Financial Management Module 2023

FINANCIAL MANAGEMENT MODULE
DR T. CHINODA
2023
C
TABLE OF CONTENTS
Acknowledgements...............................................................................................................iv
To the Student.........................................................................................................................v
CHAPTER 1...............................................................................................................................1
AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL
ENVIRONMENT.......................................................................................................................1
INTRODUCTION......................................................................................................................1
Financial Management Definition:.........................................................................................2
Responsibilities of Corporate Financial Management............................................................2
Objectives of Corporate Financial Management....................................................................5
Forms of Business Ownership:...............................................................................................6
The principal objective of a Corporation (company).............................................................9
CHAPTER 2.............................................................................................................................18
TIME VALUE OF MONEY CONCEPTS...........................................................................18
Simple Interest..................................................................................................................19
Time lines..........................................................................................................................23
For a simple interest rate calculation, the time line is as follows:....................................23
Simple Discount................................................................................................................26
Equivalent Simple Interest Rate........................................................................................29
Practise Question...............................................................................................................31
Cardinal Rules of Time Value..........................................................................................31
Interest and date values.....................................................................................................33
Payments and obligations of different dates.....................................................................33
Practice Questions.............................................................................................................37
Compound Interest............................................................................................................38
Compounding More than Once a Year.............................................................................40
Nominal and Effective Annual Rates................................................................................42
Continuous Compounding................................................................................................46
Self Test Problems............................................................................................................51
CHAPTER 3.............................................................................................................................53
ANNUITIES.............................................................................................................................53
Annuities...............................................................................................................................53
Tough Chinoda [ PhD-FINANCE (UKZN), MSC Banking & Financial Services (NUST), BBS-
Banking & Finance (BUSE)] Page i
Future Value of an Ordinary Annuity...................................................................................54
Future Value Interest Factor Annuity [FVIFA]....................................................................54
Practice Questions................................................................................................................55
Future Value of an Annuity Due..........................................................................................55
Present Value Interest Factor Annuity , (PVIFAOD)...........................................................57
CHAPTER 4.............................................................................................................................64
ARMOTIZATION AND SINKING FUNDS..........................................................................64
Amortisation of Loans..........................................................................................................64
To find the periodic payment we apply our knowledge of annuities...................................64
Construction of amortization table.......................................................................................65
Sinking Funds.......................................................................................................................66
To find the periodic payment we apply our knowledge of annuities...................................67
Sinking Fund Schedule.........................................................................................................69
Practise Questions.................................................................................................................71
CHAPTER 5.............................................................................................................................73
CAPITAL BUDGETING.........................................................................................................73
Importance of capital budgeting...........................................................................................73
Incremental cash flows.........................................................................................................74
Types of Project Cashflows..................................................................................................76
Practice Question..................................................................................................................78
Steps in Investment Appraisal..............................................................................................79
Discounted Payback Method................................................................................................81
The Net Present Value (NPV)..............................................................................................83
Practice Question..................................................................................................................85
Internal Rate of Return (IRR)...............................................................................................86
The Modified Internal rate of return [MIRR].......................................................................96
The Accounting Rate of Return............................................................................................99
Capital rationing.................................................................................................................100
Profitability index (PI)........................................................................................................101
Practice Questions..............................................................................................................102
Sensitivity analysis.............................................................................................................103
Banking & Finance (BUSE)] Page ii
CHAPTER 6...........................................................................................................................105
SOURCES OF FUNDS AND COST OF CAPITAL.............................................................105
Introduction........................................................................................................................105
Practise Question.............................................................................................................130
CHAPTER 7...........................................................................................................................131
VALUATION OF SECURITIES.......................................................................................131
Valuation of Bonds.............................................................................................................134
Bond Valuation at Exact Dates.......................................................................................142
Practise Questions...........................................................................................................151
One Period Valuation......................................................................................................157
Two Period Valuation.....................................................................................................158
N- Period Valuation:.......................................................................................................158
Practise Questions:..........................................................................................................162
CHAPTER 9...........................................................................................................................163
DIVIDEND POLICY AND CAPITAL STRUCTURE THEORY....................................163
Capital Structure Theory.................................................................................................163
Introduction.....................................................................................................................163
Traditional and Modern Theory of Capital Structure.....................................................163
Initial Assumptions of the Modigliani-Miller Model.....................................................164
Modigliani and Miller without Corporate or Personal Taxes.........................................164
Proposition 1...................................................................................................................164
Proposition 2...................................................................................................................165
Modigliani and Miller with Corporate Taxes.................................................................167
Proposition 1...................................................................................................................167
Proposition 2...................................................................................................................167
Dividend Policy Theories................................................................................................169
The residual approach to dividends................................................................................169
The dividend irrelevance theory.....................................................................................169
Dividend relevancy theory (Bird in the Hand Fallacy....................................................169
Tax based theories...........................................................................................................170
Signal hypothesis and clientele effect.............................................................................170
Factors Affecting the Dividend Decision........................................................................170
Practice Questions...........................................................................................................172
Banking & Finance (BUSE)] Page iii
About The Author
Dr Tough Chinoda is a Senior lecturer in the Department of Accounting and Finance at the
University of Zimbabwe. He has lecturing experience in various universities that includes
Women’s University in Africa, Africa University, Bindura University and Midlands State
University. He is a renounced lecturer and researcher with over 10 years of experience in
teaching, supervision and examination of MSc and BSc dissertations in Accounting and
Finance has more than 20 research publications. He has particular research interests in
financial economics, financial inclusion, risk management, and public finance, as well as the
application of quantitative research methods to development practice. Recent research and
publications focus on the nexus between ICTs, financial inclusion and economic growth in
Africa. His doctoral research was centered on the nexus between mobile phones diffusion,
financial inclusion and economic growth in Africa.
Education and Qualifications

2019 PhD in Finance, University of KwaZulu Natal, South Africa
2014 MSc in Banking and Financial Services, NUST, Zimbabwe, UK
2008 BSc Honours in Banking and Finance, BUSE, Zimbabwe
Record of Employment
2022: Senior Lecturer-University of Zimbabwe
2022: Part Time Lecturer: Midlands State University
2022: Senior Lecturer: Bindura University (GBS)
2019: Senior Lecturer: Women’s University in Africa
2011: Teaching Assistant: Chinhoyi University of Technology
To God Be the Glory
Banking & Finance (BUSE)] Page iv
CHAPTER 1
AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL

ENVIRONMENT
INTRODUCTION
Discusses in this introductory chapter to financial management are the

various responsibilities of the corporation’s financial managers and how to
tackle many of the problems financial managers are expected to solve. To
begin with is a discussion of the corporates, the financial decisions they
need to make, and why they are important.
To survive and prosper, a company must satisfy its customers. It must also
produce and sell products and services at a profit. In order to produce, it
needs many assets—plant, equipment, offices, computers, technology, and
so on. The company has to decide (1) which assets to buy and (2) how to pay
for them. The financial manager plays a key role in both these decisions.
The investment decision, that is, the decision to invest in assets like plant,
equipment, and know-how, is in large part a responsibility of the financial
manager. So is the financing decision, the choice of how to pay for such
investments.
The chapter started by explaining how businesses are organized; a brief

introduction to the role of the financial manager and why corporate
managers need a sophisticated understanding of financial markets. Next are
the goals of the firm and what makes for a good financial decision. Is the
firm’s aim to maximize profits? To avoid bankruptcy? To be a good citizen?
Some conflicts of interest that arise in large organizations were also
considered and a review of some mechanisms that align the interests of the
firm’s managers with the interests of its owners.
Banking & Finance (BUSE)] Page 1
Finance Management Definition:
It is a discipline that involves decisions about sourcing finance,
management and employment of capital so as to attain corporate goals.
Scope of Financial Management decisions
Sourcing Finance Employment of Capital Management of Finance
It also deals with size of the organisation (level of employment, structure of

financing and composition of assets (Employment of capital).
Responsibilities of Business Financial Management
The financial manager is tasked with the responsibility of acquiring funds

for the business and using those funds in order to maximize the value of the
firm.
Specifically, the financial manager has several duties to perform within the
firm. These are investment and financing decision making, management of
risk, management of value, planning and managing the Statement of
Financial Position. We discuss these roles below:
1. Financial Planning. The main responsibility of the financial manager

in a large concern is to forecast the needs and sources of finance and
ensure the adequate supply cash at proper time for the smooth
running of the business. He is to see that cash inflow and outflow
must be uninterrupted and continuous. For this purpose, financial
planning is necessary, i.e., he must decide the time when he needs
money, the sources of supply of money and the investment patterns
so that the company may meet its obligations properly and maintains
its goodwill in the market. The financial manager is also to see that
there is no surplus money in the business which earns nothing.
2. Investment and financing decisions. The financial manager must

play a leading role in the investment and financing decisions of the
business. He must help to decide the assets that must be acquired
and the way in which the assets will be financed. For example, there
are several options to be considered with regards to financing. These
are debt finance versus equity finance, long-term finance versus short
term finance.
3. Management of risk. The financial manager is responsible for the

management of risk. The firm's overall risk is determined by the way
in which its assets have been financed. For example, the introduction
of debt into the business brings with it financial risk. The introduction
of fixed assets also brings with it operating risk.
4. Raising of Necessary Funds. The second main responsibility of the

financial officer is to see the nature of the need, i.e., whether finances
are required for long-term or for short-term. He must assess the
alternative sources of supply of finance taking into view the cost of
raising funds, its effect on various concerned parties, i.e.
shareholders, creditors, employees and the society, control and risk in
financing and elasticity in capital structure etc.
5. Controlling the Use of Funds and management of value. The

financial manager is responsible for the management of value. The
financial manager must keep in touch with the financial market that
is the money market and capital market. This is because funds must
be raised on the financial markets through the issuance of securities
(shares and bonds). These securities are then traded on the financial
markets by the investors who have provided funds to the firm. He is
also responsible for the proper utilization of funds. Assets must be
used effectively so as to earn higher profits; inflow and outflow of cash
must be controlled in a manner so as to meet the current as well as
future obligations; unnecessary expenditure should be curtailed and
there should be left no possibility for misappropriation of money.
6. Disposition of Profits. Appropriation of profits is one of the main

responsibilities of the financial manager. He is to advise to the top
executive as how much of the profits should be retained in the
business as reserves for future expansion; how much to be used in
repaying the debts; and how much to be distributed to the
shareholders as dividend. On the basis of the advice given by the
financial mange, the resolutions regarding depreciations, reserves,
general reserves and distribution of dividends are carried out in the
meeting of the board of directors of the company.
7. Other Responsibilities. Over and above, the responsibilities stated
above, there are certain other responsibilities of the financial
manager. These are:
a. Responsibility to owners. Shareholders or stock-holders are the

real owners of the concern. Financial manager has the prime
responsibility to those who have committed funds to the enterprise.
He should not only maintain the financial health of the enterprise,
but should also help to produce a rate of earning that will reward the
owners adequately for the risk capital they provide.
b. Legal Obligations. Financial manager is also under an obligation

to consider the enterprise in the light of its legal obligations. A host of
laws, taxes and rules and regulations cover nearly every move and
policy. Good financial management help to develop a sound legal
framework.
c. Responsibilities to Employees. The financial management must

try to produce a healthy going concern capable of maintaining regular
employment at satisfactory rate of pay under favourable working
conditions. The long term interests of management, employees and
owners are common.
d.Responsibilities to Customers. In order to make the payments of

its customers' bill, the effective financial management is necessary.
Sound financial management ensures the creditors continued supply
of raw materials.
e. Wealth Maximization. Prof. Soloman of Stanford University has

argued that the main goal of the finance function is wealth
maximization. The other goals may be achieved automatically.
In the light of the above discussion, we can conclude that the main
responsibility of the financial manager is not only to maintain the
financial health of the organisation but also to increase the economic
welfare of the shareholders by utilizing funds invested.
Objectives of Business Finance Management
The objectives or goals or business finance management are-
(a) Profit maximization,
(b) Return maximization, and
(c) Wealth maximization.
Three goals of corporate financial management shall be explained below:
1. Goal of Profit maximization.

Maximization of profits is generally regarded as the main objective of a
business enterprise. Each company collects its finance by way of issue
of shares to the public. Investors in shares purchase these shares in
the hope of getting profits from the company as well as dividends. This
is possible only when the company's goal is to earn maximum profits
out of its available resources. If company fails to distribute higher
dividend, investors will not be keen to invest their money in such firm
and those who have already invested will like to sell their stocks. On
the other hand, higher profits are the barometer of its efficiency on all
fronts, i.e., production, sales and management. A few replace the goal
of 'maximization of profits' to 'fair profits'. 'Fair Profits' means general
rate of profit earned by similar organisation in a particular industry.
2. Goal of Return Maximization.

The second goal of financial management is to safeguard the economic
interests of the persons who are directly or indirectly connected with
the company, i.e. shareholders, creditors and employees. The all such
interested parties must get the maximum return for their
contributions. But this is possible only when the company earns
higher profits or sufficient profits to discharge its obligations to them.
Therefore, the goal of maximization of profits and returns are inter-
related.
3. Goal of Wealth Maximization.

Frequently, maximization of profits is regarded as the proper objective
of the firm but it is not as inclusive a goal as that of maximising it
value to its shareholders. Value is represented by the market price of
the ordinary share of the company over the long run, which is
certainly a reflection of the performance of the company's investment
and financing decisions. It is the prime goal of the corporate financial
management to ensure its shareholders have the value of their shares
maximized in the long-run. In fact, the performances of the company
can well be evaluated by the value of its share in the long run.
Forms of Business Ownership:
There are three main forms of business organization: (1) sole

proprietorships, (2) partnerships, and (3) corporations. In terms of numbers,
about 80% of businesses are operated as sole proprietorships, while most of
the remainder are divided equally between partnerships and corporations.
Sole Proprietorship
A sole proprietorship is an unincorporated business owned by one

individual. Going into business as a sole proprietor is easy—one merely
begins business operations. However, even the smallest business normally
must be licensed by a governmental unit.
The proprietorship has three important advantages:

1. It is easily and inexpensively formed,
2. it is subject to few government regulations, and
3. The business avoids corporate income taxes.
The proprietorship also has three important limitations:

1. It is difficult for a proprietorship to obtain large sums of capital;
2. The proprietor has unlimited personal liability for the business’s
debts, which can result in losses that exceed the money he or she
invested in the company; and
3. The life of a business organized as a proprietorship is limited to the
life of the individual who created it.
For these three reasons, sole proprietorships are used primarily for small-
business operations. However, businesses are frequently started as
proprietorships and then converted to corporations when their growth
causes the disadvantages of being a proprietorship to outweigh the
advantages.
Partnership
A partnership exists whenever two or more up to twenty persons associate
to conduct a non-corporate business with a goal of making profit.
Partnerships may operate under different degrees of formality, ranging from
informal, oral understandings to formal agreements filed in the state in
which the partnership was formed. The major advantage of a partnership is
its low cost and ease of formation.
The disadvantages are similar to those associated with proprietorships:

1. Unlimited liability,
2. limited life of the organization,
3. difficulty transferring ownership, and
4. Difficulty raising large amounts of capital.
Regarding liability, the partners can potentially lose all of their personal
assets, even assets not invested in the business, because under partnership
law, each partner is liable for the business’s debts. Therefore, if any partner
is unable to meet his or her pro rata liability in the event the partnership
goes bankrupt, the remaining partners must make good on the unsatisfied
claims, drawing on their personal assets to the extent necessary.
The first three disadvantages—unlimited liability, impermanence of the

organization, and difficulty of transferring ownership—lead to the fourth, the
difficulty partnerships have in attracting substantial amounts of capital.
This is generally not a problem for a slow-growing business, but if a
business’s products or services really catch on, and if it needs to raise large
sums of money to capitalize on its opportunities, the difficulty in attracting
capital becomes a real drawback. Thus, growth companies such as Hewlett-
Packard and Microsoft generally begin life as a proprietorship or
partnership, but at some point their founders find it necessary to convert to
a corporation.
Corporation
A corporation is a legal entity created by the state in terms of the

Company’s Act in Zimbabwe, and it is separate and distinct from its owners
and managers. This separateness gives the corporation three major
advantages:
1. Unlimited life. A corporation can continue after its original owners and
managers are deceased.
2. Easy transferability of ownership interest. Ownership interests can be
divided into shares, which, in turn, can be transferred far more easily
than can proprietorship or partnership interests.
3. Limited liability. Losses are limited to the actual funds invested.
To illustrate limited liability, suppose you invested $10,000in a partnership

that then went bankrupt owing $1 million. Because the owners are liable for
the debts of a partnership, you could be assessed for a share of the
company’s debt, and you could be held liable for the entire $1 million if your
partners could not pay their shares. Thus, an investor in a partnership is
exposed to unlimited liability.
On the other hand, if you invested $10,000 in the stock of a corporation that
then went bankrupt, your potential loss on the investment would be limited
to your$10,000 investment. These three factors—unlimited life, easy
transferability of ownership interest, and limited liability—make it much
easier for corporations than for proprietorships or partnerships to raise
money in the capital markets.
The corporate form offers significant advantages over proprietorships and

partnerships, but it also has two disadvantages:
1. Corporate earnings may be subject to double taxation—the earnings of
the corporation are taxed at the corporate level, and then any earnings
paid out as dividends are taxed again as income to the shareholders.
2. Setting up a corporation is more complex and time-consuming than
for a proprietorship or a partnership. A proprietorship or a
partnership can commence operations without much paperwork, but
setting up a corporation requires that the incorporators prepare an
Articles of Association and Memorandum of Association.
The Memorandum includes the following information:

1. Name of the proposed corporation,
2. Types of activities it will pursue,
3. Amount of capital stock,
4. Number of directors,
5. Names and addresses of directors.
The memo is filed with the Registrar of Companies, and when it is

approved, the corporation is officially in existence. Then, after the
corporation is in operation, quarterly and annual employment, financial,
and tax reports must be filed with state authorities.
The Articles are a set of rules drawn up by the founders of the corporation.
Included re such points as
1. how directors are to be elected (all elected each year, or perhaps one-
third each year for three-year terms);
2. whether the existing shareholders will have the first right to buy any
new shares the firm issues; and
3. Procedures for changing the articles themselves, should conditions
require it.
The principal objective of a Corporation (company)
Shareholders are the owners of a corporation, and they purchase shares

because they want to earn a good return on their investment without undue
risk exposure. In most cases, shareholders elect directors, who then hire
managers to run the corporation on a day-to-day basis. Because managers
are supposed to be working on behalf of shareholders, it follows that they
should pursue policies that enhance shareholder value.
Consequently, throughout this module we operate on the assumption that

management’s primary objective is stockholder wealth maximization, which
translates into maximizing the price of the firm’s common stock/shares.
Firms do, of course, have other objectives— in particular, the managers who
make the actual decisions are interested in their own personal satisfaction,
in their employees’ welfare, and in the good of the community and of society
at large. Still, stock price maximization is the most important objective for
most corporations.
Agency theory
Agency theory suggests that the firm can be viewed as a nexus of contracts
(loosely defined) between resource holders. An agency relationship arises
whenever one or more individuals, called principals, hire one or more other
individuals, called agents, to perform some service and then delegate
decision-making authority to the agents.
The primary agency relationships in business are those;
1. Between shareholders and managers and
2. Between debt holders/creditors and shareholders.
These relationships are not necessarily harmonious; indeed, agency theory
is concerned with so-called agency conflicts, or conflicts of interest between
agents and principals. This has implications for, among other things,
corporate governance and business ethics. When agency occurs it also tends
to give rise to agency costs, which are expenses incurred in order to sustain
an effective agency relationship (e.g., offering management performance
bonuses to encourage managers to act in the shareholders' interests).
Accordingly, agency theory has emerged as a dominant model in the
financial economics literature, and is widely discussed in business ethics
texts. We will further discuss the issue below.
The Problem
The discretion that the board enjoys with regards to the amount that may be
put into the distributable reserves gives rise to the "agency problem".
An agency relationship arises whenever one or more individuals, called

principals, hire another individual, an agent, to perform some service and
then delegates decision making authority to that agent. In an agency
relationship, the principal determines the work that is undertaken by the
agent. Under conditions of incomplete information and uncertainty, two
problems may arise: adverse selection and moral hazard.
Adverse selection is the situation in which the principal cannot be certain

that the agent has accurately represented his ability to do the work for
which he is being paid. Moral hazard is the situation in which the principal
cannot be sure if the agent has put maximum effort.
The shareholders of the company appoint a board of directors to direct the

affairs of the company. The board, in turn, appoints managers to manage
the affairs of the company. Thus, managers are the agents of the board and
the board members are also agents of the shareholders.
The agency problem emanates from the fact that a company is an artificial
person created by the law. This legal person created by the shareholders,
who are natural persons appoint directors who are also natural persons to
act on their behalf. The problem usually arises because of the gap between
the management and shareholders as managers do not always make
decisions that maximise the interest of the shareholders and thus the
conflict.
The agency problem is aggravated because of the distance that has been
created between the shareholders and the management team. The
shareholders, as the principals, expect the board members, their agents, to
make decisions that will lead to the maximization of the value of their
equity. At the same time, the board, as the principals, expect the
management team, their agents, to make decisions that are in agreement
with their own goals as the board.
Additionally, some board members may also be members of the management
team of the company. Thus, the management team may be in a great
position to influence the decision making process at board level. This is
especially true if the chairman of the board is also the chief executive or
managing director of the firm.
Because of this problem, managers and board members may pursue goals
which do not necessarily lead to the maximization of the value of the
shareholder's equity, leading to a conflict of goals. This is the agency
conflict.
The Agency Conflict
Since the board may not be fully independent from management and there
is a large gap between the management and the board, the managers and
the board may be tempted to have goals that compete with shareholder
wealth maximization. For example, managers may increase retained
earnings in order to finance some projects which would not necessarily
enhance shareholder wealth, or they may create certain reserves whose
purpose may not be clearly apparent to the shareholders. Managers and
directors may own some shares in the company, but this is usually only a
small percentage of the total. Managers may also take actions to maximize
the size and growth of the firm, to enhance their own security, power and
status.
Agency Costs
Managers are exposed to a moral hazard in that it is possible for them to

take these actions unobserved because shareholders are unable to monitor
all their actions. A cost is therefore incurred by shareholders in their
attempt to encourage managers to act in their best interests through a set of
incentives, constraints, and punishments for the managers.
Three categories of agency costs can be identified. We list them below.

1. Expenditures to monitor managerial actions through administrative
procedures such as regular audits.
2. Expenditures to structure the organisation in a way that limits
undesirable managerial actions. An example of this is the case where
shareholders appoint outside investors to the board of directors.
3. Opportunity costs in the form of delays in making timely decisions
that would enhance the wealth of shareholders. An example of this is
when shareholders impose restrictions such as the requirement that
they must vote on certain issues that are deemed important, limit the
ability of managers to take actions that advance shareholder wealth.
Discussion Point
What is the primary goal of management? How does the agency conflict
arise?
Mechanisms for Dealing with Shareholder-Manager Conflicts
There are two popular positions for dealing with shareholder-manager

agency conflicts. At one extreme, the firm's managers are compensated
entirely on the basis of stock price changes. In this case, agency costs will
be low because managers have great incentives to maximize shareholder
wealth. It would be extremely difficult, however, to hire talented managers
under these contractual terms because the firm's earnings would be affected
by economic events that are not under managerial control.
At the other extreme, stockholders could monitor every managerial action,

but this would be extremely costly and inefficient. The optimal solution lies
between the extremes, where executive compensation is tied to performance,
but some monitoring is also undertaken.
Henceforth, shareholders need to deal with the agency problem effectively so

that they are not disadvantaged
This they can do by offering incentives such as performance shares.

Offering incentives to managers helps to maximize the value of the
shareholder's equity. This approach is based on the belief that fixed wage
contracts are not always the optimal way to organize the relationship
between principals and agents. It is more efficient to replace fixed wages
with compensation based on residual claim on the profits of the firm. The
provision of ownership rights reduces the incentive for agents' adverse
selection and moral hazard since it makes their compensation dependent on
their performance.
There are two forms of managerial incentives that may be offered:

performance based plan and share option scheme. The performance based
plan may be in the form of a share option scheme in which managers are
given the option to purchase the shares of the company sometime in the
future at a predetermined price. If the share price turns out to be more than
the option price, the manager will exercise the option, thereby reaping a
capital gain on the shares. The option has a value only if the market price of
the shares rises above the exercise price of the option. Because of this
possibility, managers are compelled to take actions that enhance the share
price and therefore, incidentally, the wealth of the shareholders.
Share option schemes have, however, failed to provide the necessary

incentive because there may be other factors beyond the control of the
managers that may affect the price of the share. These are usually macro-
economic factors.
For example, if interest rates increase, share prices in general may decrease.
Another form of incentive plan are performance shares. These are shares
that are offered to managers as a reward for performance which enhances
shareholder wealth. The performance measures used are therefore those
that are directly linked to the price of the share such as the return on
equity, earnings per share, return on assets, etc. If the managers exceed
agreed targets on these measures, which are objective in that they are
largely within their control, they are rewarded with an agreed number of
shares in the company.
For example, a manger may be allocated 10 000 performance shares. If the

target growth in earnings per share is 20%, and this is achieved, the
manager is issued 100% of the allocated shares, that is 10 000. If the target
is exceeded, say by 5%, the manager is issued 105% of the allocation.
Performance share will have value regardless of the share price at the end of
the year.
Economic value added [EVA] is another form of performance measurement

which is used to tie managerial compensation to shareholder wealth
maximization. When we assess the profitability of the company we deduct
interest on debt, a financing charge, from the operating expenses. The
residual income is the income that is attributable to the shareholders. The
residual income arises as follows:
Operating earnings xxx

Less interest on debt xxx
Taxable income xxx
Less taxation xxx
Income attributable to shareholders xxx
You can see that shareholders receive the residual after we have deducted
payments to debt holders and tax from the operating income. A measure of
the firm's performance based on this residual income is the return on equity
(ROE), which is found by dividing the income to shareholders by the
shareholders' equity.
As we also know from the Statement of Financial Position, that a company

also uses shareholders' equity in addition to debt capital in earning its
profits.
Thus, it is only logical that we deduct the cost of all the types of capital,
including equity that the firm uses in order to get the true net income. Thus,
we should re-write the statement as:
Operating earnings xxx

Less interest on debt xxx
Taxable income xxx
Less Taxation xxx
Less Cost of equity xxx
Income attributable to shareholders xxx
Thus, if we accept that the cost of debt finance is the interest that we pay on
the borrowed funds, we should also accept that equity must have a cost.
Accordingly, if we deduct an "imputed' cost of equity from the earnings, we
get a more realistic measure of the ROE. We call this measure, the
"Economic value added" (EVA).
Put most simply, EVA is net operating profit minus an appropriate charge
for the opportunity cost of all capital invested in an enterprise. As such, EVA
is an estimate of true "economic" profit, or the amount by which earnings
exceed or fall short of the required minimum rate of return that
shareholders and lenders could get by investing in other securities of
comparable risk.
EVA is the financial performance measure that comes closer than any other
to capturing the true economic profit of an enterprise. EVA also is the
performance measure most directly linked to the creation of shareholder
wealth over time. If the EVA is positive, then we are creating wealth for the
shareholders.
Direct intervention by shareholders may be possible especially when the
shares are held by large, institutional shareholders. Examples of institutions
that hold shares of other companies are pension funds, mutual funds, and
insurance companies. The managers of these institutions usually have the
power and take an active interest in the management of the companies in
which they hold shares. They can lobby for the interests of all shareholders
and suggest ways in which the business may be run. The managers of the
firm must listen to them because if they decide to off-load their shares, the
price of the shares is likely to be adversely affected.
The threat of firing is also increased especially where the shareholders are
institutional. This may also be enhanced where hostile takeovers are
possible. A hostile takeover is likely to happen when the shares of the
company are undervalued relative to their potential due to poor
management. Thus, managers may be forced to take shareholder
maximising actions simply in order to keep their jobs.
Appointment of Non-Executive board members. They may also be

appointed as "neutral" members of the board. We have seen that one of the
reasons for the existence of the agency conflict is the appointment of board
members who are also members of the management team (executive board
members). A non-executive board member would not normally sympathize
with decisions that are in conflict with the goal of maximising the wealth of
shareholders.
Shareholders/Creditors:
A Second Agency Conflict
In addition to the agency conflict between stockholders and managers, there

is a second class of agency conflicts—those between creditors and
shareholders. Creditors have the primary claim on part of the firm's
earnings in the form of interest and principal payments on the debt as well
as a claim on the firm's assets in the event of bankruptcy. The shareholders,
however, maintain control of the operating decisions (through the firm's
managers) that affect the firm's cash flows and their corresponding risks.
Creditors lend capital to the firm at rates that are based on the riskiness of
the firm's existing assets and on the firm's existing capital structure of debt
and equity financing, as well as on expectations concerning changes in the
riskiness of these two variables.
The shareholders, acting through management, have an incentive to induce
the firm to take on new projects that have a greater risk than was
anticipated by the firm's creditors. The increased risk will raise the required
rate of return on the firm's debt, which in turn will cause the value of the
outstanding bonds to fall. If the risky capital investment project is
successful, all of the benefits will go to the firm's stockholders, because the
bondholders' returns are fixed at the original low-risk rate. If the project
fails, however, the creditors are forced to share in the losses.
On the other hand, shareholders may be reluctant to finance beneficial

investment projects. Shareholders of firms undergoing financial distress are
unwilling to raise additional funds to finance positive net present value
projects because these actions will benefit bondholders more than
shareholders by providing additional security for the creditors' claims.
Managers can also increase the firm's level of debt, without altering its
assets, in an effort to leverage up shareholders' return on equity. If the old
debt is not senior to the newly issued debt, its value will decrease, because a
larger number of creditors will have claims against the firm's cash flows and
assets. Both the riskier assets and the increased leverage transactions have
the effect of transferring wealth from the firm's bondholders to the
stockholders.
Shareholder-creditor agency conflicts can result in situations in which a

firm's total value declines but its stock price rises. This occurs if the value of
the firm's outstanding debt falls by more than the increase in the value of
the firm's common stock. If shareholders attempt to expropriate wealth from
the firm's creditors, bondholders/creditors will protect themselves by
placing restrictive covenants in future debt agreements. Furthermore, if
creditors believe that a firm's managers are trying to take advantage of
them, they will either refuse to provide additional funds to the firm or will
charge an above-market interest rate to compensate for the risk of possible
expropriation of their claims. Thus, firms which deal with creditors in an
inequitable manner either lose access to the debt markets or face high
interest rates and restrictive covenants, both of which are detrimental to
shareholders.
Management actions that attempt to usurp wealth from any of the firm's
other stakeholders, including its employees, customers, or suppliers, are
handled through similar constraints and sanctions. For example, if
employees believe that they will be treated unfairly, they will demand an
above-market wage rate to compensate for the unreasonably high likelihood
of job loss.
Agency vs Contract
Although the notions of agency and contract are closely intertwined, some
academics bristle at the suggestion they are essentially the same.
Specifically, they point out a number of unique features of agency versus
contractual relationships. There are two major sets of differences.
First, agents are usually retained not for any particular or discrete set of
tasks, but for a broad range of activities, which may change over time, that
are consistent with basic objectives and interests set forth by the principals.
In this instance principals must be concerned to some degree about agents'
personal attitudes, dispositions, and other characteristics that are usually
not a concern in contractual agreements. Principals hire out broad
objectives to be fulfilled instead of specific tasks.
Second, in an agency relationship there is typically much less independence

between agent and principal than between contracting parties. Typically this
also means that the principal-agent relationship is more hierarchical and
power-driven than a contractual relationship, and included in this power is
greater latitude for principals to reward, punish, and control agents.
A conventional view holds that agency is a special application of contract

theory. However, some argue that the reverse is true: a contract is a
formalized, structured, and limited version of agency, but agency itself is not
based on contracts.
Discussion points
1. How would the use of the concept of economic value added to reduce
the problem of agency conflict?
2. Relate the main goals of corporate financial management to their
importance to shareholders.
CHAPTER 2
TIME VALUE OF MONEY CONCEPTS
Introduction
The concept of the time value of money is an integral concept in the study
of financial management. This is the focus of this unit which you have to
study now before you proceed to other topics. The discussion may appear to
be very "technical", however, you are advised to make an effort to grasp the
concepts that are covered in this unit as they will come up from time to time
in our study of the other topics.
For example, you need the concepts covered in this unit in order to study
Capital Budgeting, Valuation of Shares, the Cost of Capital and many other
issues covered in corporate financial management. Additionally, most of the
concepts covered in this unit will come in handy in your advanced studies of
the subject.
Time Value of Money
The notion that money has a time value is one of the most basic concepts in
finance and investment analysis. Making decisions today regarding future
cash flows requires understanding that the value of money does not remain
the same throughout time.
A dollar today is worth less than a dollar sometime in the future for two
reasons.
Reason No. 1: Cash flows occurring at different points in time have different
values relative to any one point in time.
One dollar one year from now is not as valuable as one dollar today. After
all, you can invest a dollar today and earn interest so that the value it grows
to next year is greater than the one dollar today. This means we have to take
into account the time value of money to quantify the relation between cash
flows at different points in time.
Reason No. 2: Cash flows are uncertain. Expected cash flows may not
materialize.
Uncertainty stems from the nature of forecasts of the timing and/or the
amount of cash flows. We do not know for certain when, whether, or how
much cash flows will be in the future. This uncertainty regarding future
cash flows must somehow be taken into account in assessing the value of an
investment.
Translating a current value into its equivalent future value is referred to as
compounding. Translating a future cash flow or value into its equivalent
value in a prior period is referred to as discounting. We are going to deal with
e basic mathematical techniques used in compounding and discounting.
An investment of money has different values on different dates. The

adjustment in time value is a function of the following factors: time, inflation
rate, risk.
A lender will need compensation from a borrower for delaying payment and
this compensation will be determined by above three factors. This
compensation is the interest rate, which represents the opportunity cost of
funds. Let’s now discuss the following:
 Future Value
 Present Value
 Simple Interest
 Simple Discount
 Compound Interest
Simple Interest
Remark: Interest is the price paid for the use of borrowed money.
Interest is paid by the party who uses or borrows the money to the party
who lends the money. Interest is calculated as a fraction of the amount
borrowed or saved (principal amount) over a certain period of time. The
fraction, also known as the interest rate, is usually expressed as a
percentage per year, but must be reduced to a decimal fraction for
calculation purposes. For example, if we’ve borrowed an amount from the
bank at an interest rate of 12% per year, we can express the interest as:
12% of the amount borrowed
When and how interest is calculated result in different types of interest.
For example, simple interest is interest that is calculated on the principal

amount that was borrowed or saved at the end of the completed term.
Remark: Simple interest is interest that is computed on the principal for the
entire term of the loan, and is therefore due at the end of the term. It is given
by
I = Prt
Where;
I-is the simple interest (in $) paid at the end of the term for the use of the
money
P - is the principal or total amount borrowed (in $) which is subject to interest
(P is also known as the present value (PV) of the loan)
r- is the rate of interest, that is, the fraction of the principal that must be paid
each period (say, a year) for the use of the principal (also called the period
interest rate)
t - is the time in years, for which the principal is borrowed
NB: Interest is earned only on the original investment; no interest is earned

on interest
Example
Suppose you have $10 000 to invest in a bank savings account at a simple
interest of 20% per annum. How much will you have at the end of the year?
Given that I=Prt
I = 10000×0.20×1
I =$2000 is the interest due (I) Simple Interest
Therefore Total amount due S=Interest+Principal Payment
=2000+10000
= 12000
Remark: The amount or sum accumulated of Future Value (S) (also known as
the maturity value, accrued principal) at the end of the term t, is given by
S = Principal value + Interest
S=P+I
S = P + Prt
S = P (1 + rt).
Remark: The date at the end of the term on which the debt is to be paid is
known as the due date or maturity date.
Example
Suppose you deposit $10000 today in an account that pays simple interest
of 20% per annum. How much will you have at the end of 3 years?
S =P (1+rt)
S= 10000(1+20%×3)
S =10000(1+0.20×3)
=$16000
Example
You borrow $18 000 for a simple rate of 22% per annum for 125 days. How
much will you have to pay to the lender?
t= ………note that t- is always in years so set it as a fraction

of number of days in a year.
P=18000
r =0.22
So applying, S=P (1+rt)
S=18000(1+0.22×125/365)
S=$19356
This is the Future Value of the amount to be paid to the lender.
Practice Questions
1. Suppose you deposit $10000 today in an account that pays simple

interest of 20% per annum. How much will you have at the end of 5
years?
2. Calculate the simple interest and sum accumulated for $5 000
borrowed for 90days at 15% per annum. ($5 185)
3. Calculate the sum accumulated at the end of 3 years on a deposit of
$20 000 and an interest rate of 18.27% per year.
4. Calculate (a) the interest payable and (b) the total amount owing on
the following deposits at simple interest.
i. $300 borrowed for 5 years at 8% p.a.
ii. $1000 invested for 4 years at 9.5% p.a.
iii. $50 borrowed for 2 years at 18% p.a.
iv. $2500 invested for 6 months at 8.75% p.a. (T = 0.5 years)
v. $45 000 borrowed for 2 weeks at 15.5% p.a.
Present Values [discounting]
Sometimes we not only consider the basic formula I = Prt but also turn it
inside out and upside down, as it were, in order to obtain formula for each
variable in terms of the others. Of particular importance is the concept of
present value P or PV, which is obtained from the basic formula for the sum
or future value S, namely
S = P (1 + rt)
Dividing by the factor (1 + rt) gives
.
How do we interpret this result? We do this as follows: P is the amount that
must be borrowed now to accrue to the sum S, after a term t, at interest rate
r per year. As such it is known as the present value of the sum S.
Remark: Discounting is a process of moving the future value of an

obligation/investment back to the present/today.
For Simple Interest =
For Compound Interest=
Example
A promissory note with a future value of $12000, simple interest rate is 12%
per annum is sold 3 months prior to its due date. What is the Present Value
on the day it is sold?
S=$12000 r=0.12 t=3/12
Given that,
Then
= $11 650
Remark: A promissory note is a written promise by a debtor (called the

maker of the note) to pay a creditor (called the payee) a stated sum of money
(the so-called “maturity value”) on a specific date (the due date), and stating a
specific rate of interest. Such notes can be bought and sold, that is, they are
negotiable. Obviously with such transactions it is the present value of the note
that counts.
Time lines
A time line is a useful way of representing interest rate calculations
graphically. Time flow is represented by a horizontal line. Inflows of money
are indicated by an arrow from above pointing to the line, while outflows are
indicated by a downward pointing arrow below the time line.
For a simple interest rate calculation, the time line is as follows:
t- term
r
=Interestrate
At the beginning of the term, the principal P (or present value) is deposited
(or borrowed) – that is, it is entered onto the line. At the end of the term, the
amount or sum accumulated, S (or future value) is received (or paid back).
Note that the sum accumulated includes the interest received.
Remember that
FV or Sum accumulated (S) = Principal + Interest received that is

S = P + Prt
= P (1 + rt)
or equivalently
Future value = Present value + Interest received.
Counting days
The convention is that to determine the exact number of days between the
two relevant term dates, we include the day the money is deposited or lent
and exclude the day the money is repaid (or withdrawn). . The reasoning
behind this is the simple fact that if you deposit money on the 12th of June
and withdraw it on the 13th of June, there is only one day between the two
dates, not two. However, when a security is issued and held until maturity,
we include the day on which it was issued.
Let us look at the following example.
Example
Calculate the number of days between 25 May and 17 August.
You must remember that some months have 31 days while others have 30
days. You should be able to get the number of days by a simple count of
your fingers:
Month Days
May (including 25 May) 7
June 30
July 31
August (excluding 17 August) 16
Total 84 days
Now, let’s look at the following examples.
Example
On 1 May 2012 you purchase an NCD with a maturity date of 31 July 2012,
nominal value of $1 000 000 and an interest rate of 34.65%. Subsequently,
on that same day, the yield on similar securities falls to 33%. You then
decide to sell the NCD. How much should you expect?
Since we have seen that S= P (1+rt ), we can deduce that the consideration,
or market value, P, is given by the following relationship:
P = S/( 1 + rd )
Where:S is the maturity value,

d is the days remaining to maturity,
r is the yield per year.
Therefore, the consideration, P, will be equal to:

P =1 087 336.99
(1 + 0.33 x 91 /365)
P = 1 087 336.99
1.082273973
P = $1 004 678.13
Practice Exercise
1. Determine the number of days between 19 March and 11 September.
Simple Discount
Remark: is interest calculated on the face (future) value of a term and paid at
the beginning of the investment term.You will receive interest in advance
Previously, we emphasised the interest that has to be paid at the end of the
term for which the loan (or investment) is made. On the due date, the
principal borrowed plus the interest earned is paid back.
In practice, there is no reason why the interest cannot be paid at the

beginning rather than at the end of the term. Indeed, this implies that the
lender deducts the interest from the principal in advance. At the end of the
term, only the principal is then due. Loans handled in this way are said to
be discounted and the interest paid in advance is called the discount. The
amount then advanced by the lender is termed the discounted value. The
discounted value is simply the present value of the sum to be paid back and
we could approach the calculations using the present value technique as
before.
Expressed in terms of the time line of the previous section, this means that
we are given S and asked to calculate P.
P or PV
t- term
S= d= discount
rate
The discount on the sum S is then simply the difference between the future
and present values. Thus the discount (D) is given by
D = S − P.
The discount D is also given by
D = Sdt
(compare to the formula for simple interest I = Prt) where d= simple discount
rate and the discounted (or present) value of S is
P=S−D
= S − Sdt
P= S(1 − dt)
or
Present Value = Future Value − Future Value × discount rate × time.
PV = FV − FV × d × t
= FV (1 − dt)
(compare to the formula for the accumulated sum or future value for simple
interest)
S = P(1 + rt).
Example
Suppose the government floats Treasury bills of face value $10 at a discount
of 10%. Lisa wants to subscribe and has t= $10. The tenure of the TB is 1
year. How much does Lisa Pay now and how much will she get at the end of
1 year.
Solution
When Lisa subscribes to the issue she pays $9 and at the end of the tenure
she will get $10 from Treasury.
Discounted Value = S (1-dt) or (S-D)
Discount = Sdt
= 10× 0.10×1
=$1
Therefore PV given above is P=S-D = $10-$1
= $9
Or better still, Discounted Value = S (1-dt)
= 10 (1-0.10×1)
= $9
Which is the amount paid by Lisa to be paid back $10 in one years’ time.
Example
A treasury bill with a tenure of 90 days and a face value of $100 000 is
issued at a discount of 18%. At what consideration is it being issued?
PV=S (1-dt)
PV=100000[1-(0.18×90/365)]
PV=$95561
Example
A customer signs a promissory note agreeing to pay $100000 in 3 months’

time. He then decides to discount the note with a bank at a discount rate of
22%. How much will he receive from the bank now?
PV=S (1-dt)
PV=100000[1-(0.22×3/12)]
PV=$94500
The person receives $94500 from the bank now.
NB. Money-market instruments that are traded on a discount basis are

bankers’ acceptances (referred to as BAs) and treasury bills. The value
appearing on the acceptance or bill, the so-called “face value”, is what the
owner thereof will receive on the maturity date. On the other hand, the price
paid is the present value, which is calculated as described above using the
current rate as set by the market.
Practice Question
Suppose that a discount security has a nominal value of $1000 but is
issued at $945 with a tenor of 90 days. Calculate the discount rate, d.
Equivalent Simple Interest Rate
It establishes a relationship between Simple Discount and Simple Interest.

The calculation of the discount rate is based on the assumption that the
security is held to its full tenor. If an investor buys a security, he may not
necessarily hold it to its full tenor. The investor may opt to sell the security
before it matures. The yield will be the difference between what the investor
gets when he sells the security and what he paid for it. This is also called
the equivalent simple interest rate. When a note is discounted, the interest
rate which is equivalent to the discount rate will be greater than the actual
discount rate. This difference arises from the fact that the Discount Rate is
calculated on the Face Value whereas Interest is calculated on the Present
Value.
Example
Determine the discount, discount value and the equivalent simple interest
rate on a loan of $35000 due in 9months with a discount rate of 26%?
S= $35 0000 d= 26% t= 9/12
⟹Discount (D) =Sdt
=35000×0.26× 9/12 = $6 825
⇒ Discounted Value (PV) =S-D or S (1-dt)
=35000-6825
=$28175
The discounted value is $28175. In order to determine the equivalent

interest rate r, we note that 28 175 is the price now and that 35 000 is paid
back nine months later.
I=S−P
= 35000 – 28 175
= 6825
The interest is thus 6825. The question can thus be rephrased as follows:
What simple interest rate, when applied to a principal of $ 28 175, will yield
$6825 interest in nine months?
But remember
I = Prt
and with substitute we get
6825 = 28 175 ×r × 9/12

If we make r subject, we get
r = 0.32298
=32%
Thus the equivalent simple interest rate is 32 % per annum.
NB
Note the considerable difference between the interest rate of 32% and the
discount rate of 26%. This emphasises the important fact that the interest
rate and the discount rate are not the same thing. The point is that they act
on different amounts, and at different times – the former acts on the present
value, whereas the latter acts on the future value.
Practise Question.
1. Determine the Discounted Value on a promissory note of $3000 due
in 8months at a discount rate of 15%. What is the equivalent Simple
Interest rate?
2. A bank’s simple discount rate is 18%. If you sign a promissory note to
pay$4 000 in six months’ time, how much would you receive from the
bank now?
What is the equivalent simple interest rate?
Time Line
Represented on a time line, these statements yield the following picture:
916.54
$1 000
t=3/12 t=6/12
16% 1 080
now
1 000
This is summarised as below:
1. To move money forward(determining the Face Value)

a. Where simple interest is applicable you inflate the relevant sum by
multiplying (1+rt)
b. Where compound interest is applicable you inflate by (1+i)n
2. When you want to move money backwards(determining the present
value)
a. Where simple interest is applicable, we deflate by (1+rt)
b. Where compound interest is applicable you deflate the relevant sum
by (1+i)n
The point is that the mathematics of finance deals with dated values of
money. This fact is fundamental to any financial transaction involving
money due on different dates. In principle, every sum of money specified
should have an attached date.
Practice Question
Jack borrows a sum of money from a bank and, in terms of the agreement,
must pay back $1 000 nine months from today. How much does he receive
now if the agreed rate of simple interest is 12% per annum? How much does
he owe after four months? Suppose he wants to repay his debt at the end of
one year. How much will he have to pay then?
Interest and date values
Payments and obligations of different dates

The value of a sum of money is determined by the date at which it is paid or
received
Example
If you owe $2000 to be paid in 10months time at an interest of 27%. How

much would you pay?
Given that S=P (1+rt)
=20000 (1+0.27×10/12)
=$24500
Example
If you want $20000 today, how much should you have invested 5months
ago at the same interest rate of 27%.
The above examples are represented in a time line as following:
PV?t= 5/12 t=10/12
-5 0 10 months
20000 FV?
Given that PV=
PV=
PV=$17977, 53
Example
Suppose you owe $100000 to be paid 4months from now, $120000 to be

paid 7months from now. You then negotiate to pay all the amounts owed
10months from now. How much will you eventually pay? (Use a simple
interest rate of 22% for the evaluation purpose)
Time line presentation is as follows;
T=6 months
T=3 months
r=22% PV=? 100 000 120 000
0 4 months 7 months 10 months
Future Value??
So we need to calculate the values of the new obligation (t=6months for

$100000 and t=3months for $120000) at a time period 10months at a
simple interest rate of 22%.
NB-For comparison purpose, all date values must be brought to the same
date. Only cashflows evaluated at the same date are comparable.
New Obligation
1) S ($100000for 6 months ) =P(1+rt)

=100000(1+0.22×6/12)
=$111000
2) S ($120 000for 3 months) =P(1+rt)
=120000(1+0.22×3/12)
=$126600
⇒Therefore Total obligation owing will be (Obligation 1 + Obligation 2)
= (111000+126600)
=$237600
Suppose you offered to pay $20000 now in part settlement of the debt, this
amount cannot simply be deducted from the amount ($237600). The $20000
must be extended (evaluated for time value at an appropriate rate) for
10months for comparison purposes (inflating- finding the future value).Then
find the final amount needed to liquidate the resultant obligation.
Time value concept illustrated below in a timeline;
t=10 months
P=20 000 S ?? @10 months
Given that S= P(1+rt) ; S@ 10 months= 20000(1+0.22×10/12)
S=$23667
To find final owing, at the final due date, the Total obligations should equal
the Total payments.
Total Owing = Total Payments
Total Owing =Part Payment + Final Payment (say X to be

determined)
⇒What he owes $237600 less what hepaid $23667 (time value adjusted)
gives what he has to pay to level off the debt(X).
Their fore Final payment (X) =$237600-$23667
X=$213933
From time to time a debtor may wish to replace a set of financial

obligations with a single payment on a given date. In fact, this is one of the
most important problems in financial mathematics. It must be emphasised
here that the sum of a set of dated values due on different dates has no
meaning. All dated values must first be transformed to values due on
the same date (normally the date on which the payment that we want to
calculate is due). The process is simply one of repeated application of the
key rules of time value as the following example illustrates:
Example
Lisa owes Tracy $5000 due in 3months and $2000 due in 6months. Lisa
offers to pay $3000 immediately, if she can pay the balance in one year.
Tracy agrees that they use simple interest rate of 16% per annum. They also
agreed that the $3000 paid now will also be subject to the same rate of 16%
for evaluation purposes. How much will Lisa pay at the end of the year?
Time Line
5000 t=9/12 r=0.16
2000 t=6/12 r=0.16
0 3 6 12 months
3000 t=12/12 r=0.16 ????
Finding values of Obligation at Final Due Date
a) S(5000@ 12 months) =P (1+rt)r= 0.16 t=9/12
=5000(1+0.16×9/12)
=$5600
b) S(2000@ 12 months) =P (1+rt) r=0.16 t=6/12
=2000(1+0.16×6/12)
=$2160
Total obligations = (a) + (b)
=$5600+$2160
=$7760
Finding the values of Payments
S(3000@12 months) =P (1+rt) given r=016 t= 1 year
= 3000(1+0.16×1)
=$3480
At the Final due date value, which is 12 months;
Total obligation=Total payments (i.e. part payments + final payment[X])
This way we find what Lisa owes Tracy at the end of 12 months
⇒ 7760 = 3480+X
⇒ X=7760-3480
⇒X=$4280
Lisa owes $4 280.
Practice Questions
1. Noma owes 8 500 due in 10 months. For each of the following cases,
what single payment will repay her debt if money is worth 15% simple
interest per annum?
a) now
b) six months from now
c) in one year
2. LK owes AT $20 000 due in six months and $6 000 due in 11 months.
LK offers to pay $10 000 immediately if he can pay the balance in two
year. AT agrees, on condition that they use a simple interest rate of
18% per annum. They also agree that for settlement purposes the $10
000 paid now will also be subject to the same rate. How much will LK
have to pay at the end of the two years? (Take the comparison date as
one year from now!)
3. Mufaro must pay the bank $2 000 which is due in one year. She is
anxious to lessen her burden in advance and therefore pays $600
after three months, and another $800 four months later. If the bank
agrees that both payments are subject to the same simple interest rate
as the loan, namely 14% per annum, how much will she have to pay
at the end of the year to settle her outstanding debt?
Compound Interest
Compound interest arises when, in a transaction over an extended period of

time, interest due at the end of a payment period is not paid, but added to
the principal. Thereafter, the interest also earns interest, that is, it is
compounded. The amount due at the end of the transaction period is the
compounded amount or accrued principal or future value, and the difference
between the compounded amount and the original principal is the
compound interest. Essentially, the basic idea is that interest is earned on
interest previously earned.
Examples
You deposit $1000 at 10% per annum into a savings account, how much
will you have at the end of 4 years if interest is compounded once per year.
Year/Period Beginning Interest factor Ending amount Interest

Amount
1 1000 0.1 1100 100
2 1100 0.1 1210 110
3 1210 0.1 1331 121
4 1331 0.1 1464,10 133,10
Compound 464,10
interest=
Compound Interest = Ending amount (1464.10)- Beginning amount (1000) =

464.10
As shown in the example, compound interest in fact is just the repeated

application of simple interest to an amount that is at each stage
increased by the simple interest earned in the previous period. It is,
however, obvious that where the investment term involved stretches over
many periods, compound interest calculations along the above lines can
become tedious.
To remedy this we use a formula for calculating the amount generated for
any number of periods.
S (FV) =P (1+i)n
Where n, is number of periods and i, compound interest rate per period and
P is Present value
It also follows when that when given the future value amount S, you can
find the Present value, P by the process of discounting as follows;
P=
Example
Find the present value of $170000 which should be received at the end of
8years when the interest rate is 22.67% compounded once a year.
Solution
Timeline
PV?? t=8
0 8 years
170K
Given that
PV=170000/ (1+0.2267)8
PV=$33154
Practice Questions
1. Find the compounded amount on $5 000 invested for ten years at

7.5% per annum compounded annually.
2. How much interest is earned on $9 000 invested for five years at 8%
per annum and compounded annually?
Compounding More than Once a Year
Perhaps you have noticed that we have been careful to use the phrase
“compounded annually” in the above examples and exercises. This is
because the compound interest earned depends a lot on the intervals or
periods over which it is compounded.
Financial institutions frequently advertise investment possibilities in which
interest is calculated at intervals of less than a year, such as semi-annually,
quarterly, and monthly or even on “daily balance”. What difference does this
make? A few examples should help us answer this question.
To find the Future Value when interest is paid more than once per year we
use the following relationship :
Where S ≡ the accrued amount, also known as the future value

P ≡ the initial principal, also known as the present value
i≡jm/m, the annual interest rate compounded m times per year
n≡ t × m, = number of compounding periods
t≡ the number of years’ of investment
m≡ the number of compounding periods per year
jm≡ the nominal interest rate per year
The above equation is same as: S=P (1+i)n
Where i= jm/m
n=tm
Example
Find the future value of $40 000 deposited into an account that earns
12.62% per annum for 6 years, compounded:
i. Once per year

ii. Semi-annually
iii. Quarterly
iv. Monthly
v. Daily
Solution
Given that S=P (1+i)n or that
We will have the following results with t=6 ,P= $40 000 , jm =0.1262 and
changing value of m
i. S =40 000(1+0.1262/1)6 where m=1
ii. S =40 000(1+0.1262/2)6×2 where m=2
=115 487.42
iii. S =40 000(1+0.1262/4)6×3 where m=3
=192 779.87
iv. S =40 000(1+0.1262/12)6×12 where m=12
=511 095.58
v. S =40 000(1+0.1262/365)6×365 where m=365
=14630 261.50
Other Formulas useful in Time Value calculations
You don’t need to cram these but you can deduce them by yourself by
rearranging the above formulas for time value.
Check for yourself if you come up with these;
where i can be replaced by jm/m
jm=
Practice Questions
1. How much time does it take for an investment to double e.g. from 5
000 to 10 000 @ 10% compounded twice a year?
2. At what interest rate per annum must money be invested if the
accrued principal must treble in ten years?
Self-Test Problems
1) At what rate of simple interest will $600 amount to $654 in nine months?
2)The simple discount rate of a bank is 16% per annum. If a client signs a
note to pay $6 000 in nine months’ time, how much will the client receive?
What is the equivalent simple interest rate?
2) A small businessman borrowed some money from the bank under the
following conditions:
 $500 000 to be paid after 3 months from the date of the loan.
 $800 000 to be paid one 1 year from the date of the loan.
 $900 000 to be paid 1 year 6 months from the date of the loan.
The businessman has found things to be tough this year and fails to
make any payments.
 6 months from now he makes a payment of $300 000.
 9 months later he pays $250 000.
The bank accepts this arrangement provided that the balance is to be
paid on the last date as agreed. If simple interest is charged at 22% per
year, how much is to be paid by the businessman? Illustrate in a time
line.
6) Determine the future value of an annuity after five payments of $600

each, paid annually at an interest rate of 10% per annum.
7) Mrs. Dudley decides to save for her daughter’s higher education and,
every year from the child’s first birthday onwards, puts away $1 200. If she
receives 11% interest annually, what will the amount be after her daughter’s
18th birthday?
8) Determine the amount and the present value of an ordinary annuity with
payments of $200 per month for five years at 18% per annum compounded
monthly. What is the total interest paid?
CHAPTER 3
ANNUITIES
Annuities
An annuity is a series of equal payments made at fixed intervals for a

specified number of periods. For example, a promise to pay $ 1 000 a year
for 3 years is a 3-year annuity. There are two types of annuities: annuity
due and ordinary (deferred) annuity.
Diagram for Ordinary Annuity
R R R R R R R
FV
If the payments are made at the end of each period, that is, they are made at
the same time that interest is credited, it is an ordinary annuity. If the
payments are made at the beginning of each period, the annuity is known as
an annuity due.
Diagram for Ordinary due
R R R R R R R
FV
If the payments begin and end on a fixed date, the annuity is known as an
annuity certain. On the other hand, if the payments continue for ever, the
annuity is known as perpetuity.
The FV of an annuity is the sum of all payments made and the accumulated
interest at the end of the term.
The PV is the sum of payments, each discounted to the beginning of the

term, that is, the sum of the present value of all payments.
Future Value of an Ordinary Annuity
Example
Suppose you deposit $ 100 at the end of each year for 3 years in a savings
account that pays 5% interest per year, how much will you have at the end
of 3 years?
In this example, each payment is compounded out to the end of period n,

and the sum of the compounded payments is the future value of the annuity
Timeline presentation of the problem:
100 100 100
0 1 2 3
100
105
110.25315.25
Thus, the future value of the annuity = [100 (1.05) 2 + 100 (1.05)1 + 100] =
$315.25.
You should notice that this type of calculation becomes tedious if the
investment term spans over a very long period of time, so we engage a
formula, the derivation of which shall be beyond the scope of this
course/module.
Future Value Interest Factor Annuity [FVIFA]
The future value of an annuity of $1 for a period of n years at an interest

rate of i is given by the following formula:
(1+i )n −1
FVIFA n ,i %=
i
( 1+0 .05 )3−1

FVIFA 3,5 %=
0 .05
For the above example;
= 3.1525
To find the FV, we multiply the FVIFA by the size of periodic payment
FV= 3.1525×100 = 315.25
Generally, The FV of an ordinary annuity is given by the following

formulation;
( 1+i )n −1
FV OD =[ ]×R
i
Where i is interest rate i per payment interval,
R is annuity payment amount per period
n is the number of payment intervals of the annuity
NB.
The annual interest rate jm compounded m times per year jm/mis denoted by
i [i= jm/m]
While the number of interest compounding periods tm is denoted by n.
As such;
Practice Questions
1. Mrs Tough decides to save for her daughter’s higher education and,
every year, from the child’s first birthday onwards, puts away $1 200.
If she receives 11% interest annually, what will the amount be after
her daughter’s 18th birthday?
2. What is the accumulated amount (future value) of an annuity with
a payment of $600 four times per year and an interest rate of 13% per
annum compounded quarterly at the end of a term of five years?
Future Value of an Annuity Due.
If the $100 payments had been made at the beginning of each year, this
would be an annuity due and the time line would look as shown below :
100 100 100
0 1 2 3
105
110.25115.76
331.01
Thus, the future value of the annuity due is [100 (1.05) + 100 (1.05) 2 + 100
(1.05)3 ] = $331.01.
Since the payments occur earlier, more interest is also earned, thus the
future value of an annuity due is larger ($331,01) than that of an ordinary
annuity ($315.25).
To get the future value of an annuity due we compound the future value of
an ordinary annuity by an extra period.
Future value of annuity due [FVAD] = R× FVIFAOD (1+i)
In our example, the future value of the annuity due is 100 (3.1525) (1.05) =
$331.01.
Present Value of an Ordinary Annuity.
Remark: The present value of an annuity is the amount of money that must
be invested now, at i percent, so that n equal periodic payments may be
withdrawn without any money being left over at the end of the term of n
periods.
Example
Suppose an investor has the following alternatives: a three year annuity of

$1 000.00 or a lump sum payment today. What must the lump sum
payment be to make it equivalent to the annuity if the interest rate is 10%?
If the payments come at the end of each year, the annuity is an ordinary
annuity and the time line will look as shown below :
1000 1000 1000
0 1 2 3
909.10
826.40
751.302 486.80
Thus, the present value of the annuity is given by :

[ (1 000 ) / (1.10) + (1 000 ) / (1.10)2 + (1 000 )(1.10)3] = $2 486.80
This is the present value of three payments of $1 000 each deposited at the
end of each year.
Present Value Interest Factor Annuity, (PVIFAOD)
The present value of an annuity of $1 for a period of n years at an interest

rate of i is given by the following formula:
(1+i )n −1
PVIFA OD =
i ( 1+i )n
Where iis interest rate i per payment interval,
R is annuity payment amount per period
n is the number of payment intervals of the annuity
NB.
The annual interest rate jm compounded m times per year jm/m
is denoted by i [i= jm/m], while the number of interest compounding periods
tm is denoted by n.[tm=n]
To find the PV of the annuity , we can make use of the formula: Multiply the
PVIFA by the periodic payment,R. So we have;
PVOD=PVIFAOD× R
PV OD =
[
( I +i )n −1
]
i ( 1+i )n
×R
or where interest is earned more than once
For the above example, this would be;
PV OD =
[ (1+ 0. 10 )3 −1
]
0. 10 ( 1+0 .10 )3
×1000
= $2 486.80
Present Value of an Annuity Due
We can establish a relationship between the present value of an annuity due

and an ordinary annuity, namely
PV (of annuity due with n periods)= first payment +PV ( of ordinary annuity
with (n − 1) periods)
Thus the present value of an annuity due is given by
Present Value of Annuity[PVAD] = R× PVIFAOD (1+i)
Or use the following relationship
Present Value of Annuity[PVAD] = R× PVIFAOD (1+i)
Working:
Summary
1. Present Value of Ordinary Annuity [PVOD] = R× PVIFAOD

2. Present Value of Annuity Due [PVAD] = R× PVIFAOD (1+i)
3. Future Value of Ordinary Annuity[FVOD] = R× FVIFAOD
4. Future Value of Annuity Due [FVAD] = R× FVIFAOD (1+i)
Practice Questions
1. Calculate the present value of an annuity that provides $1 000 per

year for five years if the interest rate is 12,5% per annum.
2. Max puts $3 000 down on a second-hand car and contracts to pay

the balance in 24 monthly instalments of $400 each. If interest is
charged at a rate of 24% per annum, payable monthly, how much did
the car originally cost when Max purchased it? How much interest
does he pay?
3. Determine the present value of an annuity with semi-annual

payments of $800 at 16% per year compounded half-yearly and with a
term of ten years.
CHAPTER 4
ARMOTIZATION AND SINKING FUNDS
Amortisation of Loans
When a firm borrows money, the repayments may be in the form of fixed
instalments which include both the interest payment and the repayment of
the principal amount borrowed. The interest payment is an expense which is
allowed for tax purposes. Therefore it is important to split the instalments
into their two components in what is called the Amortization table.
Remark: A loan is said to be amortised when all liabilities (that is both

principal and interest) are paid by a sequence of equal payments made at
equal intervals of time.
Period payment = Principal repayment + Interest payment
To find the periodic payment we apply our knowledge of annuities.
PVOD = R× PVIFAOD
We can deduce that
P
R=
PVIFA
P
R=
(1+i )n −1
i (1+i )n
Which is;
Or
Example
A firm borrows $100 000 which should be paid off by 3 equal monthly
instalments made at the end of each year. The applicable interest rate is
12% compounded once per year. Determine the monthly payment and
construct an amortization table splitting capital from interest payments.
Solution
Stage 1: Determining the period payment given the following parameters
i =1 mp= 1 P=$100 000 t=1
P
R[ annualpayment ]=
PVIFA
100000
AnnualPayment =
( 1+0 .12 )3 −1
0 . 12 ( 1+0 . 12 )3
= $41 634.90
Construction of amortization table
An amortization table shows how the periodic payments are split between
principal and interest for the purpose of analysis.
Period(1) Beginning Period Interest Principal Outstanding

amount(2) payment(3) rate(I=Prt)(4) repayment(3- balance(2-
4=5) 5=6)
1 100 000 41 634 90 12 000 29 634.90 70 365.10
2 70 365.10 41 634 90 8 443.812 33 191.09 37 174.01
3 37 174.01 41 634 90 4 460.88 37 174.01 0
124 904.7 24 904.70 100 000
0
Thus, the total amount paid is $124 904.70 of which $24 904.69 is interest
and $ 100 000.00 is the principal amount.
Practice Questions
1. You purchase a small apartment for $180 000 with a down payment
(often referred to as a deposit) of $45 000. You secure a mortgage
bond with a bank for the balance at 18% per annum compounded
monthly, with a term of 20 years. What are the monthly payments?
2. Your Great Aunt Agatha dies and leaves you an inheritance of $60
000 which is to be paid to you in 10 equal payments at the end of
each year for the next 10 years. If the money is invested at 12% per
annum, how much do you receive each year?
Sinking Funds
A not infrequent method of discharging a debt is when the debtor agrees to

pay to the creditor any interest due on the loan at the end of each payment
interval, and the full principal borrowed (the“face value of the debt”) at the
end of the term. In such cases, there is usually an agreement that the
debtor will deposit enough money each period into a separate fund so that,
just after the last deposit, which coincides with the end of the term, the fund
amounts to the original debt incurred. This fund usually earns interest, but
generally not at the same rate as the interest on the debt. Companies often
use sinking funds to accumulate capital that is to be used later for the
purchase of new fixed assets.
Remark: A sinking fund is nothing other than a savings account used to

accumulate the capital needed to pay back the principal value of a loan at the
end of the term of the loan. If it is created for the replacement of, say, a
machine, it is known as a replacement fund.
In other words it is the way of discharging a loan where interest is paid

periodically as per the loan agreement and periodic deposits are made into a
fund such that the fund accumulates to the amount of the principal by the
time that the last deposit is made at the end of the term of the loan. The
objective is to accumulate the principal value, at the end of the term by
redeeming the loan when it matures.
Finding the period deposit into a sinking fund
To find the periodic payment we apply our knowledge of annuities.
[S]FVOD = R× FVIFAOD
We can deduce that
S
R=
FVIFA
S
R=
(1+i )n −1
i
Which is;
Or
Example
A firm issues 100 000 bonds with a par value of (maturity/nominal) of

$1 000 each and a coupon rate (interest rate) of 20% p.a . The bonds are
redeemable at par in 5 years’ time and interest is payable semi-annually.
The firm then sets up a sinking fund into which a certain amount is
deposited each month to earn 18% per annum compounded monthly.
1. Calculate the periodic payment into the sinking fund?

2. How much will it cost to service the debt each year?
Solution
To determine the monthly deposit into the sinking fund we need to know the
obligation we are seeking to discharge. In this case;
Value of Debt to be discharged = $1000×100 000 =$100 000 000
This amount is to be paid by monthly instalments into an account earning

18% compounded monthly over 5 years. We need also to note that we have
two sets of parameters here;
1. Loan parameters and

2. Sinking fund parameters.
Such distinction is paramount so that we don’t we don’t use the wrong

information correctly in our workings. [lol]
a) To determine the period deposit we use sinking fund paramters
S=$100 000 000 jm= 0.18 t= 10 m=12 (no need for

conversion, they match)
So;
R=
= 1 039 342.74
We should deposit this amount into an account which earns 18%
compounded monthly over 5 years to accumulate the principal
amount needed to discharge the debt.
b) The cost of servicing the loan

Is the sum of annual sinking fund payments /deposits and the
interest payment on a loan.To calculate the interest component we
make reference to loan parameters which are;
P=$100 000 000, jm= 0.20 mi=2 and t=1 ( since you want find
the annual cost)
Total yearly cost C = Interest + Sinking fund deposits
Remember Period Simple Interest (I)=Prt
Thus
C = [(1039342.74×12)]+ [(Prt)×2]
i.e.[1/2 yearly interest so multiply by 2 to make it annual]
=[1039342.74×12]+[(100 000 000×0.2×1/2)×2]
= $32 472 112.88
Sinking Fund Schedule

Is a table showing the way the in which the fund will grow subject to
the investment rate as a result of regular deposits in the funds.
Example
A company borrowed $500 000 for a period of 4 years and wants to set up a

sinking fund for discharging of the loan when it becomes due at the end of
the term. The fund will earn interest at 22% per annum compounded semi-
annually. The company will deposit equal amounts at the end of every 6
months into the fund.[b. also deal with when the company will deposit equal
amounts at the end of every 4 months into the fund].Determine the size of
the deposit into the fund and construct a sinking fund schedule for analysis
Solution
Stage 1 : Calculate the periodic payment into the fund
The Sinking fund parameters are;
S=500 000 t=4 mp=2 mi=2 jm=22
Since mp=2 = mi=2 , then;
S=
= 42 160.53
This is the monthly deposit into the fund required to settle in full the debt at
maturity.
Stage 2: construction of sinking fund schedule
Period Period Deposit(1) Period Increase in Total in the

Interest(2) fund(3)=(1+2) fund
1 42 160.53 0 42 160.53 42 160.53
2 42 160.53 4637.66 46 798.19 88 958 72
3 42 160.53 9785.46 51 945.99 140 904.71
4 42 160.53
5 42 160.53
6 42 160.53
7 42 160.53
8 42 160.53
337 284.24 162 115.24 500 000
Note that column 2, Simple Interest = Prt in this case t=1/2 and r=0.18.
Also that P is the Total in Fund in each case i.e. the amount available to
earn interest at beginning of each successive period.
Complete the above table
Summary
a. Amortisation was defined as the process whereby a loan is paid off by

a sequence of equal payments made at equal intervals of time. If a
loan has an initial value of P, and must be amortised by means of n
payments at interest rate i, then the payments are;
R=
b. The concept of a sinking fund, is away of discharging debts whereby

the interest on a loan is paid periodically and a deposit is paid into a
fund so that the fund accumulates to the amount of the initial loan
over the term of the loan. The payments into the sinking fund are;
R=
Practise Questions
1. Tough Enterprises owned by an indigenous entrepreneur borrowed
$80 000 from a local bank. The interest rate was 25 % p.a.
compounded continuously and the company will have to pay back at
the end of every six months for three years.
Required
(i) Determine the size of each instalment. [5]
(ii) Draw up an amortisation table splitting interest payment from

principal payments. (5)
2. a) The Amortisation and sinking fund aspects are methods of

discharging a debt. Discuss the two methods in relationship to
future value and present value. [5]
a) Royal Glass (Pvt) Ltd borrowed $400 000 for 16 years at 19% p.a.
compounded monthly. The company wants to discharge the debt by
creating a sinking fund that earns interest at 17% p.a. compounded
half yearly. The sinking fund deposits will be made at the end of each
4 months.
i. Determine the payments into the sinking fund [6]
ii. The total cost of servicing the debt (yearly and after ten
years).
3) You purchase an apartment for $180 000 with a down payment of $45
000. You secure a mortgage bond with a bank for the balance at 18% p.a.
compounded monthly, with a term of 20 years.
a. What are the monthly payments?

b. Draw up an amortization table for the first six payments of the loan,
and one for the last six payments (that is 235th to the 240th payments).
4)Draw up an amortization table for a loan of $4 000 for three years at 12%
per annum compounded half-yearly and repayable in six half-yearly
payments. How much interest will you pay over the life of the loan?
6) Mr. Wheel and Deal wishes to borrow $50 000 for five years for a business
venture. The Now Bank is willing to lend him the money at 15% p.a. if the
debt is amortizes by equal yearly payments. On the other hand, the
Yesterday’s Bank will lend the money at 14% p.a. provided that a sinking
fund is established with it on which it will pay 11% p.a. to accumulate the
principal by the end of the term, with equal annual deposits. What is the
difference in total annual payments between the two plans?
7) Jonathan purchases an apartment by making a down payment of $60

000 and obtains a 20-year loan for the balance of $120 000 at 20% p.a.
compounded monthly. After four and a half years the bank adjusts the
interest rate to 18%.
a. What is the new amount that he must pay if the term of the loan
remains the same?
b. If we assume that the interest rate of 20% p.a. will remain fixed over
the 20-year period, what is the total amount Jonathan pays back to
the bank?
c. Again assuming a fixed interest rate of 20% p.a. for the full term of the
loan, what is the total real cost of the loan if the expected average rate
of inflation over the term of the loan is 10% per year?
8) Edgar, a dynamic young executive, calculates that he can sell his house
so as to have $180 000 available for a down payment on a new house. The
price that the seller is willing to accept for Edgar’s dream house is $760 000.
To this Edgar will have to add an extra $52 000 made up of estate agent’s
duties, transfer fees and the premium on an insurance policy that will cover
the outstanding principal owed in the event of Edgar’s death. His company
will pay him a housing subsidy of $1 700 per month and also has sufficient
financial leverage to secure him the necessary mortgage bond at 18% p.a.
(compounded monthly) for a period of 20 years. Assuming that Edgar is, for
the next few years, willing to commit himself to up to a third of his gross
monthly salary of $21 000, should he buy or not?
CHAPTER 5
CAPITAL BUDGETING
This unit introduces you to the concept of Capital Budgeting. A capital

expenditure is an expenditure on fixed assets and other long-term
infrastructure necessary for the implementation of projects. The assets
bought for the project are expected to generate cash flows. The appraisal of
capital projects is done in two steps. Firstly, we must determine the cash
flows that are expected to be generated by the project. Secondly, we must
estimate the cost of the funds (cost of capital) that have been used in the
project. Finally, we subject the expected cash flows to certain appraisal
techniques.
Capital budgeting involves long-term decision making on the use of funds.

This implies the evaluation of investment opportunities, the essence of
which is the detailed consideration of expected future cash flows. A cash
flow may be defined as the receipt or expenditure of cash during an interval
of time. For the sake of simplicity, it is generally assumed that cash flows
occur at the end of each interval of time (usually at the end of each year).
It is a budget that deals with Capital Expenditure, for example the purchase
of plant and equipment, construction of a building. It is expenditure that is
not easily reversible due to the values committed. There are different types
of capital budgeting expenditures, e.g. Replacement projects and Expansion
projects. So a detailed risk analysis needs to be done before the investment
introduction of new projects and regulatory projects. The investment in the
project is prescribed by the regulatory board on the safety issues.
Importance of capital budgeting.
You recall that the goal of financial management is to maximize the wealth
of shareholders by acquiring funds at the least possible cost and utilizing
them to obtain the highest possible return for the shareholders. Capital
budgeting techniques are used to make an appraisal of the company’s
investment projects, whereby assets are acquired in order to carry out
approved investment projects. It is expected that a project will generate cash
flows. In project appraisal, it is the project’s cash flows that are subjected to
a series of tests in order to find out whether the wealth of the shareholders
is being maximized by embarking on a particular project. In making this
appraisal, we utilize the discounted cash flow [DCF] techniques, which are
based on the time value of money concept, as well as other methods which
are not based on the time value of money concept.
Incremental cash flows
In capital budgeting we should be careful not to include cash flows that are
not relevant to the decision under consideration. The relevant cash flows for
capital budgeting purposes are incremental cash flows. Cash flows for a
project are defined as the difference between the cash flows of the firm
without the project and the cash flows with the project:
Project = for the firm - for the

firm
with project without project
Sunk Costs
Sunk costs are not incremental costs, so they should not be included in
capital budgeting. A sunk cost is an outlay that has already occurred (or
been committed). Since the outlay has already occurred, it is not affected by
the decision to accept or reject a project.
Opportunity Costs
An opportunity cost is the benefit lost or alternative foregone in making a

decision. For example, the use of a factory building to implement a project
may require that the other alternative uses to which the building could be
put have to be foregone, for example rentals to other users of the building.
Opportunity costs should be charged to the project as an additional cost.
Externalities
The effects of the project on other projects are called externalities.

Externalities may be positive or negative. For example, a project may result
in the production of a new product for the firm. If this results in the
reduction of the demand for the firm’s other products as some of the existing
customers shift to the new product ( this is known as “cannibalization”) ,
these reduced sales should be deducted from the new product sales [a
negative externality]. On the other hand, the new product may create sales
for other related existing products, and these should be attributed to the
new product [ a positive externality].
Types of Project Cashflows
Project cash flows are divided into three categories: the initial investment;
the annual cash flows; and the terminal cashflow.
The Initial investment [I0]
The initial investment is the net cash outlay on buying the capital, that is
the plant and equipment, buildings, and other infrastructure for the project.
The amount of the initial payment and the way it is calculated is determined
by whether the project is a new investment project or a replacement project.
A new investment is when a totally new project is being analysed, or the

implementation of the project does not have any effect on the present cash
flows of the firm. If a new investment is being considered the initial
investment can be made up of the following:
1. The cost of the assets and installation, and
2. Change in net working capital.
The cost of the assets including installation costs is an outflow (-) including
any other opportunity costs.
Change in net working capital caused by the implementation of the project.

Normally additional inventories are required to support a new project, and
the new sales will also generate additional accounts receivable. At the same
time, accounts payable and accruals may also spontaneously increase. If
there is a net increase, this is an outflow (-). At the end of the project’s life,
the firm’s total working capital may revert to prior levels, the net increase in
net working capital is therefore recovered and becomes an inflow (+).
In a replacement project, some assets are replaced, and this may result in
the firm no longer deriving any cash flows from the replaced assets but from
the new assets. The following factors make up the initial investment in a
replacement project:
 The cost of the new project + installation costs + changes in net
working capital. This is a cash outflow (-).
 The disposal value of the old assets. The implementation of the new
project results in the old assets being disposed of. The funds that are
received at the disposal of the old assets are an inflow (+).
Tax effects. Selling a fixed asset can result in tax effects. The tax savings or
tax payable as a result of the disposal of the old assets must be incorporated
in the initial investment calculation.
Annual Cash Flows.

The annual cash flows are the result of revenues less expenses. Remember
we always use net incremental, relevant, after-tax cash flows. We therefore
need to incorporate tax effects in these cash flows. Let us do this now.
To convert before-tax cash flows into after-tax cash flows we use the
following procedure:
1. After-tax cash flow = Before-tax CF - Tax payable.
2. Tax payable = Taxable × tax rate.
3. Taxable CFs = Before-tax CF - Tax allowance.
In Zimbabwe, tax allowances e.g W&T and SIA are claimed in place of
depreciation charges, which are not recognized for tax purposes.
The terminal cash flow
The terminal cash flow is the net after tax amount received by the firm when
a project is terminated. For a new investment the estimated terminal cash
flow might include the following: the estimated salvage value of the new
assets, the tax effects due to the disposal of the assets and the recovery of
the net working capital.
 The estimated salvage value of the new assets is the amount that is
expected to be received when the assets are sold at the termination of
the project. This is a cash inflow (+).
 The tax effects due to the disposal of the assets. This depends on
whether there is a net taxable recoupment (-) or scraping allowance
(+)
 Recovery of the net working capital. If there is a change in net working
capital when the project is implemented, we expect an opposite
change to occur at termination of the project. The change is usually
an inflow (+).
Thus, the terminal cash flow will be equal to:

Proceeds from sale of assets XXXX
Tax on recoupment (XXXX)
Recovery of working capital (XXXX)
Total (XXXX)
Practice Question
Tough Bus Company is considering the replacement of one of its buses with
a new one. It is estimated that the new bus will bring in extra revenues
amounting to $12 000 000 per year as well as savings in maintenance costs
amounting to $1 300 000 per year. The new bus is expected to cost $19 000
000 plus shipping costs of $1 200 000. The bus is expected to operate for
five years and to have a salvage value of $5 000 000. There will be an
increase of $100 000 per year in working capital resulting from the use of
the new bus.
The old bus was bought four years ago and now has a market value of $300
000 and a zero book value.
The company elects to claim SIA on the bus using the current rates and has
a tax rate of 30% per year.
Calculate:
1. The initial investment.
2. The annual cash flows.
3. The terminal cash flow of the project.
Classification of Capital Projects
The effects of a capital budgeting decision continue over many years and
therefore, such a decision may not be easy to reverse. Capital budgeting
decisions also define the strategic direction of the firm because a decision to
move into new products, services or markets, for example, must be preceded
by a capital budgeting expenditure.
A company usually considers more than one project at a time. Based on this
notion, there are basically two types of the projects: mutually exclusive or
independent.
 Mutually exclusive projects cannot be carried out at the same time. If

project A and project B are mutually exclusive, for example, accepting
one of them means the rejection of the other. On the other hand,
 Independent projects, the acceptance of one may not necessarily mean
the rejection of other projects that may be under consideration.
Another issue related to the classification of projects is the types of

decisions. In investment appraisal there are two types of decision that we
face.
1. We either have to accept or reject decisions, for mutually exclusive
projects.
2. We have to rank independent projects. Projects which are more
attractive according to the appraisal, are ranked higher than those
which are less attractive.
Steps in Investment Appraisal
We have seen that the first step in the appraisal of a capital expenditure
project is the determination of the project's net, after-tax cash flows. The
next step after this, is to determine the cost of the funds used in the project.
This is especially important if we are to use discounted cash flow techniques
in our appraisal.
In estimating the cost of funds, we need to consider the sources of those
funds, since the cost of funds is the return that is required by the suppliers
of both debt and equity capital that has been used to finance the project,
taking into account the risk of the project. In other words, it is the weighted
average cost of debt and equity.
The following example clarifies this.
Example
A firm requires $400m to finance its capital project. $300 of this will come
from the issue of new shares on which the investors require a return of 20%.
The balance will be borrowed at an interest rate of 18%.
Ignoring taxation, the weighted average cost of capital for this project would
be:
[(300 / 400) x 0.20] + [(100 /400) x 0.18] = 0.195 = 19.5%.
Project appraisal techniques
After we have got our cash flows as well as the cost of the funds used in the
project, we are now in a position to make an appraisal of the project. There
are various elements of the accounting system that are used including;
 Payback period.
 Discounted payback period.
 Net Present Value [NPV] method
 Internal Rate of Return [IRR] method.
 Modified Internal Rate of Return [MIRR] method.
 Profitability Index [PI].
We discuss each of these, including the problems associated with them, and
their merits and demerits in the following subsections.
The Payback method
The payback period tells us the number of years required to recover the
initial cash outlay from the project’s expected net cash flows (The payback
period, defined as the expected number of years required to recover the
original investment). It is the ratio of the initial cash outlay to the annual
net cash flows.
Example: payback period with equal annual cash flows.
A firm is considering a project whose expected net, after-tax cash flows are
as follows:
Initial Investment = $ 18 000.00
Annual cash flows = $ 5 600.00 per year for the next 5 years. What is the
payback period?
Solution
The payback period = 18 000 / 5 600 = 3.2 years.
Example: payback period with unequal annual cash flows.

A project has the following expected annual net, after-tax cash flows:
Year Expected Net Cash flow Cumulative Cash Flow

0 ($ 18 000) ($ 18 000)
1 $ 4 000 ($ 14 000)
2 $ 6 000 ($ 8 000)
3 $ 6 000 ($ 2 000)
4 $ 4 000 $ 2 000
5 $ 4 000 $ 600
In this example, you can see that the payback period falls between 3 years
and 4 years. To get the actual payback period, we use the following formula:
Payback = Year before full recovery + [unrecovered cost at start of year / cash
flow during year]
Therefore the payback period = 3 + [2 000 / 4 000] = 3.5 years.
Decision criteria of Payback period
A company might have a standing policy that all projects must recover their
full cost within a certain period of time. If the payback for a particular
project falls within this stipulated period, then the project is acceptable.
If, for example, the company policy payback was 3 years, then the project
would be accepted. In this sense therefore, the payback period may be said
to be a rough measure of the risk associated with the project. The longer the
payback, the greater the risk, therefore the less acceptable a project is.
In the case of mutually exclusive projects, those with longer paybacks are
eliminated in favour of those with shorter paybacks. As for independent
projects, those with shorter paybacks would be ranked higher than those
with longer paybacks.
Criticism of payback period
 The regular payback does not take into account the time value of
money, assuming that cash flows received in the future are just as
good as cash flows received today. In this sense it does not take into
account the cost of capital. A project may be financed by both debt
and equity and we need to factor in the cost of obtaining these funds,
using an appropriate discount rate.
 It suffers from “Fish-bait criteria” i.e. (the size of the fish matters, not
just catching something). It focuses only on the covering the initial
investment than profitability.
 it ignores cash flows beyond the payback period, as is evident from
the above examples.
Discounted Payback Method
It is a refinement of the payback method and seeks to overcome the

problems of the time value of money before calculated.
To overcome the problems of the regular payback, the expected cash flows
are discounted at the project’s cost of capital. The discounted payback
period is therefore the number of years required to recover the investment
from discounted cash flows.
Example
A project has the following net after tax cash flows;
Year 0 1 2 3 4
Cash flows -1000 500 400 300 100
Calculate the discounted payback period if the cost of capital is 10%.
Solution
Year 0 1 2 3 4
Cash flows -1000 500 400 300 100
Discounted -1000
Cash flows =454. = =2 =
55 330.5 25.39 68.30
Cumulative -1000 -545.45 -214.89 10.5 78.8
cash flow
Discounted Payback Period=2 years + 214.89/225.39
= 2.95 years
The discounted payback shows the break-even year after covering the cost of
debt and equity.
General critique of payback methods
The payback provides information on how long funds will be tied up in a

project. Therefore, the shorter the payback, the greater the project’s
liquidity. Since cash flows expected in the distant future are generally riskier
than near-term cash flows, the payback can be used as a crude measure of
risk. The company that is cash poor may find the method useful in gauging
the early recovery of funds invested.
The proper measure of risk, however, is the standard deviation of expected

cash flows, which takes into account the dispersion of the possible cash
flows. The payback measures only the magnitude and timing of the expected
cash flows relative to the original investment. It cannot therefore, be
considered an adequate indicator of risk. It is more appropriately treated as
a constraint to be satisfied rather than a measure of profitability.
The payback discriminates against longer term projects, which may turn out
to be more profitable for the shareholders, by ignoring the cash flows after
the payback period. This is demonstrated for you in the following example.
Example
The cash flows for projects X and Y are as follows:
Project X Project Y
Year 0 (10 000) (10 000)
Year 1 1 000 5 000
Year 2 2 000 3 000
Year 3 3 000 2 000
Year 4 4 000 1 000
Year 5 8 000 500
The payback period for project X is 4 years whereas that for Y is 3 years. If
these projects were mutually exclusive, Y would be accepted and X rejected.
Project Y is, however, a shorter-term project than X in that the cash flows of
X show a rising trend and those for Y are decline drastically after the
payback period.
The Net Present Value (NPV)
It is the difference between the present value of the initial cash outlay and
the present value of the cash inflows of project discounted at the cost of the
capital.
The steps to be followed in evaluating a project using the NPV method are as
follows:
 Find the present value [PV] of each period’s cash flow, including both
inflows and outflows, discounted at the project’s cost of capital,
 Sum the PVs to find the NPV.
 If the NPV is positive, accept the project and if the NPV is negative,
reject the project.
 For two or more projects, accept the project with the highest NPV, if
the projects are mutually exclusive. If the projects are independent,
accept the project with the highest NPV first and rank them
accordingly.
The NPV is found by the following formula:
NPV= – I0
Where I0=Initial cash outlay
t=time of periods 1,2,3,4 ……n
n=number of periods
Example
Using the information from the example on discounted payback period

calculate the Net Present Value of the project.
Solution
Given that; NPV= – I0
NPV=∑(( + + + )-1000)
=$1078.82-$1000
=$78.82
This investment has a total value or present value of future cash flows of
$1078.82. Since the investment is acquired at a cost of $1000(the initial
outlay). The investment company is giving up $1000 of its wealth in
exchange of an investment worth $1078.82. This means the investors wealth
has increased by a margin of $78.82.
It can be safely said that: the NPV is the amount by which the investors’
wealth increases or decreases as a result of an investment. The decision rule
is:
1. Invest: if NPV >0,

2. Do not invest: if NPV <0
It should be noted that positive NPV investments are wealth increasing
whilst negative NPV investments are wealth decreasing.
Example: Calculating NPV with Constant Cash flows

A project is expected to generate net cash flows of $600.00 per year for the
next three years. The initial investment in the project is $ 1000.00 and the
cost of capital is 10%.
Solution
Since this is an annuity, the NPV will be found as follows:

NPV = [600.00 ( PVIFA10%, 3years ) ] - 1 000.00
= [600.00 (2.487) ] - 1 000.00.
= $ 492.00.
Rationale for the NPV
An NPV of zero signifies that the project’s cash flows are exactly sufficient to
repay the invested capital and to provide the required rate of return
demanded by the providers of the capital used on the project [both equity
and debt].
If the NPV is positive, the project’s cash flows are generating more than the
required rate of return [RRR]. Since the return to bond holders [the
providers of debt capital] is fixed [ the interest on debt], the extra return
accrues solely to the firm’s stock holders [the providers of equity capital,]
who receive their return [dividend] only after the bond holder have been
paid their fixed amount. It therefore follows that if a firm takes on a zero-
NPV project, the position of the shareholders remains unchanged. The firm
only becomes larger to the extent of the size of the project, but the wealth of
the shareholders, that is the price of the company’s shares, remains
constant.
If the firm takes on a positive-NPV project, the position of the shareholders

is improved by the amount of the NPV. Thus, if the firm takes on the project,
the wealth of the shareholders is increased directly by the NPV amount, thus
enhancing the share price of the firm.
Practice Question
A project has an initial cash outlay of $800000. The life of the project is 4
years; residual value of the asset in 4 years is $90000. Expected revenue per
year is $650000. $450000 of the capital required is borrowed at 15% after
tax amount. The balance is raised through the issue of new shares at a
required rate 18%. Evaluate if the project is worth investing in or not.
(-$55622.09) NPV=Reject the project
Internal Rate of Return (IRR)
The IRR is the yield or rate of return generated by the project’s internal cash
flows. It is an internally generated rate of return. It can also be defined as a
discount rate that makes the present value of the future after tax cash flows
of a project equal to the initial outlay. It yields an NPV of zero (NPV=0).
NPV=
At the IRR, NPV=0
Therefore IRR is a rate of return generated by the internal cash flows of a

project.
Decision Rules for IRR
It is such that: Accept the project: if IRR >Required Rate of Return
: Reject the project: if IRR < Required Rate of Return
The Required Rate of Return is equivalent to the Weighted Average Cost of

Capital.
How do we find the IRR?
We find the IRR using the Iterative Methods- specifically Estimation by

Interpolation
Example
An investment with an initial outlay of $12000 returns a constant after tax

cash flows of $24000 per annum for 10 years. What is the IRR for the
project?
Solution
Given that ;
I= + + +............
120000= + + +............
Let’s try to make IRR the subject of the formulae and see if we can win.[we
can’t ]….lol
Also notice that the pattern of the payments is in the form of an annuity.
Let’s employ our knowledge of annuities then.
120000= R×PVIFAn,%
=24000×
Even so , we cannot make IRR subject by mere algebraic manipulation. So

we use trial and error then we interpolate.
Formulas for estimation of the value of IRR
If Z is to the left of both X and Y we use:
IRR =a- (b-a)
If Z is between X and Y we use:
IRR =a+ (b-a)
If Z is to the right of both X and Y we use:
IRR =b+ (b-a)
Where: Z=initial outlay or investment initial outlay (PV)
a=is the lower discount rate
b=is the higher discount rate
x=is the Present Value associated with the lower discount rate
y= is the Present Value associated with the higher discount rate
The relationship between the Present Value and a Discount Rate;
To reduce the Present Value you increase the discount rate (an inverse
relationship) and vice versa.
Finding IRR by trial and error then Interpolation
You can just try any percentage and calculate the PVs so that you compare
with the I0.
For the problem above;
Try with 10%
PV (10%) =10%= *24000
=147469.61
This is not the same with Z of $120 000 ,it is greater than Z so let’s
increase the discount rate to get a r PV that is slightly lower or the same as
Z
Try with 18%
PV (18%) =18%= *24000
=107858.07
This is also not equal to Z of $120000. We have to look for another discount
rate which will equalize the PV to Z,but this may take us forever so we resort
to interpolation to find an estimate of this IRR.
The next step is to compare the relationship of X, Y and Z ,so that we knw
which formula to use for our interpolation.
If we compare the 2values (a= 10%) ⇛X=147469.61 and (b=18 %) ⇛( Y=

107858.07) with Z= 120 000 ,we can see that our Z figure lies between the
two figures X and Y so we construct a table.
a% IRR b%
X Z Y
10% IRR 18%
147469.61 120000 107858.07
So our Z is between X and Y so the formulae to use is the formulae #2
Graphical line representation
Y Z X
107 858.120 000 147 469.61
So IRR =a+ (b-a)
= 0.1+ (0.18-0.10)
= 0.1+ (0.08)
=0.1+0.693474931*0.08
=15.5%
Example
An investment has an initial capital outflow of $600000 and is going to

generate the following successive yearly cash flows of $50000, $70000,
$150000, $200000, $250000 and $300000. If the investor RRR is 14%.
Determine whether the project is worthwhile using the IRR method.
Solution
Use the same methods above.
Example
A company is trying to decide whether to buy a machine for $ 80 000.00.

The machine will save the company costs of $ 20 000 per year for five years
and have a resale value of $ 10 000 at the end of that period. What is the
IRR? (Ignoring tax effects).
Solution
The IRR is found by trial and error [interpolation] if one is not using a
financial calculator.We apply different discount rates to the cash flows until
we get one which produces an NPV of zero.
Try 9%:
Year Cash flow x PVIF = present value

0 (80000) x 1.000 = (80000)
1 –5 20 000 x 3.890= 77 800
5 10 000 x 0.650 = 6 500
NPV = 4 300
Since this is a positive NPV, we try a higher discount rate, say 12% , to get a
negative NPV:
NPV = [20 000 (3605) + 10 000 (0.567) ] - 80 000
= - 2 230.
Since the NPV is negative, the required discount rate lies somewhere
between 12 % and 9%, as shown in the following diagram, known as the
NPV profile of the project :
NPV Profile for the project
NPV ($)
IRR = 10.98%
$ 4 300
0 9% 10.98% 12% Discount Rate (%)
-$ 2 230
The IRR is the discount rate that will result in a zero NPV, therefore lies
somewherebetween 9% and 12%. It is found by the following formula :
IRR = A + [(a / a + b)][(B – A)]
Where A = the lower discount rate which produces a positive NPV,

a = the NPV resulting from a discount rate of A%,
B = the higher discount rate which produces a negative NPV,
b = the NPV resulting from a discount rate of B%.
NB. We treat the –NPV as a positive in the formulae.
Thus, in this example, the IRR is equal to 10.98%, which is approximately

11%.
The decision rule for the IRR is that we should accept the project if the IRR
is greater than the RRR, that is the cost of capital. If the IRR is less than the
RRR, then the project should be rejected. If we are comparing two mutually
exclusive projects, we would take the one with the higher IRR.
Rationale for the IRR
The IRR is the return that is expected to be generated by the project's net
cash flows, assuming that all the cash flows are reinvested into the project.
If the IRR exceeds the cost of the funds used to finance the project [the
RRR], a surplus remains after paying for the funds, and this surplus belongs
to the firm’s shareholders. Therefore, taking on a project whose RRR exceeds
the cost of capital increases the shareholders’ wealth.
The decision criterion is therefore that if the project's internal rate of return
exceeds the required rate of return, the project should be accepted.
The decision criteria for independent projects is to take those projects with a
higher IRR first. If the projects are mutually exclusive, we take on those
projects with a higher IRR and reject those with a lower IRR.
Conflict between the NPV and the IRR
There may be a conflict between the decision resulting from an NPV analysis
and that resulting from an IRR analysis. This conflict arises when the
projects are mutually exclusive rather than independent.
For independent projects, the NPV and the IRR always lead to the same
accept / reject decision, that is if NPV says accept, IRR also says accept. The
criterion for acceptance is that the project’s cost of capital [RRR] is less than
[to the left of] the IRR. Whenever the project’s cost of capital is less than the
IRR, its NPV is positive, therefore the project is acceptable using both
methods. Both methods reject the project if the cost of capital is greater
than the IRR.
If IRR >Cost of Capital(RRR), then NPV >0
If two projects, A and B are mutually exclusive, we can choose either A or B,

or we can reject both, but we cannot accept both projects.
Let us suppose we had two projects, A and B.
PROJECT A PROJECT B
NPV $100 000 $150 000
IRR 20% 18%
You can see that project A has a lower NPV than project B, but it has a
higher IRR. This conflict between A and B is illustrated as below :
Conflict between projects
NPV($)
Cross-over rate
IRRb
IRRa
NPVb
NPVa
RRR Discount Rate (%)
NPV profile (A)

NPV profile (B)
According to the NPV method, project B should be accepted and A rejected.

But according to the IRR project A should be accepted and B rejected.As
long as the cost of capital [RRR] is greater than the cross-over rate, the NPV
of project A is greater than the NPV of project B and the IRR for project A is
greater than the IRR for project B.
Therefore for IRR greater than the cross-over rate, the two methods lead to
the selection of the same project. However, if the cost of capital [RRR] is less
than the cross-over rate, a conflict arises. The NPV ranks project B higher
but the IRR ranks A higher.
Why conflicts arise
Conflicts arise for two reasons :

 When project size [scale] differences exist, that is when the initial
capital outlay on one project is greater than that on the other.
 When timing differences exist, that is the timing of the cash flows
from the two projects differs such that most cash flows from one
project come in the early years and most of the cash flows from the
other project come in the later years.
You may be wondering ‘How can I deal with such a conflict ?” Let us study
the next example for the answer.
Example: Resolving conflict between NPV and IRR
The following two projects are mutually exclusive:

Project A Project B
Year 0 (10200) (35250)
Year 1 6 000 18 000
Year 2 5 000 15 000
Year 3 3 000 15 000
The company’s cost of capital is 16%.
At this rate of discount the NPV for A is $610.00and the NPV for B is $ 1
026. The IRR for A is 20% and the IRR for B is 18%. Therefore,using the
NPV method, B is preferred to A but using the IRR, A is preferred to B.
In actual fact, B is better if we consider the differential [or incremental] cash

flows that would occur from the adoption of B rather than A. If we discount
these incremental cashflows at 16% we find that the present value of the
incremental benefits from project B exceed the present value of the
incremental costs, that is, the NPV of the differential cashflow is positive.
Therefore, it is worth spending the extra capital on project B and also the
IRR of the differential cash flows exceed the cost of capital [16%].
Year Project A Project B Difference PVIF (16%) PV of Differential CF

0 (10 200) (35 250) (25 050) 1.000 (25 050)
1 6 000 18 000 12 000 0.862 10 344
2 5 000 15 000 10 000 0.743 7 430
3 3 000 15 000 12 000 0.641 7 692
NPV = 416
The IRR of the differential cash flows is 18%.
Why the NPV is regarded as superior to the IRR
We have seen that the cost of capital is the weighted average between the
cost of debt and the cost of equity. When a project generates cash flows,
they must be paid out to the debtholders and equity holders, who on
average require a return which is equal to the cost of capital [the discount
rate, or the RRR].
We have also seen that there are two sources of funds for the firm, debt and
equity.However, in the case of equity, we have internally generated equity,
that is retained earnings, and new equity. Thus, the cash flows of the project
can be paid out as dividends after we have paid interest on debt.
Alternatively, the cash flows can be retained and used as a substitute for
outside sources of funds, after paying out the interest on debt capital.
Now, suppose that the cost of capital ( RRR, or WACC ) is 18%. This means
that by retaining all the cash flows, we are saving the firm the cost of
obtaining outside sources of funds at a cost of 18%. We can, therefore say
that the value of the cash flows to the firm is18%. As you can see, this value
is an opportunity cost. In other words, it is the required rate of return, which
the shareholders would obtain on alternative investments of similar risk if
we had paid them their dividend instead of retaining the cash flows.
The NPV is regarded as superior to the IRR due to the assumptions they
both make about the treatment of the project’s cash flows. The IRR assumes
that the cash flows are reinvested at the IRR itself. Obviously, the IRR will
vary from project to project,depending on the cash flows of each particular
project. As we have seen, a project is only acceptable if the IRR is greater
than the RRR.
Now, if a firm can get funds from outside at the same cost as the RRR,
which is also the discount rate that is applied to projects, the appropriate
reinvestment rate would be the opportunity cost of capital, that is the RRR.
The NPV assumes that the cash flows from the project are reinvested at the
RRR, which is built into the NPV method. Thus, when evaluating mutually
exclusive projects, especially those with timing and scale differences,the NPV
should be used rather than the IRR.
Problems with IRR
The use of IRR in appraising projects is fraught with problems. Firstly, the
IRR ignores the relative size of the projects, as shown in the following
example:
Project A Project B
Year 0 (350 000) (35 000)
Year 1 – 6 100 000 10 000
Project A is 10 times bigger than project B, therefore more profitable, but

both have the same IRR of 18%.
Secondly, the IRR is not effective when it comes to unconventional cash

flows.
Let’s study the following example involving two projects.
PROJECT A PROJECT B
Cash flows ($) Cash flows ($)
YEAR
0 (100 000) (120000)
1 (50000) 50 000
2 60 000 80 000
3 90 000 (50000)
4 80 000 20 000
Project B is not a conventional project. As you can see, we have an outflow

in year 0 which is followed by two inflows before we get another outflow in
year 3, which is followed by another outflow in year 4. If the cash flows from
the project are not conventional [out flows followed by inflows, as in project
A], there may be more than one IRR.
The equation for the IRR is a polynomial of n degrees, therefore it has n

different roots or solutions. All except one of the roots are imaginary
numbers when the cash flows are normal, therefore in the normal case only
one value of IRR appears. For non-conventional cash flows, there are
multiple real roots, hence multiple IRRs. In the case of project B,there would
be two internal rates of return.
Thus, the IRR is inferior to the NPV method.
The Modified Internal rate of return [MIRR]
In spite of the strong academic preference for the NPV over the IRR, surveys
have shown that the IRR is by far the preferred method of investment
appraisal. The IRR is easier to understand as it looks at percentages rather
than absolute figures. In order to take into account the objections regarding
the re-investment assumption, we can modify the IRR by assuming that the
cash flows are re invested at the required rate of return before calculating
the IRR.
The modified internal rate of return (MIRR) is given by the following formula:
MIRR = PV Costs = TV / (1 + MIRR)
Where: TV = the future value of the inflows reinvested at the cost of capital
[known as the terminal value ]
MIRR=the discount rate that forces the present value of the terminal value
to equal the present value of the costs is the.
The following example illustrates this.
Example: Calculating the MIRR
Suppose we have the following time line for a particular project with a cost
of capital of 10%
Timeline: Modified Internal Rate of Retrun
0 1 2 3 4
(1000) 500 400 300 100 100.00

330.00
484.00
665.50
1 579.50
PV[TV]= 1000[I0] @ MIRR = 12.1%
To calculate the MIRR you take the following steps.
Step 1: Find the terminal value [TV] . This is the total of the future values of
all the cash flows reinvested, that is compounded, at the cost of capital
[RRR], 10%. The TV =$ 1 579.50.
Step 2:Find the discount rate that will give a present value of $1 000 on a
future value of$1 579.50, the IRR. This is found by trial and error in the
normal way. This discount rate is12.1%, which is the MIRR for the project.
Since the MIRR is greater than the cost of capital, 10%, the project is
acceptable. The conventional IRR for this project would have been 14.5%.
The Accounting Rate of Return
The accounting rate of return (ARR) is based on the return on investment

ratio (ROI). The ROI is the ratio between the operating income for the year
(from the income statement) and the total assets employed (from the balance
sheet). It is a measure of the effectiveness with which the company is
utilizing its assets to generate profits. Since management is often evaluated
on the basis of this ratio, it is also an appropriate measure of the likely
performance of a project. When applied to projects, the ratio is known as the
ARR. Using this ratio, a project can be evaluated on the basis of an
appropriate ARR. A project with a good ARR will in turn contribute positively
to the firm’s overall ROI.
Where:
1. Average incremental net income is the expected annual average
increase in net income if the project is accepted. This is equal to
Total net Income from the project/Project economic life
However, as we have discussed before, when we are analyzing project cash

flows, we must first deduct depreciation and other non-cash flow items from
the net income.
2. Average investment = Cost of the investment
Example
A firm is considering a project with an expected economic life of fiveyears.
The following data also relate to the project:
Capital outlay: $ 200 000
Residual value: nil (assuming straight line depreciation)
Expected Annual Net Income :
Year Expected Net Income ($)
1 60 000
2 80 000
3 76 000
4 58 000
Total 274 000
The project’s ARR is calculated as follows :

1. Total net income = 274 000.
2. Average net income = 274 000 / 5 years = 54 800 per year.
3. Depreciation per year = 200 000 / 5 year = 40 000 per year
4. Average investment = 200 000 / 2 = 100 000
5. Average net cash flow = 54 800 – $ 40 000 = 14 800
ARR = Average net cash flow/Average investment
= 14 800 / 100 000 = 0.148, or 14.8%.
The ARR can alternatively be calculated on the basis of the total investment
rather than the average investment as follows:
ARR = 14 800 / 200 000 = 0.074, or 7.4%.
A major criticism of the ARR is that it ignores the time value of money and is
therefore inferior to other methods which are based on discounting
techniques. If the ARR is calculated purely on the basis of accounting
income, without adjusting for depreciation and other non-cash flow items, it
becomes even less suitable to apply to project appraisal.
Capital rationing.
Capital rationing is a situation in which the firm does not have adequate
funds for all its viable projects.
Single period capital rationing is where capital is limited for the current
period only but will be freely available in the future.
Multi-period capital rationing is where capital will be limited for several

periods.
Divisible projects are those that can be undertaken completely or in

fractions. This also means that the NPV is divisible. Indivisible projects are
those which must be undertaken completely or not at all because it is not
possible to invest in a fraction of the project.
Profitability index (PI)

The profitability index is the ratio between the present value and the cash
outlay on the project. The PI is a measure of the present value per dollar of
capital invested. A project should be accepted if the PI is greater than 1. If
we have capital rationing, projects should be ranked according to their PIs.
Formula:
Profitability Index = Present Value of Future Cash Flows

Initial Investment Required
= 1+ Net Present Value

Initial Investment Required
Profitability index is actually a modification of the net present value method.

While present value is an absolute measure (i.e. it gives as the total dollar
figure for a project), the profibality index is a relative measure (i.e. it gives as
the figure as a ratio).
The Decision Rule is to Accept a project if the profitability index is greater

than 1, stay indifferent if the profitability index is zero and don't accept a
project if the profitability index is below 1.
Profitability index is sometimes called benefit-cost ratio too and is useful in

capital rationing since it helps in ranking projects based on their per dollar
return.
Example: Capital rationing with divisible projects

A company has available $250 000 for investment in the forthcoming period
at a cost of capital of 25%. The following six projects are under
consideration.
PROJECT REQUIRED INVESTMENT PV @ 25%
1 $50 000 $90 000
2 $70 000 $100 000
3 $40 000 $70 000
4 $100 000 $160 000
5 $90 000 $120 000
6 $80 000 $95 000
The first step is to rank the projects according to the PI.
PROJECT PROFITABILITY INDEX RANKING

1 1.8 1
2 1.4286 4
3 1.75 2
4 1.6 3
5 1.33 5
6 1.1875 6
The next step is to allocate the available funds according to the PI.
PROJECT INVESTMENT CUMULATIVE INVESTMENT

1 50 000 50 000
3 40 000 90 000
4 100 000 190 000
5 90 000 280 000
6 80 000 360 000
The company should take projects 1, 3, and 4. These would require $190
000. The balance of$60 000 (i.e. $250 000 - $190 000), will then be invested
in a fraction of project 5. This fraction will be 67% (i.e. $60 000 / $90 000).
Project 6 cannot be undertaken this year.
If the projects are not divisible, then both 5 and 6 will be shelved for this
year and the funds left over, $60 000, should be placed in other
investments, such as money market securities.
Practice Questions
1. Discuss the conflict between NPV and IRR.
2. Distinguish between single and multi-period capital rationing.
3. Explain how the profitability index (PI) is used in appraising projects.
PRACTICE QUESTIONS
Question 1
ABC Ltd has a 5-year acceptable maximum payback period. The firm is considering the
purchase of a machine and must choose between two alternative ones. The first machinery
requires an initial investment of $140 000 and generates annual after tax cash inflows of $30
000 for each of the next 7 years. The second machinery requires an initial investment of $210
000 and provides an annual after tax cash inflows of
$40 000 for 10 years. The cost of capital for both investments is 10%. Determine the
following for each machine and comment on the acceptability of the machines, assuming they
are independent projects
a) Payback period;
b) Discounted payback period;
c) Net Present Value;
d) Internal Rate of Return; and
e) Profitability Index
CHAPTER 7
VALUATION OF SECURITIES
Introduction
The purpose of this section is to equip you with knowledge on how to arrive
at the value of the firm. The value of a firm is the value of its assets. As you
already know from unit 1 the firm's assets are financed by both debt and
equity. Therefore, the value of the firm is the value of the debt and equity
that is used to finance the firm's assets.
Importance of security valuation
Securities are pieces of paper [certificates] that represent claims that

investors have against the assets of the firm. When an investor buys a
security that has been issued by a firm, that investor is actually supplying
funds to the firm. These claims therefore, arise because the firm must buy
assets in order to generate income and it obtains funds from investors who
supply the funds in the form of loans [ loan capital ] or shares [ share capital
]. The most important forms of long-term securities that a firm can issue are
shares and debentures, or bonds.
It is important for us to study the value of these claims since the claims
represent a cost to the company. The value of a security is determined by
the expected cash flows that the investor expects to get from holding the
security. It is also determined by the riskiness of these expected cash flows,
as measured by the variability of the expected return from the cash flows.
The expected return from the cash flows of a security is an opportunity cost
to the investor in the sense that it is the minimum return that they would
expect to obtain from holding a security of similar risk from another firm.
Thus, to justify the use of the funds supplied by the investors, the firm must
earn a return which is at least equal to or greater than the required rate of
return on that particular security.
Since securities, that is shares and bonds, are traded on a market, they
have a market value which is determined by the forces of supply and
demand at a particular point in time. As you have seen in unit 4, the market
value is, obviously, not the same as the book value. It is this market value
which represents the wealth of the investor, since it is what he gets when he
sells the security.
The value of the security may, however, be different from the market price at
that time.
This is because the firm may be earning a return which is higher or lower
than what investors require from that security. If, for example, the firm is
earning a return which is lower than the required rate of return on the
security, the security will have a market value which is below the expected
value and this will negatively affect the wealth of the shareholders. Thus, the
valuation of securities is important to the financial manager.
Types of Securities
There are basically two types of securities: direct claim securities and indirect
claim securities.
Direct claim securities are those securities which have direct claims against
the cash flows produced by the firm’s assets. The values of these securities
are therefore tied directly to the values of the assets on which the investors
have a claim. Examples of direct claim securities are bonds [also known as
debentures] and shares.
Indirect claim securities [also known as derivatives] are securities whose
values are derived from the values of other securities. The most common of
these are options and futures. For example, a call option on a share is a
contract between one party who writes the option and another purchases it.
If, for example, you buy a call option on the shares of Delta, you get the
right to buy (call) Delta's shares for the seller of the option at an agreed price
after an agreed period of time. Note that, your investment is not in Delta's
shares but on the option on Delta. This is not an obligation on the part of
Delta which issued the shares upon which the option is based, but the seller
of the option. You yourself do not have any direct claim to the cash flows
arising from the assets of Delta.
The General Valuation Model
The value of a security, such as a bond or a share, is the present value of

the expected cashflows discounted at the security’s required rate of return.
That is:
Where V0 =Value of the asset at time now
CFt =Expected Cash flows at time t
i= Required Rate of Return at time t
n= the life of the asset
This can also be presented as;
Vo = + +..............+
Example
The cash flows from an asset are expected to be $100/year for 10 years. The
RRR is 10%. Calculate
100 100 . . . . . 100
0 1 2 10
The pattern of the CFs mimics an ordinary annuity so;
PV= PVIFAn,%× R
PV =
= 614.46
An investor will value the investment at $ 641.16, given his risk reward
coefficient of 10%. A different investor with different perspectives on risk
reward profile of the asset will value the asset differently. This ultimately
has an impact on how they value the investment and the price that they are
prepared to pay for it.
Valuation of Bonds
Debt is a contractual obligation which calls for specific payments at

specified points in time. These payments include the principal amount
borrowed as well as the interest. When a company issues a bond, this
means that it has borrowed money from the investors who have bought the
bond. There are certain concepts or features about bonds we need to
highlight before we proceed.
 The par value is the nominal or face value of the bond, which
represents the amount of money actually borrowed by the firm. This is
the money which the firm promises to pay back at some future date.
 The coupon [interest] rate. The bond will require that the issuer, that is
the firm, pay a specified number of dollars each year [or semi-
annually] in the form of interest. For example, if a bond is issued at a
par value of $1 000 and a coupon rate of 15%, the annual coupon
payment will be $1000 x 0.15 = $150. As you will see shortly, the
coupon rate has a direct impact on the price of a bond. The higher the
coupon rate compared to the required rate of return, the higher the
market price or value of the bond.
 Interest date or coupon date. It is the date on which interest or the
coupon accrues and becomes payable on a bond. For semi-annual
coupon bonds, it is twice per year which are 6 months apart. By
convention the maturity date is one of the coupon dates.
 The maturity date is the date at which the par value must be paid. If
the debenture is redeemable, the maturity date is the redemption date.
If it is convertible, the maturity date is the conversion date.
 The settlement date is the day on which the deal is settled – that is,
the day on which an investor must pay for the bond.
 Required rate of return or Yield to Maturity (YTM). This is the coupon or
interest rate that the firm must pay investors if it wants to issue
similar bonds to its existing bonds. Please note that the required rate
of return is not the same as the coupon rate. At any particular point
in time, the required rate of return can be greater or less than the
coupon rate.
 Callable and convertible bonds. A callable bond is a bond which may
be paid off, that is called, prior to the date of maturity. This is
advantageous to the company of the interest rates are expected to fall
in the future. If interest rate do fall, the firm can then sell a new issue
of low interest bonds and then use the proceeds to retire the old, high
interest, bonds.
 A convertible bond is one which can be converted into an agreed
number of the firm's ordinary shares after an agreed period of time.
This enables the firm to “recapitalise” by replacing debt with equity,
thus replacing the contractual obligation of interest payments with
dividends, which are not contractual. You must, however, note that
conversion is an option which the investors may or may not exercise,
depending on the share price at the time of conversion and the
investor's view of the firm's future prospects. When we come to the
valuation of convertible securities, we always assume that all
investors are expected to exercise their option to convert, which may
not necessarily turn out to be true.
 New Issues versus outstanding issues. A bond that has just been
issued is known as a new issue. The market value of a new issue is
always very close to the par value. An outstanding bond, is a bond
that has been on the market for some time. Such a bond is known as
a seasoned bond. The market value of a seasoned bond is often very
different from its par value.
Value of Redeemable Bonds
When we look at a bond with a maturity date, there are two cash flows:
annual interest payments that are received from the date of issue up to the
date of maturity, and the terminal cash flow that is received at the end of the
year of maturity. The value of the bond today is the present value of these
cash flows when they are discounted at the required rate of return.
This can be represented in the following equation:
Where n = number of years to maturity,

INT = annual interest payments starting from period t = 1 up to period
t = n.
kd = required rate of return or YTM on the bond,
M = the principal repayment when the bond is redeemed, also known
as the redemption value.
In short:
Vb = INT (PVIFA kd, n) + M ( PVIFkd,n )
PVIFA kd, n = just like PVIFA of an ordinary annuity we

covered before in class
PVIFkd,n =
Example 7.2: Present value of a redeemable bond.

A company has bonds which are outstanding whose characteristics are
shown below. Use this information to calculate the value of the bond.
 Required rate of return / YTM, kd = 15%
 Years left to maturity, n, = 15 years,
 Coupon rate = 20%
 Par value = $ 1000.
Solution
Vb = Vb = INT (PVIFA kd, n) + M ( PVIFkd,n )
Where, INT = 0.20 x 1 000 = $200, kd = 0.15
Thus, Vb = 200 ( 5.8474 ) + 1 000 ( 0.1229 )

= 1 169.48 + 122.90
= $1 292.38
Exercise 7.2 (TRY THIS ONE)
A firm has in issue redeemable bonds with 15 years to maturity and a

coupon rate of
20% pa. The required rate of return on these bonds is 24%. Calculate the
value of the bonds on the market and comment on your results.
Answer: $839.96
NB
Now, what are your comments regarding the results in both of the
above exercises?
Notice that when we increased the required rate of return for the bond in
example 7.2 and Ex 7.2 above from 15% to 24%, the value of the bond
declined from $1 292.38 to $839.96
Discounts and Premiums on Bonds
If interest rates increase, the required rate of return on a bond will also
increase. If the required rate of return then becomes higher than the coupon
rate, the bond will sell at a discount, that is below the par value. If, on the
other hand, interest rates decline, the required rate of return will also
decline. If the required rate or return falls to a level which is below the coupon
rate, the bond will sell at a premium.
We have seen that the required rate of return is the coupon rate that
investors would expect the firm to offer if it were to issue similar bonds
today. If, for example, we had a bond which was issued three years ago at a
coupon rate of, say, 15% and then interest rates in general have since
increased, we would expect investors to demand a coupon of more than 15%
on similar bonds today. This means that our existing bond has more sellers
than buyers since it is offering a coupon which is less than the expected.
Thus, the bond must sell at a discount to its par value. The opposite would
be true if interest rates decline. Our existing bonds would be superior to any
new bonds which are being issued, thus they would be premium bonds.
The premium or discount on a bond can be calculated as the present value of

the difference between the annual payments on the old bond and the annual
payments if a new bond were issued at the new required rate of return,
discounted at the new interest rate:
Let us look at the this bond in Eg .7.1
A firm has in issue irredeemable bonds with a par value of $1 000 and a
coupon rate of 18% pa. The required rate of return on these bonds is 24%
( that is if the firm where to issue similar bonds today, it would have to offer
a coupon of 24% ). What should be the value of these bonds on the market?
Answer : 750
This bond is currently selling at a discount because the coupon rate is less
than the required rate of return. The discount is calculated as follows :
Old annual payment - new annual payment = $180 - $240 = - $ 60.
Now, if we take the discount of $60 as an annuity for 15 years, the present
value of this annuity:
PV= 40 x (PVIFA24%, 15 years ) = 60 x (4.0013) = $240.078.
The changes that occur to the value of a bond can be illustrated in the
following diagram:
VALUE OF A BOND OVER TIME
Vb
Time path for premium bond
$1 125
Time path when kd = coupon rate

$1000
$750
Time path for discount bond
time
Maturity
This diagram illustrates that the value of a bond gradually moves towards
the par value as the date of maturity approaches. In summary discussion so
far:
 When kd is equal to the coupon rate , the bond will sell at par,
 When kd is greater than the coupon rate, the bond will sell at a
discount,
 When kd is less than coupon rate, the bond will sell at a premium,
 An increase in interest rates will cause the prices of outstanding
bonds to decline,
 A decline in interest rates will cause the prices of outstanding bonds
to increase.
 The market value of a bond will always approach par value as its
maturity date approaches.
Bond Values with Semi-annual Compounding.
Remember from our discussion of the time value of money that the interest
rate on any investment does not have to be paid once per year. In fact, in
the case of bonds, the coupon rate is usually paid twice per year. Thus,
when there is semi-annual compounding, the value of the bond is calculated
using the following steps :
 Divide the annual coupon interest payment by 2 to determine the
amount of interest paid each six months,
 Multiply the years to maturity by 2 to determine the number of semi-
annual periods,
 Divide the annual interest rate [ k d or YTM] by 2 to determine the
periodic [ semi-annual ] interest rate.
The value of the bond will now be found as :
Vb = +
= × +
Example 7.3
A company has outstanding a bond with the following characteristics:
Coupon rate = 15% per year payable semi-annually,
Required rate of return, YTM / kd, = 20%
Par value = $ 1 000
Years to maturity, t, = 15 years.
The value of the bond will be equal to:
Vb = $75 ( PVIFA10%,30yrs ) + $ 1 000 ( PVIF10%,30yrs )

= $75 ( 9.4269 ) + $ 1 000 ( 0.0573 )
= $ 707.0175 + $ 57.30
= $764.32
Exercise 7.3
A firm has a bond with a par value of $1 000 and a coupon rate of 18%pa,
payable semi-annually. The required rate of return is 14% and the bond has
8 years to maturity. Calculate the value of the bond.
Interest rate risk and reinvestment rate risk.
As you can see from this discussion so far, there is a risk attached to the
holding of bonds arising from changes in interest rates. There are in fact two
categories of such risk. These are interest rate risk and reinvestment rate
risk.
With the interest rate (also known as price risk) Risk, an increase in interest
rates leads to a fall in the values of outstanding bonds. Thus, if you are the
holder of such bonds, the value of your investment portfolio will also fall.
With the reinvestment rate risk, as the holder of a bond, you would want to
reinvest the cash flows from your bonds. These are the annual interest
payments and the principal when the bond matures. This means that if
interest rates decline, you will earn a lower rate of return on the reinvested
cash flows, and this will reduce the value of these cash flows. There are
basically two types of bonds i.e. Treasury Bonds and Corporate Bonds
Example 7.4
In the practice question above Example 7.3, determine the value of the
bond, supposing interest is paid semi-annually.
Restatement of bond features:

Coupon rate = 15% p.a payable semi annually
RRR/YTM = 20%
Par value =$1000
Term to Maturity =15 years
Solution
1. Find the annual coupon= 0.15×1000 = $150
2. Find the semi-annual coupon= $150/2 =$75
3. Find n =tm where m=2 and t=15: n =15× 2=30 periods
4. Annual YTM = 20/2 =10%
⟹ Vb = 75×PVIFA 10%, 30 + 1000×PVIF 10%, 30
= $764.32
Practise Questions
1) An Old Mutual bond has a 10 percent coupon rate and a face value of $1
000. Interest is paid semi-annually and the bond has 20 years to
maturity. If investors require a 12% yield (i.e. YTM = 12%), what is the
bond’s value.
2) Massmart, a leading retail chain in South Africa, has just issued a bond
on the market. The bond has a nominal value of $500 000, a yield to
maturity of 18.98%, a coupon rate of 17% (where coupons are paid out
semi-annually). The bond matures on 1st September 2095. What would
be the Price of the bond on the following settlement dates:
a) 1 September 2021
b) 1 September 2025
Comment on your answers.
3) Consider the following bond AM 16 issued by Don-Ash Mining

Corporation, to finance its mine A expansion program.
Nominal value 120 000 000
Coupon rate (half yearly) 16% p.a.
Redemption date 1 November 2083
The company’s financial advisors set 1 November 2010 as the settlement

date
You estimate your clients’ required yield to maturity as 13.8% p.a. As

a junior advisor of your client Thodes Holdings who want to subscribe
to the bond issue, you are required to calculate the Price of the bond
providing detailed comments about the figure’s relevance in
investment decision making. [20]
CHAPTER 8
SHARE /EQUITY VALUATION
Introduction
Income from equity is neither predictable nor fixed as is the case with bonds
which pay a fixed periodic coupon. We also know that the payment of a
dividend is not contractual on the part of the firm, unlike in the case of
interest and principal on debt, which must be paid on specific dates. Thus,
the cash flows that accrue to the investor in equity securities are not fixed.
There are two categories of equity, preferred equity and common equity. We
start with the valuation of preferred equity.
Valuation of preferred equity
You recall that, preferred equity is a hybrid between debt and common
equity. This is because preferred equity has certain elements of both
common equity and debt. It is similar to debt in that the annual dividend
payments are fixed upon the date of issue of the security. Additionally, the
dividend is paid [preferred] before the payment of the ordinary dividend. It
is, however, similar to common shares in that the dividend can be omitted
[passed] without bankrupting the firm, that is to say, the dividend is not a
contractual obligation on the part of the firm, unless it has been declared
and the funds to pay the dividend are available.
Preference shares, like common shares, are assumed to be held in

perpetuity. Because of this, the value of a preference share is calculated as
the present value of a perpetuity :
Value of preference share, Vps, = Dps / kps,
Where, Vps, is the value per share,

Dps is the annual fixed dividend, and
kps is the required rate of return on the preference shares.
Example 8.1
A Ltd has preferred equity outstanding which pays a dividend of $150
peryear. The required rate of return on this equity is 20%. The value of the
preference shareswill be equalto :
Vps = $150 / 0.20 = $750.00

Exercise 8.1
A firm has in issue 12% preference shares with a nominal value of $100.
The required rate of return on this equity is 17%. Calculate the value of the
preference shares.
Valuation of Common Equity
Recall from our discussion regarding agency theory, common equity entitles
the owner to dividends but only if the earnings out of which they can be
paid are adequate and only if management chooses to pay them rather than
retain them for reinvestment. In other words, the firm is not under
contractual obligation to pay common share dividends, unless they have
been declared.
We have already come across the dividend valuation model which was
developed by
Myron Gordon when we were looking at the cost of equity. The model says
thatthe required rate of return on equity is given by :
ke = ( D1 / P0 ) + g
Now, if we rearrange this equation you find the value of a share to be :
Let’s take note of the following terms are used in calculating the value of a
common share.
 D0 = the most recent dividend, which has just been paid,

 D1 = the first dividend that is expected to be paid at the end of this
year.
 Po = the current market price of the share today.
 g = the expected growth rate in dividends,
 ke = the minimum acceptable, or required rate of return, on the
shares,
Normal, Constant growth in dividends
This model is based on the assumption that the earnings and dividends of
most companies are expected to grow each year at a constant rate, g. Thus if
the last dividend that was paid was equal to , the expected dividend in
any future year (t) may be forecasted as :
Dt = (1 + g)t
Example 8.2
If a company has just paid a dividend of 320 cents (D o = 320), and investors
expect a constant growth rate in dividends of 5%, then the estimated
dividend next year will be :
D1 = 320 (1.05) = 336c.
In year 2 the dividend will be:

D2 = 320 (1.05)2 = 353c,
and in year 5 it will be :

D5 = 320 (1.05)5 = 408 cents
Example 8.3: Value of a share with constant growth rate

A company has shares outstanding on which it has just paid a dividend of
$1.20 per share. The dividends are expected to grow at a constant growth
rate of 8% per year in perpetuity. The required rate of return on the shares
is currently 30%.. Find the intrinsic value of the share.
Solution
The intrinsic value of the share today, P0, can be calculated as :
= 1.296 / 0.22
= $5.89
Estimating the growth rate in dividends, g.
There are two methods of estimating the expected growth rate in dividends.
One way is to estimate the growth rate directly from the current financial
statements that is the Income Statement and the Statement of Financial
Position. The other method is to use the historical growth rate in either
earnings per share (EPS) or dividend per share (DPS).
Method 1
We can use financial statements to estimate the expected growth rate in

dividends, g, using the following formula:
g = r x ROE
Where, r is the retention ratio, and ROE is the return on equity.
The retention ratio is the ratio between the retained income for the year and
the EPS.
The return on equity [ROE]is found by dividing the earnings attributable to

ordinary shareholders by the ordinary shareholders' equity.
The EPSis found by dividing the income attributable to ordinary

shareholders by the number of ordinary shares in issue.
Method 2
The other method of estimating g is to collect a time series of the DPS or

EPS that havebeen achieved in the past. We then calculate the average
growth rate of the DPS or EPSover these years.
Example 8.4: Estimating g using historical EPS or DPS.
Let us suppose XYZ Ltd achieved the following EPS and DPS during the last
past five years:
YEAR EPS DPS

2011 230 cents 124 cents
The expected growth rate in dividends, g, is estimated using the following

formula :
(1 + g )n = D0 /Dn
Where Dn is the dividend that was paid in the first year of observation, in
this case this is the dividend paid in 2007. D 0 is the dividend that has just
been paid. In this case this, equal to 124 cents.
In calculating g, we are using the geometric mean, which implies that n is

the number of data points between the observations, not the number of
observations.
In this case, n is equal to 5 - 1 = 4 data points.
Thus, the estimated growth rate in dividends is:
( 1 + g )4= 124 / 92
( 1 + g )4 = 1.3478, finding the fourth root of 1.3478:
(1 + g ) = 1.2479, therefore :
g = 0.2479 = 24.79%.
One Period Valuation
We assume an investor holds the investment for just one period and the
cashflows include the price received at the end of period and the dividend
receipt in the period, such that;
P0 = +
Example 8.5
The expected dividend for firm’s shares is 70cents; the expected price at
end of holding period is $20/share. Cost of equity is 15%. Calculate the
value of this share to the investor.
Solution
P0 = +
= +
=$18.00
Two Period Valuation
Suppose the same investor (mentioned above) plans to hold the share for 2
years before selling.The expected dividend in the second year is 75cents and
the expected price at the end of year is $22.25. The RRR is 15%. Calculate
the value of the share at the end of the second year.
Solution
P0 = + +
= + +
=$18.00
N- Period Valuation:
For an investor who wants to invest in a share for n periods and sell,the
value of the stock is represented by:
P0 = + + +......
Example 8.6
An investor in FML expects a $2.00 dividend for each share, per year .The
selling price of the share will be $50.00 at the end of 10 years and the
investors discount rate is 10%. Find the price that the investor is willing to
buy the share at?
Solution
Pn=$50.00 D=$2.00 Ke =10% t=10 m=1
P0 =PVIFA 10,10% ×D +PVIF 10,10 %)×Pn
Where PVIF = and PVIFA =
Theirfore;
P0= *2 +
= $31.57
Non constant growth rate in dividends and Valuation
Firms go through life cycles and it is to be expected that the growth rate of
dividends will also change in tandem with the phase of growth at the time.
For example, the firm may go through an early phase of super-normal
growth, during which the growth rate of dividends may be quite high .This
may then be followed by a normal growth phase, during which the growth
rate of dividends would have slowed down.
The opposite may also be true in that mature companies tend to pay higher
dividends than younger ones since they can afford to borrow more. Younger
companies tend to rely more on retained earnings and therefore pay less
dividends than mature companies. This may be explained by the way in
which the company was financed initially. For example, a firm thathas been
set up through the assistance of a venture capital company may pay
highdividends, as the venture capitalist tries to harvest its investment before
floating thecompany of the stock exchange.
The growth in earnings and dividends is not practically constant but may
fluctuate with the conditions in the economy at the same time the investors
view or perception about risk associated with an investment in a share may
also change with the outlook in the economy. As such, these factors have to
be included in the determination of a fair price of a share.
Example 8.7
Meikles Hotel Africa(Pvt) Ltd has just paid a dividend of 170 cents per share.
The company’s dividend and earnings have been growing at 40% p.a. for the
past 2 years. With the change in the economic outlook of the country, the
company advisers have predicted the following growth rates in dividends
and earnings based on fundamentals:
 25% p.a. for the next 3 years,15% p.a. for the next 2 years after
that,10% p.a. thereafter.
 They also found out that the shareholders RRR is 21.7% for the period
now until the 5th year and thereafter it will change to 24% p.a. unto
perpetuity.
Calculate the current value of Meikles that investors will be prepared to
invest/pay.
Solution
Let’s show the stages of growth in earnings and dividends,g,
diagrammatically as below:
(g)
Growth rate
g=10%
g=15%
g=25%
Time 0 1 2 3 4 5 6 7
RRR 21.7% 24%
Let’s now calculate the share CFs into perpetuity:
Dividend incomes;
D0=170
D1= D0 (1+g) =170(1+0.25) = 212.50
D2 = D0 (1+g) 2=170(1+0.25)2 =265.63
D3=D0 (1+g) 3=170(1+0.25)3=332.03
D4=D0 (1+g) 4 =170(1+0.25)3(1+0.15)=381.84
D5=D0 (1+g) 5 =170(1+0.25)3(1+0.15)2 =439.11
Now we need to find the terminal cash flow / value of the share with
assumption that the share is held into perpetuity at the perpetual growth
rate.
The terminal Value is given by;
Terminal Value =
Where Dn =5 , such that Dn+1= D6 and D6=D5( 1+g)
Therefore ; TV =
=3450.15
Since we know that the value of an asset is equivalent to the PV of all

cashflows generated by an asset. It follows that;
P0 = + + +.....+ +
= + + + +
NB. We are discounting CFs at 21.7% until year end of the 5 th year, beyond
the 5th year we use the discount rate (RRR) of 24% which applies for the
perpetual growth period.
=2053.59 cents
=$20.53
Significance of this Fundamental price value;
We use this value assess whether the shares are overpriced or undervalued.
If the market price is greater than $20.53 the share is overpriced and if the
market price is under $20.53,then it is under-priced meaning its profitable
to buy the share to realise a gain when it finally adjusts to its real market
value.
Practise Questions:
1) National Foods has just paid a dividend of 162 cents per share.
Dividends and earnings have been growing at 40% for the past two years.
Due to changes in the economy, and the firm’s intention to down-scale its
operations in the future, the financial advisor to firm has now predicted
the following growth rates in dividends and earnings:
27% per year for the next three years
20% per year for the next four years
15% per year thereafter
The required rate of return on the company’s equity is 18.5%. What

would you expect to be the current value of the company’s shares?
2) Econet has just paid a dividend of 175 cents per share. Dividends and
earnings have been growing at 38% per year for the past two years. A
corporate financier from Imara Asset management has predicted the
following growth rates in dividends and earnings:
32% per year for the next five years
25% per year for the three years after that
10% per year in perpetuity
The required rate of return on the company’s equity is 21% for the next
eight years and it will change to 14% in perpetuity thereafter. What is the
intrinsic value of Econet shares?
National Foods has just paid a dividend of 162 cents per share. Dividends
and earnings have been growing at 40% for the past two years. Due to
changes in the economy, and the firm’s intention to down-scale its
operations in the future, the financial advisor to firm has now predicted the
following growth rates in dividends and earnings:
27% per year for the next three years
20% per year for the next four years
15% per year thereafter
The required rate of return on the company’s equity is 18.5%. What would
you expect to be the current value of the company’s shares?
[20]
CHAPTER 9
DIVIDEND POLICY AND CAPITAL STRUCTURE THEORY
Introduction
Stocks and bonds are the most basic and important instruments that are
used by firms to raise its required capital. The firm’s mix of different
securities is known as its capital structure.
Traditional and Modern Theory of Capital Structure

Traditional theory assumes that an optimal capital structure does not exist
and depends on the level of gearing. The company cannot maximise wealth
unless the optimal weighted average cost of capital (WACC) is achieved.
Because debt has a lower after tax cost than equity, as it is moderately
increased, the WACC falls.
The modern theory of capital structure was put forward by Modigliani and
Miller (1958, 1963). It proposes that there is no optimal structure of capital
because the advantages of debt would be exactly counteracted by an
increase in the cost of equity, such that WACC will always equal business
risk.
Modigliani and Miller argued that the cost of capital is independent of the
capital structure and hence the value of the firm is independent of the
proportion of total debt to total capitalisation. As debt finance increase the
effect is to lower the WACC, thus increasing the value of the firm. The model
however argues that increased gearing results in shareholders requiring an
increased return to equate the increased risk. As gearing increases, the
WACC will remain constant and so no optimal level of capital gearing exists.
Initial Assumptions of the Modigliani-Miller Model

The assumptions included the following:
 The debt of firms and individuals is riskless so the interest rate on

debt is the risk free rate.
 Business risk can be measured by EBIT, and firms with the same
degree of business risk are said to be homogeneous risk class.
 Investors have homogeneous expectations about expected future
corporate earnings and the riskiness of those earnings. It assumes
symmetrical information, where managers and all investors have the
same set of information about the firm.
 Stocks and bonds are traded in perfect capital markets that is ,there
are no brokerage costs and investors, both individual and
institutions ,can borrow at the same rate as corporations.
 The firm is a zero growth firm with an exceptionally constant EBIT,
and its bonds are perpetuities.
Modigliani and Miller without Corporate or Personal Taxes
Proposition 1
MM Proposition 1 concerns the irrelevancy of the value to capital structure.
Financial instruments are assumed to take only two forms: stocks and
bonds. The value of the firm is defined as:
V =B+S
Where B is the market value of the firm’s debt and S is the market value of
the firm’s equity
Example
Suppose a firm has a $10000000 debt and 5million shares of stock.

Assuming the stock sells at a market price of $20, then:
V =10000000+ (5000000× 20) =$110 000 000
The Value of the Levered Firm, VL, must be equal to the Value of the
Unlevered Firm, VU.
Suppose a firm earns $100 in perpetuity, and it is all equity with 100 shares
of stock. If each sells for $10, the value is:
VU =$ 100× $10=$1000
Assume the manager suddenly decides the firm should issue $500 of debt.
The equilibrium price of the stock will drop to $5 per share and so the value
of the levered firm is:
VL =500+ (100×5) =$1000
, the same as before.
M &M argues that:
VL =VU= =
Where VL=value of the levered or geared firm,
VU=value of the unlevered firm and
KU=cost of equity of the ungeared firm.
Since no taxes have been assumed, the operating income (EBIT) is

equivalent to the net income which is all paid out as dividends. Thus, the
value of the firm is equal to:
Proposition 2
V=D+E
Since the value of the firm is equal to the sum of the value of the debt and
equity.
Then: KuV=Ku (D+E)
and
Ku =Keg ( ) +Kd ( )
Substituting the last equation into the preceding equation and solving for K s
yields:
Keg=Ku+ (Ku-Kd)
Where Keg =cost of equity of the geared firm,
Ku=cost of equity of the unlevered firm,
Kd=cost of debt,
D=value of debt and
E=value of equity.
Thus Keg must go up as debt is added to the capital structure as shown here
below in Figure 9.1
Figure 9.1: Capital Structure and Keg
Keg% WACC
Kd
Debt/Equity
Modigliani and Miller with Corporate Taxes
Proposition 1
It was informed that corporate taxes have an impact on the valuation. The
value of the firm increased with increased leverage.
VL =VU+ T×D
= +T ×D
Proposition 2
The cost of equity of a geared firm is given by:
Keg =Ku+(Ku-Kd)(1-T)
Example 9.1
North Ltd has the following information:
Sales 23 400 000
Operating costs 15 000 000
EBIT 8 400 000
Interest 1 600 000
6 800 000
Tax 2 720 000
Net Income 4 080 000
The corporate tax is 40%. The cost of equity of an equivalent ungeared firm
in the same risk class is 24%. Debt capital has a yield of 16%.
a) What is the value of the firm according to MM Proposition 1?

b) What should be the cost of equity of the geared firm (K e) according to
MM Proposition 2?
c) What is the value of the firm according MM with corporate taxes?
d) What is the cost of equity of the firm according toMM Proposition 2
adjusted for corporate taxes?
Solution
a) Value of the Unlevered firm VL=EBIT/WACC

=8400 000/0.24
=$35 000 000
b) Given that ; Keg = Ku + (Ku-Kd )
=0.24+ (0.24-0.16)
= 27.2%
NB: The value of debt= =10 000 000
But the Value of the firm=10 000 000+25 000 000 =$35 000 000
c) TheValue Of The Levered Firm

VL=VU+T×D
= + T×D
= +
=21 000 000 +4 000 000
=$25 000 000
d) Given that; Keg =Ku+(Ku-Kd)(1-T)
= 0.24+ (0.24-0.16) (1-0.4)

=27.2%
Dividend Policy Theories
Does the dividend decision have any effect on the value of a company?
Several theories have been put forward to explain dividend policies.
The residual approach to dividends
The approach contends that dividends are a passive parameter and do not
matter in decision making. They are “what is left over after decisions
regarding investment and financing have been made”. This means dividends
can only be paid after the company has invested in all projects that offer a
return greater or equal to their required rate of return. To adopt this
approach, a company must know:
 Its set of investment opportunities

 Its required rate of return
 Its target debt ratio
The company should accept all projects exceeding the required rate of return
and if there is any money left over, then dividends can be paid.
The dividend irrelevance theory

M&M, in 1961, argued that dividends were irrelevant, thereby supporting
the residual dividend theory. They argued that dividends do not affect the
wealth of shareholders and as such they do not matter to shareholders.
They put forward the following assumptions:
 Perfect markets
 No floatation costs
 A given investment policy
 Perfect certainty(they dropped this assumption latter)
Dividend relevancy theory (Bird in the Hand Fallacy)
Myron Gordon and John Lintner argue that dividends are important. They
argue that investors prefer current dividends and there is a direct
relationship between dividend policy and share value. Investors are risk
averse and they attach less risk to current dividend than to future dividend
or capital growth. Investors would prefer current dividends as they can then
reinvest the money in the market. Empirical studies fail to provide
conclusive evidence in support of dividend relevancy theory.
Tax based theories

If the dividend tax is lower than capital gains tax then the argument would
be that the firm should pay all of its income as a dividend as this reduces
the tax, paid by the shareholders on their income.
Signal hypothesis and clientele effect

Signal hypothesis and the clientele effect are two other factors that need to
be looked at in trying to determine the relevancy of dividends:
 Signal hypothesis
Signals often observed when there is a movement of share prices on stack
exchanges after a dividend declaration are that:
 When a firm announces an increased dividend, the price of shares

increases.
 When a firm announces a reduced dividend the share prices
decreases.
 When a firm’s dividend remains the same the price of shares usually
remain the same.
The conclusion is that price movements reflect a preference for dividends.
This is why investors are prepared to pay more for the firm.
 Clientele effect
Investors in equity can be placed into different clientele groups.
The main clientele groups are those investors who prefer dividends and
those who prefer capital gains. Investors prefer dividends because they pay
no tax or a lower tax on dividend income as compared to capital gains.
Some prefer dividends because they invest in equity to obtain a regular

income.
Other investors prefer capital gains. This is a group of those who pay less
tax on capital gains income or no tax at all.
Factors Affecting the Dividend Decision

There are several factors that need to be considered when looking at
dividend policy decisions.
1) Legal requirements
Common law rules determine the amount that can be distributed as
dividends.
These rules are:
 Dividends may not be paid from share capital
 Book value must exceed liabilities
 Dividends may be paid from profits without providing for
depreciation.
 Losses in previous years may be disregarded.
2) The information content of dividends

Investors use the dividend information to judge the performance of the
company. When a company announces a high dividend, which will be
viewed by investors as indicating that management is confident about
the company’s future earnings.
3) Contractual obligations
Dividend payment can be restricted by some loan agreements. The
agreements may restrict the payment of dividends until certain
conditions are met.
4) Internal constraints
Availability of cash may influence a firm’s ability to pay dividends.
Some companies are profitable, but they lack cash due to the accrual
concept.
5) The nature of shareholders

The policy must maximise the shareholders wealth. Shareholders are
attracted to companies that satisfy their needs with regards to cash
income and capital growth.
6) Market considerations
Shareholders value a fixed or increasing dividend as opposed to a
fluctuating one. So an awareness of the markets response to certain
dividend policies is crucial in maximising the owner’s wealth.
7) Dividend payment policies

Dividend policy must be formulated with two objectives:
 Maximising the wealth of owners
 Providing for sufficient financing
8) Owners investment opportunity

The company should not retain funds to invest in projects yielding
lower returns than the owners could obtain from external investments
of equal risk.
9) Constantpay-out ratio
A constant portion of earnings is paid out as dividends e.g. 30% of
earnings regardless of the amount of earnings.
10) Regular dividend

This allows the company to pay fixed dollar amounts each period e.g.
$0.40/share each year.
Practice Questions
a) Discuss the theories surrounding the capital structure decisions

(8)
b) Evaluate some of the practical considerations surrounding the
capital structure decisions (7)
c) Differentiate and discuss the differences between the dividend
irrelevance theory, bird in the hand theory and the tax preference
theory (10)
d) Discuss and evaluate the Millers proposition with regard to
personal taxes in the context of dividend policy
(5)

Financial Management Module 2023

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Financial Management Module 2023

Uploaded by

Copyright:

Available Formats

FINANCIAL MANAGEMENT MODULE

Education and Qualifications

AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL

Discusses in this introductory chapter to financial management are the

The chapter started by explaining how businesses are organized; a brief

Scope of Financial Management decisions

Sourcing Finance Employment of Capital Management of Finance

It also deals with size of the organisation (level of employment, structure of

Responsibilities of Business Financial Management

The financial manager is tasked with the responsibility of acquiring funds

1. Financial Planning. The main responsibility of the financial manager

2. Investment and financing decisions. The financial manager must

3. Management of risk. The financial manager is responsible for the

4. Raising of Necessary Funds. The second main responsibility of the

5. Controlling the Use of Funds and management of value. The

6. Disposition of Profits. Appropriation of profits is one of the main

a. Responsibility to owners. Shareholders or stock-holders are the

b. Legal Obligations. Financial manager is also under an obligation

c. Responsibilities to Employees. The financial management must

d.Responsibilities to Customers. In order to make the payments of

e. Wealth Maximization. Prof. Soloman of Stanford University has

The objectives or goals or business finance management are-

(a) Profit maximization,

(b) Return maximization, and

(c) Wealth maximization.

Three goals of corporate financial management shall be explained below:

1. Goal of Profit maximization.

2. Goal of Return Maximization.

3. Goal of Wealth Maximization.

Forms of Business Ownership:

There are three main forms of business organization: (1) sole

A sole proprietorship is an unincorporated business owned by one

The proprietorship has three important advantages:

The proprietorship also has three important limitations:

The disadvantages are similar to those associated with proprietorships:

The first three disadvantages—unlimited liability, impermanence of the

A corporation is a legal entity created by the state in terms of the

To illustrate limited liability, suppose you invested $10,000in a partnership

The corporate form offers significant advantages over proprietorships and

The Memorandum includes the following information:

The memo is filed with the Registrar of Companies, and when it is

The principal objective of a Corporation (company)

Shareholders are the owners of a corporation, and they purchase shares

Consequently, throughout this module we operate on the assumption that

An agency relationship arises whenever one or more individuals, called

Adverse selection is the situation in which the principal cannot be certain

The shareholders of the company appoint a board of directors to direct the

The Agency Conflict

Managers are exposed to a moral hazard in that it is possible for them to

Three categories of agency costs can be identified. We list them below.

Mechanisms for Dealing with Shareholder-Manager Conflicts

There are two popular positions for dealing with shareholder-manager

At the other extreme, stockholders could monitor every managerial action,

Henceforth, shareholders need to deal with the agency problem effectively so

This they can do by offering incentives such as performance shares.

There are two forms of managerial incentives that may be offered:

Share option schemes have, however, failed to provide the necessary

For example, a manger may be allocated 10 000 performance shares. If the

Economic value added [EVA] is another form of performance measurement

Operating earnings xxx

As we also know from the Statement of Financial Position, that a company

Operating earnings xxx

Appointment of Non-Executive board members. They may also be