GENERAL INTRODUCTION

Introductionto Finance is the first course in Financial Management (Corporate Finance) and
an essential part of your education in Management. Finance can be defined as an
aspect of economics that deals with management of money. The course teaches
some of the basic concepts of Financial Economics with emphasis on Capital
Budgeting or Investment Decision and Financing Decision. Students who want to
major in Accounting, management and finance should, however, find this module
useful as an introduction to the main principles, which will serve as a foundation for
further study.
The content of the text is divided into two modules. There are five Study Sessions in Module
One and five Study Sessions in module Two.The Session focus on the basic
principles, underlying concepts, technical aspects, and the ways in which financial
information can be used to improve the quality of decision making. To support this
practical approach, there are, throughout the text, numerous illustration extracts with
commentary from company reports and other source. Therefore, you are expected to
study each of the Sessions carefully as you peruse the concepts and worked
examples to aid good understanding of the content of each section of the study
sessions.

How to Study the Modules

You should read each study session of the modules very carefully and make sure you
understand the concept(s) and the underlying principle that is presented. Write down
the new things you have find in each session of the module. You should pay
attention to the solved examples, and attempt all the in-text questions (ITQs) and
self-assessment questions (SAQs) on your own. If you encounter any difficulty,
contact your course lecturer for more explanation. You should note that all answers
to the (SAQs) are at the Appendix to the course text.

Note that the following:

• The symbol used to indicate In-Text Questions

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o The symbol used to indicate In--Text Question/Answer

STUDY SESSION 1:
NIGERIAN FINANCIAL SYSTEM
INTRODUCTION
Money plays two important roles in the economic system. First, as a medium
ofexchange, and second, as a store of wealth, money provides the foundation for a
financial system. Adeveloped
developed financial system is a necessary part of an expanding
economy as it mobilizes
mobilizesthe financial resources of the economy to support
investment and technological
technologicaldevelopment.According
According to Kayode (2011) the entire
Nigerian financial system may broadly be viewed as the totality of the key and
financially related factors interplaying in the entir
entiree Nigerian economy. There are
various financial institutions in the economy with specific functions allotted to them
by the law or Act that established them and the functions performed by these
institutions represent their regulatory environment or their rregulatory
egulatory boundary.
Secondly; money and changes in the money supply are important determinants of
thestate
state of the economic activity. The level of prices, unemployment balance of
paymentsand
and economic growth are influenced significantly by money supply. You
will also be exposed to the regulatory environment of each of the financial
institutions in the economy and how it will enable the operators or intending
investors to ascertain where to approach in terms of a particular investment
portfolio. In this sessionn, you will learn the whole spectrum of the regulatory
framework, financial institutions, financial markets, financial instruments, other
actors and participants, including the overall financial intermediation process
between them.

Learning
ing Outcomes for study Session
At the end of the Session, you will be able to;
1.1 Define the concept
oncept of financial System, institutions and regulatory environment

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1.2 Discuss the various components
ponents of the financial system and
andillustrate
llustrate graphically the
structure of the Nigerian financial system
1.3 Discuss the nature of the financial system and financial market discuss the operators
in some of the institutions.
1.4 Discuss fully financial asset or securities and instruments
1.5 Distinguish between Direct and Indirect Finance.
1.1 GENERAL DEFINITION OF THE FINANCIAL SYSTEM:
SYSTEM:-
The financial system may be defined as the network of Institutions, Markets,
Instruments, Savers and Borrowers, that constitute the money economy. The most
basic function of the financial system is to facilitate the flow of payments in the
economy between the Surplus economic units and the deficit economic units.

Fig 1: The structure of the financial system

REGULATORY INSTITUTIONS
CBN, NDIC, SEC, (NSE) PENCOM, FMF

SURPLUS UNIT
1. Individuals OPERATING INSTITUTIONS (FINANCIAL DEFICIT UNITS/BORROWERS
INSTITUTIONS & INTERMEDIARIES - INDIVIDUALS
2. Business firms
Banks – DMB, Merchant, Development - BUSINESS FIRM
3. Governments - GOVERNMENTS
4. Foreigners Non-Banks – Insurance Firms, Pension Funds,
Stockbrokerage Firm etc. - FOREIGNERS

Securities/Assets,
FINANCIAL MARKETS Instruments, products
PRIMARY/SECONDARY Demand Deposits – Savings.
MONEY/CAPITAL Time Fixed Deposits, CDs,
CPs, Repos Treasury
Bills/Certificates, CBN Note.
1.1.1 Components of the
he Financial System Bonds Equities Insurance
Policies etc.
There are five broad components of the financial system namely:
i. Regulatory Institutions
ii. Operating Institutions (Financial Institutions and Intermediaries)
iii. Financial Markets

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iv. Financial Securities
v. Savers or Surplus Spenders and Borrowers or deficit spenders
• There are…………broad components the financial systemin an economy a. 2b.5 c. 3 d. 4
o ANS; B

1.1.2 Regulatory Institutions:

At the Apex of the Financial System are the regulatory institutions who are responsible for
the orderly and effective operations of the financial system. Financial system
regulation is undertaken in order to ensure that the operating institutions are acting
in accordance with the needs of society. Regulators control the commercial banking
and other financial institutions are acting as regulate dealings in securities
markets. There are two forms of regulation viz prudential Regulations and
Economic Regulations.
The objective of prudential regulation is to ensure that financial institutions are able to
honour their commitments to their customers, that people have access to relevant
and accurate information before they enter into financial contracts and that dealings
in securities is fair to all concerned. Economic regulation, on the other hand, is
undertaken though the instrumentality of monetary and fiscal policies to promote
economic management and to guard against monopolistic tendencies in the
financial system: Regulatory Institutions in the Nigeria Financial tern are: The
Central Bank of Nigeria (CBN), The Nigerian Deposit Insurance (NDIC), The
Securities and Exchange Commission (SEC), Stock Exchange (NSE), which
though a self-regulatory institution, is also regulated by SEC. The National Insurance
Commission (NAICOM), Pension Commission (PENCOM) and the Federal
Mortgage Finance Institution (FMFI). An institution is any structure or mechanism
or social order governing the behaviour of a set of individuals or corporate body in
order to achieve a particular aim or to ensure compliance with a given
norm.Regulatory environment, on the other hand, consists of laws and regulations
that have been developed by the federal, state or local government in order to ensure
compliance with rules and subject institution to control of a body of rules.

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From the foregoing, institution and regulatory environment means institution and their
functions as provided by the law or Acts that established each of the institution.
• There are two types of financial system regulation namely economic regulation anda.
prudential regulation b. Bank regulationc. Capital market regulationd. Investment
regulation
o ANS; A
THE REGULATORY FRAMEWORK
The concepts of the regulatory framework cover among others, the following:
a. Company and Allied matters Act 2004: This law covers the establishment, operational
activities and winding up of corporate entities. This is provided for under section 7
of the Act.
The provisions of the Acts cover both private and public limited, hence the banks which
must be public limited liability company by the provisions of BOFIA its activities is
subjected to this Act.
b. Banks and other financial institution Act (BOFIA) 2004: The Act covers mainly the
activities of financial institutions which could either be Banking Financial
Institutions and Non-banks financial institutions.
c. Other regulations are:
i. Insurance law: This law governs the mode of operations of the insurance companies. It
specifies the powers, right and duties of the insurers and their mode of operations. It
also covers the activities of the insured, their right and duties.
ii. Financial policies: The financial policiesisvested with the power to make some
regulations to ensure the smooth running of the banking industries and other
financial institutions in the economy.
iii. Various statutes and promulgations, as long as it is related to financial issues.
• Which of the following is not part of business regulatory framework (a) CAMA (b)
BOFIA (c) Financial bye-laws (d) Delegated legislation
o ANS; D

1.1.3 Securities and Exchange Commission (Sec)

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The evolution of Securities and Exchange Commission could be traced to 1962 when the
capital issues committee (CIC) was established. The CIC was an adhoc body that
assembled only when the need arose.Moreover, the committee handled or issued
between 1962 – 1975 going by the relevance and increased activities of CIC by the
Decree 1973 was promulgated for its creation and to provide for a supervisory
authority for the Nigeria Capital Market, the Securities and Exchange Commission
(SEC) was established in 1979. And its scope was expanded in 1988 Decree.

1.1.4 Functions of Securities and Exchange Commission (SEC)

1. To determine the time and amount of which securities are to be sold to the public either
through offer for sale or subscription
2. Register all securities proposed to be offered for sale or subscription by the Public
3. To maintain surveillance over the securities market and ensure orderly, fair and equitable
dealings in securities
4. To protect the integrity of the securities market against any abuses arising from the
practice of inside trading.
5. Acting as regulatory apex organisation for the Nigerian Stock Exchange and its branches
to which it would be at liberty to delegate powers.
6. To create the necessary atmosphere for the orderly growth and development of the capital
market
7. To review, approve and regulate mergers, acquisitions and all forms of businesses
combinations.
• The apex body regulating the Nigerian Stock Exchange Market is the……….
o ANS; Securities and Exchange Commission

1.1.5 The Second-Tier Securities Market (SSM)

It is the market which came into existence in 1985. It was established for the purpose of
serving the need of small and medium scale industries which require long-term

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 financing but are unable to meet the stringent requirements for quotation on the
Nigeria Stock Exchange, the first-tier market.

1.1.6 Issuing Houses

An issuing house is currently the corporate finance department of a Merchant Bank or a
Stock broking firm that arranges the issuance and sale of securities on behalf of
another company or government agencies.
1.1.6.1 Functions of Issuing Houses
1. It advertises its clients as to the optimum capital structure and the most suitable form of
sourcing capital and the terms of the issue.
2. It prepares the issue documents
3. It helps to file application to the Nigeria Stock Exchange, if need be in price of interest
rate determination.

1.1.7 The Central Securities Cleaning System (CSCS)

It was incorporated as a subsidiary of the Nigeria Stock Exchange in 1977. The CSCs rests
on the concept which provides an integrated central securities deposition and
clearing (electronic/book entry transfer of shares from sellers to buyers) and
settlement (payment for securities purchased). All securities listed on the Nigerian
Stock Exchange and their register of members are under the custody of CSCs
limited. This arrangement enables all securities transaction.

1.1.7.1 Functions of CSCS Limited

it helps to safe-guard the certificate of quoted securities
it helps to maintain register of shareholders
It serves as a clearing and custodian agency for local and foreign instruments.
It Issues central securities identification numbers to stockholders.
• What is the full meaning of CSCS (a) Central Securities Clearing System (b) Control
Securities Central System (c) Company Security Control System (d) Control System
of Central Securities
o ANS; A

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1.2 OPERATING INSTITUTIONS
Operating institutions is an intermediary that mobilized fund from the surplus of the
economy to the deficit of the economy. It performs a variety of functions namely;
mobilizing savings, facilitating investment, transforming maturities, averaging
and transforming risks, reducing information and transaction costs. They are
also classified into two major components -Financial Institutions and Financial
Intermediaries or Banking Institutions and Non-Bank financial institutions.As
financial institutions, they stand between the opposing demands of the surplus
and deficit economic units, to ensure smooth flow of funds from savers to
borrowers (investors).
This could basically be divided or classified into two: these are as follows:
i. Bank financial institutions
ii. Non-banks financial institutions

1.2.1 Bank financial institutions

This is a component of the financial system in Nigeria. It covers the following:
a. Commercial banks
b. Merchant banks
c. Development banks
d. Specialized banks
(a) Commercial Banks: These banks play major role in the Nigerian Financial
intermediation system. They are commonly referred to as the retail banks. Aside
their primary functions of giving out short and medium term loans, they also offer
other services that include overdraft facilities, safeguarding important documents,
re-entering financial advice and serves as guarantors to their customers in same
cases.
(b) Merchant Banks: They are commonly referred to as wholesale bankers for the
reason that they are mainly increased to cater for corporate customers needs. Their
role in the economy is to provide medium and long-term finance by engaging in

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 activities such as equipment leasing, loan syndication and debt financing including
project financing (Kayode 2011).
(c) Development Banks: They occasionally provided medium terms and long term
funds. Development banks perform this function by providing long-term loans for
capital projects in specific areas. In Nigeria, we have the following:
The Nigerian Industrial Development bank (NIDB)
The Federal Mortgage Bank of Nigeria (FMBN)
The Nigerian Bank for Commerce and Industry (NBC)
The Nigerian Agricultural Co-operative bank (NACB) now known as Nigerian
Agricultural Co-operative and Rural Development Bank limited (NACRD)
These banks are owned by the federal government.
Following the reconstruction of the Nigeria Industrial Development Bank Limited, NIDB in
2001, which incorporated the mandate of the Nigerian Bank for Commerce and
industry (NBCI), the (NBCI) appears to have lost its identity. Today, you may
discuss the BNCI without seeing it as a part of NIDB.
• Which of the following is an example of development bank (a) First bank (b) Eco bank (c)
World Bank (d) Federal Mortgage Bank of Nigeria
o ANS; D
(d) Specialized Bank: These are created by the federal government to cater mainly for
the banking needs of the relatively neglected segments of the Nigerian society as
petty traders, peasant farmers and suppressed communities. The three main banks
established to meet these ever-going requirements are the People’s Bank of Nigeria
(PBN) Community Banks (now micro-finance banks) and Urban Development bank
(UDB) Kayode, (2011).
• BOFIA mainly governs the activities of ____ (a) Banking institutions only (b) Non-bank
financial institutions only (c) both bank and non-bank financial institutions (d) the
insurance company
o ANS; C

1.2.2 Non-Bank Financial Intermediaries/ Institutions

(a) The Nigerian Stock Exchange (NSE)

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(b) The second-tier securities market (SSM)
(c) Issuing Houses
(d) The Central Securities Cleaning System (CSCS)
(e) International Stock Exchange

1.2.3 The Evolution of Nigerian Stock Exchange (NSE)

The Nigerian Stock Exchange with operating branches in Lagos, Kaduna, Ibadan, Onitsha,
Kano and Port Harcourt was registered on September 15 1960 at the Lagos Stock
Exchange on the initiative of private sector individuals and institutions. However,
the Lagos Stock Exchange commenced operation on June 5, 1961.Official and legal
incognito was provided by the enactment of the Lagos Stock Exchange Act of 1961.
Today, the organisational structure of the Nigerian Stock Exchange can be broken down into
three principal parts, which are as follows;
b. Ordinary members who consist of the staff of the Nigerian Bank for Commerce and
industry.
c. Dealing members: These are companies that are involved in issuing work or best
described as issuing houses.
d. Council of Exchange: This comprises of the members drawn from ordinary members and
dealing members. This implies that it does not involve all the members in ordinary
and dealing members.

1.2.3.1 Functions of Nigerian Stock Exchange

1. It provides facilities for trading to buyers and sellers of new and existing securities like
shares, stocks and debentures by acting as a meeting part.
2. It facilitates the channeling of long-term friends to commerce and industry in the country.
3. It provides investments outlets to individuals and corporate bodies with surplus investible
funds.
4. It provides opportunities for continued attraction of foreign capital into Nigeria for
development purposes.
5. It facilitates the maintenance of fair prices for securities funded in the capital market.

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6. It helps government in implementing its indigenization programmes
7. It prescribes requirements for new listings as well as regulates secondary trading activities
by dealers.
8. It provided business and economic information through the daily official list on securities
and performance of participants in the capital market.

1.2.4 Operators in the Stock Market

There are various operators in the stock market based on their interest and their regulatory
restrictions. The following are some of the operators in the institution of the stock
market.
(i)Stockbrokers:
They are intermediaries who bring together both providers and users of capital for
commission called broking. They are vital link and members of stock exchange who
are required at all time to obey the rules and regulations set for dealing members.
Functions of Stockbrokers
They provide advisory and investment service.
They underwrite and handle primary distribution of securities
Stockbrokers sponsor issue to the exchange for listing
They serve as key operators in the secondary market by helping to facilitate the sales of
second hand securities.
(ii) INVESTMENT ADVISERS:
Unlike the stockbrokers who are members of a recognized stock exchange, many investment
advisers are not. Their functions are similar, however, to those of stockbrokers but
for the fact that they cannot sponsor issues to the Exchange for listing. Consequently
they cannot deal in listed securities.They can, however, provide advisory and
investment management services freely without any control or regulation. Now the
regulation of the Securities and Exchange Commission has become operational and

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 makes it illegal for any person or groups to operate as investment adviser(s) without
registering with the commission.

(iii) REGISTRARS:
Registrars keep the register of members of companies and perform other auxiliary services.
They form a very important group of experts on whom successful shares transfer,
dispatch of shares/stock certificate to their respective owner, allotment, issue
interest and dividend warrant and forward notice of meeting together with reports
and accounts to shareholders or stockbrokers and registration of shares.

(iv)BULLS:
They are speculators who buy shares at lower prices in anticipation that prices will rise when
they will sell and make profit. A state bull who lacks cash and does not wish to sell
at a loss may be able to carry the margin over into the next account by a “cash and
new” deal.

(iv) BEARS:
The bear is the opposite of the bull. He sells share he does not own. A bear who owns the
shares he sells in anticipation of a fall is called a “covered near”. A bullish market
connotes a rising market due to optimism in the economy typified by buying. A
bearish market is a falling market typified by selling due to pessimism about the
economy on the part of investors who are willing to take over or take gains under
the safety of cash.

1.3 FINANCIAL MARKETS:

Organized financial markets provide alternative and complementary mechanisms to
financial institutions and intermediaries for meeting the needs of savers and
borrowers. They provide liquidity, facilitate savings mobilization, disseminate
information and reduce transaction cost.Financial markets are classified into
primary or New Issue Market which helps companies and governments to raise new

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 capital, Secondary market such as the Stock Exchange is where trading in existing
securities takes place.Also we can classify the market as the money market which
facilitates short-term deposit and borrowings and capital markets for long-term
capital transactions

1.4 FINANCIAL ASSETS

These are the products traded in the financial markets through which the financial
institutions meet the variety of conflicting needs of savers and borrowers either
for safe custody, yield and investment capital. The terms financial assets,
financial securities, financial instruments, and financial products can therefore be
used synonymously.

1.4.1 Financial Instruments

Debt instrument is defined as a particular type of security that requires the borrower to pay
the lender certain fixed Naira amounts at regular intervals until a specified time is
reached. A debt instrument is an acknowledgement of debt in written agreed to pay
a certain coupon on the value of the debt instruments. Therefore, debt instrument
can be decomposed to captures the following as thus;
Short term instrument
Long term instrument
1.4.2 Short Term Debt Instrument
A short term debt instrument is one that has a maturity of less than one year from the date of
issue. The four short term investment instruments available to investor in Nigeria
are Treasury bills (and other short term issues of governmental bodies both domestic
and foreign), Commercial paper, certificates of deposit, and bankers acceptances.
They are generally highly liquid and are typically used to employ temporarily idle
cash balance when better long term instruments normally offer a higher yield, but
the more distant maturity date subjects the investor to a price risk (selling for less

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 money than was committed to acquire the instrument) if interest rates rise after
purchase and the funds are needed.

1.4.3 Long Term Debt Instrument

The major forms of long term debt instruments used by corporations are bonds, notes,
equipment obligation and commercial bank term loans. The major short term debt
instrument issued by corporations which is available to individual investors, is
commercial paper, promissory notes, simple IOUs of the issuer are typically
exchange between institutions on the basis of personal agreement and are generally
available to individual investors.

1.4.4 The Classification of Long Term Debt Instrument

The classifications of all financial assets and liabilities, is based primarily on the degree of
liquidity and the legal characteristics of the instruments that describe the underlying
creditor-debtor relationships. The liquidity of a financial instrument embraces
characteristics such as negotiability, transferability, marketability, and
convertibility.
In addition to classifying debt instruments by the characteristics of the financial instrument,
they are also classified according to the residence of the other party to the
instrument (the debtors for financial assets and the creditors for liabilities).
Classification of Debt Instruments based on the definition of debt and the following
are debt instruments:
• Debt securities
• Bond;
• Loans;
• Nonparticipating preferred stocks or shares
• Stripped securities
• Securities lending
• A MORTGAGE BOND

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• Asset-backed securities and collateralized debt obligations; and

DEBT SECURITIES
Debt securities are negotiable financial instruments serving as evidence of a debt and it is a
government securities (government bonds, government bills, central bank bonds),
corporate bonds (issued by industrial entities, local governments or commercial
banks), mortgage bonds and certificates of deposit. The holder of debt securities is
usually entitled to payment of principal and interest, together with other contractual
rights under the terms of the issue, such as the right to receive certain information.
Debt securities are generally issued for a fixed term and are redeemable by the
issuer at the end of that term. Debt securities may be protected by collateral or may
be unsecured.
The security normally specifies a schedule for interest payments and principal repayments.
Examples of debt securities are:
Bills;
Banker’s acceptances;
Commercial paper;
Negotiable certificates of deposit;
Bonds and debentures, including bonds that are convertible into shares;
Loans that have become negotiable from one holder to another;
Similar instruments normally traded in the financial markets.
BONDS
A bond is an interest-bearing debt security/instrument issued by corporate bodies,
governments and government agencies for the financing of infrastructure or for
expansion purposes. It involves a promise to make periodic investment payment to
the subscribers and also the repayment or the initial amount borrowed at maturity of
the bond. Repayment of the principal is usually on a steady and regular stream of
payments. This is done by means of a sinking fund. Each year, certain sum of
money is kept in the sinking fund, which is used to repay the debt at maturity (A

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 financial system usually has units with surplus funds at its disposal and deficit units
with insufficient funds). Bond investment belongs to the unit with surplus funds and
would include insurance companies, investment and fund managers, pension
fund administers, etc.)
General Features of a Bond
It is an IOU for a fixed amount.
It is a debt instrument with a par/face value printed on the face of the selling document.
It usually has a redemption / maturity date.
It is a negotiable instrument. This means that it can be transferred to a third party either
through sale at the stock exchange or through a nominal transfer to a blood relation.
It has a market price which may be different from its face value. The initial market price is
the price at which the bond was sold in the primary market, while the subsequent
market price at which it is sold on a stock exchange (which is dependent on the
forces of demand and supply).

THE INTEREST PAYMENT IS USUALLY TWICE A YEAR.

Bonds and debentures are securities that give the holders the unconditional right to
fixed payments or contractually determined variable payments on a specified date or
dates. The earning of interest is not dependent on earnings of the debtors.
Zero-coupon bonds are long-term securities that do not involve periodic payments during the
life of the bond. Similar to short-term securities, zero-cou-pon bonds are sold at a
discount and a single payment, that includes accrued interest, is made at maturity.
Deep-discount bonds are long-term securities that require periodic coupon payments
during the life of the instrument, but the amount is substantially below the market
rate of interest at issuance.
Therefore, instruments with embedded derivatives are not classified as financial derivatives.
If a primary instrument, such as a security or loan, contains an embedded derivative,

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 the instrument is valued and classified according to its primary characteristics—
even though the value of that security or loan may well differ from the values of
comparable securities and loans because of the embedded derivative. Examples are
corporate bonds that are convertible into shares of the same corporation at the option
of the bondholder. If the conversion option is traded separately, then the option is
treated as a separate instrument, classified as a financial derivative, and it is not
debt.
STRIPPED SECURITIES
These are securities that have been transformed from a principal amount with coupon
payments into a series of zero-coupon bonds, with a range of maturities matching
the coupon payment date(s) and the redemption date of the principal amount(s). The
function of stripping is that investor preferences for particular cash flows can be met
in ways different from the mix of cash flows of the original security.
There are two cases of stripped securities:
When a third party acquires the original securities and uses them to back the issue of the
stripped securities. Then, new funds have been raised and there is a new financial
instrument.
When no new funds are raised and the payments on the original securities are stripped and
marketed separately by the issuer or through agents (such as strip dealers) acting
with the issuer’s consent. In this case, there is no new instrument.

COMMON STOCKS SECURITIES

Common stocks, which offer a potential return bounded only by company profit
expectations, have generally been of greater appeal to individual investors than
bonds or other fixed-income securities. Thus, individual holdings of corporate debt
issues represented only 2.6 percent of their total financial assets and 26 percent of
their holdings of all debt securities. The interest of individual investors in bonds
increased markedly in the late 1960s and early 1970 because;

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(1) Stock market price behave in an erratic fashion and rates of return on stocks were often
disappointing after 1966; and
(2) A security is a fungible, negotiable instrument representing financial value. Securities
have made good progress up to now. Securities may represent the largest proportion
of the financial instruments. For debtors, securities are financing alternatives.
Several types of securities have been created through financial innovation. We can
classify securities into various categories, according to the right that the security
represents: debt, equity or goods. Securities are broadly categorized into three main
groups:
GOVERNMENT SECURITIES
These are securities issued by the government of a given sovereign country, and come with a
guarantee for the payment of capital and interest. Government securities represent
the government debt of the country. The Hungarian government has frequently
issued government securities to finance the budget and refinance its expired
securities. These securities may be bought by players in the economy, e.g.
households. Government securities can be classified by their maturity. International
methodology distinguishes two main types of government securities: Government
bills with maturity of less than one year, and Government bonds with maturity of
more than one year.

ASSET-BACKED SECURITIES
Asset-backed securities and collateralized debt obligations are arrangements under which
payments of interest and principal are backed by payments on specified assets or
income streams. This process is also described as “securitization”. Asset-backed
securities are backed by various types of financial assets, for example, mortgages
and credit card loans, government’s future revenue streams. First, the legal and
institutional requirements to exercise creditor rights are simpler because the assets
are backed by collateral—such as a property or a vehicle—and foreclosing should
be less complicated than going through bankruptcy proceedings, as would be

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 required in the case of unsecured corporate bonds. Second, the problem of small
size of the firms can be circumvented by pooling a large number of firms in a
structured security. Banks can use their superior expertise in selecting credits and
can avoid carrying an excessive volume of correlated risk credits in their books,
especially in cases where banks have been very conservative in lending, asset-
backed securities can be an effective instrument for increasing financial
intermediation and investment
A MORTGAGE BOND
A mortgage bond is secured by the assets of the corporation. In the case of bankruptcy,
mortgage bondholders have first claim for repayment from either liquidation or
organisation proceeds mortgage bond developed from the practice of making
secured loans on homes and business properties, with the loans secured by pledges
of real estate. Mortgage bond are widely used by utility and railroad corporations,
but Industrial Corporation generally unsecured bonds, known as debentures.
Therefore, mortgage may be either open, closed, open-end mortgage.

1.5.1 Savers and Borrowers (Surplus and Deficit Economic Units)

The most important components of the Financial System are the savers and the borrowers,
referred to as the ultimate users of the system. The savers are those who have
money in the excess of their current need - the surplus unit. These could be
individuals, business firms, governments or foreigners. The borrowers on the other
hand are those who want to spend in excess of their current income - the deficit
unit. Again, these could be individuals, business firms, governments or foreigners.
There is a lack of correspondence between the needs of borrowers and the demands
of savers. While savers emphasize safety, liquidity and marketability of their
asset/securities, investors/borrowers prefer issuing long-term liabilities. The
separation of the act of saving from investment as well as the differing and
conflicting requirements of the surplus and deficit economic units creates
opportunities for financial intermediation.
• Economic units are classified into how many groups a.2b.3c.5d.4

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o ANS; B

1.5.1 The Nature of the Financial System:

The nature of the financial system can be illustrated by considering the economy
composed of following economic units:
(i) Households
(ii) Business Firms and
(iii) Governments (Local, State andFederal).
Each group and the units within each group can be evaluated in terms of a budget
framework i.e. the relationship between receipts and payments of the groupings
above, effect the differentreceipt and payments characteristics of each group,
nature of incomes and payments for each group differs. For example - households
receiveincome, in the form of wages and salaries and make expenditures on
food, shelters and ices. Business forms receive income from sale of goods to
households, governments and other businesses while their expenditure is on cost of
production, and additions to capital stockbuildings, equipment and machinery.
Government income is derived through taxation, duties and fees, and expands
money on social infrastructure and economic development projects.The budget
position of any unit within a group as well as the entire group itself has three
possible outcomes namely: BALANCED Budget position, where receipts equal
expenditure, Surplus Budget where receipts exceed expenditure and DEFICIT
Budget where expenditure exceeds receipts. The financial System is concerned and
is relevant in an economy with surplus or deficit units. In an economy where
economic units balance that Budgets the financial system has no relevance, there is,
however, a grid-pro-quo between the surplus and the deficit economic units and the
financial system is the mechanism" that allows the two units to engage in a financial
transfer or exchange of IOUS for money.
• The level of prices, unemployment, balances of payments and economic growth
are influenced by-a. Economic activity b.Money Supplyc. Exchange rate
d.evaluation

20
o ANS; B

1.6 DIRECT VERSUS INDIRECT FINANCE

The direct versus indirect finance can be inferred from the concept of financial
intermediationin which financial resources are mobilized from the surplus of the
economy to the deficit of the economy. Therefore, in n order to have in-depth
in
understanding of this concepts and relationship, we define the concept
conce of direct
versus indirect finance separately as thus;

1.6.1 Direct Finance:

Direct Finance occurs when the deficit unit and the surplus unit exchange money and
IOUs directly.
ectly. The surplus unit and deficit unit in this case deal directly with each
other "eyeball" to Eyeball" or as is often the case, through the services of
specialized brokers and agents. The brokers and agents, merely act as
"matchmakers" between the surpl
surplus units and the deficit it’s and charge a
commission fee for their services. They do not take a position in the IOUs being
be
traded nor do they assume the risk of the deficit unit.
3. of a financial institutions, markets and insti
institutions
tutions comprises the Financial
Systema. Networkb. Totalc.Majorityd. Category
o ANS; A

1.6.2 Indirect Finance:

Indirect Finance involves the introduction of a financial intermediary between the surplus
unit and the deficit unit. The Intermediary assumes the risk of the deficit unit and
relaxes the requirement
irement of a successful transfer of fund between surplus and
deficit.
• The basic function of any financial system is to facilitate in an Economy
a.Money Supply b. Transfersc. Flow of paymentsd. Balance of Payments
o ANS; C

SUMMARY:

21
Money is of paramount importance in the economic system, the financial systems is a
necessary component of a developed economy and consists of a network of
institutions, markets and instruments designed to facilitate payments in an
economy.The financial system is relevant only in an economy in which economic
units have surplus or deficit budgets. The financial system will be irrelevant in an
economy of balanced budget. There are four basic components of a financial system
comprising - regulatory institutions, operating institutions, financial markets and
instruments, savers and borrowers.You have learnt that legal framework is peculiar
to the nature or composition of the business. For instance corporate entities are
governed by the company and Allied matters Act of 2004, and the provisions of
Bank and other financial institutions. Act (BOFIA). The Bank financial institutions
include commercial banks, merchant banks, development banks and specialized
banks. The non-bank financial institutions include the finance house, insurance
companies, bureau de change, national economic reconstruction fund, natural
provident fund etc. Now that you have done so well to have completed this study
session, attempt both the multiple choice questions (MCQs) and the essay questions
below. Find time to discuss any area that is not very clear to you with your friends
and Tutor.

SELF-ASSESSMENT QUESTIONS:
Select the most appropriate option from A-D to complete each of the following statements.
1. As medium of exchange and store of value, money provides the foundation for (a)-
Monetary System, (b) Exchange economy (c) Financial System (d)Barta System
2. _____ was established for the purpose of serving the need of small and medium scale
industries which require long term financing but unable to meet the stringent
requirement for quotation on the Nigeria stock exchanging (a) SSM (b) First tier
market (c) issuing houses (d) discount houses
3. Mobilizing savings, facilitating investments and transforming maturities are the
functions ofa.Financial investmentsb.Banksc.Stockbrokersd. Markets

22
4. Savers and Borrowers are referred to as the a.Economic unitsb.Surplus unitsc.Deficit unitsd.
Ultimate users of the financial system
5. There are two types of financial system regulation namely economic regulation
anda.prudential regulationb.Bank regulationc.Capitalmarket regulationd. Investment
regulation
6. The financial system is not relevant in an economy where there isa. Deficit budgetb.
Balanced budgetc. Surplus budgetd. Improper budget
7. Which of the following laws govern the activities of limited liability companies
(a) BOFIA (b) CAMA (c) Minister policy (d) Insurance law
8. The Ministry of finance is also vested with the power of regulating the activities of the
financial system in Nigeria apart from the legislative provisions (a) true(b) false (c)
indifference
9. A bank established mainly to give short term loan and accept deposit from members of the
public is _____ (a) merchant banks (b) Micro finance banks (c) commercial bank (d)
specialized bank
10. Security and exchange commission was established in _____ (a) 1979 (b) 1980 (c)
1988 (d) 1978

23
 REFERENCES
Ayode A.O. (2005) Comparative Banking System 2nd ed. Immaculate Press Ibadan.
Bain, A.D (1981) "The Economics of the Financial System" Marten Robertson & Company
Ltd, Oxford.
Midley Kenneth Ronald G. Burus (1979) "Business Finance and the Capital Market" The
Macmillan Press Ltd, London
Ezike J. E. (2003) "Economics of Banking and Finance" Concept Publications Ltd, Lagos.
Kayode O. (2000) Principles of finance 2nd ed. Y2k Publishers Lagos.
Jegede O. (2002) Introduction to finance 2nded. University of Ibadan press

24
Should you require more explanation on this study session, please do not hesitate to contact
your e-tutor
tutor via the LMS.

Are you in need of General Help as regards your studies? Do not hesitate to
contact the DLI IAG Center by ee-mail or phone on:

iag@dli.unilag.edu.ng
08033366677

STUDY SESSION 2
SCOPE AND METHODOLOGY IN FINANCE

INTRODUCTION

Financial managers and investors don

donot operate in a vacuum they make decision within a
large and complex financial environment. This environment includes financial
market and institutions, tax and regulatory policies
policies,, and the state of the economy.
This study session is in line with the study session 1 because both environments
define the financial alternative
alternativesavailable as well asfactors affecting the outcomes of
various decisions. Therefore, ggood financial decisions require an understanding of
the current direction of the economy, inter
interest
est rates, and the stock market.Thus, it is
crucial forthe financial manage
managers and investors to have a good understanding
understand of the
environment in which they operate. Financial management as an area of study in
finance is concerned with three central and related issues –investment,
investment, financing and
dividend decisions in firms. These thr
three
ee decisions are worthwhile if they lead to the

25
 maximization of the corporate value and in turn give the best streams of returns to
the owners as reflected by the various valuation
valuations of their firm
In this study session, we shall dwell on the definition of finance and you should able to learn
the characteristicss of finance, definition of financial management, the scope of
strategic financial management
management, identify the steps that need to be taken in strategic
financial decision
ion making and also hig
highlight
hlight other related activities in which the
financial manager is involved
involved.

LEARNING OUTCOMES

After studying this study session, you should be able to;

2.1 define and explain thecharacteristics
haracteristics of finance
2.2 define financial management
ent and state its responsibilities
2.3 highlight the steps
teps in strategic financial decision making
2.4 identify and explain the types
ypes of financial decision in finance
2.5 statethe activities in an organisation in which financial managers are involved

2.1DEFINITION
DEFINITION OF FINANCE
Finance is a branch of economics that deals with management of money in an organisation.
organ
Most organisation cannot exist without the involvement or availability of funds
which implies money and thus
thus, its serves as a link that makes business inter-
inter
relationship
ip possible. Finance implies cash inflows and outflows of funds within the
firm which are usually handled by financial manager
managers. Therefore, it is germane to
know the available finance
finances for different types of investment in an organisation.
organisation

2.1.1 Characteristics of Finance iin a Business Firm

Finance enhances business growth

26
 It serves as a stand upon which business can be measured
Finance is a new discipline which has grown so rapidly
Finance links all other activities together in marketing, purchasing, production, selling and
distribution towards the achievement of the corporate values.
Finance involves the sources and allocation of funds to the productive sectors of the
economy.
• The size and importance of the finance function in a business firms depend primarily on
the………….. (a) firm’s size (b) custom and practice of particular country (c)
firm’s financial structure (d) firm’s profitability
o ANS; A

2.2 DEFINITIONOF FINANCIAL MANAGEMENT

Financial management may be defined as management process of planning, provision and
effective utilization of funds as well as management of finances in a reporting
entity. The financial management captures both financial planning and control in
order to achieve the financial objectives of a firm. Financial objective will be
discussedextensively in the next study session. It is one of the management
functions that deal with actual and effective’s sources, as well as the use of firm’s
financial resources. Thus, financial management helps firms to achieve itsoptimum
utilization of available scare resources and the objectives of the firm.
Financial management is concerned with making decisions about the provisions and use of a
firm’s finances. A rational approach to decision-making necessitates a fairly clear
idea of what the objectives of a decision maker are or, more importantly, of what is
the objectives of those on behalf of whom the decisions are being made. We can
therefore infer two issues from this definition:the source of funds and
utilization,where the two key officials that are responsible for these are the
treasurerandcontroller. The treasurer keeps the money, while the controller’s duty
extends to planning, analysis and improvements of every face of the company’s
operation which are measured with a financial yardstick.

27
2.2.1 Roles of Financial Manager
The Financial managers are faced with the following roles and responsibility expected of
them. Therefore, most organisation must have the information below as the
prerequisite for the objective of a financial manager.
1. Investment Decision: This involves profitable utilization of company’s money most
especially in long-term project i.e. a finance manager will advise the organisation
where to invest and how much they should invested.
2. Financing Decision: Advising the company of the alternative source funds available to
them, the relative cost, the inter-dependence of the cost and the relative risk
associated with the funds.
3. Dividend Decision: Finance manager will advise the division of profit between dividend
or re-investment of the profit into the business.
4. Acquisition Decision: This covers acquiring of new company or companies or merging
with other companies. A decision must be taken on whether or not to acquire for the
shares of the company to be valued appropriately.
5. Working capital management: This involves the efficient management of stocks,
debtors, cash and liabilities.
6. Financial control and reporting: A manager must have a plan of what he wishes to
achieve and works towards achieving them. He must exercise control i.e. where
things are not going according to his plans, he must take prompt action to correct the
variance. To aid the planning and control processes, the finance manager must
supply management with regular financial reports.
• The role finance manager in the firm is principally to…….(a) provide financial
information to managers and other interested parties (b) prepare periodic financial
reports, statements and analysis (c) ensure the quality, relevance and timeliness of
financial information (d) make decisions involving finance.
o ANS; D

2.3 STEPS IN STRATEGIC FINANCIAL DECISION MAKING

28
The following are the steps involved in the strategic financial decision making in the
organization and this will be arrangedto establish the standard of performance in an
organisation as thus;
Determine the objectives of the company
Identify all possible courses of action
Collect, collate and record data in respect of each alternative course of action
Analyze, summarize and present data in a form suitable for decision making
Arrive at a decision taking into account quantitative, non-quantitative, social culture
normative psychology factor
Execute the decision through pragmatic and coordinated action to actualize the plan.
Highlight the difference between planned results and actual results
Take necessary corrective action that will improve performance or lead to the adjustment
of the original plan.
• Which among these steps is not in the correct sequence in financial decision making
process? (a) defining objectives which the subject of decision is intended to achieve
(b) identifying the possible or alternative course of action necessary to attain the
defined goals. (c) monitoring the effects of the decision (d) assembling and
assessing data relevant to the decision
o ANS; C

2.4FINANCIAL MANAGEMENT DECISIONS

The financial managers also become involved in strategic planning and control of the
company and make decisions relating to the following areas.
i.Investment Decision
ii,Financing Decision
iii.Dividend Decision

29
2.4.1 Investment Decisions
This is the process of evaluating or appraising investment criterion for all various alternative
investment opportunities in terms of cost, risk and expected return to be
recommended to company management. The investment decision involves
determining the size and composition of company assets. We can see the results of
previous investment decisions by looking at the left-hand side of a balance
sheetwhich consists of current and non-current asset. Therefore, investment decision
is greatly complicated where the probability of an outcome is not estimable.
However, some useful techniques have been devised and developed by economists,
statisticians and management experts to facilitate business decision making under
the conditions of risk and uncertainty. Many of such techniques are applied to
investment decision-making. The techniques and methods are many and are applied
under different business conditions and for evaluating investment projects. Thus, the
financial managers must invest in new assets, as needed, and remove assets that are
no longer productive as well as estimate the extent of risk and uncertainty in
investment decisions when it arises because financial manager should be able to
forecast the possible future events of the projects with certainty.
Examples of different types of investments decisions are as follows.
a) Internal Decisions to the business enterprise
whether to undertake new projects
Whether to invest in new plant and machinery
Research and development decisions
Investment in a market or advertising campaign
b) External Decisions involving parties
Whether to carry out a takeover or a merger involving another business
Whether to engage in a joint venture with another enterprise
c) Disinvestment decisions
Whether to sell off unprofitable segments of the business
Whether to sell old or surplus plant and machinery

30
 The sale of subsidiary companies

2.4.2 Financial Decisions

Financing decision determines how a company’s assets are financed. The right-hand side of a
balance sheet shows the results of previous financing decisions. It involves current
liability, long term debt, and stockholders’ equity. Financial managers must make
financing decisions that result in the best mix of debt and equity. Investments in
assets must be financed somehow. Financial management is also concerned with the
management of short-term funds and with how funds can be raised over the long
term, for example by the following methods.
Taking more credit
Retention of profits for reinvestment in the business
The issue of new shares to raise capital
Borrowing, from banks or other lenders
Leasing of assets, as an alternative to outright purchase
In the previous discussion,we examined in some detail the amount of funds investment in
assets, the funds required in the immediate future (financial forecasting) and the
amount of capital required financing long term capital expenditures. These areas
wouldlargely correspond to the investment decision area of financial management.
To ensure that the projected investment plans can be carried out, it is necessary to plan the
financing of these investments, i.e. the source of the money required to build the
plant, finance the extra stocks, or, in some instances, pay the workers. Assuming
that a firm has established decisions, such decision must be made by management
on the types of finance to be used.As with investments financing, there are different
types of finance which are generally classified into short, medium and long term
sources. The following session examine the various sources and attempt to describe
the risks, benefits and costs attached to each. In making a decision on sources of
finance, management should try to put together an optimum blend which combines
low costs with an acceptable level of financial risk.

31
Financial riskis the risk arising from mismatching sources with users. This can be best
explained by reference to the commonly known concept of overtrading. It is distinct
from the commercial risk faced by any firm. Rapidly expanding firms very often
find themselves depending to a large extent on short term sources of finance such as
trade credit or bank overdraft. For any of a number of reasons, management may
suddenly discover that they have no cash and face liquidation. Possibly banks have
had to refuse further accommodation, suppliers are becoming anxious about
payments, debtors are not paying in time, etc. there are too many cases of firms
failing which could have grown profitably if only their investments had been
properly financed.
A firm is putting itself in obvious danger if it finances long term assets, such as buildings,
from short term sources which may not be replaceable when they fall due. What
might not be so obvious is that the firm is in an equally dangerous position if uses of
long term finance for short term investments. This refers to the fact that loan capital
has fixed charges annually, i.e. interest and capital repayments. If too much of this
type of capital is used and the firm is unable to meet its obligations, the lenders will,
in most cases, be entitled to foreclose on the business and liquidate the assets.
In general, it can be stated that the sources of finance used by a firm should be matched to
the capital requirement of the firm. In particular, long term investment should be
financed from long term sources with due regard to the cost and commitments
attaching to these sources. Medium and short term investments should be matched
to medium and short term sources available to the firm. It should be particularly
noted that part of working capital investments are long term and should be financed
from long term sources.

2.4.3 Dividend Decisions

The dividend decision determines how earnings after taxes are distributed to preferred and
common shareholders or retained for investment and it shows how earnings after

32
 taxes were determined, the amount of preferred stock dividends, and the relationship
between earnings per share and dividends per share.
Therefore, the retention of profits was mentioned above as a financial decision. The other
side of this decision is that if profits are retained, there is less to pay out to
shareholders as dividends and this might deter investors. An appropriate balance
needs to be struck in addressing the dividends decision: how much of the profits
should the company pay out as dividends and how much should they retain for
investments to provide for future growth and new investments opportunities?
• ‘The financial manager should identify surplus assets and dispose of them’. Why?
Answer;
A surplus assetearns no returns for the business. The business is likely to be paying the cost
of capital’ in respect of the money tied up in the assets, i.e. the money which it can
realize by selling it.If surplus assets are sold, the business may be able to invest the
cash released in more productive ways, or alternatively it may be used to cut its
liabilities by either way, it will enhance the return on capital employed for the
business as a whole. Although selling surplus assets yields short-term benefits, the
business should not jeopardize its activities in the medium or long term by disposing
of productive capacity until the likelihood of it being required in the future has
already been fully assessed.
In much of economic theory, it is assumed that the firm behaves in such a way as to
maximize profits, where profit is viewed in an economist’s sense. To the economist,
profit is the difference between the total revenue received by the firm and the total
cost which it incurs. Unlike the accountant’s concept of cost, total costs by its
economist’s definition includes an element of reward for the risk taking of the
entrepreneur, called ‘normal profits’. This is because entrepreneurship is viewed by
the economist as one of the factors of production which the firm makes use of. Like
the other factors of productions – land, labour, and capital- entrepreneurship
requires the prospects of a reward if it is to be prevented from being used elsewhere
(in another firm) instead.

33
2.5OTHERRELATED ACTIVITIES INVOLVEDBY FINANCIALMANAGERS
The other related activities in which financial managers are involved include;
Financial manager works with other mangers within the organisation in the preparation of
the various plans with a view to producing the projected financial statements of the
company.
Financial managers match each aspect of the business plan with the financial resources
available and ensure that each plan, in financial terms, falls within the total funds
available. This entire overall strategic plan must be financially feasible
Financial managers concern themselves with the events in the legal, political and socio-
economic environment, since it may affect the organisation cash flow. Financial
mangers work hand -in -hand with capital market operators, particularly the issuing
houses and the stockbrokers. They are concerned with the effect of their decisions
on the share price
Financial managers, along with other managers, are involved in monitoring and
controlling the activities of the organisation. Therefore, actual resources should be
compared with the planned resources, deviations are highlighted and appropriate
corrective action is taken in each case.
• The importance of business finance to the business firm as an area of study is
because….(a) decisions on financing and investment are at the heart of a business
firm’s success or failure and once made, are not easily reversible (b) it draws from
aspects of accounting economics, law, behavioral science and quantitative methods
which also play important roles in business activities (c) it is relatively new subject
area that is displacing accounting (d) it deals with only long-term financing and
investment decisions of the business firm
o ANS; A

34
 SUMMARY
The two major activities in which financial managers are primarily involved are investments
in assets of the organisation and the financing of those assets. Thereare
Ther of course,
many management decisions which fall within these two broad categories. After
privatization, strategic and tactical decisions will be on the company’s share and
market valuation. Investment decisions, financial decisions and dividend decision
are all likely
ly to affect share price. The financial manager will need to decide upon
an appropriate dividend policy and should have a larger choice of sources of
financing. The choice of investments, sourcing of raw materials and components,
pricing, marketing, produc
production
tion and staffing decisions should no longer be subjected
to any government imposed constraints that previously existed. The company’s
capital structure will become more important and gearing levels should reflect what
the market
ket considers to be acceptable
acceptable. There are also other activities of an
organisation in which financial managers are involved. These are, stock market
activities and the external environmental activities; particularly those external
limitations which financial managers should recognize w
when
hen they take
decisions.Financial manger must appreciate how critical certain steps are, in the
decision making process. You have also been exposed to what job opportunities are
available in finance as well as sspecifying the primary goal of management in a
corporation, and describing
escribing the function of managerial finance

35
SELF ASSESSMENT QUESTIONS
SAQs 2.1 (Test learning outcomes of 2.1, 2.2)
When you graduate, what job opportunities will be available to you in finance? How will you
take advantage of these opportunities?
SAQs 2.2(Test learning outcomes of 2.2.1, 2.3)
Highlight various steps involved in the strategic financial decision making in a corporate
organisation and state the roles of a financial management
SAQs 2.3 (Test learning outcomes of 2.2.1)
Describe the duties of the financial manager in middle-size and larger private companies.
How would you fit into this structure as a financial manager?
SAQs 2.4(Test learning outcomes of 2.4,)
What are the traditional functions of managerial finance? What additional responsibilities
would you have as a financial manager?
SAQs 2.5(Test learning outcomes of 2.4.1, 2.4.2 and 2.4.3)
How do the investment, financing, and dividend decisions relate to a company’s financial
statements?

SAQs 2.6Multiple Choice Question

1. How do you assess the following two statements?
According to the ‘separation theorem’, the business should be guided by the personal
consumption preferences of the shareholders when making investment decisions.
According to the ‘separation theorem’, shareholders’ wealth is not affected by the
financing method used by the business(A) false, false (b) false, true (c) true, false
(d) true, true
2. The separation theorem say that two decision making areas should be considered
separately, these are (a) investment and financing (b) borrowing and consumption
(c) investment and consumption (d) borrowing and lending
3. All the following are the component of disinvestment decisions except
(a) Whether to sell off unprofitable segments of the business (b) Whether to sell old or
surplus plant and machinery (c) The sale of subsidiary companies (d) leasing of
plants
4. Financial managers are faced with the following roles and responsibility except.
(a) Investment Decision (b) Dividend Decision (c) Acquisition Decision (d) Capital
requirement decision

36
5. Finance manager will advise the division of profit between dividends or re-investment of
the profit into the business is known as…….. (a) Financing decision (b) Dividend
decision (c) Investment decision (d) Acquisition decision
6. ……is a form ofadvising the company of the alternative source funds available to them,
the relative cost, the inter-dependence of the cost and the relative risk associated
with the funds. (a)Financing decision (b)Dividend decision (c) Investment decision
(d) Acquisition decision
7. ……… is the duty extends to planning, analysis and improvements of every face of the
company’s operation which are measured with a financial yardstick. (a) Financial
controller (b) cost manager (c) financial manager (d) treasurer (e) director

37
 REFERENCES
Brealey, R. A and S. C Meyers.; Principle of Corporate Finance, (4thed), McGraw
pushing CO, New York, 1991

BPP Publishing Limited Financial Reporting (BPP 1994)

ICAN (2009) Study Pack on Financial Reporting and Ethics; VI Publishers,

Igben, O. R. (2007) Financial Accounting Made Simple Vol 1. Lagos. ROL Publishers

Jennings, A. R Financial Accounting Manual (3rd ), D. P. Publications Ltd Grand Union

Industrial Estate,
state, Unit 6 Abbey Road, London

Ezike I.E. (2001); "Contemporary Investment Analysis and Portfolio Management

(Mineograph)

James C. Van llorne (1977): "'Financial Management and Policy", Prentice-Hall

Hall Int.

Jensen M.C. (1972) ed. "Studies in the Theory of Capital Market", New York. Praeger
Publishers.

Johnson R. W. (1991); "Financial Management, Boston, Allyn and Beacon Inc.

New York, McGraw Hill Publishing Co., Gitman, L.I. (1985)

(1985)"Principles
"Principles Managerial
Finance" New York (4th Ed), Harper and Row

Oba Ekiran (1999): "Basic Understanding of Capital Market

MarketOperations",
Operations", The CBN Press
Limited.

Olowe R.A (1997): "Financial Management: Concept Analysis and

andCapital
Capital Investment",
Lagos Brierfly
ly Jones Nigeria Ltd.

Owualah, S.I Understanding Business Finance, G

G-Mag
g Investments Ltd (Educational
publishers), Lagos, 1997.

OwualahS.I. (2000); "Principles of Financial Management, Lagos.

Lagos.MAG
MAG Investments Ltd.

Pandey, I.M.; Financial Management (6th ED), Vikas Pushing House New Delhi, 1993.

Past Question and Answers on Financial Reporting and Ethics (FRE)

Qurin. G. David (1967); "The Capital Expenditure Decision",

Decision",Homewook
Homewook III. Richard Irwin.

Should you require more explanation on this study session, please do not hesitate to contact your
e-tutor via the LMS.

38
 Are you in need of General Help as regards your studies? Do not hesitate to contact
the DLI IAG Center by ee-mail or phone on:

iag@dli.unilag.edu.ng
08033366677

STUDY SESSION 3
OBJECTIVES OF FINANCIAL MANAGEMENT

INTRODUCTION
The objective of an organisation is the ends which the organisation intends to achieve and
which investment and financing decisions encourage it to achieve as discussed in
the previous study session. The decisions identified in Study Session One will help
in defining
ining good objectives of a firm and upholding the goals. If decisions
ecisions were not
matched with the objectives, there would be:
a. Absence of relevant information with which the decision maker will work; and
b. No basiss for financial managers’ decisions
These may result in decisions being taken that may not be congruent with the organisation’s
objectives. Every business must have an objective(s) as a basis upon which short-
short
term targets can be established. Without clearly defined objectives, it is impossible
to;
i. Develop evaluation techniques for selecting investment opportunit
opportunities
ii. Devise suitable performance measures which will ensure that the company is moving in
the right direction.

39
Therefore, in this Study Session we shall enumerate the objective of a firm to capture the
financial and non-financial
nancial objectives as well as to look
ook at commercial objectives.
You will also learn the agency problems and how to overcome this problem when
such is faced by a manager
manager,creditors and shareholders.

LEARNING OBJECTIVES
After studying this Session,you should be able to:
3.1 Explain the objectives of an organisation
3.2 Identify the various financial objectives of a business organisation
3.3 Bring out the overall financial objective which the financial managers should
assume;
3.4 State and briefly explain the non
non-financial objectives of a business organisation
3.5 State the Objectives of a commercial organisation
3.6 Identify the roles of treasury management in an organisation
3.7 Define agency theory and analyze agency relationship be
between
tween the shareholders and
their managers
3.8 Identify the ways of managing agency problem and how management can achieve
ach
their objectives throughdependent upon the success of managers.

3.1 DEFINITION OF OBJCTIVES OF AN ORGANISATION

Every organisation has oneobjectives
objectivesor another they intend to achieve. Theeseobjectivesare
clearly achievable goals and are derived from its vision and mission statement of the
organisation.. There is little agreement in the literature as to what objectives of firms
fir
are even what they ought to be. However, most financial management textbooks
make the assumption that the objective of a limited company is to maximize the
wealth of its
ts shareholders. The reasons for this assumption and the arguments
a
against it will now be presented
presented.
Vision is the long term objectives of a firm and it must align to mission statement. Examples
here include the pursuit of market leadership at any cost, even profitability. This
may arise because management assumes that high sales equal high profits which is

40
 not necessarily so. In practice, the goals which a company actually pursues are
affected to a large extent by the management. As a last resort, the directors may
always be removed by the shareholders lack of voting power and information. These
companies can, therefore, be dominated by the management.
• According to the technocrat’s view of the objectives of the firm, one of the objectives
pursued by firms is (a) the maximization of the utility of shareholders (b) the
maximization of the wealth of shareholders (c) pursed of the technical innovations
as a means of securing corporate growth (d) satisficing individual interests of
members of the firm.
o ANS; C
3.2 FINANCIAL OBJECTIVES OF A FIRM
There are many objectives which a firm can pursue. It is generally accepted that there should
be one overall objective with all other objectives giving support for this overall
objective can be achieved. However, this objective serves as the real objective of the
organisation and thus, for a business organisation, a financial objective is generally
taken as the overall objective.
Financial Objectives
The financial objectives of a business organisation include, among others, the following:
a. Profit maximization
b. Profitability maximization
c. Liquidity
d. Long-term stability
e. Growth
f. Corporate wealth maximization
g. Shareholders wealth maximization
These financial objectives are further discussed as follows:

3.2.1 Profit Maximization Objective

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 This objective refers to accounting profits and it means that financial managers should
attempt to make as much profits as possible. The essence of profit is to be able to
finance all viable and to meet other exogenous costs of the firms. Financial
managers tend to pursue this objective because of the fact that the ordinary
shareholders are, in law, the owners of the organisation. They have ultimate control
of the company and take residual profits.
However, profit maximization is a good objective but it has its deficiencies.
i. A company, for the purpose of expanding its operation may raise additional capital but the
additional profits generated may not justify the additional capital obtained. In this
case, profits may be rising but earnings per share may be falling.
ii. A company may be earning short-term profits at the expense of long-term profitability.
For example, management may be tempted to cut down say, research and
development expenditure in a particular year. This may increase the profits of that
year but jeopardize future sales and profitability.
iii. Profit maximization, as an objective, ignores risk. Risk, particularly business risk, is an
unavoidable fact of business life as business organisation operates into the future.

3.2.2 Profitability Maximization Objectives

The economist’s assumption of profit maximization would seem to be very reasonable. Then,
the company can be thinking of maximization of profit and even in companies
owned by shareholders but run by non-shareholding managers, where the
entrepreneur is in full managerial control of the firm, as in the case of a small
owner-managed company or partnership where the manager is serving the
company’s (i.e. the shareholders’) interests, we might expect that the profit
maximization assumption should be close to the truth.
However, some writers have suggested that objectives other than profit maximization might
be pursued by firms. Managers are paid to make the decision about price and output,
but it is the shareholders who expect to benefit from the profits. Managers, it is
argued, will not necessarily make pricing decision that will maximize profits,
because:

42
a) They have no personal interest at stake in the size of profits earned, except in so far as
they are accountable to the shareholders for the profits they make; and
b) There is no competitive pressure in the market to be efficient, minimize costs and
maximize profits.
Given the divorce of management from ownership, it has been suggested that price and
output decisions will be taken by managers with a managerial aim rather than the
aim of profit maximization, within the constraint that managers must take some
account of shareholders’ interest because they are formally responsible for them and
so are accountable to shareholders for their decisions.
• State one reason why a business organisation should have an overall objective
o ANS; It serves as the basis for all decisions made in the company

3.2.3 Corporate Wealth Maximization

The financial objective of a company is to maximize the value of the company, and in
particular the value of its ordinary shares, we need to be able to put values on a
company and its shares. How do we do it? The financial manager’s job is to
maximize the market value of the companyand seeks to ensure that investments earn
a return, thereby increasing the market price of share for the benefit of shareholders.
Specifically, the main financial objective of a company should be to maximize the
wealth of its ordinary shareholders. Within this context, how are the wealth of
shareholders and the value of a company measured?
Three possible methods for the valuation of a company might occur here.
A balance sheet valuation, with assets valued on an on-going concern basis. Certainly,
investors will look at a company’s balance sheet. If retained profits rise every year,
the company will be a profitable one. Balance sheet values are not a measure of
‘market value,’ although retained profits might give some indication of what the
company could pay as dividend to shareholders.
The valuation of a company’s assets on a break-up basis. This method of valuing a
business is only of interest when the business is threatened with liquidation, or when

43
 its management is thinking about selling off individual assets (rather than a
complete business) to raise cash.
Market values. The market value is the price at which buyers and sellers will trade stocks
and shares in a company. This is the method of valuation which is most relevant to
the financial objectives of a company.
When shares are traded on a recognized stock market, such as the Stock Exchange, the
market value of a company can be measured by the price at which shares are
currently being traded. When shares are in a private company, and are not traded on
any stock market, there is no easy way to measure their market value. Even so, the
financial objective of these companies should be to maximize the wealth of their
ordinary shareholders. The wealth of the shareholders in a company comes from
dividends received and the market value of the shares. A shareholder’s return on
investment is obtained in the form of dividends received and capital gains from
increases in the market value of his or her shares.
• Which of the following is not reason why wealth maximization provides a reasonable
working basis for financial decision making than profit maximization?
(a) Recognition of shareholder perception of their realizable returns (b) Explicit
consideration of the inherent risks in investment (c) recognition of the important of
the distribution of returns to shareholders (d) recognition of a firms short-run
prospects.
o ANS: D
3.2.4 Maximization of Shareholder Wealth
Maximization of shareholder wealth is one of the primary financial objective of a firm,
where organization need to make positive net present value of estimated future cash
flows and thus increase the wealth of shareholders.It’s also underpins much of
modern financial theory in determining what constitute the financial objectives of a
firm. However, there has been some recent debate as to whether this should or can
be the only true objective particularly in the context of the multinational company.
While the relevance of the wealth maximization goal is under discussion, it might
also be useful to consider the way in which this type of objective is defined,sincethis

44
 will impact upon both parallel and subsidiary objectives. It cannot be defined as a
single attainable target but rather as a criterion for the continuing allocation of the
company’s resources. A widely adopted approach is to seek to maximize the present
value of the projected cash flows. In this way, the objective is both made
measurable and can be translated into a yardstick for financial decision making.
• In terms of global business activities what is that objective that is usually regarded as an
alternative to shareholders wealth maximization? (a) long-term stability (b) long-
term growth (c) corporate wealth maximization (d) share price maximization (e)
cost minimization
o ANS:C

3.2.5 Liquidity
This is purely a short-term objective which should be pursued only in a period of temporary
economic meltdown. During this period, it is the “survival instinct” that is critical.
Shareholders are not likely to put their funds in a company whose management
lacks the required aggressiveness for long-term profitability and growth.
3.2.6 Long-Term Stability
Here, the company does not want to grow but to maintain its present size over a relatively
long period of time. This is not good enough as it shows lack of aggressiveness on
the part of the managers.

3.2.7 Growth
This implies growth in profits and assets. It is a good objective as it shows that short-term
profits will not be pursued at the expense of long-term financial stability. However,
this objective is deficient in some way since growth can be achieved by merely
raising funds in the capital markets.
• What should be the objectives of a company with respect to the local community in which
it operates?

45
o ANS. Behave responsively and responsibly by providing welfare facilities avoiding water
and air pollution oil spillage supporting sport programmes
• What is the term given to situations where managers make decisions which are not in line
with the overall strategic objectives of the business?
o ANS.Goal divergence or sub-optimization

3.2.8 Arguments Against Wealth Maximization Objective

It has been proved that a company would not only achieve profit maximization objective
because of the following reasons.
1. Before profit maximization can be achieved, there must be perfect market i.e. free entry
and perfect information, homogeneity of products, notification etc but because of
imperfection in the system.
2. Wealth maximization is only possible when ownership and control is in the hand of a
single person but in the economic environment, there is separation of ownership
from control.
3. The stakeholders’ view of corporate objectives is that many groups of people have a stake
in what the company does. Each of these groups, which include suppliers, workers,
managers, customers and governments as well as shareholders, has its own
objectives, and this means that a compromise is required. For example, in the case
of the multinational firm with a facility in a politically unstable third world
economy, the directors may at times need to place the interests of local government
and economy ahead of those of its shareholders, in part at least to ensure its own
continued stability there. Before profit maximization can be achieved, there should
be only stakeholder.
4. Poor economic condition. Generally, there has been a global economic recession which
now makes survival objective more pressing than every other objective.
• Wealth maximisation objective should make financial managers to make decisions which
balance…………and………….in any organisation.
o Answer; RISK; RETURN

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3.3 OBJECTIVES OF COMMERCIAL ORGANISATION
The most basic objective of any commercial organisation is the wealth maximization
objectives of its shareholders. Maximizing the wealth of the shareholder is the same
as maximizing the value of the equity. Most financial management models are based
on the assumption of wealth maximization and there are at least four reasons for
these assumptions:
1. Managers are morally obliged to pursue the wealth maximization of the shareholders
because this is what they are paid to do.
2. Increase in the share value will enable the managers to approach other investors for more
capital to expand in order to achieve alternative objectives
3. If the share of a company is allowed to fall below a reasonable level, this will attract take-
over bid from the public or interested individuals (predators)
4. The “invisible hand” theory of Adam Smith states that, if the wealth of maximization
objective is achieved all over the company, this will translate to economic well-
being of the nation as a whole i.e. it will contribute to the growth of Gross Domestic
Product (GDP).
3.3.1 Other Objectives Of Commercial Organisation
1. Market share or growth: Each company may be interested in planning increase in the
market share or a reasonable percentage of the market in order to be well-unknown
as a competitor in the market.
2. Profitability: Making additional profits over the years i.e. a reasonable return on capital
employed is another objective companies will like to achieve.
3. Survival: Since economic recession has being the general trend in the system, most
companies nowadays objectives.
4. Social responsibility: Most large companies e.g. NBC, blueship companies are more
interested in satisfying their immediate environment through scholarship awards,
environmental protections, safety and health employee welfare etc in order to
achieve a “good corporate label”

47
 5. Quality of service: Companies usually take high interest in the quality of service they
render to their customers. Nowadays, high quality service delivery, after-sales
services are being employed by companies to retain the patronage of the valued
customers
• State one major problem of the objective of not-for-profit organisation.
o ANS. (i) Measurement or (ii) Normative problem

3.4 NON-FINANCIAL OBJECTIVE

Non-financial objectives are not in direct opposition to the aim of maximizing financial
value, and may even contribute to it by improving the image and popularity of the
firm. As discussed in the first section of this study, recent work on corporate
objectives suggests that firms should take specific account of those areas which
impact only indirectly, if at all, on financial performance. The firm has
responsibilities towards many groups in addition to the shareholders. However, in
the short term at least they are likely to act as constraints on value maximization
Non- financial objectives could include:
i. Maintaining good relationships with customers and suppliers and acting ethically as well
as to give the highest quality service to customer
ii. To be technical leaders in their field through training and career development priority
iii. Acting as a responsible member of the community within which the firm operates and to
acknowledge their social responsibilities
iv. Employees: To provide good working conditions and remuneration, the opportunity for
personal development, out-placement help in the event of redundancy and so on;
v. To produce an adequate return for shareholders
vi. To improve productivity, be market leaders and maintain a contented workforce
vii. Customers: To provide products of good and consistent quality, good service and
communication, and open fair commercial practice;
viii. The public: To ensure responsible disposal of waste products

48
Non-financial objectives may often work directly to the financial benefit of the firm in the
long term, but in the short term they do not often appear to compromise the primary
financial objectives. There are many other interest groups that should also be
included in the discussion process. At the moment, some companies now act within
the framework of a clearly defined environmental policy which is regulated by a
separate supervisory board.
• The ideal objectives of managers in the management of business organisation should be
to: (a) minimize profits (b) maximize profits (c) maximize shareholders wealth and
relegate the interest of other groups (d) maximize shareholders wealth but give due
attention to other interest groups.
o ANS:D

3.5 THE ROLES OF TREASURY MANAGEMENT IN AN ORGANISATION

In its official terminology, the Chartered Institute of Management Accountants, CIMA,
defined treasurership as the function concerned with the provision and use of
finance as distinct from the control function.Treasurership includes provision of
capital, short-term borrowing, foreign currency management, banking, collections,
money market investment and sometimes, insurance. Therefore, the following are
the approaches implore by the treasury manager;
1. Corporate financial objective: Treasury manager assists the management in formulating
financial aims and strategies, treasury policies and system.
2. Liquidity management: Making sure that the company has the liquid funds it needs and
invest any surplus fund even for every short term e.g. treasury bills, treasury
certificate, commercial paper etc. to generate return. Other functions under liquidity
management are; (a). working capital and money transmission management (b).
banking relationship and arrangement (c). money management
3. Funding Management: Funding policies and procedure to be followed, sources of fund
and types of funds. The treasurer has to know where funds are obtainable, for how

49
 long, at what interest rate, whether security will be required or not and whether the
interest is fixed or variable.
4. Currency Management: He needs to know the exposure policies and procedures,
international monetary economic and exchange regulations (e.g. globalization)
5. Corporate Finance: Corporate finance is concerned with matters such as, raising share
capital, obtaining a stock exchange listing, dividend policy, financial information
from management, mergers, acquisition and business sales all these are the areas of
corporate finance
6. Related Subjects: Risk management and insurance pension funds investment
management

3.6 AGENCY THEORIES

The term ‘agency relationship’ describes the relationship which exists between a principal
and a person hired by the principal to act on his behalf. The relationship between
shareholders and managers may clearly be descried as one of agency: shareholders
appointing managers (directors) to run the company on their behalf. Also,the
relationship between shareholders and creditors is not an obvious one in agency,
though it could be argued that creditors purchase goods on behalf of their customers.
Therefore, an agency theory is one of the key issues that must be resolved in the
organisationin order to meet up with the corporate objective of firms.

3.6.1 Agency Relationship Between The Shareholders and Their Managers

A situation where the principal (owner) appoints an agent (manager) to work on his behalf.
The manager will run the affairs of the company on behalf of the shareholders in a
good faith or in the best interest of stakeholders. Thus, in modern day business,
there is separation of control from ownership. The management of organisation is
now rest in the hand of managers while ownership rests with the shareholders. There
is need for proper understanding of the type of relationship that exists between these
two groups of people. The form of relationship is aimed to be an agency one. This

50
 agency rule expects the managers to disclose all information in respect of all the
operation to the duty of care in all his undertakings.
However, it is noteworthy to state here that there are conflicts of interest between
shareholders’ expectation and managers’ performance. Often time, managers are
accused of pursuing objectives that are contrary to the expectation of wealth
maximization. Some of the accusations leveled against them include high
remuneration packages, overseas holidays, and parks (bonuses, gifts) Owners are
now advised to build-in some forms of control to enable them manages this agency
problem.

3.6.2 To what extent is management dependent upon the success of manager?

It is generally assured that the prime corporate objective is the maximization of shareholders
wealth. However, since the day-to-day activities of the company are conducted by
its management, there is no guarantee that, where the interest of managers and
shareholders conflict, managers will take decision to benefit shareholders.
The way this policy could be implemented includes:
a. Issuing shares to managers. In the situation, the managers become shareholders and
therefore should take decisions which will benefit all shareholders as well as
themselves. The disadvantage are however that managerial and shareholders,
managers will choose the latter. (The managers may get greater personal benefit by
ignoring shareholders’ interests). Furthermore, the company cannot ensure that the
managers will retain their shares;
b. Base reward upon the achievement of financial targets, e.g. profit, and return on
capital. If the achievement of those targets maximizes shareholders wealth, then
shareholders will benefit as managers endeavour to meet the targets. However, such
a policy could well encourage sub-optimal decision making e.g. retention of fully
depreciated fixed assets (to boost profit, ROCE etc). Furthermore, concentration is
placed on short-term rather than long-term achievement. Managers may hit targets
by making short-term decisions and then leave: no long-term commitment to the
firm is guaranteed;

51
c. Issuing managers deferred equity
equity. This should encourage
urage concentration on long-term
long
maximization of the firm’s wealth (as long as the date on which the equity is
obtained is not too far in the future). However, the managerial reward – in the form
of shares – is not directly related to the performance of the company: the share
price may be depressed on the day of the reward because of factors beyond
managerial control. Furthermore, such a policy will encourage managers to retain
profits for future expansion whereas shareholders may wish for constant distribution
distri
of earnings as their reward for investing funds.
• State one way in which leveraged buy
buy-out
out creates conflict of interest between shareholders
and managers
o Answer; Managers taking actions that might drive down the price of the company

3.6.3 Ways off Managing Agency Problem

1. Institute a management audit or additional reporting requirement
2. Relating manager’s compensation tto achievements of company owner--oriented target.
Some of them include remuneration package scheme, executive share, option
scheme,
cheme, performance share in incentive scheme.
3. Pledging assets as security or collateral
4. Rewarding managerial efficiency and not managerial luck
• What is the term given to the action of managers when they try to give the impression of a
rosy financial condition
ion of the company (via the balance sheet) when it is in reality
not the case?
o ANS: Window dressing
• Give one reason why threat of dismissal may not reduce conflict of interest between
shareholders and managers?
o ANS: Wide dispersal of shareholders

52
SUMMARY
You have been able to learn how firms operate within a matrix of different objectives and
constraints, both financial and non-financial objectives could include targets for
operating profitability. They may conflict with the aim of maximizing value in the
long-terms.
It has been suggested, therefore, that to overcome this situation and to encourage good
congruence that managerial remuneration should be made dependent upon the
success of the firm. You have also learned the roles of treasury management in an
organisation and the ways of managing agency problem, as well as agency
relationship between the shareholders and their managers
In this study session, efforts have been made to identify the objectives of commercial
organisation and there are various arguments put forward for why a company ought
to attempt to maximize profits. Shareholders is a powerful argument provided that
the shareholders are seeking wealth maximization.in order to maximize the wealth
of ordinary shareholders, it appears that each company should have its own unique
decisions model. The objective of maximizing the wealth of equity shareholders
seems the least objectionable

SAQs(TestingOutcomes 3.1, 3.2, 3.3, 3.4, 3.5, 3.6)

1. The objective of a non-profit organisation should be: (a) cost effectiveness (b) profit
maximization (c) shareholders wealth maximization (d) value for money (e)
market position
2. In a business organisation, the overall corporate objective should be the company’s; (a)
marketing objective (b) technological objective (c) production objective (d)
financial objective (e) personnel objective
3. Which of the following should NOT be the social objective of a business organisation vis-
à-vis the government? (a) pay tax as at when due (b) obey laws enacted by the
National Assembly (c) keep clean environment (d) encourage tax avoidance (e)
encourage tax evasion

53
4. Which of the following provides a good example of agency relationships in a typical
business organisation? (a) employees and government (b) employees and creditors
(c) creditors and shareholders (d) creditors and government (e) debtors and
creditors
5. In all these specific areas of gearing there are conflicts of interest between shareholders,
managers EXCEPT (a) increase gearing and increase tax-deductible interest cost (b)
reduce gearing and reduce tax deductible interest cost. (c) reduce gearing and reduce
risk (d) do nothing (e) increase gearing and reduce tax-deductible interest cost.
6. Which of the following is NOT a way of ensuring goal congruence in connection with
Agency Theory? (a) unlimiting the activities of the board (b) threat of dismissal (c)
liquidation of the company (d) threat of take-over bid (e) compensation through
allocation of shares
7. Which of the following is NOT included in agency costs? (a) annual salaries of top
executives (b) extra payments as perquisites (c) physical monitoring costs (d)
organisation re-structuring costs (e) profits lost when managers act as agent instead
of as owner-managers
8. In what way might exposure to take-over bid encourage managers to pursue goal
congruence? Deterrence from, (a) making large borrowing (b) paying their
employees fat salaries (c) offering good welfare packages (d) diversifying the
company’s operation (e) suppressing the potentials of the company
9. State one shortcoming of profit maximization as an objective
10. State one factor that might not really make performance shares to be effective as an
instrument of goal congruence.

54
 REFERENCES
Aborode, R.(2012); A Practical Approach to Financial Accounting. Lagos EL-TOBA
Ventures Ltd
Copeland T.E. and J.F. Weston., Financial Theory and Corporate Policy ( 3rd ED), Addison –
Wesley, 1998
Gordon, M.J; The Investment, Financing and valuation of the Corporation, Irwin,
Homewood, Illinois, 1962.
ICAN (2009) Study Pack on Financial Reporting and Ethics; VI Publishers,
Igben, O. R. (2007) Financial Accounting Made Simple Vol 1. Lagos. ROL Publishers
Jennings, A. R Financial Accounting Manual (3rd ), D. P. Publications Ltd Grand Union
Industrial Estate, Unit 6 Abbey Road, London
Owualah, S.I Understanding Business Finance, G-Mag Investments Ltd (Educational
publishers), Lagos, 1997.
Past Question and Answers on Financial Reporting and Ethics (FRE)

Stevenson Richard A and Edward 1.Jennings (1981); "Fundamentals ofInvestment", West

Publishing Co., New York.

TabansiOchiogu A (1997); "Nigeria Taxation For Students" Enugu,A.C. Ochiogu Publisher

Ltd.

The Nigerian Stock Exchange "Daily Official List".

Van Horne, J.; Financial Management and Policy, (8th ED), Prentice Hall Inc, Englewood
Cliff, New Jersey, 1989.

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Should you require more explanation on this study session, please do not hesitate to
contact your e-tutor
tutor via the LMS.

Are you in need of General Help as regards your studies? Do not hesitate to
contact the DLI IAG Center by ee-mail or phone on:

iag@dli.unilag.edu.ng
08033366677

56
 STUDY SESSION 4
FORMS OF BUSINESS ORGANISATION

INTRODUCTION
Generally,every business firmoperates
operates with a view of making profit. This assumption was
derived from capitalism where all business ownership whether individual and by a
group of individual has some important characteristic as discussed in the Study
Session 1. The right to own property and use it for profit making purpose is basic to
a free enterprise
terprise system. However, some
somecorporation does not operate with the
motives of making profit. For example public corporation
corporation, for instance might just
aimed at breaking even since operating capital is often sourced periodical (annually,
quarterly, etc) the subvention released either to local, state or federal government.
Government ownership of business nevertheless also exists in a capitalist economy.
Therefore, this Study Session will capture various forms of business organisation
and its advantages and advantages of sole proprietorship, partnership, public
corporation, corporate society and Joint Stock Company.. You will also learn the
classification as well as various sources of finance in terms of durations of financing
short term finance medium term finance and long term finance.

LEANING OUTCOMES
After studying this Study Session,, you should be able to:
4.1 Define sole proprietorship
ietorship, state its advantages and disadvantages
4.2 Define partnership and identifyits various types
4.3 Highlight the advantages
dvantages and disadvantages of partnership
4.4.1 Define Joint Stock Company and state its advantages and disadvantages
4.4.2 Explainsothersvarious
various types of company and it component
4.5 Define cooperatives society and statesits advantages and disadvantage
4.6 Have anin-depth
depth knowledge of public enterprises, its characteristic
characteristics and formation

57
4.1 SOLE PROPRIETORSHIP OR A TRADER
A Sole Proprietorship is an unincorporated business owned by one individual. Going into
business as a sole proprietor is easy – one merely begins business operations and it
serves as most common form of organisation. Thus, this is normally the type of
organisation used for small businesses and enterprises; it is sometimes the legal
form of medium sized business. The sole trader type of organisation is extremely
easy to form and there are no legislative controls on its formation apart from the
necessity to register a business name. However, in Nigeria, all the smallest business
normally must be licensed by a governmental unit. Business firms are organized and
structured in different ways to suit the circumstances of operation of individual
businesses. Sole ownership is a useful form of organisation for small business and is
extensively used by owners of small shops.
The sole trader has total independence and the advantage that the business is owned,
operated and controlled by one individual who can take all the decisions regarding
his business. The total responsibility for the business rests with him and his fortunes
are dependent on the success or failure of the business. If the business fails the sole
trader is totally responsible for the debts of the business and cannot protect any of
his own assets against the creditors of the business. Such businesses find difficulty
in arranging the finance for expansion as there are basically only three sources of
such finance – the personal funds of the sole trader, his borrowing power and
accumulated profits which he does not draw from the business. These three sources
are usually very limited. A further problem in the expansion of a sole trader arises
from the necessity to spread the weight of decision taking to executives who do not
carry total responsibility. Difficulties also arise in this form of organisation where
they share in responsibility or decision taking.

58
4.1.1 Advantages of Sole Proprietorship
It is easily and inexpensively formed in term of the amount of capital required which is so
minimal that no formal statement of ownership is required
It is subject to few government regulations. The sole proprietor are free from government
control to a greater extent than any form of business ownership.
The business avoids corporate income taxes
Ownership of all profit goes directly to one individual. In partnership at least one other
person will receive a portion of the profits even though it might be a very small
share
Freedom and promptness of action is mostly applicable to the sole proprietor in terms of
quick decision making process
Personal incentives and satisfaction if their business are successful, the individual owners
enjoy a sense of accomplishment that cannot be matched when the glory must be
shared with others.
Secrecy in respect of information to its rivals firms trigger profit.

4.1.2 Limitations of a Sole Proprietorship

The following are the important limitation for a sole proprietorship
It is difficult for a sole proprietorship to obtain large sum of capital and the only sources
of fund is by borrowing from friends as well as the amount one has
The proprietor has unlimited personal liability for the business debt which can result to
losses that exceed the money he or she has invested in the company
Lack of continuity because the life of business organized as a proprietorship is limited to
the life span of the individual for small business operations.
Lack of opportunity for employees to becomes part of the management of the business
even if the employer decided to increase its profit, until he becomes the partners of
the firms.

59
 Difficulty of the management in term of assuming responsibility for managing such
diverse tasks as purchasing, merchandising, extending credit, financing, and
employing personnel.
However, businesses are frequently started as proprietorships and converted to corporations
when their growth causes the disadvantages of being a proprietorship outweigh the
advantages.
• A sole proprietorship form of business organisation has a number of advantages. Which of
these is not among its advantages over a limited liability company or corporation?
(a) Ownership of all profit by the owner or proprietor (b) Low organisational costs
(c) tax savings (d) unlimited liability
o ANS:D

4.2 PARTNERSHIP
A partnership is an association of two or more persons carrying on a business in common
with a view to profit. Legally, its membership may not be more than twenty unless
in the case of Banks. Therefore, a partnership business is an unincorporated
business. Also, as the case of the sole trader the liability of the partners for the debts
and obligations of the partnership is unlimited and this further extends to all their
private assets. Examples of a partnership form of business are a common form of
business ownership for brokerage firms that sell securities, insurance brokers,
accounting and auditing firms, law firms etc

4.2.1 The Partnership Contract

Partnership contract is an agreement between two or more people which is enforceable by
law. Partnership contract is the most desirable agreement although usually it is not
necessary that the agreement between two parties be written and signed. Such a
contract is known as articles of partnership which will guard the business and
among the partners at a future date. The partnership agreement must contain in the
partnership deed and this agreement in term of how profit and loss will the shared,

60
 the partners’ interest on capital and on partners drawings, the salaries of each
partners as well as how to admit new partner etc.
In law each partners carriers full powers to commit the partnership e.g. in the purchase of
goods, and even though partners may agree that these powers might be limited, there
is no way in which this could be notified validly to third parties. Since all partners
are liable for the debts of the firm each partner must have complete trust in the way
in which the other partner conducts business.
Partner usually are seen to have a blend of dissimilar skills and it is quite usual to find, say
three partners, one a marketing man, one with production or technical skills and one
with a financial background. There is a high possibility, however, of disagreement
developing between partners and the possible break-up of the firm. This may be
covered to some extent by the Deed of partnership but this cannot cover all possible
situations.

4.2.2 Types of Partnership

The common provisions of types of partnership are discussed below:
1. General partnership where each partner contributes an agreed amount of capital is an agent
of the partnership and has full liability for all debts. Shares are not transferable.
2. Limited partnerships have been widely used in recent years as an ownership form for
highly speculative undertakings such as drilling for oil or operating cattle feeding
lots. Where there is at least one general partner and any number of limited partners.
Limited partners are only liable for the amounts of capital they have subscribed.
They cannot take an active part in the business. Limited partnerships are rarely
used.Members of a limited partnership who do not assume responsibility for the
debts beyond the amount of their investment are limited or special partners.
3. Partners are defining as individuals who comprise a partnership and are also known as co-
partners. Theirpartnership have greater access to capital than sole traders but the
limitations set by the availability of additional partners’ capital, borrowing powers
and profit still exist. The sharing of responsibility for the firm among a number of

61
 partners allows a larger type of firm to emerge under this form of organisation than
under that of the sole trader.
• In the absence of no agreement partner, profit or loss will be shared according to...
o ANS. The capital contributed by the partners
• The liability of a limited partner is……………
o ANS Limited to the amount of capital contributed to the partners

4.3.1 Advantages of Partnership Business

All forms of unincorporated business, including partnership share some advantages when
contrasted with incorporated forms of business ownership. A partnership can be
organized as easily as a sole proprietorship share some advantages when satisfy
Larger amount of capital can easily be doubled, trebled or otherwise increased by bringing
in additional owners.
Credible credit standing is achieved since the partners would enjoy the highest credit
standing
Retention of valuable employees through the retaining the services of a valuable employee
by making him a partner
Combining the judgment and managerial skills of two or more people about the proposed
actions and a wiser course of procedure may result.
All the members put their best interest in the business, since each general partner is liable
for the actions of the other partners

4.3.2 Limitation of Partnership Business

Partnership operates under different degrees of formality, ranging from informal oral
understandings to formal agreements.
Partnership operate on a low cost and ease of formation
The tax treatment of a partnership is similar to that for proprietorships.
Disadvantages
Unlimited liability of the partners because all general partners is liable personally for the
partnership debts.

62
 Lack of continuity: if a partner dies or withdraws from the business, the partnership is
dissolved. Also, if a partner becomes mentally impaired or takes out bankrupt
papers, the business is dissolved.
Difficulty of raising large amount of capital as compared to incorporated business with it
is registered.
• The terms and conditions of a partnership agreement are containing in……..
o ANS: PARTNERSHIP DEED

4.4 JOINT STOCK COMPANIES

A joint stock companies was important in the early development of Nigeria but has now been
almost replaced by the corporation. It was formed by article of association, not
Joint stock registered company is a corporate body which can sue and be sued under
its own name i.e. it is a legal entity. The companies Act provides the method of
incorporation for joint stock companies. The two major divisions of registered
companies under the joint stock in the sub-sessions are:

4.4.1 Private Companies

Private companies are generally family businesses. The main features of a private company
are:
a. It has between two and fifty members. A minimum of two shareholders is necessary for
incorporation
b. The right of transfer of shares is restricted
c. Business can commence immediately on incorporation whereas a public company has to
comply with a number of formalities.
d. Copies of its accounts do not have to be filed for public inspection – publicity therefore is
avoided

63
e. The company is prohibited from inviting the public to subscribe for its shares or
debentures.

4.4.2 Public Companies

The main features of a public company are:
a. A minimum of seven persons is required to incorporate a public company. The maximum
number is governed by the number of shares which the company proposes to issue.
b. Shares are, generally speaking, freely transferable
c. Though incorporated, a public company cannot commence business until the Register of
Companies issues a certificate to commence business. This certificate depends on
compliance with a number of formalities.
d. Accounts must be audited each year and filed with the Register of Companies. Members
of the public may inspect these accounts.
e. If permission is granted by the Stock Exchange authorities shares and debentures of public
companies may be quoted on the Stock Exchange.
• One of these is not an attribute of a limited liability company or corporation. (a) Ease of
expansion due to access to large amount of capital (b) Longer life span (c) Ease of
establishment (d) Limited liability for owner
o ANS; C

4.4.3 Formation of a Limited Company

A lawyer normally drafts the necessary documents for registration with the Registrar of
Companies; the main documents required are:
1. Memorandum of association – governing the relationship of the company with others
(covers company name, directors, number of shares plus a declaration that liability
is limited).
2. Articles of association – governing the internal working or management of the company.
The company may draw up its own or adopt the set in Table A of the Companies
Act. The articles cover division of share capital, right of classes of shareholders,
voting procedures, directors procedures, etc.
3. Statutory declaration of compliance with all the requirements of the Companies Act.

64
4. Statement of nominal capital
5. List of persons who have consented to be directors
6. Form of consent to act as director from those who have consented to be directors

4.4.4 Three kinds of company may be registered under the companies Act:
a. Companies limited by guarantee: This is where the liability of the members is limited to
the amount which they agree to contribute to the assets in the event of liquidation.
This is usually a nominal figure. This method of incorporation is infrequently used.
Association, clubs and societies are the main users.
b. Companies limited by shares: This is where the liability of the members is limited to the
amount unpaid on their shares. If the shares are fully paid up the members have no
further liability, unless they have given personal guarantees for any debts, such as to
a bank.
Guarantee and unlimited companies are rarely used for trading purposes and may be given
permission not to include the word ‘limited’ in the title.

4.4.5 The Operation of Limited Companies

Limited companies have a corporate existence which is independent of its shareholders or
directors and in contrast to the situation in a sole tradership or partnership the dent
or bankruptcy of one of its members does not bring the firm to a cessation. Shares in
a limited company can be transferred subject to certain rules in private companies
and because of the effect of limited liability this form of organisation can attract
significant additional capital for expansion from new shareholders.
The control of limited companies is delegated by the shareholders to an elected Board of
Directors and it, in turn appoints a managing director who controls the day-to-day
operation of the business. As this form of business enterprise may be used for small,
medium and large businesses, there is no one structure of management which can be
said to be a normal one. Responsibility for decision taking can under this form of
organisation be spread throughout the management under the managing director
with the ultimate control being shared by board members.

65
4.5 CO-OPERATIVE SOCIETIES
A co-operative society is formed by individuals who join together to carry out business and
provide the capital to do so. The co-operative society has many of the advantages of
the joint-stock company. If registered with the Registrar of Friendly Societies the
members of a co-operative society gain the privilege of limited liability. Co-
operative as they are commonly called, are incorporated under the law of a state.
They are to be distinguished from corporations in the following respects;

4.5.1 Distinguishing Features of Co-Operative

a. Voting depends on the number of members, not the number of shares held, i.e. one man-
one vote
b. Each member is restricted in the amount of shares that he may hold
c. Shares held are not transferable but are withdrawable, i.e. a member may withdraw what
he has invested
d. A surplus at year end, after all payments may be distributed amongst members in
proportion to the business carried on by the individual member with co-operative
society
e. Each co-operative unit is owned by the user-members of the group
f. There is a limitation on the amount of stock that each member may own
g. The capital for the enterprise is subscribed only by its member

4.5.2 Types of Co-Ops

Denmark and Britain provide the best example of co-operative retailing. In the UK, some
thirteen million people are members of retail co-ops. The Co-operative Wholesale
Society is not only the biggest wholesalers in England but also services thousands of
retailers and operates 200 factories. The purpose of retail co-ops was primarily to
introduce bulk buying at discount prices. These discounts would then be passed on

66
 to the customer-member in the form of lower-prices. The wholesale co-ops were
formed in Ireland to regulate and stabilize distribution.

4.5.3 Advantages of Cooperatives Society

Cooperative has all of the advantages of corporation although the requirement of ownership
by user-member s limits the size and ease of expansion. They also have a tax
advantage on those patronage dividends are considered a refund of overpayments
rather than a distribution of profits, and the federal government provides financial
assistance not available to profit seeking corporation. In agricultural co-ops,
members are frequently intensely loyal to their firm and support the business with
zeal and enthusiasm

4.5.4 Disadvantages of Corporate Society

Cooperatives lack the profit–making incentive common to other forms of ownership which
appears to be a serious handicap. Also, there is an unfortunate tendency to rely on
volunteers; for example, members of the board of directors customarily are not paid
for their services and the salary scales for the employees are usually on the low.

4.6 VARIOUS KINDS OF COOPREATION

The most extensive use of co-ops is in the field of agriculture. Farm products that are
marketed through farmer cooperatives include citrus fruits, butter potatoes, milk,
and rice. Recently, cooperative health plans have shown some growth but in other
retail areas, the cooperative movement has failed to generate any enthusiasm among
our general public. There is a possibility however, that the recent rise in
consumerism may increase interest in the cooperative retailing of consumer goods.
This is a good potential trend worth watching in the immediate years ahead.

4.6.1 Public Enterprise

67
Public corporation is a government establishment, basically set up to produce goods or
provide essential services to the people at very low prices. A public corporation is
set up by an act of parliament, run and managed with taxpayers money and expected
at least to sustain itself, if it is not making profits. The following are examples of
public corporations; Nigeria Railway Corporation (NRC), the Nigeria ports
Authority (NPA), NationalElectricity Power Authority NEPA, and Nigerian
National Petroleum Corporation NNPC.Their capital is subscribed by the
government and many such companies are in receipt also of government guaranteed
loans. Alternatively, state-sponsored bodies may be formed by registration under the
companies act: this method is frequently used for Trading companies and their
organisation and operation is the same as that of Minister for Finance and that the
company is under the general policy control of a Minister of State. Therefore, public
enterprises are in the hands of the people and, as such, managed or controlled by the
government; or that which is open to anyone and is for the benefit directly or
indirectly of all its citizens. e.g Nationalized industry.
4.6.2 Characteristics of Public Enterprises.
It is owned and finance by government, this fund is generated from the people’s money
through the annual budget of government, although it may have some financial
independence in later years.
The capital involved in setting up a public corporation is astronomical and often beyond
the reach of ordinary businessmen, so government goes into such business for the
benefit of the people.
A public corporation has a board of directors that is headed by a chairman; the board of
directors managed and run the corporation on a day-to-day basis
A public corporation is established by an act of parliament which spells out its power,
functions and responsibilities.
The main business of a public corporation is often to provide essential goods and services
to the general public at an affordable prices, examples are the Nigerian National
Petroleum Corporation

68
 The staff that controlled these types of corporation are not called civil servants, although
they work indirectly for government and their services are for the benefit of all.

4.6.3 The Organisation Structure Of Public Enterprises

The organisation structure of a public enterprise can be drawn below, which shown different
levels and stages headed by the Board of directors and are accountability moved
from director general to the board. The Director General offices are composed of
Secretary to DG, Legal Counsel, Procurement Adviser and Audit Adviser. Director
of different ministering are also report directly to the DG. For example the director
general gives responsibility to Director- Business services and Director training
programme. Each of these directors has different sub-division offices in the
ministries. The relevant Minster is the political head of corporation in the public
parastatal.

ORGANISATIONAL STRUCTURE OF PUBLIC ENTERPRISES

69
Source: Adapted from Naptin- National Power Training Institute of Nigeria

SUMMARY
You have leant the basic forms of business organisations, such as sole trader,
partnership,joint stock companies and cooperatives society. A sole trader’s
trader business
is run by one person. The maximum number of pa
partners is 20 persons
ersons except for
banks, therefore, both forms are unincorporated business and they have unlimited
liabilities.
You have also been exposed to the formation of relevant documents as well as Memorandum
of Association and Article of Association to register companies
mpanies through the
corporate affairs commission. The law governing the formation
formations and regulations
regulation of
business enterprisess in Nigeria is the Companies and Allied Matter
Matters Act 1990.

SELF
ELF ASSESSMENT QUESTION
QUESTIONS
This self-assessment
assessment question will evaluate the different types of business organisationsthat
organisation a
prospective businessman can registered to in Nigeria and describe the necessary
requirements for formation and regulati
regulation.

SAQs 4.1 (Testing Outcomes 4.1,

4.1,)
What is sole proprietorshipbusiness
business;State its advantages as well as its disadvantages
SAQs 4.2 (Testing Outcomes 4.2 4.2, 4.3,)
What are the advantages of partnership forms of business over Limited Liability Company?
SAQs 4.3 (Testing Outcomes 4.1, .1, 4.2,)
What are the advantages of partnership form of business over sole traders
SAQs 4.4 (Testing Outcomes 4.2
4.2)

70
What do you understand by partnership contract and is it differs from partnership deed
SAQs 4.5 (Testing Outcomes 4.46)
Differentiate between the purposes of Memorandum of Association and Article of
Association
MULTIPLE CHOICE QUESTIONS
1. …… is a form of business in which the owner bear the whole risk and return of the
business (a) partnership business (b) company limited company (c) sole
propiertorship (d) private limited company
2. …………. is the documents containing the name of the company, address, object clause,
nature of the business (a) Memorandum of association (b) article of association (c)
company registrar (d) company information book
3. Without agreement among the partners profit or loss are share in accordance to …… (a)
equally (b) capital contributed (c) active partners (d) aged of partners
4. ……….. is the document containing the list of partnership agreement business (a) partners
deed (b) partnership deed (c) partnership act (d) partnership law
5. ………. is the firm where the liabilities of the member is limited to capital contributed by
the partners. (a) private limited company (b) public company (c) limited liability
partnership (d) limited by guarantee
6. One of these is not an attribute of a limited liability company or corporation. (a) Ease of
expansion due to access to large amount of capital (b) Longer life span (c) Ease of
establishment (d) Limited liability for owner
REFERENCES

Aborode, R.(2012); A Practical Approach to Financial Accounting. Lagos EL-TOBA

Ventures Ltd
Brealey, R. A and S. C Meyers.; Principle of Corporate Finance, (4thed), McGraw Hill
pushing CO, New York, 1991
BPP Publishing Limited Financial Reporting (BPP 1994)
Copeland T.E. and J.F. Weston., Financial Theory and Corporate Policy ( 3rd ED), Addison –
Wesley, 1998
Gordon, M.J; The Investment, Financing and valuation of the Corporation, Irwin,
Homewood, Illinois, 1962.
ICAN (2009) Study Pack on Financial Reporting and Ethics; VI Publishers,
Igben, O. R. (2007) Financial Accounting Made Simple Vol 1. Lagos. ROL Publishers

71
Jennings, A. R Financial Accounting Manual (3rd ), D. P. Publications Ltd Grand Union
Industrial
ndustrial Estate, Unit 6 Abbey Road, London
Owualah, S.I Understanding Business Finance, G
G-Mag
Mag Investments Ltd (Educational
publishers), Lagos, 1997.
Pandey, I.M.; Financial Management (6th ED), Vikas Pushing House New Delhi, 1993.
Past Question and Answers rs on Financial Reporting and Ethics (FRE)
Walter J.E (1967); "Dividend Policy and Enterprise Valuation",
Valuation",Calif.
Calif. Wadsworth Pub.Co.
Weston, J. F. and E. F. Brigham (1977)
(1977)'"Managerial Finance" Illinois The Dryden Press,

Should you require more explanation on this study session, please do not hesitate to
contact your ee-tutor via the LMS.

Are you in need of General Help as regards your studies? Do not hesitate to
contact the DLI IAG Center by ee-mail
mail or phone on:

iag@dli.unilag.edu.ng
08033366677

72
 STUDY SESSION 5

THE NIGERIA
NIGERIAN FINANCIAL MARKET

5.1 INTRODUCTION
A highly developed financial system is a hallmark of any modern business enterprise
economy. The market, instruments, and institution that comprise this system
facilitate the efficient production of goods and services. They
They, thereby contribute to
the society’s wellbeing as well as rising standard of living. The financial
financi system
performs this essential function by channeling the nation’s savings into its highest
and best uses. It does this by bringing together those who have funds to lend and
those who wish to borrow to finance their expenditures. People and organisation
wanting to borrow money are bbrought
ought together with those having surplus funds in
the financial markets. Therefore, this Study Session will showcase where you can
source different kinds of fund for inves
investment
tment purposes as discussed in Study Session
S
2.
This study session will describe and illustrate some of the important functions of financial
markets and institutions.. This will help you to make decision of the technical details
in later study session. T
The
he functions of financial market and institutions are
introduced here.

LEARNING OUTCOMES
After studying this Study Session,, you should be able to;
5.1 Define the financial markets in general
5.2 Function of the Nigeria financial market
5.3 State the major types of financial markets and the roles of money market in Nigeria
as well as explain the characteristics of money market instruments
5.4 Define the capital market, state participants and instrument

73
5.5 Classify the Nigeria financial market in difference form of market
5.6 Justify the roles of financial manager and the markets; and
5.7 Understand the implication of financial market activities

5.1 DEFINITION OF FINANCIAL MARKET

Financial markets are markets where individual and organisation raise capital through sale of
securities and invest their surplus funds through purchase of securities. Financial
markets also include the institutions through which these transactions are carried
out. Therefore, financial market make it possible for people to buy, sell, borrow,
lend, give and exchange claims to future flow of income or wealth in an almost
infinite number of ways and with the greatest speed and convenience.
Activity in financial markets involves the exchange of one financial asset for another. In
most exchanges, lenders exchange money for other financial assets that provide a
future return. In effect, they buy a claim against someone’s money holding at a
future date – they buy an IOU. These IOUs, or “securities,” provide an expected
return in the form of interest or dividends. In some cases, the lender may hold a
security until it matures, that is, until the borrower repays the loan on the specified
date. In other cases, the lender may sell the security to someone else before it
matures. Thus, although the borrower continues to use loaned funds, the lender is
now a different person. We say that lenders “supply loanable funds” to the market
whereas borrowers “demand loanable funds.”
• In which respect are the financial markets different from other markets such as
commodity, real estate, automobile, etc
A. Inter-relatedness of the constituent markets
B. Allocation of scarce resources by the price system
C. Influence of price elasticity
D. Intangibility of operation
o ANS: B

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5.2 FUNCTIONS OF FINANCIAL MARKETS
Financial markets perform an economic function and they facilitate the transfer of real
economic resources from lenders to borrowers. Lenders have earned money income
and wish to save part of their earnings for future use. They can earn interest on their
savings by lending their purchasing power to someone who wishes to obtain
command over real resources (by purchasing labour services, plant and equipment,
land, and so on). Thus, real resources flow to borrowers and away from lenders.
Lenders have reduced their present consumption and will have higher income (and a
higher consumption level if required) in the future when the loan matures.
Secondly, the borrowers will source the fund from the financial market and use the borrowed
funds productively – by investing in new machines, for example – they will produce
a larger income, thereby raising the real standard of living not only of borrowers,
but of others in the economy. Thirdly, by facilitating transfers of real resources,
financial markets serve the nation’s economy and the welfare of its citizens. Under a
free enterprise pricing system, profit-seeking entrepreneurs provide people with
commodities that are willing and able to pay for. As consumer desire change over
time, it is necessary that factors of production flow readily into the hands of
producers who respond to those changing desires. Because financial markets permit
shifts of real resources far more efficiently than the barter agreements that would be
necessary in their absence, such markets are highly productive; in a modern highly
developed economy they are essential.Fourthly, financial markets also perform a
financial function. They provide borrowers with funds (purchasing power) that they
need to have now to carry out their plans. Also, they provide lenders with earnings
assets so that a leader’s wealth may be held in a productive form without the
necessity of direct ownership of real assets. There is, of course, no sharp dichotomy
between economic and financial function of financial market, and it is only for
analytical purpose that economists draw such a distinction.In general, when real
resources are affected, we refer to economic functions, but many financial transfers

75
 have only slight effects upon real resources allocation, and in these cases economists
refer to financial functions.
• Which of these descriptions does not appropriately define the value of a marketable
security?
A. Current market price
B. Future monetary returns
C. Future monetary returns on the current market price as a percentage of rate of return
D. Past yield on the security
o ANS: D
5.3 THE BROAD CLASSIFICATION OF FINANCIAL MARKET
The broad classifying of financial markets can be divided into money and capital markets.
“Money markets” refer to markets in which short term instruments are traded.
Usually, we define a short term instrument as one year or less remaining until its
maturityand. “Capital markets” are those markets for long term debt instruments
and stocks. However, the dividing line is arbitrary, and in some markets the one year
line may not be appropriate, but it is the most often used. Capital market securities
are, therefore, those that mature in more than one year, or that have no maturity
dates, as in the case of stocks. The securities bought and sold are known as financial
assets. Therefore, these two broad categories of financial markets can be elaborated
as thus;
(a) The money market; and
(b) The capital markets.

5.3.1 The Money Market

The money market is a market for mobilizing short-term securities, that is, securities with
tenure of one year or less. The main institution of participant of money market is the
commercial banksand therefore, the instrument traded in the money market are
characterized by low level of return, that is, low level of risk, high degree of
liquidity and good institutional structure. Examples of instruments traded in the

76
 Nigerian money market include, treasury bills, Central Bank of Nigeria (CBN)
certificates, commercial banks deposit, certificate of deposit (negotiable and non-
negotiable), bankers acceptance (BAs) and commercial papers (CPs).
Money markets are important for two reasons:
They provide a major means by which participants can adjust their liquidity position and
The Federal Reserve System, which is responsible for controlling the money supply
conduct most of its operation in the money market. Through this operation, it seeks
to achieve many of our nation’s economic goals.
Liquidity is important both to individuals and to institutions. Individuals and firms may
have tax or other payments to make in the near future. By temporarily investing in
money market instruments, they can earn interest and, when necessary, sell the
money, the market assets to obtain money to make their payments. Banks and other
financial institutions also buy money market instruments that mature shortly or can
easily be sold to provide for withdrawals of funds by depositors or for making loans
to customers

5.3.2 Money Market Instruments

Money markets: In the financial market, money market is that part of the market that is
involved in short term investment. Among the participants in the money market are
CBN, commercial and merchant banks, discount houses, brokers etc. Some of the
instruments used in the money market will include, treasury bills, treasury
certificates, negotiable certificates of deposit, commercial papers, bankers
acceptance, promissory notes. Etc.The following are the characteristics of each of
these instruments in major money market instruments:
(a) TREASURY BILLS
These are short-term securities issued by the Central Bank of Nigeria (CBN) on behalf of
Federal Government of Nigeria (FGN). Aside from cash investments, they are the
most liquid and safest of all investments as they backed by the Federal Government.
They are therefore, regarded by financial managers as risk-free securities.Treasury

77
 bills are issued in denominations of N1, 000 and are sold on auction basis. They
have 91 days, 182 days, and 365 days maturity and are sold at a discount to their
face or par value.
(b) CBN Certificates
These are issued also by the CBN on behalf of the Federal Government to bridge the
financing gap between treasury bills and long-term Federal Government bonds.
They are sold for maturities of 180 days and 364 days. The CBN certificate is one of
the instrument in money market in which it captures for long term investment
opportunity in which investor cannot reduce in the underlying asset or lose the
whole investment rather he makes proceeds on investment
(c) COMMERCIAL BANKS’ DEPOSIT
These are usually referred to as savings accounts. They are the simplest forms of
investments. The minimum required amount varies from bank to bank. There is no
maximum. Deposit accounts normally pay a stated rate of interest which also varies
among banks. Withdrawals can take place without penalty even when there is no
notice. However, a minimum balance which varies among banks must be
maintained to keep the account alive. Thus, this type of investment is a risk free
investment and it’s proceed is relatively small compared to the forms of money
market instrument
(d) CERTIFICATE OF DEPOSIT (CDS)
These are also known as fixed deposits. A certificate of deposit is a receipt issued by a bank
to a depositor who puts in an agreed sum of money for a fixed period of time
ranging from one month to any period as agreed with the bank. Banks usually pay a
fixed rate of interest that is higher than on the regular savings account and that
increases with the period of deposit.
By issuing the certificate, a bank undertakes to pay the amount of money deposited (with
interest) to the holder of the receipt on the specified date. There are negotiate and
non-negotiable certificates of deposit. Negotiable certificates issued by CBN can be
sold before maturity on the secondary market or discounted at CBN. Non-negotiable

78
 certificates are held to maturity. Termination of the deposit before maturity usually
attracts penalty.
(e) BANKERS ACCEPTANCES (BAS)
A banker’s acceptance is a negotiable time draft belonging to a class of instrument known as
bill of exchange. A bill is usually drawn on a bank and properly signed by the
drawer. It is made payable to the drawer himself or to a named third party. If and
when the drawee bank signs the bill across by writing “accepted”, the bill becomes a
“banker’s acceptance”. Bankers’ acceptances have three parties- drawer, drawee,
and payee – and maturity periods ranging from 30 days and 180 days. There is
considerable safety and liquidity but not as high as those on treasury bills. Banker’s
acceptance is a form of guarantee by the bank and can be used to finance domestic
or international trade. Bankers’ acceptance are bought and sold on a discount basis.
(f) COMMERCIAL PAPERS
These are short-term negotiable unsecured promissory notes sold by big and reputable
companies mostly finance companies to raise money in the money market.
Commercial papers have two parties- promisor and the promissee. A bank only
comes in as an agent of either party or both parties.The rates on commercial papers
are higher than those on banker’s acceptances and risk is also higher. Commercial
papers are also traded on a discount basis.
• Which of the following is NOT an instrument of money market in Nigeria? (a) certificates
of deposits (b) commercial banks deposits (c) bankers acceptances (d) state
revenue bonds (e) treasury bills
o ANS: D
• Which of the following is NOT a characteristic of money market instruments? (a) high
level of liquidity (b) high level of safety (c) low maturity period (d) high degree
of return (e) good institutional organisation
o ANS: D

5.3.4 Roles of Money Market in an Economy

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The role of money market is immense as an instrument that stimulates growth and
development. This can be achieved through the participation of money market, in
making funds available for short term investment and it’s derive roles are as
follows:
1. It provides short-term funds to the public and private company needing such financing for
their working capital requirement
2. It provides an opportunity for banks and other institutions that have short-term surplus
fund
3. The existence of a developed money market removes the idea of commercial bank
borrowing from central bank.
4. The money market helps the government in borrowing short-term funds at low interest
rate on the basis of treasury bills
5. Well-developed money markets helps in the successful implementation of the monetary
policies of the central bank.

5.4 THE CAPITAL MARKET

The capital markets are the markets for intermediate and long term securities; that is, security
that have more than one year of maturity say three years, five years, and ten years.
The capital market comprises the bond market and stocks. As earlier defined, capital
markets are markets where long term finance is raised by companies and federal,
state and local governments. The capital markets comprise the primary capital
market – market for new funds – and the secondary capital market- market for
existing (second hand) securities. The market where long-term capital formation is
made, that is, new issues of shares is used for intending companies. Participant will
include security and exchange commission (sec), Nigerian stock exchange market,
investors and corporate bodies. Some of the instruments will include shares, stocks,
bonds and debentures

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The primary purpose of the capital market is to channel savings into investments. This
process, by adding to the nation’s stock of capital goods, increases output per
worker hour and ultimately raises our standard of living. The capital markets
facilitate this process in two ways. First, savers may buy newly issued long term
instrument that provide business, firms with fund to finance capital expenditures.
Second, financial institutions, such as savings and loans associations, commercial
banks, life insurance companies and other use the savings of individuals and
business to acquire capital market securities, including mortgages. In both ways,
savings are made available for investment purposes.
In Nigeria currently, three major instruments in the capital market are Federal Government
Development Loans stock as well as State Government issues of loan stocks,
commercial and industrial loan stocks and debentures and industrial and commercial
equities. It is imperative to note that financial institutions lend short term funds
when they accept demand deposit because such funds may be withdrawn within a
short term period. However, when financial institutions invest these funds in capital
market, the funds are usually provided for longer period of time. Thus, the short
term and long term markets are connected through the operations of the financial
institutions.
• In term of risk, state the main difference between money market and capital market
o ANS; Money market instruments have lower risk when compared with capital market
instrument
• State the relationship between yields and price of fixed-interest securities (a) the higher
the yield the higher the price (b) the higher the yield the lower the price (c) the yield
is always equals to the price (d) the yield is unrelated to the price (e) the lower the
yield the lower the price.
o ANS: B
• This is the market for longer-term funds. The key issue is the time for which the funds are
provided. We “draw the line” at one year. So, if a security will pay back for a term
greater than a year, it is in this market. This is called the………

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o ANS: Capital market

5.5 OTHERS CLASSIFICATION OF FINANCIAL MARKET

Financial market can also be classified according to the sources of the financial asset and this
can be primary market and secondary market as well as their components.

5.5.1 Primary Market

Primary markets are the markets for new issues of securities and markets for existing claims.
The markets for new issues of securities are here, consumers, managers of business
firms, and government units issue new securities to raise funds to finance their
expenditures. These securities may be purchased directly by financial institutions or
other lenders who have funds to invest. However, most new issues of private long-
term securities and of state and local (but not federal obligations are initially
purchased by investment bankers or underwriters. After the underwriter has
purchased the securities, they are resold in the market and any profit to the
underwriter will be determined by the spread between the initial purchase price and
the resale price.
This market, also called “the new issues market” is a market for new issues of securities,
principally shares and at times debentures. Funds which are raised in this market are
primarily long-term funds through the issuance of long term fixed/variable-interest
corporate securities and shares. These securities are bought by investing public who
put down their funds in exchange for these securities. The buyers of these securities
are known generally as investors. They may be lenders when they have contractual
agreement with the issuing company for the receipt of periodic interest and
repayment of their capital. They may also be part-owners of the issuing company
when no such contractual agreement exists.

5.5.2 Methods of Making New Issues in Primary Market

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There are five methods of making new issues in the primary market. These are offer for
subscription, offer for sale, stock exchange introduction, rights offer and private
placement.
Offer for Subscription
These are issues of shares or debentures made directly by the company to the public. The
proceeds of issue go directly to the company to finance its fixed assets, other
expansion programmes and working capital as stated in the prospectus. The
company normally goes through an issuing House which advises on such things as
pricing and timing of the issue. This method may be used by companies coming to
the market for the first time or already quoted companies. Underwriting is usually
necessary under this method.
Offer for Sale
This is an offer of existing securities, to the public. There are two known forms this type of
offer may take. First, it might occur where the issuing company initially sells the
shares to an issuing house which in turn sells the shares to the investing public at a
slightly higher price. Second, it might occur where the shares were already owned
by government and it decides to privatize these holdings. In both cases, the proceeds
go to the vendor and not the company. Most of the Federal government parastatals
that were sold under the privatization programme fall into the second category.
Underwriting is, usually, not necessary in this case.
Stock Exchange Introduction
Under this method, the company already has a wide spread of shareholders and it is only
seeking quotation on the stock exchange. Some Nigerian companies got listed on the
stock exchange via introduction. They had already satisfied the listing requirements
of the “The Exchange” regarding the member and spread of shareholders.

Rights Offer
This is an offer to the existing shareholders of the company, usually at a price lower than the
current market price. Details of this offer will be discussed later in this chapter.

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Private Placement
Under this method, securities are sold to a select group of investors through special direct
invitation to prospective investors who can only subscribe to such offer. Shares
issued under this method would not be listed on the stock market, so subsequent
trading in these shares on the exchange would not take place.

5.5.3 The Secondary Market

A secondary marketisthe markets for existing claims (that is financial assets). Since the
original issuers are not obligated to redeem securities until maturity, these markets
allow investors to exchange securities for money before they mature. The focus of
this subsection is on the secondary capital market in which equities change hands
between one investor and the other. Purchase and sale of stocks and shares do take
place anywhere and such transactions do not have to be on the floor of an exchange
building. Thus, the secondary capital market is any place where quoted long-term
securities of companies and government are traded. Nevertheless, the most
important part of the secondary capital market anywhere in the world is the
country’s official stock exchange or stock market. Most of this official stock
exchange hasprimary function as well as a secondary one. Thus, active secondary
markets enhance the value of financial assets. The ease and convenience with which
such assets can be sold prior to maturity without a significant loss is a measure of
their “liquidity”.
A second way of classifying financial markets is to divide them into markets for loans and
markets for securities. A loan is usually negotiated directly between the borrower
and the lender; they deal face to face. In contrast, securities markets are impersonal
or open markets; buyers and sellers of securities are usually unknown to each other,
and usually trade through brokers or dealers. Most consumer credit to finance the
purchase of durables and of housing takes the form of loans. Business firms also
obtain loans, principally from commercial banks, especially for short-term needs.
Most large business firms rely on both loans and sale of securities to obtain needed
funds.

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Some loans, having been made by one institution may be sold to another institution in a
secondary market; this is especially true for mortgage loans. On the other hand,
some securities issues are negotiated directly by borrowers with lenders, as in the
so-called private placement of bonds issued by a business firm and sold to an
insurance company.
Therefore, whether or not borrowers and lenders are known to each other does not always
provide a sufficient criterion for distinguishing between a loan market and a
securities market.
Securities markets may be subdivided into other categories. For example, there are markets
for debt instruments, such as bonds, and there are markets for equities, such as
common stock. The former represents obligations of companies or government units
to creditors. Stocks, on the other hand, are evidence of ownership of firms by stock
holders. Although bondholders and stockholders have different legal status, it is
often convenient to regard both bonds and stocks as securities, since capital may be
obtained by firms through the issue of either type of instrument.
Securities may also be traded on the “floor” of a securities exchange or “over the counter” by
personal or telephone contact with dealers and brokers. Although the New York
System Exchange and the American Stock Exchange get most attention in
newspaper articles, more securities are traded over the counter than on the
exchanges unlike Nigerian Stock Exchange.
• Which of the following is NOT and advantage of federal government fixed interest
securities? (a) risk (b) safety of capital (c) safety of income (d) liquidity (e)
good institutional arrangement
o ANS: A
• The price at which new issues are made in the primary market is determined by: (a)
security and exchange commission (SEC) (b) registrars (c) Nigerian Stock
Exchange (NSE) (d) Issuing House and Issuing company (e) stockbrokers
o ANS: D

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THE NIGERIAN STOCK EXCHANGE (NSE)
The Nigerian Stock Exchange (NSE) was incorporated in 1960 limited by guarantee and
started operations in Lagos and it was first known as Lagos Stock Exchange.It
presently has its Head-Quartersand branches in Abuja, Kaduna, Port-Harcourt,
Kano, Oni Abeokuta and Yola, with each having a trading floor. The
exchangestarted operation with only 9 securities (3 equities and 6 government
stocks). The number of securities traded on the Nigerian Stock Exchange is about
300.
The NSE is governed by a team of shareholders elected at an AnnualGeneral Meeting.
These shareholders constitute the governing council (Board) of the NSE. The
Council is headed by a President (Chairman) while the National Secretariat is led by
a Director General (DG) (Chief Executive 0fficer)who is responsible for the day-to-
day administration of the exchange

The duties of the Council include:

Policy making;
Enforcing discipline among members;
Making rules and regulations for dealing members;
Giving approvals to quotations and listing of securities;
Protecting the interest of the investing public; and
Investigating and settling disputes and complaints against and among members.
Roles of the Stock Exchange
The roles of any recognized stock exchange market include the following:
1. The existence of any recognized stock exchange gives liquidity to investors who may want
to sell their shares for cash as and when needed. This is its principal role.
2. Also investors would have opportunities to diversify their portfolios of securities, if they
want.

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3. Existence of the exchange is vital to firms that wish to raise long-term finance. It enhances
the success of the new issue.
4. The absence of secondary market facilities tends to make the raising of long-term funds
very expensive in terms of returns demanded by investors.
5. Economic development of a nation may be hindered by lack of established secondary
capital market which may result in lack of long-term investment finance.
6. Existence of an officially recognized stock market will ensure that securities traded in
such markets do not only have established prices but are also efficiently priced.
7. Accountability and transparency can be guaranteed as there are rules and regulations
which dealing members must abide with in the conduct of their affairs.
8. Investors are adequately protected as securities are, normally, properly screened before
they are listed on the Stock Exchange.
9. Stock Exchange transactions can now take place through computer, internet telephone, fax
and are no longer limited to the trading floors of an exchange building.

The Trading System

The NSE made a dramatic change to its system of trading in stocks and shares when it
introduced the Automated Trading System (ATS) e-trading in April 1999. Prior to
this time, a system known as call-over system was in operation. This system
involved shouting by brokers on the floor of "The Exchange" to declare their
intentions to stocks/shares.
The new system, that is electronic trading system, is a computerized one under which
stockbrokers interacts with one another through interconnected work stations that is
across a network of computers. The main sub-systems of the Automated Trading
System (ATS) are the work station (CPU, monitor and printer), the trading engine
(the server) and the trading software (the horizon). The workstation is the electronic
facility with which the brokers interact and each workstation is available for each
broker (currently) on the trading floor of the exchange. Here brokers input their buy
and sell orders on their systems. The trading engine is the computer server which

87
 generates the actual start of the day's market transactions (Open State) and matches
brokers buy/sell order, followed by continuous trading. This is done before allowing
the transaction, otherwise the transaction is rejected.
After brokers have input orders, into their individual systems, the server goes into the
Computer Securities Clearing System CSCS Clearing House to verify if the account
numbers entered by the brokers actually exist and if the stocks are available in the
clients' accounts.
Trading on the ATS starts usually at 10.00am each trading day with the Pre-Open State
(situation when brokers input their buy/sell orders which are yet to be matched and,
therefore, subject to partial or total variations). At about 10.40 am trading moves to
the Open/Continuous State. At 12 noon trading moves to the close state, that is,
market closes. The ATS is configured for remote trading. Already stockbrokers in
some branches are trading on line. At present, some brokers engage in remote
trading from their different offices.

Trading, Clearing and Settlement Processes of the NSE/CSCS

The investor initiates the buy or sells order, going through stockbroker.
He deposits his money with his stockbroker when he is buying, or deposits his certificate
for verification when he is selling. When his certificate has been dematerialised
(immobilized), he gives instruction to his stockbroker to sell from his shareholding
account in the CSCS system.
He completes the necessary documentation including transfer form.
In respect of partial sale, he gives instruction to his stockbroker to sell from the stocks.
The stockbroker receives instructions from his client and fills the certificate of deposit
form and sends them with the share certificate, if any, for verification to the
registrar.
A stockbroker verifies clients' signatures with the Registrar.
Completes a contract note and gives it to his client as evidence of the contract.
The registrar authenticates investors claims (certificates and transfer form) as presented
through the stockbroker.

88
 Sends verified certificates and signed transfer form to the CSCS within 48 hours.
CSCS certifies that the shares are in its system c stockbrokers can trade in the shares.
Transaction takes place on the exchange and transfer CSCS on real time basis via the
ATS.
Transactions obtained from the Exchange are process
Stock brokers communicate their daily financial commitment to each other to the
settlement banks (where each stockbroker maintains a trading account) via diskettes
supported by hard copies.
It should be noted that all the above transactions are expected to be completed within 4
working days, that is, T + 3 (transaction day plus 3 working days)

5.6 THE ROLES OF FINANCIAL MANAGERS AND THE MARKETS

Financial managers carry out its functions of resources allocation in an organisation and
sourcing for funds.In line with this, financial manager is a net user of capital
resources.
He enters the money market to invest funds temporarily and make surplus fund to the
company’s requirements.
He goes to the capital market to raise long term funds for long term investment. In doing
this, he has to design strategies for choosing the best and cheapest sources of funds.
The rate of return he pays affects the choice and acceptability of the company’s
projects.
As earlier discussed, he should be interested in the price put on the company’s share on
the stock market as this may ultimately affect the security of top management
(including him) vis-à-vis their emoluments and their continued stay on the job.
Therefore, in earlier Study Session, we discussed what determines the best investment
criterion and showed how financial managers will source the best sources of funds
for the propose investment as well as know the state of their firms for suitable
financial decision. In conclusion, financial manager also need to understand the
environment and markets where capital is raised, securities are traded, and stock
prices are established as well as the institutions that operate in these markets. In the

89
 process, we also implore the principal factors that determine the level of interest
rates.

SUMMARY
You has leant that financial
inancial markets are markets where financial assets (securities) are traded
and they comprisesof money market and capital markets. Money market is a market
for short term securities. Money market instruments have common characteristics
which border
order on low risk, low return, high liquidity and good institutional structure.
Money market instruments are the securities traded in this market and they include
treasury bills, commercial banks’ deposits, fixed deposits, bankers’ acceptance and
commerciall papers. Capital markets are markets for intermediate and long term
securities. Capital markets instruments comprise, among others, Federal
Government bonds, state revenue bonds, debenture (corporate loan stocks)
Preference shares and ordinary shares. Cap
Capital
ital markets instruments have different
and unique characteristics
You have been able to learn the Participants in the financial markets and how they are more
active (as buyers and sellers), intermediating (as agents) in term of mobilization of
resources from
rom the surplus units to the deficit units of the economy or regulatory.
Participants of the Nigeria financial market are individuals, companies, banks, non-
non
banks financial institutions, issuing houses, stock brokers, Bureau de changes,
Nigeria Stock Exchange,
nge, Securities and Exchange Commission and Central Bank of
Nigeria. The activities in the financial markets have great implications for the
financial managers of a company.

SELF ASSESSMENT QUESTION

QUESTIONS

90
This self-assessment question tailor to the financial market, by assessing what are instrument
traded in money market and capital market and its definition. The institution for the
financial markets and strategies for to obtainfinance as well as the principal factors
that determine the level of interest rates.

SAQs5.1 to 5.6(Testing outcomes 5.1, 5.2, 5.3, 5.4, 5.5, 5.6, 5.6)
1. In terms of number of parties, what is the difference between bankers acceptance (Bas)
and commercial papers (CPs)
2. State the impact of inflation on money market instruments
3. State the difference between ‘par’ value and ‘market value’ of a government fixed –
interest security
4. State the primary function of stockbrokers in the capital markets.
5. This is the market for “used” securities – i.e. like the used car market. So, the securities in
this market are probably not being offered for sale by their original issuers. This is
the…………..
6. This is the first offer of a company security to the public. These are brand spanking-new
securities. This is a……………..
7. Let’s say a whole bunch of folk’s deposit, on average, N100 per week in the bank. Then,
the bank periodically “bundles up” the money and lends it out in N10 thousand or
even N100 thousand increments (clue: think about “size” here). The bank is engaged
in………….
8. With this market, time is the key characteristic of interest. Suppose a security is scheduled
to be paid off in the short-term – let’s say less than one year. The security is trading
in the:……………………
9. Suppose you are a Federal Reserve economist-worrying about how money supply changes
will influence the financial world, and ultimately, affect things like paychecks,
inventories and inflation. You are worried about the:………..
10. Think of a general term for businesses like commercial banks, credit unions, or
insurance companies…..but not including firms like Microsoft, Walmart, or Home
Depot. We are talking about examples of:……………

91
92
 REFERENCES
Aborode, R.(2012); A Practical Approach to Financial Accounting. Lagos EL-TOBA
EL
Ventures Ltd
Brealey, R. A and S. C Meyers.; Principle of Corporate Finance, (4thed), McGraw Hill
pushing CO, New York, 1991
BPP Publishing Limited Financial Reporting (BPP 1994)
ICAN (2009) Study Pack on Financial Reporting and Ethics; VI Publishers,
Igben, O. R. (2007) Financial Accounting Made Simple Vol 1. L
Lagos.
agos. ROL Publishers
Jennings, A. R Financial Accounting Manual (3rd ), D. P. Publications Ltd Grand Union
Industrial Estate, Unit 6 Abbey Road, London
Owualah, S.I Understanding Business Finance, G
G-Mag
Mag Investments Ltd (Educational
publishers), Lagos, 1997.
7.
Past Question and Answers on Financial Reporting and Ethics (FRE)
Robieher A and B Meyers (1985); "Optimal Financing Decision's NJ,
NJ,Prentice
Prentice Hal line.

Sharpe W.F. (1963); "A Simplified Model for Portfolio Analysis",

Analysis",Management
Management Science ix
June

Sharpe, W.F. (1970); "Portfolio Theory and Capital Markets" New

NewYork.
York. McGraw Hill

Solomon E. (1956);" The Arithmetic of Capital Budgeting".Journal of

ofBusiness.
Business. 29. April, 124
-129

Stephen H. Archer and Charles A.D. Ambrosio (1972): "Business

"BusinessFinance:
Finance: Theory and
Management" MacMillan

Should you require more explanation on this study session, please do not hesitate to
contact your ee-tutor via the LMS.

93
Are you in need of General Help as regards your studies? Do not hesitate to
contact the DLI IAG Center by ee-mail
mail or phone on:

iag@dli.unilag.edu.ng
08033366677

94
 STUDY SESSION 6
FINANCIAL RATIOS ANALYSIS

INTRODUCTION
This session begins with the definition of financial ratios and the interpretation of final
accounts. It is one of the fundamental tools of analyzing financial statement. The
session will takes youu one stage further and require you to look again at factors
already dealt with in Study Session 3. Accounting information summarizes
summari the
economic performances and situation of a business and in order to make use of this
information, the user needs to analyze as well as interpret its meaning. When
confronted with information
information, it is useful to have a framework of analysis available
to make an attempt to distill what is important from the mass of less important data.
The analysis of financial ratio is largely concerned with the efficiency and
effectiveness of the use of resources by a company’s management, and so also with
the financial stability of the company. Investors will wish to know, whether
additional funds could be lent to the company with reasonable safety, whether the
company would fail without additional funds. Therefore, the choice of ratio will be
determined by the needs of the user of the information. In this Study Session,the
Session
ratios which are illustrated are divided into main groups which may be identified
with the requirements of particular users.

LEARNING OUTCOME
After you have studied this session, you should be able to;
6.1 Explain the meaning of financial ratios and interpretation of ratios
6.2 Justify the relevant of financial ratios to stakeholder
6.3 Identify the usefulness of financial ratios

95
6.4 Identify the various types of financial ratios such as Profitability ratio, growth ratio,
liquidity ratio, efficiency ratios, gearing or capital structure ratio.
6.5 Highlight the limitation of financial ratios
6.6 Discuss the comparisons of ratio in the same industry

6.1 FINANCIAL RATIOS

Financial ratio analysis is one of the tool uses by management to determine the financial
health of any organisation. It is also used by investors to determine the financial
viability of an organisation. Ratios are of use principally by the higher levels of
management who are responsible for maximizing profit and planning for the future.
By the use of financial ratio analysis, it is possible to facilitate the comparison of
significant figures by expressing their relationship in the form of ratios or
percentages. Comparison may be made with ratios for earlier periods in the same
business in order to disclose trends and they may also be employed for purpose of
inter-firm comparison. Therefore, financial ratios are used to examine various
aspects of financial position and performance and are widely used for planning and
control purposes as well as its support other information in the financial statement.
6.2 USEFULLNESS OF FINANCIAL RATIOS
Finance ratio analysis has some usefulness especially to the stakeholders to make use of the
ratios in terms of decision making by investor and are as follows.
Financial ratio provides performance measurement by indicating a firm’s performance and
near present financial position
Liquidation or Reorganisation makes decisions which helps in determining whether or not
to liquidate or reorganize a business in form of a business combination, merger,
acquisition or internal reconstruction.
Ratio analysis guides the Investment or Divestment decisions as to whether to further
invest or divest where such investment is not performing satisfactorily
It aids in the construction of a pattern of a firm’s behavior and financial position

96
 Ratio helps in predicting the firm’s future performance
It facilitates the assessment of the efficiency with which the firm is utilizing assets for
income generation.
Financial ratio the helps to determine the ability of the firm to meet its current obligations
as they fall due.
It facilitates inter firm comparison.
6.3 RELEVANCE OF FINANCIAL RATIOS TO STAKEHOLDERS
The main parties interested in financial ratios include shareholders and potential
shareholders, creditors’ lenders, the Government for taxation and statistical
purposes, potential take-over bidders, employees particularly through their trade
unions, as well as management. The interests of the various parties have been
summarized in Exhibit 6.1 below, which divides the types of ratio into five main
categories. In this Study Session,it is not possible to show all possibly useful ratios
since these can run to many hundreds, rather generally useful common ratios are
illustrated. In practice, it is sensible to calculate as many ratios as appear for the
required objectives.

Exhibit 6.1
Examples of parties with an immediate interest Type of ratio
Potential suppliers of goods on credit; lenders e.g. Liquidity (credit risk): Ratios indicating how
bank managers and debenture holders; well equipped the business is to pay
management. its way.
Shareholders (actual and potential); potential take- Profitability: How successfully is the
over bidders; lenders; management; business trading?
competitive firms; tax authorities;
employees.
Shareholders (actual and potential); potential take- Use of assets: How effectively are the assets
over bidders; management competitive of the firm utilized?
firms; employees
Shareholders (actual and potential); potential take- Capital structure: How does the capital
over bidders; management lenders; and structure of the firm affect the cost
creditors in assessing risk. of capital and the return to
shareholders?

97
Shareholders (actual and potential); potential take- Investment: Show how the market prices for
over bidders; management a share reflect a company’s
performance.

Exhibit 6.2
Exhibit 6.2 shows the statement of comprehensive income and of financial position for the
Bestoyin Company Ltd. Therefore, this Exhibit 6.2 will be employed in the
preparation of financial ratio and reveal the financial performance as well as
evaluation of Bestoyin Company Ltd.

Statements of financial position as at 31 December 2010

2010 2009
Assets:
N’000 N’000
Non-current assets 20,211 21,141
Current assets (debtor N1450andN1350 for each year)7,214 4,976
Total assets 27,425 26,117
Equity and liabilities:
Share capital (16,000,000 shares of N0.50 per share) 8,000 8,000
Retained earnings 7,584 7,313
Total equity 15,584 15,313
Non current liabilities 5,000 5,000
Current liabilities (including dividend payable of
N1,696,000 (2009) and N1,800,000 (2010) 6,841 5,804
Total liability 11,841 10,804
Total equity and liabilities 27,425 26,117
Statement of comprehensive income for the year ended 31 December 2010
2010 2009
N’000 N’000

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Turnover 7,500 9,500
Cost of sales (stock 1200&1600 each) (2000) (3,500)
Gross profit 5,500 6,000
Operating expenses 1,091 1000
Interest charge on debt (500) (428)
Net income 3,909 4,572
Income tax (1,838) (2,000)
Profit after tax 2,071 2,572
Market price per share N5.00 N7.00
Calculate the following ratio and discuss their usefulness:
6.4 TYPES OF FINANCIAL RATIOS
1. Growth Potential Ratios
2. Profitability Ratios,
3. Liquidity Ratio,
4. Activity or Turnover or Efficiency Ratios and
5. Gearing or Capital Structure Ratio.

6.4.1 Short-Term Solvency and Liquidity Ratios

This ratios measure the ability of a business to meet its short-term financial obligations.
Short-term solvency and liquidity ratios. Ratios, in this category include liquidity
which is the amount of cash a company can obtain quickly to settle its obligation.
Many small businesses have themselves been forced to wind up because a large
customer has failed to pay its debt. It is hardly surprising that firms specializing in
giving advice on credit risks should have come into existence. These firms started
the consistent use of ratios to analyze company financial position. The following
ratios are useful in the measurement of liquidity and short term solvency
Current ratio
Acid Test Ratio
Cash Ratio
THE CURRENT RATIO

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Current ratio is a form of comparing assets which will become liquid in approximately
twelve months with liabilities which will be due for payment in the same period. A
company should have enough current assets that a give a promise of ‘cash to come’
to meet
et its commitments to pay its current liabilities and thus,
hus, the standard test for
liquidity is the current ratio. The formula is as follows
Current assets
Current liabilities

In interpreting the ratio, a commonly used rule of thumb would be 2:1, for banks ratio is 1.5.
Many very good firms show a lower ratio. Referring to Exhibit 7.2 This may also

conveniently;
Current ratio =Current asset
Current liabilities
7214 4976
5145 4004
= 1.402:1 1.24:1

It shows a much higher ratio by ov

over-valuing
valuing assets as a result of bad ones, Obviously, a
ratio in excess of 1 should be expected, but what is ‘comfortable’ varies between
different types of businesses.
THE ACID TEST RATIO
It measures the extent
tent to which immediately realizable assets cover the current liabilities and
this quick ratio will convert very quickly into cash. This will normally mean cash
and debtors or current assets less stock
stock-in-trade.
trade. Companies are not able to convert
all their current assets into cash very quickly. For example, manufacturing
companies, where stock turnover is slow, most stocks are not very liquid assets,
because the cash cycle is so long. Therefore, the formula is as thus
The acid test ratio, is Current asse
assets - inventory

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 Current liabilities
2010 2011
7214 –1200 4976 -1600
5,145 4004
= 1.17:1 0.84:1
:1
This ratio should ideally be at least 1 for companies with a slow stock turnover. For
companies with a fast stock turnover, a quick ratio can be less than 1 without
suggesting that the company is in cash flow difficulties.

6.4.2Activity Ratio
This ratio is used to measure the efficiency of management in using the assets employed
emplo in
carrying on its day to day activities and utilizes the assets under its control. These
ratios are also called Turnover Ratio
Ratio, Efficiency ratios and Assetsmanagementratios.
Assetsmanagement
Therefore, the following are the component of Activities ratios;
Inventory Turnover
Payable Payment Period
Receivables’ Turnover Ratio
INVENTORY TURNOVER
This inventory turnover relates the cost of sales to the average inventory .The inventory
turnover ratios gives the number of times the average inventory holding of this
company could be utilized in meeting the supply of its products for sales. This ratio
is significant to management and also shows how good management of inventory is.
Therefore,, the ratio is used to assess inventory utilization but it is well to remember
that the ratio may be distorted by industry characterized e.g. a supermarket is likely
to have a very high stock turnover while a jeweler may have a very low turnover.

Inventory turnover = Costs of Sales (in times)

Average Inventory

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2000 = 1.67 times 3500 = 2.19 times
1200 1600
INVENTORY HOLDING PERIOD
This shows the rate at which customers are planning for credit sales. It is a measure for
efficiency of credit control. The higher the ratio, the more liquid the business
increases.The question is silent on cash or credit sales, the sales figure should be
considered.

Holding periods = Average Inventory x 365

Cost of sales 1
1200 X 365 = 219 days 1600 X 365 = 167 days
2000 1 3500 1
Where average stock opening stock + closing stock
2
PAYABLE PAYMENT PERIOD
This is the ratio of creditor to credit purchases. The ratio shows how quickly creditors are
paid. This means the velocity (the no of times) per period of time at which average
stock is sold. The lower the ratio, the better for the creditors who only have to wait
for a short period to get paid ffor
or the goods supplied or service rendered and it is
calculated as follows;
Payable payment period = Trade payable x 365
Credit purchases 1
RECEIVABLES’ TURNOVER RATIO
Receivables turnover ratio
tio measure the effectiveness of debt collection functions and it
connotes that the company is effective and efficient in cash collection. By
comparison over a number of periods, management can see whether its credit policy
is working or whether debtors ar
aree showing up their payments. Also, if there was a

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 credit squeeze in country, this may make debtors avoid paying for as long as
possible.
Credit Sales (Number of times per annum)
Average Receivables
OR
Sales
Trade Receivable
7500 = 5.2 times 9500 = 7 times
1450 1350
THE AVERAGE RECEIVABLE PERIOD
This indicates a level of inefficiency in debtors’ management. Management should intensify
efforts in addressing
ssing this shortcoming. It is express
expressed as the average period for
which credit is allowed to the customer and it is calculated thus;

Average receivable x 365days

Credit sales
1450 X 365 = 71 days 1350 X 365= 52 days
7500 1 9500 1
The formula indicates that when credit and cash sales are not clearly distinguished, total
sales figures could be used. Furthermore, when the opening balance of receivable is
not available, the closing balance could be used in the calculation of this ratio. This
ratio is sometimes simply referred to as debtors’ ratio and it is a measure of the
collection period changes.
6.4.3 Profitability Ratios
Profitability is the end-product
product of the policies and decision taken by a firm and it issingle
most important measure of success because it serves as the overall operative
performance of a business. This ratio measures the overall performance and
effectiveness of a firm. Profitability ratios are used to discover how efficiently and
effectivelyy assets have contributed to the profit of the firm because of single most

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 important measure of success. Therefore, the following are the measures of
profitability ratios as thus;
Return on Capital Employed
Gross Profit Margin
Net Profit Margin
Total Asset Turnover
Individual Asset Turnover
RETURN ON CAPITAL EMPLOYED
This ratio relates profit only to long term funds, made up of equity (share capital, reserves
and debenture or loan stock). The ratio is used in determining rate of returns on
capital employed with a view to ensuring efficient use of resources. ROCE can also
be called primary ratio and investment ratios, and is perhaps the most important
profitability
ty ratio. Return on Investment relates the profit of a firm to its capital
employed or total sales.. It evaluates the ability of a firm to generate profit from sales
as well as using capital resources to generate sales. The formula is as thus;

Return on capital employed= Profit before Interest and Tax x 100

Capital Employed 1
2,071 x 100 2,572 x 100
15,584 1 15,313 1
= 13% 17%
A change in return on capital employed is usually due to itits variation of its
it component in
secondary ratio such as capital turnover ratio or asset utilization ratio and net profit
margin. Therefore, both caus
causes
es of variation can be regarded as Secondary Ratio.
However, the primary ratio for a trading out company is Return on Equity.
• The return on equity was better than the industry average both in the current year and last
year. What is the possible explanatio
explanationn for this? A. Greater use of leverage. B.
Higher liquidity. C. Lower gross margin. D. Lower asset turnover
o ANS: A

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ROCE is the primary profitability ratio, these other two are the secondary ratios,ProfitMargin
ratios
and Asset Turnover
urnover together explain the ROCE. The relationship between the three
ratios is as follows:

Profit margin x asset turnover = ROCE

PBIT x Sales = PBIT
Sales Capital employed Capital employed

ASSET TURNOVER
Asset turnover: Asset turnover is a measure of how well the assets of a business are being
used to generate sales. For example
example,, if two companies each have capital employed
of N100,000
100,000 and company A makes sales of N400,000
400,000 a year whereas company B
makes sales of only N200,00
200,00 a year, company A is making higher turnover from the
same amount of assets and this will help company A to make a higher return on
capital employed than company B. asset turnover is expressed as ‘x times’ so that
turnover is 4 times and company B’s is 2 times

NET PROFIT MARGIN

The same
ame comments apply to Net profit/sales as to Gross profit/Sales. The difference
between the two ratios will be explained by measuring the ratio of sales to the
expenses in the profit and loss account. The ratio from Exhibit 7.2 is

Net profit margin = NPBIT x 100

Sales 1
3,909 x 100 4572 x 100
7500 1 9500 1

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= 52% 48%
This percentage of 3.3 indicates by how much the profit margin can decline before the firm
makes losses
Net profit (after tax) total assets
In this calculation of return on capital employed the total assets are defined as all fixed and
other non-current
current assets plus working capital.

Return on Total Asset = Net profit (after tax)

Total assets
2010 2011
2,017 x 100 2,575 x 100
27,425 1 26,117 1
= 7.6% 9.8%
Similarly, if the assets of the business include terms of an intangible nature such as goodwill,
goodwill
it is often felt that the return on assets is better related to tangible assets alone, since
the accounting valuation of intangibles varies so much.
GROSS PROFIT MARGIN
The gross profit margin is the ratio of gross profit to sales. It seeks to highlight the aggregate
impact
ct of the firms mark
mark-up
up or pricing policy and thus, it is used to detect frauds or
errors in the trading account or to estimate the disparity between actual gross profit

margin targets. The formula is as follows

The Gross profit margin = Gross profit x 100

Sales 1
Therefore, the reasons why there might be variation in the gross profit margin can be traced
to the following; sales mix, fixing of selling price or government policies, error in

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 stock counting or valuation Cost of purchase From E
Exhibit 6.2
.2 the ratio for the
Bestoyin Company Ltd is

Gross profit margin = GP x 100

Sales 1
5,500 x 100 6,000 x 100
7500 1 9,500 1
= 73% 63%
It is impossible to state a rule of thumb for this figure which will vary considerably from
firm to firm and industry to industry.

COMMON SIZE RATIO

It measures the degree of erosion, on sales or the extent to which sales have been consumed
in relation to all operating expenses incurred. The scaling factor here is sales.

Reserved & Dev. Return = Research & Dev. x 100

Sales 1
• Common size financial statements make it easier to compare which categories of firms?
A. Firms of different sizes. B. Firms in different industries. C. Firms with different
degree of leverage. D. Firms that use different inventory valuation methods.
o ANS: A
• State the group of ratios which measure the overall performance and effectiveness of a
company-----------------------
-----------------------
o Profitability Ratios

6.4.4 Capital
tal Structure Ratios Debts aand Gearing Ratios

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Capital structure ratio is concerned with how much the company owes in relation to its size
and whether it is getting into heavier debt or improving its situation. Therefore, it
can be called Long-term solvency and stability ratios of a firm. These are the two
main reasons why companies should keep their debt burden under control:First,
when a company is heavily in debt, and seems to be getting even more heavily into
debt, the thought that should occur to you is that this cannot continue. If the
company carries on wanting to borrow more, banks and other would-be lenders are
very soon likely to refuse further borrowing and the company might well find itself
in trouble.
Second, when a company is earning only a modest profit before interest and tax, and has a
heavy debt burden, there will be very little profit left over for shareholders after the
interest charges have been paid. And so, if interest rates were to go up or the
company was to borrow even more, it might soon be incurring interest charges in
excess of PBIT. This might eventually lead to the liquidation of the company.
The four ratios that are particularly worth looking at are:
The debt ratio
The gearing ratio;
Interest cover;
The cash flow ratio.

THE DEBT RATIO

The ratio is the ratio of company’s total debts to its total assets.
a. Assets consist of fixed assets at their balance sheet value, plus current assets.
b. Debts consist of all creditors, whether amounts falling due within one year of after more
than one year.You can ignore long-term provisions and liabilities, such as deferred
taxation.
There is no absolute rule on the maximum safe debt ratio, but as a very general guide, you
might regard 50% as a safe limit to debt. In practice, many companies operate
successfully with a higher debt ratio than this, but 50% is nonetheless a helpful

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 benchmark. In addition, if the debt ratio is over 50% and getting worse, the
company’s debt position will be worth looking at more seriously

Total fixed interest charge x 100

Debt ratio =Total
Total asset 1
11841 x 100 = 43.2% 10804 x 100 = 42.4%
27,425 1 26,117 1

THE GEARING RATIO

Capital gearing is concerned with a company’
company’s long-term capital structure. As with the debt
ratio, there is no absolutee limit to what a gearing ratio ought to be. Many companies
are likely to have difficulty in the future when it wants to borrow even more, unless
it can also boost its shareholders’ capital, either with retained profits or with a new
share issue. we find that the company, although having a high debt ratio because of
its current liabilities, has a low gearing ratio. It has no preference share capital and
its only long-term
term debt is the 10% debenture stock. The company does not even
have a bank overdraftt either for including as part of prior charge capital.

Gearing ratio = Total fixed interest charge X 100

Capital employed
11841 x 100 = 46% 10804 x 100 = 44.4%
25729 1 24317 1

INTEREST COVER

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The interest cover ratio shows whether a company is earning enough profits before interest
and tax to pay its interest costs comfortably, or whether its interest costs are high in
relation to the size of its profits, so that a fall in PBIT would then have a significant
effect on profits available for ordinary shareholders.

Interest cover equals = P

Profits BeforeInterest and Tax
Interest Charges
harges
3909 + 500 = 8.8 times 4572+ 428= 11.7 times
500 428
An interest cover of 2 times or less would be low, and it should really exceed 3 times before
the company’s interest costs can be considered to be within acceptable limits.

PROPRIETARY RATIO
Proprietary ratio provides a measure of the adequacy of security to pay all liabilities and it is
a test for long-term
term financial stability as well as cushi
cushion
on for creditors. The higher the
ratio, the more creditors is secured especially in case of liquidation. Therefore, it is
the ratio of shareholders’ fund to total assets and it is calculated as;

Shareholder’s funds x100

100
Total assets 1
2010 2009
Proprietary Ratio = 15,584 x 100 15,313x100
27,425 1 26,117 1
56.8% 58.6%
THE CASH FLOW RATIO
The cash flow ratio is the ratio of a company’s net annual cash inflow to its total debts:
a. Net annual cash inflow is the amount of cash which the company has coming into the
business each year from its operations. This will be shown in a company’s cash flow
statement for the year.

110
b. Total debts are short-term
term and long
long-term
term creditors, together with provisions for liabilities
and charges
Obviously, a company needs to earn enough cash from operations to be able to meet its
foreseeablee debts and future commitments, and the cash flow ratio, and changes in
the cash flow ratio from one year to the next, provides a useful indicator of a
company’s cash position.

6.4.5 Investor Ratio Stock Market oor Equity Ratio

Growth ratio can also be called stock market ratio or investor’s ratio or investment ratio and
equity ratio. It is a measure of quality and market prospect of an investment because
the ability of a firm to survive depends on its capability to attract additional
addit equity
capital when needed. Therefore, the major factors in the assessment of this capacity
are the relationship between the earning available for ordinary shareholders and the
other contribution of the ordinary shares.
Therefore, the following are measures of stock market ratio as thus;
Earnings Per Shares
Dividend Per Share
Prices Earning Ratio
Earnings Yields
Dividend Yield
Dividend Covered
Dividend Payouts

DIVIDEND PER SHARE

This is that part of earnings per share which is receive
receivedd by the shareholders as dividend.
How much dividend is paid per share
shareand it indicates the amount of dividend
attributable to each share. It is computed thus;

DPS = Ordinary share dividend (Gross)

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Number of ordinary shares
Dividend per share = 1,800,00
1,800,000 x 100 1,696,000 x 100
16,000,000 16,000,000
= 11.25k 10.60k
This indicates that dividends and earnings attributable to each share is lower and may send a
wrong signal to the investors and potential investors, and may also have a negative
effect on the share price.

EARNINGS PER SHARE

Earnings per share can be used in measuring the performance of companies as well as in
comparing the result of several years. This ratio shows the profits attributable to
each equity share based on the profit generated for the period to the ordinary shares

ranking for dividend. The formula is as follows

EPS = Profit after tax - preference dividend

Number of ordinary share
2010 2009
Earnings per share = 2,071,000 x 100 2,572,000 x 100
16,000,000 1 16,000,000 1
= 12.94K 16.08k
Where the reporting entity is group; the profit will be reduce
reduced by the profit of the
subsidiaries attributes to Non
Non-controlling
controlling interest. EPS is used to measure the
market value of a share inn conjunction with the price earnings ratio. Hence, EPS is a
part of ratio that is computed and reported as parts of the financial statements of a
reporting entity.

PRICE EARNING RATIO

This ratio provides adequate yardstick for assessing the relative worth of share. It expresses
the relationship between the market price per share and the amount of earnings

112
 attributable to a single share and therefore, it relates the market price to the earnings
e
per share. The limitations of this ratio derive largely from those associated with
earnings per share. In addition, share price is not an absolute indicator of company
performance but can reflect for example the general state of the market.

Market price per share

Earnings per share
= 500k = 37 times
times700k = 44 times
12.94k 16.08k
A high P/E ratio indicates strong shareholder confidence in the company and a lower P/E
ratio indicates lower confidence.
• High P/E ratios tend to indicate that a company wills _______ ceteris paribus. A. Grow
quickly. B. Grow at the same speed as the average company. C. Grow slowly. D.
Not grow.
o ANS: A- Grow quickly
• For most firms, P/E ratios and risk: A. Will be direct
directly
ly related. B. Will have an inverse
relationship. C. Will be unrelated. D. Will both increase as inflation increases?
o ANS: B
• Low P/E ratios tend to indicate that a company will…….. ceteris peribus (a) grow quality
(b) grow at the same speed as the av
average
erage company (c) grow slowly (d) not grow
o ANS: C

EARNING YIELD
Earning yield is the ratio of the earnings per share to the market value of shares. This ratio is
used to determine possible returns on investment in the company’s shares at the
existing market
arket value. It gives the rate at which earning is being capitalized by the
stock market. It indicates the maximum rate of income expected by equity investors
and also it tell us the number of years within which the investor’s capital outlay will,

113
 at the present
resent level of earnings, be recoupled either by way of dividend or capital
appreciation or by virtue of retained earnings. Earning yield is calculated as thus;

Earning yield = Earnings per share x 100

Market price per share 1
12.94 X 100 = 2.6% 16.08 X 100= 2.3%
500 1 700 1
• The higher the ratio the faster the growth of the market is expecting in the company
future.
Earning yield is the reciprocal of price earnings ratio which shows the market view of the
future prospects of the share. This ratio gives capitalization rate and it is the rate at
which the stock market capitalizes the value of the current earnings.

DIVIDEND YIELD
Dividend yield is the dividend as a percentage of market prices of share and it indicates the
return attributable to each share relative to the price paid for the acquisition of such
share. It shows how capital em
employed has been efficiently used and so indicated the
minimum rate of return expected by the equity investor and this is based on
dividend declared during the year in respect of any type of share it is calculated
thus;

Annual dividend per share X 100

Market price per share 1

Dividend Yield =11.25 x 100 = 2.3% 10.60 x100=1.5%

1.5%
500 1 700 1
The dividend yield indicates how the capital employed is being efficiently utilized in
comparison with the past years or with alternative investments or returns from other
companies in the same industry.

114
DIVIDEND COVER
This indicates the number of times dividend per shares is covered by earning per share and it
measures the relationship between earnings and dividend per share. It shows how
many times the company can cover the dividend as well as the ability of a company
to pay dividend out of profit gene
generated.
rated. It is calculated thus;

Earnings per share (in times)

Dividend per share
Dividend cover = Earnings per share OR Profit after tax
Dividend per share total Dividend
Dividend cover = 12.94 16.08
11.25 10.60
OR
2,071 2, 2572
1,800 1,696
= 1.2times 1.5times
The higher it is, the smaller the amount of dividend paid out. The higher the dividends cover,
the more likely it is that the current dividend can be sustai
sustained
ned in the future and if
dividend cover is higher than the local average, it means that the company may
probably maintain dividends in the future. Thus, a higher dividend cover indicates
that only a small portion of earnings has been distributed as dividends
dividen while a
substantial portion has been ploughed back into the business.

DIVIDEND PAYOUTS
Dividend payout ratio is the percentages of earnings paid by ordinary shares as way of
dividends and thus, it a reciprocal of dividend cover.

Dividend payment ratio= DPS X 100

EPS 1
Dividend payment ratio= 11.25 X 100 10.60 X 100
12.94 1 16.08 1
= 86.9% =65.9%

115
• An investment ratio which relates the dividends announced for the period to the earnings
available for dividends which were generated in that period is: A. Dividend payout
ratio. B. Dividend per share. C. Earnings per share. D. Earnings cover ratio
o ANS: A
• Which of the following is not an investment Ratio
A. Quick Asset Ratio
B. Dividend Cover
C. Earnings Yield
D. Dividend per share
o ANS: A-Quick Asset Ratio
6.5 LIMITATIONS OF FINANCIAL RATIOS
1. Changing price levels may invalidate attempts to compare ratios over years
2. Use of different accounting policies may render inter-firm comparison less meaningful.
3. In some cases, ratios may be interpreted differently by different users of accounting
information.
4. Calculation of ratios from historical figures renders then less useful for making future
decisions
5. Ratios are less useful unless they are supported by some other qualitative information.
This is because, not all information about a business is fully reflected in its financial
statement.
6.5.1 Comparisons of Financial Ratios of Companies in the Same Industry
Making comparisons between the results of different companies in the same industry is a
way of assessing which companies are outperforming others.
a. Even if two companies are in the same broad industry (for example retailing) they might
not be direct competitors. For example, Woolworths does not compete directly with
Sainsbury’s. Even so, they might still be expected to show broadly similar
performance, in terms of growth, because a boom or a depression in retail markets
should affect all retailers in much the same way. The results of two such companies

116
 can be compared, and the company with the better growth and accounting might be
considered more successful than the other.
b. If two companies are direct competitors, a comparison between them would be
particularly interesting. Which has achieved the better ROCE, ssales
ales growth, or profit
growth? Does one have a better debt or gearing position, a better liquidity position
or better working capital ratios? How do their P/E ratios, dividend cover and
dividend
ividend yields compare? And so on.
Comparisons between companies in tthe
he same industry can help investors to rank them in
order of desirability as investments, and so judge relative share prices or future
prospects. It is important, however, to make comparisons with caution: a large
company and small company in the same indu
industry
stry might be expected to show
different results, not just in terms of size, but in terms of:
a. Percentage rates of growth in sales and profits;
b. Percentage of profits re-invested.
invested. Dividend cover will be higher in a company that needs
to retain profits to finance
ance investment and growth;
c. Fixed assets. Large companies are more likely to have freehold property in their balance
sheet than small companies

SUMMARY
In this Study Session,, you were exposed to the concept of ratios analysis and its
interpretation. Comparing
aring ratios over time within the same business to establish
whether the business is improving or declining, and comparing ratio between similar
businesses to see whether the company you are analyzing is better or worse than
average within its own business sector. Ratio analysis on its own is not sufficient for
interpreting company accounts and there are other items of information which
should be looked at. A company must be able to pay its debts when they fall due,
and in the balance sheet, foreseeable cre
creditors
ditors to be paid are represented by current
liabilities, that are amounts falling due with one year. If an analysis of a company’s

117
 published accounts is to give us some idea of the company’s liquidity, profitability
ratios are not going to be appropriate for doing this. Instead, we look at liquidity
ratios and working capital turnover ratios.
SELF ASSESSMENT QUESTION
SAQs 6.1 (Test learning outcomes of 6.1, 6.2, 6.3, 6.4,6.5)
1. A firm has a (net profit/pretax profit) ratio of 0.6, a leverage ratio of 2, a (pretax
profit/EBIT) of 0.6, an asset turnover ratio of 2.5, a current ratio of 1.5, and a return
on sales ratio of 4%. What is the firm’s ROE? A. 4.2% B. 5.2% C. 6.2% D. 7.2%
2 Edet Farm Supplies has an 8percent return on total assets of N300,000 and a net profit
margin of 5percent. What are its sales? A. N3,750,000 B. N480,000
C. N300,000 D. N1,500,000
3 A firm's current ratio is above industry average; however, the firm's quick ratio is below
industry average. These ratios suggest which of the following?
A. The firm has relatively more total current assets and even more inventory than other firms
in the industry. B. The firm is very efficient at managing inventories. C. The firm
has liquidity that is superior to the average firm in the industry. D. The firm is near
technical insolvency.
4 Inter-Firm analysis could be rendered invalid by;
A. The use of different accounting dates by the various companies B. Application of
different accounting policies C. Operating in different market segments D. The
differences in the management structures and technical expertise E The product
range and sales mix variations among the companies
SAQs 2 Activity Ratio (Test learning outcomes of 6.4.2, 6.4.3, 6.4.4)
The table below shows selected data from XYZ Limited’s financial statements:
2010 2011
Sales 9,800 10,500
COGS 6,100 6,700
Purchases 6,000 6,600
Inventory 2,400 2,370
Accounts receivable 3,900 4,400
Accounts payable 2,300 2,400
5. What is XYZ’s receivables collection period for both 2010 and 2011? (Assume 365 days
in a year). 2010 2011 A. 40 days 42 days B. 145 days 153days C. 233 days 239 days
D. 237 days 243 days
6. What is XYZ’s inventory turnover for 2010 and 2011? A. 2.10 2.33 B. 2.54 2.83 C. 3.43
3.58 D. 4.08 4.43
7. What is the working capital cycle for XYZ in 2011(assume 365 days in a year)?
A. 42 days B. 101 days C. 149 days D. 243 days
8. You are told that XYZ’s payables period dropped from 140daysin 2010to 133days in
2011. What is the most likely impact of this on the liquidity position of XYZ
Limited?

118
A. It will result in an improvement in the liquidity position. B. It will impact the liquidity
position negatively. C. It has no impact on the liquidity position. D. None of the
above

119
SAQs 6.3 Investment Ratio (Test learning outcomes of 6.4.4)
An analyst gathered the following information on Ajasco Limited.
Share price N 50.00
Shareholders’ Equity N 200 million
Retention rate 60%
Shares outstanding 20 million
Expected sales N 80 million
Total operating expenses N34 million
Profit after tax N10 million
Note: Operating expenses include N4.0 million in depreciation and amortization. Use the
following data to answer Questions 1 to 6.
• 9.Ajasco’s book value per share is: A. N2.00 B. N5.00 C. N10.00D. N 12.00
• 10.Ajasco’s earnings per share is: A. N0.2 B. N0.5 C. N2.0 D. N10.0
• 11.Ajasco’s Price to book ratio is: A. N2.0 B. N3.0 C. N4.0 D. N5.0
• 12.Ajasco’s Price/earnings ratio is: A. 10 times. B. 20 times. C. 50 times. D. 100times.
• 13. Ajasco’s dividend payout ratio is: A. 0.2 B. 0.4 C. 0.6 D. 0.8
• 14.Ajasco’s cash flow per share is: A. N2.0 B. N2.5 C. N3.0 D. N4.0

120
 REFERENCES
Copeland T.E. and J.F. Weston., Financial Theory and Corporate Policy ( 3rd ED), Addison –
Wesley, 1998
Gordon, M.J; The Investment, Financing and valuation of the Corporation, Irwin,
Homewood, Illinois, 1962.
ICAN (2009) Study Pack on Financial Reporting and Ethics; VI Publishers,
Owualah, S.I Understanding Business Finance, G
G-Mag
Mag Investments Ltd (Educational
publishers), Lagos, 1997.
R. Charles Moyer el at( 1981): "Contemporary Financial Management".
Management".West
West Publishing
Company.
Reilly Frank, K. (1979); "Investment Analysis and Portfolio
PortfolioManagement".Hindsdille
Management".Hindsdille III,
Dryden Press.

Robicheck Alexander A and Stewar C.Keyes (1967): "Optimal

"OptimalFinancing
Financing Decision.
Englewood. N.J,

Should you require more explanation on this study session, please do not hesitate to contact
your e-tutor via the LMS.

Are you in need of General Help as regards your studies? Do not hesitate to
contact the DLI IAG Center by ee-mail
mail or phone on:

iag@dli.unilag.edu.ng
08033366677

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 STUDY SESSION 7

ANALYSIS OF FINANCIAL DECISION

INTRODUCTION
In Study Session 2,, we have discussed about investment decisions as the first financial
financi
decision making in finance. Investment decision captures the risk under the
condition of certainty and uncertainty of a project. In reality, however, a large area
of investment decisions falls in the realm of risk and uncertainty. It is important to
notee that risk and uncertainty go hand in hand. Wherever there is uncertainty, there
is also risk. In this Study Session
Session,, however, we will concentrate on the popular
methods of investment decision
decision-making. Each investment proposal should be
assessed on the basis of its ability to achieve the minimum expected return by the
providers of the funds that will be channeled to that proposal. Also, in
i theory, a
number of techniques are suggested to handle risk. Som
Somee of these include:
Simulation techniques, sensitivity analysis,and standard deviation, co-efficient
co of
variation and decision trees. It is important to emphasize that we implore Net cash
flow in evaluating the payback period and Net present value and not the accounting
profit.

Learning objectives
After studying this chapter, readers should able to:
7.1 Define capital expenditure and state how it is imperativeto
to the company;
7.2 State and explain the stages involved in capital expenditure planning and control:
7.3 Know the benefits of capital expenditure planning
7.4 Identify the capital investment appraisal techniques available to a company;
7.5 Appraise a typical project using appropriate technique; and
7.6 Advise on the selection of a suitable project based on agreed decision criterion
7.7 Evaluate investment projects using traditional method of investment appraisal;
appraisal

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7.8 Carry out sensitivity analysis of a projects outcomes
7.9 Calculate the expected net present value (ENPV) of projects;
7.10 Discuss and state the qualitative factors affecting capital investment decisions.

7.1 CAPITAL EXPENDITURE PLANNING AND CONTROL

Capital expenditure is a means of planning and control in an organisation, it involves
decision on whether or not to acquirenon-current assets and other long-term projects
of the company. Capital expenditure includes all tangible and intangible assets
which are expected to produce benefits to the firm over a period of time (not less
than one year). These are critical decisions to the future profitability and success of
the company. Pandey (1989) defined capital expenditure planning and control as “a
process of facilitating decisions covering expenditure on long-term assets”. Such
investment includes purchase of equipment, acquisition of land and buildings,
introduction of new products and so on. Investment decisions are expected to yield
economic benefits to the investor at some other point in time. Usually the outlay
precedes the benefit.Investment decisions tend to be of crucial importance and
integral part of the corporate plan of an organisation.
7.2 THE CAPITAL BUDGETING PROCESS INCLUDES:
a. Identification
b. Development
c. Evaluation
d. Authorization, and
e. Control

7.2.1 Identification of Investment Opportunities

The most critical aspect of investment process is the Identification of investment proposals
and should be guided by the overall strategic considerations of a firm because it will
involve the development of cash estimates. Once the investment proposal has been
identified, each potential idea should be developed into a project and submitted for

123
 appraisal to determine its viability and worthiness. In this respect, there would be a
need to consider all cash flows, to determine the true profitability of the project.A
sound appraisal technique which should maximize the shareholders wealth should
be used to measure the economic worth of the projects.

7.2.2 Developing Cash Flow Estimation

Estimation of cash flow in a reporting entity is a difficult task because the future is uncertain.
The risk associated with cash flows should be handled properly, by eliminating the
risk factor and taken into account the decision process in the estimation of cash
flows. This therefore, requires collection and analysis of cash flows for all
quantitative and qualitative data. The next process is the evaluation of the net
benefits.

7.2.3 Evaluation of Net Benefits

In selecting a method or methods of investment evaluation, a company should take adequate
care to ensure that the criteria selected would lead, to the net increase in the
company’s wealth, that is, its benefit exceeds, its cost adjusted for time value and
risk. We can employ the net present value method and other forms of investment
appraisal to determine the suitability of the project. However, other methods in use
apart from the NPV are the payback period, the internal rate of return (IRR),
accounting rate of return (ARR) and profitability index (PI). Therefore we apply the
use of a minimum required rate of return.
• When managers are making decisions involving capital investments, what should the
decision seek to achieve?
o ANS; Investment decisions must be consistent with the objectives of the particular
business. For a private sector business, maximizing the wealth of shareholders is
usually assumed to be key objective.
7.2.4 Authorization to Spend

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The approval of acquisition of capital project depends on the reporting entity. When large
sums of capital expenditure are involved, the authority for the final approval may
rest with the Board or the top management which may be the Chief Executive of the
company. Funds are usually appropriated for capital expenditure from the capital
budget after the final selection of investment proposals. Meanwhile top management
is to ensure that funds are spent in accordance with appropriations made in the
capital budgetand thus, approving investment proposal differs from one company to
another.

7.2.5 Control and Monitoring of Capital Projects

A capital project reporting system is required to review and monitor the performance of
investment projects during and after completion. This is also a meansof comparing
the actual performance with original estimates and any deviation will be corrected
by control measures. It will require regular reporting monthly, quarterly or half-
yearly.

7.3 INVESTMENT APPRAISAL TECHNIQUES

The essential feature of investment decision is time. Investment decisions affect the value of
the firm and this will increase, if investments are profitable and add to shareholders’
wealth. It is, therefore, important to ensure that investments are evaluated on the
basis of criteria which are compatible with the objective of the shareholders’ wealth
maximization. The investment appraisal examine the different methods of selecting
investment in long-term assets, that is, capital expenditure, to be able to determine
the most valid technique of evaluating an investment project.
Investment decisions taken under uncertainty are necessarily subjective. However, analysts
have devised some decision rules to impart some objectivity to the subjective
decisions, provided decision makers are able to identify the possible states of nature
and can estimate the outcome of each strategy.The methods of measuring
investment appraisal can be divided into two as follows;
Non-Discounted Cash Flow Techniques

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 Discounted Cash Flow Techniques
7.3.1 Non-Discounted Cash Flow Techniques
The non-discounted cash flow technique is one of the traditional methods of investment
appraisal which does not consider time value of money and these include:
a. Payback period (PB); and
b. Accounting rate of return (ARR)
• The essence of discounting is to take care of… (a) inflation (b) uncertainty (c) timing of
cash flows (d) amount of cash flows (e) taxation of cash flows
o A
PAYBACK PERIOD TECHNIQUE
Payback period tells us the number or length of time an investment will recoup back its
initial investment and also, its cash outflows will equate the cash inflows from a
project. This technique measures projects on the basis of the period over which the
investments payback itself or the period of recovery of the initial investment. This
means that the full recovery of the projects cash outflows would be measured
through the cash inflows. This method pays attention to the shortness of the project
that is, the shorter the period of recovery of initial investment or capital outlay, the
more acceptable the project becomes using the payback period. Where there is
constant or uniform cash income stream or annual net cash flows from a project, the
payback period is calculated thus:-
Payback period = Initial investment (capital outlay)
Annual net cash flow
DECISION RULE
If the payback period calculated for a project is less than the maximum or standard
payback period set by management it would be accepted, if not, it would be rejected.
If the firm has to choose among two mutually exclusive projects, the project with shorter
payback period will be selected.
ADVANTAGES OF PAYBACK METHOD
i. It is simple to calculate and better understood of all the methods of capital budgeting.

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 ii. It least exposes the firm to the problem of uncertainty since it focuses on shortness of
project to pay back the initial outlay.
iii. It is a fast screening technique especially for the firms that have liquidity problems
DISADVANTAGES OF PAYBACK METHOD
i. It does not take account of the cash inflows earned after the payback period
ii. It does not take into account the time value of money
iii. It does not take into account the risk associated with each project and the attitude of the
company to risk.

ILLUSTRATION 1
DAAP Ltd, a manufacturing company, is faced with the problem of choosing between two
mutually exclusive projects.
Project A requires a cash outlay of N 250,000 and generates a net cash flow of N 100,000 per
year for 4 years.
Project B costs N 150,000 and its expected net cash flow of N 65,000 N 55,000, N 40,000
and N50,000 over its life of 4 years. If the management of the company had set the
maximum acceptable period of 2½ years, which of the projects should be embarked
upon?
SOLUTION 1
Project A
Payback Period = Initial capital outlay
Annual net cash flow
= N 250,000
N 100,000 = 2½ years
Project B
Year Net cash flow Cumulative net cash flow
N N
0 (150,000) (150,000)

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 1 65,000 (85,000)
2 55,000 (30,000)
3 40,000 10,000
4 50,000 60,000
30,000
Payback period = 2yrs + 40,000 x 12 in months
= 2yrs 9 months
Decision: Since the maximum acceptable period set by the management is 2½ years, only
project A meets the acceptance criteria and should be accepted while project B
should be rejected.

a. ACCOUNTING RATE OF RETURN (ARR)

The Accounting Rate of Return (ARR) technique is derived from the concept of return on
capital employed (ROCE) which is also known as return on investment (ROI). It
uses accounting information provided by the financial statements to measure the
profitability of an investment. It is calculated by dividing the average after-tax profit
by the average book value of the investment during its life. Therefore, it uses
accounting profit by subtracting depreciation from net cash flows. The formula is:
ARR = Average Income x 100%
Average investment 1
Decision Rule
The rule is to invest in all projects whose accounting rate of return (ARR) is higher than
the company’s pre-determined minimum acceptable rate.
Where mutually exclusive project are concerned, the rule is to accept the project with the
highest ARR.

ADVANTAGES OF ACCOUNTING RATE OF RETURN

i. It is easy to calculate
ii. It is simple to understand and use
iii. It incorporates the entire stream of income in calculating the project’s profitability

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 DISADVANTAGES OF ACCOUNTING RATE OF RETURN
i. It uses accounting profits in appraising the projects
ii. The averaging of income ignores the time value of money
iii. It uses an arbitrary cut off yardstick
iv. It is an average concept and as such will hide the sizes and timing of the individual cash
flows.
v. It does not take into considerations the risk associated with each project as well as the
attitude of the management to risk.
vi. There is no unique definition for ARR. For instance “average profit” may be profits after
depreciation, interest and before tax or profits after depreciation, interest and tax
which is adopted in the illustration 9-2. Initial investment could be initial investment
plus scrap value or just investment which is adopted in the illustration.
• What is another name for Accounting Rate of Return in investment appraisal?
o ANS; Return on Capital Employed or Return on Investment

ILLUSTRATION 2
Asua invested the sum of N800,000 in a KALOKA project. He estimates that the project will
yield the following after tax returns annually for the next five years, vizN20,000,
N40,000, N60,000, N80,000 and N120,000 respectively. The Kaloka house is
expected to be depreciated on a straight line basis.
Required
Provide the accounting rate of return of this project.
Solution 2
AlhajiUmoru
Year 1 2 3 4 5 Average
Earnings N N N N N N
After tax 20,000 40,000 60,000 80,000 120,000 64,000
Book value of
invest
ment

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Beginning (a) 800,000 640,000 480,000 320,000 160,000
Depreciation (160,000) (160,000) (160,000) (160,000) (160,000)
End (b) 640,000 480,000 320,000 160,000 ---
Average a+b 720,000 560,000 400,000 240,000 80,000 400,000
2
Accounting Rate of Return = 64,000x 100%
400,000 1 = 16%
• Which ONE of the following is not advantage of accounting rate of return? (a) easy to
calculate (b) simple to understand and use (c) inexpensive as it uses existing
accounting information (d) incorporates entire stream of income (e) it takes into
account the time value of money
o E

7.3.2 Discounted Cash Flow (DCF) Techniques

These include
a. Net present value (NPV);
b. Internal rate of return (IRR);
c. Profitability index (PI); and
d. Discounted payback period.
In evaluating an investment, three steps are involved, these are:
Estimation of cash flows;
Estimation of the required rate of return (opportunity cost of capital); and
Application of a decision rule for making the choice
a. NET PRESENT VALUE (NPV) METHOD
Net present value (NPV) is one of the discounted cash flow (DCF) techniques that
recognizes the time value of money. It is the net contribution of a project to its
owner’s wealth, that is, the present value of future cash flows minus the present
value of initial capital investment. With the present value method, all cash flows are
discounted to their present values using the required rate of return. The formula for
calculating NPV can be written as follows:

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 NPV = C1 + C2 + C3 +……Cn -C0
(1+r) (1+r)2 (1+r)3 (1+r)n
OR
n

NPV = ∑C
t =1
t - C0

(1 + r)
Where:
C1, C2 …. Represent cash inflows in year 1,2…..n
“r” represents the opportunity cost of capital
C0 is the initial cost of the investment
n is the expected life of the investment and
t=1 up to and include t=n
Decision Rule:
Accept all projects that produce positive net present value (NPV)
Accept if NPV > 0
Reject if NPV < 0
May accept or reject if NPV = 0
If mutually exclusive projects are involved, the rule is to accept the project that produces the
highest positive net present value which will increase the wealth of a shareholder

• A company intends to undertake an investment programme which has initial amount of

N2.5m. The program is expected to generate annual net cash inflows of N270, 000
for an indefinite future period. The company’s opportunity cost of fund is 12 percent
per annum. What is the net present value of the project? (a) N2,550,000 (b)
N2,000,000 (c) N2,450,000 (d) (N250,000) (e)N2,350,000
o ANS; D

ADVANTAGES OF NPV
i. It recognizes the time value of money;
ii. It uses all cash flows occurring over the entire life of the project;

131
iii. It measures in absolute terms (Naira value) the increase in the wealth of the shareholders;
and
iv. It facilitates measuring of cash flows in terms of present values. This implies that if the
values of separate assets are known, the firms value can simply be found by adding
their values. This is called the value-additivity principle.

DISADVANTAGES OF NPV
i. It is more difficult to calculate than the Payback and the Accounting Rate of Return
(ARR); and
ii. It relies heavily on the correct estimation of the cost of capital, that is, where errors occur
in the cost of capital used for discounting, the decision would be misleading.
ILLUSTRATION 3
A machine costing N200,000 will provide an annual net cash inflow of N60,000 for six years
at a cost of capital of 10 percent.
i. Calculate the net present value (NPV) of the machine
ii. Should the machine be purchased?

SOLUTION 3
(i) Year Cash flowsDCF PV
N @ 10% N
0 (200,000) 1.000 (200,000)
1 60,000 0.909 54,540
2 60,000 0.826 49,560
3 60,000 0.751 45,060
4 60,000 0.683 40,980
5 60,000 0.621 37,260
6 60,000 0.564 33,840
NPV 61,240
(ii) Decision: The machine should be purchased since the NPV is positive, that is NPV>0.
• What is the economic implication of a project that has a positive Net Present Value..
o For a project to have positive Net Present Value it will increase the wealth of a
shareholders

b. INTERNAL RATE OF RETURN (IRR)

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The internal rate of return (IRR) method is another discounted cash flow technique which
takes account of the time value of money. It is also known as yield of a project,
marginal efficiency of capital, rate of return over cost, time adjusted rate of internal
return and so on. It is defined as the cost of capital for which the NPV of a project
would be zero.
It is a break-even point cost of capital and it also serve as the cost of capital or discount rate
that will equate the cash inflows of a project with the cash outflows of that project.

The formula for calculating the IRR is given as:

n

IRR = ∑C
t =1
t - C0= 0

(1 + r) t

The above formula shows that it is the same as that for calculating NPV. The only difference
is that in NPV method, the required rate of return is assumed to be known while in
IRR method the required rate of return has to be determined, hence, the result is
equated to zero. An alternative to the above formula is the trial-and-error. This is
also known as interpolation method. In this method, the discounting factor yielding
a positive
NPV is improved to move towards negative and a midway is discovered to arrive a zero.

The formulae:
IRR = Ld+ NPV’ (Hd -Ld)
NPVp+ NPVN
Where:
Ld= Lower Discount factor yielding positive NPV
Hd = Higher Discount factor yielding negative NPV
NPVP = Positive NPV
NPVN = Negative NPV
DECISION RULE
Accepts all projects whose IRR are greater than the company’s cost of capital

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 i.e. Accept if r>k
Reject if r<k
May accept or reject if r=k
Where r= internal rate of return and k= cost of capital
If mutually exclusive projects are being considered the rule is to accept the project that
produces the higher IRR.
ADVANTAGES OF IRR
i. It recognizes the time value of money;
ii. It considers all cash flows occurring over the entire life of the project;
iii. It gives the same acceptance rule as the NPV method
iv. It is consistent with the shareholders wealth maximization objective
DISADVANTAGES OF IRR
i. It is more difficult to calculate than the other methods.
ii. It can give misleading and inconsistent results when the NPV of a project does not decline
with discount rates.
iii. In some cases, it fails to indicate a correct choice between mutually exclusive projects.
iv. Unlike in the case of NPV, the additivity principle does not hold when IRR method is
used – IRR projects do not add.
v. Sometimes, it yields multiple rates
• What is the discount rate at which Net Present Value equals zero
o ANS; Internal Rate of Return

ILLUSTRATION 4
Using the details in illustration 3, calculate the IRR of the machine
SOLUTION 4
Year Cash flows DCF PV DF @ 20% PV
N @ 10% N N N
0 (200,000) 1.000 (200,000)1.000 (200,000)
1 60,000 0.909 54,5400.833 49,980
2 60,000 0.826 49,560 0.694 41,640
3 60,000 0.751 45,0600.579 34,740
4 60,000 0.683 40,980 0.482 28,920
5 60,000 0.621 37,260 0.402 24,120
6 60,000 0.564 33,840 0.335 20,100

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 NPV 61,240 (500)

IRR = 10% +N61,240 x (20% - 10%)

N61,240 – (-500) 1
= 10% + N61, 240 x 10%
N61, 740
= 10% + 9.92%
IRR= 19.92%
• Which of the following is regarded, in theory as a traditional technique of investment
appraisal? (a) accounting rate of return (ARR) (b) internal rate of return (IRR) (c)
discounted payback (d) net present value (NPV) (e) profitability index (PI)
o ANS; B

c. PROFITABILITY INDEX (PI) TECHNIQUE

The profitability index (PI) method is another cash flow technique. It is the ratio of the
present value of cash inflows, at the required rate of the investment. It may be gross
or net that, gross minus one.
The formula is given as follows:
PI = PV of cash inflows (NPV + Initial cash outlay)
Initial cash outlay
OR
PI = NPV of Project
Initial Cash Outlay
DECISION RULE
Accepts all projects whose PI is positive or greater than 1 (one)
i.e. Accept if PI>0 or positive
Reject if PI<0 or negative
May accept or reject if PI=0
ADVANTAGES OF PI
i. It recognizes the time value of money;
ii. It is a variation of the NPV method and requires the same computation as in the NPV
method

135
iii. It is a relative measure of a project’s profitability since the present value of cash inflows is
divided by the initial cash outflow.
iv. It is generally consistent with the wealth maximization principle.

DISADVANTAGES OF PI
i. It can only be used to choose projects under simple, one period capital constraint
situations.
ii. It does not work when mutually exclusive projects or dependent projects are being
considered.

ILLUSTRATION 5
Using the details in illustration 3 calculate the PI of the machine
SOLUTION 5
PI = NPV of Project = N61,240 = 0.31
Initial Cash Outlay N200,000

OR

PI = PV of cash inflows (NPV + Initial cash outlay)

Initial cash outlay

= N61,240 + N200,000
N200,000

= N261,240 = 1.31
N200,000

d. DISCOUNTED PAYBACK PERIOD TECHNIQUE (DPPT)

This technique is an improvement over the payback method. It is aimed at overcoming the
problem of the time value of money disadvantage of the normal payback method, by
incorporating into its calculation, the discount factor. In the discounted payback
period method, the cash flows are discounted and used in the calculation of the
payback period.

ADVANTAGES OF DISCOUNTED PAYBACK PERIOD TECHNIQUE

136
 i. It recognizes the time value of money
ii. It focuses on shortness of project to payback the initial outlay
iii. In addition to the fact that it recognizes the time value of money, it has all the advantages
of the payback method.

DISADVANTAGES OF DISCOUNTED PAYBACK PERIOD TECHNIQUE

i. It does not take into account the cash inflows earned after the payback period
ii. It does not take into account the risks associated with each project and the attitude of the
company to risk.
iii. Except that it uses discounted cash flows, it has all the disadvantages of payback method.
• One of the traditional methods of capital budgeting decision criteria is… (a) net present
value (b) accounting rate of return (c) profitability index (d) internal rate of return
o ANS; B
• …….. Is the number of timesthat an investment will recoup back its initial capital outlay?
o ANS; PAYBACK PERIOD

ILLUSTRATION 6
A machine will cost N300,000 and will provide an annual net cash inflow of N100,000 for
five (5) years. The opportunity cost of capital is 10 percent.Calculate the discounted
payback period of the machine
SOLUTION 6
Cash year Cash Flows DF @ 10% PV of Cash Flows
N N
0 (300,000) 1.000 (300,000)
1 100,000 0.909 90,900
2 100,000 0.826 82,600
3 100,000 0.751 75,100
4 100,000 0.683 68,300
5 100,000 0.621 62,100
NPV 79,000
Therefore, discounted payback period method, the time required to recover the investment is
calculated as follows:
Year PV of cash flows cumulative PV of Cash Flows

137
 N N
0 (300,000) (300,000)
1 90,000 (209,100)
2 82,600 (126,500)
3 75,100 (51,400)
4 68,300 16,900
5 62,100 79,000
Discounted payback is 3yrs + 51,400 x 12 months
68,300
= 3yrs + 9.031 months = 3yrs 9 months.

7.4 CAPITAL BUDGETING INVOLVING RISK AND UNCERTIANTY

Uncertainty and risk analysis in capital investments decision play a vital role because the real
economic worth of a project cannot be properly determined if they are not
considered. The concepts of risk and uncertainty can be better explained and
understood in contrast to the concept of certainty
7.4.1 Uncertainty
Uncertainty can be describedas a situation where there is no such knowledge of
probabilities about the future outcomes.Here, let us have a closer look at the
concept ofcertaintyand this is the state of perfect knowledge about the market
conditions. In the state of certainty, there is only one rate of return on the investment
and that rate is known to the investors. However, uncertainty refers to a situation in
which there is more than one outcome of a business decision and the probability of
no outcome is known or can be meaningfully estimated. The unpredictability of
outcome may be due to lack of reliable market information, inadequate past
experience and high volatility of the market conditions. For example, if an Indian
firm, highly concerned with population burden on the country, invents an
irreversible sterility drug, the outcome regarding its success is completely
unpredictable.
Consider the case of insurance companies. It is possible for them to predict fairly accurately
the probability of death rate of houses, and so on, but it is not possible to predict the

138
 death of insured individual. Therefore, long-term investment decisions involve a
great deal of uncertainty with unpredictable outcome. But, in reality, investment
decisions involving uncertainty have to be taken on the basis of whatever
information can be collected, generated and estimated. For the purpose of decision
making, we need to assign an a priori probability to the outcome.
• One of the basic characteristics of capital budgeting decision is that……. (a) decision on
its reversible (b) the minimum life span of the project may be two years (c) the
amount involved is huge in size (d) the amount involved is small in size
o ANS; C

7.4.2 RISK
Risk is a situation in which various outcomes to a decision are possible and the probabilities
to those alternative outcomes are known. From business decision-making point of
view, risk refers to a situation in which a business decision is expected to yield more
than one outcome and the probability of each outcome is known to the decision
makers or can be reliably estimated. In common parlance, risk means a low
probability of an expected outcome.For example, if a company doubles its
advertisement expenditure, there are three probable outcomes: (i) its sales may
more-than-double, (ii) it may just double, or (iii) may be less than double. The
company has the knowledge of these probabilities or has estimated the probabilities
of the three outcomes on the basis of its past experience as (i) more-than-double –
10% (or 0.1), almost double – 40% (or 0.4), and (iii) less than double – 50% (or
0.5). It means that there is 90% risk in more than- doubling the sales, and in
doubling the sale, the risk is 60% and so on.

7.5 METHODS OF TREATING RISK IN CAPITAL BUDGETING

The method for treating risk assessment in capital budgeting involves the
probabilityapproach and Non-probability approach. The probability approaches can
be divided to capture Expected Value, variance, standard deviation, Co-efficient of
Variation, Risk adjusted discount rate certainty co-efficient factor.

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7.5.1 Expected Value
The expected value is the process of multiplying the various cash income stream with their
respective profitability level and it serves as the best measure of central tendency.
The decision making it accepts project with the highest expected value for a
mutually exclusive project.

7.5.2 Variance
The variance of a project measures the extent of risk that is associated to project. Variance is
the deviation of the expected value from the cash flows and multiplies by the
probabilities of the risk factors and finds the summation. It measures the extent of
risks associated to a project and the decision under this approach depends on the
type of investors. For a risk neutral investor, it will want to take a lower risk with a
low return, for Risk averters, he will takes some risks with higher return and for a
risk lover or seeker the higher the risk, the higher the return.

7.5.3 Standard Deviation and Variance

Standard deviation is an absolute measure of risk. It measures the dispersion of cash flow or
the spread about the mean value. TheStandard deviation is a proxy measure of total
risk for the investment and takes no account of possible offsetting variations in other
projects that may be undertaken by the same investor.Therefore, it serves as the best
measure of dispersion and thus,standard deviation is the square root of variance.
• What is the best measure of dispersion and the instrument for measuring risk
o ANS; Standard deviation
ILLUSTRATION 7
Suppose a firm has to choose between two mutually exclusive projects that cost N3 million
each. The following are the possible net cash flows of the project and their
associated probabilities, viz:
Project X Project Y

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Probability NCF Probability NCF
N ‘000 N ‘000
0.10 3,000 0.10 2,000
0.20 3,500 0.25 3,000
0.40 4,000 0.30 4,000
0.20 4,500 0.25 5,000
0.10 5,000 0.10 6,000
Determine the standard deviation and variance of each project and advise which of them is
preferable.

SOLUTION
Project x
Probability NCF (x) Expected (x − x) (x − x) 2 P (x − x) 2
value
N ‘000 N ‘000 N ‘000 N ‘000 N ‘000
0.1 3,000 300 (1,000) 1,000,000 100,000
0.2 3,500 700 (500) 250,000 50,000
0.4 4,000 1,600 0 0 0
0.2 4,500 900 500 250,000 50,000
0.1 5,000 500 1,000 1,000,000 100,000
Expected value (EV) x 4,000 300,000

The expected value of project X is N 4000

Variance of X is N 300000
Standard deviation of Project x = √ N 300,000 = N547.72
Project ‘Y’
Probability NCF (x) Expected (x − x) (x − x) 2 P (x − x) 2
value
N ‘000 N ‘000 N ‘000 N ‘000 N ‘000
0.1 2,000 200 (2,000) 4,000,000 400,000
0.25 3,000 750 (1,000) 1,000,000 250,000
0.30 4,000 1,200 0 0 0
0.25 5,000 1,250 1,000 1,000,000 250,000
0.10 6,000 600 2,000 4,000,000 400,000
Expected value (EV) x 4,000 1,300,000
The expected value is N4000
Variance of the project is N1300000
Standard deviation of Project Y = √ N 1,300,000 = N 1,140.18

7.5.4 Co-Efficient of Variation

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Co-efficient of variation is a relative measure of risk. It serves as most reliable method of
assessing the riskiness of project under consideration because it considers the best
measure of dispersion and prorate with the best measure of central tendency.
Therefore, it is simply the ratio of standard deviation of possible outcome divided
by its expected value, depicted by the following formula:
Co-efficient of variation = Standard Deviation X 100
Expected Value 1
Decision for an independent project, the lower the co-efficient of variation the less risky is
the project and the lower the risk. For a mutually exclusive project, we accept a
project that has the lowest co-efficient of variation.

ILLUSTRATION 8
Using illustration 12-4, compute the co-efficient of variation for the two projects.
Suggested solution
Project X
= 547.72 X 100 = 0.13693
4,000 1

Project Y
= 1140.18 X 100 = 0.2850
4,000 1
Using this concept, the lower risk of project ‘X’ has been confirmed. Since both projects will
yield the same positive expected value, the firm should choose the project which is
less risky. This is project x.

7.5.5 Risk Adjusted Discount Rate

The use of risk-adjusted discount rate is one of the methods used for adjusting the valuation
models for risk. The project risk effect is adjusted for in the discounting rate. For the
riskiness of a project, a risk premium is determined and added to the risk-free
discount rate. If, for instance, a firm evaluates its risk-free projects at 8% and
defines extra 4% for risk premium, risky projects will be evaluated at 12%.

142
This means that:
Risk-Adjusted Discount Rate = Risk Free Rate + Risk Premium
This is used in calculating the net present value (NVP).

7.6 QUALITATIVE FACTORS IN CAPITAL INVESTMENT DECISION

It is not simply the use of the most referred DCF techniques, (quantitative factors) that is
important in capital investment decisions, other practical considerations are as
equally important. In theory, the use of sophisticated techniques (DCF, IRR and so
on) is emphasized since they maximize shareholders wealth. However, in practice,
companies give considerable importance to qualitative factors. Since, the reliability
of figures could not be achieved without due considerations given to qualitative
factors and in this respect judgment play an imperative role. For example, vision of
judgment of the future plays an important role in factors like market potential,
possibility of changes in technology, trend of government policies and so on, which
are judgmental. Therefore, qualitative factors and judgment go together.
The qualitative factors to be considered in capital investment decisions include:
a. Adaptation to the changing market environment-market potential
b. Technological developing/ change or obsolescence. This plays a significant role in guiding
investment decisions
c. Employees morale and safety
d. Project’s critical utility in the production of main product
e. Strategic importance of capturing a new product first
f. Investors and customers image
g. Legal matters
h. Competitors
i. Risk involved in the project to be undertaken
j. Capabilities of management to cope with the implementation of the project

143
k. Consumer preference
l. Inflation
m.The environment in which the project is to be undertake
undertaken
It is, therefore, important for management to also spend time improving the quality of
assumptions and assuring that all the strategic questions have been asked before
taking final decisions on capital investments.

SUMMARY AND CONCLUSIONS

You have learnt
arnt the definition and stages of Capital expenditure,, which is for long-term
long
assets of the company both tangible and intangible et
etc.. Whereas, the expenditure on
these assets is now, returns are in the future. There is, therefore need for proper
planning and control. The planning and control process involves identification,
development, evaluation, authorization and control. You have been exposed to
various investment appraisals
appraisalsfor assessing project criterion under uncertainty and it
involves the special appraisal
ppraisal techniques such as payback period, net present values.
value
Here decisions have to be taken on whether or not a particular project is acceptable,
based on the use of an appropriate appraisal technique and on the laid down decision
criterion, such technique
ique includes the non
non-discounted
discounted cash flow techniques, namely:
the ARR and payback period and the discounted cash flow technique such as NPV,
IRR and PI. Also, you have been exposed to all these techniques which are methods
of incorporating risk into the aappraisal process, is the expected value,
value the standard
deviation
on and variance of the project. In addition to quantitative factors, finance
managers should also try to assess any qualitative benefits that accrue to a project
before
ore taking final decision. It is fundamental that a company uses the right
technique to avoid wrong decisions, bearing in mind the financial implication such
decisions can bring to the company. It should be noted that a project must first be
properly evaluated before selection. It is the acceptable project that is included in
the capital expenditure programme of the company for the year.

144
SELF ASSESSMENT QUESTIONS
The followings are the self assessment questions the whole of the study session 7 as thus;
1. The essence of discounting is to take care of… (a) inflation (b) uncertainty (c) timing of
cash flows (d) amount of cash flows (e) taxation of cash flows
2. Which of the following is regarded, in theory as a traditional technique of investment
appraisal? (a) accounting rate of return (ARR) (b) internal rate of return (IRR) (c)
discounted payback (d) net present value (NPV) (e) profitability index (PI)
3. A machine cost N3.4m. the machine is expected to produce an average annual cash flows
of N850, 000 with a nil salvage value. What is the expected payback period of the
machine if the economic useful life of the machine is 6 years? (a) 6 years (b) 4
years (c) 5 years (d) 3 years (e) 2 years
4. Which ONE of the following is not advantage of accounting rate of return? (a) easy to
calculate (b) simple to understand and use (c) inexpensive as it uses existing
accounting information (d) incorporates entire stream of income (e) it takes into
account the time value of money
5. A company intends to undertake an investment programme which has initial amount of
N2.5m. The program is expected to generate annual net cash inflows of N270, 000
for an indefinite future period. The company’s opportunity cost of fund is 12 percent
per annum. What is the net present value of the project? (a) N2,550,000 (b)
N2,000,000 (c) N2,450,000 (d) (N250,000) (e)N2,350,000
6. In carrying out sensitivity analysis of a project, what is being tested is……….. (i) The
impact of a change in output on input (ii) the impact of a change in more than one
input variable at a time on output (iii) The impact of a change in only variable at a
time on output (a) (i) only (b) (iii) only (c) (i) and (iii)(d) (i) and (ii) (e) (ii)
and (iii)
7. A project cost N8 million and it will generate cash profit as follows;
Year 1 – N3.2 million
Year 2 – N 3,250,000
Year 3 – N 3,300,000
Year 4 – N 3,350,000
Determine the project’s accounting rate of return (a) 30% (b) 31% (c) 32% (d) 33%
8. The Net Present value of a project has been estimated as follows
Discount Rate(%) Net Present Value (N,000)
20 25
22 15

145
Using the above data, determine the best approximation of the project’s internal rate of
return (IRR) (a) 22.67% (b) 21.09% (c) 20.6% (d) 21.25%
9. One of the basic characteristics of capital budgeting decision is that……. (a) decision on
its reversible (b) the minimum life span of the project may be two years (c) the
amount involved is huge in size (d) the amount involved is small in size
10. One of the traditional methods of capital budgeting decision criteria is… (a) net
present value (b) accounting rate of return (c) profitability index (d) internal rate
of return
11. The conflict between various capital budgeting decision criterions is always
resolved in favour of……… (a) net present value (b) accounting rate of return (c)
profitability index (d) internal rate of return
A project has a cost of N35,000 and it is expected net cash inflows are N 9,500 per annum
for six years. If the cost of capital is 14% from 12- 14
12. Calculate the project’s payback period to the nearest year (a) 3.68 years (b) 3.7
years (c) 4 years (d) 6 years
13. The project’s Net present value is (a) N 36,942 (b) N 81,087 (c) N 46,087 (d) N
1,942
14. The project’s profitability index is (a) 1.05 (b) 1.06 (c) 0.05 (d) 0.06

A project has the following expected cash flows over its 5-year life span
Year 0 1 2 3 4 5
Cashflow (N) -10,000 30,000 30,000 30,000 30,000 30,000
15. If the discount rate is 10%, determine the Net Present Value (NPV)
(a) N50,000 (b)N113,723.60 (c) N 83,153(d) N13,723.60

146
 REFERENCES
Copeland T.E. and J.F. Weston., Financial Theory and Corporate Policy ( 3rd ED), Addison –
Wesley, 1998
Gordon, M.J; The Investment, Financing and valuation of the Corporation, Irwin,
Homewood, Illinois, 1962.
ICAN (2009) Study Pack on Financial Reporting and Ethics; VI Publishers,
Igben, O. R. (2007) Financial Accounting Made Simple Vol 1. Lagos. ROL Publishers
Jennings, A. R Financial Accounting Manual (3rd ), D. P. Publications Ltd Grand Union
Industrial Estate, Unit 6 Abbey Road, London
L.Hand L.J Savage (1952); "Three Problems in Rationing Capital"Journal of Business, Vol.
7, March 77 – 99.
Levy H. and M Samat (1978): '"Capital Investment and Financial Decisions, N.J. Prentice -
Hall International.
Meyers S.C. (1977); "Determinants of Corporate Borrowing", Journal of Economics
November, 147-176.
Miller M.H and Franco Modigliani (1966): "Cost of Capital to ElectricUtility Industry"
American Economic Review, (56) June.
Modigliani F and M.H Miller (1963); "The Cost of Capital CorporationFinance and its Theory"
American Economic Review, June, 433 -443
Moyer Charles R et al (1981); "Contemporary Financial Management".West publishing Co.
New York.
Owualah, S.I Understanding Business Finance, G-Mag Investments Ltd (Educational
publishers), Lagos, 1997.
Pandey, I.M.; Financial Management (6th ED), Vikas Pushing House New Delhi, 1993.
Past Question and Answers on Financial Reporting and Ethics (FRE)
Van Horne, J.; Financial Management and Policy, (8th ED), Prentice Hall Inc, Englewood
Cliff, New Jersey, 1989.

147
Should you require more explanation on this study session, please do not hesitate to contact
your e-tutor
tutor via the LMS.

Are you in need of General Help as regards your studies? Do not hesitate to
contact the DLI IAG Center by ee-mail or phone on:

iag@dli.unilag.edu.ng
08033366677

STUDY SESSION 8:
MATHEMATICS OF FINANCE

INTRODUCTION
It is common in everyday transactions to determine how much a lump sum payment and
series of payments is worth in the future or in the present (today) at particular rates
of interest. This is our concern in this Study Session as we discuss the concept of
time value of money that borders on computing future and present values of fund. It
involves simple calculations using a few basic formulae that are relatively easy to
understand. In fact, you will have come across some of these interest calculation
formulae
ulae and problems in your previous study of elementary Arithmetic and
Mathematics. We will also take a look at some interesting applications of the
discounting and compounding concepts in transactions that involve accumulating
money for use in the future
future,, repayment of interest bearing loans and series of
payments that continue forever (perpetuities).

148
As noted above, you already have the basic calculation skills that would help you
comprehend and grasp the materials in this study session. It is really not heavy
mathematics, but simple calculations that involve use of interest rates that are
prevalent in everyday transactions.

LEARNING OUTCOMES
OUTCOMES;
After you have studying, this study session you should be able to;
8.1 Define concept
oncept of Time Value of Money
8.2 Calculate simple and compound
ompound Interest
8.3 Estimate the future
uture Value of a Lump Sum Payment
8.4 Calculate and make decision on the Present Value of a Single Amount
8.5 Estimate the future values
alues of Multiple Payments/Receipts
8.6 Calculate the Present Values of Multiple Payments/Receipts
8.7 Calculate the Present Value of a Perpetual Annuity
8.8 Multi Period Compounding and Effective Interest Rate per Annum
8.9 To compute the Compounding
ompounding Continuously
8.10 Apply Time Value of Money Concept Practical Problems

8.1 THE CONCEPT OF TIME VALUE OF MONEY

A basic concept in finance is that money has time value. In ootherr to make decisions
concerning present and future amount of money
money, it should be appreciated that the
value of money does not remain the same throughout time. A naira to be received
sometime in the future is not equivalent to a naira at hand today, because of the time
value of money. We can invest the naira available toda
todayy to earn interest, so that it
will increase in value to more than a naira in the future. Furthermore, future money
or cash flows are uncertain and might not materialize.. Anything can happen in the
future that can make it impossible to receive future expec
expected
ted money. Another reason
why the value of a naira today is worth more than a naira in the future is inflation.
Inflation will reduce the purchasing power of money in the future.

149
Consequently, one would rather receive a naira now than receive the same amount in the
future, even if we are certain of receiving it at the expected time. Interest is the
payment made for the use of money. Thus, an interest rate is the measure of the time
value of money. Time value of money is important in the savings and investment
process. The rest of this Study Session will discuss different concepts relating to
time value of money - simple interest, compound interest, future or compound
values and present values.
• Time value of money means (Option) time is important in business (Option) too much
time should be spent in a single transaction (Answer) one naira today cannot worth
the same value of one naira tomorrow (Option) none of the above.
o ANS; C

8.2 SIMPLE AND COMPOUND INTEREST

Simple interest is the interest earned on an initial amount invested (the principal). The
amount of principal and the interest payments remain the same from period to
period. The simple interest is computed as:
Simple Interest = Principal x Rate (% per year) x Time (in years) ( 8.1)

ILLUSTRATION 8.1
Adams and co. Ltd invests N10,000 at simple interest of 12 percent per year. What is the
amount of interest due to Adams and co. Ltd at the end of two years?
SOLUTION:
Simple Interest = Principal x Rate x Time
= N10,000 x 0.12 x 2
= N2,400

8.3COMPOUND INTEREST
The compound interest is the interest earned on the principal plus previously earned interest.
Interest is added to the principal as we earn it during any period. We then compute

150
 interest on the new balance (often called the compound amount) during the next
period. Frequency of compounding can take many firms such as daily, monthly,
quarterly, semiannually, or annually.

ILLUSTRATION 8.2
Let us assume that the investment of Adams and co. Ltd is the same as that described in
illustration 1 except that the interest is compounded annually. Calculate the total
interest for the two-year period.
SOLUTION:
The total interest for the two-year period can be calculated as:
(1) (2) (3) (4)
Year Balance at Compound interest (#) Balance at the end of the
Beginn (2) x 14% period (#)
ing (#)
1 10,000 1200 11,200
2 11,200 1344 12,544
In illustration 2, the total interest is #2,544 compared with the #2,400 computed in
illustration 8.1 earlier. The difference of #144 represents interest earned in the
second year on the first year’s interest (#1,200 x 0.12) and is the product of applying
compounding rather than simple interest. In most cases involving the time value of
money, compound interest is applicable, so our discussion in this Study Session will
be on compound interest.
Our understanding of time value of money will be developed further as we solved the
concepts of future values and present values. Also, the illustration 8.2 can be solve
through this formula Fv = Pv [1+r] n

8.4 FUTURE VALUE OF A LUMP SUM PAYMENT

As earlier discussed, an amount of money deposited in an interest yielding account today
will have a higher future value than an initial amount because of interest earned. The
future value of a lump sum (i.e., single amount) invested today can be computed as
follows;
FV = P(1 + r)n ………. 8.2

151
Where:
FV = Future value.
P = Present value of a single amount invested (principal).
r = Interest rate per annum.
n = Number of years.
The interest rate is normally expressed as an annual rate. However, interest is often
compounded more frequently - semiannually, quarterly, monthly or daily. In such
cases, the interest rate and number of periods must coincide with the compounding
schedule. For example, if we earn 12% per year interest over a two-year period with
semiannual compounding, the interest rate and number of periods used in the future
value formula are 6% and 4, respectively. This means that the annual interest rate
(12%)is divided by the number of times compounding takes place (2) within a year,
giving 6%. and the number of years (2) multiplied by the number of compounding
periods (2), giving 4 periods.
• The type of investment where the both the principal and interest will be re-invested to
generate a further profit is called
o ANS; Compound interest
The methodof compounding whereby the interest is prorated into semi-annually, quarterly
etc…….
o ANS; Multi-period compound interest

ILLUSTRATION 8.3
Calculate the future value of the investment of Adams of co. Ltd using compounding
formula:
SOLUTION
FV = #10,000 (1 + 0.12)2
= #12,544

152
As we discovered in illustration 8.3 the total value of Adams and co. Ltd’s investment at
maturity of #12,544 is the same as we computed earlier by adding the compound
interest to the principal.

8.4.1 Present Value of aSingle Amount

As noted earlier, money held today is worth more than the same amount of money received
in the future because of the time value of money. Consequently, the present value of
a given amount to be received in the future will be less than the future value. To find
the present value of a specific future amount, we must discount the future value with
an appropriate interest rate to the present. The interest rate involved is also called a
discount rate. Future value and present value have a reciprocal relationship, as can
be seen by comparing the formulas for the future and the present value of a single
amount of money. As can be recalled, from Equation 8.2 in Section 8.3, we gave the
future value of a single amount as:
FV = P(1 + r)n
In contrast, if we make P the subject of the formula, we calculate the present value of a
single amount of money as follows:
P = FV
(1 + r)n
where:
P = Present value.
FV = Future value of an amount to be accumulated.
r = Interest rate per annum.
n = Number of years.

ILLUSTRATION 8.4
Adamu and Co. received the sum of N12544 for two years investment at 12% interest rate
compounded annually, what is the constant amount for the investment or the present
amount to be invested now to receive this said amount.
SOLUTION

153
The illustration is testing the present value of compound interest and to solve this problem
just make the subject of the fomular, by discounting the futures value. Therefore, the
analysis is as follows:
Pv = FV
(1 + r)n

Pv = 12544 or 12544(1.12)-1 = N11200

1.12

8.5 MULTI PERIOD COMPOUNDING AND EFFECTIVE INTEREST RATE

PER ANNUM
In Section 8.3, we stated that the formula for calculating the future value of a single amount
for a multiple compounding period is given as from Example 8.2, the future value
becomes larger as the number of compounding periods increases. For multiple
payments/receipts, A in addition, must coincide with the interest payment period. If
A is stated annually, we can replace A with A/m. The treatment of a situation where
A does not coincide with interest payment period is beyond the scope of this book.
8.5.1 Multi Period Compounding Interest
In Equation (8.3) for future value of a single amount in a multi period compounding
situation, we replaced the r of Equation (8.2) by r/m and the n by mn where m is the
number of compounding periods in a year. We can use the same procedure for all
present values and future values calculation.Thus, in present values and future
values for multi period compounding situations, we just adjust all our previous
formulas by replacing r with r/m and n with mn. Therefore, the interest rate is
decomposed to captured the following; because investors are expecting to collect
proceeds on their investment in that order as thus:
Semi Annually or bi-annually
Quarterly
Monthly
Generally, the formular for computing the future value of a lump sum amount for a multiple
period is given as:
FV = p(1 + )mn

154
Where;
r = interest rate per annum
m = frequency of compounding
n = number of years.

ILLUSTRATION 8.5
Let us assume that the investment of Adams and co. Ltd is N10000 for the two-year period
with 12% interest rate is compounded annually. Calculate the amount to realized if
interest compounded as thus:.
i) Quarterly ii) Semi-annually and iii) Monthly
SOLUTION
Therefore, if the investment involves quarterly compounding, we must revise the formula by
dividing the 12% interest rate by 4 and multiplying the 2 years by 4 so we have the
following new computations:
FV = #10,000 (1 + 0.12)8
4
FV = #10,000 (1 + 0.03)8
= #12,667.70
The interest earned with quarterly compounding is #123.70 more than it was with annual
compounding. Fortunately, tables have been developed for various combinations of
interest rates and periods to avoid the necessity of using the formula each time a
future value of a lump sum amount (single amount) of money must be calculated.
We can obtain the future value of #1 for various interest rates and various periods
from a standard interest tables.
ii) Semiannually compounding above:
FV = #10,000 (1 + 0.12)8
2
FV= #10,000 (1 + 0.06)4
FV =
iii) Monthly compounding interest here the interest will be prorated by 12 and
multiplied by the numbers of years the investment is locked up. Therefore, the
computation is below:

155
FV = #10,000 (1 + 0.12)24
12
FV = #10,000 (1 + 0.01)24
Fv = N12697.35

8.5.2 Calculating Number of Yearsin Compound Interest

Then,you want to calculate the number it will take an investment to generate to the future
amount, It will require you to use the concept of logarithm in order for you to
determine how long it will take an investment either to double itself or triple itself at
15% discount rate. Here, we use the compound interest formula and applied change
subject of the formula. Therefore, recall the formula for compound interest as thus;
FV= Pv(1+r)n

ILLUSTRATION 8.6
How long will it take an investment to triple itself at 15% interest rate compounded annually;
SOLUTION
Let investment = X so, Pv= X and Fv=3x Since the investment will triple itself that implies
that the investment will be multiplied by 3.
; FV= Pv(1+r)n3x= x[1.15]n
3x= 1.15n
x

3= 1.15n
Take log of both sides log3 = log1.15n
nlog 1.15 = log3
n= log3 / log1.15
n=7.86years
Therefore, it will take 8 years for an investment to triple itself at 15% interest rate
• How long would it take for an initial investment to quadruple at 6% compounded
annually? (a) 4 years (b) 6 years (c) 23.8 years (d) 12 years
o C
• How long does it take for an initial investment to double at 4% compounded annually?
(A): 6.99 years (b): 18.67 years (c): 4years (d): 17.67 years
o D

COMPUTING INTEREST RATE IN COMPOUND INTEREST

156
In line with the preceding example, it is possible to compute the interest rate when all
parameters for estimating compound interest are given to except for the interest rate.
Therefore, this is a very simple task, what you need to do is to apply change subject
of the formula and find Nth root of both sides to subtract by 1. Thus, it gives interest
rate on the investment.
ILLUSTRATION 8.7
Based on the preceding example, the number of years for the investment is 8 years, calculate
the interest rate compounded annually for an investment to triple itself.
; FV= Pv(1+r)n3x= x[1+ r]8
3x= 1.158
x

3= 1.158
Find the 8 root of both sides 8√3 = (1 +r)
1+ r = 1.1472
R = 1.1472-1
R = 0.1472
Therefore, the interest rate on the investment is 15%. This evidence to buttress that is
possible to manipulate any missing variables in the compound interest

8.5.3 Continuous Compounding

If we assumed that payments are spread evenly and continuously throughout the year, the
future and present values calculation needs to be adjusted. For instance. Equation
(8.3) gave the future value of a single amount in a multi period compounding
situation which is restated as: FV =PerN
As M approaches infinity. ( 1 + r/m) approaches er where e is the base for n: logarithms and
its value is equal to 2.7183. Thus, with continuous compounding, future value of a
lump sum is given as:
FV =PerN

where P = Present value.

157
N = Number of years.
r = Interest rate per annum.
e = 2.7183
We can use the same approach for all present and future value formulae in a continuous
compounding situation by replacing (1 + r/m. )m with er

ILLUSTRATION 8.8 below

Find the present value of N 7,500 promised to be paid in 5 years time. Interest is
compounded continuously at 20 percent.
Solution
Fv = Pvenr
= 7500 (2.71828)0.2(5)
= 7500 (2.71828)1
Fv = N 2,208.51
The value of the investment at the end of eight years = N 2, 208.51

ILLUSTRATION 8.9
Find the compound value of N 1,500 deposited in a saving account at 12% per annum if
compo-is done continuously for 2 years. Calculate also the effective interest rate per
annum.
Solution
FV = Pern
FV= N1.500x2.71S300.12(2)
FV= N1.906.S8.
The effective interest rate per annum is given by er - 1
Thus, 2.71S30.12 - 1
= 0.1275
The effective interest rate = 12.75%

8.6FUTURE VALUES OF MULTIPLE PAYMENTS/RECEIPTS

In section 8.3, we discussed the future value of a single amount. An investment sometimes
might be a series of payments or receipts not necessarily a single amount. Thus, we

158
 might also be interested in calculating future value of multiple payments or receipts.
Multiple payments can be irregular series of payments/receipts or regular
payments/receipts (annuity).

8.7FUTURE VALUE OF UNEQUAL PAYMENTS/RECEIPTS

The future value of irregular series of payments is obtained by applying the future value
formula of Equation (8.2) to each individual payment and then summing the
resulting individual future values up. However, the timing of each individual
payment will affect the future value computation since interest will not accrue until
the end of each year. Each individual payment is assumed to be made at the end of
each year implying that the last payment will not attract interest. However, if
individual payment is made at the beginning of each year, the last payment will
attract interest. If we denote payment at year t by A, and interest rate at year t by r.
we can rewrite the future values of annuity in Examples 8.6 and 6.7 as follows:
For Example 8.6 (payments made at the end of each year)

FV = A1(l+r)2+A2(l+r)+A3
For Example 8.7 (payments made at the beginning of each year)
FV = A1(l+r)3+A2(l+r)2+A3(1+r)
Generally from Equations (8.5) and (8.6), we can deduce the formula for future value of
series of irregular payments as follows:
If the payments are made at the end of each year
N
FV = Σ At (1 + r ) N −t
t=

Where At = Payments/receipt in year t

r = Interest rate per annum
N= Number of years
∑= Summation sign
If the payment are made at the beginning of each year.
N
FV = Σ At (1 + r ) N
t=

8.7.1 Future Value of Regular Payments/Receipts: Annuity

159
An annuity consists of a series of equal payments or receipts over some periods, with
compound interest on the payments or receipts. We can divide annuities into
ordinary annuity and annuity due.An ordinary annuity is a series of equal payments
or receipts that occur at the end of each period involved. While an annuity due is a
series of equal payments or receipts that occur at the beginning of each period
involved.

A.FUTURE VALUE OF AN ORDINARY ANNUITY

The future value of an ordinary annuity is the sum of all payments, and the compound
interest accumulated on each. ABC Ltd lock up N60,000 in an investment that will
generate 16% interest rate at the end of 3 years, calculate the future value of an
ordinary annuity.
 (1 + r ) n − 1
FV = A 
 r 
In calculating future value of annuities will make the calculation cumbersome as the number
of annuities gets larger. Equation (8.9) has been used to derive a simplified formula
for future value of an ordinary annuity. The formula for future value of ordinary
annuity is, thus, given as follows:
Solution
 (1 + 0.16) 3 − 1
FV = 6000 
 0.16 
= N 6,000 (3.5056)
= N21,033.60

B. FUTURE VALUE OF ANNUITY DUE

The future value of annuity due is different from that of an ordinary annuity and is given as:
N
FV = Σ A(1 + r ) N
t =1

Just like future value of an ordinary annuity, the formula for future value of annuity d be
simplified as follows:

160
  (1 + r ) N − 1
FV = A 
 r 
8.8 PRESENT VALUES OF MULTIPLE PAYMENTS/RECEIPTS
In Section 8.4, we discussed the future values of multiple payments/receipts. We can, in a
similar way, calculate the present values of multiple payments/receipts. As
discussed in the last section, multiple payments can be irregular series of
payments/receipts or regular payments/receipts (annuity).
• Ina sinking fund investment…… is the formula use by analyst to compute installment
payment (a) compound interest (b) future value of annuity (c) present value of
annuity (d) Annuity due (e) ordinary annuity
o ANS; B

8.8.1 Present Value of Irregular Payments/Receipts

From Equation (8.4), the present value of a single amount is given by:
FV
P=
(1 + r ) N

The present value of irregular series of payment is found by first calculating t value of each
individual payment and then summing up the results of the calculated present
values. The formula for present value of irregular series of payment is given below
N At
FV = Σ
t =1 (1 + r ) t

Where At = payment made at the end of year t

8.8.2 Present Value of Regular Payments (Ordinary Annuity)
The present value of an ordinary annuity is the amount that would have to be invested today
at a certain compound interest rate to enable the investor to receive the series
payment over a specified period.
If many payments are involved, this approach will obviously be quite time – consuming. The
following formula can be used to obtain present value of an ordinary annuity.
• An annuity payments occur at the beginning of each period is called: (a): simple annuity
(b): ordinary annuity (c): deferred annuity (d) annuity in advance

161
o ANS; B

ILLUSTRATION 8.10
What is the present value of constant annual cashflows of N120,000 at 15% if cash flows
start:
a. In year 1 b. In year 5 c. Immediately
SOLUTION 10
PV = A 120,000 = N800,000
r .15
PV = A – A x CDF for irrelevant years
= 120,000 - 120,000 x CDF for 4 years of 15%
= 800,000 – 120,000{3.037]
= 800,000 – 364,440
= N435,560
PV = A + A
r
= 120,000 + 120,000
.15
= N920,000

PRESENT VALUE OF ANNUITY DUE

The present value of an annuity due is the amount that would have to be invested today at a
certain compound interest rate to enable the investor to receive the series of future
payment from now over a specified period. The present value of annuity due is not
common and can be derived with the following formula:
 (1 + r ) − (1 + r ) − ( n −1) 
P= A 
 r 

8.9 PRESENT VALUE OF A PERPETUAL ANNUITY

A perpetual annuity (or perpetuity) is a series of equal periodic payments or receipts
expected indefinitely. An example of perpetual payment is dividends on
irredeemable preference shares. The future value of perpetuity is infinite. Thus, the
present value of a perpetuity is given as:

162
P= A
r
where the annuity. A occurs at the end of the year as in other Sections.

ILLUSTRATION 8.11
ABC Ltd invested the sum of N10,000 in an investment that will generate 15% into
perpetuity, what is the future value of the investment at the end of the year into
perpetuity.
P= A
r
P = N10,000 / 0.15
P = N66,666.67

8.10 APPLICATION OF TIME VALUE OF MONEY CONCEPT: PRACTICAL

PROBLEMS
The time value of money concepts discussed so far can be applied to various sit-including
money market investment, bond valuation, equity valuation, personal planning,
sinking fund, loan amortization etc. In trying to solve any problem in practical
situations, readers should first identify the key variables in time value of problems
and then solve for any missing variable.The key variables in time value of money
concepts are stated in Table 8.1 below:
Let us now consider the application of time value of money concept to sinking fund and loan
amortization problems.

8.10.1 Sinking Fund

One use of time value of money concept is determining an amount that an equal periodic
amount an individual or company can set aside to accumulate a specific amount in
the future. As each periodic amount is set aside, it will be immediately invested.
This is what we call a sinking fund. It can be used in providing for replacement of
fixed assets, retirement of debentures etc.

163
• Adeolu and Co. owe deposited 8.5 million in the sinking fund quarterly at 16%
compounded quarterly; what is the quarterly instalment payment? (A): N
684,571.12 (b): N668,181.96 (C) N 669,181.96 (d): N 1,365,131.20
o ANS; C

ILLUSTRATION 8.12
Mr. Niyi, owner of Neyo Motel needs N0.5m in 5 years’ time to replace its fixed asset; he
had decided to set aside annually an equal amount out of the motel profit. Any
amount set aside would be immediately invested. Determine the equal amount Mr.
Niyi should set aside out of the motel profit annually if the annual compounding
interest rate is 20% and show the sinking fund schedule.
SOLUTION
Fv = A [(1 + r)-n_1]
r
500,000 = A [(1.2)5-1]
0.2
500,000 = [7.4416]
A = 500,00 = 67189.85
7.4416
Mr. Niyi annual installment payments N 67,189.85 annually,
Therefore, in order to prepare the sinking fund table we channel the interest rate and also add
up with the principal balance. At the end of five years, the sinking fund table will
amount to the total fund invested. Thus, see the below table
Table 8.1 SINKING FUND SCHEDULE
Year Principal At Annual Annual Principal at
beginn interes Sinkin end
ing t g Fund
N N N N
1 67,189.85 67,189.85
2 67,189.85 13,437.97 67,189.85 147,817,67
3 147,817.67 29,563.53 67,189.85 224,571.05
4 244,571.05 48,914.21 67,189.85 360,675.11
5 360,675.11 72,135.02 67,185.85 500,000
8.10.2 Loan Amortization
We can also apply time value of money concept to find the payments required under an
installment type of loan. Installment payments are prevalent in mortgage loans and
certain type of business loans. The main feature of an installment loan is that the

164
 borrower repays the loan in equal periodic payments that embody both interest and
principal.
• The amortization factor is the reciprocal of which interest factor? (A): sinking fund factor
(b): PV interest factor of an annuity (c): compound value factor (d): present value
factor
o ANS; B
ILLUSTRATION 8.13
Mrs. Aminat purchased a building at a cost of N200, 000: He was able to make a down
payment of N90, 000. The owner of the building agreed to a five years mortgage for
Mr. Andrew Clark to pay the balance yearly. The parties to this transaction agreed
to a 30% fixed rate of interest.
i. How much must Mrs. Aminat pay yearly to obtain complete ownership of the building?
ii. Show the amortization schedule of Rm. Aminat payments.
SOLUTION 4
N
Cost of the building 200,000
Less down payment 90,000
Outstanding balance 110,000

Pv = A [1-(1 + r)-n]
r
110,000 = A [1 – (1.3)-5]
0.3
110,000 = A [2.4355699752]

A = 110,000 = N 415,163.97
2.435569752
Mrs. AMINAT will pay N 45, 163.97 yearly to obtain complete ownership of the building as
regular installment and the principal amount at the beginning is N110000

Table 8.2 The amortization schedule of Mrs. AMINAT payment is as follows:

Year Principal At Annual Regular Principal at
beginn interes payme end
ing t nt
N N N N
1 110,000 33,000 45,163.97 97,836.03
2 97,836.03 29,350.81 45,163.97 82,022.87
3 82,022.87 24,606.86 45,163.97 61,465.76

165
4 61,465.76 18,439.73 45,163.97 34,741.52
5 34,741052 10,422.46 45,163.97 -

SELF ASSESSMENT QUESTION

Question 1
KemiKusibe is considering an investment that will yield the maximum return and She
invested the sum of N10,000. Union bank has offered her 24% interest compounded
quarterly and GTbankhas offered her 30% compounded annually. Which of the two
investments will provide Kemi with the highest return at the end of the five year
periods?

Self Assessment QuestionsSAQ 2

1. Time value of money means (a) time is important in business (b) too much time should be
spent in a single transaction (c) one naira today cannot worth the same value of one
naira tomorrow (d) none of the above.
2. How long would it take for an initial investment to quadruple at 6% compounded
annually? (a) 4 years (b) 6 years (c) 23.8 years (d) 12 years
3. The present value interest factor of an annuity is the reciprocal of which interest factor?
(a) sinking fund factor (b) future value factor (c) a lump sum payment (c) future
value factor
4. At what compound rate of interest will N 1000 grow to N 26660.02 in 7 years? (a) 26%
(b) 15% (c) 7% (d) 10%
5. How long does it take for an initial investment to double at 4% compounded annually?
(A): 6.99 years (b): 18.67 years (c): 4years (d): 17.67 years
6. The amortization factor is the reciprocal of which interest factor? (A): sinking fund factor
(b): PV interest factor of an annuity (c): compound value factor (d): present value
factor
7. You are promised 90,000 15 years from now. What is that promise worth today if interest
rate is 20% per annum? (A): 1,386,631.94 (b):5,490.03 (c): 584.15(d): 5,841.49

166
8. Adeolu and Co. owewe deposited 8.5 million in the sinking fund quarterly at 16%
compounded quarterly; what is the quarterly instalment payment? (A): N
684,571.12 (b): N668,181.96
,181.96 (C)N 669,181.96 (d): N 1,365,131.20
9. At what compound rate of interest will 2,000 gro
grow to 5,316.89 in 8 years? (a):
(a) 23% (b):
12% (c): 15% (d): 13%

Use the following to answer question 10-11

Mr. Badewa took aN 500,000. No Wahala loan from UBA Plc; to be paid back in two years
by monthly deductions from his salary at 18% per annum compounded monthly.
10. What is the monthlynthly instalment payment? (A) (A): 17,462.05 (b):
(b) 80,517.97(c):
24,962.05 (d):: 74,263.92
11. N2,500
2,500 was compounded continuously at 11.5% per annum for 6 years. What is the
amount at the end of the period? (A): N 4,984.29 (b): N 4,803.85 (C): (C) N 4,934.56
(d): N 4,676.04
12. An annuity payments occur at the beginning of each period is called: (a): simple
annuity (b):: ordinary annuity (c): deferred annuity (d) annuity in advance
13. Chief Ude plan to endow an annual prize of N10,000 to the best graduating student
of DLI forever. If interest rate is 5%; how much will need be paid to the endowment
account? (a): N 2 million (b) N 200,000 (C)N 20,000 (d)N 100,000

REFERENCES
Aborode, R.(2012); A Practical Approach to Financial Accounting. Lagos EL-TOBA
EL
Ventures Ltd
Brealey, R. A and S. C Meyers.; Principle of Corporate Finance, (4thed), McGraw Hill
pushing CO, New York, 1991
Gordon, M.J; The Investment, Financing and valuation of the Corporation, Irwin,
Homewood, Illinois, 1962.
ICAN (2009) Study Pack on Financial Reporting and Ethics; VI Publishers,
Igben, O. R. (2007) Financial Accounting Made Simple Vol 1. Lagos. ROL Publishers
Owualah, S.I Understanding Business Finance, G
G-Mag
Mag Investments Ltd (Educational
publishers), Lagos, 1997.
Shao Stephen P. (1974); "Mathematics for Management and Finance",
Finance",Cincinat.South
Cincinat.South-Western
Pub.Co.

Should you require more explanation on this study session, please do not hesitate to contact
your e-tutor
tutor via the LMS.

167
Are you in need of General Help as regards your studies? Do not hesitate to
contact the DLI IAG Center by ee-mail or phone on:

iag@dli.unilag.edu.ng
08033366677

168
 STUDY SECTION 9:
WORKING CAPITAL MANAGEMENT

INTRODUCTION:
A theme here is the importance of investors shaping their analytical focus according to
Companies Business Model, especially when time is short or limited. When is
working capital analysis critical?
Working capital is significant from the an
angle
gle of creditor who is concerned on the ability of
the company to pay its bill. But from the perspective of company valuation and the
company’s growth prospect, working capital is more critical to one business than to
others.

LEARNING OUTCOMES FOR STUDY SESSION 4

At the end of this Session,, the learners should be able to
9.1 Describe working capital
9.2 State the components of working capital
9.3 Calculation and interpretation of working capital
9.4 Explain the relationship between overcapitalization and working capital
9.5 Identify ratio that determined investment in working capital
9.6 Explain overtrading and its effects on working capital
9.7 Identify the causes and characteristics of overtrading
9.8 Explain the relationship between working capital and control of cash (cash cycle).

9.1 WORKING CAPITAL MANAGEMENT

Working capital management is the capital available for the daily running of a business. It is
a common measure of a business liquidity, efficiency and overall health. A
company’s working capital reflects the results of a hos
hostt of its activities including

169
 inventory management, debt management, revenue collection and payment to
suppliers.
Positive working capital generally indicates that a company is able to pay off its short term
liabilities almost immediately. While negative working capital generally indicates a
company could not pay its short-term liabilities immediately. This shows the reason
why financial analysts are interested in the strength of working capital of an
organisation.
9.2 COMPONENTS OF WORKING CAPITAL MANAGEMENT
In order to ascertain the working capital of a business, there are two major components that
must be considered. These are
(a) Current assets
(b) Current liabilities

9.2.1 Current Assets

These are assets of a company that change in composition with the level of output of the
company or change along the operational activities of a business. It comprises the
following:
(a) Stock of inventory
(b) Bills receivable
(c) Cash in hand
(d) Cash at bank
(e) Debtors etc

9.2.2 Current Liabilities

These are the debts or outstanding of a business that are due for payment within a financial
year. In accounting, they are liabilities of a company that are often settled in cash
within an accounting year. It could also be said as liability that is a claim on
company current assets. It comprises the following:
(a) Sunday creditors
(b) Bills payable
(c) Bank overdraft

170
(d) Account payable
(e) Accrued liabilities etc

9.3 LIQUIDITY RATIOS, CASH OPERATING AND OPERATING CYCLE

This measures the ability of a reposting entity to settle its short term debt and meets its
obligation as at when due. Therefore, working capital could be calculated by using
any of the following:
(a) Working capital = current assets – current liabilities
This implies that when the value of current assets is in excess of current liabilities, there is
positive working capital which means that the business has enough fund to meet its
current liabilities.
(b) Current ratio = Current asset
Current liabilities
This is the ratio of current assets to liabilities. The ideal current ratio is generally accepted to
be 2:1 but this proportion can obviously be varied in practice, depending on the
circumstances of an organisation.
(c) Quick ratio or Acidity test ratio = Current assets - stock
Current liabilities
The ideal of his is 1:1 although in practice companies often have much lower quick ratio than
the above stated one. Note: A current ratio of 2:1 and quick ratio of 1:1 are
thought to be indicative that a company is reasonably well protected against the
dangers of insolvency through insufficient liquidity.
Example:
Given the following financial statement, extract of EretanPlcas follows:
N
Fixed assets 500,000
Bank balance 1,000,000
Bank overdraft 2,500,000
Closing stock 3,000,000
Debtors 4,000,000
Bills receivable 300,000

171
Bills payable 200,000
Accrued wages 600,000
Creditors 1,000,000
You are required to calculate, interpret your answer under each of the following
(i) Working capital
(ii) Current ratio
(iii) Acidity test ratio

SOLUTION
The working capital is = N10,800,000 – N1,800,000 =N9,000,000
II) Current Ratio =N10,800,000 =
N1,800,000
iii) Acid test ratio = N 10,800,000 – N 3,000,000 =
N1,800,000

9.3.1 Cash Operating Cycle

Cash operating cycle can also be called working capital cycle. Therefore, cash operating
cycle can be defined as the length of time it takes and enterprise to acquire raw
materials on credit, convert into finished goods, sell them on credit and wait for the
debtors to pay and from the cash collected from debtors, then settle the suppliers.
The lower it is, the better for the enterprise in terms of liquidity and efficiency in
assets management.
• In cash cycle, cash is recovered when (a) creditors are paid (b) debtors paid (c) taxation
dividend (d) finished goods are sent to debtors
o B

9.3.2 Operating Cycle

Operating cycle is the length of time it takes to acquire raw materials, convert them into
finished goods, sell them on credit and then collect the cash from debtors after a
while. On the other hand, cash cycle is the length of time it takes to settle suppliers

172
 from cash collected from debtors. It is the difference between operating cycle and
creditors’ days.

9.3.3 The Differences between Operating and Cash Cycles

Firstly, operating cycle measures the number of days a firm needs to spend from the day raw
materials was acquired to the day cash was collected from debtors. On the other
hand, cash cycle tells how long it takes a firm to discharge its obligations
Secondly, operating cycle is naturally expected to have longer days than cash cycle or else,
the firm is trading supplier’s money which has a low of consequences
Lastly, Operating cycle depends on stocks and debtors days whereas cash cycle depends on
stocks, debtors and creditors days.
CASE STUDY1
The following information is extracted from the records of AdanmaPlc
Opening Closing
` N N
Stock 5,000 7,000
Debtors 1,600 2,400
Creditors 2,700 4,800
Credit sales for the year just ended were 50,000 and cost of sales was 30,000.
Within the limit of the available information, prepare for AdanmaPlc;
1) The operating cycle and (ii) the cash cycle

SOLUTION TO CASE STUDY 1

1) Operating cycle for the yearDays
Stock days (6000/30000 x 365 73
Debtors days (2000/50000 x 365) 15
Operating cycle 88

ii) Cash cycle for the year

Operating cycle 88
Less: Creditors Days (3750/32000 x 365) 43
Cash Cycle 45
Notes:
Stock of finished goods must be based on cost of sales. Creditors must be based on credit
purchases, unless opening and closing stocks were given, then it can manage cost of
sales. Credit purchases is derived as follows:
Opening Stock 5,000
Purchases 32,000

173
Closing stock ( 7,000)
30,000

9.4 OVER-CAPITALIZATION AND WORKING CAPITAL

Over-capital arises when the returns on capital employed is lower than as expected and long
term funds would be unnecessarily tied up. When there are excessive stocks, debtors
arising from inefficient management of working capital, there will be an over-
investment by an organisation in current assets, that is working capital will be
excessive and the company will be over-capitalized. Over-capitalization with
respect to working capital should not exist if there is good management, but the
warning signs of excessive working capital would be poor accounting ratios.
9.5 RATIOS THAT DETERMINE INVESTMENT IN WORKING CAPITAL
The ratios which can assist in judging whether the investment in working capital is
reasonable are:
(a) Sales/Working Capital: The volume of sales as a measure of the working capital
investment should indicate whether in comparism with previous year or with similar
companies, the total volume of working capital is too high or low.
(b) Liquidity Ratios: A current ratio in excess of 2:1 or a quick ratio in excess of 1:1
may indicate over investment in working capital.
(c) Turnover periods: Excessive turnover periods for stocks an debtors or a low period
of credit taken would indicate whether the volume of stocks or debtors is
unnecessarily high or the volume of creditors too low.
The turnover periods may be calculated approximately as follows:
i. Raw material stock turnover =
Average raw material stock x 365 days
Purchases per annum
ii. Work in progress turnover (production cycle) =
Average work in progress x 365days
Cost of production per annum
iii. Finished goods stock turnover =

174
 Average finished goods stock x 365days
Cost of Sales per annum
iv.Debtors turnover period =
Average Debtors x 365days
Sales per annum
v. Creditors turnover period =
Average trade creditors x 365days
Purchase per annum

9.6 OVERTRADING AND WORKING CAPITAL

Overtrading happens when a business tried to do too much within a short period with too
little long term capital which implies that the organisation tried to support too large
volume of trade with the capital resources at its disposal.
Under this premise, the company may be making profit but could easily run into serious
trouble because of shortage of fund and this impunity troubles could arise from the
fact that it does not have enough capital to provide the cash to pay its debts as they
fall due.
Problems only arise when overtrading gets out of control and a business finds it increasingly
difficult to pay its debts when they fall due. Uncontrolled overtrading does not
happen suddenly with a business operating comfortably in one minute. Rather, a
business sinks gradually into ever-increasing liquidity problems.
• It is economically viable for management to control over-trading (a) true (b) false
o ANS: A

9.7 CAUSES OF OVERTRADING

Emphasis has been given to the danger of overtrading when business seeks to increase the
sales turnover too rapidly without an adequate capital base. This is not the only
cause of over-trading, however, other causes could be as follows:

175
(a) Repayment of loans: When a business repays its loan, it often replaces the
occasional situations, a business may repay a loan without replacing it with the
consequence that it has less long term capital to finance its current level of
operations.
(b) Inflation: During inflation, the returned profit of a business must be insufficient to
provide finance to pay for replacement fixed assets and stocks as a result of general
increase in prices. The business would then rely increasingly on credit and find itself
eventually unable to support its current volume of trading with a capital base that
has fallen in real value over time.
• All the following are fractures of over-trading except (a)significant change in debt ratio
(b) rapid increase in the volume of current assets (c) increase in over-head cost
(d)increase in gross profit
o ANS: D

9.8 CHARACTERISTICS OF OVER-TRADING

Businessmen need to be able to detect signs of overtrading as it develops in order for
remedial action to be taken before it is too late. The following are some of the
features of over-trading.
(a) A rapid increase in sales turnover
(b) Fall in gross profit as a result of raise in cost of production and sales discount.
(c) Increase in overhead cost in such a manner as it will affect profit margin negatively.
(d) A rapid increase in the volume of current assets and possibly fixed assets.
(e) Slight or no increase in capital and most of the increase in asset is financed by credit
especially trade creditor or bank overdraft that reaches or even exceeds the limit of
the bank agreed facilities.
(f) Significant changes in debt ratio and liquidity ratio
• The inefficiency management of working capital could result in _____ (a) over trading (b)
over- capitalization (c) liquidation (d)bad debt
o ANS: B

9.9 WORKING CAPITAL AND CASH CONTROL

176
The operating cycle is the time interval between the arrival of inventory stock and the data
when cash is collected from receivable.
The cash cycle begins when cash is paid for materials and ends when cash is collected from
receivable. The cash flow time line consists of an operating cycle and a cash cycle.
The amount tied up is equal to the value of raw materials, work in progress, finished stocks
and debtors less creditors. The size of this net figure has a direct effect on the
liquidity of an organisation. The connection between investment in working capital
and cash flow may be illustrated by means of the cash cycle, operating cycle or
trading cycle as illustrated below.

177
WORKING CAPITAL AND CASH CONTROL (CASH CYCLE)
Raw
Investment of
Materials Creditors
surplus cash
Work in Permanent
Progress Finance
Cash
Finished Fixed
goods Assets

Debtors Taxation
Profit
Dividends
The operating cycle above expresses the following:
(i) Raw materials stocks are obtained from suppliers
(ii) Eventually the trade creditors were paid and cash is therefore paid out
(iii) Raw materials were held in stock until they were issued to production (WIP). At this
time, additional credits (for labour and other expenses may be incurred).
(iv) Oncompletion of production, the finished goods were held on stock until sold, perhaps
on credit.
(v) Cash is received, eventually when the debt is collected

CASE STUDY 2
The following information were extracted from the records of ZakiPlc for 2010

N’000
Stock – Raw materials 150
Work in progress 60
Finished goods 200
Purchases 500
Debtors 230
Creditors 120
Sales 900
Cost of goods sold 750
Required
Calculate the working capital cycle of the company

178
THE STEPS THAT COULD BE TAKEN TO REDUCE OR IMPROVE WORKING
CAPITAL INCLUDE:
Reduction of raw materials holding period
Reduction of production days by speeding up and still ensuring quality
Reduction of finished goods days by increasing market outlets and improve advertisement
Reduction in debtors’ days by giving reasonab
reasonable cash discounts
Increase in creditors days by obtaining their consents or rejection discounts

SOLUTION TO CASE STUDY 2 ZakiPlc

Days
Calculation of working capital cycle:
Stock – Rm (150/500 x 365) 110
- W1P (60/750 x 365) 29
- Fgs (200/750 x 365) 97
Debtors (230/900 x 365) 93
Operating cycle 329
Creditors (120/500 x 365) (88)
Cash cycle 241

SUMMARY

You have learnt in thisSession the description of working capital, its components, how it is
calculated and interpretation of working capital as well as cash operating cycle.
Also exposed you to relationship between working capital and over-capitalization,
over
over-trading
trading and control of cash (Cash cycle).
We can therefore conclude at this point the working ca
capital
pital management has been described
in term of sources of short
short-term
term funds and the management and control of stocks,
creditors, debtors and cash.

179
SELF ASSESSMENT QUESTIONS
The self-assessment questions are arranged in Multiple question as well as Easy type in this
Study Session 9. The self-question assessesand addresses all the subsessionin-depth
in the study session.
SAQ 1
A. Multiple choice questions
1. The idea current ratio for an organisation is _____ (a) 1:2 (b) 2:2 (c) 2:1 (d) 1:1
2. Acidity test ratio could also be described as ____ ratio (a) quick (b) current (c) debtor (d)
solvency
3. The inefficiency management of working capital could result in _____ (a) over trading (b)
over- capitalization (c) liquidation (d)bad debt
4. Which of the following is used to measure turnover period (a)sales/working capital (b)
liquidity ratio (c) acidity test ratio (d)creditors turnover periods
5. All the following are fractures of over-trading except (a)significant change in debt ratio
(b) rapid increase in the volume of current assets (c) increase in over-head cost
(d)increase in gross profit
6. _____ is one of the causes of over-trading (a) deflation (b) mis-management of current
asset (c) inflation (d) surplus cash
7. Repayment of loans could affect the working capital of an organisation (a) true (b) false
(c) undeterminable
8. In cash cycle, cash is recovered when (a) creditors are paid
(b)debtors paid (c) taxation dividend (d) finished goods are sent to debtors
9. It is economically viable for management to control over-trading (a) true (b) false
10. Given total assets as N10,000,000, fixed as N2,000,000. The value of the working
capital is (a) N4,500,000 (b) N2,500,000 (c) N4,000,000 (d) N3,500,000

SAQ 2 Essay
1. The following financial extract related to book ltd a manufacturing company
Cost as percentage of sales %
Selling and distribution 10
Variable overhead 15
Fixed overheads 20
Direct materials 40
Direct labour 30
While the turnover for the year is N3,000,000
On Average:
i. Debtors takes 3½ months before repayment
ii. Raw materials are in stock for 4months
iii. Work in progress represents 2months half produced goods

180
iv.Finished goods represents 2months production
v. Credit is taken as follows:
a. Direct materials – 2½ months b. Direct labour – 1week
c. Variable overheads – 2months d. Fixed overhead – 1month
e. Selling and distribution – 1month
Work in progress and finished goods are valued as materials, labour and variable expanse
cost. You are required to complete the working capital requirement of Book ltd.
Assuming the labour force is paid for 52 working weeks.
2. The Balance and loan statement of BimbiManufacturing Cooperation is given below for
the year ended 31st December, 1992-1993 as follows:

BIMBI MANUFACTURING CO-OPERATION

st
December 31 1993 and December, 1992.

Asset 1993 1992

Current assets N N
Cash 500,000 500,000
Market security (at cost) 500,000 450,000
Account receivables 2,000,000 1,600,000
Inventories 3,000,000 2,000,000
Total current assets 6,000,000 4,550,000
Net fixed assets
Land 450,000 450,000
Building 4,000,000 4,000,000
Machinery 1,500,000 800,000
Office equipment 50,000 50,000
Accumulated depreciation (2,000,000) (1,700,000)
Net fixed assets 4,000,000 3,600,000
Prepayments and deferred charges 400,000 300,000
Intangibles 100,000 100,000
10,500,000 10,500,000
Liabilities
Current liabilities:
Account payable 1,000,000 750,000
Notes payable 1,500,000 500,000
Accrued expenses payable 250,000 225,000
Taxes payable 250,000 225,000
Total current liabilities 3,000,000 3,000,000
Long Term Liabilities
First montage bonds, 5% interest 3,000,000 3,000,000
Deferred taxes 600,000 600,000
6,600,000 5,300,000
Stock Holders Equity
Shares 5, per value each: authorized:

181
Issued and outstanding 300,000 shares 1,500,000 1,000,000
Capital surplus 500,000 500,000
Accumulated retained earning 1,900,000 1,250,000
3,900,000 3,200,000
10,500,0008,550,000
Consolidated Income Statement 1993 1992
Net sales 11,500,000 10,700,000
Cost of sales and operatory expenses
Cost of goods sold 8,200,000 7,684,000
Depreciation 300,000 275,000
Selling and administration expenses 1,400,000 1,325,000
Operating Profit 1,600,000 1,411,000
Other Income:
Dividend and Interest 50,000 50,000
Total Income from operation 1,650,000 1,466,000
Less: interest on loans and other
Liabilities 300,000 150,000
Income before tax 1,350,000 1,316,000
Provision for income tax 610,000 600,000
740,000 716,000
Dividend paid out 90,000 132,000
Retained carryings 650,000 584,000

You are required to calculate the following:

(a) Average inventory
(b) Inventory turnover ratio
(c) Days in inventory
(d) Average account reachable
(e) Average receivable turnover
(f) Days in receivables
(g) Average payables
(h) Account payable deferral period
(i) Days in receivables
(j) Operating cycle
(k) Suggest the need for short term financial decision making.

SAQ 3
3A) what do you understand as cash operating cycle with respect to liquidity and activity
management of business enterprise?
3B) Discuss ‘Operating Cycle 1 and ‘Cash Cycle and bring out their differences.
3C) List the steps which might be taken in order to improve the working cycle

182
 REFERENCES

Ashamu S.O. (2012); Corporate financial security analysis and portfolio management
Anuoluwa M.U (2006); international financial management in perspective.
Mao James C. I. (1969); "Quantitative Analysis of Financial Decision".London Macmillan and
Co.

183
Should you require more explanation on this study session, please do not hesitate to contact your e-tutor
e
via the LMS.

Are you in need of General Help as regards your studies? Do not hesitate to contact the DLI
IAG Center by e-mail
mail or phone on:

iag@dli.unilag.edu.ng
08033366677

STUDY SESSION 10:

SECURITY ANALYSIS

INTRODUCTION
This last Study Session of this course text focuses on valuation of investment securities that
are instruments of raising finds from investors by companies in the capital market.
The Session first introduce you to an overview of the valuation process as we look
at basic factors that
hat affect values of financial inst
instruments
ruments in an economy. We
thereafter
after get into some detailed analyses of determining the value of debt,
preference shares and common share securities (financial instruments) in the capital
market. These are the most prevalent financial instruments in the capital
ca market.
Each of these has variant features which we do not get to analyze in this
introductory course in finance that we are in.

184
This Study Session is involved in valuing alternate investments. We will begin with
w
valuation process and then move on to the theory of valuation for various classes of
securities; bonds, preference shares and common shares.

LEARNING OUTCOME
After you have studied this session, you be able to known:
10.1 Meaning of security analysis define
ne what is security analysis and it application
10.2 General economic factor influencing the security market
10.3 Perfect Market
10.4 Form Of Efficiency
10.5 Meaning Of Security Analysis
10.6 General Economic Influences
10.7 Industry Factors Influences
10.8 Theory Of Valuation
10.9 Required Rate Of Return
10.10 Streams Of Returns
10.11 Valuation Of Bonds
10.12 Valuation Of Preference Share
10.13 Valuation of common stock
10.14 Pragmatic Multiplier Approach:

10.1 SECURITY ANALYSIS AND APPLICATION

Security analysis is the process determining the securities prices of an underlying asset and
to know what are the factor
factors that cause volatility in asset price. Majorly, asset
returns is the changes in the prices of a security market and literature have supported
the factors that driven stock prices can be as thus:
EMH VS FUNDAMENTAL
NDAMENTAL AND TECHNICAL ANALYSES
There are three broad theories concerning stock price movements. These are the fundamental
analysis, technical analysis and efficient market hypothesis. Fundamental analysts
believe that by analyzing key economic and finan
financial
cial variables they can estimate the
intrinsic worth of a security and then
then, determine what investment action to take.

185
Fundamental analysis seeks to identify underpriced securities and overpriced securities.
Their investment strategy consists in buying underpriced securities and selling
overpriced securities, thereby earning superior returns.

A Technical Analyst maintains that fundamental analysis is unnecessary. He believes that

history repeats itself. Hence, he tries to predict future movements in share prices by
studying the historical patterns in share price movements.

The Efficient Market Hypothesis is expressed in three forms. The weal form of the EMH
directly contradicts technical analysis by maintaining that past prices and past price
changes cannot be used to forecast future price changes because successive price
changes are independent of each other. The semi-strong form of the EMH
contradicts fundamental analysis to some extent by claiming that the market is
efficient in the dissemination and processing of information and hence, publicly
available information cannot be used consistently to earn superior investment
returns.

The strong form of the EMH maintains that not only is publicly available information useless
to the investor or analyst but all information is useless. Even though the EMH
repudiates both fundamental analysis and technical analysis, the market is efficient
precisely because of the organized and systematic efforts of thousands of analysts
undertaking fundamental and technical analysis. Thus, the paradox of efficient
market hypothesis is that both fundamental and technical analysis is required to
make the market efficient and thereby validate the hypothesis.

10.1.2 A Perfect Market

A perfect market is a type of market where neither the buyer nor the seller of underlying
assets can influence the security price. The perfect market of any stock in the world
must exhibit the following characteristics, as thus:
MARKETS ARE FRICTIONLESS: i.e. there are no transactions costs or taxes all
assets are perfectly divisible and marketable and there are no constraint regulations.
There is perfect competition in product and security markets.
Markets are informationally efficient i.e. information is costless and it is received
simultaneously by all individual.
All individuals are rational expected utility maximizes.

186
10.1.3 Forms of Efficiency
The forms of efficiency in the of allocating the security prices of an underlying assets can be
decompose into two forms as thus;
Operational efficiency
Allocationally efficiency
OPERATIONAL EFFICIENCY
Operational efficiency deals with the cost of transferring funds. In the idealized world of
perfect capital markets, transactions costs are assumed to be zero; therefore, we
have perfect operational efficiency. Thus, operational efficiency is indeed an
important consideration.
ALLOCATIONALLY EFFICIENCY
A market is said to be allocationally efficiently when price are determined in a way that
equates the marginal rate of return (adjusted for risk) for all problems and savers.
Therefore, in an allocationally efficient market scares saving are optimally allocated
to productive investments in a way that benefit everyone.
10.1.4 Forms of Market Efficiency
Fama (1970,76) has done a great deed to operationalize the notion of capital market
efficiency. He defines the three types of Market efficiency each of which is based on
a difference notion to exactly what type of information is understood to be relevant
in the phrase “All prices fully reflect all relevant information.
WEAK-FORM EFFICIENCY: No investor can earn excess returns by developing
trading rules based on historical price or return information. In other words, the
information in past prices or returns is not useful or relevant in achieving excess
returns.
SEMI STRONG FORM EFFICIENCY: No investors can earn excess returns from
trading rules based on any publicly available information. Example of publicly
available information is annual reports of companies, investment advisory data such
as “Heard on the street” in the wall street journal or ticker tape information.

187
 STRONG-FORM EFFICIENCY: No investor can earn excess returns using any
information whether publicly available or not obviously, If markets were efficient in
their form, price would fully reflect all information even though it might be hold
exclusively by a corporate insider. If there is any inside information the market can
use to trade then the strong form of market efficiency predicts that prices will have
adjusted so that we cannot profit.

10.2 GENERAL ECONOMIC INFLUENCES

The centre stage in this analysis is the economy and market followed by industries and
securities issued by various companies. The Federal Government has a key impact
on the aggregate economy because they control monetary and fiscal policies. These
basic economic forces exert an influence on all industries and all companies in the
economy. The same complete impact can result from a significant change in
monetary policy. A restrictive monetary policy that produces a decline in the
growth rate of money supply reduces the supply of funds available to all businesses
for working capital and expansion, and of funds available to individuals for buying
goods and services. Monetary policy affects all segments of the economy.
Fiscal policy can encourage spending (through investment credits) or discourage spending
(through taxes on petroleum products). Increases or decreases in spending on
defense, highways also influence the general economic picture. All such changes
have a major impact on those directly affected by the changes, but there is also a
multiplier effect on those who supply goods and services to those directly affected.
Another entire economic variable that must be considered is inflation; because it has a major
impact on interest rates and how consumers and companies save and spend their
money. In addition to domestic and fiscal actions, other occurrences such as war,
political conflicts in foreign countries or international monetary devaluation
influence the aggregate economy. Because events influencing the aggregate
economy also have such a profound effect on all industries and all companies
within these industries, these macro-economic factors must be considered before
industries can be analyzed.

188
10.3 INDUSTRY FACTOR INFLUENCES
Because of the importance of the general economic outlook, one should only consider
investing in alternate industries after it has been decided that the general outlook is
favourable. The industry outlook is determined by the general economic outlook
and special industry factors that are generally national in scope but have greater
influence on one or several industries. Examples of industry influence are strike,
import or export quotas or taxes or government-imposed regulations. Because of the
importance and pervasiveness of industry influences, an industry evaluation should
be conducted prior to analyzing any individual firm.

10.4 THEORY OF VALUATION

It should be noted that the value of an underlying asset is the present value of expected
returns from the asset during the holding period. An investment is expected to
provide a stream of returns during the holding period, and it is important to discount
this stream of expected returns at the investor's required rate of return to determine
the value of the asset. Thus, to derive value for an asset it is important to calculate:
(1) the stream of expected returns and (2) the required rate of return on the
investment.

10.4.1 Streams of Returns

An estimate of the future returns expected from an investment includes the magnitude of the
returns, the form of the returns, the time pattern of returns and the uncertainty of
returns. The streams of return can be viewed in two ways as follows;
Form of Returns
Time Pattern of Returns
Form of Returns
Returns from an investment can take many forms including earnings, dividends, interest
payments or gains based upon an increase in value during a period. Our emphasis is
on the earnings of the firm and the dividends, in the context of security analysis.

189
Time Pattern of Returns
In addition, it is essential to calculate when the returns will be received because money has
time value. (A Naira income today is worth more than a Naira income received a
year from now). Thus, it is essential to know the time pattern of returns from
investment so that the stream can be properly valued relative to alternate
investments.

10.4.2 Required Rate of Return

The required rate of return on an investment is determined by: (1)the economy's real risk-
free rate of return, plus (2) the expected rate of inflation during the holding period,
and (3) a risk premium. All investments are affected by the risk-free rate and
inflation (i.e., the nominal risk-free rate); the differential factor is the risk premium
for different types of assets. It should be noted that the risk premium is a function of
the uncertainty of returns on an asset.

10.5 INVESTMENTS: COMPARISON OF SECURITY VALUE AND PRICE

An investment is the commitment of funds for a period of time during which the funds are
given up and the uncertainty (risk) involved. If you are sure of going to obtain
returns on your investment, it is significant to determine the value of the asset at
your required rate of return and then compare this value with the prevailing market
price of the asset. The key point of investments is that you should purchase assets
where the market price of the asset is equal to or less than the value you have
estimated. Alternately, you should not acquire an asset if the market price exceeds
your estimated value. In summary,
If Estimated Value > Market Price = Acquire
If Estimated Value < Market price = Don't Acquire
We will now discuss valuation of different investments
o A market is said to be……… when prices are determined in a way that equates the
marginal rates of return for all producer and savers. (a) operational efficient (b)
allocationally efficient (c) consumer efficient (d) business efficient
o ANS: B

190
10.5.1 Valuation of Bonds
It is simple to determine the value of bonds because the size and the time pattern of the
returns from the bond over its life are known. A bond promises:
1. Interest payments every six months equal to one half the coupon rate times the face
value of the bond, and
2. The payment of the principal (also referred to as face value) at the maturity of the
bond.
As an example, in 2002, a N10,000 bond due in 2007 with a 10 percent coupon will pay
N500 every six month for the life of the bond (the next 15 years). In addition, there
is a promise to pay the N10.000 principal at maturity in 2007. Therefore, assuming
the borrower does not default, the investor knows that payments will be made as at
when due.
The value of any asset is the present value of the returns from the asset; the value of a bond
is the present value of the interest payments (i.e., an annuity of N500every six
month for 15 years) and the present value of the principal payment. The only
unknown for this asset is the rate of return (assuming the borrower does not
default). It is the rate of return that should be used to discount the expected stream
of payments. Assuming that the prevailing nominal risk-free rate is 9 percent and
the investor requires a 1 percent risk premium on this bond (because there is some
probability of default), the required rate of return would be 10 percent. The present
value of the interest payments is an annuity for 30 periods (15 years every six
months) at one half the required return (5 percent).
N500x 15.3725 = N7,686 (present value of interest at 10 percent)
The present value of the principal is likewise discounted at 5 percent for 30 periods and this
is N10, 000 x . 2314 = N2, 314. The value of bond at 10 percent

Present value of interest payments N7, 686

Present value of principal payments N2. 314
Value of bond at 10 percent N 10.000

191
This is the amount that an investor should be willing to pay for this bond assuming that his
required rate of return on a bond of this risk class was 10 percent. If the bond is
selling for less than this in the market, this would apparently be acceptable. If the
market price is above this value, an investor should not buy it because his promised
yield to maturity will be less than his required rate of return.
Alternatively, if the investor wants a 12percent return on this bond, the value would be as
follows:
N500x 13.7648 = N6, 882
10, 000 x . 1741 =1,741
8, 623

10.6 VALUATION OF PREFERENCE SHARES

Preference shares involves a promise to pay a stated dividend, usually each quarter, for an
infinite period, i.e., there is no maturity. As was true with a bond, stated payments
are to be made on specified dates. Nonetheless, preference shares does not involve
the same legal obligation to pay as bonds do, and payments are made only after
bond interest payments are met, so uncertainty of payments is greater. This
increased uncertainty means that a higher rate of return should be required on a
firm's preference shares than is required on a firm's debentures.
Preference shares is a perpetuity, the value is simply the stated annual dividend divided by
the required rate of return on the return on the asset as follows:
V = Dividend
kp
Let us assume that a preferred stock has a N100 par value and a dividend of N8 a year. The
required rate of return is 9 percent. Thus, the value of this preferred stock is:
N8
.09 = N88.89
Given the price of preferred stock, it is possible to derive the promised yield on this
investment:
KP =Dividend

192
Price
o Financial markets in which security prices rapidly reflect all relevant information about
asset value are called ………. Capital market (a) efficient (b) perfect (c) security
(d) informative
o ANS: B

10.7 VALUATION OF COMMON SHARES

The valuation of common stocks is definitely more difficult than that of bonds or preference
shares because almost all the required inputs are unknown. In the case of a bond,
the periodic interest payments are known, as well as the final payment at
maturity.The only unknown
nown is the discount rate, which is calculated from the
prevailing nominal RFR plus risk free rates premium that is dependent upon the
uncertainty of the interest payment. For preferred stock the only unknown is the
required rate of return on the stock. In the case of common stock, an investor is
uncertain about the size of the returns, the time pattern of returns, and the required
rate of return. Basically, the dividend model includes the assumption that the value
of a share of common stock is the present value of all future dividends as follows:

…
= + + +

Where:
= Values of the common stock j
= Dividend during period t
i = Required rate of return on stock i
A clear question is what happens in the case where the shares are not held for an infinite
period? Assume a sale of the stock at the end of year 2

2. In such a case the formulation would be as follows:

193
 = + +

Where Spj2= the sale price of stock j at the end of year 2.

The value is the two dividend payments during years 1 and 2 and the sale price (SP) for the
stock at the end of year 2. Regarding the selling of the stock at the end of year 2, it
is simply the value of all
ll remaining dividend payments as follows:
…
+ +

Given, that SPj2, is discounted back to the present by 1/(1 +i)2, this becomes:
…
+ +

…
+ +

Which is simply an extension of the original equation whenever the stock is sold, its (sale
price) will be the present value of all future dividends. When this ending value is
discounted back to the present you are back to the basic formulation.
For stocks that do not pay dividends, the example is
is-the
the same except that some of the near-
near
term dividend payments are zero. Notably, there are expectations that at some point
the firm will pay dividends. If there was no such anticipation, an investor will never
anticipate anyy cash flows, and nobody would be willing to buy such a security.
With a non-dividend
dividend paying stock the firm is not paying any thing now, but
reinvesting capital so that it will grow faster in the future. The formulation is as
follows:

…
= + + +

Where:
=0
=0

194
The anticipation is that, when the firm begins paying dividends in P3, they will grow faster.
The stock has value because of these future dividends and model is best for
different holding periods remaining from short periods to longer intervals.
o ABC Company stock has a dividend rate of N1.08, normalized earning per share of N
1.80, a discount rate of 13 percent and a growth rate of 8 percent. What is the
market price per share; (a) N21.60 (b) N 18.60 (c) N12.60 (d) N10.80
o ANS: A

10.7.1 One Year Holding Period

It is assumed that the investor wants to buy the stock, hold it for one year, and sell it at the
end of the year. To determine the value of the stock (i.e., how much the investor
should pay for it) the dividend to be received during the period and the required rate
of return on this stock must be estimated. To calculate the dividend for the coming
year will probably be based upon the current dividend and anticipations regarding
changes during the year. Assume the firm earned N2.50 a share last year and paid a
dividend of N1 a share (a 40 percent payout which has been fairly consistent over
time). In addition, the firm is anticipated to earn about N2.75 during the coming
year and to increase the dividend to N1.1 0 per share.
For now, let us assume that you prefer dividend yield approach. You anticipate the dividend
yield on this stock to be 5 percent. Given the expected dividend of N1.10 per share,
this implies a future stock price of N22(1.10/.05). It is important, however, to
determine the required rate of return on this stock investment. You have estimated
the dividend at N 1.10 (payable at year end), the ending price at N22, and the
required rate of return at 14 percent. Given these inputs, the value of this asset to
you is as follows:
= N1.10 N22.00
(1 + .14) + (1 + .14)
= 1.10 22.00
1.14 + 1.14
= .96 + 1 9 . 3 0

195
= N20.26
It is necessary to note that there has been no mention of current price of the stock. This is
because the current price is not appropriate to the investor until after he has derived
an independent value based on his estimates of the relevant variables.
10.7.2 Multiple-Year Holding Period
In this case it is assumed that you are considering buying the stock now and expect holding
the stock for several years and then selling it. The decision to hold the stock for
several years complicates the valuation procedure, because it is significant to
estimate several future dividend payments and also to estimate the value of the
stock for a number of years in the future.
In the current example, assume the anticipated holding period is three years and you
estimate the following dividend payments at the end of each year:
Year 1 = N 1 . 10/Share
Year 2 =N1.20/Share
Year3=N1.35/Share
The next estimate to be made is the expected ending price for the stock three years in the
future. If we want to use the dividend yield approach, it is essential to project the
dividend yield on this stock three years from now. Assume you estimate a dividend
yield of 4 percent. Given the N1.35 dividend payment, this means an ending price
of N33.75 (N1.35 /. 04)
The final estimate is the required rate of return on this stock during this period. Assuming
that the 14 percent desired rate is still relevant for this period, the value of this stock
is as follows:
Vi= 1.10. +1.20 + 1.35 + 33.75
1+.14 (1+.14)2 (1+.14)3 (1+.14)3
= 1.10. + 1.20 +1.35 + 33.75
1.14 (1.30) (1.4815K1.4815)
= .96 + .92 + .91 + 22.78
= N25.57
Again, at this point you will compare this derived value for the stock to its market price to
determine whether you should purchase the stock or not.

196
o The following below are the condition necessary for perfect capital market (a) market are
frictionless (b) there is imperfect competition in product and security markets (c)
markets are informational efficient and information is costless (d) all individuals are
rational expected utility maximizes
o ANS: B

10.7.3 Infinite Period Model.

It is possible to extend the discussion of the multi-period model by considering longer
holding periods (e.g., 5,10 or l5 years). It is believed that the benefits to be derived
from the extensions would be minimal and the boredom factor would quickly
dominate. The simplest assumption is that the future dividend stream increases at a
constant rate for the infinite period.

This model is specified as follows:

!
= + + "

Where:
Vj = the value of stock j
Do = the dividend payment in the current period
g = the constant growth rate of return on stock j
n = the number of periods which is assumed to be infinite
The formulation can be simplified to the following expression:
Vj = Di
i-g
In many cases, rather than Vj the expression is written:
Pj = D i
i-g
The key estimates to be made are the required rate of return (i) and the expected growth rate
of dividends (g). After estimating g, it is a simple matter to estimate D1, because it
is current dividend Do multiplied by (i + g).

197
For example, let us assume that a stock with a current dividend of N1 a share, which you
expect to increase to Nl.09 next year. You believe that over the long run, the firm's
earnings and dividend will continue to grow at 9 percent; your estimate of g is 0.09.
For the long run, you expect that the rate of inflation will fall and you believe that
the long run required rate of return on this stock should be 13 percent; your estimate
of i is 0.13. Thus, the appropriate variables are:
g= .09
i = .13
Di = 1.09 (N1.00 x 1.09)
P= 1.09
.13 - .09
P = 1. 09
.04
P = N27.25
For the near term you believe 14 percent was relevant due to a high rate
inflation. Examples are:
1. g = . 09; i = . 14; D =N1.09 (We assume an increase in i)
P = N1.09
.14- .09
= N1.09
.05
= N21.80

2. g =.10;i = .13;D = N 1.10 (we assume an increase in g)

P= N1.10
.13-.10
=N1.10
.30
= N36.67
Apparently, a 1 percent change in either g or ihas a major impact on the calculated price of
the stock. The important relationship is the spread between the required rate of
return and the expected growth rate. Anything that causes a fall in the spread will
cause a rise in prices, while any change that results in arise in the spread will cause
a fall in stock prices.
o This theory neglect an idealized world of perfect capital markets where transactions costs
are assumed to be zero (a) capital market efficiency (b) perfect allocational
efficiency (c) operational efficiency (d) semi-strong form efficiency
o ANS: C

198
10.7.4 Infinite Growth Model and Growth Companies
The three key assumptions of the growth model are:
1. A constant rate of growth
2. The constant growth rate will continue for an infinite period.
3. The required rate of return (i) exceeds the infinite growth rate (g). If not, the model
explodes and gives useless results, i.e., the denominator becomes a negative value.
10.8 PRAGMATIC MULTIPLIER APPROACH:
Many investors prefer to derive value based upon earnings multiplier approach. The basic
rationale for this approach is that assets are the capitalized value of future earnings,
which means that investors derive value by determining how many Naira they are
willing to pay for a Naira of expected earnings, (typically, earnings during the next
12 month period). If an investor is willing to pay 10 times expected earnings, a
stock that is expected to earn N2 a share will sell for N20. This multiplier, also
referred to as the price-earnings (P/E) ratio is derived as follows:
Earnings Multiplier = Price Earning Ration = Current Prices
Next 12 Month Earnings
Specifically, the basic dividend valuation model is as follows:
Pi = Di
i- g
If we divide both sides of the equation by E 1 (the expected earnings during the next 12
months):
Pi = Di/E
Ei i-g
Therefore, the P/E ratio is determined by:
a. The expected dividend payout ratio (dividend divided by earnings)
b. The required rate of return on the stock
c. The expected growth rate of dividend for the stock

199
Let us assume
me that a stock under consideration has an expected dividend payout of 50
percent (i.e., the firm usually pays out 50 percent of its earnings as dividends), a
required rate of return of 13 percent and expected growth rate for dividends of 9
percent, we would
ld have the following:
D/E = .50; i = .13; g =.09
.$%
P/E =
. &' .%)
.$%
=
.%*

= N12.5
change in either i or g will have a large impact on the multiplier as shown in the following
examples:
a. D/E = 0.50; i = 0.14; g = 0.09(we assume a rise in i )
.$%
P/E =
. *' .%)

.$%
=
.%$
=N10

b. D/E = 0.50; i = 0.13; g = 0.10(we assume a rise in g )

.$%
P/E =
. &' .%)
.$%
=
.%&
= N16.7

SUMMARY
Basic instruction of security analyses are adequat
adequately
ely covered in our discussions. Grasping
the stuff in this Study Session simply requires basic understanding of some of the
issues discussed in Study Session 8 on Mathematics of Finance. Refreshing yourself
on the discussion on time value of money as pertaining especially to discounting
methods or present value wo
would
uld help your understanding of the discussion in this
Study Session of our course text in Introduction to Finance FIN 210..

200
Before an individual makes an investment, he must determine the required rate of return and
how much he should pay for a particular investment to get this required return. The
determination of how much he should pay for an investment is really a
determination of the value of the asset

SELF ASSESSMENT QUESTIONS

1. A bond with 8 years until maturity pays an annual coupon of 75 and will also N 1000 at
maturity. What is the price of the bond if interest rate is 8%? (A): N 431.0 (b): N
1,000 (c): N 971.27 (d): N 459.73
2. JenlogbatemiPlc has in issue 18% N 1,000 irredeemable debenture currently selling at
N1.150. determine the cost of debt if the corporate tax rate is 33% (a) 10.2% (b)
11% (c) 12% (d) 13% (e) 15%
3. JelutoroPlc has just paid a dividend of 15k per share and has a projected dividend growth
rate of 8% p.a. if the current market price of the share is N1.50, what is the cost of
equity? (a) N 16.6% (b) N 17.7% (c) N 18.8% (d) N 19.9% (e) 20.22%
4. The element of cost of capital are among others the following (a) risk free (b) premium
for financial risk (c) premium for insurance risk (d) a and b
5. ………. Is the risk associated with introduction of debt into a company capital structure
(a) business risk (b) specific risk (c) interest rate (d) financial risk
6. Cost of equity can be evaluated using the……. (a) dividend valuation model (b) dividend
valuation growth model (c) dividend growth rate model (d) valuation growth
model
7. Cost of preference share is best define as the …… rate of return expected by the provider
of preference share capital (a) maximum (b) highest (c) biggest (d) minimum
8. One of the condition for using weighted average cost of capital as a discount rate for
investment project appraisal is that…………. (a) the company’s capital structure is
optimal (b) the capital structure is not optimal (c) the company’s weighted average
cost of capital reflects the company’s short future capital structure (d) all of the
above
9. One of the components of weighted average cost of capital are among others except (a)
cost of debt (b) cost of preference shares (c) cost of equity (d) value of the firm
10. From the following computed ratio, calculate the current market price of one
ordinary share of XYZ Ltd, dividend cover = 1.5times, price earnings ratio = 5
times, return on capital employed = 25%, earning per share 37 kobo, dividend per
share 25kobo. (a) N 2.85 (b) N 1.85 (c) N 4.58 (d) N 3.85

Use the following question for 11-12

201
Eddy Biggs Bugger’s stock is currently selling for N72.00 per share. The stock is expected to
pay N 2.40 kobo dividend at the end of the next year. It is reliably estimated that the
stock will sell at the end of one year.
11. Assuming that the dividend and price forecasts are accurate, would you pay N72.00
today for the stock to hold if for one year it your required rate of return were 13
percent. (a) N 87.38 (b) N 40.80 (c) N 69.38 (d) N 2.00
12. Given the present price of N72.00 and the expected dividend of N2.40 what would
the price have to be at the end of the year to justify purchase today if your required
return were 15 percent. (a) N21.60 (b) N 18.60 (c) N80.40 (d) N 3.50
13. The expected dividend per share and the price per share of a company at the end of
the year are given at N3.50 and N65.00 respectively. The investors required rate of
return is 10 percent. Calculate the current market price of the security. As an
investment analyst, would recommend a sale or a purchase of the security if the
current market price is N56? (a) N 59.05 (b) N 37.32 (c) N 12.00 (d) N 69.38
14. Prices that are equally likely to rise or fall on any particular day previous days, are
said to follow…….. (a) random walk (b) efficient market hypothesis (c) Fama
(1976) operational nation of capital market (d) efficiency theory.

SAQs 10.2
The current dividend of First Capital Plc is N3.50 per share and it is expected to grow at a
fast rate of 15% per annum for the next three years. Thereafter, dividend will
stabilize at a normal rate of 8% per annum indefinitely. What would be the value of
First Capital Plc share, if the investors require rate of return is 13%?.

SAQ 10.3
N50,000 is invested at the beginning of 19.8 and remain invested, on 1st January of each
subsequent year another N4000 is added to it. What sum will be available in six
years later on if interest is compounded each year at the rate of 5% per annum?

202
 REFERENCES
Aborode, R.(2012); A Practical Approach to Financial Accounting. Lagos EL-TOBA
Ventures Ltd
Brealey, R. A and S. C Meyers.; Principle of Corporate Finance, (4thed), McGraw Hill
pushing CO, New York, 1991
BPP Publishing Limited Financial Reporting (BPP 1994)
Copeland T.E. and J.F. Weston., Financial Theory and Corporate Policy ( 3rd ED), Addison –
Wesley, 1998
Gordon, M.J; The Investment, Financing and valuation of the Corporation, Irwin,
Homewood, Illinois, 1962.
ICAN (2009) Study Pack on Financial Reporting and Ethics; VI Publishers,
Igben, O. R. (2007) Financial Accounting Made Simple Vol 1. Lagos. ROL Publishers
Jennings, A. R Financial Accounting Manual (3rd ), D. P. Publications Ltd Grand Union
Industrial Estate, Unit 6 Abbey Road, London
Owualah, S.I Understanding Business Finance, G-Mag Investments Ltd (Educational
publishers), Lagos, 1997.
Pandey, I.M.; Financial Management (6th ED), Vikas Pushing House New Delhi, 1993.
Van Horne, J.; Financial Management and Policy, (8th ED), Prentice Hall Inc, Englewood
Cliff, New Jersey, 1989.
Lintner J. (1965); "Security Prices, Risk and Maximal Gains FromDiversification", Journal of
Finance, Vol. 20 December. 587-616. Lone L. H. and LJ. Savage (1952); "The
Problems in Rationing Capital", Journal of Business, Vol. 7, March 77 -,99.

Malkiel Burton G. (1966); "The Term Structure of Interest Rates". Princeton N.J. Princeton
University Press.

Malkiel Burton G. (1970); "The Term Structure of Interest Rate Theory Empirical Evidence and
Application", New York, McCaleb - Seller Pub. Co.

203
 APPENDIX
SOLUTION TO SELF ASSESSMENT QUESTION
STUDY SESSION ONE
Q 1 2 3 4 5 6 7 8 9 10
A C A A D A B B A C A

STUDY SESSION TWO

Q 1 2 3 4 5 6 7
A C A D D B A A

STUDY SESSION THREE

ANSWERS
Q 1 2 3 4 5 6 7 8
A D D E C E C A E
9. The following are the shortcomings of profit maximization objective
(i) Maximization of profit simply by expanding the scale of operation and not in relative
term.
(ii) Maximization of profit could be achieved at the expense of jeopardizing long run benefit.
10. (i) Vagarious of stock market prices or
(ii) stock market meltdown

STUDY SESSION FOUR

ANSWERS
Q 1 2 3 4 5 6
A C A B B A C

STUDY SESSION FIVE

a. ANS: Bankers Acceptance 3 parties commercial papers- 2 parties
b. ANS: Both income and capital values could be eroded by inflation
c. ANS: Par value; values stated in the issued document
: Market value; value as determined by investors in bond market
d. ANS: Act as agent to the two parties
e. ANS: Secondary market
f. ANS: Initial public offering or (is a primary market transaction)
g. ANS: Denomination intermediation
h. ANS: Money market
i. ANS: Transmission of monetary policy
j. ANS: Financial institutions
STUDY SESSION SIX

204
ANSWERS
Q 1 2 3 4 5 6 7 8 9 10 11 12 13 14
A B B A C B B C B C B D D B B

STUDY SESSION SEVEN

SOLUTION TO SAQ 7
Q 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
A A A B E D A C D C B A A D D D

STUDY SESSION EIGHT

Solution to SAQ 1 ESSAY
Union BANK LTD
FV = Pv (1 + r/m)nm
FV = N 10,000 {1 + 0.24}5x4
4
FV = N 10,000 (I + 0.06)20
FV = N 32,071.35

GTbank
FV = PV (1 + r)n
FV = 10,000 (1 + 0.3)5
FV = N 37,129.30
GTbank will provide Kemi with the highest return at the end of the five years period,
because N 37,129.30 > N32, 071.35

SAQ 2 Answer to question

Questions 1 2 3 4 5 6 7 8 9 10 11 12 13
Answers A C D B D B D C D C A B B

STUDY SESSION NINE

SAQ 1 Answer to questions
Questions 1 2 3 4 5 6 7 8 9 10
Answers C A B D D C A B A B

SAQ 2 ESSAY

205
SOLUTION 1
Costs incurred calculated as follows:
N
Direct materials 405 of 3,000,000 = 1,000,000
Variable overheads 15% of 3,000,000 = 450,000
Fixed overheads 205 of 3,000,000 = 600,000
Direct labour 30% of 3,000,000 - 900,000

AVERAGE VALUE OF CURRENT ASSETS

N
Raw materials 2/12 x 1200,000/1 200,000
Working in progress
(100% completed)
Materials 2/12 x 1,200,000 200,000
(50% complete)
Labour 1/12 x 900,000 74999.99
(100% complete)
Variable overheads 37,499.99
Finished goods
Materials 2/12 x 1200,000 200,000
Labour 2/12 x 900,000 150,000
Variable overheads 2/12 x 450,000 75,000
Debtors 3 ½ x 450,000 1,575,000
2,512,499.99
Less: average value of current liabilities:
Materials 25/12 x 1200,000 249,999.99
Labour 1/52 x 900,000 17,307.69
Variable overhead 2/12 x 450,000 75,000
Fixed overheads 1/12 x 600,000 49,999.99
Selling and distribution 1/12 x 300,000 24, 999.99
417,307.66
Working capital required 2,095,192.33
Note: It has been assumed that all the direct materials are allocated to work in progress
when production commenced.

SOLUTION 2

206
(a) Average inventory = opening + closing inventories
2
= 3 million + 2 million = 5 = 2.5 million
2 2

(b) Inventory turnover ratio = Cost of goods sold

Average inventory
= 8.2 million = 3.3
2.5 million

This implies that the inventory cycle occurs 3.3 a year

(c) Days in inventory = Days in a year = 365 = 110.6 days
Inventory turnover ratio 3.3
It implies that inventory cycle is slightly more than 110 days.

(d) Average account receivable = opening + closing account receivables

2
=2,000,000 + 1,600,000 = 3,600,000 = 1,800,000
2 2

(e) Average receivable turnover = Credit sales

Average account receivables
= 11, 500,00 = 6.4
1,300,000
(f) Days in receivables = Days in year = 365 = 57 days
Average receivable turnover 6.4

(g) Average payables = opening + closing account receivables

2
= 1,000,000 + 750,000 = 1,750,000 = 875,000
2 2

(h) Account payable deferral period = cost of goods sold

Average payable
= 8,200,000 = 9.4
875,000

(i) Days in payables = Days in a year

Accounts payable deferral period
= 365 = 38.8 days
9.4

(j) Operating cycle = Days in inventory + Days in receivables

207
 = 110.6 days + 57 days = 167.6 days

(b) Cash cycle = Operating cycle – Days in payables

= 167.6 days - 38.8 days = 128.8 days

SUGGESTION
The need for short-term financial decision making is suggested by the gap between the cash
inflows and cash outflows. This is related to the length of the operating cycles and
account payables period. The gap can be filled either by borrowing or by holding a
liquidity reserve for marketable securities. The gap can be shortened by changing
the inventory, receivables, and payables periods

STUDY SESSION TEN

SAQ 1
Answers
Questions 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Answers C A C D D B D C D B C C A A

SAQ 2 ESSAY
SOLUTION
1st Stage
Present value from year 1 to 3 shown below
Po = (Do [1 + g] + Do [1 + g]2 + Do [1 +g]3
( 1 + ke)1 (1 + ke)2 (1+ke)3

Po = 3.50 [1.15] + 350 [1.15]2 + 350[1.15]3

(1.13)1 (1.13) 2
(1.13) 3

Po = 3.50 [1.15] [1.13]-1 + 3.50[1.15]2 [1.13]-2 + 3.50[1.15]3[1.13]-3

Po = N10.88k

2nd stage
(Present value from year 4 to infinity is shown below)
P3 = D3[ 1+g]
Ke - g
D3 = Dividend per share at the end of year 3

208
 3.50 [1.15]3 = 5.32

P3 = 5.32 [ 1 + 0.08]
0.13 – 0.08

P3 = 5.32 [ 1.08]
0.05
P3 = N114.91k

Discounting P3 back to present

Po = 114.91
[1+ 0.13]3
Po = 114.91 [1.13]-3
Po = N79.64k
The value of first capital plc share is 90.52
Po = 10.88 + N79.64k
Po = N90.52

Solution SAQ 10.3

Compound interest with annual investment
At = (A0 + P/r) (1 + r)t = P/r
Where A0 = Initial investment, r = of interest
P = Subsequent annual investment
At = (50,000 + 4,000) (1.05)6 – 4,000
.05 .05
= N94,212

209
Should you require more explanation on this study session, please do not hesitate to
contact your e-tutor
tutor via the LMS.

Are you in need of General Help as regards your studies? Do not hesitate to
contact the DLI IAG Center by ee-mail or phone on:

iag@dli.unilag.edu.ng
08033366677

210