by the
formula
Kp = D1
P1  F

D1 = Dividend /share
P1 = Price / share
F = Flotation cost, or selling cost / share
Example:
The price per preferred stock of a firm is Birr 250. An annual
dividend of Birr 25 is paid on each share. The commission
agent charges Birr 10% share for selling the stock. Determine:
1) The investor has Required Rate of Return (RRR) and KP
RRR = KPr=

DP 25 D1 25
  10%   10.4%
PP 250 P1  F 250  10
Example: Biftu Company issued preferred stock for a net price
of $42and the preferred stock pays a $5 dividend. Then
calculate cost of preferred stock
kp =dividend/Mkt price-selling price=$5/$42-0=11.90%
Cost of retained earnings

 Retained earnings are a component of equity and therefore the cost of retained
earnings (internal equity) is equal to the cost of equity as explained above.
Dividends (earnings that are paid to investors and not retained) are a component of
the return on capital to equity holders, and influence the cost of capital through that
mechanism.

 Retained earnings belong to the common stockholders. By permitting the firm to

retain earnings, shareholders incur an opportunity cost by giving up cash
dividends. So, they expect the firm to earn the same rate of return on retained
earnings as it provides on common stock.
Cont…
Cost of RE (Kr)= D
 g
P
D = dividend,
P = selling price
g = growth rate of return:
suppose dividend is 14, selling price is 100 per one share
and growth of dividend if 8%. The calculate cost of
retained earning
14
Kr   8%  22%
100
Weighted average cost of capital (WACC)
 Weighted average cost of capital is the expected average
future cost of funds over the long run found by weighting
the cost of each specific type of capital by its proportion
in the firm’s capital structure.
The computation of the overall cost of capital (Ko) involves
the following steps.
a. Assigning weights to specific costs.
b. Multiplying the cost of each of the sources by the
appropriate weights.
c. Dividing the total weighted cost by the total weights.
 The overall cost of capital can be calculated with the help of the following
formula:

WACC=
WACC= (1-TaX)Wd
(1-TaX)Wd ++ Kp
Kp Wp
Wp ++ KeWe
KeWe ++ Kr
Kr Wr,
Wr, where
where
Where:
Where:
Kd
Kd==Cost
Costof
ofdebt
debt
Kp
Kp==Cost
Costof
ofpreference
preferenceshare
share
Ke
Ke==Cost
Costof
ofequity
equity
Kr
Kr==Cost
Costof
ofretained
retainedearnings
earnings
Wd=
Wd= Percentage of debt oftotal
Percentage of debt of totalcapital/weighted
capital/weightedofofdebt/
debt/
Wp
Wp==Percentage
Percentageofofpreference
preferenceshare
shareto
tototal
totalcapital/
capital/weighted
weightedofofpreference
preferenceshare/
share/
We
We==Percentage
Percentageofofequity
equitytotototal
totalcapital/
capital/weighted
weightedof ofequity
equityshares
shares//
Wr
Wr==Percentage
Percentageofofretained
retainedearnings
earningstotototal
totalcapital
capital/weighted
/weightedofofretained
retainedearnings
earnings
 Example:
sunshine plc estimates the following costs for each component in its capital structure

Source of Capital %age of Cost of capital

(Debt) bonds……………………….......................................kd = 10%

Preferred Stock……………………………………………….kp = 11.9%

Equity………………………………………………………….ke=10%

Common Stock

Retained Earnings……………………………………………ks= 15%

New Shares………………………………………………..kn = 16.25%,

Assume that sun shine plc desired capital structure is 40% debt, 10% preferred and

40% common equity,10% cost of equity and tax rare is 40%

The calculate WACC?

 Solution
WACC= kd(1-Tax) Wd +KpWp + Ke We + Kr Wr

= 10% (1-0.4)+11.9%(10%)+10%(40%)+10%(15%)=0.1269*100
=12.69 % ~13%
 End of chapter five

Thank for listening

 Chapter Six
Capital Budgeting
What is capital budgeting?
 The process of planning and managing a firm’s long-term

investments.
 In capital budgeting, the financial manager tries to identify

investment opportunities that are worth more to the firm

than they cost to acquire.
 It is also a process for determining the profitability of a

capital investment.
 Long-term decisions; involve large expenditures.
 The process of capital budgeting could thus be strategic

asset allocation.
Characteristics of Capital budgeting

A capital investment project can be distinguished from

current expenditures by two features:
◦ Capital investment projects are relatively large;
◦ A significant period of time elapses b/n the investment outlay
and the receipt of the benefits.
Steps in Capital Budgeting
 Estimate cash flows (inflows & outflows).
 Assess risk of cash flows.
 Determine r = WACC for project.
 WACC = Weighted Avg. Cost of Capital
 Evaluate cash flows.
Independent vs. Mutually Exclusive Projects
 Projects are:
◦ independent, if the cash flows of one are
unaffected by the acceptance of the other.

◦ mutually exclusive, if the cash flows of one

can be adversely impacted by the acceptance
of the other.
Investment appraisal Techniques
1. The Payback Period(PBP)
 It is very common in practice to talk of the payback on a
proposed investment. Simply, the payback is the length of
time it takes to recover our initial investment.
 It is the amount of time required for an investment to generate
cash flows sufficient to recover its initial cost.
Example 1

In our example, the payback works out to be exactly two

years.
This won’t usually happen, of course. When the numbers
don’t work out exactly, it is customary to work with
fractional years.
Shortcomings of Payback Period
 The payback period rule has some rather severe
shortcomings.
◦ First of all, the payback period is calculated by simply
adding up the future cash flows.
◦ There is no discounting involved, so the time value of
money is completely ignored.
◦ The payback rule also fails to consider any risk
differences.
 The payback would be calculated the same way
for both very risky and very safe projects.
2. The Average Accounting Return(AAR)
 AAR - is an investment’s average net income divided by
its average book value.
 It is the ratio of Average net income to Average book

value
Example:
 Suppose we are deciding whether or not to open a store

in a new shopping mall. The required investment in

improvements is $500,000. The store would have a five-
year life because everything reverts to the mall owners
after that time.
To calculate the average book value for this investment, we note that we started out
with a book value of $500,000 (the initial cost) and ended up at $0. The average
book value during the life of the investment is thus ($500,000 +0)/2 = $250,000.
we see that net income is $100,000 in the first year, $150,000 in the second year, $50,000 in
the third year, $0 in Year 4, and $50,000 in Year 5. The average net income, then, is:
[$100,000 +150,000+50,000 + 0 (50,000)]/5 = $50,000
Cont…
 3. Net Present Value(NPV)
NPV is the difference between present value of cash inflows
and present value of cash outflows.
 Imagine we are thinking of starting a business to produce

and sell a new product, say, organic fertilizer.

 We can estimate the start-up costs with reasonable

accuracy because we know what we will need to buy to

begin production. Refer to the table below. Would this be a
good investment? Use discounting rate as 10%.
Year 0 1 2 3 4 5

Cash flow -$100000 $20000 $30000 $40000 $35000 $10000

Cont…
 n
 CF
t

∑ - CF0
 NPV =
 (1 + r)t
 t=1
NPV decision rule:

Our fertilizer example illustrates how NPV

estimates can be used to determine whether or not
an investment is desirable. From our example,
notice that the NPV is positive and hence the effect
would be favorable.
Which project should be chosen?
• What if mutually exclusive?
• What if independent projects?

Rationale for the NPV Method

 NPV = PV inflows – Cost

 This is net gain in wealth, so accept project if NPV > 0.

 Choose between mutually exclusive projects on basis

of higher NPV. Adds most value.
Cont…
Using NPV method, which project(s) should be
accepted?
 If project S and L are mutually exclusive, accept S if

NPVs > NPVL .

 If S & L are independent, accept both; if they both

have NPV > 0.

4. The Internal Rate Of Return
 We now come to the most important alternative to NPV,
the internal rate of return, universally known as the
IRR. As we will see, the IRR is closely related to NPV.
With the IRR, we try to find a single rate of return that
summarizes the merits of a project.
 Furthermore, we want this rate to be an “internal” rate in

the sense that it depends only on the cash flows of a

particular investment, not on rates offered elsewhere.
Cont…
 It is that rate at which present value of benefits equals the
initial investment.
 In other words, it is that discount rate at which NPV equals
zero.
 IRR represents Return on Investment in terms of
percentage.
 IRR is popular appraisal criterion for capital budgeting
decision.
 It is a method of ranking project proposals using the rate of
return on an investment.
 IRR is calculated through trial and error method
Rationale for the IRR Method
 If IRR > WACC, then the project’s rate of return is
greater than its cost-- some return is left over to boost
stockholders’ returns.

 Example:
WACC = 10%, IRR = 15%.
 So this project adds extra return to shareholders
Thank you!!
All Chapter