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NATIONAL OPEN UNIVERSITY OF NIGERIA

FACULTY OF MANAGEMENT SCIENCES

COURSE TITLE: BUSINESS FINANCE

COURSE CODE: BFN732

Writer Dr. Samson Ogege

Department of Finance
Faculty of Business Administration
University of Lagos

Course Editor Assoc. Prof. Prince UmorAgundu

Department of Banking and Finance
Faculty of Humanities, Management & Social Sciences
Federal University, Wukari
Taraba State

Programme Coordinator DR. OKOH JOHNSON IFEANYI

Department of Financial Studies
Faculty of Management Sciences

Head of Department Dr. Ofe. Inua

Department of Financial Studies
Faculty of Management Sciences
 COURSE GUIDE

1.0 INTRODUCTION

This course is designed to give you self-instruction on the concept of Business Finance for PGD
in Banking and Finance of the School of Management Sciences.

2.0 COURSE AIMS

The aim of this course is to introduce Finance to first year of the programme Post Graduate
Programme (PGD) students of Banking and Finance to understand business finance in a firm,
enterprise or business organization.

3.0 COURSEOBJECTIVES

By the end of this course, the student should be able to:

 Explain working capital-Concept, stock and cash management,

 Acquit you with the concept of capital Budgeting, capital Rationing and capital
structure
 Introduce working capital management

4.0 WORKINGTHROUGHTHECOURSE

This course, BFN 732 Business Finance, it is expected of you to do a lot of reading in order
to cover the materials in the course material. It implies that you should devote much time to
this course by reading through this material and getting more information from numerous
texts and journals in research. The course material has been made easy to read and user-
friendly.

5.0 COURSEMATERIALS

The National Open University of Nigeria provides you with the following items:

 Course Guide
 Study Units
 TMA Assignment file

In addition, at the end of every unit is a list of texts for your references and for further reading.
It is not compulsory for you to read all of them. They are only essential supplements to this
course material.

6.0 STUDY UNITS

The study units in this course are located under Modules as follows:
 MODULE 1 WORKING CAPITAL MANAGEMENT
Unit 1 concept of working capital
Unit 2 Cash Management
Unit 3 Stock Management

MODULE 2 CAPITAL BUDGETING DECISION

Unit 1 Payback Period
Unit 2 Accounting Rate of Return
Unit 3 Net Present Value
Unit 4 Internal Rate of Return
Unit 5 Profitability Index

MODULE 3 CAPITAL RATIONING

Unit 1 Types and Causes of Capital Rationing
Unit 2 Different Situation of Capital Rationing
Unit 3 Project selection methods

MODULE 4 CAPITAL STRUCTURE DECISION

Unit 1 Concept of Capital Structure
Unit 2 Financing Structure and Capital Structure
Unit 3 Theories of Capital Structure
Unit 4 Planning of Capital Structure

COURSEDESCRIPTION
The modules and units are self-explanatory as they summarize BUSINESS FINANCE - for PGD students of
Banking and Finance. You will need to work in groups with other students in this course and program in order
to discuss, compare notes and thoughts and to exchange and share ideas.

6.0 ASSESSMENTS

There are two aspects to the assessment of the course: first are the tutor- marked assignments (TMA); and the
end of course examination. With in each unit are self-assessment exercises which are aimed at helping you
check your assimilation a s you proceed. Try to attempt each of the exercises before finding out the expected
answer from lecture.

8.0 TUTOR-MARKED ASSIGNMENT (TMA)

This is your continuous assessment and accounts for 30% of your total score. You are expected to answer at
least four TMA’s, three of which must be answered and submitted before you sit for the end of course
examination. Your Facilitator will give you the TMA’s and you must submit to your Centre your responses.

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9.0 FINAL EXAMINATION AND GRADING

With this examination written successfully, you have completed your course in Basic Research and one
believes you would apply your knowledge (new or up-graded) in your project. The ‘end of course
examinations’ would earn you

70% which would be added to your TMA score (30%). The time for this examination would
be communicated to you.

Table1: Course Marking Scheme

ASSESSMENT MARKS
Assignment (TMAs)1–4 Four (4) assignments, best
three (3) marks of the four
accountat10%each==10x
3=30%
End of course examination 70%of overall course marks
Total 100% of course marks

10.0 HOW TO GET THE MOST FROM THIS COURSE

In distance learning, the study units are specially developed and designed to replace the
c o n v e n t i o n a l lectures. Hence, you can work through these materials at your own pace, and at a
time and place that suits you best.

Visualize it as reading the lecture.

Each of the study units follows a common format. The first item is an introduction to the subject matter
of the unit, and how a particular unit is integrated with the other units and the course as a whole. Next
is a set of learning objectives. These objectives let you know what you should be able to do by the time
you have completed the unit. You should use these objectives to guide your study. When you have
finished the unit, you must go back and check whether you have achieved the objectives. If you make
a habit of doing this, you will significantly improve your chances of passing the course.

The main body of the unit guides you through the required reading from other sources.

This will usually be either from your set books or from a Reading Section. Activities are
interspersed throughout the units, and answers are given at the end of the units.

Practice these self-assessment exercises to help you to achieve the objectives of the units and
prepare you for the assignments and the examinations. Keep tap with your facilitator for
assistance.

In summary,

(1) Try to read this course guide;

(2) Organize a study schedule;
(3) Do everything you can to stick to the schedule;
(4) Assemble the study materials;

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(5) Work through the unit. The content of the unit itself has been arranged to provide a
sequence for you to follow. As you work through this unit, you will be instructed to
read sections from your set books or other articles.
(6) Review the objectives for each study unit confirms that you have achieved them. If you feel
unsure about any of the objectives, review the study material or consult;

(7) When you are sure of having achieved a unit’s objectives, you can then start on the next unit;

(8) After completing the last unit, review the course and prepare yourself for the final examination.
Check that you have achieved the unit objectives and the course objectives.

To gain the maximum benefit from course tutorials, prepare a question list before attempting them.

11.0 SUMMARY

This course BFN 732 is designed to introduce you to Business Finance to give you some knowledge
which would help you to understand the role of business finance in business enterprise and other
organizations. Endeavour to go through this course successfully and you would be in a good position
to pass your examination at the end of the semester. We wish you success in your examination.

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 TABLE OF CONTENTS

MODULE 1 WORKING CAPITAL MANAGEMENT

Unit 1 concept of working capital
Unit 2 Cash Management
Unit 3 Stock Management

MODULE 2 CAPITAL BUDGETING DECISION

Unit 1 Payback Period
Unit 2 Accounting Rate of Return
Unit 3 Net Present Value
Unit 4 Internal Rate of Return
Unit 5 Profitability Index

MODULE 3 CAPITAL RATIONING

Unit 1 Types and Causes of Capital Rationing
Unit 2 Different Situation of Capital Rationing
Unit 3 Project selection methods

MODULE 4 CAPITAL STRUCTURE DECISION

Unit 1 Concept of Capital Structure
Unit 2 Financing Structure and Capital Structure
Unit 3 Theories of Capital Structure
Unit 4 Planning of Capital Structure

MODULE 1 WORKING CAPITAL MANAGEMENT

Unit 1 concept of working capital
Unit 2 Cash Management
Unit 3 Financing of Working Capital
Unit 4 Forecasting Working Capital

Unit 1 CONCEPT OF WORKING CAPITAL MANAGEMENT

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CONTENTS

1.0 Introduction

2.0 Objectives

3.0 Main Contents

3.1 Definition of Working Capital

3.2 Concepts of Working Capital

3.2.1 Classification of Working Capital

3.3 Determinants of Working Capital

3.4 Theories of Working Capital

3.5 Structure of Working Capital

3.6 Working Capital Policy

4.0 Conclusion

5.0 Summary

6.0 Tutor-Marked Assignment

7.0 References/Further Reading

1.0 INTRODUCTION

Working capital is a very crucial part of capital as to represents the productive capacity applied
to productive assets yielding productive results which is known as utility. The working capital
of a company refers to the resources needed for day to day production of utility which a
company sells as goods or services. It is also known as the excess of current assets over current
liabilities.
They can be funded either by short or long-term finance. It is not a permanent investment, it is
only invested in a business production for a short while and is reinvested continually as it yields
more income for the company.
Current assets and current liabilities share a relationship of which current Assets should at least
be double of current liabilities for the firm to be said to have an ideal current ratio showing
how solvent a company is.

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Working capital is that portion of a firm’s capital which is employed in short term operations.

Current assets represent Gross Working Capital. The excess of current assets over current

liabilities is Net Working Capital. Current assets consists of all stocks including finished goods,

work in progress, raw material, cash, marketable securities, accounts receivables, inventories,

short term investments, etc. These assets can be converted into cash within an accounting year.

Current liabilities represent the total amount of short term debt which must be settled within

one year. They represent creditors, bills payable, bank overdraft, outstanding expenses, short

term loans, etc. The working capital is the finance required to meet the costs involved during

the operating cycle or business cycle. Operating cycle is the period involved from the time raw

materials are purchased to the time they are converted into finished goods and the same are

finally sold and realized. The need for current assets arises because of operating cycle. The

operating cycle is a continuous process and therefore the need for current assets is felt

constantly. Each and every current asset is nothing but blockage of funds. Therefore, these

current assets need to be financed which is done through Working Capital Financing. There is

always a minimum level of current assets or working capital which is continuously required by

the firm to carry on its business operations. This minimum level of current assets is known as

permanent or fixed working capital. It is permanent in the same way as the firm’s fixed assets

are. This portion of working capital has to be financed by permanent sources of funds such as;

share capital, reserves, debentures and other forms of long term borrowings. The extra working

capital needed to support the changing production and sales is called fluctuating or variable or

temporary working capital. This has to be financed on short term basis.

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2.0 OBJECTIVES

The objectives of this study is to enable students know the importance of efficient of working
capital and also the concept of over or under capitalization.
 To understand working capital management

 To know the classification of working capital

 How to manage working capital in firms and how it improves earnings

 To know the determinant of working capital

 To be acquainted with the theories of working capital

3.0 Main Content

3.1 Definition of Working Capital

Working Capital is a liquidity ratio that measures a company's ability to pay off its current

liabilities with its current assets. Working Capital is calculated by subtracting current liabilities

from current assets. Working Capital Management is a managerial accounting strategy

focusing on maintaining efficient levels of both components of Working Capital, current assets

and current liabilities, in respect to each other. Working Capital Management ensures a

company has sufficient cash flow in order to meet its short-term debt obligations and operating

expenses. Implementing an effective Working Capital is an excellent way for many companies

to improve their earnings. Working capital is the lifeblood of a business enterprise

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3.2 Concepts of Working Capital

A Net Working capital

This is the difference between current assets and current liabilities. It epitomize the margin of

safety for meeting current liabilities and climaxes the financial health of the company.

Therefore Net Working Capital (NWC =CA- CL)

B GROSS WORKING CAPITAL:

This refers to the amount of funds invested in current assets that are employed in the business.
It is these assets that the finance manager concerns himself with in an attempt to bring about
productivity from other assets.

3.2.1 CLASSIFICATION OF WORKING CAPITAL

Working capital may be classified in two ways:

(a) GROSS WORKING CAPITAL: This classification is directly related to the gross
concept as capitals invested in the various components of current assets such as dash,
inventories, receivables and short-term assets.
(b) PERMANENT OR TEMPORARY WORKING CAPITAL
A second classification alluding to time is also necessary. Using time as a basis, working
capital may be classified either permanent or temporary:

First, unlike fixed assets, which retain their form over a long period of time permanent working
capital is constantly changing from one asset to another. Secondly, permanent working capital
never leaves the business process. Third, as long as a firm experiences growth, the size of the
permanent working capital amount will always increase.

Temporary or variable working capital, like permanent working capital, changes its form from
cash to inventory to, receivables and back to cash, but it differs from permanent working capital
in that it is not always gainfully employed. Businesses that are seasonal and/or cyclical in nature
need more temporary working capital than firms that are into real manufacturing of physical
goods.

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3.3 DETERMINANTS OF WORKING CAPITAL

A firm’s requirement for working capital is primarily affected by the following factors:

a. VOLUME OF SALES
This is the most important factor affecting the size of the firm’s working capital. A firm
maintains current assets because they are needed to support the operational activities that result
in sales. Over time a firm will keep a fairly steady ratio of 20 to 30 percent (between current
assets and sales). This means that a firm realizing constant level of sales will operate with a
fairly constant level of cash, receivables, and inventory if properly managed. Firms
experiencing growth in sales will require additional permanent working capital. If, sales are
declining, a reduction in permanent working capital would usually be the case.

b. SEASONAL AND CYCLICAL FACTORS

Most firms experience seasonal fluctuation in the demand for their products and services. These
variations in sales will affect the level of working capital needed. Similarly, when the overall
economy experiences a varying level of economic activity, with changes in the business cycle,
the need for working capital will also be affected.

If the economy enters a recession, a firm’s, sales will temporarily decline because customers
will be more cautious in purchasing goods and services. This will decrease the need for working
capital. A boom economy will have the opposite effect.

c. CHANGES IN TECHNOLOGY
Technological changes/developments particularly those related to the production process, exert
a high impact on the need for working capital. If the faster processing requires increased
materials for efficient production runs, the permanent, inventory will increase. Thus, the
working needs of the firm.

d. FIRM’S POLICES
The Firm’s policies will affect the levels of working capital. Assuming the firm changes its
credit policy from net 30 to net 60, additional funds will be permanently tied up in receivables.
If it changes production policies, inventory requirements may be permanently or temporarily
affected, if it changes its safety level of cash on hand, permanent working capital may increase
or decrease. If the level of cash is linked to the level of sales, variable working capital may be
affected. This can be summarized as follows:

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 Table 1.1 Sources of changes in working capital needs

Sources of change Working capital Reason

affected
Sales volume Permanent Different levels of cash receivables
needed at new sales level receivables
and inventory must be available on
temporary basis
Seasoned and cyclical Variable and, Level of inventory must support the
factor technology Permanent new production capability
Policies of firm Variable and Some policies tie up working capital
Permanent while some others release it.

e. NATURE OF THE BUSINESS

A company’s working capital requirements are basically related to the kind of business it
conducts. Trading and manufacturing concerns require more working capital than concerns
engaged in provision of public utilities and services. A trading concern generally needs
comparatively small working capital, whereas manufacturing cum trading stands between these
two.

f. TYPE OF INDUSTRY
The requirement of working capital also varies from industry to industry. A plant that engages
in producing beans would require more working capital than a firm that manufactures bread.

g. PRODUCTION POLICY ANTI PROCESS

Seasonal industries obviously have varied need for working capital. Here, the working capital
requirements will depend upon the production policy adopted by the particular company.
Where a longer period is required in the manufacturing process, the need for a higher working
capital will be apparent.

h. GROWTH PROSPECTS OF THE BUSINESS

The expansion and growth of the business will lead to increased demand for finished goods of
the company, which consequently leads to increased need for working capital. Where the
growth prospect is higher, the need for working capital will also increase.

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i. BUSINESS CYCLE FLUCTUATION
The business cycle also has an impact on the requirement of working capital. In boom periods
businessmen purchase a high stock of raw materials and other goods to be used in the business
operations in order to take advantage of higher demand and incomes. Thus, more working
capital is need during boom period. The converse is the case in recession periods.

j. Dividend Policy
The dividend policy of the company also affects its working capital requirements. A company-
paying dividend in cash will require more cash than a company, which gives dividend in form
of bonus shares.

k. Economic Factors and Government Policy

Government policies have great impact on the working capital requirements of a company.
Government policy, particularly in respect of import of raw materials, foods, and spares, control
of prices and distribution, credit control, bank rates and other labour laws, have great effect on
the requirements of working capital of a firm. Besides the above, other factors may affect the
requirement of working capital of a particular company. These include transport, and
communication facilities, social responsibility etc.

Other factors that determine the amount of working capital needed by the firm include:

1. Availability of credit
2. Attitude towards profits and
3. Attitude towards risk.

3.4 THEORIES OF WORKING CAPITAL

Working capital affects the risk and return profit of a firm. The successful firms usually
maintain the necessary amount of working capital to meet their needs. In fact, studies indicate
that the most successful firms generally keep more than enough working capital. A basic fact
here is that a firm needs to concentrate attention on solving liquidity problems. We have two
theories on the effects of keeping excessive working capital:

Theory one: High levels of working capital decrease risks and decrease returns. Proponents of
this theory argue that it is logically correct to say that excessive current assets cost money. If
they are kept, the 'firm must pay for them and the additional costs lower the after-tax-profits of
the firm and the returns to shareholders.

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Theory two: This theory holds that high levels of working capital decrease risk and increase
return. Proponents of this theory observed that the large and successful firms keep just enough
working capital. They argue that the concentration on profits, rather than liquidity, overcomes
the extra cost of the excessive working capital and results both in decreased risk and higher
returns.

Each theory has its own merit and is worthy of further investigations. The two theories agree
that inadequate working capital causes high risk and low returns. The level of production
generally determines working capital only when actual production is undertaken, and the
volume required. The precise level of investment in working capital predicated on:

1. Management’s attitude towards risk, and

2. Factors that influence the amount of cash inventories, receivables and other current
assets, required to support a given volume of output.
Risk means the risk of not maintaining sufficient current assets to:

1. Meet all financial obligations as they mature, and

2. Support the proper level of sales.
i. The first principle is concerned with the relationship between the rate of working capital
and sales. This relationship could be said to be that of working capital is varied relative
to sales, tile amount of risk that a firm assumes is also varied, and the opportunity for
gain or loss increased. This principle implies that a definite relationship exist between
the degree of risk management assumes and the rate of return. This means that the more
risk that a firm assumes, the greater is the opportunity for a higher return.
ii. Funds should be invested in each component of working capital as long as the equity
position of the firm increases.
iii. The type of funds used to finance working capital directly affects the amount of risk
that a firm assumes as well as the opportunity for gain or loss and cost of capital,
iv. The, greater the disparity between the maturity of a firm’s short-term debt instruments
and its flow of internally generated funds, the greater the risk, and vice-versa.

Working capital management involves a relationship between the current assets namely cash
and marketable securities, receivables and inventories, and the current liabilities. Working
capital management has been confined to the left hand side of the balance sheet where it has

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been directed to optimizing the levels of cash and marketable securities of receivable and of
inventories.

3.5 Structure of Working Capital

The different elements or components of current assets and current liabilities constitute the
structure of working capital which can be illustrated in the table below.

Structure of Current Assets and Current Liabilities

Current Liabilities Current Assets

Bank Overdraft Cash and Bank Balance
Creditors Inventories: Raw-Materials

Work-in-progress
Outstanding Expenses Spare Parts
Bills Payable Accounts Receivables
Finished Goods
Short-term Loans Bills Receivables
Proposed Dividends Accrued Income
Provision for Taxation, etc. Prepaid Expenses

Short-term Investments

Structure of Working Capital

The study of structure of working capital is another name for the study of working capital cycle.
In other words, it can be said that the study of structure of working capital is the study of the
elements of current assets viz. inventory, receivable, cash and bank balances and other liquid
resources like short-term or temporary investments. Current liabilities usually comprise bank
borrowings, trade credits, assessed tax and unpaid dividends or any other such things. The
following points mention below are the elements of working capital:

Inventory–Inventory is the major item of current assets. The management of inventories–raw

material, goods-in-process and finished goods are an important factor in the short-run liquidity
positions and long-term profitability of the company.

Raw material inventories – Uncertainties about the future demand for finished goods, together
with the cost of adjusting production to change in demand will cause a financial manager to
desire some level of raw material inventory. In the absence of such inventory, the company
could respond to increased demand for finished goods only by incurring explicit clerical and

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other transactions costs of ordinary raw material for processing into finished goods to meet that
demand. If changes in d e m a n d are frequent, these order costs may become relatively
large.

Moreover, attempts to purchase hastily the needed raw material may necessitate payment of
premium purchase prices to obtain quick delivery and, thus, raise cost of production. Finally,
unavoidable delays in acquiring raw material may cause the production process to shutdown
and then re-start again raising cost of production. Under these conditions the company cannot
respond promptly to changes in demand without sustaining high costs. Hence, some level of
raw materials inventory has to behold to reduce such costs. Determining its proper level
requires an assessment of costs of buying and holding inventories and a comparison with the
costs of maintaining insufficient level of inventories.

Work-in-process inventory–This inventory is built up due to production cycle. Production

cycle is the time-span between introduction of raw material into production and emergence of
finished product at the completion of production cycle. Till the production cycle is completed,
the stock of work-in-process has to be maintained.

Finished goods inventory– Finished goods are required for reasons similar to those causing
the company to hold raw materials inventories. Customer’s demand for finished goods is
uncertain and variable. If a company carries no finished goods inventory, unanticipated
increases in customer demand would require sudden increases in the rate of production to meet
the demand. Such rapid increase in the rate of production may be very expensive to accomplish.
Rather than loss of sales, because the additional finished goods are not immediately available
or sustain high costs of rapid additional production, it may be cheaper to hold a finished goods
inventory. The flexibility afforded by such an inventory allows a company to meet
unanticipated customer demands at relatively lower costs than if such an inventory is not held.
Thus, to develop successfully optimum inventory policies, the management needs to know
about the functions of inventory, the cost of carrying inventory, economic order quantity and
safety stock. Industrial machinery is usually very costly and it is highly uneconomical to allow
it to lie idle. Skilled labour also cannot be hired and fired at will. Modern requirements are also
urgent. Since requirements cannot wait and since the cost of keeping machine and men idle is
higher, than the cost of storing the material, it is economical to hold inventories to the required
extent. The objectives of inventory management are:

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(1) To minimize idle cost of men and machines caused by shortage of raw materials, stores
and spare parts.
(2) To keep down:

(a) Inventory ordering cost.

(b) Inventory carrying cost,

(c) Capital investment in inventories

(d) Obsolescence losses

Receivables–Many firms make credit sales, and as a result carry receivable as a current asset.
The practice of carrying receivables has several advantages viz., (i) reduction of collection costs
over cash collection, (ii) Reduction in the variability of sales, and (iii) increase in the level of
near-term sales. While immediate collection of cash appears to be in the interest of
shareholders, the cost of that policy may be very high relative to costs associated with delaying
the receipt of cash by extension of credit. Imagine, for example, an electricity supply company
employing a person at every house constantly reading electricity meter and collecting cash from
him every minute as electricity is consumed. It is far cheaper for accumulating electricity usage
and bill once a month. This of course, is a decision to carry receivables on the part of the
company. It may also be true that the extension of credit by the firm to its customers may reduce
the variability of sales over time. Customers confined to cash purchases may tend to purchase
goods when cash is available to them. Erratic and perhaps cyclical purchasing patterns may
then result unless credit can be obtained elsewhere. Even if customers do obtain credit
elsewhere, they must incur additional cost of search in arranging for a loan costs that can be
estimated when credit is given by a supplier. Therefore, extension of credit to customers may
well smooth out of the pattern of sales and cash inflows to the firm over time since customers
need not wait for some in flows of cash to make a purchase. To the extent that sales are
smoothed, cost of adjusting production to changes in the level of sales should be reduced.

Finally, the extension of credit by firms may act to increase near-term sales. Customers need
not wait to accumulate necessary cash to purchase an item but can acquire it immediately on
credit. This behaviour has the effect of shifting future sales close to the present time.

Therefore, the extensions of credit by affirm and the resulting investment in receivables occurs
because it pays a firm to do so. Costs of collecting revenues and adapting to fluctuating

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customer demands may make it desirable to offer the convenience associated with credit to a
firm’s customers. To the extents that near sales are also increased, extension of credit is made
even more attractive for the firm.

Cash and interest-bearing liquid assets–Cash is one of the most important tools of day-to-
day operation, because it is a form of liquid capital which is available for assignment to any
use. Cash is often the primary factor which decides the course of business destiny. The decision
to expand a business may be determined by the availability of cash and the borrowing of funds
will frequently be dictated by cash position.

Cash-in-hand, however, is a non-earning asset. This leads to the question as to what is the
optimum level of this idle resource. This optimum depends on various factors such as the
manufacturing cycle, the sale and collection cycle, age of the bills and on the maturing of debt.
It also depends upon the liquidity of other current assets and the matter of expansion. While a
liberal maintenance of cash provides a sense o f security, a lack of sufficiency of cash hampers
day-to-day operations. Prudence, therefore, requires that no more cash should be kept on hand
than the optimum required for handling miscellaneous transactions over the counter and petty
disbursements etc.

It has not become a practice with business enterprises to avoid too much redundant cash by
investing a portion of their earnings in assets which are susceptible to easy conversion into
cash. Such assets may include government securities, bonds, debentures and shares that are
known to be readily marketable and that may be liquidated at a moment’s notice when cash is
needed.

Working Capital Management theory is based on the traditional models of the Cash

Conventional Cycle that is initiated by Richards and Laughlin (1980). In fact, it tells about the

investment and credit decisions in the customer, inventory and suppliers, which show average

number of days started from the date when the firm starts payments to its suppliers and the date

when it begins to receive payments from its regulars. Padachi (2006) analysed the trends in the

Working Capital and its influence on business performance for small manufacturers of

Mauritius. He reported that firm’s needs for Working Capital of change over time depending

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on the rate of creation of money and high internal investment in inventories and receivables led

to reduced profitability.

3.6 Working Capital Policy

Working Capital Policy into three categories as defensive or hedging, aggressive and

conservative Working Capital policy Arnold, (2008) and discussed as follows:

Defensive policy: Company follows defensive policy by using long term debt and equity to

finance its fixed assets and major portion of current assets. Under this approach, the business

concern can adopt a financial plan which matches the expected life of assets with the expected

life of the sources of funds raised to finance assets Paramasivan and Subramanian, (2009).

Inventory expected to be sold in 30 days could be financed with a 30- day bank loan; a machine

expected to last for 5 years could be financed with a 5-year loan; a 20-year building could be

financed with a 20 year mortgage bond; and so forth Weston and Brigham, (1977). Defensive

policy reduces the risk by reducing the current liabilities but it also affects profitability because

long term debt offers high interest rate which will increase the cost of financing Arnold, (2008).

This means a company is not willing to take risk and feel it appropriate to keep cash or near

cash balances, higher inventories and generous credit terms. Mostly companies that are

operating in an uncertain environment prefer to adopt such a policy because they are not sure

about the future prices, demand and short term interest rate. In such situation it is better to have

a high level of current assets. Which means, keeping higher level of inventory in the stock, to

meet sudden rise in demand and to avoid the risk of stoppage in production. This approach

gives a longer Cash Conversion Cycle for the company. It also provides the shield against the

financial distress created by the lack of funds to meet the short term liability but as the

researcher discussed earlier long term debt have high interest rate which will increase the cost

of financing. Similarly, funds tied up in a business because of generous credit policy of

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company and it also have opportunity costs. Hence, this policy might reduce the profitability

and the cost of following this policy might exceed the benefits of the policy Arnold (2008).

Aggressive policy: Companies can follow aggressive policy by financing its current assets with

short term debt because it gives low interest rate. However, the risk associated with short term

debt is higher than the long term debt. Paramasivan and Subramanian (2009) pinpointed that

in aggressive policy the entire estimated requirement of current assets should be financed from

short- term sources and even a part of fixed assets financing be financed from short- term

sources. This approach makes the finance mix more risky, less costly and more profitable.

Furthermore, few finance managers take even more risk by financing long term asset with short

term debts and this approach push the Working Capital on the negative side.

Managers try to enhance the profitability by paying lesser interest rate but this approach can be

proved very risky if the short term interest rate fluctuates or the cash inflow is not enough to

fulfill the current liabilities Weston and Brigham, (1977). Therefore, such a policy is adopted

by the company which is operating in a stable economy and is quite certain about future cash

flows. A company with aggressive Working Capital policy offers short credit period to

customers, holds minimal inventory and has a small amount of cash in hand. This policy

increases the risk of default because a company might face a lack of resources to meet the short

term liabilities but it also gives a high return as the high return is associated with high risk

Arnold, (2008).

Conservative policy: Some companies want neither to be aggressive by reducing the level of

current assets as compared to current liabilities nor to be defensive by increasing the level of

current assets as compared to current liabilities. So, in order to balance the risk and return these

firms are following the conservative approach. It is also a mixture of defensive Working Capital

20
policy and aggressive Working Capital Policy. Moreover, this policy not only reduces the risk

of default but it also reduces the opportunity cost of additional investment in the current assets.

On the other hand apart from the above points the level of Working Capital also depends on

the level of sale, because, sales are the source of revenue for every companies. As sales increase

Working Capital will also increase with the same proportion so, the length of Cash Conversion

Cycle remains the same. As the sales increase Working Capital increase in a slower rate. As

the sales increase the level of Working Capital rises in misappropriate manner i.e. the Working

Capital might raise in a rate more than the rate of increased in the sale. Company with stable

sale or growing sale can adopt the aggressive policy because it has a confidence on its future

cash inflows and is confident to pay its short term liabilities at maturity. On the other hand a

company with unstable sale or with fluctuation in the sale can’t think of adopting the aggressive

policy because it is not sure about its future cash inflows. In such a situation adoption of

aggressive policy is similar to committing a suicide. Hence, searching other method might be

the best choice.

Examples:

Sales 200000
Cost of goods sold 150000
Purchases 90000
Stock 50000
Debtors 15000
Creditors 11000
Assume all sales and purchases are on credit calculate cash operating cycle.

Solution:
Stock Turnover cost of goods sold/ average stock = 150000/50000 = 1/3* 365 =122 days
Average collection period trade debtors/ credit sales* 365 = 15000/200000*365 = 27 days
Average payment period trade creditors/credit purchases *365= 11000/90000*365= 45days

21
Length of cash operating cycle = 122+27- 45 = 104days

4.0 Conclusion
The management of any business need ensure that the firm has a balanced trading capital. They
should monitor the level of funds that they should allocate to the current assets and monitor the
relationship between fixed and current assets. Effects of overtrading and under trading could
be quite detrimental.
Therefore firms try to keep an optimal level of Working Capital that maximizes their value

Deloof, (2003). In addition to that, the effective Working Capital is very important because it

affects the performance and liquidity. The major problem of Working Capital Management

in a profit making organization is its optimization which is inherently complex, It is a matter

of balancing each component and each organization need to manage it carefully in order to

maintain low Working Capital and the resources they need to fund product development,

make and deliver products and offer high levels of customer services. It was observed that poor

Working Capital management in many profit making organizations has resulted into distress

in profitability and erosion of equity.

5.0 Summary

In summary, the management of working capital is the biggest challenge of making a business
a going concern, working capital refers to turning over temporary investments of operational
resources.
The operating / cash / working capital cycle is the period in between inventory of raw materials
are obtained and converted to finished goods.
If the operating cycle is properly monitored, overtrading / under capitalization could be avoided
thereby ensuring that finances are properly regulated.
Working Capital policy can be best described as a strategy which provides the guideline to

manage the current assets and current liabilities in such a way that it reduces the risk of default

Afza and Nazir, (2007). Working Capital policy is mainly focusing on the liquidity of current

22
assets to meet current liabilities. Liquidity is very important because, if the level of liquidity is

too high then a company has lot of idle resources and it has to bear the cost of these idle

resources. However, if liquidity is too low then it will face lack of resources to meet its current

financial liabilities Arnold, (2008). Current assets are key component of Working Capital and

the Working Capital also depends on the level of current assets against the level of current

liabilities.

6.0 TUTOR MARKED ASSIGNMENT

 Differentiate between operating cycle and cash cycle
 What is overtrading?
 What is capitalization?
 What is overcapitalization?
 Outline the various working capital ratios
 Explain the term Working Capital?

 Why should firms manage Working Capital?

 What is the Concept Working Capital Policy?

 List and explain the determinants of working capital

7.0 REFERENCES

Afza, T. & Nazir, M. 2008. “Working Capital Approaches and Firm’s Returns in Pakistan”,

Pakistan Journal of Commerce and Social Sciences, Vol.1, pp.25-36

23
Akinsulire .O. (2011); “Financial Management” 7th Edition Lagos. Nigeria Ltd.

Arnold, G, (2008). “Corporate financial management”, 4thed. Harlow: Financial Times.

Clark Johen et al, (1979); Capital Budgeting Planning and Control of Capital Expenditure”,

Bentice

Deloof, M. (2003). Does Working Capital Management Affect Profitability of Belgian Firms

Journal of Business Finance & Accounting, Vol 30(3/4), Pg. 573-587.

Padachi, K. (2006). Trends in Working Capital Management and its Impact on Firms‟

Performance: An Analysis of Mauritian Small Manufacturing Firms. International

Review of Business Research Papers, 2(2), 45 - 58.Pakistan Firms, Interdisciplinary

Journal of Contemporary Research in Business, 3, 8.

Robicher A. and B Meyers (1985); Optimal Financial Management” West Publishing

Company.

Van-Horn J. (1989); “Financial Management and Policy”, New Jersey, Prentice-Hall Inc.

Walter J.E. (1967); “Dividend Policy and Enterprise Valuation” Califo

Weston J.F., and Brigham E.F., (1977), “Essentials of managerial finance Illinois”, The

Dryden Press, Weston.

Unit 2 Cash Management

CONTENTS

1.0 Introduction

2.0 Objectives

3.0 Main Content

24
 3.1 Definition and importance

3.2 Reasons for holding cash

3.3 Cash budgets

3.4 Functions of cash management

3.5 Receivables management

3.6 Payables management

3.7 Workings

4.0 Conclusion

5.0 Summary

6.0 Tutor-Marked Assignment

7.0 References/ Further Reading

Introduction

The importance of cash and liquidity for a business cannot be underestimated as it is very vital
to the going concern of the firm. If a company is unable to pay what it owes at the required
time, a creditor might take legal action to recover the unpaid amount. Even if such extreme
action is not taken, but a company is slow in paying invoices, creditors will be reluctant to
provide additional credit. It is therefore essential for a business to ensure that its cash flows are
well managed and that it has sufficient liquidity.

25
2.0 Objectives

The objective here is to establish understanding of what cash management is and how it is
important to the daily activities of the firm. Various components of cash management will also
be briefly discussed and we would also discuss about the functions it plays in organisations,
receivables, payables, cash budgets. Examples will also be included to aid better understanding.

3.0 Main Content

3.1 Definition and importance of Cash Management

Cash management involves not only avoiding insolvency, but also reducing the length of
account receivables (AR), increasing collection rates, selecting appropriate short-term
investment vehicles, and increasing cash on hand to improve a company's cash position and
profitability. This involves shortening of cash collection periods, regular follow ups for
collections, negotiation of favorable terms with suppliers allowing delay in payment periods,
and preparation of cash flow forecasts. Businesses also use of technology to speed up cash
collection process. They must do all of this while maintaining adequate amount of funds to
meet daily operations.

Successfully managing cash is an essential skill for small business developers, because they
typically have less access to affordable credit and have a significant amount of upfront costs to
manage while waiting for receivables. Wisely managing cash enables a company to meet
unexpected expenses, and to handle regularly occurring events such as payroll distribution.

3.2 Reasons for holding cash

1. Transaction Motive of Holding Cash

Transaction motive refers to the need to hold cash to satisfy normal disbursement collection
activities associated with a firm's ongoing operation. Transaction means the act of giving and
taking of cash or kinds in the ordinary course of business. A firm frequently involves in
purchase and sales of goods or services. A firm should make payment in terms of cash for the
purchase of goods, payment of salary, wages, rent, interest, tax, insurance, and dividend and
so on. A firm also receives cash in terms of sales revenue, interest on loan, return on
investments made outside the firm and so on. If these receipts and payments were perfectly
synchronized, a firm would not have to hold cash for transaction motive. But in real, cash
inflows and outflows cannot be matched exactly. Sometimes receipts of cash exceed the
disbursement whereas at other time disbursement exceeds the receipt. Because of this reason,
if disbursement exceeds the receipt, a firm should hold certain level of cash to meet current
payment of cash in excess of its receipt during the period.

2. Precautionary Motive of Holding Cash

Precautionary motive refers to hold cash as a safety margin to act as a financial reserve. A firm
should hold some cash for the payment of unpredictable or unanticipated events. A firm may
have to face emergencies such as strikes and lock-up from employees, increase in cost of raw

26
materials, funds and labor, fall in market demand and so on. These emergencies also bound a
firm to hold certain level of cash. But how much cash is held against these emergencies depends
on the degree of predictability associated with future cash flows. If there is high degree of
predictability, less cash balance is sufficient. Some firms may have strong borrowing capacity
at a very short notice, so that they can borrow at the time when emergencies occur. Such a firm
may hold very minimum amount of cash for this motive.

3. Speculative Motive of Holding Cash

The speculative motive refers to the need to hold cash in order to be able to take advantage of
bargain purchases that might arise, attractive interest rates and favorable exchange rate
fluctuations. Some firms hold cash in excess than transaction and precautionary needs to
involve in speculation. Speculative needs for holding cash require that a firm possibly may
have some profitable opportunities to exploit, which are out of the normal course of business.
These opportunities arise in conditions, when price of raw material is expected to fall, when
interest rate on borrowed funds are expected to decline and purchase of inventory occurs at
reduced price on immediate cash payment.

3.3 Cash Budgets

A cash budget is a detailed plan of cash receipts and cash payments during a planning period.
The planning period is sub-divided into shorter periods, and the cash receipts and payments are
forecast/planned for each of the sub-divisions of time. For an annual master budget, the cash
budget might be prepared on a monthly basis, or possibly a quarterly basis. Some business
entities prepare new cash budgets regularly, possibly forecasting daily cash flows for the next
week, or weekly cash flows for the next month. The main uses of a cash budget are as follows:
To forecast how much cash receipts and payments are expected to be over the planning period.
To learn whether there will be a shortage of cash at any time during the period, or possibly a
cash surplus. If there is a forecast shortage of cash, to consider measures in advance for dealing
with the problem - for example by planning to defer some purchases of non-current assets, or
approaching the bank for a larger bank overdraft facility. To monitor actual cash flows during
the planning period, by comparing actual cash flows with the budget.

3.4 Functions of Cash Management

Cash management is the treasury function of a business, responsible for achieving optimal
efficiency in two key areas: receivables, which is cash coming in, and payables, which is cash
going out.

3.5 Receivables Management

27
When a business issues an invoice it is reported as a receivable, which is cash earned but yet
to be received. Depending on the terms of the invoice, the business may have to wait 30, 60 or
90 days for the cash to be received. It is common for a business to report increasing sales, yet
still run into a cash crunch because of slow or poorly managed receivables. There are a number
of things a business can do to accelerate its receivables and reduce payment float, including
clarifying billing terms with customers, using an automated billing service to bill customers
immediately, using electronic payment processing through a bank to collect payments, and
staying on top of collections with an aging receivables report.

3.6 Payables Management

When a business controls its payables, it can better control its cash flow. By improving the
overall efficiency of the payables process, a business can reduce costs and keep more cash
working in the business. Payables management solutions, such as electronic payment
processing, direct payroll deposit, and controlled disbursement can streamline and automate
the payable functions.

Most of the receivables and payables management functions can be automated using business
banking solutions. The digital age has opened up opportunities for smaller businesses to access
the same large-scale cash management technologies used by bigger companies. The cost
savings generated from more efficient cash management techniques easily offsets the costs.
More importantly, management will be able to reallocate precious resources to growing the
business.

3.7 Example

A computer manufacturing company, Techno Ltd., uses supplier Beta & Co. to purchase its
core materials. Beta & Co. has the policy of allowing its customers who buy on credit to pay
within 30-days period.

At the moment Techno Ltd. has $20 million cash resources available and has to pay $5 million
to Beta & Co. after 30-day period for the purchases. However, after 30-day period Techno Ltd.
has an investment opportunity requiring use of the full $20 million cash resources.

If the company is able to renegotiate its terms with suppliers all

4.0 Conclusion

Cash management is the efficient collection, disbursement, and investment of cash in an

organization while maintaining the company’s liquidity. In other words, it is the way in which
a particular organization manages its financial operations such as investing cash in different
short-term projects, collection of revenues, payment of expenses, and liabilities while ensuring
it has sufficient cash available for future use.

5.0 Summary

28
Cash management refers to a broad area of finance involving the collection, handling, and
usage of cash. It involves assessing market liquidity, cash flow, and investments.[

6.0 Tutor-Marked Assignment

1) Briefly define and highlight the importance of cash management in a modern day
organisation.
2) What are the motives for holding cash.
3) In what way is cash management Vital to an organisation.
4) Poor cash management could lead to insolvency of a firm True/False
5) Enumerate functions of Cash management in a firm.

7.0 References/ Further Reading

1. "cash management" Investopedia 2016

2. "Cash management" cash budgets Strategic Financial management unlocked
3. Source: Euromoney Cash Management Survey 2016: The Euromoney Cash
Management Survey receives responses from the leading cash managers, treasurers and
financial officers worldwide, and is considered the benchmark survey for the global
cash management industry. The survey includes non-financial institutions and financial
institutions.
4. "Cash Management". Reference for Business. Advameg, Inc. Retrieved 14 January
2013.
5. "Cash Management". Small Business Notes. Retrieved 14 January 2013.
6. ^"What Cash Management Tools Are Available?". Advanced Pensions. Retrieved 14
January 2013.
7. "Cash Management- An Insight" (PDF). Finacle. Archived from the original (PDF) on
10 July 2012. Retrieved 14 January 2013.
8. "Cash Management Safes".

29
Unit 3 STOCK MANAGEMENT

CONTENT

1.0 Introduction
2.0 Objectives
3.0 Main Contents
3.1 What is stock?
3.1.1 Types of Stock
3.1.2 Stock Value
3.2 What is management?
3.3 What is Stock Management?
3.3.1 Retail Supply Chain
3.3.2 Business Models
3.3.3 Competing stock requirements
3.3.4 Push and pull
3.4 Importance of Stock management
3.4.1 Avoiding stock outs
3.4.2 Overstock hazards
3.4.3 Working capital issues
3.4.4 Manufacture’s Angle
3.4.5 Stock control
3.4.6 Customer service
3.4.7 Stock
3.4.8 Sales Tracking
3.4.9 Orders
3.5 Stock control
3.5.1 Stock control methods
3.6 The Basic EOQ Model

4.0 Conclusion
5.0 Summary
6.0 Tutor-marked Assignment
7.0 References

1.0 INTRODUCTION

Understanding what you have, where it is in your warehouse, and when stock is going in and

out can help lower costs, speed up fulfilment, and prevent fraud. Your company may also rely

on stock management systems to assess your current assets, balance your accounts, and provide

financial reporting.

30
Stock management is also important to maintaining the right balance of stock in your

warehouses. You don’t want to lose a sale because you didn’t have enough stock to fill an

order. Constant stock issues (frequent backorders, etc.) can drive customers to other suppliers

entirely. The bottom line? When you have control over your stock, you’re able to provide better

customer service. It will also help you get a better, more real-time understanding of what’s

selling and what isn’t.

You also don’t want to have excess stock taking up space in your warehouses unnecessarily.

Too much stock can trigger profit losses––whether a product expires, gets damaged, or goes

out of season. Key to proper stock management is a deeper understanding of customer demand

for your products.

31
2.0 OBJECTIVES
To achieve a full understanding of

 Stock
 Types of stock
 Management
 Stock management
 Stock control
 Importance of stock management
 Who a stock manager is

3.0 CONTENT

3.1 WHAT IS STOCK?

The goods or merchandise kept on the premises of a shop or warehouse and available for sale
or distribution. The capital raised by a company or corporation through the issue and
subscription of shares.

A stock is a type of security that signifies ownership in a corporation and represents a claim
on part of the corporation's assets and earnings. There are two main types of stock: common
and preferred. Common stock usually entitles the owner to vote at shareholders' meetings and
to receive dividends.
“A stock is a share in the ownership of a company. Stock represents a claim on the company's
assets and earnings. As you acquire more stock, your ownership stake in the company becomes
greater.”

According to the Business Dictionary, Stock can be defined as:

1. A share of a company held by an individual or group.

Corporations raise capital by issuing stocks and entitle the stock owners (shareholders) to
partial ownership of the corporation. Stocks are bought and sold on what is called an exchange.
There are several types of stocks and the two most typical forms are preferred
stock and common stock.
2. The proportional part of a company's equity capital represented by fully paid up shares.
3. British term for a fixed interest government debt security issued usually in denominations

Definition: A stock is a general term used to describe the ownership certificates of any
company. A share, on the other hand, refers to the stock certificate of a particular company.
Holding a particular company's share makes you a shareholder.

32
Description: Stocks are of two types—common and preferred. The difference is while the
holder of the former has voting rights that can be exercised in corporate decisions, the later
doesn't. However, preferred shareholders are legally entitled to receive a certain level of
dividend payments before any dividends can be issued to other shareholders

there is also something called 'convertible preferred stock'. This is basically a preferred stock
with an option of converting into a fixed number of common shares, usually any time after a
predetermined date.

3.1.1 TYPES OF STOCK

Everything you use to make your products, provide your services and to run your business is
part of your stock.

There are four main types of stock:

1. Raw materials and components - Ready to use in production

2. Work in progress - Stock of unfinished goods in production
3. Finished goods -Stock of completely processed goods ready for sale.
4. Consumables - For example, fuel and stationery

3.1.2 STOCK VALUE

You can categorise stock further, according to its value. For example, you could put items into
low, medium and high value categories. If your stock levels are limited by capital, this will
help you to plan expenditure on new and replacement stock.

You may choose to concentrate resources on the areas of greatest value.

However, low-cost items can be crucial to your production process and should not be
overlooked.

3.2 WHAT IS MANAGEMENT?

The process of dealing with or controlling things or people.

The organization and coordination of the activities of a business in order to achieve defined
objectives. ... Management consists of the interlocking functions of creating corporate policy
and organizing, planning, controlling, and directing an organization's resources in order to
achieve the objectives of that policy.

Management is often included as a factor of production along with machines, materials,

and money. According to the management guru Peter Drucker (1909-2005), the basic task of
management includes both marketing and innovation. Practice of modern management

33
originates from the 16th century study of low-efficiency and failures of certain enterprises,
conducted by the English statesman Sir Thomas More (1478-1535).

The directors and managers who have the power and responsibility to make decisions and
oversee an enterprise.
The size of management can range from one person in a small organization to hundreds or
thousands of managers in multinational companies.

Management includes the activities of setting the strategy of an organization and coordinating
the efforts of its employees or volunteers to accomplish its objectives through the application
of available resources, such as financial, natural, technological, and human resources.

Management is the process of reaching organizational goals by working with and through
people and other organizational resources.

Management definition, the act or manner of managing; handling, direction, or control.

Management: the act or skill of controlling and making decisions about a business,
department, sports team, etc.

The Act or Art of managing : the conducting or supervising of something (such as a

business) The act or skill of controlling and making decisions about a business,
department, sports team, etc. The people who make decisions about a business,
department, and sports team, etc. The act or process of deci ding how to use something

3.3 WHAT IS STOCK MANAGEMENT?

Stock management is the function of understanding the stock mix of a company and the
different demands on that stock. The demands are influenced by
both external and internal factors and are balanced by the creation of purchase order requests to
keep supplies at a reasonable or prescribed level.

The monitoring and control of goods and stock so that new stock can be ordered as required and
the right numbers and quantities made available at all times

The administrative role of assessing the stock of a business and making sure it is sufficient to
meet consumer demand. The demands that a stock management process seeks to satisfy are
affected by external and internal factors, and can be expressed using purchase order requests
to help maintain appropriate stock levels.

Definition: Stock management largely refers to when a company works to obtain and preserve
a suitable assortment of goods while also keeping track of all orders, shipping and handling,
and other related costs.

34
Primarily, stock management is about specifying the size and placement of the goods that a
company has in stock. Stock management is often important for numerous departments within
a facility in order to protect the planned course of production against the possibility of running
out of critical materials or goods.

Stock management is something that should be front-of-mind for anyone in the wholesale
distribution business. In the simplest of terms, stock management involves having greater
oversight over one’s stock. Some refer to it as “internal control” or even as an accounting
system set up to safeguard assets. Let’s take a look at why stock management is so important
as well as what’s involved in developing an effective system.

3.3.1 RETAIL SUPPLY CHAIN

Stock management in the retail supply chain follows the following sequence:

1. Request for new stock from stores to head office

2. Head office issues purchase orders to the vendor
3. Vendor ships the goods
4. Warehouse receives the goods
5. Warehouse stores and distributes to the stores
6. Shops and/or consumers (e.g. wholesale shops) receive the goods
7. Goods are sold to customers at the shops.
The management of the stock in the supply chain involves managing the physical quantities as
well as the costing of the goods as it flows through the supply chain.
In managing the cost prices of the goods throughout the supply chain, several costing methods
are employed:

1. Retail method
2. Weighted Average Price method
3. FIFO (First In First Out) method
4. LIFO (Last In First Out) method
5. LPP (Last Purchase Price) method
6. BNM (Bottle neck method)
The calculation can be done for different periods. If the calculation is done on a monthly basis,
then it is referred to the periodic method. In this method, the available stock is calculated by:
 Add Stock at beginning of period
 Add Stock purchased during the period
 Average total cost by total quantity to arrive at the Average Cost of Goods for the
period.
 This Average Cost Price is applied to all movements and adjustments in that period.
 Ending stock in quantity is arrived at by applying all the changes in quantity to the
Available balance.
 Multiplying the stock balance in quantity by the Average cost gives the Stock cost at
the end of the period.
Using the perpetual method, the calculation is done upon every purchase transaction.

35
Thus, the calculation is the same based on the periodic calculation whether by period
(periodic) or by transaction (perpetual). The only difference is the 'periodicity' or scope of the
calculation. - Periodic is done monthly - Perpetual is done for the duration of the purchase
until the next purchase

3.3.2 BUSINESS MODELS

Just-in-time Stock (JIT), Vendor Managed Stock (VMI) and Customer Managed Stock (CMI)
are a few of the popular models being employed by organizations looking to have greater stock
management control.
JIT is a model that attempts to replenish stock for organizations when the stock is required. The
model attempts to avoid excess stock and its associated costs. As a result, companies receive
stock only when the need for more stock is approaching.
VMI and CMI are two business models that adhere to the JIT stock principles. VMI gives the
vendor in a vendor/customer relationship the ability to monitor, plan and control stock for their
customers. Customers relinquish the order making responsibilities in exchange for timely stock
replenishment that increases organizational efficiency.
CMI allows the customer to order and control their stock from their vendors/suppliers. Both
VMI and CMI benefit the vendor as well as the customer. Vendors see a significant increase in
sales due to increased stock turns and cost savings realized by their customers, while customers
realize similar benefits.

3.3.3 COMPETING STOCK REQUIREMENTS

Stock management also encompasses the important connections between replenishment lead
time, asset management, carrying costs of stock, future stock price forecasting, physical stock,
available stock space, demand forecasting and much more.

By balancing these competing requirements, a company will discover their optimal stock
levels. This is a never-ending process, as the company will need to shift and react to its
environment as it changes and grows.

3.3.4 PUSH AND PULL

To put it simply, stock management is ruled by first the customers, who pull goods out of stock,
and second by the company that pushes the goods out of stock based on orders and demand.

3.4 IMPORTANCE OF STOCK MANGEMENT

If your business requires maintaining a stock, you might sometimes feel like you're walking a
tightrope. Not having enough stock means you run the risk of losing sales, while having too
much stock is costly in more ways than one. That's why having an efficient stock management
system is so important.

36
3.4.1 AVOIDING STOCK OUTS

One of the worst things you can do in business is to turn away customers -- people who are
ready to give you their money -- because you've run out of the item they want. "Stock outs" not
only cost you money from missed sales, they can also make you lose customers for good, as
people resolve to take their business somewhere that can satisfy their needs. An efficient stock
management system tracks how much product you have in stock and forecasts how long your
supplies will last based on sales activity. This allows you to place orders far enough ahead of
time to prevent stock outs.

3.4.2 OVERSTOCK HAZARDS

When stock isn’t managed well, you can also wind up with overstock -- too much of certain
items. Overstock comes with its own set of problems. The longer an item sits unsold in stock,
the greater the chance it will never sell at all, meaning you'll have to write it off, or at least
discount it deeply. Products go out of style or become obsolete. Perishable items spoil. Items
that linger in storage get damaged or stolen. And excessive stock has to be stored, counted and
handled, which can add ongoing costs.

3.4.3 WORKING CAPITAL ISSUES

Stock is expensive to acquire. When you pay, say, $15 for an item from a supplier, you do so
with the expectation that you will soon sell the item for a higher price, allowing you to recoup
the cost plus some profit. As long as the item sits on the shelf, though, its value is locked up in
stock. That's $15 you can't use elsewhere in your business. So stock management isn't just
about managing the "stuff" going in and out of your company; it's also about managing your
working capital, keeping you from having too much precious cash tied up in operations.

3.4.4 MANUFACTURER'S ANGLE

Stock management isn't just a concern for companies that deal in finished goods, such as
retailers and wholesalers. It's also critical for manufacturers, who maintain three types of stock:
raw materials, works in process and finished goods. If you run out of an essential ingredient or
component, production will halt, which can be extremely costly. If you don't have a supply of
finished goods on hand to fill orders at they come in, you risk losing customers. Staying on top
of stock is essential if you're to keep the line running and keep products moving out the door.

3.4.5 STOCK CONTROL

A retail store occasionally runs out of certain items. This happens for a number of reasons:
unexpected popularity of a particular item, such as one that has attained fad appeal among
schoolchildren; an unusually large purchase, such as buying up all of a store's hotdog buns for
a party; or a failure by the manufacturer to make and ship on time certain items. Stock control

37
is a way the retailer avoids running out of stock through tracking what is on hand, what has
been sold and what is on order.

3.4.6 CUSTOMER SERVICE

Good customer service for a retailer consists partly of having adequate supplies of what the
customer wants to buy. If a store runs out of a particular product, the customer buys it
somewhere else -- perhaps establishing a relationship with a competitor. Not only has the
retailer lost a sale; it possibly has lost a good customer as well.

3.4.7. STOCK

Retail stock consists of what products are on the store shelves plus the products in boxes in the
storage room. As customers deplete the stocked shelves, more stock comes out of storage to
replace what has been sold. Keeping track of the stock on hand allows the store owner or
manager to know when to order additional stock of the items before they sell out.

3.4.8. SALES TRACKING

"Shrinkage" is a term used in retail to designate any mysterious disappearance of stock. It is

derived from a starting count of stock on the shelves and in storage. As goods are sold, the
stock should decline by the amount of sales. Sometimes, there is less stock than expected,
which normally means goods have been stolen or misplaced. Identifying missing stock helps
the retailer know to improve store security or stock tracking procedures. Tracking sales over
years also helps the retailer know how much to order of certain products at different times of
the year. For example: When hot dog buns sell out at the beginning of July, the retailer can
figure it is because of Fourth of July parties, and he will know to order more hot dog buns, and
possibly plan a special Fourth of July promotion of buns, condiments and hot dogs.

3.4.9 ORDERS

Keeping track of goods on order allows a retailer to verify that replacement stock has been
ordered. Monitoring order status alerts the retailer to possible delays in delivery in time to find
another source of those goods from an alternate distributor. Manufacturers and distributors
occasionally face fulfilment problems due to weather, machinery breakdown, labour strikes,
and unexpected demand and transportation problems. A detailed analysis of delivery times can
prompt a retailer to change distributors or to figure seasonal delays into the timing of his orders.
Customers don't care why a product is not available for purchase when they want it; they only
know the retailer failed. A detailed system of stock control keeps the customer satisfied and
the retailer in business.

38
3.5 STOCK CONTROL

A. The process of making sure that the correct level of stock is maintained, to be able to
meet demand while keeping the costs of holding stock to a minimum.

B. The fact or process of ensuring that appropriate amounts of stock are maintained by a
business, so as to be able to meet customer demand without delay while keeping the
costs associated with holding stock to a minimum.

C. Stock control, otherwise known as inventory control, is used to show how much stock
you have at any one time, and how you keep track of it.

It applies to every item you use to produce a product or service, from raw materials to
finished goods. It covers stock at every stage of the production process, from purchase and
delivery to using and re-ordering the stock.

3.5.1. STOCK CONTROL METHODS

There are many different ways to keep control of your stock. One basic way is to create a
spreadsheet with various columns for product name, item number, and quantity. You can have
a column to deduct what you sell and ship. You can also keep a log of returns and new incoming
stock.

Of course, this is an incredibly labour-intensive process that no growing business wants to deal

with. It requires continuous manual monitoring to ensure every transaction is accounted for.

The information is difficult to share, and another huge pitfall is human error. People are prone

to make mistakes, mistakes that are difficult to track and result in inaccurate stock numbers.

Ultimately, the more automated your system is, the less paperwork there will be. There is a
whole host of stock management software options out there. These software systems may offer
integration with your enterprise resource planning systems, or multichannel integrations.

You may have the option to use barcode scanners that will communicate with other devices,
such as barcode printers or mobile devices. Some are designed to track the location of the
product within the warehouse, which helps when it’s time for picking and packing.

39
Of course, once you have the tracking systems in place, you need to figure out how you’re
going to determine when to order new stock. Some use a stock control method called minimum
stock, in which new stock is ordered once it reaches a pre-set minimum level.

If your needs are very predictable, you can use a fixed quantity control system. With this
method, every time you place an order, whether it’s weekly, monthly, semi-monthly, your order
will be for the same amount. Some people refer to this as a standing order

Some of the conventional stock control models are:

Minimum stock level - you identify a minimum stock level, and re-order when stock reaches
that level. This is known as the Re-order Level.

Stock review - you have regular reviews of stock. At every review you place an order to return
stocks to a predetermined level.

Just In Time (JIT) - this aims to reduce costs by cutting stock to a minimum. Items are
delivered when they are needed and used immediately. There is a risk of running out of stock,
so you need to be confident that your suppliers can deliver on demand.

These methods can be used alongside other processes to refine the stock control system. For
example:

Re-order lead time - allows for the time between placing an order and receiving the items
ordered for.

Economic Order Quantity (EOQ) - a standard formula used to arrive at a balance between
holding too much or too little stock. It's quite a complex calculation, so you may find it easier
to use stock control software.

Batch control - managing the production of goods in batches. You need to make sure that you
have the right number of components to cover your needs until the next batch. If your needs
are predictable, you may order a fixed quantity of stock every time you place an order, or order
at a fixed interval - say every week or month. In effect, you're placing a standing order, so you
need to keep the quantities and prices under review.

40
 First in, first out (FIFO) - a system to ensure that perishable stock is used efficiently so that
it doesn't deteriorate. Stock is identified by date received and moves on through each stage of
production in strict order.

3.6 THE BASIC EOQ MODEL

OBJECTIVES OF ECONOMIC ORDER QUANTITY (EOQ)

There are two fundamental objectives

i. To determine the quantity that should be purchased anytime a fresh order is made.
ii. To reduce to the barest minimum all cost that are associated with replenishment.

DERIVATION OF EOQ FORMULA

Total Relevant Cost = total carrying cost + total ordering cost

TRC = {average stock x carrying cost per unit per year (c)}

{No of orders x ordering cost per unit (o)}

𝑄 𝐷
TRC = 2 c + 𝑄o

Where:

Q = Quantity ordered or EOQ

D = Annual demand

o = Ordering cost

c = Carrying Cost

EOQ is at the point where TCC is equal to TOC

Q2c = 2Do
𝟐𝑫𝒐
Q2 = 𝒄

𝟐𝑫𝒐
Q=√ 𝒄

41
QUESTION 1

Ebiere Ltd use a particular component at the rate of 24,000 per year. These are obtained from
an outside supplier at a basic cost of 25k each. Replenishment orders can be obtained promptly,
though it entails sending a man and a lorry to collect the components, this would cost #20, this
is assumed to be the only cost of ordering.

The storage cost of stock is 15% of the cost of the component.

Required:

1. What is the EOQ?

2. What is the total controllable cost?
3. What is the total cost of this order?
SOLUTION

𝟐𝑫𝒐
1. Q = √ 𝒄

𝟐 𝒙 𝟐𝟒,𝟎𝟎𝟎 𝒙 #𝟐𝟎
Q=√ 𝟐𝟓𝑲 𝒙 𝟏𝟓%

𝟗𝟔𝟎,𝟎𝟎𝟎
Q = √ 𝟎.𝟎𝟑𝟕𝟓

Q = 5,059.6 units

2. TOTAL CONTROLLABLE COSTS

TRC = TOC + TCC
𝑄 𝐷
TRC = 2 c + 𝑄o
5,059.6(0.0375) 24,000(20)
TRC = +
2 5,059.6
TRC = 94.87 + 94.87
TRC = #189.74

3. TOTAL COST OF THE ORDER

TC = TRC + TPC
= #189.74 + (0.25 x 24,000)
= #189.74 + 6,000
= #6,189.74

42
QUESTION 2

Green Trees Plc. uses 32,000 units of a particular component in a year. The basic purchase
price is #100 and cost per order is #200. Carrying cost is 20% of the purchase price.

The company is offered the following discounts on the purchase price:

Order quantity Discount

1,000-1,499 less 2%

1,500-1,999 less 4%

2,000 and over less 5%

Required:

Calculate the appropriate order quantity.

Solution

𝟐𝑫𝒐
EOQ = √ 𝒄

𝟐 𝒙 𝟑𝟐,𝟎𝟎𝟎 𝒙 #𝟐𝟎𝟎
Q=√ 𝟐𝟎

𝟏𝟐,𝟖𝟎𝟎,𝟎𝟎𝟎
Q=√ 𝟐𝟎

Q = 800 units

Possible Quantities 800 1,000 1,500 2,000

Purchas Price 100 98 96 95

Holding cost/unit 20 19.60 19.20 19

# # # #

Purchase cost

(32,000 x P) 3,200,000 3,136,000 3,072,000 3,040,000

Holding cost
𝑄
xH 8,000 9,800 14,000 19,000
2

43
Ordering cost
32,000
x #200 8,000 6,400 4,267 3,200
𝑄

EOQ 3,216,000 3,152,000 3,090,000 3,062,200

Recommendation

The appropriate order quantity is to buy in batches of 2,000 units.

4.0 CONCLUSION
The direction or method you chose will all depend upon the business you’re conducting and
the essentials you feel must be fulfilled.

The bottom line is that stock management is vital to the survival of your business. If you don’t
have a good handle on your stock you’ll never have a true account for how your business is
doing. It’s a competitive market out there. Don’t let stock excess or shortages become your
downfall.

5.0 SUMMARY
Efficient inventory management is crucial to the success of a business, and as such it’s
incredibly important to hire a capable inventory manager. Salary.com lists the median expected
salary for an inventory manager in the United States at $78,760; this isn’t surprising
considering these individuals are responsible for guaranteeing your organization stays in
control of its inventory needs.

Inventory managers have a number of responsibilities – many of which require daily

monitoring and evaluation. As detailed in the following job description, the obligations of an
inventory manager range from specific inventory duties to more managerial tasks.

An inventory manager is in charge of inventory in a warehouse or similar facility. Inventory

managers lead a team of inventory or warehouse workers to receive and record new stock as it
comes in and move stock onto trucks or shelves as needed.

Inventory managers also have the important responsibility of finding a supplier who will
provide your company with the goods needed to operate and be profitable. Part of that role
means maintaining a good working relationship with suppliers by communicating and dealing
with concerns or problems, such as a delay in an order being processed. In addition, an
inventory manager needs to be aware of other available suppliers in the area who may be
willing to provide your business with materials at a better cost.

Inventory managers are responsible for managing inventory documentation. They must
accurately record the quality, quantity, type, style, and any other characteristics of the inventory

44
so your company has a clear understanding of what is and isn’t available. These documents
also help your company avoid shrinkage due to loss or theft because the inventory manager
always has a running tally.

6.0 TUTOR – MARKED ASSIGNMENT

1. What is stock management

2. What is involve in stock management

3. Critically examine and discuss the job description of an inventory manger.

4. Highlight the differences between stock management and stock control.

7.0 REFERENCES/FURTHER READINGS

 www.businessdictionary.com/definition/stock.html
 economictimes.indiatimes.com › Definitions › Equity
 www.businessdictionary.com/definition/management.html
 https://en.wikipedia.org/wiki/Management
 https://managementinnovations.wordpress.com/.../define-management-its-functions/
 www.dictionary.com/browse/management
 https://www.merriam-webster.com/dictionary/management
 https://www.collinsdictionary.com/dictionary/english/stock-management
 www.businessdictionary.com/definition/stock-management.html
 smallbusiness.chron.com › Money & Debt › Stocks
 https://en.wikipedia.org/wiki/Stock_management
 https://debitoor.com/dictionary/stock-management
 http://www.waspbarcode.com

MODULE 2 CAPITAL BUDGETING DECISION

Unit 1 Payback Period

Unit 2 Accounting Rate of Return

Unit 3 Net Present Value

Unit 4 Internal Rate of Return

45
UNIT 5 Profitability Index

Unit 1 PAYBACK PERIOD

CONTENTS

1.0 Introduction

2.0 Objectives

3.0 Main Content

3.1 Workings
3.2 Decision Rule

3.3 Advantages of Payback Period

3.4 Disadvantages of Payback Period

4.0 Conclusion

5.0 Summary

6.0 Tutor-Marked Assignment

7.0 References/Further Reading

1.0 Introduction

Payback Period – Appraising capital investment on the basis of time that would be taken to
get back your initial investment is called as payback period.

Payback period is one of the easiest methods of capital investment appraisal techniques.
Projects with a shorter payback period are usually preferred for investment when compared to
one with longer payback period.

Discounted Payback Period – Capital Investment Appraisal using discounted payback period
is similar to payback period but here, the time value of money or discounted value of cash flow
is considered for calculation of payback period.

46
2.0 OBJECTIVES

1) To understand what payback period is all about and the formula involved in calculating
it.
2) To know how to make decisions after calculations especially when there are mutually
exclusive projects.
3) To understand the advantages and disadvantages of the technique.

3.0 THE MAIN CONTENT

3.1 Workings

The formula to calculate payback period of a project depends on whether the cash flow per
period from the project even or uneven. In case they are even, the formula to calculate payback
period is:

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Payback Period = 𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑝𝑒𝑟 𝑃𝑒𝑟𝑖𝑜𝑑

N/B: When cash inflows are uneven, we need to calculate the cumulative net cash flow for
each period and then use the following formula for PBP –

𝐵
Payback period = A + 𝐶

Where:

A = the last period with a negative cumulative cash flow

B = the absolute value of cumulative cash flow at the end of the period A.

C = is the total cash flow during the period after A.

N/B: Payback period uses only cash flows not profit.

Example 1 = Even Cash flow

Ogege’s Company is planning to undertake a project requiring initial investment of

N200,000,000. The project is expected to generate N45, 000,000 per year for 6 years,
calculate the payback period of the project.

Solution:

47
 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Payback Period =
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤

200,000,000
Payback Period = = 4.44 years
45,000,000

Example 2

Akoka Limited is to undertake a project requiring N1, 000,000 outlay.

Required: what is the payback period?

a) The project generates N200,000 annually.

b) The project has the following cash flow profile:
Yr cf(N)
1 2000,000
2 220,000
3 240,000
4 200,000
5 190,000
Solution:

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 1,000,000

A. Payback Period = i.e
𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 200,000𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤

= 5years

B. A B C

Yrs. Outlays N Cashflows Balance

0 1,000,000 (1,000,000)

1 200,000 (800,000)

2 220,000 (580,000)

3 240,000 (340,000)

4 200,000 (140,000)

5 190,000

48
 140,000
= 4 + = 4.74 years.
190,000

N/B: Decision Rule:

Project B should be taken and A should be rejected since B has short period than A.

Example 3

Samson. Plc is to undertake a project requiring N500,000 outlay, Discounted at 10%

Yr Cash flows
1 200,000
2 220,000
3 240,000
4 200,000
5 190,000

You are required to get the discounted payback period.

Solution

Yrs Cashflows 𝟏
Df (10%)(𝟏+𝒓)𝒕
PV Balance
0 (5000,000) 1 (500,000) (500,000)
1 200,000 0.9091 181,818 (318,182
2 220,000 0.8264 181,808 (136,274)
3 240,000 0.7513 180,312
4 200,000 0.6830 136,600
5 190,000 0.6209 117,975
𝟏𝟑𝟔,𝟑𝟕𝟒
2 + = 2.76 years
𝟏𝟖𝟎,𝟑𝟏𝟐

Example 4

Consider the following two Projects:

Project A Project B
Cost 150,000 150,000
Residual value after 5years Nil Nil
Estimated profit after depreciation.

49
 Yr 1 35,000 100,000
Yr 2 50,000 80,000
Yr 3 60,000 60,000
Yr 4 70,000 40,000
Yr 5 80,000 30,000

Which of the projects is preferable using Payback Period?

Solution:

First of all PBP uses cash flows not profit, therefore, we have to convert it to cashflow.

Cash flow = Profit after Dep. + Depreciation

150,000 − 0
Depreciation = 30,000
5

Add Back the Depreciation to get the cash flow.

Project A Project B
Cost 150,000 150,000
Annual Depreciation 30,000 30,000
Annual Cashflow (1)
35,000 + 30,000 100,000 + 30,000
Yr 2 50,000 + 30,000 800,000 + 30,000
Yr 3 60,000 + 30,000 60,000 + 30,000
Yr 4 70,000 + 30,000 40,000 + 30,000
Yr 5 80,000 + 30,000 30,000 + 30,000

Current Cashflow

Project A Project B
Cost 150,000 150,000
Cashflow for Yr 1 65,000 130,000
Yr 2 80,000 110,000
Yr 3 90,000 90,000

50
 Yr 4 100,000 70,000
Yr 5 110,000 60,000

5,000
Payback Period for Project A = 2 + 90,000 = 2.06 years

𝟐𝟎,000
Payback Period for Project B = 1 + = 1.18 years
110,000

Decision Rule:

Project B should be taken because it has lower payback period.

Example 5

A project has a cost of N53, 500 and its expected net cash inflows are N11, 500 per annum
for 6 years. If the cost of capital is 5%, what is the projects payback period.

Solution:
53,500
= 4.7 years.
11,500

N/B. Calculate the discounted payback period.

Example 6

With the illustration and example above calculate the discounted payback period.

Solution;

Cost = 53,500, discount factor = 5%, Cashflows = 11,500, Year = 6.

1− (1+𝑟)−𝑛
Present Value of Annuity = 𝑟

1− (1+0.05)−6 1− (1.05)−6
= = 5.0757.
0.05 0.05

∴ 11500 x 5.0757 = 58,370

53,500
DPBP = = 0.9 years.
58,370

3.2 Decision Rules

A. Independent project

51
1. Accept if the project has a PBP that equal to or less than that set by the management.
2. Reject if the project has a PB that is greater than the time set by the management.

B. Mutually Exclusive Project

1. Select the project with the least PBP.

2. Ensure that the project selected has a PBP that is equal to or less than that set by the
management.

3.3 Advantages of Payback period

1. It is simple to calculate.
2. It can be a measure of risk inherent in a project since cash flows that occurs later in a
projects life are considered more uncertain, payback period provides an indication of
how certain the project cash inflow are.
3. For companies facing liquidity problems it provides a good ranking of projects that
would return money early.
4. Unlike ARR, it uses cash flows instead of accounting profit, cash profit or inflows is
superior to accounting profit.
5. It serves as a first screening process i.e. as a simple initial screening process for new
projects.

3.4 Disadvantages of PBP

1. Unless discounted cash flows are used, it is ignored the time value of money.
2. It does not take into account the cash flows that occur after the payback period.
3. It may lead to excessive investment in short term projects.
4. It is unable to distinguish between projects with the same payback period.

4.0 Conclusion

Payback period as one of the budgeting techniques is one of the best traditional methods of
assessing project and it has been going a long way in selecting a good projects among bad ones.

5.0 Summary

52
Payback period always serve as the first screening process for new project. Based on the
decision rule, one can easily determine which projects to choose after calculation and it has a
lot of advantages that makes it outstanding among other budgeting techniques.

6.0 Tutor Marked Question

Ogege Plc is to undertake a project requiring an investment of N200,000 on necessary plant

and machinery. The project is to last for 5 years at the end of which the plant and machinery
will have net book value or scrap value of N40,000 – profit after depreciation are as follows.

Yrs Cash flows

1 50,000
2 45,000
3 40,000
4 30,000
5 20,000

You are required to calculate the payback period.

7.0 References

1. William, J. R. et al Financial And Managerial Accounting, McGraw-Hill, 2012 P.1117.

2. Faris, Paul N. Neil T. Bendle, Philip e. Pfecter; David T. Rabstein (2010). Marketing
Metrics; The Definition Guide to Measuring Marketing Performance – Uppoer Saddle
River. New Jersey: Person Education, Inc ISBN 0-13-705829-2

3. OyeAkinsulije: Financial Management 7th Edition, 2003, Ceemol Nigerian Ltd

Publication, Lagos, Nigeria.

53
UNIT 2: ACCOUNTING RATE OF RETURN (ARR)

1.0 Introduction

2.0 Objectives

3.0 Main Content

3.1 Workings
3.2 Decision Rule

3.3 Advantages of ARR

3.4 Disadvantages of ARR

4.0 Conclusion

5.0 Summary

6.0 Tutor Marked Assignments

7.0 References

1.0 Introduction

This Capital Investment Appraisal technique compares the profit that can be earned by the
concerned project to the amount of initial investment capital that would be required for the
project. Projects that can earn a higher rate of return is naturally preferred over ones with low
rate of return. ARR is a non-discount capital investment appraisal technique in that it does not
take into consideration the time value of money involved.

2.0 Objectives

At the end of this lesson/topic one should be able to:

1. Define and calculate the ARR technique.

2. Make decision regarding the answers and observation especially when there are
mutually exclusive projects.
3. Understand the advantages and disadvantages of ARR

3.0 THE MAIN CONTENT

3.1 Workings

Accounting Rate of Return is calculated using the following formulas:

54
 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 100
ARR = x
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 1

OR

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 100

ARR = x
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 1

N/B: The formula can be used depending on the question but if asked to get the ARR without
specifying the one to use, it is advisable to use the first formula. ARR uses profit not cash
flow, you have convert it to profit by subtracting the depreciation.

3.2 General Decision Rule

Accept the project only if it’s ARR is equal or greater than the required Accounting rate of
return. In case of mutually exclusive project, accept the one with highest ARR.

Example 1:

An initial investment of N130,000 is expected to generate annual cash flow of N32,000 for 6
years. Depreciation is allowed on the straight line basis. It is estimated that the project will
generate scrap value of N10,500 at the end of 6 years. Calculate its accounting rate of return
assuming that there are no other expenses on the project.

Solution:

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣.−𝑆𝑐𝑟𝑎𝑝 𝑉
Annual Depreciation = 𝑢𝑠𝑒𝑓𝑢𝑙 𝐿𝑖𝑓𝑒

130,000−10,500
= = N19,917
6

Accounting Income = N32,000 - 19,917 = N12,083

N/B: We were given cash flow instead of profit so we subtracted depreciation to get profit.

Then Average Investment

130,000 + 10,500
= = N70, 250
2

12,083 100
ARR = x = 17.2%.
70,250 1

55
Example 2:

Edo Plc is to undertake a project requiring an investment of N100, 000 on necessary plant and
machinery. The project is to last for 5 years at the rate of which the plant and machinery will
have net book value of N20, 000. Profit before depreciation are as follows:

Yrs Cash flows

1 40,000
2 44,000
3 48,000
4 52,000
5 58,000

You are required to calculate the ARR of the project.

Solution:

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑂𝑢𝑡𝑙𝑎𝑦−𝑆𝑐𝑟𝑎𝑝 𝑉.
Annual Depreciation = 𝑢𝑠𝑒𝑓𝑢𝑙 𝐿𝑖𝑓𝑒 𝑖𝑛 𝑌𝑒𝑎𝑟

100,000 − 20,000
= N16, 000
5

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑂𝑢𝑡𝑙𝑎𝑦 + 𝑈𝑠𝑒𝑓𝑢𝑙 𝐿𝑖𝑓𝑒

Average Investment = 2

100,000+ 20,000 120,000

=
2 2

= 60,000

Average Profit

Yr Profit Depreciation Net Profit

1 40,000 16,000 240,000
2 44,000 16,000 28,000
3 48,000 16,000 32,000
4 52,000 16,000 36,000
5 58,000 16,000 42,000
162,000
162,000
Average Profit = = 32,400
5

32,400 𝑥 100
ARR = = 54%
60,000

56
Example 3

If Eloho Plc has a project with the Initial Outlay N20, 000, annual profit of N5, 000 for 6 years
what is the ARR

Solution:

20,000 + 0
Average Investment = = 10,000
2

Average Profit = 5,000

5,000 100
ARR = x = 50%.
10,000 1

Example 4

A project has a cost of N53, 500 and its expected cash inflows are N11, 500 per annum for 6
years. If the cost of capital is 5%, what is the project’s ARR?

𝑁55,500 + 0
Average Investment = = 26,750
2

Average Profit = N11,500

11,500 100
ARR = x = 43%
26,750 1

Example 5

Consider the following two projects

Project A Project B
Cost 150,000 150,000
Residual value 0 0
Estimated Profit after Depreciation.
Yr 1 35,000 100,000
Yr 2 50,000 80,000
Yr 3 60,000 60,000
Yr 4 70,000 40,000
Yr 5 80,000 30,000

What project is ARR?

Solution:
Since we were given direct profit.

57
 295,000
Average profit for Project A = = 59,000
5

310,000
Average profit for Project B = = 62,000
5

150,000 +0
Average Investment for Project A = = 75,000
2

150,000 +0
Average Investment for Project B = = 75,000
2
59,000 100
There ARR for profit A = x = 78.67%
75,000 1

62,000 100
The ARR for Profit B = x = 82.67%
75,000 1

Decision

Chose Project B because it has higher retarded using ARR

3.3 Advantages of ARR

1. Like Payback Period, this method of investment appraisal is easy to calculate.

2. It recognizes the profitability factor of investment.
3. Unlike the Payback Period, it considered the profit over the entire life of the project.
4. It uses readily available accounting data.
5. It could be used to compare performance for many companies.

3.4 Disadvantages of ARR

1. It ignores the time value of money.

2. It can be calculated in different ways. Thus there is problem of consistency.
3. It uses accounting income instead of cash flow information.
4. It ignores risk and management attitude towards risk
5. There are no rules for setting the minimum acceptable ARR by the management.

4.0 Conclusion

Having seen the way, ARR works based on the calculations and decision using the answers
and observation one can categorically say that the objective of this unit has been achieved.

58
5.0 Summary

Accounting Rate of Return as one of the basic method of budget appraisal is very necessary
because it gives a strength forward answer and it makes use of the entire profit throughout the
project life and the decision using the technique is very easy to make.

6.0 Tutor marked Assignment

From the example 5 given in the contest above, assume that the scrap value is N10,000 for
project A and N15,000 for project B and the profit given was before depreciation.

Recalculate the ARR and choose between the two projects.

7.0 References

1. S. Chen DCF Techniques and non-financial measures in capital budgeting. A

contingency Approach analysis. Behavioural Research in Accounting. Vol. 20. No.
1:13-29.
2. P. A. Ryan G. P Ryan. Capital Budgeting practices of the fortune 1000. How have
things changed Journal of Business and Management, vol. 8, No. 4, 1-16, 2002.
3. M. T. Stanley, S. A. Sungster - Capital Investment Appraisal Technique. A survey of
current usage Journal of Business 3, 307-353, 1993.
4. Millles, Links between Net present value and shareholder value from a Business
Economics Perspective. Theory Methodology Practice Club of economics in Miskole,
vol. 8, No. 2, 31-36, 2012.

59
UNIT 3: NET PRESENT VALUE (NPV)

1.0 Introduction

2.0 Objectives

3.0 Main Content

3.1 Workings
3.2 Decision Rule

3.3 Advantages of NPV

3.4 Disadvantages of NPV

4.0 Conclusion

5.0 Summary

6.0 Tutor Marked Assignment

7.0 References

1.0 Introduction

This capital investment appraisal technique measures the cash-in-flow, whether excess or
shortfall, after the routine finance commitments are met. All capital investment appraisals have
a single objective drive towards a positive NPV. The NPV is a mathematical calculation
involving net cash flows at a particular present time ‘t’ at discount rate at the same time, i.e. (t
– Initial capital outlay). Thus, there is an inverse proportional relationship between rate and
NPV. A high discount rate would reduce the net present value of capital. A high interest rate
increases discount rates over a period of time and most capital investment appraisal are way of
such an increase.

N/B: If a scrap value occurs, it must be added to the last year inflow because it is one of the
incomes of the firm.

2.0 Objectives

At the end of the study, one will be able to:

a) Define and calculate Net Present value.

b) Make decision using the answers gotten from the calculation.

60
 c) Should be able to choose between projects especially when there are mutually
exclusive projects.
d) Understand the advantages and disadvantages of NPV.

3.0 THE MAIN CONTENT

3.1 Workings

1− (1+𝑟 )−𝑛
NPV = R x - Co
𝑟

Where:

R = Cash flow

r = Rate

n = Number of years

Co = Initial Outlay

Example 1: (even cash flows)

Calculate the Net Present Value (NPV) of a project which requires an initial investment of
N243,000 and it is expected to generate a cash flow of N50,000 each month for 12 months.
Assume the salvage value of the project is zero. The target rate of return is 12% per annum.

Solution:

Initial Investment = 243,000

Net cash inflow per period = 50,000

Number of Period = 12 months

Discounted Rate per period = 12% ÷ 12= 1%

Net Present Value = ?

(1−(1+𝑟)−𝑛 )
NPV = RX - Co
𝑟

(1−(1+0.01)−12 )
NPV = 50,000 x 0.01
- 243,000

61
 (1−(1+0.01)−12 )
50,000 x - 243,000
0.01

(1−0.887449)
50,000 x 0.01

50,000 x 11.2551 – 243,000

= 562,754 - 243,000

NPV = N319,754

Example 2:

Ebiere Plc is to start up a project worth N8m and having the following cash flows:

Yrs Cash flows (N)

1 5,000,000
2 6,000,000
3 8,000,000
If the discount rate is 25% calculate the NPV if the scrap value at the end of 3 years is
N100,000.

Solution:

Yrs Cf(N) Df 25% PV N

0 (8,000,000) 1 (8,000,000)

1 5,000,000 0.8000 4,000,000

2 6,000,000 0.6400 3,840,000

3 8,100,000 0.5120 4,147,200

NPV + = 3,987,200

N/B: Scrap value was included in the last year.

Example 3

A project has a cost of N53,500 and its expected net cash inflow are N11,500 per annum for 6
years. If the cost of capital is 5%, what is the projects Net present value?

62
Solution:

𝑅 𝑋 (1−(1𝑡𝑟)−𝑛
NPV = - Co
𝑟

(1−(1+0.05)−6 )
= 11,500 x - 53,500
0.05

(1−(0.05)−6 )
= 11,500 x - 53,500
0.05

= 11500 x 5.0757 - 53500

= 58,370 – 53500

= 4870

Example 4:

If a project has the initial cost of N150,000 and a book value of N20,000 at the end of 5 years
and the profit after. Depreciation are assume with 10% discount factor

Yr1 35,000

Yr2 50,000

Yr3 60,000

Yr4 70,000

Yr5 80,000

i. Calculate the NPV of the project.

ii. Make decision whether it should be accepted or rejected.

Solution

NPV uses cash flows not profit therefore we have to convert it to cash flow by adding
back depreciation.

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑂𝑢𝑡𝑙𝑎𝑦−𝑆𝑐𝑟𝑎𝑝 𝑉𝑎𝑙𝑢𝑒 150,000 − 20,000

Depreciation = = = 26,000
𝑢𝑠𝑒𝑓𝑢𝑙 𝐿𝑖𝑓𝑒 5

63
Current Cash flow are

Yr1 35,000 + 26,000 = 61,000

Yr2 50,000 + 26,000 = 76,000

Yr3 60,000 + 26,000 = 86,000

Yr4 70,000 + 26,000 = 96,000

Yr5 80,000 + 26,000 = 106,000

NPV =

Yrs Cf(N) Df 50% PV N

0 (150,000) 1 (150,000)

1 61,000 0.9091 55,455

2 76,000 0.8264 62,806

3 86,000 0.7513 64,611

4 96,000 0.6830 65,568

5 106,000 0.6209 65,815

Scrap Value 20,000 0.6209 12,418

NPV + = 176,673

3.2 Decision Rules

1. Accept if the project has a positive NPV.

2. Reject if the project has a negative NPV.

N/B: For mutually exclusive projects, select the project with the highest positive NPV.

3.3 Advantages of NPV

1. Net present value account for time value of money which makes it a sounder approach
than other investment appraisal techniques which do not discount future cash flows
such as Payback Period and Accounting Rate of Return.

64
2. Net Present Value is even better than some other discounted cash flow techniques such
as IRR, in situations where IRR and NPV gives conflicting decision, NPV decision
should be preferred.
3. It gives a clear accept/reject recommendation.
4. It makes use of all the cash flow over the project life span unlike Payback Period.
5. NPV gives absolute measures of profit ability which immediately reflects in the
shareholder’s wealth.
6. NPV of projects is additive, it can be summed up.

3.4 Disadvantages of NPV

1. It may be difficult to calculate.

2. Net present Value does not take into account the size of the project. For example say
project A requires initial investment of N4million to generate NPV of N1m while a
competing project B requires N2m investment to generate an NPV of N0.8m. if we
base our decision on NPV alone, we will prefer project A. because it has higher NPV,
but project B has generated more shareholder wealth per Dollar of initial investment
(N0.8m/N2m is N1m/4m).

N/B: NPV uses cash flows in the calculation i.e. profit before depreciation so if the net profit
is given i.e. profit after depreciation, we must add back depreciation to make it cash flows.

4.0 Conclusion: Net Present Value is one of the modern methods of Capital Budgeting.
It makes use of the time value of money and can be additive. With the above illustration
and examples one will be able to make a reasonable decision using NPV.

5.0 Summary

The main objective of the unit has been achieved by giving in the necessary data and
information needed in using NPV. One can also understand the importance of NPV OVER
ANY OTHER Capital Budgeting methods listed above. Even when there are disputes between
NPV and IRR in decision making NPV is always superior and it is always chosen over IRR in
decision making.

6.0 Tutor Marked Assignment

Consider the following two projects:

65
 Project A Project B
Cost 300,000 250,000

Estimated Cash flow

Yr1 40,000 90,000

Yr2 50,000 60,000

Yr3 60,000 45,000

Yr4 70,000 30,000

Yr5 80,000 25,000

Scrap value at the end of the 6th year is 10,000, for the both projects the cost of capital is 8%.
Calculate the NPV of the projects and choose between them.

7.0 References

1. K-Virtanen, control of Profit-Centre Organisation, Finland, 1984.

2. J R. Graham, C. R, Harvey: The theory and practice of corporate finance evidence from
the field Journal of financial Economics vol.60, No. 2-3. 187 – 243: 2001.
3. M. T. Stanley s. B. Block A Survey on multinational Capital Budgeting. The financial
Review vol. 19. No. 1. 36 – 54 1984.
4. E-Liljeblom M. Vaihekoski. Investment Evaluation methods and Required Rate of
Return in finished publicity listed companies. Furnish Journal of Business Economics
vol. 53, No. 1, 9-24, 2004.

66
UNIT 5: PROFITABILITY INDEX

Contents

1.0 Introduction
2.0 Objectives
3.0 Main Content
3.1 Definition and importance
3.2 Profitability index
3.3 Present value of future cash flows(numerator)
3.4 Initial investment( denominator)
3.5 Decision Process
3.6 Decision criteria
3.7 Advantages and Disadvantages
3.8 Workings
4.0 Conclusion
5.0 Summary
6.0 Tutor-Marked Assignment
7.0 References / Further Reading

Introduction

The Profitability index is one of the key techniques or indices used by financial professionals
in ranking and also estimating the value of the investment projects firms undergo. The
profitability index serves as a signal and is used in capital rationing to know what projects are
viable and which the firm should invest more in.

Objectives

The objective here is to build a basic understanding of profitability index which is a technique
used in finance and how firms utilize the use of this index. Examples are also given to enable
further understanding of the index and how it is used.

Main Content

Definition and importance

Profitability index is a method used in finance to quantify and also rank the value created by
an investment. Profitability index helps in ranking investments and deciding the best
investment that should be made. PI greater than one indicates that present value of future cash
inflows from the investment is more than the initial investment, thereby indicating that it will
earn profits.

67
 PI of less than one indicates loss from the investment. PI equal to one means that there are no
profits. Thus, profitability index helps investors in making decisions about whether or not to
make a particular investment.

Profitability index (PI), also known as profit investment ratio (PIR) and value investment
ratio (VIR), is therefore the ratio of payoff to investment of a proposed project. It is a useful
tool for ranking projects because it allows you to quantify the amount of value created per unit
of investment.

Profitability Index

Profitability index is an appraisal technique applied to potential capital outlays. The technique
divides the projected capital inflow by the projected capital outflow to determine the
profitability of a project. The main feature of using profitability index is the technique
disregards project size. Therefore, projects with larger cash inflows may result in lower
profitability index calculations because their profit margin is not as high.

Present Value of Future Cash Flows (Numerator)

The present value of future cash flows requires the implementation of time value of money
calculations. Cash flows are discounted the appropriate number of periods to equate future cash
flows to current monetary levels. This discounting occurs because the value of $1 does not
equate the value of $1 received in one year. Because the $1 received now may be invested and
gain value, money received closer to the present is considered to have more value than money
received further in the future.

Initial Investment (Denominator)

The discounted projected cash outflows represent the initial capital outlay of a project. The
initial investment required is only the cash flow required at the start of the project; all other
outlays may occur at any point in the project's life, and these are factored into the calculation
through the use of discounting in the numerator. These additional capital outlays may factor in
benefits relating to taxation or depreciation.

Decision Process

Profitability index calculations cannot be negative and must be converted to a positive figure
before they are useful. Calculations greater than one indicate the future anticipated discounted
cash inflows of the project are greater than the anticipated discounted cash outflows.
Calculations less than one indicate the deficit of the outflows is greater than the discounted
inflows and the project should not be accepted. Calculations that equal one bring about
situations of indifference where any gains or losses from a project are minimal.

68
When using the profitability index exclusively, calculations greater than one are ranked based
on highest calculation. When limited capital is available and projects are mutually exclusive,
the project with the highest profitability index is to be accepted as it indicates the project with
the most productive use of limited capital. Profitability index is also called the benefit-cost
ratio for this reason. Although some projects result in a higher net present value, those projects
may be passed over because they do not have the highest profitability index and do not
represent the most beneficial usage of company assets.

Decision Criteria

Assuming that the cash flow calculated does not include the investment made in the project, a
profitability index of 1 indicates breakeven. Any value lower than one would indicate that the
project's present value (PV) is less than the initial investment. As the value of the profitability
index increases, so does the financial attractiveness of the proposed project.

Rules for selection or rejection of a project:

 If PI > 1 then accept the project

 If PI < 1 then reject the project

Advantages And Disadvantages Of Profitability Index (PI)

Advantages Of Profitability Index (PI)

1. PI considers the time value of money.

2. PI considers analysis all cash flows of entire life.

3. PI makes the right in the case of different amount of cash outlay of different project.

4. PI ascertains the exact rate of return of the project.

Disadvantages Of Profitability Index(PI)

1. It is difficult to understand interest rate or discount rate.

2. It is difficult to calculate profitability index if two projects having different useful life.

69
3.8 WORKINGS

Example 1

Company C is undertaking a project at a cost of $50 million which is expected to generate

future net cash flows with a present value of $65 million. Calculate the profitability index.
Solution
Profitability Index = PV of Future Net Cash Flows / Initial Investment Required
Profitability Index = $65M / $50M = 1.3
Net Present Value = PV of Net Future Cash Flows − Initial Investment Required
Net Present Value = $65M-$50M = $15M.
The information about NPV and initial investment can be used to calculate profitability index
as follows:
Profitability Index = 1 + (Net Present Value / Initial Investment Required)
Profitability Index = 1 + $15M/$50M = 1.3

Example 2

Investment = $40,000, Life of the Machine = 5 Years

CFAT Year CFAT

1 18000
2 12000
3 10000
4 9000
5 6000

Calculate Net present value at 10% and PI:

Year CFAT PV@10% PV

1 18000 0.909 16362

2 12000 0.827 9924
3 10000 0.752 7520
4 9000 0.683 6147
5 6000 0.621 3726
Total present value 43679
(-) Investment 40000
NPV 3679

PI = 43679/40000 = 1.092> 1 ⇒ Accept the project

70
Conclusion

This index computes the present value of the expected cash flows that the investment can
generate. Depending on the outcome of the calculation, financial professionals decide if they
should accept the project or not. More specifically:

 if the profit index > 1, the project should be undertaken

 if the profit index < 1, the project should be abandoned
 if the profit index = 1, the project is indifferent, i.e. it makes no difference accepting or
rejecting it.

Summary

Profitability index means a financial calculation that investors use to measure the value of an
investment based on its present and future values

Tutor-Marked Assignment

1) Briefly define profitability index

2) Highlight the major importance of profitability index
3) State the advantages and disadvantages of profitability index

References / Further Reading

1. ‘Profitability Index” investopedia 2017

2. “Profitability index” Wikipedia
3. Definition of profitability iondex “ Economic times , India times 2017
4. Obaidullah Jan, ACA, CFA
5. Ready ratios IFRS

71
UNIT 4: INTERNAL RATE OF RETURN – IRR

1.0 Introduction

2.0 Objectives

3.0 Main Content

3.1 Decision Rule

3.2 Steps in Calculating IRR

3.3 Workings

3.4 Advantages of IRR

3.5 Disadvantages of IRR

4.0 Conclusion

5.0 Summary

6.0 Tutor Marked Assignment

7.0 References

1.0 Introduction

Internal rate of Return (IRR) is the discount rate at which the NPV of an investment becomes
zero. In other words, IRR is the discount rate at which equates the present value of the future
cash flows of an investment with the initial investment. It is one of the several measure used
in investment appraisal.

2.0 Objectives

At the end of this study, one will understand:

1. How to define and calculate IRR.

2. How to make decisions and choose between mutually exclusive projects using IRR.
3. The basic advantages and disadvantages of IRR over other capital appraisal methods.

72
3.0 THE MAIN CONTENT

3.1 The Decision Rule:

A project should only be accepted if its IRR is not less than the target internal rate of return.
When comparing two or more mutually exclusive projects. The project having highest value
of IRR should be accepted.

3.2 Steps in Calculating IRR

NPV = 0
Step I: = Guess the value of ‘r’ is not given and calculate the NPV of the
Project at that value.
Step II = If NPV is close to zero then IRR is equal to r.
Step III = If NPV is greater than 0 then increase ‘r’ and jump to step 5.
Step IV = If NPV is smaller than 0 then decrease ‘r’ and jump to step 5.
Step V = Recalculate NPV using the new value of ‘r’ and go back to step 2.
3.3 Workings

𝑁𝑃𝑉 +
= LDF + x (HDF - LDF)
𝑁𝑃𝑉+ −(𝑁𝑃𝑉−)

LDf = Low discount factor

HDf = High discount factor

NPV + = Positive NPV

NPV - = Negative NPV

Example 1

Calculate the IRR of a project having the following cash flows.

Yrs CF(N)

0 (5,000)

1 1,500

2 2,000

3 3,500

73
Discount factor is 15%.

Solution:

Yrs Cash flow DF 15% PV(N) DF 20% PV(N)

0 (5,000) 1 (5,000) 1 (5,000)
1 1500 0.87 1,305 0.83 1,245
2 2000 0.76 1,520 0.69 1,380
3 3500 0.66 2,310 0.58 2,030
NPV+ = 135 NPV- = (345)

𝑁𝑃𝑉 +
IRR = LDF +𝑁𝑃𝑉+ −(𝑁𝑃𝑉−) x (HDF - LDF)

135
15% +135 −(−345) x (20% - 15%)

135
15% +480 x 5%.

0.16406 = 16.4%

Example II

Calculate the projects IRR if the initial outlay is N80,000 and the cash flow are as follows:

Yrs CF (N)

Yr1 10,000

Yr2 12,000

Yr3 40,000

Yr4 25,000

Yr5 15,000

If the expected scrap value is 5,000 at the end of five years and the discount factor is 15%.

Solution

Yrs Cash flow DF 15% PV(N) DF 20% PV(N)

0 (80,000) 1 (80,000) 1 (80,000)
1 10,000 0.87 8,700 0.95 95,000
2 12,000 0.76 9,120 0.91 10,920
3 40,000 0.66 26,400 0.86 34,000
4 25,000 0.57 14,250 0.82 20,500
5 20,000 0.50 10,000 0.78 15,600

74
 NPV- (11,530) NPV+ = 10,520

N/B: Scrap value was added in the last year.

𝑁𝑃𝑉 +
IRR = LDF + x (HDF - LDF)
𝑁𝑃𝑉+ −(𝑁𝑃𝑉−)

10,520
IRR = 5% + (10520+11530)
x 10%

IRR = 5% + 0.4771 x 10%

0.098 = 9.8%
Example 3
Calculate the IRR of a project 50,000 initial outlay with the scrap value of
N5,000 and profit after depreciation of
YrsCf(N)
1 10,000
2 15,000
3 20,000
Cost of capital 10%.

Solution:
IRR use cash flows since we have profit after depreciation we have to add back
depreciation to get cash flows.

(50,000− 5,000)
Depreciation = 3

45,000
Dep = = 15,000
3

Cash flows
Yr1 10,000 + 15,000 = 25,000
Yr2 15,000 + 15,000 = 30,000
Yr3 20,000 + 15,000 = 35,000

IRR is

Yrs Cash flow DF 10% PV(N) DF 50% PV(N)

0 (50,000) 1 (50,000) 1 (50,000)
1 25,000 0.9091 22,728 0.6667 16,668
2 30,000 0.8264 25,392 0.4444 13,332
3 40,000 0.7513 80,052 0.2963 11,852
NPV+ = 28,172 NPV+ = (8,148.5)

75
 𝑁𝑃𝑉 +
IRR = LDF + x (HDF - LDF)
𝑁𝑃𝑉+ −(𝑁𝑃𝑉−)

28,172
IRR = 10% + (28172 + 8749)
x 40%

IRR = 10% + 0.7756 x 40%

IRR = 0.410 = 41%

3.4. Advantages of IRR

1. It shows the return on the original money invested.
2. IRR rates are presented in form of familiar figures that can easily be interpreted by the
user of the data.
3. IRR though peculiar to a given project avoids disputes that characterize the choice of
the appropriate cost of capital to use when appraising project.

3.5 Disadvantages of IRR

1. It is difficult to compute and interpret.

2. It most times bring conflicting answers with NPV of which NPV will be used for
decision making therefore making IRR more irrelevant.

4.0 Conclusion

With the help of illustration and examples, it will be easier now to compute IRR and make
decisions with the result. The objectives of the paper has been achieved since it covered
everything stipulated in it both the advantages and disadvantages.

5.0 Summary

IRR is one of the major tool in modern capital budgeting appraisal. It makes use of the NPV
and observed the time value of money it shows the best cost of capital of which the company
must choose. It is very tactical but good in decision making.

6.0 Tutor Marked Assignment

If the cost of capital is 10% and the scrap value is N10,000 at the end of 5 years, calculate the:

a) PBP - Payback Period

b) ARR - Accounting Rate of Return
c) NPV - Net Present Value
d) IRR - Internal Rate of Return

76
e) PI - Profitability Index

𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒
N/B: P. I = 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑂𝑢𝑡𝑙𝑎𝑦

7.0 Reference Point

R. H. Garrison Management Accounting Business, Publication Inc. Plano, Texas United State
of America, 1985.

R. H. Pike, Longitudinal Survey on Capital Budgeting practices. Journal of Business, Finance

and Accounting, vol. 23, No. 1579 – 92, 1996.

R. A. Brealey, S. C. Myers, Principles of Corporate Finance, McGraw-Hut Inc. United State of

America 61-82, 1981.

R. H. Pike, an Empirical Study of the Adoption of sophistical capital budgeting practice and
decision making. Effectiveness, Accounting and Business, Research, vol. 18, No. 72, 341-351,
1998.

Oye Akinsalife; Financial Management 9th Edition 2003, Ceemol Nigerian Limited
publication, Lagos, Nigeria.

D. Brounen – A. Jong K-Koedijik Corporate finance in Europe confronting Theory with

Practice, financial Management vol. 33, No. 4, 4 – 101, 2004.

R. W. Mills, P. J. A. Herbert; Corporate and Division influence in capital Budget; A study of

corporate Divisional practice in large U. K. companies. The chartered Institute of Management
Accountants, London, U. K., 1987.

T. Wank Pel; The practice and factors determining the selection of capital budgeting methods
– Evidence from the field – Procedia – Social and Behavioural Sciences vol. 156, 2014, 612-
616. Online available from
http://www.sciencedirect.com/science/article/pii/s187704281406070 4; Retrieved April, 2016.

77
 MODULE THREE: CAPITAL RATIONING

Unit 1: The Concepts of Capital Rationing

Unit 2: Different Situation in Capital Rationing

Unit 3: Project Selection Methods

UNIT 1: THE CONCEPTS OF CAPITAL RATIONING

1.0 Introduction

2.0 Objectives

3.0 Main Content

3.1 Definition of capital rationing

3.2 Causes of Capital Rationing

3.3 Advantages of Capital Rationing

3.4 Disadvantages of Capital Rationing

3.5 Assumptions of Capital Rationing

3.6 Reasons for Hard Capital Rationing

3.7 Reasons for Soft Capital Rationing

4.0 Conclusion

5.0 Summary

6.0 Tutor Marked Assignment

7.0 References

1.0 Introduction

Capital rationing is a common practice in most of the companies as they have more profitable
projects available for investment as compared to the capital available.

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In theory, there is no place for capital rationing as companies should invest in all profitable
projects. However, a majority of companies follow capital rationing as a way to isolate and
pick up the best project under the exiting capital restriction.

2.0 Objectives
 To know what is capital rationing
 Understand the causes of capital rationing
 Explain the advantages and disadvantages of capital rationing
 State the reason of hard and soft capital rationing

3.0 MAIN CONTENT:

3.1 Definition of Capital Rationing

It is the process of putting restriction on the projects that can be undertaken by the company or
the capital that can be invested by the company. This aims in choosing only the most profitable
investments for the capital investment decision.

This can be accomplished by putting restrictive limits on the budget or selecting a higher cost
of capital as the hurdle rate of all the projects under consideration, capital rationing can either
be hard or soft.

3.2 Causes and Types of Capital Rationing

They can be categorized into two:

1. Those that are within the company’s control i.e. artificial, internal/soft capital rationing.
2. Those that are not within the company’s control: Real/External, Hard Capital
Rationing.

The two situations can arise as follows:

1. Artificial/internal cause/soft capital rationing.

a) When management considers that raising money through the stock market may
not be possible if share prices are at depressed levels.
b) Where management decides to maintain stable dividend payment instead of
ploughing back all the profit to finance expansion.

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 c) Where the company sets for itself a cut off rate above which it will be unwilling
to borrow.

2. REAL/EXTERNAL CAUSES/HARD CAPITAL RATIONING

a) Where the financial institutions are unwilling to lend at whatever price to a
company.
b) Where the company does not belong by the fiscal policy to the priority sectors
that are favoured under the government new fiscal policy guideline.
c) Global policies as they may affect the country where such companies are based.

3.3 Advantages of Capital Rationing

Advantages

1. Budget: The first and an important advantages are that capital rationing
introduces a sense of strict budgeting of corporate resources of a company. Whenever
there is an injunction of capital in the form of more borrowings or stock issuance capital
the resources are properly handled and invested in profitable projects.
2. No Wastage: Capital Rationing prevent wastage of resources by not investing in each
and every new project available for investment.
3. Fewer Projects: It ensures that less number of projects are selected by imposing
capital restriction. This helps in keeping the number of active projects to a minimum
and this manage them well.
4. Higher Returns:
Through Capital Rationing, companies invest only in projects where the expected return
in high, thus eliminating project with lower returns on capital.
5. More Stability: As the company is not investing in every project, the finances are
not over-extended. This helps in having adequate finances for tough times and ensure
more stability and increase in the stock price of the company.

3.4 Disadvantages of Capital Rationing

Capital rationing comes with its own set of disadvantages as well. Let us describe the problems
that rationing can lead to.

1) Effective and efficient Capital Market: Under efficient capital market theory, all
the projects that add to company’s value and increase shareholders wealth should be

80
 invested in. However by following capital rationing and investing in only certain
projects, this theory is violated.
2) The Cost of Capital:
In addition to limits on budget, capital rationing also places selective criteria on the cost
of capital of shortlisted projects. However, in order to follow this restriction a firm has
to be very accurate in calculation the cost of capital. Any miscalculation could result
in selecting a less profitable projects.
3) Un – Maximizing Value: Capital rationing does not allow for maximizing the
maximum value creation as all profitable projects are not accepted and thus, the NPV
is not maximized.
4) Small Projects:
Capital rationing may lead to the selection of small project rather than larger scale
investment.
5) Intermediate Cash flow:
Capital rationing does not add intermediate cash flows from a project while evaluating
the projects. It bases its decision only the final returns from the project intermediate
cash flows should be considered in keeping the time value of money in mind.

3.5 Assumptions of Capital Rationing

The primary assumption of capital rationing is that there are restrictions on capital expenditure
either by way of all internal financing or investment budget restriction.

Firms do not have unlimited fund available to insist in all the projects. It also assumes that
capital rationing can come out with an optimal return on investment for the company whether
by normal trial and error process or by implementing mathematical techniques like integer,
linear or goal programming.

3.6 Reasons for Hard Capital Rationing

Hard Capital Rationing is an external form of capital rationing. The company finds itself in a
position where it is not able to generate external funds to finance its investment - reasons are:

81
1) Poor Management/Track Record:
The external funds can also be affected by the bad track record of the company or the
poor management team. The leaders can consider such companies as a risky asset any
and may shy away from investing in projects of the company.
2) Lenders Restriction:
Quite often, medium sized and large size companies rely on institutional investors and
banks for most of their debt requirements. There may be restrictions and debt covenants
placed by these lenders which affect the company’s fund-raising strategy.
3) Industry Specific Factors
There could be a general down fall in the entire industry affecting the fund raising
abilities of a company.
4) Start Up Firms
Generally, young start-up firms are not able to raise the funds from equity markets.
This may happen despite the high projected returns or the lucrative future of the
company.

3.7 Reasons for Soft Capital Rationing

Soft capital rationing, on the other hand, is a company-led capital restriction due to the
following reasons:

1) Promoters Decision: The promoters of the company may decide to limit raising more
capital too soon for the fear of losing control of the company’s operations. They may
prefer to raise funds slowly and over a long period to ensure their control of the
company. Moreover, this could also help in getting a better valuation while raising
capital in the future.
2) An increase in opportunity cost of capital:
Too much leverage in the capital structure makes the company riskier investment. This
leads to increase in the opportunity cost of capital. The companies aim to keep their
solvency and liquidity ratios under control by limiting the amount of debt raised.

3) Future Scenarios:

The companies follow soft rationing to be ready for the opportunity available in the
future, such as a project with a better rate of return or a decline in the cost of capital.
There is prudence in conserving some capital for such future scenarios.

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4.0 Conclusion

Though the capital rationing seems to contradict maximizing shareholders wealth, it is

a very important process of the budgeting process of a company. Depending on the
type of capital rationing, the company can decide on the techniques for analyzing the
investment.
5.0 Summary

With the text above, I believe one can easily understand what capital rationing is talking about,
the advantages and disadvantages the causes and types and the reasons for hard or soft capital
rationing. This will enable the management to make radical decision on the best way to ration
their limited capitals.

6.0 Tutor Marked Assignment

What is soft capital rationing?

Explain the concept of capital rationing?

Explain why people ration their capital

List and discuss the advantages and disadvantages of capital rationing

7.0 References

1. http://www.finweb.com/financial.planning/what-is-capital-rationing.htmlNax22
2. http://www.accountunqformanagent.org/capital-rationing.ht,m
3. http://managementstudyguide.com/types-ofcapital-rationing.htm.
4. Oye Akinsulire: Financial Manager 7th Edition, 2013, Ceemol Nigerian Limited,
Publications, Lagos, Nigeria.

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UNIT 2: DIFFERENT SITUATIONS OF CAPITAL RATIONING AND PROJECT
SELECTION

1.0 Introduction

2.0 Objectives

3.0 Main Content

3.1 Different Situations of Capital Rationing

3.2 Relationships between DPI and EPVI

3.3 Projects Selection Based on Calculations

3.4 Ranking of Projects

3.5 Decision Rule

4.0 Conclusion

5.0 Summary

6.0 Tutor Marked Assignment

7.0 References

1.0 INTRODUCTION

There are different situation of capital rationing through a project can be selected depending
on the type adopted by the management of a firm.

2.0 OBJECTIVES

At the end of the lesson one will be able to:

1. Identify the different situation through which capital can be rationed.

2. Be able to calculate following the necessary procedure for a reasonable answer.
3. Be able to select projects and make decisions based on the answers and observations
from the calculations.

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3.0 THE MAIN CONTENT

3.1 Different Situations of Capital Rationing

1. Independent Projects:
These are projects that are to be appraised for acceptance/rejection solely on each
projects individual merit.
2. Mutually Dependent Project:
These are projects that are appraised for Joint acceptance/rejection.
3. Mutually Exclusive Project
These are projects that cannot be accepted at the same time. If a particular project is
accepted, the other must be rejected.
4. Divisible Projects;
These are projects that can be part-financed i.e. fractions can be undertaken.
5. Indivisible Projects
These are projects that cannot be part-financed i.e fractions cannot be undertaken.
6. Single-Period Capital Rationing
This occurs where there is financial constraint over just a period.
7. Multi-Period Capital Rationing:
This occurs where there is financial constraint spanning more than 1 year.
8. Discounted Profitability Index:
It measures the return per every N1 invested. It is calculated as follows:
𝐺𝑃𝑉
DPI = 𝑂𝑢𝑡𝑙𝑎𝑦

Where:
GPV = Gross Present Value.

N/B: A major advantage of DPI is that it facilitates maximization of profit earned per unit
of Naira invested.

𝑁𝑃𝑉
9. Excess Present Value Index = 𝐶𝑜

3.2 Relationships between DPI and EPVI

1. DPI = EPVI + 1
2. EPVI = DPI – 1
3. NPV = Outlay x EPVI

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4. NPV = Outlay x (DPI – 1)
5. If DPI is greater than 1, NPV will be greater than 0 i.e. NPV is positive.
6. If DPI is less than 1, NPV will be less than 0 i.e. NPV will be negative.
7. If DPI equals 1, NPV equals 0.

3.3 Project Selection Based on Calculation

Example 1

Ebiere Plc undertakes a new project having the following cash flow:

Yrs CF(N)

0 (80,000)

1 36,000

2 38,000

3 52,000

The company’s cost of capital is 14%

Calculate:

1. DPI or Profitability Index

2. EPVI = Excess Present Value Index.

Solution:

Yrs Cash flows (N) DF 14% GPV

0 (80,000) 1 (80,000)

1 36,000 0.8772 31,579

2 38,000 0.7695 29,241

3 52,000 0.6750 35,100

NPV = 15,920

𝐺𝑃𝑉 95,920
a) DPI = = = 1.2
𝐶𝑜 80,000

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 15920
b) EPVI = = 0.2
80,000

There DPI = EPVI + 1

EPVI = DPI – 1

Example 2

Ration the capital of N25,000,000 among these projects if they are mutually divisible.

Yr Project A Project B Project C

0 (25) (20) (10)

1 80 16 15

2 15 30 37.5

All the initial outlay are in millions. The cost of capital is 11%

NPV - A = 59.22

NPV - B = 43.11

NPV - C = 33.95

Solution:

N/B: Since we cannot determine or ration the capital using only NPV, we quickly calculate
𝐺𝑃𝑉
the EPVI = 𝐶𝑜

59.22
1. EPVI for Project A = 25
= 2.37
43.0
2. EPVI for Project B = = 2.16
𝐶𝑜20
33.95
3. EPVI for Project C = = 3.40
10

N/B: With this EPVI, we can easily determine our DKPI which is the best for project
selection or ranking.

1. EPVI = DPI - 1
DPI = EPVI + 1
a. DPI for Project A = 37 + 1 = 3.37

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 b. DPI for Project B = 2.16 + 1 = 3.16
c. DPI for Project C = 3.40 + 1 = 4.40

N/B: You can solve with either EPVI or DPI they will always produce the same result in
ranking.

3.4. Ranking of Projects:

Project (000,000) Co NPV PI EPVI Ranking

A -25 59.22 3.37 2.37 2nd
B -20 43.11 3.16 2.16 3rd
C -10 33.95 4.40 3.40 1st

N/B: Since we have only N25m to apportion we are going to start selecting the best project
based on the ranking.

Project C = 10,000,000 NPV = 33.95

= 3⁄5
25,000,000 15,000,000
= +
15,000,000 25,000,000

33.95 +3⁄5 (59.22) = 69.482

N/B: We used the DPI to rank and select but we apportion using NPV.

Example 3

Project Year 0 Year 1 Year 2 NPV

A (10,000) 6000 7000 + 1240

B (20,000) 14,000 10,000 + 991

C (30,000) 10,000 28,000 + 2280

D (40,000) 30,000 20,000 + 3801

N/B: Without capital rationing, all four projects would be viable investments because they
have positive NPV. However, if there is a restriction to the amount of finance available, so
that only N60,000 is available in Year 0, the company will optimize its return by maximizing
the NPV generated per N1 spent in Year 0 as follows:

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 Project NPV Co EPVI PI Ranking
A + 1240 (10,000) 0.124 1.124 1st
B + 991 (20,000) 0.050 1.050 4th
C + 2230 (30,000) 0.074 1.074 3rd
D + 3801 (40,000) 0.095 1.095 2nd

N60,000 available will be spent as:

Project Ranking Outlay PVI

A 1st 10,000 1240
D 2nd 40,000 3801
C 3rd 10,000 743
TOTAL 60,000 5784

N/B: Remember Project C is 10,000, because the 1⁄3 of the outlay. Since we have only

10,000 to apportion for the project which is 10,000⁄30,000 = 1⁄3

Example 4:

If project A and C are mutually exclusive, and the company has N2m to invest on these projects,
select the projects to be invested in.

N/B: The projects are divisible.

Project Co NPV PI EPVI

A 400 154 0.39 1.39

B 800 580 0.73 1.73

C 700 800 1.14 2.14

D 1000 628 0.63 1.63

E 300 80 0.29 1.27

F 900 -100 -0.01 0.99

If the cost of capital is 18%

Solution

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 A and C are mutually exclusive.

Project Co NPV Project Co NPV

A 400 154 C 700 800

B 800 680 B 800 580

D 1000 502 D 1000 314

E 300 E 300

1236.4 1694

N/B: We removed project F because it has a negative NPV.

3.5 Decision Rule

Since they are mutually exclusive, Project C should be undertaken because it has higher NPV
than Project A.

Example 5

When the project is indivisible, Ejiro Plc has a limited of N2million in the current period.
Capital is expected to be freely available in future period. The cost of capital is 20%.

Project Outlay (000) NPV 20% EPVI

A 700 350 0.50

B 800 450 0.56

C 1300 760 0.58

D 960 630 0.66

E 460 180 0.39

You are required to calculate the optimal combination of the projects there are no alternative
investments available for any surplus funds.

N/B: Cash outlay and NPV are in (000).

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Solution:

Since the projects are not divisible we can only look for possible combination without
repetition. Remember they are in (‘000)

A + C= 2000

A+B+C = 1960

A + D = 1660

B + D= 1760

C + E= 1760

D + E= 1420

Then let’s look for cash surplus

A + C = 2000 - 2000 = 0 surplus

A + B + C = 1960 - 2000 = 40 surplus

A + D = 1660 - 2000 = 340 surplus

B + D = 1760 - 2000 = 240 surplus

C + E = 1760 - 2000 = 240 surplus

D + E = 1420 - 2000 = 580 surplus

N/B: Ignore the negative signs in the surplus. The surplus are not enough to be invested in
other projects. Remember no repetition of project.

𝑂𝑢𝑡𝑙𝑎𝑦
The weighted EPVI = x EPVI
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐿𝑖𝑚𝑖𝑡

700 1300
AC = x (0.5) + x (0.58)
2000 2000

0.175 + 0.377 = 0.552

700 800 460

ABE =2000 x (0.5) + 2000 x(0.56) + 2000 x (0.39)

0.175 + 0.224 + 0.0897 = 0.489

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 700 960
AD = (0.5) + x (0.66)
2000 2000

0.175 + 0.3168 = 0.492

800 960
BD = x(0.56) + x (0.66)
2000 2000

0.224 + 0.3168 = 0.541

1300 460
CE = x (0.58) + x (0.39)
2000 2000

0.377 + 0.0897 = 0.467

960 460
DE = x (0.6) + x (0.39)
2000 2000

0.3168 + 0.0897 = 0.407

Table showing the full detail

Projects Total Outlay Surplus fund Total NPV of Weighted

Combination (000) Comb. (000) EPVI
AC 2000 - 1110 0.552
ABE 1960 40 980 0.489
AD 1660 840 980 0.492
BD 1760 240 1080 0.541
CE 1760 240 940 0.467
DE 1420 580 810 0.407

The best combination of Project is AC i.e. Project A and C with a combined total NPV of
N1110,000 and weighted EPVI of 0.552.

Example 6

Based on example 6, assuming the surplus fund are to be invested to produce 22% per annum
in perpetuity, calculate the optimal combination of projects.

Solution

Surplus funds are:

NPV of Surplus fund

AC - -

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 ABE 40 4

AD 340 34

BD 340 24

CE 240 24

DC 580 58

NPV of surplus fund or external investment are calculated as

𝐴𝑠
NPV = 𝐾 x r - As

Where

As = surplus fund

k = Cost of Capital

r = Interest rate on investment.

40 𝑥 0.22
ABE = - 40 = 4
0.2

340 𝑥 0.22
AD = - 340 = 34
0.2

240 𝑥 0.22
BD = - 240 = 24
0.2

240 𝑥 0.22
CE = - 240 = 24
0.2

580 𝑥 0.22
DC = - 2580 = 58
0.2

Project Total Outlay Surplus NPV of Total NPV EPVI Weighted

Comb. Comb. Funds ext. Invest. including NPV of Surplus fund EPVI
Ext Ext.
AC 2000 - - 1110 0.1 0.552
ABE 1960 40 4 984 0.1 0.491
AD 1660 340 34 1014 0.1 0.509
BD 1760 240 24 1104 0.1 0.553
CE 1760 240 24 964 0.1 0.479
DE 1420 580 58 868 0.1 0.436
𝑁𝑃𝑉 𝑜𝑓 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙𝑙𝑦 𝐼𝑛𝑣𝑒𝑠𝑡
EPVI surplus funds externally invested = 𝑆𝑢𝑟𝑝𝑙𝑢𝑠 𝐹𝑢𝑛𝑑

Calculation of Weighted EPVI on surplus fund

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AC 0.552

700 800 460 40 𝑥 (0.1)

ABE = x (0.5) + x (0.50) +2000 x (0.39) + = 0.491
2000 2000 2000

700 960 340

AD = x (0.5) + x (0.60) +2000 x (0.1) = 0.509
2000 2000

800 960 240

BD = x (0.56) + x (0.66) +2000 x (0.1) = 0.553
2000 2000

1300 460 240

CE = x (0.58) + x (0.39) +2000 x (0.1 ) = 0.479
2000 2000

960700 460 580

DE = x (0.66) + x (0.39) +2000 x (0.1) = 0.436
2000 2000

N/B: Using the weighted EPVI approach, the best project combination is BD. However,
project combination AC gives us the highest total NPV of N1, 110,000. Thus, the optimal
solution is to select project A and C with a total NPV of N1, 110,000.

3.6. Observation

Weighted EVPI has to be used with caution in a situation where projects are indivisible, as it
can produce an incorrect ranking. Thus, in a situation where projects are indivisible, the
recommended approach is to select project on the basis of the total NPV of possible project
combinations. It is not necessary to calculate the weighted EPVI except if the examiner ask
for it.

4.0 Conclusion

Though capital rationing has few disadvantages, it is still followed widely in selecting
investment projects. A company should decide on following capital rationing after studying
the implications in detail.

5.0 Summary

In a multi period capital rationing the optimal combination of a project can be found through
linear programme.

In a situation where there is capital rationing, project selection techniques need modification.
Capital rationing is a situation where a company is unable to accept all projects with a positive
NPV due to shortage of funds. Capital rationing can be self-imposed (called soft rationing or
externally imposed called hard rationing).

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6.0 Tutor Marked Assignment

Emuesiri Ltd is a highly geared company that wishes to expand its operation. Six possible
capital investments have been identified. But the company only has access to a total of
N620,000. The projects are not divisible and may not be postponed until a future period. After
the projects end it is unlikely that similar investment opportunity will occur.

Expected Net Cash inflow (including salvage value).

Project Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Initial Outlay

A 70,000 70,000 70,000 70,000 70,000 246,000
B 75,000 87,000 64,000 - - 180,000
C 48,000 48,000 63,000 73,000 - 175,000
D 62,000 62,000 62,000 62,000 - 180,000
E 40,000 50,000 60,000 70,000 40,000 180,000
F 35,000 82,000 82,000 - - 180,000

Project A and E are mutually exclusive.

All projects are believed to be of similar risk to the company’s existing capital investment.
Any surplus fund may be invested in the money market to earn a return of 9% per year. The
money market may be assumed to be an efficient market. Emuesiri Ltd. Cost of capital is 12%
a year.

Required:

a. Calculate the expected Net Present Value for each of the six projects.
b. Calculate the expected profitability index associated with each of the six projects.
c. Rank the projects according to both of their investment appraisal method.
d. Give reasoned advice to Emuesiri Ltd recommending which projects should be
selected.

7.0 References

1. W. Baumol and R. Quandt “Investment and Discount Rate under Capital Rationing. A
programming Approach”. The economic Journal, vol. Lxxv, No. 298 (June 1965). Pp,
317-329.

95
2. Brown J. L. and L. R. Howard, Managerial Accounting and Guidance, 4th edition
Plymouth: Macodonald and Evans. 1982.
3. S. A. Margliun, Approach to Dynamic Investment Planning (Amsterdam: North
Holland co. 1963).
4. Ayo Alowe, Financial Management Concept, Financial system and Business Finance
2008, published by Brierly-Jones Nigeria Limited, Lagos, Nigeria.
5. OyeAkinsulire: Financial Management 7th edition 2003, Ceem,ol Nigeria Limited,
Publication Lagos, Nigeria.
6. I. Fisher, theory of interest (Mcmillian New York, 1930).
7. A Charness W. W. Cooper and M. H. Miller: Application of Linear Programming to
financial Budgeting and the costing of fund. Journal of Business (January, 1959). Pp.
20-46

96
 MODULE FOUR: CAPITAL STRUCTURE DECISION

UNIT 1: CONCEPT OF CAPITAL STRUCTURE

UNIT 2: FINANCIAL STRUCTURE AND CAPITAL STRUCTURE

UNIT 3: THEORIES OF CAPITAL STRUCTURE
UNIT 4: PLANNING THE CAPITAL STRUCTURE

UNIT 1: CONCEPT OF CAPITAL STRUCTURE

CONTENT

1.0 Introduction

2.0 Objectives

3.0 Main Content

3.1 Concept of Capital

3.2 capital structure

4.0 Conclusion

5.0 Summary

6.0 Tutor Marked Assignment

7.0 References

1.0 INTRODUCTION
For any business to be initiated, the resource called capital is importantly considered:
Generally, it is referred to as funds used to set up and run a business. It could also be referred
to as unit of ownership any investor invests in a business.
Generally, every source of capital available to a financial manager is known as what could lead
to the success or failure of any business and so the financial manager is faced with the issue of
appropriately deciding which choice or combination of choices to be selected.

97
2.0 OBJECTIVES

After completing the study of this chapter, you should be able

1. To define and understand the concepts of capital and capital structure.

2. To understand the basic approaches to the concept of capital.
3. To be able to justify what made up the capital

3.0 MAIN CONTENTS

3.1 CONCEPT OF CAPITAL

There are two possible approaches to the concept of capital. One of them is the ‘fund’ concept
while the other is the ‘asset’ concept of capital. According to the fund concept, the capital of
the firm is the sum total of the funds that have been employed for its operation. It corresponds
to the idea of total capital employed by the firm and may also be described as ‘financial capital’.
The fund concept recognizes the separate entity of a firm and consider capital from the liability
side of the balance sheet.
Accountants generally prefer, to take only the funds originally brought by the owner along with
the funds that have been subsequently ploughed back into the firm out of the retained profits.
From this standpoint, capital represents the sum of share capital, and reserves and surplus.
Funds contributed by the creditor (both long term and short term) are excluded on the ground
that they are claims by parties external to the firm, and are devoid of certain rights and
privileges enjoyed by the proprietor or shareholder. But a firm has a separate entity.

The basic character of all the funds, whether contributed by the owner or by the creditor is to
generate business income. So, long-term borrowings should also be included in the
composition of capital. Hence, capital represents the aggregate of share capital, reserves and
surplus, and long-term debt.

According -to the ‘asset’ concept, capital means money invested in fixed assets and current
assets. In both the cases, the asset may be comprising either tangibles or intangibles including
fictitious assets. To an accountant, an asset is a capitalized expenditure and represents claims
to services, it need not always be associated with a material object having a tangible, existence.
Further, though assets in general should possess value, all assets may not have value in
exchange. Thus, insofar as the intangible assets satisfy these criteria, there is no constraint on

98
the part of the accountant to the inclusion of intangibles among assets. Fictitious assets, such
as debit balance of profit and loss account, balance of securities discount account, are however,
to be treated more as deduction- from relevant liabilities than assets by themselves. Viewed
from this angle, funds represent aggregate of fixed assets (net of depreciation), intangible
assets, investments and current assets.

3.2 CAPITAL STRUCTURE

The term ‘structure’ is taken from engineering science. It connotes the arrangements of the
various parts of a building or some other construction. It is common knowledge that corporate
enterprises raise their capital from diverse sources such as the issue of shares, debentures, long-
term loans, short-term loans and ploughing back of profits. Accordingly, in the procurement of
capital from diverse sources, as also in the subsequent commitment of the said capital to various
assets, certain proportions or combinations of various elements have to be maintained.
This arrangement of capital is called Capital Structure. There are certain objectives for
maintaining a desired capital structure, such as minimization of the cost of capital and
maximization of the value of the share, etc.
Capital structure includes equity capital comprising retained earnings and long-term debt
capital. Short-term liabilities are excluded from the formulation of capital structure.

4.0 CONCLUSION:

From the above contest, ones can easily understand and define capital structure and what made
up the capital structure which includes equity capital comprising retained earnings and long
term debt capital. Short term liabilities are excluded from the formulation of capital structure.

5.0 SUMMARY

Capital means different things from different perspective. Fund and Assets approach. Fund
approach defined capital as total sum of money employed for its operation. While capital
approach defined it as money invested in fixed and current asset.

6.0 TUTOR MARKED ASSIGNMENT

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 1. Define capital with respect to two main approaches.
2. What do you understand by capital structure?
3 Define the following terms
i. Venture capital
ii. Implicit costs of capital
iii. Explicit costs of capital

7.0 REFERENCES

Archer S. Hand C.A.D Aambrosio (1972) “Business Finance Theory and Management”, Ney

York Macmillan Publishing Co

Ezike J.E. (2002); “Essential of Corporate Finance Management”, Jay Lycent

Communications, Lagos.

Owualah S. I. (2000); “Finance Management, Concept, Analysis and Capital Investment”

Lagos Bierly Jones Nigeria Limited

Van Horne H. (1992): Finance Management and Policy

Bhabatosh Banerjee, Financial Policy and Management Accounting, 7th ed. Prentice-Hall of

India, New Delhi, 2005.

James C. Van Home and John M Wachowicz, Jr., Fundamentals of financial Management 11th

ed., Prentice-Hall of India, New Delhi, 2001.

100
UNIT 2: FINANCIAL STRUCTURE AND CAPITAL STRUCTURE

CONTENT

1.0 Introduction

2.0 Objectives

3.0 Main Content

3.1 Distinctions between Capital Structure and Financial Structure

3.2 Variables Affecting Capital Supply

3.3 Classification of Capital Structure

3.3.1. According to Nature

3.3.2. According to sources

3.3.3. According to Ownership

3.3.4. According to Cost Behaviour

4.0 Conclusion

5.0 Summary

6.0 Tutor Marked Assignment

7.0 References

1.0. INTRODUCTION

This section of the unit tried to identify those factors that differentiated the financial structure
from capital structure and how capital structures are being classified.

2.0. OBJECTIVES

At the end of this unit, one should be able to:

1. The differences between capital structure and financial structure.

2. The various variables that affect capital structure.
3. To classify capital structure into sources.
4. Be able to explain how various forms capital structure are being classified

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MAIN CONTENT

3.0. MAIN CONTENT

3.0.1. Distinction between Capital Structure and Financial Structure.
Sometimes, a distinction is drawn between ‘financial structure’ and ‘capital structure’ of a firm.
The sum of various means of raising funds comprises the financial structure of a firm. That is,
financial structure comprises net worth and all liabilities (long term and short term).
When short-term borrowings are omitted from the list, the remaining claims represent the
capital structure. Thus, the distinction between the two depends on the treatment of short-term
borrowing. However, when a broad view of the matter is adopted to include short-term
liabilities as one of the components of the capital structure (that is, net worth plus all liabilities),
there is no distinction between the terms financial structure and capital structure.

3.1. VARIABLES AFFECTING CAPITAL SUPPLY

The decisions of a financial manger to choose a particular form of capital supply available to
him that will be suitable for the firm is often mainly affected by the following:
(1) Relative costs
(2) Prevailing market conditions
(3) Control level to be relinquished
(4) Duration
(5) Risks involved
They will be considered in relation to the financial manager’s influence
(1) Relative Costs: These simply refer to on them the implicit costs or explicit costs that
will be incurred while sourcing, obtaining and repaying borrowed capital. All these
factor have to be considered by a financial manager in relation to what the capital
sourced is going to reproduce for the company. They can be controlled by the financial
manager.
(2) Prevailing Market Condition: This factor mainly refers to the interest rates that are
prevailing in the market for capital depending on the forces of supply and demand for
capital. These are dependent on the savings of businesses, government and individual
in relation to the money creating activities of banking system. They are exogenous in
nature and are not in the control of the financial manager.
(3) Controlled Leveled to be Relinquished: in this aspect, the financial manager will have
to follow the business owner’s choice in whether or not the ownership structure be

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 altered thereby leading to control being relinquished. This is the case which arises in
whether or not the capital should be permanent capital or long-term capital. Example
deciding whether or not reserves should be re invested (No Control Relinquished) or
whether or not bonds or preference shares should be issued (Control Relinquished).
(4) Duration: this is a very big important factor to be considered as time can be crucial in
investments. The financial manager will be faced with choosing the right capital source
with the right timeline that could suit the capital finance need of the business at a
particular time.
(5) Risks Involved: Risk inherent in a particular capital option and the firm’s market would
definitely influence the choice of capital to be available when financing a business at a
particular time. They are usually gauged by analyzing the current ratios among many
others. Financial risk such as hearing fixed charges on bonds could also be a deciding
factor.
Other factors that may affect the supply of capital involve; security, marketability, legal form
of business, dividend pay-out, record of the firm, legal form of business and eligibility of
securities for institutional investment.

3.2. Classification of Capital Structure

It has already been pointed out that firms acquire their capital from various sources in order to
invest them in different types (If assets. Thus, a capital structure has a double-edged
manifestation-one edge being the finance structure depending on the source, and the other edge
being the asset structure depending on the nature of investment.
There have been various classification of capital structure on different characteristics or
bases. These are discussed in the following section.

3.2.1. According to Nature

A capital structure may be either: (i) simple, or (ii) complex. A simple structure comprises a
single source, e.g. equity share capital including retained earnings. But as soon as a firm
finances capital from more than one source that is not of an identical or allied nature, it is called
a complex structure.
Illustration:

(a) Simple structure:

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 (i) Balance Sheet as on...
N N
Equity share capital 100 Fixed assets 70
Retained earnings Current assets 30
Preference share capital 100 100
(ii) Balance Sheet as on...

N N
Equity share capital 80 Fixed assets 70
Retained earnings 20 Current assets 30
Preference share capital 100 100
(b) Complex structure
(i) Balance Sheet as on...

N N
Equity share capital 90 Fixed assets 70
Current liabilities 100 Current assets 30
100 100
(ii) Balance Sheet as on...

N N
Equity share capital 70 Fixed assets 70
Retained earnings 10 Current assets 30
Preference share capital 20
100 100
(iii) Balance Sheet as on...

N N
Equity share capital 40 Fixed assets 70
Retained earnings 10 Current assets 30
Preference share capital 20
Debenture on long-term loan 30
100 100
(iv) Balance Sheet as on...

N N
Equity share capital 40 Fixed assets 70
Retained earnings 10 Current assets 30
Preference share capital 20
Debenture and long-term loan 20
Current liabilities 10
100 100
The above classification of capital into ‘simple’ and ‘complex’ is possible when it is considered

104
on the basis of the fund concept. A similar classification is not possible in the case of the asset
concept of fund as the existence of any firm with only one type of asset is a rarity.
Even if a firm starts with a simple structure, it is likely to be converted into a complex one over
time because a sustained simple structure presupposes that all future expansions, in addition to
normal growth, are financed either by retained earnings or externally by equity issues only.
These are unlikely to happen because of the interplay of many factors, some of which may
remain outside the control of management.

3.2.2. According to Sources

It may be broadly classified into: (i) internal capital, and (ii) external capital. Internal capital
includes the following:
 Share capital through bonus issue
 Capital reserve
 Reserves and surplus (including balance of profit and loss appropriation account) .
External capital comprises the following:
 Share capital (excluding bonus shares)
 Share premium
 Forfeited shares
 Debentures
 Long-term and short-term liabilities

3.2.3. According to Ownership

Capital may also be classified according to ownership, e.g. ownership capital and creditorship
or debt capital. Ownership capital consists of:
 Equity share capital
 Retained earnings
Creditorship or debt capital includes the following: .
 Debentures
 Long-term loans
 Current liabilities
In the above classification, the concept of preference share capital poses a problem.
There are two approaches regarding its treatment. According to one view, it is considered as a
part of ownership capital, and should, therefore, be added to equity share capital in order to
arrive at the total ownership capital. According to the other view, preference share should be
added to debt capital as, like other debt capital, it enjoys a fixed rate of income and also a

105
priority over equity in respect of both payment of income and return of capital. There are
reasons to justify both the approaches. Accordingly, preference share capital may be treated as
a part of either ownership capital or debt capital.

3.2.4. According to Cost Behaviour

Capital is not cost free. So, classification is also possible according to the cost behaviour of
various sources of capital such as fixed cost capital, i.e. the rate of dividend or interest
remaining fixed, and variable cost capital, i.e. when the dividend rate varies.

The fixed cost capital includes:

 Preference share capital
 Debentures
 Long-term debt capital
The variable cost capital comprises:
 Equity share capital (when no uniform rate of dividend is maintained)
 Short-term liabilities (when such cost is measurable)

In any case, the study of capital structure, whether in its broad outline or in detail, depends on
the proportional or percentage contribution to the total capital of a firm. At any given point of
time, such percentage contributions cannot be the same in firms of different types within a
particular industry, or in those of different industries but of a particular type.

4.0. CONCLUSION

The study of capital structure, whether in its broad outline or in detail, depends on the
proportional or percentage contribution to the total capital of a firm. At any given point of time,
such percentage contributions cannot be the same in firms of different types within a particular
industry, or in those of different industries but of a particular type.

5.0 SUMMARY

The distinction between capital structure and financial structure has been made clear as
financial structure focus mainly on short term projects and finance while capital structure based
its assumptions on long term projects and finance. And also the various variables that affect
capital structure were defined and described

106
 6.0 TUTOR MARKED ASSIGNMENTS

1. Differentiate between capital structures and financial structures and list those
variables that affect capital structure.
2. Classify capital structure into forms and explain them. .
3. Evaluate the various type of shares we have
4. What is lease?
5. Explain the terms:
(a) Lease
(b) Bonds
(c) Debentures
(d) Commercial papers
(e) Trade credit

7.0 REFERENCES

Archer S. Hand C.A.D Aambrosio (1972) “Business Finance Theory and Management”, Ney

York Macmillan Publishing Co

Ezike J.E. (2002); “Essential of Corporate Finance Management”, Jay Lycent

Communications, Lagos.

Owualah S. I. (2000); “Finance Management, Concept, Analysis and Capital Investment”

Lagos Bierly Jones Nigeria Limited

Van Horne H. (1992): Finance Management and Policy

 Bhabatosh Banerjee, Financial Policy and Management Accounting, 7th ed. Prentice-Hall

of India, New Delhi, 2005.

 James C. Van Home and John M Wachowicz, Jr., Fundamentals of financial Management

11th ed., Prentice-Hall of India, New Delhi, 2001.

107
 UNIT 3: THEORIES OF CAPITAL STRUCTURE

CONTENT

1.0 Introduction

2.0 Objectives

3.0 Main Content

3.1 Assumptions
3.2 Net Income Approach

3.3 Net Operating Income Approach

3.4 Traditional Approach

3.5 Modigliani – Miller (M-M) Hypothesis

3.5.1. Assumptions of (M-M) Hypothesis

3.5.2. Interpretations of (M-M) Hypothesis

3.5.3. Proof of (M-M) Hypothesis

3.5.4. Criticism of (M-M) Hypothesis

3.5.5. Modigliani – Miller (M-M) Hypothesis with corporate tax.

4.0 Conclusion

5.0 Summary

6.0 Tutor Marked Assignment

7.0 References

1.0. INTRODUCTION
The key question with which we are concerned is whether a firm can affect its total valuation
(debt plus equity) and its cost of capital by changing its financing mix. That is, what happens
to the total valuation of the firm and to its cost of capital when the ratio of debt to total
capital, or the degree of leverage, is varied?

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2.0. OBJECTIVES
At the end of this unit one should be able to:
1. Those theories of capital structure
2. Be able to calculate capital structure using the formulars provided in the contest
3. To make decisions with the results of the calculations

3.0. MAIN CONTENT

1.1 Assumptions
In the discussion relating to the conceptual aspects of capital structure, we are concerned with
three different rates of return.
The first is
1 Annual interest charges
𝑘𝑑 = 𝐷 = Market value of debt outstanding

Or
1
𝐷= 𝑘𝑑

In the above equation 𝑘𝑑 is the yield on the firm’s debt, assuming that the debt is perpetual.

The second rate of return which is

𝐸 Earnings available to equity shareholder

𝑘𝑑 = 𝑆 = Market value of equity outstanding

(E = EBIT – 1 - Dp)
𝐸
𝑆= 𝑘𝑒

In the case of our assumptions of a firm whose earnings are not expected to grow and that has
a /00% dividend-payout ratio, the earnings/price ratio represents the market rate of discount
that equates the present value of the stream of expected future dividends with the current market
price of the share.

The third or the final rate of return is

𝑂 Net operating income

𝑘𝑜 = 𝑉 = Total market value of the firm
(O = EBIT)
Or
𝑂
𝑉=
𝑘𝑂

109
Where V = D + S. Here, ko is the overall capitalization rate for the firm. It is defined as the
weighted average cost of capital, and may be expressed as:

𝐷 𝑆
𝑘𝑜 = 𝑘𝑑 (𝑉 ) 𝑘𝑒 (𝑉)

We want to know what happens to kd, ke and ko when the degree of leverage, as denoted
By the ratio D/V, increases. We are also concerned with the total value of the firm. The film’s
total value, V, is the aggregate of the debt value, D, and equity value, S, that is

V=D+S

1 𝐸
𝑉= +
𝑘𝑑 𝑘𝑒
A number of theories explain the relationship between cost of capital, capital structure and
value of the firm. These are as follows:

1. Net income approach

2. Net operating income approach
3. Traditional approach
4. Modigliani-Miller hypothesis

The two extreme boundaries of the valuation of the earnings of a firm are the ‘Net Income (NI)
approach’ and the 'net operating income (NOI) approach’. According to the NI approach, the
firm is able to increase its total valuation. V, and lower its cost of capital, k; as it increases the
degree of leverage, D/V. The NOI approach implies that the total valuation of the firm is
unaffected by its capital structure. This approach is purely definitional, that is, no behavioural
or economic meaning is attached to it. Modigliani and Miller offered behavioural support for
the independence of the total valuation1 and the cost of the capital of the firm from its capital
structure. The traditional approach assumes that there is an optimal capital structure and that
the firm can increase its total value through the judicious use of leverage.

Before discussing these theories, we have to refer to the underlying assumptions.

1.2 Assumptions
In order to focus on the key issues, we begin with several simplifying assumptions:
I. The firm finances from two sources only: equity and debt.
1. There is no corporate tax. This assumption is removed later on.

110
2. All earnings are paid out as dividends, that is, there is no retention.
3. The firm’s assets (or aggregate capital consisting of debt and equity) are not growing,
and, hence, its operating income (EBIT) is expected to remain constant in the future.
4. The firm can change its capital structure, or degree of leverage, either by issuing shares
to retire debt or by raising more debt to ‘redeem’ the shares.
5. The firm’s business risk is taken as being constant over time mid is independent of its
capital structure and financial risk.
6. Investors have the same subjective probability distribution of the expected future
operating income or EBIT for a given firm.
7. The firm has a perpetual life.

1.3 Net Income Approach

Durand2 identified the two extreme capital structure theories-e-the net income approach and
the net operating income approach.

As previously mentioned, according to the NI approach, the firm is able to increase its total
valuation, V, and lower its cost of capital, ko, as it increases the degree of leverage, D/V. The
optimum capital structure is one at which the cost of capital is the lowest and the value of the
firm is the greatest. At that structure, the market price per share is maximized.

The significance of the NI approach is that a firm can lower its cost of capital continually by
the use of debt capital, and, thus, increase its total valuation. Reduction in the cost of capital
with more- and more use of debt capital and, hence increase in the value of the firm will be
possible when .

1. The cost of debt (kd) is less than the cost of equity (ke) and it remains constant: or
2. The firm’s risk perception is not changed, i.e. it does not become increasingly more risky
in the minds of investors and creditors, as the degree of leverage is increased.

So, the NI approach makes the above two assumptions. In addition, we have already assumed
that there will not be any corporate tax.

111
Assume that a firm’s EBIT is N15.000. The cost of equity, ke is 1.5% and the cost of debt,
kd is 10%. Its total capital amounts to N 100.000. Assuming that the firm can have the following
alternative degrees of leverage, calculate the cost of capital and value of the firm for each
alternative leverage using the N1 approach:

Leverage (debt to total capital): 0%, 20%, 50%, 80% and 100%
Degree of leverage
(debt to total capital 0 0.2 0.5 0.8
1.0
N N N N N
Equity capital 100,000 80,000 50,000 20,000 NIL
Debt capital - 20,000 0,000 80,000 100,000
Total 100,000 100,000 100,000 100,000 100,000
EBIT 15,000 15,000 15,000 15,000 15,000
Interest (I) Nil 2,000 5,000 8,000 10,000
Earnings to equity (0) (EBIT-I) 15,000 13,000 10,000 7,000 5,000
Market value of debt (1/Kd) (D) Nil 20,000 50,000 80,000 100,000
Market value of equity (O/ke)(S) 100,000 86,667 66,667 46,667 33,333
Total value of the firm (V) (D + S) 100,000 106,667 116,667 126,667 133,333

kd 10% 10% 10% 10% 10%

ke 15% 15% 15% 15% 15%
ko 15% 14% 12.5% 11% 10%
(see Workings)

The costs of debt and equity are 10% and 15%, respectively, and are assumed to be constant
at varying levels of the debt-equity mixed under the NI approach. The above table shows that
with an increase in the proportion of debt capital, the overall cost of capital, ko, declines, and
the value of the firm, V, also increases. Thus, when the firm uses 100% debt capital, the cost
of capital, ko, is minimum and the value of the firm, V, is also maximum.

Workings

The average cost of capital at different financing plans is computed by using the formula

𝐷 𝑆
𝑘𝑜 (𝑉 ) 𝑘𝑑 (𝑉) 𝑘𝑒
as follows:
1. When financial leverage is 0:
ko= a x 10 + 1 x 15 = 15%
2. When financial leverage is 0.2:
ko = 0.2 x 10 + 0.8 x IS = 14%

112
3. When financial leverage is 0.5:
ko = 0.5 x 10 + 0.5 x 15 = 12.5%
4. When financial leverage is 0.8:
ko = 0.8 x l O + 0.2 x 15 = 11%
5. When financial leverage is 1:
ko = 1 x 10 + a x l5 = 10%.

The NI approach can be illustrated graphically as in Figure 4.1. We use the relevant data from
Illustration 4.1. The degree of leverage, debt to total capital, is plotted along the x axis while
the cost of capital (kd, k, and ko) is on the y axis. The graph shows that as the proportion of
cheaper debt capital in the capital structure is increased, the weighted average cost of capital,
ko, decreases and, gradually, approaches the cost of debt, kd The optimal capital structure is
corresponding to the minimum cost of capital, ko, when the financial leverage is one, i.e. with
the maximum use of debt capital. At this level, the value of the firm is also maximum. But can
a company operate with 100% debt capital and zero equity capital? Thus, NI is Dot based on
logical foundation.

20 ke

15
12 ko
10 kd

0 0.2 0.5 0.8 1.0

Leverage (D/V)
Figure 4.1 Effect of leverage on the cost of capital (NOI approach).

1.4 NET OPERATING INCOME APPROACH (NOI)

If there is an increase in debt value of the firm remains constant and the cost of equity increase.

Example 1:

Jossy company’s EBIT is N750, 000 .The Company has 9% 900,000 debentures in issue. The
Cost of Capital is 12%, what will be the Value of the firm and cost of equity.

Solution

D = 900,000
INT = 99% of 9000,000 = 81,000
Ko = 0.12%

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V = ?
Ke = ?
To get the value of the firm
𝑁𝑂𝐼
Since = Ko = 𝑉

Then V will be made the subject of formula

𝑁𝑂𝐼
V = 𝐾𝑜
750,000
V = = 6,250,000
0.12

𝑃𝐴𝐼
Ke = 𝐸
𝑃𝐴𝐼
Since E = = Ke being the subject of formula
𝐾𝑒

To get E
V=D + E
E = V - D = 6,250,000 - 900,000 = 5,350,000
PBIT 750,000
INT (81,000)
PAT 669,000

669000
Ke = = 0.125 =12.5%
5350000

Example 2:
If debt increases to N950,000
NOI = 750,000
D = 950,000
INT = 9% of 950 = 855,000
Ko 0.12
V = ?
Ke = ?
𝑁𝑂𝐼
With the full knowledge from Net Income Approach that Ko = 𝑉
𝑁𝑂𝐼 750,000
V = = = 6,250,000
𝑉 0.12
𝑃𝐴𝐼
E = 𝐾𝑒
𝑃𝐴𝐼
Since E = = KE become the subject of formula
𝐾𝑒

114
To get E
V = D +E
E = V - D = 6,250,000 - 5,300,000
PBIT 750,000
INT (85,500)
PAT 664,500
664,500
Ke = = 0.1254 = 12.54%
5,300,000

Based on NOI APPROACH

The value of the firm remains constant and the cost of equity increases.

Example 3:

A company has debt worth of N300,000 issued at 12% with a Net Operating Income of
N700,000. Cost of capital is 19.3% what is the overall value of the firm and the cost of equity.
𝑃𝐴𝐼 700,000
V = = = 3,626,943
𝐾𝑒 0.193

Ke = PAI

V = D+E

E = V - D = 3,626,943
PBIT 700,000
INT (36,500)
PAT 664,500
664,000
Ke = = 0.199 = 19.9%
3326943

Example 4:
Debt Increase to 400,000
Since V remains the same
V will be 3626943
𝑃𝐴𝐼 700,000 − 480,000 652,000
Ke = = =
𝐸 3,626,000 3 226 943

= 0.202
= 20.2%

115
Formula of M & M Theory
NO TAX TAX
UNLEVERED FIRM UNLEVERED FIRM
𝑁𝑂𝐼 𝑁𝑂𝐼 (1−𝑡)
Vu = 𝐾𝑢 Vu = 𝐾𝑢

Ke = Ku + (Ku – Kd) 𝑑⁄𝐸 Ke = Ku + (Ku – Kd) (I – tax) 𝑑⁄𝐸

Ko = Ku (−1 − 𝑡𝑑⁄𝑣𝑢)
LEVERED FIRM LEVERED FIRM
VL = Vu VL = Vu (1 + tb)

𝐼𝑛𝑡 𝑜𝑛 𝑑𝑒𝑏𝑡
Ke = Ko Kd = 𝑑𝑒𝑏𝑡

𝐸𝐿
Market price par share = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑎ℎ𝑎𝑟𝑒𝑠

1.5 Traditional Approach

The traditional approach lies midway between the NI approach and the NOI approach. It is, in
fact, a compromise between the two and is also known as the intermediate approach. There are
considerable differences of opinion among the followers of the traditional approach. But all of
them are in substantial agreement, that the judicious use of debt capital reduces the overall cost
of capital and increases the value of the firm. The capital structure that gives the highest value
to the firm and the lowest cost of capital is the optimum one. We examine the traditional
approach from the point of view of two groups.

According to one variant of the traditional approach, the use of debt capital increases the value
of the firm and reduces the cost of capital up to a certain point. Beyond that, the increase in
equity more than offsets the use of cheaper debt capital in the capital structure, and the average
cost of capital begins to rise. There is a further rise in the average cost of capital when the cost
of debt also begins to rise. The optimum capital structure is the point at which the overall cost
of capital is the minimum or value of the firm maximum.

Illustration
Total Investment N100,000
EBIT N15,000

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Cost of equity:
Up to N50,000 15%
Beyond this level, but up to N80,000 18%
Between N80,001 and N100,000 20%
Cost of debt: up to N50,000 10%
Above this level but up to N80,000 13%
Above N80,000 but up to N100,000 15%

Assuming the following leverage, calculate the cost of capital and value of the firm for each
level of the alternative plans and recommend the optimum capital structure.

Leverage, (%): 0, 20, 50, 80 and 100. (Debt to total capital)

Leverage (D/V)
Particular

kd(%) - 10 10 13 15
ke(%) 20 18 15 15 -

𝐷 𝑆 20 16.4 12.5 13.4 15

𝑘𝑜 [𝑘𝑑 ( ) + 𝑘𝑒 ( )]
𝑉 𝑉

EBIT (N) 15,000 15,000 15,000 15,000 15,000

Interest on debt (l) (kd x D) (N) Nil 2,000 5,000 10,400 15,000
Earnings to equity (EBIT-I) (N) 15,000 13,000 10,000 4,600 Nil
Value of debt [l/kd] (N) Nil 20.000 50,000 80,000 100,000
Value of equity (S) (EBT/ke) (N) 75,000 72..222 66,667 30,667 -
Total value of the firm [V] (D + 75,000 92,222 116.667 110.667 100,000
S) (N)

This table 4.1 shows that the cost of capital is lowest (12.5%) and the value of the Finn is the
highest (N J 16,667), when the debt-equity combination is I: I, i.e. N. 50,000 debt and N. 50,000
equity in the above case. Therefore, the optimum capital structure, in this case, would be
N50.000 equity capital and N. 50,000 debt capital to maximize the value of the firm or to
minimize the overall cost of capital.

The approach of the traditional theory can also be shown (Figure 4.2) using the data from the
previous illustration. Here, the average cost curve is U-shaped. There is a point at which the
cost of capital would be minimized. Solomon defines this point as that precise point where the
rising marginal cost of borrowing is equal to the average cost of capital. This is denoted by the
letter x in the graph. A perpendicular drawn to the x-axis indicates the optimum capital

117
structure, i.e. debt 50%, equity 50%.
25
20
15
10
5
0
0
0.2 0.5 0.8 1

Figure 4.2 Effect of leverage on cost of capital (traditional approach).

Thus, the traditional position implies that the cost of capital is not independent of the capital
structure of the firm, and that there is an optimum capital structure. For degrees of leverage
before that point, the marginal real cost of debt exceeds that of equity. At the optimum
structure, the marginal real cost of debt is same as the marginal real cost of equity in
equilibrium.

There are others who hold a slightly different view about the manner in which the cost of capital
reacts to changes in the capital structure. In this interpretation of the traditional view, Solomon
is of the opinion that there is a definite impact on a firm's total market value as the leverage is
increased. But he divides this impact into three distinct stages as the leverage is increased from
zero. These stages are described in the following sections.

Stage I
In the first stage, the following are discernible:
a) The cost of debt (kd) remains constant or rises only slightly; and
b) The cost of equity (ke) remains constant or rises as debt is added but does not rise fast
enough to offset the benefit of cheaper capital.

As a result, the market value of the firm increases and the average cost of capital decreases. In
short, in this stage, the market value of the firm increases or the average cost of capital
decreases as the leverage increases.

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Stage II

Once the firm has reached a certain degree of leverage, the addition of debt will have an
insignificant impact on the cost of capital or the value of the firm. As a consequence, k oor V
remains relatively constant within a range. In fact, there is a range of capital structure in which
k; is minimized and V is maximized.

Stage III

After a critical point, the addition of debt to a firm's capital structure causes an increase in the
cost of capital, ko and a decrease in the value of the firm, V. This is because both the cost of
debt, kd and the cost of equity, ke rise at an abnormal rate owing to a high degree of financial
risk.

The above concepts are illustrated in Figure 4.3. It is pertinent to note that the cost of capital
curve, km is saucer-shaped rather than U-shaped as we have seen earlier. In the case of the
saucer-shaped curve, there is an optimum range over a range of leverage. (This is not true in
the case of U-shaped cost curve.) This suggests that there is 'a range of capital structures in
which the value of the firm is maximized and the cost of capital is minimized. In this range,
changes in leverage have a negligible effect on the cost of capital or the value of the firm.

1.6 Modigliani-Miller (M-M) Hypothesis

Modigliani and Miller3 have developed a theoretical argument which supports the net
operating

ke
Cost of capital %)

ko
III
kd

0
Leverage (D/V)

119
Figure 4.3 Effect of leverage on cost of capital (traditional approach-a variation).

Income approach. They argue that, in the absence of corporate tax, the cost of capital and the
market value of the firm remain invariant to the changes in the capital structure or the degree
of leverage.

1.6.1 ASSUMPTIONS

The Modigliani-Miller hypothesis is based on certain assumptions relating to the capital

Market, behaviour of investors, actions of the firm and tax environment. They are as follows:
1. Capital markets are perfect. This implies, among other things, that:
(a) There are no transaction costs, and
(b) Individual investor can borrow at the same rate of interest as corporations:

2. All present and prospective investor have identical estimates of each firm’s average
future EBIT, that is, investor have homogeneous expectations.
3. All firms can be classified into homogeneous risk classes. As the firms in a given risk
class are equally risky, their expected future earnings are capitalized at the same rate.
Thus, all firms in a given risk class have the same expected and required rates of return.
4. The dividend payout ratio is 100%, that is, films distribute all net earnings to the
shareholder.
5. There is no corporate tax. This assumption is removed later on.

On the basis of the above assumptions, Modigliani and Miller developed two propositions,
proposition I and proposition II, which are discussed now.

Proposition I: This is identical to the NOI hypothesis. According to M-M hypothesis, the total
market value of the firm, V, and its cost of capital, ko are independent of its capital structure.
The total market value of the firm is established by capitalizing the net operating income (NOI
= EBIT) at a rate appropriate for the firm’s risk class.

𝐸𝐵𝐼𝑇
𝑉=
𝑘𝑜

𝐷 𝑆
Or 𝑘𝑜 = 𝑘𝑑 (𝑉 ) + 𝑘𝑒 (𝑉)

Earnings before interest and tax is calculated before interest and is, therefore, independent of
capital structure or leverage. The cost of capital, ko, is equal to the capitalization rate of a pure

120
equity stream of its class and is independent of the capital structure. If EBIT and ko are both
independent of the capital structure, V must also be a constant and independent of the capital
structure or leverage.

The cost of capital curve, ko as hypothesized by M-M, is shown in Figure 4.4. As in the NOI
approach, the cost of capital, ko, is constant irrespective of change in the capital structure.
Cost of capital %)

ko

ko

0
Leverage (D/V)

Figure 4.4 Effect of leverage on the cost of capital (M-M. hypothesis: proposition I)

Proposition II: Modigliani and Miller argue that the cost of equity, ke, is equal to a constant
average cost of capital, ko, plus a risk premium that depends on the degree of leverage that is:

ke = ko + Risk premium

The premium for financial risk equals the difference between the pure equity capitalization
rate, ko and the cost of debt, kd, times the ratio D/S, that is
ke = ko + (ko - kd)(D/S) (9.12)

In short, proposition II states that the firm's cost of equity, ke, increases in a manner to offset
exactly the use of cheaper debt capital. In other words, as the firm’s use of debt increases, its
cost of equity also rises.

Proposition II of M-M hypothesis implies a linear relationship between k e and debt- equity
ratio, D/S.

3.5.2 Interpretation of M-M hypothesis

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When propositions I and II are combined, M-M hypothesis implies that though debt is less
expensive than equity, the inclusion of more debt in the capital structure of a firm will not
increase its value because the benefits of cheaper debt capital are exactly offset by the increase
in the cost of equity. Thus, a firm cannot change its total value, V, or its weighted average cost
of capital, ko, by leverage. Consequently, the financing decision does not matter from the
standpoint of the objective of maximizing the market price per share. One capital structure is
as suitable as the other. In other words, the value of the' firm is completely unaffected by its
capital structure.

3.5.3 Proof of M-M hypothesis

The proof is based on the arbitrage or switching process. M-M argue that if two firms differ
only (i) in the way they are financed, and (ii) in their total market values, investor will sell
shares of the overvalued firm and buy the shares of the undervalued firm. This process will be
continued till the two firms have the same market value. When this equality is reached, the
NOI conditions will be fulfilled and the value of the firms and their average cost of capital will
be equal. Thus, V and ko are independent of the capital structure.

Illustration: (Arbitrage Process)

AandB are identical firms in every respect except in terms of capital structure. There are no
taxes and capital markets are assumed to be perfect. Their relevant particular are as follows:

Firm A Firm B
(Un levered) (Levered)
Equity capital (N 100 per share) N 400,000 N 100,090
12% debentures Nil 300,000
Total capital 400,000 400,000
Net operating income (EBIT) N 100,000 N 100,000
Equity capitalization rate (ke) 15% 16%

According to the traditional position, firm B may have a higher total value and lower average
cost of capital than firm A. The valuation of the two firms is given here:

Firm A Firm B
O Net operating income 100,000 100,000

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 I Interest on debt - 36,000
O-I Earnings available to equity shareholders 100,000 64,000
ke Equity capitalization rate (ke) 0.15 0.16
S Market value of equity [(O-I)/ke] 666,667 400,000
D Market value of debt (l/kd) - 300,000
V Total value of the firm (S + D) 666,667 700,000
ko Cost of capital (O/V) (%) 14.99 14.29
Leverage (D/V) 0 0.75

Thus, the value of the levered firm, B, exceeds that of the unlevered firm, A, and M-M argue
that this situation cannot continue as arbitrage will drive the total values of the two firms
together.

Suppose, you are a rational investor and own 10% shares worth N. 40,000 (market value) in
firm B. According to M-M, you can increase your total returns without increasing your
financial risk by:
1. Selling the shares in firm B for N. 40,000;
2. Borrowing an amount equal to 10% of B’s debt (N. 30,000) at 12%; and
3. Buying 10% of A’s shares for N. 66,667.

Notice that you receive N. 70,000 from the sale of shares (N. 40,000) plus borrowing
(N30,000), and spend N. 66,667 OD A's shares, so you have an uncommitted fund of N 3,333
(i.e. N. 70,000 - 66,667). Now consider your income position:

N N
Old income 16% of N40,000 6.400
B’s
New income 15% of A's N 66,667 10.000
Less 12% on N 30,000 3,600
Net new income 6,400

Thus, your income from investment is exactly the same as before, but you have N3,333 left
over for investment elsewhere, so your total return will rise. But the risk is the same as before-
you have simply substituted personal, or ‘home-made’, leverage for corporate leverage.

According to M-M, the action of a number of investors undertaking similar arbitrage

transactions will tend to drive up the price of firm A shares, and lower its ke, drive down the
price of firm B, and increase its ke. This arbitrage process will continue until there is no further
opportunity for reducing one's investment outlay and achieving the same rupee return.
At this equilibrium the total value of the two firms must be the same. As a result, their average
costs of capital, ko must also be same:

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The important thing is the presence of rational investor in the market who are willing to
substitute personal, or ‘home-made’, leverage for corporate leverage.

3.5.4 Criticisms of the M-M hypothesis

It may be noted that M-M drew their conclusions on the basis of certain assumptions.
Therefore, those who disagree with M-M hypothesis that the value of the firm is independent
of its leverage or capital structure, attack their assumptions as being unrealistic. Following are
some of the main objections to M-M hypothesis:
1. Although it is assumed that there are no transactions costs, yet such costs do exist and
may retard the arbitrage process.
2. Firms and individuals are assumed to borrow at the same rate. This does not hold well
in reality. Because of holding of more assets and credit reputation, a firm will generally
be in a better position to borrow than an individual. Therefore, the cost of borrowing
could be higher for the individual than for the firm.
3. It is implied in the M-M hypothesis that personal and corporate leverage are perfect
substitutes. But firms may have limited liability as against the unlimited liability of
individuals. This eventuality places the firms and the individuals on a different footing
in the capital market. In the event of the liquidation of a levered firm, all investor would
lose to the extent of their original investment in shares. But if an individual engages in
arbitrage transactions, he or she not only faces the possibility of losing the holdings in
the unlevered firm, but also may be liable to return the amount of his or her personal
loan. Consequently, the creation of personal leverage and investment in the unlevered
firm is more risky than direct investment.
4. Sometimes; institutional restrictions may also retard the arbitrage process. It is true that
institutional investor dominate capital market today. Still most institutional investor are
not allowed to engage in home-made leverage.

Critics of M-M hypothesis, thus, argue that the underlying assumptions of M-M are not
Valid and that in the real world situation, the value of the firm and the cost of capital are
functions of financial leverage-they cannot remain invariant to changes in the capital structure
or the degree of leverage as advocated by M-M.

3.5.5. Modigliani and Miller hypothesis with corporate taxes

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With the introduction of corporate taxes, M-M change their position. They now recognize that
the value of the firm will increase or the cost of capital will decrease with an increase in the
leverage as the interest on debt is a deductible expense. Between two firms, levered and
Unlevered, the former film will have a higher value for the same reason. More specifically, the
value of the levered firm, L will exceed that of the unlevered firm, U, by an amount equal to
Cs debt multiplied by the tax rate, that is,

VL = VU, + tD
where,
VL = Value of the levered firm
Vu = Value of the unlevered firm
t = Corporate tax rate
o = Amount or debt in L
The proof of the above equation is as follows:

Two firms are considered identical in all respects except their capital structure. Assume that
firm U (unlevered) finances by equity only while firm L (levered) employs debt. EBIT are
identical in each firm. Under these assumptions, the operating cash flows (CF) available to
investor for firms U and L are computed as follows:
CFu = EBIT (1 - t)
and
CFL = (EBIT - 1) (1 - t) + I
or
CFL = (EBIT - kdD) (l - t) + kdD
= EBIT - kdD – EBIT (t) + tkd + kdD
= EBIT - EBIT (t) + tkdD
= EBIT (1 - t) + tkdD
where,
EBIT = Earnings before interest and taxes
I = Interest on debt capital = kdD
D = Amount of debt in L
t = Corporate tax rate
It may be mentioned that in equation (9 15), the first term to the right of the equation sign, i.e.
(EBIT-I) represents the income available to the shareholders; the term ‘I’ or ‘kdD’ providers
debt capital CFL is, thus, the total income available to all investors (equity plus debt).

Firm U does not use debt capital. Its value Vu may, therefore, be determined by discounting its
net earnings after tax EBIT (1-t), by its equity capitalization rate or cost of equity, ke, which is
𝐸𝐵𝐼𝑇(1−𝑡)
𝑉𝑢 𝐾
𝑒

The value of the levered firm is determine by capitalizing4 both parts of its after-tax earnings.
Thus,

125
 𝐸𝐵𝐼𝑇(1−𝑡) 𝑡𝑘𝑑𝐷 𝐸𝐵𝐼𝑇(1−𝑡)
𝑉𝐿 + = = 𝑡𝐷 +
𝐾𝑒 𝐾𝑑 𝐾𝑒

𝐸𝐵𝐼𝑇(1−𝑡)
Therefore, 𝑉𝐿 = 𝑉𝑢 + 𝑡𝐷 as𝑉𝑢 = 𝐾𝑒

𝐸𝐵𝐼𝑇(1−𝑡)
𝑉𝑢 𝐾𝑒

Hence, M-M hypothesis states that the value of a levered firm is equal to its value without
leverage plus the present value of the interest tax shelter, which is equal to the tax rate times
the value of the debt
𝑘𝑒
𝑘𝑜

𝑘𝑑 (1 − 𝑡)

0
Leverage (D/V)

Although, according to the M-M hypothesis, there may be 100% use of debt to maximize the
firm’s value, in reality, however, neither the firms employ a very large amount of debt nor are
the creditor ready to lend to highly levered firm. It should be emphasized that the extensive use
of debt capital would expose a firm to bankruptcy because it may be difficult for the firm to
meet the payments of interest and principal on time.

4.0 CONCLUSION
Thus, the use of too much debt may increase the cost of capital owing to increased financial
risk and reduce the value of the firm. Accordingly, the optimum capital structure takes into
account a desired combination of debt and equity. M-M also suggest that firms will adopt a
‘target debt ratio’ so as to violate the limits of leverage imposed by creditor.

5.0 SUMMARY

126
Having seen the theories that explain the relationship between cost of capital, capital structures
and value of the firm using the net income, net operating income, traditional and M-M
hypothesis, and reasonable decisions will be made based on their recommendations.

6.0. TUTOR MARKED ASSIGNMENT

A company’s total investment in assets is N. 10,000,000. It has 100,000 shares of N. 100 each.
Its expected rate of return on investment is 30% and the cost of capital is 18%. The company
has a policy of retaining 25% of its profits. Determine the value of the firm Gordon’s model

7.0 REFERENCES

Archer S. Hand C.A.D Aambrosio (1972) “Business Finance Theory and Management”, Ney

York Macmillan Publishing Co

Ezike J.E. (2002); “Essential of Corporate Finance Management”, Jay Lycent

Communications, Lagos.

Owualah S. I. (2000); “Finance Management, Concept, Analysis and Capital Investment”

Lagos Bierly Jones Nigeria Limited

Van Horne H. (1992): Finance Management and Policy

 Bhabatosh Banerjee, Financial Policy and Management Accounting, 7th ed. Prentice-Hall

of India, New Delhi, 2005.

 James C. Van Home and John M. Wachowicz, Jr., Fundamentals of financial Management

11th ed., Prentice-Hall of India, New Delhi, 2001.

UNIT 4: PLANNING THE CAPITAL STRUCTURE

CONTENT

127
 1.0 Introduction

2.0 Objectives

3.0 Main Content

3.1 Factor for Capital Structure Planning

3.1.1. Financial Leverage

3.1.2. EBIT – EPS Analysis

3.1.3. Cost of Capital

3.1.4. Flexibility

3.1.5. Control

3.1.6. Legal Constraint

3.1.7. Industrial Standard

3.1.8. Other Factor

4.0 Conclusion

5.0 Summary

6.0 Tutor Marked Assignment

7.0 REFERENCES

1.0. INTRODUCTION
Planning the capital structure means selecting a desired debt-equity combination in advance.
The initial capital structure is determined at the time the firm is promoted. So, this structure
should be designed very carefully. The initial structure changes when financing takes place
from time to time for new investment. When a desired level is achieved, the same should
preferably be maintained over a period unless it is decided to effect a change due to changes in
the variables.

While planning the capital structure, the interest of the ordinary shareholder is given due weight
age. This is done by setting the firm’s objective to maximize, in the long run, the market price
of equity shares.

128
The Finance Manager or the Board of Director may be required to determine the appropriate
capital structure of their particular firm. In some firms, the investment decisions are few and
far between. In that case, the Finance Manager may not have to confront the problem at all. In
other cases, wherein investment proposals are taken up very often, the Finance Manager, while
arranging the finance, faces the problem of arranging it from the desired sources in an
appropriate mix.

Planning of capital structure, therefore, depends on the particular need of a firm, When a
Finance Manager has to play this role, and the question arises as to how best he or she can
tackle the problem. With this end in view, he or she has to consider a number of factor, which
are mention in the following section. No one particular factor should, however, dominates his
or decision-making approach as none of the factor is completely satisfactory in itself. Taken
collectively, the factor provide the Finance Manager with sufficient information for making a
rational decision.

2.0. OBJECTIVES
At the end of this unit one should be able to:
1.0 understand what planning of capital structure is all about
2.0 state the importance of planning the capital structure and discuss its contribution factor
3.0 State the general trends of capital structure for private sector and public sector companies.

3.0. MAIN CONTENT

3.1. Factor for Capital Structure Planning

While planning the capital structure of a firm, the following important factor have to be taken
into account:
1. Financial leverage
2. Operating leverage
3. EBIT-EPS analysis
4. Cost of capital

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 5. Cash flow analysis
6. Flexibility
7. Control
8. Legal constraint
9. Industry standard
10. Other factor

3.1.1. Financial leverage

It refers to the use of fixed income securities in the capital structure of a firm. The use of debt
capital increases the earnings on equity as long as the return on the firm’s investment exceeds
the explicit cost of financing the investment. So, in taking advantage of financial leverage, that
is, the firm’s ability to use fixed financial charges to magnify the effects of changes in EBIT
on the firm’s EPS, the Financial Manager should take advantage of more and more debt capital.
In fact according to financial leverage analysis, a firm should try to use the maximum amount
of debt capital to increase the ROE when other factor held constant.

But, in reality, a firm cannot use the maximum amount of debt for various reasons. One of such
reason is the norm to be observed by the firms while raising capital from the capital market.
One such norm is the maintenance of desire debt-equity relation. When firms required to
maintain a given debt-equity ratio, it has no option to deviate from the norm prescribed by the
controlling authority or the financial institution. In India the norm is 1: 1 for the public sector
firms and 2:1 for private sector firms (with a deviation in some cases). Second assuming that
no norm is imposed on a firm, does a firm opt for the maximum amount of debt? It may be sate
that the higher the financial leverage, the greater is the financial risk. Therefore, the use of more
and more debt capita will expose a firm to more financial risk which will have an adverse
impact on the cost of debt and equity. Consequently, beyond a point of leverage, the weighted
average cost may go up. Therefore, the Financial Manager has to take into account other factors
as well along with financial leverage.

This is the first-stage leverage that depends on the operating fixed costs of the firm. If a higher
percentage of a firm’s total costs are fixed operating costs, the firm is said to have a higher
degree of operating leverage. It measures the operating risk of a firm. Operating risk is the
variability of operating profit or EBIT.

130
There is some relation between operating and financial leverages. In other words, if the
operating risk is very high, financial risk should be .kept low, On the contrary, a firm with a
low operating leverage may afford to have a high financial leverage. If a firm has both the
leverages at a high level, it will be a very risky proposition because the combined effect of two
is a multiple of the two leverages. Therefore, there should be a desired combination the two
leverages. This is the way in which the operating leverage also comes into the picture of the
capital structure decision of a firm.

3.1.2. EBIT-EPS Analysis

This is another important tool for examining the effect of leverage by analyzing the relationship
between EBIT and EPS. The firm will measure the effect on EPS at varying levels of EBIT
under alternative financing plans. The choice of a particular financing plan will depend on the
relative value of the EPS with alternative financing plans with an assumed EBIT level. In other
words, the financing plans that will give the maximum value of EPS should be selected as the
most desirable mix. On the other hand, at varying levels of EBIT, one has to examine the
variability of EPS under different financing plans. In theory, with increasing EBIT, shareholder
will gain most in the case of financing with the maximum amount of debt alternative. In other
words, the greater the level of EBIT, the more beneficial it is to employ debt in the capital
structure of a firm. The EPS analysis has certain limitations of its own. Its application may also
be objected to on the ground that it is an important performance criterion but not a decision
criterion.

3.1.3. Cost of Capital

The cost of equity, ke, is generally greater than that of debt, kd. One reason for this is the tax
advantage attached to the debt capital. The impact of a particular financing decision should be
measured in terms of the overall cost of capital. The combination of debt and equity should be
such that it minimizes the overall cost of capital or maximizes the value of the firm. Increasing
financial leverage leads to a reduction in the overall cost of capital as long as the rate of return
from the investment exceeds the explicit cost of financing the investment. But due to the use
of more and more debt capital, the financial risk increases, which leads to an increase in the
cost of equity and debt. This has the effect of raising the weighted average cost of capital of
the firm beyond a point or the range of debt-equity combination. Accordingly, financing
decision based on financial leverage analysis may not always lead to optimum capital structure.

131
The cost of capital then becomes an important variable in this decision area. According to one
school of thought, the optimum capital structure is one in which the overall cost of capital is
minimum. It may also be defined as one in which ‘the marginal real cost of each available
methods of financing is the same’.

While considering the appropriate capital Structure, it is extremely important to analyze the
solvency position, which is determined by the cash flow ability of the firm to meet its fixed
charges. The amount of fixed charges (fixed operating cost and interest on debt capital) depends
on the nature of operation, extent of automation, level of activity, etc. on the one hand, and on
the amount of debt capital in the capital Structure, on the other hand. Other things remaining
constant, an increase in the use of debt capital results in an increase in the amount of uncertainty
that the firm has to face while meeting its fixed charges. Therefore, before assuming additional
fixed financial charges arising from an increase in the debt capital, the firm should analyze its
expected future cash flows as fixed charges must be met with cash. It may be mentioned here
that the inability of the firm to meet its fixed charges may result in financial insolvency.

Cash flow analysis can be- very useful in this respect. Thus, the greater and more stable the
expected future cash flows of the firm, the higher is the proportion of debt that may be used by
the firm. On the contrary, firms whose cash flows are unstable and unpredictable will find it
more risky to employ fixed-charged securities in the capital structure.

The ratio of net cash flows to fixed charges may serve as a guide for selecting a proper balance
between debt and equity. This ratio indicates the number of times the fixed charges are covered
by the expected net cash flows, and is also known as the coverage ratio. From past experience,
a firm may also set a limit of expected coverage, such as 5:1 or 6:1, so that there is a margin of
safety to allow for an anticipated decline in .cash flows. The advantage of fixing such a limit
is that no new debt capital will be added in the capital structure unless the net cash flows for
debt servicing are in excess of some multiple of debt service requirement.

3.1.4. Flexibility
In this context, flexibility implies the firm’s capacity to adapt its capital structure to the
changing needs. Normally, debt capital is more flexible than the equity source because it can
be redeemed when the conditions are favourable. Flexibility means that a firm can substitute
one form of finance with other and vice-vice, to economize the use of funds. This may be in

132
the form of substitution of debt with equity or of ‘old debt’ with ‘new debt’. But equity does
not enjoy this benefit of flexibility as shares cannot be redeemed except on buy-back or
liquidation. Preference shares can be redeemed under certain circumstances. Normally, all the
debt sources enjoy this benefit of flexibility provided such terms are incorporated in the loan
agreement. Thus, in order to ensure greater flexibility in the capital structure of a firm, it is
desirable to have more and more amount of debt capital. But the presence of debt capital does
not itself empower the firm to redeem capital at discretion.

If the firm anticipates profitable operations leading to generation of funds ‘internally’, then it
may incorporate in the loan agreement the ‘redemption clause’ for retirement of debt before
the maturity date. Such a clause also has an advantage, when interest rates are expected to fall
in the future so that it becomes more profitable to substitute ‘old costly debt’ with ‘new cheaper
debt’. It may be mentioned here that the incorporation of such a clause in the agreement may
increase the cost of debt capital. The additional cost in this respect should be compared with
the anticipated future savings in cost and then only a decision may be made by the management.

When the need for capital is seasonal or cyclical, a firm should finance more from short-term
sources than from long-term sources because it is relatively easy to repay short-term loans than
long-term ones.

Flexibility also includes the firm's debt capacity in reserve. In other words, a firm should not
use its maximum borrowing capacity but keep available some unused capacity to raise funds
roods in future when circumstances demand so.

3.1.5. Control
Ordinary or equity shareholders have voting rights. They are the owner of the firm and can
exercise control over its overall affair. Preference shareholders do not have the voting right
except under special circumstances. So, from the viewpoint of control, it is desirable that more
and more of debt capital be used. Equity can be issued in the form of ‘right issues’ so that the
original control is not diluted. While raising capital from outside, ‘new issues’ become more
relevant than ‘rights issues’. So, between equity (new issues) and debt, the latter should be
given preference in order to avoid loss of control. But the use of a higher dose of debt capital
does not necessarily mean that the firm will have complete freedom of action in its day-to-day
management and financial matter.

133
The provider of debt capital would introduce a lot of restrictions in the loan agreement to
protect their interest. Sometimes, there is a provision to nominate director(s) in the Board to
oversee the activities of the firm. The presence of such a clause would undoubtedly curtail the
freedom of action of the firm. The use of too much debt will also increase financial risk and
may, ultimately, lead to bankruptcy, which means a complete loss of control. Therefore, the
firm should not adopt a very conservative attitude in this respect. On the contrary, it should try
to select an appropriate mix of debt and equity for the overall profitability of the firm.

3.1.6. Industry Standard

While planning the capital structure, the firm has to evaluate the capital structures of other
firms belonging to the same risk class, on the one hand, and that of the industry as a whole, on
the other hand. If the firm adopts a capital structure significantly out of line with that of similar
units in the same industry, it may not be acceptable to the investor. Also investment analysts
and creditor tend to evaluate firms in terms of the standard of the industry concerned. The
capital structure position of the firm vis-a-vis the industry position may be determined
empirically. The shareholder, in general, may not mind the firm operating within a 10% or 15%
range of the industry's average capital structure. But if the firm decides to adopt a capital
structure that is noticeably out of line in either direction, then it should be able to justify its
position in the capital market.

3.1.7. Other factor

The firm should also take into consideration certain other general factor such as the nature and
size of the firm, and market conditions. The very nature of the firm may have an influence on
its capital structure decision. For example, public utility firms, which carry out their entire day-
to-day transactions almost on a cash basis, may undertake more financial risk and therefore, go
in for more and more debt. In contrast, firms required to make heavy investments in fixed
assets and, consequently, having a high operating leverage, may prefer a low degree of financial
risk and adopt their capital structures accordingly. Similarly, the size of the firm greatly
influences the availability of funds from different sources.

The general economic conditions may also influence the nature of the capital structure. Firms
with stable sales and better growth prospects can employ more debt capital in their capital
structures than those with unstable sales and lesser or no growth prospect. The growth also
depends on the general economic conditions. Another important factor to be considered is the
firm's marketability. It denotes the ability of the firm to sell or market a particular type of

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security during a specified period of time. Marketability is greatly influenced by the conditions
prevailing in the capital market. Many firms in India have experienced that favourable public
response to issues of shares of firms is mostly confined to well-established concerns. Issues
brought out by new concerns or comparatively less established companies continue to be
unattractive even if the projects are considered viable.

Preference shares also do not appear to be attractive in the present Indian condition. Among
the various sources of debt, debenture involves a long drawn procedure and is yet to gain
popularity in the Indian capital market. However, convertible debentures have been very
popular in the recent past owing mainly to the option available for conversion into equities.
There are long-term institutional loans which are given only on the fulfillment of certain terms
and conditions. One of them is the maintenance of stated debt-equity ratio, 2:1, 1:1 or the like.
So, while planning the capital structure, these entire factor should be given due consideration.
The Finance Manager may not be able to suggest an optimum capital structure, but he or she
should be able to guide the firm towards its ultimate goal. In short, various methods of analysis
may be used-none completely satisfactory in itself, but, taken collectively, they give us enough
information to help us make a rational decision.

4.0 CONCLUSION
Capital decisions form a crucial part in the formation and the sources of a company. It is the
lifeline of any firm. The financial manager’s main objective is deciding the right choice or
combination of capital options available that will lead to the growth of the firm.

5.0 SUMMARY
Capital use in financing a business could be long-term or short-term, permanent or temporary
and sourced through internal or external sources.
Also, the term supply of capital are classified into three broad categories
(1) Life term firm of maturity or duration
(2) In term of control options
(3) The cost of capital to the firm

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There are various factors that affect the supply of capital. They include relative costs of capital,
control level of relinquished prevailing, market conditions, duration, risks among other.

6.0. TUTOR MARKED ASSIGNMENT

PROBLEM 1: Value of firm under Gordon’s model
A company’s total investment in assets is N. 10,000,000. It has 100,000 shares of N. 100 each.
Its expected rate of return on investment is 30% and the cost of capital is 18%. The company
has a policy of retaining 25% of its profits. Determine the value of the firm Gordon’s model

Solution
𝐸1 (1−𝑏) 𝑁(1−0.25)
𝑃𝑜 = = = 𝑁214.28571
𝐾−𝑏𝑟 0.18−0.25𝑥0.30

Where

EI = Earnings per share

K = Cost of capital
r = Expected rate of return
b = Retention ratio
V = nPo = 100,000 x N 214,8571= N21,428,571
ROI = N 10.000.000 x 0.30 = N 3,000,000

Therefore,
3,000,000
𝐸1 = 1,000,000 = 𝑁30

r = 0.30. k = 0.18, b = 0.25

PROBLEM 2: Optimum debt-equity mix

When considering the most desirable capital structure of a company, the following estimate of
the cost of debt and equity capital (after tax) have been made at various levels of the debt-
equity mix:

Debt as percentage Cost of debt (%) Cost of equity

of total capital (%)
employed
0 5.0 12.0
10 5.0 12.0
20 5.0 12.5
30 5.5 13.0

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 40 6.0 14.0
50 6.5 16.0
60 7.0 20.0

You are required to determine the optimal debt-equity mix for the company by calculating the
composite cost of capital.

Solution
The optimal debt-equity mix for the company will be that points were the weighted average
cost of capital would be minimized. Therefore, we first calculate the weighted average cost of
capital for each alternative mix by using the formula.
𝐾𝑜 = 𝐾𝑑 𝑤1 + 𝐾𝑒 𝑤1

Where
Ko = Weighted average cost of capital
Kd = Cost of debt
Ke = Cost of equity
W1 = proportion of debt to total capital employed
W2 = Proportion a equity to total capital employed

Kd Ke W1 W2 KdW1 Kew2 Ko
(%) (%) ( – w1)
1 (%) (KdW1 + kew2)
(%)
5.0 12.0 Nil 1.0 Nil 12.0 12.00
5.0 12.0 0.1 0.9 0.5 10.8 11.30
5.0 12.5 0.2 0.8 1.0 10.0 11.00
5,5 13,0 0.3 0.7 1.65 9.1 10.75
6.0 14.0 0.4 0.6 2.40 9.1 10.80
6.5 16.0 0.5 0.5 3.25 8.4 11.25
5.0 12.0 0.6 0.4 4.20 8.0 12.20

It appears from this table that the cost of capital is minimized when the debt-equity mix is 30%
and 70%, respectively. Therefore, we the optimum debt-equity mix for the company is:
1. Debt 30%
2. Equity 70%.

PROBLEM 3: M-M hypothesis: equilibrium value of firm

The following costs of values of Ab Ltd. (unlevered) and CD Ltd. (levered) accounting to the
traditional approach:

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 AB Ltd. CD Ltd.
O Net operating income (EBIT) (N) 10,000 10,000
I Interest on debt (N) - 3,600
O-I Earnings to equity (N) 10,000 6,400
ke Equity capitalization rate 15% 16%
S Market value of equity(O-1Ke) (N) 66,667 40,000
D Market value of debt (N) - 30,000
V Total value of the firm (S + D) (N) 66,667 70,000
Ko Average cost of capital 15% 14.3%
D/S Debt/equity ratio 0 0.75

Compute the equilibrium value for AB Ltd. and CD Ltd. using. M-M hypotheses assuming
that: (i) there are no taxes and (ii) the equilibrium value if the cost of capital is 14.5%.

Solution
Particular AB Ltd. CD Ltd
O Net operating income (N.) 10,000 10,000
I Interest on debt (N.) – 3,600
O – I Earnings available to equity (N.) 10,000 6,400
K
0 Average cost of capital 0.145 0,145
V Value of the firm (0/K0) (N.) 68,966 68.966
D Market value of debt (N.) – 30,000
S Market value of equity (V - D) (N.) 68,966 38,966
K0 Cost of equity (0- N) 14.50% 16.43%

7.0 REFERENCES

Archer S. Hand C.A.D Aambrosio (1972) “Business Finance Theory and Management”, Ney

York Macmillan Publishing Co

Ezike J.E. (2002); “Essential of Corporate Finance Management”, Jay Lycent

Communications, Lagos.

Owualah S. I. (2000); “Finance Management, Concept, Analysis and Capital Investment”

Lagos Bierly Jones Nigeria Limited

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Van Horne H. (1992): Finance Management and Policy

Bhabatosh Banerjee, Financial Policy and Management Accounting, 7th ed. Prentice-Hall of

India, New Delhi, 2005.

James C. Van Home and John M. Wachowicz, Jr., Fundamentals of financial Management 11th

ed., Prentice-Hall of India, New Delhi, 2001.

Walter J.E. (1967); “Dividend Policy and Enterprise Valuation” California Wadworth Pub-Co

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