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INTODUCTORY BUSINESS
FIANACE
FOR MBA, MPA AND ACCOUNTANCY STUDENTS
NONPUBLISHED TEXT
BUSINESS FIANACE is an essential part of the economic and non economic activities which leads to
decide the efficient procurement and utilization of finance with profitable manner. In the olden days the
subject Finance was a part of Economics with the traditional approaches. Now days it has been enlarged
with innovative and multi-dimensional functions in the field of business with the effect of
industrialization, BUSINESS FIANACE has become a vital part of the business concern and they are
concentrating more in the field of Financial Management. Financial Management also developed as
corporate finance, business finance, financial economics, financial mathematics and financial
engineering. Understanding the basic concept about the financial management becomes an essential
part for the students of economics, commerce and management.
This Study text provides detailed information about the finance and finance related area with simple
language and the concepts are explained with easy examples. This Study text is also prepared based on
the B.B.A., M.B.A, and M.P.A syllabus of various universities for the benefits of the students. This study
text takes references from different books as by Van Horne, Brigham, I.M Pandey, and C.Pramacivan.
AUTHOR
ADEEL SHAHZAD
MBA, ACMA
FINANCIAL MARKETS
2 Financial markets, Money markets, Capital markets ,Money market instruments
,Capital market instruments ,Primary and secondary Markets ,Institutional 11-15
framework
FINANCIAL STATEMENTS
3 ANALYSIS
Types of financial statements, Types of analysis , Common size analysis ,Trend
16-40
Valuation of Securities
CAPITAL BUDGETING
5 Overview , Scope , Process, Capital Budgeting Techniques, NPV,IRR,PI, payback
period
60-67
DIVIDEND POLICY
7 Types of dividend, Determinants , Policy 72-73
CHAPTER 1
INTRODUCTION
Finance is called “The science of money”. Finance was a branch of Economics till 1890
. Economics is defined as study of the efficient use of scarce resources. The decisions
Made by business firm in production, marketing, finance and personnel matters form
The subject matters of economics.
Finance is the process of conversion of accumulated funds to productive use. It is so
Intermingled with other economic forces that there is difficulty in appreciating the
Role It plays.
BUSINESS FINANCE is that managerial activity which is concerned with the planning and controlling of the
firm’s financial resources. The funds raised from the capital market needs to be procured at minimum cost
and effectively utilized to maximize returns on investments. Business Finance is also called Financial
Management.
• Dividend Decisions
Wealth
Wealth
Profit
Objectives
Profit Maximization
Main aim of any kind of economic activity is earning profit. A business concern is also
functioning mainly for the purpose of earning profit. Profit is the measuring techniques to
understand the business efficiency of the concern. Profit maximization is the traditional and
narrow approach, which aims at, maximizes the profit of the concern.
Wealth Maximization
Wealth maximization is one of the modern approaches, which involves latest innovations and
improvements in the field of the business concern. The term wealth means shareholder wealth
or the wealth of the persons those who are involved in the business concern.
TERM SHAREHOLDERS’ WEALTH: Shareholders’ wealth means market value of the share.
BUSINESS FINANCE
Profit of the concern depends upon the production performance. Production performance needs
finance, because production department requires raw material, machinery, wages, operating
expenses etc. These expenditures are decided and estimated by the financial department and the
finance manager allocates the appropriate finance to production department. The financial
manager must be aware of the operational process and finance required for each process of
production activities.
Produced goods are sold in the market with innovative and modern approaches. For this, the
marketing department needs finance to meet their requirements. The financial manager or
finance department is responsible to allocate the adequate finance to the marketing department.
Hence, marketing and financial management are interrelated and depends on each other.
Financial management is also related with human resource department, which provides manpower to
all the functional areas of the management. Financial manager should carefully evaluate the
requirement of manpower to each department and allocate the finance to the human resource
department as wages, salary, remuneration, commission, bonus, pension and other monetary benefits
to the human resource department. Hence, financial management is directly related with human
resource management.
1. Liquidity
2. Profitability
3. Asset Management
1. Liquidity
Liquidity is ascertained on the basis of three important considerations:
a. Forecasting cash flows: matching the inflows against cash outflows;
b. Resources of fund: financial management will have to ascertain the sources
from which funds may be raised and the time when these funds are needed;
c. Managing the flow of internal funds: keeping its accounts, with a number of banks to ensure
a high degree of liquidity with minimum external borrowing.
2. Profitability
While ascertaining profitability, the following factors are taken into account:
a. Cost control: Expenditure in the different operational areas of an enterprise can be analyzed with the
help of an appropriate cost accounting system to enable the financial
manager to bring costs under control.
b. Pricing: Pricing is of great significance in the company’s marketing effort, image and
sales level. The formulation of pricing policies should lead to profitability, keeping, of
course, the image of the organization intact.
c. Forecasting Future Profits: Expected profits are determined and evaluated. Profit
Levels have to be forecast from time to time in order to strengthen the organization.
d. Measuring Cost of Capital: Each source of funds has a different cost of capital which
must be measured because cost of capital is linked with profitability of an enterprise.
3. Asset Management
• The management of long-term funds, which is associated with plans for development
and expansion and which involves land, buildings, machinery, equipment, transport
facilities, research project, and so on;
• The management of short-term funds, which is associated with the overall cycle of
activities of an enterprise. These are the needs which may be described, as working
capital needs.
The functions of financial management can be broadly classified into three major decisions, namely:
1. Investment Decision
The investment decision is concerned with the selection of assets in which funds will be
invested by a firm.
• The long term investment decision: The long term assets of a business firm include
fixed assets like machinery, plant, production facility etc. Long term assets will yield a
return over a period of time in future. The long term investment decision is known as
capital budgeting decision.
• The short term investment decision: short term assets (current assets).
Whereas short term assets are those assets which are easily convertible into cash within
. an accounting period i.e. a year. The financial manager is also responsible for the
. efficient management of current assets i.e. working capital management.
Capital Budgeting means the long-range planning of allocation of funds among the
various investment proposals.
2. Financing Decision The financing decision is concerned capital structure of a firm. The term capital
structure Refers to the proportion of debt capital and equity share capital.
3. Dividend Decision Dividend decisions are concerned with the distribution of profits of a firm to the
shareholders. How much of the profits should be paid as dividend? I.e. dividend pay-out ratio. The
decision will depend upon the preferences of the shareholder, investment opportunities available within
the firm and the opportunities for future expansion of the firm. The dividend pay out ratio is to be
determined in the light of the objectives of maximizing the market value of the share.
• Cost of Capital
2. FINANCING • Capital Structure
FINACIAL DECISIONS Decisions
MANAGEMENT • Leverages
EXERCISE
1. What is finance? Define business finance?
FINANCIAL MARKETS
CHAPTER 2
TERM FINANCIAL INSTRUMENTS: The shares, bonds, debentures and other claim papers are
the Financial Instruments or Financial Assets.
FINANCIAL MARKETS
FINANCIAL MARKETS
PRIMARY MARKET
SECONDARY MARKET
_______________________________________________Rs_______
Profit after tax xxx
Less: Dividend to Preference Shareholders xxx
Profit belonging to equity shareholders (Dividend) xxx
________________________________________________________
iv) The dividend on Equity shares is not fixed and may vary from year to year depending upon
the Amount of profits available. The rate of dividend is recommended by the Board of Directors
of the company and declared by shareholders in the Annual General Meeting.
2. PREFERENCE SHARES: Preference shares have following characteristics:
I. The share holders with preference shares are not entitled to vote in Annual General
Meet (AGM) or other meeting of the Shareholders regarding affairs of the company.
II. In case of Dividend they are entitled to the fixed amount of Dividend.
III. The Preference shares are hybrid security.
TERM HYBRID INSTRUMENT: The Hybrid means dual or Combination of two. Preference Shares are Hybrid because:
I. Like Equity shareholders the preference shareholders are entitled to dividend, it is
characteristics of Equity Shares.
II. Like Debt the preference shares are entitled to fixed rate, it is characteristics of debt.
3. BONDS: Bonds are long-term Financing debt instrument, which are issued with promise to pay fixed
amount of interest (Coupon) to the holders at regular periodic intervals.
2. MONEY MARKETS: The money market as a wholesale debt market for highly-liquid, Short-term
instrument. Funds are available in this market for periods ranging from a single day up to a year. This
market is dominated mostly by government, banks and financial institutions.
TERM WHOLSALE DEBT MARKET: The place from where money cab be obtained for a short period at interest.
HIGH-LIQUID: means cash or easily convertible into cash.
MONEY MARKET INSTRUMENTS: The money market deals with the transactions of raising and supplying
money in a short period not exceeding one year through various instruments.
1. CALL MONEY MARKET: Call money refers to that transaction which is received or delivered
by the participants in the call money market and where the funds are returnable next day.
The call money transactions are also referred to as overnight funds.e.g banks, money
lenders.
2. NOTICE MONEYMARKET Notice money on the other hand is a transaction where the
participants will take time to receive or deliver for more than two days but generally for a
maximum of fourteen days. The rate at which the funds will be deployed or borrowed will
be determined on the basis of the market conditions at a given point of time. When the
market is highly liquid, the funds would be easily available.
3. Repurchase Agreements (Repos)
Repurchase agreements are simply called as ‘repos ‘arise when one party sells a security
(Shares or bond) to another party with an agreement to buy it back at a specified time and
price. Repos are active between the commercial banks. The period ranges between one
and 14 days.
EXAMPLE1: ABC Company needs Finance of Rs 20000 for a period of 10 days. It enter in Repo
arrangement with Muslim Commercial Bank .1000 Shares of the company are placed for Repo,
Current Market Price of share is Rs 20 with Terms to repurchase each Share at Rs 22.
Requirement: Determine Interest amount?
Sale Price (1000×20) 20000
Buy-Back Price (1000×22) 22000
Interest 2000
4. Treasury Bills.
Treasury Bills are short term (up to one year) borrowing instruments of the union
government. It is a promise by the Government to pay a stated sum after expiry of the
stated period from the date of issue (14/91/182/364 days i.e. less than one year).
They are issued at a discount to the face value, and on maturity the face value is paid to the
holder. The rate of discount and the corresponding issue price are determined at each
auction.
5. Commercial Paper
CP is a note in evidence of the debt obligation of the issuer. On issuing commercial paper
the debt obligation is transformed into an instrument. CP is thus an unsecured promissory
note privately placed with investors at a discount rate to face value determined by market
forces.
The Capital Market is broadly classified as Primary market and Secondary Market.
EXERCISE
1. What is financial market?
2. Explain the money market instrument?
Financial Statements
Income Statement
Income statement is also called as profit and loss account, it determines the entire
Operational performance of the concern like total revenue generated and expenses
incurred for earning that revenue.
Income statement helps to ascertain the gross profit and net profit of the concern.
Gross profit is determined by preparation of trading or manufacturing a/c and net profit
Is determined by preparation of profit and loss account.
Balance Sheet
Balance sheet reflects the financial position of the firm at the end of the financial year.
It helps to ascertain and understand the total assets, liabilities and capital of the firm.
One can understand the strength and weakness of the concern with the help of the
Balance Sheet.
Statement of Changes in Owner’s Equity
This statement provides information about the changes or position of owner’s equity
in the company.
TERM FIANCIAL YEAR: Financial year means Accounting year which consists of 12 months.
Analysis of financial statement for decision making by different users is called financial statement
analysis.
1. On Basis of Material Used: Based on the material used, financial statement analysis may be
classified into two major types such as External analysis and internal analysis.
A. External Analysis: The analysis by the outsiders (which are not part of management of the
firm) but have some stake in the company such as investors, creditors, government
organizations and other credit agencies, banks. External analysis mainly depends on the
published financial statement of the concern. This analysis provides only limited information
about the business concern.
B. Internal Analysis
This analysis is used to understand the operational performances of each and every department
and unit of the business concern. Internal analysis helps to take decisions regarding achieving
the goals of the business concern. Internal analysis is conducted by financial managers.
2. Based on Method of Operation Based on the methods of operation, financial statement analysis
may be classified into two major types such as horizontal analysis and vertical analysis.
A. Horizontal Analysis
Under the horizontal analysis, financial statements are compared with several years and based on that,
a firm may take decisions. Normally, the current year’s figures are compared with the base year (base
year is consider as 100) and how the financial information are changed from one year to another.
This analysis is also called as dynamic analysis.
B. Vertical Analysis
Under the vertical analysis, financial statements measure the quantities relationship of the various items
in the financial statement on a particular period. It is also called as static analysis, because, this analysis
helps to determine the relationship with various items appeared in the financial statement. For
example, a sale is assumed as 100 and other items are converted into sales figures.
TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS
Techniques
Trend Analysis
The financial statements may be analyzed by computing trends of series of information. It may be
upward or downward directions which involve the percentage relationship of each and every item of the
statement with the common value of 100%. Trend analysis helps to understand the trend relationship
with various items, which appear in the financial statements. These percentages may also be taken as
index number showing relative changes in the financial information resulting with the various period of
time. In this analysis, only major items are considered for calculating the trend percentage.
EXAMPLE 1 ____________________________________________________________________
Calculate Trend for the Following information of Unique Limited by taking 2001 as base:
Year Revenue(Rs) Expenses(Rs) Net income(Rs)
2001 40000 17000 23000
2002 45000 17300 27700
2003 53400 29000 24400
2004 49000 22000 27000
2005 52000 34000 18000
2006 78000 31000 47000
2007 70000 32000 38000
SOL:
YEAR Revenue Expenses Net income
Amount Trend Amount Trend Amount Trend
Rs(000) percentage Rs(000) Percentage Rs(000) Percentage
2001 40 100% 17 100% 23 100%
2002 45 45/40 ×100= 17.3 17.3/17×100= 27.7 27.7/23×100=
112.5 % 101.76% 120.43%
2003 53.4 53.4/40 ×100= 29 29/17×100= 24.4 24.4/23×100=
133.5% 170.58% 106.00%
2004 49 49/40×100= 22 22/17×100= 27 27/23×100=
122.5% 129.41% 117.40%
2005 52 52/40×100= 34 34/17×100= 18 18/24×100=
130% 200% 78%
2006 78 78/40×100= 31 31/17×100= 47 47/23×100=
195% 182.35% 204.34%
2007 70 70/40×100= 32 32/17×100= 38 38/23×100=
175% 188.23% 165.22%
Interpretations: The sale of 2001 is taken as 100% and sales of 2002 are 112.5%, it means there is an
increase of 12.5 %( 112.5-100) from 2001 t0 2002 and so on.
Common Size Analysis
In Common size Analysis Reported figures are converted into percentage to some common base.
• In the Income Statement, the Sales are assumed to be 100 percent and all figures are expressed
as percentage of this total.
• In the balance sheet the total assets figures is assumed to be 100 and all figures are expressed
as a percentage of this total.
It is one of the simplest methods of financial statement analysis, which reflects the relationship of each
and every item with the base value of 100%.
EXAMPLE 2 ______________________________________________________________________
Give Common size Analysis for following Balance Sheets of Michigan Sate Company.
Particulars Year 2010 Year 2012
Fixed Assets
Investments 30000 35000
Advances 40000 40000
Fixed Assets 75000 75000
Other Assets 15000 15000
(E) Concept implication: Apply yours Knowledge of Common size to following Income Statement:
ABC Company
Income Statement
For year ended 31 Dec 2001
___
Rs
Sales 790000
Cost of Goods Sold 49000
Gross Profit 300000
Selling, General, Administrative Expenses 100000
Profit before Interest and Tax 200000
Interest expense 25000
Profit before Tax 175000
Income Tax 16000
Profit after interest and Tax 159000
Comparative balance sheet analysis concentrates only the balance sheet of the concern at different
period of time. Under this analysis the balance sheets are compared with previous year’s figures or one-
year balance sheet figures are compared with other years. This type of analysis helps to understand the
real financial position of the concern as well as how the assets, liabilities and capitals are placed during a
particular period.
EXAMPLE 3 ______________________________________________________________________
Liabilities
Shareholders’ 220000 275,000 +55000 55/220×100=25%
equity and
Liabilities
Liquidity Ratio
It is also called as short-term ratio. This ratio helps to understand the liquidity in a business which is the
potential ability to meet current obligations.
Liquidity Ratio Classified:
• Current Ratio
• Quick Ratio or Asset test Ratio
Current Ratio: The Ratio between Current Assets and Current Liabilities Current/Liquid assets: The
is Known as Current Ratio. assets which are easily
converted into cash are called
Current Ratio
liquid assets e.g. Cash, Account
Receivable, Inventory,
Current ratio = Current Assets
Marketable securities.
Current liabilities
Current/Short-term liabilities:
Or
amounts payable within
= Cash +A/R+ Inventory+ Marketable Securities
coming one year e.g. Account
Account Payables +Notes payables
payables.
EXAMPLE 4 ________________________________________________________________________
_____
Assets Rs Liabilities Rs
Fixed Assets 60000 Equity 100,000
Current Assets
Inventory 40000 Long term liabilities 36000
Cash 60000 Short-term liabilities 24000
160000 160000
Compute Current Ratio and Quick Ratio?
SOL:
Current ratio = Current Assets
Current liabilities
= Cash +A/R+ Inventory+ Marketable Securities
Account Payables +Notes payables
=40000+60000/24000=4.17
»This ratio suggest that there are Rs 4.17 of Current Asset to Pay Rs 1 of short-term liabilities or Current
Assets are 4.17 times of current or short-term liabilities.
QUICK RATIO OR ACID TEST RATIO:
Quick ratio = Current Assets- Inventory
Current liabilities
= Cash +A/R+ Marketable Securities
Account Payables +Notes payables
SIGNIFICANCE OF LIQUIDITY RATIO: Liquidity reveals ability of a firm to pay its short-term obligation, so for
short-term money lenders these are of great importance.
Activity Ratio
It is also called as turnover ratio. This ratio measures the efficiency of the current assets and liabilities in
the business concern during a particular period.
Activity Ratios classified
• Inventory turnover(ID)
• Inventory turnover in days(ITD)
• Receivable turnover(RT)
• Receivable turnover in days(RTD) or Average Collection Period
• Payable Turnover(PT)
• Payable turnover in days(PTD)
• Operating Cycle
• Cash Cycle
1. INVENTORY TURNOVER (IT): This ratio Suggest number of times finished goods turned into Sales.
= ____Days in year___
Cost of goods sold
Inventory
4. RECEIVABLES TURNOVER IN DAYS (RTD) OR AVERAGE COLLECTION PERIOD: This ratio tells
average number of days for which Receivables were Outstanding before being collected.
= Days in a Year/Receivable turnover
= Days in a year____
Annual Credit Sales
Account Receivables
= Days in a year ×Account Receivables
Annual credit sales
5. PAYABLES TURNOVER (PT): Payable turnover ratio suggests the number of times Account
payables turned into Cash in year .The higher the turnover, shorter the time period between
credit purchases and cash payments during a year.
Payables turnover=Annual Credit purchases/Account Payables
6. PAYABLES TURNOVER IN DAYS (PTD): This ratio suggests the average number of days for which
Account payables were outstanding before being paid.
= Days in a year
Payables Turnover
= days in a year
Annual Credit Purchases
Account payables
=days in a year ×Account payables
Annual credit purchases
7. OPERATING AND CASH CYCLE:
OPERATING CYCLE: The time interval from Credit purchases to cash collection for receivables, is called
TERM operating cycle.
CYCLE CASH: The time interval from cash payment for credit purchases to the cash collection for account
receivables is called cash cycle.
Manufacturing process
Finished goods
Inventory
Turnover
Goods sold
Receivables Turnover
Receiving cash from Account Receivables
OPERATING CYCLE: Inventory Turnover in Days (INT) + Receivable Turnover in Days (RTD) = Operating
Cycle
CASH CYCLE: Operating Cycle - Payables turnover in days = Cash Cycle
EXAMPLE 5 ________________________________________________________________
ABC Company
Income Statement
For year ended 31 Dec 2008
___
Rs
Sales 790000
Cost of Goods Sold 490000
Gross Profit 300000
Selling, General, Administrative Expenses 100000
Profit before Interest and Tax 200000
Interest expense 25000
Profit before Tax 175000
Income Tax 16000
Profit after interest and Tax 159000
ABC Company
Balance Sheet
For year ended 31 Dec 2008
___
Rs
ASSETS
Fixed Assets:
Machinery 20000
Furniture 35000
Equipment 15000
Building 30000
Total Fixed Assets 100,000
Current assets:
Cash 20000
Account Receivables 20000
Inventory 30000
Marketable Securities 30000
Total Current Assets 100000
Total Assets 200000
Liabilities and Equity
Account Payables 30000
Long term liabilities 30000
Total liabilities 60000
Share capital 60000
Retained Earnings 80000
Shareholder’s equity 140000
Total liabilities and equity
INTRODUCTORY BUSINESS FINANCE 200000
BY: ADEEL SHAHZAD, MBA, ACMA (FINALIST)
27
INTODUCTORY BUSINESS FINANCE
TERM FINANCIAL RISK: The risk that firm will default with its creditors and shareholders is called financial
risk.
= ___ total Debt _____
Total assets
EAMPLE 6 __________________________________________________________________
SOL:
4. RETURN ON INVESTMENT (ROI): Investment means total assets and return means Profit after
interest and tax. Thus
Net Profit after taxes
Total Asset
5. EARNING POWER :Earning power is the Return on investment(ROI) ratio but first introduced by
Du Pont Company and is equal to :
Earning power=net profit margin × Total Asset turnover
= net profit after taxes /sales × sales/Total Assets
=net profit after taxes /total assets
6. RETURN ON EQUITY (ROE): return means profit after taxes and preferred dividend
(Residual profit) and equity means Shareholders’ equity.
Coverage Ratio
Coverage ratio measures ability of a firm to pay its financial charges.
TERM FIANCIAL CHRAGES: Financial charges mean interest.
EAMPLE 8 __________________________________________________________________________
Ratios
Long-term debt to the Long-term debt
Capitalization Ratio Total capitalization
Inventory turnover Cost of goods sold
Inventory
Inventory Turnover in Days in a year ×inventory
Days (ITD) Cost of Goods sold
Case Study
FINANCIAL STATEMENT ANALYSIS
The business volume of the bank can be analyzed by the following table:-
Rupee in million
The Balance sheet of the MCB for the five years shown:-
Cash and balances with Treasury Banks 39,684 39,631 38,775 45,407 53,123
Bill payable
Net Mark-up / Interest Income after provisions 20,860 24,441 28,314 33,149 40,358
Fee, commission and brokerage income 2,635 2,953 3,332 4,130 4,921
Income from dealing in foreign currencies 693 728 341 632 921
TH
SELECTED QUSTIONS FROM FUNDAMENTALS OF FINANCIAL MANAGEMENT 11 EDITION BY VAN C HORNE
P1: The data for various companies in the same industry are as follows:
_____________________________________________COMAPNY__________________Rs (Million) ____
A B C D E F
SALES 10 20 8 5 12 17
TOTAL ASSETS 8 10 6 2.5 4 8
NET INCOME 7 2 8 5 1.5 1
Determine the total assets turnover, net profit margin and earning power for each?
A B C D E F
P2: Cordiera Carson Company has following balance sheet and income statement for 20X2(in
thousands):
BALANCE SHEET INCOME STATEMENT___________
Cash 400 Net Sales (all credit) 12680
Accounts Receivables 1300 cost of goods sold 8930
Inventories 2100 Gross profit 3750
Current Assets 3800 selling, general and administrative 2230
Net Fixed Assets 3320 Interest expense 460
Total Assets 7120 Profit before tax 1060
Account payables 320 Taxes 390
Accruals 200 Profit after taxes 670
Short-tem loans 1100
Current liabilities 1680
Long-term debt 2000
Net worth 3440
Total liabilities and
Worth 7120
On basis of this information, compute (a) Current ratio,(b)Acid test ratio,(c)Average collection
period,(d)inventory turnover ratio,(e)The debt to net worth ratio,(f)long-term debt to total capitalization
ratio,(g)gross profit margin,(h)net profit margin and (i) return on equity?
SOL: ((a) Current Ratio= Current Assets = 3800/1680=2.26
Current liabilities
(b) Quick Ratio or Acid Test Ratio= Current Assets- Inventory = 3800-2100/1680=1.011
Current liabilities
(c) Receivables Turnover in days (RTD) or Average collection period=
Days in a year ×Account Receivables = 365×1300/12680=37.42 days
Annual credit sales
(d) Inventory turnover= Cost of goods sold =8930/2100=4.25
Inventory
(e) Debt to Equity Ratio or debt to net worth ratio=___ total Debt _____ =Total debt/net worth
Shareholder’s equity
1680+2000/3440=1.07
(f) Long term debt to total capitalization ratio= Long-term debt =2000/2000+3440=0.37
Total capitalization
(g) Gross Profit Margin Ratio= Gross Profit/net sales ×100=3750/12680 ×100=29.57%
(h) Net Profit Margin Ratio= Net Profit after taxes/net sales ×100=670/12680 ×100 =5.28%
(i) Return on equity (ROE) = Net profit after taxes and preferred dividend =670/3440=.1948
Shareholder’s equity
P3: The Following information is available on the vainer Corporation:
BALANCE SHEET AS OF DECEMBER 31,20X06 (IN THOUSANDS)
_________________________________
Assuming that Sales and production are steady throughout a 360-day year, complete the balance
sheet and income statement?
SOL:
45 DAYS=360×A.R/8000
A.R=45×8000/360=Rs 1000
TAX=1000×44/100=Rs 440
Total liabilities/3750=1/1
3/1=Current Assets/1100
CURRENT ASSETS=1100×3/1=3300
3300=500+1000+inventories
Inventories +1500=3300
3/1=C.G.S/1800
Gross Profit – Selling and administrative expense – interest expense=PROFIT BEFROE TAX
P4: A Company has Total annual Sales (all credit) of Rs 400,000 and a gross profit margin of 20 percent.
Its Current assets are Rs 80, 000, current liabilities Rs 6000, inventories Rs 30000 and Cash Rs 10000.
a. How much average inventory should be carried if management wants the inventory turnover to
be 4?
b. How rapidly (In how many days) must account receivable be collected if management wants to
have an average of Rs 50,000 invested in receivables (assume a 360-day year)?
SOL: to determine inventory level we needs inventory turnover ratio:
P5: Stoney Mason, Inc has sales of Rs 6 million, o total asset turnover ratio of 6 for the year and net
profits of Rs 120000.
Earning Power =net profit after tax/net sales × Net sales/Total assets
Earning Power=120000/6000000 × 6
= 2 × 6 =12/100 =0.12
b. Earning Power =net profit after tax/net sales × Net sales/Total assets
=0.03 × (6/1×120%)
=0.03 ×7.2=21.6%
P5: The long-term debt section of balance sheet of Queen Anne’s Lace Corporation appears as follows:
__________________________________________________________
9 ¼ % mortgage bonds Rs 2500,000
12 3/8 % Second mortgage bonds 1500,000
10 ¼ % Debentures 1000,000
14 1/2 % Subordinate debentures 1000,000
Rs 6000,000
______________________________________________________________
If the average earnings before interest and taxes of company are Rs 1.5 million and all debt is long term,
what is the overall interest coverage?
CHAPTER 4
Future value: The value of a cash flow in the future is Future value .sometime also called terminal value,
future means the next second, next minute, next hour, next days etc.
Present value: The value of a cash flow in present time is called present value.
Suppose you have deposited Rs 5000 in a Bank at 8 % Compounded annually for four years. The simple
computations are under:
FORMULA: n
FV=PV (1+i) or FV= PV (PVIF)
4
FV= 5000(1+0.08) =6802
FUTURE VALUE FORMULA:
n
FV=PV (1+i) or FV= PV (FVIF)
i,n
-n
PV=FV (1+i) or PV= FV (PVIF)
i,n
INTEREST RATE COMPOUNDING: The interest may be compounded annually, semiannually, quarterly,
monthly, weekly, daily ,Hourly,Contineously.
_
EAMPLE 1
____________________________________________________________________
The cash flow of Rs 250000 is compounded annually, semiannually, quarterly, monthly, weekly, daily,
Hourly, And Continuously at interest of 10 % for 5 years. Calculate Future value of cash flow?
SOL:
FV= PV (FVIF)
i,n
FV=250000(PVIF) (i=10% and n=5)
FV=250000(1.6105) =Rs 402625
COMPUNDED semiannually =When compounded semiannually, then i=10/2=5% n=5×2=10 years
20
FV=250000(1+0.025) =250000(1.638) =Rs 409500
COMPUNDED monthly =when compounded monthly, then i=10%/12=0.834% n=5×12=60
60
FV=250000(1+0.0.00834) =250000(1.645) =Rs 411250
60
FV=250000(1+0.001923) =250000(1.648) =Rs 412000 1 year= 52 weeks
43800
1 year= 365 days×24 hours=8760 hours
FV=250000(1+0.0000115) =250000(1.655) =Rs413750
Michilan Chemical Processing Industries Need Rs 500,000 for 5 years, the Royal Bank agree to made this
payment to Michilan if Michilan agrees to repay Rs 750,000 after 5 Years. What would be the implicit
rate of interest?
SOL: For determine implicit interest rate of compound interest we use Future value formula (Usually).
n
FV=PV (1+i) or PV (FVIF)
i,n
Michilan Chemical Processing Industries Need Rs 1000,000, the Royal Bank agree to made this payment
to Michilan if Michilan agrees to repay Rs 1400,000. The implicit rate of interest IS 11%, in how much
the amount should be returned?
=1.4 FACTOR
The factor 1.4 comes column 11 % and in row of 4 years. Thus time period is 4 years.
The cash flow of Rs 10,000 is compounded annually, semiannually, quarterly, monthly, weekly, daily,
Hourly, And Continuously at interest of 10 % for 5 years. Calculate Present value of cash flow?
CONCEPT OF ANNUITY
Annuity: The series of equal payments made at equal intervals is called annuity. e.g. You have taken a
loan form a bank payable in installment is a simple example of annuity, suppose you have taken Rs
500,000 payable in installments of Rs 50000 each year for 12 years. Rs 50000(equal amount) shall be
payable by you after each year (equal interval).
Series OF Payments
ORDINARY ANNUITY: if the each payment of the series is made at the end of each period, the annuity is
said to be ordinary annuity.
FORMULA:
Future value formula
i
FV=R (FVIFA)
PV=R [1 1i ] -n
i=interest rate
n=period
R=payments
PV=Present value
FV=future value
EAMPLE 4
_____________________________________________________________________
You need to have Rs 80,000 at end of 10 years to meet education expenses of yours son. To accumulate
this sum, you have decided to save a certain amount at end of each the next 10 years and deposit in the
bank. The bank pays 8 percent compounded annually for long-term deposits. How much will you have to
save each year?
SOL: you need Rs 80,000 after ten years; it means it is future value (FV). You accumulate at end of each
year, it means it is annuity and at end of each of next 10 years, it means it is ordinary annuity.
FORMULA:
[
80,000=R 10.0810 -1) ] 0R 80,000=R (FVIFA i=8% n=10)
0.08
80,000=R (14.487)
R=80,000/14.487=Rs 5522
Mr. Muneeb is recently retired from Government Service and he has received a sum of Rs 100,000 in
respect of Pension, he is willing to deposit this amount in an insurance company to purchase an annuity
which gives constant fixed payments for remaining of his life at end of each year and his expected
remaining life is 10 years, the interest rate is 9 % compounded annually. Required: Determine he will
receive what amount for remaining of his life. (Hints: Presently he has Received Rs 100,000, so it is
present value)?
ANNUITY DUE: If each payment of series is made at begin of each period, the Annuity is said be Annuity
due.
FORMULA:
Future value formula
i
FV=R (FVIFA)
i
i=interest rate
n=period
R=payments
PV=Present value
FV=future value
INTRODUCTORY BUSINESS FINANCE BY: ADEEL SHAHZAD, MBA, ACMA (FINALIST)
47
INTODUCTORY BUSINESS FINANCE
EAMPLE 5 ______________________________________________________________________
Mr. Muneeb is recently retired from Government Service and he has received a sum of Rs 100,000 in
respect of Pension, he is willing to deposit this amount in an insurance company to purchase an annuity
which gives constant fixed payments for remaining of his life at begin of each year and his expected
remaining life is 10 years, the interest rate is 12% compounded annually. Determine he will receive
what amount for remaining of his life?
SOL
UNEVEN CASH FLOW The series of payments which fulfill following two conditions is said to be annuity:
i) Series includes equal payments
ii) Payables at equal intervals etc each year
If condition (i) is not satisfied means series includes unequal payments, the series is said to be uneven
cash flow.
EAMPLE 6 _____________________________________________________________________
SOL
____________________________________________________________________________________
YEAR CASH FLOWS(Rs) PVIF @ 14% PRESENT VALUE______
1 1400 .877 1228
AMORTIZING A LOAN
The loan we take from banks for different purposes my be amortized and each installments is
determined by use of present value formula of annuity.
i
If installment is payable at end of period:
PV=R [1 1i ] -n
i
_______________________________________________________________________
EAMPLE 7
Mutual Trust Enterprises needs Rs 250,000 to expand its business, thus sanctioned a loan of Rs 250,000
from MB bank with following terms:
SOL
_____________________________________________________________________________________
_______________________AMORTIZATION SCHEDULE________________________________________
YEAR PAYMENT(R) INTEREST@9% PRINCIPAL LIABILITIY_______
i. Loan shall be payable in 12 equal monthly installments, each payable at end of the
month
ii. The bank charges interest at 12 % compounded annually.
LONG-TERM FINANCE
LONG-TERM FINANCE
Bank loan
BONDS
General
Public Company
MONEY
VALUATION OF BOND:
Value means Price of Bond and Valuation is the Process of determine price of bond is called Valuation.
The valuation of bond depends on type of bond.
• COUPON BOND
• ZERO COUPON BOND
• PERPETUAL BOND
VALAUTION OF COUPON BOND: Coupon bond is has following characteristic:
i. It has face value which is paid on maturity; generally the face value is Rs 1000.
ii. It pays Interest (Coupon) on face value at interest rate determined by the corporate directors.
Illustrative: ABC Company issued 5-year bonds having a face value of Rs 1000 and pays
coupon at rate of 9%.The cash flow Stream will be appear as follow:
0 1 2 3 4 5
0 90 90 90 90 90
Present 1000
Value/Price
?
P or V= R [1 1i ] + FV 1i
-n -n
i
Where p/v is price of bond
R is the Payments of Coupon/interest
FV is the Face value of bond
i is the investor’s required rate of return/Discount rate
n is the time period of bond
[ ]
As 1 1i-n = PVIFA and 1i-n =PVIF
i
BBBBBBBBBBBBBBBB___________________________________________________________________
EAMPLE 8
(Paper: introductory Business Finance, Q.NO:5, Spring2008, 2007, 2006, Sarhad University)
The Mecentile‘inc’ issued 9% Coupon bond of face value Rs 1000 for 10 years. The Investors’ discount
rate is 12%.determine value of bond.
SOL: R=1000×9/100=Rs90 i=12% 0r 12/100=0.12 n=10 FV=1000
P or V= R [1 1i ] + FV 1i
-n -n
[ ]
v=90 1 1.12
+ 1000 1.12
0.12
Or
V=90(PVIFA i=12% n=10) + 1000 (PVIF i=12% n=10)
EAMPLE 9
_____________________________________________________________________
(Paper: introductory Business Finance, Q.NO:4, Spring 2009 Sarhad University)
The Radish‘inc’ issued bond of face value Rs 1000 for 10 years. The Company pays Rs 80 Coupon and The
Investors’ discount rate is 9%.determine Price of bond?
SOL:
P or V=R (PVIFA) +FV (PVIF)
=80(PVIFA i=9% n=10) + 1000 (PVIF i=9% n=10)
=80 (6.418) + 1000 (0.422)
= 514 + 422= Rs 936
_____________________________________________________________________________________
VAUATION OF ZERO COUPON BOND: Zero Coupon bond has following characteristic:
i. It has face value which is paid on maturity; generally the face value is Rs 1000.
ii. It pays no Interest (Coupon).
Illustrative: ABC Company issued 5-year Zero Coupon bond having a face value of Rs 1000
.The cash flow Stream will be appear as follow:
0 1 2 3 4 5
0
Present 1000
Value/Price
?
P 0r V = 0 + FV (PVIF)
P 0r V = FV (PVIF)
EAMPLE 10
_____________________________________________________________________
(Paper: introductory Business Finance, Q.NO:3, Winter 2005 Sarhad University)
Rybies Company issued 8-year Zero Coupon bond having a face value of Rs 1000; the investor’s required
rate of return is 11%.Determine Price of bond?
SOL: P 0r V = FV (PVIF)
=1000(PVIF i=11% n=8)
=1000(5.146) =Rs 514.6
_____________________________________________________________________________________
P or V= R [1 1i ] + FV 1i
-n -n
i
Never matures thus n=0 and FV=0
P or V= R [1 1i ] + 0 1i
= R (1-0) + 0 =R/i
i
P or V = R/i
EAMPLE 11
______________________________________________________________________
MACNAZI COMPANY issued 1000 face value bond which pays interest at 9% and bond will never mature.
The investor’s required rate of return is 15 %. Compute Price of bond?
SOL: R=1000 ×9/100= Rs 90
P or V = R/i=90/0.15=Rs 600
_____________________________________________________________________________________
“The Present value of what is given to the bondholder is the Value or Price of bond”
EQUITY FINANCE: Equity finance means finance that involves ownership is called Equity finance. The
sources of equity finance are:
i. Equity share or Common Stock
ii. Preferred share or Preferred Stock
1. EQUITY SHARES/COMMON STOCK: The equity shareholders are the owners of the business, they
purchase shares, the money is used by the company to buy assets, and the assets are used to earn
profits, which belong to the ordinary share-holders.
FEATURES: Equity shareholders have following characteristics:
iv) They are owner of the company.
v) They have Voting rights in meeting of shareholders.
vi) They are entitled to Profit of the company after payment of dividend to preference
shareholders.
_______________________________________________Rs_______
Profit after tax xxx
Less: Dividend to Preference Shareholders xxx
Profit belonging to equity shareholders (Dividend) xxx
________________________________________________________
iv) The dividend on Equity shares is not fixed and may vary from year to year depending upon
the Amount of profits available. The rate of dividend is recommended by the Board of Directors
of the company and declared by shareholders in the Annual General Meeting.
Features of Equity Shares
Equity shares consist of the following important features:
1. Maturity of the shares: Equity shares have permanent nature of capital, which has no maturity
period. It cannot be redeemed during the lifetime of the company.
2. Residual claim on income: Equity shareholders have the right to get income left after paying fixed
rate of dividend to preference shareholder.
3. Residual claims on assets: If the company wound up, the ordinary or equity shareholders have the
right to get the claims on assets. These rights are only available to the equity shareholders.
4. Right to control: Equity shareholders are the real owners of the company. Hence, they have power to
control the management of the company and they have power to take any decision regarding the
business operation.
5. Voting rights: Equity shareholders have voting rights in the meeting of the company with the help of
voting right power; they can change or remove any decision of the business concern. Equity
shareholders only have voting rights in the company meeting.
6. Pre-emptive right: Equity shareholder pre-emptive rights. The pre-emptive right is the legal right of
the existing shareholders. It is attested by the company in the first opportunity to purchase additional
equity shares in proportion to their current holding capacity.
7. Limited liability: Equity shareholders are having only limited liability to the value of shares they have
purchased. If the shareholders are having fully paid up shares, they have no liability.
2. PREFERENCE SHARES/PREFRED STOCK: Preference shares have following characteristics:
I. The share holders with preference shares are not entitled to vote in Annual General Meet
(AGM) or other meeting of the Shareholders regarding affairs of the company.
II. In case of Dividend they are entitled to the fixed amount of Dividend IN THE YEAR OF
PROFIT.
CHRARCTERISTICS OF PREFERRED STOCK:
The Preferred Stock has no stated maturity date, thus it is also perpetual in nature.
EAMPLE 12
______________________________________________________________________
Concept implication: Apply yours Knowledge of Preferred Stock valuation to following question:
(E) Omara Corporation issued 9% preferred Stock of face value/par value Rs 250.The investors’
required rate of return is 15%.What is Value of Preferred Stock?
STEPT 1
All Cash disbursements (Dividend) to the shareholder’s are discounted at investor’s required
Rate of return (Ke) to their Present values (PV).
STEP 2
Sum up all Present values computed in step1, the Summation is Price of Common Stock.
YEAR DIVIDEND PV
1 D1 D1 1ke
or __D1__
1ke
2 D2 D2 1ke 0r __D2__
1ke
3 D3 D31ke
or __D2__
1ke
;
;
;
;
‘
;
n Dn Dn 1ke
or __Dn__
1ke
GROWTH PATTERNS: Dividend of the Company with the passage of time Grow, The Growth comes in
following patterns:
• Constant Growth
• Zero Growth
• Two Phase Growth
CONSTANT GROWTH: If the Dividend of the company is expected to grow at a constant rate Forever, This
pattern is called Constant Growth.
Illustrative: wytech Company currently paid Dividend of Rs 21 and assume that Dividend will grow at 9%
forever. So
Current dividend = D0=Rs 21
1
Dividend after one year=D1=21×9/100=1.89+21=Rs 22.89 or = D0 (1+g) =21(1+.09) =Rs 22.89
2 2
Dividend after Two year= D2=22.89×9/100=2.0601+22.89=24.9501 or = D0 (1+g) = 21(1+0.09) =24.9501
3 3
Dividend after Three year = D3 = 24.9501 ×9/100=2.25+24.9501=27.200 or D0 (1+g) =21(1+0.09) =27.200
FORMULA:
P or V = D1/Ke-g
Where D1 is the dividend in first year and D1=D0 (1+g)
P or V = Value or Price of Common Stock
Ke= Inventor’s required rate of return
g= Growth rate of dividend
EAMPLE 13 ______________________________________________________________________
KLC is public company and currently paid Rs 15.50 dividend per share, which is expected to grow at rate
of 12% forever. Investor’s required rate of return is 15%.Determine Value of Common Stock?
SOL: Company has Constant Growth, Thus formula for Constant Growth is
P or V = D1/Ke-g
EAMPLE 14
_______________________________________________________________________
WYLEN CO has common stock of Rs 40000 and the dividend expected to be Rs12 the next year, which is
expected to grow at 8% forever. Investor’s required rate of return is 12%.Determine Price of Common
Stock?
SOL: Company has Constant Growth, Thus formula for Constant Growth is
P or V = D1/Ke-g
D1=12 g=8%=0.08 Ke=12%=0.08 and V=?
P or V =12/0.12-0.08=Rs 300
_____________________________________________________________________________________
ZERO GROWTH: Under a Zero growth Dividend Policy, company pays fixed dividend through the entire
life of a company and there is no growth in the dividend, thus also called NO Growth Policy.
EAMPLE 15 ______________________________________________________________________
Hitech Communication Company is a Zero growth company and has paid a dividend of Rs 22.50/share.
Investor’s required rate of return is 10%.Determine value of common stock?
SOL: Company has Zero Growth, Thus formula for Zero Growth is
P or V = D1/Ke
P or V=22.50/0.10=Rs 225
_____________________________________________________________________________________
TWO PHASE GROWTH: The dividend of a Company may grow in two phases:
• PHASE1: initially Dividend of the company grows at a higher rate for first few years.
• PHASE2: After few years, growth rate come down to normal level and this growth remains
constant forever or perpetually.
_______________________________________________________________________
EAMPLE 16
Michilan Company has paid Dividend of Rs 5, which is expected to grow at 10 % for first four years and
thereafter at 7% forever. Investor’s required rate of return is 12%.Determine value of Common Stock?
SOL: Dividend has two phases of Growth:
Phase 1: Dividend grows at 10% for first four years.
Phase 2: After First four years, Dividend Grows at 7% forever.
PHASE 1:
YEAR DIVIDEND PVIF@12% PV
1 1
1 5(1+0.010) =5(1.10) =5.50 0.893 4.91
2
2 5(1.10) =6.05 0.797 4.82
3
3 5(1.10) = 6.655 0.712 4.74
4
4 5 (1.10) =7.3205 0.636 4.65
19.12
PHASE 2:
Value of Stock = P or V = P or V = D1/Ke-g here we need D5 Instead of D1, thus
CHAPTER 5
This Chapter Includes:
• Introduction
• Scope and Process
• Estimation of relevant cash flow
• Capital Budgeting Techniques
INTRODUCTION: Capital Budgeting is combination of Two words:
Capital: The word Capital refers to be the total investment of a company in tangible
and intangible assets. Some time also called Capital expenditure.e.g.
1. Purchase of fixed assets such as land and building, plant and machinery,
good will, etc.
2. The expenditure relating to addition, expansion, improvement and alteration
To the fixed assets.
3. The replacement of fixed assets.
4. Research and development project.
Budgeting: Budget is Future Estimate of Cost and process of making Budget is called
budgeting.
CAPITAL BUDGETING: Capital Budgeting is a process which suggests an organization
To Invest in or not in capital assets.
CAPITAL BUDGETING PROCESS:
Fixing Property
Final Approval
Implementation
1. Identification of various investments proposals: The Company may have various investment
proposals. The proposal for the investment opportunities may be defined from the top management or
may be even from the lower rank. The heads of various departments analyze the various investment
decisions, and will select proposals submitted to the planning committee of competent authority.
2. Screening or matching the proposals: The planning committee will analyze the various proposals and
screenings. The selected proposals are considered with the available resources of the concern. Here
resources referred as the financial part of the proposal. This reduces the gap between the resources and
the investment cost.
3. Evaluation: After screening, the proposals are evaluated with the help of various methods, such as
pay back period, IRR, accounting rate of return, Net present value (NPV) And Profitability Index. Each
method of evaluation used in detail in the later part of this chapter. The proposals are evaluated by.
(a) Independent proposals
(b) Contingent of dependent proposals
(c) Partially exclusive proposals.
Independent proposals are not compared with other proposals and the same may be accepted or
rejected. Whereas higher proposals acceptance depends upon the other one or more proposals. For
example, the expansion of plant machinery leads to constructing of new building, additional manpower
etc.
Mutually exclusive projects are those which competed with other proposals and to implement the
proposals after considering the risk and return, market demand etc.
4. Fixing property: After the evolution, the planning committee will predict which proposals will give
more profit or economic consideration. If the projects or proposals are not suitable for the concern’s
financial condition, the projects are rejected without considering other nature of the proposals.
5. Final approval: The planning committee approves the final proposals, with the help of the following:
(a) Profitability
(b) Economic constituents
(c) Financial violability
(d) Market conditions
The planning committee prepares the cost estimation and submits to the management.
6. Implementing: The competent authority spends the money and implements the proposals. While
implementing the proposals, assign responsibilities to the proposals, assign responsibilities for
completing it, within the time allotted and reduce the cost for this purpose. The network techniques
used such as PERT and CPM. It helps the management for monitoring and containing the
implementation of the proposals.
7. Performance review of feedback: The final stage of capital budgeting is actual results compared with
the standard results. The adverse or unfavorable results identified and removing the various difficulties
of the project. This is helpful for the future of the proposals.
Illustrative: Suppose you have opened a College for Providing Commerce Education, you have
totally invested Rs 500,000 and it is expected that the cash flow from project will be as under:
Year 1 2 3 4 5 6 7
Cash inflow (Rs) 50000 65000 67000 110000 140000 130000 120000
POINTS
PAYBACK METHOD: This Method tells in what period the amount invested in a project will be returned.
Payback Period Method When Cash inflow from Project is Even:
Pay-back period = Initial investment
Annual cash inflows
_____________________________________________________________________
EAMPLE 1
A project requires initial cash outlay of Rs 100000 and will provide cash inflows as under:
Year 1 2 3 4 5 6 7
Cash inflow (Rs) 20000 20000 20000 20000 20000 20000 20000
Required: Compute Payback Period?
SOL: Pay-back period = Initial investment = 100,000/20,000=5 years
Annual cash inflows
EAMPLE 2
________________________________________________________________________
PEPSI is a Multinational Corporation, considering a new project in Karachi, which require an initial
investment of Rs 450,000 and expected cash inflows are as under:
Year 1 2 3 4 5 6 7
Cash inflow (Rs) 50000 65000 67000 110000 140000 130000 120000
Required: Compute Payback period?
SOL:
_____________________________________________________________________________________
YEAR CASH OUTFLOW CASH INFLOW ACCUMULATIVE CASH INFLOW
0 450,000 ------------ ---------------------------
1 50,000 50,000
2 65000 115000
3 67000 182000
4 110,000 292000
5 140,000 432000 C
6 130,000 562000
7 120,000 682000
a
d
b
Accept /Reject criteria: If the actual pay-back period is less than the predetermined pay-back period,
the project would be accepted. If not, it would be rejected.
Proposal I Proposal II
ANALOG EQUIPMENT DIGITAL EQUIPMENT
Cost of the machine Rs. 2,20,000 Rs. 160,000
Estimated life 5½ years 10 years
Estimated sales p.a. Rs. 200,000 Rs. 200,000
COSTS
Material 50,000 50,000
15000 75000
Labour
Variable overheads 24000 20000
Required: Calculate Accounting Rate of return for each proposal and on its basis determine which is
better?
_____ ______
129000 161000
Profit 71000 39000
The Analog Equipment has ARR 32 % which is greater than ARR of Digital Equipment that is 24%.so
Proposal I should be pursue.
_____________________________________________________________________________________
Accept/Reject criteria If the actual accounting rate of return is more than the predetermined required
rate of return, the project would be accepted. If not it would be rejected.
NET PRESENT VALUE: Net present value is the difference between the total present value of future
Cash inflows and the total present value of future cash outflows .
EAMPLE 4 _____________________________________________________________________
__________
PEPSI is a Multinational Corporation, considering a new project in Karachi, which require an initial
investment of Rs 450,000 and expected cash inflows are as under:
Year 1 2 3 4 5 6 7
Cash inflow (Rs) 50000 65000 67000 110000 140000 130000 120000
Required: Compute NPV if investor’s required rate of return is 10%?
SOL:
EAMPLE 5 _______________________________________________________________________
__________
INTERNAL RATE OF RETURN METHOD: The Discount rate which equates the Present value of the future
net cash flows with Cash outlay is called internal rate of return.
EAMPLE 6 ____
__________ ____________________________________________________________________
PEPSI is a Multinational Corporation, considering a new project in Karachi, which require an initial
investment of Rs 450,000 and expected cash inflows are as under:
Year 1 2 3 4 5 6 7
Cash inflow (Rs) 50000 65000 67000 110000 140000 130000 120000
Required: Compute IRR if investor’s required rate of return is 10%?
SOL:
STEP 3 Looking factor calculated by step 2 in PVIFA table and choosing most appropriate rate, it
is IRR. The Close rate is 11% where factor is 4.712.Thus IRR is 11% .
This IRR is appropriate IRR but not Accurate IRR, For Accurate IRR; we have to follow further three
steps:
Let suppose 9%
STEP 6
The actual IRR lies between rates determined under step 4 and 5.o interpolate between
these rates.
RELAVENT CASHFLOWS
CAPITAL
FIXED CAPITAL: Fixed capital means that capital, which is used for long-term
Investment of the business concern. For example, purchase of permanent assets.
Normally it consists of non-recurring in nature.
WORKING CAPITAL: Working Capital is another part of the capital which is needed for meeting day to
day requirement of the business concern. For example, payment to creditors, salary
paid to workers, purchase of raw materials etc.
GROSS WORKING CAPITAL: The gross working capital is the capital invested in total
current assets of the business concern.
PERMANENT WORKING CAPITAL: It is the capital; the business concern must maintain
Certain amount of capital at minimum level at all times. The level of Permanent
Capital depends upon the nature of the business. By working capital means the cash,
Inventory etc.
TEMPORARY WORKING CAPITAL It is also known as variable working capital.
It is the amount of capital which is required to meet the Seasonal demands and
Some special purposes. It can be further classified into Seasonal Working Capital and
Special Working Capital.
The capital required to meet the seasonal needs of the business concern is called as
Seasonal Working Capital. The capital required to meet the special exigencies such
As launching of extensive marketing campaigns for conducting research, etc is the
Special working Capital.
6. Growth and expansion: During the growth and expansion of the business concern, Working Capital
requirements are higher, because it needs some additional Working Capital and incurs some extra
expenses at the initial stages.
7. Availability of raw materials: Major part of the Working Capital requirements are largely depend on
the availability of raw materials. Raw materials are the basic Components of the production process. If
the raw material is not readily available, it leads to production stoppage. So, the concern must maintain
adequate raw material; for that purpose, they have to spend some amount of Working Capital.
8. Earning capacity: If the business concern consists of high level of earning capacity, they can generate
more Working Capital, with the help of cash from operation. Earning capacity is also one of the factors
which determine the Working Capital requirements of the business concern.
WORKING CAPITAL MANAGEMENT POLICY
Conservative policy
Current Assets
Moderate policy
Aggressive Policy
Sales
EXERCISE
1. What is working capital? Define it.
2. Discuss the concept of working capital?
3. What are the types of working capital?
4. Explain the needs of working capital?
5. Critically explain the factors affecting the requirement of working capital?
6. Explain the working capital management policy?
DIVIDEND POLICY
CHAPTER 7
Meaning of Dividend
Dividend refers to the Company’s net profits distributed among the shareholders. It
May also be termed as the part of the profit of a Company, which is distributed
Among its shareholders.
TYPES OF DIVIDEND/ FORM OF DIVIDEND
Dividends are classified into:
A. Cash dividend
B. Stock dividend
C. Bond dividend
D. Property dividend
TYPES OF DIVIDEND
CASH DIVIDEND
STOCK DIVIDEND
BOND DIVIDEND
PROPERTY DIVIDEND
Cash Dividend
If the dividend is paid in the form of cash to the shareholders, it is called cash dividend.
Cash dividends are common and popular types followed by majority of the Corporations.
Stock Dividend
Stock dividend is paid in the form of the company’s stock due to less availability of cash
And Company is not available to pay cash dividend.
Bond Dividend
The payment of dividend in form of company’s bond due to less availability of cash
And Company is not available to pay cash dividend.
Property Dividend
Property dividends are paid in the form of some assets other than cash due to less
Availability of cash And Company is not available to pay cash dividend.
DETERMINANTS OF DIVIDEND
Profitable Position of the Firm: Dividend decision depends on the profitable position of the business
concern. When the firm earns more profit, they can distribute more dividends to the shareholders.
Uncertainty of Future Income: Future income is a very important factor, which affects the dividend
policy. When the shareholder needs regular income, the firm should maintain regular dividend policy.
Legal Constrains: The Companies ORDINANCE 1984 AND INCOME TAX ORDINANCE 2001 has put several
restrictions regarding payments and declaration of dividends.
Liquidity Position: Liquidity means availability of cash. Liquidity position of the firms leads to easy
payments of dividend. If the firms have high liquidity (More cash), the firms can provide cash dividend
otherwise, they have to pay stock dividend.
Growth Rate of the Firm: High growth rate implies that the firm can distribute more dividends to its
shareholders.
Tax Policy: Tax policy of the government also affects the dividend policy of the firm. When the
Government gives tax incentives, the company pays more dividends.
TYPES OF DIVIDEND POLICY
• Regular dividend policy
• Stable dividend policy
• Irregular dividend policy
• No dividend policy.
Regular Dividend Policy
Dividend payable at the usual rate is called as regular dividend policy. This type of policy is
suitable to the small investors, retired persons and others.
Stable Dividend Policy
Stable dividend policy means payment of certain minimum amount of dividend regularly.
Irregular Dividend Policy
When the companies are facing constraints of earnings and unsuccessful business operation, they may
follow irregular dividend policy. It is one of the temporary arrangements to meet the financial problems.
These types are having adequate profit. For others no dividend is distributed.
No Dividend Policy
Sometimes the company may follow no dividend policy because of its unfavorable working
Capital position of the amount required for future growth of the concerns.
EXERCISE
1. What is dividend? Explain the types of dividend.
2. Explain the factors affecting the dividend policy.
3. Discuss the various types of dividend policy.
CASH MANAGEMENT
The term cash includes coins, currency, cheques held by the business concern
And balance in its bank accounts
Business concern needs cash to make payments for acquisition of resources and services
for the normal conduct of business. Cash is one of the important and key parts of the
current assets.
Motives for Holding Cash
1. Transaction motive
It is a motive for holding cash or near cash to meet routine cash requirements to finance
transaction in the normal course of business. Cash is needed to make purchases of raw-
materials, pay expenses, taxes, dividends etc.
2. Precautionary motive
It is the motive for holding cash or near cash as a cushion to meet unexpected
contingencies. Cash is needed to meet the unexpected situation like, floods strikes etc.
3. Speculative motive
It is the motive for holding cash to quickly take advantage of opportunities typically outside
the normal course of business. Certain amount of cash is needed to meet an opportunity
to purchase raw materials at a reduced price or make purchase at favorable prices.
4. Compensating motive
It is a motive for holding cash to compensate banks for providing certain services
or loans. Banks provide variety of services to the business concern, such as clearance of
cheque, transfer of funds etc.
Cash Management Techniques
A. Speedy Cash Collections.
B. Slowing Disbursements.
Speedy Cash Collections
Business concern must concentrate in the field of Speedy Cash Collections from customers.
For that, the concern prepares systematic plan and refined techniques. These techniques
aim at, the customer who should be encouraged to pay as quickly as possible and the
payment from customer without delay. Speedy Cash Collection business concern applies
some of the important techniques as follows:
Prompt Payment by Customers:
Business concern should encourage the customer to pay promptly with the help of
offering discounts, special offer etc. It helps to reduce the delaying payment of customers
and the firm can avoid delays from the customers. The firms may use some of the
techniques for prompt payments like billing devices, self address cover with stamp etc.
Early Conversion of Payments into Cash:
Business concern should take careful action regarding the quick conversion of the
payment into cash. For this purpose, the firms may use some of the techniques like postal
float, processing float, bank float and deposit float.
Concentration Banking
It is a collection procedure in which payments are made to regionally dispersed collection centers, and
deposited in local banks for quick clearing. It is a system of decentralized billing and multiple collection
points.
Lock Box System
It is a collection procedure in which payers send their payment or cheques to a nearby Post box that is
cleared by the firm’s bank. Several times that the bank deposits the cheque in the firms account. Under
the lock box system, business concerns hire a post office lock box at important collection centers where
the customers remit payments. The local banks are authorized to open the box and pick up the
remittances received from the customers. As a result, there is some extra savings in mailing time
compared to concentration bank.
Slowing Disbursement
Slowing disbursement of cash is possible with the help of the following methods:
1. Avoiding the early payment of cash
The firm should pay its payable only on the last day of the payment. If the firm avoids early payment of
cash, the firm can retain the cash with it and that can be used for other purpose.
2. Centralized disbursement system
Decentralized collection system will provide the speedy cash collections. Hence centralized
disbursement of cash system takes time for collection from our accounts as well as we can pay on the
date.
RECEIVABLE MANAGEMENT
The term Receivable is defined as debt owed to the concern by customers arising from sale of
goods or services in the ordinary course of business.
Receivables are also one of the major parts of the current assets of the business concerns. It arises only
due to credit sales to customers, hence, it is also known as Account Receivables or Bills Receivables.
The objective of receivable management is to promote sales and profit until that point is reached
where the return on investment in further funding receivables is less than the cost of funds raised to
finance that additional credit.
The costs associated with the extension of credit and accounts receivables are identified as follows:
A. Collection Cost
B. Capital Cost
C. Administrative Cost
D. Default Cost.
Collection Cost
This cost incurred in collecting the receivables from the customers to whom credit sales have been
made.
Capital Cost
This is the cost on the use of additional capital to support credit sales which alternatively could have
been employed elsewhere.
Administrative Cost
This is an additional administrative cost for maintaining account receivable in the form of salaries to the
staff kept for maintaining accounting records relating to customers, cost of investigation etc.
Default Cost
Default costs are the over dues that cannot be recovered. Business concern may not be able to recover
the over dues because of the inability of the customers.
Factors Considering the Receivable Size
Receivables size of the business concern depends upon various factors. Some of the important
factors are as follows:
1. Sales Level
Sales level is one of the important factors which determine the size of receivable of the firm. If the firm
wants to increase the sales level, they have to liberalize their credit policy and terms and conditions.
When the firms maintain more sales, there will be a possibility of large size of receivable.
2. Credit Policy
Credit policy is the determination of credit standards and analysis. It may vary from firm to firm or even
some times product to product in the same industry. Liberal credit policy leads to increase the sales
volume and also increases the size of receivable. Stringent credit policy reduces the size of the
receivable.
3. Credit Terms
Credit terms specify the repayment terms required of credit receivables, depend upon the credit terms,
size of the receivables may increase or decrease. Hence, credit term is one of the factors which affects
the size of receivable.
4. Credit Period
It is the time for which trade credit is extended to customer in the case of credit sales. Normally it is
expressed in terms of ‘Net days’.
5. Cash Discount
Cash discount is the incentive to the customers to make early payment of the due date. A special
discount will be provided to the customer for his payment before the due date.
6. Management of Receivable
It is also one of the factors which affects the size of receivable in the firm. When the management
involves systematic approaches to the receivable, the firm can reduce the size of receivable.
EXERCISE
1. Explain the motives of holding cash?
2. Discuss the cash management techniques?
3. What is receivable management? Explain it?
Cost of capital is the rate of return that a firm must earn on its project investments to
maintain its market value and attract funds.
Cost of capital is the required rate of return on its investments which belongs to equity,
debt and retained earnings. If a firm fails to earn return at the expected rate, the market
value of the shares will fall and it will result in the reduction of overall wealth of the
Shareholders.
LONGTERM-FINANCE
TFC
Cost of Equity
Cost of equity capital is the rate at which investors discount the expected dividends of the
firm to determine its share value.
cost of equity capital (Ke) defined as the “Minimum rate of return that a firm must earn on the
equity financed portion of an investment project in order to leave unchanged the market price of
the shares”
Dividend approach
i)When company pays dividend with constant growth in dividend:
Ke =D0 (1+g) + g 0R D1 + g
P0 P0
EXAMPLE 1 _____________________________________________________________
Marizon Company plans to issue 30000 new shares of Rs. 100 each market price.
The company pays a dividend of Rs. 12 per share initially and growth in dividends is
expected to be 5%.
Compute the cost of equity?
Ke =D0 (1+g) + g
P0
ii) When Company pays dividend with no growth i.e. Zero growth g=0
Ke =D0 (1+0) + 0 0R D1 + 0
P0 P0
Ke= D0
P0
EXAMPLE 2 _________________________________________________________________________
Marizon Company plans to issue 30000 new shares of Rs. 100 each market price.
The company pays a dividend of Rs. 12 per share initially and growth in dividends is Zero.
Requirement: Calculate cost of equity?
SOL:
Ke= D0 = 12/100 =0.12 × 100 =12%
P0
_____________________________________________________________________________________
EXAMPLE 3 _______________________________________________________________________
Brilliant Corporation needs financial advice on ascertaining Cost of equity. The Risk free rate is 6% and
market rate of return is 14%, while Company’s beta is 1.20.Caculate cost of equity?
SOL:
Ke=RF + (Rm-RF) β = 6% + (14% - 6%) 1.20
= 6% + (8%) 1.20
= 6% + 9.6%=15.6%
_____________________________________________________________________________________
COST OF DEBT
DEBT
SIMILAR TECHNIQUES
Cost of debt is the after tax cost of long-term funds through borrowing (bank-loan, bonds,
debenture and Term finance certificates (TFC)).Simply the rate of interest demanded by
the lenders of long-term funds.
BANK-LOAN:
The Rate of interest charge by the bank on long term loan is the cost of debt.
BONDS, DEBENTURES AND TERM FINANCE CERTIFICATES (TFC)
The Bonds, debentures and term-finance certificates are mostly similar and collectively called debt.
The cost of debt is determined in following situations.
• Debt is redeemable:
1. When debt is issued at par value.
2. When debt is issued at premium or discount
• Debt is irredeemable:
DEBT IS REDEEMABLE: When debt (bonds, debentures or TFC) is redeem (call up back), such debt is
called redeemable debt. Cost of debt for redeemable debt is determined in following two situations:
1. DEBT IS ISSUED AT PAR OR FACE VALUE: When debt is issued at par value, the following formula
is used for computing cost of debt.
FORMULA KD=R/ VD
EXAMPLE 4 _________________________________________________________________________
Millac Corporation issued 10%bonds at a price of Rs 1000 and the face value of the bond is Rs 1000.The
bonds will be redeem after 10 years. Compute cost of debt?
SOL:
KD=R/ VD
R=1000 × 10/100=100
VD=1000 KD=R/ VD =100/1000 × 100=10%
_____________________________________________________________________________________
2. DEBT ISSUED AT DISCOUNT OR PREMIUM: When debt is issued at discount or premium from the
face value, then YTM of bond or debenture or TFC is computed, which is the cost of debt.
COMPUTING YTM
STEP 1
Using the following formula compute Reference rate, this may or may not be the YTM.
STEP 2
Use reference rate to Compute NPV for the debt, if NPV is zero, then it is the YTM of debt; if not then
follow the step 3.
STEP 3
If NPV computed at reference rate is positive, then choose a rate which generate Negative NPV and vise
versa.
STEP4
EXAMPLE 5 ______________________________________________________________________
Arabian Co , issued debenture at Rs 970 ,while par value of debenture is Rs 1000.Company pays 9%
interest on debenture ,the debenture will be redeem after 5 years.
Requirement: Compute Cost of Debt?
SOL:
Step1: Reference Rate= R+1/n (FV-Po)
1/2(FV+Po)
R=1000×9%=90
n=5
FV=1000 = 90+1/5(1000-970) = 90+6 =96_ ×100=9.75%
Po=970 1/2(1000+970) 985 985
Step2:
First take 9% for computing NPV, which is close to Reference rate.
NPV @ 9%
Page Turnover
_____________________________________________________________________________________
IRREDEEMABLE DEBT: When debt (bonds, debenture or TFC) is irredeemable (will never call up back or
will never mature), the debt is said to be irredeemable debt. To determine cost of debt for
irredeemable debt, the following formula is used.
KD=R/Po
EXAMPLE
________________________________________________________________________________
6
Abami Co Issued irredeemable bonds of par value Rs 1000 at a price of Rs 970 and company will pay an
interest of 8% on bonds. You are Chief Financial Officer (CFO) AND computing cost of debt is one of your
preliminary duties, you are required to perform your duty?
SOL:
R=1000×8%=80
Po=970 KD=R/Po =80/970 ×100=8.25%
_____________________________________________________________________________________
Cost of Preference Capital (KP)
In case of preference share dividend are payable at a fixed rate. However, the dividends are
not allowed to be deducted for computation of tax. So no adjustment for tax is required. Just
Like debentures, preference share may be perpetual or redeemable.
WIGHTED AVERAGE COST OF CAPITAL (WACC):
Weighted average cost of capital is the expected average future cost of funds over the long run found by
weighting the cost of each specific type of capital by its proportion in the firms capital structure.
LEVARAGE
CHAPTE 10
EARNING PER SHARE (EPS)
Earning per share means the profit that belongs to equity shareholders (common stock).
EPS is computed as follow:
EXAMPLE 1
____________________________________________________________________
ABC Company has 50000 numbers of shares outstanding and it has profit after tax of
Rs 600000 .The dividend given to preference shareholders is Rs 100000.
Required: Compute Earning per Share?
SOL:
____________________________________________________________________________
EXAMPLE 2 ____________________________________________________________________
MyTech Company is going want to compute Degree of operating leverage and need yours
Help (Being a Financial Analyst) .The records are as under:
• SALES Rs 30000 on Jan 1 2011
• Expected a sales of Rs 45000 next month
• Profit Rs 12000 on Jan 1 2011
• Expected a profit of Rs 19500 next month
SOL:
THE END