Financial Management

Transcription

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2 2 Contents COURSE MANUAL Financial Management MM317 Modibbo Adama University of Technology Open and Distance Learning Course Development Series

3 2016 Academic Collective. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the copyright owner Academic Collective. Institution: Tel: +234( ) mail@cdl.mautech.edu.ng Website:

4 4 Contents Course Development Team Content Editor Editor ODL Credits All illustrations (photos and charts) used are sourced from except otherwise indicated. Credits / source are properly placed by the image.

5 Financial Management Contents Course Development Team 4 Credits 4 About this Course Manual 1 How this Course Manual is structured... 1 Course overview 3 Welcome to Financial Management MM Financial Management MM317 is this course for you?... 3 Course outcomes... 3 Study Skills... 4 Timeframe... 4 Need help?... 5 Academic Support... 5 Assessments... 5 List of Figures... 6 Study Session 1 7 THE NATURE, SCOPE, AND PURPOSE OF FINANCIAL MANAGEMENT... 7 Introduction THE NATURE OF FINANCIAL MANAGEMENT THE SCOPE OF FINANCIAL MANAGEMENT THE PURPOSE OF FINANCIAL MANAGEMENT Session Review Assessment Resources Study Session 2 15 SOURCES AND COST OF FINANCE Introduction SHORT-TERM FINANCE MEDIUM-TERM finance LONG-TERM FINANCE PROBLEMS OF NEW FINANCING EVALUATION OF SHARES AND DEBENTURES THEORIES OF SHARE VALUATION... 34

6 ii Contents Session Review Assessment Resources Study Session 3 39 CAPITAL BUDGETING AND MANAGEMENT OF WORKING CAPITAL Introduction CAPITAL BUDGETING MANAGEMENT OF WORKING CAPITAL Session Review Assessment Resources Study Session 4 67 FINANCIAL MANAGEMENT OF MERGERS AND PORTFOLIO THEORY Introduction BUSINESS MERGERS PORTFOLIO THEORY EFFICIENT Portfolio Security Market Line (SML) Session Review Assessment Resources Study Session 5 91 ANALYSIS AND INTERPRETATION OF BASIC FINANCIAL STATEMENT Introduction ANALYSIS AND INTERPRETATION OF ACCOUNTS DIVIDEND POLICY AND ITS IMPLICATION Valuation of Assets and Enterprise Session Review Assessment Resources Study Session BANKING SYSTEM AND THE CAPITAL STRUCTURE OF NIGERIAN FIRMS Introduction BANKING SYSTEM Merchant, Commercial, and Universal BANKING Compared Capital Structure of Nigerian Firms

7 Session Review Assessment Resources Feedback to SAQ Items 137 Glossary of Terms Error! Bookmark not defined. References 152

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9 MM317 Financial Management About this Course Manual Financial Management MM317 is provided to you by MAUTECH-CDL, AS IS. Module is localised and adapted to ODL format under the Academic Collective. How this Course Manual is structured Course overview The course overview gives you a general introduction to the course. Information contained in the course overview will help you determine: If the course is suitable for you. What you can expect from the course. How much time you will need to invest to complete the course. Where to get help. Course assessments. We strongly recommend that you read the overview carefully before starting your study. The course content The course is broken down into Study Sessions. Each Study Session comprises: An introduction to the Study Session content. Learning outcomes. Study Session preview. New terminology. Structured content of the study session with a variety of focus articles, learning activities and learning devices. Study Session review. Self Assessments. Resources for further studying. 1

10 About this Course Manual Your comments After completing Financial Management we would appreciate it if you would take a few moments to give us your feedback on any aspect of this course. Your feedback might include comments on: Course content and structure. Course reading materials and resources. Course assessments. Course duration. Your constructive feedback will help us to improve and enhance this course. You can forward your comments to feedback.mautech@edutechportal.org 2

11 MM317 Financial Management Welcome to Financial Management MM317 Course overview This course is designed to introduce you to the fundamental issues of financial management and to the quantitative techniques used to address them. We will consider questions of concern for both corporate financial managers and investments managers. This course manual supplements and complements a blend of resources & platforms: MM317 Audiobook available via Audio Resources Library app on your official mobile device and accessible online at: MM317 Courseware available in your course pack as a disk, it is also downloadable from your course website: Schoolboard offers a multi-channel platform for you to discuss with content experts and other learners from across the nation and the globe at large. You may also use the platform to enrich your learning with engaging webinars, articulate presentations, smart puzzles, audiobooks, podcasts, interactive gloassaries, smart quizzes, case studies and discussions. Schoolboard comes with updates and is accessible on web and on app. It is also linkable from your course CD. Financial Management MM317 is this course for you? MM317 is a 2 unit course. Reading and arithmetic skills is required for this course. Course outcomes Upon completion of Financial Management MM317, you will be able to: Outcomes describe and evaluate the basic features of financial markets identify the basic components of nominal interest rates and use them to make expected return comparisons among assets 3

12 About this Course Manual apply time value of money concepts to complex cash flow scenarios price bonds and other fixed-income financial assets understand the basics of the term structure of interest rates and the yield curve determine the fundamental price for common stock, using the constantgrowth dividend discount model use the Capital Asset Pricing Model to quantify the risk-return tradeoff Study Skills Being a self-learner has become increasingly feasible due to Open and Distance Learning (ODL) Systems. Studying a course or obtaining a certificate for career advancement can occur from the comfort of your home, on your own time, and at your own pace. You can be a successful higher education student by self learning, it isn't magic! But it does require desire, dedication and a lot of work. Active listening to your audiobook, desktop publishing on your laptops, reading comprehension in your course manual, notetaking in the white margins, stress management, time management, assessment taking, and memorization are study skills required for a self learner. If you really want to learn how to become a successful student, then you should explore the links that follow: Timeframe This is a 15 week course. It requires a formal study time of 12 hours. We recommend you take an average of one to two hours for an extra personal study on each Study Session. You can also benefit from online discussions with your course tutor. 4

13 MM317 Financial Management Need help? You may contact via any of the following channels for information, learning resources and library services. CDL Student Support Desk Tel: (+234) For technical issues (computer problems, web access, and etcetera), please visit: or send mail to Academic Support A course facilitator is commissioned for this course. You have also been assigned an academic tutor to provide learning support. See contacts of your course facilitator and academic advisor at the course website: Assessments Generally, there are two types of assessment: formative assessment and summative assessment. With regards to your formative assessment, there are three basic forms of assessment in the course: in-text questions (SELF-CHECKs), self-assessment questions (SAQs), and tutor marked assessment (TMAs). This manual provides you with SELF-CHECKs and SAQs. Feedbacks to the SELF-CHECKs are placed immediately after the questions, while the feedbacks to SAQs are at the rear of manual. You will receive your TMAs as assignments at the MAUTECH schoolboard platform. Some of your TMAs will be graded and will constitute 30 percent of your course marks. Feedbacks to TMAs will be provided by your tutor in not more than 2 weeks after entries. Your summative assessment is your final examination. MM317 exam is in multiple choice / essay format; and it carries 70 percent of your total earning in the course. Schedule dates for submitting assignments and engaging in course activities is available on the course website. 5

14 About this Course Manual List of Figures Figure 3.1 EOQ 62 Figure 4.1 Indifferent curve compared 78 Figure 4.2 Efficient frontier of available investment portfolio 80 Figure 4.3 Investor s indifferent curves on the same graph as the possible portfolios of investment 80 6

15 MM317 Financial Management Study Session 1 In this study session, you will be introduced to the nature, scope, and purpose of financial management. You will begin by defining financial management and explaining the roles of a financial manager. Thereafter, you will discuss the scope of financial management. You will end this session by explaining the purpose of financial management. Learning Outcomes When you have studied this session, you should be able to: 1.1 define financial management and explain the roles of a financial manager 1.2 discuss the scope of financial management 1.3 explain the purpose of financial management The Nature, Scope and Purpose of Financial Management The Nature of Financial Management The scope of Financial Management The Purpose of Financial Managementm This Study Session requires a one hour of formal study time. You may spend an additional two hours for revision. 7

16 Study Session 1 THE NATURE, SCOPE, AND PURPOSE OF FINANCIAL MANAGEMENT Terminologies. Financial management is the managerial activity which is concerned with the planning and controlling of the firm s financial resources. Its preoccupation is the identification of the possible strategies capable of maximizing an organization s, the allocation of scarce capital resources between the competing opportunities and the implementation and monitoring of the chosen strategy so as to achieve stated objectives (CIMA). Financial management covers all organizational activities relating to sources and utilization of funds for the efficient operation of an. The role of financial management can be classified under five main headings: a. Raising of funds to finance an enterprise b. Financial analysis of firm s operation and growth consideration. c. Forecasting, monitoring, and control of willing capital cycle. d. Selection, approval, and control of capital investment, and e. Valuation of business especially in relation to acquisition and. The function of a financial manager (i.e. the person who makes decisions which directly affect the flow of funds and the generation of profit and earnings) is to manage finance. He ensures that funds are: a. made available at the right time b. made available for the right length of time c. obtained at the lowest cost, and 8

17 MM317 Financial Management d. used in the most effective way The mission of the financial manager is to contribute to the organizational results by providing information, analysis, and advice that facilitate planning, decision making, correction, and control. The financial manager has the following responsibilities: a. Safeguarding funds b. Controlling funds (receiving and disbursement) c. Controlling revenue and expenditure d. Classifying and coding of transactions e. Accounting for revenue and expenditure f. Budget preparation, maintenance, and control g. Financial control and reporting h. Financial auditing i. Operating decision-making tools j. Developing methods and techniques for evaluating effectiveness and efficiency k. Transmitting information l. Ensuring that activities comply with the laws or regulations that govern the organization m. Ensuring that funds are expended on programs initially planned. n. Raising of funds o. Giving financial advice. o funds are: A. made available at the right time B. made available for the shortest length of time (right) C. obtained at the lowest time, and (cost) D. used in the most effective way Option A is a true statement Option B is a false statement. The correct statement is the financial manager ensures that funds are made available for the RIGHT length of time Option C is a false statement. The correct statement is the financial manager ensures that funds are obtained at the lowest COST. Option D is a true statement Financial management draws from many other disciplines. It embraces accounting and economics models as well as mathematical rules, system analysis, and behavioral sciences. With the advancement of information and communication technology, the 9

18 Study Session 1 THE NATURE, SCOPE, AND PURPOSE OF FINANCIAL MANAGEMENT scope of financial management has expanded considerably. Managers now face the challenges of e-commerce, e-banking, e-business and e-government. It is, therefore, essential that managers be equipped with knowledge of information and communication technology. There are three important activities of the business firms. These are: a. Finance b. Production; and c. Marketing The firm secures the capital it needs, employs it (finance activity) and generates returns on the invested capital production and marketing activities. A business firm, therefore, is an entry that engages in activities to perform the functions of finance, production, and marketing. The firm acquires funds from the sources called. This funds, when secured and invested, are called investment. The firm expects to receive investments over time, and periodically distributes returns to its investors. These processes are not, in fact, sequential; they are performed simultaneously. The raising of capital funds and using them for generating returns and paying returns to the suppliers of funds are called the finance functions of the firm. There are two types of funds that a firm raises: and borrowed funds. A firm can sell shares to acquire equity funds. represent ownership rights to their holders. The buyers of shares are called shareholders and they are the legal owner of the firm whose shares they hold. Shareholders invest their money in the shares of a company in the expectation of returns of their invested capital. The return on the shareholders capital is called dividend. It is the role of financial management to coordinate properly manages these functions. o Options A and D are false statements. Options B and C are true. Financial management is one of the key management areas and has become even more important in recent years. The following have over the years contributed to the importance of financial management. 10

19 MM317 Financial Management a. Diversification geographically and with respect to its by-products b. Increase in the size of businesses c. Emphasis on the growth of the economy d. Increased investment in research and development e. Environment and social factors such as pollution and unemployment f. Increased competition g. The growing rate of has produced a variety of new problems from high-interest rate to the problem of measuring profit. h. Improved communication from multi-national corporation has developed i. Wages and price controls have been imposed by the government in an attempt to halt inflation. j. The development of new techniques such as forecasting capital budgeting, statistical analysis, simulation all demands a greater ability from management. It is the in-depth analysis of these factors that contributes towards a quality financial decision making based on the predetermined mission of an organization which determines the overall direction of the organization. o A. Diversification geographically and with respect to its by-products B. Increase in the size of businesses C. Emphasis on the growth of the economy D. Increased investment in research and development All of the above are correct as they all serves the purposes that financial management strives to accomplish. a. Define financial management b. What is the major assumption in the theory of government? c. Identify the role of financial management in a classified firm d. List the functions of financial manager e. Identify the purpose of financial management 11

20 Study Session 1 THE NATURE, SCOPE, AND PURPOSE OF FINANCIAL MANAGEMENT 1.1 Define financial management and explain the roles of the financial manager Financial management is the managerial activity which is concerned with the planning and controlling of the firm s financial resources. Some of the objectives that financial management strives to accomplish include raising funds to finance an enterprise, conducting a financial analysis of firm s operation and growth consideration, forecasting, monitoring and control of willing capital cycle. The mission of the financial manager is to contribute to the organizational results by providing information, analysis, and advice that facilitate planning, decision making, correction, and control. 1.2 Discuss the scope of financial management Financial management draws from many other disciplines. It embraces accounting and economics models as well as mathematical rules, system analysis, and behavioural sciences. With the advancement of information and communication technology, the scope of financial management has expanded considerably. Managers now face the challenges of e-commerce, e-banking, e-business and e-government. It is, therefore, essential that managers be equipped with knowledge of information and communication technology. Important activities of the business firms are finance, production, and marketing 1.3 Explain the purpose of financial management Financial management, as one of the key management areas, serves the following purposes. These are diversification geographically and with respect to its by-products, increasing the size of businesses, placing emphasis on the growth of the economy, propagating an increased investment in research and development, and curbing environmental and social factors such as pollution and unemployment. Define financial management and explain the roles of a financial manager Discuss the scope of financial management Explain the purposes of financial management Articulate Presentation This is a complimentary resource to facilitate the quick delivery of this session. It is available in your course pack (Schoolboard disc / online page) and also linked here. 12

21 MM317 Financial Management Schoolboard Access your school board app, or visit to access updated online activities and resources related to the units of this Study Session. 13

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23 MM317 Financial Management Study Session 2 In this study session, you will be introduced to the sources and cost of finance. You will begin by explaining short-term finance and its sources. Thereafter, you will explain medium-term and long-term finance and its sources. Subsequently, you will discuss the problems of new financing. Next, you will discuss the evaluation of shares and debentures. You will end this session by explaining the theories of share valuation. Learning Outcomes When you have studied this session, you should be able to: 2.1 explain short-term finance and its sources 2.2 explain medium-term finance and its sources 2.3 explain long-term finance and its sources 2.4 discuss the problems of new financing 2.5 discuss the evaluation of shares and debentures 2.6 analyse the theories of share valuation This Study Session requires a one hour of formal study time. You may spend an additional two hours for revision. Terminologies 15

24 Study Session 2 SOURCES AND COST OF FINANCE Sources and Cost of Finance Bank Borrowing Trade Credit Short Term Finance Factoring Invoice Discounting Deferred Tax Payment Bill of Exchange Loans from Merchant Banks and Discount Houses Hire Purchase Medium Term Finance Leasing Acceptance Credits Loans from Industrial Development Bank Euro currency Market Ordinary Share Capital Preference Share Long Term Finance Problems of New Financing Evaluation of Shares and Debentures Theories of Share Valuation Reserves Loan Capital Sale and Leases Back Loans from Mortgate firms and insurance Companies 16

25 MM317 Financial Management Short term capital requirement should be financed as much as possible by short-term borrowing of the kind made available principally by the bank in form of loans or. Compared with other methods of borrowing, this method is flexible in that when the debt is no longer required, it can be quickly and easily reduced. It is also comparatively cheap because the risk to the lender is less; also, the interest charges are lower on short term than on long-term loans and all loan interest is a tax-deductible expense. The rigid cash and liquidity ratios that bankers are obliged to maintain will impose limits on the amount they can lend. These mean that the bank issue overdraft with the right to call them at short notice. If the money is recalled, the company has to be able to repay, which would be acknowledged if the funds had been used to purchases fixed asset. The company might have to sell assets if it had obtained the loan for long-term use. Banks prefer self-liquidating loans those likely to be rapidly automatic and reasonably quick. These might include cash to finance a specific contract that will eventually result in a cash inflow for the company or a loan to a trading for the purchase of goods or commodities which could be offered as security. This is one of the most important forms of short-term finance in the company. Trade credit is entered by one company to another on the purchase or sale of goods and equipment. The use of has increased in recent years due mainly perhaps to the credit squeeze. Buyers have been unable to obtain overdraft from the banks and have consequently taken a longer time to pay their liabilities. To receive goods and delay payment of the accounts is a recognized form of short-term financing. The goods can be used to provide returns or benefits throughout the period that elapses before the bill is settled. For the receiving company, this is similar to buying grade with a bank overdraft except that overdraft carries interest charges, but when the finance is provided by another company, the cost is not so obvious. The advantages of trade credit are that when a customer s credit worthiness is well established, trade credit becomes a convenient, informal affair and is indeed a normal part of business in most industries. The offer of trade credit by a seller is part of the term of sale, a sales promoting device by which he hopes to attract business. The amount of credit offered will depend on the risks associated with the customer. The term of credit offered to customers will depend on four main factors: 1. The economic nature of the product. Products with a high sales turnover are sold on short-term credit terms. 17

26 Study Session 2 SOURCES AND COST OF FINANCE 2. The financial circumstance of the seller. If the seller s position is weak, he will find it difficult to allow very much credit and will prefer an early cash settlement. 3. The financial circumstance of the buyer if the buyer is in a weak liquidity position, he may have to take a long period liquidity position, he may have to take a long period in which to pay. 4. Cash discount when cash discounts are taken into account, the cost of trade credit may be surprisingly high. The higher the cash discount being offered, the smaller the period of trade credit likely to be taken. This involves the raising of funds on the security of the company s debt so that cash is received earlier than if the company waited for the debtors to pay. Factors usually considered includes the number of services that clients are being offered, sales credit accounting, the collection of debts, credit insurance as well as provision of finance. It is the company in need of funds that tries the banks factoring. This is usually costly. Companies turn to factoring usually during. This is an arrangement that improves the liquidity position of the user. It is designed to overcome the problem of tying working capital in book debts. A company can make an offer to the finance house by sending in its respective invoices and agreeing to guarantee payment of any debt that is purchased. The costs of this service depend upon the risks and administrative costs involved. It includes an interest charge at a similar rate to those of bank overdraft plus a service charge usually 0.5% of the value of the invoice. This is similar in character to the trade credit and the credit is supplied by the tax authorities. This is created by the interval that elapses between the earning of the profits by the firm and the payment of the taxes due. No interest is charged for the credit but the tax authorities would like to collect the payment earlier and the firm is under no obligation to pay until the due date. In order to encourage early returns, the tax authorities offer tax reserve certificates. A firm can purchase these certificates when it desires, and earn interest on them. When the time for payment of the certificate is higher than what the companies can earn themselves by their non-investment of funds, then it will be sensible to purchase the certificate. This is defined as an unconditional order in writing which is addressed by one person to another requiring the person to whom it is addressed to pay on demand or a fixed/determinable future time, a certain sum of money to or to order a specified person or to bearer. (Bill of Exchange Act 1990). It is another source of finance to business firms. A post-dated cheque is a very simple example of a bill of exchange. Nowadays 18

27 MM317 Financial Management bills of exchange are used basically in connection with overseas shipments. The seller of the goods can obtain cash immediately after the goods are dispatched, either because the bill has an early maturity date or because he discounts the bill. The buyer of the goods can delay payment of the bill. This is particularly important with overseas orders because he may have to wait for some time before receiving the goods. The bill of exchange, therefore, helps both the buyer and seller with their finance. The cost of the funds provided by a bill of exchange depends upon the rate at which the bill is discounted. If the dealer presents the returned bill to a bank, which buys it at a discount rate of 3%, a N100 bill payable in 3 months time would have a cash of 3/97 = The seller has to surrender N3 to receive N97. This is equivalent to an annual interest rate of (1.0309) x 4 = 12.4%. o o Option A is a true statement. Option B is a false statement. The correct statement is Bank borrowing. Option C is a false statement. The correct statement is Trade credit. Option D is a true statement. Instead of taking loans for their capital development, some firms have now moved towards obtaining a loan from one of the secondary banks i.e. or discount houses. This is a convenient source of medium-term finance particularly for the purchase of plant and equipment. Initially, hire purchase companies to purchase the required equipment but it can immediately be used by the hirer who after a series of regular payment, which includes interest charges, becomes the owner of the equipment. The hirer has the advantage of using the equipment/plant over the period he is making the 19

28 Study Session 2 SOURCES AND COST OF FINANCE payment and so obtains the benefit of using the equipment without having to incur a larger capital outlay. The significance of hire purchase in the financial structure of the economy is that it is a convenient source of medium term finance on a fixed-term for the purchase of equipment, where the equipment itself can provide adequate security for the loan and the loan can pay off by regular installments. The security on any loan is important for the equipment itself. To provide the security, the life of the asset must be greater than the period of which the agreement is broken. This means that there is still an asset in existence which has a value. This is usually a cheaper form of financing than hire purchase. One major difference between hire purchase and leasing is that at the end of the leasing period, the equipment does not automatically belong to the company that has been making the payments. The advantages of leasing are as follows: a. It is not necessary to own the equipment once it is available for use on the payment of the first installment. b. Working capital is left free for more profitable use c. Rentals are fully deductible d. Leasing does not interfere with other borrowing or credit possibilities e. If a company owns the equipment, it has to worry about replacement at the end of the useful life. This is not the case with leasing. Disadvantages are: a. The lease is not allowed to claim the capital allowance on the leased equipment. b. Over the long period, if it is necessary to renew the contract, it may prove to be expensive. c. The advantage of ownership of the asset is lost. This is made available to a firm by a syndicate of banks and institution. The banks and institution may consist of a cleaning bank and a number of Merchant banks, one of whom takes the responsibility for organizing the credit and for dividing the risks between the parties concerned in dome negotiable proportions. From the company s point of view, these acceptance credits are similar in nature to a medium term overdraft with either a fixed or a variable to the firm a certain level of credit. The firm can then be used in the region of 5 years. 20

29 MM317 Financial Management The Nigerian Industrial Development Bank supplies fixed asset and capital to industries. The bank assists industries by means of loans, debentures and shares. The loans are medium-term in nature and are repayable within a reasonable period at fixed rate of interest charged on the balance of the loan. This market provides varying terms of funds for industries. The market for many years has largely been a market for dollars Deutschmarks. The funds in the market come from: a. The Central Bank reserves of various countries. As a country builds up a trade surplus with other countries. b. Commercial investors: The high-interest rates that have been offered on occasion for eurodollar deposit have attracted investors in euro who have dollars available. o Option A is a false statement. Preference shares is an example of longterm finance Option B is a false statement. The correct statement is Hire purchase. Option C is a false statement. The correct statement is acceptance credits. Option D is a true statement. OSC is the foundation of many capital structures. The ordinary shareholders are the risk bearers. The main characteristics of OSC are: a. Legally, they must have a nominal value e.g. 50K or N1, 00 shares. The nominal value is usually the price at which the shares are first issued. 21

30 Study Session 2 SOURCES AND COST OF FINANCE b. Ordinary share may be issued at per i.e. their nominal value or, on the rare unusual circumstance at a price less than their nominal value, at a discount, or at premium i.e. at a price over and above their nominal value. c. At times a company may issue bonus shares to existing shareholders in proportion to the shares held. Note that is not a source of finance as they are not issued for cash. It is a book-keeping operation of distributing reserves to existing shareholders. d. The share of quoted companies changes hands frequently. A company should, therefore, maintain an up-to-date register of shareholders. e. The income of the ordinary shareholders is the residual (i.e. after prior claims have been met) profit of the company. This income is either paid to them in form of dividend or retained by the business for expansion. f. By law, companies are barred from repaying capital to its ordinary shareholders. Thus, the only way they can withdraw their capital as an individual is by selling the shares in the open market. In the event of winding up, ordinary shareholders are entitled to the whole of the residual assets, if there are any. As the name suggest, preference shares have prior claim to profit than ordinary shares. Preference shares are not nowadays a very popular source of finance because of the tax disadvantage compared with debt finance. A preference shareholder is entitled to a dividend of up to a stated maximum amount before any dividend is paid to ordinary shareholders. Dividend rights may be cumulative or non-cumulative. The dividend is cumulative when the rights are paid in the subsequent year of entitlement Non-cumulative dividend right lapses if not paid in the year it is due. In the event of winding up, any surplus assets after prior claims (e.g. creditors and lenders) have been met must first be used to repay up to a full nominal value of the preference shares. Only after this may the ordinary shareholders participate. Preference shares may be redeemable. This means that their capital value may be repaid. Company law requires that this is either out of profit appropriated for the purpose or out of the proceeds of a special issue of new shares. The rights of preference shares will not normally be varied after the share has been issued. Thus, the issue of bonus preference shares would not be made to preference shareholder as can be made to ordinary shares. There are two categories of reserves: Capital Reserve and Reserves. Capital Reserve arises as a result of a paper transaction such as capital redemption reserves fund created out of existing revenue reserve on the redemption of redeemable preference shares and reserve arising from the revaluation of property. Revenue reserve arises from a genuine inflow of cash which can be used for bonus shares. 22

31 MM317 Financial Management These are normally represented by fixed interest securities. The holders can buy and sell them in the stock market and they receive their income in the form of regular payments called interest. Loan capital has nominal value in form of stock rather than share units. The nominal value often forms the market price. The certificate given by a business corporation as a receipt for money lent at a fixed interest rate until the principal is repaid is known as capital. This is: 1. The income received by the debenture holder is a charge against revenue and is not a share of ascertained profit. The implication of this is that a fixed interest is payable in full whether profit is available or not. 2. The capital values of the loan stock are sometimes issued. A company is sometimes empowered to reduce its indebtedness by purchasing its own stock in the market. It would be illegal for it to purchase its own shares. 3. There is security for the interest and capital. This arises primarily from the contract between the company and the lender. The holder may ensure if there is any breach on the asset of the business. Convertible are sometimes issued. These are like annual debentures but carry with them the right to convert to ordinary shares at the option of the holder. The term of conversion is set out by the company. Companies may sometimes issue the so-called convertible. These are exactly like nominal debentures in most respects but carry the odd, formal right that they may be converted into ordinary shares at the option of the company. Convertible debentures give the holder all the security associated with debentures with the valuable additional opportunity to get into the equity at a later date if the company s success seems to warrant that. A company may decide to dispose some or its entire asset e.g. the premises, property, plant and equipment to an investment company coupled with leasing them back for a long period of years at an annual rent payable to the investment company. Mortgage loans may be obtained from insurance companies, financial institutions or trust funds. The amount is usually repayable over a period of 20 years. Before granting the loans, the FCI may ask certain information about the industry requiring such loans. The information that may be required include, the history of the firm, the purpose for which the loan is required, the anticipated profit during the period of loan, the name of principal competitor, details of any government department that may be interested in the loan, the total capital required, the amount required from FCI and the security required. 23

32 Study Session 2 SOURCES AND COST OF FINANCE o o All the above options are true. That is, they are all correct statements. New financing is about raising the required cash for the running and expansion of a business venture. To be able to raise the required cash, some conditions need to be fulfilled. The problem of new financing, therefore, is in the conditions attached to raising the required cash which most businesses, especially the new firms, are not able to meet and are thereby constrained in their growth and expansion goals. The bankers will usually consider the following among others in advancing loan/credit facilities to business firms. This includes: 1. The ability of the firm to pay back the loan as at when due. 2. The ability of the firm to generate sufficient revenue to pay interest on the loan regularly (P&L forecast). 3. The firm s capital contribution 4. Availability and adequacy of collateral 5. The purpose or objectives of the loan 6. Past business relationship with the bank 7. Gearing and other existing debts 8. Third party confirmation 9. Statutory provisions 10. Management competence 11. Industrial analysis 12. General economic conditions For business firms that would like to issue debt/equity, the Securities and Exchange Commission (SEC) requires such firms to fill in the following documents/information: 1. Certificate of incorporation 2. Memorandum and article of Association 3. Information on background and business operation of the firm/issuer 4. Its management and share capital 5. Five-year historical financial information and projection Some business firms by nature and length of existence cannot fulfill these requirements and therefore cannot readily raise the required finances. The situation is even worse for the sole proprietors as even their personal integrity is considered by creditors before 24

33 MM317 Financial Management granting them loans. Again, the volume of cash they can raise is limited as compared to incorporated firms. o o Option A is a true statement. Option B is a false statement. It is a requirement from the securities and exchange commission and not from the bankers Option C is a true statement. Option D is a false statement. The correct statement is industrial analysis. This is the smallest unit of ownership in a company. It could be ordinary or preference shares. Preference bear a fixed rate of interest/dividend and could either be cumulative (unpaid dividend are carried forward to a period that profit is available to pay) or noncumulative (unpaid dividend are not carried forward). Ordinary shareholders carry the greater risk as they receive dividend only on the residue of profit after settling the preference shareholder and other fixed interest instruments like debentures. However, they take the greater part of the profit when the company is doing fine. Again they stand the risk of losing all or part of the holding in a company in the event of liquidation because they are not paid until preferential and secured creditors are paid first. This is a loan of a long-term nature. They could be secured or unsecured. Debenture represents the document which acknowledges the indebtedness of a company or business firm. In practice, the term debenture may be restricted to secure loans. Their main features are: 25

34 Study Session 2 SOURCES AND COST OF FINANCE 1. They are not entitled to voting rights. 2. They are fixed or floating interest securities, entitled to annual interest payment. 3. The interest elements are tax deductible to the debtor firm. 4. They could be redeemable, irredeemable or convertible (to other classes of shareholding ordinary preference). 5. The principal amounts are usually secured on the assets of the company and could have: a. Floating charge, or b. Fixed charge, or c. A combination of (a) and (b) A floating charge covers all current assets, as they exist from time. It does not prevent the company from buying and selling current assets in the normal course of its business. A fixed charge is on one or more special assets. If the firm fails to pay interest or the principal or attempt to dispose of an asset charged, then a receiver may be appointed to take possession of the asset and sell it for the benefit of the debenture holders as provided for under the debenture deed. In such situations, the action is to be taken by the trustees to the debenture. Debentures could be redeemable or irredeemable: The date for redemption could be written in form of a range (i.e ). The date will be agreed upon at the time of negotiating the loan. Some debentures are irredeemable, in which case, no date is set for redemption but the borrower can redeem the debt whenever he wishes and force the debenture holders to settle. A borrower may redeem a debenture earlier than the due date in view of any of the following reason: 1. To take advantage of falling interest rates 2. To make use of surplus funds 3. To release assets covered by a fixed charge for usage as collateral in other debts. This is in terms of the market price/share and/or earnings per share (EPS), whereas debentures are valued in terms of their cost to the firm. Three elements (profit generation, bonus or script and right issues) affect the value of shares. These are the free issue of ordinary shares to existing shareholders. The shares are issued to them without extra cost. The firm makes payment of these shares through the profit. As an alternative to paying out cash dividends during a year, a firm may choose to pay a script dividend. This is essentially a transfer to the shareholders of a number of additional shares without the shareholder having to 26

35 MM317 Financial Management subscribe to additional cash. From the firm s point of view, this offer has the advantage of preserving liquidity, because no cash leaves the firm. The number of equity shares is increased, but as long as the annual increase is not too large, and the retained earnings are invested to yield a satisfactory rate of return, the shares should not fall. The advantage to the shareholder is that he receives a dividend which he can convert into cash whenever he wishes. This is an offer of a company s shares to its existing shareholders. It gives the existing shareholders the opportunity to first purchase shares from a new issue of shares. The term of the offer is that each existing shareholder has the right to be allotted a certain number of shares upon payment of the asking price. This offer does not have to be accepted personally by the existing shareholder. They may sell the right separately from the share or sell the share with the right offer attached. In times of depressed stock market, equity capital has no benefit either to the investors or to the issuer. A right issue can easily depress the Earning per Share (EPS) at least in the short run. This is because the number of shares immediately increases but not necessarily the earnings. The success of a right issue depends upon the size of the issue, the price asked for the shares and the investors expectation of the resulting earnings which will depend on the amount of funds invested, as well as the expected rate of return. Two factors jointly determine the number of new shares a company will need to issue: 1. The amount of new funds the company wishes to raise 2. The price considers reasonable to ask for the new shares The amount of funds to be raised depends on the earnings that can be obtained from new investments compared with the cost of the funds. The company must ensure that it can earn on the funds that it obtains at a rate at least equal to the opportunity cost. o 1. They are entitled to voting rights. 2. They are variable or floating interest securities, entitled to annual interest payment. 3. The interest elements are not tax deductible to the debtor firm. 4. They could be redeemable, irredeemable or convertible o Option A is a false statement. The correct statement is holders of debentures are NOT entitled to voting rights. Option B is a false statement. The correct statement is debentures are FIXED (not variable) or floating interest securities entitled to an annual 27

36 Study Session 2 SOURCES AND COST OF FINANCE Example interest payment. Option C is a false statement. The correct statement is the interest elements are tax deductible to the other debtor firm. Option D is a true statement. The ABC Company has 1,000 shares with a market price of N3, 00 each. It now requires additional funds and decides on the right issue of 6 for 10 at N1.50. you are required to a. Find the Ex-right price b. Find the value of 1 right Solution 1,000 shares at N300 each 3, shares at N1.50 each 900 1, 600 3,900 a. Ex right price = = N b. Value of 1 right = N3 N = N Cum right = Ex0/-right + Right N3.00 = N EPS is the profit in kobo attributable to each equity. The profit is normally the consolidated profit of the revised after tax and deducting minority interest and preference dividend, but before taking into account extraordinary items. The equity shares in this respect are those in issue and ranking for dividend in respect of the period. The EPS is calculated by dividing the net profit after tax, minority interest and before extraordinary items by the number of ordinary shares in issue and ranking for dividend in respect of the period. Example JTJ Ltd has the following capital structure N500, 000 in 7% cum. Preference shares of N100 N1,000,000 ordinary shares at 25K and trading results of PAT Year 2 Year 1 N535, 000 N435, 000 Assuming there has been no change to the ordinary shares in issue, extraordinary shares, and minority interest, Calculate the EPS for the two periods. 28

37 MM317 Financial Management Solution Year 2 Year 1 Profit after tax 535, ,000 Less: Pref Dividend 35,000 35, , ,000 No. of shares = N1,000, = 4,000,000 Year 1 Year 2 EPS 500, ,000 4,000,000 = 12.5K 4,000,000 = 10K Where further equity share capitals have been issued during the financial year, they probably have been issued by one of the following methods. a. Issue at full market price: This is where new equity shares have been deemed issued either for cash at a full market price or as consideration for the acquisition of a new asset, the earnings should be appropriated over the average number of shares ranking for dividend during the period weighted on a time basis. b. Capitalization or bonus/script issue: Under this method of issue, the earnings should be appropriated over the number of shares ranking for dividend after the capitalization. The corresponding figures for all earlier period should be adjusted accordingly. Similarly, considerations will apply but these are split into shares of smaller nominal value. b. Share exchange: This is where shares c. (ranking for dividend) or loan stock has been issued during a given period as consideration for shares in a new subsidiary. It should be assumed that for the purpose of calculating the EPS, these securities were issued on the first day of the period for which the profit of the new subsidiary is included in the earnings of the group. d. Rights issues at less than full market price (EPS for prior year): This is where equity shares are issued by way of right during the period, it is recommended that factor for adjustment of past EPS after a right issue be based on the closing price (the official idle markets quotation published on the following day on the last day of quotation of the shares cum. Rights). The factor is, therefore: 29

38 Study Session 2 SOURCES AND COST OF FINANCE Actual right price comes on the last day of quotation. Where a right issue is made during the year under review, the EPS for the previous year and for all earlier years will need to be adjusted by the factor, calculated, to correct for bonus element in the right issue. For the current year in which right issue is made, it would be undesirable to split the earning into two periods, one before the right and one after this event. It is necessary to adjust the weighted average share capital by taking the proportion of the capital in issue before the right issue, applying to this figure the reciprocal of the factor set out above as follows: Actual Cum right price Theoretical Ex right price Adding the proportion in issue after the right price. Example Assume that the information given in respect of JTJ Ltd remain the same except that the ordinary shares were issued on 1st October during the year ended 31st December year 2. Year 2 Year 1 Net earning 500, ,000 Weight average of shares at 1 Jan. Issued 1st October Year 2 (1,000,000 x 3/12) 4,000,000 4,000, , ,000 4,250,000 4,000, , ,000 EPS = 4,250,000 4,000, K 10k When new equity shares have been issued by way of capitalization (bonus/script issue) during the period, the earnings should be appropriated over the number of share ranking for dividend after the capitalization. The corresponding figures for all previous periods should be adjusted accordingly. Assume further than JTJ Ltd issued 1,000,000 ordinary shares fully paid by way of capitalization of reserves in proportion 1 for every 4. 30

39 MM317 Financial Management Year 2 Year 1 Earning 500, ,000 No. of ordinary 1st January 4,000,000 4,000,000 Capitalization issue 1st October Year 2 1,000,000 1,000,000 Number of shares after issue 5,000,000 5,000,000 EPS on shares of 25K 10K 8K Where equity is issued by way of rights during the period, all past EPS should be adjusted by the factor: Theoretical Ex-right Price Actual Cum-right price In order to allow for the bonus element in the right issue in computing the EPS for the current year, the weighted average share capital should be computed after adjusting the proportion of the capital issue before the right issue by the reciprocal of the factor shown above. Again assume that JTJ Ltd made a right issue of ordinary shares in the proportion 1 to 4 on its4, 000,000 on 1st July Yr2. The market price of the ordinary share on the last day of quotation cm-right was N100 theoretical market value of the shares after the right issue. Solution a. First multiply the market value before issue by the number of shares before the issue. b. Add the total money raised by the issue to (a) c. Then divide the total of (b) by the total number of shares. 4,000,000 x 1 4,000,000 1,000,000 x ,000 4,500,000 Theoretical market value will be 4,500,000 = 90K/share 5,000,000 Thus reciprocal factor for adjusting the number of shares for the current year is Cum right = 100 Ex- right 90 31

40 Study Session 2 SOURCES AND COST OF FINANCE Year 2 Year 1 Earnings 500, ,000 EPS Year 1: EPS reported last year is 10K Adjusted for right issue 10 x 90 = 9K 100 EPS Year 1 Number of shares: 4,000,000 x 6 x 100 = 2,222, ,000,000 6/12 = 2,500,000 EPS = 500,000 4,722,222 = 10.6K Computation of EPS so far considered are either based on the weighted average in the period or, in the case of a capitalization issue, the equity share capital ranking for dividend at the financial year and Where a quoted company has an outstanding: a. A separate class of equity shares which do not rank for dividend in the period but will do so in the future. b. Debentures or loan stock/or preference shares convertible into equity shares of the company c. Options or warrants to subscribe for equity shares of the company The company has entered into obligations which may dilute the earning per share in the future. In these circumstances, in addition to the basic EPS, the fully diluted EPS should be computed and shown on the profit and loss account. Example Joy Ltd wants to raise N600, 000 either from equity or loan. It will either raise it through the issue of rights 1 for 1@ 60K or through the issue of debenture 8% interest. The company s forecast maintainable earnings before interest and tax are N120, 000. Corporation tax is 40% Required: Should joy Ltd issue right or debentures? Solution: 32

41 MM317 Financial Management (a) Rights Debentures EBIT 120, ,000 Interest - (48,000) EBIT 120,000 72,000 Tax@ 40% (48,000) (28,800) EAIT 72,000 43,200 No of shares 2,000,000 1,000,000 EPS 3.6K 4.32K Suggestion: the company, joy Ltd should issue debenture as it gives a higher EPS (b) Let X represents earnings Rights Debentures EBIT X X Interest - 48,000 _ EBIT X X 48,000 EAIT 0.6X 0.6 (X 48,000) No. of shares 2,000,000 1,000, X = 0.6(X 48,000) 2,000,000 1,000, X = 1.2X 47,600 Break event point or Indifferent EBIT X= 47600/0.6 = N Suggestion: The company should choose right issue when the earning is below N79, 333 and debenture when the earning is above N79,000 Joy Ltd has an issued share capital of N1, 000,000 all in ordinary shares of N1, 00 each and a current rate of earning of N125, 000 with a tax rate of 50%. Assume that it needs to raise a further N1, 000,000 in order to expand its business and the proposals include 33

42 Study Session 2 SOURCES AND COST OF FINANCE an issue of N1, 000,000 6% preference shares and the issue of N1,000,000 6% Debentures. Solution: Present Right issue 6% Preference shares a B c d N N N N 6% Debentures EBIT 125, , , ,000 Interest ,000 EBT 125, , ,000 65,000 62,500 62,500 62,500 32,500 EAIT 62,500 62,500 62,500 32,500 Profit dividend 60, Equity earning 62,500 62,500 2,500 32,500 No of shares 1m 2m 1m 1m EPS 6.25K 3.125K 0.25K 3.25K The modern school of thought on Efficient Market Hypothesis (EMH) put forward that there are three basic theories of how to value shares on the stock market. It states that, at any point in time, a share (debenture) has an intrinsic value which is the discounted present value of the expected future cash receipts from the share (debentures). MV = d/ke Where dividend is expected to be constant MV = do (1 + g) Ke g where MV = Market value of shares 34

43 MM317 Financial Management d = dividend payable g = growth rate of dividend Ke = shareholders cost of capital The expectation of future receipts may relate to: 1. Past result of the company 2. Ratio analysis of the latest publisher accounts 3. Future plants or expectation of the company, possibly as a result of published statements (e.g. the company s reports). 4. Influences affecting the economy or industry, as a whole. 5. As investor s expectation about future earnings change, the intrinsic value of the shares, and therefore their market price, move up or down. It states that future pattern of the share price is a repetition of the previous pattern of price movement. i.e., historical price pattern is repeated in the future. The proponents of the theory believe that share price/values can be measured in the following ways: 1. Primary trends show the upward or downward movement of share price over a year or more 2. Secondary trends show the fluctuations over a month 3. Tertiary trends show fluctuations over a period of days. Chartist does not attempt to explain the justification or merit of this theory, except by pointing to empirical evidence of the past. It is believed that the new market price of a share relates to the expectation about the future (thereby arguing against technical theory but consistent with fundamental theorists). The theory says that investors will have different ideas about the future expectations of a business. New information affecting these expectations arises at random intervals, and because investors react to them in different ways, the new share price may be any of a number of possible new values. Shares prices may deviate from an intrinsic value, but they will not equate to an intrinsic value. Intrinsic values exist in a thing of natural or permanent quality. Research carried out by Harry Markowitz, the artons protagonist of the random walk theory, went further by identifying the reasons why share values behave in a random walk. He suggested that the type of information available at any point in time determines shares values and the market for security will become efficient if the necessary information is available to other investors. The content of any new information that is available will be quickly digested by market participants. If the information forces them to change their option of the security s 35

44 Study Session 2 SOURCES AND COST OF FINANCE intrinsic value, their subsequent actions will rapidly cause an equivalent change in the security s market. This is the Efficient Market Hypothesis (EMH). Markowitz asserted that there are three forms of market efficiency, depending on the extent of information deemed available to market participants. They are 1. Weak Form: This information available is restricted to past share price, returns, and trading volumes. Consequently, further price cannot be predicted from historical price data alone. This implies that the Chartist approach cannot consistently produce excess returns if this hypothesis is true. 2. Semi-Strong from: Here, share prices reflect all publicly available information, reaction to the public announcement, and published accounting information. All of these will not produce excess returns as the information content of such announcement is reflected in the share prices. o A. Current result of the company B. Ratio analysis of the past publisher accounts C. Future plants or expectation of the company, possibly as a result of published statements D. Influences affecting the economy or industry 1. Identify the various sources of finance Highlight the problem of new financing 2.1 Explain short-term finance and its various sources Short-term financing refers to business or personal loans that have a shorter-than-average timespan for repaying the loan, typically one year or less. Short-term financing is designed to help borrowers finance for 36

45 MM317 Financial Management an immediate need without the burden of long-term financing. Sources of short-term finance include: 1. Bank Borrowing 2. Trade Credit 3. Factoring 4. Invoice Discounting 5. Deferred Tax Payment 6. Bill of Exchange 2.2 Explain long-term finance and its various sources Long-term finance can be defined as any financial instrument with a maturity exceeding one year. Sources of long-term finance are: 1. Ordinary Share Capital (OSC) 2. Preference Shares 3. Reserves 4. Loan Capital. 5. Sales and Leases Back 6. Loans from Mortgage Banks and Insurance Firms 2.3 Explain medium-term finance and its various sources Medium Term finance is sources of finance available for the mid-term of between 3 5 years typically used to finance an expansion of a business or to purchase large fixed assets. They include bank loans, hire purchases and leases. Sources of medium-term finance includes 1. Loans from Merchant banks and Discount houses. 2. Hire Purchase 3. Leasing 4. Acceptance Credit 5. Loans from Industrial Development Banks 6. Eurocurrency Market 2.4 Discuss the problems of new financing New financing is about raising the required cash for the running and expansion of a business venture. To be able to raise the required cash, some conditions need to be fulfilled. The problem of new financing, therefore, is in the conditions attached to raising the required cash which most businesses, especially the new firms, are not able to meet and are thereby constrained in their growth and expansion goals. 2.5 Discuss evaluation of shares and debentures Shares: This is the smallest unit of ownership in a company Debentures: This is a loan of a long-term nature. The value of a share is in terms of the market price/share and/or earnings per share (EPS), whereas debentures are valued in terms of their cost to the firm. Three elements that is, profit generation, bonus or script and right issues affect the value of shares. Bonus Shares are the free issue of ordinary shares to existing shareholders. 2.6 Explain the theories of share valuation The modern school of thought on Efficient Market Hypothesis (EMH) put forward that there are three basic theories of how to value shares on the stock market. These include: 37

46 Study Session 2 SOURCES AND COST OF FINANCE 1. The Traditional theory/fundamental theory 2. The Technical theory/chartist theory 3. The Random Walk Theory Explain short-term finance and its sources Explain medium-term finance and its sources Explain long-term finance and its sources Discuss the problems of new financing Discuss evaluation of shares and debentures Explain the theories of share valuation Articulate Presentation This is a complimentary resource to facilitate the quick delivery of this session. It is available in your course pack (Schoolboard disc / online page) and also linked here. Schoolboard Access your school board app, or visit to access updated online activities and resources related to the units of this Study Session. 38

47 MM317 Financial Management Study Session 3 In this study session, you will be introduced to capital budgeting and management of working capital. Thereafter, you will discuss capital budgeting/investment decision and the techniques for assessing economic worth/profit. You will end this session by explaining the management of working capital. Learning Outcomes When you have studied this session, you should be able to: 3.1 discuss capital budgeting/investment decision and the techniques for assessing economic worth/profit 3.2 explain the management of working capital This Study Session requires a one hour of formal study time. You may spend an additional two hours for revision. Terminologies 39

48 Study Session 3 CAPITAL BUDGETING AND MANAGEMENT OF WORKING CAPITAL Capital Budgeting and Management of Working Capital Pay Back Period Accounting Rate of Return (ARR) Net Present value (NPV) Capital Budgeting Internal Rate Return (IRR) Profotability Index (PI) Capital Rationing Decision Capital Investment under Inflation Working Capital Requirement Finacial Ratios Control of Stocks Management of Working Capital Basic Underlying the Assumptions of the EOQ Relevant Cost Associated with Inventory Management Illustration of EOQ 40 Long Term Financing Decision

49 MM317 Financial Management Should we replace the equipment? Should we add this product to our lives/should we buy or make this equipment? Managers must make these and similar decisions having significant financial effects beyond the current year; they are called Capital-Budgeting or investment Decision. /Investment decision is faced by managers in all types of organizations including religious, medical or governmental subunits. Capital-Budgeting/Investment decision has three phases: 1. Identification of potential investment. 2. Selection of the investment to undertake (including the gathering of data to aid the decision) 3. Post-audit (or follow-up or monitoring) of investments. Accountants usually are not involved in the first phase, but they play important roles in phase s (ii) and (iii). Managers use many different capital budgeting models in the selection of investments. Each model summarizes facts and forecast about an investment in a way that provides information for a decision maker. The use of this model is helpful in evaluating every capital budgeting/investment decision for its profitability by comparing the investment of current financial resources with the expected streams of future benefit. Once the necessary financial information has been collected, the figures will be subjected to various evaluation models or techniques to assess the economic worth or profitability of the proposals. The techniques that have been developed for assessing the economic worth or profits are: 1. Non-discounting Cash Flow Models i. Pay Back period (PBP) ii. Accounting Rate of Return (ARR) 2. Discounting Cash Flow Models i. Internal Rate of Return (IRR) ii. Net Present Value (NPV) iii. Profitability Index (PI) The PBP approach is one of the most used traditional models of evaluating. It is simply the length of time that it takes to recover the entire initial capital outlay invested in a project. In evaluating a project using PBP model, the net cash flow from the project is used for the evaluation. Where there are constant or uniform annual net cash flows from the project, the formula for computing the PBP is: PBP = Initial Investment Capital Outlay Annual net cash flow 41

50 Study Session 3 CAPITAL BUDGETING AND MANAGEMENT OF WORKING CAPITAL PBP under irregular cash inflow or unequal cash flow: i. Where the cash inflows are receivable EVENLY throughout the period, the actual PBP may be pirated into months and weeks as the case may be. ii. Where the cash inflow is receivable on the LAST day of the year, the PBP must not be pirated (i.e. should not include months or weeks). Acceptance Rule: For accepting a project using the PBP criterion, the project must be within the maximum period set by the management prior to the evaluation of the project. However, if PBP calculated is more than the maximum acceptable period, the project will be rejected. The major drawback of PBP model is that it fails to consider the cash that occurs after the PBP consequently, it cannot be regarded as a tool for measuring profitability. For example, two projects costing N 10,000 each would have the same PBP if they both had a sum of N 10,000 cash flow for the first year; but where one of the projects is expected to earn N 4,000 in year 3 the other provides no cash flow, the acceptance criterion may be misleading. Again, the model does not take account of the minimum rate of return by the investor (i.e. the cost of capital) and the magnitude or timing of cash flows during the PBP. o Example Fulbe Ltd is faced with the problem of choosing between two mutually exclusive projects. Project A requires a cash outlay of N 100,000 and generates a net cash flow of N 37,000 per year for three years. Project B costs N 81,000 and is expected to generate a net flow of N 40,000 N 35,000 and N 30,000 over its life of three years. Assume the management of the company had set the maximum acceptable period at 2.5 years. 42

51 MM317 Financial Management Required: Which of the projects should Fulbe Ltd embark upon? Solution: Project A PBP = Initial capital outlay = 100,000 Project B Annual net cash flow 37,000 = 2 years 8 months approximately Years NCF Cumulative NCF 0 (81,000) (81,000) 1 40,000 (41,000) 2 35,000 (6,000) 3 30,000 24,000 PBP = 2years + 6,000 x 12 months Decision: = 2years 2 months 30,000 Since the maximum acceptable period set by the management is 2.5 years and the projects are mutually exclusive, only project B meets the acceptance criterion and should be accepted while project A should be rejected. The ARR uses accounting information provided by the financial statement to determine the economic worth of an investment. It is calculated as the average project s earning after tax and depreciation divided by the average book value of the investment during its life: 1. ARR = Average Net Income Average Investment Where Average investment = S/V = Initial investment outlay S/V = salvage value of investment 43

52 Study Session 3 CAPITAL BUDGETING AND MANAGEMENT OF WORKING CAPITAL The net income for y year is the net cash flow minus depreciation and tax. ARR is also known as Return on Investment (ROI). Acceptance Rule: 1. Where many projects are being evaluated, the rule is to accept all projects whose ARR are higher than the minimum established ARR of the organization. 2. Where mutually exclusive projects are being considered the rule is to accept the project with the higher ARR provided the higher ARR exceeds the minimum ARR of the organization. The major shortcoming/drawback of the ARR is that is uses accounting profit rather than cash flows in appraising projects. Again, the ARR model ignores the time value of money and offers no guidance on what the right targeted rate of return should be. Example Joshua Ltd is considering the selection of a pair of mutually exclusive investment projects. Both would involve the purchase of machinery with a life of 5 years. Project 1 would generate annual cash flow (receipt less payment) of N 200,000. The machinery costs N 556,000. Project 2 would generate annual cash flow of N 500,000. The machinery would cost N 1,616,000 Joshua Ltd uses the reducing balance method of depreciation of 17%. Assume that annual cash flow arises on the anniversaries of the initial outlay. Acceptance of one of the projects will not alter the required amount of working capital. Company tax is 35%. The management of Joshua Ltd has approved 17% as the minimum acceptable rate of return. Required: Which of these projects should be chosen by Joshua Ltd? 44

53 MM317 Financial Management Solution Joshua Ltd Project 1 Period Average N. Cash Flow 200, , , , ,000 Annual Deposit (94,520) (78,452) (65,115) (54,045) (44,858) Net Income 105, , , , ,142 35% (36,918) (42,542) (47,218) (51,084) (54,300) Income after taking 86,191 68,562 79,006 87,675 94, ,842 Average Investment Book value of Beginning 556, , , ,913 The end 461, , , , ,868 Average 508, , , , , ,759 Project 2 Ave cash flow 500, , , , ,000 Annual Depreciation (274,720) (228,018) (189,255) (157,081) (130,377) Net income 225, , , , ,623 35% (78,848) (95,194) (108,761) (120,022) (129,368) Income after 197, , , , , ,255 Average investment 45

54 Study Session 3 CAPITAL BUDGETING AND MANAGEMENT OF WORKING CAPITAL Book value of Beginning 1,616,000 1,341,280 1,113, ,007 The End 1,341,280 1,113, , , ,549 Average 1,054,350 1,478,640 1,227,271 1,018, , ,737 Given that ARR = Average Net Income Average Investment Project 1 Project 2 ARR = 86,191 x , 671 x 100 Decision: 362,759 1,054,350 = 23.76% = % Considering the decision of the management of the firm that minimum acceptable accounting rate of return is 17% and has the highest ARR. NPV is one of DCF techniques/models that recognize the time value of money. It is the net contribution of a project to its owner s wealth, i.e. the present value of future cash flows minus the present value of initial capital investment/outlay. With the PVC method, all cash flows are discounted to express as: NPV(i, N) = Rt (1 + i) t N t=0 In the summation of the present value of cash flow (cf) over the range of value t = 1 up to including t = n. C1 and C0 are cf for respective years and K is the required rate return. A variation of the NPV is the (NTV) sometimes called net future value. It is the sum of money that the investor will have at the end of the project in excess of the amount that would have been obtained had the project not been undertaken. This method usually gives the same acceptance or objective decision for the project as NPV, if the same required rate of return is used. In relation to an individual investment opportunity, the NPV decision rule is to invest in the project if the NPV is positive and not to invest if the NPV is negative. The positive NPV will result only if the projects generate cash inflows at a rate higher than the opportunity cost of capital. Where the NPV is equal to zero, this implies that the project generates cash flows at a rate just equal to the opportunity cost of capital and may be accepted or rejected depending on further analysis of some qualitative factors. 46

55 MM317 Financial Management In selecting between mutually exclusive projects, the one with the highest positive NPV should be selected. Example Enoch Ltd can choose between one and other of two projects. Project A cost N100, 000 to yield a net return of N50, 000 and N66, 000 at the end of each of the two years respectively. Project B cost N40, 000 to yield a net return of N40, 000 and N9, 000 at the end of two years respectively. If there is a common discounting rate of 5%. Required: Which project should Enoch Ltd choose? Project A Year CF 5% NPV 0 (100,000) 1,000 (100,000) 1 50, , , ,962 Project B 7462 Year CF 5% NPV 0 (40,000) 1,000 (40,000) 1 40, , , ,163 Decision: 6,243 Since project A would give Enoch higher NPV of N7, 462 compounds with project in NPV of N6, 243, A should be chosen. The IRR is also known as the yield of a project, it is defined as the cost capital for which a project would be zero. It is that rate of return, which if applied, would cause the indifference between investing in a project and not doing so. The formula for calculating the IRR is given as:.npv = N n=0 Cn (1+r) n = 0 47

56 Study Session 3 CAPITAL BUDGETING AND MANAGEMENT OF WORKING CAPITAL It can be deduced from the formula above that it is the same with that of NPV. The only difference is that in NPV, the required rate of return is assumed to be known, while in IRR method the required rate of return is to be determined. If this approach is adopted, the IRR calculated is compared with the company s cost of the yield of the project (u. IRR). If it exceeds the cost of capital, the investment is undertaken while if it is less than the cost of capital the investment is rejected. There is also the trial by error also known as interpolation method where the discount factors in. The discounting factor yield a positive NPV which is improved to move towards the midway and is discovered to arrive at zero given by: NPV p Where: Example DF p + NPV p (DF N - DF p ) NPV p NPV N DF p = Discount factor yielding positive NPV DF N = Discount factor yielding negative NPV NPV p = Positive NPV NPV N = Negative NPV Using the information in Enoch Ltd under the NPV method determines which of the project is accepted using IRR approach? Solution: Project A Years CF DCF@ 8% NPV DCF@ 11% NPV 0 (100,000) 1,000 (100,000) 1,000 (100,000) 1 50, , , , , ,592 IRRA = 8% + (2,862) (1,358) (2862) + (11% 8%) ( ) = 8% (3%) 4220 = 8% = 10.03% 48

57 MM317 Financial Management Project B Year CF DCF@15% NPV DCF@20% NPV 0 (40,000) 1,000 1,000 1,000 (40,000) 1 40, , , ,246 (434) IRR B = 15% (20% 15%) = 15% (5%) = (5%) 2038 Decision: 15% = 18.94% The project B has a higher IRR of 18.94% compared with that of A of 10.03%, therefore, it should be accepted. Normally, the IRR and NPV method for mutually exclusive projects as in the above example should always give the same accept or reject decision. However, where there are conflicts in the decision rules, an incremental of basis assists, in this regards. For instance, if from the incremental CF perspective of project A B, the IRR (A - B) exceeds the cost of capital, accept A. However, if the IRR (A - B) is less than the cost of capital accept B. Taking into cognizance the foregoing, which of the projects should be chosen? Solution: Cash Flow Year 0 Year 1 Year 2 Project A (100,000) 50,000 60,000 Project B (40,000) 40,000 9,000 Incremental CF (60,000) 10,000 57,000 Incremental 49

58 Study Session 3 CAPITAL BUDGETING AND MANAGEMENT OF WORKING CAPITAL Year CF NPV 8% NPV 0 (60,000) (60,000) (60,000) 1 10, , , , , ,849 1,219 (1,891) 1219 IRR = 5% + (8% 5%) IRR = 5% (3%) = 5% % = 6.18% As the computed IRR (A - B) exceeds the 5% cost of capital of the firm, project A s IRR is also known as DCF yield, the marginal efficiency of capital, the actual rate of return. This method is also known as the benefit to cost Ratio (BCR). It implies that the ratio of the cash inflows at the required rate of return, to the initial cash outflows of the investment measure of projects profitability as criterion producer per unit return of the capital P1 formula is given by t=1 = C 1 - C 0 (1 + K) 1 Using the information in Enoch Ltd, the P1 of projects A and B can be calculated. Cash Flow NPV Year Project A Project B DIF 5% Project A Project B (100,000) (40,000) 1,000 (100,000) (40,000) 1 50,000 40, ,600 38, ,000 9, ,862 8, P 1A = 7462 = ,000 P 1B = 6243 = ,000 50

59 MM317 Financial Management Decision: Project B should be chosen because it has higher P2 of as compared with A of o The ARR uses accounting information provided by the financial statement to determine the economic worth of an investment. where many projects are being evaluated, the rule is to accept all projects whose ARR are higher than the minimum established ARR of the organization. The major shortcoming of the ARR is that is uses accounting profit rather than cash flows in appraising projects. In relation to an individual investment opportunity, the NPV decision rule is to invest in the project if the NPV is positive and not to invest if the NPV is negative. o All of the above options are true. That is, options A to D are all true, statement. (CR) will occur when there are so many profitable investments, but inadequate finances prevent their acceptance. CR may also be described as an extension of optional product mix. However, under the optional product mix, contribution margin per key factor is applied in ranking product whereas, under the CR situation, profitability index will be applied. 1. Artificial, soft or internal rationing This represents a situation where the financial restriction is internally imposed on the organization through some of their own activities like: a. Payment of dividend out of capital reserve. Unwillingness to accept c. Unwillingness to dilute existing shareholders of the organization d. Persistent net operation losses. 2. Real, external or hard rationing This will also be described as a situation where the financial restriction is externally imposed on the organization through any of the following reason. 51

60 Study Session 3 CAPITAL BUDGETING AND MANAGEMENT OF WORKING CAPITAL a. Unwillingness on the part of the investors to invest in the organization. b. Interest rate considered being too high c. Inability to obtain the required finances from the capital market due to the stringent listing requirement. 1. Financial restriction is limited to a single period and as such finance is available thereafter. 2. There is a linear relationship between the NPV of a project and the capital outlay. 3. All projects are divisible i.e. it is possible to invest in a fractional part of a project. 4. No Project can be delayed till another period. 5. Finance will always be available at a cost irrespective of the amount needed. 1. Identify the period of financial restriction (year of CR). 2. Compute the NPV for each of the projects. 3. Divide the NPV by the capital required in the year of financial restrictions or determines the profitability index for each of the projects using any of the following methods. a. PI = b. Pi = NPV Capital Required in the year if CR GPV Capital Required in the year if CR 4. Rank the result obtained in (3) above in descending order 5. Allocate the available resources among the various competing projects based on the order of ranking established in (4) above. Example: Fruits Ltd has N 1,000,000 available for investment and the under listed projects which mutually exclusive have been identified. Project A B C D E Initial outlay Residual value 280, , , , ,000 10,000 NILL NILL 5,000 NILL Net cash flow during 6 years life of the projects are: Project A Project B N 80,000 annually N 160,000 for each of the first 3 years and N120, 000 for next 3 years respectively. 52

61 MM317 Financial Management Project C Project D Project E N120, 000 for each of the first 3 years and N160, 000 for the remaining three years N 80,000 annually for the first 3 years 20% less than annual amount for the next 3 years First year Nill, and remaining 5 years at N 100, 000 per annum The expected rate return on capital is 15% Required: Advise the management of Fruits Ltd with supporting calculation on which of the project selected for investment. Dcf = 1 (1+r)n R First, determine the individual NPVs Project A Year NCF 15% PV 0 (280,000) 1.00 (280,000) , , , Project B NPV 27,040 Year NCF 15% PV 0 (360,000) 1.00 (360,000) , , , (180,000) Project C NPV 184,800 Year NCF 15% PV 0 (400,000) 1.00 (400,000) , , , ,000 NPV 113,600 53

62 Study Session 3 CAPITAL BUDGETING AND MANAGEMENT OF WORKING CAPITAL Project D Year NCF 15% PV 0 (340,000) 1.00 (340,000) , , , , , , 160 NPV (5440) Project E Years NCF 15% PV 0 (240,000) 1.00 (240,000) , ,000 SUMMARY Project P1 Ranking A 27,040 = th 280,000 = B 184,800 = st 360,000 C 113,600 = nd 400,000 D (5440) = th 349,000 E 51,000 = rd 240,000 Capital allocation based on ranking N 000 Available 1,000 Less: Capital For B 360 Balance 640 Less: Capital for C 400 Balance 240 Less: Capital E 240 Balance NIL Decision: Accept Project B, C, and E 54

63 MM317 Financial Management In a situation where the financial restriction occurs in more than a single period then, the actual capital is allocated using the Linear Programming (LP) Approach. This will, therefore, involve the following steps. 1. Identify the periods of financial restriction 2. Calculate the various NPV for the projects 3. Use the NPV of the project as object function 4. Express the constraints in a form of inequalities 5. Include the concept of non-negativity 6. Solve the LP model using simplex approach o A. Identification of the period of financial restriction (year of CR). B. Compute the NPV for each of the projects. C. Use the NPV of the project as object function D. Express the constraints in a form of inequalities o Option A is a true statement. Option B is a true statement Option C is a false statement. It is a step of multi-period capital rationing. Option D is a false statement. It is a step of multi-period capital rationing. Inflation is an important factor of economics and therefore must be given cognizance in capital budgeting. Since the flows (cash) of an investment project may occur over a long period of time, the impact of inflation should be correctly included for the investment analysis to be free of bias. The impact of inflation on capital budgeting could be adjusted for either in the cash flow or the discounting rate. The discount rate is usually market determined and it is therefore, stated in normal terms. However, where either cash flows or discount rates are expressed in real terms, they can be reverted to their nominal value through the following formula: Nominal Rate = (1 + Real Rate) + (1 + inflation Rate) 1 To convert real cash flows to nominal cash flows, the formula is: Real cash flows (1 + inflation rate) 1 55

64 Study Session 3 CAPITAL BUDGETING AND MANAGEMENT OF WORKING CAPITAL If the discount rate is stated in nominal term, then it is consistent that cash flows be estimated in nominal terms, thus taking account of the inflation rate of prices. Costs are usually sensitive to inflation; some costs increase at a faster rate than others. Certain item is not affected by inflation. For example the tax shield on depreciation (depreciation is not allowed on the book value of the asset for tax purposes). In evaluating the economic worth of a project, the real cash flow should be discounted at a real discount rate, although not commonly done or discounting nominal cash flows at the nominal rate. Both methods will usually give the same answer, subject to approximation error. Example Suppose Cal Ltd forecasts the following project cash flows in real terms and discounts at 15% nominal rate. Should firm invest in it if 10% of inflation is assumed? Year 0 Year 1 Year 2 Year 3 Project cash flows (100,000) 35,000 50,000 30,000 Solution: It would be inconsistent to discount the real cash flows at 15% nominal rate. The question can be solved by converting real cash flow to nominal cash flows and discounting at 15% nominal rate to obtain the real rate of return. Alternative A converting real cash flows to nominal terms Yrs Real cf Working Nominal cf 0 100, ,000(1 0.1) 0 100, ,000 35,000(1 0.1) 1 38, ,000 50,000(1 0.1) 2 60, ,000 30,000(1 0.1) 3 39,930 NPV = N (100,000) + 38, , ,930 = N (1.15) 2 (1.15) 3 = N (100,000) + (33, , ,255) Alternative B converting nominal rate to real rate Nominal rate = (1+ Real rate) (1 + inflation rate) Real rate = 1 + Nominal Rate 1 + Inflation Rate Real Rate = 1 + Nominal Rate Inflation Rate Real rate =

65 MM317 Financial Management = = = 4.55% NPV = N (100, 000) + 35, , ,000 = N (100,000) , ,251 = N (1.0455) 2 (1.0455) 3 Conclusively, project cash flows should be adjusted for inflation so that profitable ones would not be rejected. The major objective of the financial manager is to maintain sufficient cash on hand or at the short call to meet any normally predictable expense without resorting to expensive overdraft or other costly emergency measures. The extent to which cash is put to effective use within the business will reflect agreeably in the profit levels. The success of working capital management depends upon the knowledge of the cash flow position of the company. Working capital is the excess of current liabilities. It is not a state entity as the capital is continually in use, being turned over many times a year. Working capital represents the investment of the company s resources in assets which are expected to be realized within a year of trading. In the management of working capital the following need to be asked: 1. What size of the investment is allocated to the different forms of current assets? 2. What proportion of these current assets should be financed by short-term or longterm funds? 3. What proportion of the total assets should be in form of current assets? To determine the level of a company s requirement, it is necessary to prepare cash where minimum balance needed from month will be determined. The size of the cash balance the company might need depends on the nearness or availability of other sources of funds at short-term and not the credit standing of the company. Also important is the control of debtors and creditors a critical factor for short-term financial planning. 57

66 Study Session 3 CAPITAL BUDGETING AND MANAGEMENT OF WORKING CAPITAL The debtor s problem revolves around the choice between profitability and liquidity. The management of is important for the company s term financial situation as a way to ensure the management of cash. Similarly, a balance has to be found; this time between typing up money that is not earning anything and losing sales and profit. The cost involved in using trade credit might include forfeiting the discount normally given for pro-payment of loss of goodwill. o A. The major objective of the financial manager is to maintain sufficient cash on hand. B. The success of working capital management depends upon the knowledge of the liquidity position of the company. C. The size of the cash balance the company might need depends on the availability of other sources of funds at short-term. D. The debtor s problem revolves around the choice between profitability and cash-flow. o Option A is a true statement. Option B is a false statement. The correct statement is the success of working capital management depends upon the knowledge of the CASH FLOW position of the company. Option C is a true statement. Option D is a false statement. The correct option is the debtor s problem revolves around the choice between profitability and LIQUIDITY In assessing the liquidity position of a company, two key indicators are often used. These are the current ratio and liquidity ratios. However: 1. All ratios are imperfect and imprecise and should only be treated as informal guidelines. 2. While the company must account for these ratios, it should not regard them as only governing all aspects of financial management. It is also dangerous to judge the liquidity position of a company on the basis of the balance information which relates to only one day in the year. The impression can be 58

67 MM317 Financial Management misleading, particularly if the company engaged in a business subject to cyclical variation. The current ratio equals current assets divided by current liabilities. The satisfactory ratio which is taken to indicate that the company s short-term financial position is healthy is the ratio 2:1. A lower ratio than this, let s say 1:5:1, commonly implies a shaky short-term position. Quick ratio is defined as the current assets except stock divided by current liabilities. A ratio 1:1 is the acceptable minimum. An interesting test of the usefulness of financial ratios as a guide to the financial strength comes up in the research conducted by Altman in assessing the state of companies bankruptcy. The research selected five rates to serve as the best guide to the financial strength of a company. The ratios are as follows: 1. Working capital Total assets 2. Rent earning Total assets 3. Earnings before interest and tax (EBIT) Total assets 4. Market equity value Book value of total debt 5. Sales Total assets These ratios term discriminate ratio model proved to be remarkably successful with current predictions in 94% per cent bankruptcy. Altman claims that with the use of the above ratios, bankruptcies can be predicted up to two years prior the actual failure. o A. The current ratio is used in assessing the liquidity position of a company. B. The liquidity ratio is used in assessing the cash-flow position of a company. C. A ratio of 1:1 is the acceptable minimum for current ratio. 59

68 Study Session 3 CAPITAL BUDGETING AND MANAGEMENT OF WORKING CAPITAL D. A ratio of 2:1 is the acceptable minimum for quick ratio. o Option A is a true statement. Option B is a false statement. The correct statement is the liquidity ratio is used in assessing the liquidity position of a company, Option C is a false statement. The correct statement is a ratio of 1:1 is the acceptable minimum for QUICK RATIO. Option D is a false statement. The correct statement is a ratio of 2:1 is the acceptable minimum for CURRENT RATIO. The control of the stock is primarily the responsibility of the stock controller assisted by the information provided by the management accountant. The stock comprises of raw materials, component part, work-in-progress (WIP), finished (SG) maintenance tools, and room and consumable stocks. The essential stock control is that stock levels should be optimal, that is, neither too larger nor too small. If a business deviates from the optimum level, the following are the repercussions. 1. The stocks are too high (maximum inventory police) a. surplus capital is tied up on productively b. costs of storage e.g. Warehousing and insurance have to be made. c. There is the risk of deterioration due to the length of time that the items are in store. 2. There is that change in demand or technology, which will render the surplus unusable. a. Pilferage. 3. The stocks are low (minimum inventory police) a. There is a risk of interruption in production due to staging. b. Frequent ordering with associated costs will be necessary. c. Economies resulting from bulk buying loss. This account for calls for stocks control through the use of economic other Quantity (EOQ) model. EOQ may be described as an inventory management policy specifically designed to identify the specific quantity of inventories or raw materials that an organization will need to acquire and maintain in the warehouse in other to reduce the barest minimum cost associated with inventory management. EOQ can also be described as a means of getting the right quantity of raw materials at the right price in order to satisfy the production policy requirement of an organization. 60

69 MM317 Financial Management 1. It is assumed that there will be no stock loss in the cost of production. 2. Annual purchase cost must remain constant throughout the period. 3. Annual demand is done with certainty. 4. Lead is also certain. 5. There is instantaneous built of inventory. 6. Annual holding or camping cost must remain constant. 7. Ordering cost per order must remain stable throughout the year. 1. Purchase cost: This will represent the amount payable to the supplier of the raw materials. Under EOQ with discount, purchase cost will be considered as a relevant cost item but without discount, purchase cost will remain constant at various levels of activity and as such, will be irrelevant in the inventory model. 2. Stock-out cost: This represents the total cost associated with stock out as the result of an inability to ascertain in specific terms the actual amount associated with stock out. Stock out cost is therefore considered to be irrelevant in decision making. However, if it is possible to identify the actual stock-out cost then, the amount may be included in the process of establishing EOQ. 3. Carrying or Holding cost: This is expressed as a percentage of the purchase cost per unit, to the carrying cost per unit. Therefore, it represents the product of the average stock with the carrying cost per unit i.e. TCC = Q/2 x C. 4. Ordering cost: This will also represent the total amount of expenditure incurred between when an order is placed and when the order has been brought into the warehouse. Ordering cost will include: a. Transportation cost b. Insurance cost c. Legal and administrative charges etc. The order cost is determined to represent the product of number of orders per annum with ordering cost per order i.e. TOC= dd/q X 0 o A. It is assumed that there will be no stock loss in the cost of production. B. Annual purchase cost must remain constant throughout the period. C. Annual demand is done with uncertainty. D. All of the above are correct 61

70 Study Session 3 CAPITAL BUDGETING AND MANAGEMENT OF WORKING CAPITAL o Option A is a true statement Option B is a true statement Option C is a false statement. The correct option is annual demand is done with CERTAINTY. Option D is a false statement. All of the above are not correct because option C is a false statement. a. Graphical: EOQ is graphically determined at a position within the cost structure of the organization where the total purchase cost, total ordering cost, and the total carrying cost are at their lowest point as shown below. TPC Cost TOC o EOE qty b. Tabular Illustration: EOQ may be determined in a columnar format where different levels of activity are provided by the examiner. EOQ will, therefore, represent the actual level that has the lowest cost of the following procedures must have been adhered to. 1. Identify the quantity inherent in each of the activity level 2. Calculate the number of order for each of the activity level i.e. dd/q 3. Determine the average stock for each of the activity levels i.e. Q/2 4. Calculate the total ordering cost by multiplying the number of order as obtained in (ii) above with the ordering cost (o) per order i.e. dd/q x O 5. Identify the Total Carrying cost (TCC) for each of the activity level by multiplying average stock obtained in (iii) above with the carrying cost (CC) per unit i.e. O/2 x C 62

71 MM317 Financial Management 6. Where there is no discount, determine the total relevant cost through the summation of the TOC and TCC. 7. Under discount, determine the total purchase cost for each of the activity level i.e. annual demand (dd) multiplied by purchase cost per unit. 8. Determine the total relevant cost by adding TOC, TCC, and TPC. 9. Identify the EOQ based on the activity level with the lowest cost. c. EOQ Model: These represent a situation where the mathematical modeling approach is used in selecting the EOQ as follows: Example i. EOQ without stock out cost = Q = ((2 Do)/C) ii. EOQ with stock out cost = Q = ((2 Do)/C) x ((C+S)/S) Where: Q = EOQ D = annual demand O = Ordering cost per order C = Carrying/holding cost per unit S = Stock out cost per unit UEB Ltd printers and publisher used 100,000 rolls of newsprint which it obtains from a factory at Pilgani at N50 a roll. The ordering and handling cost amount to N200 per order, while the carrying costs are 12% p.a. You are required to: a. Calculate the order most economical to the company b. Assume that the order quantity is 4000 rolls Calculate i. The number of order p.a ii. Total cost p.a c. Compute the EOQ assuming that stock costs are permitted to occur when a stockout occurs and order reoccurred for newsprint. The company has agreed to retain the order and when replenishment is received, to use express courier service for the delivery at a Cost of N1.50 a roll. Another administrative cost with stock out is estimated at N0.50K per roll. Solution a. Q = 2 Do C Q = 2 x100,000x (N50) = 40,000,000 6 = 2582 units b i. number of order per annum 63

72 Study Session 3 CAPITAL BUDGETING AND MANAGEMENT OF WORKING CAPITAL ii. DD/Q = 100, = 25 times TOC + TCC = 100, 000 x x = N17, 000 c. Q = 2 Do C = C+S S S = = x = 2582 x 2 = 5164 units Management of working capital also involves establishing credit standing of customers, debtors and creditors control, cash control and budgeting. The student is advised to make a study on these topics. The financial manager has the responsibility to provide information which will assist in making decisions concerning the investment of capital funds. Long term financing requires justification. The justification of any capital expenditure has to assessed by applying the various method of appraisal e.g. return on investment (ROI), the payback period (PBP) and the discount cash flow techniques (all discussed earlier in this chapter). The possibility of sale and lease back hire purchase should also be explored. The following factors need evaluation in investment appraisals. 1. The phasing of the expenditure under the project 2. The estimated life of the investment 3. Initial cost of the project 4. The amount of which the project will have on the operations or profitability of the rest of the undertaking. 5. Working capital required. o The phasing of the expenditure under the project C. The estimated life of the investment 64

73 MM317 Financial Management D. The total cost of the project o Option A is a true statement Option B is a true statement Option C is a true statement Option D is a false statement. The correct statement is the INITIAL COST of the project. 1. What is capital rationing? What are the reasons for rationing in industries? 2. Compare and contrast the various methods of investment appraisal 3.1 Discuss capital budgeting/investment decision and the techniques for assessing economic worth/profit Capital budgeting/investment decisions refers to decisions managers must make which have significant financial effects beyond the current year. Capital budgeting/investment Decision are faced by managers in all types of organizations including religious, medical or governmental subunits. Capital- Budgeting/Investment decision has three phases: i. Identification of potential investment. ii. Selection of the investment to undertake (including the gathering of data to aid the decision) iii. Post-audit (or follow-up or monitoring) of investments. 3.2 Explain the management of working capital The major objective of the financial manager is to maintain sufficient cash on hand or at the short call to meet any normally predictable expense without resorting to expensive overdraft or other costly emergency measures. The extent to which cash is put to effective use within the business will reflect agreeably in the profit levels. The success of working capital management depends upon the knowledge of the cash flow position of the company. Working capital is the excess of current liabilities. It is not a state entity as the capital is continually in use, being turned over many times a year. Working capital represents the investment of the company s resources in assets which are expected to be realized within a year of trading. Discuss capital budgeting/investment decision and the techniques for assessing economic worth/profit. 65

74 Study Session 3 CAPITAL BUDGETING AND MANAGEMENT OF WORKING CAPITAL Explain the management of working capital Articulate Presentation This is a complimentary resource to facilitate the quick delivery of this session. It is available in your course pack (Schoolboard disc / online page) and also linked here. Schoolboard Access your school board app, or visit to access updated online activities and resources related to the units of this Study Session. 66

75 MM317 Financial Management Study Session 4 In this study session, you will be introduced to financial management of mergers and portfolio theory. You will begin by explaining business mergers. Thereafter, you will discuss the portfolio theory and explain its application in investment planning. Subsequently, you will explain the efficient portfolio. You will end this session by discussing the security market line (SML). Learning Outcomes When you have studied this session, you should be able to: 4.1 explain business mergers 4.2 discuss the portfolio theory and explain its application in investment planning 4.3 explain the efficient portfolio 4.4 discuss the security market line (SML) This Study Session requires a one hour of formal study time. You may spend an additional two hours for revision. Terminologies 67

76 Study Session 4 FINANCIAL MANAGEMENT OF MERGERS AND PORTFOLIO THEORY Regulation of Mergers Who are those involved in Mergers? Steps Necessary in Mergers Actions to take for the prevention of hostile bid Business Mergers Reasons for Success and Failures in Mergers Procedure Financial Management of Mergers and Portfolio Theory De-Merger/Divestment Separability Theorem and Interior Decorator Assumption of Portfolio theorem Diversification The Optimum Portfolio Efficient Portfolio Risk of two-asset portfolio Return of a three asset portfolio Capital Asset Pricing Model (CAPM) Asset Beta Security Market Line (SML) Problems of CAPM Arbitrate Pricing Theory (APT) 68

77 MM317 Financial Management Merger is a situation where two or more companies combine to form a larger business organization. On the other hand, takeover or an acquisition involves the purchase of the controlling share by one company in another company. These are schemes that are carefully planned to achieve a synergistic effect. Synergy is the generic term used in the field of business acquisitions and mergers to cover the economies which can result through integration often mathematically expressed as = 5. It means that the sum of the whole is more than the summation of the individual component parts that make up the whole. The type of economics which can be obtained, for example, is avoidance of duplication of staff services, economies of scale through greater output, wider technology, marketing and financial base, and access to cheaper and wider. Reasons for mergers: 1. Operating economies (i.e. in the area of purchasing and marketing) 2. Management acquisition (i.e. getting aggressive management with fresh ideas for better projects and enhancement of shareholders wealth) 3. Diversification (i.e. spreading risk through conglomerate diversification especially where it is suspected that the firm s traditional markets will decline). 4. Financial liquidity (i.e. access to wider sources/ability to raise new finance that will improve the EPS). 5. Production (i.e. gives the necessary expertise in the production team) Factors to be considered in Mergers: 1. Consideration of valuation 2. Form of consideration 3. Attitude of a target company s shareholders 4. Attitude of a predator company s shareholders 5. Contract of employment of key management staff 6. Dividend policy after merger 7. Taxation implication 8. Company culture clash 9. Goodwill 10. Location 11. Age of assets 12. Patent and rights o A. Take-over is a situation where two or more companies combine to form a larger business organization. B. Merger involves the purchase of the controlling share by one company 69

78 Study Session 4 FINANCIAL MANAGEMENT OF MERGERS AND PORTFOLIO THEORY in another company. C. Diversification and location is a reason for mergers Dividend policy after merger is a factor to be considered in mergers. o Option A is a false statement. The correct statement is Merger is a situation where two or more companies combine to form a larger business organization. Option B is a false statement, the correct statement is TAKEOVER involves the purchase of the controlling share by one company in another company. Option C is a false statement. The correct statement is diversification is a reason for merger. On the other hand, location is a factor to be considered in mergers. Option D is a true statement. The Securities and Exchange Commission (SEC) is tasked with overseeing mergers. This main objective is to ensure that mergers and acquisition do not create a. The investment and securities commission (ISC) is charged with the duty of reviewing, approving and regulating all forms of business combinations. This is also amplified in the companies and allied matters Act (CAMA) 1990 (as updated, section 591 to 593). The central Bank of Nigeria (CBN) is to approve and regulate merger and acquisitions amongst banks other financial institution. The essence of this regulation is to ensure that business combination does not restrain competition (create a monopoly). Thus, it strives to eliminate imperfection and abuses that are detrimental to the orderly development of the economic and financial system. The process of obtaining the commissions approval involves the following: 1. Filling pre-merger notice with the commission. 2. Filling a formal application for approval of the proposed merger with the commission. 3. Submission of all documents relating to the merger after its completion. The Nigerian Stock Exchange (NSE) approval is required where both or only the acquiring company is listed on the Exchange. The federal Inland Revenue Service (FIRS) is important for tax purpose (i.e. the application of schedule 2 of the companies income tax to the value of the transferred assets and the capital gains. Tax (CGT) to shareholders where there is cash exchange). In any merger where foreign are involved, the federal Ministry of finance (FMF) gives dispensation to the foreign shareholders with regards to approval status for the shares held in the acquiring company. 70

79 MM317 Financial Management All mergers and acquisition require the approval of the federal High Court before it is binding on the shareholders. 1. Financial advisers to both companies: These often give advice on the financial implication of the merger. 2. Reporting Accountants to the companies: They review the accounts prepared for the purpose of the merger. 3. Solicitors to the companies: They handle all legal issues on behalf of their companies relating to the merger. 4. Registrars: They handle the transfer of shares, update the register of members, cancel old certificates and issue new. 5. Tax consultants: They deal with all tax matters relating to the merger. 6. Stock brokers: They market the shares, and assist in taking the shares to the stock exchange. 7. Solicitors to the scheme: They handle all legal issues relating to the merger. The basic steps that a company must ensure that the merger is legally consummated are: 1. The decision to combine the companies involved 2. Fact finding: To gather all necessary data and information of companies involved. 3. Inflation: To identify prospects through the Board and Management 4. Negotiation: often done between the key officers of both companies 5. Confirmation: This is the consent of the Board of Directors and shareholders Other steps involving legality and procedural requirement are: 1. Preparation of scheme of arrangement: This contains the agreed terms and conditions of the merger. 2. Forward scheme of arrangement to the approving authorities for their approval. 3. Court-ordered meeting: In line with CAMA, the federal High Court summons separate meetings of the shareholders of both companies to consider and approve the scheme of arrangement. 4. Reporting to the court the outcome of the meeting 5. Obtaining final sanctions from the court to proceed with the merger. 6. Filling of the court order with the registrar of companies. 7. Seal deals and implement terms that are, share or cash exchange. 71

80 Study Session 4 FINANCIAL MANAGEMENT OF MERGERS AND PORTFOLIO THEORY o Option A is a false statement. The correct statement is Financial advisers. Option B is a false statement. The correct statement is Reporting accountants. Option C is a true statement. Option D is a false statement. The correct statement is solicitors to the scheme. 1. Seek management take-over or budget 2. Seek government injunction i.e. restricting the predator company under antimonopoly or anti-trust law, where this is in existence. 3. Appeal to shareholders not to sell their shares by promising them better prospect and share appreciation. 4. Attack the intention of the predator company 5. Shark repellents: Amendment to the company s memorandum and Article of association in such a way that makes the take-over very difficult for the acquiring company. For instance increasing the merging of majority votes as AGM required for approving such to take-over. 6. Green Mall is an anti-takeover tactic in which a target of firm pays a premium to an unfriendly firm holding a larger block of its stock in exchange for its own shares. 7. Lock-up defense: This a strategy that is employed by the management of the target company whereby a third party is granted the right to buy the firm s assets in order to discourage the acquiring firm from going ahead with the bid. This plan is particularly effective when the target company offers for sale its crown jewel, that is, the target firm s most valued asset. It is also known as scorched earth strategy. 8. Pac-man defense: This is an anti-takeover strategy in which the target company tries to buy up the acquiring firm s shares. 72

81 MM317 Financial Management 9. White Knight involves the target company sourcing for a friendly company (white knight) whose offer is more appealing for the takeover bid. 10. This strategy gives shareholders of a firm not involved in the takeover the right to buy the target firm s securities at a favourable price if the takeover goes through. 11. People Pill Where competent management team resigns unblock in the event of a takeover if losing them could seriously harm the company. 12. Management can also launch a publicity campaign to discourage its own shareholders from accepting the offer from the predator. Such campaign are usually accompanied by other actions like a. Management can revalue assets of the company to prove that the company is more than the offer price. b. Firm commitments as higher dividend levels in the future. c. Changes in the management structure to improve efficiency and profits. o All of the above statements are true, i.e. they are all correct statement. 1. Proper planning is required: Here, the objective of the merger should be clearly set out. A proper comprehension of the complexities in the different unit before the merger and an adequate appraisal of the potentials is essential. 2. Managers of Change: The quality of management talent determines the success or its failure. The management style that is readily adaptable to changes is required. 3. Careful analysis of future requirements: Proper appraisal, for instance, of subsidiary s future requirements for parent company s funds, is needed. 4. Organization after the merger: Management must follow-up if possible, by the use of a checklist, to ensure the achievement of the present objectives. The tendency to retain after a merger could run the set-up. 73

82 Study Session 4 FINANCIAL MANAGEMENT OF MERGERS AND PORTFOLIO THEORY Procedure for calculating the minimum amount acceptable and maximum amount payable in a merger situation 1. Compute the value of the company being taken over prior to the takeover (target/prey/victim/acquired company). 2. Compute the value of the company taking the other over prior to the takeover (acquiring company). 3. Compute the post-acquisition value of the enlarged company after the acquiring. 4. The minimum sum to pay the shareholders of the company being taken over is the value computed in (1) above 5. To calculate the maximum sum to pay the shareholders of the company being taken over. This is the direct opposite of merger. This is the breaking down of a company into two or more separate entities and the disposal of unviable ones. If a company has financial difficulties, it can also dispose of its investment in order to improve the company s finance. Advantage of Divestment 1. Sales of unprofitable subsidiary 2. Enable firms to be more focused 3. Reduces business risk Disadvantage of Divestment 1. Loss of economics of sales 2. Low turnover associated with small company 3. Higher operating cost as a result of lower turnover A reverse merger/takeover occurs when a small company takes over a higher company in terms of assets, liabilities, and potentials. A roll-up concept occurs where many small companies are merged to form a big company. A roll-off is a form of divestment involving the sales of some parts of a company to a third party usually another company. Generally, cash will be received in exchange. In a spin-off, a new company is formed whose shares are owned by the shareholders of the original company, which is making the disposal of the assets. There is no change in the ownership of the assets as the shareholders own the same proportion of shares in the newly formed company as they did in the old company. If a bidding company is able to procure the shares of the target company at a price on the stock exchange which is cheaper than the price that the victim company has stated a Corporate occurs if the bidding company buys the shares on the stock exchange at that cheaper price. 74

83 MM317 Financial Management A friendly merger is a merger which the management of an acquiring firm and a target firm puts out on suitable terms that are agreed upon to buy both firms. A hostile bid is a merger that a target company resists. Since a joint working out of the merger terms is not possible in such cases the acquiring company will usually make a turnover bid to target firm s shareholders. o Roll-Up concept occurs where many small companies are merged to form a big company. B. Roll-Off is a form of divestment involving the sales of some parts of a company to a third party usually another company. C. In Reverse merger/takeover, a new company is formed whose shares are owned by the shareholders of the original company, which is making the disposal of the assets. D. A Spin-off occurs when a small company takes over a higher company in terms of assets, liabilities, and potentials. Option A is a true statement. Option B is a true statement. Option C is a false statement. The correct statement is in a SPIN-OFF, a new company is formed whose shares are owned by the shareholders of the original company, which is making the disposal of the assets. Option D is a false statement. The correct statement is a REVERSE MERGER/TAKEOVER occurs when a small company takes over a higher company in terms of assets, liabilities, and potentials. A rational investor will prefer to commit his fund in as many securities as possible, which put a together will form his portfolio. A portfolio is the collection of several securities. Investors will always seek to minimize risk and maximize return. They will, therefore, prefer the project having the higher return at the same level of risk with another and where two securities have the same return they will select the one with the lower risk. 75

84 Study Session 4 FINANCIAL MANAGEMENT OF MERGERS AND PORTFOLIO THEORY The Separability theorem states that all investors ranging from the risk-averse to the cavaliers the risk to hiring) should have the same mix of risky securities in their portfolio. This contradicts interior decorator school of thought who stipulate that a skilled analyst is expected to give information on the securities that suit his client s psychology. For instance, a skilled analyst is not expected to introduce a hypertensive client to transport business as this is most unsuitable to his being The risk under consideration is made up of two parts: a. Unsystematic Risk Also known as diversifiable, unique, specific and non-market improve risk. It is caused by the following events: 1. Bad management 2. Location 3. Dependency on limited market 4. Nature of the products b. Systematic Risk Also known as non-diversifiable, non-specific, general and market improve risk. It is caused by the following events: 1. Inflation 2. Economic problems 3. Political problems 4. War 5. The death of the president. o Irrational investors will prefer to commit their fund in as many securities as possible A portfolio is the collection of several securities. C. Investors will always seek to maximize risk and minimize return. D. Systematic risks is caused by political problems Option A is a false statement. The correct statement is that Rational Investors will prefer to commit their funds in as many securities as possible. Option B is a true statement. Option C is a false statement. The correct option is investors will always 76

85 MM317 Financial Management seek to minimize risk and maximize return. Option D is a true statement. 1. Investment seeks to maximize utility which is a function of risk and expected return. 2. There is a linear relationship between the return obtained from an individual security and the average rate of return from all securities in the market. 3. All investors view securities as the same way with respect to return, risk, and correlation with the securities. In other words, their expectations are homogenous. 4. All investors can borrow and lend infinitely larger sums of money at the same risk-free rate 5. There are taxes. This is a strategy usually adopted by rational investors by spreading and committing their funds in several investments in such a way that when one goes bad such investor has other securities to fall back on. By diversifying, investors are trying to minimize approach to which considers two Rs Risk and Returns but that the relationship between securities is equally important. Hence, it recognizes 3Rs Risk and Relationship. The relationship is known as correlation, which is of three types as follows: 1. Positive correlation occurs where the performance of security affects a number positively. If A does well, B will perform likewise. 2. Negative correlation projects are negatively correlated where the performance of one has a negative effect on the order. For instance, if security A is doing well, security B will perform badly. 3. A neutral correlation occurs where the performance of one security will not affect the other security. The relationship is measured by the coefficient of correlation that is calculated as follows: Coefficient of correlation (r) = CaAB ɗaɗb Where: ɗa = standard deviation of security A ɗb = standard deviation of security B A coefficient +1 indicates perfect positive correlation 77

86 Study Session 4 FINANCIAL MANAGEMENT OF MERGERS AND PORTFOLIO THEORY A coefficient -1 indicates perfect negative correlation A coefficient of zero (0) indicates no correlation Portfolio theory concludes that where projects are perfectly (highly) negatively correlated i.e. (r = -1) Overall risk should be at the barest minimum. The indifferent curve shows the combination of expected return and risk that the individual investor will find to be of equal benefit (i.e. be indifferent to). An indifferent curve on a graph shows the expected return and its associated risk plotted along the two lines of the graphs, investors is indifferent to any combination of expected return and risk on the curve. Expected Return A Y 1 B Y 2 X Risk The indifferent curve shown above are typical in that: Every point on each curve has a higher expected return or a lower risk than other points or curve; a An investor would choose the combination of risk and expected return on one curve with indifferent. However, he would prefer the combinations of returns risk on indifferent curve A than on B because curve A offer higher returns for the same degree of riskiness than the risk for the same amount of expected returns. For instance, for the same amount of risk, the expected return on indifferent curve A is Y1, wherein curve B it is only Y2. 78

87 MM317 Financial Management o Investment seeks to maximize utility which is a function of risk and expected return. B. There is a linear relationship between the return obtained from an individual security and the average rate of return from all securities in the market. C. All investors view securities in different ways with respect to return, risk, and correlation with the securities D. Only A and B is true. Option A is a true statement Option B is a true statement. Option D is a false statement. The correct statement is all investors view securities as the same way with respect to return, risk, and correlation with the securities. Option D is a true statement. This is a portfolio which gives the higher expected return for a given standard deviation for a given expected return. As investor s indifference curve shows what portfolio an investor would be indifferent about. If we draw a graph to show the expected return and risk of many possible portfolios of investment which could be undertaken, we would (according to portfolio theory) plot an egg shaped dots on scatter graph as shown below: 79

88 Study Session 4 FINANCIAL MANAGEMENT OF MERGERS AND PORTFOLIO THEORY Expected Return Efficient frontier Risk (Standard deviation) In this graph, there is some portfolio that would not be as good as the others. However, there are other portfolios which are neither better nor worse than each other, because they have either a higher expected return with a higher risk or a lower expected return with a lower risk. These portfolios lie along the so-called efficient portfolios. It is now possible to place investor s indifferent curves on the same graph as the possible portfolios of investment (the egg-shaped scatter graph). An investor would prefer portfolio of investments on indifference curve P to a portfolio on curve S which in return is preferable to a portfolio on curve T than in turn is preferable to curve R. No portfolio exists, however, which touches curve P or S. The return of two-asset portfolio is calculated using the formula RP = WaRa + WbRb 80

89 MM317 Financial Management Where Rp = Return of a two-asset portfolio Ra = Expected return from securities A Rb = Expected return from securities B Wa = Proportion of funds committed to asset A Wb = Proportion of funds committed to asset B Instead of calculating the standard deviation of each security separately and combining them as appropriate, the risk of a two-asset portfolio can be calculated using the following formula: ɗp = A + B + C Where A = Wa 2 a 2 B = W b 2 b 2 And Where C = 2W a awb br ab ɗp = Standard deviation of the two-asset portfolio ɗa = Standard deviation of asset A ɗb = Standard deviation of asset B Wa = proportion of funds committed to asset A Wb = proportion of funds committed to asset B r ab = Coefficient of correlation between securities A and B R = +1 it indicates prefer positive correlation = -1 it indicates prefer negative correlation = 0 it indicates prefer neutral correlation The return of a three-asset portfolio can be calculated, using the formula Rp = WaRa + WbRb + WcRc Risk of the three-asset portfolio can be calculated using the formula ɗp = D + E + F + G + H + I Where: D = Wa 2 a 2 81

90 Study Session 4 FINANCIAL MANAGEMENT OF MERGERS AND PORTFOLIO THEORY E = Wb 2 b 2 F = Wc 2 c 2 G = 2Wa awb r ab H = 2Wb bwc cr bc I = 2Wb bwc cr bc Example (Two-asset portfolio) For an investment portfolio consisting of a number of securities, the important features determining the riskiness of the portfolio is the way which the returns on the individual securities vary together. a. Illustrate this statement by making calculation from the simplified data given in the table below in relation to a portfolio comprising 40% of security A and 60% of security B. ignore the possibility of no correlation between the rates of return. Predicted Return Predicted Return Probability Security A (%) Security B (%) An investor in risk securities is presumed to select an investment portfolio which is on the efficient frontier and touches one of its indifferent curves at the target. Solution b. Required 1. Give a details explanation of the above statement with particular attention to the expression in italics. 2. Illustrate your answers with a relevant diagram SECURITY A X P PX X-X (X-X ) X ɗa =

91 MM317 Financial Management SECURITY B X P PX X-X (X-X ) ɗb = The return of the portfolio Rp = WaRa + WbRb = 0.4 x x 20 = = 18 The risk of the portfolio: Coefficient of Correlation (r) = CoV AB ɗa ɗb Covariance AB = P A-A B-B P(A-A)(B-B) r = 6 i.e x ɗp = Wa 2 ɗa 2 + Wb 2 ɗb 2 + 2Wa2WaɗaWbɗbrab ɗp = (0.4) 2 (1.8974) 2 + (0.6) 2 (3.1623) 2 + 2(0.4)(0.6)(1.894)(3.1623)(+1) = 0.16)(3.6) + (0.36)(10) = 0.576) = = If perfectly negatively correlated (r = -1) ɗp = Wa 2 ɗa 2 + Wb 2 ɗb 2 + 2WaaWbbrab 83

92 Study Session 4 FINANCIAL MANAGEMENT OF MERGERS AND PORTFOLIO THEORY ɗp = (0.4) 2 (1.8974) 2 + (0.6) 2 (3.1623) 2 + 2(0.4)(0.6)(1.894)(3.1623)(0) = 0.16)(3.6) + (0.36)(10) + 0 = 0.576) = = It can be seen that prefer positive correlation, with movements in the expected return of securities going in the same direction, gives the highest risk for the portfolio; while preferring negative correlation has the lowest risk. If there is no discernable correlation, the risk factor will fall somewhere between standard deviation shown. B (i) Investors tend to push for the highest possible returns at lowest possible risk levels. There are of course limits to what can be attained, and in general, the higher the return, the higher the graph of risk (measured by the standard deviation, ɗ, of the return on a portfolio). As expected return is plotted, such combinations between which an investor is indifferent fall on an indifferent curve. Such curves slope up to the right as higher risk acceptable only if matched by a higher expected return. ii. An investor would prefer to have a portfolio on an indifferent curve as far to the left as possible (curve A in the graph below). That represents high returns and low risks. However, if we plot the actual portfolio available (the dots in the graph), we may find out that the best obtainable portfolio lies on another indifference curve. This portfolio, the one lying on the left - most indifference curve which meets any actual portfolios, will be the best available. It is marked X in the graph, it is clearly preferable to portfolio Z, which lies on indifference curve C and offers lower expected returns at higher risk levels. The actual portfolio will be the best available. It is marked X in the graph. It is clearly preferable to portfolio Z, which lies on indifference curve C and offers lower expected returns at higher risk levels. The actual portfolio covers an area of which the left-hand boundary is the efficient frontier. Any portfolio within the area can be improved upon by one of the efficient frontiers either by offering the same return at lower risks or a higher returns at the same risk. The best portfolio for an investor will therefore always lie on the efficient frontier, at a point where it just touches (is tangential to) an indifference curve. Any indifference curve, which crosses the efficient frontier, must be further to the right and therefore less desirable than one, which only touches the efficient frontier. 84

93 MM317 Financial Management The capital asset pricing model was developed in an attempt to simplify the assumption of portfolio theory as it relates to investment in securities. A risk-free security has a ɗ of O, while the risk premium is also O. the market portfolio has a ɗ of 1 and risk premium of (Rm - Rf) where RM = is the market rate return Rf = is the risk-free rate A problem arises as regards the risk premium if a security does not have a ɗ of 0 or 1. This is what the capital Asset pricing model attempt to solve. Investment in security does not imply the complete elimination of both unsystematic and systematic risk. When an investor takes up securities, it is assumed that the unsystematic risk, would have been eliminated while systematic risk can only be reduced. CAPM states that an investor shall: a. Not be rewarded if he accepts alpha risk because it is avoidable.\ b. Be rewarded if he undertakes beta risk because it is unavoidable. Beta is determined by the beta factor of each security. CAPM can be used to determine the cost of equity capital by recognizing the risk of each security. The formula is made up of two part Viz: i. The risk-free rate; and ii. The risk premium The CAPM formula is given by Rs = Rf + B(Rm - Rf)..(y) Where 85

94 Study Session 4 FINANCIAL MANAGEMENT OF MERGERS AND PORTFOLIO THEORY Rs = the return of the security Rf = the risk-free rate Rm = the market rate of return β = Beta (movement of risk) (Rm - Rf) = market premium for risk β(rm - Rf) = risk premium Calculate of Beta the CAPM formula we can drive - Transforming the CAPM formula β = Rs - Rf Rm Rf - The use of regression analysis β = n xy - x y n x - (x) 2 Where x = Rm Rf y = Rs Rf n = the number of period data - using the co-variance of the project and market, the variance of the market β = p(rp - Rp) (Rm - Rm) p(rm - RM) 2 Where Rp = Forecast return from the payment Rp = Expected return from the project Rm = Forecast return from the market Rm = Expected return from the market The sum of correlation approach β = ɗr x r ɗm Where: ɗp = Standard deviation of the project ɗm = Standard deviation of the market r = Coefficient of correlation 86

95 MM317 Financial Management o It is a portfolio which gives the higher expected return for a given standard deviation for a given expected risk B. CAPM was developed in an attempt to simplify the assumption of portfolio theory as it relates to investment in securities. C. Investment in security implies the complete elimination of both unsystematic and systematic risk. D. CAPM can be used to determine the cost of equity capital by recognizing the risk of each security. Option A is a false statement. The correct statement is efficient portfolio gives the higher expected return for a given standard deviation for a given expected RETURN. Option B is a true statement. Option C is a false statement. The correct statement is an investment in security DOES NOT imply the complete elimination of both unsystematic and systematic risk. Option D is a true statement. This is the line that relates the returns with the Beta value of the security. On the SML, the return has linear relationship with the market return using the formula RS = Rf + β(rm - Rf) The gradient of the CML can be expressed as Rs = Rf + Rm Rf (ɗm) sp This represents the extent to which required returns from a portfolio should exceed the risk-free rate of return, to compensate investors for risk. Β An asset beta reflects a company s risk. It is the weighted average beta of equity and beta of debt including any relevant tax effects. The difference between a company s 87

96 Study Session 4 FINANCIAL MANAGEMENT OF MERGERS AND PORTFOLIO THEORY asset beta and equity beta reflects the financial risk. Only systematic risk, which cannot be diversified away, is considered in an asset beta. An asset beta is calculated as follows: Where: β A = β A Ve + β D Vd (1-1) Ve + Vd (1-1) Ve + Vd (1-1) Β E = Beta of equity Β D = Beta of debt Ve = Value of equity Vd = Value of debt t = Corporation rate In the case of the equity beat, it is calculated as follows: β A = β A + (β A + β D ) x Vd (1-1) Ve 1. Beta is difficult to measure accurately for an individual company 2. Beta estimated from historical data may be inappropriate when considering future investment. 3. CAPM is a theoretical one-period project. 4. In the real world, a perfect market does not exist. Thus, calculating expected return on a market portfolio will not be feasible. 5. The model examines only investments from the shareholders point of view. The model is based solely on the shareholders valuation of risk and does not consider the effect on any other interested parties. 6. The model considers only the systematic risk. This assumes that investors always hold balanced portfolios which eliminate unsystematic risk. Similarly, companies may not hold fully diversified portfolios. The Arbitrate Pricing Model (APM) is similar to the CAPM with their origins being significantly different. While CAPM is a single-factor model, the APM is a multifactor model with the whole set of beta values one for each factor, unlike CAPM, APM states that the expected return on an investment is dependent upon how that investment reacts to a set of individual macroeconomic factors (the degree of reaction being measured by the beta value) and the risk premium associated with each of those macroeconomic factors. 88

97 MM317 Financial Management CAPM s application is as stated above, except that it only looks at one factor, the return in the market portfolio (Rm). CAPM is interested in how the return on an individual investment reacts to changes in the return on the Rm and risk premium in the portfolio. While acknowledging the idea behind APM, it is not of any practical use at the moment. o It is the line that relates the returns with the Beta value of the security. It represents the extent to which required returns from a portfolio should exceed the risk-free rate of return, to compensate investors for risk. C. An asset beta reflects a company s risk. D. Only A and C are true Option A is a true statement Option B is a true statement Option C is a true statement. Option D is a false statement. This is because all the options (A, B, & C) are true. 4.1 Explain business mergers Merger is a situation where two or more companies combine to form a larger business organization. On the other hand, takeover or an acquisition involves the purchase of the controlling share by one company in another company. These are schemes that are carefully planned to achieve a synergistic effect. 4.2 Discuss the portfolio theory and explain its application in investment planning A rational investor will prefer to commit his fund in as many securities as possible, which put together, will form his portfolio. A portfolio is the collection of several securities. Investors will always seek to minimize risk and maximize return. They will, therefore, prefer the project having the higher return at the same level of risk with another and where two securities have the same return they will select the one with the lower risk. 4.3 Explain the efficient portfolio Efficient portfolio is a portfolio which gives the higher expected return for a given standard deviation for a given expected return. As investor s indifference curve shows what portfolio an investor would be indifferent about. 89

98 Study Session 4 FINANCIAL MANAGEMENT OF MERGERS AND PORTFOLIO THEORY 4.4 Discuss the security market line (SML) This is the line that relates the returns with the Beta value of the security. On the SML, the return has a linear relationship with the market return. This represents the extent to which required returns from a portfolio should exceed the risk-free rate of return, to compensate investors for risk. Explain business mergers Discuss the portfolio theory and explain its application in investment planning Explain the efficient portfolio Discuss the security market line (SML) Articulate Presentation This is a complimentary resource to facilitate the quick delivery of this session. It is available in your course pack (Schoolboard disc / online page) and also linked here. Schoolboard Access your school board app, or visit to access updated online activities and resources related to the units of this Study Session. 90

99 MM317 Financial Management Study Session 5 In this study session, you will be introduced to analysis and interpretation of the basic financial statement. You will begin by discussing the analysis and interpretation of account. Thereafter, you will explain dividend policy and its implication. You will end this session by discussing the valuation of assets and enterprise. Learning Outcomes When you have studied this session, you should be able to: 5.1 discuss the analysis and interpretation of account. 5.2 explain dividend policy and its implication. 5.3 discuss the valuation of assets and enterprise. This Study Session requires a one hour of formal study time. You may spend an additional two hours for revision. Terminologies 91

100 Study Session 5 ANALYSIS AND INTERPRETATION OF BASIC FINANCIAL STATEMENT Definition of Ration Analysis Types of Ratios Analysis and interpretion of Basic Financial Statement Analysis and Interpretation of Accounts Operating Cycle Uses and Limitations of accounting Ratios The Limitations of Accounting Ratios Dividend Supremacy Dividend Policy and its implication Dividend irrelevance: MM Hypothesis Method of valuation of Business Enterprise Earning basis method Valuation of assets and Enterprise Dividend yield basis P/E Ratio Model P/E Ratio ModeS 92

101 MM317 Financial Management. The principal techniques employed in the analysis and interpretation of accounts is the use of important ratios. These are: i. Interval comparison (intra-firm) with a. The company s own past records b. the and forecasts ii. External comparison (inter-firm) with the accounts of other companies. Projection of trends should take into cognizance the following factors. i. General economic climate ii. Technical development in the industry iii. Industries relations iv. Possible takeovers An is described as a mathematical relationship between two accounting balances in a financial statement. It is a means to an end to obtain information about an entity given the window dressing of business organizations. Generally, Ratio is used to obtain further information about an enterprise which ordinarily may not be disclosed in the financial statements. In specific terms, the various users of financial statement use ratio to obtain information on areas of the business that are relevant to them. For example, the table below shows the various users and the uses of accounting ratios: USR USES 1. Management -Strategic business unit -Efficiency of management -Profitability of the enterprises -Liquidity of the enterprise; 2. Lenders -Financial stability of the enterprise -Growth of the business -Efficiency of management 3. Owners -Returns of investment -To obtain information so as to assure 4. External Auditor themselves that the financial statement under review is free of significant errors. All ratios mentioned below are used. 93

102 Study Session 5 ANALYSIS AND INTERPRETATION OF BASIC FINANCIAL STATEMENT LIMITATIONS 1. Accounting ratios are based on a financial statement which had been prepared using historical information. 2. The parameters and variables used in computing some ratios are not generally uniform therefore comparison between different companies might be misleading due to the use of inconsistent variables in the formula. 3. The use of data obtained from the financial statement which is static excludes the material effect of changes in the business environment over time (e.g. problems of window dressing; may cause misleading judgment). 4. Ratios are based on quantifiable data not reflecting the effect of nonquantifiable factors such as: a. The position of the enterprise within the industry. b. The product life cycle. c. The management team. d. The capital structure e. The cash flow. f. Changes in legal environments. o An accounting ratio is described as a mathematical relationship between two accounting balances in a financial statement. The ratio is used to obtain further information about an enterprise which ordinarily may not be disclosed in the financial statements. C. Various users of financial statement use ratio to obtain information on areas of the business that are relevant to them D. Lenders are one of the users of accounting ratios All of the options are true. That is, options A, B, C, and D are true statements. Accounting ratios can be classified using three approaches namely: a. User approach i.e. Ratios are analyzed according to the user (s) b. Use approach i.e. ratios are analyzed according to uses which we put them. c. Profit, Loss and Balance Sheet ratios. Since the objective of a ratio is to provide further information, the useful approach is commonly used in practice. 94

103 MM317 Financial Management In essence, the ratios are therefore analyzed under the following heading: 1. Efficiency ratios. 2. Profitability ratios. 3. Liquidity ratios 4. Financial stability ratios 5. Investment ratios; and 6. Earnings ratio. (A). This is measured by the ROCE (Return on Capital Employed) ROCE(%) = Profit X 100% CE However, ROCE is a function of profitability and real efficiency. Profitability is measured by profit margin while real efficiency is measured by asset turnover:- ROCE = Profitability x Real Efficiency = Profit Sales X Sales Capital Employed The formula above reveals 3 things: 1. A company may be efficient without being profitable. 2. A company may be profitable without being efficient. 3. A company may be efficient and profitable. In order to access the efficiency of management, the company that is efficient whether or not it is profitable is better than a company that is profitable without being efficient. PROFIT CAPITAL EMPLOYED PBIT Total Capital= E + D (Equity + Debt) PAT Share Capital (Ordinary + Preference) PAT Preference Dividend Equity Capital only + Resources The profit used in this analysis depends on the definition of our capital employed as summarized below: (B). Stock Management: 1. Rate of stock turnover = Cost of sale Average Stock 95

104 Study Session 5 ANALYSIS AND INTERPRETATION OF BASIC FINANCIAL STATEMENT This ratio measures the number of times goods and services were produced and sold. The higher the ratio of stock turnover, the better it is for the company in terms of profitability and management efficiency. 2. Stock (in days) = Average Stock x 365 days Average Stock This ratio indicates the number of days it takes the company to sell all goods that were produced or purchased for resale. The lower the number of days the better it is for the company. The two ratios above indicate how vigorously a business is trading. An increase in the stock days when compared with the previous year, for instance, may indicate a slowdown in the trading activity and build up in stock levels. To reach conclusion based on these ratios, the company s stock holding policy with regard to the following should be considered: 1. Lead time. 2. Seasonal fluctuations. 3. Reliability of suppliers 4. Bulk buying decision; and 5. The risk of stocks obsolescence (C). Debtors management 1. Debtors Turnover: This ratio indicates the number of times goods were sold on credit and payment received within a year. DT = Total Sales during the period Trade Debtors per Balance Sheet The higher the turnover, the better it is for the company in terms of short-term liquidity 2. Debtors Collection Period: This ratio indicates the length of time debtors are allowed to buy on credit before making payment. The ratio is a measure of the effectiveness of the credit policy of the company. DCP = Trade Debtors x 365 days Total Credit Sales If the debtors collection period is increasing when compared with the previous year s ratio, this means that the management is not efficient and this may likely lead to a high risk of bad debt and short-term liquidity problem. (D). Creditors Management 1. Creditors Turnover: This ratio measures the number of times the company is able to buy goods on credit and payment made. CT = Total Credit Purchases 96

105 MM317 Financial Management Trade B/S Date 2. Creditors payment period: This ratio measures the length of times it takes the company to pay for goods and services purchased. When compared with the previous year s ratio, an increase in average payment period is beneficial to the company in terms of liquidity and efficiency. CPP (day) = Trade Creditors x 365 days Total credit purchases In practice, a longer payment period could be as a result of:- 1. Management s efficiency (i.e. management is able to retain money outside to finance their business). 2. The inability of the company to pay because of liquidity problem. Irrespective of the reason why the company could not pay, if the situation is not well-managed, it will give rise to bad credit rating. o Efficiency ratios D. Profitability ratios o Option A is a false statement. Ratios are not analyzed under this heading. Option B is a false statement. Ratios are not analyzed under this heading. Option C is a true statement. Option D is a true statement. (A). Gross Profit Margin: This ratio measure how much profit the company is making from its trading activities relative to its total sales. Gross Margin (%) = Gross Profit x 100% Total sales When compared with the previous year s ratio, an increase in the gross margin may imply an improvement in the profitability of the company, while a decrease will lead to a decline in profitability. Before reaching a conclusion, however, other factors should be considered such as:- 97

106 Study Session 5 ANALYSIS AND INTERPRETATION OF BASIC FINANCIAL STATEMENT 1. The selling price, sales volume and sales mix 2. Purchase price, production cost. 3. Stock level and stock valuation method (B). Net Profit Margin: This measures the profitability of the enterprise in total relative to sales. The decision-based on net profit margin should be arrived at by comparing the ratio with that of the past and/or the budget and that of a similar company in the same industry. Other factors to considered should include the marking cost relative to sales level, administrative expenses, depreciation, and depreciation policy and other income accruing to the business. Net Margin (%) = Profit Before Tax x 100% (if tax is seen as an appropriate) Total Sales = Profit After x 100% (if tax is seen as an expense) Total Sales (C). Expense margin: This ratio measures the effect of each on the profitability of the company. Each Expense x 100% Total Sales The expenses margin when compared with the budget and the previous year may indicate an improvement or a decline in profitability and inefficiency on the part of management. A decrease in the expense margin may imply an improvement in profitability and efficiency on the part of management, while an increase indicates declining profitability and efficiency. This ratio indicates the company s ability to meet the short-term obligation to creditors out of its available short-term assets. The current ratio = CA or CA: CL CL In practice, the ratio should be 2:1. The decision is normally based on comparison with that of the previous year or the standard for the industry. Also, the transaction cycle of the enterprise should be considered. 98

107 MM317 Financial Management Cash Debtors Raw Material Stock Sales Finished Good Stock (B). Quick Asset ratio: This ratio is called the acid test ratio. It measures the relative amount of cash or items which can easily be converted into cash, and are available to meet on-the-spot obligation to creditors. QAR = CA - Stock CL This ratio, when compared with the previous year and the industry average, will indicate improvement or a decline in liquidity position of the company. In order to reach a meaningful conclusion, the following factors should be considered. 1. The type of business of the company 2. The nature of stock item 3. The sales policies/credit policies of the company 4. The composition and quality of debtors; and 5. The transaction cycle Every investment on FA must be tied to your turnover. o A. Gross Profit Margin refers to the ratio that measures how much profit the company is making from its trading activities relative to its total sales. B. Net Profit Margin measures the profitability of the enterprise in total relative to sales. C. Current Ratio indicates the company s ability to meet the short-term obligation to creditors out of its available short-term assets. None of the above is correct. 99

108 Study Session 5 ANALYSIS AND INTERPRETATION OF BASIC FINANCIAL STATEMENT Option A is a true statement. Option B is a true statement. Option C is a true statement. Option D is a false statement. This is because options A, B, and C are all true statements. (A). Gearing Ratio/Leverage The gearing ratio measures the long-term stability of the company by comparing fixed interest capital with equity capital. The gearing ratio is a measure of the financial risk inherent in the capital structure of an enterprise. Gearing ratio = Fixed Interest Capital x 100 Total Capital Employed A highly geared company by definition has a lot of debt capital which generally carry a fixed rate of interest/dividend (i.e. Preference share + Debentures). Consequently, a larger amount of profit may have to be paid out before equity shareholder can take the dividend. The consequence of such a high gearing ratio on the company and the ordinary shareholders may be bad or good depending on the profitability of the company. When the profitability is improving a high gearing ratio will lead to an increase in the earning per share, dividend per share and the overall value of each share (i.e. market). On the other hand, when profits are declining a highly gearing company will suffer because the risk of take-over by the creditors becomes very high. This will also increase the cost of equity capital. (B). Debt Ratio This ratio indicates how much a company owes in relation to its size. A high debt ratio will lead to the following: 1. Inability to get further financial supports. 2. A decline in profit/earning capital. Debt Ratio = Total debt x 100% Total assets Total Debt = Short and Long-term debts 100

109 MM317 Financial Management (C). Interest Cover Ratio This ratio indicates the number of times interest on debt capital is covered by profit. It is an indication of the long-term stability of a company because it shows how well or otherwise, a company can afford to pay its interest expense out of its current profits. Interest Cover = PBIT Fixed Interest A high-interest cover gives greater confidence to lenders, about the ability of the company to pay interest when due. (D). Fixed Dividend Cover This ratio indicates the number of times are covered by available profit. When the dividend cover is high, there is an assurance of a stable dividend income in future, which will ultimately contribute to the financial stability of the company. FDC = Profit After Tax Preference Dividend When the dividend cover is low, the preference shareholders are discouraged and their support of any financial reconstruction scheme will never be obtained. This may lead to the collapse of the company eventually. o The gearing ratio measures the long-term stability of the company by comparing fixed interest capital with equity capital. B. The debt ratio is a measure of the financial risk inherent in the capital structure of an enterprise. C. Interest Cover ratio indicates how much a company owes in relation to its size. D. Fixed Dividend Cover ratio indicates the number of times interest on debt capital is covered by profit. Option A is a true statement. Option B is a false statement. The correct statement is the Gearing ratio is a measure of the financial risk inherent in the capital structure of an enterprise. Option C is a false statement. The correct statement is the indicates how much a company owes in relation to its size. 101

110 Study Session 5 ANALYSIS AND INTERPRETATION OF BASIC FINANCIAL STATEMENT Option D is a false statement. The correct statement is interest cover ratio indicates the number of times interest on debt capital is covered by profit (A). Net Asset per Share (NAPS) This ratio measures the unit of the asset owned by equity shareholder. The asset per share measures the ability of the company to have access to debt capital because a higher asset per share (APS) implies higher security for loans. NAPS = NBV of Net Tangible Assets Preference share Capital No of Ordinary Share Issued Balance Sheet Date When compared with the previous year, an increase in the NAPS implies that business is growing, while a decrease could imply a negative growth in the business. In order to conclude, we need to consider the source of that increase which could be as a result of revaluation or as a result of new acquisitions or as a result of retained profits. It is only the growth as a result of acquisitions that investors should really be happy about as these are mainly the real growth. (B). Earnings per Share In relation to equity investors, the earning per share is a measure of growth and profitability when compared with the previous year. The institutional investors use EPS and asset per share to measure the growth of the business. Basic EPS = PAT - MI Preference Dividend EOI No of Ordinary Share Issued and ranking for Dividend NB: in the calculation the EPS, EOI (gain or loss should be excluded from the PAT). A decrease in EPS compared with prior year could be as result of Bonus or Right issue. If it is a bonus issue, the EPS of the prior year should be adjusted in order to have a meaningful result as the reserves capitalized had been in existence since the previous years and have been contributing towards earnings since then. (C). Dividend per Share Marginal investors use dividend per share to measure how much of the profit of the enterprise is paid to him for every share owned in the company. DPS (Pref.) = Preference Dividend Proposed in the Year No of Preference Shares Issued Ordinary Dividend proposed in the year DPS(ord) = (Interim + Final) No. of Ordinary Shares Issued for Dividend 102

111 MM317 Financial Management In order to make a meaningful use of this ratio the EPS, the retention policy and Dividend policy of the company should be considered along with those of other companies in the industry and that of the previous year. A higher dividend per share would be preferred by marginal investors. Efficiency ROSE (S) = PAT PSD x 100% Equity Cap PSD = preference share dividend Potential Investors = Payback period (D). Earning Yield = P/E returns = price EPS This ratio measures the actual return on investment in a company s equity capital E/Y(%) = EPS Market Price Per Share X 1 To an existing investor, the earnings yield when compared with the previous year will indicate a growth or decline in the E/Y, which will be used to arrive at a meaningful investment decision. For such a purpose, the investor must compare the E/Y with those of other companies in the industry and average rate in the economy. (E). Dividend Yield This ratio is used to measure the cost of equity. D/Y(%) = EPS X 100% Market Price Share (F). Price-earnings Ratio This is also called pay Back period (PBP). The ratio measures the length of time it takes investors to recoup his initial investment in a company s equity capital. P/E = Market Price EPS OR 1 E/Y o Earning per share measures the unit of the asset owned by equity shareholder. B. The Net Asset per share is a measure of growth and profitability when compared with the previous year. 103

112 Study Session 5 ANALYSIS AND INTERPRETATION OF BASIC FINANCIAL STATEMENT C. Marginal investors use dividend per share to measure how much of the profit of the enterprise is paid to him for every share owned in the company. D. This ratio measures the actual return on investment in a company s equity capital. Option A is a false statement. The correct statement is Net asset per share measures the unit of the asset owned by equity shareholder. Option B is a false statement. The correct statement is Earning per share is a measure of growth and profitability when compared with the previous year. Option C is a true statement. Option D is a true statement. The working capital or operating cycle is the cycle between the payment for raw materials purchased and the receipt of the proceeds from sales. The objective of a good management is to minimize risk. The operating cycle is such a way that investment in working capital is reduced to the barest minimum. The shorter the operating cycle the better it is for the company in terms of profitability, liquidity, and stability. The working capital cycle is calculated using the following ratios:- 1. Stock in days (R/M, WIP, FG) 2. Debtors collection period 3. Creditor s payment period. The sum of these ratios is the operating cycle of the company. When compared with the previous year, a shorter period implies an improvement in efficiency of management which certainly leads to improvement in liquidity and profitability. On the other hand, when the operating cycle is increasing there is going to be a run on company s liquidity position which will certainly bring about increases in overdraft facilities. In order to reduce such operating cycle, the company can adopt any of the following strategies: 1. Reduce raw material stockholding i.e. by reviewing slow moving lines or a review of the reorder level e.g. JIT 2. Obtain more finance from suppliers by displaying payment to them. 3. Reduce finished goods stock either by re-organizing your production schedule or your distribution method. 4. Reduce credit given to customers either by following up the outstanding amount as quickly as possible and by offering cash discounts. 5. Increase turnover by aggressive marking and advertising strategy to quickly convert finished goods stock to sales and cash. 104

113 MM317 Financial Management The uses of ratio analysis may be summarized as follows to:- 1. Act as a measure for financial performance and control. 2. Act as a guide to management or safe operation. 3. Assist in investment decision 4. Provide the basis for analysis of a company s ailment such as overtrading or low productivity for instance. 5. A business taking a much longer time to pay off creditors\stock increase with no increase in turnover or worse still, stock increase while turnover falls. 6. Facilitate growth in the rate of borrowing so that the proportion of borrowing in relation to assets owned by the company is excessive. 7. Growth and/or net profit beings to fall. 1. Differences in accounting definitions and technique which can render an invalid comparison with other companies. 2. Financial statements are based upon past performance and may not be a good guide for the future. Past data is useful only to the extent that it can be reasonably considered as relevant for future decisions. 3. The difficulties of deciding on a proper standard of performance in certain comparisons. The direction of change that represents goods or better is quite clear e.g. a higher return on capital employed is better than a low one. However, in many cases, it is not possible to determine the optimum ratios; instead, it may be better to suggest a range within which the actual ratio should fall (the deciding factor is the company s target ratio). 4. Differences in the condition affecting the period under review may vitiate the comparison. 5. Changes in the value of money and therefore changes in price levels may weaken the validity of comparison of ratios calculated for the different period of time. This is particularly so in a time of high inflation. Dividend decision is one of the three main decision of any firm and it involves the determination of the proportion of a company s earning to payout or return. Dividends are described as current earnings, which are paid or distributed by companies to their shareholders as a return on their investment. Ordinarily, dividends should convey the impression to the shareholders that the company is profitable and financially strong. As shareholders consider dividend payment desirable as it increases their current return, companies, on the other hand, 105

114 Study Session 5 ANALYSIS AND INTERPRETATION OF BASIC FINANCIAL STATEMENT consider retained earnings as a significant internal management source of financing corporate growth. There are two schools of thought about whether or not affects the value of a firm. The first school of thought argues that dividend policy affects the value of a firm (dividend supremacy) while the second school believes otherwise Dividend/relevance). Dividend policy is, therefore, defined as the trade-off between retaining earnings, on the one hand, and paying out cash dividend on the other. Under this school of thought, we shall consider two major studies carried out by Professor James Walter and Myron Gordon as follows: Walter in his studies asserts that dividend policies usually affect the value of the firm stating that the rate of return and the cost of capital are important in determining the dividend policy which will maximize the value of the firm. He based his argument on the following assumptions. 1. Internal financing The firm finances all investment opportunities through retained earnings. This means that debt or new equity is not issued. 2. Constant rate return and cost of capital % pay out retention. All earning of the firm are either distributed as a dividend or reinvested internally, immediately. 4. Constant earning per share (EPS) and dividend per share (DPS). 5. Infinite time The firm has a very long or infinite life. In determining the market price per share, Walter gave the evaluation model as P = DIV K Where r/k (EPS DIV) + K P = Market price per share DIV = DPS EPS = Earning per share r = Firm s rate of return K = Firm s cost of capital This valuation model consists of two present values 1. DIV is the dividend per share (DPS) 2. K is present value of the infinite stream of constant dividend payments r/k (EPS DIP) K is the present value of the infinite stream of capital gains. 106

115 MM317 Financial Management In demonstration of how dividend policies affect value of the firm, Walter classified all firm into 1. Growth firms where r > K 2. Normal firm where r = K 3. Declining firms where r < K In the growth firm, Walter concluded that the market price per share will increase as the dividend payout ratio declines. He said that the firms have enough investment opportunities which will yield returns higher than the opportunity cost of capital. Consequently, the optimum payout ratio is Zero (0). For the normal firms dividend policy does not affect the value of share price. And for the declining firm s a payout ratio is 100% since the companies do not have investment opportunities that will yield earning up to the opportunity cost of capital. Example The EPS of UK Ltd is N8. It has an internal rate of return of 15% and the capitalization rate of its risk class is 121/2%. If Walters s model is used, you are required to calculate: 1. What should be optimum payment ratio of UK Ltd 2. What would be the price of the shares at this payment ratio 3. How would the price of the share be affected if 40% of the earning were paid out? Solution a. Using Walter s model, the optimum payout ratio for any firm whose rate of return is greater than the cost of capital (i.e. r > K) is zero. This means that the firm should not pay any dividend. b. The price of a share when the pay-out ratio is zero. P = DIV K P = P = r/k (EPS DIV) + K /k0.125 (8 0) P = = N76.80 c. If the pay-out ratio of the firm is 40% P = DIV K r/k (EPS DIV) + K P = 0.4 (8) 0.125/0.125 (8 (0.4)8) P = (8 3.2)

116 Study Session 5 ANALYSIS AND INTERPRETATION OF BASIC FINANCIAL STATEMENT P = = = N71.68 Myron Gordon s model is based on the following assumptions. a. Internal financing b. The firm is entirely financed by equity; there is no debt c. There is constant rate of return and cost of capital d. Cost of capital is greater than their growth rate e. The firm s stream of earnings is perpetual f. There is a constant rate of retention b than the growth rate (g = br) is also constant forever. His valuation model is given as follows: Po = DIV (+g) + DIV (1 + g) DIV (1 + g) n This can further be written as: Po = DIV (1 + g) 1 + K (1 + K) 2 ( 1 + K) n K g Since DIV 1 = DVI 0 (1 + g) and g = rb DIV 1 = EPS (1 b) Po = K = rb Gordon s conclusion on the relationship between dividend policy and value of the firm is similar to Walter s Model. Under the growth firm s assumption, the market price of share increases as retention ratio increases and for declining firms, market price reduces as retention ratio increases. But for normal firm, dividend policy does not matter at all. However, the dividend supremacy school of thought suffers from such limitations as a constant rate of return, the constant cost of capital and no external financing. o It involves the determination of the proportion of a company s earning to pay-out or return. B. It is the trade-off between retaining earnings and paying out cash dividends. C. Walter classified all firms into growth and declining firms only 108

117 MM317 Financial Management D. The dividend supremacy school of thought suffers from such limitations as a constant rate of return, the constant cost of capital, and no external financing. Option A is a true statement. Option B is a true statement. Option C is a false statement. Walter classified all firms into growth, normal, and declining firms. Option D is a true statement. Example AD Ltd has a total investment of N1, 000,000 in asset and 100,000 outstanding ordinary shares at N10/share. It earns a rate of 15% on its investment and has a policy of retaining 30% of the earnings. If the appropriate discrete rate of the firm is 10%, you are required to a. Determine the price of its shares using Gordon s model b. What will happen to the price of the shares if the AD 1td has a payment ratio of 80% Solution Using Gordon s Model Po = DIV = EPS (1 - b) K g K rb EPS = 15% (1,000,000) = 150,000 = , , 000 Growth the pay-out ratio increases to 80% Growth rate rb = 15% (20%) = 0.03 Po = 1.5 (1 0.2) = 1.5 (0.8) = 1.2 = N Scholars of the dividend irrelevance school of thought believe that the dividend policy of a company does not make any difference to the value of that firm, once the investment decision has been made for the present and all future periods. They also agreed that once an ideal pattern of company investment has been established, the dividend policy follows as a by-product. 109

118 Study Session 5 ANALYSIS AND INTERPRETATION OF BASIC FINANCIAL STATEMENT This hypothesis is based on the following assumptions: ii. iii. iv. i. Perfect capital Market: The firm operates in a perfect capital market which is characterized by these factors: a. Investors behave rationally b. There is free flow of information c. Transaction and floatation costs do exist d. No single investor is big enough to affect the market price of a share ii. No taxes Taxes are assumed not to exist. Even if they exist, the same rate is charged on both dividends and capital gains. Homogenous computations: All individuals have the same belief concerning future investments, profit, and dividends. The investment policy of the firm is set ahead of time and is not altered by changes in dividend policy. NO risk uncertainty does not exist. Investors are able to forecast future prices and dividends with certainty and one discount rate is appropriate for all securities at all time period. MM valuation model is given by: V = npo = ndiv i + (n + m) P i - mp i Where 1 + K n = number of share outstanding in period 0 m = number of new shares at time 1 Since the firm s investment program in a given period of time can be financed by either retained earnings, issue of new shares or both. The amount of new shares issued will be: MPi = 1i (x i - ndiv i ) Where = 1i - x i -ndivd i 1i = total amount of investment during the first period x i = total net profit of the firm during the first period Substituting the value of MP i into the first formula; the valuation model becomes V = npo = (n + m) Pi 1i +Xi 1 + K M & M asserts that it does not matter to the shareholder in which pattern he receives the dividends. With perfect market and condition of certainty, he can distribute the time pattern of the dividends if he wants to defer consumptions, or he can borrow against dividends if he wishes to consume at an earlier date than the receipt of the dividends. 110

119 MM317 Financial Management They concluded that since DIV, completely cancel out the equation, dividends do not matter in the determination of the firm s value. Example Nacha Plc has 5,000,000 shares of N1 nominal value. These are currently quoted at N5 each ex-div. The dividend proposed for the current year is 50K/share. No increase in this dividend is anticipated unless new projects are accepted. There is no long-term debt. To compute the effect on the shareholders wealth (cash and capital) for the following options being considered by the company: i. Continuing with the current dividend and investment policy ii. Retaining an extra: a. N1,000,000 b. N2,500,000 In both cases investment at 10% and paying out the returns as additional dividends. iii. Paying out the normal dividend and raising an additional N1, 000,000 for investment at 10% by right issue. Ignore taxation and issuing cost. Solution: NOTE: There is need to assess the impact of each option on the shareholder's cash position and market value of their shares. The cash will be affected by the level of current dividend received and cash contributions made. The capital position will be affected by the level of future dividends expected and their required return. As any new investment is not expected to change the risk, it should have the same required return as prevails at the moment: Ke = DW = 0.5 a. Continuing Current Polices Po 5 = 10% or 0.1 Market value 5,000,000 N5 each = 25,000,000 Dividend 5,000,000 N0.50 each = 2,500,000 Shareholders wealth 27,500,000 b. (i) Retaining N1,000,000 and 10% new (future) dividend + investment Return = N2, 500, % (N1, 000,000) = N2, 600,000 New market value: New Dividend = 2,600,000 = 26,000,

120 Study Session 5 ANALYSIS AND INTERPRETATION OF BASIC FINANCIAL STATEMENT Ke 0.1 Dividend = Normal Dividend Retention N2,500,000 N1,000,000 = 1,500,000 Shareholders wealth 27,500,000 ii. Retaining N2, 500,000 and 10% New (future) Dividend = Current Dividend + Investment return = N2, 500, % (2,500,000) = N2, 750,000 New Market Value: New Dividend = 2,600,000 = 26,000,000 Ke 0.1 Dividend = Normal Dividend Retention N2, 500,000 N1,000,000 = 26,000,000 Shareholders wealth 27,500,000 iii. Retaining N2,500,000 and 10% New (future) Dividend + Investment return = N2,500, % (2,500,000) = N2,750,000 Dividend = normal Dividend Retention = N2, 500,000 N2, 500,000 = 0 New market value = New Dividend = 2,750,000 Ke 0.1 = 27,500,000 Share holders wealth 27,500,000 C. raising additional N1, 000,000 for investment New (future) dividend = N2, 500, % (1,000,000) = N2, 600,000 Market value = New Dividend 2,600,000 = 26,000,000 Ke 0.1 Normal Dividend 2,500,000 Subscribed for shares by right issue (1,000,000) Shareholders wealth 27,500,

121 MM317 Financial Management NOTE: The shares holders wealth is the same in each case, illustrating that it makes no difference whether the new investment is funded by retention of dividend or new raising of additional equity capital. Valuation of business enterprise is usually carried out for specific purposes which include: 1. Take-over bid 2. Unquoted companies going public 3. A share of the merger. 4. Sale of shares 5. Shares being pledged at collateral for a loan by unquoted companies. Business valuation does not only require the mastery of one or two accounting techniques, but also an in-depth appreciation of many commercial and financial matters. Unlike other difficult accounting problems, there are no precise or current answers. 1. Earning asset basis made up of: i. Balance sheet (historical) method ii. Realizable value method iii. Replacement value method. 2. Earning basis method comprising of: i. ARR approach ii. P/E ratio approach 3. Dividend yield basis method 4. CAPM method 5. Discounted future profit method Each method will give a different valuation. It is most likely that each method would be used in isolation, and several valuations may be made, each using a different technique or assumptions. The valuation may be compared and a final price reached as a compromise between the different values. This method involves the use of the total value of the tangible assets attributable to the company. Intangible assets (i.e. fictitious assets) are to be excluded from the computation. 113

122 Study Session 5 ANALYSIS AND INTERPRETATION OF BASIC FINANCIAL STATEMENT The total of all the liabilities is then deducted from the total of the tangible assets, which is the basis of valuation. The Net Assets Basis of Valuation should be used: 1. When the company is on the verge of liquidation 2. When unquoted shares are offered as collateral for a loan 3. As a measure of comparison in a scheme of merger. The difficulty in an asset valuation method is not the arithmetic involved, but the process of establishing the asset value to use. The values appearing in the balance sheet provided are net-book-values, which are derived from the accounting concept. A more realistic set of figures should be used instead of the net-book-values. These are the market worth, i.e. the assets be sold. The replacement value approach involves the use of the prices o new asset; hence, it is appropriate for use when a similar new company is being set-up. o A. When the company is beyond the level of liquidation B. When quoted shares are offered as collateral for a loan C. As a measure of comparison in a scheme of merger D. A & C are true Option A is a false statement. The correct statement is the net asset basis of valuation can be used when the company is on the verge of liquidation. Option B is a false statement. The correct statement is the net asset basis of valuation can be used when unquoted shares are offered as collateral for a loan. Option A is a true statement. Option D is a false statement. Only option C is a true statement while option A is a false one. AN earning basis valuation is the most popularly used method of estimating share prices when a substantial holder or when two companies are planning a merger A company may be valued on an earning basis using either 1. An accounting Rate Return (ARR) or 2. A price-earning (P/E) ratio 114

123 MM317 Financial Management The two approaches are basically the same since the P/E ratio is the reciprocal of the earnings yield, which is in itself a measure of the return on Capital Employed (ROCE). The ARR method of assessing the value of a business enterprise is to use some predetermined notion of the rate of return an investor would expect from a particular type of investment as having decided on the earnings of the company, to calculate the capital sum that would result in such a rate of return. Formula for valuation = Estimated future Profit Return on Capital Employed The price-earnings multiples (or ratios) have become the most favored tools for share valuations. The P/E ratio is the index of a share price to the earnings per share (based on the company s most recent published results). P/E ratio = MV/EPS if MV is to be calculated, it becomes MV = EPS x P/E ratio Investors do not use a P/E ratio to value a quoted company s shares; the P/E ratio is a measure of the relationship between the investor s valuation of a share and its earning. The P/E ratio is a means of comparison but it has no inherent significant in its own right. It would, therefore, be unusual to try to value a quoted company s shares with a P/E ratio because the market value already has been established by market transactions of buying and selling. The P/E ratio method of valuation is suitable for estimating the value of unquoted company shares. 1. ARR is likely to be used in a takeover bid when the acquiring company is trying to assess the maximum amount it is to pay. This is because it is a measure of management efficiency and the rate used can be selected to reflect the return, which the acquiring company thinks, should be obtainable after any post-acquisition and re-organization have been completed. 2. ARR method is more appropriate in valuing a controlling interest in a way a small company can be realistically compared with any quoted one. 3. P/E ratio method of valuation is suitable for unquoted company s shares. 4. The use of an average P/E ratio (published and interim account) for each sector in which a company operates will automatically take account of the average growth expected for that sector. A valuation based on a simple ARR will not take account of growth although it is possible to make suitable adjustment. Hence analysts will often use prospective P/E ratio. 115

124 Study Session 5 ANALYSIS AND INTERPRETATION OF BASIC FINANCIAL STATEMENT o The price-earnings multiples (or ratios) have become the most favored tools for share valuations. B. The P/E ratio is the index of a share price to the earnings per share. C. Investors often use a P/E ratio to value a quoted company s shares D. The P/E ratio is a measure of the relationship between the investor s valuation of a share and its earning. Option A is a true statement Option B is a true statement. Option C is a false statement. The correct statement is investors DO NOT use a P/E ratio to value a quoted company s shares. Option D is a true statement. This method is suitable for the valuation of small shareholdings in unquoted companies. It is based on the principle that the value of shares is the present value if all future dividend payments are discounted at a suitable rate of interest. There are two approaches to this techniques using net and gross dividend, these are: i. Dividend without growth ii. Dividend with growth Recall that Ke = d/mv Where MV MV = d/ke(r) Where MV = Market value of share d = Dividend payable Ke = Shareholders cost of capital MV = Do (1 + g) R g = Market value of share d = Dividend payable g = Growth rate 116

125 MM317 Financial Management Example Ke = Shareholders cost of capital The Director of LY Plc, lager conglomerates are considering the acquisition of the entire share capital of DIA Ltd, a private company which manufactures a range of engineering machinery. Neither company has any long-term debt capital. The Director of LY Plc, believe that if DIA Ltd is taken over the business risk of Ly Plc, will not be affected. The accounting reference date of DIA Ltd is 31st July. Its balance sheet as at 31st July 2005 is as follows: Fixed assets (Net of depreciation) 651,600 Current assets: stock and W.I.P 515,900 N Debtors 745,000 Bank 158,100 1,419,000 Current Liabilities: Creditors 753,600 Financed by: Capital and Reserves: N 2,070,600 Bank O/D 862,910 (1,616,500) 454,100 Issued ordinary shares of N1 each 50,000 Distributable reserves 404, ,100 The summarized financial statement of DIA Ltd for five years to 31st July 2005 is as follows: N N N N N Profit before EOI 30,400 69,000 49,400 48,200 53,200 EOI 2900 (2,200) (6,100) (9,810) (1,000) Profit after EOI 33,000 66,800 43,300 38,400 52,200 Dividend (20,500) (22,600) (25,000) (25,000) (25,000) 12,800 44,200 18,300 13,400 27,

126 Study Session 5 ANALYSIS AND INTERPRETATION OF BASIC FINANCIAL STATEMENT The followings additional information is available a. There have been no charges in the issue share capital od DIA Ltd during the past five years. The estimated values of DIA s Ltd fixed assets and stocks and WIP as at 31st July 2005 are: Replacement Realizable Cost N Value N Fixed Assets 725, ,000 Stock and WIP 550, ,000 b. It is expected that 2% of DIA Ltd s debtors at 31st July 2005 will be uncollectable. c. The cost of capital of LY Plc is 9%. The Directors of DIA Ltd estimate that the shareholders of DIA Ltd require a minimum return of 12% p.a from their investment in the company. d. The current P/E ratio of LY Plc is 12. Quoted companies with business activities and profitability similar to those of DIA have P/E ratios of approximately 10, although the companies tend to be larger that DIA Ltd. You are required to 1. Estimate the value of the total equity of DIA Ltd on 31st July 2005 using each of the following basis: i. Balance sheet value (Net Assets) basis ii. Replacement cost basis iii. Realizable value basis iv. The Gordon dividend growth model v. The P/E ratio model 2. Explain the role and limitation of each of the above valuation basis in the process by which a price might be agreed for the purchase by LY Plc of the total equity capital of DIA Ltd. 3. State and justify briefly the approximate range within which the purchase price is likely to be agreed. Ignore taxation. Solution (A). i. i. Balance sheet value net assets basis = N454, 100 ii. Replacement cost basis = N454, (N725,00 651,600) + (550, ,900) = N561,600 iii. Realizable value basis N454, (N450, ,600) + (N570, ,900) N14, 900 = N271,

127 MM317 Financial Management *N14, 900 = 2% x N745, 000 (Bad debts). Bad debts are assumed not to be of relevance to balance sheet and replacement cost value. iv. Using the rb model (Gordon dividend growth model) Average proportion of earning retention (B). = 12, , , , ,200 33, , , , ,200 = (approximately 0.5 i.e 50%) Return on investment this year = N53, 200 Average investment = The g = rb = 0.5 x 12% = 6% So MV cum div = = N466, ,200 (454,100 27,200/2) N25,000( ,000) 0.06 = appro. 12% Comparable quoted companies to DIA Ltd have P/E ratio of 10 DIA Ltd is much smaller and being unquoted (too small for USM) I P/E ratio would be less than 10 by how much? If we take a P/E of 5: MV = N53, 200 x 5 i.e. N266, 000 If we take a P/E 10 x 2/3 i.e. N354, 667 If we take a P/E of 10 (main possible) MV = N53, 200 x 10 i.e. N53,200 i. Balance sheet value: Unless both parties are financially naïve, the balance sheet value will not play a part in the negotiation process. Historical costs are not relevant to a decision on the future value of the company. ii. Replacement cost: This gives the cost of setting up a similar business. Since this gives a higher figure than any valuation, in this case, it could show the maximum price for LY Plc, to offer. There is clearly goodwill to value. iii. Realizable Value: It shows the cash which the shareholders in DIA Ltd could realize by liquidating the business. It is, therefore, the minimum price which DIA Ltd would accept. All the method (i) (iii) stated above suffer from the limitation that they do not look at the going-concern value of the business as a whole. Method (iv) and (v) do consider this 119

128 Study Session 5 ANALYSIS AND INTERPRETATION OF BASIC FINANCIAL STATEMENT value. However, the realizable value is of use in assessing the risk attached to the business as a going concern, as it gives the base value if things go wrong and the business has to be abandoned. iv. Dividend Model: The figures have been calculated using DIA Ltd Ke (12%) of (2) or (3) were followed; the value would be the minimum that DIA s shareholders would accept (realizable value in iii). The relevance of a dividend valuation to LY Plc will depend on whether the current retention and reinvestment policies would be continued. Certainly, the value to LY Plc should be based on 9% rather than 12% (both companies are ungeared and in the same risk class so the difference required returns must be due to the relative sales and the fact that LY Pl s shares are more marketable). The P/E ratio model is an attempt to get at the figure which the market would put on a company as DIA Ltd. It does provide an external yardstick, but a crude measure. As already stated, the P/E ratio which applies to the larger quoted companies has to be lowered to allow for the size of the index which is very dependent on the expected future growth of the firm. It is therefore not easy to find a P/E ratio of a similar firm. However, in practice, the P/E model may well feature in the negotiations over price, simply because it is an easy to understand yardstick. The range of the purchases price is likely to be agreed will be the minimum price which the shareholders of DIA Ltd will accept and the maximum price which the Director of LY Plc will pay. Examining the figures in part (a), the range is N291, 700 (realizable value) and (N561,600 replacement cost). The main problem with this method of valuation is that a company is not worth the value of its assets. Rather, it is worth the value of the income and profits that its asset can generate at a break up. Valuation has meaning if the company will break up and its assets sold off. Put a going concern valuation is only really of interest when the buyer of a company wishes to acquire assets of substance for the purchase price. The terms that might be offered to the shareholders of a victim company are as follows: i. Price: The price would have to be sufficiently attractive to persuade a majority of the shareholders to sell. ii. Purchases consideration: The purchase consideration might be cash, share, loan stock, or a combination of any of these. The main advantages are: 1. Cash has the advantage of allowing the shareholders to realize their investment. The disadvantage is that they will have an equity interest in the enlarged company. 120

129 MM317 Financial Management 2. Loan stock would only be attractive if the rate of interest on it is competitive and if the stock is marketable, or if the stock is convertible into equity at some date in the future, on the terms that are attractive to the shareholders. 3. A share-for-share exchange has the advantage that shareholders in the victim company will become shareholders in the enlarged company after the take-over. The enlarged company, in this case, will also be a public company, whose shares are readily marketable. The main disadvantages are: 1. The purchase price of the victim company s shares will depend on the value of the buying company s shares. If their shares fall in value after the take-over, the value of the purchase price would also fall. 2. If the victim company is bought on a lower P/E ratio than the buying company s P/E ratio, their comparable EPS after the take-over will be less. These are the price quoted on the stock exchange. The quoted price are used to multiply the number of shares under consideration. Theoretically, the valuation procedure is straight forward. The purchasing company is buying the difference between its own cash flows before the acquisition, and the combined company s cash flows after the acquisition. The difference needs to be estimated, discounted and summed up to give its present value. This is the present value of the receipts from the purchase exercise. Example JP Ltd wishes to make a bid for the entire company QR Ltd. The new company makes after tax profit of N40, 000 per annum. JP Ltd believes that by spending additional money to acquire more investment, the after cash flows would be: Yr NCF 0 (100,000) 1 (80,000) 2 60, , , ,000 The after-tax cost of capital of JP Ltd is 15%. The company expected all its investment to pay discounted value terms, within 5 years. You are required to: Compute the minimum price the company should be willing to pay for the share of QR Ltd? Solution 121

130 Study Session 5 ANALYSIS AND INTERPRETATION OF BASIC FINANCIAL STATEMENT Years NCF 15% PV N N 1 (100,000) 1 (100,000) 2 (80,000) (69,568) 3 60, , , , , ,580 Maximum Purchase Price (NPV) 101, Discuss the analysis and interpretation of accounts The principal techniques employed in the analysis and interpretation of accounts is the use of important ratios. These are: 1. Interval comparison (intra-firm) with: a. The company s own past records b. the budgets and forecasts 2. External comparison (inter-firm) with the accounts of other companies. Ratio Analysis: An accounting ratio is described as a mathematical relationship between two accounting balances in a financial statement. It is a means to an end to obtain information about an entity given the window dressing of business organizations. 5.2 Explain dividend policy and its implication Dividend decision is one of the three main decision of any firm and it involves the determination of the proportion of a company s earning to pay-out or return. Dividends are described as current earnings, which are paid or distributed by companies to their shareholders as a return on their investment. Dividend policy is, therefore, defined as the trade-off between retaining earnings, on the one hand, and paying out cash dividend on the other hand. 5.3 Discuss the valuation of assets and enterprise Valuation of business enterprise is usually carried out for specific purposes which include take-over bid, unquoted companies going public, a share of the merger, the sale of shares, shares being pledged as collateral for a loan by unquoted companies. Business valuation does not only require the mastery of one or two accounting techniques, but also an in-depth appreciation of many commercial and financial matters. Discuss the analysis and interpretation of accounts. 122

131 MM317 Financial Management Explain dividend policy and its implication Discuss the valuation of assets and enterprise Articulate Presentation This is a complimentary resource to facilitate the quick delivery of this session. It is available in your course pack (Schoolboard disc / online page) and also linked here. Schoolboard Access your school board app, or visit to access updated online activities and resources related to the units of this Study Session. 123

132 Study Session 6 BANKING SYSTEM AND THE CAPITAL STRUCTURE OF NIGERIAN FIRMS Study Session 6 In this study session, you will be introduced to the banking system and the capital structure of Nigerian firms. You will begin by describing the banking system and its relation with the money market and universal banking. Thereafter, you will make a comparison between the merchant, commercial, and universal banking. You will end this session by discussing the capital structure of Nigerian firms and its components. Learning Outcomes When you have studied this session, you should be able to: 6.1 describe the banking system and its relation with the money market and universal banking 6.2 make a comparison between the merchant, commercial, and universal banking 6.3 discuss the capital structure of Nigerian firms and its components This Study Session requires a one hour of formal study time. You may spend an additional two hours for revision. Terminologies 124

133 MM317 Financial Management Banking System and the Capital Structure of Nigerian Firms The Money market Banking System Universal Banking Merchant, Commercialand Universal banking The Capital Structure of the Nigerian Firm Assessing the Capital Structure of Business Firms Capital Structure of Nigerian Firms Capital Requirement Over and under capitalization Suggestion over Capitalization 125

134 Study Session 6 BANKING SYSTEM AND THE CAPITAL STRUCTURE OF NIGERIAN FIRMS In Nigeria, the banking system is at the front of. Financial intermediary is the process by which financial intermediaries provide a linkage between surplus and deficit units in the economy. Surplus units are firm/individuals which/who have excess funds above their immediate needs. Those who need the funds for immediate investment programs are referred to as deficit units. It is the financial intermediaries that develop facilities and instruments, which make lending borrowing possible. In Nigeria, financial intermediaries include: a. Commercial bank b. Merchant bank c. Development banks d. Mortgage banks e. Financial banks f. Insurance bank houses g. Pension fund managers The activities of this bank are regulated by the apex bank the Central Bank of Nigeria (CBN). There are four aspects of the intermediation of the banking/finance system. A larger portion of the deposits mobilized by banks have short-terms maturity since most customers withdraws on demand where the banks will lend the money for a longer period. The satisfaction of these two contradictory objectives (that of deposition and borrows) is what is referred to as maturity transformation. A great deal of expertise is required here on the part of the banks to avoid mismatch. It is the long-term loans which sustain the development of the economy. Despite the short duration of the deposits they mobilize with the terms of loans they give, banks still need to ensure the liquidity of the economy, i.e. they have no excuse for not meeting the demand of their customers when they come to withdraw their money. The confidence which depositors have in the banking system is crucial to the functioning of the system or market. Bank accepts both small and large deposits from diverse customers and makes these available as loans. Without financial intermediaries, it can be said that it would be difficult for a deficit unit to move from one small surplus unit to another in search of investment funds. Bank spread-out deposit risk by accepting deposits from heterogeneous depositors (such as individual and companies in various industries) of various sizes. Banks 126

135 MM317 Financial Management minimize lending risks by making loans available to diverse borrowers of various sizes. In financial parlance, banks have different kinds of loans and deposits in the portfolio. o Merchant bank B. Liability banks C. Mortgage banks D. Financial banks Option A is a true statement Option B is a false statement. The correct statement is development banks. Option C is a true statement Option D is a true statement This creates opportunities for raising or investing short-term funds. The terms may range from overnight to about one or two years. Various are exchanged in the money market. These include Treasury bill, Treasury Certificates,, Commercial Papers, Certificates of Deposits, and. Banks are major participants in this market. Other participants include non-bank financial institutions such as insurance companies, National Social Insurance trust Fund (NSITF), Mortgage banks, finance houses, community banks, and pension fund administrators. The Central Bank of Nigeria (CBN) being the apex bank in Nigeria oversees the operations of the money market. The function of the CBN includes: 1. Regulation of the financial system 2. Serving as a banker to all other banks and government. 3. Regulation of the economy through its monetary policies. 4. Lenders of last resort. 5. Leases on behalf of Federal Government of Nigeria, with the monetary authorities of other countries. 6. Exchange rate management 7. Public debt management. Management of The essential features of monetary policy guidelines: 1. Credit ceiling (BOP) position and reserves. 127

136 Study Session 6 BANKING SYSTEM AND THE CAPITAL STRUCTURE OF NIGERIAN FIRMS 2. Sectoral allocation of credit 3. Cash reserve requirements 4. Liquidity ratio 5. Interest rate policy The monetary policy guidelines have the following objective 1. To reduce excess liquidity in the financial system 2. To moderate the high rate of inflation 3. To reduce the pressure on the balance of payment 4. To build up external reserves and stabilization of naira exchange rate 5. To ensure efficient allocation of scarce resources to the productive sector of the economy. 6. To encourage direct local production; and 7. To generate employment. For a bank to engage in universal banking, it must be registered not only as a bank with twenty-five billion naira (25b) minimum fully paid-up capital but also select and apply to be a universal bank and obtain a license as such. o Insurance companies, National Social Insurance trust Fund (NSITF), Mortgage banks, Finance houses All of the above are true. That is, all the statements are correct. 128

137 MM317 Financial Management Merchant Bank Commercial Banking Universal Banking Wholesale banking mobilizes larger deposits and lends larger currency mainly from institutional investors to institutional investors and firms. It deals with a relatively small number of the larger account. Deposits are usually fixed with interest bearing. The loan given is less of overdraft type, and more of term loans granted on a long-term basis. Branch networks are less needed as the concentration is in both industrial and financial centers. Customers are special and concentrated. Services rendered are special in nature and is geared towards specialized customers mainly in the international banking and finance area. It is a Retail bank that mobilizes deposits and lending in both small and large currencies from/to individuals and firms. It deals with a relatively large number of the small and large account. Deposits may be fixed or on demand, with or without interest The loan given is of both overdraft and term loans granted on a short-term basis. There is a greater need for branch networks to ensure that there is spread out. Customers are of various types and widespread. Services rendered are more of a varied nature to different types of customers. It is mainly in the domestic banking and finance areas. A supermarket of financial products. It offers all financial products, such as banking, insurance, stockbroking, discounting e.t.c. Services are harnessed at every location o A. is a retail bank that mobilizes deposits and lending in both small and large currencies from/to individuals and firms. B. Universal banking is a supermarket of financial products. C. Customers are special and concentrated in the merchant banks D. All of the above are correct 129

138 Study Session 6 BANKING SYSTEM AND THE CAPITAL STRUCTURE OF NIGERIAN FIRMS Option A is a false statement. The correct statement is commercial banking is a retail bank that mobilizes deposits and lending in both small and large currencies from/to individuals and firms. Option B is a true statement. Option C is a true statement. Option D is a false statement. Not all the options are correct since option A is a false statement. The capital structure of a company depicts its long-term financial position. It is the foundation of the firm where short financial activities are carried out. The issue of equity shares and debts is the principal method of raising long-term funds from the money and capital markets. As obtained and regulated by the banking system, the capital structure of the Nigerian Firm comprises of: 1. Ordinary shares 2. Preference share 3. Reserves 4. Debentures 5. Secured and unsecured long term loans Shares are the smallest unit of ownership in the company. This is divided into: A. Authorized ordinary share the maximum amount a company is authorized by law to raise. There is no legal restriction on the size of authorized capital but a change can only be effected by a resolution of the shareholders, such a resolution is itself only possible if the articles of association allow such an action in the absence of a suitable clause in the articles, they must first be altered by a special resolution of the shareholders. B. Issued and fully paid for These are the shares for which the company received all monies due on application, allotment, and all calls including money on forfeited shares are re-issued in cash. They form part of authorized shares. This is the total outstanding share capitals that rank for the dividend. 130

139 MM317 Financial Management o Ordinary shares B. Preference shares C. Reserves D. Debentures All of the above options are true. That is, options A, B, C, & D are all correct statements. This class of shares as the name implies, have a prior claim in terms of dividend and repayment of capital than the ordinary shares. Preference shares carry a fixed rate of dividend. Preference shares are further sub-divided into: 1. Cumulative preference share: This refers to dividend obligation that is carried forward from year to year until there is available profit to discharge it. 2. Non-cumulative preference share: This refers to under-charged dividend obligations that are not carried forward, but rather are canceled in the year to arise. 3. Redeemable preference share: This carries with it a repayment/redemption date. This is usually used when interest and dividend rates are very high. 4. Irredeemable preference share: This carries no redemption date. 5. Convertible preference share: This gives the holder the right to exchange same for ordinary shares at a future date. This is also divided into: 1. Capital Reserve: This originates mainly from the sales of shares whether ordinary or preference, at a price above the par value of the share, giving rise to share premium. It also arises from revaluations of assets, and re-appraisal of market value shares. 2. Revenue Reserve: This is also called retained earnings which represent undistributed profits of the business firm. It serves as a major internal source of long-term fund. No outsider has any control on this source of finance. This is a legal agreement through which a company acknowledges a loan. The trust deed to the debenture will record a statement of the interest payable, the terms of repayment of the principal, and any other charges that are agreed upon. Debenture holders have a 131

140 Study Session 6 BANKING SYSTEM AND THE CAPITAL STRUCTURE OF NIGERIAN FIRMS (general claim against all the assets of the company) over the company s assets. A debenture can either be: 1. Redeemable 2. Irredeemable 3. Convertible o called retained earnings B. Cumulative preference shares refer to under-charged dividend obligations that are not carried forward, but rather are canceled in the year to arise. C. from revaluations of assets, and re-appraisal of market value shares. Debenture holders have a fixed charge over the company s assets. called retained earnings. Option B is a false statement. The correct statement is Non-cumulative preference shares refer to under-charged dividend obligations that are not carried forward, but rather are canceled in the year to arise. Option C is a true statement. Option D is a false statement. The correct statement is debenture holders have a floating charge over the company s assets This can be arranged in direct negotiation with financial institutions and other financial market. A factor of interest in all balance sheets is the volume and proportion of capital debt to other assets and capital balance. The item of great importance is the cost to the firm of its existing capital structure. The efficient financial manager will want to know that charges can be effected to lower/reduce the cost. The following techniques are used to assess the capital structure of firms: i. Gearing ratio This is the amount that N1, 00 ordinary share capital bears to the fixed interest capital. A low geared company is one in which the ordinary share 132

141 MM317 Financial Management capital exceeds the fixed interest-bearing capital and a high geared company is one in which the ordinary. The share capital is less in proportion than the fixed interest-bearing capital. Gearing ratio is calculated using the following formula. Gearing ratio = Fixed term/interest debt Ordinary Shareholder sfunds ii. iii. Leverage: This measures the proportion of total capital employed to the total term debt given by Leverage = Loan Term Debt Total Capital Employed Times interest earning: This measure the proportion of fixed interest charges to total earnings. The capital market views a time interest earned 3 4 times as a minimum level a company should maintain. The formula is Times Interest Earned = Earnings before tax Fixed Interest Charges When establishing a business, it is necessary to decide the minimum output that will yield returns sufficient for the business to be carried on at a reasonable profit. Factors to be considered for company s capital requirements are: 1. Cost of the necessary land for erecting of factory 2. The cost of patents, secret processes trademark, goodwill etc. 3. Initial expense which includes promoters fees, registration, advertising and the cost of issuing prospectus. 4. The working capital which is the excess of current assets over current liabilities. It is after these have been established that a company approaches the bank and other financial houses to raise the required capital for the kick-off of the business venture of the company. In a company, over capitalization exists when the capital of the company is too large relative to the volume of its business, with the resultant effect that profits are grossly insufficient to keep preference dividends and pay a reasonable return on the ordinary shares. This condition is very often the result of assets having been purchased at inflated values. Again, excessive plowing back of profit and excessive loan will result in overcapitalization, which is the possession of more funds than the business actually needs. 133

142 Study Session 6 BANKING SYSTEM AND THE CAPITAL STRUCTURE OF NIGERIAN FIRMS On the other hand, under capitalization arises when there is a shortage of liquid funds. The companies probably over depended on the credit granted by suppliers. Amongst other result which may be expected, is that the business will lose the benefits of cash discounts which would otherwise be available. The company s own ability to grant credit and selling power will be handicapped, and will also be unable to seize special opportunity to buy at a low price (cash discounts). If a business is being extended without a proportional increase in its resources, it is known as overtrading. One of the causes of the shortage of funds is the payment of dividends at a time when cash resources are really required for employment in the business. Features of overtrading includes: i. A poor current ratio and quick (acid-test) ratio caused by: a. Excessive creditors or bank O/D b. High stock levels (the business having acquired larger amount of stock on credit) or by increasing its O/D in anticipation of an increase in production and sales. ii. A high stock to current assets ratio. iii. Bank O/D consistency at the limit. iv. New fixed assets on hire purchase. v. Fall in profit margin as result of cash discount given to debtors in order to reduce the collection period. 6.1 Describe the banking system and its relation with the money market and universal banking Financial intermediary is the process by which financial intermediaries provide a linkage between surplus and deficit units in the economy. Surplus units are firm/individuals which/who have excess funds above their immediate needs. Those who need the funds for immediate investment programs are referred to as deficit units. It is the financial intermediaries that develop facilities and instruments, which make lending borrowing possible. 6.2 Make a comparison between the merchant, commercial and universal banking. Merchant banks deal with wholesale banking. This means that it mobilizes larger deposits and lends larger currency mainly from institutional investors to institutional investors and firms. Here, deposits are usually fixed with interest bearing, and services rendered are special in nature. It is often geared towards specialized customers 134

143 MM317 Financial Management mainly in the international banking and finance area. Commercial banking is essentially a retail bank that mobilizes deposits and lending in both small and large currencies from/to individuals and firms. It deals with a relatively large number of small and large accounts. 6.3 Discuss the capital structure of Nigerian firms and its components. The capital structure of a company depicts its long-term financial position. It is the foundation of the firm where short financial activities are carried out. The issue of equity shares and debts is the principal method of raising long-term funds from the money and capital markets. The capital structure of the Nigerian firm comprises of ordinary shares, preference shares, reserves, debentures, secured and unsecured long-term loans. Ordinary shares are divided into authorized ordinary share, Issued and fully paid for. Preference shares have a prior claim in terms of dividend and repayment of capital than the ordinary shares. Preference shares carry a fixed rate of dividend. They are sub-divided into cumulative, non-cumulative, redeemable, irredeemable, and convertible preference shares. Describe the banking system and its relation with the money market and universal banking Make a comparison between the merchant, commercial, and universal banking Discuss the capital structure of Nigerian firms and its components Articulate Presentation This is a complimentary resource to facilitate the quick delivery of this session. It is available in your course pack (Schoolboard disc / online page) and also linked here. Schoolboard Access your school board app, or visit to access updated online activities and resources related to the units of this Study Session. 135

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145 MM317 Financial Management SAQ 1.1 Feedback to SAQ Items Financial management is the managerial activity which is concerned with the planning and controlling of the firm s financial resources. Its preoccupation is the identification of the possible strategies capable of maximizing an organization s net present value, the allocation of scarce capital resources between the competing opportunities and the implementation and monitoring of the chosen strategy so as to achieve stated objectives. Some of the objectives that financial management strives to accomplish include raising funds to finance an enterprise, conducting a financial analysis of firm s operation and growth consideration, forecasting, monitoring and control of willing capital cycle. The function of a financial manager is to manage finance. He ensures that funds are made available at the right time, made available for the right length of time, obtained at the lowest cost, and used in the most effective way. The mission of the financial manager is to contribute to the organizational results by providing information, analysis, and advice that facilitate planning, decision making, correction and control. Some of the responsibilities of a financial manager are: a. Safeguarding funds b. Controlling funds (receiving and disbursement) c. Controlling revenue and expenditure d. Classifying and coding of transactions e. Accounting for revenue and expenditure SAQ 1.2 Financial management draws from many other disciplines. It embraces accounting and economics models as well as mathematical rules, system analysis, and behavioral sciences. With the advancement of information and communication technology, the scope of financial management has expanded considerably. Managers now face the challenges of e-commerce, e-banking, e-business and e- government. It is, therefore, essential that managers be equipped with knowledge of information and communication technology. Important activities of the business firms are finance, production, and marketing The firm secures the capital it needs, employs it (finance activity) and generates returns on the invested capital production and marketing activities. A business firm, therefore, is an entry that engages in activities to perform the functions of finance, production, and marketing. The raising of capital funds and using them for generating returns and paying returns to the suppliers of funds are called the finance functions of the firm. There are two types of funds that a firm raises: equity and borrowed funds. SAQ 1.3 Financial management, as one of the key management areas, serves the following purposes. These are diversification geographically and with respect to its by-products, increasing the size of businesses, 137