CHAPTER OnE NATURE OF FINANCE 1 Introduction Finance Is a field that deals with ¢ and llabilities over time under condi uncertainty (en.wikpedla.org/wiki/finance), A key point in france Is the time value of money, which states that purchasing pawer of one unit of currency can vary over time. Asan applied field of Management, finance borrowed fram other areas of Management such as economics, accounting, marketing among others. Finance has changed from a Primarily descriptive study toone that encompasses rigorous analysis normative theary, itemerged from a field that was concerned primarily with the procurement of funds to one that include the management of assets, the allocation of capital, and the valuation of the firm In the overall market. The role of the financial manager is considerably different from what it was fifty years ago and from what it will no doubt be in another fifty years. Intellectuals and financial managers must grow to accept the changing environment and master Its challenges. They must thoroughly understand the underlying objectives of the firm. he allocation of assets tions of certainty and 1.2 Definition of Finance There are several ways of defining finance. However, we shall define finance in three ways. Firstly, finance can be defined as the process of raising funds on a favourable term by financial managers (Pandey, 1 Si. 2 Scand wih Camszaner- the institutions » ion encompasses UCh as 1999)- This gt specialized institutions such as Bank of deposit Lesh include Instruments such as. treasury bills, Industry ar tineabe among others that are used [py the son of getting loans. Se nasi can also be defined as the oney. That is, the management of the flows maragemen’ say "ke Ne of money (Olowe, 2011), Sal finance can be defined as the sourcing of funds and their effective utilization by financial managers, This definition appears to be more acceptable than the other two definitions of finance as It takes into consideration the efforts ‘of the financial managers in getting funds and how those funds sourced will be judiciously utilized in the best interest of the firm, 1.3 Types of Finance Finance can be grouped into three categories; 1) Personal Finance: This is concerned: with the investment of personal savings, family budget and the use of consumer credit. Public Finance: This is primarily concerned with the acquisition and allocation of funds by governmental units. It equally deals with the levying of taxes by the government, 3) Business or Corporate Finance: This Is concerned with the acquisition, planning, and administration of funds employed in the production of goods and services. 2 Scanned wth Camscanner4.4 Evolution of Finance Finance as @ Separate discipline is of recent origin. Originally it was an Integral part of economics, liomearaih the era of technological innovation, new industries, new javestment opportunities in the 1920s. It became apparent that the firms needed more funds. The resuit was greater emphasis on liquidity and financing of the firm, Considerable attention was directed to Gescribing methods of external financing and little to managing firms internally, During this period, there was a widespread interest in securities, particularly In stocks. This interest became intense towards the end of the 20th century, and the role and function of the investment dealer was Particularly important in the study of corporate finance during this period (Iniegbenebor and Agbadudu, 1995), The depression of the 1920's necessarily focused the study of finance on the defensive aspects of survival, A great deal of attention was directed towards the preservation of liquidity and towards guiding against bankruptcy, liquidation and reorganization. The principal concern in external financing was how a lender could protect himself, Conservatism, naturally reigned supreme with considerable emphasis on a company maintaining a sound finanelal Structure, Finance, during the 1940's through the early 1950's was dominated by the traditional approach. This approach, which had evalved during the 1920's and 1930's, was from the point Of view of an outsider such as a lender or investor-analyzing the firm and did not emphasize decision making within the firm. Scanned wth CanSeannerriod, a greater emphasis on analyzin, puring HE arin and on the planning and cones cash flows within did develop. In the middle of 1950: these flows in capital budgeting and aif, = reat Interest arose nd allie considerations. Hence, capital budgeting, the concurrent emphasis on present value served as a catalyst for sweeping changes that subsequently occurred. With the development of new methods and techniques for selecting capital investment projects came as frameworks for the efficient allocation of capital within the firm. A major event in the 1960's was the development of portfolio theory and Its eventual application to financial management. Basically, this theory tells us that the risk of individual assets should not be judged on the basis of possible derivations fram its expected returns but rather in relation to its marginal contribution to the overall risk of a portfolio of assets, The use of the computer as an analytical tool added much to the development of finance. With the advent of the computer, complex information systems have been developed that provide the financial manager with the data needed ta make sound decisions. Great strides have equally heen made in the application of analytical toals to financiat problems. 1,5 Summary Finance was originally an integral part of economics. Finance as a separate discipline is of recentorigin. Ssanned with CamSeannerTechnological innovation, new investment opportunities braught development of finance. ght about the Industries and new Finance can be defined as the Procurement of funds and its effective utilization by financial managers, Finance can be grouped into three categories; namely personal finance, public finance and corporate or business finance. Review Questions 1) How would you define finance? 2) Trace the historical background of finance as a discipline 3} With appropriate Illustrations, examine the various types offinance, 7 7\ ‘Scanned with CamScannerCHAPTER eM oveRviEW OF THE SCOPE OF FINANCE FUNCTiqns. nance Functions 2d oe firm Is involved In three main activities namely, finance, production and marketing. The securing of capital and its emplayment in a firm is known as finance activity, while the generation of returns on the investey capltal is known as production and marketing activities, A business firm therefore is an entity that engages in activities to perform the functions of finance, production ang marketing (Pandey, 1999). The firm acquires funds from the sources called investors, The funds so secured, when invested, are called investments. The firm expects to receive returns on investments over time, and periodically distributes returns to investors. These processes are not, in fact, sequential; they are performed simultaneously and continuously. The ralsing of capital funds and using them for generating returns and paying returns to the suppliers of funds are called the finance functions of the firm. There are two types of funds that a firm raises namely, * equity funds and borrowed funds. A firm has to sell shares to acquire equity funds. Shares represent ownership rights of their holders. The buyers of shares are called shareholders; they invest their money in the shares of a company in the expectation of returns on their invested capital, The returns on the shareholders’ capital Is called dividend. Shareholders can be of two types, namely, ordinary and preference. 6 ‘Scanned with CamSeannerpigeon receive dividends ata fixed rate and a pe T ordinary shareholders j idends. The dividend rate for ordinary shereainne and can vary from year to year dipandtin oe ne gecsidn of the board of directors. The payment af dividends to shareholders is not a legal obligation, it is an absolute gscretion of the board of directors. Since ordinary gnarenolders received dividends for payment of invested capital, If the company Is wound up in the end, they are generally called owners of residue (Pandey, 2001) Dividends paid by a company are not deductible charge for calculating company incomes taxes, Another important source of raising capital is creditors or lenders, Lenders are not owners of the company. They make money available to the firm on lending basis and retain title to the funds lent. The returns on loans or borrowed funds Is called interest. Loans are furnished for a specified period at a fixed rate of interest. Payment of interest is a legal obligation, The amount of interest is allowed to be treated as an expense for computing company Income taxes. A firm may borrow funds fram banks, other financial institutions, debentures holders among others. A company can also secure funds by retaining a portion of the returns available for shareholders. This method of acquiring funds is called retained earnings or plough back profit. The retained earnings is an undistributed returns on equity capital, they are therefore rightfully a part of equity capital. The retention af earnings can be considered as 3 form of raising new capital; If 2 company distributes all s2rmings to shareholders, then, itean reacquire new capital 7 AD, Scanned wth Camscanner2 same source by issuing new shares, Sources = th f from snd management will be discussed in ‘detail in finance chapter four. . The funds raised by a company will be invested in the available investment opportunity. Each Investmery opportunity available to a company is called investment project or simply a project. A project involves use of funds presently in the expectation of future benefits. The company may also have on-going projects. These on- going projects may also invelve outlays of cash te maintain or to Increase their profit abilities. It would be reatized that generation of revenue, a production activity is possible only when funds are invested in projects. There exists an inseparable relationship between the finance function on the one hand and the production, marketing and other functions on the other. Almost all kinds of business activities directly or indirectly involwe the acquisition and use of money. For example, recruitment, promotion of employees in production Is clearly a responsibility of production department; but recruitment and Promotion of employees require payment of wages and salaries and other benefits, and thus, involve finance. Similarly, buying a new machine or replacing an old machine for the purpose of increasing productive capacity affects the fiow of funds. The sales pramotion polices come within the purview of marketing, but advertising and other sales Promotion activities require outlays of cash and, therefore affect financial resources. Where, then is the separation between production and marketing operations? Where does the production or marketing functions end and the finance 8 a ‘Scanned with CamScannerfunction begins? There are no clear- cut answe questions. The finance function of raising and Sie aie ahhough has a significant effect on other functions, yet It neednecessarily limit or constraint the general running of the business. A company in a tight financial position will of course, give more weight in financial considerations and will device its marketing and production strategies in the light of the financial constraints. On the other hand, management of acompany, which has plentiful supply of funds, will be more flexible in formulating its production and marketing palices In fact, the financial polices will be devised ta fit the production and marketing decision under such a situation, Although It may be difficult to separate the finance function from production, marketing and other functions, yet the function themselves can be readily identified. We may Identify two kinds of finance functions: 1. Managertal finance functions 2. Routine finance functions Managerial finance functions are so-called because they require skilful planning, control and execution. On the other hand, routine finance functions do not require a great Managerial ability to carry them out, They are chiefly clerical and are incidental to the effective handling of the managerial finance functions. The three Important manage! Investment aa mix} decision, financing (or capital mix) decision and dividend (or profit allocations) decision, Thess financial decisions directly concern the firm's oe : acquire the commitment or recommitmant of funds 3 rial finance functions are: 9 - ‘Scanned with CamScanneraig, itis in this context that finance furnetig, cantinuous ice the production, marketing and og are said the firm. This, in consequence, will affect 4 functions oF rofitability and risk of the firm and ultimatery. a of the firm. According to (Soloman,1979 in Pa 3901) “the function of financial management is to review . | decisions ta commit or recammmit funds: to new ar on going uses". Thus, In addition be raising funds, financig) management 15 directly concerned with production, marketing and other functions within an enterprise whenever decisions are made about the acquisition or distribution of assets, : For the effective execution of the managerial finance functions, the Incigental or routine functions have to be performed. These decisions concern the procedures and Involve lot Of paper work and time. Some of the Important routine finance functions include among others: 1) Supervision ef cash recelpts and payment and the Safeguarding of cash balances. 2) Custody and safeguarding ef securities, insurance pollces and other valuable papers. 3} Teking care of the mechanical details of new outside financing. 4) Record keeping and reporting. : A Scanned with CamScannerThe chief finance executive in the Medern enter é mainly Involved in the managerial finance hee coe functions is to the extent of setting up ald : dure, selecting forms to be used, establishing gtandards far the employment of competent personnel ane check up the: performances to see that the rules are observed andfunds property used, 2.2 Functions of Financial Managers The financial manager plays significant roles in campany's goals, policies and financial success, The role of financial managers keep on changing due to the dynamic changing environment. The financial managers role Ils deeply rooted In the finance function. However, the financial manager performs the following functions among others: |. Ralsing funds: This Is the traditional function of a financial manager as he hes to procure funds on a more favaurable term fer the day te day running of the finm, I. Planning for funds: This is another function of financlal managers as he has to makean effective planon how the sourced funds will be effectively utilized to Increase the wealth of shareholders lil, Use of funds: This relates to Investment of funds as a financial manager has to commit funds to lang term asteté which would yleld benefits for thé firm in the future. ya ‘Scanned with CamSeanner 11teraction with other managers: A financial manage, Inbe " eeds to interact with other managers of the firm ta fh achieve corporate goals. y. Dividend/proflt allocation: This function entalls determination of the distributlan of met profits or surpluses between retained earnings and dividends by the financial manager. Other functions of financial managers Include: + Betermination of the financial strategies. > Bevelopment of corporate strategies of the firm. > Formulation of capital structure. > Leng and short tenm financial planning, * Betermination of long tenm capital investment, such as Capital budgeting, mergers and acquisition among others. - Treasury management, such as cash ma nagement, insurance, foreign excha nge management, working capital management among others. 2.3 Financial Decisions The financial manager carries out financial decisions in such a manner that the wealth of shareholders Is maximized. Some of these decisions according to Pandey (1999 ) Include: Investment Decision: This |s othenwise known as capital budgeting and It deals with the allocation of a firm's capital funds that would yield future benefits that will meet the expectatlons of all shareholders, Since the future is rather uncertain, the Investment proposals, should thecefore be evaluated In terms oF hoth expected returns and the risk. y 12 ‘Scanned with CamScannerpinancial Decision: Another Important decision ta be performed by the financial manager is the financing decision wence, he Must decide when, where and how to Soguits funds to meet the firm's investment needs, The central issue before him is to determine the proportion of equity capital and debt capital. He Must strive to obtain the best financing mix of optimum capital structure for his firm, The returns on equity will Increase, but also the risk. The use of debt capital affects the retunns and risk of sharcholders. & proper balance will have to be struck between returns and risk, When the shareholders return is maximized with minimum risk, the market value per share will be maximized and firm's capital structure would be optimum. Once the financial manager is able to determine the best combination of debt and equity, he must rage the appropriate amount through the bestavailable sources. Dividend Decision: This decision relates to firms dividend policy. The financial manager must decide whether the firm should distribute all profits or retain them, or distribute a portion and retain the balance. The dividend policy should be determined in terms of its Impact on the shareholders wealth. The optimum dividend policy ts one, which maximizes the market value per share. Thus, If the shareholders are not indifferent to the firm's dividend policy, the financial manager e optimum dividend: payout ratio, He the question of dividend stability, cash ers. must determine th should also cansider dividends amend 13 ‘Scanned with CamScanner¢ Apart (ror ee TE long. te, Liquid nelal manager has a duty to manage Uren assets, the a to safequard the firm against IMlquigity 6, gsscts ee ante in current assets affect the fi, insalvency: i uidity, Ifthe firm does not Invest sutficen pena nt assets, It may become illiquid but it Wouly a promabilty as idle current assets would not eam partiea: THE a proper trade-off must be achieved between profitability and liquidity. In order to ensure that nelthe; insufficient nor unnecessary funds are Invested in current assets, the financial manager should develap soung techniques of managing current assets. He should estimate firm's working capital needs and make sure that funds would be made available when needed, 3 2.4 The Finance Function The finance department/unit/section of a firm Ilke all other departments or units or sections must operate in such Away as to maximize the objective(s) of the firm. The finance function is however very precise; focusing on financial decision-making, Thus, the finance function is primarily to plan, raise and Invest funds and make dividend declsfans. The use of funds Im 4ny organization must be contralled, The . finance function Creates a link between an organization and the financial markets where Funds are raised and the firm's financial Instruments are traded, It is the duty of the finance denrtment to link up with the outside world to satisfy the financial needs ofthe Organisation, 14 a ‘Scanned with Camscanneeaccounting Versus Finance = gceounting essentially deals wit ymulation le dissemination of information © lecision making, | secountabtlity of Funds of the cramintin i. em For pend, finance largely deals with decision making whi n Ta financial nature. It involves raising funds, Investing pth of optimally and dividend-retention policy, ds Hh the measurement, Monetized economic 2,6 The Finance Manager and His Environment The Finance Manager as a dynamic member of the management team is usually responsible for shaping the fortunes of the enterprise. He is invalyed in the most vital decision of allocation of capital; he ensures that the funds af the enterprise are utilized In the most efficient manner. He must realize that his action has very far reaching consequences on the firm because It will influence the profitability, growth, risk and survival ef the firm and as a consequence will affect the overall value of the firm. He ig concerned with the company's activities that are finance - oriented. As a result, he must be familiar with the finance, economic and business environment (FEB). il. Financial Environment - The Finance Manager must be versatile and have 9 deep knowledge of the functions of the financial syste and financial markets such as the Central Bank of Nigeria (CBN), Nigeria Deposit Insurance tion {NOLC). Banks and Other Financlal Roane ‘Act, No. 25 of 1991 with Its amendments, mpanies and vllied Matters Act (CAMA) 1990 (as sorended) and ascertain its provisions. He must know is ‘Scanned with CamScannerand pruvisians ee ee slack the areas and Exchange Commission a ie expart-Import Bank (NEXIM), Arig pevelopment Bank (AfDB), African Investment Ban international Monetary Fund (IMF), Paris cy) Creditors, London Club of Creditors among others, ii, Economic Environment - The finance manager must bg uptodatein what goeson within the econamy, Particular, he must appreciate the Impact of government fiscal and manetary policies as they affect his arqanization, merger and acquisition, recapitalization and restructuring, He must be very familiar with the details of the natien's annual budget, li, Business Environment = The impact of taxation and inflation on the company's fortune must be appreciated by the financial manager. 2.7 Career Opportunities in Fina nee ne Is. a challenging discipline, which Is Alghly highly and exciting. Taking finance as a course of study Is finance ay ed te" te those who da not choose to major in thete hy Yl be confronted with financial decisions in SMES and in, theireareers on a dally basis, Graduates j, fi Inthe Following een find employment apportunities a. rate ti b. Investment! agement c Financial anay, ig d. Banking 16 ‘Scanned with CamScannerance a Wivestate and . public sector specifically 8 finance mana nwing capacities, 76F an be employed in the fll 3, Financial Analyst: A finance ma hager is ex review the organization's bel pected to Security Analyst: Analyzing stocks and ether Sources of financing, interpreting dl financial information and recommending appropriate actions ta betaken, Corporate Banking: Client services and marketing of banking products. ‘Credit Manager: This involves credit Policies, payables and receivables, Project Finance Manager: Analyzing the viability of specific projects; it involves ‘sourcing the finance/furds heeded for specific projects and monitoring the use of such funds. Pension Fund Manager: Belmg responsible for the inwestment and management of employees" pension fund. Séturity Broker: Advises and counsels client on marketable securities 45 weil as the purchase and sale of these securithes on behalf of chents, ker: Responsible for negotiations on foe ongand reél estate Investment. 7 a ee Scanned with CamSeanner; Ensuring that the firm Is protected againg, b a a impact of unexpected losses using ee services, loss control methods as well a5 other rance: ere techniques and methods. Consultant: Act as financial consultants to individuats and corporate organizations. k. Internal Revenue Officer; Belng an officer in the Internal "revenue office of either the state or federal levels and being involved ln revenue generation, 2.8 Summary Finanee, production and marketing are the three important activities of ary fier, The raising of capital funds and using them for generating returns and paying returns to the suppliers of funds is known as the finance function ef the firm. Afirm ean raise funds through equity and debt finance, The financial decision taken by financial manager Intiude investment, financial, dividend and liquidity decisions, Financial Managers perform the funetions of raising funds, planning for funds, using funds, Interacting with other managers among, others, 16 ‘Scanned with CamScannerreview Questions 1, There exists an inseparable relationship between the finance function on one hand and the production, marketing and other functions on the other hand. Justify this assertion. , 2. Discuss the major functions of financial managers in the light of modern day dynamic changing environment. 3, Financial Managers carries gut financing decisions in order to increase the wealth of shareholders. Critically examine these decisions and how they can be attalned. 4, Examine the relationship between Accounting and Finance as separate disciplines, ig ‘Scanned with CamScanneeCHAPTER THREE THE THEORY OF THE FIRM roduction a C generally agreed that the starting point fo, developing a firm Is the definition of workable objectives that the firm may be able to achieve such desired objectives or goals. 9 However, there Is a disagreement today on the theory of the firm in three aspects namely; (i) Whatthe theory Is? (ii) The extent of its defectiveness, (ili) Appropriate methods of improving it. Assuming that the firm is Operating within a perfectly competitive market, the generally recelved theory asserts that the objective of the firm is to maximize het revenue In the face of given prices and a technologically determined Production function, ‘The first requirement of any economic theory is an assumption as .to the alms of the ‘economic agent whose behaviour is to be explained, In this case where the theory Is ‘Of a company's financial behaviour, The aim of a company is assumed to be to further the interest of its owners, that is the shareholders (Van Horne, 1989). In order words, the generally agreed objective of the firm is to maximize its value to its shareholders. Value here is represented by the market price of the companies ordinary 20 Ae Seamed with Comscannerct which In turn Is a reflection of iny ngdvidend decistons(Van Horne,200 4), The frequently encountered financ gmmare discussed below: estment, financing lal objectives of the 43.2 Profit Maximisation Concept Profit maximization is one of the objectives of the firm. Mast organizations assert that as long as they are increasing revenue and on the other hand keeping dawn costs, profit maximization objective is being achieved. Thus the underlying motive of profit maximization is efficiency and for efficient allocation of resources under competitive market condition, profit maximization is looked upon as the appropriate measure of a firm's performance (Olowe, 2011). Profit maximization is basically a single period or at Most a short-term goal (Shim and Siegel, 1999). It is usually interpreted to mean the maximization of profits within a given period of time. It should be noted that this traditional goal (profit maximization) 1s not sufficient for most firms today. Limitations of Profit Maximization (1) It Is not all Inclusive, that Is it does not totally explain the behaviour of all firms or organizations. (I) Tt is undefined or vague - which definition of pot - gross, net, short run, long run (before or after tax, published or unpublished). (i) The third timitation relates to the Inability of this 21 AEN Ssanned with CamSeannerbetween Profits of : ing to decide i ting anjective ie oe with respect to their timing projects thal d benefits that j uality of the expecte i8 the (iv) anor certainty/with which the benefits ca, is led expected. deals with a particular set of decisions, pr tv) ft duction etc that are viewed as functions of g Few catch-all variables (e.g. demand, cost, tc) leaves aut human elements. {vl} The theory uses aggregation as a tactics, it atte pts to specify total market supply and demand curves. (vii) There [s no attention to dr Interest in the actual process by which individual firms reach decisions, 3.3 Satisficing Concept Cyert and March ¢ 1963) have argued that Individuals have goals but collectives of individuals do not. The final objective of a firm [s a result oF compromise either by vote which does not provide rational answer or coalition which is resorted to after attempt at voting fails ‘ They see business firms as a coalition of Individuals SOMe of which are organized into sub-coalition, For instance, the private sector arganizations include managers, shareholders, Suppliers, customers, regulatory agencies, labour among others while public sector Organizations include political ®ppointees, legislators, technical staffamong others. The objectives they argued should reflect ete teed he coalition so that the firm should seek - ‘Scanned with CamScannerpot pants a saUsactary returns for their Participation rather Ss seek to Maximize the returns of any one of them, The ration of satisficing objective is that the Participants in m oalition value profits In the same way and they are willing ro take the same risk. However satisficing objective ignores. metiming of returns and It is rather undefined or vague. 34 Shareholders Wealth Maximization Concept Shareholders wealth maximization entalls maximizing the wealth or value of shareholders. In other words it translates into maximizing the price of the firm's ordinary shares. Wealth maximization ts a long-term goal of a firm since shareholders are interested In future as well as present profits. Value or wealth maximization refers to the maximization of the discounted net benefits to shareholders. This can be expressed algebraically as: wo= G+ CF Gy Fee tG (1+r) . (ry (ltr? (1+r" eG eg “sry Where C,, C, ——— G, Fepresents the stream of benefits expected to occur Ifa course of action Is adopted. W = Wealth position of the shareholders c cash benefits in period Lp BpBe veeeeeees n r 5 ve “appropriate” rate of discount which reflects the timing and risk associated with the net cash recelpts. 23 WM ‘Scanned with CamScannerpt a course of action only whey Wis The firm should ado| inthe wealth of the firm, creas ve. thatisan in positive, E ealth Maximization RT the timing of returns fects risk or uncertainty Itconsiders shareholders returns Ttemphasizes long term goal of the firm I. ii. fii. iv. Agency Problem The objectives of management may differ widely from that of the shareholders, The shares of an organization may be widely held that shareholders exercise less control or Influence on management, hence leading to a Separation between ‘ownership and control In an organization as management may act in its own best Interest rather than that of the shareholders, thatthe agent (management) will make ‘optimal decision anty If appropriate incentives are given and If only the agent is Monitored, Agency problem arises if there is conflict of interest een the goats of managers and the Qoals of the firm. The agency problem can be Solved if the agent is given incentives Such as share ‘options, perquisite of office, bonuses among others and they are directly related to how close Management decisions Come to the Interest of shareholders. Monitoring can be done by the principal pues Bending that agent, systematically reviewing managcmen ' A ‘Scanned with CamScannerites, auditing financial sta ved management decisions inane. ma me agency problems Can also arise in credita cparevolders having different objectives, thereby i me party to want to monitor the others, In sdatonaie gtakenolders such @S suppliers, customers, em = among others may also want to monitor the bohenicue of shareholders. Above all agency problem arises in investment, financing and dividend decisions of a campany. Conflict of Goals Apart from regulatory and management controls, there are other constraints imposed by the influences of the various groups of participants on the management of firms. These include creditors, employers, government/management and the public. The interests of these groups conflict. The most important conflict of Interest is perhaps that between the shareholders and the management of the company. This is because whereas shareholders invest their funds In many securities In a diversified portfolio and so can play around with risks, managers usually have one job. So management may reject high risk, high yielding Investments, which may ordinarily be acceptable to shareholders. 3.5 Othertypes of Objectives i. Production objective li, Sales objective lil. Stock objectives 25 a Seamed with Comscannerwill. Employees ; shareholders satisfaction objective Innawation objective Summary The starting point for developing a firm Is to have 3 workable objective. The financial objectives of the firm Include profe maximization, wealth maximization, satisficing among others. Profit maximization suffers from various Ilmitations such as mot taking Into consideration the time value of money among others. Wealth maximization takes into consideration all the limitations of profit maximization concept. Review Questions ) (2) Q) Profit maximization has been rejected 252 criterion for measuring the wealth of shareholders. Justify the assertion. Critically examine the other objectives of the firm. Examine the major advantages of wealth maximization concept over profit maximization 26 ‘Scanned with CamScannerCHAPTER FOUR SOURCES OF FINANCE AND MANAGEMENT 4.1 Introduction Owners and managers of businesses may often not be aware of the full range of sources of funds available or the best means of access to them. As a business expands, it is important to the continuing success of the enterprise that Itis able to identify both the type and the amount of finance it needs. A businessman must, therefore, be conversant with . the sources of finance appropriate for his purpose and equally must understand the attitudes and requirements of those who are to provide the funds. Itis Important for businessmen to be able to identify the types of finance or package which may be appropriate to particular needs (Ojo, 2010). Many independent businesses are started with the original owner's available funds, perhaps with the help of his family and friends, and often with recourse to bank overdraft. Thereafter, growth of the business brings about growing financial needs, and these can lead into @ whole new range of options. Each type of finance can be particularly appropriate for some situations, but can be quite inappropriate. A firm's sources of finance can be broadly classified either as owners/shareholders” funds (equity finance), OF aS borrowing (debt finance). Equity finance Is essentially permanent risk capital. Additional equity can be provided by the present owners of the firm, can be built up out of retained profits, or ean be obtained from a source hitherto outside the 27 Scanned wth Camscannerf DOrroyy) the many forms O ng weeh devt at include overdrafts, bill finang” fm of obtaing ring, bank loans, morte. ways ™ pine purchase, Factoring, Ttgage, jaasings amongothers- rces of finance for different pur us Sou! OS Bg Me ted under the following main categories: shy canbe ce, medium-term finance, equity capital, exporg term finan financeamong others. 42 Short-Term Finance These are financing sources of up to 1 year duration, qt is a flexible source of financing usually used in financing shart-tenm working capital needs, Sources of short term financing Include: | Borrowing from friends and family members: Friends and family members will likely advance foan more than any other group because of intimation, Here, credibility plays a part because if the borrower is not honest and credible, family members and friends may not be willing to lend. However, this source of finance Is highly risky and unreliable as enforcement of payment may be diffloult. |. Borrowing from co-operative, thrift and credit society: Funds here is restricted to members of the co- Operative. The amount that can be borrowed Is alse lirnited, depending on the co-operatives, the loans fram the co-operatives might be Interest free or carry & little interest rate, 28 ‘Scanned with CamScannervi. Vil. Trade Credit: It is a system whereby a firm supplies goods for a resale on credit terms without signing 4 formal agreement for the liability. In other words, the geller finances the buyers purchase of supplies by delaying the date at which the priceis due. Bill Finance: A bill of exchange may be thought of as like a post-dated cheque which can be sold for cash ata discount. It enables the seller (often an exporter) of goods to abtaln cash for them as soon a5 possible after their dispatch, and yet allows the buyer (importer) to defer payment until the goods reach him or until he has had time to process and market them. There are (wo main types of bills; trade bills and bank bills. Factoring: A factor is an agent that manages trade debts. Factoring thus involves turning over the responsibility for collecting a firm's debt to & specialist institution. Invoice discounting: This is a means of generating cash by selling to. an invoice discount company either a selection of invoices on a firm's larger debtors or an entire sales ledger. It is a simple, flexible source oF finance enabling a business temporarily to increase Its working capital while maintaining a normal relationship with custamers, who need not know of the arrangements. Bank loan: This is a conventional loan from a financial Institution such as 4 bank in which there is a formal agreement between the bank and the borrower in which the bank lends a specific amount of money for a 29 Scanned wth Camscannerviii. 43 ich Interest Is charged. Hows, specified en borrower the bank usually tay," i es ration the canons of lending such as th into ee and financial standing of the borrower. ee of the loan, duration, amount requirag’ reral, credit worthiness, cash flow management business plan that demonstrates the knowledge dle the business successfully. collal and a of and ability to han Overdraft: This is a process whereby a bank allows a firm to overdraw its account even though such a firm has insufficient funds in its account. Before a firm can obtain this source of financing such a firm needs to maintain a current account with the bank. The bank charges Interest on the amount overdrawn outstanding atanyone time. Medium-Term Finance ‘These are financing sources of 1 to 5 years duration, Itis used by companies to help buy assets with a corresponding life such as certain plantand machinery, or to provide general working capital. ‘The sources of medium term financing Include: Term-loans: Medium-term loans are provided principally by the merchant banks until recently deposit money banks and other banks widely used often as part of a package of financial facilities. Hire purchase: A hire purchase agreement Is @ good source of finance. By the operation of the purchase agreement, an initial down payment Is made In respect 30 ‘Scanned with CamScannerill, (a) of the asset, coupled with installment payments. The hire purchase company remains the legal owner a the goods before the final option is exercised. Any violation of the hire purchase agreement could lead to forfeiture of the purchaser's interest in the goads, Leasing: Thls source of finance has become popular in recent times due largely to the impact of industrialization and proliferation of manufacturing ms. Companies with huge asset requirements coupled with the substantial capital often tied up In providing infrastructural need have taken to leasing facilities provided by deposit money banks and finance companies This approach tends to reduce the strain on the initial funding. Leasing can thus be defined as a contract whereby ane party (the lessee) hires equipment or services from another party (the lessor) In a way that the lessee acquires the use of the asset without purchasing it. ‘There are two types of leasing: Financial Lease: A finance lease is a transaction in which the lessor agrees to lease the asset to one lessee upon the latter's agreement to make series of payments for its use. The payment received will in total usually exceed the purchase price. This premium represents the profit on the leased asset. The tenor of & finance lease Ig usually fixed in advance and Is tallared to enable the lessor to recover the principal cost of the assets Including 4 reasonable yield on the capital Invested. Under @ finance lease, the lessor is not Involved with the 31 , ‘Scanned with CamSeannerir mai dayro-doy eennings insurance or maintenance oy th jeased asset ting Lease: An operating lease is one in wh (b) opera ats involved with the running, insurance an thelessor ge of the equipment, It Is one where the ee ocul expect to lease the asset to more than ang jessee during its working life and does not therefor, jook to the first lessee for the repayment of the cost of the asset a5 in the case of the finance lease Congequently the term is relatively short with respect ty the useful life of the property, which could be cancelley atanytime, subject toa specific notice period. maint Leasing is under the umbrella of the equipment leasing association of Nigeria (ELAN) formed on 29th June, 1983. In between the two broadly classified types of leasing arrangements are other variants which Include sale and lease back, syndicated lease, leverage lease among others. Advantages of leasing ranges fram financing, flexibility, safeguard against risk, tax savings among others, 44° Long-Term Finance These are financing sources of more than 5 years duration, Tt can be used ta purchase Fixed assets that have a fairly long life and can also be used to Provide semi Permanent working capital orto purchase other businesses, Sources of lang tern financing Inciude: {) Ordinary shares: These are the owners of the firm and lee. 3 4a ‘Scanned with CamScanner(i) (tii) ey are the source of estes Tsk In the for ment capital. They bear the 9 ™m. They do not receive a fi dividend although they are entitied to divid ae Dividends are pald to ordinary shareholders a Income claims of others have been satisfied, ‘ves incase the firm is wind up they can exercise their claims on assets after the claim of other creditors might have beenmet. Preference shares: Preference shareholders are entitled to a fixed rate of dividends and they receive dividends before the ordinary shareholders. Preference-shares could be cumulative as they are entitled toarrears of dividends. Term loans: These are conventional loans from banks and other financial institutions for a period of over five years and are usually at fixed rates of interest related to the corresponding yields currently in the market. (Iv) Mortgage loans: These are loans for which specific wv) assets In land and bulldings are used as security. They are usually for a period ranging form 20-30 years. Mortgage Institutions such as the federal mortgage bank of Nigeria (FMBN), primary mortgage institutions and pension funds often specialize in mortgage loans. Debentures/Loans Stocks: Debentures are a form of loan stock that is legally defined as the written acknowledgment of a debt Incurred by a company. With well secured debentures, the borrower benefits by a 33 Scand wih Camszanerlower rate of INterest than With oth ks n stocks are usually issued py | pentures OF = to raise money from inst coms ssurance companies, Pension funds, . mpanies wishing to obtain long-te,” ital market. m esti ike banksy 195! a nies, Col an aay goto the cap! as Equity Capital and Start Up Finance Start-up capital: Most businesses began with ay individual or individuals providing the Initial equity capital from their own resources known as personaj fund and with a bank probably assisting with some short-term working capital together they can provide the finance that is necessary to get the business going, Apart from these sources, the provision of start-up capital is the business of a number of specialized institutions, mainly in the public sector (in developing countries). Most sources provide funds in whole or in part by the purchase of a minority of the equity capital hence becoming partners in the business. fi, Venture Capital: Venture capital is a term for start-up capital; often used in the context of the provision of funds for businesses concemed with technical innovation, There are specialist sources of finance for Innovation mainly in the public sector. 4.6 Finance for Exports Finance can be made available to cover the whole cycle ca ‘Scanned wih CamSeannerof negotiation, production, shipment and ST an overseas buyer. In line with government policy in man countries, the banks and other financial institutions ave priority to export finance. Export credit quarantee schemes are yet to be developed in less developed countries as those in Britain and similar ones in the United States of America, japan, and some European countries. 4,7 Public Sector Finance and Assistance Awide range of government incentives and assistance are available, much of It to companies of all sizes, with a number of measures aimed specifically at industrial and agricultural production by the government through such speelfic Financing institutions or develapment banks such as the Bank of Industry (BO1), Bank of Agriculture (BOA) and Small and Medium Enterprises Development Agency (SMEDAN) among others. 4.8 Choice of Finance Here, we will make the assumption that finance is available and the only problem we have to solve concern choice from among the various sources or types of finance on offer. In making a choice from the various possible sources of finance, the final option for a company seeking additional finance is influenced by the following considerations: 1, The basic choice between short-term, medium term and long term finance - the term of the finance, ji. Whether finance used for capital expenditures should be supplied from surpluses on existing operations Mea, 35 Scanned wth amseannertii, vi. vil. vili. 49 generated) or should come fram 4 shy internally any. eg external tothe comm st of borrowing by different Methods ative CO: me orcaptl and administrative costs, qhe effect of taxation The value and nature of corporate assets avallable a security. The nature of conditions Imposed by lenders on a company's freedom of action. The company’s abllity to earn a sufficlent cash flow to pay fixed charges and repay loans. The company's existing capital structure Market conditions, for example, severe "credit squeeze". Summary A firm's sources of finance can be broadly classified either as owners'/shareholders' funds (equity finance) or as borrowing (debt finance). ‘The various sources of finance for different categories can be classified into short-term, medium-term and long-term financing. / Short-term financing are financing sources of up to 1 ‘year duration. . & Scanned wth CamscannerFinancing Sources of 1 year tos ag medium term financing, Years duration isknown Long term financing are financing sou Se aiaton, ig rCaSs of mone than Review Questions 1. a. 4. Examine the major sources of short term financing. Discuss the factors that should be taken inte consideration In making a choice from the various possible sources of finance, Borrowing from friends and family members is highly risky and unreliable. Justify the statement, ttemize the various government institutlans and agencies in Nigeria that can provide financial assistance and incentives to Individuals and organizations wanting to go into business. How would you define venture capital? Q . ‘Scanned with CamScannereS qHE RISK DIMENSION IN FINANCE Introduction a To be a successful finance manager, we nee understanding of investment tisk and realistic expectatge of returns. We should understand the trade-off between the retums we are expecting from an investment and the q of risk we must assume to earn the returns, By return, y mean the expected yield from an investment, It is the Tewarg for Investing. Return is the only rational way Investor compare alternative investments with the decision he hat taken after serious considerations of risk. It helps the investor to assess what they have done and how well investment managers have done on their behalf. More 54, realized retums helps in future estimation of unknown returns The two major components of returns are yield and Capital gain or loss 5.2 Definition of Risk Risk can be defined In various ways, however it is Important to recognize that the actual returns on security May be different from the expected returns; all the factors that will affect this likelihood are commonly referred to as risk, Risk therefore can be defined as "the possibility that the actual returns (cash flaws) from an investment wi! a from the expected returns". It is the Poe idesing. baat auteome turing aut ta be as expected consieene PRs ®vent for future estimates. in other words, Inve ° fa ‘Scanned with CamScanneeet the (ee Pre!c| Feast returns from the Investme, at are uncertain. rl i statistical language, however, tisk as the variance (or standard ted returns On investment itude of deviation and the gre, : ill ing cee the greater is said tah iene Aoteen ; are eu investment decision gives rise to a peobabiile pedi Sion or absolute certainty Nt and the timing of those fan also be deviation) of the the greater the fined anticipal w i gjstribution of cash flows which are subjectively determined the investor. For exé mple, XYZ Utd plans to invest NGOD,000 in equipment, which yields the following probability distribution of cash flows. Year Cash flow Probability N 2,000,00 0.50 0.30 0.20 8,000,00 0.40 0.20 0.40 3 5,000,00 0.10 0.20 0.40 Because we are not sure of the actual cash flow of the investment, it may be necessary to atta ch probability toeach ofthe expected cash flaw. 53 Distinction between Risk and Uncertainty Risk and uncertainty are used interchangeably, but they are not the same. Risk occurs where it is not known what the future outcome will be but where the various possible #ematives can be estimated with some degree of ‘unfidence based on existing knowledge, past knowledge af 39 Scanned with CamScannerhes are SValaDle. paility estima : erences ees hand, Is a situation where jt ;, yncertalnty a ; uityre outcome will be and where the Varig, known wnat IN’ be predicted based on the knowlega, * altersati —S thereis no probability estimate, % tl the pasty that actual returns on an investr,, There are chance a out as expected. Investors would like thei, nat te as large as possible but this fs Subject to man, constraints especially risk, Every rational Investor wow, prefer certainty to uncertainty. Most investors are ris averse. An investment in government treasury BINS car, jesser risk because it is certain that government will redeer, ag expected. But on the other hand, there is a higher risk that Cadbury Nigeria ple will be unable to redeem its 15 years debenture stock when they mature. A rational investor will reduce risk to the minimum while it maximizes its returns, There if usually a conflicting attitude towards investment risk and returns. Most investors would like to invest in an Investment that promise higher rates of expected returns but most investments that carry higher rate of returns also have higher risks attached to them, Since investors do mot like risk they must be paid additional rate to compensate for the additional risk. Investments are assessed on two parameters namely, Feturn and risk The diagram below shows the relationship between Conceptual risk and return. . he Mey will returns to DE ‘Scanned with CamSeannerRts Ordinary Shares € Rt Bond & Debenture = @ Rt Government Security Rs, Rs; Rs, Risk Figure 5.1: Risk-Return relationship From figure 5.1 above, investment In government security is a risk free investment with lower expected rate of return. Bond and debenture with greater expected rate of return than government security but with more risk. The ordinary shareholders who are the residual owners of the company have the greatest expected rate of return and the highest risk because of the nature of the ordinary shares. 5.4 Attitude To Risk Inan investment decision, estimating and assessing the , risk is not the end. One should also be able to know the attitude of the investor towards risk .It is not the Investment itgelf that is risky but how you choose to use the investment that Is risky. The ability to embark on risky or a less risky project will depend on individual's attitude towards risk, which can be displayed by analyzing the utility function which Is way of measuring the satisfaction one derives from Investment decision and the return associated with it, The individual's attitude to risk involves: 41 Scand wih Camszaner(a) (b) (c) 5.5 r: This [6 one who prefers the ExDecte. me with a certainty. He is not will ing st for the sake of it but will be Willing ,. take risk provided the expectation Is adequate ,, compensate for It. That is, the risk averter will only take risk If he Is suire of a higher rate of returns compared j. the risk. Suppose there are two investments. Project & ¥, Project X wlll yield N40, DOO with 100% certaj while project ¥ will yield return of N60,000 Ifi tsuceeeds, but if it fails, It will be Zero, A risk averter will opt foe project A, Risk Neutral: One who is indifferent to any of the two extremes discussed above. He does not bother himself with risk analysis; his concern Is the rate of return. 4 risk neutral person is a perfect example of economic rationality. Risk Taker: A person wha laves to take risk. The risk taker will opt for project ¥ (above) that will give a return of N60, 000 if it succeeds, Risk Averte adverse outco assume risk jul Sources of Risk 4 wide range of factors creates risk, such factors include: fa} (ib) fc) td) (e) (rf) Economic instability Political insta bility Competition Technological development Market conditions Labour ‘Scanned with CamScanner(9) (n) Natural occurrences such as flood, drought, earthquake etc. : Other unexpe: ed disasters such as burglary, fire ete. ct ‘fi . These factors are discussed below: (a) (b) (c} Economic instability: The economy of any nation should be stable ta a reasonable extent. Where there is economic instabllity, risk will always thrive. An investor for instance may be embarking on an undue risk if he invests In an unstable economy. A case In paint is Nigeria where the exchange rate is on the high side because the naira Is very weak, instability: This has often been a permanent f the Nigerian political setting. In the present the country has been witnessing a lot of ging from ethnic to religious ffect therefore is that an Investor may fee! so uncomfortable with the situation In the country. Where an investor is wooed and he embarks on an Investment process under such a situation, he will be deemed to have embarked on a risky venture. Competition: Companies In have competitive products and one of them may have competitive advantage over the other. A situation af risk may have arisen particularly when it is obvious that the weaker of the twa companies may not be able to survive the tense competition. Political feature 0! dispensation, palitical disturbances fan clashes. The attendant e the same Industry may 43 Scanned wth amseanner(e) (4) (6) 5.6 ical development: Where there j, .. y in place, @n existing structure nies ‘ tnctmaley sckete. This may therefore culminate ce id order to survive the test of time, conditions: Even when an extensive ne ee has been conducted and the product has perfectly developed, the conditions in the market be harsh and unfavourable to the new product, Gen disturbances In the economy will have an adverse on the market situation; the mode of distribution i be faulty such that the product is not property circulatey inthe market. Natural occurrences: This could include flood, drought, earthquake which are unavoidable risks ang their occurrence will marthe fortunes ‘of a company, Unexpected disasters: Unexpected disasters such as fire outbreak, burglary among others will naturally make a company to suffer serious setbacks In its ‘operations. Types of Risk The risk associated with a business or an Investment tan be categorized into different types, namely; (ay {b) (c) Business risk Financial risk Purchasing — power risk (a) Interest - rate risk (@) Uquidity risk (fF) Moral, Legal and political risk, ‘Scanned with CamSeanner(a) Business Risk: This refers to the total risks associated with a company In business operation. The factors that affect a company’s operations are Inter alia, its size product mix, competition and the overall net effect of all these factors. Financial Risk: This refers to the risk that results from the way In which a company is financed. Debt financing involves @ fixed cost that the company must pay out of fit from operations. Consequently, when sales revenue falls or costs rise, interest being 2 fixed cost takes a larger proportion of the profits available. In this way, interest payments constitute an added burden on the company and the more the debt, the greater the burden. Ifa company uses a lot of debt financing, it will be viewed as having 4 significant amount of financial risk. The more the debt financing used by a company, the greater the fina ncial risk. (e) Purchasing-Power Risk: Refers to the purchasing power of the returns earned on investments. The process of investment involves investing funds now for a stream of benefits in future. These benefits may Include Interest, dividend etc. The funds can purchase @ certain amount of goods and services now or In other words; such funds have @ certain amount of purchasing power. However, if prices are rising, the naira received in the future will have less purchasing power than the nalra originally used to make the investment. (b) (d) Interest Rate Risk; It ls a major source of risk to the holders of high-quality bonds. The prevailing level of 45 an. ‘seamed with Camscannerte) (A in the market determines the price 4, i ponds. As 2 result, if interest rates fall, the prices these bonds will rise and vice versa. An interest isk affects all investors in high quality bond rega,, of whether the investor holds short-term or long-ter, bond. Changes in Interest rates have the Greate, Impact on the market price of long-term bonds, sin,. the longer the period before the bond matures, the greater the effect of a change in Interest rates. On the other hand, changes in interest rates will not have s- much impact on the market price of short-term bonds but the interest income on a short-term band may fiuctuate from period te period as interest rates change. Consequently, changes In interest rate affect investors in both long-term and short-term bonds. interest rate Liquidity Risk: This is a risk that has to do with possibility that a business firm will not run out of cash so that its going concern Is not jeopardized. Ifa company is not liquid It will not be able bo meet its obligations as at when they fall due and its continuous existence is not sure, Moral, Legal and Political Risks: Moral risk applies to the risk of dishonesty. A situation where management Is perpetuating fraud. A typical example of legal risk is » change in taxation laws that are likely to affect the holding of an Investment, Political risk refers to actions of the government of the day. “a ‘Scanned with CamScanner5.7 Classifications of Risk All the risks discussed above can be classified into two roups: a gystematic Risk 2. Non-Systematic systematic Risk: This Is a risk that affects all firms. It is a force that cannat be diversified away. itis otherwise known as non-diversifiable risk, Almost all securitles have some systematic risk, whether bond, shares or stocks, because systematic risk encompasses interest rate, market and inflation risks. The Investor cannot escape this part of the risk irrespective of haw well he diversified. The risk of the averall market cannot be avoided. Forinstance, market risk Is critical to all investors. No matter what a single Investor does if the stock market falls sharply most shares wilt be adversely affected and vice versa. Examples of systematic risk Is war, global financial meltdown, International incidents {like Septernber 11 terrorist attack on World Trade Centre), political event such as the annulment of the June 12, 1993 general election in Nigeria among others. Non-Systematic Risk: This is a risk that Is unique to a particular company. These are risks that can be diversified away. It is avoidable, sometimes called diversification risk. It Is residual or company specific. It is an unsystematic risk, which may be as a result of a strike action, outcome of an unfavourable litigation or natural catastrophe, Risk such as business, liquidity or financial risks are associated to such isk. It should be noted however; that all securities have un- systematic risk, particularly shares. a7 a, ‘Scanned wih CamSeanner(a) (b) (cy (a fon: — investments that make up ee total investments. The investment might ee rojects or eecurities. An investor the zB eo foremost divide his portfolio into fixe, shou investment and equity. While fixed interes interest | Income, equities are variahi, estments offer steady : taal securities. In the same veln, while equities giv. the chance of capital appreciation, they equally do nee offer any protection against the risk of capital loss, the protection which fixed capital investments normally give. portfolio Size: The size of each type of Investment will to a larger extent depend on personal factors but generally speaking, the smaller the Investment In each of the components the better. Ease of Realization: The investor should examine the avallable fixed interest investment with a view to guaranteeing him the necessary liquidity or solvency, Investors with smaller investments in Particular are advised to apportion his Prorated capital in a form in Which he can easily turned Inte cash, Industrial and Geographical Spread: Equity A portfolio describes thy. Investment should be Spread geographically and ie la ‘Scanned with CamScannerindustrially. Different industries have their own characteristics and within an industry there are highly successful companies. The investor should spread his equity among the first class companies within the Industry and can also be involved in investment overseas. (e) Investments in Real Property: Investments in real perty Isa wise and good Investment. This is because it serves as a hedge against inflation. Rather than investing entirely in securities, investment in property could provide the needed spread. 5.8 Summary Risk is the possibility that the actual return from an investment may deviate from the expected returns. Under risk, the future outcome is unknown but the likelihood of various possible future outcomes may be assessed with some degree of confidence. + With uncertainty, future outcome cannot be predicted with any degree of confidence. The reasons accountable for risk are economic Instability, political instability, competition among others. There are three types of attitude to risk - the risk averter, the risk neutral and the risk taker. 49g Mm Scanned wth CanSeannerrisk can be classified into busing... Lie ly, essentially, purchasing powerrisk among othare financial risk, Risk can be spread by constructing a po, determining the size of each investment in the Portfaj investing in real property etc. i, ReviewQuestions = 1, Distinguish between risk and uncertainty. With appropriate Illustrations, examine the Major 2 sources of risk. 3. Critically examine the risks that are associated with an investment project. 4. Discuss the various ways In which we can spread risk in finance. 5. Discuss the attitude of individuals to risk, - Scand with SeatCHAPTER SIX RISK AND RETURN 6A Introduction nig chapter x-rays the relationshi P between risk peturn for 2 security. Sharpe et al (2001) defines cer the legal representation of the right to receive prospective future benefits under stated conditions. 2 Risk and Return ofa Single Security Individuals and firms Invest their financial resources so as to increase their wealth. In order words, so as to earn more money In the future. Hence investors expect a rate of return or simply return on their invested funds, Retum = End of period wealth - Beginning of period wealth Alternatively, Return = Amount recelved at the end of the period - Initial amount received. Illustration 6.1 Qjo Salami invests 90,000.00 in a business today and after one year he disposed the business for N 100,000. Required = Calculate the return. Return = 4100,000 ~N90,000 = 410,000 We can also express Investment return in of return which can be expressed in percentages- terms of rate 51 Scanned wth CamSeamerus: aoa or = @ tnitlal amount Investe niustration 6.2 invests N25,000 In @ business tog bu i i's ee disposed the business for N35,000, ng after on! Required: Calculate the rate of return RateofReturn= 35,000-N25,000 =0,4 425,000 sane 6.3 Measuring Risk: Expected Rate of Return and Standard Deviation Investors commit their financial resources in anticipation of future money but they cannot Predict with certainty what will happen to their Investments when there js an element of risk that is involved. In other words, there is a possibility the actual return from holding a security will be different from expectations. If itis possible to find the probability of Occurrence of Possible returns of a security, then assessing the risk of the Security is possible, The Probability distribution in the @ssessment of risk can be assessed through the expected value of return and Standard deviation. Hence information about the expected retum and standard deviation helps an investor to make decision about investments. 52 1 Scanned wth CamSeamerExpected return Iscaleulated by the formula eign: E(Ry= PP et where: (r= the expected value of returns on security| R = the return associated with an eventi po&the probability associated with eventi n = tatal number of events. ‘The formula for variance Is: a= ZIR-E (RIT While the standard deviation Is the square roat of the variance. a =F RE (RITA, Tilustration: 6.3 The retum on security J fora one — year holding period is uncertain but the probability distribution of possible returnsof security Jis given as follows: late of Economy | Possible Returns % Probability of Event 53 ‘Scanned wih CamSeannercatculate the expected value and st, rig return on security J. arg Req deviation ofthe Expected value of returns = 12.9% Standard deviation (3) of returns: = {0.000684 = 2.62% 6.4 Coefficient of Variation This can be used to measure risk when comparing two alternate investments that have the same standard deviation but different expected returns or the same expected returns but different standard deviations, The higher the coefficient of variation, the higher the risk of the investment. The formula for coefficient of variation Is given below: Coefficient of variation = Standard deviation Expected return Illustration 6.4 ‘Two investments X and Y have the following standard deviation and expected returns. 54 Scanned wth CanSeanneroo OE ee Required: (i) Calculate the coefficient of variation, (ii) Which of the two securities are riskier ? Solution: a Coefficient of variation = Standard Deviation Expected Return x ¥ Coefficientofvariation = _405% 30% 18% 20% = 2.22% 1.5% (if) Security A of 2.22% Is riskier than security Bof 1.5%. 6.5 Summary Individuals and investors invest their financial resources so as to increase their wealth. Information about the expected return and standard deviation helps an Investor to make decision about Investments. 55 ‘Scanned with CamScanners al — Security A Security ¢ Standard deviation 20% 15% Expected returns 13% 18% Required: Calculate the coefficient of variation Iwajowa Invested N500,000 in a business today an, after one year he sold off the business for M750,000 Required: Calculate the rate of return. 2 565 ‘Scanned with CamScannerCHAPTER SEVEN JHE CONCEPT OF TIME VALUE OF Maney the Time Value of Money The concept of the time value of tant in taking financial decisions, Hanes 000 today’ cannot be the same 41,000 In 2 years time. If we invest wi,000 today something would have been added to it in 2 ars time such that we will have a different value entirely. Under normal circumstances, it becomes desirable for this addition to be higher than the inflationary rate in the economy except where the investment is unprofitable. Numerically, the value of money would have changed over a period of time. However, the real or economic value of money drops with the passage of time such that N100 received In 2 years time will not have the same value as WLOO received today. The timing of cash flows, profits or benefits generated by an investment matters since WLOO that is available today is worth than the same amount that is promised to be pald in two or more years, Hence most individuals value the opportunity ta receive money now rather than waiting for one or mare years to receive the same amount - This is the time value of money 71 7.2. Factors that Affect the Value of Money Money may lose its value over time due to any of the following reasons: (a) Inflation; 57 Seanad wih Camscannetoruncertainty; e ai erence far consumption; aD Investment opportunities. ee a basic reallty of our economic life that Makeg money lose some of its value over time. Unless the rap. af returns expected from an investment Is over and above the inflationary rate In the economy, such Investment Will by worthless to the investor. Since inflation is a basic fact OF life, a rational investor or decision maker would prefer to have g certain amount of mo ney now rather than waiting to have the same amount sometimes later. Risk or Uncertainty We live in a world of uncertainty where projected returns on investments May not be forthcoming In the same magnitude and dimension. An Individual may not be certain about future cash receipts and may prefer cash now. A certain sum of money now would therefore be incom Parable Ordinarily toan equivalent sum sometime in the future, Preference for consumption Most people have subjective preference for resent consumption over future consu Moption of goods and Services either because of the urgency of thelr present wants or the Fisk of not being In a position fo enjoy future consumption that may be Caused by illness or death, or because of inflation, AS money is the means by which individuals acquire most goods and services, they May prefer money now, 58 Seamed with Comscannerinvestment opportunities Most individuals or even business firms Prefer present cash to future cash where there are available investment opportunities. For instance Ni, 900 now would be preferred ta Ni, 000 in the future particularly where the N1,000 can Ke invested to earn NSO between now and the nearest future, The total cash of the individual in one year from now will be ni, 050. Thus, If he wishes to increase his cash resources, the opportunity to earn Interest would lead him to prefer wi,000now, not ¥1,100 after ane year, How Money Loses its Value Overtime? This entails the discussion of real life situations of how Nigerian currency has been losing its value over time, enables us to have practical understanding of the time value of maney. 7.3 Simple Interest A borrower usually pays certain sum of money for the privilege of using something, which belongs to the lender. When money is borrowed, the price paid for its hire is called interest. Where such interest earned is not added back to the principal amount borrowed or invested, itis known as SIMPLE INTEREST, It is often earned In equal amount, at regular Intervals such as monthly, quarterly, half yearly and yearly. It Susually a given proportion of the original loan or investment. Exampfe7.1 Suppose that N1, O00 Is Invested at 10% simple interest Per annum. The following table shows the state of the vestment year by year. 59 Seamed with Comscannerborrowed is called PRINCIPAL and jt |, The money i he interest is calculated for a periag ort My this amount that t andata pa ticular rate. Example 7.2 Find the simp! annum. #1,000in 1 yearearns N40 W6,000in Syearsearns N40x6x 5 =N1,200 le interest on N6,000 for 5 years at 4% p, Formula SI=PxRxT 100 Where SI = Simple Interest P = Principal R= Rate T=Time PxPxT = Pro 100 P=P, R=, Tsn RT=m In simple interest estimation, Interest only accrues or 60 Scanned wth CanSeannercipal; the Interest Is assumed not re-invested and hence ; does notearn more interest. The basic formula for estimating simple interest due on aprincipal sum isgiven as: si=Prm WhereS! = Simple Interest P = Principal r = Rate of interest n = Number of years (Time) OR I=FV-P Where FV = Future Value P =Principal cample 7.3 Find the simple interest on N 150, 000 for @ years at 3% ‘Scanned wih CamSeanner7.4 Future Value ‘This is the principal amount invested plus the simple interest. Wo= Pts = P+Pm = P(it+m) Example 7.5 ____How much will an investor have after 5 years if he invests 420,000 at 10% simple interest per annum?Example 7.6 What amoun 15% simple interest for 3 years? = @ t will generate an interest of M 50,000 at m 0 0.45 = W111111.11 Example 7-7 What amount should be invested to accumulate Np4,000at20% simple interest in Syears? po = _FV (i+rn) 84.00 [1 + (0.20) (3)] 84.000 16 = N52, 500 Time _This represents the period involved when computing neipal. It could be our simple interest, future value or pri annually, bl-annually, quarterly, monthly etc. Example 7.8 Find the time In which N 15,. perannum. 420 will earn 3,969 at 3¥2% 63 Scanned with CamScannerSolution: T= 3 Pr 7 = 3,969 \ 15,120 x 0.035 years = 7.5yearsor? va years This Is the fixed percentage payable by the borrower ¢g realizable on the Investment for each time of period during which he keeps or invests the money. R= si Pa Example 7.9 Fi 7a ae at which 16,790 will earn 4295.701n Solution ; Rs 1690x 7 = 0.0249 ~ oe 7.5 Compound Interest This is : 5 will be compe ot erest at which an individual or firm later or In the future, 1 1 awlanging money now for money the amount per unit of tin ressed as a perenne lender-at the end of the period, tha wre merest Is 10 F Seanned wth CamScannerriod Le. to add the Interest Eo the Principal so that the Frincipal For the next interest period is larger. The interest eamed is converted to the principal at the end of the interest. gaming period. Compound interest therefore assumes all meney is productive that ts, earned interest automatically, _ gets re-Invested at the same terms.as the original principal. ample 7.10 Asum of N2, 000 is invested to carn 10% interest. After ‘year, the original principal plus interest willamounttaa2,200 the beginning 2,200 Band year (10%) _—__ 220 attheend of 2nd year M2.420 table shows the state of the Investment ‘Scanned with CamScannerBasic formula for Compound Interest: A = P(i+ry Where: A P r n Sum Invested after 'n' periods Original sum Invested Rate of interest Number of periods From the example above and using the formula A = P(itry A= 2,000(1+0.1) = 2000 (1.1) Interest earned over 3 years can be determined using FV~P = 2662 - 2000 = W662 (Note that FY = Future Value = A) Principal | Formula Ti (14r)n (ley Example 7.11 ie A principal amount accrues to we,500 If It compounded at 14.5% over 6 years. Find the value. Solution A = N8,500 eee de n Semeio Pare 5 —A_ = 8500 _— ay (01145) at 66 canned wih Camseanner(1-145)° = 6372.12 pate Example 7.12 At what annual rate of compound interest will N2,000 grow toW2,721 after 4 years? : ution las A, = P(Leey a 2 = zn ami = (At) 2000 l4+r itr +r take for an Initial amount to inded annually using the logarithm ‘Scanned with CamScannerSolution qdy | =40 aebAsy = * (isy =4.0 ‘Using the logarithm approach nlogi15 = Log4 n & ) Logs Log 1.15 = 0.6021 0.0607 = 10 periods or 10 years. Distinction between Simple and Compound Interest (1) The compound interest basic formula FV =P (1 +rJ" has an automatic in-built mechanism for estimating Interest plus principal while simple interest does not. (2) The future amount due for collection under compound interest Is usually higher than thatof simple Interest. (3) The time value of money finds its Initial application i Compound interest while It is not so for simple interest. *, 7.6 Compounding j This is the arithmetic Process of determining the fina! value of @ payment or a soles 5p " || applied. of payment when interes! However, We will be limit ng o und value or final valu@ ofa payme 19 Ourselves to the compo! tor lump sum. | 68 Seanned wth CamScannerexam ple 7.14 Calculate the future value of the investmentof Ralnbow Fic. Assume Rainbow Pie invests N60, 000 for a period of 3 years at 18% Interest rate perannum. solution: The future value or compound value of a lump sum or single amount can be calculated thus: FY = Pit+r)" N60,000 (1+0.18)" = 60,000(1,18)" = 498,518.90 at Interest rate is narmally expressed a5 Interest is often compounded more Please note th annual rate. However, frequently e.g. semi-annually, quarterly etc. The formula for calculating the future value of a lump sum ofa multiple compounding period is given as: Fy. = °( itr r m Where: t = Interest rate per annum. m =Numberofcompouw nding periads within a year, n = Number of years. Letus now assume the investmen tof Rainbow Pic above Involves quarterly compounding. Bere PR ( itr ie m £ = 0.18 m 4 = 0.045 ni ax4=12 69 ‘Scanned with CamScannee