Financial Management in Construction

WACHEMO UNIVERSITY
COLLEGE OF ENGINEERING AND TECHNOLOGY

DEPARTMENT OF CONSTRUCTION TECHNOLOGY AND
MANAGEMENT
MODULE OF FINANCIAL MANAGEMENT IN CONSTRUCTION

(CoTM 5161)
PREPARED BY:
MIHIRETAB ACHISO
November, 2022
Hosanna, Ethiopia
Financial Management in Construction CoTM 5161
WACHEMO UNIVERSITY
COLLEGE OF ENGINEERING AND TECHNOLOGY
DEPARTMENT OF CONSTRUCTION TECHNOLOGY AND MANAGEMENT
FINANCIAL MANAGEMENT IN CONSTRUCTION

( CoTM 5161)
READING MODULE FOR CONSTRUCTION TECHNOLOGY AND MANAGEMENT
STUDENTS
BY:-
MIHIRETAB ACHISO (MSc.)
REVIEWED BY:
ABENEZER TADIWOS (MSc.)
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Table of Contents
List of Tables……………………….…..…………………………...……………………………….v
List of Figures………………………...………………………………………………………….....vi
1. INTRODUCTION ..................................................................................................................... 1
1.1 Capital Requirement of a Corporation .................................................................................. 1
1.2 Fields of Finance.................................................................................................................... 4
1.3 Goals of Financial Management ........................................................................................... 6
1.4 Functions of Financial Management ..................................................................................... 8
1.5 Organization of Finance Function....................................................................................... 10
Summary .......................................................................................................................................... 12
Review Questions ............................................................................................................................. 12
References: ....................................................................................................................................... 13
CHAPTER TWO ............................................................................................................................. 14
2. Financing Decisions ................................................................................................................. 14
2.1 Short-term financing ........................................................................................................... 15
2.2 Intermediate-Term Financing ............................................................................................. 18
2.3 Long-Term Financing ......................................................................................................... 20
Summary .......................................................................................................................................... 23
References: ....................................................................................................................................... 25
CHAPTER THREE ......................................................................................................................... 26
3. FIRM’S FINANCIAL OPERATION ........................................................................... 26
3.1 Financial Statement ................................................................................................................. 30
3.2 Financial Analysis ............................................................................................................... 37
Summary .......................................................................................................................................... 41
References: ....................................................................................................................................... 45
CHAPTER FOUR ........................................................................................................................... 46
4. INVESTMENT POLICY ...................................................................................................... 46
4.1 The Time Value of Money .................................................................................................... 47
4.2 Investment Appraisal .......................................................................................................... 49
4.3 Capital Budgeting on Contract Investment: ........................................................................ 54
4.4 A System of Control Levels ................................................................................................ 58
Summary .......................................................................................................................................... 63
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References: ....................................................................................................................................... 66
CHAPTER FIVE ............................................................................................................................. 67
5 WORKING CAPITAL MANAGEMENT ............................................................................ 67
5.1 Working Capital Policy ....................................................................................................... 68
5.2 Cash & Liquid Management ............................................................................................... 74
5.3 Credit Management ............................................................................................................. 82
5.4 Inventory Management ....................................................................................................... 86
Summary .......................................................................................................................................... 90
References: ....................................................................................................................................... 96
CHAPTER SIX ................................................................................................................................ 97
6 Project Appraisal ..................................................................................................................... 97
6.1 Meanings of Project Appraisal ................................................................................................ 98
6.2 Project Appraisal - A Methodology ....................................................................................... 100
6.3 Appraisal Methods ................................................................................................................. 103
6.4 Capital Budgeting: ................................................................................................................. 114
6.5 Capital budgeting Techniques: .............................................................................................. 115
Summary ........................................................................................................................................ 120
Review Questions: .......................................................................................................................... 121
References: ..................................................................................................................................... 123
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List of Tables
Table1.1 Areas of Finance ................................................................................................................... 4

Table3.1 Examples of Balance sheet ................................................................................................. 33
Table3.2 Examples of Income Statement….. .................................................................................... 35
Table4.1 Examples of Payback Period…………………………………………………………...…50
Table6.1 Costs and Benefits over 7 years………………………………………………….……....104
Table6.2 Computing Net Present Values…………………………………………………………..107
Table6.3 Computing Net Present Values 2…………………………….…………………………..108
Table6.4 Computing the Benefit Cost Ratio….…………………………..………………………..109
Table6.5 Computing the Internal Rate of Return…….……………….…………………………...110
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List of Figures
Figure1.1 Fund Flows of Corporation. ................................................................................................ 3
Figure1.2 Organization of Finance Function ..................................................................................... 11
Figure1.3 Fund Requirement. ............................................................................................................ 15
Figure3.1 Financial Statement ………………………………………………………...……………28
Figure3.2 Types of Financial Analysis……………………………………………………………...29
Figure3.3 Sources, Uses of funds and the Working Capital Pool……………………………...…...36
Figure4.1 Future Values of Money for Different Interest……..……………………………………48
Figure5.1 Current Asset Cycle……………………………..……………………………………….70
Figure5.2 Operating and Cash Cycle……………………..…………………………………………71
Figure5.3 Cash Flow Forecast…………………………..…………………………………….…….80
Figure5.4 Gross and Net Cash Requirement…………………..….………………………………...81
Figure5.5 Terms of Payment……………..…………………………………………………………83
Figure6.1 Project Appraisal Methods……………..………………………………………………..98
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CHAPTER ONE
1. INTRODUCTION
Learning Outcomes*
When you have completed this chapter, you should be able to:
 Discuss the role of the finance function within a business.
 Identify and discuss possible objectives for a business and explain why shareholder
wealth maximization is considered to be the most appropriate.
 Explain how risk and ethical considerations influence the pursuit of shareholder
wealth maximization.
Brainstorming Questions*
Suppose one is planning to start his own business. No matter what the nature the proposed business
is and how it is organized, he has to address the following questions.
1. What capital investment should be made? That is what kind of material and
equipment should be purchased, the type of land to be leased or building to be
rented, etc.
2. How and where the money to pay for the proposed capital investment will be raised?
That is, what will be the equity and debt mix in the financing plan?
3. How the day-to-day financial activities are handled like collecting the receivables
and paying the suppliers?
1.1 Capital Requirement of a Corporation
In the modern society, Financial Management goes beyond answering those fundamental questions.
It assumes the responsibility of dealing with the problems and decisions associated with managing
the firm‟s assets that has made it an exciting and challenging area in managing large organizations.
Financial decision making is primarily concerned with developing the skills needed to make correct
Wachemo University Page 1

decisions in a fast moving and technologically complex corporate environment. Some of these
issues include:
 Which new proposals for employing capital should be accepted by the firm?
 What steps can be taken to increase the value of the firm‟s common stock?
 How much working capital will be needed to support and expand the company‟s operation?
 Where should the firm go to raise the short and long-term capital demand and how much
will it cost?
 Should a firm declare a cash dividend on its common stock and if so, how much a dividend
should be declared?
Finance is a specialized functional field of business administration. The term finance can be defined
as the management of the flows of money through an organization, whether it to be a corporation or
non-corporate business or government agency. Finance concerns itself with the actual flow of
money as well as any claims against money.
The flow of funds within a corporation is basically a continuous process, particularly if the
corporation has been in business for a period of time. Fig 1.1 illustrates a typical cash flow diagram
with the focal point being the reservoir of cash. One could see the following as inflow and outflow
of cash.
 Cash is raised through equity, debt or through investment by other corporations,
 Cash inflow includes net credit sales, net cash sales and sales of assets,
 Cash is disbursed through purchase of materials, fixed assets, expenses as wages and salaries
to workmen,
 Cash is repaid to stockholders in form of dividends, creditors in the form of loan repayment
and also to other corporations stocks or bonds.
If total cash inflow exceeds all costs (including depreciations) for a given period, then there is a
profit for that particular period, if not there is a loss.

Stockholders‟ Other Corporations, Creditors (Debt)

Equity Businesses and Agencies
Outside Investment Loan Payment Loan

Dividends
Cash
Investment
Collections
Purchase of Sale of Payment of Accounts

Assets Assets Expense Receivables
Payment for
Material
Personal Expenses
Fixed Wages, Benefits
Raw Materials Net Credit Net Cash
Assets & Operating Exp. Sales Sales
Sales
Depreciation Expense
Labor Expense
Work in Process Product Inventories
Figure 1.1 Fund Flows of Corporation.

1.2 Fields of Finance
The academic discipline of financial management may be viewed as being made up of four
specialized fields as shown in Table 1.1.
In each field, the financial manager is dealing with the management of money and claims against
money. Distinctions arise because different organizations pursue different objectives and do not
face the same basic set of problems.
Four areas of finance:
Table1:1 Areas of Finance
Fields of finance Fund owned by Fund collected through Use of fund
Public Finance Federal, State and Local Revenue from taxes and To accomplish Social and
Government levies, Loan , Grant etc Economic objectives.
Perform non-profit oriented
corporations.
Finance Individuals, Institutional Purchase and sale of Means of raising finance for
Securities investors stocks and bonds. institutional investors.
Means of achieving profit
for individuals.
International Individuals, businesses Through International Means of collecting foreign
Finance and governments transactions currency.
involved in international
transactions
Institutional Banks, Insurance Individual savers Finance function of the
Finance companies, and pension economy through capital
funds and credit unions. formation.
Financial Management:
 Studies financial problems in individual firms,

 Seeks sources of low-cost funds

 Seeks profitable business activities.
Debt versus Equity
Financial securities, a means for raising finance for a corporation.
i) Debt Security. It arises when a firm borrows money from creditors. The firm incurs liability to
repay the amount of money borrowed in some future maturity date.
ii) Equity Security. It represents ownership claim in the firm. People who purchase equity
securities are entitled to rights and conditions that are different from those of firm‟s creditors
The three forms of financial securities:
a) Bond (Loan): a security representing a long-term promise to pay a certain sum of money at
a certain time or over the course of the loan, with a fixed rate of interest payable to the
holder of the bond.
Two forms of bond: Secured bond and unsecured bond.
 Secured bond: Denote borrowings of the firm against which specific collateral have
been provided. Example, Mortgage bond : secured by a piece of property or
building
 Unsecured bond: Borrowings of the firm against which no specific security has been
provided.
Example, advance payment, inter-corporate borrowings, unsecured loan from banks
based on the good reputation with the firm.
b) Common Stocks (equity): a security representing the residual ownership of a corporation.

 Guarantees only the right to participate in sharing the earnings of the firm if the firm
is profitable,
 Common stockholders have the additional right to vote at stockholders‟ meeting on
issues affecting fundamental policies of the corporation,
 They have the right to elect the board members and directors,
 They have the right to inspect the firm‟s books and documents.
 Common stockholders are entitled to receive dividends if and only when they are
declared by board members.

 Common stockholders have the right to transfer their ownership by selling their
stock without the consent of the corporation.
1.3 Goals of Financial Management
The starting for developing a goal-oriented financial structure is the defining of workable
goals for the firm as a whole. Properly defined and understood goals are the key to
successfully move a firm to a future desired position.
Two primary objectives are commonly encountered: Maximization of profits and
maximization of wealth.
Profit Maximization:
Frequently, stated goal of a firm is to maximize profits. It is a simple and straight forward
statement of purpose. It is easily understood as a rational goal for business and focuses the
firm‟s efforts toward making money.
Profit maximization has several weaknesses.
i) It is vague: Profit in the short run may be quite different from profits in the long run.
If a firm continues to operate a piece of machinery without proper maintenance, it
may lower this year‟s operating expenditure and increase profits. But the firm will pay
the short run saving in future years, when the machine is no longer capable of
operating due to prior neglect.
ii) It leaves consideration of timing and duration undefined. There is no guide for
comparing profit now with profit in future or for comparing profit streams of different
durations.
iii) It overlooks future aspects.
 Some businesses have placed a high value on the growth of sales and are willing
to accept lower profits to gain stability of the market sales,
 Other businesses recognize diversifying their activities into different products that
strengthen the firm but short-term decline in profits.
 Others firms use a portion of their profits to achieve social goals or to make
contributions to society.
Maximization of Wealth

The second frequently encountered goal of a firm to maximize value of a firm in the long run. The
maximization of wealth is linked with long term profits of the firm. A firm who is maximizing
wealth must do the following.
 Avoid high levels of risk: Projects that promise exceptionally high profits with
relatively high degrees of risk should be avoided.
 Pay consistent dividend: By paying consistent dividends, the firm helps attract
investors seeking cash income, which maintains the market value of the stocks and
keep up its present value.
 Seek growth in sales. As a firm increases its sales and develops new markets for
products, it protects itself against economic recessions, changes in consumer
preferences or other reductions in demand for the firm‟s products. However profit
may decrease from the additional cost required for promotion and secure attraction of
various customers.
 Maintain market price of stock. A company‟s manager can take a number of positive
steps to maintain the market price of the stock at reasonable level by
- taking time to explain company‟s actions
- encourage individuals to invest in the firm
- seek sound investments, the firm will appear to be a wise investment choice
over the long-term.

1.4 Functions of Financial Management
Goals of Financial Management Functions of finance

Maximize Profits: Maximize Wealth:
A weak Statement of A good statement of  Liquidity functions
Achieved
Goal goal  Profitability functions
It is vague, Implies avoiding risk  Managing funds
Overlooks quality Seeking growth
 Managing assets
Ignores timing Paying dividends
In the context of achieving their goals, financial managers perform tasks in several areas which are
referred as functional areas of finance. This includes:
i) Functions leading to liquidity

This means that the firm has adequate cash on hand to meet its obligations at all times. Stated
Another way, the firm can pay all its bills when due and have sufficient cash to take
unanticipated
Discounts for large cash purchases
In seeking sufficient liquidity to carry out the firm‟s activities, the financial manger performs
the following:
 Forecasting cash flows. Successful day-to day operations require the firm to pay its
bills promptly. This is a matter of matching cash inflows against cash outflows.
 Raising funds. The firm receives finance from a variety of resources. The financial
manager must identify the amount of funds available from each source and the periods
when they will be needed. Then the manager must take steps to ensure that the funds
will actually be available and committed to the firm.
 Managing the flow of internal funds. In a large firm, the financial manager should
control and manage the flow of cash within the different bank accounts for various
operating divisions. A manager can achieve a high degree of liquidity and reduce costs
associated with short-term borrowing by continuously checking the cash level in each
bank account and monitor the timely transfer of cash.

ii) Functions leading to profitability
In seeking profits for the firm, the financial manager shall provide specific input into the decision-
making process based on financial training and actions. Some of his specific functions are the
following:
 Cost Control. Firms require detailed cost accounting systems to monitor expenditures
in the operational areas of the firm. Because of supervising the accounting and
reporting functions, the financial manager is in a position to monitor and measure the
amounts of money spent or committed by the company.
 Pricing. Important decisions by the firm involve pricing established for products,
product lines and services. Determination of the appropriate price should be a joint
decision of marketing and finance. E.g. Reasonable and fair preparation of
engineering cost estimates for projects using the cost break down of activities is
important for a firm to achieve profitability. The financial manager can supply
important information about costs, changes in cost, risk and profit margin in pricing
decisions.
 Forecasting Profits. The financial manager is usually responsible for gathering and
analyzing the relevant cost and sales data and forecast profit levels. Before funds are
committed to new projects, the expected profits must be determined and evaluated.
Will the profits justify the initial expenditures?
 Measuring risk-return of a proposal. Every time when a firm invests, it must make
risk-return decisions. Is the level of return offered by the project adequate for the
level of risk therein?
iii) Managing Assets.
Assets are the resources by which the firm is able to conduct business. The term asset
includes buildings, machinery, vehicles, inventory, money and other resources owned by the
firm. A firm‟s asset must be carefully managed and a number of decisions must be made
concerning their use. The decision making role crosses liquidity and profitability lines.
Converting idle equipment to cash improves liquidity, reducing costs improves profitability.

1.5 Organization of Finance Function
Although there is no complete agreement, many firms designate three major financial
positions in their corporate structure as shown in Fig 1.2 below.
i) Chief Finance Officer: the top financial officer with responsibilities over all financial
activities. The
Chief finance officer is accountable for all the firm‟s financial activities, including
control of funds, decision making, and management and planning. The officer works
closely with other members of the top management team in formulating policies and
strategies. He supervises the staff including the treasurer and controller, who work
together closely to monitor the financial impact of operations of other departments.
ii) Treasurer: The treasurer‟s principal responsibilities include:

 Managing the firm‟s cash flow
 Forecasting financial needs
 Maintaining relations with financial institutions
 Capital budgeting
iii) Controller: The functions related to management and controls of assets come under the
scope of the controller:
 Financial accounting
 Internal auditing
 Taxation
 Management accounting and control
 Payroll functions

Chief Finance
Officer
Treasurer Controller
Cash Credit Financial Management

Manager Manager Accounting Accounting
Manager Manager
Capital Fund Tax Data

Budgeting Raising Manager Processing
Manager Manager Manager
Portfolio Internal
Manager Auditor
Figure 1.2 Organization of Finance Function

Summary
The main points in this chapter may be summarized as follows:

The finance function
 Helps managers in carrying out their tasks of strategic management, operations
management and risk management.
 Helps managers in each of these tasks through financial planning, investment appraisal,
financing decisions, capital market operations and financial control.
Shareholder wealth maximization
 Is assumed to be the primary objective of a business.
 Is a long-term rather than a short-term objective.
 Takes account of both risk and the long-run returns that investors expect to receive.
 Must take account of the needs of other stakeholders.
 Is often proclaimed in the mission statements of businesses.
Review Questions
1. What is finance? Define business finance.

2. Explain the types of finance.
3. Discuss the objectives of financial management.
4. Critically evaluate various approaches to the financial management.
5. Explain the scope of financial management.
6. Discuss the role of financial manager.
7. Explain the importance of financial management.

References:
1. Tasks of the Finance Function, Rose, H., Financial Times Mastering Management
Series, supplement issue no. 1, 1995, p. 11.
2. Corporate Governance: Improving competitiveness and access to capital in global
markets, OECD Report by Business Sector Advisory Group on Corporate Governance,
Organization for Economic Co-operation and Development, 1998.

CHAPTER TWO
2. Financing Decisions
In this chapter, we identify the main sources of finance available to businesses and discuss the main
features of each source. We also consider the factors to be taken into account when choosing among
the various sources of finance available.
Learning Outcomes*
 Identify the main sources of external finance available to a business and explain the
advantages and disadvantages of each source.
 Identify the main sources of internal finance available to a business and explain the
advantages and disadvantages of each source.
 Discuss the factors to be taken into account when choosing an appropriate source of finance.
1. Have you ever heard about the term financing business?
2. What would be the advantages and disadvantages of short term and long term
financing?
Management acceptance of proposal is based not only on the feasibility of the proposals itself in
terms of technical criteria, but on the status of the corporation relative to profitability and risk.
Projects require the acquisition and utilization of manpower, raw material, and fixed assets, such as
real state, facilities and capital equipment. The availability of these resources is dependent on the
current cash position of the corporation and the ability to acquire additional sources of funding for
project support. Thus part of the investment and financing decisions, management should:
 Review the corporation‟s profitability and cash position
 Forecast future cash needs,
 Determine possible methods of attaining additional funds through short-term and/or
long-term financing.

2.1 Short-term financing
Short-term financing usually includes loans that mature within a year or less. Such loans are
frequently used to raise temporary funds to cover seasonal or cyclic business peak or special finding
needs involving a short time frame. Sort-term loans are generally self-liquidating, in that the assets
acquired with the borrowed money should be easily convertible to cash with a high degree of
certainty.
Long-term financing
Total requirements Decision level
for funds
Fund
(Birr)
Time (Years)
Figure 1.3 Fund Requirement.

Goals of short-term financing:
 Funds are needed o finance inventories during a production/construction period; excessive

finds are on hand once inventories are sold or payments are collected after delivery of
services. Short financing allows the firm to match its funds against its needs over an annual,
seasonal or other cyclical period.
 To achieve low-cost financing. The interest-free sources provide low-cost financing for the
firm by reducing its borrowing need from interest-bearing sources.

Short-term financing sources:
i) Unsecured Interest-Free Sources:

Two major sources of short-term financing arise spontaneously from the daily activities
of the firm and have no interest charges associated with them. These are accounts
payable and accruals.
 Accounts Payable. Accounts payable are created when the firm purchases raw
materials, supplies or goods for resale on credit terms without signing a formal note
for the liability. These on „open account‟ or „credit invoice‟ are for most firms the
largest single source of short-term financing. Payables represent unsecured form of
financing since no specific assets are pledged as collateral for the liability.
 Accruals are short-term liabilities that arise when services are received but payment
has not yet been made. Examples:
 Sub-contract works for excavation, masonry works etc.
 Salaries/wages payable
 Taxes payable
Employees work for 2 weeks or months before receiving a paycheck. These form
unsecured short-term financing for the firm.
 Advance Payment: It is a common practice to pay an advance payment for delivery

engineering services upon signing of contract agreement. Contract stipulations
require that an advance payment amounting to 10-30 % of the contract price to be
paid to firm delivering the services. This is deemed to alleviate the firm‟s high
financial requirement in connection with site mobilization at the commencement of
the contract works.
 Advance for purchase of materials/ Material on site. Pursuant to the terms of any
international contracts, the contractor is paid after accomplishing and reaching a
certain minimal amount of construction activities/works which are certified through
measurement by the Engineer. Furthermore to alleviate the cash demand of the
contractor, he will be paid for the raw material on site including any transportation
cost rendered for consignment to the site. Sometimes, in order to minimize the time

delay arising from cash shortage and assist in expediting the work progress, Clients
are involved in the purchase of materials or transfer the cash to suppliers for the
purchase of materials and the corresponding price will be deducted from the
successive payment to be due to the contractor.
ii) Unsecured Interest-Bearing Sources:

A stable and profitable firm can borrow funds from short-term sources at competitive
rates of interest.
 Self-Liquidating Bank Loans. The bank provides finance for an activity that will
generate cash to pay off the loan. Short-term bank loans are generally tied in to the
prime rate plus a premium to reflect the degree of financial risk against the
borrower. Three kinds of unsecured short-term bank loans are commonly used:
 Single payment note: lending a business customer with as lump sum
repayable with interest in a single payment and at a specified maturity,
usually 30 to 90 days.
 Unsecured Overdraft Facility/ Line of Credit: An agreement between Bank
and Firm where by the bank agrees to make available upon demand up to a
stipulated amount of unsecured short-term funds, if the bank has the funds
available. It is normally established as one year and the interest rate is
expressed as prime plus some fixed percentage.
 Revolving Credit Agreement: Extended Lines of Credit to avoid the need to
reexamine the credit worthiness of a customer each time a small loan is
required.
 Non-bank short-term sources

 Commercial Paper/ Bond (Treasury bond): These consist of promissory
notes with maturities of few days say 270 days. Commercial paper is
purchased by other firms that are seeking marketable securities to provide a
return on temporarily idle funds. Individuals, commercial banks, insurance
companies, pension funds and other institutions also purchase the
commercial notes.

 Private Loans: A short-term unsecured loan may be obtainable from a

wealthy shareholder, a major supplier, or any other party interested in
assisting the firm through a short-term difficulty. This kind of arrangement
generally occurs when a temporary liquidity problem endangers the firm‟s
operation and their stock in the company is in danger.
iii) Secured Short-term Sources

A secured loan occurs when the borrower pledges a specific asset, called collateral, to
back a loan. The collateral may be in the form of:
 Warehouse receipt loan: it is a form of short-term financing that is secured by a pledge
of inventory controlled by the lender. The lender which may be a commercial bank
or finance company, selects the inventory that is acceptable as collateral for the
loan.
 Receivables: Receivables are normally quite liquid, they are attractive as collateral to
finance companies. Two techniques of secured short-term financing are commonly
employed with accounts receivable as collateral.
- Pledging of accounts receivable: An assignment is a transfer of claim or right
in an asset from one party to another. By pledging or assigning an account
receivable, a firm gives up the rights to the cash collected on that account.
- Factoring receivables: is the outright sale of the accounts receivable to a factor
that generally accepts all credit risks associated with collection of the
accounts.
 Physical assets: Short-term financing by holding physical assets of a company which
are easily convertible to cash.
2.2 Intermediate-Term Financing
It is defined as borrowings with maturities greater than 1 year and less than 5 to 7 years. Many
analysts and accountants ignore the distinction between intermediate and long-term debt. They
consider only two kinds of debt: short-term for maturities of 1 year or less; long-term for maturities
in excess of 1 year. When intermediate-term debt is identified as a separate category, three types are
common:
i) Revolving Credit Agreement: This is a guaranteed line of credit whereby the bank agrees
to lend money on demand in a future period, frequently 2 to 3 tears.
ii) Term Loan. This is a loan from bank, finance company, insurance company and other
financial institutions for a period of 1-7 years accompanied with fixed or floating interest
rates.
iii) Lease: This is an agreement that allows the use of assets without ownership of the assets.
The owner agrees to allow a user to use the fixed assets in return for a rental payment
over a stipulated period of time.
Intermediate-Term Financing Institutions:
Commercial Bank Loans: These are primary intermediate-term lenders to business firms.
Commercial Bank Loans offer both advantages and disadvantages to firms.
Advantages: Establishing a working relationship with a bank that can result in advice and financial
expertise from the bank‟s officer.
Disadvantages: The need to reveal confidential information and the restrictions that may be imposed
as part of the loan agreement.
Insurance Companies: A number of life insurance companies make term-loans to business firms
but concentrate on low risk loans to large and very strong companies only.
Advantage: Insurance company term loans are the longer terms and higher amounts of money as
compared to commercial bank financing.
Disadvantage: slightly higher interest rates are charged and the fact that only the most creditworthy
business can borrow from insurance companies.
Pension Funds: A minor source of intermediate-term financing is the employee pension funds that
make secured loans to businesses. These loans are frequently secured by mortgages on property and
have terms and conditions similar to loans made by life insurance companies.
Equipment Manufacturers: Manufacturers of industrial equipment make loans to assist in the

purchase of fixed assets. The loans may require the firm to make a down payment of 10-30 percent,
and the assets must be pledged and mortgaged to secure the loan.

2.3 Long-Term Financing
Long-term financing usually refers to the borrowing of money for a long period of time in order to
invest in fixed assets relatively permanent in nature with long life. Equity and debt represent the two
broad sources of finance for a business firm. Equity capital refers to ownership money acquired
through the sale of common stocks, preferred stock and retained earnings. Debt refers to borrowed
money acquired from term loans and sale of bonds.
Key difference between equity and debt are:
 Debt investors are entitled to a contractual set of cash flows (interest and principal)
whereas equity investors have a claim of residual cash flows of the firm after it has
satisfied all other claims and liabilities.
 Interest paid to debt investors represents a tax-deductible expense whereas dividend
paid to equity investors has to come out of profit after tax.
 Debt has a fixed maturity whereas equity ordinarily has infinite life.
 Equity investors enjoy the prerogative to control the affairs of the firm whereas debt
investors play a passive role- of course they often impose certain restrictions on the
way the firm is run to protect their interests.
Equity Capital
i) Common Stock: Represents ownership capital as equity shareholders collectively own

the company. They enjoy the rewards and bear the risks of ownership. However, their
liability, unlike the liability of sole proprietors and general partners, is limited to their
capital contributions.
Rights and Position of Equity Shareholders:

 Right to income: The equal investors have a residual claim to the income of the firm.
The income left after satisfying the claims of all other investors belong to the equity
shareholders. This income is simply equal to profit after tax minus preferred
dividend.
 Right to Control: Equity shareholders as owners of the firm elect the board of directors
and have the right to vote on every resolution placed before the company.
 Pre-emptive Right: It enables existing equity shareholders to maintain their proportional
ownership by purchasing the additional equity shares issued by the firm.
 Right in Liquidation: In the event of liquidation, claims of all others – bondholders,

secured and unsecured lenders, preferred stock – are prior to the claim of equity
shareholders.
Advantages to the firm:
 There is no compulsion to pay dividends, if the firm has insufficiency of cash,
 Equity capital has no maturity date and hence the firm has no obligation to redeem.
 It enhances the creditworthiness of the company. The larger the equity base, the greater the
ability of the firm to raise debt finance on favorable terms.
Disadvantages to the firm:

 Sale of equity shares to outsiders dilutes the control of existing owners,
 The cost of equity capital is high. The rate of return required by equity shareholders is
generally higher than the rate of return required by other investors,
 Equity dividends are paid out of profit after tax, whereas interest payments are tax
deductible expenses.
ii) Preferred Stock: represents hybrid form of financing. It resembles equity in the following
ways,
 Dividend is payable only out of distributable profits

 Preference dividend is not an obligatory payment,
 Preference dividend is not a tax-deductible payment
 It is an expensive source of financing.
Preferred Stock is similar to debt in several ways:
 Preference shareholders do not enjoy the right to vote,
 The claim of preference shareholders is prior to the claim of equity shareholders,
iii) Retained Earnings:
Depreciation charges and retained earnings represent the internal sources of finance
available to a firm. If we assume that depreciation charges are used for replacing worn-out
plant and equipment, retained earnings represent the only internal source of financing
expansion and growth. Companies retain 30-80% of profit after tax for financing growth. It

is referred as internal equity since it retained through a sacrifice made by equity

shareholders.
Advantages to the firm:
 Retained earnings are readily available. Low-cost to the firm,
 No dilution of control when a firm relies on retained earnings,
 The stock market generally views the equity issue with skepticism.
 Retained earnings, however, do not carry any negative connotation.
Disadvantage to the firm:
 The amount that can be raised by way of retained earnings may be limited, because
companies pursue a stable dividend policy,
 The opportunity cost of retained earnings is quite high. The cost foregone by equity
shareholders is quite high, by not paying dividend.
Long-Term Debt
i) Term Loans: Represents a source of debt finance which is generally payable in 5 to 10 years.
They are employed to finance acquisition of fixed assets and working capital margin.
Advantages of debt financing:
 Debt financing doesn‟t result in dilution of control,
 Debt lenders do not partake in the value created by the company except payments of
interest and principal.
 If there is a abrupt decline in the value of the firm, shareholders have the option of
defaulting their debt obligations and turning over the firm to debt lenders.
 Issue costs of debt are significantly lower than those on equity and preferred stock.
Disadvantages of debt financing:
 Debt financing entails fixed interest and principal repayment obligation. Failure to
meet these commitments may cause to bankruptcy.
 If the rate of inflation turns out to be unexpectedly low, the real cost of debt will be
greater than expected.
ii) Bonds/ Debenture/. Corporations, in search for outside funds to support operation and
growth, may initiate a bond issue with the promise of paying the investor (Bond holding
firm) a designated interest on his money at certain scheduled intervals of time. The

obligation of a company toward its debenture holders is similar to that of a borrower who
promises to pay interest and principal at specified times. Bonds often provide more
flexibility than term loans as they offer greater variety of choices with respect to maturity,
interest rate, security, repayment and special features.
Summary
The main points in this chapter may be summarized as follows:

Sources of finance
 Sources of long-term finance are expected to provide finance for at least one year whereas
sources of short-term finance would provide it for a shorter period.
 External sources of finance require the agreement of outside parties, whereas internal
sources of finance do not.
 The higher the level of risk associated with a particular form of finance, the higher the level
of return expected from investors.
Internal sources of finance
 An internal source of long-term finance is retained profits. It is by far the most important
source of new long-term finance (internal or external).
 Retained profits are not a free source of finance, as investors will require levels of return
from retained profits similar to those from ordinary shares.
 The main internal sources of short-term finance are tighter credit control of receivables,
reducing inventory levels and delaying payments to trade payables.
When considering the choice between sources of long-term and short-term borrowing, a business
should take into account factors such as matching the type of borrowing with the nature of the assets
held, the need for flexibility, refunding risk, and interest rates.
Review Questions
1. H. Brown (Portsmouth) Ltd produces a range of central heating systems for sale to builders‟
merchants. As a result of increasing demand for the business‟s products, the directors have decided
to expand production. The cost of acquiring new plant and machinery and the increase in working
capital requirements are planned to be financed by a mixture of long-term and short- term
borrowing.

Required:
(a) Discuss the major factors that should be taken into account when deciding on the appropriate
mix of long-term and short-term borrowing necessary to finance the expansion programme.
(b) Discuss the major factors that a lender should take into account when deciding whether to grant
a long-term loan to the business.
(c) Identify three conditions that might be included in a long-term loan agreement, and state the
purpose of each.

References:
1. Corporate Finance and Investment, Pike, R. and Neale, B., 5th edition, Financial Times
Prentice Hall, 2006, chapters 15 and 16.
2. Corporate Financial Management, Arnold, G., 3rd edition, Financial Times Prentice Hall, 2005,
chapters 11 and 12.
3. Corporate Finance, Brealey, R., Myers, S. and Allen, F., 9th edition, McGraw-Hill International,
2007, chapters 14, 25 and 26.

CHAPTER THREE
3. FIRM’S FINANCIAL OPERATION
In this chapter we consider the analysis and interpretation of financial statements. We shall see how
financial (or accounting) ratios can help in assessing the financial health of a business. We shall also
discuss the problems that are encountered when applying this technique.
Financial ratios can be used to examine various aspects of a financial position and performance and
are widely used for planning and control purposes. As we shall see in later chapters, they can be
very helpful to managers in a wide variety of decision areas, such as profit planning, working-
capital management, financial structure and dividend policy.
Learning Outcomes*
 Identify the major categories of ratios that can be used for analysis purposes.
 Calculate important ratios for assessing the financial performance and position of a
business, and explain the significance of the ratios calculated.
 Discuss the limitations of ratios as a tool of financial analysis.
 Discuss the use of ratios in helping to predict financial failure.
1. Can you think of any bases that could be used to compare a ratio you have
calculated from the financial statements of a particular period?
2. Discuss the following three main possibilities.
You may have thought of the following bases:
 Past periods for the same business
 Similar businesses for the same or past periods
 Planned performance for the business.
Introduction
A financial statement is an official document of the firm, which explores the entire financial
information of the firm. The main aim of the financial statement is to provide information and

understand the financial aspects of the firm. Hence, preparation of the financial statement is
important as much as the financial decisions.
Meaning and Definition
Financial statement is an organized collection of data according to logical and consistent accounting
procedures. Its purpose is to convey an understanding of financial aspects of a business firm. It may
show a position at a moment of time as in the case of a balance-sheet or may reveal a service of
activities over a given period of time, as in the case of an income statement.
Financial statements are the summary of the accounting process, which provides useful information
to both internal and external parties.
Financial statements provide a summary of the accounting of a business enterprise, the balance-
sheet reflecting the assets, liabilities and capital as on a certain data and the income statement
showing the results of operations during a certain period as shown in Fig3.1.
Financial statements generally consist of two important statements:
(i) The income statement or profit and loss account.
(ii) Balance sheet or the position statement.
A part from that, the business concern also prepares some of the other parts of statements, which are
very useful to the internal purpose such as:
(i) Statement of changes in owner‟s equity.
(ii) Statement of changes in financial position.

Financial Statement
Income Statement Position Statement
Statement of changes in Statement of changes in

Owner's Equity Financial Position
Figure 3. 1 Financial Statement

Income Statement
Income statement is also called as profit and loss account, which reflects the operational position of
the firm during a particular period. Normally it consists of one accounting year. It determines the
entire operational performance of the concern like total revenue generated and expenses incurred for
earning that revenue.
Income statement helps to ascertain the gross profit and net profit of the concern. Gross profit is
determined by preparation of trading or manufacturing a/c and net profit is determined by
preparation of profit and loss account.
Position Statement
Position statement is also called as balance sheet, which reflects the financial position of the firm at
the end of the financial year.
Position statement helps to ascertain and understand the total assets, liabilities and capital of the
firm. One can understand the strength and weakness of the concern with the help of the position
statement.
Statement of Changes in Owner’s Equity
It is also called as statement of retained earnings. This statement provides information about the
changes or position of owner‟s equity in the company. How the retained earnings are employed in
the business concern. Nowadays, preparation of this statement is not popular and nobody is going to
prepare the separate statement of changes in owner‟s equity.

Statement of Changes in Financial Position

Income statement and position statement shows only about the position of the finance, hence it can‟t
measure the actual position of the financial statement. Statement of changes in financial position
helps to understand the changes in financial position from one period to another period.
Statement of changes in financial position involves two important areas such as fund flow statement
which involves the changes in working capital position and cash flow statement which involves the
changes in cash position.
Types of financial statement analysis
Analysis of Financial Statement is also necessary to understand the financial positions during a
particular period. Financial statement analysis is largely a study of the relationship among the
various financial factors in a business as disclosed by a single set of statements and a study of the
trend of these factors as shown in a series of statements.
Analysis of financial statement may be broadly classified into two important types on the basis of
material used and methods of operations as shown in Fig 3.2.
Types of Financial
Analysis
On the basis On the Methods

of Materials of Operations
Used
External Internal Horizontal Vertical

Analysis Analysis Analysis Analysis
Figure 3.2 Types of Financial Statement Analysis
Based on Material Used

Based on the material used, financial statement analysis may be classified into two major types such
as External analysis and internal analysis.

A. External Analysis
Outsiders of the business concern do normally external analyses but they are indirectly involved in
the business concern such as investors, creditors, government organizations and other credit
agencies. External analysis is very much useful to understand the financial and operational position
of the business concern. External analysis mainly depends on the published financial statement of
the concern. This analysis provides only limited information about the business concern.
B. Internal Analysis
The company itself does disclose some of the valuable information to the business concern in this
type of analysis. This analysis is used to understand the operational performances of each and every
department and unit of the business concern. Internal analysis helps to take decisions regarding
achieving the goals of the business concern.
Based on Method of Operation
Based on the methods of operation, financial statement analysis may be classified into two major
types such as horizontal analysis and vertical analysis.
A. Horizontal Analysis
Under the horizontal analysis, financial statements are compared with several years and based on
that, a firm may take decisions. Normally, the current year‟s figures are compared with the base
year (base year is consider as 100) and how the financial information are changed from one year to
another. This analysis is also called as dynamic analysis.
B. Vertical Analysis
Under the vertical analysis, financial statements measure the quantities relationship of the various
items in the financial statement on a particular period. It is also called as static analysis, because,
this analysis helps to determine the relationship with various items appeared in the financial
statement. For example, a sale is assumed as 100 and other items are converted into sales figures.
3.1 Financial Statement
A financial Statement is a collection of monetary data and information organized according to

logical and consistent accounting procedures. The main purpose is to convey an understanding of
some financial aspects of a business firm. It provides understanding of what happens to the firm‟s
money as the firm pursues its business activities.
Uses of Financial Statement

 To present a historical record of the firm‟s financial development when complied over a
number of years.
 Used to forecast a course of action for the firm. Financial statement is often prepared for a
future period. It expresses the financial manager‟s estimate of the firm‟s future performance.
 A means employed by firms to present their financial situations to stockholders, creditors
and the general public.
Major Forms of Financial Statements:
 The Balance Sheet
 The Income Statement ( Profit and loss statement)
 A Flow of Funds Statement
3.1.1 The Balance Sheet
 It shows the financial position of the firm at a moment of reporting,

 It declares the assets, liabilities and equity for the firm at the last day of the accounting
period,
 It matches resources (assets) with sources (liabilities and equity).
i) ASSETS: Assets are classified into two categories: (a) Fixed Assets and (b) Current Assets. They
represent what a company owns, and are usually presented at the top (first part) of a balance sheet.
Current Assets of a construction company are usually cash, accounts receivable, construction
material inventory and so on which have high liquidity (i.e. can be turned into cash easily). Fixed
Assets of a construction company are usually property and equipment, construction plant, trucks
and so on which cannot be readily turned into cash in a short time. Fixed Assets are also called
Long-term Assets. When Fixed Assets and Asset Assets are added together, the sum is called Total
Assets.
a) Fixed Assets: The assets used by the firm to generate revenues. These assets can not be converted
into cash in the accounting period. This includes:
 Plant & Equipment Cost. This includes building, machinery and other equipments
and is adjusted by the depreciation record.
 Real Estate (if any): This account lists the property owned by the firm. (Land)

b) Current Assets: Contains all assets to be converted into cash within the current accounting period
or within the next year through the ordinary operations of the business.
 Cash and Cash equivalents ( highly liquid investments),
 Marketable Securities: stocks or bonds of other firms that the firm has purchased.
 Receivables: Cash to be gained after the making of sales on credit. ( Work in
progress)
 Inventories: goods held by the firm for eventual resale. This includes raw material
and goods tied up in the production process.
ii) Liabilities: These are debts of the firm. They represent sources of assets since the firm either
Borrows the money or make use of certain assets that have not yet been paid for. There exist
two forms of liabilities: current liabilities and long-term liabilities.
a) Current Liabilities: debts of the firm that must be paid during the current accounting period.
This includes:
 Accounts payable: when a firm makes purchase on credit,
 Short-term notes payable: promissory notes that mature in one year,
 Other payables: accruals (wages payable), tax liabilities.
b) Long-Term Liabilities: liabilities that will not be paid off during the next year. This includes
the long- Term secured and unsecured financing which covers mortgage and notes where a building
or other fixed assets are pledged as specific collateral for debts.
iii) EQUITY: Ownership rights in the company and includes:
 Preferred Stock,
 Common Stock,
 Contributed capital in excess,
 Retained earnings.

Table 3. 1 Example of Balance Sheet

Balance Sheet
As at
31/12/2012 31/12/2011
Assets
2,589,000 1,967,890
Current Assets Cash
5,767,000 5,403,670
Accounts receivable Retention money
1,641,750 1,350,918
Material Inventory
850,000 520,000
Costs and estimated earnings in excess
547,250 450,306
of billings on work in progress
Prepaid expenses and others 894,500 983,944
Total Current Assets Fixed assets 12,289,500 10,676,728

Property and equipment
Construction plant Vehicles/Trucks 15,536,900 13,800,000
Furniture and fixtures Total 2,680,040 2,039,480
depreciable assets
2,070,000 1,812,000
Less accumulated depreciation Net
345,000 379,000
Fixed Assets
20,631,940 18,030,480
Total Assets Liabilities
12,529,373 11,158,000
Current Liabilities Accounts
8,102,567 6,872,480
payable Accrued expenses Notes
20,392,067 17,549,208
payable
Retention money payable
Billings in excess of costs and
estimated earnings on work in
4,325,250 4,773,240
progress
1,586,037 1,475,918
Other current liabilities Total
647,250 491,973
Current Liabilities
919,380 756,514

Long-term Liabilities 617,205 678,922

Total Liabilities 355,713 292,699
Equity (i.e. Net Worth) 8,450,835 8,469,266
Capital stock 3,528,557 3,695,267
Additional paid-in capital Retained 11,979,392 12,164,533
earnings
Total Equity
3,500,000 2,500,000
Equity + Total Liabilities
1,000,000 1,000,000
3,912,675 1,884,675
8,412,675 5,384,675
20,392,067 17,549,208
3.1.2 The Income Statement
The income statement is a report of a firm‟s activities during a given accounting period. Firms often
publish income statements showing the results of each quarter and the full accounting year. It shows
the revenues and expenses of the firm, the effect of interest and taxes and the net income for the
period. It may be called as the profit-and-loss statement or the statement of earnings. The balance
sheet offers a view of the firm at a moment in time, whereas the income statement summarizes the
profitability of operations over a period of time. It is an accounting device designated to show
stockholders and creditors whether the firm is making money. It can also be used as a tool to
identify the factors that affect the degree of profitability.
It includes cost accounting of:
 Net sales or construction income or work execution in monetary terms.
 Construction costs/ production costs/ that include the direct costs,
 General and administration costs / over Birred costs/
 Interest: the fixed charges paid by the firm on the money that it borrows.

Table 3. 2 Example of Income Statement

Income
Statement
Period (one year) ended on
31/12/2012
31/12/2011
Revenue 40,185,000 38,483,000
Cost of Revenue
Materials 13,000,000 12,500,000
Labour 5,500,000 5,400,000
Subcontracts 12,500,000 12,000,000
Other direct costs 1,087,000 1,085,000
Total Cost of Revenue 32,087,000 30,985,000
Gross Profit 8,098,000 7,498,000
Operating Expenses
Variable over Billed 2,036,500 1,943,500
Fixed over Billed 3,358,500 2,979,500
Total Operating Expenses 5,395,000 4,923,000
Operating Profit 2,703,000 2,575,000
Other Income/Expense
Gain/loss on sale of assets 30,000 (38,000)
Miscellaneous income/expense (5,500) 4,000
Interest income 19,000 12,900
Interest expense (42,500) (41,000)
Total Other Income/Expense 1,000 (62,100)
Net Profit before Tax 2,704,000 2,512,900
Tax Expense (25% tax rate) 676,000 628,225
Net Profit after Tax 2,028,000 1,884,675

3.1.3 Flow-of-Funds Statement
This statement shows the movement of funds into the firm‟s current asset accounts from external
sources such as stockholders, creditors and customers. It also shows the movement of funds to meet
the firm‟s obligation, or pay dividends. The movements are shown for a specific period, normally
the same time period as the firm‟s income statement.
Sales of Fixed Sales of stock Debts Funds from
Assets Operations
Working-Capital Pool
(All current accounts)
Marketable
Securities Cash Accounts Receivables
Inventory
Purchase fixed assets Pay Dividends Retire debt Tax, Interest
Figure 3.3 Sources, uses of funds and the Working capital pool
The difference between sources and uses is shown as an increase or decrease in net working capital.
The pool is a measure of net working capital as shown in Fig 3.3. If the firm has more funds coming
in than going out, net working capital increases.

Sample on Flow-of-Funds
2012 2011
Source of funds
Net Income from operations Birr 148,262 Birr 127,065
Noncash expenses 107,296 92,297
Total funds from operations 255,558 219,362
Proceeds from long-term borrowing 92,621 41,831
Sales of property 6,101 1,499
Sales of common stock 2,112 1,804
Total sources of Funds Birr 356,392 Birr 264,497
Application of funds
Expenditures for property and equipment Birr 234,511 Birr 174,408
Miscellaneous investments 4,728 3,215
Payments of cash dividends 50,924 48,107
Funds held for plant construction 975 45,378
Total application of funds Birr 291,138 Birr 271,108
Increase (decrease) in net working capital Birr 65,254 Birr (6,611)
3.2 Financial Analysis
If properly analyzed and interpreted, financial statements can provide valuable insights into a
form‟s performance. Analysis of financial statements is of interest to:
 Lenders (short-term as well as long-term)
 Investors,
 Security analysts,
 Managers, public and others.
Financial statements analysis is helpful in assessing:
 Corporate excellence,
 Judging creditworthiness,
 Forecasting bond ratings,
 Predicting bankruptcy and assessing market risks.

Financial ratio can be extracted from financial statements for analyzing financial performance. The
financial ratios relevant to the construction industry can be classified into five categories. The
following examples on each ratio category are from Table 3.1 and 3.2 of balance sheet and financial
statements.
1. Profitability Ratios,
2. Liquidity Ratios,
3. Working Capital Ratios,
4. Capital Structure Ratios, and
5. Activity Ratios.
1. Profitability Ratios
Profitability ratios measure the construction company‟s ability to earn profit from its
operation. The three most commonly used profitability ratios are:
1.1 Gross Profit Margin Ratio= Gross profit / Revenue
= 8,098,000 / 40,185,000 = 20.15%
(The goal for net profit margin ratio is 25% minimum; if subcontractors (pay-as-paid
basis) occupy a significant portion of the cost of revenue, the goal can be reduced to
20% minimum)
1.2 Net Profit Margin Ratio = Net profit before tax /Revenue
= 2,704,000 / 40,185,000 = 6.73%
(The goal for net profit margin ratio is 5% minimum)
1.3 Return on Equity Ratio = Net profit before tax / Owners‟ equity
= 2,704,000 / 8,412,675 = 32.14%
(The return on equity ratio should be between 15% and 40%)
ii) Liquidity Ratios

Liquidity ratios indicate the construction company‟s ability to pay its obligations as they come due.
The three most common liquidity ratios used are shown below.
2.1 Current Ratio = Current assets / Current liabilities

= 12,289,500 / 8,450,835 = 1.45

(The current ratio should be higher than 1.3 for a financially healthy construction company)
2.2 Acid Test Ratio (or Quick Ratio) = (Cash + Accounts receivables) / Current
liabilities
= (2,589,000 + 5,767,000) / 8,450,835
= 0.99
(The acid test ratio or quick ratio should be higher than 1.1 for a construction company)
2.3 Current Assets to Total Assets Ratio = Current assets / Total assets
= 12,289,500 / 20,392,067
= 60.27%
(The current assets to total assets ratio should be between 60% and 80%)
a) Working Capital Ratios
These ratios measure how well the construction company is utilizing its working capital. The three
most commonly used working capital ratios are shown below.
3.1 Working Capital Turnover = Revenue / Working capital
= 40,185,000 / (12,289,500 – 8,450,835) = 10.47 times

(The working capital turnover should be between 8 and 12 times per year)
3.2 Net Profit to Working Capital Ratio = Net profit before tax / Working capital
= 2,704,000 / (12,289,500 – 8,450,835) = 70.44%

(The net profit to working capital ratio should be between 40% and 60%)
3.3 Degree of Fixed Asset Newness = Net depreciable fixed assets / Total depreciable fixed
assets
= 8,102,567 / 20,631,940 = 39.27%
(The degree of fixed asset newness should be between 40% and 60%)
b) Capital Structure Ratios
Capital structure ratios indicate the ability of the construction company to manage liabilities.
These ratios also indicate the approach that the company prefers to finance its operation. The two
major capital structure ratios are:

4.1 Debt to Equity Ratio = Total liabilities / Owners‟ equity
= 11,979,392 / 8,412,675 = 1.42

(The debt to equity ratio should be lower than 2.5)
4.2 Leverage= Total assets / Owners‟ equity
= 20,392,067 / 8,412,675 = 2.42

Or
Leverage = Total assets / Owners‟ equity
= (Total liabilities + Owners‟ equity) / Owners‟ equity
= (Total liabilities / Owners equity) + 1
= Debt to Equity Ratio + 1
= 1.42 + 1 = 2.42
(The leverage should be lower than 3.5. Some construction companies prefer to use leverage of 3.5
or close to it but some conservative ones prefer to use a lower leverage. This relates to, of course,
the use of a higher or lower debt to equity ratio by the company.)
c) Activity Ratios
Activity ratios indicate whether or not the construction company is using its assets effectively, and
if yes, how effective they are. There are quite a number of activity ratios, and the seven commonly
used ones are shown below.
5.1 Average Age of Material Inventory = (Material inventory / Materials cost) × 365 days
= (850,000 / 13,000,000) × 365 = 23.87 days
(The average age of material inventory should be shorter than 30 days)
5.2 Average Age of Under Billings = (Under billings / Revenue) × 365 d
= (547,250 / 40,185,000) × 365 = 4.97 days
(The average age of under billings should be the shorter the better)
5.3 Average Age of Accounts Receivable = (Accounts receivable / Revenue) × 365 d
= (5,767,000 / 40,185,000) × 365 = 52.38 days
(The average age of accounts receivable should be shorter than 45 days)
5.4 Cash Conversion Period = Average age of material inventory + Average age of under billings
+ Average age of accounts receivable

= 23.87 + 4.97 + 52.38 = 81.22 days

(The cash conversion period should be shorter than 75 days)
5.5 Average Age of Accounts Payable = [Accounts payable / (Materials + Subcontracts)] × 365 d
= [4,325,250 / (13,000,000 + 12,500,000)] × 365
= 61.91 days
(The average age of accounts payable should be shorter than 45 days)
5.6 Average Age of Over Billings = (Over billings / Revenue) × 365 d
= (617,205 / 40,185,000) × 365 = 5.61 days
(Usually there is no guideline on average age of over billings)
5.7 Cash Demand Period = Cash conversion period – Average age of accounts payable
– Average age of over-billings
= 81.22 – 61.91 – 5.61 = 13.70 days
(The cash demand period should be shorter than 30 days)
Summary
The main points of this chapter may be summarized as follows.

Ratio analysis
 Compares two related figures, usually both from the same set of financial statements.
 Is an aid to understanding what the financial statements really mean.
 Is an inexact science so results must be interpreted cautiously.
 Past periods, the performance of similar businesses and planned performance are often used
to provide benchmark ratios.
 A brief overview of the financial statements can often provide insights that may not be
revealed by ratios and/or may help in the interpretation of them.
Profitability ratios are concerned with effectiveness at generating profit
 Return on ordinary shareholders‟ funds (ROSF)
 Return on capital employed (ROCE)
 Operating profit margin
 Gross profit margin.
Efficiency ratios are concerned with efficiency of using assets/resources
 Average inventories turnover period

 Average settlement period for trade receivables

 Average settlement period for trade payables
 Sales revenue to capital employed
 Sales revenue per employee.
Liquidity ratios are concerned with the ability to meet short-term obligations
 Current ratio
 Acid test ratio.
Review Questions
1. Conday and Co. Ltd has been in operation for three years and produces antique reproduction
furniture for the export market. The most recent set of financial statements for the business is set
out as follows:
Statement of financial position (balance sheet) as at 30 November
Birr 000
Non-current assets
Property, plant and equipment (Cost less depreciation)
Land and buildings 228
Plant and machinery 762
990
Current assets
Inventories 600
Trade receivables 820
1,420
Total assets 2,410
Equity
Ordinary shares of £1 each 700
Retained earnings 365
1,065
Non-current liabilities
Borrowings – 9% loan notes (Note 1) 200
Current liabilities
Trade payables 665
Tax due 48
Short-term borrowings (all bank overdraft) 432 1,15
Total equity and liabilities 2,410

Income statement for the year ended 30 November

Birr 000
Revenue 2,600
Cost of sales (1,620)
Gross profit 980
Selling and distribution expenses (Note 2) (408)
Administration expenses (194)
Operating profit 378
Finance expenses (58)
Profit before taxation 320
Tax (95)
Profit for the year 225
Note:
1. The loan notes are secured on the land and buildings.
2. Selling and distribution expenses include 170,000 in respect of bad debts.
3. A dividend of 160,000 was paid on the ordinary shares during the year.
4. The directors have invited an investor to take up a new issue of ordinary shares in the
business at 6.40 each making a total investment of 200,000. The directors wish to use the funds to
finance a program of further expansion.
Required:
a. Analyze the financial position and performance of the business and comment on any
features that you consider being significant.
b. State, with reasons, whether or not the investor should invest in the business on the terms
outlined.
2. The directors of Helena Beauty Products Ltd have been presented with the following abridged
financial statements:

Helena Beauty Products Ltd

Income statement for the year ended 30 September
2007 2008
Birr 000
Sales revenue 3,600 3,840 Cost
of sales
Opening inventories 320 400
Purchases 2,240 2,350
2,560 2,750
Closing inventories (400) (2,160) (500) (2,250)
Gross profit 1,440 1,590
Expenses (1,360) (1,500)
Profit for the year 80 90
Statement of financial position (balance sheet) as at 30 September

2007 2008
Birr 000
Non-current assets
Property, plant and equipment 1,900 1,860
Current assets
Inventories 400 500
Trade receivables 750 960
Cash at bank 8 4
1,158 1,464
Total assets 3,058 3,324
Equity
1 ordinary shares 1,650 1,766
Retained earnings 1,018 1,108
2,668 2,874
Current liabilities 390 450
Total equity and liabilities 3,058 3,324
Required:
Using six ratios, comment on the profitability (three ratios) and efficiency (three ratios) of the
business as revealed by the statements shown above.
References:
1. Financial ratios as predictors of failure‟, Beaver, W. H., Empirical Research in Accounting:

Selected studies, a supplement to the Journal of Accounting Research, 1966, pp. 71–111.
2. Predicting corporate bankruptcy: an empirical comparison of the extent of financial distress
models, Zmijewski, M. E., Research Paper, State University of New York, 1983.
3. „Predicting financial distress of companies: revisiting the Z-score and Zeta models‟,
Altman, E. I., Working paper, New York University, June 2000.
4. „Predicting corporate failure: empirical evidence for the UK‟, Neophytou, E., Charitou, A.
and Charalamnous, C., Working Paper 01-173, Department of Accounting and Management
Science, University of Southampton, 2001.

CHAPTER FOUR
4. INVESTMENT POLICY
In this chapter we shall look at how businesses can make decisions involving investments in new
plant, machinery, buildings and similar long-term assets. In making these decisions, businesses
should be trying to pursue their key financial objective, which is to maximize the wealth of the
owners (shareholders). Investment appraisal is a very important area for businesses; expensive and
far-reaching consequences can flow from bad investment decisions.
Learning Outcomes*
 Explain the nature and importance of investment decision making.
 Identify the four main investment appraisal methods found in practice.
 Use each method to reach a decision on a particular investment opportunity.
 Explain the methods used to monitor and control investment projects.
1. What do you understand about investment?
2. Have you ever planned to be investor?
3. What will be your selection criteria to select from different investment options?
4. When managers are making decisions involving capital investments, what should the
decision seek to achieve?
Investment (capital budgeting) may be defined as the decision making process by which firms or
promoters evaluate the purchase of fixed assets, including buildings, machinery and equipment.
Investment policy describes the firm‟s formal planning process for the acquisition and investment of
capital and results in capital budget for expenditure of money to purchase fixed assets.

Significance of investment
 Substantial expenditure,
 Long Time Periods,
 Implied sales forecasts.
 Investment appraisal
 Planning horizon/ decision regarding return on investments.
4.1 The Time Value of Money
Money has time value. If one is given the choice to receive 100 birr today or 100 birr next year. The
individual will definitely choose 100 birr today. This is because money has value.
 Individuals in general prefer current consumption to future,
 To account for opportunity cost and inflation of money through time. Opportunity cost is a
cost foregone by not using resources at their best possible option.
Financial investments involve cash flows occurring at different points in the time series. These cash
flows have to be brought to the same point of time for purposes of comparison and aggregation.
4.1.1 Present and Future Value of a Single Amount

Compound Interest: refers to the case where interest payment is reinvested to earn further interest in
future periods. The relationship is given by:
FVn = PV (1+r)n
Where, FV: Future Value
PV: Present Value
n: number of years over which the cash flows occurs
r: Interest rate or discount rate.
Simple interest: no interest is earned on the interest. Interest is accounted only for the principal.
FV = PV (1+ nr)

Compound Interest
FV
Simple Interest
PV
Periods
Figure 4. 1 Future Values of Money for Different Interest

Example, if the firm is due to receive Birr 550,000 in 2 years at a time when money is worth 10
percent compounded annually. What is the present value?
PV = FV / (1+r)n
„
r‟ here designates a discount rate.
PV= Birr 454,545
4.1.2 Present Value of an Uneven Series
In financial analysis, one often comes across uneven cash flow streams. The present value of cash
flow stream –uneven or even- may be calculated as follows:
n
A1 A2 An AT
PVn  
1  r  1  r 2
 ...   
1  r  t 1 1  r t
n
At = cash flow occurring at the end of year t

4.1.3 Present Value of Annuity
An annuity is a stream of constant cash flow occurring at regular intervals of time.
 1  1 
PVn  A 1  
 r  1  r  
n
If a firm is due to receive Birr 400,000 annually for three years with annual discount rate of 10
percent. What is the present value?

PV = 400,000 (1/0.1) (1-1/ (1.1)3 = Birr 994,741

4.1.4 Future Value of an Annuity
 1  r n  1 
FVn  A 

 r 
4.2 Investment Appraisal
The decision making processes of determining the economic analysis and financial viability of
capital investments under conditions of certainty. Financial viability analysis values investment
proposals toward meeting the profitability and/or wealth maximization targets of firms or
individuals. However economic analysis in addition, values social and economic costs and benefits
of an investment proposal pursuant with local or national development plan. Often firms and
governments have more investment opportunities than financial resources. Investment analysts
should look to the available evaluation methods to distinguish among the competing proposals and
develop a ranking procedure that will determine the method of allocation of capital funds.
A wide range of methodology has been suggested to judge the worthwhileness of investment
projects. The important investment evaluations from simple to more complex methods are the
following.
 Payback Period,
 Net Present Value (NPV)
 Internal Rate of Return (IRR)
 Cost-Benefit Analysis
 Cost-effective analysis
 Multi-Criteria analysis
 Linear Programming ( e.g. Simplex Methods)
 Dynamic Programming (e.g. Combinatorial Problems).
Under this section, we deal only the top four evaluation techniques.
4.2.1 The Payback Period

The payback period is the length of time required to recover the initial cash outlay on the project.
According to the payback criterion, the shorter payback period, the more desirable the project
would be. Firms using this criterion generally specify the maximum acceptable payback period. If

this is „n‟ years, projects with a payback period of „n‟ years or less are deemed worthwhile and
projects with a payback period exceeding „n‟ years are considered unworthy.
Table 4. 1 Example of Payback Period:
Year Cash Flow Discounting Present Value Cumulative net

(Birr) Factor (10%) cash
0 -10,000 1.000 -10,000 -10,000
1 3,000 0.909 2,727 - 7,273
2 3,000 0.826 2,478 -4,795
3 4,000 0.751 3,004 -1,791
4 4,000 0.683 2,732 941
5 5,000 0.621 3,105
6 2,000 0.565 3,130
Looking to the above simple example, the payback period is between 3 and 4 years.
The payback period seems to provide the following advantages:
 Quite simple and readily understood,
 It is a rough and ready method for dealing with risks. It favors projects that generate
substantial cash inflows in earlier years. If risk tends to increase in the future, the payback
period may be helpful in screening risky projects.
 Since it emphasizes earlier cash flows, it may be a sensible method of evaluation for firms
pressed with problems of liquidity.
Major shortcoming:
 It ignores cash flows beyond the payback period. This leads to discrimination against
projects which generate substantial cash inflows in later years. Hence the payback period is
a measure of the project‟s capital recovery not profitability.
4.2.2 The Net Present Value (NPV)
The net present value of a project is the sum of the present values of all the cash flows both positive
and negative that are expected to occur over the life of the project.
n n
NPV   Bt 1  r    Ct 1  r 
t t
t 1 t 1

Where, Bt = the benefit or return at the end of year t

Ct = the cash outlay or investment at the end of year t
r = the required return
With the NPV method, the cash flows are discounted using the required return as discount rate. If
the net present value is positive, the proposals‟ forecast return exceeds the required return and the
proposal is acceptable. If the net present value is negative, the forecast return is less than the
required return and hence the proposal is not acceptable.
The Required Return – Acceptance Criterion

The most important single factor in evaluating proposals is the level of risk inherent in the project
and the required return. If a project offers high risk that the return will not be achieved, the required
return on the project will also be high. The trading off of risk and return is the process that the firm
should use in determining acceptability of its proposals
Expected Return
Business Risk
Risk less
Degree of Risk
To illustrate the net present value assessment of projects, consider the following cash flow streams.
Year Benefit (Birr) Cost (Birr)

0 -- 1,000,000
1 200,000 --
2 200,000 --
3 300,000 --
4 300,000 --
5 350,000 --

200,000 200,000 300,000 300,000 350,000 1,000,000

NPV      
1.11 1.12 1.13 1.14 1.15 1.10
NPV = Birr 5,273. The net present value is shown positive with firm‟s required return accounted
10% to compensate for time and risk.
Application:
For investments of large size with longer project life whose future conditions are certain or future
potential risks associated with the project market and finance are predictable. It is useful for
comparing mutually exclusive projects of equivalent size when potentially higher return or
profitability is a concern.
4.2.3 The Internal Rate of Return (IRR)
The internal rate of return method calculates the actual rate of return provided by a specific stream
of net cash benefits compared to a specific net cash outlay. It uses a trial-and-error approach to find
the discount factor that equates the original investment to the net cash benefits. In other words, it is
the internal discount rate which equates NPV with zero.
n n
 B 1  r   C 1  r 
t t
t t
t 1 t 1
The idea is to find „r‟ that equates benefits with cost outlay. Investment projects that yield higher
internal rate of return as compared with the required rate return by the firm will be accepted and
those that fail to meet this acceptance criterion would be rejected.
NPV
IRR
Discount Rates

Example for IRR:

Consider the following cash flow stream:
Year Benefit (Birr) Cost (Birr)

0 -- 100,000
1 30,000 --
2 30,000 --
3 40,000 --
4 45,000 --
The IRR is the value of „r‟ that satisfies the following equation.
30,000 30,000 40,000 45,000

100,000    
1  r 1 1  r 2 1  r 3 1  r 4
The calculation „r‟ involves a process of trial and error. Let‟s begin with r=15%:
The right hand side provides net present value of Birr 100,802. Since this is higher than the cost, we
require higher discount rate to arrive at the value of 100,000. Try with 16% of discount rate. The
value drops to Birr 98,641. We can conclude that the IRR is between 15 and 16%.
Application
Very similar application with NVP except that it is not effective for ranking of competing
proposals. Managers and financial analysts prefer to think of return of projects in terms of IRR to
required return. Because this can easily be related with the expected inflation, current borrowing
interest rates, the opportunity cost and so on. Furthermore, in the absence of required return rate, it
is still possible to determine the IRR and analyze the acceptance range of the project.

4.2.4 The Cost Benefit Ratio
This evaluation method related the benefits with its investment cost:
 B (1  r )
t
1
CBR  t 1
n
 C (1  r )
t 1
t
1
When CBR is greater than 1.0, the project accepted and if it is less than 1.0, the project is rejected.
This criterion measures the benefit out of the project per unit of the cost outlay. It is can
discriminate better between large and small investments. The cost benefit ratio may rank projects
correctly in the order of decreasing efficient use of capital.
4.3 Capital Budgeting on Contract Investment:
Cash flow budgeting, monitoring and control are a natural progression in the functioning of a
construction company. Cash, while being a resource in its own right, is also the means by which
other resources are acquired. The provision of cash in the desired amounts, and at the right time, is
one of the most important aspects of managing a construction company.
The majority of cash flows experienced by a construction company occur as a result of the
contractual and credit arrangements existing on a series of contracts in any trading period. Every
contract carried out by a construction company requires an initial investment which will not be
recovered until sometime in the future. The sources of finance needed to carry out contracts can be
divided into two distinct classifications:
 Internal Sources: generated from the company‟s operations within the contract, which are
most of the time „locked up‟ in a contract from the following two factors:
 stage payments as a requirement of the contract itself,
 During disagreements that might be a case for many contract.
 External Sources: costing a market interest rate measured by risks perceived by the lenders.
This cost is prepared from the head office.
The important aspect of a construction company, in the establishment of corporate budget planning
and monitoring, is to consider the profitability at the end of the day and evaluate and monitor with
the one anticipated at the time the tender was prepared. The two distinct concepts that affect a
company‟s profitability:
 The company‟s desired return on capital employed (ROCE) and its ability to maintain
market share,
 The mark-up on contract costs required to achieve the desired ROCE and its effect on
tender success rates.
4.3.1 Establishing ROCE & Mark-up in the corporate budget planning:
ROCE is a successful measurement of profitability of a company. It represents the return anticipated

by the company in relation with the total capital employed to perform the business. Budget
preparation or performance measurement starts by establishing ROCE. ROCE is determined at the
corporate level. The ROCE will be established to account the following costs:
 The average weighted cost of capital ( Interest of capital employed)
 Profit margin (dividends, capital reserves...)
 Corporate obligations such as taxations and deprecation costs.
 Contingencies to cover uncertainties ( Risks)
Example:
Balance Sheet Summary of a Company:
Fixed Asset: Birr 230,000
Current Assets: Birr 550,000
Current Liabilities: Birr 450,000
Net Current Assets: Birr 100,000
Total Capital Employed: Birr 330,000
Financed By:
Share Capital: Birr 32,080
Reserves: Birr 132,920
Loans: Birr 153,234
Preference shares: Birr 11,766
Funds Employed: Birr 330,000

The ROCE target can be evaluated as follows:

 The average weighted cost of capital ( Interest of capital employed)………………….8%
 Profit margin (dividends, capital reserves...) …………………………………………….5%
 Corporate obligations such as taxations and deprecation costs………………………..5%
 Contingencies to cover uncertainties ( Risks)…………………………………………….2%
Required ROCE………………………………………………..20%
ROCE = Birr 66,000 (20% of Birr 330,000)
Since company cash flow represents a series of aggregated cash flows generated by contracts, The
ROCE shall be collected from the cash flows of the individual contracts through the inclusion of a
Mark-up.
Mark-up (Head Office) = Administrative Expenses + ROCE
Administrative expenses (Head Office Expenditure) can be identified within a company‟s accounts
by items such as rent, telephone charges, electric bills, office equipment hire charges, payment to
staff directors etc. Often it is established in relation with the total turnover planned in the trading
year. If the company mentioned above is planning for a total turnover of Birr 2,200,000 in the
planning year, one can assume a 10% fee as administrative expenses.
Administrative expense: Birr 220,000
Mark-up = 220,000+ 66,000 =Birr 286,000
This contribution has to be earned from the respective contract investment.
Turnover = ∑ Production Cost of Contract + Mark-up,
Where, Production Cost = Direct cost + Site Over Billed Cost
∑ Production Cost of Contract = 2,200,000- 286, 000 = Birr 1,914,000.
This refers to a cost incurred at the site to produce the end deliverables.
Mark-up at individual projects = Birr 286,000/ Birr 1,914,000 = 15%
Managements or quantity surveyors need to add 15% to the estimated costs (Direct cost + site over
Billed costs) in order to turn an estimate into a tender, in order that general over Billed, risks and
profit are covered.

4.3.2 The corporate Budget

The corporate budget is the starting point for setting up a monitoring and reporting system. It also
becomes the reference point at the end of a financial year, against which the measurement of
financial performance and the achievement of planned objectives are made. The production of this
budget will be a rolling exercise, looking back at past performance and taking advice from staff.
However, the important element of a corporate budget is that, the company has to prepare cash flow
at the corporate level (head office cash flow) to maintain and secure its commitment to a set of
objectives for a given period.
The gross and net cash demand in the planning period has to be collected from the individual
contracts. The administrative expenses should also be identified such that the planner can establish
the entire cash flow expenses, define financing sources at a low cost to the corporate and the right
timing for funding the respective contracts.
Cash Inflow
Time in Months
Max. Capital Required

Cash Outflow
Corporate Budget (Cash Outlay) = Administrative Cost + ∑ Capital Required by Individual

Contracts
This has to be balanced with:
Capital Budget (Cash Inflow) = Net Working Capital + Finance Sources (Debt, Sales of stocks,
Sales of Fixed Assets)

4.4 A System of Control Levels
The estimate should be seen as the starting point for a company‟s cost control considerations. If all
the tender sums of contracts are added together, it will represent the company‟s turnover for a given
tendering period. It must be stressed that a tender sum and amounts agreed at the final account stage
will generally be different for many reasons. It is important to identify the difference between
anticipated turnover and actual turnover. The cost calculated within the estimate represent „cost
targets‟ against which „actual costs‟ must be measured, the outcome of such comparisons represent
profit or loss on individual contracts and goes to make up company‟s profit/loss. It is important to
establish a strong system of controlling levels, especially if liquidity is to be managed effectively.
Responsibility Responsibilities Statements used Logical Links

Level
Board/ General Company turnover profitability, Corporate Budget
Management Over Billed control systems (Master Budget)
Pay accounts,
Secure work
Manage Contracts
Contracts Management Contract costs (production costs) Contract Budget
Set performance objectives Statement,
Operational Budget,
Control Statement
Site Management Activity costs Activity cost statement,
Operational cost
Control Responsibility Components:
Managing Director Level:
 Major contracts- Production costs
 Administrative expenses
 Return on Contracts Employed (ROCE)
Contracts Management Level:

 Contract 1
 Contract 2 - Production Costs

 Contract 3
 Contract 4
Site Management Level:

 Labor cost
 Material cost Direct Costs
 Plant cost
Monitoring and Control at Contracts Management Level
It is at this level that the monitoring of actual cash flow on a contract and its comparison with
estimated cash flow takes place. The contract managers have to produce a contract budget
statement, operational budget and control statement with the help of quantity surveyors.
a) Contract 1 Contract Budget Statement /sample Date March 2005
Operations Labor Materials Equipment Sub- Cost Value Margin

Cost (Birr) Contractor. Total (Tender)
(Birr) (Birr)
Site over
Billed
Earth work
Concrete
Work
Exterior
Walls
Roofing
Work
* ** ***
Totals

Information on the first five columns can be driven from the cost break down prepared during
estimates.
The last two columns are taken from the tender values.
* Production Cost (Direct Cost + Site Over Billed Cost)
** Tender Sum (The price at which the contractor is awarded the contract)
*** Contracts Mark-up by the corporate (Aggregated contract mark-up will cover the administrative
expenses and ROCE of the company)
b) The operational Budget:

Once the contract budget is established, the contract manager should produce the operational budget
on monthly basis using the contract work program. It is worth noting that the statements produced
at this level have two primary functions:
 To provide managers with cost data on a monthly basis,
 To enable managers at each level to take decisions or implement corrective actions when
necessary.
Contract 1 Operational Budget Statement /sample Date March 2005
Operations Budget April, 2005 May 2005 June 2005
Total Cost Value Cost Value Cost Value
Cost Margin Margin Margin
(Birr)
Site over billes
Earth Work
Concrete Work
Exterior Walls
Roofing Work
Monthly Totals
Cumm. Totals
The monthly total enables the monthly cost target to be monitored

The Cumulative total enables the total period cost to be viewed.
c) Control Statement:
It is of vital importance that the value of the work carried out is accurately monitored and
adequately recorded and presented for agreement and subsequent payment by the client.
Contract1: Contract Manager‟s Control Statement

Item May 2005 Previous Month (April)
Actual Estimated Actual Estimated
Variance Variance
Materials
Delivered
Materials on site
Materials Fixed
Labour Cost
Plant Cost
Sub-Contractors
Over Billed Costs
Contract Cost
(Total)
The project manager has to identify the reasons behind why the contract might be under or over-
valued:
 Additional order of the client, work change
 Omission of the original work,
 Design errors , omissions or mistakes of the quantity surveyor
 Contractor‟s default by not maintaining quality of work,
 Unforeseen Circumstances, etc.
Once a variation has occurred it is important that it is first identified. Agreement that it has
caused a change in the nature of the work must be sought and from this a valuation must be
made to ensure that payment is issued to adequately maintain cash flow in a contract.

Monitoring and Control at Site Level
Item Quantity Unit Rate Value Labor Plant Material

Est. Cost Est. Cost Est. Cost
Act. Cost Act. Cost Act. Cost
Earth Work
Concrete
Work
Exterior
Walls
Roofing
Work
Finishing
Work
Total

Summary

The accounting rate of return (ARR) is the average accounting profit from the project expressed as a
percentage of the average investment.
 Decision rule: projects with an ARR above a defined minimum are acceptable; the greater
the ARR, the more attractive the project becomes.
 Conclusions on ARR:
 it does not relate directly to shareholders‟ wealth
 it can lead to illogical conclusions;
 it takes almost no account of the timing of cash flows;
 it ignores some relevant information and may take account of some that is irrelevant;
 it is relatively simple to use;
 It is much inferior to NPV.
The payback period (PP) is the length of time that it takes for the cash outflow for the initial
investment to be repaid out of resulting cash inflows.
 Decision rule: projects with a PP up to defined maximum period are acceptable, the shorter
the PP, the more desirable.
 Conclusions on PP:
 it does not relate to shareholders‟ wealth, it ignores inflows after the payback date;
 it takes little account of the timing of cash flows;
 it ignores much relevant information;
 it does not always provide clear signals and can be impractical to use;
 It is much inferior to NPV, but it is easy to understand and can offer a liquidity insight,
which might be the reason for its widespread use.
The net present value (NPV) is the sum of the discounted values of the net cash flows from the
investment.
 Money has a time value.
 Decision rule: all positive NPV investments enhance shareholders‟ wealth; the greater the
NPV, the greater the enhancement and the more desirable.

 The act of discounting brings cash flows at different points in time to a common valuation
basis (their present value), which enables them to be directly compared.
 Conclusions on NPV:
 it relates directly to shareholders‟ wealth objective;
 it takes account of the timing of cash flows;
 it takes all relevant information into account;
 it provides clear signals and is practical to use.
Review Questions
1. The pavement of a road requires 400,000 Birr per year to maintain. The feasibility of a new
pavement is being considered for reducing maintenance costs. If the new pavement needs no
maintenance in the first three years, then 200,000 Birr per year for the next seven years, and
then 400,000 Birr per year thereafter, what is the immediate expenditure for the new
pavement that is justifiable? (Assume a discount rate of 10% p.a.).
2. A contractor borrowed 500,000 Birr from a bank to buy earth-moving equipment with an
estimated service life of 10 years. The bank charged the contractor 12% interest p.a. and
required him to pay back the loan in 10 years‟ time.
a) Assuming that the contractor paid back the bank in 10 equal installments (once every
year), calculate the amount of each end-of-year payment.
b) The contractor at the end of year 4 wished to make an early redemption (i.e. pay all the
money that he owed the bank). How much should he pay?
c) The bank negotiated with the contractor and reduced the interest rate to 10% p.a. at the
beginning of the 5th year in order to attract the contractor to stay borrowing. What would
be the contractor‟s repayment schedule if he chose to pay back the bank in the form of six
uniform payments from the end of years 5 to the end of year 10?
d) If the bank changed the interest rate back to 12% p.a. at the beginning of the 8th year,
what would be the amount of the contractor‟s last payment (i.e. payment at the end of
year 10) if he kept on paying the bank the same installment as calculated in (c) above at the
end or years 8 and 9?

3. There are two alternatives to construct a storage house. Both serve the purpose of allowing
construction materials to be stored in the house. However, due to different construction
methods (one is made of wood and the other made of bricks), different life spans and cash
flow patterns are associated with each alternative as follows:
Alternative 1 (wood) Alternative 2 (bricks)
Life 10 years 15 years
Initial capital cost 900,000 Birr 1,300,000 Birr
Operation and 80,000 Birr 20,000 Birr
maintenance cost
Assuming the discount rate to be 16% p.a., choose the better alternative by:
a) the present value method, and
b) the equivalent annual cost method.
(Hints: compare the alternatives based on the same number of years, i.e. 30 years)

References:
1. Reckoning with Risk, Gigerenzer G., Penguin, 2002.
2. „Strategic capital investment decision-making: A role for emergent analysis tools. A study of
practice in large UK manufacturing companies‟, Alkaraan, F. and Northcott, D. The British
Accounting Review 38, 2006, p. 159.
3. „How do CFOs make capital budgeting and capital structure decisions?‟, Graham, R. and
Harvey, C., Journal of Applied Corporate Finance, vol. 15, no. 1, 2002.References:

CHAPTER FIVE
5. WORKING CAPITAL MANAGEMENT
In this chapter we shall consider the factors that must be taken into account when managing the
working capital of a business. Each element of working capital will be identified and the major
issues surrounding them will be discussed. Working capital represents a significant investment for
many businesses and so its proper management and control can be vital. We saw in Chapter 4 that
an investment in working capital is typically an important aspect of new investment proposals.
Learning Outcomes*
 Identify the main elements of working capital.
 Discuss the purpose of working capital and the nature of the working capital cycle.
 Explain the importance of establishing policies for the control of working capital.
 Explain the factors that have to be taken into account when managing each element of
working capital.
 What kinds of changes in the commercial environment might lead to a decision to change
the level of investment in working capital? Try to identify four possible changes that could
affect the working capital needs of a business.
 At costs might a business incur as a result of holding too low a level of inventories? Try to
jot down at least three types of cost.
 An electrical retailer stocks a particular type of light switch. The annual demand for the
light switch is 10,400 units, and the lead time for orders is four weeks. Demand for the
light switch is steady throughout the year. At what quantity of the light switch should the
business reorder, assuming that it is confident of the information given above?
 Assume the same facts as in question 3. However, we are also told that the business
maintains buffer inventories of 300 units. At what level should the business reorder?

5.1 Working Capital Policy
One of the most important areas in the day-to-day management of the firm deals with the
management of Working Capital, which is defined as all the short term assets used in daily
operations. As discussed in the previous chapters, the key difference between long-term financial
management and short term financial management (also referred as working capital management) is
in terms of the timing of cash. While long term financial decisions like buying capital equipment,
building structures or issuing debentures involve cash flows over an extended period of time, short
term financial decisions typically involve cash flows within a year or within the operating cycle of
the firm.
There are two concepts of working capital: gross working capital and net working capital. Gross
working capital is the total of all current assets. Net working capital is the difference between
current assets and current liabilities. The constituents of current assets and current liabilities are
shown hereunder.
Current Assets: Liquidating assets in the accountable period

 Inventories that comprise
 Raw materials and components
 Work in progress
 Finished goods
 Trade debtors ( Accounts receivable)
 Cash and marketable securities
Current Liabilities: Cash or services delivered in advance but repayment not yet effected.
 Sundry creditors ( Accounts payable)
 Trade advances
 Short term borrowings
 Accruals, deferred tax etc,
Working capital management is the functional area of finance that covers all the current accounts of
the firm. It is concerned with the adequacy of current assets as well as the level of risk posed by
current liabilities. Arranging short term financing, negotiating favorable credit terms, controlling the
movement of cash, administering accounts receivable and monitoring the investment in inventories

consume a great deal of time of financial managers. It is a discipline that seeks proper policies for
managing current assets and liabilities and practical techniques for maximizing the benefits from
managing working capital.
5.1.1 Characteristics of Current Assets
In the management of working capital, two characteristics of current assets must be borne in mind:
 Short life span,
 Swift transformation into other asset forms.
Current assets have a short life span. Cash balances may be held idle for a week or two, accounts
receivables may have a life span of 30 to 60 days, and inventories may be held for 30 to 100 days.
The life span of current assets depend upon the time required in the activities of procurement,
production, sales and collection and the degree of synchronization among them.
Each current asset is swiftly transformed into other asset forms: cash is used for acquiring raw
materials; raw materials are transformed into finished goods ( these transformation may involve
several stages of work in process); finished goods generally sold on credit basis are converted to
accounts receivable; and finally accounts receivable, on realization, generate cash. Fig 5.1 shows
the cycle of transformation of current assets.

Finished Goods
Accounts
Receivable Work in Progress
Wages, Salaries,
OveBirreads
Raw Materials
Cash Suppliers
Figure5.1 Current Asset Cycle

5.1.2 Operating Cycle and Cash Cycle
Investments in working capital are influenced by four key events in the production and sales cycle
of the firm:
 Purchase of raw materials,
 Payment for raw materials,
 Sale of finished goods
 Collection of cash sales.
Fig 5.2 depicts these events on the cash flow line. The firm begins with the purchase of raw
materials which are paid for after a delay which represents the accounts payable period. The firm
converts the raw materials into finished goods and then sells the same. The time lag between the
purchase of raw materials and the sale of finished goods is the inventory period. Customers pay the
bills sometime after the sales. The period that elapse between the date of sales and the date of
collection of receivables is the accounts payable period. The time that elapse between the purchase
of raw materials and the collection of cash for sales is referred to as the operating cycle, whereas the

time length between the payment for raw material purchases and the collection of cash for sales is
referred to as the cash cycle. The operating cycle is the sum of the inventory period and the
accounts receivable period, whereas the cash cycle is equal to the operating cycle less the accounts
payable period.
Order Cash
Received
Stock
arrives
Inventory Period Accounts Receivable
Accounts Payable
Credit Cash paid for

Invoice Materials
Operating Cycle
Cash Cycle
Figure 5. 2 Operating and Cash Cycle

From the financial statement of the firm, one can estimate the inventory period, the accounts
receivable period and the accounts payable period.
Acc. Receivable Period (days) = Accounts Receivable / (Annual Sales / 365 days)
Acc. Payable Period (days) = Acc. Payable / (Annual Cost of Goods / 365 days)
Inventory Period (days) = Inventory / (Annual Cost of Goods sold /365 days)
For the example below, estimate the operating and cash cycle of the firm given the following data
taken from the financial statement.
 Annual Sale: Birr 500 million
 Total cost of goods sold: Birr 360 million
 Inventories: Birr 60 million
 Accounts Receivables: Birr 80 million

 Accounts Payable: Birr 50 million
Solution:
Accounts Receivable = (80/ 500) X 365 = 58 days
Accounts payable = (50/ 420) X 365 = 43 days
Inventory Period = (60/ 420) X 365 = 52 days.
Operating Cycle = 52 + 58 = 110 days
Cash Cycle = 110- 43 = 67 days.
5.1.3 Factors Affecting Working Capital Requirements
The working capital needs of a firm are influenced by numerous factors. The important ones are:
i) Sales Volume: A firm maintains current assets because they are needed to support the
operational activities that culminate in sales. Over time, a firm will keep a fairly steady rate of
current assets to annual sales. A firm realizing a steady level of sales operates with a fairly constant
level of cash, receivables, and inventory, if properly managed. Firms experiencing growth in sales
require additional working capital. If sales are declining, a reduction in working capital can be
expected.
ii) Nature of Business: The working capital requirement of a firm is closely related to the
nature of its business. A service firm with a short operating cycle and which sells predominantly on
cash basis has modest working capital requirement. On the other hand, a firm which has a long
operating cycle and which sells largely on credit has a very substantial working capital requirement.
iii) Production Policy: A firm marked by pronounced seasonal fluctuation in its sales may
pursue a production policy which may reduce the sharp variations in working capital requirements.
For example, a manufacturer of ceiling fans may maintain a steady production throughout the year
rather than intensify the production activity during the peak business season. Such a production
policy may dampen the fluctuations in working capital.
iv) Market Conditions: The degree of competition prevailing in the market place has an important
bearing on working capital needs. When competition is keen, a larger inventory of finished goods is
required to promptly serve customers who may not be inclined to wait because other manufacturers
are ready to meet their needs. Further, generous credit terms may have to be offered to attract
customers in a highly competitive market. Thus working capital needs tend to be high because of
greater investment in finished goods inventory and accounts receivable.
v) Conditions of Supply: The inventory of raw materials, spares and stores depend on the
conditions of supply. If the supply is prompt and adequate, the firm can manage with small
inventory. If, however the supply is unpredictable and scant with the firm, to ensure continuity of
production, the firm would have to acquire stocks as and when they are available and carry large
inventory on average.
5.1.4 Cash Requirement for Working Capital
As a finance manager, one will be interested in figuring out how much cash to be arranged to meet
the working capital need of the firm. To do this, two step procedures shall be followed:
Step 1: Estimation of the cash cost of various current assets require by the firm:
This follows to estimate the following:
 Cash cost of debtors (receivables) by removing the profit element (ROCE),
 Raw materials in stock
 Finished goods in stock
 Cash balance
Step 2: Deduct the current liabilities from the cash cost of current assets:
A portion of the cash cost of current assets is supported by trade credit and accruals of wages and
expenses, which may be referred to as spontaneous current liabilities. The balance left after such
deduction has to be arranged from other sources.
Example: Given the following annual figures of a firm:
 Annual sales ( Two months credit is given) : Birr 240 million
 ROCE: 20%
 Material cost (Suppliers give three months credit): Birr 72 million
 Wages ( wages are paid with one month arrears): Birr 48 million
 Manufacturing Expense (Plant expense) paid in one month arrears: Birr 48 million
 Administrative expenses (Paid as incurred) : Birr 32 million
 The firm keeps two months‟ stock of raw materials and one month‟s stock of finished goods.
 The firm wants to maintain a cash balance of Birr 5 million.
 Neglect work in progress

Estimate the working capital requirement of the project.
Solution:
Given cost of sale = Birr 200 million
ROCE = Birr 40 million
Step1: Current Assets:
 Receivables = (200/12) x 2 = Birr 33.33 million
 Raw material in stock = (72/12) x 2 = Birr 12 million
 Finished goods = (168/12) x 1 =Birr 14 million
 Cash Balance = Birr 5 million
Total Current Assets = Birr 64.33 million
Step 2: Current Liabilities

 Sundry creditors = (72/12) x 3 = Birr 18 million
 Wages = ( 48/12) x 1 = Birr 4 million
 Plant expense = (48/12) x 1 = Birr 4 million
Total current liabilities = Birr 26 million
Working Capital requirement = Birr 64.33 million – Birr 26 million = Birr 38.33 million
Birr 38.33 million should be arranged from other financial sources.
5.2 Cash & Liquid Management
In a financial sense, the term cash refers to all money items and sources that are immediately
available to help pay a firm‟s bill. Cash, the most liquid asset, is of vital importance to the daily
operations of business firms. On the balance sheet, cash assets include deposits in financial
institutions and cash equivalents in money market funds or marketable securities. All highly liquid
short-term securities are treated as cash.
Three securities are widely used as short-term investments and alternative forms of cash. Each
security offers different characteristics that make it suitable for different firms.
i) Treasury Bills: A treasury bill is an unconditional promise by Government‟s Treasury
Agent to pay to the holder of the bill a specified amount at maturity. Treasury bills are issued for

short periods of time, normally 3, 6 or 12 months. Two characteristics of treasury bills should be
noted:
 Non-interest bearing: Treasury bills are sold at a discount on a bid basis, mainly to security
dealers and large commercial banks, who resell them to individuals and firms.
 Most secure and liquid marketable security: Treasury bills are most secured and liquid kind
of marketable security because government guarantees their redemption.
ii) Commercial Paper: Commercial paper represents short term unsecured promissory notes
issued by firms that are generally considered to be financially strong. Commercial paper usually has
a maturity period of 90 days or 180 days. They are purchased by individuals or other firms with
excess cash that have a desire to earn a higher yield than available from treasury bills. In turn for the
higher yield, the firm accepts slightly greater risk and less liquidity.
iii) Certificates of Deposit: A certificate of deposit represents a negotiable receipt of funds
deposited in a bank for a fixed period. The bank agrees to pay the bearer the amount of the deposit
plus a stipulated amount of interest at maturity. Certificate of deposits are a popular form of short
term investment for companies since they are fairly liquid, generally risk free and offer a higher rate
of interest than treasury bills.
5.2.1 How large a cash balance is needed?

The size of a firm‟s cash balance depends basically upon the three major reasons for liquidity. This
includes:
i) Transaction needs: A firm needs cash to carry out the day-to-day functions of the
business. Just as the firm‟s level of operations affects working capital requirements, it
affects the need for cash. If the volume of sales increases, cash will be received from
customers and will be expended for materials and wages in large amounts. Adequate
cash to cover these and other transactions allow the firm to pay its bills on time.
ii) Contingency needs: If the firm could perfectly forecast its needs for cash, it would not
have to be concerned with unexpected occurrences or emergencies that require cash.
Because this is not possible, the firm must be prepared for contingencies.
iii) Opportunity needs: These involve the chance to profit from having cash available. For
example, a supplier may have several cancellations of orders and may wish to move a
large unwanted inventory of raw materials from his warehouse. If the supplier offers a

large discount for cash purchasing of the materials, the firm will have the opportunity to
realize a substantial savings on its purchase and, hence, profits from the sale of the
finished goods.
5.2.2 Forecasting Cash Flow

Once the financial manager has identified the firm‟s policies on cash flow management, he must
face the problem of predicting the amounts and timing of future inflows and outlays of cash. This is
a difficult process for most firms because cash flows are affected by many factors. The failure to
prepare for the proper level of cash poses three risks to the company:
i) Default: The failure to pay interest or principal payments on a firm‟s borrowings or failure
to perform as per contract is a default, a situation that may result in legal actions by the firm‟s
creditors.
ii) Overdue Bills: The failure to pay short-term obligations, such as payables, is less serious
than default but may result in a lowering of the firm‟s credit rating in the business community. This
may be accompanied by higher interest rates when the firm applies for loans or may cause creditors
to refuse to ship supplies on credit.
iii) Lost Savings on Purchases: Inadequate cash may cause the firm to lose opportunities to
make special cash purchases or to take generous trade discounts on purchases of goods.
In attempting to minimize these risks, the firm pursues the twin goals of cash forecasting, namely:
 Liquidity: By predicting cash surpluses or cash shortages, the firm achieves liquidity-
sufficient money in the bank to pay debts as they come due.
 Profitability: Accurate cash forecasting achieves profits by allowing the firm to take
profitable discounts on purchases, invest surplus funds, or reduce the costs of maintaining
idle cash balances.
Example: On Cash flow forecast & Working Capital
Given the following information for a construction project:

 A contract budget has been prepared and the monthly evaluation forecasts are as indicated
hereunder:
Month 1 2 3 4 5 6
Monthly 8,000 10,000 12,000 14,000 10,000 6,000
Value (Birr)
 Profit included in the estimate is 12 %

 Payments are to be made monthly within 28 days
 Retention money for every monthly payment – 3 % where 1.5% will be released during the
completion period and the remaining at the expiry of defects liability period.
 Defects liability period – 6 months
 No advance payment
 5 % of the total project cost is used as mobilization cost.
i) Prepare the gross and net cash requirements for the project.
ii) Assuming even contract budget throughout the contract period, estimate the working capital.
 Material on site to be considered in the payment as delivered to the site: 50% of production
cost
 Wages and plants : every month amounting to 40% of production cost
 Over Billed cost 10%
Solution:
i) Cash flow forecast:
1) Cumulative contract value forecast from the monthly value forecast.

Months 1 2 3 4 5 6
Cumulative 8,000 18,000 30,000 44,000 54,000 60,000
Forecast (Birr)

2) Cumulative self-cost of contract & expenditure:

Cumulative self-cost = Cumulative contract value – profit release- mobilization cost
Months 1 2 3 4 5 6
Cumulative self-cost 6,640 14,940 24,900 36,520 44,820 49,800
(Birr)
Cumm. Expenditure = Cumulative self-cost + mobilization

Months 1 2 3 4 5 6
Cumm. Expenditure 9,640 17,940 27,900 39,520 47,820 52,800
(Birr)
3) Cumulative Income
Monthly Income Forecast: It can be determined from cumulative contract value forecast subject to
deductions as retention money, advance payment and any previous payments.
Income month ( i+1) = Cumm. Contract Value month( i) – retention – previous payments
Income month (2) = 8,000 – 0.03(8,000) -0 = Birr 7,760
Income month (3) = 18,000 – 0.03 (18,000) – 7,760 = Birr 9,700
Income month (4) = 30,000 – 0.03(30,000) – (7,760+9,700) = Birr 11,640
Income month (5) = 44,000 – 0.03(44,000) – (7,760 +9,700+11,640) = Birr 13,580
Income month (6) = 54,000 – 0.03 (54,000) – (7,760+9,700+11,640+13,580) = Birr 9,700
Income month (7) = 60,000- 0.015(60,000) – (7,760+9,700+11,640+13,580+9,700) = Birr 6,720
Income month (12) = 0.0015 (60,000) = Birr 900

Cumulative 1 2 3 4 5 6 7 12
Income:
Months
Monthly 0 7,760 9,700 11,640 13,580 9,700 6,720 900
Income
(Birr)
Cumulative 0 7,760 17,460 29,100 42,680 52,380 59,100 60,000
Income
(Birr)
4) Gross and Net Cash Requirements

Net cash required (monthly) = Cumm. Income after receipt of each monthly payment - Cumm.
Expenditure
Gross cash required (monthly) = Cumm. Income prior to receiving monthly payment - Cumm.
Expenditure
Months 1 2 3 4 5 6 7 12
Net Cash -9,640 -10,180 -10,440 -10,420 -5,140 -420 6,300 7,200
Req‟d
(Birr)
Gross cash -9,640 -17,940 -20,140 -22,060 -18,720 -10,120 -420 6,300
Req‟d
(Birr)

Value (Birr)
60000
Expenditure
Value Forecast
Income/ Revenue
30000
0
1 2 3 4 5 6 7 Time, months
Figure5. 3 Cash Flow Forecast

Cash (Birr)
+ 30000
Self-Financing Date
Surplus
1 2 3 4 5 6 7 Time, Months
Short
Fall
Gross Cash Requ‟t
Net Cash Requ‟t
-30000 Max. Capital Required
Figure 5. 4 Gross and Net Cash Requirements.
ii) Working Capital Requirement:

Given cost of sale = Birr 52,800
ROCE = Birr 7,200
Step 1: Current Assets
 Receivables: (52,800/6) x 1 = Birr 8,800
 Raw material on stock= ((0.5 x 52,800)/6) x 1 = Birr 4,400
Total current assets = Birr 13,200
Step 2: Current Liabilities

 Wages and plant cost = (( 0.4 x 52,800)/ 6) x 1 = Birr 3,520
 Raw material (( 0.5 x 52,800)/6) x 1 = Birr 4,400
Total Current liabilities = Birr 7,920
Working capital Requirement = Birr 5,280 monthly.

iii) Working Capital assuming 20% advance payment.

5.3 Credit Management
While business firms would like to sell on cash, the pressure of competition and the force of custom
persuade them to sell on credit terms. Firms grant credit to facilitate sales. It is valuable to
customers as it augments their resources. It is particularly appealing to those customers who cannot
borrow from other sources or find it very expensive or inconvenient to do so. The credit period
extended by business firms usually ranges from 15 to 60 days. When goods are sold on credit,
finished goods get converted into accounts receivable (trade debtors) in the books of the seller. In
the books of the buyer, the obligation arising from credit purchase is represented as accounts
payable (trade creditors).
A firm‟s investment in accounts receivable depends on how much it sells on credit and how long it
takes to collect receivables. For example, if a firm sells Birr 1 million worth of goods on credit a
day and its average collection period is 40 days, its accounts receivable will be Birr 40 million.
5.3.1 Terms of Payment
Terms of payment vary widely in practice. At one end, if the seller has financial sinews it may
extend liberal credit to the buyer till it converts goods bought into cash. At the other end, the buyer
may pay cash in advance to the seller and finance the entire trade cycle. Most commonly, however,
some in between arrangements is chosen wherein the trade cycle is financed partly by the seller,
partly by the buyer, and partly by some financial intermediary. The major terms of payment are
discussed below:
Order Delivery Sale
Cash Terms Credit Terms
Converted to cash
Cash in Cash on
Advance Delivery
Figure 5. 5 Terms of Payment

i) Cash Terms: When goods are sold on cash terms, the payment is received either before the
goods are shipped (cash in advance) or when the goods are delivered (cash on delivery). Cash in
advance is generally insisted upon when goods are made to order. In such a case, the seller would
like to finance production and eliminate marketing risks. Cash on delivery is often demanded by the
seller if it is in a strong bargaining position and/or the customer is perceived to be risky.
ii) Credit Terms:

 Open Account: Credit sales are generally on open account. This means that the seller first
ships the goods and then sends the invoice. The credit terms (credit period, cash discount for
prompt payment, the period discount, and so on) are stated in the invoice which is
acknowledged by the buyer.
 Bill of exchange: A more secure arrangement that represents an unconditional order by the
seller asking the buyer to pay on demand or at a certain future date, the amount specified on
it. It is typically accompanied by shipping documents that are delivered to the buyer when
he pays or accepts it. The bill of exchange performs three useful functions:
 It serves as a written evidence of a definite obligation
 It helps in reducing the cost of financing to some extent,
 It represents a negotiable instrument.
 Consignment: When goods are sent on consignment, they are merely shipped but not sold to
the consignee. The consignee acts as the agent of the seller. The title of the
goods is retained by the seller till they are sold by the consignee to the third
party.
 Letter of Credit (L/C): Commonly used in international trade. A letter of credit is issued by a
bank on behalf of its customer to the seller. As per this document, the bank agrees to honor
drafts drawn on it for the supplies made to the customer if the seller fulfills the conditions
laid down in the L/C. The L/C serves several useful functions:
 Virtually eliminates credit risk,
 Reduces uncertainty as the seller knows the conditions that should be fulfilled to
receive payment,

 Offers safety to the buyer who wants to ensure that payment is made only in
conformity with the conditions of the L/C.
5.3.2 Costs of Maintaining Receivables:

As with all assets and operations, the willingness to allow credit sales involve certain costs. These
include:
i) Financing the Receivables: Carrying accounts receivables ties up a portion of the firm‟s
financial resources seeking for addition in working capital. These resources must be financed from
other sources such as past profits retained in the business, contributed capital from owners and debt
from creditors.
ii) Administrative and Collection Expenses: To keep records on credit sales and payment and
the efforts made to aware and push debtors to settle their payments incurs additional cost to the
firm. In addition, most firms conduct investigations of potential credit customers to determine their
creditworthiness. These and other expenses, such as telephone charges and postage constitute the
administrative and collection costs of maintaining receivables.
iii) Bad Debt Loss: After making serious efforts to collect on overdue accounts, the firm may
be forced to give up. If a customer declares bankruptcy, no payment may be forthcoming. If the
customer leaves the city or state, it may be too costly to trace him and demand payment. In these
cases, the firm is forced to accept a bad debt loss on the account.
5.3.3 Policies for Managing Receivables

The firm should establish its receivable policies after carefully considering both the benefits and
costs of different policies:
i) Profit: The firm should investigate different possibilities and forecast the effect of each on
its future profits. The cost of funds tied up in receivables, collection costs, bad debt losses and
money lost with discounts for early payment should be compared with additional sales as a
consequence of the proposed policy.
Degree of relaxing the credit policy as determined by residual income may be estimated as follows:
R  S  p   S r   I k 
R : Residual Income
S  p  : Profit from change in sale

S r  : Bad debt loss

I k  : Opportunity cost of additional funds locked in receivables.
p, r ,& k : Multiplying factors for profit, bad debt loss and opportunity cost
respectively.
ii) Growth in sales: Sometimes firms are willing to accept short term setbacks with
respect to profits if a new policy enables the firm to increase its sales significantly. Because growth
is so important aside from profits, it should be viewed as a separate factor in determining receivable
policies.
5.3.4 Credit Policy Variables
The important dimensions of a firm‟s credit policy are credit standards, credit period, cash discount
and collection effort. These variables are related and have a bearing on the level of sales, bad debt
loss, discounts taken by customers, and collection expenses.
i) Credit Standards: A pivotal question in the credit policy of a firm is: What standard should
be applied in accepting or rejecting an account for credit granting? A firm has a wide
range of choice in this respect. At one end of the spectrum, it may decide not to extend
credit to any customer, however strong his credit rating may be. At the other end,
it may decide to grant credit to all customers irrespective of their credit rating. Between
these two extreme positions lie several possibilities, often the more practical ones.
In general, liberal credit standards tend to push sales up by attracting more customers. This is,
however, accompanied by a higher incidence of bad debt loss, a larger investment in receivables,
and a higher cost of collection. Stiff credit standards have the opposite effects. They tend to depress
sales, reduce the incidence of bad debt loss, decrease the investment in receivables and lower the
collection cost.
ii) The credit period refers to the length of time customers are allowed to pay for their
purchases. When a firm does not extend any credit, the credit period would obviously be
zero. Lengthening the credit period pushes sales up by inducing existing customers to
purchase more and attracting additional customers. This is, however, accompanied by a
larger investment in debtors and a higher incidence of bad debt loss. Shortening of the

credit period should have an opposite effect. It tends to lower sales, decrease investment
in debtors, and reduce the incidence of bad debt loss.
iii) Cash Discount: Firms generally offer cash discounts to induce customers to make
prompt payments. The percentage discount and the period during which it is available
are reflected in the credit terms. For example, credit terms of 2/10, net30 mean that a
discount of 2 percent is offered if the payment is made by the tenth day; otherwise the
full payment is due by the thirteenth day.
Liberalizing the cash discount policy may mean that the discount percentage is increased and/or the
discount period is lengthened. Such an action tends to enhance sales, reduce the average collection
period and increase the cost of discount.
iv) Collection Effort: The collection program of the firm, aimed at timely collection of
receivables may consist of the following:
 Monitoring the state of receivables,
 Dispatch of letters to customers whose due date is approaching,
 Electronic and telephonic advice to customers around the due date,
 Threat of legal action to overdue accounts,
 Legal action against overdue accounts.
A rigorous collection program tends to decrease sales, shorten the average collection period, reduce
bad debt percentage and increase the collection expense. A lax collection program, on the other
hand, would push sales up, lengthen the average collection period, increase the bad debt percentage
and perhaps reduce the collection expense.
5.4 Inventory Management
Inventory may be defined as the goods held for eventual resale by the firm. Decisions relating to
inventories are taken primarily by executives in production, purchasing and marketing departments.
Usually, raw material policies are shaped by purchasing and production executives, work in process
inventory is influenced by the decisions of production executives, and finished goods inventory
policy is evolved by production and marketing executives. Yet, as an inventory management has
important financial implications. The financial manager has the responsibility to ensure that
inventories are properly monitored and controlled. He has to emphasize the financial point of view

and initiate programs with the participation and involvement of others for effective management of
inventories.
Generally three types of inventories may be identified.
 Raw materials: These are goods that have not yet been committed to production.
 Goods in process: This category includes those materials that have been committed
to production process but have not been completed. Goods in process include such
items as components and sub components that are not yet ready to be sold.
 Finished goods: These are completed products awaiting sale. In construction
process, they are the final output of the production process. For retail firms and
wholesalers, they are usually referred to as the merchandise inventory.
5.4.1 Benefits of Holding Inventories

Inventories are used to provide cushions so that the purchasing, production, and sales functions can
proceed at their own optimum paces.
In achieving the separation of these functions, the firm realizes a number of specific benefits.
i) Avoiding Losses of Sales: If the firm does not have goods available for sale, it will lose
sales. Customers requiring immediate delivery will purchase their goods from the firm‟s
competitors, and others will decide that they do not need the goods after all, if they must
wait for delivery. The ability of the firm to give quick service and to provide prompt
delivery is closely tied to the proper management of inventory.
ii) Gaining Quantity Discounts: If a firm is willing to maintain large inventories in selected
product lines, it may be able to make bulk purchases of goods at large discounts.
Suppliers frequently offer a great reduced price if the firm orders double or triple its
normal requirement. By paying less for its goods, the firm can increase profits, as long
as the costs of maintaining the inventories are less than the amount of discount.
iii) Reducing Order Costs: Every time a firm places an order, it incurs certain costs. Forms
must be types, checked, approved and mailed. When goods arrive, they must be
accepted, inspected and counted. The variable costs associated with individual orders
can be reduced if the firm places a few large rather than numerous small orders.
iv) Achieving Efficient Production Runs: Once an assembly line or work team is prepared
and composed to receive certain raw materials and perform selected production

operation, a setup cost has been incurred which must be absorbed in the subsequent
production run. If the firm has to change setups frequently, it would experience high unit
costs of production.
5.4.2 Costs of Holding Inventories

When a firm holds goods for future sale, it exposes itself to a number of risks and costs. The
effective management of inventory involves a tradeoff between having too little and also too much
inventory. The benefits of holding inventory have already been discussed, basically helps to reduce
risks, hold down costs and increase revenues. To examine inventory from cost side, one shall
identify the following categories of costs:
 Ordering Costs: relating to purchased items would include expenses on the following:
requisitioning, preparation of purchase order, expediting, transport and receiving and placing
in storage.
 Carrying Costs: includes expense on the following: interest on capital locked up in
inventory, storage, insurance, obsolescence, and taxes.
 Shortage Costs: arise when inventories are short of requirement for meeting the needs of
production or the demand of customers.
5.4.3 Inventory Management - Minimizing Costs
The goal of effective inventory management is to minimize the total costs that are associated with
ordering and holding inventories. One need to estimate the different expenses with varying
inventory levels and chooses the level with the lowest total cost.
The lowest total cost considers both in carrying costs and ordering costs.
There are two basic questions relating to inventory management.
 The size of the order- Q optimal
 The level to order – Q level.
i) Order Quantity- Economic Order Quantity( EOQ)
The Economic Order Quantity refers to the order size that will result in the lowest total of order and
carrying costs for an item of inventory. If a firm places unnecessary orders, it will incur unneeded
order costs. If it places too few orders, it must maintain large stocks of goods and will have

excessive carrying costs. By calculating an economic order quantity, the firm identifies the number
of units to order that results in the lowest total of these two costs.
Variables in the EOQ model:
U: The forecast usage/demand for goods or raw materials for a year is known,
Q: Quantity Ordered,
F: Cost per Order,
C: Percent Carrying Cost
P: Price per Unit,
TC: Total Costs of ordering and carrying.
TC 
U
F   Q P C 
Q 2
The first term on the right hand side is the ordering cost, obtained as the product of the number of
orders (U/Q) and the cost per order (F), and the second term on the right hand side is the carrying
cost, obtained as the product of the average value of inventory holding (QP/2) and the percentage
carrying cost (C).
The total cost of ordering and carrying is minimized when the derivative of the above equation is
equated to zero:
dTC UF PC
 2  0
dQ Q 2
2UF
Q2 
PC
2 FU
Q
PC
Example: Given the following for a company:
U= Annual sale= 20,000 Units
F= fixed cost per order = Birr 2,000
P= Purchase price per unit= Birr 12
C= Carrying cost = 25% of inventory value

2 x 2,000x 20,000
Q  5,164units
12x0.25
ii) Order Level/Order Pont
The standard EOQ model assumes that materials can be procured instantaneously and hence implies
that the firm may place an order for replenishment when the inventory level drops to zero. In the
real world, however, procurement of materials takes time and hence the order level must be such
that the inventory at the time of ordering suffices to meet the needs of production during the
procurement period.
If the usage rate of materials and lead time for procurement are known with certainty then the
ordering level would simply be:
Lead time in days for procurement X Average daily usage.
Summary
Working capital
 Working capital is the difference between current assets and current liabilities.
 That is, working capital = inventories + receivables + cash − payables − bank overdrafts.
 An investment in working capital cannot be avoided in practice – typically large amounts
are involved.
Inventories
 There are costs of holding inventories, which include:
 lost interest
 storage cost
 insurance cost
 Obsolescence.
 There are also costs of not holding sufficient inventories, which include:
 loss of sales and customer goodwill
 production dislocation
 loss of flexibility – cannot take advantage of opportunities
 Reorder costs – low inventories imply more frequent ordering.

 Practical points on inventories management include:

 identify optimum order size – models can help with this
 set inventories reorder levels
 use forecasts
 keep reliable inventories records
 use accounting ratios (for example, inventories turnover period ratio)
 establish systems for security of inventories and authorization
 Consider just-in-time (JIT) inventories management.
Trade receivables
 When assessing which customers should receive credit, the five Cs of credit can be used:
 capital
 capacity
 collateral
 condition
 Character.
 The costs of allowing credit include:
 lost interest
 lost purchasing power
 costs of assessing customer creditworthiness
 administration cost
 bad debts
 Cash discounts (for prompt payment).
 The costs of denying credit include:
 Loss of customer goodwill.
 Practical points on receivables management:
 establish a policy
 assess and monitor customer creditworthiness
 establish effective administration of receivables
 establish a policy on bad debts
 consider cash discounts

 use financial ratios (for example, average settlement period for trade
receivables ratio)
 Use ageing summaries.
Cash
 The costs of holding cash include:
 lost interest
 Lost purchasing power.
 The costs of holding insufficient cash include:
 loss of supplier goodwill if unable to meet commitments on time
 loss of opportunities
 inability to claim cash discounts
 Costs of borrowing (should an obligation need to be met at short notice).
 Practical points on cash management:
 plan cash flows
 make judicious use of bank overdraft finance – it can be cheap and flexible
 use short-term cash surpluses profitably
 bank frequently
 operating cash cycle (for a wholesaler) = length of time from buying
inventories to receiving cash from receivables less payables‟ payment period
 Transmit cash promptly.
 An objective of working capital management is to limit the length of the operating cash
cycle (OCC), subject to any risks that this may cause.
Trade payables
 The costs of taking credit include:
 higher price than purchases for immediate cash settlement
 administrative costs
 Restrictions imposed by seller.
 The costs of not taking credit include:
 lost interest-free borrowing

 lost purchasing power

 inconvenience
 Paying at the time of purchase can be inconvenient.
 Practical points on payables management:
 exploit free credit as far as possible
 Use accounting ratios (for example, average settlement period for trade
payables ratio).
Review Questions
1. How might each of the following affect the level of inventories held by a business?
(a) An increase in the number of production bottlenecks experienced by the business.
(b) A rise in the level of interest rates.
(c) A decision to offer customers a narrower range of products in the future.
(d) A switch of suppliers from an overseas business to a local business.
(e) A deterioration in the quality and reliability of bought-in components.
2. What are the reasons for holding inventories? Are these reasons different from the reasons for
holding cash?
3. Identify the costs of holding:
(a) Too little cash;
(b) Too much cash.
4. The managing director of Sparkrite Ltd, a trading business, has just received summary sets of
financial statements for last year and this year:

Sparkrite Ltd
Income statements for years ended 30 September last year and this year
Last year This year
Birr 000
Sales revenue 1,800 1,920
Cost of sales
Opening inventories 160 200
Purchases 1,120 1,175
1,280 1,375
Closing inventories (200) (250)
(1,080) (1,125)
Gross profit 720 795
Expenses (680) (750)
Profit for the year 40 45
Statements of financial position (balance sheets) as at 30
September last year and this year
Last year This year
Birr000
Non-current assets 950 930
Current assets
Inventories 200 250
Trade receivables 375 480
Bank 4 2
579 732
Total assets 1,529 1,662
Equity
Fully paid £1 ordinary shares 825 883
Retained earnings 509 554
1,334 1,437
Current liabilities 195 225
Total equity and liabilities 1,529 1,662
The finance director has expressed concern at the increase in inventories and trade
receivables levels.
Required:
(a) Show, by using the data given, how you would calculate ratios that could be used to measure
inventories and trade receivables levels during last year and this year.
(b) Discuss the ways in which the management of Sparkrite Ltd could exercise control over:

(i) inventories levels;

(ii) trade receivables levels.
1. International Electric plc at present offers its customers 30 days‟ credit. Half the customers,
by value, pay on time. The other half take an average of 70 days to pay. The business is
considering offering a cash discount of 2 per cent to its customers for payment within 30
days. The credit controller anticipates that half of the customers who now take an average of
70 days to pay (that is, a quarter of all customers) will pay in 30 days. The other half (the
final quarter) will still take an average of 70 days to pay. The scheme will also reduce bad
debts by Birr 300,000 a year. Annual sales revenue of Birr 365m is made evenly throughout
the year. At present the business has a large overdraft (Birr 60m) with its bank at an interest
cost of 12 per cent a year.
Required:
(a) Calculate the approximate equivalent annual percentage cost of a discount of 2 per
cent, which reduces the time taken by credit customers to pay from 70 days to 30 days.
(Hint: This part can be answered without reference to the narrative above.)
(b) Calculate the value of trade receivables outstanding under both the old and new
schemes.
(c) How much will the scheme cost the business in discounts?
(d) Should the business go ahead with the scheme? State what other factors, if any,
should be taken into account.
(e) Outline the controls and procedures that a business should adopt to manage the level
of its trade receivables.

References:
1. Business Finance: Theory and Practice, McLaney, E., 8th edn., Financial Times Prentice
Hall, 2009, chapter 13.
2. Corporate Finance, Brealey, B., Myers, S. and Allen, F., 9th edn., McGraw-Hill, 2008,
chapters 30 and 31. Corporate Finance and Investment, Pike, R. and Neale, B., 5th edn.,
Prentice Hall, 2006, chapters 13 and 14.
3. Corporate Financial Management, Arnold, G., 3rd edn., Financial Times Prentice Hall,
2005, chapter 13.

CHAPTER SIX
6. PROJECT APPRAISAL
Learning Outcomes*
 Understand the nature project and ways of project appraisal.
 Differentiate different approaches for project appraisal mechanisms.
 List the difference between traditional methods and discounted Cash flow methods
1. Do you remember the term project in construction industry?
2. How do you evaluate the impact of project success for the end users?
3. List some mechanism that you use for the evaluation of projects.
Although, we are familiar with tools such as Gantt chart, PERT, CPM, IRR, NPV and others
associated with project management. Yet when it comes to real project scenario, we find practical
problems which could bring deviations. This is not to suggest that the tools and techniques are
inadequate, but assumptions on which the project reports are prepared are either invalid or
unrealistic. A review of the Ministry of Programme Implementation has shown that about 70%
of project time or cost overruns are due to unrealistic assumptions at the project formulation
stage. It is therefore necessary to pay attention to this, often overlooked, but vital aspect of project
formulation. Project appraisal is the process of analyzing the technical feasibility and economic
viability of a project proposal with a view to financing their costs. Project appraisal enables to take
a decision on investment with long term effects. During the appraisal stage, measurement of costs
and benefits are difficult as these are spread over a long term with high degree of uncertainty. The
Fig 6.1 below shows types of appraisal generally required for a project.

Technical
Economical Social
Project
Appraisal
Financial Legal
Institutional Commercial
Figure6.1 Project Appraisal Methods
6.1 Meanings of Project Appraisal
Technical Appraisal
Technical appraisal determines whether the technical parameters are soundly conceived, realistic
and technically feasible. Technical feasibility analysis is the systematic gathering and analysis of
the data pertaining to the technical inputs required and formation of conclusion there from. The
availability of the raw materials, equipment, hard/software, power, sanitary and sewerage services,
transportation facility, skilled man power, engineering facilities, maintenance, local people etc.,
depending on the type of project are coming under technical analysis. This feasibility analysis is
very important since its significance lies in planning the exercises, documentation process, risk
minimization process and to get approval.
Checklist
 Physical scale
 Technology used & Type of equipments & Suitability conditions
 How realistic is the implementation schedule
 Labour intensive method or others
 Cost estimates of Engineering Data

 Escalation are taken care of or not

 Procurement arrangement
 Cost of operation & Maintenance
 Necessary raw material & Inputs
 Potential impact of project on human & physical Environment
Financial Appraisal
To determine whether the financial costs and returns are properly estimated and whether the project
is financially viable. Following minimum details are determined in the financial appraisal;
1. Total Cost
2. O & M Expenditure
3. Opportunity costs
4. Other costs
5. Returns on Investment over project life
6. NPV
7. CBR
8. IRR
Institutional Appraisal
Institutional appraisal is used to determine whether the implementing agencies as identified in the
report are capable for effective implementation, monitoring, and evaluation of the scheme.
Managerial competence, integrity, knowledge of the project, the promoters should have the
knowledge and ability to plan, implement and operate the entire project effectively. The past record
of the promoters is to be appraised to clarify their ability in handling the projects.
Checklist
 Whether the entity is properly organized do the job
 Strength to use capability and take initiatives to reach the objectives
 Openness to new ideas and willingness to adopt long term approach to extend
over several projects

Commercial Appraisal
The demand and scope of the project among the beneficiaries, customer friendly process and
preferences, future demand of the supply, effectiveness of the selling arrangement, latest
information availability on all areas, government control measures, etc. The appraisal involves the
assessment of the current demand/market scenario, which enables the project to get adequate
demand. Estimation, distribution and advertisement scenario also to be here considered into.
Commercial Appraisal
The demand and scope of the project among the beneficiaries, customer friendly process and
preferences, future demand of the supply, effectiveness of the selling arrangement, latest
information availability on all areas, government control measures, etc. The appraisal involves the
assessment of the current demand/market scenario, which enables the project to get adequate
Environmental Appraisal
It is important to see any detrimental environmental impacts and how to minimize the impacts.
Environmental appraisal concerns with the impact of environment on the project. The factors
include the water, air, land, sound, geographical location etc.
Economic Appraisal
How far the project contributes to the development of the sector, industrial development, social
development, maximizing the growth of employment, etc. are kept in view while evaluating the
economic feasibility of the project.
Legal Appraisal
To determine whether the project satisfies the legal issues related to land acquisition, title deed,
environmental clearance demand. Estimation, distribution and advertisement scenario also to be
here considered into.
6.2 Project Appraisal - A Methodology
Approach
The cost and returns, estimated after discussions with concerned Engineers, are projected for its life
period of ten to fifteen years for which the loan is taken. The Net Present Value (NPV) shows the
percentage recovery of the capital cost within its project life period. The Internal Rate of Return
(IIR) indicates the percentage returns of the individual projects over a fixed period for town.

Once the cost estimate is made and the cost of construction is known, the annual returns are
assessed. With the expenditure, construction period and the returns per annum are known, the
financial appraisal of the project-including the annuity of loan repayment is assessed by depending
on the financial viability of the project.
Appraisal involves a careful checking of the basic data, assumptions and methodology used in
project preparation, an in-depth review of the work plan, cost estimates and proposed financing, an
assessment of the projects organizational and management aspects, and finally the viability of
project. It is mandatory for the Project Authorities to undertake project
Appraisal or at least give details of financial, economic and social benefits. Projects are examined
for technical, institutional/organizational/managerial, financial and economic point of view
depending on nature of the project. On the basis of such an assessment, a judgment is reached as to
whether the project is technically sound, financially justified and viable from the point of view of
the economy as a whole.
The concerned Technical Section in consultation with other technical sections undertakes the
technical appraisal, wherever necessary. This covers engineering, commercial, organizational and
managerial aspects, while the Economic Appraisal Section carries out the pre-sanction appraisal of
the development projects from the financial and economic points of view. Economic appraisal of a
project is concerned with the desirability of carrying out the project from the standpoint of its
contribution to the development of the national economy. Whereas financial analysis deals with
only costs and returns to project participants, economic analysis deals with costs and returns to
society as a whole. The rationale behind the project appraisal is to provide the decision-makers with
financial and economic yardsticks for investment in the projects.

The techniques of project appraisal include discounted techniques that take into account the time
value of money and include
(a) Net Present Value (NPV),
(b) Benefit Cost Ratio (BCR),
(c) Internal Rate of Return (IRR)
(d) Sensitivity Analysis.
Economic viability of the project is invariably judged at 12 percent discount rate/opportunity cost of
capital. However, in case of financial analysis, the actual rate of interest i.e. the rate at which capital
is obtained is used. For the government-funded projects, the discount rate is fixed by the
Government. In case the project is funded by more than one source, the financial analysis is carried
out on the weighted average cost of capital (WACC) for each project. Normally, if the project is
financed through foreign grants, the financial analysis is undertaken at zero discount rate. However,
the economic analysis is undertaken at 12% discount rate.
Many investment projects are addition to existing facilities/activities and thus benefits and costs
relevant to the new project are those that are incremental to what would have occurred if the new
project had not been added. During the operating life of a project, it is very important to measure all
costs and benefits as the difference between what these variables would be if no project (without
project) were undertaken and what they will be should the project be implemented (with project). It
is very common error to assume that all costs and benefits are incremental to the new project when,
in fact, they are not. Hence, considerable care must be taken in defining a “base case” which
realistically sets out the profile of costs and benefits expected if no additional investment is
undertaken.
Social Costs –Benefits Analysis
Social Cost-Benefit analysis is an appraisal system that helps selecting socially remunerative
projects for implementation. Every project tends to use up resources pre- empting its allocation in
other uses. The inputs used up in the projects constitute the social cost of the project. The process of
Social Cost-Benefit Analysis consists of determining the social feasibility or profitability of a
project by expressing its social benefits and social costs in terms of a common counting device or

numeral. If the social benefits of a project exceed its social costs, it is qualified for implementation.
Projects emanate from different sources, such as individuals, firms or institutions, and Governments
at the state and the central levels. In instances when the state is not the owner, the traditional
yardstick of commercial or financial profitability is used for selection of projects. In these cases the
primary criterion is the profit potential for promoter or the owner. But this may not necessarily
result in socially most profitable project. But then can decision makers overlook this vital aspect of
project evaluation, especially in a developing country?
A project has to be formulated and implemented in a social environment. Its impact on the society
in general and to the community in the near vicinity, in particular, is a major concern to be taken
into account at the time of project formulation. This includes land acquisition, rehabilitation, loss of
livelihood, adequate compensation, building up harmony with the community, through close
interaction. All these areas are importance. Yet very few projects have considered it necessary to
take these factors into account. Techno- economic parameters are only guidelines for project
formulation. But then a project cannot be implemented in a vacuum. It needs an elaborate support
system.. A time delay often means a cost overrun, and a cost overrun can also lead to time delay,
because of budgetary constraints. Time and cost are the dimensions in which projects are measured.
But then there are web of other interconnected activities which also impact on the project time and
cost flow. Thus the main emphasis on a project, even at the formulation stage is not the technical
parameters alone but on the control and coordination aspects.
6.3 Appraisal Methods
There are appraisal techniques that take into account the variations in the expected inflows and
outflows of the project that the project must inevitably face during its life cycle. The crux of these
methods lies in their consideration of time.
Project Analysis as per Cash Flows
It is common knowledge that projects do not earn the same level of profit every year. In some years,
profits are high; in others they are low. In many years, it can be expected that the project will earn
no profit at all. The question that confronts planners and administrators is how to examine projects

that have different time sequence of costs and benefits, and therefore of profit/losses. Table 1 can be
taken as the starting point for examining this question.
Table 6.1 shows the costs and benefits of a hypothetical project over its life cycle of seven years. In
the first year, costs are greater than the benefits; in later years, benefits exceed costs.
Two questions arise with respect to Table 6.1.
Table 6.1 Costs and Benefits over 7 years (in 000)
Year Costs Benefits Difference between
benefits and costs
0 250 0 -250
1. 250 290 40
2 250 290 40
3. 255 300 55
4. 260 335 75
5. 260 335 75
6. 260 335 75
Total 1785 1895 110
1. From the table 6.1, it is seen that the overall profitability of a project cannot be
assessed on a year-to-year basis. Expected profits of this project as shown in the table
vary between years. Also, if a year-to-year assessment is attempted, it will be a time-
consuming exercise, and may not be able to give any definite conclusion as to its
profitability. So, the task for the planners is to reduce the flows into a single figure that
can indicate the earning capacity or the profitability of the project in question. How
should this be done?
2. How should the “value” of money over time be treated? Should the value of 75,000
that is likely to be the level of net profits in the fourth year of the project (see Table
6.1) be taken at its face value, or be adjusted to take note of the fall in the value of
money from inflation as well as the uncertainty that is implicit in any consideration of
the “future”. What is the method by which the problem of time can be resolved?
The method of dealing with the flows of costs and benefits over time in project analysis is called
time-discounting. This is a method of reducing to a comparable base the costs and benefits of a

project that accrue at different intervals. The underlying thesis in this concept is that the value of
money is different at different points of time; for instance 1,000 received today is not of equal worth
to a similar amount ten years from now. In other words, costs which have to be paid in the distant
future have, at present, a lower significance or value than those to be paid now. Similarly, the
benefits which accrue from a project now are of a greater value than those accruing later.
Calculation of the present value of costs and benefits involves the use of a discount factor, which is
nothing but a rate at which the future is to be discounted. Discount rate represents the present value
of the future.
To repeat: the crux of time-discounting is that the value of money is different at different points in
time. One thousand rupees received today cannot be equal in worth to 1,000 received in one year‟s
time. Inflation and uncertainty reduce the value of money over time.
How can the time-discounting method be applied to projects?
In order to explain the application of the time-discounting method, it is useful to briefly recall the
manner in which compound interests are calculated. Assume that there is an amount of 100 that is
expected to earn interest at 8 percent per annum. In one year, the amount of 100 will increase at this
rate to 108.00 [=100(1+(8/100)]; [={100(1+(8/100)}2 ] and in two years, this amount will be 116.00
[=100(1+8/100)}2], and in three years the amount will increase to 125.90 [=100((1+8/100)}3}], and
so on. The formula that is used is conveniently written as:
F = P(1+r)n
Where F = future worth
P = present worth R= rate of interest
n = number of years
or

Future worth (F) =P (1+r) Year (1)

= P (1+r) 2 Year (2)
= P (1+r) 3 Year (3)
= P (1+r) n Year (n)
Compounding is nothing other than finding out the future worth of the present at a given rate of
interest. Discounting is just reverse of compounding. In discounting, the expected future values are
given and their present values have to be determined at a given discount rate. This involves using
the inverse of the compounding formula:
P = F x 1/(1+r)n
Present worth (P) = F x 1 --------------------------Year (1)

(1+r)
=Fx 1 ------------------------ Year (2)

(1+r) 2
=Fx 1 ------------------------ Year (3)

(1+r) 3
=Fx 1 ------------------------- Year (n)

(1+r) n
Time-discounting is used for calculating the profitability of the project when cash flows spread over
a medium to long term with differing costs and incomes. It is thus important for practitioners to be
acquainted not only with the mechanics of discounting, but when, and under what conditions, they
should use higher or lower discount rates. When the future carries greater risk and uncertainty, and
the fear of inflation or deteriorating economic situations, a higher discount rate is generally used.
Conversely, a lower discount rate would suffice when the economic and social situations are stable,
and no dramatic changes are expected to take place in the future.
Three methods are discussed here.
These are
(1) Net present value,
(2) Benefit cost ratio, and
(3) Internal rate of return.

Net Present Value Method

The net present value method can be used by taking the following steps
Step1. Estimate the cash inflows and outflows on a year-to-year basis.
Step2. Work out the net cash flows for individual years.
Step3. Find out for individual years the discount value of 1 at the given discount rate
Step4. Multiply the net cash flows for each year by the corresponding discount factor.
Step5. Add up the present values
It can be seen from the example in Table 6.2 below that at a 12 percent rate of discount the net
present values of the project are negative (-15.1). The project, therefore, cannot be accepted. If,
however, a lower discount rate is used, say 8 percent, the net values of the project would turn
positive, and the project may gain acceptability. The net values at 8 percent discount rate are shown
in Table 6.3.
Table 6. 2 Computing the Net Present Values (1) (in ` 1,000)
Year Costs Benefits Benefits-costs Values of 1 at Discounted Net
(out (inflow) (Net Cash 12% Discount Cash Flows
flows) Flows) Rate
Step 1 Step 2 Step 3 Step 4
0 250 0 -250 1.00 -250
1 250 290 40 0.892 35.7
2 250 290 40 0.797 31.9
3 255 300 55 0.712 39.2
4 260 335 75 0.635 47.6
5 260 335 75 0.567 42.5
6 260 335 75 0.507 38.0
1,185 1,295

Table 6. 3 Computing the Net Present Values (2) (in ` 1000)

Benefits-Costs Values of 1 at Discounte
Year (Net Cash 8% Discount d Net Cash
Flows) Rate Flows
Step 2 Step 3 Step 4
0 -250 1.00 -250
1 40 0.92 37.2
2 40 0.86 34.4
3 55 0.79 43.5
4 75 0.74 54.8
5 75 0.68 51.0
6 75 0.63 47.2
18.1
Benefit-Cost Ratio
The benefit-cost ratio is a ratio calculated by dividing the sum of discounted benefits by discounted
costs. Steps for calculating the benefit-cost ratio are:
Benefit – Cost Ratio = Sum of Discounted Benefits

Sum of Discounted Costs
Step1. Estimate the cash inflows and outflows on a year-to-year basis

Step2. Find out for individual years the discount value of 1 at the given discount rate.
Step3. Multiply the cash inflows and cash outflows for each year by the corresponding discount
factor.
Step4. Add up the discounted values of cash inflows and outflows separately.
Step5. Divide the discounted values of cash inflows by cash outflows to obtain the benefit-cost
ratio.

The computation of benefit-cost ratio is shown in Table 6.4.

Table 6. 4 Computing the benefit-cost ratio
Ye a r Benefits Discounted Values
Costs Discount
(inflows)
(outflow) Factor at 8%
Costs Benefits
Step 1 Step 2 Steps 3 and 4
0 250 0 1 250 0
1 250 290 0.93 232.5 269.7
2 250 290 0.86 215 249.4
3 255 300 0.76 193.8 228
4 260 335 0.73 189.8 244.55
5 260 335 0.68 176.8 227.8
6 260 335 0.63 163.8 211.05
Total 1421.7 1430.5
Step 5: Benefit Cost Ratio= 1430.5/1421.7 = 1.00619

The benefit-cost ratio in the above example is greater than 1, indicating that the sum of the
discounted benefits is greater than the sum of the discounted costs. If the ratio has been less than 1,
as indeed it is at 12 percent discount rate, it would not be advisable to accept the project. Also, as in
the case of the NPV, the higher the benefit-cost ratio of a project, the better it is in terms of
profitability.
Internal Rate of Return

The internal rate of return is a rate of discount at which the net present values of a project are zero.
Or, expressed differently, it is a rate at which the discounted costs and discounted benefits become
equal. The rate represents the “effective interest earned on the investment in the project
Internal Rate of Return = A rate at which the discounted costs are equal to discounted benefits
Unlike the two other methods discussed earlier where the present values or the benefit-cost ratios
are calculated on the basis of the given discount rates, in the case of the internal rate of return, a rate

at which the discounted costs would become equal to discounted benefits has to be found out. The
higher the IRR, the stronger is the project.
The calculation of the internal rate of return involves the following steps.
Step 1. Estimate the cash inflows and cash outflows on a year-to-year basis
Step 2. Work out the net cash flows for individual years.
Step 3. Select any random discount rate and compute the net present values.
Step 4. If the NPV thus arrived at is positive, then select a higher discount rate at which the NPV
may come close to zero. If, however, the NPV is negative, then select a lower discount rate at which
the NPV may come close to zero.
Step 5. Repeat the exercise until a discount rate that reduces the net present values to zero is found.
An example using the figures given in Table 6.5 may once again to be taken to illustrate the
computation of the internal rate of return.
Table 6.5 Computing the Internal Rate of Return (1)

Year Costs Benefits Net Cash Net Present Values
(Cash (Cash Flows Discounted
outflow) inflows)
Step 1 Step 2 Step 3 Step 4
8% 12%
0 250 0 -250 -250 -250
1 250 290 40 37.2 35.7
2 250 290 40 34.4 31.9
3 255 300 55 43.5 39.2
4 260 335 75 54.8 47.6
5 260 335 75 51.0 42.5
6 260 335 75 47.2 38.0
Total 18.1 -15.1

In this example, the initial discounting of the net cash flows (Step 3) has been done at 8 percent,
which gives a positive net present value of 18.1. Step 4, that is, discounting at 12 percent, turns the
net values to a negative figure of 15.1, suggesting that the rate at which the discounted net values
would turn zero must lie somewhere between 8 and 12 percent.
It would thus be noted that the calculation of the internal rate of return requires repetitive
computations and is often taxing. An alternative to the use of repetitive computations is
“interpolation”, which is a technique of finding the intermediate values between any two figures, or
any two discount rates in the present context. The equation for interpolation is as follows:
Internal rate of return = Lower discount rate +
Difference
Between the Net present value
Discount rates lower discount rate
X
Sum of the net present
OR
Internal rate of return = 8+ (12 – 8) 18.1 ..................... (1)
(18.1) - (-15.1)
= 8+ (4) x 18.1 ............................................................ (2)
33.2
= 8 + (4) (.54) ……………….. (3)
= 8 + 2.1
= 10.1 rate of discount
Discount Rates (ignore sign)
This is the way in which the internal rate of return is calculated. As mentioned earlier, projects with
higher IRRs are considered financially safer and stronger. Evidently, it would be inadvisable to
accept a project who‟s IRRs is lower than the prevailing lending or borrowing interest rates in the
capital market of the country.

It would be mentioned that the internal rate of return is the most widely used method for appraising
development projects. Most international and bilateral aid agencies rely on this method as a guide to
decisions on projects in question, of course, among several other considerations. The main
advantage of the IRR is that it is less subject to maneuvering than either the net present value or the
benefit-cost ratio methods. In their cases, almost everything about projects depends on the discount
rates: by changing the discount rates, results as desired by the planners or administrators can be
obtained. This is not possible to be done in the case of the internal rate of return where, if favorable
results were to be sought on a particular project, the entire stream of costs and benefits of the project
will need to be changed.
Another example of assessing a water supply project for a town by IRR is illustrated below
Key Questions
a) Will the project have a positive cash flow at any time during the project life?
b) In the case of income – generating projects: what is the projected net profit and when
will project break even?
Key Issues
1. To calculate the incremental net benefit because only the net benefits with the project
in excess of those which would have accrued without the project should be taken in to
account. If the project results in cost reductions, they should be considered as
incremental net benefits.
2. To determine the project life. It is usually the economic life of the major investment
item which is shorter than the technical life due to technological obsolescence.
3. To assess the debt-servicing capacity of the project during the entire project life in
order to ensure that the project will be capable of meeting its financial obligations at
any time. Cash flow analysis calculates the expected net cash flow as the differences
between receipts and expenses for each year over the project life. Receipts and
expenses for each year over the project life. Receipts and expenses comprise all
monetary transactions (cash inflows and out flows) irrespective of an impact on real
income. A continuous project implementation and later operation requires a positive net
cash flow at any time.

In case of an income – generating project, the commercial profitability of the project has to be
assessed by estimating all revenue and costs. Revenue and costs comprise all transactions that
generate or reduce real income irrespective of cash flows. The commercial profitability is only
given, if a net profit is likely to be achieved at the end of the project life or, in the case of a
continuous operation, after an respected point in time depending on the project type. Funding
assistance is usually required to finance the capital investments needed to get project started
Case Study: APPRAISAL OF A TOWN LEVEL WATER SUPPLY PROJECT
Pricing and cost recovery in water supply projects has become almost unworkable for the small and
medium towns due various reasons. Irregular supply, enormous maintenance and high energy costs,
inadequate water treatment, poor recovery, inadequate pricing of water supply to consumers,
provision of underground drainage, sewage treatment are some the intricate reasons for not
providing minimum supply of water as per the normative standards. Water Supply project
implemented by Rural Area Development Corporation, JUSCO and a few city corporations have
become sustainable and income generative. Increased efficiency and full cost recovery by billing,
metering, technical designs, automation of metering, etc. would help. Billing system covering
variable charges for economically weaker sections, commercial, high income groups etc., need to be
adopted suitably. Appropriate service providers like SPV could be used. Therefore, a small example
of how a town level water supply project can be remunerative even with minimum pricing is
illustrated below;
Minimum Data
1. PROJECT: Supply of Water to a residents of a town consisting of 10,000 houses
2. Capital Expenditure : 100 Million ETB
3. Cost of Capital : 10%
4. Operations and maintenance 2 Million ETB per annum
5. Average revenue from each house hold 100,000 per month
6. Life of the project: 10 years
With the above data available with us, we can now work out Net Present Values, Benefit Cost Ratio
and IRR based on the incomes and expenditure over the period of 10 years as below

ANALYSIS OF NET COST BENEFIT OF THE WATER SUPPLY PROJECT
Years
Particular s 1 2 3 4 5 6 7 8 9 10 Total
Increment al 1.8 1.8 1.8 1.8 1.8 1.8 1.8 1.8 1.8 1.8
Revenue
Incremental 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25
cost
Net cash 1.55 1.55 1.55 1.55 1.55 1.55 1.55 1.55 1.55 1.55
flow
PVIF at 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386
10%
PV of cash 1.41 1.28 1.16 1.06 0.96 0.87 0.80 0.72 0.66 0.60 9.62
flows at
10%
PVIF at 0.833 0.694 0.579 0.482 0.402 0.335 0.279 0.233 0.194 0.162
20%
PV of cash 1.29 1.08 0.90 0.75 0.62 0.52 0.43 0.36 0.30 0.25 6.5
flows at
20%
BCR at 10%=9.62/7=1.37
IRR -10%+(20-10)X(9.62-7)/
(9.62-6.5) IRR-18.40%
Return on investment=18.4%-10%= 8.4%
6.4 Capital Budgeting:
Capital budgeting is the process of making investment decision in long-term assets or courses of
action. Capital expenditure incurred today is expected to bring its benefits over a period of time.
These expenditures are related to the acquisition & improvement of fixes assets.
Capital budgeting is the planning of expenditure and the benefit, which spread over a number of
years. It is the process of deciding whether or not to invest in a particular project, as the investment
possibilities may not be rewarding. The manager has to choose a project, which gives a rate of
return, which is more than the cost of financing the project. For this the manager has to evaluate the

worth of the projects in-terms of cost and benefits. The benefits are the expected cash inflows from
the project, which are discounted against a standard, generally the cost of capital.
6.5 Capital budgeting Techniques:
The capital budgeting appraisal methods are techniques of evaluation of investment proposal will
help the company to decide upon the desirability of an investment proposal depending upon their;
relative income generating capacity and rank them in order of their desirability. These methods
provide the company a set of norms on the basis of which either it has to accept or reject the
investment proposal. The most widely accepted techniques used in estimating the cost-returns of
investment projects can be grouped under two categories.
1. Traditional methods
2. Discounted Cash flow methods
1. Traditional methods
These methods are based on the principles to determine the desirability of an investment project on
the basis of its useful life and expected returns. These methods depend upon the accounting
information available from the books of accounts of the company. These will not take into account
the concept of „time value of money‟, which is a significant factor to determine the desirability of a
project in terms of present value.
A. Pay-back period method: It is the most popular and widely recognized traditional method
of evaluating the investment proposals. It can be defined, as „the number of years required to
recover the original cash out lay invested in a project‟.
According to Weston & Brigham, “The payback period is the number of years it takes the firm to
recover its original investment by net returns before depreciation, but after taxes”.
“The payback period is the number of years required to recover initial cash investment.

Merits:
1. It is one of the earliest methods of evaluating the investment projects.
2. It is simple to understand and to compute.
3. It does not involve any cost for computation of the payback period
4. It is one of the widely used methods in small scale industry sector
5. It can be computed on the basis of accounting information available from the books.
Demerits
1. This method fails to take into account the cash flows received by the company after the
payback period.
2. It doesn‟t take into account the interest factor involved in an investment outlay.
3. It doesn‟t take into account the interest factor involved in an investment.
4. It is not consistent with the objective of maximizing the market value of the company‟s share.
5. It fails to consider the pattern of cash inflows i. e., the magnitude and timing of cash inflows.
B. Accounting (or) Average rate of return method (ARR):
It is an accounting method, which uses the accounting information repeated by the financial
statements to measure the probability of an investment proposal. It can be determined by dividing
the average income after taxes by the average investment i.e., the average book value after
depreciation.
Accounting rate of return on an investment can be calculated as the ratio of accounting net income
to the initial investment, i.e.,

On the basis of this method, the company can select all those projects who‟s ARR is higher than the
minimum rate established by the company. It can reject the projects with an ARR lower than the
expected rate of return. This method can also help the management to rank the proposal on the basis
of ARR. A highest rank will be given to a project with highest ARR, where as a lowest rank to a
project with lowest ARR.
Merits
1. It is very simple to understand and calculate.
2. It can be readily computed with the help of the available accounting data.
3. It uses the entire stream of earning to calculate the ARR.
Demerits:
1. It is not based on cash flows generated by a project.
2. This method does not consider the objective of wealth maximization
3. IT ignores the length of the projects useful life.
4. It does not take into account the fact that the profits can be re-invested.
II: Discounted cash flow methods:
The traditional method does not take into consideration the time value of money. They give equal
weight age to the present and future flow of incomes. The DCF methods are based on the concept
that a rupee earned today is more worth than a rupee earned tomorrow. These methods take into
consideration the profitability and also time value of money.
A. Net present value method (NPV)
The NPV takes into consideration the time value of money. The cash flows of different years and
valued differently and made comparable in terms of present values for this the net cash inflows of
various period are discounted using required rate of return which is predetermined.
“It is a present value of future returns, discounted at the required rate of return minus the present
value of the cost of the investment.”
NPV is the difference between the present value of cash inflows of a project and the initial cost of
the project.
According the NPV technique, only one project will be selected whose NPV is positive or above
zero. If a project(s) NPV is less than „Zero‟. It gives negative NPV hence. It must be rejected. If

there is more than one project with positive NPV‟s the project is selected whose NPV is the highest.
The formula for NPV is
NPV= Present value of cash inflows – investment.
Co- investment
c1, c2, c3… cn= cash inflows in different years.
k= Cost of the Capital (or) Discounting rate D= Years.
Merits:
1. It recognizes the time value of money.
2. It is based on the entire cash flows generated during the useful life of the asset
3. It is consistent with the objective of maximization of wealth of the owners.
4. The ranking of projects is independent of the discount rate used for determining the present
value.
Demerits:
1. It is different to understand and use.
2. The NPV is calculated by using the cost of capital as a discount rate. If self is difficult to
understood and determine.
3. It does not give solutions when the comparable projects are involved in different amounts of
investment.
4. It does not give correct answer to a question whether alternative projects or limited funds are
available with unequal lines.
B. Internal Rate of Return Method (IRR)
The IRR for an investment proposal is that discount rate which equates the present value of cash
inflows with the present value of cash out flows of an investment. The IRR is also known as cutoff
or handle rate. It is usually the concern‟s cost of capital.
The internal rate is the interest rate that equates the present value of the expected future receipts to
the cost of the investment outlay.
The IRR is not a predetermine rate, rather it is to be trial and error method. It implies that one has to
start with a discounting rate to calculate the present value of cash inflows. If the obtained present
value is higher than the initial cost of the project one has to try with a higher rate. Likewise if the
present value of expected cash inflows obtained is lower than the present value of cash flow. Lower
rate is to be taken up. The process is continued till the net present value becomes Zero. As this
discount rate is determined internally, this method is called internal rate of return method.
L- Lower discount rate

P1 - Present value of cash inflows at lower rate.
P2 - Present value of cash inflows at higher rate.
Q- Actual investment
D- Difference in Discount rates.
Merits:
1. It consider the time value of money
2. It takes into account the cash flows over the entire useful life of the asset.
3. It has a psychological appear to the user because when the highest rate of return projects are
selected, it satisfies the investors in terms of the rate of return on capital
4. It always suggests accepting to projects with maximum rate of return.
5. It is inconformity with the firm‟s objective of maximum owner‟s welfare.
Demerits:
1. It is very difficult to understand and use.
2. It involves a very complicated computational work.
3. It may not give unique answer in all situations.
C. Probability Index Method (PI)
The method is also called benefit cost ration. This method is obtained cloth a slight modification of
the NPV method. In case of NPV the present value of cash out flows are profitability index (PI), the
present value of cash inflows are divide by the present value of cash out flows, while NPV is a
absolute measure, the PI is a relative measure.
It the PI is more than one (>1), the proposal is accepted else rejected. If there are more than one
investment proposal with the more than one PI the one with the highest PI will be selected. This
method is more useful in case of projects with different cash outlays cash outlays and hence is
superior to the NPV method.
The formula for PI is
Merits:
1. It requires less computational work then IRR method
2. It helps to accept / reject investment proposal on the basis of value of the index.
3. It is useful to rank the proposals on the basis of the highest/lowest value of the index.
4. It is useful to tank the proposals on the basis of the highest/lowest value of the index.
5. It takes into consideration the entire stream of cash flows generated during the useful life of the
asset.
Demerits:
1. It is somewhat difficult to understand
2. Some people may feel no limitation for index number due to several limitations involved in their
competitions
3. It is very difficult to understand the analytical part of the decision on the basis of probability
index.
Summary
 Project appraisal approaches

 Technical appraisal
 Social appraisal
 Legal appraisal
 Commercial appraisal
 Institutional appraisal
 Financial appraisal
 Economical appraisal
 Capital budgeting mechanism
 Traditional method
 Discounted cash flow method

Review Questions:
1. Project appraisal enables

a. To know cost benefits
b. Technical feasibility
c. Economic & Environmental viability
d. All of the above
2. As a result of poor project appraisal
a. We may end up with no demand for the project
b. We may incur losses
c. We will save money
d. a & b
3. Project appraisal gives an indication about the
a. Total viability of the project
b. Financial, Economic & Social benefits only
c. Only technical viability
d. None of the above
4. The appraisal techniques used are
a. NPV & IRR
b. BCR
c. Sensitivity analysis
d. All of the above
5. Economic viability of the project is judged normally at discount rate of
a. 4%
b. 25%
c. 12%
d. 40%
6. Financial analysis takes into account discount rate of
a. Actual borrowed rate of interest of the capital
b. 20%
c. 3%


7. In case the project is funded by more than one source, the financial analysis is carried out using
a. Weighted average cost of capital for each project
b. More than the weighted average
c. Less than the weighted average
8. Project is acceptable if
a. NPV is positive
b. NPV is negative
c. NPV is Zero
9. Project is acceptable if BCR is more than 1
a. True
b. False
10. Internal Rate of Return (IRR) indicates
a. Net return on investment in the project
b. No return on investment in the project
c. None of the above
d. Only b
11. Social cost benefit analysis helps
a. Selecting financially remunerative project
b. Selecting socially remunerative project
c. In knowing whether social benefits exceed its social cost
d. b & c
12. Time discounting of cash flows means
a. Calculation of the present value of cost & benefits during the project life
b. It is the method of reducing to a comparable base the costs & benefits that accrue at
different intervals
c. a & b

References:
1. Akalu, M.M., (2001), Re-examining Project Appraisal and Control: Developing a focus on
Wealth Creation. International Journal of Project Management.
2. Benson, M., (1999), Real Estate and Business Value: A New Perspective. The Appraisal
Journal, 67(2), 205-212

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WACHEMO UNIVERSITY

COLLEGE OF ENGINEERING AND TECHNOLOGY

MODULE OF FINANCIAL MANAGEMENT IN CONSTRUCTION

FINANCIAL MANAGEMENT IN CONSTRUCTION

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Table1.1 Areas of Finance ................................................................................................................... 4

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 Discuss the role of the finance function within a business.

1.1 Capital Requirement of a Corporation

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Stockholders‟ Other Corporations, Creditors (Debt)

Outside Investment Loan Payment Loan

Purchase of Sale of Payment of Accounts

Work in Process Product Inventories

Figure 1.1 Fund Flows of Corporation.

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1.2 Fields of Finance

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 Seeks sources of low-cost funds

b) Common Stocks (equity): a security representing the residual ownership of a corporation.

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1.3 Goals of Financial Management

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1.4 Functions of Financial Management

Goals of Financial Management Functions of finance

i) Functions leading to liquidity

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ii) Functions leading to profitability

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1.5 Organization of Finance Function

ii) Treasurer: The treasurer‟s principal responsibilities include:

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Cash Credit Financial Management

Capital Fund Tax Data

Figure 1.2 Organization of Finance Function

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The main points in this chapter may be summarized as follows:

1. What is finance? Define business finance.

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2.1 Short-term financing

Figure 1.3 Fund Requirement.

 Funds are needed o finance inventories during a production/construction period; excessive

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Short-term financing sources:

i) Unsecured Interest-Free Sources:

 Advance Payment: It is a common practice to pay an advance payment for delivery

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ii) Unsecured Interest-Bearing Sources:

 Non-bank short-term sources

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 Private Loans: A short-term unsecured loan may be obtainable from a

iii) Secured Short-term Sources

2.2 Intermediate-Term Financing

Intermediate-Term Financing Institutions:

Equipment Manufacturers: Manufacturers of industrial equipment make loans to assist in the