BUAD 839 G

Role of Managerial Finance
Finance plays a central role to the growth and survival of business organisations. A
business entity is likely to thrive more rapidly if a sound financial structure which
aims at maximizing shareholders return and minimizing risk is created for it. The
role of Managerial Finance in an organisation is therefore to provide the basic
framework on which financial principles and concepts can be deployed to make the
right financial decisions for the firm. These decisions are in three core areas:
Financing decision, Investment decision and Dividend decision. The three
decision areas which the financial manager makes are explained below:
Financing decision: He should be able to make decisions about when, where and
how the organisation should acquire funds, and decide also on the appropriate channels of
utilizing such funds. Funds can be generated for the business through many ways either by equity
contribution from the stockholders or through borrowing. In general, a good ratio of equity to debt
has to be maintained for the organization; the mix of equity capital and debt is known as a firm’s
capital structure.
Investment decision: A firm has many options to invest its funds but firm has to select the
most appropriate investment which will bring maximum benefit for the firm and deciding or
selecting the most appropriate proposal is an aspect of investment decision. The firm invests its
funds in acquiring fixed assets as well as current assets.
Dividend Decision: Businesses are generally operated for profit motive. Earning
profit or generating a positive return on investment for the stockholders is a major concern of all
business entities. It is therefore the key function of the financial manger to decide whether to
distribute all the profits generated by the business to the shareholders or retain all of it, or distribute
part to the shareholders and retain other part in the business.
Functions of the Financial Manager:

The important functions of the financial manager in modern businesses shall
include, but not limited, to the following:
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i. Raising of capital: to arrange and execute programmes that will facilitate
the provision of capital required by the business.
ii. Investor relations: to establish and maintain adequate information with
respect to company’s securities and to maintain a liaison with investors,
bankers, financial analysts and share holders.
iii. Sourcing Short term finance: to maintain adequate sources for
company’s current borrowing from commercial banks and other lending
institutions.
iv. Financial Custody: to maintain banking arrangement for receiving and
banking funds in the accounts of the business.
v. Credit collections: to direct the granting of credit and the collection of
accounts due to the company as at when due.
vi. Investments: to invest the company’s funds as required and to establish
and co-ordinate policies for investment in pension and other similar
trusts.
vii. Insurance: to comprehensively provide insurance cover on the assets of
the business as required.
viii. Financial Planning and control: to establish, co-ordinate and administer
an adequate financial plan for the control of operations.
ix. Reporting and interpreting: to compare information with operating

standards and to report and interpret the results of operations to all levels
of management and to the owners of the business.
x. Tax administration: to establish and administer tax policies and

procedures.
xi. Government reporting: to supervise and co-ordinate the preparation
of reports to government agencies.
xii. Protection of assets: To ensure protection of assets of the business
through internal control, internal auditing, etc.
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In summary, the entire functions and responsibilities of the Financial Manager
in an organization can be grouped into the following headings:
i. Development Of Financial Strategy

(a) Determination of financial objectives.
(b) Planning of capital structure
(c) Short and long-term planning
ii. Treasury Management

(a) Forex management
(b) Cash forecasting
(c) Insurance
(d) Working capital
(e) Credit policy
(f) Raising of funds
iii. Long-Term Planning

(a) Mergers and Acquisitions
(b) Capital budgeting
Relationship between Financial management, Accounting and Economics:

Financial management has a close relationship with economics on one hand and
accounting on the other hand. In economics, there are two important ties that bind
economics to finance. First, the macroeconomic factors like the growth rate in the
economy, the domestic savings rate, the role of the government in economic affairs,
the tax environment, the availability of funds to the corporate sector, the rate of
inflation, the real rate of interest, and the terms on which the firm can raise finances
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define the environment in which the firm operates. Therefore, a basic knowledge of
macro economics is necessary for you to understand the environment in which the
firm operates by the financial manager. On the micro-economic environment
however, relevant theories and concepts of micro economic provide the conceptual
framework on the basis of which financial tools and models are developed.
The knowledge of the principles and concepts of micro economics can sharpen
greatly the analysis of decision alternatives in finance. Financial management, in
essence, can be regarded as applied micro economics. For example, the principle of
marginal analysis which is a key principle of micro economics for decision making
is also applicable to a number of managerial decisions in finance.
In terms of the relationship between Finance and Accounting, it is the accounting

functions that provide the necessary input which the finance manager relies on in
the discharge of his responsibilities. The functions of the financial manager should
not be misunderstood with those performed by the Accountant. The financial
Manager relies mostly on the processed information supplied by the Accountant. In
practice, the basic knowledge of accounting is required by the financial manager in
order to appreciate and interpret financial statements and to make reports from
them.
The Financial Market Environment:

The financial market environment is made up of both physical and an imaginary
setting and/or atmosphere within which various financial markets, financial
institutions and regulatory bodies inter play in an attempt to ensure smooth flow of
funds between surplus economic units and deficit economic units.
This environment is characterized by the various functions of commercial banks,
investment banks, micro finance institutions/banks, pension funds, mutual funds,
insurance companies, finance and investment houses, mortgages institutions and
banks, mutual funds, hedge funds, and their regulatory bodies such the central
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banks, pension commissions, insurance commissions, world bank, International
Monitory Funds, and other related regional bodies. It also involves the activities of
money and capital markets.
There are three key players in the financial market environment,

1. the Financial managers,
2. the Financial institutions
3. and the Investors.
The financial managers and investors are the active participants of the financial
market, while the financial institutions play the role of financial intermediaries.
Financial intermediation is the process by which financial intermediaries provide a
linkage, between surplus units and deficit units in the economy. Surplus units are
firms or individuals who have excess funds above their immediate needs while
those who need these funds for immediate investment programmes are referred to as
deficit units. It is the financial intermediaries that develop the facilities and
instruments, which make this lending and borrowing possible.
FINANCIAL INTERMEDIATION simply means sourcing of surplus funds from

the market and 'selling' same to the deficit side of the market, that is, to those
requiring finance for their businesses.
Financial intermediation is the process by which financial intermediaries

provide a linkage, between surplus units and deficit units in the economy.
Surplus units are firms or individuals who have excess funds above their
immediate needs while those who need these funds for immediate investment
programmes are referred to as deficit units.
To actively participate in the financial market activities, the financial manager must
understand the environment within which his business operates; he should be
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conversant with the workings and interactions of financial institutions that interact
in both the local and international markets. In the Nigerian context, the financial
manager must get familiar with the functions of institutions like:
 Central Bank of Nigeria (CBN),

 Nigeria Deposit Insurance Corporation (NDIC),
 Bank of Industry (BOI),
 Nigeria Agricultural Co-operative & Rural Development Bank (NACORDB),
 Nigeria Export-Import Bank (NEXIM),
 Commercial Banks,
 Merchant and Development Banks,
 Mortgage banks,
 Finance houses,
 Insurance companies,
 Pension funds, Micro finance institutions, etc.
At the international market environment however, the financial manager should

be acquainted with the workings of agencies like the World Bank, International
Monetary Fund, the London Club, the Paris Club, African Development Bank
(ADB), African Export-Import Bank (AFREXIM), etc.
Financial Statements and Ratio Analysis
Financial statements are records that outline the financial activities of companies,
organizations and/or any other body. They usually present financial information of
those bodies in a clear and concise manner for their internal uses and for the
regulatory authorities and/or the general public. For the purpose of business entities,
financial statements normally include: balance sheet, income statements, cash
flows, and statements of retained earnings, among others.
Uses of Financial Statements:
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Financial Statements are used in a variety of ways. They are important
documents which provide useful information to a wide range of users as listed
below:
1. Managers require Financial Statements to manage the affairs of the company

by assessing its financial performance and position and taking important
business decisions.
2. Shareholders use Financial Statements to assess the risk and return of their
investment in the company and take investment decisions based on their
analysis.
3. Prospective Investors need Financial Statements to assess the viability of

investing in a company. Investors may predict future dividends based on the
profits disclosed in the Financial Statements. Furthermore, risks associated with
the investment may be gauged from the Financial Statements. For instance,
fluctuating profits indicate higher risk. Therefore, Financial Statements provide
a basis for the investment decisions of potential investors.
4. Financial Institutions (e.g. banks) use Financial Statements to decide whether

to grant a loan or credit to a business. Financial institutions assess the financial
health of a business to determine the probability of a bad loan. Any decision to
lend must be supported by a sufficient asset base and liquidity.
5. Suppliers need Financial Statements to assess the credit worthiness of a

business and ascertain whether to supply goods on credit. Suppliers need to
know if they will be repaid. Terms of credit are set according to the assessment
of their customers' financial health.
6. Customers use Financial Statements to assess whether a supplier has the

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resources to ensure the steady supply of goods in the future. This is especially
vital where a customer is dependent on a supplier for a specialized component.
7. Employees use Financial Statements for assessing the company's profitability

and its consequence on their future remuneration and job security.
8. Competitors compare their performance with rival companies to learn and

develop strategies to improve their competitiveness.
General Public may be interested in the effects of a company on the economy,
environment and the local community.
9. Governments require Financial Statements to determine the correctness of tax

declared in the tax returns. Government also keeps track of economic progress
through analysis of Financial Statements of businesses from different sectors of
the economy.
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Financial ratios
Financial Ratios are numerical relationship that relates two or more accounting
numbers as stated in the business financial statements. Financial ratios analysis is
used in evaluating the business’ financial conditions and performances to determine
its financial health or otherwise. Ratios are useful indicators of the financial strength
of business organisations and are used in making comparison among businesses or
make a prediction of their future performance. The process of calculating the
various financial ratios and interpreting same for managerial decision making is
called Ratio Analysis.
Relevance of Ratio analysis in Financial Planning

Ratio analysis is an important tool used in analyzing the financial performance of a
business. The following are some of the relevance of ratio analysis:
1. Analyzing Financial Statements
Ratio analysis is an important technique of financial statement analysis.
Financial ratios are useful for understanding the financial position of the
company. Different groups such as Investors, Management. Bankers and
Creditors use ratios to analyze the financial situation of the company for their
decision making purpose.
2. Used in Judging Efficiency of the business

Financial ratios are important tools for judging the efficiency of the company in
terms of its operations and management. They help in the assessment of how
well the company has utilized its resources.
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3. Ability to point a Weakness
Financial ratios can also be used in identifying the weakness attributable to
company's operations even though its overall performance may be quite good.
Management can then pay attention to the weakness areas and
take remedial measures to overcome them.
4. Assist in Formulation of Plans

Although accounting ratios are used to analyze the company's past financial
performance, they can also be used to estimate future financial performance. As
a result, they help formulate the company's future plans.
5. Comparison of Performance
It is important for a company to know how well it is performing over the years in
relation to other firms of similar nature. Also, it is also important to know how
well its different divisions are performing among themselves over the years.
Ratio analysis facilitates such comparison.
Types of Financial Ratios

Financial ratios are broadly categorised into balance sheet ratios, income
statement ratios as well as balance sheet/Income statement ratios. Another way to
classify ratios is to group them into Liquidity or Short- term solvency ratios,
Gearing or Long-term solvency ratios, Profitability and Efficiency Ratios, and
lastly the Growth Ratios: Below are some of the commonly encountered financial
ratios and the method of calculating each:
Short-Term Solvency and Liquidity:

The ratios which measure this include:
(i) Current ratio.
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(ii)Liquidity/Quick/Acid test ratio.
(iii) Stock Turnover.
(iv) Debtors Turnover.
(v) Debtors average collection period.
(vi) Creditors Turnover.
(vii) Creditors Average payment period.
Current ratio = Current Assets / Current Liabilities
Indicates the ability of a business to meet its short-term liabilities as they fall due, out of its short-term assets.
Liquidity/Quick Acid test ratio = Current Asset – Stock / Current Liabilities
Extent to which current liabilities are covered by immediately realizable assets.
Stock Turnover = Cost of Sales /Average Stock
Indicates the velocity in number of times per period at which the average figure of trading stock is being
"turned over" i.e sold.
Debtors Turnover = Credit Sales / Debtors
The number of times debts are "turned over"

The higher the turnover ratio, the better the liquidity of the company.
Average Collection period = Debtors / Credit Sales
How long it takes debtors to pay up

Helps to ascertain how the debtors are paying up.
Creditors Turnover = Credit Purchases / Creditors
Indicates the average period for which it takes debtors to pay up.
Creditors Average payment period = Creditors / Credit Purchases
Indicates the average period for which creditors remain unpaid.

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Long -Term Solvency and Stability:
Applicable ratios are:-
(i) Long-term debt to share holders’ fund.
(ii) Total debt to share holders' fund
(iii) Gearing ratios
(iv) Proprietary' ratios.
(v) Fixed interest cover
(vi) Fixed dividend cover
Long-term debt to shareholders fund = Long term debt / Shareholders fund (SHF)
If it is high, investment is risky.

It shows a great dependency on borrowed funds.
Total debt to shareholders fund = Total Debt / Shareholders' funds
If it is high, investment is risky.

It shows a great dependency on borrowed funds.
Gearing ratios = Fixed Interest / Capital Equity + Reserves
OR '
Fixed Interest Capital / Equity + Fixed Interest Capital
If it is above 50%, it is high; If it is below 50%, it is low
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Proprietary ratios = Tangible Assets / Shareholders fund
Shareholders fund / Tangible Assets
It shows exposure in terms of liabilities a company has. The higher the percentage the better
for the creditors while the lower the percentage the riskier for the creditors.
Fixed interest cover = Profit Before Interest and Tax / Fixed Interest
The higher the fixed interest cover the greater the confidence of shareholders.
Fixed dividend cover = Profit After Tax / Dividend Payable
The higher the dividend cover the greater the confidence to investors.
Efficiency And Profitability:

Net Profit to Sales

Gross Profit to Sales
Return On Capital Employed (ROCE)
Assets Turnover'
Expenses to Sales"
Stock Holding period
Net Profit Margin = (Net Profit / Sales) x 100
Gross Profit to Sales = (Gross Profit / Sales) x 100
Return on Capital Employed (ROCE) = Net Profit / Capital Employed x 100
Assets turnover = Sales / Capital Employed
Expenses to Sales = (Expenses / Sales) x 100
Stock Holding period = (Average Stock / Cost of Sales) x 365
To determine the number of days, say 1 month or 1 week of holding stock.
Potential and Growth:

Dividend per share = Dividend Payable / Number of Issued Ordinary Shares
Dividend cover = Profit After Tax / Dividend Payable
Show percentage of earning being retained to enhance expansion.
Earnings per share = Profit After Tax - Preference Dividends / Number of Issued Ordinary Shares
Earnings Yield = (Earnings per Share / Market Value) x 100
Dividend Yield = (Dividend Per Share / Market Value) x 100
Price Earnings ratio = Market Value / Earnings per Share
Limitations of Ratio Analysis

Although ratio analysis is useful in financial management, there are limitations to
its use, some of which are listed below:
1. Many large companies actually operate a number of different divisions in
quite different industries making it difficult to develop a meaningful
set of industry averages for comparison purposes.
2. Even for those companies operating in one industry it is difficult to
decide on a proper basis for comparison. Ratios of a company have
meaning only when they are compared with some standards.
3. The interpretation and comparison of ratios are also rendered invalid by
the changing value of money. The accounting figures presented in the
statements are expressed in monetary units which are assumed to be
constant. In fact prices change over the years and as a result, assets
acquired at different dates will be expressed at different Naira in the
balance sheet. This makes comparison meaningless.
4. The differences in definitions of items in the balance sheet and Income
Statements make the interpretation of ratios difficult. In practice,
differences exist as to the meaning of certain terms cg. Capital
Employed.
5. The ratios calculated at a point in time are less informative and effective
as they suffer
Cash Flow and Financial Planning
Cash flow is an expense or a revenue stream that varies a cash account over
certain period of time. Cash inflows usually occur from operations financing or
investment activities. It might also occur as a result of donations in cash. Cash
outflows on the other hand happen as a result of expenses and/or investment.
The Statement of Cash flow is therefore a concise summary of the firm's cash
flow over a given period of time.
The key characteristics of Cash flow Statement are:

 It gives a summary of cash inflows and outflows of cash during a
particular period
 It links the balances in the balance sheet at the beginning of the period and
end of the period after considering the result of the income statement. The
ending balance of a given period becomes the opening balance of another
period.
 The net increase or decrease in cash and marketable securities should be
equivalent to the difference between the cash and marketable securities
on the balance sheet at the beginning of the year and end of the year.
• As opposed to accounting profits, business organisations often focus

attention on both operating cash flow, which is used in managerial
decision making, and free cash flow which is closely monitored by
financial managers as evidence of the ability to meet financial
obligations.
2.1 Financial planning:

• Financial planning is a key tool used by businesses that serves as a road
map for coordinating, guiding and controlling their activities in achieving
their financial goals and objectives. It certainly involves cash budgeting,
profit planning, pro forma statements as well as financial plans, which
can be short term, medium term and long term financial plans. Two key
aspects of financial planning are cash planning and profit planning.
Cash planning simply involves the preparation of the firm’s cash budget,
while Profit planning involves the preparation of both cash budgets and
pro forma financial statements.
The Financial Planning Process

The steps or procedures involved in the financial planning process of a business
enterprise are outlined below:
Long-term strategic financial plans lay out a company’s planned financial actions
and the anticipated impact of those actions over periods ranging from 2 to 10 years.
Long-term financial plans consider a number of financial activities including:
Proposed fixed asset investments; Research and development activities; Marketing and
product development; Capital structure; Sources of financing. These plans are generally
supported by a series of annual budgets and profit plans.
Short-term (operating) financial plans specify short-term financial actions and

the anticipated impact of those actions and typically cover a one to two year
operating period.
Short-term financial planning begins with a sales forecast. From this sales forecast,
production plans are developed that consider lead times and raw material requirements.
From the production plans, direct labor, factory overhead, and operating expense
estimates are developed. From this information, the pro forma income statement
and cash budget are prepared—ultimately leading to the development of the pro
forma balance sheet.
The cash budget or cash forecast is a statement of the firm’s planned inflows and
outflows of cash. It is used to estimate short-term cash requirements with particular attention to
anticipated cash surpluses and shortfalls; Surpluses must be invested and deficits must be
funded; The cash budget is a useful tool for determining the timing of cash inflows and outflows
during a given period; Typically, monthly budgets are developed covering a 1-year time period;
The cash budget begins with a sales forecast, which is simply a prediction of the sales activity
during a given period.
A prerequisite to the sales forecast is a forecast for the economy, the industry, the
company and other external and internal factors that might influence company
sales. The sales forecast is then used as a basis for estimating the monthly cash
inflows that will result from projected sales—and outflows related to production,
overhead and other expenses.
Time value of money is all about the assumption that it is better to receive money
sooner than later. The proponent of this idea believe that money received sooner can
be invested to generative positive value, that is, rate of return and produce more
money later. It is all about understanding the relationship between present and
future value of money. Put differently, time value of money simply explains that,
individual investors generally prefer the possession of a given amount of money
now instead of having the same amount of money at a future date. Three reasons
may be attributed to this which is Risk, Consumption and
Investment.
Annuity due is a series of fixed receipts or payments starting at the beginning

of each period for a specific number of periods.
Interest Rates and Bond Valuation:
Interest rate is a value charged by lenders as compensation for the loss of the asset’s use. But in the case of
money lent, it is a value gained by the lender of such money to others as against what he ought to have earned
himself if he were to invest the funds instead of lending them out. In other words the allocation of funds in an
economy happens primarily on the basis of price, expressed in terms of expected return. It is compensation that
a supplier of funds expects and a user of funds must pay in return. Interest rates are normally applied to debt
instruments such as bonds and bank loan facilities. Bonds are debt obligations with long-term maturities issued
by governments and large corporations. They are securities that pay a stated amount of interest to the investor,
period after period, until it is finally retired by the issuer. Bond valuation is can be compared to the valuation of
capital budgeting project, businesses and/or real estate. A bond has some basic features, namely: a face value,
maturity period, fixed interest known as coupon payment and a redemption value. An important thing to note
about a bond is that, its value depends largely on the prevailing rate of interest in the economy. Bonds and
interest rates have an inverse relationship; A rise in interest rate will force the value of the bond to decline,
while a reduction in interest rate has the consequence of making the value of the bond to rise. To demonstrate
the reason behind the inverse relationship, you will need to understand the concept of yield. Bond yield is
simply the amount of return that an investor will realize on a bond. It is important to remember that a bond
yield to maturity is inverse to its price. As the bond's price increases, its yield to maturity falls.
Types of Bonds:
a) Secured/Unsecured Bond: A secured bond is when the bond is secured
on the real asset of the issuer. Unsecured bond on the other hand is when
the bond is issued mainly on the name and fame of the issuer without any
backing for the fall back option of the investor.
b) Perpetual/Redeemable Bonds: Bonds that do not or never mature at all

are called perpetual bonds. The only advantage to the investor is that
perpetual bonds carry high interest rate which makes them attractive to
investors. Redeemable bonds on the other hand are bonds that are
expected to be repaid (redeemed) after a specified period of time. They
are the opposite of perpetual bonds.
c) Fixed Interest Bonds/Floating Interest Bonds: Fixed interest bonds do
carry fixed interest on their face value and investors must be paid the
fixed interest on the bonds regardless of the financial standing of the
issuer. Floating interest bonds on the other hand are bonds issued with the
understanding that interest will not be fixed, and can be up or down
depending on the financial disposition of the issuer or the prevailing
interest rate in the economy.
d) Zero Coupon Bonds: These bonds do not carry or bear interest but are
sold at a discount initially and at maturity, the investor is paid the full
face value of the bond.
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Stock Valuation
There are different methods of stock valuation such as; price-earnings (PE)
method, dividend discount model, free cash flow model, capital asset pricing
model, and arbitrage pricing model. Some of the methods of valuing stocks will
be illustrated below:
Valuation of Shares through Price-earnings (P/E) Ratio:

Price-earnings (P/E) ratio can also be a useful tool for valuing shares of a company.
The P/E ratio describes the relationship between the share price of a company and
its earnings per share, and can be calculated by dividing the share price of the
company by its earnings per share.
Formula:
Price-earnings (P/E) Ratio = Market Price per Share/ Earnings per Share
Earnings per Share = Net Profit / Number of Shares
III. Valuation of Stock through Dividend discounting method:

The valuation of ordinary or equity shares can also be done on the basis of
dividend discounting. To do this, we need to consider whether the shares are
held by the investor for one single period or a multiple period.
a) Single Period Valuation:
In the single period valuation, the investor is assumed to buy shares and hold
same for a single period of one year, and will sell the share at the end of the first
year. During this period, the investor will receive dividend for one year (D1),
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and can also sell the shares at the end of the year possibly at a price (P1). In this
respect, the value of that share can be determined as follows:
P0 = D1 / (1 + r) + P1 / (1 + r)
Where P0 = Present value of the Stock

P1 = End Period Price
D1 = Dividend one period
r = Required Rate of Return
IV. Constant Growth Rate of Dividend:

Where the dividend on the share of a company is expected to grow at a constant
rate into an indefinite future, the value of the share of such company can be
determined by the following formula:
P0 = D1 / ( r – g)
Where D1 = Dividend
r = rate of return
g = Growth rate
2.0 Valuation of Preference shares:

Preference shares can be issued with maturity or without maturity period. The
holders of preference shares receive fixed interest income on their investments
and also have priority of claim over equity stock holders.
For preference shares with maturity period, the value of the shares is determined
by the following formula:
Pf0 = PD1 + PD2 + PD3 + PD4......+ PDn+ Pfn

(1+r)1 (1+r)2 (1+r)3 (1+r)4 ( 1+ r )n
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The above can be reduced to:
Where:
Pf0 = Present Value of Preferred Stock
PDi = Preferred Dividend at any one period
Pfn = Price of Preferred Stock at maturity
r = Required Rate of Return
n = Number of periods
Risk and Return

Return is an income received on an investment and any change in market price,
usually stated as a percentage of the beginning market price of the investment. In
other words, it is a reward from holding an investment for some period-say, a year.
Risk is a measure of the uncertainty surrounding the return that an investment will
earn. Investments whose returns are more uncertain are generally considered as
being riskier. In other words, risks on investment are referred to as the variability
of returns associated with a given asset.
The Risk-averse financial mangers (those afraid of risks) tend to invest
in less risky stocks while the Risk-seekers or lovers invest in highly risky
securities because of their desire for higher returns. This explains why some
investors speculate on higher risks ventures, but the rational investor will always
try to determine the level of risk associated with a given investment before he
commits his funds into it.
2.0 Risk-Return Trade-off

Investment decisions involve varying degree of risk. If an Investor makes an
investment in government securities, the risk of the investment is minimal
because the likelihood of default on the investment might not be there.
However, the rate of return (interest) on such securities will be smaller due to
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the low level of risks involved. Generally, we can expect lower returns and
lower risks on government securities, and higher returns with higher risks on the
shares of private companies.
Risk and Return move in the same direction (direct relationship).The greater the
risk, the greater the return. The relationship between risk and return can be
expressed in the following equation:
Return = Risk free rate + Risk Premium.
Risk-free rate is the rate applicable to government securities, while the Risk
premium is the additional risk over and above the risk-free rate which is added to
the risk-free rate to get the expected return. Therefore, in government securities,
return = risk free rate, while in other investments, Return = Risk free rate + Risk
Systematic and Unsystematic Risks:

Risks can be grouped into two component parts, systematic and unsystematic risks
Systematic Risks: These are risks caused by factors external to the business, and
therefore cannot be controlled by the business or the investor. These risks affect the
entire market and neither the company nor the investor can prevent their occurrence.
Systematic risks can be sub- divided into;
Market Risk: This is a risk that arises due to changes in the market behaviour of
the capital. The market may experience a decline in the prices of stocks due to
factors such as unstable political climate, government policy changes, war, economic
meltdown, religious and other ethnic crises.
Interest Rate Risk: The rise or fall in interest rates affects the availability of funds
in the hand of the investors, especially the Speculators. If the cost of borrowing is
low, people will borrow money from the banks to invest in stocks with the
expectation of making higher returns. High cost of borrowing on the other hand
implies low money in the hand of investors for stock purchases.
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Purchasing Power Risk: Generally, inflation in the economy leads to reduction in
purchasing power of consumers, and variations in the expected returns from
investments are caused by loss in purchasing power. The increase in the cost of raw
materials, labour and equipment will lead to increase in the cost of production and
hence, increase in the prices of goods and services.
Unsystematic Risks: These are risks which are unique and peculiar to the business,
and can therefore be controlled by the business. Unsystematic risks can arise due to
managerial inefficiency, poor machinery, liquidity (finance) problem, disruption in
the production system, labour problems, unavailability of raw materials, change
in consumer preference, etc. Unsystematic risk can be broadly classified into:
Business Risk: an aspect of the unsystematic risks which is caused by the business
operating environment.
Financial Risk: an aspect of the unsystematic risk caused by the variability of
income due to capital structure of the company. The capital structure of the
company consists of equity and borrowed funds. The presence of debt funds in the
capital structure of the company can affect the payments of dividend to be made to
equity holders.
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STOP
2.0 Cost of Capital

This is the cost of funds used in financing a business. Depending on the mode of
financing used, it might be referred to as cost-of-equity if it is financed solely
through equity or cost-of-debt if it is financed solely through debt. But the true
life situation is that most companies are financed through the combination of
debt and equity and for those companies, their cost of capital is derived from a
weighted average of all capital sources, normally called the ‘weighted average
cost of capital’ (WACC). In other words, cost of capital represents the
24
company’s cost of financing and its minimum rate of return that a project must
earn to increase company value.
It should be noted that the cost of various capital sources varies from one
company to the other and depends on other factors such as profitability, credit
worthiness; operating history of company’s financing policies and so on. All
companies must therefore come up with definite road maps for financing their
businesses at early stages.
ITQ 1: What is cost of capital?
What constitutes the Cost of capital of a firm depends on the mode of financing
used or the Capital structure of the firm. Cost of capital can be the cost of equity
if the business is financed solely through equity, or can be the cost of debt if it is
financed solely through debt. Many companies use a combination of debt and
equity to finance their businesses, and for such companies, their overall cost of
capital is derived from a weighted average of all capital sources, widely known
as the weighted average cost of capital (WACC). The cost of capital thus
becomes a critical factor in deciding which financing track to follow – debt,
equity or a combination of the two. The cost of debt is merely the interest rate
paid by the company on such debt.
ITQ 2: What is weighted average cost of capital?

118
However, since interest expense is tax-deductible, the after-tax cost of
debt is calculated as: Yield to maturity of debt x (1 - t) where t is the company’s
marginal tax rate. The cost of equity is more complicated, since the rate of
return demanded by equity investors is not as clearly defined as can be on debt
financing. Theoretically, the cost of equity is approximated by the Capital Asset
Pricing Model (CAPM) = Risk-free rate + (Company’s Beta x Risk
Premium).
Therefore, the firm’s overall cost of capital is based on the weighted average
costs of the various components of Capital. For example, if we consider debt
and equity as the only components of Capital, with a capital structure
composition of 70% equity and 30% debt; if the cost of equity is 10% and after-
tax cost of debt is 7%. Therefore, its WACC would be (0.7 x 10%) + (0.3 x 7%)
= 9.1%. This is the cost of capital that would be used as discount rate by the
firm.
Generally, companies strive to attain the optimal financing mix, based on the
cost of capital for various funding sources. Debt financing has the advantage of
being more tax-efficient than equity financing, since interest expenses are tax-
deductible.
ITQ 3: What constitutes the Cost of capital of a firm?

119
3.0 Tutored Marked Assignment
4.0 Session Summary:

 Cost of capital is simply the cost of funds used in financing a business.
 If a business is financed solely by equity or debt, then its cost capital can
be regarded as the cost of the equity or the debt.
 In practice, most organisations use a combination of debt and equity to

finance their businesses, and for such firms, their overall cost of capital is
derived from the weighted average of all capital sources, widely known
as the weighted average cost of capital (WACC).
 Business organisations strive to attain the optimal financing mix based

on the cost of capital for various funding sources. Debt financing has the
advantage of being more tax-efficient than equity financing, since interest
expenses are tax-deductible.
5.0 Self-Assessment Questions

1. What role does the cost of capital play in the firm’s long-term investment
decisions? How does it relate to the firm’s ability to maximize
shareholder wealth?
2. What are the typical sources of long-term capital available to the firm?
3. How do the constant-growth valuation and capital asset pricing model
methods for finding the cost of common stock differ?
4. Why is the cost of financing a project with retained earnings less than the
cost of financing it with a new issue of common stock?
5. What is the relationship between the firm’s target capital structure and the
weighted average cost of capital (WACC)?
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6.0 Additional Activities (Videos, Animations & Out of Class activities) e.g.
a. Visit U-tube https://goo.gl/q83aQW . Watch the video & summarise in 1
paragraph
b. View the animation on https://goo.gl/KrWwfP and critique it in the discussion
forum
c. Take a walk and engage any 3 students on ???????????; In 2 paragraphs
summarise their opinion of the discussed topic etc.
ITA 1: Cost of capital is simply the cost of funds used in financing a business.
ITA 2: WACC is the combination of both debt and equity to finance a

company.
ITA 3: The cost of capital of a firm depends on the mode of financing used
or the Capital structure of the firm.
7.0 References
1. Akinsulire, O. (2014). Financial Management, 8th edition. El-Toda
Ventures Ltd, Lagos, Nigeria
2. Danladi, Y. (2013). Introduction to Investment Analysis and Portfolio

Management, Karlmedia Publishers, Kaduna, Nigeria
3. Gitman, J. L. and Zutter, C.J. (2012): Principles of Managerial Finance,
13th edition , The Prentice Hall, Boston USA
4. Madura, Jeff (2010): Financial Institutions and Markets, 9th edition,
South-Western Cengage Learning, United Kingdom
121
5. Von Horne, J.C. and Wachowicz, J.M. Jr.(2010) Fundamentals of Financial
Management, 13th edition , PHI Learning Private Limited, New Delhi
India.
To read more on Cost of Capital, visit:

http://www.investopedia.com/terms/c/costofcapital.asp#ixzz43CBiRsWn
122
STUDY SESSION 2
Capital budgeting and Payout Policy:
Section and Subsection Headings
Introduction
1.0 Learning Outcome
2.0 Main Content
2.1 Capital budgeting and Payout Policy
i Payback Period (PBP)
ii Accounting Rate of Return
iii Net Present Value
iv Internal Rate of Return
v Profitability Index
4.0 Session Summary
5.0 Self-Assessment Question and answers
6.0 Additional Activity (Videos, animation and out of class activities)
7.0 References
Introduction:
In this session, the Capital budgeting process is explained. You will understand
that it is a process by which a business enterprise determines how capital
projects such as building a new plant or investing in long term plant and
123
equipment are being worthy of undertaken. The procedure and techniques of
Capital budgeting are also explained.
1.0 Learning Outcome of Study Session 10
At the end of this session, you should be able to:

1. Understand Capital expenditure profile of the firm and its basic
classifications.
2. Understand Capital budgeting decision process
3. Know the various techniques of Capital budgeting appraisal
4. Understand the rationale for time value of money in Capital budgeting.
5. Understand the criteria for project selection in Capital budgeting.
2.0 Main Content

2.1 Capital budgeting and Payout Policy
Capital budgeting is the process by which a business enterprise determines
how capital projects such as building a new plant or investing in long term plant
and equipment are being worthy of undertaken. The procedure is normally to
estimate the prospective cash inflows and outflows of the project in order to
determine if the cash-inflows generated will be able to meet the expected cash
outlay. There are two popular groups of techniques which are used in
conducting capital budgeting appraisal. The first group is called the Traditional
techniques which comprise of the Payback period (PBP) and Accounting rate
of return (ARR). We should note that traditional techniques do not take into
account the time value of money in analysis.
124
The second group is called the Discounted cash flow techniques which
consists of the Net present value
(NPV), Profitability index (PI) and the Internal rate of return (IRR) as methods
of analysis. They are called Discounted techniques because they take into
account the time value of money in analysis. However, all the different
techniques of Capital budgeting are based on the comparison of cash inflows and
outflow of a project even though they differ substantially in their approach.
ITQ 1: What is capital budgeting? What are the techniques used for conducting
capital budgeting appraisal capital?
A brief description of each of the methods of Capital budgeting is given below:

1. Payback Period (PBP) measures the time in which the initial cash outlay is
repaid or recouped by the project. Cash flows are not discounted. A lower
payback period is preferred to longer payback period.
2. Accounting Rate of Return (ARR) measures the profitability of the project
calculated as projected total net income divided by initial or average investment.
Net income is not discounted. A higher ARR is preferred to a lower ARR.
3. Net Present Value (NPV) is equal to initial cash outflow less the sum of
discounted cash inflows. Higher NPV is preferred to a lower NPV, and an
investment is only viable if its NPV is positive.
125
4. Internal Rate of Return (IRR) is a method used in capital budgeting to
measure the profitability of potential investments. It is the discount rate at
which net present value of the project becomes zero. Higher IRR is referred to
lower IRR.
5. Profitability Index (PI) is the ratio of present value of future cash flows of a
project to initial investment required for the project. A project is most preferred
if its PI is greater than 1. When comparing among projects, the project with
higher PI is accepted.
ITQ 2: What are the methods of capital budgeting appraisal?
4.0 Session Summary

 Capital budgeting is the process by which a business enterprise
determines how capital projects such as building a new plant or
investing in long term plant and equipment are being worthy of
undertaken.
 The procedure is normally to estimate the prospective cash inflows
and outflows of the project in order to determine if the cash-
inflows generated will be able to meet the expected cash outlay
 There are different techniques of Capital budgeting, and all are
based on the comparison of cash inflows and outflow of a project.
 Discounted cash flow techniques such as NPV, IRR and PI take
into account Time value of money in analysis while PBP and
ARR methods do not.
126
1. What is the financial manager’s goal in selecting investment projects for
the firm? Explain the capital budgeting process and explain how it helps
mangers achieve their goal.
2. What weaknesses are commonly associated with the use of the payback
period to evaluate a proposed investment?
3. What are the acceptance criteria for NPV? How are they related to the
firm’s market value?
4. How is a net present value profile used to compare projects? What causes
conflicts in the ranking of projects via net present value and internal rate of
return?
a. Visit U-tube https://goo.gl/ap4oQZ . Watch the video & summarise in 1
paragraph
b. View the animation on https://goo.gl/U6ryCn and critique it in the discussion
forum
ITA 1: Capital budgeting is the process by which a business enterprise

determines how capital projects such as building a new plant or investing in
long term plant and equipment are being worthy of undertaken. The techniques
used for conducting capital budgeting appraisal are: Traditional techniques and
discounted cash flow techniques.
ITA 2: Payback period, Accounting rate of return, Net present value, Internal
rate of return and profitability index.
127
7.0 References
1. Akinsulire, O. (2014). Financial Management, 8th edition. El-Toda
Ventures Ltd, Lagos, Nigeria

3. Gitman, J. L. and Zutter, C.J. (2012): Principles of Managerial Finance,
13th edition , The Prentice Hall, Boston USA
5. Von Horne, J.C. and Wachowicz, J.M. Jr.(2010) Fundamentals of
Financial Management, 13th edition , PHI Learning Private Limited, New
Delhi India.
128
STUDY SESSION 3
Working capital management
Introduction:
1.0 Learning outcome
2.0 Main Content
2.1 Working capital management:
2.2 Types of working capital:
i Gross and Net Working Capital
ii Permanent Working Capital
iii Variable Working Capital
2.3 Objectives of working capital management:
2.4 The working capital cycle:
i Cash
ii Creditors and Debtors:
4.0 Session Summary
7.0 References
Introduction:
In this Study Session, the concept of Working Capital management is

introduced to you with explanations on the components of working capital.
Working capital management simply involves the management of current assets
which include inventories, accounts receivables (debtors), bills payable and
129
cash, and the management of current liabilities which include creditors/accounts
payable, notes payable, accrued expenses, bank loan, etc. The main objective of
working capital management is to ensure adequate cash flow is maintained for
operations, and also to achieve the most effective use of resources by the
business.
1.0 Learning Outcomes:

After studying this session, you should be able to:
1. Understand the principle of Working capital management and its
implications to the business cycle
2. Know the different types of working capital and the characteristics of each
3. Know the management of current assets and current liabilities.
4. Understand the objectives of working capital management
5. Know the firm's operating cycle and how it is financed
2.0 Main Content

2.1 Working capital management:
Working capital management involves an examination into the relationship
between a firm's short-term assets and its short-term liabilities. The goal of
working capital management is to ensure that a firm is able to carry out its
operations and be able to satisfy both maturing short-term obligations and future
operating expenses. In this regard, the management of working capital shall
involve the management of current assets which include inventories, accounts
receivables (debtors), bills payable and cash. The management of the current
assets is matched against the management of current liabilities which include
creditors/accounts payable, notes payable, accrued expenses, bank loan, etc.
130
There are factors internal and external to the businesses that affect Working
Capital needs of the firm.
The internal factors include:

a. Company size and growth rates
b. Organisational structure
c. Sophistication of working capital management
d. Borrowing and investing positions/activities/capacities,
The external factors include:

a. Banking services
b. Interest rates
c. New technologies and new products
d. The economy
e. Competitors
ITQ 1: What is working capital management?
131
2.2 Types of Working Capital:
Working capital, as mentioned above, can take different forms as follows:
i. Gross and Net Working Capital: The total of current assets is known as
gross working capital whereas the difference between the current assets
and current liabilities is known as the net working capital.
ii. Permanent Working Capital: This type of working capital is the
minimum amount of working capital that must always remain invested. In
all cases, some amount of cash, stock and/or account receivables are
always locked in. These assets are necessary for the firm to carry out its
day to day business.
iii. Variable Working Capital: This is a Working capital requirements of a
business firm that might increase or decrease from time to time due to
various factors. Such variable funds are drawn from short-term sources
and are referred to as variable working capital.
2.3 Objectives of Working Capital Management:

The main objectives of working capital management are:
i. Maintaining the working capital operating cycle and to ensure its
smooth operation. Maintaining the smooth operation of the operating
cycle is essential for the business to function. The operating cycle here
refers to the entire life cycle of a business. From the acquisition of the
raw material to the smooth production and delivery of the end products –
working capital management strives to ensure smoothness, and it is one
of the main objectives of the concept.
ii. Minimising cost of capital: Minimising the cost of capital is another
very important objective that working capital management strives to
achieve. The cost of capital is the capital that is spent on maintaining the
working capital. It needs to be ensured that the costs involved for
132
maintenance of healthy working capital are carefully monitored,
negotiated and managed.
iii. Maximising return on investment in

current assets: Maximising the return
on current investments is another
objective of working capital
management. The ROI on currently invested assets should be greater than
the weighted average cost of the capital so that wealth maximisation is
ensured.
ITQ 2: What are the types of working capital?
2.4 The Working Capital Cycle:

The working capital cycle refers to the minimum amount of time which is
required to convert net current assets and net current liabilities into cash. From a
simple viewpoint, working capital cycle is the amount of time between the
payment for goods supplied and the final receipt of cash accumulated from the
sale of the same goods.
ITQ 3: What are the objectives of working capital cycle?
133
There are mainly the following elements of which the working capital cycle is
comprised of:
1. Cash: The cash refers to the funds available for the purchase of goods.
Maintaining a healthy level of liquidity with some buffer is always a best
practice. It is extremely important to maintain a reserve fund which can be
utilized when:
-There is a shortage of cash inflow for some reason. In the absence of reserve
cash, the day to day business will get hampered.
-Some new opportunities can spring up. In such a case, the absence of reserve
cash will pose a hindrance.
-In case of any contingency, absence of a reserve fund can cripple the
company and pose a threat to the solvency of the firm.
2. Creditors and Debtors:

The creditors refer to the accounts payable. It refers to the amount that has to be
paid to suppliers for the purchase of goods and /or services.
Debtors refer to the accounts receivables. It refers to the amount that is
collected for providing goods and/or services.
Inventory: Inventory refers to the stock at hand. Inventories are integral
component of working capital and careful planning, and proper investment is
necessary to maintain the inventory in a healthy state of affairs. Management of
inventory has two aspects and involves a trade-off between cost and risk factors.
Maintaining a sizable inventory has its accompanying costs that include locking
of funds, increased maintenance and documentation cost and increased cost of
storage. Apart from these, there is also a chance of damage to the stored goods.
On the other hand, maintaining a small inventory can disrupt the business life
cycle and can have serious impacts on the delivery schedule. As a result, it is
extremely important to maintain the inventory at optimum levels which can be
134
arrived at after careful analysis and proper implementation of inventory control
techniques.
Short-Term Financial Decisions

These decisions are normally guided by financial management principles for
short term periods say for days, weeks, and months instead of years. It
fundamentally revolves around working capital and current assets management
on the one hand while on the other hand it touches on current liabilities
management.
This area deals with cash conversion cycle, its funding requirements and the key
strategies of managing it. Others are credit selection process and the quantitative
procedure for evaluating changes in credit standards as well as management of
receipts and disbursements.
Long-Term Financial Decisions

These are financial decisions for long-term bases as against those of the short-
term bases, with their major emphasis on leverage and capital structure on the
one hand and on the other dealing with payout policy.
The area deals with leverage, capital structure, breakeven analysis, the operating
breakeven point and the effect of changing costs on the breakeven point. It also
focuses on the review of the return and risk of alternative capital structures.
The term payout policy means the decision that companies make about whether
to distribute cash to shareholders, how much cash to distribute, and by what
means it should be distributed. This revolves around, factors involved in
establishing a dividend policy, cash payout procedures, their tax treatments, role
135
of dividend reinvestment plans as well as the residual theory of dividends and
the key arguments with regard to dividend irrelevance and relevance.
Long-Term Investment Decisions

This is a process for evaluating and selecting investment projects. That is, the
managers’ role in deciding which investment opportunities to pursue. Long-
term investment decisions focus on capital budgeting techniques, capital
budgeting cash flows as well as risk and refinements in capital budgeting.
It involves calculations, interpretations and evaluations of Net Present Value

(NPV), Internal Rate of Return (IRR) and Economic Value Added (EVA).
Other areas covered are terminal cash flows, international capital budgeting,
Risk-Adjusted Discount Rates (RADRs) and Annualized Net Present Values
(ANPVs).
4.0 Session Summary:

 Working capital management simply involves the management of current
assets which include inventories, accounts receivables (debtors), bills
payable and cash, and the management of current liabilities which include
136
creditors/accounts payable, notes payable, accrued expenses, bank loan,
etc.
 The goal of working capital management is to ensure that a firm is able to
carry out its operations and be able to satisfy both maturing short-term
obligations and future operating expenses.
 There are factors internal and external to the business that affect Working
Capital needs of the firm.
 Working capital can take different forms, such as, Gross and Net
Working Capital, Permanent Working Capital and Variable Working
Capital.
 The working capital cycle refers to the minimum amount of time which is
required to convert net current assets and net current liabilities into cash.

1. Why is working capital management one of the most important and time-
consuming activities of the financial manager? What is significance of net
working capital to the firm?
2. Why does an increase in the ratio of current assets to total assets decrease
both profit and risk as measured by net working capital? How do changes
in the ratio of current liabilities to total assets affect profitability and risk?
3. Describe and compare the basic features of the following methods of
using account receivables to obtain short-term financing:
a) Pledging account receivable, and
b) Factoring account receivable.
4. Examine the basic features of commercial paper and the key aspects of
international short-term loans.
137
5. What is the important difference between international and domestic
transactions? How LC is used in financing international trade
transactions?
a. Visit U-tube https://goo.gl/xXEBT1 . Watch the video & summarise in 1
paragraph
b. View the animation on https://goo.gl/dytdYb and critique it in the discussion
forum
ITA 1: Working capital management involves an examination into the

relationship between a firm's short-term assets and its short-term liabilities.
ITA 2: Gross and networking capital, permanent working capital and variable
working capital.
ITA 3: Maintaining the worth capital operation cycle, Minimising cost of

capital, Maximising return on investment.
7.0 References
1. Akinsulire, O. (2014). Financial Management, 8th edition. El-Toda Ventures
Ltd, Lagos, Nigeria

138
3. Gitman, J. L. and Zutter, C.J. (2012): Principles of Managerial Finance, 13th
edition , The Prentice Hall, Boston USA
4. Madura, Jeff (2010): Financial Institutions and Markets, 9th edition, South-
Western Cengage Learning, United Kingdom
Management, 13th edition , PHI Learning Private Limited, New Delhi India.
For further reading on working capital management visit:

http://www.cleverism.com/working-capital-management-everything-need-
know/
139
STUDY SESSION 4
Mergers, LBOs, Divestures and Business failures

Introduction
1.0 Learning Outcome
2.0 Main Content

2.1 Special Topics in Managerial Finance
2.2 Mergers, LBOs, Divestures and Business failures:
4.0 Session Summary
7.0 References
Introduction:
In this study session, you are going to learn some special topics in financial
management such as Mergers and acquisitions, Divestures, Leverage buy out
(LBO) and Business failure. Mergers and acquisitions (M&A) are common
terms used to refer to the consolidation of companies. A merger is a
combination of two companies to form a new company, while an acquisition is
the purchase of one company by another in which no new company is formed.
Divesture simply means a reduction of some kind in the assets of a company or
140
the outright sale of an existing line of business of a company for the purpose of
raising cash to fund other operations. The session also explains Leveraged
buyout and Business failure.
1.0 Learning Outcome of Study Session 4

After studying this session, you should be able to:
1. Appreciate the meaning and reasons why Mergers and acquisitions by
businesses
2. Understand the method of Combination as opposed to mergers and
acquisitions.
3. Understand Divesture, its technicalities and the reasons for Divestures in
business
4. Know what leverage buy out is and the various types of LBOs
5. Understand Business failures, types and causes.
2.0 Main Content

2.1 Special Topics in Managerial Finance
These are topics that require special attention in managerial finance as
businesses are becoming more complex and more global in nature than they
were as such making managerial finance more challenging than ever before.
These topics focus on hybrid and derivative securities, mergers, leverage

buyouts (LBOs) and other forms of business combinations, divestures and
business failures. Other areas of focus are in international managerial finance
141
such as: financial operations of multinational companies (MNCs) and their
capital structures, international environment of managerial finance, international
cash, credit, and inventory management as well as recent trends in international
mergers and joint venture.
2.2 Mergers, LBOs, Divestures and Business failures:

Mergers and acquisitions (M&A) is a common term used to refer to the
consolidation of companies. A merger is a combination of two companies to
form a new company, while an acquisition is the purchase of one company by
another in which no new company is formed. Divestures on the other hand is
defined as a reduction of some kind in the assets of a company or outright sale of
an existing line of business of a company for the purpose of raising cash to fund
other operations. A leveraged buyout (LBO) is the acquisition of another
company using borrowed funds so as to meet the cost of such acquisition. In
most LBO cases, the assets of the company being acquired are used as collateral
for the loan obtained. Business failure is the closure of business activity by a
firm due to inability to meet creditors’ obligations. It is a situation where a
company stops operation as a result of liquidity problems. There are two types of
business failure, technical failure and operational failure. A technical failure
arises when a company is unable to meet its maturing obligations, while
operational failure exists when the liabilities of the company exceed its assets.
142
4.0 Session Summary

 Mergers and acquisitions are common terms used to refer to the
consolidation of two companies to form a new company,
 Acquisition is the purchase of one company by another in which no new

company is formed.
 Divesture is a reduction in the assets of a company or the outright sale of

an existing line of business of a company for the purpose of raising cash
to fund other operations.
 Leverage buy out (LBO) is the acquisition of another company using

borrowed funds so as to meet the cost of such acquisition.
 Business failure is the closure of business activity by a firm due to

inability to meet creditors’ obligations.

1. What is the general relationship among operating leverage, financial
leverage, and total leverage of the firm? Do these types of leverage
complement one another? Why or Why not?
2. What is firm’s capital structure? What ratios assess the degree of
financial leverage in a firm’s capital structure?
3. What are business risk and financial risk? How does each of them
influence the firm’s capital structure decisions?
4. Discuss the agency problems that exist between owners and lenders. How
do lenders cause firms to incur agency costs to resolve this problem?
143
5. How does the cost of debt, cost of equity, and the weighted average cost
of capital (WACC) behave as the firm’s financial leverage increases from
zero? Where is the optimal capital structure? What is its relationship to
the firm’s value at that point?
a. Visit U-tube https://goo.gl/Tch4hY . Watch the video & summarise in 1
paragraph
b. View the animation on add/site??????? and critique it in the discussion forum
7.0 References
Ltd, Lagos, Nigeria

144
STUDY SESSION 5
International Managerial finance
Introduction
1.0 Learning outcome
2.0 Main Content
2.1 The Multi National Company and its Environment
2.2 Why Firms Pursue International Business
i Theory of Comparative Advantage
ii Imperfect Market Theory
iii Product Cycle Theory

4.0 Session Summary
7.0 References
Introduction
We are going to briefly discuss international managerial finance in this study
session.
1.0 Learning outcome of study session 13
At the end of this study session, you should be able to:
1. Understand the multinational company and its environment.
2. Know the reasons why companies pursue international business.
145
2.0 Main Content
2.1 The Multi National Company and its Environment
In recent years, as world markets have become significantly more
interdependent international finance has become an increasingly important
element in the management of multinational companies (MNCs). These firms,
based anywhere in the world, have international assets and operations in foreign
markets and draw part of their total revenue and profits from such markets. The
principles of managerial finance are applicable to the management of MNCs.
However, certain factors unique to the international setting tend to complicate
the financial management of multinational companies. A simple comparison
between a domestic U.S. firm (firm A) and a U.S.-based MNC (firm B),
indicates the influence of some of the international factors on MNCs’ operations.
In the present international environment, multinationals face a variety of laws
and restrictions when operating in different nation-states. The legal and economic
complexities existing in this environment are significantly different from those a
domestic firm would face. However, the newly emerging trading blocs are in
North America, western Europe, and South America; GATT and the WTO; legal
forms of business organization; taxation of MNCs; and financial markets.
ITQ 1: What are the challenges faced by multi nationals in the international
environment?
2.2 Why Firms Pursue International Business

The commonly held theories as to why firms become motivated to expand their
business internationally are (1) the theory of comparative advantage, (2) the
imperfect markets theory, and (3) the product cycle theory. The three theories
overlap to a degree and can complement each other in developing a rationale for
the evolution of international business.
146
Theory of Comparative Advantage
Multinational business has generally increased over time. Part of this growth is
due to the heightened realization that specialisation by countries can increase
production efficiency. Some countries, such as Japan and the United States,
have a technology advantage, while other countries, such as Jamaica, Mexico,
and South Korea, have an advantage in the cost of basic labour. Since these
advantages cannot be easily transported, countries tend to use their advantages to
specialise in the production of goods that can be produced with relative
efficiency.
This explains why countries such as Japan and the United States are large
producers of computer components while countries such as Jamaica and Mexico
are large producers of agricultural and handmade goods. MNCs such as Oracle,
Intel, and IBM have grown substantially in foreign countries because of their
technology advantage. When a country specialises in some products, it may not
produce other products, so trade between countries is essential. This is the
argument made by the classical theory of comparative advantage.
Comparative advantages allow firms to penetrate foreign markets. Many of the
Virgin Islands, for example, specialize in tourism and rely
completely on international trade for most products. Although these islands
could produce some goods, it is more efficient for them to specialize in tourism.
That is, the islands are better off using some revenues earned from tourism to
import products rather than attempting to produce all the products that they
need.
Imperfect Market Theory

If each country’s markets were closed from all other countries, there would be
no international business. At the other extreme, if markets were perfect, so that
the factors of production (such as labor) were easily transferable, then labor and
other resources would flow wherever they were in demand. The unrestricted
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mobility off actors would create equality in costs and returns and remove the
comparative cost advantage, the rationale for international trade and investment.
However, the real world suffers from imperfect market conditions where factors
of production are somewhat immobile.
There are costs and often restrictions related to the transfer of labor and other
resources used for production. There may also be restrictions on transferring
funds and other resources among countries. Because markets for the various
resources used in production are “imperfect,” MNCs such as the Gap and Nike
often capitalise on a foreign country’s resources. Imperfect markets provide an
incentive for firms to seek out foreign opportunities.
Product Cycle Theory

One of the more popular explanations as to why firms evolve into MNCs is the
product cycle theory. According to this theory, firms become established in the
home market as a result of some perceived advantage over existing competitors,
such as a need by the market for at least one more supplier of the product.
Because information about markets and competition is more readily available at
home, a firm is likely to establish itself first in its home country. Foreign
demand for the firm’s product will initially be accommodated by exporting. As
time passes, the firm may feel the only way to retain its advantage over
competition in foreign countries is to produce the product in foreign markets,
thereby reducing its transportation costs. The competition in the foreign markets
may increase as other producers become more familiar with the firm’s product.
The firm may develop strategies to prolong the foreign demand for its product.
A common approach is to attempt to differentiate the product so that other
competitors cannot offer the same product.
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ITQ 2: What are the commonly held theories as to why firms become motivated to
expand their business internationally?
4.0 Session Summary

This study session was able to briefly discuss the multinational company and its
environment and the reasons why firms pursue international business.

1. When the market price of the stock rises above the conversion price, why
may a convertible security not be converted? How can a call feature be
used to force conversion in this situation?
2. How can a firm use currency options to hedge foreign-currency exposures
resulting from international transactions?
3. What role do investment bankers often play in the merger negotiation
process? What is tender offer? When and how is it used?
4. What are the long-run advantages of having more local debt and less
MNC-based equity in the capital structure of a foreign subsidiary?
5. What are some of the major reasons for the rapid expansion in
international mergers and joint venture firms?
a. Visit U-tube https://goo.gl/JqCzCF . Watch the video & summarise in 1
paragraph
b. View the animation on https://goo.gl/LvEySs and critique it in the discussion
forum
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ITA 1: They face variety of laws and restrictions in different nation state.
ITA 2:(1) the theory of comparative advantage, (2) the imperfect markets
theory, and (3) the product cycle theory.
7.0 References
Ltd, Lagos, Nigeria

150
FURTHER READING
1. Eugene F. Brigham and Michael C. Ehrhardt (Mar 3, 2010): Financial
Management: Theory & Practice. South-Western Cengage, Mason
OH, USA
2. Gitman, J. L. and Zutter, C.J. (2012): Principles of Managerial
Finance, 13th edition , The Prentice Hall, Boston USA
4. Scott Beley and Eugene Brigham (2007): Essentials of Managerial
Finance, 14th edition, South-Western Cengage, Mason OH, USA
5. Scott Beley and Eugene Brigham (2009): Study Guide to accompany
essentials of Managerial Finance. South-Western Cengage, Mason
OH, USA
6. Von Horne, J.C. and Wachowicz, J.M. Jr.(2010) Fundamentals of
Financial Management, 13th edition , PHI Learning Private Limited,
New Delhi India
7. Corporate Valuation and Take overs. Site: bookboon.com/en/corporate-
valuation-takeover-ebook
8. Strategic Financial Management: Exercise. Site:
bookboon.com/en/Strategic-Financial-Management-exercise-ebook
9. Working Capital Management: Theory and Strategy. Site:
bookboon.com/en/working-capital-management-ebook
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GLOSSARY
1. ABC inventory system: Inventory management technique that divides inventory into three
groups—A, B, and C, in descending order of importance and level of monitoring, on the
basis of the dollar investment in each.
2. Ability to service debts: The ability of a firm to make the payments required on a scheduled
basis over the life of a debt.
3. Accept–reject approach: The evaluation of capital expenditure proposals to determine

whether they meet the firm’s minimum acceptance criterion.
4. Accounting exposure: The risk resulting from the effects of changes in foreign exchange
rates on the translated value of a firm’s financial statement accounts denominated in a given
foreign currency.
5. Accounts payable management: Management by the firm of the time that elapses between
its purchase of raw materials and its mailing payment to the supplier.
6. Accrual basis: In preparation of financial statements, recognizes revenue at the time of sale
and recognizes expenses when they are incurred.
7. Accruals: Liabilities for services received for which payment has yet to be made.
8. ACH (automated clearinghouse) transfer: Preauthorized electronic withdrawal from the

payer’s account and deposit into the payee’s account via a settlement among banks by the
automated clearinghouse, or ACH.
9. Acquiring company: The firm in a merger transaction that attempts to acquire another firm.
10. Activity ratios: Measure the speed with which various accounts are converted into sales or
cash—inflows or outflows.
11. After-tax proceeds from sale of old asset: The difference between the old asset’s sale
proceeds and any applicable taxes or tax refunds related to its sale.
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12. Agency costs: Costs arising from agency problems that are borne by shareholders and
represent a loss of shareholder wealth.
13. Annuity due: An annuity for which the cash flow occurs at the beginning of each period.
14. Articles of partnership: The written contract used to formally establish a business
partnership.
15. ASEAN: A large trading bloc that comprises ten member nations, all in Southeast Asia.
China is expected to join this bloc in 2010. Also called the Association of Southeast Asian
Nations.
16. Ask price: The lowest price at which a security is offered for sale.
17. Assignment: A voluntary liquidation procedure by which a firm’s creditors pass the power
to liquidate the firm’s assets to an adjustment bureau, a trade association, or a third party,
which is designated the assignee.
18. Asymmetric information: The situation in which managers of a firm have more
information about operations and future prospects than do investors.
19. Authorized shares: Shares of common stock that a firm’s corporate charter allows it to issue.
20. Average age of inventory: Average number of days’ sales in inventory.
21. Average collection period: The average amount of time needed to collect accounts
receivable.
22. Average payment period: The average amount of time needed to pay accounts payable.
23. Average tax rate: A firm’s taxes divided by its taxable income.
24. Balance sheet: Summary statement of the firm’s financial position at a given point in time.
25. Bankruptcy: Business failure that occurs when the stated value of a firm’s liabilities
exceeds the fair market value of its assets.
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26. Bankruptcy Reform Act of 1978: The governing bankruptcy legislation in the United
States today.
27. Bar chart: The simplest type of probability distribution; shows only a limited number of
outcomes and associated probabilities for a given event.
28. Basic EPS: Earnings per share (EPS) calculated without regard to any contingent securities.
29. Broker market: The securities exchanges on which the two sides of a transaction, the buyer
and seller, are brought together to trade securities.
30. Business ethics: Standards of conduct or moral judgment that apply to persons engaged in
commerce.
31. Call feature: A feature included in nearly all corporate bond issues that gives the issuer the
opportunity to repurchase bonds at a stated call price prior to maturity.
32. Call option: An option to purchase a specified number of shares of a stock (typically 100)
on or before a specified future date at a stated price.
33. Call premium: The amount by which a bond’s call price exceeds its par value.
34. Call price: The stated price at which a bond may be repurchased, by use of a call feature,
prior to maturity.
35. Callable feature (preferred stock): A feature of callable preferred stock that allows the
issuer to retire the shares within a certain period of time and at a specified price.
36. Capital asset pricing model (CAPM): Describes the relationship between the required
return, and the non-diversifiable risk of the firm as measured by the beta coefficient, b.
37. Capital asset pricing model (CAPM): The basic theory that links risk and return for all
assets.
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38. Capital budgeting: The process of evaluating and selecting long-term investments that is
consistent with the firm’s goal of maximizing owners’ wealth.
39. Capital budgeting process: Five distinct but interrelated steps: proposal generation, review
and analysis, decision making, implementation, and follow-up.
40. Capital expenditure: An outlay of funds by the firm that is expected to produce benefits
over a period of time greater than 1 year.
41. Capital gain: The amount by which the sale price of an asset exceeds the asset’s purchase
price.
42. Capital market: A market that enables suppliers and demanders of long-term funds to make
transactions.
43. Capital rationing: The financial situation in which a firm has only a fixed number of
dollars available for capital expenditures, and numerous projects compete for these dollars.
44. Cross-sectional analysis: Comparison of different firms’ financial ratios at the same point
in time; involves comparing the firm’s ratios to those of other firms in its industry or to
industry averages.
45. Cumulative (preferred stock): Preferred stock for which all passed (unpaid) dividends in
arrears, along with the current dividend, must be paid before dividends can be paid to
common stockholders.
46. Current assets: Short-term assets, expected to be converted into cash within 1 year or less.
47. Current liabilities: Short-term liabilities, expected to be paid within 1 year or less.
48. Current rate (translation) method: Technique used by U.S.–based companies to translate
their foreign-currency denominated assets and liabilities into dollars, for consolidation with
the parent company’s financial statements, using the year-end (current) exchange rate.
49. Current ratio: A measure of liquidity calculated by dividing the firm’s current assets by its
current liabilities.
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50. Current yield: A measure of a bond’s cash returns for the year; calculated by dividing the
bond’s annual interest payment by its current price.
51. Date of record (dividends): Set by the firm’s directors, the date on which all persons whose
names are recorded as stockholders receive a declared dividend at a specified future time.
52. Dealer market: The market in which the buyer and seller are not brought together directly
but instead have their orders executed by securities dealers that “make markets” in the given
security.
53. Debentures: A long-term, unsecured debt instrument.

54. Debt: Includes borrowing incurred by a firm, including bonds, and is repaid according to a
fixed schedule of payments.
55. Debtor in possession (DIP): The term for a firm that files a reorganization petition under
Chapter 11 and then develops, if feasible, a reorganization plan.
56. Debt ratio: Measures the proportion of total assets financed by the firm’s creditors.
57. Deflation: A general trend of falling prices.
58. Divestiture: The selling of some of a firm’s assets for various strategic reasons.
59. Dividend irrelevance theory: Miller and Modigliani’s theory that in a perfect world, the
firm’s value is determined solely by the earning power and risk of its assets (investments)
and that the manner in which it splits its earnings stream between dividends and internally
retained (and reinvested) funds does not affect this value.
60. Dividend payout ratio: Indicates the percentage of each dollar earned that a firm distributes
to the owners in the form of cash. It is calculated by dividing the firm’s cash dividend per
share by its earnings per share.
61. Dividend per share (DPS): The dollar amount of cash distributed during the period on
behalf of each outstanding share of common stock.
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62. Dividend policy: The firm’s plan of action to be followed whenever it makes a dividend
decision.
63. Dividend reinvestment plans (DRIPs): Plans that enable stockholders to use dividends
received on the firm’s stock to acquire additional shares—even fractional shares—at little or
no transaction cost.
64. Dividend relevance theory: The theory advanced by Gordon and Lintner, that there is a
direct relationship between a firm’s dividend policy and its market value.
65. Dividends: Periodic distributions of cash to the stockholders of a firm.
66. Double taxation: Situation that occurs when after-tax corporate earnings are distributed as
cash dividends to stockholders, who then must pay personal taxes on the dividend amount.
67. DuPont formula: Multiplies the firm’s net profit margin by its total asset turnover to
calculate the firm’s return on total assets (ROA).
68. DuPont system of analysis: System used to dissect the firm’s financial statements and to
assess its financial condition.
69. Dutch auction repurchase: A repurchase method in which the firm specifies how many
shares it wants to buy back and a range of prices at which it is willing to repurchase shares.
Investors specify how many shares they will sell at each price in the range, and the firm
determines the minimum price required to repurchase its target number of shares. All
investors who tender receive the same price.
70. Earnings per share (EPS): The amount earned during the period on behalf of each
outstanding share of common stock, calculated by dividing the period’s total earnings
available for.
71. Expectations theory: The theory that the yield curve reflects investor expectations about
future interest rates; an expectation of rising interest rates results in an upward-sloping yield
curve, and an expectation of declining rates results in a downward-sloping yield curve.
72. Expected value of a return: The average returns that an investment is expected to produce
over time.
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73. Extendible notes: Short maturities typically 1 to 5 years that can be renewed for a similar
period at the holder.
74. Extension: An arrangement whereby the firm’s creditors receive payment in full, although
not immediately.
75. External financing required (“plug” figure): Under the judgmental approach for
developing a pro forma balance sheet, the amount of external financing needed to bring the
statement into balance. It can be either a positive or a negative value.
76. External forecast: A sales forecast based on the relationships observed between the firm’s
sales and certain key external economic indicators.
77. Extra dividend: An additional dividend optionally paid by the firm when earnings are
higher than normal in a given period.
78. Factor: A financial institution that specializes in purchasing accounts receivable from
businesses.
79. Factoring accounts receivable: The outright sale of accounts receivable at a discount to a
factor or other financial institution.
80. FASB No. 52: Statement issued by the FASB requiring U.S. multinationals first to convert
the financial statement accounts of foreign subsidiaries into the functional currency and then
to translate the accounts into the parent firm’s currency using the all current-rate method.
81. Federal Deposit Insurance Corporation (FDIC): An agency created by the Glass-Steagall
Act that provides insurance for deposits at banks and monitors banks to ensure their safety
and soundness.
82. Finance: The science and art of managing money.
83. Financial Accounting Standards Board (FASB): The accounting profession’s rule-setting
body, which authorizes generally accepted accounting principles (GAAP).
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84. Financial Accounting Standards Board (FASB) Standard No. 52: Mandates that, U.S.–
based companies translate their foreign-currency-denominated assets and liabilities into
dollars, for consolidation with the parent company.
85. Free cash flow (FCF): The amount of cash flow available to investors (creditors and
owners) after the firm has met all operating needs and paid for investments in net fixed
assets and net current assets.
86. Free cash flow valuation model: A model that determines the value of an entire company
as the present value of its expected free cash flows discounted at the firm’s weighted
average cost of capital, which is its expected average future cost of funds over the long run.
87. Friendly merger: A merger transaction endorsed by the target firm’s management,
approved by its stockholders, and easily consummated.
88. Functional currency: The currency in which a subsidiary primarily generates and expends
cash and in which its accounts are maintained.
89. Future value: The value at a given future date of an amount placed on deposit today and
earning interest at a specified rate. Found by applying compound interest over a specified
period of time.
90. General Agreement on Tariffs and Trade (GATT): A treaty that has governed world
trade throughout most of the postwar era; it extends free-trading rules to broad areas of
economic activity and is policed by the World Trade Organization (WTO).
91. Generally accepted accounting principles (GAAP): The practice and procedure guidelines
used to prepare and maintain financial records and reports; authorized by the Financial
Accounting Standards Board (FASB).
92. Glass-Steagall Act: An act of Congress in 1933 that created the federal deposit insurance
program and separated the activities of commercial and investment banks.
93. Golden parachutes: Provisions in the employment contracts of key executives that provide
them with sizable compensation if the firm is taken over; deters hostile takeovers to the
extent that the cash outflows required are large enough to make the takeover unattractive.
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94. Gordon growth model: A common name for the constant-growth model that is widely cited
in dividend valuation.
95. Gramm-Leach-Bliley Act: An act that allows business combinations (that is, mergers)
between commercial banks, investment banks, and insurance companies, and thus permits
these institutions to compete in markets that prior regulation prohibited them from entering.
96. Greenmail: A takeover defense under which a target firm repurchases, through private
negotiation, a large block of stock at a premium from one or more shareholders to end a
hostile takeover attempt by those shareholders.
97. Gross profit margin: Measures the percentage of each sales dollar remaining after the firm
has paid for its goods.
98. Hedging: Offsetting or protecting against the risk of adverse price movements.
99. Hedging strategies: Techniques used to offset or protect against risk; in the international
context, these include borrowing or lending in different currencies; undertaking contracts in
the forward, futures, and/or options markets; and swapping assets/liabilities with other
parties.
100. Historical weights: Either book or market value weights based on actual capital
structure proportions.
101. Holding company: A corporation that has voting control of one or more other
corporations.
102. Horizontal merger: A merger of two firms in the same line of business.
103. Hostile merger: A merger transaction that the target firm’s management does not
support, forcing the acquiring company to try to gain control of the firm by buying shares in
the marketplace.
104. Hybrid security: A form of debt or equity financing that possesses characteristics of
both debt and equity financing.
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105. Implied price of a warrant: The price effectively paid for each warrant attached to
a bond.
106. Incentive plans: Management compensation plans that tie management

compensation to share price; one example involves the granting of stock options.
107. Income bonds: Payment of interest is required only when earning are available.
Usually issued in reorganization of a failing company.
108. Income statement: Provides a financial summary of the firm’s operating results
during a specified period.
109. Incremental cash flows: The additional cash flows—outflows or inflows—

expected to result from a proposed capital expenditure.
110. Independent projects: Projects whose cash flows are unrelated to (or independent
of) one another; the acceptance of one does not eliminate the others from further
consideration.
111. Individual investors: Investors who own relatively small quantities of shares so as
to meet personal investment goals.
112. International bond: A bond that is initially sold outside the country of the borrower
and is often distributed in several countries.
113. International equity market: A market that allows corporations to sell blocks of
shares to investors in a number of different countries simultaneously.
114. International stock market: A market with uniform rules and regulations
governing major stock exchanges. MNCs would benefit greatly from such a market, which
has yet to evolve.
115. Inventory turnover: Measures the activity, or liquidity, of a firm’s inventory.
116. Inverted yield curve: A downward-sloping yield curve indicates that short-term
interest rates are generally higher than long-term interest rates.
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117. Investment banker: Financial intermediary that specializes in selling new security
issues and advising firms with regard to major financial transactions.
118. Investment bankers: Financial intermediaries who, in addition to their role in

selling new security issues, can be hired by acquirers in mergers to find suitable target
companies and assist in negotiations.
119. Investment banks: Institutions that assist companies in raising capital, advise firms
on major transactions such as mergers or financial restructurings, and engage in trading and
market making activities.
120. Investment flows: Cash flows associated with purchase and sale of both fixed assets
and equity investments in other firms.
121. Investment opportunities schedule (IOS): The graph that plots project IRRs in
descending order against the total dollar investment.
122. Involuntary reorganisation: A petition initiated by an outside party, usually a
creditor, for the reorganization and payment of creditors of a failed firm.
123. Issued shares: Shares of common stock that have been put into circulation; the sum
of outstanding shares and treasury stock.
124. Joint venture: A partnership under which the participants have contractually agreed
to contribute specified amounts of money and expertise in exchange for stated proportions of
ownership and profit.
125. Judgmental approach: A simplified approach for preparing the pro forma balance
sheet under which the firm estimates the values of certain balance sheet accounts and uses its
external financing as a balancing, or “plug,” figure.
126. Junk bonds: these are bonds that are rated Ba or lower by Moody’s or BB or lower
by Standard and Poor’s they are commonly used by rapidly growing firms to obtain growth
capital, most often as a way to finance mergers and takeovers.
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127. Just-in-time (JIT) system: Inventory management technique that minimizes
inventory investment by having materials arrive at exactly the time they are needed for
production.
128. Lease-versus-purchase (or lease-versus-buy) decision: The decision facing firms

needing to acquire new fixed assets: whether to lease the assets or to purchase them, using
borrowed funds or available liquid resources.
129. Leasing: The process by which a firm can obtain the use of certain fixed assets for
which it must make a series of contractual, periodic, tax-deductible payments.
130. Lessee: The receiver of the services of the assets under a lease contract.
131. Lessor: The owner of assets that are being leased.
132. Letter of credit: A letter written by a company’s bank to the company’s foreign
supplier, stating that the bank guarantees payment of an invoiced amount if all the
underlying agreements are met.
133. Letter to stockholders: Typically, the first element of the annual stockholders’
report and the primary communication from management.
134. Leverage: Refers to the effects that fixed costs have on the returns that shareholders
earn; higher leverage generally results in higher but more volatile returns.
135. Leveraged buyout (LBO): An acquisition technique involving the use of a large
amount of debt to purchase a firm; an example of a financial merger.
136. Leveraged lease: A lease under which the lessor acts as an equity participant,
supplying only about 20 percent of the cost of the asset, while a lender supplies the balance.
137. Leveraged recapitalization: A takeover defense in which the target firm pays a
large debt-financed cash dividend, increasing the firm’s financial leverage and thereby
deterring the takeover attempt.
138. Lien: A publicly disclosed legal claim on loan collateral.
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139. Limited liability: A legal provision that limits stockholders’ liability for a
corporation’s debt to the amount they initially invested in the firm by purchasing stock.
140. Low-regular-and-extra dividend policy: A dividend policy based on paying a low

regular dividend, supplemented by an additional (“extra”) dividend when earnings are higher
than normal in a given period.
141. Macro political risk: The subjection of all foreign firms to political risk (takeover)
by a host country because of political change, revolution, or the adoption of new policies.
142. Mail float: The time delay between when payment is placed in the mail and when it
is received.
143. Maintenance clauses: Provisions normally included in an operating lease that

require the lessor to maintain the assets and to make insurance and tax payments.
144. Managerial finance: Concerns the duties of the financial manager in a business.
145. Manufacturing resource planning II (MRP II): A sophisticated computerized

system that integrates data from numerous areas such as finance, accounting, marketing,
engineering, and manufacturing and generates production plans as well as numerous
financial and management reports.
146. Marginal cost–benefit analysis: Economic principle that states that financial
decisions should be made and actions taken only when the added benefits exceed the added
costs.
147. Marginal tax rate: The rate at which additional income is taxed.
148. Marketable securities: Short-term debt instruments, such as U.S. Treasury bills,
commercial paper, and negotiable certificates of deposit issued by government, business,
and financial institutions, respectively.
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149. Market/book (M/B) ratio: Provides an assessment of how investors view the firm’s
performance. Firms expected to earn high returns relative to their risk typically sell at higher
M/B multiples.
150. Market makers: Securities dealers who “make markets” by offering to buy or sell
certain securities at stated prices.
151. Market premium: The amount by which the market value exceeds the straight or
conversion value of a convertible security.
152. Market ratios: Relate a firm’s market value, as measured by its current share price,
to certain accounting values.
153. Market return: The return on the market portfolio of all traded securities.
154. Multiple IRRs: More than one IRR resulting from a capital budgeting project with
a nonconventional cash flow pattern; the maximum number of IRRs for a project is equal to
the number of sign changes in its cash flows.
155. Mutually exclusive projects: Projects that compete with one another, so that the
acceptance of one eliminates from further consideration all other projects that serve a similar
function.
156. NASDAQ market: An all-electronic trading platform used to execute securities

trades.
157. National entry control systems: Comprehensive rules, regulations, and incentives
introduced by host governments to regulate inflows of foreign direct investments from
MNCs and at the same time extract more benefits from their presence.
158. Negatively correlated: Describes two series that move in opposite directions.
159. Net cash flow: The mathematical difference between the firm’s cash receipts and its
cash disbursements in each period.
165
160. Net operating profits after taxes (NOPAT): A firm’s earnings before interest and
after taxes, EBITx (1-T).
161. Net present value (NPV): A sophisticated capital budgeting technique; found by
subtracting a project’s initial investment from the present value of its cash inflows
discounted at a rate equal to the firm’s cost of capital.
162. Net present value approach: An approach to capital rationing that is based on the
use of present values to determine the group of projects that will maximize owners’ wealth.
163. Net present value profile: Graph that depicts a project’s NPVs for various discount
rates.
164. Net proceeds: Funds actually received by the firm from the sale of a security.
165. Net profit margin: Measures the percentage of each sales dollar remaining after all
costs and expenses, including interest, taxes, and preferred stock dividends, have been
deducted.
166. Net working capital: The difference between the firm’s current assets and its
current liabilities.
167. No-par preferred stock: Preferred stock with no stated face value but with a stated
annual dollar dividend.
168. Nominal (stated) annual rate: Contractual annual rate of interest charged by a
lender or promised by a borrower.
169. Offshore centers: Certain cities or states (including London, Singapore, Bahrain,
Nassau, Hong Kong, and Luxembourg) that have achieved prominence as major centers
forEuromarket business.
170. Open-market share repurchase: A share repurchase program in which firms

simply buy back some of their outstanding shares on the open market.
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171. Operating breakeven point: The level of sales necessary to cover all operating
costs; the point at which EBIT = $0.
172. Operating cash flow (OCF): The cash flow a firm generates from its normal
operations; calculated as net operating profits after taxes (NOPAT) plus depreciation.
173. Operating cash inflows: The incremental after-tax cash inflows resulting from
implementation of a project during its life.
174. Operating-change restrictions: Contractual restrictions that a bank may impose on

a firm’s financial condition or operations as part of a line-of-credit agreement.
175. Operating cycle (OC): The time from the beginning of the production process to
collection of cash from the sale of the finished product.
176. Operating expenditure: An outlay of funds by the firm resulting in benefits received
within 1 year.
177. Operating flows: Cash flows directly related to sale and production of the firm’s
products and services.
178. Operating lease: A cancelable contractual arrangement whereby the lessee agrees
to make periodic payments to the lessor, often for 5 or fewer years, to obtain an asset’s
services; generally, the total payments over the term of the lease are less than the lessor’s
initial cost of the leased asset.
179. Operating leverage: The use of fixed operating costs to magnify the effects of
changes in sales on the firm’s earnings before interest and taxes.
180. Operating profit margin: Measures the percentage of each sales dollar remaining
after all costs and expenses other than interest, taxes, and preferred stock dividends are
deducted; the “pure profits” earned on each sales dollar.
181. Operating unit: A part of a business, such as a plant, division, product line, or
subsidiary that contributes to the actual operations of the firm.
167
182. Opportunity costs: Cash flows that could be realized from the best alternative use
of an owned asset.
183. Optimal capital structure: The capital structure at which the weighted average cost
of capital is minimized, thereby maximizing the firm’s value.
184. Option: An instrument that provides its holder with an opportunity to purchase or
sell a specified asset at a stated price on or before a set expiration date.
185. Order costs: The fixed clerical costs of placing and receiving an inventory order.
186. Ordinary annuity: An annuity for which the cash flow occurs at the end of each
period.
187. Ordinary income: Income earned through the sale of a firm’s goods or services.
188. Outstanding shares: Issued shares of common stock held by investors, including
both private and public investors.
189. Overhanging issue: A convertible security that cannot be forced into conversion by
using the call feature.
190. Over-the-counter (OTC) market: Market where smaller, unlisted securities are
traded.
191. Paid-in capital in excess of par: The amount of proceeds in excess of the par value
received from the original sale of common stock.
192. Partnership: A business owned by two or more people and operated for profit.
193. Par-value common stock: An arbitrary value established for legal purposes in the
firm’s corporate charter and which can be used to find the total number of shares outstanding
by dividing it into the book value of common stock.
194. Par-value preferred stock: Preferred stock with a stated face value that is used
with the specified dividend percentage to determine the annual dollar dividend.
168
195. Payback period: The amount of time required for a firm to recover its initial
investment in a project, as calculated from cash inflows.
196. Payment date: Set by the firm’s directors, the actual date on which the firm mails
the dividend payment to the holders of record.
197. Payout policy: Decisions that a firm makes regarding whether to distribute cash to
shareholders, how much cash to distribute, and the means by which cash should be
distributed.
198. Pecking order: A hierarchy of financing that begins with retained earnings, which
is followed by debt financing and finally external equity financing.
199. Quarterly compounding: Compounding of interest over four periods within the
year.
200. Quick (acid-test) ratio: A measure of liquidity calculated by dividing the firm’s
current assets minus inventory by its current liabilities.
201. Range: A measure of an asset’s risk, which is found by subtracting the return
associated with the pessimistic (worst) outcome from the return associated with the
optimistic (best) outcome.
202. Ranking approach: The ranking of capital expenditure projects on the basis of
some predetermined measure, such as the rate of return.
203. Ratio analysis: Involves methods of calculating and interpreting financial ratios to
analyze and monitor the firm’s performance.
204. Ratio of exchange: The ratio of the amount paid per share of the target company to
the market price per share of the acquiring firm.
205. Ratio of exchange in market price; Indicates the market price per share of the
acquiring firm paid for each dollar of market price per share of the target firm.
169
206. Real options: Opportunities that are embedded in capital projects that enable
managers to alter their cash flows and risk in a way that affects project acceptability (NPV).
Also called strategic options.
207. Real rate of interest: The rate that creates equilibrium between the supply of
savings and the demand for investment funds in a perfect world, without inflation, where
suppliers and demanders of funds have no liquidity preferences and there is no risk.
208. Recapitalization: The reorganization procedure under which a failed firm’s debts
are generally exchanged for equity or the maturities of existing debts are extended.
209. Recaptured depreciation: The portion of an asset’s sale price that is above its book
value and below its initial purchase price.
210. Recovery period: The appropriate depreciable life of a particular asset as

determined by MACRS.
211. Red herring: A preliminary prospectus made available to prospective investors

during the waiting period between the registration statement’s filing with the SEC and its
approval.
212. Regular dividend policy: A dividend policy based on the payment of a fixed-dollar
dividend in each period.
213. Risk: The chance that actual outcomes may differ from those expected.
214. Risk (in capital budgeting): The uncertainty surrounding the cash flows that a
project will generate or, more formally, the degree of variability of cash flows.
215. Risk (of insolvency): The probability that a firm will be unable to pay its bills as
they come due.
216. Risk-adjusted discount rate (RADR): The rate of return that must be earned on a
given project to compensate the firm’s owners adequately—that is, to maintain or improve
the firm’s share price.
170
217. Risk averse: Requiring compensation to bear risk.
218. Risk averse: The attitude toward risk in which investors would require an increased
return as compensation for an increase in risk.
219. Risk-free rate of return, (RF): The required return on a risk-free asset, typically a
3- month U.S. Treasury bill.
220. Risk neutral: The attitude toward risk in which investors choose the investment
with the higher return regardless of its risk.
221. Risk seeking: The attitude toward risk in which investors prefer investments with
greater risk even if they have lower expected returns.
222. Safety stock: Extra inventory that is held to prevent stock outs of important items.
223. Sale-leaseback arrangement: A lease under which the lessee sells an asset to a
prospective lessor and then leases back the same asset, making fixed periodic payments for
its use.
224. Sales forecast: The prediction of the firm’s sales over a given period, based on
external and/or internal data; used as the key input to the short-term financial planning
process.
225. Sarbanes-Oxley Act of 2002 (SOX): An act aimed at eliminating corporate

disclosure and conflict of interest problems. Contains provisions about corporate financial
disclosures and the relationships among corporations, analysts, auditors, attorneys, directors,
officers, and shareholders.
226. Scenario analysis: An approach for assessing risk that uses several possible
alternative outcomes (scenarios) to obtain a sense of the variability among returns.
227. Strike price: The price at which the holder of a call option can buy (or the holder of
a put option can sell) a specified amount of stock at any time prior to the option’s expiration
date.
171
228. Subordinated debentures: claims are not satisfied until those of the creditors
holding certain (senior) debts have been fully satisfied.
229. Subordination: In a bond indenture, the stipulation that subsequent creditors agree
to wait until all claims of the senior debt are satisfied.
230. Subsidiaries: The companies controlled by a holding company.

231. Sunk costs: Cash outlays that have already been made (past outlays) and therefore
have no effect on the cash flows relevant to a current decision.
232. Super voting shares: Stock that carries with it multiple votes per share rather than
the single vote per share typically given on regular shares of common stock.
233. Takeover defenses: Strategies for fighting hostile takeovers.
234. Target Company: The firm in a merger transaction that the acquiring company is
pursuing.
235. Target dividend-payout ratio: A dividend policy under which the firm attempts to
pay out a certain percentage of earnings as a stated dollar dividend and adjusts that dividend
toward a target payout as proven earnings increases occur.
236. Target weights: Either book or market value weights based on desired capital
structure proportions.
237. Tax loss carry forward: In a merger, the tax loss of one of the firms that can be
applied against a limited amount of future income of the merged firm over 20 years or until
the total tax loss has been fully recovered, whichever comes first.
238. Tax on sale of old asset: Tax that depends on the relationship between the old
asset’s sale price and book value and on existing government tax rules.
239. Temporal method: A method that requires specific assets and liabilities to be
translated at so-called historical exchange rates and foreign-exchange translation gains or
losses to be reflected in the current year’s income.
172
240. Tender offer repurchase: A repurchase program in which a firm offers to
repurchase a fixed number of shares, usually at a premium relative to the market value, and
shareholders decide whether or not they want to sell back their shares at that price.
241. Trustee: A paid individual, corporation, or commercial bank trust department that
acts as the third party to a bond indenture and can take specified actions on behalf of the
bondholders if the terms of the indenture are violated.
242. Two-bin method: Unsophisticated inventory-monitoring technique that is typically

applied to C group items and involves reordering inventory when one of two bins is empty.
243. Two-tier offer: A tender offer in which the terms offered are more attractive to
those who tender shares early.
244. U.S. Treasury bills (T-bills): Short-term IOUs issued by the U.S. Treasury;
considered the risk-free asset.
245. Uncorrelated: Describes two series that lack any interaction and therefore have a
correlation coefficient close to zero.
246. Underpriced: Stock sold at a price below its current market price, P0.
247. Underwriting: The role of the investment banker in bearing the risk of reselling, at
a profit, the securities purchased from an issuing corporation at an agreed-on price.
248. Underwriting syndicate: A group of other bankers formed by an investment banker

to share the financial risk associated with underwriting new securities.
249. Unlimited funds: The financial situation in which a firm is able to accept all
independent projects that provides an acceptable return.
250. Unlimited liability: The condition of a sole proprietorship (or general partnership),
giving creditors the right to make claims against the owner’s personal assets to recover debt
sowed by the business.
251. Unsecured short-term financing: Short-term financing obtained without pledging

specific assets as collateral.
173
252. Unsecured, or general, creditors: Creditors who have a general claim against all
the firm’s assets other than those specifically pledged as collateral.
253. Valuation: The process that links risk and return to determine the worth of an asset.
254. Variable-growth model: A dividend valuation approach that allows for a change in
the dividend growth rate.
255. Venture capital: Privately raised external equity capital used to fund early-stage
firms with attractive growth prospects.
256. Venture capitalists (VCs): Providers of venture capital; typically, formal

businesses that maintain strong oversight over the firms they invest in and that have clearly
defined exit strategies.
257. Vertical merger: A merger in which a firm acquires a supplier or a customer.
258. Voluntary reorganization: A petition filed by a failed firm on its own behalf for
reorganizing its structure and paying its creditors.
259. Voluntary settlement: An arrangement between an insolvent or bankrupt firm and

its creditors enabling it to bypass many of the costs involved in legal bankruptcy
proceedings.
260. Warehouse receipt loan: A secured short-term loan against inventory under which
the lender receives control of the pledged inventory collateral, which is stored by a
designated warehousing company on the lender’s behalf.
261. Warrant premium: The difference between the market value and the theoretical
value of a warrant.
262. Weighted average cost of capital (WACC) reflects the expected average future
cost of capital over the long run; found by weighting the cost of each specific type of capital
by its proportion in the firm’s capital structure.
174
263. White knight: A takeover defense in which the target firm finds an acquirer more to
its liking than the initial hostile acquirer and prompts the two to compete to take over the
firm.
264. Widely owned (stock): The common stock of a firm is owned by many unrelated
individual or institutional investors.
265. Wire transfer: An electronic communication that, via bookkeeping entries,

removes funds from the payer’s bank and deposits them in the payee’s bank.
266. Working capital; Current assets, which represent the portion of investment that
circulates from one form to another in the ordinary conduct of business.
267. Working capital (or short-term financial) management: Management of current

assets and current liabilities
268. World Trade Organization (WTO): International body that polices world trading
practices and mediates disputes among member countries.
269. Yield curve: A graphic depiction of the term structure of interest rates
270. Yield to maturity: Compound annual rate of return earned on a debt security
purchased on a given day and held to maturity.
271. Zero-balance account (ZBA): A disbursement account that always has an end-of-
day balance of zero because the firm deposits money to cover checks drawn on the account
only as they are presented for payment each day.
272. Zero- (or low-) coupon bonds: bonds issued with no (zero) or a very low coupon
(stated interest) rate and sold at a large discount from par.
273. Zero-growth model: An approach to dividend valuation that assumes a constant,

non growing dividend stream.
175

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Role of Managerial Finance

Functions of the Financial Manager:

ix. Reporting and interpreting: to compare information with operating

x. Tax administration: to establish and administer tax policies and

i. Development Of Financial Strategy

ii. Treasury Management

iii. Long-Term Planning

Relationship between Financial management, Accounting and Economics:

In terms of the relationship between Finance and Accounting, it is the accounting

The Financial Market Environment:

There are three key players in the financial market environment,

FINANCIAL INTERMEDIATION simply means sourcing of surplus funds from

Financial intermediation is the process by which financial intermediaries

 Central Bank of Nigeria (CBN),

At the international market environment however, the financial manager should

Financial Statements and Ratio Analysis

Uses of Financial Statements:

1. Managers require Financial Statements to manage the affairs of the company

3. Prospective Investors need Financial Statements to assess the viability of

4. Financial Institutions (e.g. banks) use Financial Statements to decide whether

5. Suppliers need Financial Statements to assess the credit worthiness of a

6. Customers use Financial Statements to assess whether a supplier has the

7. Employees use Financial Statements for assessing the company's profitability

8. Competitors compare their performance with rival companies to learn and

9. Governments require Financial Statements to determine the correctness of tax

Relevance of Ratio analysis in Financial Planning

2. Used in Judging Efficiency of the business

4. Assist in Formulation of Plans

Types of Financial Ratios

Short-Term Solvency and Liquidity:

Current ratio = Current Assets / Current Liabilities

Liquidity/Quick Acid test ratio = Current Asset – Stock / Current Liabilities

Extent to which current liabilities are covered by immediately realizable assets.

Stock Turnover = Cost of Sales /Average Stock

Debtors Turnover = Credit Sales / Debtors

The number of times debts are "turned over"

Average Collection period = Debtors / Credit Sales

How long it takes debtors to pay up

Creditors Turnover = Credit Purchases / Creditors

Creditors Average payment period = Creditors / Credit Purchases

Indicates the average period for which creditors remain unpaid.

If it is high, investment is risky.

Total debt to shareholders fund = Total Debt / Shareholders' funds

If it is high, investment is risky.

Gearing ratios = Fixed Interest / Capital Equity + Reserves

Fixed Interest Capital / Equity + Fixed Interest Capital

If it is above 50%, it is high; If it is below 50%, it is low

Shareholders fund / Tangible Assets

Fixed dividend cover = Profit After Tax / Dividend Payable

Efficiency And Profitability:

Net Profit to Sales

Net Profit Margin = (Net Profit / Sales) x 100

Gross Profit to Sales = (Gross Profit / Sales) x 100

Return on Capital Employed (ROCE) = Net Profit / Capital Employed x 100

Assets turnover = Sales / Capital Employed

Expenses to Sales = (Expenses / Sales) x 100

Stock Holding period = (Average Stock / Cost of Sales) x 365

To determine the number of days, say 1 month or 1 week of holding stock.

Potential and Growth:

Dividend cover = Profit After Tax / Dividend Payable

Show percentage of earning being retained to enhance expansion.

Earnings Yield = (Earnings per Share / Market Value) x 100

Dividend Yield = (Dividend Per Share / Market Value) x 100