Code: ACU 07314

Name: Financial Management

Number of Credits: 14

2023/2024

Program: FIRST
BAC II- semester
FT&ET
 Introduction
Finance
 The money required to carry out business activities is known as finance.
 Finance may be defined as the art and science of managing money. It
includes financial service and financial instruments.
Financial Management
 Financial Management is concerned with the proper procurement and
usage of finance.
 Financial management is that managerial activity which is concerned with
the planning and controlling of the firm’s financial resource
 Financial Management means the efficient and effective management of
money in such a manner as to accomplish the objectives of the
organization.
 Though it was a branch of economics till 1890, as a separate activity or
discipline it is of recent origin. It includes business activities such as
procuring funds, reducing the cost of funds, keeping the risk under
control and deployment of such funds.
 SCOPE OF FINANCIAL
MANAGEMENT
 Financial Management means the entire excise of
managerial efforts devoted to the management of
finance, both its sources and uses of financial
resources of an enterprise.
 The scope of financial management can be
presented as investment decisions, finance
decisions, dividend decisions and decisions
regarding the management of working capital.
I. Investment decision
II. Financing decision
III. Dividend decision
IV. management of working capital.
 A. Investment Decision
 A company invests in order to maintain or improve its profit-earning
capacity. Investment decisions usually relate to the acquisition of fixed or
non-current assets (capital investments) e.g:
 new equipment
 automated or more advanced production technology
 land and buildings
 business units
 Investment decisions in an organization are taken in both long term and
short term
 investments must be evaluated for financial viability before being selected or
rejected.
 Factors to consider would include the relevant cash inflows and outflows
associated with each project, the projects’ risks and returns and the
company’s cost of capital
 It might be that more than one investment proposal is financially acceptable.
 B. Financing Decision
• Under this the financial managers of the organization decide the sources
from which to raise long-term funds. The main source of funding is
shareholders' fund and borrowed funds.
 Shareholders' funds include share capital, reserves and surpluses and
retained earnings(Equity finance consisting of ordinary shares.
Companies may wish to issue new shares or use reserves)
 Borrowed funds refer to funds raised through issue of debentures and
other forms of debt(Debt finance consisting of fixed interest finance
e.g. debentures, loans).
• The decision of raising funds from various sources in appropriate
proportion lies in the hands of the financial managers.
• Interest on loan has to be paid regardless of the profitability of the
project.
• Debt is considered to be the cheapest form of finance.
 C. Dividend Decision
 When shareholders invest in companies, they undertake the
risk of the success or failure of the business, and thus usually
require a return commensurate with the level of risk. Their
return can take two forms: dividends and/or capital gains
(where the share price increases). In this decision, it must be
decided that,
If all profits are to be dispersed,
Whether all earnings will be retained in the business, or
Whether a portion of profits will be retained in the
business and the remainder distributed among
shareholders.
 The decision considers:
 the required rate of return to the shareholders and
 the future investment policy of the company.
 2Working capital management
 Working capital is equal to current assets (stocks, debtors and
cash) net of current liabilities; in effect, it is equal to the
amount of current assets funded through long term finance.
The following needs to be decided upon:
the optimal level of working capital
the form the working capital should take
how the working capital should be funded
 A balance needs to be brought about between the conflicting
objectives of profitability and liquidity when managing working
capital. T
 Financial Manager (Roles)

◦ Funds management (effective acquisition and

allocation)
◦ Tax management
◦ Financial and public relations ( esp. between
firms and financing sources)
Goal of the firm/ Objective of
Financial Management
 Efficiency ratios provide information about how well the
company is using its assets to generate sales.
1. Maximization of profit: earning profit is
the main aim of any economic activity.
 A firm, being an economic entity, should aim at
earning profit in order to not only cover its costs
but also ensure availability of funds for growth.
 This goal can also be studied in the light of
maximization of earnings per share of a firm.
 Goal of the firm/ Objective of
Financial Management
 The profit maximization goal of a firm can be justified on the
grounds of the following:
◦ Efficiency of a firm would be measured in terms of its
profit earning capacity. Moreover, only an efficient firm
can survive in a competitive market.
◦ A firm is always exposed to adverse economic and
business conditions like recession, severe competition,
limited availability of credit, fall in prices, etc. Profits
enable a firm to face such risks.
◦ Under imperfect market conditions, the firm which can
earn high profit will be able to gain maximum market
advantage.
◦ Profits also enable a firm to meet its social goals.
 Goal of the firm/ Objective of Financial
Management
 Maximization of shareholders’ wealth: creation of value is considered to
be the driving force behind financial management.
Thus, a more appropriate goal of a firm would be to create
and increase wealth of its shareholders by increasing the
value of their investment.
Moreover, by maximizing a shareholder’s wealth (or
economic welfare), a firm is also able to maximize its
consumption utility over time.
The wealth maximization goal is considered to be the
most important goal of a firm.
A public limited company aims to achieve this goal by
maximizing its market value as reflected by the prices of its
shares and securities in the long run.
 Other objectives: There can be other objectives such as optimum
utilization of financial resources, choosing the most appropriate source,
ensuring easy availability of funds at reasonable costs etc.
 Motivations and interests of
different stakeholders in
financing decisions
Stakeholders
◦ A stakeholder is a group or an individual who has
vested interest in the organization.
◦ They are affected by what a company does, either
positively or negatively.
◦ They want and expect different things from the
organisation. It is therefore said that they have a
‘stake’ in the business.
 Stakeholders can be divided into two broad
categories:
1. internal stakeholders
2. external stakeholders
 1. Internal stakeholders and
their objectives
(a) Employees
 To have a cordial working environment.
 To have ethical labor practices, e.g. reasonable working hours, safe working
conditions etc.
 To have opportunities for learning and advancement.
 Direct, two-way communication between management and employees.
 To receive a fair remuneration according to ability and performance.
 To get satisfaction from doing meaningful and creative work.
(b) Managers
 To get satisfaction from doing meaningful and creative work.
 To have opportunities for learning and advancement.
 To have the freedom to take decisions for the work under their individual
charge.
 To have an input in decision-making.
 To receive a fair remuneration according to ability and performance.
 1. Internal stakeholders and
their objectives
(c) Directors
 To have freedom to take decisions.
 To have sufficient resources to implement the decisions.
 To get technical support whenever required in taking various
decisions.
 To gain the support of the shareholders in the general meetings
towards the well-intended decisions and actions of the directors.
 To receive a fair remuneration according to ability and
performance.
 To get notices of meetings well in advance, as laid down in the
rules.
 To have the full support of managers and employees in the
fulfilment of corporate objectives e.g. work discipline, team work
etc.
 To have the full support of suppliers and contractors in the
fulfilment of corporate objectives e.g. social responsibility,
environment protection etc.
 2. External stakeholders and
their objectives
(a) Customers
 To get high quality and attractive products and services from the
company.
 To pay a reasonable (and not exorbitant) price for the goods /
services.
 Company should consider the opinion of the customers while
designing the products.
 To get good after sale service, e.g. warranty maintenance, supply of
spares etc.
(b) Suppliers and contractors
 To get reasonable prices and other terms for the material or services
supplied.
 To receive payment on time.
 To get the opportunity to grow alongside the company.
 Regular interaction with the company to share each other’s
viewpoints and act on them, if appropriate
 2. External stakeholders and
their objectives
(c) Shareholders
 To increase wealth through dividends or capital
appreciation (i.e. increase in share values).
 Ethical behavior from the directors who should
not benefit at the cost of shareholders.
 To receive financial statements and other
information from the board of directors.
 Participation in the general meetings, asking
questions, discussing the company’s performance
and voting on certain issues, for example,
appointment of directors, auditors etc.
 2. External stakeholders and
their objectives
(d) Government and local community
 To behave as a responsible citizen
 To protect the health, safety and environment.
 To use the natural resource efficiently.
 To pay all due taxes on time.
 To work as tax collectors in the case of indirect taxes.
 To follow good labour practices.
 To have regular dialogue with government agencies.
 To generate economic growth and job opportunities. The government
may provide appropriate tax incentives and grants for this purpose.
 To have a wider spread of ownership.
 To follow all applicable laws and regulations.
 To practice corporate social responsibility
 2. External stakeholders and
their objectives

(e) Financial community (banks etc.)

 To abide by the terms and conditions (warrants)
agreed at the time of disbursement of finance.
 To grow economically and provide further
opportunities to the financial community for
additional business.
 To not compromise the assets provided as a
security to the bank, and maintain its financial
health, in order to protect its creditors from
losses.
 Stakeholders and financing
decisions
 Financing decisions refer to the decisions regarding
the capital structure of the firm. Debt and equity are
the two major sources of finance and each of them is
associated with varied levels of risk, control and
benefits.
 Consequently, the financial investors in a company
would be:
Debt holders who earn a pre-determined rate of
return, exercise lower control and are protected by
contractual obligations with regard to the amount
invested
Shareholders who exercise control over the
company, are the owners of the company and
therefore absorb greater risk
 Stakeholders and financing
decisions
 Firms deploy debt capital to avail tax advantages;
however, debt brings with it financial distress,
agency problems and loss of financial flexibility.
Every finance and business strategy is affected by
relevant actions of key stakeholders.
 Similarly, financing decisions can affect the value of
the firm according to the existence of a conflict
of interest between:
Management
Financial stakeholders – shareholders and lenders
Non-financial stakeholders – suppliers, customers,
government, competitors
 Role, motivations and interests of non financial
stakeholders in financing decisions (and related
conflicts)
 Non financial stakeholders are the business associates who have no direct
financial stake in the company but are concerned with the financial status of
the company.
 This is because any financial crisis would impact them negatively and vice-
versa.
 Therefore, capital structure decisions influence them and they also play a
role in financing decisions. It is important that these interests are kept in
mind while making financing decisions.
 The level of gearing has an influence on the perception which non-financial
stakeholders have about a company.
 For example:
Employees may view a highly geared company negatively and the management
may stand to lose good talent due to this negative perception on employee
growth prospects.
In the event of liquidation (due to non-payment of debt), customers may not
be able to obtain the required products and after-sales service.
Suppliers may go out of business in the event the company goes through
financial crisis.
 Role, motivations and interests of non financial
stakeholders in financing decisions (and related
conflicts)
 Therefore, the above stakeholders may demand compensation
for increased risk while dealing with the firm.
 Furthermore, the earnings have deteriorated significantly,
leading to risk of financial crisis. Apart from significant
pressure on management from lenders, the non-financial
stakeholders are also demanding increased payments from the
firm.
 The suppliers have stopped credit terms and are demanding
advance payment for supplies; key employees are on the verge
of resigning for fear of salary delays. Customers are shifting to
competition for fear of no fulfillment of delivery terms. They
are also concerned about after-sales service in the event of
liquidation of the firm.
 AGENCY RELATIONSHIP AND
COST:
 Agency Problem: In this type of relationship there is a chance of
conflicts to occur between the principal and the agent. This conflict is
termed as agency problem.
 Agency Costs: The costs incurred by stockholders in order to minimize
agency problem and maximize the owner‟s wealth are called agency costs.
 A principal-agent relationship exists where one party appoints
another to fulfill certain responsibilities on their behalf. Generally,
the agent should act in the best interests of the principal and should
not aim to benefit at the expense of the principal.
 The most prominent among the agency relationships in a business is the
relationship between the shareholders and the managers.
 This occurs because of the divorce of ownership and control. Shareholders
are the legal owners of companies but because, many times, they are not in
a position to run the company on a daily basis, directors are appointed.
 The overriding goal of financial management is maximization of
shareholder wealth. It is the duty of the directors (agents) to act in the
best interests of the shareholders (principals), never aiming at personal gain
at the cost of the shareholders
Diagram 1: Agency relationships in
the company
 Other agency relationships
 Investors, and therefore managers, are particularly
interested in the profitability of the firms that they own.
There are many ways to measure profits. Profitability
ratios provide an easy way to compare profits to earlier
periods or to other firms. Furthermore, by
simultaneously examining the first three profitability
ratios, an analyst can discover categories of expenses
that may be out of line.
 Directors/ shareholders and creditors
 The directors and shareholders (acting through
the directors) are responsible for safeguarding
the money the company owes to the creditors
and repaying them on time.
Other agency relationships
 Employees and management
 The employees of the company, in the discharge of
their duties, perform numerous acts on behalf of the
company. Therefore, they are the agents of the
managers / shareholders as they are responsible for
fulfilling the duties allocated to them.
 Directors / shareholders and customers
 The customers expect certain standards to be
fulfilled as regards quality and credibility. Directors
need to ensure that these expectations are met at
all times to achieve customer loyalty
 The agency problem
1. Directors vs. shareholders
 The agency problem arises when the directors, as agents, have
different aims and objectives from the shareholders, as
principals; there is said to be a conflict of objectives. The
directors may seek to further their own interests rather than
shareholder wealth, in the following ways:
Directors may design remuneration packages which are beneficial
to them, e.g. during a period of high profits; they may keep the
fixed element of remuneration packages relatively low, but award
higher percentage bonuses linked to profits. Alternatively, in times
of low profits, fixed remuneration may be increased.
Directors will want to ensure that they are seen to be ‘earning
their keep’. They may therefore focus on short term profitability,
opting for projects with shorter payback periods and better
short-term profits, ignoring the projects which may give better
long-term results and stability to the company.
 Directors vs. shareholders
 Some directors, in order to gain power and prestige, may engage in ‘empire
building’. They may therefore engage in unprofitable takeover bids.
 As a means of artificially boosting the results, directors may engage in
creative accounting practices e.g. off Statement of financial position
financing.
 To achieve a wider public profile, managers may go for diversification, which
may not be what shareholders desire. It may result in a loss of focus on the
core business activity.
 The managers may push forward social projects where they have personal
interests e.g. funding the construction of a gym at the school of the finance
director’s son. If the above is allowed to continue, the personal objectives of
the managers become a priority, thereby relegating the objectives of the
shareholders.
 As the earnings of the company improve, the employees may believe that
they need to be rewarded adequately on a consistent basis. They may look
forward to additonal bonuses apart from regular salaries. Furthermore,
employee unions may exert force on the management if their demands are
not fulfilled.
 The agency problem cont….
2. Creditors vs. management
 Creditors to whom the company owes significant
sums of money may wish to exercise greater control
on the company. They may require regular reports on
operating revenue, financial status, project progress
etc, which management may resist.
3. Customers vs. management (shareholders)
 Customers may have strict preferences and may
exercise resistance to changes in products.
Management may sometimes be constrained between
consumer interest vs. cost considerations.
Furthermore, in all the above conflicts, the additional
conflict arising out of the effect of government /
regulatory interventions cannot be ignored.
 1. Overcoming the
agency problem
 As seen earlier, there may be a conflict of interest
between the objectives of different stakeholders. In the
case of a company where the shareholding is widely held,
the shareholders may have little control / influence on
management. Since it is management that looks after the
day-to-day operation of a company, it takes most of the
important decisions which affect the achievement of
objectives.
 Therefore, the focus of the efforts to resolve the conflicts
is on the management. Similarly, as we discussed earlier,
the main conflict of interest is likely to arise in the
relationship between shareholders and managers,
although there may also be other conflicts of interest.
 1. Overcoming the agency problem
Market forces to reduce agency problems
 There are certain market forces which may operate to
reduce / eliminate agency problems.
Certain large institutional shareholders /
participants who hold significant shares in the
company may act together to resolve the agency
problem. For example, in case the management is in
competitive, they may act to exercise voting rights
jointly to replace the management.
Weak management may face the pressure of
takeovers by firms in the same industry who may
wish to take over the company and improve its
financial position through efficient management. The
management would act in shareholder interest due
to the pressure of a hostile takeover.
 2. Resolving the agency problem
 The key is to achieve goal congruence, i.e. the goals of management
and the goals of the shareholders should, as far as possible, be the
same or equivalent.
a). Performance-related pay
 The shareholders may choose to compensate management on the
basis of its proven performance i.e. compensation is linked to the
achievement of specific objectives of the organization. However,
managers still manage to manipulate these to their advantage.
1. Profits
 This may lead to short-termism. Managers will seek to maximize
profits in the short term to boost their own income. Projects which
may benefit the company in the long term, but which may be
unprofitable in its early days may be rejected.
2. Resolving the agency problem
ii.Sales
 Sales growth can be achieved by increasing spending
on marketing, promotions and advertising, by
reducing the selling price or a combination of both.
If this is done, sales growth would be achieved, but
at the expense of profitability.
iii. Return on capital employed (ROCE) / earnings
per share (EPS)
 ROCE expresses profits before interest and tax as a
percentage of capital employed. Some performance
related pay schemes may reward managers for
maintaining, achieving or exceeding a certain ROCE.
 2. Resolving the agency problem

b) Employee stock option plans (ESOPs)

 The share option scheme gives the manager the option to
purchase a specified number of shares at a fixed price, within a
specified period. If the price of a company’s shares increases
above this price, then the managers gain by exercising their
options. There is no obligation to exercise the options if the
share prices are lower. Share options can therefore act as an
incentive for managers.
c) Monitoring performance
 The shareholders as principals may monitor the actions of their
agents (the management) to ensure that they act in the interest
of shareholders. This is achieved through engagement of audit
and control procedures. This cost would have to be incurred to
ensure that they act to achieve the objective of shareholder
wealth maximization.
2.The Time
Value of
Money
Learning Objectives
 Time value of money(TVM) concept
 TVM means that the value of money is different at different points of
time.
 TVM is the idea that money available at the present time is worth more
than the same amount in the future due to its potential earning capacity.
 Sound financial decisions need comparable cash flows (CCFs)
 CCFs need to be adjusted for time, risk and timing
 Which would you rather have -- TSH100,000 today or TSH100,000 in 5
years?
 Obviously, TSH100,000 today
 TIME allows one the opportunity to postpone consumption and earn
INTEREST.
 The sooner the cash flows occur the more valuable they are.
“A bird in hand is worth two or more in the bush”
 Reasons of TVM
1. Risk: there is no certainty about the future and involves risk;
a business enterprise does not have much control over
future cash inflows as it depends on external factors like
debtors etc. Therefore, a person prefers receiving cash in the
present rather than in the future.
2. Consumption: a person generally prefers current
consumption to future consumption.
3. Investment opportunity: money received today can be
invested by the person to earn a high rate of return in the
future.
4. Inflation: in an inflationary economy, money received today
has more purchasing power than money received in future.
 Role of TVM

To an
To a financial Individual
manager • Personal financial
decisions e.g.
• All financial
mortgage, saving
decisions need
schemes, providing
logically
for pensions,
comparable CFs
insurance policies
etc.
 Simplifying Assumptions

Costs and
benefits are Specific
All cash respectively Interest effects of All cash
flows occur interpreted rates inflation on flows are
at the end as cash remain investment certain and
of the outflows constant decisions prices are
period (negative) over time are ignored constant
and inflows (for now!)
(positive)

TVM 40
 Perspectives of time value of
money
 Any financial decision involves comparison of the cash inflows and
outflows which accrue over a number of years.
 For example, when investment is made in a project, the firm has to
acquire assets which are used in – say - production.
 The inflows from this activity will be accrued over a number of years.
However, the firm will have to invest in fixed assets at the time of
inception for enabling production.
 This means that there will be cash outflows at the time of setting up
the plant which will have to be c compared with the inflows over a
period once production starts.
 Thus, cash inflows and outflows accrue over different periods of time.
 Comparing the inflows and outflows as they are generated will be
incorrect as they accrue over different periods of time.
 In order to enable a meaningful comparison, adjustment has to be made
for the difference in timing of the cash flows.
Two perspectives of TVM
Future Value (FV)
• the amount to which an
initial sum deposited (the
principal, PV) will grow
when it is compounded at a
specified interest rate (r)
and in a number of years
(n).

Present Value (PV)

• Present value (PV) is the
cash equivalent today of a
sum of money (FV) to be
received or paid at a
TVM
specified future date (n), 42
discounted at a known rate
 Future Value(compounding technique)

FVn = PV0 (1+r)n, for n-year period;

FVn = future value at the end of period n

• PV0 = initial principal or present value
• r = annual rate of interest paid
• n = the number of periods (typically years) that the
money is left on deposits.

TVM 43
 Future Value

• If you deposit 1,000,000/= today in a bank

account that pays an annual rate of
interest of 10%, what will be its value in 5
Example years?
• Solution:
1 • FV (10%,5) = 1,000,000 (1+0.10)5 =
1,610,510
• FVn = PV0 x (FVIF 10%,5)
• = 1,000,000 (1.61) = 1,610,000/=

TVM 44
 FV
 In the above example, we have considered annual compounding
that means compounding is done once in a year; interest can be
compounded more than once a year also.
 Semi - annual compounding (half=2times)
 quarterly compounding (after three months)
 Monthly compounding means thati compounding will happen
FV  PV (1  )
every month m

Example: Calculate the amount to be received by investors when they

invest Tshs 100,000 for 2 years at an interest rate of 10% compounded
quarterly.
Amount to be received will be?:
 FVs, time and Interest rates
35.000
20%

30.000

 ll
FV of One Shilling

25.000 15%

20.000

15.000

10.000 10%

5.000 5%
0%
0.000
0 2 4 6 8 10 12 14 16 18 20 22 24
Periods

TVM 46
Present Value(Discounting
Technique)
 Present value is the current value of a future amount.
 Present value of money that will be received in the
future will be less than the value of money in hand
today.
 This technique determines the present value of a future
amount assuming that the investor has an opportunity
of earning a return on his money.
 This return is known as the discount rate.
 Present value is the opposite of compound value. In
compound value, money invested increases because of
compounding effect.
 Present Value(Discounting Technique)

 From FVn = PV0 (1+r)n, for n-year

period; we have;

;

FVn
PV0 
(1  r ) n

TVM 50
 Present Value(Discounting Technique)

Example 2:
 You are due to receive 1,610,510/= five years
from now and wishes to find out how much it is
worth today if interest rate is 10%

1,610,510
PV10%, 5   1,000,000 / 
(1  0.10) 5

TVM 51
Present Value, Time and Interest rate

1.250
Present Value of One Shilling
0%
1.000
0%

0.750

0.500
5%

0.250
10%

20% 15%
0.000
0 2 4 6 8 10 12 14 16 18 20 22 24
Periods

TVM 52
 Relationship between
FVs and PVs

 the concept of PV is exactly the opposite of the

FV concept; [i.e., given n and r, discounting an nth year
future value of a shilling results into a shilling and vice
versa].
 the concepts of FV and PV are inversely related;
[i.e., over time, the PV will decrease while the FV will
increase. We can therefore find the PVIFs given a table of
FVIFs and vice versa].

TVM 54
 Manipulations (Finding n)
Example 3:
You inherited a small sum of 2,000,000/=. You are
wondering how long it will take for this amount
to double if you deposit it into a bank account
that can earn you interest at 10% compounded
annually.
Solution:
◦ solve the FV equation for n.
◦ 4,000,000 = 2,000,000(1+0.10)n
◦ 2 = 1.10n
TVM 55
 Manipulation (Finding n)
 Solve for n in 2 = 1.10n
Either:
◦ look up in FVIF tables using r = 10% on the top row
and the value 2.000 in the middle of the table;
OR
algebraically as follows:
◦ Take log of both sides;
◦ log 2 = log1.10n
◦ log 2 = n log 1.10; using rules of logarithm
◦ n=log2/log 1.10 = 0.3010/0.0414 = 7.27 years

TVM 56
 Manipulations (Finding r)

Example 4:

Your uncle retires and receives 3,000,000/=

payment. He wishes to invest the money such
that he will have 4,500,000/= in five years time.
Advise your uncle as to what interest rate he
must earn if he is to achieve his investment
objective, assuming annual compounding.

TVM 57
 Manipulation (Finding r)

 Solution:
◦ 4,500,000 = 3,000,000 (1+r)5
◦ Dividing both sides by 3,000,000 we have; 1.5
= (1+r)5
◦ Either look up in the FVIF tables using n = 5,
reading a number close to 1.50 in the inside of
the table and read the resulting r right on the
top of the column.

TVM 58
 Manipulation (Finding r)
OR
◦ solve for the unknown value r algebraically as
follows:

◦ Take the fifth root of both sides;

◦ 1.5 = (1+r)5
◦ 1.08447 = (1+r);
◦ r = 1.08447-1 = 0.08447 = 8.447%

TVM 59
 Multiple Cash flows [FVs]

Example 5:
 Suppose you will be able to deposit 100,000; 200,000; and 300,000
shillings into a bank account, in year 1, year 2, year 3 from now
respectively. How much will you have in five years, assuming 7%
interest through out?
 Solution:
0 1 2 3 4 5

100,000 200,00 300,0

0 00
300,000x1.072 =
343,470/=
200,000x1.073 =
245,010/=
100,000x1.074 =
131,080/=
Total FV =
719,560/=
TVM 60
 Multiple cash flows (PVs)
Example 6:
Assume you are offered an investment opportunity that
will pay you 200,000; 400,000; 600,000 and 800,000 at
the end of each of the next four years, respectively. If
you can earn 12 percent on very similar investments,
how much would you be prepared to pay for this
investment offer today?

TVM 61
 Multiple Cash flows (PVs)

0 1 2 3 4

200,000 400,000 600,000 800,000

200,000 x (1/1.121 ) = 178,570/=

400,000 x (1/1.122 ) = 318,880/=

600,000 x (1/1.123 ) = 427,070/=

800,000 x (1/1.124 ) = 508,410/=

Total PV 1,432,930/=
TVM 62
 Level Cash flows (ordinary annuities)
 Assumes that cash flows occur at the end of the year.
 Annuity:
◦ A series of consecutive payments or receipts of equal amount
 Future Value of annuity
 FVAr,n =PMT x FVIFAr,n or
◦ PMT= Payment per period(Annuity)
◦ FVA= Future value
◦ FVIFA=Future Value Interest Factor of Annuity

 1  r n  1
 or
FVAr , n  PMT  
 r 
TVM 63
Level Cash flows (Ordinary Annuities)

Example 7:
Suppose you decide to set aside 3m/= at the end of
each year in order to buy your first dream car. If
your savings earn interest of 8% a year, how much
will the savings be worth at the end of 4 years?

TVM 64
 Level Cash flows (Ordinary Annuities)

0 1 2 3 4

3 m/= 3 m/= 3 m/= 3 m/=

= 3.00 m/=

3 /=x1.081 = 3.24m/=

3 /= x1.082 =3.50m/=
3 /=x 1.083 =3.78m/=

Total FV = 13.52m/=

TVM 65
 Level Cash flows (Ordinary Annuities)

FVAr ,n  3m  4.51  13.53

 Or

 1  0.084  1
FVAr ,n  3m     13.518336
 0.08 
TVM 66
 Level cash flows (Ordinary Annuities)

 Present Value of annuity

 PVAr,n = PMT x PVIFAr,n

 OR
1 1 
PVAr ,n  PMT   n
 r r 1  r  
TVM 67
 Level cash flows (Ordinary Annuities)

Example 8
 Find the present value of a series of equal periodic payments
in an ordinary annuity of 1,000,000/= received at the end of
each of the five years discounted at 6% rate.
◦ PVA 6%,5 = 1,000,000 x 4.21 = 4,210,000/=

 1 1 
PVAr ,n  1m    5 
 0.06 0.061  0.06 
 4,212,363.79
TVM 68
Level cash flows (Ordinary Annuities)

1 2 3 4 5

1m 1 1 1m 1m
m m

TVM 69
 Level cash flows Annuity due
 Assumes cash flows occur at the beginning of
the period
 Example 9: If you deposit TShs. 1mil in a saving
account at the beginning of each year for four years to
earn a 6 percent interest, how much will be the
compound value at the end of the 4 years?

 FVA4=
1(1.06)4+1(1.06)3+1(1.06)2+1(1.06)1=4.637
TVM 70
 Level cash flows Annuity due

 each cash flow of an annuity due earns interest

for one more year than an ordinary annuity.
Multiplying FVIFA by (1+r) simply adds an
additional year’s interest to each annuity cash
flow.
 Thus;

 1  r n  1
FVAr ,n  PMT   1  r 
 r 
TVM 71
 Level cash flow annuity due

 Present value
◦ Needs similar adjustment

Example 10:
 Let us consider a 4-year annuity of Tshs 1,
the interest rate being 10%. If the first cash
flow occurs at the beginning of the first year,
what is its present value?
TVM 72
 Level cash flow annuity due

 Discount each of the subsequent three cash

flows to the present and add the results up
together with the first cash flow; or simply use a
similarly adjusted PVIFA as follows:

TVM 73
Present Value of Perpetuity
 Perpetuity means the annuity that occurs indefinitely. For
example, in case of irredeemable preference shares,
 the company is required to pay dividend perpetually. In
perpetuity, the time period is so large that mathematically
 it reaches infinity; hence present value of perpetuity is given
as follows:
 Present value of perpetuity =perpetuity/interest rate
Example
 If A expects to receive a perpetual sum of Tshs 100,000
annually from his investment with interest rate of 12%per
annum, what will be the present value of perpetuity:
As per above formula,
 Present value of perpetuity =100,000/0.12
 = 800,333
 Level cash flow (perpetuity)
Example 11:
 Find the present value of a perpetuity of
500,000/= assuming a discount rate of 8%.

PVP8% = PMT/r = 500,000/0.08 = 6,250,000/=

TVM 75
 Compounding frequency (general)

Future value
mn
 r
FVn  PV0 1  
 m
Present
value FVn
PV0  mn
 r
1  
m
TVM 76
 Compounding Frequency
 Definite frequencies
 Infinite/indefinite frequencies
 Applications
◦ Sinking funds
◦ Deferred annuity
◦ Retirement plan
◦ Capital recovery and loan amortizations

TVM 77
 Effects of inflation
 The nominal interest rate, or coupon rate, is the actual
price borrowers pay lenders, without accounting for any
other economic factors. The real interest rate accounts
for inflation
 The relationship between nominal and real rates of interest
is normally referred to as the Fisher relationship presented in
the following equation:

1  no min al rate
1  real rate 
1  inf lation rate
1  no min al rate
 the real rate  1
1  inf lation rate
TVM 78
 Effects of inflation
Example 14:
 Suppose that you invest your funds at r=8%.
What is the real rate of interest if inflation
stands at 5%?

1.08
real rate   1  0.02857  2.86%
1.05
consistency is the key factor. •
discount nominal cash flows by nominal interest •
rate and real cash flow by real interest rate.
TVM 79
 Sinking Fund
 A sinking fund is a fund which is created by contributing fixed
amounts at regular fixed intervals so that a pre - decided sum is
accumulated at the end of the specified period.
 Sinking fund is generally created by borrowers; e.g. companies create
sinking fund to repay debentures or bonds on maturity. Borrowers
may pay interest at regular intervals during the life of the loan but
may not have sufficient provision to repay the principal on maturity of
the loan. Hence, sinking funds are created to make provision for
repayment of loan on maturity.
 Time value of money is taken into account to calculate the amount
that needs to be contributed to the sinking fund so that funds are
available to repay loan on maturity. Funds contributed are so invested
that amount is available at the time of repayment of loan.
 The factor that is used to calculate the equal annual contribution
every year is called the Sinking Fund Factor (SFF) and it ranges
between 0 and 1.0.
 Sinking Fund
 PQR Plc intends to establish a sinking fund to repay Tshs 10 million
7% debentures 10 years from today. The first payment will be made
at the end of the current year. The company expects that the funds
will earn 6% interest per year.
Required:
 What equal annual contributions should be made to accumulate
Tshs 10 million after 10 years?
Answer
According to the annuity tables, annuity factor for 10 years @ 6% per
annum is 13.181 which means that a unit of Tanzanian Shilling
invested at the end of each year for 10 years will accumulate to
Tshs 13, 181 at the end of the 10th year. In order to have Tshs 10
million, the required amount of annual contribution will be:
Sinking Fund
 (Tshs 10 million/758,669)=Tshs 13.181
 If the company makes a contribution of Tshs 758,668 at the end of
each year for 10 years, it will have Tshs 10 million in the account
for retiring the debentures on maturity. Formula for computing
sinking fund can be given as follows
 A=A(1/Compound value factor of annuity)
 A= Sinking Fund contribution
 F= Future Value
 In the above example, annual sinking fund contribution can be
computed using the above formula:
 A=TZS10mil(1/13.181)
 A= Tshs 10 million x 0.07586
 A= Tshs 758,680

 Application (Sinking fund)
Example 15
 Suppose a company wishes to set aside an
equal annual end-of-year amount in a sinking
fund account earning 10% per annum over the
next 5 years. The firm wants to have 5m/= in
the account at the end of 5 years in order to
retire/pay off 5m/= in outstanding bonds.
How much must the firm deposit in the
account at the end of each year?

TVM 83
 Sinking fund
FV5  5m , r  10% n  5
FVA5  PMT FVIFA 0.10, 5 
 1  r n  1 
FVAr , n  PMT  
 r 
 1  0.15  1 
5,000,000  PMT  
 0 .1 
5000000
PMT   819,000
6.105
TVM 84
 Deferred Annuity
 Deferred annuity means that the equal annual payments begin after a
specified number of periods and not from the first period.
 For example, an ordinary annuity of six instalments deferred for 3
years means that the first payment will occur only at the beginning of
the fourth year and that no payments will occur in the first three
years.
(a) Future Value of a deferred annuity
 The deferred period is not taken into account while calculating the
future value of a deferred annuity just like in case of an ordinary
annuity which is not deferred.
(b) Present Value of Deferred Annuity
 While computing present value of deferred annuity, we compute the
present value of ordinary annuity as if the cash flow has occurred for
the entire period; deduct present value of cash flows not received/
paid during the deferred period; balance is the present value of cash
flows actually received/ paid subsequent to deferral period.
 Deferred Annuity
Example
 A has agreed to pay rent of Tshs 50,000 per month
for 10 months beginning 5 months from today.
Interest rate is 8% per annum. What is the present
value of the payments?
 Present value of annuity is calculated as below:
 Monthly rent: Tshs 50,000
 Present value of ordinary annuity of 1 for total periods
(10 months): 6.71
 Less: Present Value of annuity of 1 for the deferred
periods: 3.31213
 Difference: 3.39795
 Present value of six months’ rent: 50,000 x 3.39795
 Deferred annuity
Example 16
Suppose you wish to provide for college
education for your daughter. She will begin
college 5 years from now and you wish to
have 1.5 million available for her at the
beginning of each year in college. How much
must you invest today at 12% annual interest
rate in order to provide the 4 year 1.5m/=
annuities for your daughter?

TVM 87
Application (Deferred Annuity)

TVM 88
 Application (Deferred annuity)

 Option 1
Year PMT5,t PVIF0.12,t PV0
5 1,500,000 0.567 850,500
6 1,500,000 0.507 760,500
7 1,500,000 0.457 678,000
8 1,500,000 0.404 606,000
2,895,000

TVM 89
 Application (Deferred annuity)

Option 2
Step 1. Calculate PV of the 4 year annuity
evaluated at the end of year 4

=1,500,000 x PVIFA12%,4 PVA4

1,500,000 x 3.037 =
4,555,500 =

TVM 90
Application (Deferred Annuity)

 Step 2. Calculate the PV at t = 0, of the

annuity value (PV4) by discounting it as a
single lump sum 4 years to year zero (PV0)

PVA4 x PVIF12%,4 = PV0

4,555,500 x 0.636 =
2,897,300 =

TVM 91
 Application (Deferred annuity)
 Option 3
Simply multiply the annuity payment by the
difference between the PVIFA12%,8 and PVIFA12%,4.
You are effectively viewing the problem as an 8-
year annuity that has no payments during the first
4 years.

1,500,000[PVIFA12%,8 – PVIFA12%,4] = PV0

1,500,000 [4.968 – 3.037] =

2,896,500 =
TVM 92
Retirement Plans
 Time value concept is very important in
retirement planning. For retirement planning,
it is necessary to determine the sum of
money that needs to be paid every year to
provide adequately for retirement. An
investor needs to consider the following
factors for the retirement planning:
◦ Time frame available upto retirement
◦ Return that will be earned on the investments till
the retirement
◦ Amount of funds that will be required at the time
of retirement
Retirement Plans
 Example
 Tom earns Tshs 30,000 per month at the age
of 25. Tom wishes to maintain the same
standard of living after retirement which will
be at the age of 55. Average rate of inflation
is assumed as 6%. Determine the amount
that will be required by Tom every month
after retirement to maintain the same
standard of living.
 Fv=PV(1+r)n
 =30,000(1+0.06)30=Tshs 172,304.74
Retirement Plans
Assignment
 An old friend approached you for help. She is 35 years
old today and is planning for her retirement at the age
of 60 years. She wants to set aside an equal amount of
money in a bank account at the end of each of the next
25 years so that she would be able to draw 5 million
annually from her 61st through to the 80th birthday, her
expected end of life. The account is expected to earn
10 percent interest for the entire period. Determine the
annual deposits that she must make
Application (Capital recovery or
loan amortization)
 Capital recovery factor gives the amount of equal
payments to be received at the end of the period of n
years to recover the investment made.
 A capital investment decision needs to consider two
factors- outflow for the capital investment occurs in
the current period whereas the cash inflows will
occur over a number of years in the future.
 So, it is necessary to convert the cash flows to a
single point in time in order to enable meaningful
comparison.
 Companies generally use the present value to make
this comparison rather than future value because the
initial cost of investment is already in the present
value.
Application (Capital recovery or loan
amortization)
Example 17
 Suppose you borrowed 10,000/= from
NBC. The loan is for a 3 year period at an
interest rate of 10%. NBC requires that
you make three equal end-of-year payments
that include both principal and interest on
outstanding balance.

TVM 97
 Capital recovery

 Step 1
◦ compute the equal annual instalments.
PMT x PVIFA10%,3 = PVA0
PMT x 2.487 = 10,000
10,000/2.487 = PMT
4,020.91 =

TVM 98
 Application (Capital recovery or loan
amortization)

 Step 2
◦ use this amount to amortize the loan,
separating the amount of the instalment meant
to recover the interest and the amount meant
to recover the principal.

TVM 99
 Application (Capital recovery or loan
amortization)

EOY PMT Interest Principal Balance

0 10,000
1 4020.91 1000 3020.91 6979.09
2 4020.91 697.91 3323.00 3656.09
3 4020.91 365.61 3656.09 0

10
TVM 0
 Value real securities
 Securities like shares and bonds are called
financial assets.
 Present value concept can be used to value
the securities so that an investor can take an
informed decision to maximize the value of
investment.
 The present value concept as discussed
above takes into consideration the time as
well as risk factor while determining the
value of investment.
 Present value concept cannot measure the
degree of risk.
 Valuation of debentures
 A bond (also known as debenture) is a long- term debt instrument.
Bonds are issued by government as well as by private sector
companies.
 In case of debentures or bonds, rate of interest is fixed and known to
the investor.
 Generally, the interest rate and maturity period of bonds is specified
by the company issuing them.
 Bonds involve payment of interest at fixed intervals over the term of
debentures and maturity value at the end of the period for which
bonds are issued.
 Since interest payments happen over a considerable period of time till
the maturity of bonds, present value is determined.
 Comparison of present value of bonds with its market value will
enable the investor to know whether the bond is undervalued or
overvalued.
 Discount rate used for calculating present value of bonds is the rate
of interest that investors will earn on bonds with similar
characteristics.
 Valuation of debentures
 Lewis is considering purchase of five- year
Tshs 50,000 value bond carrying interest of
7% p.a. Lewis’ required rate of return is 8%
p.a. Determine the amount that Lewis can
pay now to purchase the bond if it matures
at par. Present value can be determined as
follows:
 Interest received every year: Tshs 3,500 and
amount received on maturity Tshs 50,000
 Present value will be calculated as follows:
 PV= n
c A

t 1 (1  r )
t
(1  r )
n
 Valuation of debentures
5
3,500 50,000

t 1 (1  0.08)
t
(1  0.08)5
Using the values from the present value table, the
present value of bonds will be:
PV= 3,500 x 3.993 + 50,000 x 0.681
PV= 13,975 + 34,050 = Tshs 48,025

The above indicates that a bond of Tshs 50,000 has a

present value of Tshs 48,025 today with a required rate of
return of 8%. The investor will not pay more than Tshs
48,025 for the bonds today.
 Valuation of preference shares
 A company issues two types of shares: ordinary and preference shares.
In case a company is wound up, preference shares get a preference in
terms of payment of dividend and repayment of capital.
 The rate of dividend is fixed in case of preference shares. Like in case of
bonds, generally the interest rate and maturity period of preference
shares is specified by the company issuing the preference shares.
 Preference shares involve payment of dividend at fixed intervals and
payment of maturity value at the end of the period for which shares are
issued. Since dividend payments happen over a considerable period of
time till the maturity of preference shares, present value of preference
shares is determined.
 Comparison of present value of preference shares with its market value
will enable the investor to know whether the preference shares are
undervalued or overvalued. Discount rate used for arriving at the
present value is the rate of dividend that investors will earn on
preference shares with similar characteristics.
 Classes of Shares

Deferred
Ordinary or founder
Shares Shares

Preference
Shares
 Preference Shares
 Preferential rights to a fixed rate of dividends
before dividends to ordinary shareholders are
declared
 Repayment of capital when company is wound
up
 Participation in surplus assets and profits
 Cumulative and non-cumulative dividends
 Voting rights
 Priority of payment of capital and dividends
Preference Shares
 Annie is considering purchase of preference shares with the
following features:
 10 year 10 per cent Tshs 10,000 par value preference shares.
On maturity, the value of preference shares will be Tshs
15,000. Annie’s required rate of return is 11%. What would
be the price that Annie would be willing to pay for the
preference shares?
 Annie would receive dividend of Tshs 1,000 for 10 years and
Tshs 15,000 on maturity. To find out the price that Annie
would be willing to pay for the shares, we need to find out
the present value of the dividends to be received over 10
years and present value of the maturity amount to be
received after 10 years. The present value annuity factor will
be used to find out the value of the equal annual amount of
preference dividends and present value factor to find out the
value of the amount received on maturity.
 Preference Shares
 Value of preference share will be
calculated by the below formula:
1 1 A
PV  PDx (  )(
r r (1  r )n (1  r )n
PD= Preference Dividend
R= required rate of return
A= Maturity value
In the above example, present value will be as follows:

1 1 15,000
PV  1,000 x(  )(
0.11 0.11(1  0.11)10 (1  0.11)
Preference Shares
 = 1,000 x 6.206515 + 15,000 x 0.317
 = 6,206 + 4755
 = Tshs 10,961
 The Tshs 100 preference share is worth
Tshs 10,961 today at 11 per cent required
rate of return. Annie can purchase the
share at Tshs 10,000 today.
 Valuation of ordinary shares
 Valuation of equity shares is difficult because the amount and timing
of cash flows expected by equity share holders is not fixed. This is
because the rate of dividend is determined by the company every
year and also it is not mandatory for the company to pay dividend
every year; the company may opt not to pay dividend in a particular
year due to low performance or low profitability or for any other
reason.
 An ordinary share consists of two cash flows- the dividends that the
shareholder expects to receive during the period that the shares are
held, and the price expected to be received on sale of shares.
 However, when an investor sells the shares to the buyer, the buyer
will further sell the shares to another buyer after a certain period of
time.
 Thus, it is concluded that for equity shareholders, the expected cash
inflow consists of only dividends expected to be received in the
future and therefore value of an ordinary share is the present value
of future expected dividends.
 Valuation of ordinary shares

 Bob intends to buy an equity share and hold it for 1 year. He

expects to receive dividend of Tshs 500 in the next year and
he expects the selling price of the share to be 3,000 at the
end of the year. The required rate of return is 15 per cent.
What amount should Bob pay today for acquiring the share?
 The price that Bob should pay will be calculated as follows:
 P = (Dividend + Selling Price)/(1+ r (required rate of
return))
 P= (500+3,000)/(1+0.15)
 3,500/1.15
 = Tshs 3,043
 Bob will buy the share if the price of the share is less than
Tshs 3,043.
Topic 3

Risk and Return

Learning outcomes
 Explain return and risk
 Describe the relationship between risk and
return
 Measure return and risk
 Compute rate of return, variances and
standard deviation of returns
 Define risk and expected return in a
portfolio context
 Analyse the power of diversification in
achieving superior return
 Determine optimal portfolio weights.
 Defining Return
Return on an asset/ investment is the actual
income received plus any change in the market
price of an asset/ investment. This is generally
expressed as a percentage of the opening
market price.

Dt + (Pt - Pt-1 )
R=
Pt-1
 R= Return on asset/ investment
 𝐷𝑡 = annual income/ cash dividend
at the end of the time period t
 𝑃𝑡 = security price at time period t
(closing security price)
 𝑃𝑡−1 = security price at time
period t-1 (opening security price
 Return Example
The stock price for Stock A was $10 per share 1
year ago. The stock is currently trading at $9.50
per share and shareholders just received a $1
dividend. What return was earned over the past
year?
 Return Example
The stock price for Stock A was $10 per share 1
year ago. The stock is currently trading at $9.50
per share and shareholders just received a $1
dividend. What return was earned over the past
year?

$1.00 + ($9.50 - $10.00 )

R= = 5%
$10.00
 Defining Risk
The variability of returns from those
that are expected.
What rate of return do you expect on your
investment (savings) this year?
What rate will you actually earn?
Does it matter if it is a bank CD or a share of
stock?
Expected rate of return
 Expected rate of return is the weighted
average of all possible returns multiplied
by their respective probabilities.
 Determining Expected
Return (Discrete Dist.)
n
R = S ( Ri )( Pi )
i=1
R is the expected return for the asset,
Ri is the return for the ith possibility,
Pi is the probability of that return occurring,
n is the total number of possibilities.
 How to Determine the Expected
Return and Standard Deviation

Stock BW
Ri Pi (Ri)(Pi)
The
-.15 .10 -.015 expecte
-.03 .20 -.006 d return,
.09 .40 .036 R, for
.21 .20 .042 Stock
BW is
.33 .10 .033 .09 or
Sum 1.00 .090 9%
 Determining Standard
Deviation (Risk Measure)
n
s= S ( R i - R )2 ( Pi )
i=1
Standard Deviation, s, is a statistical measure of
the variability of a distribution around its mean.
It is the square root of variance.
Note, this is for a discrete distribution.
 How to Determine the Expected
Return and Standard Deviation

Stock BW
Ri Pi (Ri)(Pi) (Ri - R )2(Pi)
-.15 .10 -.015 .00576
-.03 .20 -.006 .00288
.09 .40 .036 .00000
.21 .20 .042 .00288
.33 .10 .033 .00576
Sum 1.00 .090 .01728
Determining Standard
Deviation (Risk Measure)
n
s= S
i=1
( R i - R ) 2( P )
i

s= .01728

s= .1315 or 13.15%
 Coefficient of Variation
The ratio of the standard deviation of a distribution
to the mean of that distribution.
It is a measure of RELATIVE risk.
CV = s / R
CV of BW = .1315 / .09 = 1.46
 Discrete vs. Continuous
Distributions

Discrete Continuous
0.4 0.035
0.35 0.03
0.3 0.025
0.25 0.02
0.2 0.015
0.15 0.01
0.1 0.005
0.05
0
0

13%
22%
31%
40%
49%
58%
67%
4%
-50%
-41%
-32%
-23%
-14%
-5%
-15% -3% 9% 21% 33%
 Determining Expected
Return (Continuous Dist.)
n
R = S ( Ri ) / ( n )
i=1
R is the expected return for the asset,
Ri is the return for the ith observation,
n is the total number of observations.
 Determining Standard
Deviation (Risk Measure)
n
s= S ( Ri - R )2
i=1
(n)
Note, this is for a continuous distribution where
the distribution is for a population. R represents
the population mean in this example.
 Continuous Distribution
Problem
 Assume that the following list represents the
continuous distribution of population returns for a
particular investment (even though there are only 10
returns).
 9.6%, -15.4%, 26.7%, -0.2%, 20.9%, 28.3%, -5.9%,
3.3%, 12.2%, 10.5%
 Calculate the Expected Return and Standard
Deviation for the population assuming a
continuous distribution.
Let’s Use the Calculator!
Enter “Data” first. Press:
2nd Data
2nd CLR Work
9.6 ENTER ↓ ↓
-15.4 ENTER ↓ ↓
26.7 ENTER ↓ ↓
 Note, we are inputting data only
for the “X” variable and ignoring
entries for the “Y” variable in this
case.
Let’s Use the Calculator!
Examine Results! Press:
2nd Stat
 ↓ through the results.
 Expected return is 9% for the 10
observations. Population
standard deviation is 13.32%.
 This can be much quicker than
calculating by hand, but slower
than using a spreadsheet.
 Risk Attitudes
Certainty Equivalent (CE) is the amount of cash
someone would require with certainty at a
point in time to make the individual indifferent
between that certain amount and an amount
expected to be received with risk at the same
point in time.
 Risk Attitudes
Certainty equivalent > Expected value
Risk Preference
Certainty equivalent = Expected value
Risk Indifference
Certainty equivalent < Expected value
Risk Aversion
Most individuals are Risk Averse.
 Risk Attitude Example

You have the choice between (1) a guaranteed dollar

reward or (2) a coin-flip gamble of $100,000 (50%
chance) or $0 (50% chance). The expected value of
the gamble is $50,000.
◦ Mary requires a guaranteed $25,000, or more, to
call off the gamble.
◦ Raleigh is just as happy to take $50,000 or take the
risky gamble.
◦ Shannon requires at least $52,000 to call off the
gamble.
 Risk Attitude Example
What are the Risk Attitude tendencies of each?

Mary shows “risk aversion” because her “certainty

equivalent” < the expected value of the gamble.
Raleigh exhibits “risk indifference” because her
“certainty equivalent” equals the expected value of
the gamble.
Shannon reveals a “risk preference” because her
“certainty equivalent” > the expected value of the
gamble.
Measuring Risk
 The risk in relation to a single asset is measured with
respect to behavioural and quantitative or statistical
pointof view.
1.The two techniques for behavioral assessment of
risk are
 (a) Sensitivity analysis
 (b) Probability analysis
Measuring Risk
a) Sensitivity Analysis
 This technique considers the various possible estimates
of outcomes for assessing the risk.
 It takes into consideration the worst (recession in
economy), the most likely (normal conditions in the
economy) and the most optimistic outcome (boom)
associated with the asset under consideration.
 The difference between the worst outcome and the
most optimistic outcome is referred to as the range.
Range is the basic measure of risk according to the
sensitivity analysis technique.
 The higher the range, the higher is the risk to which the
asset/investment is exposed
Measuring Risk
 Given below are details of expected
returns from two assets of a company:

Particulars Asset 1 Asset 2

Expected Return under various
scenarios in percentages:
Pessimistic 15 23
Most likely 19 25
Optimistic 23 29
Range 12 6

Asset 1 has a higher range, which means that asset

1 is riskier than asset 2.
Measuring Risk
(b) Probability analysis
 This technique is considered to be more
accurate than Sensitivity Analysis. As
already explained above,
 probability is the likelihood or a chance of
occurrence of an event.
Techniques for quantitative or
statistical analysis of risk
(a) Standard deviation
(b) Coefficient of variation
(a) Standard Deviation
 This commonly used measure of risk measures the
standard deviation from the most likely/ expected value
of return.
(b) Coefficient of variation
 This is the measure of risk per unit of expected return.
This is useful for comparing risk of assets with different
expected returns.
 Relationship between risk and
return
 Any investment involves some amount of risk
 risk is the possibility that investment made may not yield returns as
expected and that the objectives of investment may not be fulfilled.
Risks are generally
 classified as market risk (economic changes, market conditions etc),
liquidity risk (investments cannot be sold easily), concentration
risk (investing in only one investment or type of investment; no
diversification), capital risk(risk of losing the capital invested) etc.
 Returns are the amount earned on the investment.
 Returns may be in the form of interest and dividend as well as in the
form of capital gains.
 Returns are affected by inflation and the tax regulations in the
economy.
 Relationship between risk and
return
 Risks and returns are directly related to each other.
 The higher the risk an investment carries, the higher will be the
expected returns from the investment.
 Higher risk in an investment is compensated by a potential for
higher returns. For example, fixed deposits or government bonds
have a lower rate of return as compared to mutual funds and stocks.
 In the case of fixed deposits or government bonds, the returns are
guaranteed; also the investor is sure to get his principal back. In
some cases, the returns are not guaranteed but the investor is
certain of
 getting the principle back. In the case of stocks or mutual funds,
there is a possibility that an investor not only gets
 lower returns but can also lose their principal amount invested.
Relationship between risk and
return
 Risk and return also depend upon the
time period for which the investment is
held.
 Returns from investments carrying high
risk tend to be higher if held for a long
period of time.
 For short term investments, the more
conservative options yield higher returns.
 Relationship between risk and return
An investment may be classified in any of the following categories:
(a) High Risk High Return: in this case, investment will yield high
returns but the risk will also be high. For example, shares, mutual
funds etc.
(b) Low Risk Low Return: the investment will carry low risk and
the return will also be low. For example, money in fixed deposits,
government bonds etc.
(c) High Risk Low Return: in this case, the investment carries a
high risk and a high return up to a certain point but after that the
returns do not increase in proportion to the increase in risk.
(d) Low Risk High Return: this is not a common phenomenon.
This will be possible when say government needs money in an
emergency and issues bonds at a high rate of interest, then the
investor will get high returns at low risk.
 Relationship between risk and
return
 An investor makes investment decisions based on information available about
the risks and returns of investment options under consideration.
 The decision also depends upon the risk preference of the investor.
 Investors generally show preference for investments with higher returns and
lower risks.
Investors can be generally classified as follows:
1. Risk averse investor- in the case of equal rates of returns from various
investment options, the investor will choose the ones with the lowest standard
deviation and vice versa.
2. Risk neutral investor- is the one who does not take risks into consideration
and selects investments with higher returns.
3. Risk seeking investor- is the one who shows preference towards investments
with higher risk, irrespective of the rate of return.
Definition risk and expected return in a
portfolio
 A portfolio means a combination of two or more assets/
securities.
 Each portfolio will have different risks and returns.
 Investors generally prefer to invest in a portfolio of assets
rather than a single asset or a few assets as the investment is
diversified in case of portfolio investment, and risk is therefore
reduced.
 An investor is concerned with the return and risk of the
portfolio rather than with individual assets.
 Portfolio theory assumes that returns of assets of a portfolio
are normally distributed.
 Portfolio Return
 Expected return of a portfolio is the weighted average of
the expected rates of return on assets comprising the
portfolio.
 There are two aspects of portfolio returns:
 Expected rate of return on each asset in the portfolio
 Relative share of each asset in the portfolio
 The expected rate of return of a portfolio is given as:
𝐸(𝑟𝑝)= ∑ 𝑤𝑖 𝐸(𝑟𝑖 )
◦ 𝐸(𝑟𝑝) = Expected return from portfolio
◦ 𝑤𝑖 = Proportion invested in asset i
◦ 𝐸(𝑟𝑖 ) = Expected return for asset i
Example 1
 Expected returns on Asset 1 and Asset 2
are 15 and 20 percent respectively and
the corresponding shares ofbassets in the
portfolio are 0.75 and 0.25 respectively.
The expected portfolio return will be
calculated as follows:
 0.75 x 0.15 + 0.25 x 0.20 = 0.1625 or
16.25%
Portfolio Risk
 The portfolio risk is not measured as the weighted
average of variance of returns on individual assets in the
portfolio. Portfolio risk is affected by three factors:
Standard deviation of each asset in the portfolio
Proportion/ share of each asset in the portfolio (this
factor is within the control of the investor and can be
 decided by them)
 Correlation between returns of two assets
measured by covariance of returns
 What is Correlation?


 Total risk
 Total risk of a portfolio having two assets:
 𝜎2𝑝 = (𝑤1𝜎1)2 + (𝑤2𝜎2)2 + 2𝑤1𝑤2(𝐶ov 1&2) or
 𝜎2𝑝 = (𝑤1𝜎1)2 + (𝑤2𝜎2)2 + 2𝑤1𝑤2(𝜎1𝜎2𝜌12)
Where
◦ 𝜎𝑝 = Variance of returns of portfolio
◦ w1 = Share of total portfolio invested in Asset 1
◦ w2 = Share of total portfolio invested in Asset 2
◦ σ 1 = Variance of asset 1
◦ σ 2 = Variance of asset 2
◦ σ 1 = Standard deviation of asset 1
◦ σ 2 = Standard deviation of asset 2
◦ Cov 1&2 = Covariance between returns of two assets
◦ ρ12 = Coefficient of correlation between the returns of two assets
 Total risk
 Expected returns on Asset 1 and Asset 2 are 12
and 16 percent respectively and the
corresponding shares of assets in the portfolio
are 0.75 and 0.25 respectively.
 Standard deviation of Asset 1 and Asset 2 is 16
and 20 percent respectively and Coefficient of
correlation between their returns is 0.6.
 Expected return on the portfolio is: (0.75 x 12%)
+ (0.25 x 16%) = 9% + 4% = 13%
 Expected return of the portfolio of Asset 1 and
Asset 2 is 13%.
 Determining Portfolio
Expected Return
m
S ( Wj )( Rj )
RP = j=1
RP is the expected return for the portfolio,
Wj is the weight (investment proportion) for the
jth asset in the portfolio,
Rj is the expected return of the jth asset,
m is the total number of assets in the portfolio.
Total Risk
 Variance of the portfolio = (0.75 x 16)2 +
(0.25 x 20)2 + 2x 0.75 x 0.25 x [0.6 x (16 x
20)]
 = 144 + 25 + (0.375)(192)
 = 144 +25 +72
 = 241
 𝜎𝑝 = √214 = 15.52%
 Analyse the power of diversification
in achieving superior return
 Investors generally invest in more than two assets in a portfolio, which is called
diversification.
 Diversification is done in order to reduce the risks associated with the
investment.
 It reduces the impact of any one security on the overall performance of the
portfolio and lowers the risk of the portfolio.
 The following points should be considered to ensure the best effects of
diversification:
◦ The portfolio must cover multiple investment options such as shares, mutual
funds, bonds etc.
◦ Investments with different risk types and risk levels should be selected.
◦ Investments should be spread across a number of industries so that the
portfolio is not affected by industry specific risks.
Two types of risks:
 Systematic risk: this is also known as market risk. This
risk arises due to the uncertainties in the economy and
cannot be reduced by diversification. Examples of
systematic risk are increase in inflation rate, changes in
tax policies etc.
 Unsystematic risk: this is also known as unique risk
and arises from unique uncertainties of individual
securities. Uncertainties of individual securities in a
portfolio cancel out each other and hence this risk can
be reduced through diversification. Examples of
unsystematic risk are new competitors in the market,
strike in the company etc.
 Types of diversification
1. Naive Diversification
 This indicates random selection of securities in the portfolio.
Ideally, as the number of securities in a portfolio increases, the risk
should reduce. However, it is not possible to reduce the risk to
zero by increasing the number of assets in the portfolio.
2. Markowitz Diversification
 According to Markowitz diversification, an increase in the number
of securities in the portfolio leads to the portfolio risk
approaching the level of systematic risk.
 In a portfolio of assets that have strong negative covariance, it is
possible to reduce the portfolio risk below the level of systematic
risk.
Types of diversification
3. Perfect Positive Correlation
 Perfect positive correlation between assets in a
portfolio is not very common.
 There is a direct relation between risks and
returns; the higher the expected return, the
higher will be the risk and vice versa.
 An investor can choose the portfolio depending
upon their risk preference.
 Diversification does not reduce risk when the
returns on assets have perfect positive
correlation.
 Types of diversification
4. Perfect Negative Correlation
 The portfolio returns increase and portfolio risk declines when
the proportion of the high-risk asset increased.
 An investor gets maximum benefit of diversification when
returns of two securities have perfect negative correlation.
5. Zero Correlation
 The above table which gives the risks and returns for different
correlation coefficients) indicates that where both assets are in
equal proportion in the portfolio, the standard deviation of the
portfolio is less than the standard deviation of either of the
assets in the portfolio.
 Hence, an investor can invest in high risk security and get higher
expected returns when there is zero correlation between the
assets in the portfolio.
 Determine optimal portfolio
weights
 The optimum portfolio theory assumes that an
investor’s objective is to achieve maximum returns
with minimum risk from their investments.
 According to the theory of optimal portfolio, investors
will make decisions aimed at maximizing returns for
their accepted level of risk.
 An investor has to decide how much risk they are
ready to accept and then construct their portfolio.
 Selecting the Optimum Portfolio
 According to the Harry Markowitz theory, there are two
methods for selecting the Optimum Portfolio:
a) Two-step Optimization (also known as Top-down approach)
-According to this approach, there are three steps for selection of the portfolio:
1. Capital allocation decision where the total funds to be invested are divided
between the risk- free asset and the optimum portfolio of risky assets.
2. Asset allocation decision involves selecting the assets that will constitute
the portfolio of risky assets, i.e. allocating the funds between shares, bonds etc.
3. Security selection decision which involves selecting securities within each
asset class.
 The focus of the investor in this approach is on optimisation of the asset class
i.e. shares, bonds etc. and then on the securities within each class
 Selecting the Optimum Portfolio
b) Efficient Portfolios
 In this approach, an investor determines the risk- return
opportunities available to them.
 This is also known as determining the portfolio opportunity set
or the minimum- variance portfolio opportunity set.
 Graphically, this is represented by the minimum- variance frontier
of risky assets. The minimum variance represents the lowest
possible variance for a given portfolio’s expected return whereas
the efficient portfolios have maximum return at each level of risk.
Efficient portfolios dominate all other portfolios and individual
assets which lie below the efficient frontier.
 Dominant portfolios provide maximum return for a
 given level of risk or minimum risk for the given rate of
return.
 Efficient Portfolios
 Expected return of the total portfolio C is
calculated as follows:
 𝐸(𝑟𝑐) = 𝑟𝑓 + 𝑤[𝐸(𝑟𝑏 ) − 𝑟𝑓 ]
 Where,
 𝐸(𝑟𝑐 ) = Expected rate of return on complete
portfolio
◦ 𝑟𝑓 = Risk- free rate of return
◦ w= Proportion of total funds of portfolio C invested in
portfolio B
◦ 𝐸(𝑟𝑏) = Expected return for risky portfolio B
◦ 𝐸(𝑟𝑏) − 𝑟𝑓 = Risk premium of the risky portfolio
 Standard deviation of the
complete portfolio is given by:
• 𝜎𝑐 = 𝑤𝜎𝑏
 Where,
 𝜎𝑐 = Standard deviation of complete portfolio C
 w= Proportion of total funds of portfolio C invested in portfolio B
 𝜎𝑏 = Standard deviation of risky portfolio b
 Investors prefer to invest in efficient portfolios. A risk-averse
investor prefers to invest in risk- free assets or in risky assets with
positive risk premium.
 (An investor considers the average return on government bonds
over a number of years in the past and compares it with the
average return on the stock market.
Determining optimal portfolio weights
 The total risk of the portfolio depends upon the
relation between returns on assets in the
portfolio i.e. the correlation coefficient between
the assets.
 For a given correlation coefficient, there is a
minimum risk portfolio which has a standard
deviation smaller than that of the individual
assets in the portfolio.
 The optimal weights that will give the minimum
risk portfolio can be obtained by way of the
equation given below:
 Determining optimal portfolio
weights

Determining optimal portfolio
weights
Example
 Expected returns on Asset 1 and Asset 2
are 12 and 16 percent respectively.
Standard deviation of Asset 1 and Asset 2
is 16 and 20 percent respectively and the
coefficient of correlation between their
returns is 0. Determine optimal portfolio
weights of Asset 1 and Asset 2.
Determining optimal portfolio
weights

Topic 4
APPLICATION OF
FINANCIAL MANAGEMENT
PRINCIPLES TO PERFORM
CAPITAL BUDGETING
 Learning Outcomes
a) Explain nature of long term investment
b) Describe investment process and the framework for
evaluating investment projects
c) Explain appropriate discount factors or rates used to
undertake an investment appraisal
d) Assess appropriate investment appraisal techniques
based on a given business
e) Calculate discounted cash flow by using appraisal
techniques(NPV, IRR,MIRR, discounted pay-back period,
PI)
f) Calculate non discounted cash flow by using (Payback
period and ARR)
Capital investment
 It is the investment made to buy non-
current assets or to improve the earning
capacity of non-current assets already
held in the business.
 As a result of the capital investment, the
non-current asset works more efficiently,
lasts longer or improves revenue
generation.
 Hence, a capital investment increases the
value of a non-current asset and the value
Types of capital investment
i. Purchase of non-current assets:
computers, vehicles, building, land, plant
and machinery
ii. Legal and professional fees paid for
purchasing non-current assets:
stamp duty, registration fees, solicitor’s
fees, architect’s fees, consultant’s fees
iii. Improvement to existing non-
current assets: fitting of air
conditioner in vehicles, extension to a
Capital investment planning
and control
 Capital investment planning and control allows the
management to assess the effectiveness of the capital
investment decision-making process that is used by it.
 It allows the management to refine its policies and
procedures for appraising and implementing capital
investment projects.
 This ensures that the capital investments made by an
organization:
a) (a) Are in line with its long-term goals / objectives.
b) (b) Support the business needs of the
organization.
c) (c) Minimize the risk and maximize the returns
throughout the non-current asset’s life.
 Role of of capital investment
planning and control
 Maximizing shareholders’ wealth
 Taking strategic decisions
 Minimizing the cost structure
 Avoiding loss
 Avoiding fraud
 Growing through diversification
 Correcting discrepancy between planning and
actual results
Investment process and the framework for
evaluating investment projects
Capital budgeting process
-is the process through which an
organization generates, evaluates and
selects various capital investment proposals.
It allows the organization to assess the
financial viability of a capital investment
proposal.
Issues considered and steps taken while
preparing a capital expenditure budget
 Investment appraisal is the most
important part of the capital budgeting
process.
 It is at this stage that a decision is taken
as to which projects are to be accepted
and which are to be rejected.
 Investment proposals are appraised to
determine if they lead to the fulfillment of
the overriding objective of shareholder
wealth maximization.
 Step 1: Quantify the costs and benefits
The costs and benefits of an investment proposal are identified and
quantified.
 Step 2: Compare the costs and benefits with
appropriate techniques
The costs and benefits should be compared to each other by using
techniques such as the payback period, Internal Rate of Return (IRR) or
Net Present Value (NPV).
 Step 3: Evaluate the risks involved and the sensitivity to
changed situations
When we estimate the future cash flows, there is a risk that they may not
actually materialize as the future is uncertain; the actual outcome may be
different. It is necessary to consider how this will affect the final outcome.
 Step 4: Consider qualitative factors such as the environment or
employment generation
◦ The decision on the project will not depend only on the numerical
calculations. We must also take into consideration qualitative factors or non-
financial factors. (This is covered in Paper C2 in more detail.)
◦ A few factors considered at this stage are:
Legal issues: any legal action that the organization may face due to the
project.
Ethical issues: a project involving legal but unethical action will damage
the image of the organization.
Government regulations: various regulations that are applicable to the
project e.g. employment laws, environment laws, competition laws etc.
Political issues: whether any change in government will have an effect on
the project.
Competition: the reaction of the competitors to the project.
Step 5:Take a decision
 Management of the organization will review all the investment
proposals and make a decision of any one of the following types:
(a) Accept/reject
This applies to independent projects. They do not compete
with each other.You can either accept the proposal or reject it.
If a proposal meets the minimum standards required, it is
accepted; otherwise it is rejected.
(b) Mutually exclusive choice
◦ Sometimes projects may compete with each other in such a manner that
acceptance of one signifies rejection of the other. A criterion for the
project is laid down. The best project is accepted, and the others are
rejected.
 Capital expenditure budget
 The capital expenditure budget is an outline of an organization's decision to
allocate funds amongst its various existing and upcoming projects.
 The managers may overlook the risk of obsolescence while preparing their
short- term capital expenditure plans. Hence, it is advisable that an
organization must prepare its capital expenditure budget on the basis of the
long-term capital expenditure plans of its managers.
 A capital expenditure budget is decided on the basis of:
An individual manager’s request for issuing funds to the projects he
handles.
The senior management’s decision to allocate funds amongst the various
projects of the organization. The decision is made according to the long-
term objectives of the organization.
 An organization can decide the amount of its expected capital
expenditure by:
Forecasting the capital investment projects that it is going to
undertake. Usually the amount of expected capital
expenditure exceeds the amount of cash surplus that the
organization will have during the budgeted period. In such a
case the organization has to make arrangements to borrow
money from various sources to finance the projects.
Obtaining the expected cash balance by preparing a long-
term budget. The organization chooses the capital
investments depending upon the expected cash surplus that
it expects to have during the budgeted period.
 Capital investment framework for
evaluating investment projects
1. Appraisal of capital investment project
 The stages involved in the project appraisal process of a capital investment
project are as follows:
(a) Initial evaluation
 Before actually starting a project, a decision evaluating the technical feasibility
and commercial viability of the project must be taken. In order to do this, the
company should consider whether the project is in line with the company’s
long-term strategic objectives.
(b) Detailed assessment
 Following the initial evaluation of the project, the company should consider
whether the cash flows generated from the project would add any economic
value to the value and activities of the company. The organisation considers the
various costs and benefits that it will obtain by implementing the project. This
stage also involves performing sensitivity analysis and analysing the available
sources of finance.
c) Management’s approval
 Certain significant projects which have a material impact
on the functioning and cash flows of the company
should be approved by the organization's senior
management.
 For this approval to be obtained, the organization's
senior management should be satisfied that:
◦ A detailed evaluation has been carried out.
◦ The project conforms to the organization's long-term
strategy.
◦ The project will contribute to profitability of the organization.
(d) Project implementation
 During this stage, the project is assigned
to a party who will assume responsibility
for the project and oversee its
development. The resources will be made
available for implementation and specific
targets will be set. The project team
would then work towards meeting those
targets.
(e) Monitoring the project
 Projects involving capital expenditure take place over a
significant period of time.
 It is necessary to monitor the progress of a project by
checking whether or not it is on schedule.
 Any delays in the implementation of a project invariably
increase the cost of the project. It is also necessary to
check whether or not the cost of the project is within
the budget.
 In case any unforeseen events occur, all the costs and
benefits associated with the project should be re-
assessed.
(f) Post-completion audit
 This last and final stage involves
conducting an enquiry into the benefits,
costs, wastages and deviations from the
initial project plan.
 This investigation points whether or not
the project is performing in line with
expectations, and what lessons can be
drawn for future appraisals.
Investment appraisal
techniques
 Capital projects go on for several years
requiring estimations to be made for the
revenues, costs and savings over the life of
the project, which can often lead to
problems of inaccuracy in assumptions
and calculations.
 There are a number of investment
appraisal techniques a company can use
to assess the viability of capital investment
projects.
Types Project appraisal
techniques
a) Non-Discounted Cash Flow Techniques
b) Discounted Cash Flow Techniques
 a) Traditional Methods (Non
Discounting Methods)
 A non-discount method of capital budgeting is one that
does not consider the time value of money.
 In other words, all dollars earned in the future are
assumed to have the same value as today's dollars.
 These methods are based on the principles to determine
the desirability of an investment project on the basis of
its useful life and expected returns.
 These methods depend upon the accounting information
available from the books of accounts of the company.
 1. ROCE

ROCE

 RECO
 Spielberg Transport is considering
purchasing a new transport vehicle. It has
two offers. The expected life of both the
vehicles is 5 years. The following
information is available
Offer A Offer B
(TSHS) (TSHS)
Original Cost 1,100,000 1,600,000
Scrap value at the end 120,000 150,000
Expected annual net cash inflows* 360,000 630,000
Assume the depreciation of the vehicle has already been
deducted from the expected annual net cash flows

Calculate the ROCE on both offers and state which offer will be accepted.
 ROCE

 ROCE
1. Advantages of ROCE
 (a) It is reasonably simple to understand and use.
 (b) It uses the familiar concept of percentage return: the percentage
return can be compared with the company's ROCE in order to decide whether it
is in line with the company’s overall ROCE.
 (c) It considers the cash flows for the entire life of the project (d) It can
be used to compare mutually exclusive projects
2. Disadvantages of ROCE
 (a) It uses accounting profit which is subject to manipulations: if
different estimates and accounting policies are used in two otherwise identical
situations, then the accounting profits will be different even though the cash flows
are the same.
 (b) It ignores time value of money: this is indicated by the fact that this
method as well as the payback
 method does not discount the cash flows.
 (c) It is a relative measure and ignores the size of the investment and
the length of the project
Decision Rule - Accept the project if it pays back
on a discounted basis within the specified time


2. Payback Period
PBP

PBP
 A project is expected to have the
following cash flows:

Year Cash flow in

Tshs (000’s)
0 (19,000)
1 3,000
2 5,000
3 6,000
4 8,000
5 5,000
What is the expected payback period?
 PBP
 First, we need to calculate the cumulative cash flows
over the 5-year period as follows:
Year Cash flow in Cumulative cash
Tshs (000’s) flow Tshs (000’s)
0 (19,000) (19,000)
1 3,000 (16,000)
2 5,000 (11,000)
3 6,000 (5,000)
4 8,000 3,000
5 5,000 8,000

Pay Back Period = Base Number of Years + (Unrecovered Amount ÷ Next

Year’s Net Cash Flow
payback will be three years plus ( Tshs 5,000/8,000) of Year 4. This is
because the cumulative cash flow is Tshs 5,000 (negative) at the start of the
year and the year 4 cash flow would be Tshs 8,000. Therefore, payback will
be after 3.625 years.
PBP
1. Advantages of payback period
 (a) It is easy to calculate and understand.
 (b) It is useful under certain situations
 (c) It favours quick return
 (d) It considers the cash flows, not accounting profit
2. Disadvantages of payback period
 (a) It ignores any return after the payback period
 (b) It ignores time value of money
 (c) It ignores the project profitability
 3. Average rate of return(ARR)/
Average Accounting Return
 This is a more meaningful and complex method of investment
appraisal. It works out a % return for each investment and is a
much more useful comparison to other tools such as ROCE.

 There are four simple steps:

1. Work out the total return of the project.
2. Subtract the cost of the project. This gives the net return.
3. Divide by the number of years. This gives the net return per
annum.
4. Divide the net return per annum by the cost of the project and
multiply by 100 (see worked example).
 Average rate of return
 Worked example
Cost: (TZS100,000)
Year 1: TZS50,000
Year 2: TZS50,000
Year 3: TZS50,000
Year 4: TZS150,000
Year 5: TZS150,000

Step 1: add up all cash flows = £450,000

Step 2: deduct outlay = TZS450,000 – TZS100,000 = TZS350,000
Step 3: divide by number of years = TZS350,000/5 = TZS70,000
Step 4: divide by outlay = TZS70,000/£100,000 and multiply by 100 = 70% return
Average rate of return (3)
 Advantages
 Uses all the cash flows over the project’s life.
 Focuses on profitability, unlike payback.
 Easy to compare.
 Disadvantages
 Ignores the timing of the cash flows (unlike NPV).
 As later years included it could be argued to be less accurate
than payback.
 It’s only a forecast (can be very unpredictable).
 3.4 Discounting future cash
flows
 Money received today is worth more than the same money
received in the future, i.e. money has a time value. The time
value of money occurs for three main reasons:
1. Potential for earning interest / cost of finance
2. Impact of inflation
3. Effect of risk
 Discounted cash flow (DCF) techniques such as Net Present
Value and Internal Rate of Return take the time value of money
into account. These apply a discount rate to work out the
present-day equivalent of future cash flows.
 1. Net Present Value (NPV)
 The net present value (NPV) of an investment
(project) is the difference between the present
value of cash inflow and cash outflow
 NPV = Present value of cash inflows - Present
value of cash outflowsd the present value of
cash outflow.
Year Tshs
1 60,000,000
2 50,000,000
3 45,000,000
Calculation of present value
 Net Present Value (NPV)
Discount
Year Cash flow factor Present value
Tshs Tshs
0 (100,000,000) 1.000 (100,000,000)
1 60,000,000 0.893 53,580,000
2 50,000,000 0.797 39,850,000
3 45,000,000 0.712 32,040,000
NPV 25,470,000

Since the project’s NPV is positive, it should be accepted. The

positive NPV equates to a net cash inflow which would add to
shareholder wealth.
 NPV
• Timing assumptions made about cash flows when calculating NPV
 The discounted value depends on the date of expected cash flows. Some
assumptions relating to NPV calculations include:
 Initial cash outlay is incurred at the beginning of the first period, i.e. the
year is taken as 0. The present value of this initial investment is the same as the
amount of investment; it is not required to be discounted since the time is
‘now’. The discount factor for year 0 is 1.000.
 Any transaction during a period is assumed to occur at the end of the
period. E.g. receipts during year 2 are assumed to have taken place at the end
of year 2.
 Cash flows occurring at the beginning of a year will be assumed to have
occurred in the previous year for discounting purposes.
 Cash flows generated during the life of the project will be reinvested at a rate
equal to the cost of capital.
 NPV
Advantages of Net present value method
(a) It assumes that cash flows are re-invested at the company’s cost of
capital
(b) (b) It is directly related to the objective of maximizing
shareholders’ wealth
(c) (c) It is not a relative measure of return
(d) (d) It considers the time value of money
(e) (e) It does not consider the accounting profit
(f) (f) It considers all the cash flows over the life of a project.
(g) It can be used to appraise projects with non-conventional cash
flows
2. Disadvantages of Net present value method
• (a) It is more complex than ROCE, payback and IRR investment appraisal
techniques.
• (b) It fails to relate the return of the project to the size of the cash outlay.
• (c) It requires detailed forecasts of long-term cash flows which can be
 2. Discounted payback method
• Payback period has been discussed in detail earlier in this Study Guide.
• Discounted payback method is similar to the payback method.
• It is the length of time that the discounted cash flows require to recover the
initial investment.
• Under this method, the cash flows are discounted at the organisation’s cost of
capital.
 After this, the present values of the cash flows are cumulated until they are equal
to the initial investment.
 Payback period uses nominal cash flows While Discounted payback period uses
the discounted cash flows.
 The advantages and disadvantages of the discounted payback period are similar
to those of the payback period. However, the discounted payback period
overcomes the shortcoming of the payback period, which is ignoring the time
value of money.
 2. DPBP
 Example
 Let’s assume that cost of capital for a company is 10% and the following table
shows the cash flows as well as cumulative discounted cash flows for one of
the company’s Project C:
Present value Cumulative

Discounting of cash flows discounted

Cash flow factor at 10% at 10% cash flows
Tshs
Year No. 000's Tshs 000's Tshs
0 (300.00) 1.000 (300.00) (300.00)
1 80.00 0.909 72.73 (227.27)
2 150.00 0.826 123.97 (103.31)
3 140.00 0.751 105.18 1.88
4 80.00 0.683 54.64 56.52
5 70.00 0.621 43.46 99.98
 3. Internal Rate of Return (IRR)
 An investment project’s internal rate of return
is the required rate of return or cost of capital
which produces a net present value of zero
when used to discount the project’s cash
flows.
 In other words, when internal rate of
return is used to discount the cash flows,
the present value of outflows and the
present value of inflows will be equal.
 Calculation of IRR
 Two different methods can be used for
calculation of IRR in the following two
situations:
 1. when the project cash inflows are identical
 2. when the project cash inflows are not
identical
 1. When the project cash inflows are
identical
 Calculation of IRR for a project with
identical cash inflows
 IRR Acceptance Criteria

 If IRR > k, accept project.

 If IRR < k, reject project.

 If projects are independent, accept both

projects, as both IRR > k = 10%.
 If projects are mutually exclusive, accept
S, because IRRs > IRRL.
 IRR
 The following table gives the particulars of a proposed
project X of Strilco.
Period 0 1 2 3 4 5 6

Cash flow
in
000's (
Tshs (6,000) 1,450 1,450 1,450 1,450 1,450 1,450

In this case, the inflows are identical; therefore, we can use the
cumulative present value factors table. As we know, IRR represents the rate
where NPV is Nil

Therefore, ( Tshs 1, 450,000 x CPVFr,6) – Tshs 6, 000,000 = 0

CPVFr,6 is the cumulative present value factor for 6 years, and r is

IRR
CPVFr,6 = 6,000,000/1,450,000 = 4.137931Where,
IRR
 If we look at the cumulative present value
factor table and check the row of 6 years,
we will find that the value of 4.111 (refer
to the cumulative present value table
below) which is the nearest to 4.137
appears in the 12% column.
 Therefore, we can conclude that the
internal rate of return is approximately
12%.
IRR
 Continuing from the previous example of Strilco,
 The following table give the particulars of a proposed
project Y:

Cash flow in 000’s ( Tshs )

Period
0 (6,000)
1 1,450
2 3,250
3 500
4 1,450
5 600
6 1,450
 IRR
 The internal rate of return of the above project can be calculated
in the following way.
 First, we take 10% as a PV factor. That gives us a positive NPV of
Tshs 560 Next, since the NPV is positive, we increase the rate to
14%
Present value
Perio 10% Present valuein 14% in000’s ( Tshs)
d Cash flow in PVfactors 000’s ( Tshs) PVfactors
000’s ( Tshs )
(6,000)
0 1.000 (6,000) 1.000 (6,000)
1 1,450 0.909 1,318 0.877 1,272
2 3,250 0.826 2,685 0.769 2,499
3 500 0.751 376 0.675 338
4 1,450 0.683 990 0.592 858
5 600 0.621 373 0.519 311
6 1,450 0.564 818 0.456 661
NPV 560 (61)
IRR

 IRR
 2. Disadvantages of IRR
a) It is not a measure of absolute profitability.
b) Interpolation only provides an estimate, and an accurate estimate requires
the use of a spreadsheet programme.
c) (It is fairly complicated to calculate.
d) (d) It cannot be used to appraise projects with non-conventional
cash flows: projects that have nonconventional cash flows are those where
negative cash flows occur during the life of the project. Nonconventional cash
flows may give rise to multiple IRRs, which means the interpolation method
cannot be used.
Decision Rule
 Accept all independent projects where the IRR is greater than the company’s
cost of capital or target rate of return.
 MIRR (Modified Internal Rate of Return)
– This is the discount rate which causes the project’s PV of the
outflows to equal the project’s TV (terminal value) of the inflows.
– Discount rate at which preseant value of a project cost is equal to
present value of its terminal value where the terminal value is
obtained as the sum of the future values of the cash inflows
compounded at firm cost of capital

TFVinflows
PVoutflow = n
(1 + MIRR)
– Assumes cash inflows are reinvested at k, the safe re-investment
rate.
– assumes that positive cash flows are reinvested at the firm's cost
of capital and that the initial outlays are financed at the firm's
financing cost
– MIRR avoids the problem of multiple IRRs.
– We accept if MIRR > the required rate of return.
 What is the P R O J E C T
Time A B
MIRR for 0 (10,000.) (10,000.)
Project B? 1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
Safe =2%
0 1 2 3 4

(10,000) 500 500 4,600 10,000

(10,000)/(1.02)0 500(1.02)3 500(1.02)2 4,600(1.02)1 10,000(1.02)0

10,000
4,692
520
531
(10,000) 15,743 15,743 43
10,000 =
(1 + MIRR)4 MIRR = .12 = 12%
 MIRR
Advantages
 Is better and improved for project evaluation
 It takes into consideration the practically possible reinvestment
rate
 The method of calculation eliminates the problem of multiple
IRR for projects with abnormal cash flows.

Disadvantage:
 The disadvantage of MIRR is that it asks for two additional
decisions, i.e., determination of financing rate and cost of capital.
 MIRR less reliable because a project's earnings are not always
fully reinvested.
Decision rule
 Reject if MIRR < k and accept if MIRR > k
 Benefit-Cost Ratio (BCR)/
Probability Index Method (PI)
 A Benefit Cost Ratio is an indicator, used in the formal discipline of cost- benefit
analysis, that attempts to summarize the overall value for money of a project or
proposal. A BCR is the ratio of the benefits of a project or proposal, expressed
in monetary terms, relative to its costs, also expressed in monetary terms. All
benefits and costs should be expressed in discounted present values.
 This method is obtained after a slight modification of the NPV method.
 If the PI is more than one (>1), the proposal is accepted else rejected. If there
are more than one investment proposal with the more than one PI, the one with
the highest PI will be selected. This method is more useful in case of projects
with different cash outlays and hence is superior to the NPV method.
 In other words, since the present value of costs is nothing but the initial
investment, the BCR may be defined as the ratio of present value of benefits to
initial investment.
 BCR

 Decision making:
1. If BCR is >1, the project should be accepted and
would be beneficial.
2. If BCR =1, we interpret it as being indifferent.
3. If BCR <1, the project should be rejected.
 The formula for PI (BCR) is
◦ Gross Profitability Index (PI) = Total Present Value of
Cash Inflow / Total Present Value of Cash Outflow
◦ Net Profitability Index (PI) = Net Present Value of
Cash Inflow / Net Present Value of Cash Outflow
 BCR
 Example 1: A choice is to be made between the
two competing proposals which require an
equal investment of Rs50,000/- and are
expected to generate net cash flows as under.
Cost of capital of the company is 10%.
Cash Flows
Year
Project A (Rs.) Project B (Rs.)
1 25,000 10,000
2 15,000 12,000
3 10,000 18,000
4 NIL 25,000
5 12,000 8,000

6 6,000 4,000
 BCR
 Solution: Present Value of Cash Outflow = Initial investment + Present Value of Additional
Working Capital
= Initial investment + (Additional Working Capital x Discounting Factor)
= Rs. 50,000 + NIL
= Rs. 50,000 Cash Flows Present Value of Cash
*Discounting Flows
Year Project A (Rs.) Project B Factor @ 10% (c) Project A (Rs.) Project B
(a) (Rs.) (a)x(c) (Rs.)
(b) (b)x(c)
1 25,000 10,000 0.9091 22,725 9,090
2 15,000 12,000 0.8265 12,390 9,912
3 10,000 18,000 0.7513 7,510 13,518
4 NIL 25,000 0.6830 NIL 17,075
5 12,000 8,000 0.6209 7,452 4,968

6 6,000 4,000 0.5645 3,384 2,256

53,461 56,819
Total 68,000 77,000
Less: Present Value of Cash Outflow (50,000) (50,000)
(Initial Investment + PV of additional working capital)
Net Present Value of cash flows 3,461 6,819
 BCR
 Gross Profitability Index (PI) = Total Present Value of
Cash Inflow / Total Present Value of Cash Outflow
Gross PI of Project A = 53,461/ 50,000 = 1.07 : 1
 Gross PI of Project B = 56,819/ 50,000 = 1.14 : 1
 Net Profitability Index (PI) = Net Present Value of Cash
Inflow / Net Present Value of Cash Outflow Net PI of
Project A = 3,461/ 50,000 = 0.07 : 1
 Net PI of Project B = 6,819/ 50,000 = 0.14 : 1
 Interpretation: Since project B has the highest PI,
hence project B should be accepted
 BCR
Merits:
 It requires less computational work than IRR method
 It helps to accept / reject investment proposal on the basis of value of the
index.
 It is useful to rank the proposals on the basis of the highest/lowest value of the
index.
 It takes into consideration the entire stream of cash flows generated during
the useful life of the asset.
Demerits:
 When cash outflow occurs beyond the current period, the PI is unsuitable as a
selection criterion.
 It requires estimation of cash flows with accuracy which is very difficult under
ever changing world.
 It also requires correct estimation of cost of capital for getting correct result.
 When the projects are mutually exclusive and it has different cash outlays,
different cash flow pattern or unequal lives, it may not give unambiguous
results
Topic 5
APPLY FINANCIAL
MANAGEMENT
PRINCIPLES TO PERFORM
COMPLEX INVESTMENT
APPRAISAL
 Learning Outcome
a) Explain factors to be considered in investment
appraisal analysis other than quantitative
factors
b) Explain the impact non-financial factors on
making an appropriate investment decisions
c) Calculate risk and inflation into investment
appraisal using various techniques
d) Perform investment appraisal (Calculate optimal
investment and capital rationing)
Other factors that may need to be considered beyond basic
investment appraisal analysis

i. Assessment of Risk
ii. Subjective factors
iii. Intangible factors
iv. Limitations in data and
information
 Assessment of risk
 The terms risk and uncertainty have different meanings though in
practical life they are sometimes used interchangeably.
Risk refers to quantifiable sets of circumstances, to which probabilities
can be assigned. implications:
i. Expected returns may vary in the future
ii. Different outcomes are possible
iii. risk increases proportionately with the project life
iv. risk also increases proportionately with the greater variability
v. companies show more concern for the ‘downside risk’ (i.e.
possibility of receiving lower returns than expected in comparison
to a higher return than expected)
vi. probabilities can be assigned, and the risks can be quantified
 Cont.……
 Uncertainty refers to a situation where it
is impossible to assign probabilities to sets of
circumstances.
 implications.
Different outcomes are possible.
Assignment of probabilities or quantification of
costs and benefits is difficult mainly due to little
past experience.
 2. Subjective factors
a)Capital Structure
 Aims of investment appraisals is to maximize shareholder
wealth.
 The company value is influenced by the way it is financed;
therefore, the capital structure should be used to its full
potential.
 Beyond the basic investment appraisal analysis, management
needs to also consider the way it decides to finance a project.
 It needs to identify the optimum capital structure which
involves external debt and internal capital through shares, for
example, and then choose the option that leads to the highest
shareholder wealth.
Cont….
 b) Inflation
 Inflation is also a subjective factor as the
impact of inflation on an investment
appraisal is forward looking and therefore,
only an estimate can be made as to what
the rate is anticipated to be.
 3. Intangible factors
b) Management vs. Shareholders
 There is often a difference between the interests and opinions of
management compared to shareholders.
 Therefore, within the investment appraisal analysis this intangible
factor should also be taken into consideration.
 This intangible factor takes into consideration incentives and
information problems that occur due to the information being
interpreted by different people, with their own opinions and
perspectives.
 The interests or incentives of both parties make the information
on the project sensitive to the available resources of the
company.
 Cont…
b) Characteristics of those in charge of
governance
 Certain research has shown that the characteristics of the Chief
Executive Officer (CEO) of an organization can influence the
investment policy implemented by the firm. Any misrepresentation in
the policy can lead to over confident management together with
over estimation in the cash flow calculations of the project’s return,
mainly in cases with excess cash flow.
 On the other hand, if the CEO is uncertain of its rewards as a result
of investment decisions, the level of investments undertaken by the
company is expected to be low.
 Similar to the point above, shareholders require an effective
incentive scheme to encourage management to make investment
decisions that are in the best interests of the firm and be value
enhancing.
 4. Limitations in data and
information
a) Source of data and information
 The information used in the calculations or
assessment of non-financial factors has an impact
on the advice given.
 There are a number of sources of information,
such as via television, newspapers, magazines,
word of mouth etc.
 There are limitations in this type of information,
as it is dependent on where the data has come
from.
b)Quality of information
Similar to the above point, the presentation and quality of the
information impacts the decision made.
c) IT limitations
 there can be limitations in information due to the limitations of IT
functionality.
 The company may not have the appropriate IT resource to perform
a full estimation of a project and then perform sensitivity analysis as
an example.
 Cont……..
d) Availability of experts
 For certain projects, management may require the use of experts
in the performance of evaluating a potential project.
 The company may not have sufficient resources to perform the
calculations themselves or the technical knowledge, in which case
external experts may be required.
 It is possible that management are unable to spend the capital on
experts or that the required level of experts for the particular
project are not available, which has an impact on the reliability of
the information.
The impact non-financial factors on making an
appropriate investment decisions –Qualitative factors
 After the quantitative analysis is completed, management then need
to make a decision on which project (s) to implement or whether
the project being reviewed should be accepted or not.
 However, management will not automatically base this decision purely
on whether the project has a positive NPV or whether one
alternative has a higher overall return than other projects.
 In this decision, they will need to take into account non-financial
factors that may affect the project (s).
 A company has used the NPV method of appraisal on Project X,
which has a positive NPV and therefore, financially will increase the
value of the company. However, the project involves some damage to
the environment, and this factor alone can change the decision to
accept the project, due to the adverse impact it will have on the
company’s image.
 Cont…..
i. Legal issues: any legal issues the company may face as a result of undertaking
the project, e.g. whether the project will meet the requirements of current and
future legislation etc.
ii. Ethical issues: a project may be legal, but if the actions involved in the project
are deemed unethical, this can have severe adverse impact on the company’s
image and reputation.
iii. Industry issues: e.g. does the project conform to industry standards and good
practice.
iv. Government regulation: this can include various regulations such as
employment laws, environmental law, competition law and also planning
permissions given by local governments etc.
v. Environmental issues: e.g. will the project have an adverse impact on the
surrounding environment.
vi. Strategy of company: consideration needs to be given as to whether the
project is in-line with the aims and objectives of the business.
vii. Impact on various relationships: will the project lead to improved staff
morale, better relations with suppliers, customers and local community.
viii. Developing the skills of the company: will the project lead to an increase in
skills and experience in a particular field, which overall leads to stronger
capabilities.
 Incorporate risk and inflation into the investment
appraisal using various techniques/models.
 Techniques of adjusting for risk and
uncertainty
a)Sensitivity analysis
 Sensitivity analysis is a method used to
estimate the risk of an investment project by
evaluating how much the NPV of the project
changes when the variables from which it has
been calculated change.
Relevant variables
 The following items can be considered as
relevant variables while calculating the net
present value (NPV) of a project.
Methods used for sensitivity
analysis
a) Quantifying the change in each key
variable that will make the NPV zero.
b) Changing each key variable by a set
percentage and checking the impact on
the NPV.
c) Certainty equivalent approach
 i) Quantifying the change in each variable that will
make the NPV zero
 In this method, it is verified as to how much change in each key variable will
cause the NPV to become zero.
 These changes are converted into percentage terms.
 Then a conclusion is reached about which variables are most important.
 It can be said that the project is more sensitive to those variables of which
even a small percentage change can cause the NPV to become zero.
 Management needs to keep a close watch on these variables if it wants the
project to succeed.
Example
 A 3% reduction in sales volume is sufficient to make the NPV of a project zero.
As against this, it requires a 15% increase in the initial investment to make the
NPV of a project zero. This project is more sensitive to reduction in sales
volume. Management needs to take care that the sales volume does not dip.
 ii)Changing each variable by a set
percentage and checking the impact on the
NPV
 Since we are more concerned with the downside risk, a
percentage change that will reduce the NPV is considered.
 The project is more sensitive to the variables that cause
higher reduction.
Example
 A 5% reduction in the selling price reduces the NPV by
Tshs 50,000,000; a 5% reduction in sales volume reduces
the NPV by Tshs 10,000,000. The project is more sensitive
to changes in sales price than to changes in sales volume.
 Limitations of sensitivity
analysis
a) Only one variable can be changed at a time. This
requires that the changes in each key variable
must be isolated.This may be unrealistic.
b) This analysis only identifies key variables. It does
not assess the risk in the real sense, since it does
not consider the probabilities or likelihood of
variables actually changing.
c) Management may not have control over the key
factors, even if they are identified.
d) Unless parameters are set, this analysis in itself
does not provide a decision rule.
 b) Probability analysis
 Instead of using single point estimates that have been used so far, a
probability distribution of expected cash flows can be prepared. It can be
used to arrive at an expected NPV. This probability analysis can be used to
find out the possibility of achieving a negative NPV and the probability of the
best- and worst-case scenario.
 Simple probability distributions may just have a few probabilities.

Probability Cash flow

Tshs 000’s
0.3 200,000
0.6 300,000
0.1 100,000
Expected net present value = (0.3 x Tshs 200,000,000) + (0.6 x Tshs 300,000,000) + (0.1 x
Tshs 100,000,000) =
Tshs 250,000,000.
 Probability distribution of
expected cash flows
a) Using different probabilities or joint probabilities, a probability
distribution is prepared. This approach recognises that there are
several possible outcomes.
b) Expected NPV is calculated.
c) Risk is analysed from different angles.
Example
 The cost of capital for Supernova Inc is 14%. The initial investment
for the project is Tshs 470,000,000. Estimate the cash flows of the
project under different economic circumstances. Their respective
probabilities are as follows
 Net cash flows for Year 1
Economic
Conditions Weak Moderate Good
Probability 0.3 0.5 0.2
Cash Flow ( Tshs
000’s) 150,000 300,000 450,000
Net cash flows for Year 2

Economic
Conditions Moderate Good
Probability 0.7 0.3
Cash Flow ( Tshs
000’s) 375,000 525,000
Find the expected value (EV) of the project’s NPV assuming that the economic conditions in
Year 2 are not dependant on Year 1. Also find out how much is the risk that NPV will become
negative.
Standard deviation of NPV

 Example
 Two mutually exclusive projects P or Q
are to be considered by Grill Plc. There is
some uncertainty about the running costs
with each project. The probability
distribution of the NPV for each project
has been estimated as follows:
NPV Tshs million Project probability NPV TZS Million Project Q probability
-10 0.15 5 0.2
10 0.2 10 0.3
15 0.35 20 0.4
35 0.3 30 0.1
Which project should the company opt for?
 Step 1: Calculation of the EV of
the NPV for project P and Q
P
NPV Tshs million Project probability EV TZS million
-10 0.15 -1.5
10 0.2 2
15 0.35 5.25
35 0.3 10.5
16.25
Q
NPV TZS Million Project Q probability EV TZS million
5 0.2 1
10 0.3 3
20 0.4 8
30 0.1 3
15

Project P has higher EV of NPV, but we need to find out the risk
of variation in the NPV above or below the EV;
this is to be measured by Standard Deviation of the NPV. It can
be calculated as:
S=√𝑃(𝑥 − ̅)2
Where, x is the EV of the NPV
 Step 2: Calculation of Standard
Deviation of a project’s NPV
X TZS Million P X- ̅X Tshs million P(X- X ̅) 2TZS
-1.5 0.15 -17.75 47.26
𝑥 𝑥 𝑥 𝑥
2 0.2 -14.25 40.61
5.25 0.35 -11 42.35
10.5 0.3 -5.75 9.92
140.14

X TZS Million P X- ̅X Tshs million P(X- X ̅) 2TZS

1 0.2 -14 39.2
𝑥 𝑥 𝑥
3 0.3 -12 43.2
8 0.4 -7 19.6
3 0.1 -12 14.4
116.4

Project P Project Q
SD=√140.14 SD=√140.14
= 11.838 = 10.789
= TZS 11.838m TZS 10.789m
Cont…
 Project P has higher EV of NPV, it also has higher
standard deviation of NPV and therefore has a higher
risk attached to it. Selection of a project depends on the
management’s appetite to risk.
 If the management is risk averse, it will select the less
risky project, Project Q.
 If the management is prepared to take a risk with a low
NPV in the hope of a higher NPV, it will select Project P.
 3. Evaluation of probability
analysis
 This method is growing in popularity. The fact
that it is based on the subjective estimates of
the managers does not reduce their utility.
These estimates are made by the managers on
the basis of the information available.
 They represent the assessments of the
likelihood of future events. Such assessments
are made by the managers regularly in the
normal course of business.
 c) Simulation
 One major limitation of sensitivity analysis is that it analyses the sensitivity of the
project’s NPV to changes in one variable at a time. In reality, a change in one
variable may have knock-on effects on another.
 Simulation models are useful to handle changes in more than one variable at a time.
They determine by repeated analysis, how simultaneous changes in these variables
affect NPV. This method is also called Monte Carlo method.
 The following steps are included while using a simulation model for appraising a
project:
a) For each project variable, a range of random numbers is assigned to the values at
different probabilities.
b) A computer generates a set of random numbers and uses these numbers to
randomly select a value for each variable.
c) NPV of this set of variables is calculated.
d) This process is repeated and a frequency distribution of the NPVs is generated.
e) From the frequency distribution, the expected NPV and its standard deviation are
calculated.
 However, the variables are likely to be interdependent, e.g. an increase in prices may
reduce sales volume. Simple simulation models assume that these factors are
unrelated to each other. Such interrelationships are frequently complex to model.
 Example
 The Finance executive of J.W. Pillers Plc has drawn the
following projections with probability distributions
Wages and Proba
Raw material Probability Sales revenue Probability
salaries bility

Tshs
Tshs million Tshs million
million
10-Aug 0.3 8-Jun 0.2 28-32 0.1
12-Oct 0.5 10-Aug 0.3 32-36 0.2
14-Dec 0.2 12-Oct 0.3 36-40 0.5
14-Dec 0.2 40-44 0.2
Fixed costs are Tshs 12,000,000 and available cash balance is Tshs 52,000,000.
Students are required to simulate the cash flow projection and expected cash balance at
the end of the sixth month. Use the following random numbers:

Wages and salaries 3 8 9 3 9 7

Raw materials 4 5 1 0 3 4
Sales Revenue 0 5 6 8 0 2
1. Simulation of cash flow
projection
(a) Random number allocation
Random numbers are allocated on the basis of cumulative
probabilities of the lowest to the highest values e.g. if the
available random numbers for wages and salaries are taken
as 10 (0 to 9) the random numbers range based on the
cumulative probability of 0.3 is (0-2). It covers three digits
of 0, 1 and 2. Next cumulative figure is 0.8 (3-7) It covers
next five digits 3,4,5,6 and 7.The next cumulative
probability is 1.0. (8-9).It covers the next two digits 8 and
9.
 Wages and Salaries Raw Materials Sales Revenue
Midpoint Cum. Random Midpoint Cum. Random Midpoint Cum. Random
Tshs Tshs Tshs
Prob. Nos. Prob. Nos. Prob. Nos.
million million million

9 0.3 0-2 7 0.2 0-1 30 0.1 0

11 0.8 7-Mar 9 0.5 4-Feb 34 0.3 2-Jan
13 1 9-Aug 11 0.8 7-May 38 0.8 7-Mar
13 1 9-Aug 42 1 9-Aug
(b) Simulation of cash flow
 Actual random numbers for the
respective months are given above.
Depending upon the range under which
the number falls, the amount for that
month is determined. For example,
random numbers for wages and salaries
for 6 months are 3, 8, 9, 3, 9 and 7. They
fall under the classes having midpoints 11,
13, 13, 11, 13 and 11 respectively. These
values are filled up in the table below.
 Wages
Sales Raw Fixed Net Cash
Cash balance
and
revenues materials costs Flow
Month Opening
salaries
balance
Tshs Tshs Tshs Tshs
Tshs 52 million
million million million million
million

1 30 11 9 12 -2 50
2 38 13 11 12 2 52
3 38 13 7 12 6 58
4 42 11 7 12 12 70
5 30 13 9 12 -4 66
6 34 11 9 12 2 68

From the above simulation it will be observed that there are 4 months which have net cash inflows, the probability of net cash inflows can therefore be estimated as
4/6 = 0.66. From the above table, the estimated cash balance at the end of sixth month is Tshs 68,000,000.
 2. Expected Value (EV) Method
of Cash Flow Projection
Tshs
million
EV of salaries and wages (9 x 0.3) + (11 x 0.5) + (13 x 0.2) 10.8
EV of raw materials (7 x 0.2) + (9 x 0.3) + (11 x 0.3) + (13 x 0.2) 10
EV of sales revenue (30 x 0.1) + (34 x 0.2) + (38 x 0.5) + (42 x 0.2) 37.2
Expected net cash inflow per month Tshs 37.2 – 10.8 – 10.0 – 12.0 4.4
Expected cash balance after six months Tshs 52.0 + (4.4 x 6) 78.4

The dif erence between Tshs 68,000,000 and Tshs 78,400,000 is due to sample errors. If a number of simulation iterations were carried out, then the mean of the balances
predicted should approach the expected value more closely as the number is increased.
 Inflation incorporated into
investment appraisal
 The above case study shows that the factors of inflation
and taxation affect the investment decisions.You may be
wondering how these are reviewed in investment
decisions.
 In this Study Guide, we understand the techniques used
to do this. In our discussions on DCF methods so far,
the effect of inflation was considered, but the impact on
investment decisions were not detailed.
 This Study Guide discusses how when inflation
increases, the rate of return expected by the investors
also goes up.
Real vs. nominal cash flows (the effect of
inflation on investment appraisal)
 Real cash flows are cash flows that have
not been subjected to inflation.
 Nominal cash flows or money cash flows
have been influenced by inflation.
 Example
 Steve will receive Tshs 100,000,000 in cash next
year. During the year, inflation of 3% is expected.
Next year, the nominal value will be Tshs
100,000,000 but the real value (after stripping
away the effects of inflation) will be Tshs
97,087,379 ( Tshs 100,000,000 / 1.03).
 The discount rate used in assessing projects so far, has been
the real rate of return required by investors. This is the rate
which compensates investors for the risk of undertaking the
activity and for not being able to use the money. Since inflation
erodes the purchasing power of money, investors will require
compensation for this additional factor. Therefore, the rate of
return required for investments will increase.
 The rate of interest which incorporates the real rate and the
inflation rate is known as the nominal or money rate of return.
It can be calculated using the following formula:
(1 + Nominal rate or money rate) = (1+ Real rate) x (1+ Inflation
rate)
If Steve’s real rate of return required is 10% and inflation is 3%, the effective nominal rate wil be:
Nominal rate = (1+ 0.10) x (1+ 0.03) – 1
1.10 x 1.03 - 1
1.133 - 1
0.133
13.3%
Which rate is to be used for
discounting?
 The answer depends upon which cash
flows are being discounted. If real cash
flows are being discounted, the real cost
of capital should be used.
 If nominal cash flows are being
discounted, the nominal cost of capital
should be used.
 Continuing Steve’s example
from above
Nominal cash flow Tshs 100,000,000
Nominal cost of capital 13.3% Discounted value of the
cash flow = Tshs 100,000,000/1.133 Tshs 88,261,253

Real cash flow Tshs 97,087,379

Real cost of capital 10% Discounted value of the cash
flow = Tshs 97,087,379/1.10 Tshs 88,261,253
 HW
 Fisher’s plans to make an investment in a production line which
will facilitate the sale of a new product called XBX. An initial
investment of Tshs 396,000,000 in working capital would also be
needed. Non-current assets costing Tshs 840,000,000 would be
needed, with Tshs 600,000,000 payable at once and the balance
payable after one year. Fisher’s expects that, after four years, the
XBX will be obsolete and the disposal value of the non-current
assets will be zero.
 The project would incur incremental total fixed costs of Tshs
660,000,000 per year at current prices, including annual
depreciation of Tshs 216,000,000. Expected sales are 130,000 units
per year at a selling price of Tshs 25,000 per unit and a variable
cost of Tshs 18,000 per unit, both in current price terms.
 Fisher’s expects the following annual increases because of inflation:
 Cont…
%
General prices 7.4
Variable costs 7
Selling price 5
Fixed costs 5
Working capital 6

Assuming Fisher’s real cost of capital is 8 per cent, is the project viable? Ignore taxation for this question
 Perform investment appraisal (Calculate
optimal investment and capital rationing)
 Capital rationing arises when the amount of funds
available for investments are restricted or limited.
 This restriction on funds may apply to only one
time period (single period capital rationing) or
may extend indefinitely into the future (multi-
period capital rationing).
 In both cases, the finance manager must ensure
that projects yielding the greatest returns are
prioritised. In this Study Guide the issues relating
to single period capital rationing are discussed.
 Calculation of profitability indexes for
divisible investment projects

1. Divisible investment projects

 A divisible investment project is the one where
any portion of the project may be undertaken. In
other words, if funds are insufficient, the
company may partly invest in the project.
 Along with being divisible, it is also assumed that
the project is non deferrable (if not
undertaken now, it cannot be undertaken in the
future) and non repeatable (it can be
undertaken only once).

3. Decision rule
• Projects will be ranked according to their PI and
invested in accordingly, starting with the project
producing the highest PI.
• This will be done until the available funds are
exhausted. If this approach is adopted for divisible
projects, it will ensure that the company achieves
the highest possible NPV.
• The PI approach to capital rationing is more
suitable for single-period capital rationing
situations.
 Determine the optimal combination of
products assuming that the projects are
divisible. Total funds available are Tshs
4,200,000.
Project A B C D

1 Initial investment ( Tshs 000’s) 1,250 1,625 2,000 2,125

2 Net present value ( Tshs 000’s) 1,625 1,790 2,000 1,910

3 Initial investment + NPV ( Tshs 000’s) 2,875 3,415 4,000 4,035

 Cont,..
Project A B C D

Profitability index (3/1) 2.3 2.1 2 1.9

Ranking by profitability index 1 2 3 4
Profitability Index = PV of future cash flows / Initial Investment

Cumulative
Optimum investment schedule: NPV (
investment
Tshs 000’s) ( Tshs 000’s)
Tshs 1,250,000 invested in Project A 1,625 1,250
Tshs 1,625,000 invested in Project B 1,790 2,875
Tshs 1,325 invested in Project C ( Tshs
1,325 4,200
4,200,000 - 1,250,000 - 1,625,000)* Total
NPV for $4200 invested: 4,740
(4,200 − 2,875)
* × 2,000 ( Tshs 000’s)
2,000

Therefore, the optimal combination of projects is project

A, B and 2/3rd of project C.
 Calculation of the NPV of combinations of
non-divisible investment projects
 If projects are non-divisible it is a case of ‘all or nothing’ i.e. the
option to partly invest, as in the example above, will not be
available. In such a case, the PI approach will not apply. The finance
manager will use a ‘trial and error’ approach to maximise the
company’s NPV.
Continuing the example of the previous page,
 Assuming that the projects are now indivisible, the combined
investment schedule is as follows:
Projects A and B Total NPV = 3,415
Projects A and C Total NPV = 3,625
Projects A and D Total NPV = 3,535
Projects B and C Total NPV = 3,790
Projects B and D Total NPV = 3,700
Projects C and D Total NPV = 3,910

As project C and D have the highest NPV, so the optimum investment schedule is a
combination of project C and D.
 Nature of project
Indivisible (no fractional investment)
Divisible (fractional investment)
Meaning Approach to decision making
(a) Determine the combination of
Investment should be made in full.
projects to
utilise the available amount
Partial / proportional investment is not (b) Calculate the NPV of each
possible. combination
(c) Select the combination with the
highest NPV
Partial investment is possible and (a) Compute the profitability indices (PI)
proportional NPV can be generated of various projects and rank them
b) Select the projects based on
maximum PI
 Reasons for capital rationing
 Ideally, a company would prefer to implement all possible
projects that will maximise the shareholder value if it had
unlimited capital.
 In theory, any project can be put to market so as to raise funds.
 However, in reality there is a limit to the amount of capital that a
company has or can raise from the capital market.
 This gives rise to the need for capital rationing.
 The reasons for capital rationing may arise due to external
restrictions by the capital market, in which case it is called ‘hard
capital rationing’.
 Alternatively, they may arise due to internal limits imposed by the
managers, in which case it is called ‘soft capital rationing.
 Hard capital rationing may be caused
due to any of the following reasons:
 (a) If capital markets are depressed, raising money may
not be possible.
(b) Based on the credit appraisals, the financial institutions may
consider lending to a company too risky.
(c) Cost of capital issue may be disproportionate, especially if the
amount of capital requirement is small.
(d) Due to the credit policy of the government, there may be
restrictions on lending.
 In reality, hard capital rationing is less frequent. Most of
the capital rationing is self imposed (soft).
 Soft capital rationing may be caused by any of the
following reasons:

a) Management may refuse to raise additional funds through

the issue of new shares to avoid dilution of control for
existing shareholders.
b) To avoid commitment to large payments of interest or
installments of principal. This applies to debt finance.
c) Small and Medium Enterprises (SMEs) may decide to rely
only on internally generated funds for the purpose of
expansion.
d) Managers may wish to create an internal market for funds,
thereby ensuring that only the most financially viable
projects are selected.
e) There may be a lack of managerial time or expertise to
manage projects, therefore a limitation on the amount of
investments may be imposed.
 HW
Required initial investment NPV at appropriate cost of capital
Project Tshs Tshs
P 50,000 10,000
Q 150,000 17,500
R 25,000 8,000
S 100,000 12,500
T 50,000 15,000
The amount available with the company is Tshs 150,000,000:

Determine the optimal combination of projects assuming

that the projects are:

Divisible
Indivisible
Topic 6

APPLY FINANCIAL
MANAGEMENT
PRINCIPLES TO MANAGE
WORKING CAPITAL
 Learning Outcomes
 Explain working capital management
 Explain principles underlying effective management of working
capital
 Explain working capital policies and its impact of each on
profitability and liquidity position of the business
 Estimate the working capital requirements of a firm
 Decide on the level of inventory
 Determine credit policy variables and their impact on the wealth
of the shareholders as well as managing collections
 Determine the optimal cash balance (Baumol’s and Miller-Orr
models)
 Concept of working capital
 Gross working capital refers to the firm’s investment in
current assets. Current assets are basically those assets which
can be liquidated within a period of twelve months in the normal
course of business. . Example - inventory, debtors, cash and bank
etc. Gross working capital gives us an idea of the total
investment required in the various forms of current assets. The
planning for short term financing starts with estimation of gross
working capital needs.
 Net working capital is the difference between current assets
and current liabilities. It helps us to understand the short-term
liquidity position of the company.
 Current liabilities are those claims which must be repaid within a
period of twelve months
 Current
Current assets
liabilities
Cash and bank balances Trade payables
Inventories of raw materials, work in
Current tax liability
progress and finished goods
Trade receivables Dividends payable
Marketable financial assets Short-term loans
Long-term loans i.e. the part
Advances to suppliers
maturing within twelve months
Other liabilities payable within 12
Other assets realisable within 12 months
months
 Excess working capital has its
disadvantages in terms of:
a) Funds not being put to productive use and
impact on company earnings
b) Excess inventory
c) Diluted focus on debtor control
d) Leakages in the system which might go
unnoticed due to excess liquidity
e) Inefficiency in the organization ultimately
affecting market value of the firm.
 On the other hand, inadequate working capital
would be disadvantageous in terms of

i. Impact of liquidity and non-availability of

liquid funds for fulfilling various obligations
ii. Impact on company reputation due to
danger of non-fulfilment of commitments.
iii. No benefits of economies of scale
iv. Impact on sales, i.e. needing to sell below
target prices on account of liquidity
pressure
v. Delay in implementation of certain growth
strategies affecting profit goals
Principles of working capital
management
 Working capital management refers to the
management of current assets and current
liabilities and the interrelationship between
them. Cash management, receivables
management and inventory management are all
important facets of working capital
management.
 The following are the principles underlying
effective working capital
 1. Principle of equity position
 According to this principle, every shilling of investment
made in working capital should enhance the net worth of
the firm i.e. to determine the ideal working capital level.
The finance manager should enhance investment in
working capital so long as it has a positive impact on
equity.
 The level of current assets can be measured with two
ratios:
a) Current assets as a percentage of total assets
b) Current assets as a percentage of total sales
 ZYT Ltd has reported sales of Tsh150 million. The fixed assets
were Tshs 50 million. If the current assets stand at Tsh50 million,
the ratios would be computed as follows:
Current assets
(a) = 50/(50+50) = 50/100 = 50%
Total assets

Current assets
(b) = 50/150 = 33.33%
Total sales
 2. Principle of risk variation
 This is very critical in order to manage working capital effectively.
 Generally, the higher the risk the management is willing to take,
the higher is the return that it can expect.
 Risk in this case refers to the risk of non fulfillment of liabilities.
 If the current assets are reduced beyond a certain level,
there will not be enough liquidity to meet all obligations.
 We shall study in the subsequent Learning Outcomes how
different working capital policies are followed depending on the
management appetite for risk and reward.
 3. Principle of cost of capital
 In evaluating different sources of finance, one has
to be guided by the fact that different sources
have different costs of capital.
 Working capital financing can happen through
debt or equity or a combination of both. While
debt capital is relatively cheaper than equity
capital (due to the tax arbitrage), overall risk also
increases with deployment of debt capital.
4. Principle of maturity of
payment
 This principle requires one to match the
maturities of payment in respect of
liabilities with the flow of funds - i.e. cash
inflows and outflows should be matched
across maturities, else it would jeopardise
the liquidity and solvency position of the
firm.
 Working capital management should be
guided by this principle at all times.
 working capital policies and the impact of each on the profitability
and liquidity position of the business.
 Permanent and temporary working capital
 Current assets, by their very nature, are assets which are held by the
business for periods of twelve months or less.
 These assets, in total, fluctuate depending on the level of business
activity. However, in most businesses a particular base level of
inventory is always held and cash balances are never allowed to fall
below a certain level.
 These represent the proportion of current assets permanently held
i.e. the proportion of current assets which are fixed (hence the term
‘permanent current assets’). It is also called core working capital.
 From this point of view, the assets of a company are classified into
non-current assets, permanent current assets and fluctuating current
assets.
Permanent working capital = Minimum inventory level + Minimum cash balance +
Level of trade receivables - Level of trade payables
 The changes in working capital
occur on account of
1. Changes in policy
 In case management changes its current asset policy (after
review), i.e. decides to shift to a more conservative / aggressive
policy, it would impact the working capital position.
2. Changes in sales
 Current assets change in direct relation to a changes in sales. The
quantum of current assets would increase / decrease with change
in sales. For example, with an increase in sales there would be an
increase in stock, receivables, collections etc.
3.Technological improvements
 Technological advancements would have a positive impact on
improving efficiency and thereby reducing the working capital
cycle. This would change the working capital position of the firm.
Distinction between Fluctuating Current Assets,
Permanent Current Assets and Non-Current
Assets
Working capital policies
 Working capital policy is concerned
with policy decisions such as:
i. Maintaining an adequate amount of
working capital (current assets and
current liabilities)
ii. Deciding on the sources of finance of
working capital
1. Maintaining an adequate amount of
working capital (current assets and current
liabilities)

 Cont….
 The current ratio mainly gives an idea of the company's ability to
pay back its current liabilities i.e. short-term debt and payables
with its current assets i.e. cash, inventory and receivables.
 The higher the current ratio, the more capable the company is of
paying its obligations. This is because a high current ratio depicts
that the company has more current assets as compared to its
current liabilities. Furthermore, a ratio less than 1 suggests that
the company would be unable to pay off its obligations if they fall
due at that point.
 The current ratio can give an idea of the efficiency of a
company's operating cycle or its ability to turn its products into
cash.
 Cont…

 Example
 The following information is extracted from the
financial statements of Padidas Co
20X9 20X0
Tshs
Tshs million
million
Current Assets
650 700
Inventory
Trade receivables 900 1,030
Cash and bank 50 75
Total current assets 1,600 1,805
Current liabilities
490 410
Trade payables
Bank overdraft 480 530
Total current Liabilities 970 940
Credit sales 5,100 5,300
Total sales 6,200 7,300
Credit purchases 2,500 2,600
Cost of sales 6,100 6,800
 Average production period is 30 days.
 Let’s calculate current ratio and quick ratio.
Curre nt ra tio
Current assets 1600 1805
Current liabilities 970 940
1.65 1.92
Quick ra tio
Quick assets 950 1105
Quick liabilities 490 410
1.938 2.695

 From 20X9 to 20X0 both the current and the quick

ratios have improved indicating better liquidity for the
company. Padidas’s ability to cover its current liabilities
has improved.
 2. Deciding on the sources of finance of working capital
 The working capital can be financed either through short term or
long-term sources of finance.
 Short term sources of finance include:
a) Short term credit lines offered by banks in terms of bank overdraft, cash credit
b) Trade creditors
c) Short term debt instruments
d) Customer advances (if the business practice permits)
 Short term sources of finance are:
 Cheaper: since lenders are deprived of cash for a relatively short
period, interest rates on short-term finance are likely to be lower than those
on long term. This is in line with the liquidity preference theory. In addition, no
interest is usually charged on trade credit from suppliers (unless payment
deadlines are missed).
 More flexible: these sources are flexible; in the sense that the company can use
them to the extent needed.
 But: More risky: as the sources are short term, it may be withdrawn at any
time.
 Cont…
Long term sources of finance include
a) Equity – issue of additional share capital
b) Retained earnings ploughed back into business
c) Secured debt in terms of debentures
d) Long term loans from banks / financial institutions
e) Public deposits (subject to the laws of the land)
 Long term sources of finance tend to be more expensive (as the
lender’s money is tied up for a longer period) but more secure.
Terms for payment of interest and re- payment of the principal
amount borrowed are agreed up front which allows businesses to
plan their cash flows. Since everything is agreed beforehand, the
likelihood of long term finance being withdrawn is minimized. When
deciding on the mix of long term and short-term finance, the
company must consider its view on risk
 2.3 Types of working capital
policies
 There are three types of policies that can be followed
1. Conservative policy
 Under this policy, the current assets are held at a fairly high level.
In firms where the conservative policy is followed, the current
ratio (i.e. current assets divided by current liabilities) would be
higher than the generally accepted 2:1.
 Furthermore, the working capital requirement under this policy is
met largely though funds obtained from long term sources. The
use of short- term funds is restricted to emergency situations.
This policy is a low profit – low risk measure. Since long
term funds are used for working capital finance it ensures
sufficient liquidity. However, profitability may be impacted since
long term funds, as discussed above, would have higher cost as
compared to short term funds (in general).
 Cont…
2. Matching policy (also called hedging policy)
 According to this policy, the current assets are divided
into
(i) those current assets which are essential at any point in time
i.e. hard-core working capital and
(ii) balance which varies from time to time i.e. temporary
working capital.
 This policy endeavors to match the maturity profiles of
assets and liabilities i.e. permanent working capital is
treated like fixed assets and financed through long term
funds, while the fluctuating current assets are financed
through short term funds.
 Example
 The management of New Horizon Ltd has estimated the
working capital requirements for the next six months:
Split as
Total working
Permanent Temporary
Month
capital required
( Tshs m) ( Tshs m)
( Tshs m)

Apr 10,000 8,500 1,500

May 8,500 8,500 -
Jun 11,000 8,500 2,500
Jul 9,000 8,500 500
Aug 10,900 8,500 2,400
Sep 9,500 8,500 1,000

 Under the matching policy, Tshs 8,500 m would be financed

through long term sources since this is permanent working
capital and the balance through short term sources.
 Let’s compare the above two policy styles in terms of their
impact on liquidity and profitability
 (a) Liquidity
i) When we compare the two policies in terms of risk involved, it is
evident that hedging policy is riskier than conservative policy. This is
because in hedging policy only short term funds are used to finance
short term working capital needs. The use of short term loans always
carries a risk of early repayment since they are repayable on demand.
 The ability to liquidate the current assets to match the repayment
of short term funds is questionable. Furthermore, short term funds
also carry repricing risk since rates can be revised by the lenders at
any time based on the liquidity and interest rate scenario in the
economy. Therefore, profitability forecasts may get affected.
ii) In contrast, the conservative approach does not deploy short term
funds and is financed completely through long term funds with
comfortable level of working capital. So there is no strain on liquidity.
 (b) Profitability
i) Under the conservative approach, in contrast to other policies,
there would be an impact on profitability on account of increase in
cost due to:
Higher amount of investment in working capital
Financing through long term funds
 Since long term funds in general carry a higher rate than short term
funds, the overall cost of funds would be higher under the
conservative approach.
ii) There is another type of impact on profitability on account of
inefficient use of working capital. In case funds are not put to
optimum use, profitability would be negatively impacted due to the
cost of idle funds.
Trade-off between the two
approaches
 There is no one policy which can be considered suitable
for a business at all points in time. It would depend on
the management perception of the level of acceptable
risk.
 One possible financing mix which can be considered to
be a trade-off between the two approaches is to arrive
at an average of maximum and minimum monthly
requirements for a given period. Upto this level,
financing can be done through long term funds and the
balance through short term funds.
 Example
 Continuing the example of New Horizon Ltd, the above
trade-off is worked out as follows
Split as

Total w orking
Permanent Temporary
Month
capital required
( Tshs m) ( Tshs m)
( Tshs m)

Apr 10,000 9,750 250

May 8,500 9,750 -
Jun 11,000 9,750 1,250
Jul 9,000 9,750 -
Aug 10,900 9,750 1,150
Sep 9,500 9,750 -

 Thus the average is worked out at Tshs 9,750 million (average of

maximum and minimum of working capital required, i.e.11,000 plus
8,500 divided by 2) which is financed through long term funds. At
this level, short term funding is required only in three months.
 3. Aggressive policy
 Under this policy, the management adopts an aggressive approach
to working capital management. Working capital is squeezed and
kept at a minimal level. Furthermore, the financing is also done
largely through short term sources. This is advantageous from the
viewpoint of returns i.e. it would have a positive impact on
profitability since fund requirement is minimized and funding is
through cheaper sources.
 This policy measures high in terms of risk. This is because
components of current assets like inventory cannot be liquidated
and converted to cash as quickly as may be required to meet the
short term obligations. Therefore, aggressive policy adversely
affects liquidity and in extreme cases, can jeopardized the solvency
position of the firm.
 Determinants of the working
capital policy of businesses.
1.The industry in which the organisation operates
i. Manufacturers: manufacturing organizations will hold high levels of inventory in the
form of raw materials, work in progress and finished goods. They may also benefit from
high levels of credit from suppliers.
ii. Supermarkets and retailers: supermarkets and other retailers receive most of
their sales in cash, by credit card or by debit card. Thus the level of trade receivables
tends to be relatively low. Trade payables, on the other hand, tend to be quite high as
they purchase from suppliers mainly on credit. As a result they may have the advantage
of significant cash holdings which they may choose to invest.
iii. Wholesalers: a company which supplies to other companies, such as a wholesaler, is
likely to be buying and selling primarily on credit; and coordinating the flow of cash may
be quite a problem. Such a company may make use of short-term borrowings such as
an overdraft to manage its cash.
iv. Small companies with relatively low turnover: smaller companies with a limited
trading record may face severe problems especially in obtaining credit from suppliers.
At the same time, customers will expect to receive the length of credit period that is
normal for the particular business concerned. As a result, trade receivables could be
moderate or high. Such firms may encounter problems in their management of cash
 Cont…
2. Business dynamics
 The working capital needs vary widely with the fluctuations in
business. During a boom there is an increase in sales accompanied by
an increase in each of the components of current assets, requiring
additional investments. On the other hand, in the case of a slowdown
/ recession, the level of activity decreases causing a decline in
debtors, level of inventory etc.
 Therefore, working capital requirements are significantly influenced
by the business cycle.
3 Operating cycle
 The size of working capital is influenced by the operating cycle i.e.
time taken from procurement of raw materials to manufacturing of
finished goods. In other words it is the production cycle time and as
such will be determined by the skill and efficiency of labour as well
as technical factors, such as the processing time taken by a machine.
 Cont…
4 Demand linked production policies
 In the case of certain lines of business, demand is seasonal wherein peak demand lasts for
only certain months of a year. In such cases, management has two options. Either production
can be undertaken only for certain months of the year adjusted to the demand period or
production can be undertaken for the entire year based on the forecasted demand.
 In case production is done for certain months only, there is a problem of maintenance of
idle machinery and labour, unless the management is able to involve them in some alternate
activity. Hence, each organisation should formulate a working capital policy which considers
the impact of its production policy.
5 Raw material availability
 In case certain inputs / raw materials are not available on a continuous basis, it becomes
necessary to stock them. They can then be utilised in the periods of short supply. This would
require an increase in the quantum of working capital. Furthermore, the firm should have
ready funds when the raw materials are available in the market.
6 Terms of credit
 Working capital policies are influenced by the terms of credit which are offered to
customers and received from suppliers. Sometimes, due to the prevailing market practices,
the firm is required to offer credit terms to all customers. Also, due to fierce competition,
the firm would need to stock a variety of products, requiring an increase in the level of
working capital.
 Cont…
7 Growth strategy
 All companies which are on a growth trajectory require increased working
capital. However, another important aspect is that companies which foresee
growth opportunities should make additional investments in all facets of
business, including working capital. It is important to adjust working capital to
changing growth estimates and plan the cash flow accordingly.
8 Profits earned
 The cash profit generated by a firm is absorbed in order to finance working
capital. The earnings need to be adjusted for depreciation and other non-cash
outflows to arrive at the amount of cash profit. It is essential to estimate the
level of earnings for each period to ascertain the quantum that would be
available for working capital financing.
9 Taxation
 Taxes form an integral part of any business venture and adequate provision has
to be made for payment of taxes.
 According to the laws applicable, taxes also need to be paid in advance based on
profit forecasts.
10 Depreciation policy
 Depreciation is a non-cash expenditure; however, depreciation provisions impact
cash flows through their impact on tax provisions. If the depreciation provision
reduces due to a change in the depreciation policy, the tax liability would
increase, requiring additional funds to fulfil it.
 If the actual capital expenditure to replace a fixed asset is lower than the
accumulated depreciation provisions, the company would stand to gain. In the
case of a reverse situation, the shortfall would have to be funded through long
term funds, in the absence of which, the working capital position would be
adversely impacted.
11 Dividend policy
 Dividend is generally paid in the form of cash dividend. The payment of dividend
would reduce the working capital on hand. On the other hand, in case dividend is
not paid and profits are ploughed back, it would strengthen the cash position of
the company.
12 Efficiency in operations
 If a firm monitors its resources in such a way so as to ensure optimum utilisation, it
would contribute to a strong working capital position. All inefficiencies in the
system in terms of leakages need to be ironed out. This would automatically
contribute to increase in cash profits.
13 Changes in prices
 Any variations in the prices of raw materials, cost of operations etc. need to be
factored in. If the effect of these variations can be passed on to consumers through
increased prices, there is no material effect on cash flows. However, if the effect of
the variations is to be absorbed by the firm for some time, considering the current
market situation, then additional funds would be required. This would have a direct
impact on the working capital position.
 Estimate the working capital requirements of a firm
Operating or working capital cycle
-Working capital cycle is the time taken from the procurement of raw materials and
conversion to finished goods to realisation of proceeds from sales.

Any lender of working capital finance has to first estimate the operating cycle of the
company to determine the credit limit required. The faster the movement of stock, debtors
etc., the lower is the length of the operating cycle. It is in the interest of the company to
reduce the working capital cycle to the extent possible in order to minimise the requirement
for external funds.
 Cont..
Average time the raw material remains in inventory 1.5
Less: Credit period allowed by suppliers (2)
Time taken to convert raw material into finished goods 1
Average time the finished goods remain in inventory Negligible
Credit period allowed to customers 1
Cash cycle period 1.5
 Estimation of working capital on the basis of current
1. Current
assets and current liabilities
assets
Sr Current
Formula
no. asset

{Budgeted prod. X estimated raw mat cost /unit} X Average holding period
Raw material
1

stock 360 days or 12 months

Work-in- {Budgeted prod. X estimated WIP cost /unit} X Average holding period of WIP
2

progress 360 days or 12 months

Finished {Bud. prod. X cost of prod.(per unit exclg depreciation)} X Average holding period
3

goods 360 days or 12 months

{Est. credit sales X Cost of sales (Exclg depreciation per unit} X Avg. collection period
4 Receivables

360 days or 12 months

5 Cash Estimated based on minimum required cash and bank balances to be maintained
 2. Current liabilities
Sr. Current
Formula
no. liability

Trade {Budgeted prod. x estimated raw mat cost /unit} x Average credit period by suppliers
1

Creditors 360 days or 12 months

{Budgeted prod. x Overhead cost /unit} x average time lag in payment of overheads
2 Overheads

360 days or 12 months

{Budgeted prod. x direct labour cost /unit} x Average time lag in payment of wages
3 Direct wages

360 days or 12 months

 Example
 The finance manager of Trustwell Ltd is estimating the working
capital requirements for the year. Production is budgeted at
1,000,000 units per annum. The costs as a percentage of sale price
are raw materials 25%, direct labour 30%, and overheads 10%.
 Raw materials are held in stock for 15 days and finished goods for
25 days. Production takes 30 days, credit given to customers is 60
days (60% is credit sales) and credit availed from suppliers is 1
month. While each unit is expected to be in process for 1 month,
the raw materials are fed into the pipeline immediately and labour
and overheads accrue evenly during the month. The selling price is
Tshs 1000/ unit.
Cost of production
soln
Raw materials 1,000,000 X 1000 X0.25 Tshs

Labour 1,000,000X1000 X 0.30 250,000,000

Overheads 1,000,000 X 1000 X0.10 Tshs
Total Tshs
Credit sales 1,000,000 X 1000 X0.6 650,000,000

Particulars Tshs Ts

Stock of raw materials 250,000,000 X 15/360 104,166,6

Work in progress
250,000,000 X30/360
Raw materials 20,833,333
Labour 300,000,000X30/360 X 1/2 12,500,000
Overheads 100,000,000 X 30/360 X 1/2 4,166,667 37,500,0
Finished goods 650,000,000 X25/360 45,138,8
Debtors 600,000,000*60/360 100,000,0

Current assets
286,805,5
Creditors 250000000X30/360 20,833,3

Current liabilities
20,833,3

Estimated working capital Current assets - current liabilities

265,972,2
 Estimation of working capital on cash cost basis
 Under this approach, the components of working capital are estimated on
cash cost basis i.e. actual cost of production. Depreciation and other non-
cash costs are excluded from the cost of production. Cost of production
rather than sales is considered in estimation of debtors.

The following figures relate to Leap Ahead Ltd.

Tshs
Materials consumed (credit by suppliers: 2 months) 10,00,000
Wages paid (30 days in arrears) 7,00,000
Manufacturing expenses (outstanding at year end) (1 month in
80,000
arrears)
Sales promotion and administration expenses (quarterly in
4,00,000
advance)
Sales (credit of 60 days) 40,00,000

The company sells its products at a profit of 25%, counting depreciation as part of cost of
production. Cash balance is estimated at Tshs 1,00,000 and the company keeps one-month
stock of raw material and finished inventory. Safety margin is 10%.

Estimate the working capital requirements of the firm:

 working
Particulars Tshs
Stock of raw materials 10,00,000 X 1/12 83,333
Stock of Finished goods (W1) 2,660,000 X 1/12 221,667
Cash 100,000
Sales promotion and admin
expenses paid
100,000

quarterly in advance i.e. 1/4th )

Current assets
1,015,000

Trade creditors 1,000,000 X 2/12 166,667

Wages 700,000 x 1/12 58,333

Direct expenses 80,000

Current liabilities 305,000

Current assets -
Net w orking capital 710,000

current liabilities
Add: Safety margin @10% 71,000

Estimated net w orking capital 781,000

Workings
W1 Cost of production

Particulars Tshs Tshs

Raw materials 1,000,000
Wages 700,000
Direct Expenses (80000 X 12) 960,000 2,660,000
 Cont….
Workings
W1 Cost of production

Particulars Tshs Tshs

Raw materials 1,000,000
Wages 700,000

Direct Expenses (80000 X 12) 960,000 2,660,000

W2 Cost of goods sold

Particulars Tshs Tshs
Cost of production 2,660,000
Other overheads 400,000 3,060,000
level of inventory
 Inventories are a major constituent of
working capital. Manufacturers hold the
widest variety of inventory i.e. raw
materials; work in progress and finished
goods or consumables. Other types of
businesses e.g. service organisations or
retailers may hold fewer categories.
 1. Holding cost
i. Warehousing costs: inventory occupies space for which the
company incurs costs such as rent (for rented premises) or
depreciation, interest on capital, insurance (for owned premises),
and repairs and maintenance.
ii. Handling costs: salary to warehouse keeper, costs of movement
of material.
iii. Cost of capital or opportunity cost: cash tied up in idle
inventory could be invested elsewhere to earn a return.
iv. Insurance: inventories are invariably insured against risks such as
fire, flood, theft etc.
v. Deterioration and obsolescence: the quality of inventory lying
in hand may deteriorate due to external factors such as heat or
dust. It may become technologically obsolete.
vi. Pilferage: a small percentage of inventories are often lost due to
theft.
 2. Ordering cost
a) Ordering costs: salaries to the purchasing staff, stationery,
and telephone bill.
b) Delivery costs: salaries to the staff checking the quality of
material.
 If a company wants to hold fewer inventories in order to
reduce holding costs, it will have to place orders more
frequently and incur higher ordering costs. On the other
hand, if a company reduces the number or orders, it will have
to purchase and store larger quantities. The costs of holding
and ordering, therefore, have an inverse relationship.
Economic Order Quantity
(EOQ)

 Economic Order Quantity

The above diagram illustrates the inverse relationship between holding costs and ordering costs.
It can also be
seen that total cost is the lowest where total holding costs and total ordering costs are equal.
 The following formulae will be useful in calculating ordering and
holding costs
=Average inventory x Cost of
Total cost of holding
holding one unit
Q/2 ×Cℎ
=No. of orders x Cost per order
Total cost of ordering (D/Q)xC0

 ABC Ltd is a distributor of mobile handsets. Handsets are

ordered in lot sizes of 1,000 and each order costs Tsh40 to place.
Demand for handsets is 40,000 per month and carrying cost is
Tsh0.05 a handset per month.
 calculate the optimum order quantity.


Soln

 Question
Nellone Co provides the following information:
Tshs
Annual requirement of component Z 50,000
Price per unit 0.12
Holding costs per year per unit 0.02
Ordering costs per order 6

Required:

Calculate the EOQ for Z.

Calculate the total cost of holding and the total cost of ordering.
Prove that EOQ is the cheaper option.
 Bulk Discounts and EOQ
 Bulk discounts encourage the purchase of larger
quantities at a cheaper price. The quantity required to
obtain the discount may not be the same as the EOQ.
 In addition, once bulk discounts are filtered in, ordering
according to the EOQ may no longer be the most
economical ordering policy.
 In such a case the total annual costs associated with
adhering to the EOQ as well as the costs associated with
the quantities where the bulk discounts are obtained need
to be calculated.The cheapest option will be selected.
 Total annual costs (TAC) = Annual cost of (Purchasing
+ Holding + Ordering
 Just-in-time (JIT) techniques
 This technique originated in Japan. Its use was pioneered in a Toyota plant in
1970. This philosophy regards inventories as a “poor excuse for bad planni ng!”
Inventory levels are minimised (sometimes to zero) by manufacturing the exact
quantities required by customers for the exact time needed. It concentrates on
the elimination of waste i.e. any activity performed which does not add value to
the product.
The JIT system requires:
i. Reliable suppliers in terms of delivery times, quality and quantity of materials.
ii. Accurate production planning taking into account defects and wastage.
Businesses will aim for total quality management (TQM) i.e. the elimination of
waste and defects.
iii. Factory layout where there is a minimum movement and handling of
material. Work centres should be adjacent to each other to allow for quick
and easy flow of work between centres. This should help in reducing queues
of work in progress.
iv. Minimal finished goods stock held. Production by order only. This serves to
eliminate holding costs for finished goods.
 Benefits of using the JIT
technique
a) Minimises or eliminates inventory levels and
related costs.
b) Minimises or eliminates time between delivery
and use of inventory.
c) On receipt, material is sent directly to the
production line. This saves on material holding
and handling costs.
d) It forces managers to plan more accurately and
encourages efficiency through the elimination of
wastage and work in progress.
 External extended just-in-time
 With the advent of the internet, JIT systems are
extended outside the company borders.
 Suppliers are connected to the network and
have up-to-date information on the plans of the
company.
 They can therefore plan their production and
deliveries in such a manner that the deliveries
reach the company just in time for assembly.
 Thus, the benefits of JIT spill over to suppliers.
 Other techniques for managing inventory
1. Reorder Level
 As the name indicates, this is the inventory level at which an order should be
placed with the supplier for replenishment of the used inventory. This is calculated
as:
 Reorder level = Maximum consumption x Maximum lead time
 (Lead time means the delay between ordering and physical delivery of the material)
 This level aims to eliminate the risk of an inventory out. Actual consumption and
actual lead time are likely to be lower than the maximum numbers used in this
formula. Therefore, the fresh material will be delivered well before the
existing inventory is finished.
2. Minimum level
 Minimum level is a level that serves as a warning that the inventory levels are
dangerously low and that stock outs are possible. If stock out does occur,
it will bring production to a halt. For this reason, management wants to avoid a
stock out situation. This level is also known as safety level.
 This level aims to maximise customer service levels while minimising stock
investment, and is calculated as follows:
 Minimum level = Reorder level - (Average usage x Average lead time)
3. Maximum level
 Maximum level is a level beyond which there is a risk of compromising
appropriate storage and handling conditions. It is a potentially wasteful
level, and is calculated as:
 Maximum level = Reorder level + Reorder quantity - (Minimum usage x
Minimum lead time)
4. Average inventory level
 Average inventory level = (Minumum level + Maximum level) /2
5. Buffer stock
 Buffer stock is the minimum level of inventory that an organisation carries
as reserve against emergency or short-term shortages. It allows an
organisation to avoid fluctuations in the price of raw materials.
 If the organisation carries buffer stock then average inventory level is
calculated as:
 Average inventory level = Buffer stock + Economic order quantity/ 2
 Example
 Magna Co uses a component called 'Neel'. The company
provides the following details:
Monthly demand for finished goods (units) 100
Cost of placing an order Tshs 10
Annual carrying cost per unit Tsh1.50

Normal usage of input Neel per week (units) 40

Maximum usage per week (units) 65

Minimum usage per week (units) 25

Reorder period (weeks) 4 to 6

Calculate the following for Neel:
(a) Reorder quantity
(b) Reorder level
(c) Minimum level
(d) Maximum level
(e) Average inventory

 Cont….
(c) Minimum level = Reorder level - (Average usage x Average lead time)
 Reorder level = 390 units
 Average usage = (Maximum usage + Minimum usage)/2
 (65 + 25)/2 =45
 Average lead time = (Maximum lead time + Minimum lead time)/2
 (4 + 6)/2 =5
 Minimum level = 390 - (45 x 5)
 = 390 - 225
 =165 units
(d) Maximum level = Reorder level + Reorder quantity - (Minimum usage x
Minimum lead time)
 = 390 + 167- (25 x 4)457 units
 (e)Average inventory level = (Minimum level + Maximum level)/2
 = (165 + 457)/2=311 units
 Credit policy variables and their impact on the wealth of the
shareholders as well as managing collections.

 Receivables management is an integral part of overall working capital management.

When an organisation sells goods on credit, receivables are created. In addition to
cash sales, selling goods on credit helps to boost the sales of the firm. However,
there are certain costs involved in receivables management.
 Cost of additional capital required for investment in debtors
 Collection costs in terms of setting up of a credit department which would
handle the entire receivables management in terms of setting up credit policies,
analysis and credit approval, monitoring and collections.
 In event of delay in payment by debtors, delinquency costs to collect the
outstanding, legal charges etc.
 In case of default, bad debts which would have to be written off.
 Credit policy is a decision on whether or not to extend credit, and what should be
the quantum. It is important to evaluate the decision to extend credit or not based
on the impact it has on the wealth of shareholders through increase in profitability
and on managing collections i.e. the incremental benefit from extending credit
should exceed the costs / managerial issues involved.
 Credit benchmarks
 Each organisation / line of business would have certain criteria for extending
credit. These benchmarks can either be extremely stringent / tight or relaxed.
These credit standards can be established based on quantitative inputs such as:
a) Credit references: obtained from others in the same line of business having
dealing experiences
b) Credit ratings: if available as provided by various rating agencies
c) Financial ratios which can be developed as standards over a period of time.
Ratio analysis to determine long term financial position, short term liquidity etc
can be used.
d) Average collection period (based on past experience)
To analyse the trade-off between benefit to the firm in terms of profitability and cost
to the firm in terms of management of receivables, let’s evaluate the impact of
relaxation / tightening of credit benchmarks on each ofthese factors:
 1. Sales volume: relaxing the credit policy would increase the sales volume and
vice- versa. However, if the increased volume can be sold at the same rate or a
discount is warranted needs to be determined.
 Cont…
 2. Increase in working capital finance requirements: an increase in sales as
discussed above would require a consequent increase in requirement of funds. This
is because the quantum of receivables would increase as also the collection period
would go up.
 3. Bad debts: another factor which needs to be considered is bad debts which
would emerge in the event of default. An increase in bad debts beyond expected
level can erode shareholder wealth significantly depending on the size of receivable
outstanding.
 3. Investment in credit and collection mechanisms: a loosening of credit
standards would mean increased credit flow requiring larger staff to service the
receivables. Beyond a point, a full fledged credit and collections department would
be required to handle the following:
i. Maintenance of complete records
ii. Customer service
iii. Follow ups and soft collections
iv. Hard collections (including legal procedures)
 Therefore with a relaxation in credit standards there is an increase in sales
accompanied by increase in collection costs, investment etc. The reverse is true
when the credit standards are tightened.
 Example
 Danon Plc is selling a product at Tshs 100 per unit. The variable cost is 60%
of sales and fixed cost is Tshs 500,000. The firm currently sells 25,000 units.
The average collection period is 25 days.
 The finance manager has received a request from the sales department to
increase the credit to 40 days which would increase sales by 15%. The firm
would require additional working capital of Tshs 100,000. The cost of
additional finance is 12%.
 In the above scenario, let us evaluate the impact of credit relaxation on
sales and cost on a marginal basis.
 Incremental revenue
Tshs Tshs
Incremental sales 25,000 X 15/100 3,750
Contribution Tshs 100 - Tshs 60 150,000
Fixed costs (absorbed by existing units)
Incremental revenue 150,000
 Cont…
 Incremental cost
 Let us compute the incremental investment in receivables
Tshs Tshs
Working capital
Cost of sales
-Present 25000 X 80 2,000,000
25000 X 80 plus
Proposed 2,225,000
3750 X 60

Average investment in receivables

-Present 2,000,000 X 25/360 138,889

-Proposed 2,225,000 X 40/360 247,222
Incremental investment
108,333

Incremental cost @15% funds 16,250

100,000X15
Cost of additional working capital = Tshs 15,000

100

 Therefore, incremental revenue less incremental cost = 150,000 –

(16,250 +,15 000) =118,750, so we can conclude that the finance
manager should allow the increase in credit lines.
 Credit Analysis and Scrutiny
 Once the credit benchmarks are established, the second aspect of credit policy is
credit analysis and scrutiny. This involves:
1. Data mining to obtain credit information
 To evaluate the credit worthiness of the client, the company has to obtain all the
necessary information to arrive at an informed decision. This can be obtained from
 (a) External sources
 There are various sources of information which can be tapped in terms of:
I. Company financial statements, director’s report, quarterly results etc. which
would help in analysing the financial standing and solvency position of the client.
II. Trade references – references from firms who are in the same line of business
based on past dealings with the client.
III. Bank references – firms can write to the bankers of the client to obtain their
references maintaining strict confidentiality.
IV. Organised credit rating agencies – depending on the maturity of the industry, if
rating by external agencies is available, it can be utilised.
Cont….
Internal sources
i. Payment and performance report based
on past experience with the client.
ii. Information obtained from client itself in
terms of forms / documents. This could
be supported through personal
discussions with the client to
understand the promoter background,
business acumen etc.
 Determine the optimal cash balance
(Baumol’s and Miller-Orr models)
 Cash management is an integral part of working
capital management. The aim of working capital
management is to ensure optimal investment so
that all other forms of current assets can be
easily converted to cash. However, excess cash
can also be counter -productive. In this section,
let’s discuss the motives of holding cash and how
to determine optimal cash balance.
 Reasons for holding cash
 It is generally maintained that surplus cash should be invested to earn returns as
surplus cash on hand is considered to be an idle asset. It follows, therefore, that
if a business expects to have surplus cash even for one day, that surplus should
be invested for that one day. However, there are exceptions as businesses need
to hold some cash. Reasons for holding cash include:
1.Transactions motive
 This refers to cash held for conducting day-to-day business e.g. paying suppliers,
employees and general expenses.
2. Precautionary motive
 In the normal course of business, there may be some unexpected cash outflows.
Any cash balances held for this purpose are referred to as precautionary
balances and satisfy the same function as buffer inventory levels. In some cases,
however, instead of holding these balances in cash, a company may hold them in
the form of highly liquid investments so that it can earn a return on the
balances while they are not required.
 Cont…
3. Speculative motive
 Sometimes attractive investment opportunities may arise. To
benefit from these opportunities, companies build cash reserves.
 As a result of announcements by the government about monetary
and interest policy, bond prices are expected
 to increase sharply. The company wants to capitalise on this. It
invests in bonds which it later sells off at a profit.
4. Finance motive
 E.g. cash required to redeem a debenture or to pay off a loan.
 Baumol’s model of determining optimal
cash balance
 The aim of this model is to calculate the amount of cash which a
finance manager should maintain by counter balancing the following
two objectives
Converting the securities to cash at a minimum cost
Minimising the cost of keeping idle funds which could have been invested
elsewhere to earn a rate of return.
 Earlier the EOQ model of inventory management was discussed.
Baumol developed a model similar to this for cash management.
This model treats
i. Cash as inventory
ii. The costs of arranging funds (buying and selling securities, issue of equity
finance or negotiating overdraft) as ordering costs
iii. Interest lost (opportunity cost) as the cost of holding cash.
 

The total cost split as conversion cost plus opportunity cost can be
Frepresented as: [𝐶/2] + [𝑁F/C]


Drawbacks of the Baumol
model
 One major problem with the Baumol model is that it
assumes that cash requirements are known and cash is
used on a steady, predictable basis. In reality, this is not
the case. Cash flows can fluctuate tremendously and
balances can therefore be uncertain.
 The Miller-Orr model, as discussed below, is seen to be
superior to the Baumol model as it takes the
uncertainty of cash flows into account. It is more
realistic from this perspective.
 Miller-Orr Model
 This approach to cash management establishes upper and lower
cash limits and a return point (or optimal cash balance) to which
the cash balance will be restored on reaching any of the limits.
 The firm buys securities when cash exceeds the upper limit and
sells securities when cash is less than the lower limit.
 There are no securities transactions when cash is between the
limits. The model takes the following variables into consideration
The fixed cost of securities transactions which are assumed to be the
same for both buying and selling transactions,
The daily interest rate on marketable securities and
The variance of the daily net cash flows.
The Miller-Orr model can be
depicted by the following graph
 The Miller-Orr formula
 𝑆𝑆 = 3 ×((3/4×𝑇C×𝑉C)/3)1/3
Where,
 S= Spread between lower and upper limits
 LL= Lower point
 TC= Transaction cost
 VC= Variance of cash flows
 i = Interest rate per day on marketable securities
 Return point or Zero point = Lower limit + 1/3 x
Spread
 Upper limit = Lower limit + Spread
Steps
 1. Set the lower limit. (The question will
normally give this).
 2. Identify the variance of cash flows.
 3. Note interest rate and transaction cost.
 4. Calculate spread.
 5. Calculate return point by adding 1/3 of
the spread to the lower limit.
 6. Calculate the upper limit by adding the
spread to the lower limit.
 A company disburses a total of Tshs 50,000,000 per
year in cash. It costs Tshs 75 on an average every time
securities are sold for cash. The treasury manager
estimates that the variance of change in the daily cash
flowbalance is Tshs 20,000,000. He also establishes that
the lower cash limit is Tshs 50,000.
Required:
 Calculate the return point and the upper cash limit if
the current short-term investment rate is 5%.
Daily interest rate = Rate per annum/365
= 0.05/365
= 0.000137
Spread =3 x (3/4 x 75 x 20,000,000/0.000137)1/3
=3 x (1,125,000,000/0.000137)1/3
= 3 x 20,175
= Tshs 60,525
Return point = Lower limit + 1/3 x Spread
= 50,000 + 60,525 /3
= Tshs 70,175
Upper limit = Lower limit + Spread
= 50,000 + 60,525
= Tshs 110,525
APPLY FINANCIAL
MANAGEMENT PRINCIPLES
TO PERFORM FINANCIAL
PLANNING AND
FORECASTING IN AN
ORGANIZATION
 Learning Outcomes
1) Explain financial planning ,forecasting and budgeting
2) Explain characteristics of short term and long term
planning
3) Construct proforma financial statements
4) Interpret the result from proforma financial statements
5) Prepare cash budget
6) Determine uses and sources of financing
7) Establish the shortage or surplus in cash budget
8) Develop short-term and long-term financing plans
9) Interpret results from short term and long term
financing plans
 Financial planning is the task of
determining how a business will afford to
achieve its strategic goals and objectives.
 A financial plan represents what an
organisation intends to do in the future.
Generally, financial plans cover the
performance and requirements of the
organisation over a period of three to five
years in the future.
 Elements considered in the financial
planning
1. Economic environment: factors like inflation rate, rate of foreign
exchange, interest rates etc. all play an important role in financial
planning.
2. Sources of financing: adequate planning about the sources of
finance for initial capital expenditure as well as for operating
expenses (working capital) is critical for any business organization.
3. Forecast and budgeting: sales forecast plays an important role in
financial planning as almost all other factors
4. are related to sales; in budgeting, cash budget is the most important
element.
5. Proforma statements: preparation of proforma financial
statements and cash flow statements is also an important step in
financial planning.
 Financial planning process
i. Analysing past performance of the organisation.
ii. Understanding the current financial position and other operating
elements of the organisation like nature of product, market
position etc.
iii. Projecting future growth.
iv. Evaluating various future investment opportunities available.
v. Estimating the future fund requirements.
vi. Analysing the various options for fulfilling future requirements.
vii. Deciding on the financing option.
viii. Measuring actual performance against planned performance
USE FINANCIAL
MANAGEMENT
TECHNIQUES TO ANALYSE
FINANCIAL STATEMENTS
IN AN ORGANIZATION
 Learning Outcomes
a) Identify components of annual report
b) Explain users of financial statements
c) Explain tools used to analyse financial
statements (ratio and common sized analysis)
d) Determine the financial performance and
position of a company
e) Analyse financial statements by using Du
Pont system
 components of annual report
 An organisation’s financial statements / financial reports
are the accounting records of an organization
summarised and presented in a predetermined format.
Financial statements have the following
components:
i. Statement of profit and loss and other comprehensive
income
ii. Statement of financial position
iii. Statement of changes in equity
iv. Statement of cash flows
v. Notes to the financial statements
1. Statement of profit or loss and other
comprehensive income (income statement)
 This is a statement for a period, typically one year.
 revenue;
 finance costs;
 tax expense;
 profit or loss.
PURPOSES
◦ To show whether an entity has made a profit or loss in an accounting period.
◦ To describe how the profit or loss arose
◦ Gves much more information than a company's earnings.
◦ It provides important information about management’s efficiency in controlling
expenses, amount of income, and taxes paid.
◦ Investors can use it to calculate financial ratios that will ultimately give the rate
of return.
◦ To compare a company's profits with that of its competitors by examining
various profit margins e.g. the operating profit margin, gross profit margin and
net profit margin.
2. Statement of financial
position (SOFP)
 A statement of financial position is a statement of assets,
liabilities and capital of a business at a given moment.
i. Assets
ii. Liabilities
iii. Capital
Purpose
 The worth of the business can be ascertained.
 The lenders use statement of financial position to make a decision
regarding provision of finance.
 It helps as information to take major decisions such as expansion.
 The risk bearing capacity of the entity can be known.
 The comparison of statement of financial position helps to know
where the business was and where it is now.
 Liquidity position of the entity can be calculated by analyzing the
ratios.
 3. Statement of changes in
equity
 It summarises all the transactions the organisation has had with
its owners / shareholders. It is designed to show whether the
owners / shareholders have:
◦ maintained their original investment in the organisation and /
or
◦ if this capital has been added to or reduced over a particular
period
◦ In addition it shows the level of profit earned by the
organisation that has been:
 reinvested into the business and
 paid out to the owners / shareholders in the form of
dividends.
 4. Statement of cash flows
 The cash flow statement (CFS), is a financial statement
that summarizes the movement of cash and cash
equivalents (CCE) that come in and go out of a company.
 The CFS measures how well a company manages its cash
position, meaning how well the company generates cash
to pay its debt obligations and fund its operating
expenses.
 As one of the three main financial statements, the CFS
complements the balance sheet and the income
statement. In this article, we’ll show you how the CFS is
structured and how you can use it when analyzing a
company.
 5. Notes to financial statements
 Notes are the supplementary schedule and other information
provided along with the financial statements in order to help the users of
financial statements to understand the financial statements. Notes form
an integral part of financial statements.
 Notes to financial statements may include the following information:
◦ significant accounting policies and explanatory notes
◦ risk and uncertainties affecting the organization,
◦ resources and obligations not recognized in the financial statements (such as
mineral reserves), information about geographical and business segments,
◦ information regarding certain events which occur after the end of reporting
period,
◦ information on the key assumptions made by the management concerning
the company’s future, etc
 Other annual financial reports
I. Chairman’s message
II. Directors’ report or discussions and analysis by the
management, or management commentary
III. Auditors’ report
IV. Fund flow analysis
V. Ratio analysis
 This type of information is usually provided to help readers gain a
better understanding of the financial position and performance of
the organisation.
 However, it should be noted that there are no standardised
principles or format for presenting this non-financial
information.
 Users
1. Owners / Shareholders i.e.
the providers of capital for
running the operations of the
entity
2. Potential Investors i.e. the
potential owners of the
organisation
3. Management of the
company who are appointed
by the owners to supervise
the day-to-day activities of
the company
Use of information on the financial statements
(a) To assess whether the entity has utilised the capital efficiently.
(b) To ascertain the financial position of the entity i.e. information about
the assets and liabilities of the company.
(c) To determine whether the financial condition and performance is
improving / deteriorating over time.
(d) To determine the managements’ efficiency in running the operations
of the entity.
(e) To know the extent to which the available profits can be distributed
the shareholders.
(f) To assess the safety and growth of their investment.
(g) To assess the stewardship function of the management.
(a) To assess the organisation as a profitable investment destination.
(b) To compare the financial statements of a number of companies from
the same industry to make investment decision.
(a) Information relating to current and future financial position of the
entity.
(b) Financial statements act as a report card which reflect:
the efficiency of the management in taking timely decisions
throughout the year
whether the business is profitable
the effectiveness of managements control and planning

4. Providers of finance to the

(a) To know about the future profitability of the entity.
company, which include:
(b) To assess the entity’s ability to generate sufficient cash flows to
trade payables funding the
satisfy their debt repayments going forward.
operations of the company
(c) To determine the value of the assets that the company has pledged
bank providing overdraft
as security / collateral.
facility long term finance, etc.

(a) Suppliers want to know the financial stability of the entity, i.e. the
5. Trade relations i.e.
ability of the company to pay for the goods and services supplied.
Suppliers and Vendors
(b) Customers want to be assured about the continuity of operations an
Customers
regular supply of goods and services.
(a) Employees are interested in the company’s financial position as the
salaries are dependent on it.
6. Employees (b) Employees use the financial statements to determine their future
prospects for promotions, career development, etc.
(a) To know the allocation of resources taking different policy decisions
7. Government and their
(b) To collate the information of all entities and compile national
agencies
economic statistics. e.g. GDP
8. Financial analysts and
(a) To make predictions on the future financial conditions of the entity o
advisers i.e.
the basis of the current financial statements.
Stock Brokers
(b) To advise their clients (potential investors) on whether to invest in a
Credit Agencies
particular organisation or not.
Journalists
(a) To know the business profits.
9. Tax Authorities (b) To determine the amount of tax payable by the company, e.g.
income tax or VAT liability from revenue and purchase figures.
 Tools used to analyse financial
statements
 Financial statement analysis is as a process of understanding
the risk and profitability of a business by analysing the financial
information reported in the statement of profit or loss and the
statement of financial position
Following tools can be used for financial statement analysis:
I. Ratio Analysis
II. Study of shareholding pattern of the company
III. Understanding the company’s exposure towards
contingencies
IV. Cash flow analysis
V. Ageing analysis
VI. Analysis of Statement of profit or loss
VII. Comparative Analysis
 1. Ratio Analysis
 Ratio analysis is one of the most important tools for evaluation of financial
statements.
 It is important to note that an analyst would be interested in gauging the overall
performance and position of the company and not necessarily only the profitability
hence following categories of ratios may be considered: Liquidity Ratios,
Profitability ratios, Turnover ratios and Management ratios.
◦ Liquidity ratios include Current Ratio and Quick Ratio
◦ Turnover ratios include Inventory Turnover ratio and Accounts Receivable
Turnover Ratio
◦ Profitability Ratios include Gross profit Ratio, Net Profit Ratio, EBITDA
(Earnings before Interest, Taxation, Depreciation and Amortisation to Net Sales)
ratio
◦ Management ratios include Return of Equity, Return on Assets, Debt Equity
Ratio
a)Current ratio is calculated as Current assets/ Current Liabilities. This ratio indicates
company’s ability to pay its current liabilities without resorting to external financing.
 Cont…
(d) Inventory turnover ratio indicates how fast inventory is sold during
the year. Lesser inventory by the company indicates lesser carrying
costs. To compute inventory turnover ratio, divide cost of goods sold by
average inventory.
(e) Profit margin ratios indicate how efficiently the company is managing
costs.
(f) Return on Assets is calculated as Net Income before tax/Total assets
and indicates how well a company utilizes its assets to generate
revenue.
(g) Return on Equity reflects the profit earned by a company for every
rupee invested and is calculated as Net Income/Average Owners Equity
(h) Debt equity ratio indicates the proportion of a company’s
borrowings to owned capital. A higher than industry average ratio
indicates that the company is exposed to a higher risk than its
counterparts in the industry.
 2. Shareholding pattern of the
company
 Shareholding pattern of a company shows the composition of the
ownership of the company for e.g. number of shares held by
individual promoters, number of shares held by financial
institutions etc.
 The impact of share- holding pattern on the position of the
company can be seen from the fact that if a portion of the shares
of a company is held by financial institutions, it indicates better
possibility of inflow of further capital in the business when
required as against entire shares of the company held only by
individual promoters.
 This is because; financial institutions have better capacity of
funding projects than the promoters. Furthermore, general public
will also be more attracted to make investments in such
companies due to the financial standing of the various financial
institutions who have invested in the company.
3. Understanding the company’s
exposure towards contingencies
 Understanding the tax status of the
company and any other contingencies that
the company is exposed to gives an
analyst a fair idea of the risk that the
company is carrying. This risk could be
financial risk or legal/ compliance risk.
 4. Cash flow analysis
 Cash flow analysis indicates the manner in which funds are
sourced and utilized.
 Analysis of the cash flow statement can be divided into analysis of
operating activities, investing activities and financing activities of a
company.
 Cash flow from operating activities helps to understand the
earning capacity as well as position of working capital of the
company and the ability of the company to meet its short term
obligations.
 Cash flow from investing activities refers to investment in capital
assets which are used for the purpose of production and cash
flow from financing activities indicates the sources used by the
company to finance its operating activities.
 5. Ageing analysis
 Ageing analysis of debtors, creditors and
inventory of the company is an important tool
for understanding the position of a company.
 A company carrying large amount of old/
obsolete inventory may be an indication that the
company is not able to sell its goods and has a
low inventory turnover ratio.
 Similarly, debtors and creditors ageing analysis
helps in understanding the liquidity position of
the company.
 6. Analysis of statement of profit or loss (SOPL)
and statement of financial position (SOFP)

 SOPL determines the profitability of the company.Various

ratios like gross profit ratio, Net Profit ratio, Earnings from
operations can help understand the profitability of the
company at various levels. It also helps in determining the
income available for distribution to stakeholders.
 The SOFP includes assets and liabilities; liabilities represent
sources of funds and assets indicate application. Analysis of the
balance sheet over various periods will help an analyst to
determine the company’s ability to collect receivables, satisfy
liabilities, manage inventory and investments and provide
returns on investment by stake holders.
 7. Comparative analysis
 This indicates comparison of financial statements of a
company for the current period with the previous
periods as well as with other companies in the same
industry

Comparative analysis with previous period

Particulars Current year Previous year Increase / (Decrease)

( Tshs ’000) ( Tshs ’000) ( Tshs ’000) %

Net Sales 10,00,000 880,000 120,000 13.63

Cost of goods sold 575,000 528,000 47,000 8.90

Gross Profit 425,000 352,000 73,000 20.74

Operating Expenses 250,000 175,000 75,000 42.86

Net Profit 175,000 177,000 (2,000) (1.13)
 Key accounting Formula Interpretation Favourable
Ratios situation

High Low
A Profitability ratios

1 Gross profit Gross profit Reflects gross margin

margin Sales revenue × 100 made on sales

3 Net profit margin Net profit (PBT) Reflects net margin made
Sales revenue × 100 on sales
5 Return on assets Operating profit
Reflects relationship
x 100 between profits earned and
Total assets total assets

B Liquidity ratios

1 Current ratio Current assets Measures ability to pay

Current liabilitie s current liabilities from the
current assets
2 Quick ratio Quick assets Indicates the ability to pay
all current liabilities if they
Current liabilities
become due for payment
immediately

C Working capital efficiency ratios

1 Total asset Sales revenue (times p.a.)

Shows how much revenue
turnover Total assets generated by a Tshs1,000
worth of assets
2 Inventory turnover Cost of sales Indicates how many times
(times p.a.) the inventory is being
Inventory
turned over in a year
Continued on the next page
 3 Receivable days Recievable Reflects the number of
Credit sales × 365 days days it takes for a customer
to pay
4 Payable days Payables Reflects the number of
Credit purchases x 365 days days it takes for a company
to settle its bills

D Investor performance ratios

1 Earnings per share Profits available for distribution to
(EPS) ordinary shareholders/Weighted
average number of ordinary
shares outstanding
2 Price / Earnings Current market price per share
ratio Earnings Per Share
Amount which an entity has
earned per share for the
given period.
Helps to assess the relative
risk of an investment

3 Dividend yield Dividend per share Measures the return on

× 100 capital investment as a
Market price per share
percentage of market
prices

E Financial risk ratios

1 Capital gearing Total long - term debt × 100 It expresses the

ratio or Debt equity relationship between a
ratio Shareholders funds company’s borrowings and -
its own funds
2 Interest cover Profit before interest and tax Indicates the number of
times, the profit covers the
Interest expenses
interest charge

2.2 Computation of financial ratios

 Analyse financial statements by
using Du Pont system.
 This is the oldest ratio system and is well
known. The Du Pont system of financial analysis
sets out various basic financial ratios to study
the relationships between them and evaluate
the company’s financial strength.
 Return on assets is derived by multiplying net
profit margin with assets turnover.
 Return on assets = Net profit margin x Asset
turnover
 Cont…

Du Pont system.
 Cont,,..
 As portrayed in the above diagram, the Du Pont system is divided
into two parts
◦ Top section: summary of statement of profit or loss activities
◦ Bottom section: summary of statement of financial position
activities
 This system is commonly used as it allows the finance manager
to split the ROE into THREE separate components i.e. net profit
margin, asset turnover and financial leverage multiplier.
 It indicates that management should focus on the following three
areas to maximise ROE
◦ How much profit can be earned on sales
◦ How efficiently assets are being utilised
◦ How much financial leverage is in use
 Example
 The following information related to
Pepper Co is given for analysis
20X7 20X6 20X5 20X4
TZS TZS TZS TZS
million million million million
Net income (from SOCI) 4,854 5,556 4,126 2,853
Revenue (from SOCI) 21,018 20,056 16,678 12,962
Assets (from SOFP) 25,177 23,104 18,988 14,003
Equity (from SOFP) 18,702 15,436 13,498 9,712

 Required:
 Comment on the performance of the
company.
 Answer
 The following is the statement of ratios
for analysing Pepper Co’s performance

20X7 20X6 20X5 20X4 Evaluation

Profit margin % (W1) 23.10 27.70 24.74 22.01 Profits have fallen during 20X7

Asset turnover (W2) 0.83 0.87 0.88 0.93 Efficiency has been low since 20X4

Return on Assets % (W3) 19.28 24.05 21.73 20.37 Return on assets is lowest in 20X7

Equity multiplier (W4) 1.35 1.50 1.41 1.44 In 20X7, leverage has decreased

In 20X7, return on equity has dropped the

Return on equity % (W5) 25.96 35.99 30.57 29.37 most

 Cont… Net income 4,854
W1 = x 100 = x 100 = 23.10 %
Profit margin % Revenue 21,018

W2
Revenue 21,018
= = = 0.83 times
Asset turnover
Asset 25,177

W3 = Profit margin x Asset

Return on assets % turnover = 23.10 x 0.83 = 19.17%

W4
Asset 25,177
= = = 1.35 times
Equity multiplier Equity 18,702

W5 = Return on assets x Equity

Return on
OR equity% multiplier = 19.17 x 1.35 = 25.88%

W5 (a) Net income Revenue Assets

= x x = 25.96
Revenue Assets Equity
Cont….
 According to the Du Pont system, the
maximisation of return on equity is
equivalent to wealth maximisation.