TABLE OF CONTENTS

CHAPTER ONE ........................................................................................................................ 1

THE NATURE AND PURPOSE OF FINANCIAL MANAGEMENT ................................ 1

CHAPTER TWO ..................................................................................................................... 16

STAKEHOLDERS AND THEIR IMPACT ON CORPORATE OBJECTIVES ................ 16

CHAPTER THREE ................................................................................................................. 19

SOURCES OF FINANCE ................................................................................................... 19

CHAPTER FOUR .................................................................................................................... 38

WORKING CAPITAL MANAGEMENT ........................................................................... 38

CHAPTER FIVE ..................................................................................................................... 47

MANAGEMENT OF STOCKS, DEBTORS, CREDITORS AND CASH ......................... 47

CHAPTER SIX ........................................................................................................................ 76

CAPITAL BUDGETING ..................................................................................................... 76

CHAPTER SEVEN ................................................................................................................. 79

CAPITAL BUDGETING TWO........................................................................................... 79

CHAPTER EIGHT .................................................................................................................. 96

FURTHER ASPECTS OF INVESTMENT APPRAISAL .................................................. 96

CHAPTER NINE ................................................................................................................... 115

RISKS AND UNCERTAINTIES IN PROJECTS APPRAISAL ...................................... 115

CHAPTER TEN..................................................................................................................... 120

FURTHER QUESTIONS .................................................................................................. 120

 CHAPTER ONE

THE NATURE AND PURPOSE OF FINANCIAL MANAGEMENT

1.0 Financial Management

This is concerned with the management of all issues associated with cash flows of an organisation in both
the short and the long-term, and includes how a company uses its funds in the acquisition of non‐current
assets, funding its working capital and the sources of those funds, typically from the shareholders (equity)
or by borrowing from third parties (loans/debt). Financial Management could be defined as management
of financial resources to achieve the objectives of an organisation through planning, organising, directing
and control.

Planning
Planning is about resource analysis and that the finance director will need to plan to ensure that enough
funds are available at the right time to meet the needs of the organisation for short, medium and long-
term.

Organising
Organising is a process of creating a culture of relationships among employees to enable them carry out
management’s plan and to meet overall objectives. Effective ways of organising help managers to better
coordinate human and material resources. Organising includes firm structure, creation of departments, job
descriptions/division of work as well as person specifications/staff selection.

Directing
Someone must lead the organization in the use of its financial resources. Directors should have the
following characteristics: Good Communication skills; Motivating; Inspiring; Lead by example; and
Recognition. Directing is sometimes referred to as leading or influencing.

Control
This is the process where organisations consciously monitor performance by checking actual against
forecasted figures or standards to ensure satisfactory progress and taking corrective action. It may include
the setting up of control systems to monitor transactions and to arrest issues of misappropriation and
misapplications of assets.

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1.1 Financial objectives and its relationship with corporate strategy
Strategy is the course of action taken in order to achieve an objective. Strategy can be short-term or long-
term, depending on the time horizon of the objective it is intended to achieve. The above definition
indicates that strategy depends on objectives and thus the obvious starting point for the study of financial
management strategy is the identification and formulation of corporate and financial objectives.

Corporate objectives are relevant for the organisation as a whole, relating to key success factors for
business such as profitability (return on investment), market share, growth, cash flow, customer
satisfaction, quality of the firm's products, industrial relations, highly skilled personnel and added value.
The objectives of finance department should therefore be aligned with those of the wider corporate
objectives. These corporate objectives may be divided into two.

1. Primary objective:
Maximisation of shareholder’s wealth - Shareholders’ wealth is measured primarily by the market value
of the company’s shares (capital gains) and thus directors should manage resources in a way to increase
and improve the share price. Dividend is another measure of shareholders’ wealth. However, it should be
noted that while some shareholders may be looking for a quick return on their investments in terms of
dividend to meet their short-term financial objectives, some may be looking forward to build the business
for the long‐term and to maximise their wealth through capital gains. This primary objective is suitable
than any other objectives of a firm as it serves the interest of equity holders and other stakeholders of a
firm and its consistent with the objective of owners economic welfare, wealth maximisation support long-
term survival and growth of the firm, takes into consideration of investment risk and time value of money
as such is how present value of any particular course of action is measured, and finally, the primary
objective leads to maximising shareholders utility through the increase in share price.

2. Secondary objectives
A company may have some important financial and non-financial objectives, which will limit the
achievement of the primary objective. Examples of such secondary financial objectives include:
Maximisation of profit – It is known that some correlation exist between increasing profit and increasing
shareholders’ wealth. However, wealth is measured on cash basis and not on profits
Satisficing/satisfying other stakeholders- Satisficing is where an organisation is primarily concern about
surviving rather than growing. This means the firm attempts to generate an acceptable level of profit with
minimal risk. It may also involve satisfying the needs of all various stakeholders including employees.

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Non-financial objectives are:
Customer satisfaction – Firms duty towards customers may include the provision of products or services
of quality that they expect, and dealing honestly and fairly with customers and even, in terms of adverts,
reliable supply arrangements, and after-sales service arrangements.
Growth – Firms tend to go through different forms and phases of growth. Growth may tell us just how
fast a company is improving in terms of sales. It could be expressed in terms of net profit and dividend
pay-out which are known to be good indicators of a sound financial health of a firm.
Survival – This is a measure of going concern where the organisation is expected to continue in
operational existence for the foreseeable future. Solvency and liquidity status of the organisation are the
financial measures of survival in the long-term.
Innovation - Innovation leads to new products and services that are higher in quality and lower in prices,
may be defined as the design, development, and implementation of new or altered products, services,
processes, structures, and business models to create value for the customer and financial returns for the
firm.

Welfare of employees - A company might try to provide competitive wages and salaries, comfortable
and safe working conditions, good training and career development, and good pensions for employees.
If redundancies are necessary, many companies will provide generous redundancy payments, or spend
money trying to find alternative employment for redundant staff.
Social responsibility and Environmental sustainability are other non-financial objectives of corporate
entities.

Question
1. Describe six key factors that are indicative of a successful organisation
2. Explain how corporate wealth could be measured
3. Explain why maximisation of a firm’s share price is preferred to a financial objective of maximisation
of its sales or revenue?
4. Identify and explain four non-financial objectives of a corporate entity

1.2 The Finance Functions/ Roles of the Finance Director

Basic management functions are planning, organising, directing and control. The finance functions,
however, are:
1. Investment decisions

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- Short-term: working capital management
- Long-term: capital budgeting
Decisions have to be made as to where funds should be invested - to acquire or merge with other
companies, to embark on market or product penetration, investment in the expansion of fixed assets, etc.
The following decisions are also to be considered:
a. What method of investment appraisal should be used (NPV, IRR, etc.)?
b. In times of capital rationing, how are competing projects to be evaluated?
It should be noted that the decision to invest funds into capital assets should be considered against
Profitability, Liquidity, Safety or security.

2. Financing decisions
- Financing mix, capital structure and
- Overall cost of capital or finance
It is the responsibility of the finance director to be aware of the different sources of finance available to
them, cost of issue and tax implications, required gearing level, debt covenants or restrictions and its
implications on certain key financial ratios

3. Distribution and Retention decisions

- Policy on retained earnings: investment in positive NPV projects
- Dividend policy: zero, residual, constant, stable dividend policies
Retained earnings are a significant source of finance for investments and thus a balance needs to be struck
between that and dividend pays out. Paying out too much may require an alternative source of finance to
be found to finance any capital expenditure or working capital requirements and, paying out too little may
fail to give shareholders their required income levels which may tend to reduce the share price.

4. Financial planning and control

Planning is about the determination of the organizational or agency’s current resources or resource
requirements and finding out strategies or directions within which organizational objectives could be
achieved based on the available resources. It includes systems and procedures for funds mobilization and
utilization. Budgets are good tools for Financial Planning. Linked to the organisation’s strategic and
operational plans, the budget is the cornerstone of any financial management system and plays an
important role in monitoring and controlling the use of organisational funds. With financial control,
finance managers should ensure that effective management systems appropriate for the achievement of

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the organisation's objectives, including financial monitoring and internal control systems have been put in
place. These financial controls may include:
- Setting up a book-keeping system to record all transactions as managers are financially accountable
to stakeholders,
- Setting up financial policies to govern the way in which decisions are taken, and specify the criteria
to be considered in the evaluation of any potential strategy. Policy helps to keep an organisation
transparent and accountable and then helps to set standards for how an organisation conducts itself
- Audit - An audit report covers how much money the organisation received and spent within a financial
year, and on what the money was used for. It again finds out whether the accounts (the book-keeping
system) have been properly and honestly kept and whether the money has been spent in accordance with
management decisions and investor requirements.

5. Risk management decisions

Shareholders will invest in companies with a risk profile that matches that required for their portfolio. The
finance manager should be wary of altering the risk profile of the business without shareholder support.
Possible solutions for dealing with risk include:
- Mitigating the risk – that is reducing it by putting in place internal control systems and procedures
- Hedging the risk – taking action to ensure a certain outcome. To hedge is to enter into transactions
which protect a business or assets against changes in value of some underlying items.
- Diversification – reducing the impact of one outcome by having a portfolio of different on-going
projects to do away of unsystematic risks.

Other functional areas of the Finance Director

1. Communication with stakeholders
Finance managers are to keep both external and internal stakeholders informed of all significant matters
including corporate goals and financial policies. Shareholders will need information about dividend
policy, expected returns on new investment projects, gearing levels. Suppliers will need information about
payment policies whiles customers will need information about pricing policies. Government is interested
in the profitability of the firm and is continual existence and the payment of its taxes.

2. Ethics and social responsibility

Social responsibility covers the firm’s role towards society as a whole and the extent to which the firm
should fulfil or exceed its obligations towards shareholders. Ethics may refer to the behaviour expected of
individuals within the firm itself. Employment, payment of taxes, sponsoring arts and culture, pollution,
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moral conduct and adherence to legal issues are some of the areas where the Finance Manager should look
at as part of his/her duties

3. Corporate governance
This is about how companies are directed and controlled including issues of risk management. Publication
of directors’ remunerations, preparation and publication of audited financial statements annually are some
other roles of the finance director.

4. Environmental sustainability
The underlying principle for firms is that environmental, social and economic systems are interdependent
and that decisions of firms must address all these three concerns coherently (triple bottom line approach).
Reducing an environmental footprint involves the development and implementation of policies for more
efficient resource management, ‘green’ procurement and waste minimisation.

Question
1. State and explain four finance director’s functions or decisions
2. a) Explain the term ‘financial management’.
b) What is the primary objective of a corporate organisation?
c) On the 1st January 2013, the shareholder bought shares in a company when the share price was ¢50,000
per share. On 31st December 2013, the share price had risen to ¢58,000 per share. The dividend paid at
the year end of 2013 amounted to ¢4,500 per share. You are required to:
i. Calculate the capital gain per share.
ii. The total shareholder’s income per share.
iii. The shareholder’s return on capital.
3. The other functional areas of the Finance Manager include communication with stakeholders, ethics
and social responsibility, corporate governance and environmental sustainability. State some of the roles
to be played by the Finance Manager for the achievement of organisational goals in the above-mentioned
areas.
4. Suggest reasons why it would be important to keep the various stakeholders of an organisation informed
of general corporate and financial goals and intentions.

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1.3 Financial and other objectives of NOT‐FOR‐PROFIT organisations
Not‐for‐profit organisations are established to pursue non‐financial aims and exist to provide services to
the community (social needs). Their major objectives are the welfare of society, welfare of employees,
survival, fundraising, compliance with tax laws to achieve tax exemptions, and endowment (creation of
an endowment fund to generate enough to support charitable activities). Such organisations also need
funds to finance their operations. Their major constraint is the amount of funds they would be able to raise.
As a result, not‐for‐profit organisations should seek to use the limited funds judiciously to obtain value
for money. Value for money simply means getting the best possible service at the least possible cost.
Value for money involves providing a service which is economical, efficient and effective.

- Economy means sourcing and purchasing inputs at minimum cost consistent with the required quality
of the output.
- Efficiency means making best use of resources, whiles
- Effectiveness means being able to achieve your objectives.
Value for money as a concept assumes that there is a yardstick against which to measure the achievement
of objectives. It can be difficult to determine where there is value for money. However, not-for-profit
organisations tend to have multiple objectives and that even if they can all be clearly identified it is
impossible to say which the overriding objective is. Again, outputs can seldom be measured in a way that
is generally agreed to be meaningful. For example, are good exam results alone an adequate measure of
quality teaching? Right, but that is the case. In the National Health Service, success is measured in terms
of fewer patient deaths per hospital admission, shorter waiting times for operations, and average speed of
patient recovery and so on. Not-for-profit organisations include such ones as Charities, NGOs, state health
service and the police force which are not run to make profits but to provide a benefit to the people.
Although sound financial management of these organisations is important, they do not have their financial
objectives same as that for companies. Their focus is primarily on value for money and the provision of
social need.

It should however, be noted that value for money and maximisation of wealth are both corporate objectives
which can be used to measure performance of directors, and as performance measure benchmarks, both
ensure efficient resource mobilisation and utilisation for the acquisition of inputs to yield best results and
being able to achieve both objectives have positive social impact. Meanwhile, whiles value for money is
an objective for not-for-profit entities, shareholder wealth maximisation is for profit making entities.
Whereas value for money considers social welfare at large, value maximisation focuses on the interest of
only ordinary shareholders. Value for money may sacrifice economic benefit for overall social good
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(especially for vulnerable groups) while’s value maximisation focuses on economic returns for the owners
for every resource utilised.

Question
1. Briefly explain the following value for money concepts: economy, efficiency and effectiveness
2. Suggest three appropriate measures each for economy, efficiency and effectiveness that could be set for
a newly built ultra-modern library and internet facility for a local community, based on targets.
3. Compare and contrast value for money and corporate shareholders wealth maximisation

1.4 Performance analysis of corporate firms

Performance measurement is part of the system of financial control of an enterprise as well as being
important to investors. Triple Bottom Line (TBL) reporting would have been the ideal means of measuring
corporate objectives where firms are expected to report on their economic, social and environmental
footprints. However, firms are able to report solely on their economic or financial status as that is where
performance measures are fully developed. A common means of doing this is through ratio analysis, which
is concerned with comparing and quantifying relationships between financial variables, such as those
variables found in the statement of financial position and income statement of the firm.
Ratios can be grouped into a number of categories such as Profitability ratios which measures investment
returns and sustainability of firms; Liquidity ratios which measures liquidity and solvency position of
firms and how firms are able to meet short-term debts as they fall due; investment ratios, gearing ratios
and efficiency ratios. The key to obtaining meaningful information from ratio analysis is comparison.
Comparing ratios over a number of periods within the same business to establish whether the business is
improving or declining, and comparing ratios between similar businesses to see whether the company you
are analysing is better or worse than average within its own business sector offer meaningful conclusions.

Exercise
Define the following ratios under the following category of performance measures.
a) Profitability c) Liquidity
i) % increase in sales i) current ratio
ii) Gross profit margin ii) acid-test ratio
iii) Operating profit margin d) Solvency
iv) % increase in operating profit i) Gearing market value [ncl/(ncl+Equity)]
v) Net profit margin ii) Gearing book value [ncl/(ncl+equity+res)

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vi) % ROCE [operating profit ÷ iii) Interest cover (PBIT/Interest)
(Shareholder’s fund + long-term debt)]

b) Investment/Efficiency e) Efficiency/Activity
i) EPS [(PAT – pref. div)/no. of shares] i) Asset turnover (sales/total assets – C.L)
ii) P/E ratio (share price/EPS) ii) Inventory turnover (COS/inventory)
iii) Dividend per share iii) Inventory days
iv) Dividend cover (DPS/EPS) iv) Receivable’s days
v) Dividend yield % (DPS/share price) v) Payable’s days
vi) Capital gains (P2 – P1) vi) Cash operating cycle
vii) TSR % [(P2 – P1 + D)/P1]
viii) Return on equity % (PAT/Shareholders fund)

Question
AD Co is a listed company which has traditionally manufactured children’s clothing and toys with long
lives. Five years ago, it began manufacturing electronic toys and has since made significant investment in
development and production facilities. Statement by AD Co’s chief executive
Assume it is now September 20X3. AD Co’s annual report for the year ended 31 March 20X3 has just
been published. Its chief executive commented when announcing the company’s results: ‘I am very
pleased to report that revenue and gross profits have shown bigger increases than in 20X2, resulting in
higher post-tax earnings and our company being able to maintain increases in dividends. The sustained
increase in our share price clearly demonstrates how happy investors are with us. Our cutting-edge
electronic toys continue to perform well and justify our sustained investment in them. Our results have
also benefited from improvements in operational efficiencies for our older ranges and better working
capital management.’ Steve represents an institutional investor who holds shares in AD Co. Steve is
doubtful whether its share price will continue to increase, because she thinks that AD Co’s situation may
not be as good as its chief executive suggests and because she believes that current share price levels
generally may not be sustainable.

Financial information
Extracts from AD Co’s financial statements for the last three years and other information about it are given
below. Statement of profit or loss in years ending 31 March (in ¢m)

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 20X1 20X2 20X3
Sales revenue 1,385 1,636 1,914
Gross profit 381 451 528
Operating profit 205 252 300
Finance costs (46) (50) (66)
Profit before tax 159 202 234
Taxation (40) (51) (65)
Profit after tax 119 151 169
Dividends (60) (72) (84)

AD Co statement of financial position in years ending 31 March (amounts in ¢m)

20X1 20X2 20X3
Non-current assets 2,070 2,235 2,449
Cash and cash equivalents 10 15 15
Other current assets 150 130 125
Total non-current and current assets 2,230 2,380 2,589
Equity
Ordinary shares (¢0•50) 400 400 400
Reserves 805 884 969
Total equity 1,205 1,284 1,369
Non-current liabilities 920 970 1,000
Current liabilities 105 126 220
Total equity and liabilities 2,230 2,380 2,589
Other information
Market price per ¢0.50 share (in ¢, ¢2.50 at
31 March 20X0, ¢5.06 in September 20X3) 2.76 3.49 4.44
Earnings per share (¢) 0.15 0.19 0.21
Dividend per share (¢) 0.075 0.09 0.105
Analysis of revenue
Electronic toys 249 319 390
Non-electronic toys 302 350 404
Clothing 834 967 1,120
1,385 1,636 1,914

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Analysis of gross profit
Electronic toys 100 112 113
Non-electronic toys 72 88 105
Clothing 209 251 310
381 451 528

Note: None of AD Co’s loan finance in 20X3 is repayable within one year.
Evaluate AD Co’s performance and business prospects in the light of the chief executive’s comments and
Steve concerns. Provide relevant calculations for ratios and trends to support your evaluation.

1.5 Economic environment for corporate firms

A firm will strive to achieve its objectives, but it has to do so in an economy where the government tries
to steer its own affairs to achieve its own objectives. In this concept we are moving away from
microeconomics of individual firms to the macroeconomics of the economy as a whole. Firms need to
understand how government policies can impact on different aspects of the economy, and the implications
for the firm’s own activities and future plans.
The main macroeconomic policy tools we need to look at are fiscal, monetary, interest rate, and
exchange rate policies. Again, a cursory look at the impact of some specific government policies on
businesses will also be taken into consideration.
Microeconomics is concerned with the behaviour of individual firms and consumers or households.
Macroeconomics is concerned with the economy at large, and with the behaviour of large aggregates of
demand such as national income, the money supply and the level of employment. Governments are
concerned with the state of the economy and that economic policies are pursued to serve various
objectives; economic growth (Growth implies an increase in national income in 'real' terms – increases
caused by price inflation are not real increases at all), control price inflation (achieving stable prices),
balance of payment stability (wealth of a country relative to others, a country's creditworthiness as a
borrower, and the goodwill between countries in international relations. These might all depend on the
achievement of an external trade balance over time. Deficits in external trade, with imports exceeding
exports, might also be damaging for the prospects of economic growth, and full employment (full
employment does not mean that everyone who wants a job has one all the time, but it does mean that
unemployment levels are low, and involuntary unemployment is short-term). To achieve its intermediate
and overall objectives, a government uses a number of different policy tools or policy instruments
including:

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(a) Monetary policy
Monetary policy aims to influence monetary variables such as interest rate and money supply in order to
achieve certain economic targets set for employment, inflation, economic growth and the balance of
payments.

(b) Fiscal policy

Fiscal policy involves government fund mobilisation through taxation and its utilisation in order to
influence aggregate demand in the economy.

(c) Exchange rate policy

Some economists argue that economic objectives can be achieved through management of the exchange
rate by the government. The strength or weakness of the cedi's value, for example, will influence the
volume of Ghana imports and exports.

(d) External trade policy

A government might have a policy for promoting economic growth by stimulating exports. Another
argument is that there should be import controls to provide some form of protection for domestic
manufacturing industries by making the cost of imports higher and the volume of imports lower. Protection
could encourage domestic output to rise, stimulating the domestic economy.

These policy tools are not mutually exclusive and a government might adopt a policy mix of monetary
policy, fiscal policy, exchange rate policy and external trade policy in an attempt to achieve its
intermediate and ultimate economic objectives.

Macroeconomic policies can affect planning and decision-making of firms in various ways, for example
through interest rate changes, which affect borrowing costs and required rates of return. Note also that a
government might adopt policies which try to exert influence at the microeconomic level too. Examples
include policies to restrict the maximum hours an individual can work or the imposition of a minimum
wage.

Example
Outline the effects on the economy of a policy of high interest rates to dampen demand and inflation

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Solution
An increase in interest rates is thought to reduce money supply in the economy and thereby to reduce the
level of effective demand which will, in turn, decrease inflation and improve the balance of payments (the
latter by decreasing the demand for imports, and freeing more domestic output for sale abroad). Aggregate
expenditure in the economy will decrease, for various reasons.
(a) A higher interest rate encourages savings at the expense of consumer expenditure.
(b) Higher interest rates will increase mortgage payments and will thus reduce the amount of disposable
income in the hands of home buyers for discretionary spending.
(c) The higher cost of consumer credit will deter borrowing and spending on consumer durables.
(d) Higher prices of goods due to higher borrowing costs for industry will also reduce some consumer
expenditure in the economy.
(e) Investment expenditure may also decline

Impact of the economic environment on corporate firms

1. Fiscal policy and demand management
Fiscal policy is action by government to spend money, or to collect money in taxes, with the purpose of
influencing the condition of the national economy. A government might intervene in the economy by:
(a) Spending more money and financing this expenditure by borrowing
(b) Collecting more in taxes without increasing public spending
(c) Collecting more in taxes in order to increase public spending, thus diverting income from one part of
the economy to another government spending is an 'injection' into the economy, adding to aggregate
demand and therefore national income, whereas taxes are a 'withdrawal' from the economy.
Fiscal policy can thus be used as an instrument of demand management. Fiscal policy appears to offer a
method of managing aggregate demand in the economy.
(a) If the government spends more – for example, on public works such as hospitals, roads and sewers –
without raising more money in taxation (ie by borrowing more) it will increase expenditure in the
economy, and so raise demand.
(b) If the government kept its own spending at the same level, but reduced the levels of taxation, it would
also stimulate demand in the economy because firms and households would have more of their own money
after tax for consumption or saving/investing.
(c) In the same way, a government can reduce demand in the economy by raising taxes or reducing its
expenditure.

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Fiscal policy and corporate firms
Fiscal policy affects firms in both service and manufacturing industries in various ways. For example:
(a) By influencing the level of aggregate demand for goods and services in the economy, high fiscal policy
affects the environment for business by reducing their profits and retained earnings for reinvestments, and
it creates restrictions on taking credit decisions for customers as VAT, for example, needs to be paid when
due regardless of whether payments have been received or not. Business planning should take account of
the likely effect of changes in aggregate demand for sales growth. Business planning will be easier if
government policy is relatively stable.
(b) Tax changes brought about by fiscal policy affect businesses by reducing their sales and consequently,
profits. For example, labour costs will be affected by changes in employer's social security and national
insurance trust contributions. If indirect taxes such as sales tax or excise duty rise, firms facing price elastic
demand will have to either, absorb the additional cost and risk lower profits or pass on the additional cost
to consumers in higher price to risk lower demand. In either case, profits of such firms will definitely drop.

2. Monetary and interest rate policy

Monetary policy is the regulation of the economy through control of the monetary system by operating on
such variables as the money supply, the level of interest rates and the conditions for availability of credit.
Money is important because:
(a) It 'oils the wheels' of economic activity, providing an easy method for exchanging goods and services
(i.e., buying and selling).
(b) The total amount of money in a national economy may have a significant influence on economic
activity and inflation.

Interest rate policy and corporate firms

Interest rate changes brought about by government policy affect the borrowing costs of firms. Increases
in interest rates will mean that fewer investments will be undertaken by firms and will reduce positive
returns, deterring companies from expanding. Increases in interest rates will also exert a downward
pressure on share prices, making it more difficult for companies to raise monies from new share issues.
Businesses will also be squeezed by decreases in consumer demand that result from increases in interest
rates
3. Exchange rates
An exchange rate is the rate at which one country's currency can be traded in exchange for another
country's currency. Dealers in foreign exchange make their profit by buying currency at one exchange
rate, and selling it at a different rate. This means that there is a selling rate and a buying rate for a currency.
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The exchange rate between two currencies is determined primarily by supply and demand in the foreign
exchange markets. Demand comes from individuals, firms and governments who want to buy a currency
and supply comes from those who want to sell it. Supply and demand in turn are subject to a number of
influences.
a) The rate of inflation, compared with the rate of inflation in other countries
b) Interest rates, compared with interest rates in other countries
c) The balance of payments
d) Speculation
e) Government policy on intervention to influence the exchange rate

Exchange rates and corporate firms

Changes in exchange rates affect the relative prices of domestic and foreign produced goods and services.
Lower exchange rate makes domestic goods cheaper in foreign markets so demand for exports increases,
foreign goods become more expensive so demand for imports falls and, imported raw materials are more
expensive so costs of production is high. Higher exchange rate makes domestic goods more expensive in
foreign markets so demand for exports falls, foreign goods are cheaper and so demand for imports rises,
and imported raw materials are cheaper so costs of production falls. Fluctuating exchange rates create
uncertainties for firms involved in international trade. A service industry is less likely to be affected
because it is less likely to be involved in substantial international trade.

Questions
1. Identify the effects on the economy of a policy of high interest rate on expenditure and investments
2. what are the differences between fiscal and monetary policies
3. Explain two adverse effects on firms of an economy of higher fiscal policies

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 CHAPTER TWO

STAKEHOLDERS AND THEIR IMPACT ON CORPORATE OBJECTIVES

2.0 The Stakeholder view

Stakeholders are those who affect or are affected by the activities of an organisation. Some of these
stakeholders are directors and/ or managers, employees, shareholders, customers, investors, debt holders,
suppliers, government, and the community in which the organisation finds itself. It is interesting to note
that the various stakeholders have conflicting interests in the organisation. The interest of
directors/management may not be the same as interests of shareholders. Whiles directors are interested in
high remuneration levels and empire building, shareholders may be interested in the continuing existence
of the organisation and regular dividend payments. Also, whiles employees may be interested in job
security and high salaries or wages, investors and debenture holders may be interested in the repayment
of their funds and its associated interest cost.
With these varying interests, organisations have the responsibility to balance the requirements of all those
stakeholder groups in relation to their relative economic power or influence. Depending on the degree of
influence with which each stakeholder possesses, the company must deliver to the various stakeholders
the returns that each is seeking. It is obviously very difficult to satisfy everyone at the same time.

2.1 Agency theory

Agency relationship is a description of the relationship between management and shareholders expressing
the idea that managers act as agent for the shareholders (principal), using delegated power to run the
company in the shareholders’ best interest. Similarly, an employee is an agent of the directors. The
difficulty with an agency relationship is that once the agent has been appointed, they act in their own
selfish interests rather than pursuing the objectives of the principal. Conflict of interest comes to play
when the interests of the agent are different from the interests of the principal.
In the case of shareholders and directors, this means that shareholders do not earn optimum returns and
thus, there is an agency loss. It is therefore important for the principal to find ways of reducing the conflict
of interest through some prudent organisational strategies

How can goal congruence be achieved?

Goal congruence is defined as the state which leads individuals or groups to take actions which are in their
self-interest and also in the best interest of the entity. In order to achieve goal congruence there should be
an introduction of carefully designed remuneration packages for managers and the workforce which would
motivate them to take decisions that will be consistent with the objectives of the shareholder.

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1) Including share options scheme as part of a manager’s remuneration package incentivises the
managers to try and maximise the share price as this will maximise capital gains to satisfy shareholders.
In a share option scheme, selected employees including financial directors and managers are given a
number of share options, each of which gives the holder the right after a certain date to subscribe for shares
in the company at a fixed price. The value of an option will increase if the company is successful and its
share price goes up.

2) Performance related pay incentivises both managers and the workforce to maximise shareholders’
wealth. Objectives and targets are set and if they are met then bonuses are paid in accordance with an
agreed formula.

3) Regulatory requirements such as corporate governance codes of best practice and stock exchange
listing regulations are other good ways to be followed to encourage the achievement of stakeholder
objectives.

Corporate governance provides a framework for a firm to pursue its strategy in an ethical and effective
way from the perspective of all stakeholder groups, and offer safeguards against misuse of resources
(physical or intellectual). Good governance is not just about externally established codes, but requires a
willingness to apply the spirit as well as the letter of the law.
Good corporate governance involves risk management, introduction of internal control systems and
accountability to stakeholders. Corporate governance is the system by which organisations are
directed and controlled. Some of the corporate governance codes of good practice are:
a) The board should be responsible for taking major policy and strategic decisions. Directors should
have a mixture of skills and their performance should be assessed regularly.
b) Appointment of directors should be conducted by formal procedures administered by a nomination
committee.
c) Division of responsibilities at the board level of the organisation is most simply achieved by
separating the roles of the chairman and the chief executive.
d) Independent non-executive directors have a key role in governance. Their number and status should
mean that their views carry significant weight.
e) Directors' remuneration should be set by a remuneration committee consisting of independent non-
executive directors. Remuneration should be dependent upon organisational and individual performance.
f) Financial reports should disclose remuneration policy and packages of individual directors.

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g) Boards should regularly review risk management and internal control, and carry out a wider review
annually, the results of which should be disclosed in the accounts.
h) Audit committee of independent non-executive directors should liaise with external audit, supervise
internal audit, and review the annual accounts.
i) The board should maintain a regular dialogue with shareholders, particularly institutional
shareholders. The annual general meeting is the most significant forum for communication.
j) Annual reports must convey a fair and balanced view of the organisation. They should state whether
the organisation has complied with governance regulations and codes, and give specific disclosures
about the board, internal control reviews, going concern status and relations with stakeholders.

Stock Exchange listing regulations

The stock exchange sets rules and regulations to ensure that the stock market operates fairly and efficiently
for all parties involved. A stock exchange is an organisation that provides a marketplace to trade shares
and stocks. It also sets rules and regulations to ensure that the stock market operates efficiently and fairly
for all parties involved. The stock exchange operates as two different markets:
- It is a market for issuers who wish to raise equity capital by offering shares for sale to investors (a
primary market).
- It is also a market for investors who come to buy and sell shares at any time, without directly affecting
the entities in which they are buying the shares (a secondary market)
To be listed on a stock exchange, an organisation must meet the listing requirements laid down by that
exchange in its approval process. Listed companies are required to publish a report on directors'
remuneration. The report must include details of individual pay packages and justification for any
compensation packages given the previous year. The report must be voted on by shareholders

Questions
1. What is agency problem within the context of a limited liability company?
2. Explain two causes of agency problem
3. Explain four remedies to agency problem

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 CHAPTER THREE

SOURCES OF FINANCE

3.0 Introduction
In this chapter we will look at the range of short-term and long-term sources of finance available to
businesses and discuss the criteria which may be used by companies to choose between each source of
finance. Firms need funds to provide as working capital, invest in non-current assets and for all financial
needs of the organisation. The main source of funds available to firms is retained earnings, but these are
unlikely to be sufficient to finance all their financial needs.

3.1 Criteria for choosing between sources of finance

A firm must consider the following factors in their selection between the various sources of finance.
a) Availability and Accessibility - Not all sources of finance are available to all firms. Only listed
companies will be able to make a public issue of bonds on a stock exchange. Smaller companies may have
to obtain debt financing from their bank.

b) Duration - Long-term finance is more expensive but secure. Organisations usually match duration to
assets purchased. That is, if loan finance is sought to buy a particular asset to generate revenues for the
business, the length of the loan should match the length of time that the asset will be generating revenues.

c) Fixed or floating rate - Fixed rate finance may be more expensive but the business runs the risk of
adverse upward rate movements if it chooses floating rate finance

d) Term structure of interest rates - This is about the relationship between interest and loan duration –
usually short-term is cheaper – but not always.

e) Security and covenants - The choice of finance may be determined by the assets that the business is
willing or able to offer as security and also the restrictions in covenant that the lenders wish to impose.
These covenants restrict the borrower’s right to take certain actions until the debt has been repaid in full.

f) Gearing - Using mainly debt sources of finance is cheaper in terms of tax reliefs on interest payments
but high gearing is risky and can create financial distress
g) Issue cost – this is usually the cost associated with the arrangements for the loan application or issuing
new shares (prospectus costs, stock exchange fees, stamp duty). Debt is usually cheaper than equity due

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to lower risk faced by the providers of the finance and the tax relief possible on interest payments.
However, some debt, such as an unsecured bank loans, may be more expensive than equity.

h) Tax position – the high levels of investment will attract capital allowances. Depending on the current
tax position of the firm and the treatment of those allowances by the revenue, the company may find itself
in a non-tax paying position. This would negate the benefits of the cheaper debt finance.

i) Cash flow profile – cash flow forecasts are central to financing decisions – for example, ensuring that
two sources of finance do not mature at the same time.

3.2 Short-term sources of finance

Short-term finance is usually needed for companies to run their day-to-day operations including payment
of salaries, wages to employees, financing debtors and purchase of inventory. A range of short-term
sources of finance are available to businesses. Some of these sources include:
Trade credit
This means that when goods or services are delivered to a firm for use in its production they are not paid
for immediately. These goods and services can then be used to generate income before the invoice has to
be paid. Trade credits represent an interest free short-term loan.

Bank Overdrafts
Overdrafts can be arranged relatively quickly, and are flexible with regard to the amount borrowed at any
time.
The rate of interest charged on an overdraft will vary according to how creditworthy the customer is
perceived by the bank. The purpose of an overdraft generally should be to cover short-term deficits.
Repayment is technically on demand. Overdrafts are the most important source of short-term finance
available to businesses.

Bank or term loans

A term loan is for a fixed amount for an agreed time and on specified terms. It is drawn in full at the
beginning of the loan period and repaid at a specified time or in defined instalments. A term loan is not
repayable on demand by the bank but however, if the borrower does not act in accordance with the terms,
the loan can be considered in default and the bank may demand payment. Term loans are offered with a
variety of repayment schedules. Often, the interest and capital repayments are predetermined.

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Leasing
A business may lease an asset rather than buying it outright. We have finance and operating lease, sale
and lease back. Operating lease commit the lessee to only a short-term contract or one that can be
terminated at short notice. These are certainly not expected to last for the entire useful life of the asset.
Operating lease is where the lessor retains most of the risks and rewards of ownership and is responsible
for servicing and maintaining the leased asset. The lessee has possession and use of the asset on payment
of specified rentals over a period. The rentals paid on an operating lease are tax deductible and attracts tax
reliefs. A finance lease is one that transfers substantially all of the risks and rewards of ownership of an
asset to the lessee and for most or all of the asset's expected useful life. A finance lease is defined as one
in which the present value of the lease payments equals the fair value of the asset. For finance leases the
tax treatment is linked to the modern accounting treatment following IAS 17 leases. The interest rate
implicit in the finance lease contract is tax deductible in the relevant year and the capital cost for each year
of its useful life also attracts writing down allowances.

There are other important characteristics of a finance lease.

a) The lessee is responsible for the upkeep, servicing and maintenance of the asset.
b) The lease has a primary period covering all or most of the useful economic life of the asset. At the end
of this period, the lessor would not be able to lease the asset to someone else, because the asset would be
worn out. The lessor must therefore ensure that the lease payments during the primary period pay for the
full cost of the asset as well as providing the lessor with a suitable return on his investment.
c) With this type of lease the lessee usually has no right of cancellation or termination as huge cost may
be incurred by this action
d)
Sale and leaseback are when a business that owns an asset agrees to sell the asset and lease it back on
terms specified in the sale and leaseback agreement. The business retains use of the asset but has the funds
from the sale, whilst having to pay rent.

3.3 Long-term sources of finance

These sources may be categorised as equity and debt and are used usually to finance long-term
investments. The term equity relates to ordinary shares only. Equity finance therefore, is the investment
in a company by the ordinary shareholders, represented by the issued ordinary share capital plus reserves.
There are other types of share capital relating to various types of preference shares but these are not
considered part of equity, as their characteristics bear more resemblance to debt finance.

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Equity sources
The main sources of equity finance are through the sale of ordinary shares to investors through a rights
issue or new external share issues (placing, offers for sale, public issue, etc) and internally generated
funds. Internally generated fund comprises retained earnings which is the undistributed profits
attributable to ordinary shareholders and other non-cash charges against profits.

Ordinary shares
Ordinary shares represent the equity share capital of the firm and it forms the backbone of the financial
structure of the business. The holders of these securities share in the rising prosperity of the business.

These investors, as owners of the firm, have the right to exercise control over the company. They can vote
at shareholder meetings to determine such crucial matters as the composition of the team of directors
approve or disapprove of major strategic and policy issues such as the type of activities that the firm might
engage in, or the decision to merge with another firm. There is no agreement between ordinary
shareholders and the company that the investor will receive back the original capital invested. What the
ordinary shareholder receives depends on how well the company is managed.

The main disadvantage for investors holding ordinary shares compared to other securities is that they
are the last in the queue to have their claims met. When the income for the year is being distributed others,
such as bond holders and preference shareholders, get paid first. If there is a surplus after that, then
ordinary shareholders may receive a dividend. Also, when a company is wound up, employees, tax
authorities, trade creditors and lenders all come before ordinary shareholders.

From the company’s point of view there are two significant advantages of raising finance by selling shares.

1. Usually there is no obligation to pay dividend and so when losses are made the company does not have
the problem of finding money for a dividend
2. The capital does not have to be repaid and thus do not have redemption date.
There are, however, disadvantages of this form of finance.
• High cost of issuing shares usually, are higher than the cost of raising the same amount of money by
obtaining loans.
• Also, dividends cannot be used to reduce taxable profit as dividends are paid out of after-tax earnings,
whereas interest payments on loans are tax deductible.

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Rights Issue
This is a very popular method of raising new funds. It is easy and relatively cheap compared with new
external issues. A right issue is an offer to existing shareholders to subscribe for new shares, at a discount
to the current market value, in proportion to their existing holdings.
This enables them to retain their existing share of voting rights and those not wishing to take up their
rights can sell them on the stock market. It is issued at the discretion of directors without the consent of
shareholders or the stock exchange. The new share price after rights issue is known as the theoretical ex-
rights price and is calculated by finding the weighted average of the old price and the right issue price,
weighted by the number of shares.
market value of shares already in issue + proceeds from new share issue
Ex-rights price =
number of shares in issue after the right issue

Example
AIMS company limited announces a two for five right issue at ¢2.00 per share. There are currently 10
million shares in issue, and the current market price of the shares is ¢2.70. Calculate for the theoretical
ex-rights price

Solution
Current number of shares = 10m
Value of shares before rights issue = ¢27m (10m x ¢2.70)
Number of shares for the rights issue = 4m (2/5 x 10m)
Value of new shares to be raised = ¢8m (4m x ¢2.00)
Total market capitalisation = ¢35m (27 + 8)
Total shares in issue = 14m (10 + 4)
Theoretical ex-rights price = ¢35/14
= ¢2.50 per share

To make the offer relatively attractive to shareholders, new shares are generally issued at a discount on
the current market price.
The value of a right = theoretical ex-right price – issue price (subscription)
Those failing to take up their shares and wishing to sell them can do so on the stock market in the period
between the announcement of the rights issue and the date that new issue actually takes place, at a price
equal to the value of a right.

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Example
Beauty Plus Co, has an issued capital of two million shares, currently trading at ¢2.70 each, makes a right
issue of one new share for every two existing shares at a price of ¢2.10. Calculate the theoretical ex-rights
price and the value of the right

Solution
Current number of shares = 2m
Value of shares before rights issue = ¢5.4m (2m x ¢2.7)
No of shares for the rights issue = 1m (½ x 2m)
Value of new shares to be raised = ¢2.1m (1m x ¢2.1)
Total market capitalisation = ¢7.5m (5.4 + 2.1)
Total shares in issue = 3m (2 + 1)
Theoretical ex-rights price = ¢7.5/3
= ¢2.50 per share
Value of a rights = 2.50 – 2.10
= ¢0.40 per share

Example
MGA Co has issued capital of 100 million shares with a current market value of ¢0.85 each. It announces
a 1 for 2 rights issue at a price of ¢0.40 per share. Calculate the theoretical ex-rights price. Maxwell, a
shareholder having 1,000 shareholdings in MGA Co is considering his wealth in the company. What will
his value be if he
a) Takes up his rights
b) Sell his rights
c) Buys 300 shares and sells the rights of the remainder
d) Takes no action [Answer: ¢0.70; ¢850, ¢850, ¢850, ¢700]

Other external share issues

There are several methods of issuing new shares, depending on the circumstances of the company. If a
company is already quoted on a stock exchange, then the following methods are available for the issue of
new shares:

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Offer for sale
The company offers shares to an issuing house, which then offers the shares to the general public by
advertising prospectus in which the issue price is shown. The company may take this action because it
wishes to change its status to that of a public company. In such a case it is not always an issue of new
shares but a sale of existing ones to different group of investors

Offer for subscription

This is a sale direct to the general public. Shares are advertised at a fixed offer price and the public are
invited to buy them. In this offer, shares are sold to the issuing house by the existing shareholders at an
agreed price and then the issuing house offer them for sale at a slightly higher price to the public

Public issue
A sale direct to the general public but the price for the shares are not fixed and the public are invited to
bid for shares.

Placing
With a placing, a sponsor (usually a merchant bank) arranges for its private clients (institutions) to buy
shares. However, at least 25% of the shares placed must be made available to the general public. The costs
of this method are considerably lower than those of an offer for sale.

New shares – unquoted companies

If a company is unquoted, then they have only two choices: to remain unquoted or become quoted. If they
choose to become quoted on a stock exchange, then sources of finance listed above become available to
them. When choosing between the various sources of equity finance, account must be taken of factors
such as the amount of the finance and issue costs. The cheapest source of equity finance is retained
earnings, then rights issues, then new issues.

Debt sources
Put at its simplest, debt is something that has to be repaid. The usual method of debt repayment is a
combination of a regular interest, with capital (principal) either spread over a period or given as a lump
sum at the end of the borrowing. Long-term debt usually in the form of bonds, bank loans, preference
shares, venture capital, and finance lease are frequently used as sources of long-term finance, an
alternative to equity.
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Straight bonds
They are traded on stock markets in much same way as shares, and are usually denominated in blocks of
¢100 nominal value, may be secured or unsecured and may be redeemable or irredeemable.
Irredeemable debt is not payable at any specified time in the future but instead, interest is payable in
perpetuity. If the debt is redeemable then, the principal will be repayable at a future date. For example, if
an organisation has 6% 20x9 loan notes redeemable at par, and is quoted at ¢95 ex-interest, then this
description refers to loan notes that:
❖ Pay interest at 6% nominal rate normally called the coupon rate
❖ Is redeemable in the year 20x9
❖ Will be repaid at par value, i.e., each ¢100 nominal value will be repaid at ¢100
❖ Currently have a market value of ¢95 per ¢100, without rights to the current year’s interest payment.
A bond is a long-term contract in which the bondholders lend money to a company and in return the
company (usually) promises to pay the bond owners a series of interest payments, known as coupons, until
the bond matures. At maturity the bondholder receives a specified principal sum called the redemption
value of the bond. Bonds may be regarded as merely IOUs with pages of legal clauses expressing the
promises made (debentures).

Convertible bonds and Warrants

Some types of finance have elements of both debt and equity. Examples are convertible loan notes and
loan notes with warrants.
Convertibles are debentures that give the investor the choice on redemption of either taking cash or taking
a pre-determined number of shares in the company. The investor remains a lender to the business and will
receive interest on the amount of the loan until such time that the conversion takes place. The investor is
not obliged to convert the loan to ordinary shares. This will only be done if the market price of the shares
at the conversion date exceeds the agreed conversion price. However, there will be some dilution of
control if holders of convertible loans exercise their option to convert. Warrants give the holder or the
investor the right, but not obligation to subscribe for new shares at a fixed future date at a predetermined
price. If warrants are issued with loan notes, the loan notes are not converted into equity. Instead, bond
holders make cash payment for the shares and retain the loan notes until redemption. Interest rate on the
loan is low and loan may be unsecured. The warrant will usually state the number of shares the holder
may purchase and the time limit within which the option to buy shares can be exercised.

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Example
What will be the difference in status within a business between holders of convertible loan capital and
holders of loans with share warrants attached if both groups decide to exercise their right to convert?

Solution
The main difference will be that when holders of convertible loan capital exercise their option to convert,
they become ordinary shareholders and are no longer lenders of the business. However, when lenders with
warrants exercise their option to convert, they become both ordinary shareholders and lenders of the
business. When convertible loan capital holders exercise their option to convert, they swap their loan for
shares. When warrant holders exercise their right to buy shares, they pay cash for it.

Bond pricing
To determine the current market price or value of a bond in issue, the bond market takes into consideration
the coupon rate, current investor return (effective interest rate), time to maturity and redemption conditions
agreed in the loan contract. At maturity, bonds may be redeemed at par or at a discount or at a premium
to the nominal value of ¢100. The embedded future cash streams embedded in the bond contract are then
discounted at the investors rate of return to obtain the market price of the bond and will thus, enable us to
identify whether the bond is issued at a discount, par or at a premium.

Example
An organisation has 8% 20x7 loan notes in issue redeemable at par three years from now. If the investors’
rate of return is 10%, determine the market price of the bond.

Solution
Nominal value of loan notes is ¢100, and the coupon interest is 8% p.a of the nominal value yielding ¢8
each year for three years. At maturity the loan is to be redeemed at ¢100 (par value). The present value of
cash flows in this bond arrangement at 10% p.a is as follows:
Year Cash flow DF (10%) PV
1–3 Interest ¢8 2.487 ¢19.90
3 Redemption ¢100 0.751 ¢75.10
Market price = ¢95.00
The current market bond price is ¢95 per each ¢100 nominal value which means that the loans are issued
at a discount and that for each loan note of ¢100, ¢95 is rather offered as loan to the issuer. Thus, a

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company that seeks to borrow 15 units of the loan notes of ¢1,500 (15 x ¢100), will effectively get net
loan amount of ¢1,425 (¢95 x 15) today. The difference of ¢75 (1,500 – 1,425) is seen as an issue cost.

Example
A company has in issue 8% bonds 20x7. At maturity the bonds may be redeemed at par or converted to
20 ordinary shares in the company for every ¢100 nominal value. The share price is currently ¢4.5 per
share.
a) What will the bond holder choose to do on maturity if the share price of the company in 2017 is:
i. ¢4 per share
ii. ¢6 per share
b) Investors required returned on bonds is 10%, and if today is the end of 20x4 and the share price is
expected to grow at 7% p.a
i. Calculate the market value of the bonds
ii. Calculate the conversion premium

Solution
a)
i) At maturity the investor will redeem the loan at par, a value of ¢100.
If the investor decides to convert the loan and to accept shares, the value of 20 shares at ¢4 per share will
amount to ¢80 (20 x ¢4) which is far less value. The loan should not be converted at ¢80
ii) The value of the shares at ¢6 per share at maturity will yield ¢120 (20 x 6) which is better than ¢100.
Convert at ¢120
b)
i) Market value of the shares at end of 20x7 = ¢4.5 (1 + 7%) 3 = ¢5.51
ii) Value of shares on conversion will have a value of ¢110.2 (20 x ¢5.51). The investor will convert at
¢110.20. The market price of the bond is given by the present value of interest payments and the
redemption amount
Year Cash flow DF (10%) PV
1–3 Interest ¢8 2.487 19.90
3 Redemption value ¢110.20 0.751 82.76
Market value = ¢102.66

Conversion premium is ¢12.66 = 102.66 – 90 (20 x 4.5)

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Example
CW Co is to undertake an investment requiring ¢40m in new financing and directors of the firm has
decided to raise the money through a bond issue. At the stock market bonds with nominal value of ¢1,000
comes with a coupon rate of 6.5% p.a. The loan notes will be redeemed in 7 years’ time at a premium of
3%. How much loan should be raised in the stock market to have a net amount of ¢40m if investor effective
interest rate is 9%?

Solution
Year Cash flow DF (9%) PV
1–7 ¢65 5.033 ¢327.15
7 ¢1030 0.547 ¢563.41
Market price = ¢890.56

This means that bonds currently are trading at ¢890.56 for each ¢1,000 and that a total net amount of
¢35,622,400 could be raised (¢40m x ¢890.56/¢1,000) which accounts for 89.056% of the total amount
100
needed. Grossing it up to 100% yields [ x ¢40m] which approximately is equal to ¢44, 915,558.75.
89.056

Therefore, ¢44, 915, 558.75 be requested and raised by the issuer to have a net loan amount of ¢40m. The
excess amount of ¢4,915,558.75 form part of the issue costs for raising the loan at the bonds market.

Example
A company has issued some units of bonds, each with a nominal value of ¢100 and a coupon rate of
interest of 6% payable yearly. Each ¢100 of the bonds may be converted into 25 ordinary shares of the
company in 8 years’ time. Any bonds not converted will be redeemed at par. The shares of the company
is currently trading at ¢3.55 per share. Estimate the likely current market price for ¢100 of the bonds, if
investors in the bonds now require a post-tax return of 10%, and the expected value of the company’s
ordinary shares grows at a rate of 3%
Solution
Value of shares at maturity = 3.55 (1 + 3%) 8 = ¢4.5 per share
Value of convertible bond = ¢4.5 x 25 = ¢112.5 (convert)
Year cash flow DF (10%) PV
1–8 ¢6 5.335 32.01
8 112.5 0.4665 52.48
84.49

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The estimated market value is ¢84.49 per ¢100 of debt

Basically, there is an inverse relationship between investors effective interest rates or return and market
price of bonds and that, as interest rates rise, bond prices drop and vice versa,

Bank borrowing
An alternative to going to the capital markets to raise money via a public bond issue or a private bond
placement is to borrow directly from a bank. The bank makes the loan from its own resources and over
time the borrowing company repays the bank with interest. Borrowing from banks is attractive to
companies for the following reasons:
❖ Administrative and legal costs are low – because the loan arises from direct negotiation between the
borrower and lender there is an avoidance of the marketing, arrangement, regulatory and underwriting
expenses involved in a bond issue
❖ Quick – the key provisions of a bank loan can be worked out speedily and the funding facility can be
in place within a matter of hours.
❖ Flexibility – if the economic circumstances facing the firm should change during the life of the loan,
banks are generally better equipped – and are more willing – to alter the terms of the lending agreement
than bondholders.
❖ Available to small firms – bank loans are available to firms of almost any size whereas the bond
market is for the big players only.

Venture capital
Venture capital is a provision of risk bearing capital, usually in the form of a participation in equity, to
companies with high growth potential. Venture capitalists provide start-up and late-stage growth finance,
usually for small firms. Venture capitalists are interested in investing in SMEs that have higher levels of
risk than would be acceptable to many traditional lenders. The attraction of investing in higher-risk
businesses for the venture capitalist is the prospect of higher returns. In assessing an application for
funding by a venture capitalist the following conditions are considered:
• Nature of the company’s products and its potential to generate adequate sales and earn profits that are
sustainable.
• Demonstrated technical expertise and value driven skills and ability to develop new and innovative
products
• Management should demonstrate commitment, skills and experience in promoting the business

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• Demonstrate competitive strategies to maintain and expand its market share

Leasing
Long-term lease arrangements are likely to be finance lease. Lease exists for the whole useful life of the
asset, risks and rewards associated with the use of the asset resides with the lessee, and the lease cannot
be cancelled without cost to the lessee. This is effectively a source of medium-to-long-term debt finance

Preference shares
This is not an equity source of finance but has every characteristic of a debt source. Preference
shareholders receive their interest payments each year but in the form of dividends. The interest is taken
after taxes have been paid by the entity.

3.4 Finance for small and medium enterprises

As smaller companies tend to be unquoted, it becomes difficult for equity investors to liquidate their
investment. Therefore, small firms rely on finance from retain earnings and bank borrowings. Initial
capital, usually called seed money, is often from family and friends, and that seriously limits the scope
for further rights issues thereby, creating a funding gap which arises from wanting to expand beyond these
means of finance but are not yet ready for a listing on the Stock Exchange.
This gap may be bridged with a number of ways including the use of financial investors as Business
angels, venture capitalists and banks. There are other various government solutions including the provision
of tax incentives and other specific forms of assistance. Business angels are often wealthy individuals
who have been successful in business and are willing to invest in a start-up business or a business that is
at an early stage of development through a shareholding.

Example
What factors should be considered by a company when selecting a source of debt finance and the factors
considered by lenders of finance in deciding how much to lend to the company?

Solution
Essentially a company should look to match the characteristics of the debt finance with its corporate needs.
Factors that should be considered when selecting a suitable source of debt finance may include:
Availability
The kinds of debt finance available will depend upon the relative size of the company, its relationship
with its bank and the capital markets to which it has access. It is likely that a bank loan, rather than any
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other kind of debt finance, may be selected by small firms, since very few SMEs are able to issue traded
bonds

Issue and interest costs

Companies should consider both issue costs and the rate of interest to be charged on the funds borrowed.
Also, they should consider the repayment terms. With a bank loan, for example, there may be an annual
capital payment in addition to the annual interest payment. Again, some types of debt have early
repayment penalties.

Gearing or financial risk

Debt will increase gearing and hence the financial risk of companies. The company should consider how
gearing will change over the life of the debt finance selected and how the company will be viewed from a
risk perspective by future investors.

Maturity
The period over which the debt is taken should be matched against the period for which the company
needs the finance and the ability of the company to meet the financial commitments associated with the
debt finance selected. Another factor to consider is that short-term finance can be more flexible than long-
term finance. If a company takes on long-term debt finance it takes on a long-term commitment to which
it has a contractual obligation.

Factors to be considered by lenders of finance

There are a number of factors that may be considered by lenders of finance in deciding how much to lend
to a company.

Security
The amount of funds made available to companies may depend on the availability of assets to offer as
security. Debt investors will expect security in order to reduce the risk of the investment from their point
of view. If security is not available or is limited, companies may be asked to pay a higher rate of interest
in compensation for the higher level of risk

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Legal restrictions or covenants
Another factor to consider is whether there are any legal restrictions on the amount of debt that the
company can take on, for example in existing debt contracts (restrictive or negative covenants), or in the
company’s memorandum or articles of association

Risk and the ability to meet financial obligations

When considering the amount and the terms of the funds to be made available to a company, providers of
debt finance will assess the ability of the company to meets its future financial obligations and the risk of
the company. The previous record of the company can be used as a guide to the ability of its management
to manage its finances in a responsible and effective manner.

Example
Discuss the attractions to a company of convertible debt compared to a bank loan of a similar maturity as
a source of finance

Solution
Convertible is debt that, at the option of the holder, can be converted into ordinary shares. At maturity
date if not converted, will be redeemed like ordinary/straight debt. Convertible debt has a number of
attractions compared with a bank loan of similar maturity, as follows:
Self-liquidating
Provided that the conversion terms are pitched correctly and expected share price growth occurs,
conversion will be an attractive choice for bond holders as it offers more wealth than redemption.
This occurs when the conversion value is greater than the redemption value (if conversion and redemption
are on the same date), or when the conversion value is greater than the floor value on the conversion date
(if conversion is at an earlier date than the redemption date). If the debt is converted into ordinary shares,
it will not need to be redeemed, i.e. self-liquidation has occurred. A bank loan of a similar maturity will
need to have all of the capital repaid.

Lower interest rate

The interest rate on convertible debt will be lower than the interest rate on ordinary debt such as a bank
loan because of the value of the option to convert. The returns on fixed-interest debt will not increase with
corporate profitability, so debt providers will have a limited share of the benefits from the investment of
the funds they have provided. When debt has been converted, however, bond holders become shareholders

Page | 33
and will potentially have unlimited returns, or at least returns that are higher than the returns on debt
finance.

Increase in debt capacity on conversion

Gearing will increase with a bank loan for the time that the debt is outstanding, and gearing will then
return to its previous level when the bank loan has been paid off.
Gearing also increases when convertible debt is issued, but if conversion occurs, the gearing will fall not
only because the debt has been removed, but will fall even further because equity has replaced the debt.
The capacity of the company to service debt (debt capacity) will therefore be enhanced by conversion,
compared to redemption of a bank loan of a similar maturity.

More attractive than ordinary debt

It may be possible to issue convertible debt even when ordinary debt such as a bank loan is not attractive
to lenders, since the option to convert offers a little extra that ordinary debt does not. This is the option to
convert in the future, which can be attractive to optimists, even when the short- and medium-term
economic outlook may be poor.

3.5 Islamic financing

In Islam, riba (interest) which refers to any predetermined charges by way of gains on the part of a lender
to a borrower is absolutely forbidden. It is unfair to see the borrower struggling to raise the required
amount and the interest when the profit generated is less than the predetermined interest cost. Also, the
attractiveness of riba will lead to inefficient allocation of resources in the economy and contribute to
instability as capital will flow to the most credit worthy customers. In Islamic financing, mudaraba is
equivalent to rights issue whiles sukuk is like a loan note (bond) issue. Musharaka is similar to venture
capital whiles Ijara is similar to lease finance.

Mudaraba
A mudaraba contract is between a capital partner (rab al mal) and an expertise partner (mudarab) for the
undertaking of business operations. The business operations must be compliant with Sharia’a law and are
run on a day-to-day basis by the mudarab. The rab al mal has no role in relation to the day-to-day
operations of the business. Profits from the business operations are shared between the partners in a
proportion agreed in the contract. Losses are borne by the rab al mal alone, as provider of the finance, up
to the limit of the capital provided.

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Musharaka
The two partners called musharik jointly contribute capital and expertise for the business.

Murabaha
A seller sells goods to a buyer on credit and the buyer pays for the goods later by instalments.

Sukuk
Conventional loan notes are not allowed under Sharia’a law because there must be a link to an underlying
tangible asset and because interest (riba) is forbidden by the Quran. Sukuk are linked to an underlying
tangible asset, ownership of which is passed to the sukuk holders, and do not pay interest. Since the sukuk
holders take on the risks and rewards of ownership, sukuk also has an equity aspect. As owners, sukuk
holders will bear any losses or risk from the underlying asset. In terms of rewards, sukuk holders have a
right to receive the income generated by the underlying asset and have a right to dismiss the manager of
the underlying asset, if this is felt to be necessary.

Ijara
In this form of Islamic finance, the lessee uses a tangible asset in exchange for a regular rental payment
to the lessor, who retains ownership throughout the period of the lease contract. The contract may allow
for ownership to be transferred from the lessor to the lessee at the end of the lease period. Major
maintenance and insurance are the responsibility of the lessor, while minor or day-to-day maintenance is
the responsibility of the lessee. The lessor may choose to appoint the lessee as their agent to undertake all
maintenance, both major and minor.

3.6 Pecking order theory

Pecking order theory suggests that companies have a preferred order in which they seek to raise finance
in the simplest and most efficient manner, beginning with retained earnings. The order is as follows:
1. Use all retained earnings available;
2. Then issue debt;
3. Then issue equity, as a last resort.
The advantages of using retained earnings are that issue costs are avoided, its use is without reference to
a third party. Issuing equity will incur high levels of issue costs whiles issuing debt may incur moderate
issue costs.

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Questions
1. Joy has issued 50,000 units of convertible bonds, each with a nominal value of ¢100 and a coupon rate
of interest of 10% payable yearly. Each ¢100 of convertible bonds may be converted into 40 ordinary
shares of Joy in three years’ time. Any bonds not converted will be redeemed at ¢110 (that is, at ¢110 per
¢100 nominal value of bond). Estimate the likely current market price for ¢100 of the bonds, if investors
in the bonds now require a pre-tax return of only 8%, and the expected value of Joy ordinary shares on
the conversion day is:
(a) ¢2.55 per share (b) ¢3.00 per share

2. A firm has in issue 6% bonds 20x7. At maturity the bonds may be redeemed at par or converted to 18
ordinary shares in the company for every ¢100 nominal value. Today is 1/1/20x5 and the following table
shows the firm’s share price over the last three years. If it is assumed that share price growth rate over the
last three years is to continue into the foreseeable future, determine the market price of the bond if investors
effective rate of return is 8%.
Year 31/12/20x2 31/12/20x3 31/12/20x4

Share price (¢) 4.93 5.12 5.33

3. Richeal Co is considering issuing a new 10-year bond in the domestic market. The interest rate on the
bond is 20%. Interest will be paid semi-annually. The directors are considering the appropriate price at
which the new bonds should be sold. The market required return is 25% pa. Calculate the price investors
would be willing to pay for each ¢100 face value bond. Explain how changes in average interest rate
affects the market price or value of bonds.

4. OAS plc has issued 10,000 ¢1 par equity shares which are at present selling for ¢3 per share. It has also
issued 50, 000 warrants, each entitling the holder to buy one equity share. The warrants are protected
against dilution. The firm has plans to issue rights to purchase one new equity share at a price of ¢2 per
share for every 4 shares. Calculate the theoretical ex-rights price and value of a right of OAS equity shares.
The board chairman of the company receives a phone call from an angry shareholder who owns 1,500
shares. The shareholder argues that he will suffer a loss in his personal wealth due to the rights issue
because the new shares are being offered at a price lower than the current market value. Show the effects
of the rights issue on this particular shareholder’s wealth, assuming:
i) he sells all his rights iii) he does nothing
ii) he exercises half of his rights and sells the other

Page | 36
5. Explain the following types of contracts
i) mudaraba contract ii) murabaha contract iii) sukuk bonds

6. Island Bank currently has six million shares in issue and the company maintains a dividend pay-out
ratio of 50% and its earnings per share currently is ¢1.60. Dividend growth is 5% pa and this is expected
to continue into the foreseeable future. The Board of Directors of Island Bank have decided to raise
additional capital through rights issue to meet the new capital requirements by Bank of Ghana. The firm
plans to issue one new share for every three shares held by existing shareholders at 10% discount to its
current market price. Island’s Bank cost of equity capital is 15%. Calculate for the theoretical ex-rights
price.

7. Explain five conditions that a venture capitalist will consider in assessing an application for funding.
8. AAR Co has in issue 12% with a nominal value of ¢150 and redemption value of ¢165 with interest
payable quarterly. The cost of debt on the bonds are 8% annually and the bonds are redeemable three and
a half years from now. Calculate the market value of the bonds.

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 CHAPTER FOUR

WORKING CAPITAL MANAGEMENT

4.0 The Nature, Elements and Importance of Working Capital

Working capital may be defined as the difference between current assets and current liabilities. Working
capital thus means net current assets or net current liabilities (if current liabilities exceed current assets).
It is the investment a company makes in assets which are in continual use and are turned over many times
in a year.

The major elements of current assets are cash (in hand and at bank), inventories of raw materials, work‐
in‐progress, finished goods and accounts receivable (debtors). The major elements of current liabilities
are accounts payable, taxation payable, dividend payments due, short-term loans (including bank
overdraft, if any), long-term loans maturing within one year and lease rentals due within one year. It is
necessary for managers to decide how much of each element should be held as there are costs associated
with holding both too much and too little of each element. Hence, the potential benefits must be weighed
against the likely costs in order to achieve the optimum investment.

The working capital needs of a particular business are likely to change over time as a result of changes in
the commercial environment. Financial managers must try to identify changes in an attempt to ensure the
level of investment in working capital is appropriate. In addition to changes in the external environment,
changes arising within the business such as changes in production methods and changes in the level of
risk that financial managers are prepared to take could alter the required level of investment in working
capital.

Example
What kind of changes in the commercial environment might lead to a decision to change the level of
investment in working capital?

Solution
a) changes in interest rates
b) changes in market demand
c) changes in the seasons
d) changes in the state of the economy

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Objectives of working capital management
The aim of working capital management is to achieve balance between having sufficient working capital
to ensure that the business has sufficient liquid resources to continue in business but not too much that
the level of working capital may reduce its profitability. Every business needs adequate liquid resources
to maintain day-to-day cash flow. It needs enough to pay wages, salaries and accounts payable if it is to
keep its workforce and ensure continuous supplies.

Liquidity means that the business has sufficient inventory and cash so that it can trade without its cash or
inventory depleting. Maintaining adequate working capital is not just important in the short term only.
Adequate liquidity is needed to ensure the survival of the business in the long term as well. Even a
profitable company may fail without adequate cash flow to meet its short-term liabilities.

On the other hand, an excessively conservative approach to working capital management resulting in high
levels of cash holdings will harm profits because the opportunity to make a return on the assets tied up
as cash will have been missed. A business must therefore have clear policies for the management of each
component of working capital.

Different industry types require different levels of working capital. Service industries need little or no
inventory whereas retailers need more. Again, depending on the retailer’s business their inventory needs
will also vary. Manufacturers will probably require more working capital because they need raw materials,
work‐in‐progress and finished goods.
Retailers may sell for cash therefore having few receivables and producers may have trade customers and
have greater receivables. If supply deliveries are uncertain the level of inventory will be greater.

Investment in working capital

All companies need some working capital in order to keep their businesses running. They need to allow
customers to buy on credit; otherwise, they would lose business to competitors. They need to carry
inventories of finished goods in order to be able to fulfil demand. They need to have a short-term cash
balance in order to be able to pay bills. Thus, working capital needs financing just as does the investment
in non-current assets.

Working capital funding policies

There are three alternative policies for working capital as sales rises. These are the conservative, moderate
and aggressive funding policies.
a) Conservative funding policy – this represents a relatively relaxed approach with large cash or near-
cash balances, more generous customer credit and/or higher inventories. This may be a suitable policy for
a firm operating in a relatively uncertain environment where safety stocks of raw materials, WIP, and
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finished goods are needed to avoid production stoppages and lost sales due to stock-outs. Customers may
demand longer time period to pay and suppliers are less generous with credit. Basically, this is where the
organisation uses long term funding for the permanent working capital.

b) Aggressive funding policy – the aggressive stance is more likely to be taken in an environment of
greater certainty over future cash flows which permit working capital to be kept to relatively low levels.
Here the firm would hold minimal safety stocks of cash and inventories and/or would be able to press
customers for relatively early settlement while pushing trade creditors to increase the time interval
between receipt and payment for inputs. The aggressive policy approach will exhibit a shorter cycle for
cash conversion.

In summary, this is where the organisation uses short‐term funds to finance its permanent working capital.
This is cheaper but high risk because short‐term funds can be recalled on demand.

Question
Identify the three types of working capital funding policies of an organisation

Overtrading or under-capitalisation
Aggressive funding policies has the potential to create overtrading. Overtrading occurs when there are
signs of:
• Rapid increase in sales which is not matched by a corresponding increase in working capital
• Non-replacement of long-term debt
• Increased reliance on short-term sources of finance (increase in trade credit, overdraft, short-term bank
loans, etc)
• Rapid increase in current assets with its associated increases in debtor days, inventory and creditor
days
• Decline in liquidity and solvency ratios
Overtrading can be overcome by supporting operations with long-term sources of finance.

Question
NGK Co is concerned that it may be overtrading. Financial information relating to the company is as
follows. All figures are in thousands of cedis
20X5 20X4
Credit sales income 17,100 12,000
Cost of sales 8,550 7,500

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Current assets
Inventory 2,500 2,100
Trade receivables 2,000 1,000

Current liabilities
Trade payables 1,900 1,250
Overdraft 2,400 850
Net working capital 200 1,000
Long-term debt 3,000 3,000

Companies which are similar to NGK Co have the following average values for 20X5:
Inventory days 65 days
Trade receivables days 30 days
Trade payables days 50 days
Current ratio 1·7 times
Quick ratio 0·8 times

Assume there are 360 days in each year.

Considering the background information of NGK and the financial data provided above, evaluate whether
NGK can be considered to be overtrading and discuss how overtrading can be overcome.

Working capital ratios - Liquidity

Two key measures, the current ratio and the quick ratio (acid test) are used to assess short-term liquidity.
Generally, a higher ratio indicates better liquidity.

a) Current ratio
Measures how much of the total current assets are financed by current liabilities
Current assets
Current ratio =
Current liabilities

We would normally expect this to be > 1 and that a current ratio less than 1 could indicate liquidity
problems. A measure of 2:1 means that current liabilities can be paid twice over out of existing current
assets.

b) Quick (acid test) ratio

This ratio measures how well current liabilities are covered by liquid assets and it is particularly useful
where inventory holding periods are long.
Current assets − inventory
Quick ratio =
Current liabilities

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The cash operating cycle
The cash operating cycle is the average length of time between the company’s outflow on raw materials,
wages and other expenditures and the inflow of cash from the sale of goods. It is the average length of
time between paying trade payables and receiving cash from trade receivables. It should be noted that, the
faster a firm can ‘push’ items around the cycle the lower its investment in working capital will be.
Cash operating cycle = Inventory days + receivable days ‐ payable days
Inventory days = Inventory / Cost of sales x 365days
Receivable days = Receivables / Sales x 365
Payable days = Payables / Cost of sales x 365

The sales revenue/net working capital ratio

sales revenue
The ratio of
Current assets − Current liabilities

Clearly shows the level of working capital supporting sales. Working capital must increase in line with
sales to avoid liquidity problems and this ratio can be used to forecast the level of working capital needed
for a projected level of sales.

Example
You have been given the following information for a company:
Summarised statements of operations and financial position at 30 September
20x3 20x2
¢m ¢m
Sales revenue 2,065.0 1,788.7
Cost of sales 1,478.6 1,304.0
Gross profit 586.4 484.7
Current assets
Inventories 119.0 109.0
Accounts receivable (note 1) 400.9 347.4
Short-term investments 4.2 18.8
Cash at bank and in hand 48.2 48.0
572.3 523.2
Current liabilities
Loans and overdrafts 49.1 35.3
Corporation taxes 62.0 46.7
Dividend 19.2 14.3
Accounts payable (note 2) 370.7 324.0
501.0 420.3

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Net current assets 71.3 102.9
Notes
2013 2012
¢m ¢m
1 Trade accounts receivable 329.8 285.4
2 Trade accounts payable 236.2 210.8

a) Calculate the liquidity ratios for 20x3 and 20x2

b) Calculate the length of the cash operating cycle in 20x3 and 20x2
c) Comment on your results and appraise how effectively the working capital is being managed

Solution
a) 20x3 20x2
572.3 523.2
Current ratio =1.14 = 1.24
501.0 420.3

453.3 414.2
Quick ratio = 0.90 = 0.99
501.0 420.3

b)
329.8 285.4
Account receivable days x365=58 days x365=58
2065.0 1788.7

119.0 109.0
Inventory days x365=29 days x365=31
1478.6 1304.0

236.2 210.8
Account payable days x365=58 days x365=59
1478.6 1304.0

Cash operating cycle 29 days 30 days

c) The company's current and quick ratios have fallen but are still reasonable, and the quick ratio is not
much less than the current ratio. This suggests that inventory levels are strictly controlled, which is
reinforced by the low inventory turnover period.
The relationship between the cash operating cycle and the level of investment in working capital is that
an increase in the length of the cash operating cycle will increase the level of investment in working
capital. The length of the cash operating cycle depends on working capital policy in relation to the level
of investment in working capital, and on the nature of the business operations of a company

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Question
RTD currently operates a long-term cash operating cycle and management is now considering an initiative
to reduce the cash cycle in order to manage the size and cost of the company’s working capital. Extracts
under the current working capital policy is as follows:

Cash ¢1,000 Debtors ¢4,000

Inventory ¢6,000 Creditors ¢4,000

Under the proposed policy, cash is expected to increase by 50%, Debtors is expected to reduce by 25%,
Creditors is expected to increase by 25% and current ratio is expected to be 1.9 times. Working capital is
financed by the use of an overdraft facility which is procured at an interest rate of 20%.
a) Calculate the firm’s net working capital under the existing and proposed policies
b) Compute the change in the firm’s working capital financing cost if the new policy is implemented
c) Advise management on the benefits or otherwise of the implementation of the new policy
d) Compute the working capital cycle under the existing and proposed policies
e) Explain the importance of cash conversion cycle to the firm’s directors

Funding working capital

Working capital can be funded either by short‐term or long‐term finance. Short‐term finance is cheaper
than long‐term finance because lenders would demand a greater compensation for having their money tied
up for long periods. Again, short‐term finance is more flexible and easier to arrange than long‐term
finance. A business will only pay interest on the amount of overdraft (short‐term) utilised whereas with
long‐term the business will pay fixed interest even though the loan might not fully be utilised. Again, an
overdraft is normally unsecured against the company’s assets. Also, long-term fund will run for the full
term of the loan as against the overdraft which could be paid early. In terms of cost, the term structure of
interest rates suggests that short-term debt finance has a lower cost than long-term debt finance. Again,
when considering the financing of working capital, it is useful to divide current assets into fluctuating
current assets and permanent current assets.

Permanent Current Assets

Permanent current assets are the normal level of stock and debtors that the company needs in order to keep
the business going. Put simply, permanent current assets represent the core level of investment in current
assets needed to support a given level of turnover or business activity. As turnover or level of business
activity increases, the level of permanent current assets will also increase. This relationship can be
measured by the ratio of turnover to net current assets.

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Fluctuating Current Assets
These are the levels of current assets that fluctuate up and down with the seasonal nature of the business.
Fluctuating current assets represent changes in the level of current assets due to the unpredictability of
business activity.

The matching principal or the rule of thumb suggests that long-term finance should be used for long-
term investments. Applying this principle to working capital financing, long-term finance should be
matched with permanent current assets and non-current assets whiles short-term funds be used to finance
fluctuating current assets. A financing policy with this objective is called a ‘matching policy’. A situation
where the rule of thumb is reversed for short-term funds to be used to finance long-term investments is
called an aggressive strategy. Reliance on short-term finance makes the management of working capital
much riskier than a matching approach, but also more profitable due to the lower cost of short-term
finance. Following an aggressive approach to financing can lead to overtrading (under capitalization)
and the possibility of liquidity problems.

Benefits of good working capital management

Working capital is a vital part of a business and can provide the following advantages to a business:
• Higher returns on capital
• Improved credit profile and solvency
• Higher profitability
• Increased business value
• Favourable financing conditions
• Uninterrupted production
• Ability to face shocks and peak demands
• Competitive advantage

Question
Zodiac Co, a multinational company, has annual credit sales of ¢5,400 and related cost of sales are ¢2,160.
Approximately half of all credit sales are exports to an Asian country, which are invoiced in cedis. Extracts
from the financial statement of position of Zodiac Co is as follows:
Inventory ¢473
Trade receivables ¢1,332
Trade payables (¢178)
Overdraft (¢1,327)
Net working capital ¢300

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Zodiac Co plans to change working capital policy in order to improve its profitability. This policy change
will not affect the current levels of credit sales, cost of sales or net working capital. As a result of the
policy change, the following working capital ratio values are expected:
Inventory days 50 days
Trade receivables days 62 days
Trade payables days 45 days

Assume there are 365 days in each year then, for the change in working capital policy, calculate the change
in the operating cycle and its effect on the current ratio.

Question
1. What are the key factors to be considered when formulating a working capital funding policy?
2. Explain four advantages a company a company may derived from proper working capital management

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 CHAPTER FIVE

MANAGEMENT OF STOCKS, DEBTORS, CREDITORS AND CASH

Stock Management
A business may hold stock for various reasons of which the most common reason is to meet the immediate
day-to-day requirements of customers and production. However, a business may hold more than is
necessary for this purpose if it believes that future supplies may be interrupted or become scarce. Similarly,
if the business believes that the cost of stock will rise in the future, it may decide to stock pile. Inventories
are held in three forms: raw materials, work-in-progress and finished goods. It thus forms a major
investment for many organisations and for manufacturing firms, stock held may represent a substantial
proportion of the total assets held.

However, there are significant costs associated with holding high stock levels. These may include storage
and handling costs (rent, security, insurance), financing costs, the risks of pilferage and obsolescence,
deterioration, and the opportunities forgone in tying up funds in this form of asset. It should also be noted
that if the level of stock held is too low, there will also be associated costs such as loss of sale, loss of
profits, loss of goodwill from customers, high transportation costs incurred to ensure stock is replenished
quickly, and higher price than what might otherwise have been necessary in purchasing stock.
It is therefore important to reduce the levels of inventory held to the necessary minimum to balance off
liquidity and profitability. To ensure that stock is properly managed, a number of procedures and
techniques are used. These are reviewed below:

1. Forecasts of future demand: - To ensure that there is stock available to meet future sales, companies
are to produce appropriate sales forecasts. These forecasts will determine future ordering and production
levels. These forecasts may be developed using statistical techniques, or market research techniques, or
they may be based on the judgment of the sales and marketing staff.

2. Recording and reordering systems: - there must be proper procedures for recording stock purchases
and sales. Periodic stock checks are usually required to ensure that the amount of physical stock held is
consistent with what the stock records indicates. There should also be clear procedures for the re-ordering
of stock. The time between the placing of an order and the receipt of the goods (lead time) and the likely
level of demand is also required. The amount of safety stock to be held, however, is a matter of judgment
and will depend on the degree of uncertainty concerning the rate of demand and the lead time.
3. Levels of control: - the use of decision models is appropriate – economic order quantity (EOQ) model,
or just-in-time (JIT) stock management model where raw materials are delivered just before they are
needed and finished goods are produced just before being sent to the customers.

Page | 47
The objective of good inventory management is therefore to determine the optimum re-order level –
quantity of items left in inventory when the next order is placed, and the optimum re-order quantity –
how many items should be ordered when the order is placed for all material inventory items. In practice,
this means striking a balance between holding costs on one hand and re-order costs on the other.

Stock Management models

If the usage and delivery of stock can be predicted accurately management are likely to avoid stock-out
costs and will need only to concern themselves with achieving the optimal balance between ordering costs
and holding costs. Given a steady usage of raw materials we can calculate the optimum size of order to
be placed with suppliers.

Example
A company deals in electrical switches and keeps a particular type of light switch in stock. The annual
demand for the light switch is 10,400 units and the lead-time for orders is four weeks. Demand is steady
throughout the year. At what level of stock should the business reorder, assuming that it is confident of
the figures mentioned above?

Solution
The average weekly demand = 10,400/52 = 200 units
Stock required for the lead-time = 4 x 200 = 800 units
So the business should order not later than when the stock level reaches 800 units
If the business maintains a safety stock of 300 units, then, 1100 units would be the minimum level to re-
order.

Economic order quantity (EOQ) model

The EOQ model assumes that the key costs associated with stock are the costs of holding and ordering
it. The cost of holding stock can be substantial and so managers may try to minimise the average amount
of stock held.
However, by reducing the level of stock held, and therefore the holding costs, there will be a need to
increase the number of orders during the period and so ordering costs will rise. The total costs curve,
which represents the sum of the holding costs and ordering costs, will fall until such a point which may
represent the minimum total cost. The EOQ model therefore, is to minimise the total cost of holding and
ordering inventory. The economic order quantity (EOQ) is therefore, the optimal ordering quantity for
an item of inventory which will minimise total costs.

Let D = usage in units for one period (the annual demand)

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Co = cost of placing one order (cost per order)
CH = holding cost per unit of inventory for one year
Then the EOQ is calculated by the formula:
2CoD
EOQ = √
CH

Assumptions
Demand and lead time are constant and known
Purchase price is constant
No buffer inventory held
No discounts are available for bulk purchases

Example
Picker plc uses 20,000 units per year of a particular item of stock. It costs ¢28 for each order and the cost
of holding each of the units is ¢1.20. Determine the economic order quantity and calculate the total annual
cost at that minimum level quantity [Answer: 966 units, ¢1,159.31]

Solution
2CoD
EOQ = √
CH

Substituting the required quantities give the following

2 x 28 x 20,000
EOQ = √
1.2

EOQ = 966 units

Total cost = D Co/Q + CH Q/2
Total cost = 20,000 x 28/966 + 1.2 x 966/2
Total cost = ¢1,159.31

Example
Derive the total cost equation from which the EOQ is derived.

Solution
If Co is the cost of placing an order, D is the annual usage of stock (demand), and Q, the order quantity
then the annual ordering costs (OC) is given by:
OC = number of orders per year x cost of each order
= D/Q x Co = D Co/Q
Again, if CH is the cost of holding one unit of stock for one year, then the total holding cost (HC) is given
by:

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HC = Average stock level (in units) x holding cost per unit per year
= Q/2 x CH = CH Q/2
Total cost = total annual ordering cost + total annual holding cost
Total cost = D Co/Q + CH Q/2
If this total cost is differentiated with respect to Q and the derivative is set equal to zero, the optimum
ordering quantity which minimises the total cost, called EOQ will be obtained.

Question
An organisation requires 1000 units of cement per month. The cost per order is ¢30 regardless of the size
of the order. The holding costs are ¢2.88 per unit per annum. Find the economic order quantity [Answer:
500 units]

The basic EOQ model has a number of limiting assumptions.

1. It assumes that demand for the product can be predicted with accuracy and that this demand is even
over the period. This may be incorrect as demand may be subject to fluctuations and again, the overall
annual demand may be impossible to predict with accuracy.
2. There may be uncertainty over the time it takes for an order to be delivered. That is, the ‘lead time’ is
neither zero (as assumed in the theory where instant delivery takes place) nor necessarily predictable.

The expected maximum and minimum levels of stock

In practice the lead time is not zero and the minimum stock level is usually greater than zero as firms will
like to hold a certain amount of safety or buffer stock to meet unexpected usage or delays in delivery
which may extend beyond the lead time. The ideal model could be adjusted to suit practical situations.

Maximum stock level

This is the level above which stocks are not allowed to rise.
Maximum level = Re-order level + EOQ – (Minimum usage x Minimum lead time)

Minimum stock level

This is the level below which stock is not allowed to fall as there is a real danger of stock-out occurring
and stoppages of production as final result.
Minimum level = Re-order level – (Average usage x Average lead time)
Re-order level
Re-order level = Maximum usage x Maximum lead time

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Example
The following data relate to a particular stock item:
Minimum usage 50 units per day
Maximum usage 140 units per day
Lead time 25 – 30 days
Economic order quantity 5,000 units
Calculate the various stock control levels

Solution
Re-order level = Maximum usage x Maximum lead time
= 140 x 30
= 4,200 units
Minimum level = Re-order level – (Average usage x Average lead time)
= 4,200 – (95 x 27.5)
= 1,587.5 units
Maximum level = Re-order level + EOQ – (Min. usage x Min. lead time)
= 4,200 + 5,000 – (50 x 25)
= 7,950 units

Question
A manufacturing firm gave out the following information with regards to their stock management.
Usage 113 - 115 units per week
Lead time 3 – 4 weeks
It cost the firm ¢42 per order regardless of the size of the order and the holding costs are ¢1.04 per unit
per annum. Determine the firm’s expected maximum and minimum stock control levels [Answer: EOQ –
695 units; Re-order level – 460 units; Min. level – 61 units; Max. level – 816 units]

Just-in-Time (JIT) systems

Some manufacturing businesses have tried to eliminate the need to hold stock by adopting just-in-time
stock management. The essence of this approach is, as the name suggests, to have supplies delivered to a
business just in time for them to be used in the production process. By adopting this approach, the
stockholding problem rests with the suppliers rather than the business itself. That is, Just-in-time is a series
of manufacturing and supply chain techniques that aim at minimising inventory levels and improve
customer service by manufacturing not only at the exact time customers require, but also in the exact
quantities they need and at competitive prices. With just-in-time, inventory is reduced to an absolute
minimum or eliminated altogether and also eliminates all activities performed that do not add value
(waste). Introducing JIT therefore, might bring the following potential benefits.
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➢ Reduction in inventory holding costs
➢ Reduced manufacturing lead times
➢ Improved labour productivity
➢ Reduced scrap/rework/warranty costs
Reduced inventory levels means that a lower level of investment in working capital will be required.

Management of Debtors (Accounts Receivable)

Selling goods and services on credit to customers result in costs being incurred by a business. These costs
include credit administration costs, bad debts and opportunities forgone in using the funds for other
profitable purposes. However, these costs must be weighed against the benefits of increased sales resulting
from the opportunity for customers to delay payment. When a business offers to sell its goods or services
on credit, then it must have clear policies in place concerning:

1. Which customer should receive credit? When considering a proposal from a customer for the supply
of goods or services on credit, the business must take a number of factors into account. These may include
asking the customer to provide trade references, ask for bank references, look at his published accounts
which may provide some liquidity information about the customer, consult credit rating agencies about
the customer, visiting the register of court judgments where any money judgments given against a
business or individual are maintained, or may ask for some kind of security (collateral) for goods supplied
on credit.

2. How much credit should be offered? Once a customer is considered credit worthy, a credit limit for
the customer should be established but this limit should really be a matter of judgment on the part of the
company. These are normally determined by the amount of sales made to the customer or the financial
capacity of the business to allow for credit.

3. Length of credit period. This may be influenced by such factors as typical credit terms operating
within the industry, the bargaining power of particular customers, or on the risk of non-payment. The
marketing strategy of the business and cash flow forecasts must depend on debtors’ turnover days.

4. Offer of cash discounts. A business may decide to offer a cash discount as a means of encouraging
prompt payment from its credit customers. However, the cost of offering discounts must be weighed
against the likely benefits in the form of a reduction in both the cost of financing debtors and the amount
of bad debts.

5. Collection policies. A business offering credit should ensure that amounts owing them are collected
as quickly as possible. Various steps are taken to achieve this including publicizing credit terms, issuing

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invoices promptly along with regular monthly statements and where necessary, dispatching reminders
promptly, monitoring outstanding debts by producing payment schedule for debtors and answering
customer queries quickly. Others include producing an ageing scheduled of debtors, identifying the pattern
of receipts from credit sales on monthly basis which may involve monitoring the percentage of trade
creditors that pays in the month of sale and the percentage that pays in subsequent months and, dealing
with slow payers by calling in debt collection agencies.

Question
Identify and explain the key areas of debtor (accounts receivable) management

Costs of financing receivables

The main cost of offering credit is the interest expense lost and its effect on profit.
Finance cost = receivable balance x interest (overdraft) rate

Example
Riches Co has sales of ¢20 million for the previous year, receivables at the end of the year were ¢4 million
and the cost of financing receivables is covered by an overdraft at the interest rate of 12% pa. Assume 365
days in a year
a) Calculate the receivables days for Riches
b) Calculate the annual cost of financing receivables

Solution
a) Debtor days = debtors amount x 365/ sales
= 4 x 365/20
= 73 days
b) Finance cost = debtors amount x interest rate
= 4, 000,000 x 12%
= ¢480,000

Extension of credit period

To determine whether it would be profitable to extend the level of total credit period, it is necessary to
assess:
❖ The extra sales that a more generous credit policy would stimulate
❖ The profitability of the extra sales
❖ The extra length of the average debt collection period
❖ The required rate of return on the investment in additional accounts receivable

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Example
A company is considering a change of credit policy which will result in an increase in the average
collection period from one to two months. The relaxation in the credit period is expected to produce an
increase in sales in each year amounting to 25% of the current sales volume. The following information
is also given.
Selling price per unit ¢10.00
Variable cost per unit ¢8.50
Current annual sales ¢2,400,000
The required rate of return on investments is 20%. Assume that the 25% increase in sales would result in
additional inventories of ¢100,000 and additional accounts payable of ¢20,000. Advise the company on
whether or not to extend the credit period offered to customers, if:
(a) All customers take the longer credit of two months
(b) Existing customers do not change their payment habits, and only the new customers take the full two
months credit

Solution
The change in credit policy will be justifiable if the rate of return on the additional investment in working
capital would exceed 20%.
Extra profit
Contribution/sales ratio 15%
Increase in sales revenue ¢600,000
Increase in contribution and profit ¢90,000

(a) Extra investment, if all accounts receivable take two months credit
Average debtors after the sales increase (2/12 x ¢3,000,000) 500,000
Less current average accounts receivable (1/12 x ¢2,400,000) (200,000)
Increase in accounts receivable 300,000
Increase in inventories 100,000
400,000
Less increase in accounts payable (20,000)
Net increase in working capital investment ¢380,000
Return on extra investment =¢90,000/¢380,000
= 23.68%
(b) Extra investment, if only the new accounts receivable take two months credit
Increase in accounts receivable (2/12 of ¢600,000) 100,000
Increase in inventories 100,000
200,000
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Less increase in accounts payable (20,000)
Net increase in working capital investment ¢180,000

Return on extra investment =¢90,000/¢180,000

= 50%
In both cases the new credit policy appears to be worthwhile.

Example
Davis Ltd produces a new type of a product and has an annual turnover of ¢600,000. The following data
relate to each product produced.
Selling price ¢36
Variable costs ¢18
Fixed cost ¢6 ¢24
Net profit ¢12
The cost of finance for the company is estimated at 15%. Ruth, the marketing manager, wishes to expand
sales of this new product and believes this can be done by offering a longer period in which to pay. The
average collection period of the business is currently 30 days. The business is considering three options
in an attempt to increase sales. These are as follows:
Option 1 Option 2 Option 3
Increase in average collection period 10 days 20 days 30 days
Increase in sales ¢30,000 ¢45,000 ¢50,000
Determine the option that maximises profits

Solution
Contribution/sales ratio 50%
Increase in contribution/profit ¢15,000 ¢22,500 ¢25,000
New level of debtors
40/365 x ¢630,000 ¢69,041
50/365 x ¢645,000 ¢88,356
60/365 x ¢650,000 ¢106,849
Less current level of debtors
30/365 x ¢600,000 (¢49,315) (¢49,315) (¢49,315)
Increase in debtors ¢19,726 ¢39,041 ¢57,534
15% interest cost ¢2,959 ¢5,856 ¢8,630
Net increase in contribution/profit ¢12,041 ¢16,644 ¢16,370

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The results above clearly shows that option 2 offers the highest profit or contribution of the policy to
extend the credit days and thus should be elected

Early settlement cash discounts

Cash discounts are given to encourage early payment by customers. The cost of the discount has to be
balanced against the savings the company receives from having less capital tied up due to a lower
receivable balance and a shorter average collection period. Discounts may also reduce the number of
irrecoverable debts.

Example
Poor Lady Ltd has sales of ¢20 million for the previous year and its cost of financing receivables is covered
by an overdraft at an interest rate of 12% pa. Currently, customers take 73 days to pay up and Poor Lady
Ltd is considering offering a cash discount of 2% of sales for the payment of debts within 10 days. Should
this policy be introduced if 40% of customers do take up the discount?

Solution
Current position:
Average receivable = 73 x 20,000,000/365 ¢4,000,000
New policy:
Average debtor days = (10 x 40% + 73 x 60%) = 47.8 days
Average receivables = 47.8 x 20,000,000/365 ¢2,619,178
Fall in receivables ¢1,380,822
Benefits of new policy:
Interest saving: = 12% x ¢1,380,822 ¢165,699
Cost of new policy:
Discount given = (2% x 40% x ¢20,000,000) ¢160,000
Net benefit ¢5,000

Since the benefits of the new policy outweigh its associated cost, the organisation is encouraged to offer
discounts to its customers.

Example
On average it takes customers of Gloria Wholesalers Ltd 70 days to pay their credit offers. Sales amount
to ¢4m pa and bad debts, ¢20,000 pa. The company is planning to offer a cash discount of 2% for payment
within 30 days. It is estimated that 50% of the customers will accept this facility but the remainder will
not pay until 80 days after the sale. At present the business has a partly-used overdraft facility costing

Page | 56
13% pa. If the plans goes ahead, bad debts will be reduced to ¢10,000 per year and there will be savings
in credit administration expenses of ¢6,000 per year. Should Gloria Wholesalers Ltd offer the new credit
terms to customers? You should support your answer with any calculations and explanations that you
consider necessary.

Solution
Current policy:
Existing level of debtors = (¢4m x 70/365) ¢767,123.29
New policy:
Average debtor days = (30 x 0.5) + (80 x 0.5) = 55 days
Average debtor level = (¢4m x 55/365) ¢602,739.73
Reduction in debtor levels ¢164,383.56
Benefits of new policy:
Interest savings = 13% x 164,383.56 ¢21,369.86
Administration cost ¢6,000.00
Bad debt ¢10,000.00
¢37,369.86
Cost of new policy:
Discount = (2% x 50% x ¢4m) ¢40,000.00
Net cost of policy ¢2,630.14
The business will be worse off by offering the discounts

Question
Redeemer plc has sales of ¢20,000,000 pa. Customers currently take credit as follows:
Days Percentage
30 20%
60 50%
90 30%
The company is considering offering a discount of 1% of revenue for payment within 30 days. It is
estimated that 60% of the customers will take advantage of the discount and that the remainder will take
the full 90 days. The company’s bank overdraft rate is 15% pa. Calculate the net cost or benefit of the
change of policy. Should the company offer the discount? (Assume 365 days in a year)

Invoice discounting
Invoice discounting is a method of raising finance against the security of receivables. Selected invoices
are used as security against which the company may borrow funds at a discount. This is a temporary source

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of finance, repayable when the debt is cleared. The key issue of this transaction is that it is a confidential
service and the customer need not know about it.

Factoring
Factoring is the outsourcing of the credit control department to a third party. A factor is defined as 'a doer
of business for another', but a factoring organisation specialises in trade debts, and manages the debts
owed to a client (a business customer) on the client's behalf. Factoring is an arrangement to have debts
collected by a factor company, which advances a proportion of the money it is due to collect. The debt of
the company is sold to the factor who takes on the responsibility to collect the debt for a fee. The company
can choose some or all of the following three services offered by the factor
➢ Debt collection and administration – recourse or non-recourse
➢ Financing
➢ Credit insurance
Non-recourse factoring is more expensive as the factor bears the costs of any irrecoverable debts.

Example
A company had sales of ¢10 million for the year. Customers currently pay as follows:
% of time Month
20%
30%
50%
The company is considering whether or not to factor its debtors. The factor will pay them 100% of the
debtors’ value after one month and will charge a fee of 2% on the company’s turnover. As a result, the
company will be able to lose some credit control staff at a saving of ¢20,000 pa. The company’s bank
overdraft rate is 18% pa. Calculate the net cost or benefit per annum of changing to the new policy. Should
the company employ the factor?

Solution
Current policy:
Average debtors’ period (1x0.2) + (2x0.3) + (3x0.5) = 2.3months
Average debtors cost 2.3/12 x ¢10m = ¢1,916,667
New policy:
Average debtors’ period 1 month
Average debtors cost 1/12 x ¢10m =¢833,333
Fall in receivables ¢1,083,334
Benefit of new policy:
Interest saving 18% x 1,083,334 ¢195,000
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Staff savings ¢20,000
Total benefit of using factor ¢215,000 pa
Cost of new policy:
Factor fee (2% x ¢10m) ¢200,000 pa
Net benefit ¢15,000 pa
Conclusion: Do employ the services of the factor

Example
Light Bulbs Co makes all sales to customers on credit and has an annual turnover of ¢37,400. Current
receivable figures are ¢4,600. The average variable overdraft interest rate in each year is 5%. A factor has
offered to take over the administration of trade receivables on a non-recourse basis for an annual fee of
1% of credit sales. The factor will maintain a trade receivables collection period of 30 days and Light Bulb
Co will save ¢100 per year in Administration costs and ¢350 per year in Bad debts. A condition of the
factoring agreement is that the factor would advance 80% of the face value of receivables at an annual
interest rate of 7%. Comment on the financial acceptability of the factor’s offer and discuss the possible
benefits to Light Bulb Co of factoring its trade receivables.

Solution
Current receivables ¢4,600
Receivables under factor = 37,400 x 30/365 ¢3,074
Reduction in receivables = (4,600 – 3,074) ¢1,526
Benefits
Savings in finance cost = 1,526 x 0·05 ¢76.30 pa
Administration cost savings ¢100.00 pa
Bad debt savings ¢350.00 pa
¢526.30 pa
Factors cost
Factor’s annual fee = 37,400 x 0·01 ¢374.00 pa
Extra interest cost on advance = 3,074 x 80% x (7% – 5%) ¢49.18 pa
¢423.18 pa
Net benefit of factoring ¢103.12 pa
The factor’s offer can be recommended, since the evaluation shows financial benefit arising.

Possible benefits of employing a factor

There are a number of benefits of factoring that could be discussed, as follows:
1. The expertise of the factor

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It is possible the factor can improve the efficiency of the receivables management due to its expertise in
the areas of credit analysis, credit control and receivables collection. This would lead to a lower level of
bad debts, as indicated by the factor’s offer.
2. Insurance against bad debts
Non-recourse factoring offers protection from bad debts, although the factor’s fee will include the cost of
this insurance element, as indicated by the difference between the factor’s fees.
3. Factor finance
A factor will advance up to 80% of the value of invoices raised, allowing a company quicker access to
cash from sales than would be possible if it had to wait for accounts receivable to be settled.
4. Lower administration costs
Since administration of trade receivables would be taken over by the factor, administration costs of the
company would decrease over time, although some incremental short-term costs, such as redundancy
costs, might be incurred.

Example
Eden Vale Ltd is a company that manufactures computer accessories. The statement below is an extract
from the recent financial statements of Eden Vale Ld. Figures are in ¢000

Statement of income
Turnover 21,300
Cost of sales 16,400
Gross profit 4,900

Statement of financial position

Non-current assets
Land and Building 3,000
Current assets
Inventory 4,500
Trade receivables 3,500
8,000
Total assets 11,000
Current liabilities
Trade payables 3,000
Overdraft 3,000
6,000
Equity
Ordinary shares 1,000
Page | 60
Reserves 1,000
2,000
Non-current liabilities
Bonds 3,000
11,000

A factor has offered to manage the trade receivables of Eden Vale Ltd in a servicing and factor-financing
agreement. The following terms and conditions have been agreed upon by the company and the factor
firm.
1. The factor expects to reduce the average trade receivables period from its current level to 35 days;
2. To reduce bad debts from 0·9% of turnover to 0·6% of turnover;
3. To save Eden Vale Ltd ¢40,000 per year in administration costs.
4. The factor would make an advance of 80% of the revised book value of trade receivables. The interest
rate on the advance would be 2% higher than the 7% that Eden Vale Ltd currently pays on its overdraft.
5. The factor would charge a fee of 0·75% of turnover on a with-recourse basis, or a fee of 1·25% of
turnover on a non-recourse basis.
Assume that there are 365 working days in each year and that all sales and supplies are on credit.
a) Explain the meaning of the term ‘cash operating cycle’ and discuss the relationship between the cash
operating cycle and the level of investment in working capital.

b) Calculate the cash operating cycle of Eden Vale Ld.

c) Calculate the value of the factor’s offer:
i) On a with-recourse basis;
ii) On a non-recourse basis.
d) Comment on the financial acceptability of the factor’s offer and discuss the possible benefits to Eden
Vale Ltd of factoring its trade receivables.

Solution
a) The cash operating cycle is the average length of time between paying trade payables and receiving
cash from trade receivables. Using working capital ratios, the cash operating cycle is the sum of the
average inventory holding period and the average trade receivables period, less the average trade payables
period. The relationship between the cash operating cycle and the level of investment in working capital
is that an increase in the length of the cash operating cycle will increase the level of investment in working
capital.

b) Inventory days = 365 x 4,500/16,400 100 days

Trade receivables days = 365 x 3,500/21,300 60 days
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Trade payables days = 365 x 3,000/16,400 67 days
Cash operating cycle = 100 + 60 – 67 93 days

c) i) With-recourse offer
As the factor’s offer is with recourse, Eden Vale Ltd will gain the benefit of bad debts reducing from 0·9%
of turnover to 0·6% of turnover.
Current trade receivables ¢3,500,000
Revised trade receivables = 21,300,000 x 35/365 ¢2,042,466
Reduction in trade receivables under factor ¢1,457,534
Benefits
Finance cost saving = 1,457,534 x 0·07 ¢102,027
Administration cost saving ¢40,000
Bad debt saving = 21,300,000 x (0·009 – 0·006) ¢63,900
Total saving ¢205,927
Factor cost
Interest on advance = 2,042,466 x 0·8 x 0·02 ¢32,680
With-recourse factor fee = 21,300,000 x 0·0075 ¢159,750
Total cost ¢192,430
Net benefit of with-recourse offer ¢13,497
ii) Calculation of value of non-recourse offer
Current trade receivables ¢3,500,000
Revised trade receivables = 21,300,000 x 35/365 ¢2,042,466
Reduction in trade receivables under factor ¢1,457,534
Finance cost saving = 1,457,534 x 0·07 ¢102,027
Administration cost saving ¢40,000
Bad debt saving = 21,300,000 x 0·009 ¢191,700
Total savings ¢333,727
Factor cost
Interest on advance = 2,042,466 x 0·8 x 0·02 ¢32,680
Non- recourse factor fee = 21,300,000 x 0.0125 ¢266,250
Total cost ¢298930
Net benefit of non-recourse offer ¢34,797
d) Financial acceptability of the factor’s offer
The factor’s offer is financially acceptable on a with-recourse basis, giving a net benefit of ¢13,497. On a
non-recourse basis, when the elimination of bad debts is considered, the non-recourse offer from the factor
is financially more attractive than the with-recourse offer giving a net benefit of ¢34,797.

Page | 62
Questions
1. Sir Max Co has annual sales revenue of ¢6 million and all sales are on 30 days’ credit, although
customers on average take ten days more than this to pay. Contribution represents 60% of sales and the
company currently has no bad debts. Accounts receivable are financed by an overdraft at an annual interest
rate of 7%. The company plans to offer an early settlement discount of 1.5% for payment within 15 days
and to extend the maximum credit offered to 60 days. The company expects that these changes will
increase annual credit sales by 5%, while also leading to additional incremental costs equal to 0.5% of
turnover. The discount is expected to be taken by 30% of customers, with the remaining customers taking
an average of 60 days to pay. Evaluate whether the proposed changes in credit policy will increase the
profitability of Sir Max Co.

2. Melly Co has annual credit sales of ¢1million. Credit customers take 45 days to pay. Bad debts are 2%
of sales. The company finances its trade debtors with a bank overdraft, on which interest is payable at an
annual rate of 15%. A factor firm has offered to takeover administration of the debtors’ ledger and
collections for a fee of 2.5% of the credit sales. This will be a non-recourse factoring service. It has also
guaranteed to reduce the payment period to 30 days and will provide finance for 80% of the trade debtors,
at an interest rate of 8% per year. Melly Co estimates that by using the factor firm, it will save
administration costs of ¢8,000 per year. What would be the effect on annual profits if Melly Co decides
to use the factor’s services? Assume a 365-day year.

3. MAG Ltd has current credit sales of ¢1.5million per year. Cost of sales and bad debts are 75% and 1%
of credit sales respectfully.
Cost of sales comprises 80% variable costs and 20% fixed costs, whiles the company’s cost of debt is 12%
p.a. MAG currently allows customers 30 days credit, but is considering increasing this to 60 days credit
in order to increase sales. It has been estimated that this change in policy will increase credit sales by 15%
and bad debts will increase from 1% to 4%. It is not expected that the policy change will result in an
increase in fixed costs and creditors and stocks will be unchanged. Advise whether MAG Ltd should
introduce the proposed policy. Support your answer with relevant computations.

3. Differentiate between factoring and invoice discounting.

5. The annual credit sales of SAO Co are ¢24million. The average age of debtors is one month and the
percentage of bad debts is 1% of the credit sales. The company feels sales could be improved and increased
up to ¢30million if new customers are to be taken on and debtor days increased to an average period of
two months. It is expected that this new policy will increase bad debts to 1.5% of credit sales. Variable
cost is 70% of the selling price and the company’s cost of capital is 20%. Advise whether the company
should take on the new customers.
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Cash Flow Management
Most businesses will hold part of their assets in the form of cash. This may be used to meet some
transitionary motives (payments of wages and salaries, overheads, buy materials, pay taxes, service
debts, and other host of day-to-day transactions), precautionary motives (sales shortfall, strikes, or failure
of a supplier), and for speculative motives (to cater for any unsuspected profitable opportunities, for
example to purchase a competitor’s firm when a fleeting opportunity presents itself). Although cash can
be held for each of the reasons identified above, the decision as to how much cash a particular business
should hold is a difficult one. Failure to carry sufficient cash levels can lead to loss of settlement discounts,
loss of supplier goodwill, poor industrial relations, and potential liquidation. Holding much cash may also
lead to loss of earnings which would otherwise have been obtained by using the funds in another way.
The financial manager must try to balance liquidity with profitability.

Methods of cash management

To ensure that cash is properly managed effectively, a number of procedures and techniques are used and
this includes:
1. Preparation of projected cash flow statements. Cash budget is an important tool since it allows for
both forward planning and control purposes. The cash projections will identify periods when cash
surpluses and deficits are expected. When a cash surplus is expected to arise, managers must decide on
the best use of the surplus funds. When a cash deficit is expected, they must make adequate provision by
borrowing, liquidating assets or rescheduling cash payments and or receipts to deal with this. Having
considered the projected cash flows, management might also consider ways of boosting net cash inflows
by shortening the cash conversion cycle, for example holding less stock or offering early settlement
discount to customers.
2. Cash flow synchronization: - Management should try to reduce the level of cash balances needed by
ensuring that cash outflows occur around the same time as cash inflows. The reduced cash balances mean
lower bank loans.
3. Cash transmission techniques: - when payment from customers is by cheque there is normally a delay
of some number of working days before they are cleared through the banking system. In the case of a
business that receives large amounts in the form of cheques, the opportunity cost in this delay can be very
significant. To avoid this delay, a business could require payments to be made by standing order or by
direct debit.
4. Other measures that can be taken are to defer or reduce dividends, asking receivables to pay early,
postpone the payment of payables, use short-term borrowing (overdraft), and sell surplus assets. The use
of cash flow models may be helpful.

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Cash flow forecasts
Cash flow forecast is an estimate of cash receipts and payments for a future period under existing
conditions.

Cash budgets
A cash budget is a commitment to a plan for cash receipts and payments for a future period after taking
any action necessary to bring the forecast into line with the overall business plan. Cash budgets are used
to assess and integrate operating budgets, plan for cash shortages and surpluses, and to compare with
actual spending. The budget may be drawn up on a daily, weekly, monthly, quarterly and yearly basis.
Cash flow forecasts can be prepared based on:
▪ Receipts and payments forecasts – this is a forecast of cash receipts and payments based on predictions
of sales and cost of sales and the timings of the cash flows relating to these items
▪ Balance sheet (statement of financial position) forecast. This is a forecast derived from predictions of
future balance sheets.
▪ Working capital ratios. Future cash and funding requirements can be determined from the working
capital ratios

Example
The table below shows the cash budget for Cephas plc over the next six months. The company
manufactures bolts and nuts and has its peak sales in December. One-third of sales in any month are paid
for in the month of delivery, with the remainder paid after one month’s credit.
Sales ¢000s
Total of delivery Paid for in month Paid for 1 month later
August 90 30 60
September 90 30 60
October 120 40 80
November 150 50 100
December 600 200 400
January 60 20 40

Note: sales on credit outstanding at the end of July are ¢60,000.

During October an old machine tool will be replaced at a cost of ¢100,000 payable upon installation. Also,
in the November edition of a glossy food and drink magazine that the company sponsors will cost the firm
¢50,000. In January ¢150,000 tax will be payable. Operating lease payments for rent are ¢10,000 each
month for the period. At the beginning of August, the cash balance will be a positive ¢50,000. The table
below shows the other cash payment estimates for the period and are all in ¢000s.

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 Materials Wages Other expenses
August 50 20 10
September 50 20 10
October 55 22 11
November 55 25 9
December 55 30 10
January 55 22 11

Prepare the cash budget for Cephas plc for the six-month period.
Solution
To calculate the cash budget we can split the problem into three stages:
1. Show outflows/payments of cash on when it is actually received rather than when the transaction took
place
2. List the cash inflows in the month of occurrence
3. Display the opening cash balance for each month less the cash surplus (or deficit) generated that month
to show a closing cash balance.
Cash flow forecast for the six months
Aug Sept Oct Nov Dec Jan
¢ ¢ ¢ ¢ ¢ ¢
Payments
Materials 50 50 55 55 55 55
Wages 20 20 22 25 30 22
Rent 10 10 10 10 10 10
Other expenses 10 10 11 9 10 11
New machine - - 100 - - -
Sponsorship - - - 50 - -
Tax payable - - - - - 150
Total payments 90 90 198 149 105 248
Receipts
Sales (same month) 30 30 40 50 200 20
Sales (month after) 60 60 60 80 100 400
Total receipts 90 90 100 130 300 420
Balances
Surplus/deficit 0 0 (98) (19) 195 172
Opening balance 50 50 50 (48) (67) 128
Closing balances 50 50 (48) (67) 128 300

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Example
Mark Price has worked for some years as a sales representative, but has recently been made redundant.
He intends to start up a business on his own account, using ¢15,000 which he currently has invested with
a micro finance firm. Mark maintains a bank account showing a small credit balance, and he plans to
approach his bank for the necessary additional finance. Mark provides the following additional
information.
a) Arrangements have been made to purchase non-current assets costing ¢8,000. These will be paid for
at the end of September and are expected to have a five-year life, at the end of which they will possess a
nil residual value.
b) Stocks costing ¢5,000 will be acquired on 28 Sept. and subsequent monthly purchases will be at a
level sufficient to replace forecast sales for the month.
c) Forecast monthly sales are ¢3,000 for October, ¢6,000 for November and December, and ¢10,500
from January 2013 onwards.
d) Selling price is fixed at the cost of inventory plus 50%.
e) Two months' credit will be allowed to customers but only one month's credit will be received from
suppliers of inventory.
f) Running expenses, including rent but excluding depreciation of fixed assets, are estimated at ¢1,600
per month.

Mark Price intends to make monthly cash drawings of ¢1,000. Prepare a cash flow budget for the six
months to 31 March 2013

Solution
The opening cash balance at 1 October is ¢7,000 which consists of Mark's initial ¢15,000 less the ¢8,000
expended on non-current assets purchased in September. Cash receipts from credit customers arise two
months after the relevant sales.
Payments to suppliers are a little trickier. We are told that cost of sales is 100/150 x sales. Thus for October
cost of sales is 100/150 x ¢3,000 = ¢2,000. These goods will be purchased in October but not paid for
until November. Similar calculations can be made for later months. The initial inventory of ¢5,000 is
purchased in September and consequently paid for in October. Depreciation is not a cash flow and so is
not included in a cash flow forecast. Figures are in ¢00

Cash flow forecast for the six months ending 31st March 2013
Oct Nov Dec Jan Feb Mar
Payments
Suppliers 50 20 40 40 70 70

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Running expenses 16 16 16 16 16 16
Drawings 10 10 10 10 10 10
76 46 66 66 96 96
Receipts
Accounts receivable – – 30 60 60 105
Surplus/(shortfall) (76) (46) (36) (6) (36) 9
Opening balance 70 (6) (52) (88) (94) (130)
Closing balance (6) (52) (88) (94) (130) (121)

Example
Samuel Ltd is a supplier of computers and in recent times the company is experiencing liquidity problems.
It has an overdraft and the bank has been pressing for a reduction in this overdraft over the next six months
but the company is unwilling to raise finance through long-term borrowing. The statement of financial
position of the business at the last day of its financial year in November is as follows:
Fixed asset
Freehold land and premises at cost 250
Less Accumulated depreciation 24 226
Fixtures and fittings at cost 174
Less Accumulated depreciation 38 136
362
Current assets
Stock at cost 142
Debtors 120 262
624
Shareholder’s equity and reserves
¢1 ordinary shares 200
Retained earnings 109 309

Current liabilities
Trade creditors 145
Bank overdraft 126
Corporation tax 24
Dividend 20 315
624

The following projections for the next six months are available

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1. Sales and purchases for the six months are as follows
Sales Purchases
¢000 ¢000
December 160 150
January 220 140
February 240 170
March 150 110
April 160 120
May 200 160
2. 70 percent of sales are on credit and 30 percent are cash sales. Credit sales are received in the following
month. All purchases are on one month’s credit.
3. Wages are ¢40,000 for each of the first three months. However, this will increase by 10% from March.
All wages are paid in the month they are incurred.
4. The gross profit percentage on goods sold is 30%
5. Administration expenses are expected to be ¢12,000 in each of the first 4 months and ¢14,000 in
subsequent months. These figures include a monthly depreciation of ¢4,000 in respect of depreciation of
fixed assets. Administration expenses are paid in the month they are incurred.
6. Selling expenses are expected to be ¢8,000 per month except for May when an advertising campaign
costing ¢12,000 will be paid for. The advertising campaign will commence at the beginning of June.
Selling expenses are paid for in the month they are incurred.
7. The dividend outstanding will be paid in December
8. The company intends to purchase, and pay for, new fixtures and fittings at the end of April for ¢28,000.
These will be delivered in June.
You are required to prepare a cash flow budget for Samuel Ltd for each of the six months and prepare a
projected profit and loss account for the six months to 31 May. Discuss ways in which the company might
reduce the bank overdraft as required by the bank.

Cash Management Models

Models have been developed which attempt to set cash levels at a point, or within a range, which strikes
the best balance between the costs associated with holding too little cash or too much cash. Cash
management models are aimed at minimising the total costs associated with movements between:
❖ A current account (very liquid but not earning interest) and
❖ Short-term investments (less liquid but earning interest)
The models are designed to answer the following questions:
At what point should funds be moved?
How much should be moved in one go?

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There is however the danger of managers using these models in a mechanical fashion, and neglecting to
apply the heavy dose of judgement needed to allow for the less easily quantified variables ignored by the
models.

The Baumol cash management model

The model assumes that the firm operates in a steady state environment where it uses cash at a constant
rate which is entirely predictable. Baumol model is based on the idea that deciding on optimum cash
balances is like deciding on optimum inventory levels and therefore, developed a model based on the
economic order quantity (EOQ).
The formula calculates the amount of funds to inject into the current account or to transfer into short-term
investments at one time:
2CS
Q=√
I

Where C = transaction costs (brokerage, commission, etc)

S = demand for cash over the period
I = interest cost of holding cash

Example
A company generates ¢10,000 per month excess cash, which it intends to invest in short-term securities.
The interest rate it can expect to earn on its investment is 5% pa. The transaction costs associated with
each separate investment of funds is constant at ¢50.
a) What is the optimum amount of cash to be invested in each transaction?
b) How many transactions will arise each year?
c) What is the cost of making those transactions pa?
d) What is the opportunity cost of holding cash pa?

Solution
2 x 50 x 10,000 x 12
a) Cash investment, Q = √
0.05

= ¢15,492

120,000
b) Number of transactions per annum =
15,492

= 7.75 times
c) Annual transaction cost = 7.75 x ¢50
= ¢387
d) Annual opportunity cost = 5% x 15,492/2 = ¢387

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Example
Appearance Co faces a fixed cost of ¢4,000 to obtain new funds. There is a requirement for ¢24,000 of
cash over each period of one year for the foreseeable future. The interest cost of new funds is 12% per
annum; the interest rate earned on short-term securities is 9% per annum. How much finance should
Appearance Co raise at a time?

Solution
The cost of holding cash is 12% – 9% = 3%
2 x 4,000 x 24,000
The optimum cash transfer is: Q =√
0.03

= ¢80,000
The optimum amount of new funds to be raised is ¢80,000.

Drawbacks of the Baumol model/Assumptions

The inventory approach illustrated above has the following drawbacks.
a) In reality, it is unlikely to predict amounts required over future periods with much certainty.
b) No buffer inventory of cash is allowed for. There may be costs associated with running out of cash.
c) There may be other normal costs of holding cash which increases with the average amount held.
d) Cash use is steady and predictable
e) Day-to-day cash needs are funded from current account

The Miller-Orr cash management model

The Miller-Orr model controls irregular movements of cash flows by setting up an upper and lower control
limits on cash balances. The model is used for setting the target cash balance and has the advantage of
incorporating uncertainty in the cash inflows and outflows. The Miller-Orr model manages to achieve a
reasonable degree of realism. We can begin looking at the Miller-Orr model by asking what will happen
if there is no attempt to manage cash balances. Clearly, the cash balance is likely to 'meander' upwards or
downwards. The Miller-Orr model imposes limits to this meandering. The diagram below shows how the
model works over time. The model sets higher and lower control limits, P and Q, respectively, and a target
cash balance, R. If the cash balance reaches an upper limit (point P) the firm buys sufficient securities
to return the cash balance to a normal level (called the 'return point', point R). When the cash balance
reaches a lower limit (point Q), the firm sells securities to bring the balance back to the return point.

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 P Upper limit

Purchase of securities

R Return point

Sale of securities

Q Lower limit

Time

How are the upper and lower limits and the return point set? The lower limit, Q is set by management
depending upon how much risk of a cash shortfall the firm is willing to accept, and this, in turn, depend
both on accesses to borrowings and on the consequences of a cash shortfall. Miller and Orr further showed
that the answer to this question depends on the variance of cash flows, transaction costs and interest
rates.
If the day-to-day variability of cash flows is high or the transaction cost in buying or selling securities is
high, then wider limits should be set. If interest rates are high, the limits should be closer together. To
keep the interest costs of holding cash down, the return point is set at one-third of the distance (or 'spread')
between the lower and the upper limit. Thus,
1
Return point = lower limit + ( x spread), where
3
3 Transaction cost x Variance of cash flows 1/3
Spread = 3{ x }
4 Interest rate

Variance and interest rates should be express in daily terms.

To use the Miller-Orr model, it is necessary to follow the steps below.
1. Set the lower limit for the cash balance. This may be zero, or it may be set at some minimum safety
margin above zero.
2. Estimate the variance of cash flows, for example from sample observations over a 100-day period.
3. Note the interest rate and the transaction cost for each sale or purchase of securities (the latter is
assumed to be fixed).
4. Compute the upper limit and the return point from the model and implement the limits strategy.
You may be given the needed information to help you through the early steps, as in the example below.

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Example
The following data applies to a company.
1. The minimum set cash balance is ¢8,000.
2. The variance of daily cash flows is 4,000,000, equivalent to a standard deviation of ¢2,000 per day.
3. The transaction cost for buying or selling securities is ¢50. The interest rate is 0.025 per cent per day.
You are required to formulate a decision rule using the Miller-Orr model.

Solution
The spread between the upper and the lower cash balance limits is calculated as follows
3 Transaction cost x Variance of cash flows 1/3
Spread = 3{ x }
4 Interest rate
3 50 x 4,000,000 1/3
= 3{ x }
4 0.025%

= ¢25,303
The return point = lower limit + spread/3
= 8,000 + 25,303/3
= ¢16,434
Upper limit = lower limit + spread
= 8,000 + 25,303
=¢33, 303

Example
The minimum cash balance of ¢20,000 is required at Victoria Co, and transferring money to or from the
bank costs ¢50 per transaction. Inspection of daily cash flows over the past year suggests that the standard
deviation is ¢3,000 per day. The interest rate is 0.03% per day. Calculate:
i) The spread between the upper and lower limits
ii) The upper limit
iii) The return point
[Answers: ¢31,201; ¢51,201; ¢30,400]

The usefulness of the Miller-Orr model is limited by the assumptions on which it is based. However, the
Miller-Orr model may save management time which might otherwise be spent in responding to those cash
inflows and outflows which cannot be predicted.

Question
Gossip Co, a subsidiary of Liar Co, has set a minimum cash account balance of ¢7,500. The average cost
to the company of making deposits or selling investments is ¢18 per transaction and the standard deviation
of its cash flows was ¢1,000 per day during the last year. The average interest rate on investments is 5.11%
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pa. Determine the spread, the upper limit and the return point for the cash account of Gossip Co using the
Miller-Orr model and explain the relevance of these values for the cash management of the company.

Management Creditors or Account Payables

Trade credit is the simplest and most important source of short-term finance for many companies. Again,
the management of account payables (creditors) is a balancing act between liquidity and profitability.
Delaying payments to suppliers to obtain ‘free’ source of money could be suicidal to the organisation
a) Supplier may refuse to supply in future
b) Supplier may only supply on a cash basis
c) There may be loss of reputation

When a company credit purchase from its suppliers, it is always advisable that when the suppliers
offer discounts for prompt payments, careful consideration would be given to paying up within
the discount period. The cost of discount forgone within a year can be very huge.

Question
AIPD Ltd is a wholesaler and distributor of electrical components. The most recent financial statements
of the business revealed the following: Amounts are in cedis

Statement of income for the year ended 31 December

Sales 14.2
Cost of sales (7.8)
Gross profit 6.4
Administration expenses (3.0)
Distribution expenses (2.1)
Finance cost (0.8)
0.5
Corporation tax (0.2)
Net profit 0.3

Statement of financial position as at 31 December

Fixed assets
Land and buildings 3.8
Equipment 0.9
Motor vehicles 0.5
5.2

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Current assets
Stock 3.8
Trade debtors 3.6
Cash at bank 0.1
12.7

Capital and reserves

Ordinary ¢1 shares 2.0
Retained earnings 1.8
Long-term liabilities
Debentures 3.5
Current liabilities
Trade creditors 1.8
Bank overdraft 3.6
12.7

In recent months, trade creditors have been pressing for payment. Management have thus decided to
reduce the level of trade creditors to an average of 40 days outstanding and in order to achieve this, they
approached a bank with the view of securing an additional overdraft to finance the necessary payments.
The company is currently paying 12% interest on the overdraft. No dividend has been paid to ordinary
shareholders for the past three years
a) Comment on the liquidity position of the business
b) Calculate the amount of finance required in order to reduce trade creditors as shown on the balance
sheet, to an average of 40 days outstanding
c) State, with reasons, how you consider the bank would react to the proposal to grant an additional
overdraft facility
d) Evaluate four sources of finance (excluding bank overdraft) that may be used to finance the reduction
in trade creditors and state, with reasons, which of these you consider the most appropriate.

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 CHAPTER SIX

CAPITAL BUDGETING

Introduction
Investment appraisal techniques used are Payback, Discounted Payback, Accounting Rate of
Return/ROCE, Return on Investment, Net Present Value, Internal Rate of Return, Duration and Urgency.
Most firms use more than one method for capital budgeting project appraisal. The NPV profile is the most
useful item as it provides the most complete view of the project.

1. Payback Method
The payback is the length of time it takes for the project’s cash flows to equal its investment. It measures
how long it takes to get the investment capital back.
Decision Rule:
Undertake the project if the payback period is less than a pre-set amount of time.

2. Discounted Payback Method

The discounted payback is the length of time it takes for the project’s discounted cash flows to equal its
investment.
Decision Rule:
Undertake the project if the discounted payback is less than a pre-set amount of time.

Example
The net cash flows for two mutually exclusive projects X and Y are shown below. The cost of capital for
each project is 12%. Compute the NPV, the payback, and the discounted payback for each project. Which
project should the firm choose?
Year Project X Project Y
0 (¢8,000) (¢8,000)
1 ¢4,000 ¢2,000
2 ¢4,000 ¢2,000
3 ¢2,000 ¢4,000
4 ¢2,000 ¢6,000

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Solution
Project X
Payback Discounted payback
Year Cash cumulative cash cumulative
Flow (¢) cash flow (¢) flow (¢) cash flow (¢)
0 (8,000) (8,000) (8,000) (8,000)
1 4,000 (4,000) 3,571 (4,429)
2 4,000 0 3,189 (1,240)
3 2,000 1,424 184
4 2000 1,271
Payback = 2 years Discounted payback = 2.87 years NPV = ¢1,455

Doing same for project Y, we will have the following summary

Project X Project Y
Payback 2 years 3 years
Discounted payback 2.87 years 3.46 years
NPV ¢1,455 ¢2,040

Which of the two projects should be taken first?

Payback ignores the time value of money and both require an arbitrary cutoff value. Payback ignores risk
differences between projects and both ignore cash flows after the payback period.

Example
The payback method has been criticised for not taking into account the time value of money. Could this
limitation be overcome? If so, would this method then be preferable to the NPV method?

3. Accounting Rate of Return (ARR)

Average annual profit
ARR =
Average amount invested

The ARR method distorts all cash flows by averaging them over time. It ignores time value of money. It
may have struck you that ARR and ROCE adopt the same approach to performance measurement and that
could be a popular means of assessing the performance of a business as a whole, after the period has
passed. Again, ARR produces a percentage return that managers understand.

Illustration
Given the two mutually exclusive projects X and Y above, the calculation for ARR for project X could be
illustrated as follows:
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Project X
Average cash inflow = (4,000 + 4,000 + 2,000 + 2,000) / 4
= ¢3,000
Average annual depreciation = ¢2,000
Average annual profit = ¢3,000 - ¢2,000 = ¢1,000
outlay+scrap value
Average amount invested =
2
8,000+0
=
2

= ¢4,000
Thus,
Average cash inflow
ARR =
Average amount invested
1000
=
4000

= 25%
In order to decide whether the 25% return is acceptable, we need to compare this percentage return with
a minimum required return set by the business

4. Urgency
This method says “invest in the project when you absolutely have to.”
Decision rule:
Replace asset after it has completely broken down! It ignores planning ahead, accepting the fact that “A
pound of prevention is worth a pound of cure!”

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 CHAPTER SEVEN

CAPITAL BUDGETING TWO

Introduction
In this chapter we will be looking at how the Finance director should go about making capital investment
decisions using discounted cash flow methods. It should be noted that the required return is the minimum
rate of return that you need to earn to be willing to make an investment. It is the rate of return that
compensates you for the risk of the expected future cash flows.

Present value
From the compound interest formula of At = p (1 + r) t, you could make p the subject as:
𝐴𝑡
p=
(1+𝑟%)𝑡

P (principal) would now be called present value (PV) and At, the future amount to be received or to be
paid. The process of dividing the future amount at the opportunity cost of capital, r over a period of time,
t to obtain the present value is called discounting. Thus, present value is obtained by discounting all net
future cash flows associated with an investment/project at the opportunity cost of capital over the life
of the project. The r value will now be called the discount rate or cost of capital.

Example: An amount of ¢242 is to be received from a customer in two years’ time. Calculate the present
value of this amount at a discount rate of 10% p.a.
Solution:
The future amount to be received, At = ¢242, discount rate, r = 10%, t = 2 years
Thus, the present value would be calculated as:
242
PV = = ¢200
(1+10%)2
1
The present value could also be calculated as, PV = 242 x
(1+10%)2

= 242 x 0.82645
= ¢200
Example
If a company expects to earn at a rate of return of 15% compound interest on its investments, how much
would it need to invest now to have the following investments?
(a) ¢11,500 after 1 year
(b) ¢15,000 after 3 years

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Solution
The discounting formula to calculate the present value of a future sum of money at the end of n time
periods is
1
PV = FV x
(1 + r ) n
1
(a) After 1 year, ¢11,500  = ¢10, 000
1.15
Or ¢11,500 x 0.8696 = ¢10,000
(b)
After 3 years, 15,000 x 1/1.153 = ¢9862.74
Or ¢15,000 x 0.6575 = ¢9862.74
The figures 0.82645, 0.8696 and 0.6575 are called discount factors and can be obtained from the present
value/discount tables (copy is at the back of the book)

Example:
Fire Ltd is thinking of investing in a new technology company. There are two possible investments, whose
profits can be summarized as follows:
▪ Option 1 gives a profit of ¢300,000 in 6 years’ time.
▪ Option 2 gives a profit of ¢500,000 in 9 years’ time.
Which option should the company choose if it uses a discount rate of 20% p.a for future profits?

Solution
Fire Ltd has to compare amounts of money generated at different times, and can do this by comparing the
present value of each.
▪ Option 1 has i = 20%, n =6 and A6 = 300,000.
Then: PV = A6 × (1 + 20%)-6
= 300,000 × 0.3349
= ¢100,470
▪ Option 2 has i = 20%, n = 9 and A9 = 500,000.
Then: PV = A9 × (1 +20%)-9
= 500,000 × 0.1938 = ¢96,900

Example:
For the following net cash flows, calculate the net present value using a discount rate of 12%. Amounts
are in millions of cedis
Year 0 1 2
A -3000 1400 2600
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Solution:
Year cash flow DF (12%) PV
0 (3000) 1.000 (3000)
1 1400 0.893 1250
2 2600 0.797 2072
NPV = 322

The Net Present Value Method

Net present value or NPV is the value obtained by discounting all cash outflows and inflows of a capital
investment project at a given rate of return or cost of capital.
Decision rule:
When NPV > 0 (Accept project)
When NPV < 0 (Reject project)

Example: A company is considering a capital investment, where the estimated cash flows are as follows.
Year 0 1 2 3 4
Cash flows (¢) (100,000) 60,000 80,000 40,000 30,000
The company’s cost of capital is 15%. You are required to calculate the NPV of the project and to assess
whether it should be undertaken.

Solution
Year 0 1 2 3 4
Cash flow (¢) (100,000) 60,000 80,000 40,000 30,000
DF (15%) 1.000 0.870 0.756 0.658 0.572
PV (100,000) 52,200 60,480 26,320 17,160
NPV = ¢56,160
The PV of cash inflows exceeds the PV of cash outflows by ¢56,160, which means NPV is positive and
that the project should therefore be undertaken.

Advantages of NPV
To make a sensible investment decision, an investment appraisal method that takes account of all the costs
and benefits of each investment opportunity and also, makes a logical allowance for the timing of those
costs and benefits should be employed. The NPV technique makes use of the above concepts. The
discount rates/cost of capital employed is influence by factors such as interest rates on the funds forgone,

Page | 81
inflation rates and the risks associated with the investment. For these reasons the NPV technique is very
valuable and it incorporates the following:
- Time value of money: - by discounting the various net cash flows associated with each project
according to when they are expected to arise, NPV takes account of the time value of money
- Opportunity cost of investors’ funds
- The whole of relevant and incremental cash flows are considered
- Discounting cash flows to a common point in time
- The essence of being cash flow based rather than accounting profit based

Net Cash Flows

In practice, all benefits and costs associated with an investment are measured in terms of net cash flows
and not earnings or profits. Thus, all non-cash cash items such as depreciation, provisions, profit/loss on
disposal of assets should not be included in the appraisal process. Also, do not include all sunk costs
meant for research or feasibility studies before carrying out the investment even though, that is normally
a cash transaction. Then again, cash flows must be on an incremental (or marginal) basis.
Benefits/ Cash inflows: - includes receipts from sale of goods and services and receipts from sale of
physical assets
Cash outflows: - may be expenditure on materials, labour, selling and administrative costs, finance
costs/interest and taxes

Example:
A senior management team at Railcam, a supplier to the railway industry, is trying to prepare a cash flow
forecast for the year’s 20x1 – 20x5. The estimated sales are:
Year 20x1 20x2 20x3 20x4 20x5
Sales (¢) 20m 22m 24m 21m 25m
These sales will be made on 3 months’ credit and there will be no bad debts. There are only 3 cost elements.
The first is wages amounting to ¢6m p.a. 2nd, raw materials costing half of sales of the year. Raw material
supplier grants 3 months of credit.
3rd, direct OH at ¢5m per year. Calculate the net operating cash flow for the year’s 20x2 – 20x4. Start
date: 1.1.20x1.

Question:
Consider a firm that needs to buy a new Air-condition system. They only need one but the choice is down
to two systems:
1. System Q has high up-front costs and low maintenance costs.
2. System R is inexpensive, but has high maintenance costs.

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Either system will offer savings over the system in place at the firm now. The existing system at the firm
costs GH¢400 per year to maintain. Again, the system already in place at the firm can be sold for GH¢400
at time 0.
The costs to purchase and maintain the two alternative systems are as follows:
Year 0 1 2 3 4 5
Q -1,000 -50 -50 -50 -50 -50
R -600 -200 -250 -300 -350 -400
The firm’s cost of capital is 15% and depreciates its fixed assets on a reducing balance basis. Which of
the two systems should the firm buy using the NPV appraisal method?

Annuity
It is an arrangement whereby fixed sum is paid now in exchange for regular amounts to be received at
fixed intervals for a specific period of time. If an annuity consists of payments ¢A over n years subject to
a discount rate of i%, then (assuming an ordinary annuity) the present values of the 1st, 2nd, 3rd… n-th
payments (at the end of the 1st, 2nd, 3rd …….n-th years) is given by:
A A A A
P= + + + ................. +
1 + i (1 + i ) (1 + i )
2 3
(1 + i )
n

This is a GP whose sum is given by

(𝟏−(𝟏+𝒊)−𝒏
P =𝑨[ ]
𝒊

The expression in the square bracket gives the annuity factor. Given the discount rate, i and an annuity
that runs for n years, the annuity factor could be obtained from the annuity tables (at the end of this
handbook).

The annuity concept is so beneficial that amortization of personal loans from the bank is a familiar fixed-
term annuity. Other examples include mortgages (assuming a steady interest rate), and some leasing
arrangements.

Amortisation of debt
If an amount of money is borrowed now and it is to be paid over a period of time, one way of repaying
the debt is by amortization. This consists of a regular annuity in which each payment accounts for both
repayment of capital and interest.

Example
A company negotiated a loan of ¢200,000 over 15years at 10.5% per annum. Calculate the annual payment
necessary to amortize the debt.

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Solution
(𝟏−(𝟏+𝒊)−𝒏
From the formula: P =𝑨[ ], we have, on substitution
𝒊
(𝟏−(𝟏+𝟏𝟎.𝟓%)−𝟏𝟓
200,000 = 𝑨[ ]
𝟏𝟎.𝟓%

200,000 = 7.3950A
A = ¢27,045.30
Question
David took ¢4000 personal loan from the bank at a monthly interest rate of 4% for a period of 5 years.
Calculate how much David would be paying monthly towards the amortization of this debt. (Answer: A=
¢176.81)
Question
A mortgage of ¢25,000 is to be repaid over 20 years at an annual discount rate of 15%. What annual
repayment would be required to repay the mortgage?

Amortisation Schedule
An amortization schedule is a period by period (normally year by year) of the state of the debt. It is usual
to show for each year:
a. Amount of debt outstanding at beginning of year;
b. Interest paid,
c. Annual re-payment.

Example:
A debt of ¢5000 with interest at 5% p.a compounded 6 – monthly is to be amortized by equal semi –
annual payments over the next three years
a. Find the value of each payment
b. Construct an amortization schedule.

Solution
Making the standard time period of 6 months, the interest rate is 5%/2 = 2.5% with n = 6 time periods.
i.e., P = 5000; n = 6 repayment annuity. From the annuity formula,
¢907.75 = A (six-monthly payments)
The amortization schedule is shown below.

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 6-months Outstanding Interest Payment Principal
(2.5%) paid
1 5000.00 125.00 907.75 782.75
2 4217.25 105.43 907.75 802.32
3 3414.93 85.37 907.75 822.3
4 2592.55 64.81 907.75 842.94

Perpetuity
5 1749.61 43.74 907.75 864.61
Perpetuity6 is a special885.61 22.14a contract907.75
case of an annuity where 885.61
runs indefinitely, there being no end to the
payments. From the annuity formula, if we take the limit as n goes to infinity, (1 + r)−𝑛 goes to zero and
the present value of perpetuity is simply:
𝐴
PV =
𝑟

Example:
For example, the PV of ¢1 per annum in perpetuity at a discount rate of 10% would be ¢1/0.10 = ¢10.
Similarly, the PV of ¢ 1 per annum in perpetuity at a discount rate of 15% would be
¢1/0.15 = ¢6.67 and at a discount rate of 20% it would be ¢1/0.20 = ¢5.

Example:
An organization with cost of capital of 14% is considering an investment in a project which will cost
¢500,000 now and would yield net cash inflows of ¢100,000 per annum in perpetuity. Assess whether the
project should be undertaken.
Solution:
Year Cash flow Discount factor 14% Present value
0 (¢500,000) 1.000 (500,000)
1-  ¢100,000 1/0.14=7.143 714,300
NPV = ¢214,300
The NPV is positive and so the project should be undertaken.

Question
A business project is being considered which has ¢12,000 initial costs and associated revenues (i.e.,
inflows) over the following four years of ¢8,000, ¢12,000, ¢10,000 and ¢6,500 respectively. If the project
costs (i.e. outflows) over the following four years are estimated as ¢8,500, ¢3,000, ¢1,500 and ¢1,500
respectively and the discount rate is 18.5%, evaluate the project’s NPV.

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Example
A company is considering buying a machine which will improve its cash flows by ¢30,000 per annum for
the next five years, at the end of which the machine will be worn out and of no value. The machine will
cost ¢75,000, and will be bought for cash. The discount rate which the company assumes is suitable is
15%. Calculate the net present value of this project.

Solution
Year Cash flow DF (15%) PV
0 (75,000) 1.000 (75,000)
1-5 30,000 3.352 100,560
Net present value 25,560

Since the project has a positive NPV, it means that the company will be getting a return on its investment
of more than 15%.
Note: The discount factor of 3.352 can be found from the annuity tables, and is used to save the effort of
multiplying ¢30,000 in turn by the individual figures from present value tables for years 1 to 5 inclusive.

Incorporating Working Capital

One of the consequences of any new project, apart from the initial outlays and the annual cash inflows
which arise from it, is that working capital is often increased. Increased sales mean that debtors would
increase, as do stocks of raw materials, work-in-progress, and stocks of finished goods. On the other hand
creditors also tend to increase, but not usually to the same extent. This increase of working capital is
almost immediate as far as the project is concerned, and it lasts for the life of the project although it may
fluctuate during the time, and is released at the end of the project when debtors pay up and the stock return
to nil. All we have to do is to introduce the increase in working capital as:
➢ A cash outflow at year 0 (start of year 1);
➢ A cash inflow at project end.
In order to see how this operates, we will re-work the example above.

Example
A company is considering buying a machine which will improve his cash flows by ¢30,000 per annum for
the next five years, at the end of which the machine will be worn out and of no value. The machine will
cost ¢75,000, and will be bought for cash. The discount rate which the company assumes is suitable is
15%. Calculate the net present value of this project. ¢40,000 of working capital will be required at the
beginning of the project.

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Solution
Year Detail Cash flows (¢) DF (15%) PV
0 Purchase of machine (75,000) 1.000 (75,000)
0 working capital (40,000) 1.000 (40,000)
1-5 Net cash inflow 30,000 3.352 100.560
5 Working capital 40,000 0.497 19,880
Net present value 5,440
The project is still worthwhile with a positive NPV of ¢5,440 at a discount rate of 15%
Calculations which take working capital into account are more realistic, since working capital is a factor
that should not be ignored. It has to be financed, a fact which sometimes comes as an unpleasant surprise
to businessmen who overlook it. The treatment of working capital is thus as follows:
Initial investment is a cost at the start of the project
At the end of the project all working capital is ‘released’ and treated as a cash inflow

Example
A company expects sales for a new project to be ¢225 in the first year growing at 5% pa. The project is
expected to last for 5 years. Working capital, equal to 10% of annual sales is required and needs to be in
place at the start of each year. Calculate the working capital flows for incorporation into the NPV
calculation

Solution
Year 0 1 2 3 4 5
Sales 225 236 248 260 273
WC (10%) 22.5 23.6 24.8 26.0 27.3
The working capital treatment in the appraisal process takes into consideration the timing of that capital
requirement and the incremental costs associated with it. The initial working capital amount of ¢22.5 is to
be provided at the beginning of year one and so it should be placed under year 0. This is redeemed at the
end of year 1, but year 2 requires ¢23.6 and so an additional cash outflow of ¢1.1 is needed to top up the
22.5 cedis to get the total working capital requirement for year 2. The final treatment is as follows:
Year 0 1 2 3 4 5
WC (22.5) (1.1) (1.2) (1.2) (1.3) 27.3

The NPV profile

An NPV profile plots the project’s NPV as a function of the discount rate. It can be used to identify the
range of cost of capital at which the project would add value to the firm. Given a conventional project

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which has only one initial cash outlay followed by one or more future net cash inflows, a graph of discount
rate against NPV could be drawn which would have the following shape, called NPV profile.

$ 6 ,0 0 0

$ 5 ,0 0 0

$ 4 ,0 0 0

$ 3 ,0 0 0

$ 2 ,0 0 0

$ 1 ,0 0 0

$-
0% 5% 10% 15% 20% 25%

$ (1 ,0 0 0 )

$ (2 ,0 0 0 )

The graph above shows that at a discount rate of about 17%, NPV is zero and that at discount rates less
than 17% NPV is positive. Beyond that rate NPV is negative making projects not worthwhile.

Internal Rate of Return (IRR)

Internal rate of return (IRR) is a technique of investment appraisal which is related to the NPV method
earlier. In simple terms IRR is the discount rate that sets NPV of the expected cash flows to zero or the
discount rate which applies when the PV of outflows and the PV of inflows are equal.

Decision Rule: The IRR method of investment appraisal is to accept projects whose IRR (the rate at which
the NPV is zero) exceeds a target rate of return, r. The IRR is calculated using interpolation
Without a computer or calculator program, the calculation of the internal rate of return is made using a
technique known as the interpolation method.
Step 1 Calculate the net present value using the company’s cost of capital.
Step 2 Having calculated the NPV using the company’s cost of capital re-calculate the NPV using a second
discount rate.
Step 3 Use the two NPV values and the two discount rates to estimate the IRR. The formula to apply is
as follows.
 NPVa 
IRR  a %+  (b − a ) %
 NPVa − NPVb 
Where, a = the lower of the two rates of return used

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 b = the higher of the two rates of return used
NPVa = the NPV obtained using rate a
NPVb = the NPV obtained using rate b

Example
A company is trying to decide whether to buy a machine for ¢80,000 which will save costs of ¢20,000 per
annum for 5 years and which will have a resale value of ¢10,000 at the end of year 5. Calculate the projects
IRR

Solution
Step 1 Calculate NPV1 using a discount rate of 10%
Year Cash flow PV factor 10% PV
0 (80,000) 1.000 (80,000)
1–5 20,000 3.791 75,820
5 10,000 0.621 6,210
NPV = 2,030
This is positive, which means that the IRR is more than 10%
Step 2 Calculate the second NPV, using a rate that is greater than the first rate. As the first rate gave a
positive answer let’s use a discount rate of 12%
Year Cash flow PV factor 12% PV
0 (80,000) 1.000 (80,000)
1-5 20,000 3.605 72,100
5 10,000 0.567 5,670
NPV = (2,230)
This is fairly close to zero and negative. The IRR is therefore greater than 10% (positive NPV of ¢2,030)
but less than 12% (negative NPV of ¢2,230)
Step 3 Use the two calculated NPV values to estimate the IRR.
Using the formula
 NPVa 
IRR  a +   ( b − a ) %
 NPVa − NPVb 
 2030 
IRR  10 +   (12 − 10 ) %
 2030 + 2230 
IRR  10.95%

If it is company’s policy to undertake investments which are expected to yield 10% or less, this project
would be undertaken.

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Example:
Find the IRR of the project given below and state whether the project should be accepted if the company
requires a minimum return of 17%
Time 0 1 2 3 4
Cash flow (4,000) 1,200 1,410 1,875 1,150

Solution
Time Cash flow DF (16%) PV DF (14%) PV
0 (4,000) 1.000 (4,000) 1.000 (4,000)
1 1,200 0.862 1,034 0.877 1,052
2 1,410 0.743 1,048 0.769 1,084
3 1,875 0.641 1,202 0.675 1,266
4 1,150 0.552 635 0.592 681
NPV = (81) NPV = 83
The IRR must be less than 16%, but higher than 14%. The NPVs at these two costs of capital will be used
to estimate the IRR.
Using the interpolation formula:
 NPVa 
IRR  a +   ( b − a ) %
 NPVa − NPVb 
83
IRR = 14% +   (16% − 14%)  = 15.01%
83 + 81
The project should be rejected as the IRR is less than the minimum return demanded

Non-conventional cash flow projects

A non-conventional project may have several net cash outflows and inflows. That is some net cash
outflows may occur in the future. For example, an environmental clean-up cost at the end of a project or
a major overhaul during the project’s life.

Example
Consider a proposal to mine asbestos in an ecologically sensitive area. The project will require investment
of ¢5.2million today, generate ¢12.3 million cash inflow at the end of year one and require shut down and
reclamation expenses of ¢7.25 million at the end of year 2. At a discount rate of 12%, the project has a
zero NPV. Does that mean that if our cost of capital is 10% that we should start the project?
Fig: NPV Profile of Non-Conventional Projects

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 $40

$0
0% 5% 10% 15% 20% 25% 30%

($40)

($80)

($120)

($160)

Lack of knowledge of multiple IRRs could therefore lead to serious errors in the decision of whether to
accept or reject a project. In general, if the sign of the net cash flow changes in successive periods, the
calculations may produce as many IRRs as there are sign changes. IRR should not normally be used when
projects have non-conventional cash flows. Thus, the main problem with non-conventional cash flow
projects is that multiple IRRs create a number of possible solutions

NPV and IRR Compared

Most of the time NPV and IRR are both valuable guides to making decisions and there are advantages and
disadvantages to each appraisal method. Make sure that you can discuss them. There are occasions,
however, where NPV and IRR disagree and when in doubt, you can trust the NPV. The main advantage
of the IRR method is that the information it provides is more easily understood by managers, especially
non-financial managers.

Kinds of Projects
- Independent and/ divisible
Two or more projects are independent and/ divisible if undertaking one does not affect the other. But the
limitation is the fund available for the projects. Capital rationing is the situation when the organisation has
several projects that they wish to invest in, but have a limited amount of capital available for investment.
Profitability index (PI) is applied to investments where projects are divisible in order to maximise the
benefits to be derived from the investment.

- Mutually Exclusive Projects

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Two projects are mutually exclusive and/indivisible if undertaking one precludes taking the other, even
though other projects may be acceptable in terms of the decision rules for independent selection. To
maximized investments in projects that are mutually exclusive, use the calculated NPV values to do the
ranking.

Profitability index
When there is a limited capital in only one year (single-period capital rationing) then we will need to rank
all positive NPV and divisible projects based on the profitability index to maximise the investment. The
profitability index (PI) is a ratio which compares the absolute value of the discounted cash inflows with
the original investment. The calculation required is:
PI = PV of Cash inflows
Initial investment
NPV
=1+
Initial investment

Example
XYB limited is considering two divisible one-year projects, whose cash flows are shown below. The cost
of capital for either project is 12%. Compute the NPV and the PI for each project and indicate which one
should be undertaken.
Project CF0 CF1
Alpha (¢1,000) ¢1,200
Beta (¢8,000) ¢9,200

Solution
Alpha Beta
Year 0 cash flows (¢1,000) (¢8,000)
Year 1 cash flows ¢1,200 ¢9,200
NPV @ 12% 71.43 214.29
PI 1.071 1.027

Based on the NPV calculations project Beta would be selected over Alpha but for divisible projects, the
ranking and selection of projects to maximise the investment is done by the use of profitability index and
for that reason, Alpha may be pursued over Beta. Note that Profitability index (PI) is applied to
investments where projects are divisible in order to maximise the benefits to be derived from the
investment.

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Example
The Washer division of Plumber plc is permitted to spend ¢5m on investment projects at time zero. The
cost of capital is 12% and all projects are divisible and none may be repeated. The cash flows for five
proposed projects are:
Year 0 1 2 3 4
G -1.5 0.5 0.5 1.0 1.0
H -2.0 0.0 0.0 0.0 4.0
J -1.8 0.0 0.0 1.2 1.2
K -3.0 1.2 1.2 1.2 1.2
L -0.5 0.3 0.3 0.3 0.3

a. Which projects should be undertaken to maximise NPV in the presence of the capital constraint?
b. If the Washer division was able to undertake all positive NPV projects, what level of NPV could be
achieved?
c. If you now assume that these projects are indivisible, how would you allocate the available ¢5m

Solution
Project G
NPV = - 1.5 + (0.5×0.8929) + (0.5×0.7972) + (1×0.7118) + (1×0.6355)
= 0.6924 (Accept project)
Project H
NPV = - 2.0 + (4×0.6355) = 0.5420 (Accept)
Project J
NPV = - 1.8 + (1.2×0.7118) + (1.2×0.6355) = -0.18324 (Reject)
Project K
NPV = - 3.0 + (1.2×3.0373) = 0.6448 (Accept)
Project L
NPV = - 0.5 + (0.3×3.0373) = 0.4112 (Accept)

Summary
Project Investment (¢m) NPV PI Ranking
G 1.5 0.6924 1.4616 2
H 2.0 0.5420 1.2710 3
K 3.0 0.6448 1.2150 4
L 0.5 0.4112 1.8220 1

a) Allocation of the ¢5m

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Project Investment (¢m) NPV (Available)
L 0.5 0.4112
G 1.5 0.6924 1.0 × 0.6448
H 2.0 0.5420 3.0
K 1.0 0.2149
5.0 1.8605
Therefore, the maximum NPV available is ¢1.8605m and the projects that can be taken are L, G, H, and
part of K. Note: PI is the profitability index.
b) If the Washer division is able to undertake all positive NPV projects, then the total level of NPV
expected is the sum of all the positive NPVs and is ¢2.2904
c) Given that all Projects are not divisible but mutually exclusive then, the calculated NPV values will
be used for the ranking
Project Investment (¢m) NPV Ranking
G 1.5 0.6924 1 1
H 2.0 0.5420 3 3
K 3.0 0.6448 2 2
L 0.5 0.4112 4 4
Allocation of ¢5m
Project Investment (£m) NPV
G 1.5 0.6924
K 3.0 0.6448
L 0.5 0.4112
5.0 1.7484
Maximum NPV available when the projects are mutually exclusive is ¢1.7484
From the results obtained in (a) and (c) above, it can be seen that organisations are likely to maximise the
use of their capital outlay on investments or projects that are divisible as against mutually exclusive ones.

Question
The information below was obtained from the organisation of Pretty Face limited.
The net cash flows for six proposed projects are given below. All figures are in thousands of cedis.
Year 0 1 2 3 4 5 6 NPV IRR
A (620) 280 400 120 55 16%
B (640) 80 120 200 210 420 (30) 69 13%
C (240) 120 120 60 10 20 15%
D (1000) 300 500 250 290 72 13%
E (120) 25 55 75 21 19 17%
F (400) 245 250 29 15%
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All except project A are divisible. Project A is a potential fixed three-year contract and cannot be varied.
The company has a limited capital budget of ¢1.2 million and is concerned about the best way to allocate
its capital to the projects listed. The company has a current cost of finance of 10%.
a) Which of the projects should be adopted giving the priorities for investment?
b) What is the NPV and IRR of the projects adopted in a),
c) Estimate the IRR to finance the investments in all of the remaining projects available to it.

[Answers: a) Without project A, maximum NPV is ¢123,000 and with project A, maximum NPV is
¢124,000, thus projects A, B and E should be selected; b) The NPV of the adopted projects is ¢124,000
and IRR is 14.5%; c) IRR = 17.74%]

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 CHAPTER EIGHT

FURTHER ASPECTS OF INVESTMENT APPRAISAL

Incorporating Inflation
Inflation is a general increase in prices leading to a general decline in the real value of money. Inflation
effects can be complex because asset value is a function of both the required return and the expected future
cash flows. In times of inflation, the fund providers will require a return which is made up of two elements:
➢ Real return for the use of their funds
➢ Additional return to compensate for inflation
The overall required return is called the money or nominal rate of return.
Notation:
rr = cost of capital in real terms
rn = cost of capital in nominal terms
i = expected annual inflation rate, then
(1 + rn) = (1 + rr) (1 + i)
The NPV of the project is unchanged as long as the cash flows and the cost of capital are expressed in
consistent terms.
❖ Both in real terms
❖ Both in nominal terms
If inflation is expected to affect revenues and expenses differently then these differences must be
incorporated in the analysis.

Example
An organisation is considering investing ¢4.5m in a project to achieve an annual increase in revenues over
the next five years of ¢2m. The project will lead to an increase in wage costs of ¢0.4m p.a and will also
require expenditure of ¢0.3m p.a to maintain the level of existing assets to be used on the project.
Additional investment in working capital equivalent to 10% of the increase in revenue will need to be in
place at the start of each year.
The following forecasts are made of the rates of inflation each year for the next five years.
Revenue 10% Assets 7%
Wages 5% General Prices 6.5%
The real cost of capital of the organisation is 8%.
All cash flows are in real terms. Selling price and costs are all in current price terms.
The machinery will have zero scrap value at the end of the fifth year. Ignore taxation. Determine whether
the project is worthwhile

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Solution
All amounts are expressed in thousands of cedis
0 1 2 3 4 5
Revenue 2,200 2,420 2,662 2,928 3,221
Wages (420) (441) (463) (486) (510)
Assets (321) (343) (367) (393) (421)
Outlay (4,500)
WC (220) (22) (24) (27) (29) 322
NCF (4,720) 1,437 1612 1,805 2,020 2,612
DF 1.000 0.870 0.756 0.658 0.572 0.497
PV (4,720) 1,250 1,219 1,187 1,155 1,298

NPV = ¢1,389 which suggests that the project is worthwhile

Discount factor calculations

From the fisher formula, (1 + rn) = (1 + rr) (1 + i)
1 + rn = 1.08 x 1.065
rn = 15%
Question
Handsome plc plans to invest ¢7m in a new product. Net contribution over the next five years is expected
to be ¢4.2m pa in real terms. Marketing cost of ¢1.4m pa will also be needed. Expenditure of ¢1.25m pa
will be required to replace existing assets which will be used on the project. Additional investment in
working capital equivalent to 12% of the contribution will need to be in place at the start of each year.
The following forecasts are made of the rates of inflation each year for the next five years:
Contribution 8% Marketing 3%
Assets 4% General prices 4.7%
The real cost of capital of the company is 6% and all cash flows are in real and current terms. Ignore tax.
Determine whether the project is worthwhile. [NPV = ¢1,207,000]

A Little More About Taxes

Since most companies pay tax, the impact of corporation tax must be considered in any investment
appraisal. The impact of taxation on cash flows is such that
 Operating cash inflows will be taxed at the corporation tax rate
 Operating cash outflows will be tax deductible and attract tax relief at the corporation tax rate
 Investment spending attracts capital allowances (or writing down allowances) which get tax relief
 Tax is paid one year after the related operating cash flow is earned (unless told otherwise)

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 Example
A machinery was bought on the first day of the year for ¢10,000 and will be used for four years after
which it will be disposed of on the last day of year 4 for ¢2,500. Tax is payable at 30%, one year in arrears
and capital allowances are available at 25% reducing balance.
a) Calculate the WDA and hence the tax savings/reliefs for each year
b) How would your answer change if the machinery was bought on the last day of the previous accounting
year?

Solution
a) Time WDA Tax relief TRT
Y1 10,000 x 25% = 2,500 x 30% = 750 y2
Y2 7,500 x 25% = 1,875 x 30% = 563 y3
Y3 5,625 x 25% = 1,406 x 30% = 422 y4
Y4 4,219 – 2,500 = 1719 x 30% = 516 y5
7,500 2,251

b) The machinery is still bought at time zero but falls into the previous accounting period for tax purposes.
The overall value of WDAs claimed and therefore the total tax relief remains unchanged, but the timing
and amount of cash flows will alter. Because of time value of money, this will impact on the final value
of the NPV.

Time WDA Tax relief TRT

Y0 10,000 x 25% = 2,500 x 30% = 750 y1
Y1 7,500 x 25% = 1,875 x 30% = 563 y2
Y2 5,625 x 25% = 1,406 x 30% = 422 y3
Y3 4,219 x 25% = 1,055 x 30% = 317 y4
Y4 3,164 – 2,500 = 664 x 30% = 199 y5
7,500 2,251

Example
An organisation wish to buy an asset for ¢26,000 and it will be used for 3 years after which it will be
disposed of on the final day of year 3. Tax is payable at 30% one year in arrears, and capital allowances
are available at 25% reducing balance. Ignore inflation
a) Calculate the WDA and hence the tax savings (relief) for each year if the proceeds on disposal of the asset
is ¢12,500
b) If net trading income from the project is ¢16,000 p.a and the cost of capital is 8%. Calculate the NPV of
the project and indicate if the project is worthwhile.

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 Solution
a) Time WDA Tax relief TRT
Y1 26,000 x 25% = 6500 x 30% = 1,950 y2
Y2 19,500 x 25% = 4875 x 30% = 1,463 y3
Y3 14,625 - 12,500= 2,125 x 30% = 638 y4

c) 0 1 2 3 4
Contribution 16,000 16,000 16,000
Tax (30%) (4,800) (4,800) (4,800)
Outlay (26,000)
Scrap value 12,500
Tax relief 1,950 1,463 638
Net cash flow (26,000) 16,000 13,150 25,163 (4,162)
DF (8%) 1.000 0.926 0.857 0.794 0.735
PV (26,000) 14,816 11,270 19,979 (3,059)
NPV = ¢17,006 (Accept)

Example
For the above example, recalculate for the tax reliefs for each year and the NPV if the asset was bought
on the last day of the previous accounting period and taxes are paid one year in arrears.

Example
Kaiser P is undertaking a project which will require an investment in a new machinery at a cost of ¢10,000.
It will be used on the project for four years after which it will be disposed of on the final day of year 4 for
¢2,500. Tax is payable at 30% one year in arrears, and capital allowances are available at 25% reducing
balance. Net operating cash inflows from the project are expected to be ¢4,000 pa. The company’s cost of
capital is 10%. Ignore inflation.
a) Calculate the WDA and hence the tax reliefs/savings for each year
b) Identify the net cash flows for the project and calculate its net present value
c) How would your answer for the NPV change, in turn, if:
i) The corporation tax rate was increased to 40%
ii) The capital allowance rules were changed to allow a 50% deduction in the first year, with 25%
allowances thereafter.

Example
AGEOM Ltd needs to increase production capacity to meet increasing demand for an existing product,
‘Water’, which is used in food processing. A new machine, with a useful life of four years and a maximum
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output of 600,000 kg of Water per year, could be bought for ¢800,000, payable immediately. The scrap
value of the machine after four years would be ¢30,000. Forecast demand and production of Water over
the next four years is as follows:
Year 1 2 3 4
Demand (kg) 1·4 1·5 1·7 1·8
Demand is in millions of kilogram

Existing production capacity for Water is limited to one million kilograms per year and the new machine
would only be used for demand beyond this capacity. The current selling price of Water is ¢8·00 per kg
and the variable cost of materials is ¢5·00 per kg. Other variable costs of production are ¢1·90 per kg.
Fixed costs of production associated with the new machine would be ¢240,000 in the first year of
production, increasing by ¢20,000 per year in each subsequent year of operation. AGEOM Ltd pays tax
one year in arrears at an annual rate of 30% and can claim capital allowances on a 25% reducing balance
basis. A balancing allowance is claimed in the final year of operation. Additional investment in working
capital equivalent to 10% of the increase in revenue will need to be in place at the start of each year.
AGEOM Ltd uses cost of capital of 10% for all investment projects
a) Calculate the net present value of buying the new machine and advise on the acceptability of the
proposed purchase.
b) Calculate the internal rate of return for the project

Solution
a) NPV calculation
Year 1 2 3 4 5
¢000 ¢000 ¢000 ¢000 ¢000
Contribution 440 550 660 660
Fixed costs (240) (260) (280) (300)
Taxable cash flow 200 290 380 360
Tax (30%) (60) (87) (114) (108)
Tax relief 60 45 34 92
Scrap value 30
Net cash flows 200 290 338 310 (16)
Discount at 10% 0·909 0·826 0·751 0·683 0·621
Present values 182 240 254 212 (10)

Net present value = Total present value - Initial investment

= 878,000 – 800,000
= ¢78,000

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The net present value is positive and so the investment is financially acceptable. However, demand
becomes greater than production capacity in the third and fourth year of operation and so further
investment in new machinery may be needed after two years. The new machine will itself need replacing
after four years if production capacity is to be maintained at an increased level. It may be necessary to
include these expansion and replacement considerations for a more complete appraisal of the proposed
investment. A more complete appraisal of the investment could address issues such as the assumption of
constant selling price and variable cost per kilogram and the absence of any consideration of inflation, the
linear increase in fixed costs of production over time and the linear increase in demand over time. If these
issues are not addressed, the appraisal of investing in the new machine is likely to possess a significant
degree of uncertainty.

b) Internal rate of return evaluation of investment

Year 1 2 3 4 5
Net cash flows 200 290 338 310 (16)
Discount at 20% 0·833 0·694 0·579 0·482 0·402
Present values 167 201 196 149 (6)
Net present value = 707,000 – 800,000
= - ¢93,000
Internal rate of return = 10 + [((20 – 10) x 78)/ (78 + 93)] = 10 + 4·6 = 14·6%

Workings
1. Annual contribution
Year 1 2 3 4
Excess demand (kg/year) 400 500 700 800
New machine output (kg/year) 400 500 600 600
Contribution (¢/kg) 1·1 1·1 1·1 1·1
Contribution (¢/year) 440 550 660 660

2. Fixed costs 1 2 3 4
(240) (240 + 20) (240 + 40) (240 + 60)
(240) (260) (280) (300)
Year 2 3 4 5
3. Taxation (30%) (60) (87) (114) (108)
Taxes are imposed on taxable income

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 4. Capital allowance (CA) tax benefits
Year Amount CA Tax relief Tax year
1 800,000 x 25% 200,000 x 30% 60,000 t2
2 600,000 x 25% 150,000 x 30% 45,000 t3
3 450,000 x 25% 112,500 x 30% 33,750 t4
4 337,500 – 30,000 307,500 x 30% 92,250 t5

Tax and Inflation put together

Combining tax and inflation in the same question does not make it any more difficult than keeping each
item separate. Such problems are best tackled using the money method. Inflate costs and revenues before
determining their tax implications. Also, calculate working capital on these inflated figures, unless given
and use a post-tax money discount rate.

Example
4Kidz Co is a listed company which plans to meet increased demand for its products by buying new
machinery costing ¢5 million. The machinery would last for four years, at the end of which it would be
scraped at a value equal to 5% of the initial cost. Capital allowances would be available on the cost of the
machinery on a 25% reducing balance basis, with a balancing allowance or charge claimed in the final
year of operation. This investment will increase production capacity by 9,000 units per year and all of
these units are expected to be sold as they are produced. The selling price for units produced is ¢650 per
unit and the variable cost is expected to be ¢250 per unit. Incremental annual fixed cost of ¢250,000 will
be incurred. Selling price and costs are all in current price terms and are expected to increase due to
inflation as follows: Selling price 4·0% per year; Variable cost 5·5% per year; Incremental fixed cost
5·0% per year
In addition to the initial cost of the new machinery, initial investment in working capital of ¢500,000 will
be required. Investment in working capital will be subject to the general rate of inflation, which is expected
to be 4·7% per year. 4Kidz Co pays tax on profits at the rate of 20% per year, one year in arrears. The
company has a nominal (money terms) after-tax cost of capital of 12% per year.

a) Calculate the net present value of the planned purchase of the new machinery using a nominal (money)
approach and comment on its financial acceptability.
b) Discuss the difference between a nominal (money terms) approach and a real terms approach to
calculating net present value.
c) Identify two financial objectives of a listed company and discuss how each of these objectives is
supported by the planned investment in the new machinery of 4Kidz Co
Solution
a) Net present value of investment in new machinery
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Year 0 1 2 3 4 5
Sales income (¢) 6,084 6,327 6,580 6,844
Variable cost (¢) (2,374) (2,504) (2,642) (2,787)
Fixed costs (263) (276) (289) (304)
Cash flow 3,447 3,547 3,649 3,753
Taxation (689) (709) (730) (751)
Tax reliefs 250 188 141 372
Cash flow 3,447 3,108 3,128 3,164 (379)
WC (500) (24) (25) (26) 575
Scrap value 250
Outlay (5,000)
NCF (5,500) 3,423 3,083 3,102 3,989 (379)
DF (12%) 1.000 0·893 0·797 0·712 0·636 0·567
PV (5,500) 3,057 2,457 2,209 2,537 (215)
NPV = ¢4,545,000
As the net present value of ¢4·545m is positive, the expansion can be recommended as financially
acceptable.
Workings
Year 1 2 3 4
Selling price (¢/unit) 676·00 703·04 731·16 760·41
Sales (units/year) 9,000 9,000 9,000 9,000
Sales income (¢000) 6,084 6,327 6,580 6,844
Year 1 2 3 4
Variable cost (¢/unit) 263·75 278·26 293·56 309·71
Sales (units/year) 9,000 9,000 9,000 9,000
Variable cost (¢000) 2,374 2,504 2,642 2,787
Year 1 2 3 4
Capital allowance 1,250·0 937·5 703·1 1,859·4
Tax benefit 250 188 141 372

Year 0 1 2 3 4
Working capital 500 523·50 548·11 573·87
Incremental (500) (24) (25) (26) 575

b) A nominal (money terms) approach to investment appraisal discounts nominal cash flows with a
nominal cost of capital. Nominal cash flows are found by inflating forecast values from current price

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estimates, for example, using specific inflation. Applying specific inflation means that different project
cash flows are inflated by different inflation rates in order to generate nominal project cash flows. A real
terms approach to investment appraisal discounts real cash flows with a real cost of capital. The net present
value for an investment project does not depend on whether a nominal terms approach or a real terms
approach is adopted, since nominal cash flows and the nominal discount rate are both discounted by the
general rate of inflation to give real cash flows and the real discount rate, respectively. Both approaches
give the same net present value.

c) A listed company such as 4Kids Co is likely to have a range of financial objectives. Maximization of
shareholder wealth is often suggested to be the primary financial objective, and this can be substituted by
the objective of maximizing the company’s share price. Other financial objectives that might be used
could relate to earnings per share, operating profit, revenue and so on. These examples of financial
objectives can all be quantified, so that progress towards meeting them can be measured over time. The
investment in the new machine has a positive net present value (NPV), so the market value of the company
is expected to increase by the amount of the NPV. This increases the wealth of shareholders irrespective
of how the investment is financed, since financing costs were accounted for by the discount rate (whether
nominal or real). The investment in the new machine will therefore support the objective of shareholder
wealth maximization.

Example
Sam Co plans to buy a new machine to meet expected demand for a new product, Product T. This machine
will cost ¢250 and last for four years, at the end of which time it will be sold for ¢5. Sam Co expects
demand for Product T to be as follows:
Year 1 2 3 4
Demand (units) 35 40 50 25
The selling price for Product T is expected to be ¢12.00 per unit and the variable cost of production is
expected to be ¢7.80 per unit. Incremental annual fixed production overheads of ¢25 per year will be
incurred.
Sam Co has an after-tax real cost of capital of 5.7% and pays tax at an annual rate of 30% one year in
arrears. It can claim capital allowances on a 25% reducing balance basis. General inflation is expected to
be 5% per year. Depreciation is charged on a straight-line basis over the life of an asset. Selling price and
costs are all in current price terms. Selling price and costs are expected to increase due to inflation as
follows: Selling price - 3% per year; Variable cost - 4% per year; fixed overheads - 6% per year. Calculate
the net present value of the project and comment on your findings (work to the nearest ¢100).

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Example
Brenda Co is evaluating the purchase of a new machine to produce product KGB, which is used to cure
dandruff. The machine is expected to cost ¢1 million. Production and sales of KGB are forecast to be as
follows:
Year 1 2 3 4
Production and sales (units/year) 35,000 53,000 75,000 136,000

The selling price of product KGB (in current price terms) will be ¢20 per unit, while the variable cost of
the product (in current price terms) will be ¢12 per unit. The following forecasts are made of the rates of
inflation each year for the next five years.
Revenue 4% Variable cost 5%

No increase in existing fixed costs is expected since Brenda Co has spare capacity in both space and labour
terms. Producing and selling product KGB will call for increased investment in working capital. Analysis
of historical levels of working capital within Brenda Co indicates that at the start of each year, investment
in working capital for product KGB will need to be 7% of sales revenue for that year. Brenda Co pays tax
of 30% per year in the year in which the taxable profit occurs. Liability to tax is reduced by capital
allowances on machinery (tax-allowable depreciation), which Brenda Co can claim on a straight-line basis
over the four-year life of the proposed investment. The new machine is expected to have no scrap value
at the end of the four-year period. Brenda Co uses a nominal (money terms) after-tax cost of capital of
12% for investment appraisal purposes.
a) Calculate the net present value of the proposed investment in product KGB.
b) Calculate the internal rate of return of the proposed investment
c) Advise on the acceptability of the proposed investment in product KGB and discuss the limitations of
the evaluations you have carried out.
d) Discuss how the net present value method of investment appraisal contributes towards the objective
of maximising the wealth of shareholders.

Solution
a) Calculation of net present value

Year 0 1 2 3 4
Sales 728,000 1,146,390 1,687,500 842,400
Variable costs (441,000) (701,190) (1,041,750) (524,880)
Contribution 287,000 445,200 645,750 317,520
Tax (30%) (86,100) (133,560) (193,725) (95,256)

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Cash flow 200,900 311,640 452,025 222,264
Capital allowances 75,000 75,000 75,000 75,000
Working capital (50,960) (29,287) (37,878) 59,157 58,968
Outlay (1,000,000)
Net cash flows (1,050,960) 246,613 348,762 586,182 356,232
Discount at 12% 1·000 0·893 0·797 0·712 0·636
Present values (1,050,960) 220,225 277,963 417,362 226,564
NPV = ¢91,154

The net present value is positive and so the investment is financially acceptable
Workings
1. Sales revenue
Year 1 2 3 4
Selling price (¢/unit) 20·80 21·63 22·50 23·40
Sales volume (units) 35,000 53,000 75,000 36,000
Sales revenue (¢) 728,000 1,146,390 1,687,500 842,400
2. Variable costs
Year 1 2 3 4
Variable cost (¢/unit) 12·60 13·23 13·89 14·58
Sales volume (units) 35,000 53,000 75,000 36,000
Variable costs (¢) 441,000 701,190 1,041,750 524,880

3. Total investment in working capital

Year 0 investment = 728,000 x 0·07 = ¢50,960
Year 1 investment = 1,146,390 x 0·07 = ¢80,247
Year 2 investment = 1,687,500 x 0·07 = ¢118,125
Year 3 investment = 842,400 x 0·07 = ¢58,968
Incremental investment in working capital
Year 0 investment = 728,000 x 0·07 = (¢50,960 )
Year 1 investment = 80,247 – 50,960 = (¢29,287)
Year 2 investment = 118,125 – 80,247 = (¢37,878)
Year 3 recovery = 58,968 – 118,125 = ¢59,157
Year 4 recovery = ¢58,968

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4. Capital allowance tax reliefs
Straight line capital allowance of ¢1,000,000 over 4 years, gives yearly allowance of ¢250,000. Tax relief
for each year is thus ¢75,000 (250,000 x 30%) given in the year it occurs.
1 2 3 4
5. Taxation (30%) (86,100) (133,560) (193,725) (95,256)
Taxes are imposed on taxable income and in the same year it occurs
0 1 2 3 4
6. Net cash flows (1,050,960) 246,613 348,762 586,182 356,232

b) Calculation of internal rate of return

Year 0 1 2 3 4
Net cash flows (1,050,960) 246,613 348,762 586,182 356,232
Discount at 20% 1·000 0·833 0·694 0·579 0·482
Present values (1,050,960) 205,429 242,041 339,399 171,704
NPV at 20% = (¢92,387)
NPV at 12% = ¢91,154
IRR = 12 + [(20 – 12) x 91,154/ (91,154 + 92,387)]
= 12 + 4
= 16%
c) Acceptability of the proposed investment in Product KGB
The NPV is positive and so the proposed investment can be recommended on financial grounds. The IRR
is greater than the discount rate used by Brenda Co for investment appraisal purposes and so the proposed
investment is financially acceptable. The cash flows of the proposed investment are conventional and so
there is only one internal rate of return. Furthermore, only one proposed investment is being considered
and so there is no conflict between the advice offered by the IRR and NPV investment appraisal methods.

Limitations of the investment evaluations

Sales volume
Both the NPV and IRR evaluations are heavily dependent on the production and sales volumes that have
been forecast and so Brenda Co should investigate the key assumptions underlying these forecast volumes.
It is difficult to forecast the length and features of a product’s life cycle so there is likely to be a degree of
uncertainty associated with the forecast sales volumes.

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Inflation rates
The inflation rates for selling price per unit and variable cost per unit have been assumed to be constant
in future periods. In reality, interaction between a range of economic and other forces influencing selling
price per unit and variable cost per unit will lead to unanticipated changes in both of these project variables.
The assumption of constant inflation rates limits the accuracy of the investment evaluations and could be
an important consideration if the investment were only marginally acceptable.
Fixed cost
Since no increase in fixed costs is expected because Brenda Co has spare capacity in both space and labour
terms, fixed costs are not relevant to the evaluation and have been omitted.
d) The primary financial management objective of private sector companies is often stated to be the
maximization of the wealth of its shareholders. While other corporate objectives are also important, for
example due to the existence of other corporate stakeholders than shareholders, financial management
theory emphasises the importance of the objective of shareholder wealth maximization. Shareholder
wealth increases through receiving dividends and through share prices increasing over time. Changes in
share prices can therefore be used to assess whether a financial management decision is of benefit to
shareholders. In fact, the objective of maximising the wealth of shareholders is usually substituted by the
objective of maximising the share price of a company.
The net present value (NPV) investment appraisal method advises that an investment should be accepted
if it has a positive NPV. If a company accepts an investment with a positive NPV, the market value of the
company, theoretically at least, increases by the amount of the NPV. For example, a company with a
market value of ¢9 million investing in a project with an NPV of ¢1 million will have a market value of
¢10 million once the investment is made.
Shareholder wealth is therefore increased if positive NPV projects are accepted and, again theoretically,
shareholder wealth will be maximised if a company invests in all projects with a positive NPV. The NPV
investment appraisal method also contributes towards the objective of maximising the wealth of
shareholders by using the cost of capital of a company as a discount rate when calculating the present
values of future cash flows. A positive NPV represents an investment return that is greater than that
required by a company’s providers of finance, offering the possibility of increased dividends being paid
to shareholders from future cash flows.

Question
Eleanor Co is considering a project with the following forecasts:
Now year 1 year 2 year 3
Initial investment (¢m) 1,000
Disposal proceeds (¢m) 200
Demand (millions of units) 5 10 6

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The initial investment will be made on the first day of the new accounting year. The selling price per unit
is expected to be ¢100 and the variable cost per unit to be ¢30. Both of these figures are given in today’s
terms. Tax is paid at 30%, one year after the accounting period concerned. Writing down allowances is
available at 25% reducing balance. The company has after tax real cost of capital of 6.8%. General
inflation is predicted to be 3% pa but the selling price is expected to inflate at 4% pa and variable costs by
5% pa. Additional working capital equal to 10% of annual sales is required and needed to be in place at
the start of each year.
a) Determine the NPV of the project.
b) Calculate the internal rate of return

Lease versus buy decisions

Once the decision has been made to acquire an asset for an investment, a decision still needs to be made
as to how to finance it. The choices that we will consider are:
 Lease
 Buy
The NPV of the cash flows for both options are found and compared and the lowest cost option selected.
The finance decision is considered separately from the investment decision.

Leasing
The asset is never owned by the user company from the perspective of the taxman. The user receives no
WDAs but is able to offset the full rental payment against tax.
The relevant cash flows would be:
The lease payments
Tax relief on the lease payments

Buying
The user is the owner of the asset and thus receives WDAs on the asset and tax relief. The relevant cash
flows would be:
The purchase cost
The residual value
Any associated tax implications due to WDAs.
Do not include the interest payments arising on the loan for the purchase of the asset in the NPV
calculation, as this is dealt with in the cost of capital.

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Cost of capital
As the interest payments attract tax relief, we will use the post-tax cost of borrowing as our discount rate.
Post-tax cost of borrowing or cost of debt capital, ka = (1 – T) kb,
T is corporation’s tax, ka is cost of debt capital after tax, and kb is cost of debt capital before tax.

Example
A company has decided to acquire a new asset which will cost ¢6,400 and will have an economic life of
five years. Taxation of 30% is payable on operating cash flows, one year in arrears. Capital allowances of
25% pa on a reducing balance basis are available for the investment in the asset.
The company intends to finance the new asset by means of a five-year fixed interest loan at a pre-tax cost
of 11.4% pa, principal repayable in five years’ time.
As an alternative, a leasing company has proposed an operating lease over five years at ¢1,420 pa payable
in advance. Scrap value of the asset under each financing alternative will be zero. Evaluate the two options
for the acquisition of the asset and advise the company on the best alternative.
Solution
Buying the asset
0 1 2 3 4 5 6
Asset (6,400)
Relief 480 360 270 203 608
NCF (6,400) - 480 360 270 203 608
DF (8%) 1.000 0.926 0.857 0.794 0.735 0.681 0.630
PV (6400) - 411 286 198 138 383
NPV = ¢ (4,984)

Leasing the asset

0 1 2 3 4 5 6
Lease payments (1420) (1420) (1420) (1420) (1420)
Reliefs 426 426 426 426 426
NCF (1420) (1420) (994) (994) (994) 426 426
DF (8%) 1.000 0.926 0.857 0.794 0.735 0.681 0.630
PV (1420) (1315) (852) (789) (731) 290 268
NPV = ¢ (4,549)
The cost of leasing is lower than the cost of buying the asset and thus acquiring the asset under operating
lease is the better option.

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Example
Montessori has decided to install a new milling machine. The machine costs ¢20,000 and it would have a
useful life of five years with a trade-in value of ¢4,000 at the end of the fifth year. A decision has now to
be taken on the method of financing the project.
(a) The company could purchase the machine for cash, using bank loan facilities on which the current rate
of interest is 13% before tax.
(b) The company could lease the machine under an agreement which would entail payment of ¢4,800 at
the end of each year for the next five years.
The rate of tax is 30%. If the machine is purchased, the company will be able to claim a tax depreciation
allowance of 100% in Year 1. Tax is payable with a year's delay.

Solution
Cash flows are discounted at the after-tax cost of borrowing, which is at 13% x 70% = 9.1%, say 9%.

The present value (PV) of purchase costs

Cash Discount
Year Item flow factor PV
¢ 9% ¢
0 Equipment cost (20,000) 1.000 (20,000)
5 Trade-in value 4,000 0.650 2,600
2 Tax savings, from allowances
30% x ¢20,000 6,000 0.842 5,052
6 Balancing charge
6 30% x ¢4,000 (1,200) 0.596 (715)
NPV of purchase (13,063)

The PV of leasing costs

The lease payments are fully tax-allowable.
Lease Savings Discount
Year payment in tax (30%) factor (9%) PV
¢ ¢ ¢
1-5 (4,800) pa 3.890 (18,672)
2-6 1,440 pa 3.569 5,139
NPV of leasing (13,533)
The cheapest option would be to purchase the machine

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Question
A Company is considering an investment in a new technology that will reduce operating costs through
increasing energy efficiency and decreasing pollution. The new technology will cost ¢1 million and have
a four-year life, at the end of which it will have a scrap value of ¢100,000. The company is called Brenda
Pharmaceuticals.
A licence fee of ¢104,000 is payable at the end of the first year. This licence fee will increase by 4% per
year in each subsequent year. The new technology is expected to reduce operating costs by ¢5·80 per unit
in current price terms. This reduction in operating costs is before taking account of expected inflation of
5% per year.

Forecast production volumes over the life of the new technology are expected to be as follows:
Year 1 2 3 4
Prod. (Units) 60,000 75,000 95,000 80,000
If the company bought the new technology, it would finance the purchase through a four-year loan paying
interest at an annual before-tax rate of 8·6% per year.

Alternatively, the company could lease the new technology. The company would pay four annual lease
rentals of ¢380,000 per year, payable in advance at the start of each year. The annual lease rentals include
the cost of the licence fee.

If the Company buys the new technology, it can claim capital allowances on the investment on a 25%
reducing balance basis. The company pays taxes one year in arrears at an annual rate of 30%.

a) Based on cash flows, calculate and determine whether the Company should lease or buy the new
technology.
b) With the selected strategy at (a), determine the NPV of the project
HINT: The licence fees also attract tax reliefs

Replacement decisions
Decisions as to whether or not to invest in a project have been considered in the previous topics. However,
very often we may have decided to purchase a machine, but knowing that it will not last forever we have
to decide how often to replace it. By doing this you will avoid paying very high maintenance costs but the
downside, of course, is that you would have to pay the price of a new one more frequently.

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Equivalent annual costs (EAC)
The EAC is the equal annual cash flow (annuity) to which a series of uneven cash flows is equivalent in
PV terms. It is calculated as:
PV of costs
EAC =
Annuity factor

The optimum replacement period (cycle) will be the period that has the lowest EAC, although in practice
other factors may influence the final decision. The steps to follow in arriving at the replacement decision
are:
Calculate the NPV of each strategy or replacement cycle
Calculate the EAC for each strategy
Choose the strategy with the lowest EAC

Example
A company operates a machine which has the following costs and resale values over its three-year life.
Purchase cost is ¢25,000
Year 1 Year 2 Year 3
¢ ¢ ¢
Running costs 7,500 11,000 12,500
Resale value 15,000 10,000 7,500

The organisation's cost of capital is 10%. You are required to assess how frequently the asset should be
replaced.
Solution
Replace every year
1
Outlay (25,000)
Running cost (7,500)
Scrap 15,000
NCF (25,000) 7,500
DF (10%) 1.000 0.909
PV (25,000) 6,818
NPV = (¢18,183)
EAC = (¢20,003)

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Replace every two years
0 1 2
Outlay (25,000)
Running cost (7,500) (11,000)
Scrap 10,000
NCF (25,000) (7,500) (1,000)
DF (10%) 1.000 0.909 0.826
PV (25,000) (6,818) (826)
NPV = (¢32,644)
EAC = (¢18,815)

Replace every three years

0 1 2 3
Outlay (25,000)
Running cost (7,500) (11,000) (12,500)
Scrap 7,500
NCF (25,000) (7,500) (11,000) (5,000)
DF (10%) 1.000 0.909 0.826 0.751
PV (25,000) (6,818) (9,086) (3,755)
NPV = (¢44,659)
EAC = (¢17,957)

The optimum replacement policy is the one with the lowest equivalent annual cost, and that is every three
years.

Example
A machine costs ¢72,000 and has a maximum life of 3 years.
The maintenance costs each year are as follows: The estimated scrap values are as follows:
Year Year
7,200 24,000
9,600 16,600
12,000 9,600

The cost of capital is 15%. How often should the machine be replaced

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 CHAPTER NINE

RISKS AND UNCERTAINTIES IN PROJECTS APPRAISAL

Introduction
Buying a machine to manufacture a product that is to be sold in the market is often a risky venture. Things
may not turn out as expected:
- The machine might not work as well as expected (break down, loss of production)
- Sales of the product may not be as buoyant as expected
- The life of the product may be shorter than expected
- Labor costs may prove to be higher than was expected
- The scrap value of the machine could prove to be less than was estimated
How risky a particular project is, and thus, how large the risk premium should be, are matters that are
difficult to handle. It is usually necessary to make some judgment on these questions, and we consider this
point in more detail under this chapter.

Definition
Risk is the chance of exposure to adverse consequences of uncertain future events. They are uncertain
events which can hinder an organization from achieving its objectives. Risk refers to the situation where
probabilities can be assigned to a range of expected outcomes arising from an investment project and the
likelihood of each outcome occurring can therefore be quantified.
Uncertainty refers to the situation where probabilities cannot be assigned to expected outcomes.
Investment project risk increases with increasing variability of returns, while uncertainty increases with
increasing project life. The two terms are often used interchangeably in financial management, but the
distinction between them is a useful one.
Scenario and probability analysis are some of the methods used in dealing with the problems of risks
and uncertainties. Probability analysis refers to the assessment of the separate probabilities of a number
of specified outcomes (scenario) of an investment project

For example, a range of expected market conditions could be formulated and the probability of each
market condition arising in each of several future years could be assessed. The net present values or IRRs
arising from combinations of future economic conditions could then be assessed and linked to the joint
probabilities of those combinations. The expected net present value (ENPV) could be calculated, together
with the probability of the worst-case scenario and the probability of a negative net present value. In this
way, the downside risk of the investment could be determined and incorporated into the investment
decision.
Other methods used in dealing with risk and uncertainties in an investment project are the sensitivity
analysis and the breakeven analysis.

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Sensitivity Analysis
In many business situations it is desirable to generate a more complete and realistic impression of what
may happen to NPV in conditions of uncertainty. The appraiser does make assumptions about some crucial
variables: for example, the sale price of the product, the cost of labour and the amount of initial investment
are all set at single values for input into the formula. Sensitivity analysis assesses how the net present
value or IRR of an investment project is affected by changes in such project variables.
By considering each project variable in turn, it is possible to build a picture of the nature of the risks facing
the project and their impact on project profitability.

However, sensitivity analysis does not assess the probability and the possibility of changes in project
variables and so is often dismissed as a way of incorporating risk into the investment appraisal process.
Sensitivity analysis may only want to find out what happens to or the change in the NPV/ IRR might be
upon a risk of change in a project variable but does not necessary say as to whether the risk event may or
may not occur.

It does not include the possibility of occurrence or otherwise of that risk but scenario and probability
analysis does.

Example
A company called Wales is deciding on whether to make a ¢400,000 investment in a new product. The
project will last for 10yrs and the ¢400,000 machinery will have a zero-scrap value. Other best estimate
forecasts are:
- Sales volume of 22,000 units per year;
- Sales price of ¢21 a unit;
- Variable direct cost of ¢16 per unit.
There are no other costs and the company’s cost of capital is 20%
1. Calculate the NPV of this project based on these estimates
2. Recalculate the NPV on the assumption that each of the following variables changes adversely by 5%
in turn:
- Sales volume;
- Sales price;
- Variable direct cost

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Solution
By carrying out a series of calculations it is possible to build up a picture of the nature of the risks facing
the project and their impact on project profitability.
a) Annual Cash Flows:
Sales (22,000 × ¢21) ¢462,000
Direct variable cost (22,000 × ¢16) (¢353,000)
Net annual cash inflows ¢110,000

Year cash flow DF (20%) PV

0 (400,000) 1.000 (400,000)
1 – 10 110,000 4.192 461,120
NPV1 ¢61,120

b) i) Sales volume change adversely by 5%

New sales volume = 95 × 22,000 = 20,900 units
100
Sales revenue (20,900 × ¢21) ¢438,900
Direct variable cost (20,900 × ¢16) (¢334,400)
Net annual cash inflow ¢104, 500
Year cash flow DF (20%) PV
0 (400,000) 1.000 (400,000)
1 – 10 104,500 4.192 438,064
NPV2 ¢38,064

ii) Selling price changes adversely by 5%

New selling price = 95 × ¢21 = ¢19.95
100
Thus: Sales (22,000 × ¢19.95) ¢438,900
Direct variable cost (22,000 × ¢16) (¢352,000)
Net cash flow ¢86,900

Year cash flow DF (20%) PV

0 (400,000) 1.000 (400,000)
1 – 10 86,900 4.192 364,285
NPV3 (35,715)

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iii) Direct variable cost changes adversely by 5%
New direct variable cost = 105 × ¢16 = ¢16.8
100
Sales (22,000 × ¢21) ¢462,000
Direct variable cost (22,000 × ¢16.8) (¢369, 600)
Net cash flow ¢92,400

Year cash flow DF (20%) PV

0 (400,000) 1.000 (400,000)
1 – 10 92,400 4.192 387,341
NPV4 (12,659)

Sensitivity analysis allows investors to be more informed about the project sensitivities, to know the room
they have for judgemental error and to decide whether they are prepared to accept the risks. It does not
however say anything about the possibility of the risk occurring or happening.

Scenario and Probability analysis

This concept incorporates the probability of occurrence of the various anticipated risks. From the above
example, given the four scenarios of economic conditions for the investment, we may assign probabilities
to each scenario based on the possibility of its occurrence. Let’s assume the following happenings:
NPV Probability NPV x p
61,120 0.3 18,336
38,064 0.2 7,613
(35,715) 0.4 (14,286)
(12,659) 0.1 (1,266)
The mean or the expected net present value could be determined to ascertain if the project would still be
viable if it is to be undertaken under all the four economic conditions and their occurrence are as likely as
predicted.
ENPV = 18,336 + 7,613 – 14,286 – 1,266
= ¢10,397
Since the expected NPV is positive, the project should be accepted and embarked upon.

Other risk adjustment techniques

Other risk adjustment techniques include the use of simulation models, adjusted payback (discounted
payback) and risk-adjusted discount rates

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Risk-adjusted discount rates
Investors want higher returns for higher risk investments. The greater the risk attached to future returns,
the greater the risk premium required. Investors also prefer cash now to later and require a higher return
for longer time periods. In investment appraisal, a risk-adjusted discount rate can be used for particular
types of risk class of investment projects to reflect their relative risks. We will study risk-adjusted discount
rates in more detail at second semester.

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 CHAPTER TEN

FURTHER QUESTIONS

Question:
Suppose you notice a run-down house for sale in your neighborhood. The price is ¢80,000 as the house
stands today and the house will require ¢40,000 worth of repairs. The repairs would take a year to
complete. Fixed up, you could sell the house in one year for ¢135,000. Having a slightly better
neighborhood increases the value of your own home by ¢5,000. If your discount rate is 10%, determine
whether it is worthwhile buying this house. Will it still be worthwhile to buy the house if not found in that
neighborhood

Question:
a) Explain the difference between risk and uncertainty in the context of investment appraisal, and
b) Describe how sensitivity analysis and probability analysis can be used to incorporate risk into the
investment appraisal process.

Question:
Consider a firm that needs to buy a new air-conditions system. They only need one and the choice is down
to two systems:
1. System A has high up-front costs and low maintenance costs.
2. System B is inexpensive, but has high maintenance costs.
Either system will offer savings over the current system in place at the firm. The current system costs
¢400 per year maintenance cost o operate. The current system can be sold for ¢400 at time 0. The costs to
install and operate the two alternative systems are shown below:
Year 0 1 2 3 4 5
A -1,000 -50 -50 -50 -50 -50
B -600 -200 -250 -300 -350 -400
The firm’s cost of capital is 15%. Deduce the relevant annual cash flows associated with buying any of
the two systems. Which of the two systems should they buy?

Question:
Explain what is meant by conventional and non-conventional cash flows and what problems they might
cause in investment appraisal
Describe the differences between divisible and mutually exclusive events citing examples
A company is considering four major projects which have either two or three year lives. The shareholders
regard the investment as relatively risky given its existing portfolio of projects.

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Other companies who share in this risk class have generally been given a return of 16 percent per annum
and this is taken as the opportunity cost of capital for the investment projects. The risk level for the
proposed projects is the same as that of the existing range of activities.
Project net cash flows
0 1 2 3
A (5266) 2,500 2,500 2,500
B (8,000) - - 10,000
C (2,100) 200 2,900 -
D (1,975) 1600 800 -
Ignore taxation and inflation.

a) Calculate which of the four projects should be proceeded with, if there are no limitations to the number
which can be undertaken using IRR.
b) State which is the best project if they are mutually exclusive (i.e., accepting one excludes the
possibility of accepting another), using IRR.
c) Use the NPV decision rule to rank the projects and explain why, under conditions of mutual
exclusivity, the selected projects differs from under (b).
d) Write a report for the managing director of the firm, detailing the value of the net present value method
for shareholder wealth enhancement and explaining why it may be considered of greater use than IRR.

Question:
Smart plc has an ageing piece of equipment which is less efficient than modern equivalents. This
equipment will continue to operate for another 15 years but operating and maintenance costs will be
¢3,500 per year. Alternatively it could be sold, raising ¢2,000 now, and replaced with its modern
equivalent which costs ¢7,000 but has reduced operating and maintenance costs of ¢3,000 per year. This
machine could be sold at the end of its 15-year for scrap for ¢500. The third possibility is to spend ¢2,500
for an immediate overhaul of the old machine which will improve its efficiency for the rest of its life, so
that operating and maintenance costs become ¢3,200 per annum. The old machine will have zero scrap
value in 15 years, whether or not it is overhauled. Smart plc requires a return of 9% on projects in this risk
class. Select the best course of action assuming that cash flows arise at the year ends.

Question:
A company is considering investing in a project with the following cash flows
Year 1 2 3 4 5 6 7 8
Net cash flow (¢) 1,000 1,500 2,000 1,750 1,500 1,000 500 500
The initial investment outlay is ¢6,250. The company has a required rate of return of 10%. Calculate
a. The payback period
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b. The discounted payback
c. The net present value
What are the main objections to the use of payback? Why does it remain a very popular method?

Question:
Francis plc has an ordinary share price of ¢3 and is quoted on the stock market. It intends to raise ¢20m
through a one-for-three rights issue priced at ¢2.
1. What will the ex-rights price be?
2. How many old ordinary shares were in circulation prior to the rights issue?
3. Maxwell owns 9,000 shares and is unable to find the cash necessary to buy the rights shares. Reassure
Maxwell that he will not lose value. How much might he receive from the company?
4. What is the value of a right on one old share?
5. What do the terms cum-rights and ex-rights mean?
6. What are the main advantages and disadvantages of raising finance through selling ordinary shares?

Question:
Imagine that the market yield to maturity for three-year bonds in a particular risk class is 12%. You buy a
bond in that risk class which offers an annual coupon of 10% for the next three years, with the first payment
in one year. The bond will be redeemed at par (¢100) in three years.
a. How much would you pay for the bond now?
b. If you paid ¢105 what yield to maturity would you obtain?

Question:
Explain the following terms and their relevance to debt-finance decision makers:
a. Negative covenant
b. Conversion premium
c. Collateral
d. Grace periods
Times plc has issued ¢60m 15-year 8.5% coupon bonds with a par value of ¢100. Each bond is convertible
into 40 shares of Times ordinary shares, which are currently trading at ¢1.90.
1. What is the conversion price?
2. What is the conversion premium?

Question:
The Biscuit company has taken delivery of ¢10,000 of flour from its long-established supplier. Biscuit is
in the habit of paying for flour deliveries 50 days after the invoice or delivery date. However, things are
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different this time round. The supplier has introduced an early settlement discount of 2% if the invoice is
paid within 10 days. The rate of interest being charged on Biscuit’s overdraft facility is 11% per annum.
You may assume no tax to avoid complications. Calculate whether Biscuit should pay on the 10th day or
the 50th day following the invoice.

Question:
A factoring company has offered a one-year agreement with Pius Ltd to both manage its debtors and
advance 80% of the value of all its invoices immediately a sale is invoiced. The annual sales on credit of
Pius are ¢6m spread evenly through the year, and the average delay in payment from the invoice date is
at present 80 days.
The factoring company is confident of reducing this delay to only 60 days and will pay the remaining 20%
of invoice value to Pius immediately on receipt from the customer.
The charge for debtor management will be 1.7% of annual credit turnover payable at the year end. For the
advance payment on the invoices a commission of 1% will be charged plus interest applied at 10% per
annum on the gross funds advanced.
Pius will be able to save ¢80,000 during this year in administration costs if the factoring company takes
on the debtor management.

At the moment it finances its trade credit through an overdraft facility with an interest rate of 11% per
annum.

Advise Pius on whether to enter into the agreement. Discuss the relative advantages and disadvantages of
overdraft, factoring and term loan financing

Question:
Cassandra plc has standard trade terms requiring its customers to pay after 30 days. The average invoice
is actually paid after 90 days. A junior executive has suggested that a 2.5% discount for payment on the
20th day following the invoice date be offered to customers. It is estimated that 60% of customers will
accept this and pay on the 20th day, but the remainder will continue to pay, on average, on the 90th day.
Sales are ¢10m per annum and bad debts are 1% of sales.
The company’s overdraft facility costs 14% per annum.

The reduced collection effort will save ¢50,000 per annum on administration and bad debts will fall to
0.7% of turnover.

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Should the new credit terms be offered to customers? What are the main considerations you would give
thought to in setting up a good credit management system?

Question:
a) Why do firms hold cash or near cash?
b) What are the strengths and weaknesses of Baumol cash management model?
c) Describe the advantages and disadvantages of retained earnings as a source of finance
d) What are the main considerations when deciding on whether to borrow long or short-term source of
finance?
e) What is an ‘aggressive’ working capital policy?
f) What is economic order quantity?

Question:
You have been asked to prepare a cash budget for Brenda plc for the next three months, October,
November, and December. The managers are concerned that they may not have sufficient cash to pay for
a ¢150,000 investment in equipment in December. The overdraft has reached its limit of ¢70,000 at the
present time – the end of September.
Sales during September were a total of ¢400,000, of which ¢55,000 was received cash, ¢165,000 is
expected to be paid in October, with the remainder likely to flow in during November. Sales for the next
three months are as follows:
Total sales cash sales credit sales
October 450,000 90,000 360,000
November 550,000 110,000 440,000
December 700,000 140,000 560,000
There is a gross profit margin of 40% on sales. All costs (materials, labour, and others) are paid for on
receipt. Only 20% of customer sales are expected to be paid for in the month of delivery. A further 70%
will be paid after one month and the remainder after two months.
Labour and other costs amount to 10% of sales each month. Debtor levels at the end of September are
¢400,000 and the investment in stock is ¢350,000. Prepare a cash budget for October, November and
December, and state if the firm will be able to purchase the new equipment. Recommend action that could
be taken to improve the working capital position of Brenda plc

Question:
Seth buys 100,000 washing machines per year at a cost of ¢15 per machine for use in his laundry sites.
The cost of holding one machine in stock, in terms of interest, security, insurance, storage, etc is ¢1.20
per year. The cost of reordering and taking delivery of machines is ¢250 regardless of the size of the order.
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Calculate the economic order quantity and the total cost of inventory management on the assumption that
usage is predictable and even throughout the year.

Question:
Beacon chemicals plc is considering buying some new equipment to produce a chemical X14. The new
equipment’s cost is estimated at ¢100,000 and if its purchase is approved now, the equipment can be
bought and commence production by the beginning of year one. The business has already spent ¢50,000
on research and development work. Estimates of revenues and costs arising from the operation of the new
plant are as follows:
1 2 3 4 5
Sales price (¢/unit) 100 120 120 100 80
Sales volume (units) 800 1000 1200 1000 800
Variable costs (¢/unit) 50 50 50 50 50
Fixed costs (¢000s) 30 30 30 30 30
If the equipment is bought, sales of some existing products will be lost, resulting in a loss of contribution
of ¢15,000 a year over its life. The accountant has informed you that the fixed costs include depreciation
of ¢20,000 a year on new equipment. They also include an allocation of ¢10,000 for fixed overheads. A
separate study has indicated that if the new equipment is bought, additional overheads, excluding
depreciation, arising from its use will be ¢8,000 a year. The project would require additional working
capital of ¢30,000. Ignore inflation and taxation.
a) Deduce the relevant annual cash flows associated with buying the equipment.
b) Deduce the payback period and
c) Calculate the net present value using a discount rate of 8%.

Question
M Co, an unquoted manufacturing company, has been experiencing a growth in demand, and this trend is
expected to continue. In order to cope with the growth in demand, the company needs to buy new
machinery which is expected to cost 30% of the current value of the company. In the past, a high
proportion of earnings have been distributed by way of dividends so few cash reserves are available. 60%
of the shares in M Co are still owned by the founding family. A decision must now be taken about how to
raise the funds for the machinery. Existing loan finance was secured against the company land and
buildings.
Suggest the issues that should be considered by the board in determining whether debt would be an
appropriate source of finance.

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Question
a) Assume that you are the credit manager of a business and that a limited liability company approached
you with the view to buying goods on credit. What sources of information might you decide to use to help
assess the financial health of the potential customer and its willingness to pay the amounts owing?
b) Why do you think a business may decide to hold at least some of its assets in the form of cash?

c) Identify the costs of holding:

- Too little cash, and
- Too much cash

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